Monthly Archives: December 2012

Is American manufacturing on track for a resurgence in 2013? There are several reasons to think so, and that’s good news because a strong manufacturing sector matters for the health of the US economy.

Manufactured goods account for 60 per cent of US exports of goods and services. It funds 68 per cent of all business research and development and R&D is the major source of innovation. Manufacturing enjoys strong productivity growth, which drives growth in wages and living standards, and demand for other economic activities. Every dollar in final sales of manufactured products supports $1.34 in output in other sectors—the largest multiplier of any sector. And manufacturing provides goods jobs. Even after controlling for demographic, geographic and job characteristics, manufacturing jobs enjoy higher wages and benefits compared to jobs in the rest of the economy. (The source for these statistics is here.)

After a dramatic cyclical slowdown in 2008-2009, industrial production in manufacturing has grown by more than 10 per cent since January 2010, and manufacturing employment has increased by about 500,000 — the strongest cyclical rebound since the recessions of the early 1980s. Nonetheless, there are still 1.8m fewer manufacturing jobs now than in December 2007 when the recession hit and more than 5m fewer than in 2000.

There are grounds for optimism that the recovery of manufacturing will gain strength in 2013. The US has maintained its lead in manufacturing productivity by an increasing margin. Between 2007 and 2011, manufacturing productivity grew more rapidly in the US than in any other developed country. During the same period, unit labour costs in US manufacturing declined while they increased in other large manufacturing countries including Germany, Japan, and China. Wages in China, measured in dollars, are now five times higher than they were in 2000 and are rising at double-digit rates. The natural gas boom in the US has also boosted the competitiveness of US manufacturing by lowering the cost of energy: natural gas in Asia now costs about four times as much as in the US.

These new competitive conditions are reducing the allure of offshoring. Higher transportation costs, rising skill requirements for manufacturing workers as a result of the addition of high-tech components to everyday manufactured goods, and unanticipated costs, quality control problems,and intellectual property risks of doing business in emerging market countries are also undercutting the business case for offshoring.

Tim Cook, Apple chief executive, recently announced that the company would invest $100m to bring some of its manufacturing jobs back to the US, noting that Apple has “the responsibility to create jobs” in the US. Apple’s announcement is the latest in a series of announcements by US multinational companies that they plan to “reshore” some jobs. Indeed, some companies such as GE have already acted on their re-shoring plans and are investing in new US facilities to manufacture products they used to manufacture abroad. By redesigning its assembly line, GE has been able to lower its labor costs, energy costs and material costs compared to those it was paying to produce the same product in China.

Some business leaders predict that reshoring might bring about 1m jobs back to the US over the next few years. So far, however, reshoring has not created many additional US manufacturing jobs, and the incentive for offshoring low-skill, labour-intensive parts of the manufacturing supply chain remains powerful. As a result of labour-saving and skill-biased changes in manufacturing technology, a growing share of all manufacturing production in the US is highly automated, requiring highly skilled workers but not many of them.

Overall, barring a self-inflicted recession caused by political gridlock and a harsh dose of fiscal austerity, look for stronger growth in US manufacturing and more reshoring by US companies in 2013. But look for only a modest increase in manufacturing employment.

Rationality and politics aren’t easy bedfellows, so we shouldn’t be surprised that the relationship between the EU and Turkey has become more prickly than is sensible for either side. But the case for them to forge closer links is overwhelming on economic, security and cultural grounds. 2013 could – and should – be the year the relationship takes a turn for the better.

We have come a long way from the heady days in 2005 when the EU and Turkey opened accession negotiations for Turkish membership. Only 8 “chapters” out of more than thirty have been opened – the rest blocked by the intransigence of Cyprus, France and other sceptics. Meanwhile there has been growing concern about human rights and other alleged abuses inside Turkey, including of journalists.

Turkish ardour has waned too. This is partly a popular response to the perception of the European rebuff. But it also reflected Turkish confidence about its power in the Middle East and beyond. “Zero problems with our neighbours” was the aspiration.

Both Europe and Turkey have good reason to think again about the current course. Europe because there is an economic giant on its doorstep, and it needs all the help it can get. Turkey because its neighbourhood is in such flux that Europe, with its democratic resilience and strong legal order, looks like an area of relative stability. And remember that Turkey is already a member of Nato.

The game changer could come from an unlikely source: France. Under Nicolas Sarkozy, France led the way in blocking the idea of Turkish membership of the EU. Francois Hollande, by contrast, has not said anything. But he has quietly announced a state visit to Turkey in April 2013, and those who know him stress the pragmatic and open-minded world view that he will bring to this issue.

The issue for President Hollande, and the rest of us, is not whether Turkey should join the EU in 2013. It is whether the commitment to membership is allowed to die by neglect, or whether it is given life through practical cooperation to overcome the obstacles to membership. The economics is not straightforward, nor are migration and other issues, but given the rate at which Turkey is growing, and the momentum a few years ago for internal reform, including new rights for Kurds, they are far from insuperable.

For those of us who desire an EU that is not just open to the world, but an advocate for a rules-based international order is not just rational but essential. France has a huge interest in this question. Its own European and global role is under question. It would be an important act of statesmanship for Mr Hollande to mark a clean break with the Sarkozy years on this year. I think he will do it.

