Monthly Archives: September 2012

If you want to cause major discomfort at a meeting of European policymakers, just try mentioning “OSI”, or official sector involvement. The notion that official creditors, and by that I mean governments and regional/multilateral institutions, may need to accept a reduction in their contractual claims on Greece is anathema to many. Yet the issue will surface repeatedly, and more frequently, given the current overly-constrained approach to solving Greece’s deep problems.

Official creditors have good reasons to resist OSI. Their sizeable lending to Greece was not a commercially-based decision but rather an emergency intervention. The aim was both to stabilise Greece and to limit destabilising spillover for other European economies.

They came in at a time when private creditors were exiting Greece en masse, and in a highly disorderly fashion. Their financing was extended at concessional interest rates. Loan maturities extended well beyond what a private creditor would envisage. And, when push came to shove, the official sector provided even more funding to Greece so that the country could meet its debt-servicing obligations.

None of this would have occurred if the official sector did not think of itself as a “preferred creditor”. That is what a lender of last resort reasonably expects, especially when it is stepping in to counter a disorderly financing implosion (and thus limit the losses to be incurred by private creditors). And it is what many parliaments in creditor countries believe as they encumber domestic tax receipts with actual or contingent Greek liabilities.

Yet the story is not that simple for two distinct reasons: there are precedents; and without further debt reduction, Greece has little hope for restoring growth, jobs and, therefore, financial solvency.

It is not so long ago that western countries willingly engaged in debt and debt service reduction for developing economies under the auspices of the Paris Club. This was often combined with the type of private sector involvement that has already occurred in Greece, and that has wiped out more than half of the contractual claims of most private creditors.

Even multilateral institutions, known to fanatically guard their preferred creditor status, have found ways in the past to de facto provide concessions to over-indebted countries. Indeed, just a few weeks ago, the European Central Bank used a clever mechanism to channel money to Greece so that it could be recycled as a debt service payment from the country to the central bank.

Then, and even more importantly, there is the urgent reality of Greece’s repeatedly faltering adjustment and reform effort.

More than three years into a series of troika-supported programmes, Greece has consistently failed to generate growth, to control its explosive debt dynamics and to attract new capital. Indeed, when it comes to outcomes, virtually all of the programmed targets have been missed.

Failing to see any light at the end of a very long and painful tunnel, the result has been an unprecedented level of rejection by the population – economic, financial, political and social. And who would blame the Greek people for their disillusionment?

Most economists would agree that, given the conditions on the ground, the situation could well get even worse unless there are fundamental changes to Greece’s debt and/or competitiveness parameters. Put another way, no realistic amount of domestic austerity and structural reforms – even if socially and politically palatable, which is a big if – would work unless Greece regains greater degrees of operational flexibility. In most scenarios, another round of debt reduction constitutes a necessary, though not sufficient, requirement for a sustainable solution to a very difficult situation.

Without a substantial decline in its debt overhang, Greece will find it virtually impossible to attract new capital inflows. Why should new creditors come in when the risk of concerted principal haircuts is so high? And without fresh capital, private sector activity will continue to collapse, arrears will increase further, and growth and employment will remain elusive.

The time has come for European creditor governments to think long and hard about the cost-benefit of OSI for Greece, as well as the broader regional implications. The longer they wait and curtail sensible analyses, the greater the likelihood of an unplanned and badly managed debt reduction, and the lesser eventual benefits for Greece and Europe as a whole.

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

The Federal Reserve has now embarked on a very dangerous strategy, buying $40bn of mortgage-backed securities each month for an indefinite number of years. That could lead to high inflation, to destabilising asset bubbles and to legislative changes that limit the Fed’s future powers.

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The Federal Open Market Committee has announced that it will continue those purchases for as long as “the labour market does not improve substantially” and will maintain “a highly accommodative stance of monetary policy … for a considerable time after the economic recovery strengthens”. It specifically noted that its highly accommodative stance would continue at least until mid-2015, implying nearly $1.5tn of increased bank liquidity.

Although economic weakness now prevents inflationary price increases, these conditions will not last forever. At some point, demand will increase and companies will recover the ability to raise prices. Such price inflation has historically been associated with tight labour markets and rising wages. But this time the unprecedented high level of long-term unemployment could cause the unemployment rate to remain high even when product markets tighten.

The Fed has locked itself into a policy of monetary ease for as long as the unemployment rate remains high. Although the FOMC said that its policy would be conducted “in the context of price stability”, it is clear that its real focus will be on unemployment.


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And even when the Fed wants to start raising interest rates to reduce inflationary pressures, Congress is likely to object if the unemployment rate is still high. Although the Fed is technically independent of the White House, it is legally accountable to the Congress. The recent Dodd-Frank legislation showed how Congress can limit the Fed’s powers. Faced with the alternative of antagonising the Congress, the Fed might delay in raising interest rates to control incipient inflation. The result could be significant increases in inflation and in inflation expectations.

The FOMC justifies its unprecedented easing by pointing to the persistently high rate of unemployment. Indeed, the current rate would still be at the 9.1 per cent level of a year ago if the number of people looking for work had not declined sharply during the year. But the weakness of the labour market is not a reason for taking the risks of an excessively accommodative monetary policy if the resulting lower interest rates will not stimulate demand and employment.

Under current conditions, the Fed’s new policy is not likely to strengthen the economic recovery. Mortgage rates are at record lows and home sales are already up sharply. Other potential homebuyers are blocked by tough credit standards (that is, by the need for a high credit score) rather than the level of mortgage rates. Lower mortgage rates may spill over to reduce rates on corporate debt but large businesses with enormous cash balances are reluctant to invest and to hire because they fear future tax increases. Many small businesses, which depend on local banks, are unable to secure credit because their banks lack the capital needed to increase lending.

The clear impact of the Fed’s easing has been to raise share prices, a key part of the Fed’s quantitative easing strategy. Ben Bernanke has pointed to this as the “portfolio balance channel” by which monetary easing increases household wealth and therefore stimulates consumer spending. Although that worked in the fourth quarter of 2010 after the last round of quantitative easing, its favourable effect on gross domestic product only lasted for one quarter, followed by an annual growth rate of less than 0.5 per cent in the first quarter of 2011. The danger now is that an economic downturn or a rise in interest rates to normal levels could cause share prices to decline sharply.

European observers of the Fed’s recent decision may see similarities with the new open-ended strategy of the European Central Bank. The ECB will buy short-term Italian and Spanish bonds without any limit on the amount for as long as those countries have economic adjustment plans approved by the European Commission and the European Stability Mechanism. In doing so, the ECB can substantially reduce the interest rates on the sovereign debt of those countries, helping them to grow but removing the discipline that the bond market has had on their fiscal actions.

Once the process of buying large amounts of sovereign debt has begun, the ECB will face a difficult choice. Italy and Spain may improve their policies but they are also likely to stray, at least to an extent, from whatever plan they have agreed with the commission and the ESM. When that happens, will the ECB stop buying their bonds, allowing their interest rates to rise sharply? Or will it accept the deviations from plans and thus weaken their incentive for fiscal reform?

In short, the ECB, like the Fed, is now locked into a high-risk strategy.

The writer, a former chairman of the Council of Economic Advisers, is professor of economics at Harvard University

Poverty is on the retreat. Despite the global economic downturn, the World Bank and UN reported this year that the number of people living in extreme poverty has dropped in every region of the world for the first time since record keeping began. Though progress on the UN’s Millennium Development Goals has been uneven, we should be heartened that we have already reached, three years before the target date of 2015, the first of these eight goals – that of halving the number of people still living on less than $1 a day. However, we risk allowing these gains to come undone if we fail to strengthen the rule of law in developing countries.

Without basic legal empowerment, the poor live an uncertain existence, in fear of deprivation, displacement and dispossession. A juvenile is wrongfully detained and loses time in school; village land is damaged by a mining company without compensation; an illiterate widow is denied the inheritance she is entitled to and is forced on to the streets with her children. By what means can individuals and communities protect their rights in daily life?


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Tens of millions of people live without a legal form of identity, such as a birth certificate. This identity is the cornerstone of justice. Without it, one may be denied opportunities to overcome poverty, including access to immunisations, school, land deeds and welfare. One of the first MDG 2.0 targets, therefore, should be reducing statelessness and providing universal legal identity: the enactment and enforcement of legislation ensuring every citizen has universal access to a documented legal identity and is registered at birth.

But legislation is not enough, which is why the second and third targets should concern awareness and access. In developed countries, even those accused of heinous crimes are apprised of their legal rights, and rightfully so. Yet the vast majority of people living in poverty do not even know their rights. Governments must implement concrete measures, or enable civil society to do so, making sure the poor are fully aware of rights under the law.

The targets must include safeguards and regulations to ensure that everybody, regardless of background or circumstances, has full access to the formal justice system. Special attention should also be given to women, as well as to vulnerable groups such as the landless, slum dwellers, sex workers, pre-trial prisoners and juvenile offenders. In many places, laws exist on paper to protect the vulnerable from exploitation, yet informal norms and institutions hold sway, and all too often, these norms and institutions work against the poor and vulnerable, women especially. Where the formal legal system is itself corrupt, there should also be mechanisms such as alternative dispute resolution, which work to provide justice outside the courts.

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These need not be costly solutions. We have already seen how they might work in places such as Bangladesh, where civil society organisations like BRAC have strengthened the legal rights of the poor by training thousands of “barefoot lawyers” in poor communities.

Events in Tahrir Square and beyond have sparked optimism about a global democratic resurgence. But at the same time, there is fear of instability and lawlessness. Let us not forget that in 2015, 1bn people will still be living in extreme poverty. A hard road still lies ahead. Strengthening the rule of law is more important than ever. A legally empowered citizenry is both the guarantor and lifeblood of democracy. Poverty will only be defeated when the law works for everyone.

The writers are the founders and chairmen respectively of the Open Society Foundations and of BRAC, a civil society group

Anti-Japan protests in China over the Senkaku/Diaoyu islands have died down but with Taiwanese and Chinese ships looking for mischief and the likelihood of more provocative acts, it will not take much for emotions to flare up again.

Neither Chinese nor Japanese leaders are well positioned to handle a prolonged confrontation given pressures to revive their respective economies. And politically, both sides cannot afford to be distracted at a time when Beijing is trying to complete a complicated once-in-a-decade leadership transition and Tokyo’s political scene is in disarray as it gears up for yet another election. Nor can either side afford to be seen as caving in to nationalistic pressures.

The more level-headed realise that there is much to be gained in fostering closer economic ties and cooling tensions. Both sides could use “benign neglect” to postpone emotionally charged issues until sentiments allow for a softening in animosities. This is a path that mainland China and Taiwan have followed with some success in recent years.

Clearly both China and Japan would stand to lose if the disputes led to a breakdown in relations that interrupted production and triggered boycotts. Bilateral trade has tripled over the past decade to more than $340bn. China is now Japan’s major export market and Japanese investment in China has been running at twice that of the US and South Korea in recent years.

It would seem obvious that both sides have more to lose in disrupted economic relations than they could gain from controlling a few mostly inconsequential islands. But if combative rhetoric and political grandstanding prevail, then the economic calculus may shift from protecting mutual benefits to assessing which side will be hurt more if economic pressures are brought to bear.

Japan has a much more substantial economic presence in China’s domestic market than vice versa. Japanese chain restaurants are quite popular and their retail outlets sell everything from cars to electronics in China. But most Chinese consumers would not consider switching to European and other Asian brands much of a sacrifice and on this score Japan could be more vulnerable to a trade breakdown or boycott. However, China also stands to lose – most of these goods are produced by Chinese-owned companies with local labour and materials – and thus the second-round effects would take a toll on China’s interests.

The more important consequences in terms of the impact on growth, however, come from the complementary roles that the two countries play in the east Asian production network. China may be the face of this network, as the assembly plant for the world, but the largest share of the sophisticated components for assembly originates from Japan. China, however, has benefited greatly from the jobs generated in export-oriented industries. And both China and Japan have thrived because these arrangements make use of their relative advantages, allowing them to specialise and achieve scale economies. China’s large trade surplus with the west, which emerged partly because of this network structure, has fomented considerable tensions with the US. But often overlooked is that Japan accounts for a large share of this surplus in value-added terms.

Assessing the relative costs for the two sides if the production network became hostage to the island disputes is more complicated because other countries are also involved and roles are evolving. Increasingly, China has the potential to operate at both the low and high ends of the technology spectrum. In the past, with its abundance of surplus labour and relative technological backwardness, China had a greater advantage in labour-intensive sectors. But rapidly rising wages, appreciation of the renminbi and a shrinking labour force have pushed it into competing at the higher end of the value chain. By aggressively upgrading its technological capacity and solidifying its infrastructure, China has strengthened its position in more skill-intensive production lines.

Increasing transport costs and the complexities of a dispersed supply chain are also encouraging firms that previously outsourced components to integrate more within China. As Chinese technology-intensive companies such as Huawei expand, local linkages have deepened. Processing-related imports and exports have fallen by about 10 percentage points as a share of total trade over the past decade as production has become more integrated within China. The net effect is that forces are pushing China to become more of a competitor with Japan in the production network rather than a complementary partner.

Regional economic and trade considerations also affect the calculus. Both countries are competing for access to resources from hydrocarbons to base metals. Bilateral tensions are raised every time a deal is struck, such as determining the route for the Russian oil pipeline serving Asia or awarding extraction contracts in Myanmar. As a mature economy, Japan’s growth is less resource intensive than China’s. But its vulnerabilities may not be any less, given special factors such as China’s near-monopoly position in rare earths that are vital to Japan’s more sophisticated production lines.

How both sides handle politically tinged regional trade agreements also matters. Japan may now feel that joining the Trans-Pacific Partnership would draw Japan closer to an American-led trade bloc as a hedge against China’s growing economic clout. But along with America’s “pivot” toward Asia, this may reinforce insecurities among China’s hardliners that this is all part of a “containment” strategy and that stronger economic ties with Japan may not be worth it.

All this is a reminder that seemingly minor but emotionally charged disputes can trigger actions with far-reaching negative consequences for everyone. Both sides need to put this dispute on the back burner where it belongs.

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


Is the US experiencing a “reverse Volcker moment” in which low and stable inflation gets subordinated to other economic objectives? Markets seems to hint this and an increasing number of central banks in the rest of the world appear concerned about it.

It is now over 30 years since Paul Volcker came into the US Federal Reserve and unambiguously put crushing inflation at the top of his agenda. What followed was a period of price stability – by the middle of the last decade, many people had bought into the concept of “the great moderation” and the “Goldilocks” economy (not too hot, not too cold).

The 2008 global financial crisis did little to alter the perception that inflation had been conquered. Indeed, the price challenge at that time was not too much high inflation but rather, a real threat of a disorderly decline in the general price level.

This may now be in the process of changing. There is a growing sense among some that today’s Fed would not only tolerate higher inflation but may also be wishing it – if not already targeting it.

The immediate catalyst is, of course, the central bank’s recent actions and statements. Four merit particular mention: the extension to mid-2015 of the forward guidance language on rock-bottom interest rates; the further ballooning of the Fed’s balance sheets through the commitment to open-ended purchases of securities; clear signals that such an unprecedented expansionary monetary policy stance will continue well into the economic recovery; and, related to all this, a subtle evolution of the official inflation narrative;

There certainly are legitimate and sensible reasons for a change in the Fed’s ranking of the components of its dual mandate: by placing employment well above inflation. Joblessness is stubbornly high, and has been so for far too long. As this situation persists, and it hits more disproportionately the young and the long-term unemployed (as is the case today), the greater the risk that this horrid crisis will get deeply embedded in the structure of the economy.

It also helps that many feel it is virtually impossible for the US to experience high inflation in the context of such large spare capacity.

America’s debt is another reason. It is not easy to safely deleverage a highly-indebted economy – and I stress safely – when growth is so sluggish. Financial repression, the technical term for the manner in which the Fed suppresses interest rates so that creditors de facto subsidise debtors, can help. But it is not enough. With the political process hindering meaningful reforms and refusing to sensibly allocating principal losses, the temptation to resort to “somewhat higher” inflation is unquestionably there.

An important and consequential question is how the system would respond, nationally and globally.

Already, financial markets are starting to notice. Just witness the 25 basis point surge in break evens in the hours following the Fed’s QE3 announcement on Thursday last week, representing a “5-sigma event” for this market-measure of inflationary expectations.

Then there is the reaction of other countries. An increasing number of central banks, be it Brazil’s recent market interventions or Wednesday’s surprise announcement of additional Japanese balance sheet expansion, are being forced into a more expansionary monetary policies. Their intention is clear. They wish to counter the collateral damage emanating from the fed’s unconventional policies – from potentially destabilising surges in capital inflows to currency appreciation that erodes competitiveness.

These may be leading indicators of a global economy that is slowly starting to sense that, as my colleague Bill Gross recently put it, we may be entering an age of higher inflation. Having so decisively been eradicated from the collective psyche of Americans more generally, it will take time for society as a whole to adjust to the real possibility of both higher and less stable inflation over the medium term.

The average American does not worry much today about inflation judging from the allocation of their investment and retirement assets, price setting, and how wage settlements are negotiated. This could well be on the verge of evolving if the Fed is indeed in the midst of engineering a reverse Volcker moment.

One of the few issues on which Barack Obama and Mitt Romney agree is the need for tax reform. Since the last overhaul in 1986, loophole after loophole has been added, producing a tax system that is complex, unfair, inefficient and detrimental to growth. Today, tax reform must also address three major challenges: escalating federal debt, rising income inequality and intensifying global competition.

Addressing the long-run deficit and stabilising the debt will require more revenue. Even after the economy recovers, current tax policies will not generate enough revenue to cover future spending on social security, health, defence and debt interest, let alone basic government operations and investments. In 2012, federal tax revenues are likely to be less than 16 per cent of gross domestic product, compared with an average of more than 18 per cent in the 20 years before the crisis hit in 2008.


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When the US economy is operating near capacity, total tax revenues – federal, state and local – are much smaller as a share of GDP than in other developed countries. And there is scant evidence that taxes as a share of GDP and economic growth are negatively correlated. Indeed, there is a small positive correlation between income per capita and tax revenue as a share of GDP.

Special tax rates and allowances are a major reason why tax revenues are comparatively low in the US. So-called tax expenditures amount to about 7 per cent of GDP; more than what the federal government spends individually on defence, health and social security. Reducing the number and limiting the size of tax expenditures would simplify the tax code, remove distorting incentives and raise revenue. Mr Obama proposes to use some of the revenue from reforming tax expenditures for deficit reduction; Mr Romney would use all of it to cut tax rates, with disproportionate benefits to high-income taxpayers.

But tax reform should not come at the expense of progressivity. Income inequality is greater in the US than in the other developed countries of the OECD. The US tax system is considerably less progressive than it was a few decades ago and it does less to counteract pre-tax income inequality than other OECD systems.

Widening inequality is reflected in opportunity gaps between children born into different income groups and a decline in intergenerational mobility: an American child’s future income is more dependent on his or her parents’ income than in most other OECD nations. Mr Obama’s plan counters these trends. The Romney-Ryan plan exacerbates them.

Proponents of greater progressivity often call for an increase in corporate taxes but this would lead to slower growth and fewer jobs. The US has the highest statutory corporate tax rate in the developed world. Even after tax expenditures are included, its effective marginal corporate tax rate is one of the highest in the world. Business decisions about where to locate investments are responsive to differences in taxes and have become more sensitive over time. Of all taxes, corporate income taxes do the most harm to economic growth.

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Both Mr Obama and Mr Romney advocate corporate tax reform that lowers the rate and broadens the base. The economic benefits could be significant. The current system has large unjustifiable differences in effective tax rates that influence business choices about what to invest in, how to finance an investment, where to produce and even what form of organisation to adopt. These differences distort capital allocation, add complexity, increase compliance costs and reduce corporate tax revenues.

A lower rate would stimulate investment, narrow the tax preference for debt over equity financing and weaken the incentives for international companies to move production to lower-tax locations. But lowering the corporate tax rate is expensive – each percentage point reduction would cut revenues by about $120bn over 10 years. Scaling back the three largest corporate tax expenditures to pay for a cut could increase the cost of capital, thereby reducing investment and growth.

A more efficient and progressive way to pay for a lower corporate tax rate would be to increase taxes on dividends and capital gains. This would shift more of the burden towards capital owners and away from labour, which bears the burden in the form of fewer jobs and lower wages. Mr Obama proposes to raise rates on capital gains and dividends for the top 2 per cent of taxpayers. Most capital gains and dividends go to this group. Mr Romney would leave these rates unchanged for this group.

The US economy needs efficient and progressive tax reform and it needs more revenues for deficit reduction. Revenue increases have been a significant component of all major deficit-reduction packages enacted over the past 30 years. This must be the case now, too. Additional revenues as part of a credible long-run deficit-reduction plan and supported by progressive tax reforms will boost economic growth and job creation.

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

Eurozone leaders have decided to create a banking union to help break the vicious circle between banking fragility and state insolvency. This is a bold move and an adequate response to the growing financial fragmentation of the European currency area. Last week the European Commission tabled its proposals for a single supervisory mechanism. Discussions on concrete proposals will start soon. They are bound to be highly complex, technical and controversial, because mistrust prevails and because participant countries hold very different views. However, it is important they succeed, so here is our five-point guide for the negotiators.

1. Be comprehensive. A true banking union must involve supervision, as currently discussed, but also resolution – how to wind-down ailing institutions – and access to a common fiscal backstop. The three go together. Common supervision without any kind of fiscal backstop would ultimately mean that national taxpayers have to pay for the failures of the European Central Bank supervisor. A common fiscal backstop without common resolution would also be a recipe for conflict as national resolution authorities would have every incentive of shifting costs on to the European taxpayer instead of “bailing in” the banks’ creditors. Having one element missing or poorly designed would undermine the whole. As for the space shuttle Challenger that exploded because of a tiny O-ring seal failure in the right rocket, banking union would be as effective as its weakest component. Indeed, getting even a small part wrong may undermine the effectiveness of an entire endeavour.

2. Don’t confuse legacy issues with permanent ones. Banking ailments are daunting, but banking union is not meant to be a hospital. It should be introduced for banks healthy enough to have passed a robust screening. The costs of bad bank debt should be left to those that have been primarily responsible for them, ie creditors and national supervisors. The only exception should be for cases where government solvency is endangered. In such cases, partner countries will probably be affected one way or another and it is advisable to proceed with direct recapitalisation by a European institution. Again, this would require having at least the beginnings of the respective European supervisory and resolution tools at hand.

3. Dont get distracted. Banking systems in Europe are heterogeneous. France has basically only systemic banks whereas the German system includes Deutsche Bank, a world-class institution, and a myriad of small local saving banks. Germany has six deposit insurance schemes. An attempt to merge deposit guarantee schemes is bound to consume considerable time and political capital, for very limited benefits.

4. Plan for the worst. Good resolution policy aims at minimising costs to taxpayers while at the same time preserving economic and financial stability. Measured bail-ins of creditors and bank closures are crucial in this regard. Yet, historical evidence shows that major banking crises involve substantial fiscal costs: in one-third of all crises in advanced economies, the direct cost to the budget exceeded 10 per cent of gross domestic product. Leaving such fiscal costs exclusively to the national taxpayers would risk undermining sovereign solvency. The currently observed financial and real economic disintegration is the consequence. To complete the banking union, it is therefore indispensable to agree on fiscal burden-sharing.

5. Get the incentives right. The organisation of a common fiscal backstop raises important questions about potential distributional biases, moral hazard and contributions to the insurance pool. The design of the system should ensure that incentives are set right. This means that national taxpayers should be always involved but it also means that burden-sharing arrangements need to be made before the cost occurs. Relying on constructive ambiguity would be the wrong approach as it would not be credible in case of a crisis. The fiscal backstop thus needs to be designed with a strong institutional set-up that is robust to withstand major crises. Different options for a fiscal backstop can be envisaged. A European resolution fund financed by contributions from the financial industry would have major advantages but would unlikely have sufficient funds for the next 10 years. The European Stability Mechanism could also serve as a fiscal backstop. While insufficient in case of a dramatic banking crisis, it has the advantage of a strong governance structure. In the long-run, contingent European taxation power with appropriate democratic legitimacy should be envisaged.

Banking union is an essential piece of Europe’s plan to ward off the fragmentation of the eurozone. It can be built step-by-step but cannot be left unfinished.

This post was co-authored by Guntram B. Wolff and draws on the authors’ recent report, The Fiscal Implications of a Banking Union, Bruegel Policy Brief No 2012/02.

UK U-turn

It is the mark of science and perhaps rational thought to operate with a falsifiable understanding of how the world works. So it is fair to ask economists a fundamental question: what could happen that would cause you to revise your views of how the economy operates and acknowledge that the model you had been using was flawed? As a vigorous advocate of fiscal expansion as an appropriate response to a major economic slump in an economy with zero or near-zero interest rates, I have for the past several years suggested that if the British economy – with its major attempts at fiscal consolidation – were to enjoy a rapid recovery, it would force me to substantially revise my views about fiscal policy and the macroeconomy.

Unfortunately for the British economy, nothing in the past several years compels me revise my views. British economic growth post-crisis has lagged substantially behind the US and the gap is growing. British gross domestic product has not yet returned to its pre-crisis level and is more than 10 per cent below what would have been forecast from the pre-crisis trend. The cumulative output loss from this British downturn in its first five years exceeds even that experienced during the 1930s. Forecasts continue to be revised downwards, with a decade or more of Japan-style stagnation emerging as a real risk.


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Whenever policy is failing to achieve its objectives, as in Britain today, there is a debate as to whether the right response is doubling down – perseverance and intensification of the existing path – or recognition of error or changed circumstances and a change in course. In Britain today such a debate rages on the aggressive fiscal consolidation that the government has made its economic centrepiece. Until and unless there is a substantial reversal on near-term fiscal consolidation, Britain’s short and long-run economic performance is likely to deteriorate.

An effective policy approach to Britain’s economic problems must start with the recognition that the principal factor holding back the British economy over both the short and medium term is the lack of demand. It is true that Britain also faces important structural issues ranging from difficulties in promoting innovation to deficiencies in the system of worker training. Still, it is apparent from the relatively low level of vacancies, the reluctance of workers to leave jobs and the pervasiveness across industries of increased unemployment that it is lack of demand that is holding the economy back. Testimony from companies on their investment plans also supports this view.

During the depression, John Maynard Keynes compared Britain’s economic woes to a “magneto” problem, referring to the fact that a car might have many infirmities but if its electrical system did not work the car would not go. If that was fixed, the car would run, even with other problems. So it is today. Moreover, to a greatly under-appreciated extent in the policy debate, short-run increases in demand and output would have medium to long-term benefits as the economy reaps the rewards of what economists call hysteresis effects. A stronger economy means more capital investment and fewer cuts to corporate research and development. It means fewer people lose their connection to good jobs and become addicted to living without work. It means that more young people get first jobs and it means more businesses choose leaders oriented to expansion rather than cost-cutting. The most important structural programme for raising Britain’s potential output in the future is raising its output today.

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The objection to this view comes in many forms but it is in essence that reversing course on fiscal expansion now would undermine credibility, backfire with respect to growth by risking a spike in capital costs and risk catastrophe down the road as debts became unsustainable. This line of argument is profoundly flawed. First, the behaviour of financial markets suggests that economic weakness rather than profligacy is the main source of concern about future credit problems. Why else would the tendency be for the costs of buying credit insurance on the UK to rise when overall interest rates fall? In a similar vein, a tendency has emerged in both the UK and US for interest rates to rise and fall with stock prices, implying that it is evolving optimism and pessimism about the future, not changing views about fiscal policy driving markets. Second, the reality is that the primary determinant of fiscal health in both the US and UK over the medium term will be the rate of growth. An extra percentage point of growth maintained for five years would reduce Britain’s debt-to-GDP ratio by close to 10 percentage points whereas austerity policies that slowed growth could even backfire in the narrow sense of raising debt-to-GDP ratios and turning debt unsustainability into a self-fulfilling prophecy.

Britain must change the pace of fiscal consolidation to stand a chance of avoiding a lost decade. Rather than starving public investment, now is the time to add to confidence by making plans for structural reforms to contain the growth of public consumption spending over time. It is also time to take overdue measures to promote exports and, after years of appropriately low investment, to restart housing investment. But when demand is needed for growth and the private sector is hanging back, the first priority must be for the public sector to stop exacerbating the contraction.

The writer is Charles W. Eliot university professor at Harvard

The affair began with The Satanic Verses going up in flames in Bradford. Western Muslims lit the spark. Ayatollah Ruhollah Khomeini fanned it into a global blaze and, with American embassies under attack in the Arab world, the fatal dialectic between Islamic rage and western free speech once again leaves death in its wake.

On the day the fatwa was pronounced, February 14 1989, Salman Rushdie attended a memorial service for Bruce Chatwin in central London. When the service ended, we watched as he was pushed into the back of a car and driven off, looking bewildered and frightened.


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In his forthcoming memoir, Joseph Anton – named after the alias he chose to assume – Mr Rushdie will tell us what the next decade was like for him. I once had a glimpse inside. In the 1990s, he and his protection team drove me home after dinner. We circled the north London streets, they watched through the tinted windows and when the car came to a stop and I tried to open the door, the officer said, “Better let me, sir”, the reinforced glass and steel making it too heavy to open. Mr Rushdie was caged in glass and steel for a decade.

The affair erupted into a conflict between the European Enlightenment – reason, tolerance, dialogue, secularism – and radical Islam – theocratic, literalist and intolerant. While Mr Rushdie knew a lot about Islam, his liberal followers like me knew less. Looking back, we purchased moral clarity about our own values at the price of greater confusion about Islam.

We fell for the idea that the ayatollah was speaking for the whole faith. In reality, he was recovering from the disastrous war with Iraq, battling with the Saudis for mastery of the Muslim masses and in need of a cause célèbre to reignite an Iranian revolution becalmed. The affair was a gift from the gods and he used it to bolster a terrorist theocracy in difficulty.

The risk to Mr Rushdie was never from Islam or from its western believers, but from a terrorist state. Twenty-three years later, the fatwa, though not enforced, still hangs over Mr Rushdie, Iran lurches towards possession of a nuclear weapon, it still proclaims death to the “Zionist entity” and it is still a terrorist state. Perhaps that is what the wily ayatollah, architect of permanent revolution, wanted all along.

The imams who organised the book-burning in Bradford got what they wanted too. When I went to Bradford in the spring of 1989 to listen to Muslim leaders, their sincerity was clear enough. It was their authenticity that I questioned.

They told stories that expressed unease about what their daughters and sons were learning on the streets and unease about the compromises that western life was forcing upon them. One prosperous restaurant owner – who loudly supported death for Mr Rushdie – admitted he made his living selling alcohol to the infidel. The Rushdie affair was exactly what he needed. The angrier the reaffirmation of his faith, the more authentic he felt.

The affair gave liberals and the worldwide ummah of Muslim believers a chance to define what was sacred for each. It allowed both to express strong emotions, but neither side closed the gap between the sincerity of their emotions and the authenticity of their faith.

An authentic faith might have made us both more humble about our beliefs and more curious about the convictions of others. We might have learnt something from each other. Instead we had a painful awakening to our differences.

The affair was the moment that westernised Muslims encountered the hidden demand of life in a secular democracy. They discovered that their faith could be mocked and they demanded that freedom of expression be circumscribed by respect. Their demand was backed, at least among a marginalised and angry minority in Europe, with a threat to burn the multicultural house down.

The threat was as unacceptable as the fatwa. No one should be required to rethink the terms of free speech with a gun to his head. If it is true that no western author now will dare to insult Islam after the Rushdie affair, the death of his translators, the attack on the Danish cartoonists, then all of us will lose.

So if resentful self-censorship on the liberal side and violent explosions in European banlieues would be the worst possible consequence of the affair, what might be a positive outcome?

We need to rethink what it means to live together. Everyone in a free society shares the deepest possible interest in protecting Muslim minorities, indeed all faith communities, from discrimination, defamation, violence or incitement to acts of hate. But no free society has an interest in protecting their doctrines, beliefs and practices from criticism, scorn, ridicule or belittlement.

This is a hard bargain for faith communities. It is not pleasant to live in societies that appear to hold nothing sacred except the liberty to get rich and the freedom to be sarcastic and sacrilegious. But tolerance is a hard bargain for secular liberals too, requiring them to live with those who believe in the subjection of women, the subordination of reason to faith and the division of humankind into the faithful and the infidel.

So we come out of the Rushdie affair with one thing in common: democratic life together is a hard bargain. Each of us, Muslim believer and secular liberal, wishes the other were different. But we are not, and living together requires us to accept what we cannot change.

Living together should not be in resentful silence, each in our own ghettos. It means shouldering a burden of mutual justification without privilege. Faith has no privilege, no exclusive rights, and secular reason has none either. We are stuck with each other, with the burden of justifying ourselves, living with each other in freedom and trying to persuade the other to be different, free from menace or violence. That is what democratic life demands.

The writer teaches human rights at Harvard and the University of Toronto

On Thursday, CNN released a revealing poll. It asked people this question: “Do you think the policies of Barack Obama and the Democrats or George W. Bush and the Republicans are more responsible for the country’s current economic problems?”

Remarkably, 54 per cent of “likely voters” put primary blame on Mr Bush and the Republicans versus only 38 per cent who blame Mr Obama and the Democrats. Among registered voters, the disparity is even larger, with 57 per cent blaming Mr Bush and only 35 per cent Mr Obama.

Among subgroups, those under age 50 are much more likely to blame Mr Bush than Mr Obama; those over 50 are more inclined to blame Mr Obama, although a majority still blames Mr Bush. Those with low incomes are more inclined to blame Mr Bush than those with high incomes; those in the Northeast or in cities are more inclined to blame Mr Bush than those in the Midwest or in the suburbs. But again, majorities blame Mr Bush.

Indeed, every subgroup blames Mr Bush more than Mr Obama with the obvious exceptions of Republicans and conservatives. However, even among these groups, a significant percentage blame Mr Bush—15 per cent of Republicans and 36 per cent of conservatives. Perhaps most importantly, from an electoral point of view, 53 per cent of independents blame Mr Bush while only 37 per cent blame Mr Obama.

The CNN poll results are not unique. An August ABC News/Washington Post poll asked people, “Who do you think is more responsible for the country’s current economic problems – Barack Obama or George W. Bush?” Mr Bush was held responsible by 54 percent of respondents, with 32 percent blaming Mr Obama.

An August impreMedia/Latino Decisions poll that tracks only Latinos, a critical voting group for both parties, found 68 per cent of them primarily blame Mr Bush for the economic downturn of the last few years, with only 14 per cent blaming Mr Obama.

In July, a CBS News/New York Times poll found 48 per cent of voters blame Bush “a lot” for the economic downturn, a third blame him “some” and only 18 per cent don’t blame him at all. Regarding Obama, 34 per cent blame him a lot, 30 per cent some, and 35 per cent don’t blame him at all.

I don’t know if these results are unprecedented, but they are certainly remarkable given that Mr Obama has now been president for almost four years. One would think that as the years have gone by memories of Mr Bush would have faded, and as Mr Obama’s policies were implemented that he would in essence “own” the economy.

At least in my lifetime, new presidents have tended to get blamed for economic conditions unreasonably quickly, well before their policies really had a chance to take effect. That was certainly true for Ronald Reagan in the early 1980s.

Why so many people continue to blame Mr Bush long after he left office is intriguing. It suggests that they are far more sophisticated about the impact of presidents on the economy than is generally believed. It may also be the price Republicans are now paying for obstructing Mr Obama’s agenda in Congress.

Voters, more so than pundits, seem to know that our current economic difficulties began during the Bush administration. According to the National Bureau of Economic Research, the recession began in December 2007, while Bush was president, and ended in June 2009. However, polls show that the vast majority of people think the recession never ended. A Fox News poll released on Wednesday found that 80 per cent of voters believe the economy is still in recession, with another 10 per cent believing that while the recession is over another is on the way.

During the Democratic convention, former president Bill Clinton argued strenuously that the economic mess Mr Obama inherited was so severe that no president could fix it in just four years. Apparently, this is a message that resonates with many voters—and also reminds them that the seeds of our economic problems were sown during the previous administration.

Republicans clearly know that Mr Bush is an albatross around their necks, which is why he is almost never mentioned and wasn’t even invited to appear at the Republican convention last month. Mr Bush himself seems to keep out of sight as much as possible. On the other hand, Democrats haven’t done much to exploit peoples’ aversion to their last president. Perhaps they feel it is unnecessary and might engender sympathy for him.

In any event, the Bush presidency is important subtext for this year’s presidential election. Given Mr Obama’s now-solid lead in the polls, it appears that voters are more willing to give him another four years, despite a generally poor economy, than take the risk of turning the White House over again to the party of Bush.

Through both its actions and what it refrained from doing, the Federal Reserve confirmed on Thursday that it is operating in policy purgatory: incapable of delivering the good economic outcomes it desires, yet unable to exit from an experimental policy stance that risks a widening array of collateral damage and unintended consequences.

To grasp the Fed’s policy dilemma, we must first discuss the why and what of additional unconventional Fed measures.

Three realities anchor the case for additional measures, notwithstanding the fact that the results of prior policy interventions actions have consistently fallen short of policymakers’ own expectations.

First, the FOMC reiterated concerns about the country’s economic prospects, and rightly so. It echoed Chairman Ben Bernanke’s speech at Jackson Hole on August 31. There he cited America’s “daunting economic challenges,” including the “grave concern” of a stagnant labour market where high unemployment – even if predominantly cyclical in nature as Mr Bernanke believes – would get embedded in the structure of the economy were it to persist for long.

Such worries were accentuated in the last week by the disappointing August employment report, as well as the more recent high frequency jobless claim data released earlier on Thursday. Both confirm weak job dynamics. They come at a time when long-term and youth unemployment is way too high, Americans are dropping out of the labour force, poverty is on the rise, and income inequality is widening.

Second, the Fed is not helped by the fact that it is the only entity properly engaged in addressing America’s challenges. Others, including those paralysed by deep congressional splits, are standing on the sidelines even though they have better suited policy instruments.

Then there are the unusual “tail risks” facing the economy and additional policy insurance they appear to warrant – from the threat of the European debt crisis to the self-inflicted fiscal cliff in the US and mounting political risks in the Middle East. If even one were to materialise, America would soon find itself again in a recession which would accentuate economic, financial, political and social fragilities.

With this in mind, Fed officials decided to experiment even more. They extended forward guidance, stating that policy rates are expected to stay exceptionally low “at least through mid-2015”. Importantly, they also committed to additional, open-ended purchases of mortgage-backed securities (what will likely be labeled “QE3”).

History and detailed analyses of the problems underpinning America’s prolonged economic malaise suggest that these well-intentioned measures will again fail to secure a much better economic situation. This is also behind the widening gap between economists urging the Fed to do even more and those favouring less.

In refraining from going beyond forward guidance and QE3, the Fed is seeking to balance these two competing views. It thus refused to cut the interest it pays on excess reserves (IOER) despite some arguing that this would induce banks to lend more to the real economy and thus encourage greater economic activity. It also declined to move from an intermediate policy target (boosting asset prices) and time commitment (mid 2015) to specific economic targets (including nominal GDP).

With both options having been discussed by Fed officials, their revealed preference speaks to important considerations that will grow in the months ahead.

They signaled growing recognition of the “costs and risks” of unconventional policies – from undermining the functioning of certain market mechanisms to hampering entire segments that provide financial services to citizens (such as money market accounts, life insurance products and pension coverage). For example, a cut in the IOER would have dealt an even bigger blow to the money market industry. They also reinforced Mr. Bernanke’s earlier view that “monetary policy cannot by itself [deliver] what a broader and more balanced set of economic policies might achieve.”

Like the ECB, its Frankfurt-based European counterpart, the Fed cannot by itself secure the results that so many desire – high growth, robust job creation and financial stability. At best, it can keep buying time in the hope that other government entities will get their act together. Until this happens, the Fed will remain in policy purgatory.

Mario Draghi’s bond buying plan has restored some control over interest rates in those parts of the eurozone which, it seemed, were in danger of becoming detached from the European Central Bank mothership. While many in the private sector harbour doubts, the ECB president has to be fully signed up to the euro’s survival. It can therefore justify purchasing assets that others might regard as untouchable. And with yesterday’s qualified ratification of the EU bailout programmes by the German constitutional court, the ECB can look back on an effective week.

Yet problems remain. To get their hands on the ECB’s largesse, countries have to sign up to austerity and structural reform programmes. That’s entirely understandable. No one – least of all, the Bundesbank – wants to see the ECB writing unconditional cheques to renegade governments with dubious fiscal ambitions. However, no government will want to sign up for blank cheques if the cost ends up being excessive austerity and political downfall – one reason why Mariano Rajoy, Spanish prime minister, nervously looking at Catalonian protests, has yet to buy into the ECB’s plan.

Imagine that a country volunteers for the ECB’s deal. Once the European Financial Stability Facility or the European Stability Mechanism buys in the primary market, the ECB buys bonds in the secondary market at the short-end of the yield curve, ensuring relatively low interest rates.

There are then two risks. The first is the danger of fiscal backsliding. If the country fails to deliver – perhaps because the regions are recalcitrant or because the electorate is uneasy – does the ECB, doubtless prompted by the EFSF/ESM, withdraw support? The answer surely should be “yes”. In the eurozone, however, failure in one country has a nasty habit of infecting others.

The second, more worrisome challenge, is the possibility that even with low interest rates, economies may still end up slipping into recession, thanks to a combination of fiscal austerity and losses of competitiveness. We surely know by now that monetary policy has its limitations. The Bank of England, for example, has been able to deliver remarkably low interest rates, quantitative easing and a much weaker currency, yet the benefits of these policies have not been good enough to prevent a return to – admittedly shallow – recession.

Let’s say that Spain or Italy stays in recession – or, worse, that their current recessions deepen – despite the help provided by the ECB. Budget deficits might then end up spiralling out of control even if governments were sticking to austerity measures pre-agreed with the higher powers. The European Commission rightly focuses only on “structural”, not “cyclical”, deficits but disentangling one from the other in the midst of ongoing stagnation has become nearly impossible. A cyclical deficit is only cyclical if there is eventually recovery.

The Stability and Growth Pact, the EU’s fiscal rulebook, allows for delays in fiscal consolidation if the excess deficit “results from a negative annual GDP volume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth relative to potential”. Importantly, however, “the excess … shall be considered as temporary if the forecasts provided by the Commission indicate that the deficit will fall below the reference value (3 per cent of GDP) following the end of the … severe economic downturn.” This is a another way of saying that there is a risk of fiscal tightening at the wrong time, locking in recession and stagnation for the long term.

The “circuit breakers” – allowing countries to postpone the day of fiscal reckoning – do not seem to be flexible enough. In contrast, for example, under the Gramm-Rudman-Hollings law, US deficit reduction was to take place each and every year in the late-1980s and early-1990s but the process would be automatically suspended in the event of a recession or weak growth: there was a bias against pro-cyclical fiscal tightening. But in the eurozone, this type of bias is hard to find.

What if such a bias was introduced in the eurozone? It might be a good thing for growth but, to the extent that fiscally-weak countries would then become even more dependent on handouts. it would only serve to emphasise the limits beyond which monetary policy cannot go. Ultimately, successful monetary unions are invariably successful fiscal unions too. Mr Draghi’s actions, the German Constitutional Court ruling, or the Dutch election do little to change that conclusion.

With its decision of September 6 the European Central Bank has taken a large part of the “convertibility risk”, i.e. the risk of a break-up of the eurozone, off the table. Spreads have come down substantially in the following days, especially in Spain and Italy. Today’s decision by the German constitutional court to allow ratification of the bailout programmes should see those spreads come down further still.

The question now is whether countries will decide to activate the ECB’s intervention.

Requesting such programs entails costs and benefits.

The cost is mainly political, due to the stigma attached to any type of IMF or EU support. By asking for support, a government implicitly admits that its previous policies have not succeeded in convincing the markets. The negotiation of an adjustment program and the regular monitoring by the so-called troika (IMF-EU-ECB) is considered to entail a loss of sovereignty. Any government accepting intervention also fears losing political support. And the tougher the conditions attached to a programme, the higher the political cost associated with it.

The benefit consists mainly in the reduction of interest rates, especially at the low end of the yield curve, obtained by the ECB’s intervention, which reduces the cost of adjustment and alleviates tensions in financial markets. The lower the yield targeted by the ECB, the larger the benefit for the country to enter into a programme.

The reduction in interest rates that followed the ECB’s announcement may have temporarily reduced the incentives to request financial support. Furthermore, the assessment of the respective costs and benefits is still unclear. On the one hand, there are uncertainties about what the IMF or EU programmes will imply for the various countries, especially in terms of additional policy measures, although this will probably be clarified bilaterally over the coming days. On the other hand, the ECB has not – and will probably not – indicate any target for the level of Government bond yield it intends to achieve, making the benefit for governments uncertain.

Two scenarios may thus develop over the coming weeks and months.

A positive scenario would see financial markets continuing to react positively to the ECB’s announcement, achieving a permanently lower level of interest rates throughout the maturity curve. Under these conditions countries might not even need to apply to any program and the ECB’s threat for action would not have to be implemented.

However, in a negative scenario, the ECB’s announcement would have short lived effects as financial markets would not be convinced that countries can manage on their own. Rates would soon start rising again, amid renewed financial turbulence, forcing countries to apply to an IMF/EU program. The political costs of such a move would then be even higher, as countries would be perceived as being forced into a programme, rather than autonomously choosing to request one. The ECB would have to intervene, as indicated, starting however from a much higher level of interest rates and thus with much larger amounts.

The likelihood of the two scenarios depends on a series of factors.

The first is the reaction of governments and parliaments to the improved market conditions that have resulted from the ECB’s announcement. If national authorities take the opportunity of the renewed calm in financial markets for strengthening their reform programs aimed at increasing growth prospects, and adopt further measures, in particular privatisation, to accelerate the reduction of the debt, the likelihood of a positive scenario might increase .If instead the euphoria that followed the ECB’s announcement leads to a relaxation of the reform effort, or even to question some of the measures, the negative scenario would become more likely.

The second factor is the prospects for economic recovery in the various countries. Any unexpected cyclical improvement, which would contribute to ease the adjustment of the budget deficits and debts, could consolidate market confidence and make the virtuous scenario more likely. If, on the contrary, the general deterioration of economic conditions continues, with further downward revisions of growth prospects and upward revision of unemployment prospects, the risks of a negative outcome increase.

A related factor concerns the correlation between sovereign and banking risk. The improvement in government bond markets observed after the ECB’s announcement has been accompanied by a spectacular recovery in bank stocks. This suggests that the correlation is still strong. It may even increase if the process for bank restructuring and recapitalisation is delayed and if non-performing loans continue to rise as a result of a further slowdown of economic activity and weakness of the housing market. This could contribute to a worsening of the scenario.

The third factor is the development of monetary conditions in the eurozone, compared in particular to those in other major currency areas, which determine the external competitiveness of the euro. An improved competitiveness of the whole eurozone would contribute to support economic growth and tilt the balance towards the virtuous scenario.

A fourth factor is the management of pending critical eurozone issues, from the Greek adjustment program to the design of the longer term integration process, starting with the forthcoming discussion on the banking union. Negative developments in any of these areas could produce contagion effects that would push towards the negative scenario.

The balance between the two scenarios is not entirely in the hands of policy makers. But their actions can make a difference. We have already experienced in the past situation in which the improvements in market conditions, resulting for instance from the measures implemented by the ECB (for instance, last year’s 3-year LTRO), led to a relaxation of the adjustment process and a slowdown in the joint effort for improving the institutional framework supporting the euro. Restarting the effort again, once markets have deteriorated, proved each time to be much more difficult.

Regaining the confidence of the markets, once it has been lost, is extremely demanding. Regaining the confidence of the people is nearly impossible.

The question at the core of America’s upcoming election isn’t merely whose story most voting Americans believe to be true – Mitt Romney’s claim he can pull it out of its stall because he’s a businessman who has turned around failing companies, or Barack Obama’s claim the economy is slowly mending from the worst downturn since the Great Depression because his approach is working.

If that were all there was to it, Friday’s report from the Bureau of LaborStatistics showing that the economy added only 96,000 jobs in August,would appear to bolster Romney’s assertion that the economy is in a stall. Since January, the United States has added an average of only 139,000 jobs a month, compared to last year’s average of 153,000 a month. Second quarter growth was a weak 2.2 percent, down from 4 percent last year. In other words, the economy isn’t improving.

The deeper question is what should be done starting in January to boost a recovery that by anyone’s measure is still anaemic — and on this neither candidate has offered specifics.

At last week’s Republican convention in Tampa, Florida, Romney produced nothing more than a vague and predictable set of Republican bromides: cut taxes, reduce the budget deficit, and get government out of the way. On Thursday night at the Democratic convention in Charlotte, North Carolina, President Obama provided little more, but from an opposing perspective: reduce the deficit by increasing taxes on the wealthy rather than cutting programs the middle class and poor depend on (such as Medicaid), give tax incentives to companies that create jobs in the United States, and invest in education.

The lack of detail about how to reignite the economy is understandable. Political reality militates against specificity. Winning depends more on firing up likely supporters with rhetoric they want to hear than convincing the very few who haven’t made up their minds that you’ve got the better detailed plan. Besides, bold new ideas at this stage are only likely to provide fodder for opponents eager to show why they won’t or can’t work, or are downright dangerous.

But another explanation for why neither candidate has come up with a concrete plan is profound disagreement even among experts about what’s gone wrong, and a paucity of credible ideas for righting it. Keynesians want more government spending but can’t come up with a convincing scenario for what happens after the pump is primed. The big stimulus in 2009 and 2010 had a positive impact but hardly enough to rescue the economy. Some Keynesians call for more spending, but how much more before credit markets begin to scream? Some want the Fed to keep interest rates near zero, but it’s kept them near zero for almost three years – along with two rounds of “quantitative easing” – with little to show for it.

So-called supply-siders want lower taxes and fewer regulations but can’t come up with a convincing argument for why American businesses would hire more workers under those circumstances. After all, much of their current profitability has come from cutting payrolls — either by substituting computers and software or outsourcing the jobs abroad. Why would they hire additional workers, especially when American consumers – whose spending is 70 per cent of the nation’s economic activity – are holding back? Deficit hawks, meanwhile, want to raise taxes and reduce public spending but have no idea how to do this without bringing on another recession as long as private spending remains in the doldrums. And if the economy contracts, the government debt only worsens in proportion. Markets are already spooked by next January’s “fiscal cliff”.

Noticeably absent from this interminable debate is the damage to the economy from America’s increasingly concentrated income and wealth at the very top. Mr Obama alluded to this Thursday night when he said the “basic bargain” that once rewarded hard work and gave everyone a fair shot had come undone. But, notably, he did not say, as he did last December 6, in Osawatomie, Kansas, that that basic bargain had eroded because “fewer and fewer of the folks who contributed to the success of our economy actually benefited from that success” while “those at the top grew wealthier from their incomes and investments than ever before.”

Neither Keynesian pump-priming nor any other remedy is likely to work if the vast middle class doesn’t have enough income to keep the economy going. As Mr Obama said last December, “this kind of inequality – a level we haven’t seen since the Great Depression – hurts us all” because “middle class families can no longer afford to buy the goods and services that businesses are selling.” He noted then that “countries with less inequality tend to have stronger and steadier economic growth over the long run”.

But Thursday night in Charlotte, the President made no mention of inequality. Perhaps he and his advisors thought the topic too provocative to raise nine weeks before Election Day. That may be the case. But if he’s reelected, Mr Obama will have to tackle the problem head on if the United States is to return to the robust growth it once enjoyed — when the “basic bargain” linking wages and productivity was still at the core of the American economy.

This year, the critical question in Europe has changed from whether policymakers could find the required policy instincts – they have – to whether they are moving fast enough to get ahead of the deleveraging by the private sector.

By announcing a new conditional bond purchase program on Thursday, the European Central Bank took a major step to close what, at one time, seemed a near-insurmountable deficit in this race. It now needs the support of other policymaking bodies to fully eliminate the gap.

European policymakers and politicians were very slow in 2009-10. Insufficient understanding of regional debt dynamics, together with widespread denial that Europe could be on the receiving end of a typical “emerging market crisis,” made it even harder to coordinate policy in a monetary union with very different initial conditions among its 17 member countries. The longer this persisted, the more policies fell behind the exiting of private capital.

As the regional crisis deepened in 2011,  governments and the ECB adopted a policy approach more commensurate with the complexity of the crisis. Namely, seeking to break the link between sovereign credit deterioration and banking sector weakness, trying to change the policy mix for struggling countries and, at the regional level, addressing design flaws in the original monetary union through banking and fiscal unions and closer political integration.

But words came easier than actions. As implementation lagged, private capital outflows broadened and accelerated. Outflows took two distinct forms. Firstly, out of an expanding universe of peripheral eurozone countries and to a very small inner eurozone core. Secondly, out of the eurozone as a whole to the rest of the world, in particular Switzerland and the US.

These outflows did more than increase market volatility, raise financing costs for struggling economies and ration funds to their governments and (especially) companies. They also put in place the seeds for a fragmentation of the single financial market, threatening  structural damage to the very idea of investment in Europe.

The danger to the single financial market and the related increase in “convertibility risk” were cited in the historic remarks made by Mario Draghi, in London on July 28th. They set the stage for a much bolder policy response that, after a summer of intense work and  consultation aimed at reconciling debtors’ demand for financing and creditors’ emphasis on policy conditionality, culminated in what the ECB announced on Thursday.

According to MrDraghi, the ECB will start buying short-dated (up to three-year maturity) bonds issued by government subjecting themselves to appropriate policy conditionality. It will do so with no pre-specified limit, thereby seeking to sustainably lower borrowing costs while removing concerns about these countries’ refunding prospects. According to preliminary information, the policy component of this more transparent new programme will strike a better balance between conditionality and financing – one that, critically, may be more agreeable to both creditor and debtor countries.

Returning to the race analogy, Thursday’s ECB actions can significantly close the gap between private capital outflows and what, until now, have been lagging official policy reactions. They would reduce the tail risk of immediate fragmentation. But it remains to be seen whether this latest policy sprint can totally eliminated the gap, thus putting in place conditions for a reversal in capital outflows.

Our analysis of the underlying drives of financial flows suggests that policy still needs a further nudge to get ahead of the de-leveraging. Specifically, exploiting the window offered to them by bold ECB actions, national and regional policy entities need to implement – rapidly, comprehensively and simultaneously – the list of corrective measures that have been widely discussed in official circles but languish on the drawing board.

If they fail to do so, the ECB will find that it has mis-timed its impressive sprint. Within a few months, policies will again fall further behind the de-leveraging process, and the credibility of Europe’s policymaking process will be dented further. This is a possibility that should be avoided – not just for Europe’s sake but also for that of the global economy.

Having recently declared that I am not likely to vote this year here in the Financial Times, I should have added that that is just how I feel now. I am certainly open to persuasion and my feet are not set in concrete.

Last week’s Republican convention did nothing to encourage me to vote for Mitt Romney. All of the speakers simply recited well-worn conservative talking points that won cheers from true believers in the convention audience, but did nothing to win over the undecided.

Polls universally show that Romney got no “bounce” from the convention and did much worse than John McCain four years ago. Moreover, television ratings for the 2012 Republican convention were well down from those in 2008, suggesting that only party loyalists watched the proceedings.

Thus far, the Democratic convention, which has been meeting in Charlotte, North Carolina since Tuesday, has bested both the Republican convention and Democrats’ expectations. The only Republican speech that was memorable was a rambling, incoherent monologue by the actor Clint Eastwood.

By contrast, Democrats are raving about the speeches by Michele Obama, former president Bill Clinton and other party luminaries. When Barack Obama speaks tonight, I as an undecided voter am primarily looking for one thing: Will the next four years be different than the last four? If so, how? And what reasons do I have for thinking that they will be better?

Obviously, Obama has to walk a fine line between admitting failure in certain respects and talking about the need for change. After all, it is his administration’s own policies are the ones that need changing. At the same time, he must avoid sounding like he is whining about bad luck—of which he has certainly had more than his share in terms of the economy—and all the nasty things Republicans have done to frustrate his policies and ensure their failure.

It is not necessary to remind Democrats that the Republican leader in the Senate, Mitch McConnell of Kentucky, said publicly back in 2010, “The single most important thing we want to achieve is for President Obama to be a one-term president.” Ironically, this may give him an opening for Republicans to work with him in a second term— something independents want to hear. The Constitution limits presidents to two terms, so Obama will be not be able to run again. Therefore, Republicans have no reason to go out of their way to make him into a failure.

Indeed, it may be in their interest to get some of the messy work of fixing the budget accomplished while there is a Democratic president to share the blame for any political pain that will be required. Mr Obama should talk about bringing new leadership into the government. His Treasury secretary, Tim Geithner, has already announced plans to leave after the election. And in any case, a second term is an appropriate opportunity to clean house and bring in fresh blood.

Mr Obama might also talk about opportunities presented by the so-called “fiscal cliff” that will result from automatic tax increases and spending cuts already programmed into law to take effect on Jan. 1. And the expected pullout of all American troops from Afghanistan by 2014 will create new opportunities and challenges for American foreign policy that deserve discussion and will contrast Obama from the unpopular sabre-rattling of the Republicans. In short, there are plenty of ways Obama can promise something different and something better in another term. I, for one, will be listening for them.

The release last month of the Congressional Budget Office’s update to the budget and economic outlook for the next decade rightly draws attention to the “fiscal cliff” – the large tax increases and spending cuts that are currently scheduled for January 1. But there’s more to the CBO report than its analysis of what may happen in the next few months.

The CBO analysed the consequences for deficits and debt over the next decade of keeping tax and spending policy on autopilot. Relative to the agency’s baseline, deficits would increase by almost $8tn over the next decade. And debt held by the public would reach about 90 percent of gross domestic product; its highest level since the second world war.

Elevated federal spending is the source of the widening deficits over the next decade. The CBO estimates that revenues as a share of GDP would average about 18 per cent, roughly their 40-year average. Federal spending at 23 per cent of GDP would at stand about 10 per cent higher than its 40-year average, 21 per cent.

Higher debt levels crowd out private investment. And they reduce household and business spending on account of higher expected future taxes to close the budget gap. The debt problem that the CBO identifies will get worse after the next decade with large and growing shortfalls in Social Security and Medicare. It is not an understatement to observe that the challenge of avoiding a high-debt, low-growth economy is the key domestic policy issue.

So what are the approaches of Governor Mitt Romney (who I advise) and President Barack Obama (who speaks tonight at the Democratic convention) to this central challenge?

Mr Romney’s budget (for which I wrote the foreword) focuses on reducing debt burdens and enhancing economic growth through spending restraint and tax reform. Mr Romney proposes to reduce federal spending as a share of GDP to 20 percent by 2016 and gradually reduce the growth in Social Security and Medicare spending, particularly for more affluent households. The GOP candidate would reform the corporate and individual income taxes, reducing marginal tax rates by just under one-third for the corporate tax and by 20 per cent for the individual income tax, while broadening the tax base to make up lost revenue. The Romney plan addresses the deficit and debt challenge comprehensively, though both spending restraint and tax reform pose political challenges.

Mr Obama has proposed to continue current elevated levels of federal spending, while raising taxes on higher-income households and businesses to reduce the deficit and debt consequences of higher spending.

Indeed, Larry Summers, the president’s former chief economic adviser,  recently argued in the Financial Times that reducing federal spending as a share of GDP is not achievable. Mr Summers pointed to demographic change (population aging), higher interest payments on the large public debt (which has increased substantially in the past few years) and increases in the relative price of health (a significant component of government spending). This view is consistent with Mr Obama’s budget, which assumes elevated levels of spending over his presidency and thereafter.

In contrast with Mr Romney’s plan, the president’s plan does not address medium-term and long-term deficit and debt problems. Taken at face value, the Obama plan will require acceptance of the costs of much higher levels of deficits and debt or substantial tax increases on all Americans. The CBO’s report shows the consequences for deficits and debt over the next decade of such continued budget inaction.

But the president is proposing higher tax burdens on certain households and businesses. Will those tax changes close the budget gap? No.

The president says he will raise marginal tax rates on upper-income workers and business owners (against the grain of tax reform efforts over decades, including his own Fiscal Commission, which argued for lower marginal tax rates financed by broadening the tax base). His proposed revenue increases include the “Buffett rule” (effectively a new alternative minimum tax on high-income taxpayers), tax increases on dividends and capital gains, plus raising the top income tax rate to its pre-2001 level.

What are those tax increases? The Buffett rule imposes a minimum effective tax rate on taxpayers with annual incomes over $1m (most of whom already face a higher tax rate). For higher taxes on saving and investment, the president would raise taxes on capital gains to 20 per cent from 15 per cent and on dividends to 39.6 per cent from 15 per cent. Next, the president calls for restoring the pre-2001 tax rates for high-income individuals, including increasing the top marginal income tax rate to 39.6 per cent from 35 per cent. In addition, the president’s budget also calls for phasing out exemptions and lower-bracket tax rates for higher-income taxpayers, raising marginal tax rates further. And the president would limit certain tax deductions for individuals with incomes over $200,000.

Adding up the proposed tax increases on upper-income taxpayers should raise $148bn per year in additional revenue, according to US Treasury department estimates. Viewed next to proposed additional spending by the president of roughly $500bn per year, Mr Summers’s claim that federal spending will remain high, or this year’s federal budget of $1.1tn, the president faces an arithmetic challenge.

Assuming the Obama administration wanted to close the budget gap – to be comparable with the lower deficits in the Romney plan – what additional tax increases would be required? To begin, let’s call the maximum additional revenue from upper-income taxpayers $148bn per year, as the administration has not identified more tax increases on those taxpayers.

To close the budget gap, one could raise additional revenue by broadening the tax base. But the president’s proposals already accomplish much of that for upper-income taxpayers. Additional tax base broadening would be required for middle-income taxpayers. Of course, the administration could propose an increase in marginal tax rates. Unless, though, the administration wants to raise marginal tax rates further on high-income individuals, marginal tax rates would have to be raised – and substantially – on middle-income taxpayers. Of course, the deficit and debt could simply be allowed to rise, not a sustainable long-term solution for the country.

The choices of the size of government and how we pay for it are fundamental ones. They are also the ones we should be analysing and debating. Mr Romney has proposed a plan of fiscal consolidation and tax reform. Accomplishing it will require reducing the growth of federal spending and broadening the tax base. These changes will not be easy. Mr Obama proposes a larger government with explicitly higher taxes on high-income taxpayers but, by the arithmetic of higher spending levels, eventually higher taxes on all Americans.

The increasing role that monetary policy has acquired in addressing the current financial crisis is raising concerns for the independence of central banks. Such independence is protected by the statutes of central banks, which specify, among other things, the mandate, the way in which the members of the decision-making bodies are nominated or can be dismissed, the length of the term of office, the kind of operations which can be conducted. Central banks must also be accountable.

The way in which central banks account for their policies varies across countries. In the US and the UK, for instance, the minutes of central bank meetings are made public – albeit with some delay – and individual members of the decision-making bodies are required to disclose their votes and explain their views. In the eurozone there are no detailed minutes of the meetings and only the view of the whole European Central Bank Governing Council is disclosed. In the US and UK, central bank accountability is individual; in the eurozone, accountability is collegiate.

The difference depends on the underlying political structure. In fully integrated political systems, like the US or the UK, accountability is exercised and monitored by the entirety of the country’s public opinion, media and political system. A central banker suspected to act under the pressure of a political party or interest group would be publicly criticised throughout the country. The reputation of the political body which nominated him would be seriously undermined. This represents a strong incentive for nominating independent personalities and for the latter to act independently in an open way.

The eurozone is based on a yet imperfect political integration. The governors of the 17 National Central Banks, out of the 23 members of the ECB Governing Council, are nominated by their respective national authorities (while the six members of the Executive Board are nominated by the European Council) but are expected not to be influenced by their nationality when they express their views. They cannot be called by their national parliaments to give account of their votes, given that they are supposed to take decisions for the interest of the whole eurozone.

National politicians, media and the wider public have not yet fully understood that the ECB Council members do not represent the interests of their respective countries. They often associate the names of the members with their nationality, forgetting that each member participates in the ECB Council on a personal basis. The exercise of accountability in a collegiate way aims to protect the ECB Council members from the possible pressure coming from their own countries. As a result, the discussions – sometimes quite animated – take place within the ECB Council, but only the decision is made public. The members of the ECB Council are expected to loyally support and defend in public whatever decision is taken.

This system has served the ECB well for many years. Even when decisions were not unanimous, there was little public interest in understanding the nationality of the dissenting voices.

Things changed in Spring 2010, when dissenting views were publicly expressed on specific policy measures, in particular concerning the purchase of government bonds on the secondary market.

The departure from collegiate accountability and the expression of dissenting views on important policy issues has not strengthened the independence of the ECB. It might have actually seriously undermined it.

The expression of a dissenting opinion, especially when the opinion coincides with the view of a large part of the population of the respective country, generates the impression that discussions within the Governing Council are politicised, and that all members reflect national views. This may encourage pressures by national constituencies on the different ECB Council members to act on the basis of national interests, rather than the broader European ones. It may also encourage some national central banks to publicly express views on monetary policy issues, which is against the letter and the spirit of the Treaty because monetary policy is not anymore a competence of the NCBs but only of the ECB. The Treaty clearly states that the ECB Council members should not be influenced by any national or European institution, not even their own central bank.

The breach of collegiate accountability has led to requests for modifying the statutes of the ECB with a view to better reflect nationalities. An example is the recent call by some German politician and academics to change the currentone-man-one-vote ECB voting system to one based on national weights. This would certainly end the independence of the ECB.

Finally, in the current environment characterised by high uncertainty, not only in financial markets but also in the population at large, uncoordinated communication adds to instability. It ultimately undermines the credibility of the central bank and reduces the effectiveness of its policies. Central banks are expected to send clear messages, explaining the reasons for their actions, possibly also the risks, including the risks of non-action.

Preserving the independence of the ECB requires that personal considerations, even when well-founded, remain subordinated to the pursuit of the common good. If this cannot be achieved, there is only one way out.

What should one make of the indicators coming out of Beijing that have regularly fallen short of market expectations; the most recent being an August PMI — further revised downwards this morning – showing manufacturing intentions hitting a nine-month low?

GDP growth for this year could fall short of Beijing’s target of 7.5 per cent, which would be a two-decade low. At one extreme, bears foresee a long-anticipated collapse while others feel that a more benign landing is underway. Some argue for letting this cycle play itself out, rather than risk incurring distortions from another stimulus. Yet another group is focused on long-standing concerns about rebalancing the economy.

Sorting through this morass of advice, one is reminded that China’s slowdown is a mix between a longer-term structural transition and a frenetic cycle of expand-contract-expand policies in the wake of the 2008 financial crisis. This all began with the $600bn stimulus program four years ago, followed by tightening policies to curb an overheated economy and, over the past half-year, mildly expansionary policies to cope with the eurozone difficulties and a lacklustre US recovery.

But China’s longer-term structural transition involves moving to a more sustainable growth model appropriate for a maturing economy – one that is more innovative and less resource-intensive. The structural transition should have begun much earlier but China’s 2008 stimulus pushed growth back into unsustainable double-digit levels when it should have nurtured a gradual decline to around 8 per cent.

This transition is characterised by two interconnected rebalancing processes. The first is a spatial rebalancing in commercial activity from the coast to the interior and from rural to urban areas. The second is a macroeconomic rebalancing from foreign to domestic demand, of which the gradual shift from investment to consumption within domestic demand is but one aspect. This two-fold rebalancing should not be seen as objectives in their own right. Comparative experience tells us that imbalances are often associated with successful growth processes and their role and duration will vary.

The spatial rebalancing is the result of the increasing demand for services and goods from China’s rising middle class and an aging population in the midst of rapid urbanisation. These trends are ratcheting-up domestic demand relative to foreign. The central provinces with improved transport connectivity will gradually play a more important role as the bridge between a trade-driven coast and a consumption-driven interior. With lower wages and property costs than in the coastal areas, serving both the domestic economy and even some export industries from the central region is becoming attractive.

Aspects of the spatial rebalancing are well underway. China’s inland regions have been growing more rapidly than along the coast after three decades during which the opposite happened. Less well known provinces like Inner Mongolia, Hunan, Sichuan, and Guizhou all grew by 14 per cent or better last year, while the headlines from China’s powerful manufacturing centres along the coast are of declining orders.

This two-speed path is what intrigues foreign investors seeking a continuation of their 20 per cent returns as the coastal mega cities mature. Provinces like Henan and Hunan would rank among the top 20 globally in population size as individual countries, while the municipality of Chongqing is as large as Venezuela or nearly six times the size of Singapore.

The macro rebalancing from external to domestic demand has taken place sooner than expected, as the massive 2008 stimulus absorbed much of the excess savings that had generated the large trade surpluses during 2005-8. This resulted in a sharp decline in China’s trade surplus from over 8 per cent five years ago to around 2 per cent last year.

The concern over the apparent imbalance between low consumption and high investment as shares of GDP within domestic demand, however, is overdone. This is partly because of distorted expenditure statistics – including undervaluation of housing services in personal consumption and inflated investment figures. So consumption as a share of GDP may be underestimated by as much as 10 percentage points of GDP. It is overdone also because personal consumption has continued to grow at an unmatched 8-9 per cent annually through one global crisis after another.

As the abnormally high investment from the 2008 stimulus fades, the consumption-investment shares will moderate. Expenditure rebalancing is also being supported by the spatial rebalancing, since the inland regions have a higher consumption to GDP share than the coastal. But this will be a decade-long process as urbanisation accelerates.

So what, if anything, should China do about all this?

The reality is that depressed foreign demand and inventory adjustments necessitated by the slowdown have cut growth prospects by at least 1 percentage point more than anticipated last year. Mildly expansionary policies carry little risk now that inflation has moderated but are less effective in these circumstances.

Major adjustments in headline exchange and interest rates are not realistic options since they would run counter to longer-term objectives although recent reforms to introduce more flexibility are positive steps. More can be gained, however, in supporting spatial rebalancing through affordable housing and liberalising labour migration policies.

Cushioning the impact of the current recessionary pressures through fiscal reforms that would strengthen social services also make sense. So would more support for the private sector through diversified sources of financing and freer entry into state dominated activities. Such actions would contribute to the desired structural transition.

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