The number 13 is unlucky in Western minds. It is not in Asian minds. This may explain in part why many Westerners view 2013 with foreboding. Most Asians do not.

Of course, if the US Congress takes the world off the fiscal cliff or if the eurozone finally cracks up, all bets are off. The global economy will then have another painful stumble. Fortunately, this is not likely to happen. Indeed, the prospects are that both the US and China will do better in 2013 than in 2012. So too will many other Asian countries.

Asia’s underlying trend – its resurgence – will continue in 2013. In 2012, about 500m Asians enjoy middle class standards. By 2020, that number will grow to 1.75bn. The demand for all kinds of products will grow. India had no cellphones in 1990. It had 752m in 2010. Now they are switching to smartphones. In 2012, there are 17 m smartphones in India. In 2015, there will be 79m. Tourism will flourish. New hotels are everywhere. Asian budget carriers grew 23 per cent in 2012 versus 8 per cent for traditional airlines, while analysts project that online bookings for budget airlines will grow 55 per cent from 2011 in 2013. Asians are on the move.

The material rise of Asia is easier to document. The mental and spiritual resurgence is harder to keep track of, even though there has been recently an undeniable explosion in the cultural confidence of Asians. Nevertheless, some key projects provide symbols of a new era. Nalanda University, Asia’s greatest university from 500 AD to almost 1200 AD, will continue its gentle restoration under Nobel laureate Amartya Sen, who heads the “Nalanda Mentor Group”. In August 2013, the first batch of students will enroll at the Yale-NUS College. From this tiny seed, a great plant will grow. Projects that bring together the best of Eastern and Western learning will demonstrate that the fusion of civilisations (not the clash of civilisations) will represent the main dynamic of the 21st century. It will all be part of the great convergence of human history that we will experience as the planet continues to shrink inexorably.

Yes, there will be challenges aplenty. Geopolitics will rear its head everywhere. But countries can also learn from mistakes. In 2012, China committed a huge geopolitical blunder by trying to divide the Association of Southeast Asian Nations at the Phnom Penh meeting in November. As Xi Jinping gradually consolidates his power and wiser counsel prevails, China may realise the wisdom of Deng’s advice to China to hide its strength and bide its time. With major leadership transitions over in Beijing and Washington, DC, the main geopolitical relationship of our time will veer towards stability and predictability in 2013.

All this may be seen as pure wishful thinking by sceptical Western minds. But the evidence that history has finally turned a corner in the second decade of the 21st century is undeniable. This is why it will be clearer, as this decade unfolds, that the sun will continue rising in the east and continue gently setting in the west.

In foreign policy, there are many ways to do more with less. Policy makers can, for example, use a mix of economic leverage and coercive diplomacy to get the results they want without a conflict or a trade war. In 2013, we will surely see more of these less risky, more cost-effective tactics as US, European, and Chinese officials resist entanglements abroad to focus their attention on domestic issues. But if they learnt anything from 2012, they will resist the temptation to pass off empty ultimatums as forceful foreign policy.

Consider some examples. The Obama administration has warned Syria’s Bashar al-Assad that “there will be consequences” if he uses chemical weapons to kill rebels. Leon Panetta, US defence secretary, says that “the whole world is watching”. Unfortunately, the world sees Washington drawing a red line that appears to imply that Mr Assad’s ongoing use of conventional weapons to murder his own people will not provoke a consequential response. It suspects that Mr Assad’s government will continue its fight to the finish, far more afraid that opposition forces will seize the capital than that Mr Obama will order airstrikes.

Mr Obama also says that the US will not allow Iran to develop a nuclear weapons capability. But this line was drawn mainly to protect the president’s political reputation at home. It will not persuade Iran’s leaders to renounce their nuclear plans.

The US (and the rest of the world) can take a lesson on this subject from Angela Merkel. Germany’s chancellor has carefully chosen both her words and deeds throughout the eurozone crisis. That strategy has helped keep negotiations on track while she maintains healthy approval ratings at home. Those who draw lines in the sand put their own credibility at risk.

In 2013, the US and Chinese governments will use pledges of regulatory action to gain leverage in commercial competition and to manage the risk of conflict in cyberspace. China and its neighbours will continue to trade threats over competing claims in the waters that separate them. American and European officials will demand that Iran make a deal on its nuclear programme. EU officials will insist that governments in Greece, Spain, Portugal and Italy must keep their reform processes on track. Governments in the Middle East will tell one another to mind their own business. India and Pakistan will exchange warnings over Afghanistan as Nato accelerates the drawdown of its troops there.

But only ultimatums that do not impose significant costs or risks on those who issue them will be taken seriously.

The writer is the president of Eurasia Group, a political risk consultancy, and author of ‘Every Nation for Itself: Winners and Losers in a G-Zero World’

2013 will be the year of an EU-US free trade agreement, or at least serious negotiations towards that goal. Although this possibility has been raised many times before, only to stall in the face of tough regulatory or subsidy issues, the economic stakes are higher and the political obstacles are lower next year. Both the EU and the US desperately need faster economic growth. Monetary policy is essentially exhausted; fiscal policy is set to tighten. That leaves trade: expanding markets by removing tariffs and – more importantly – non-tariff barriers, such as licencing requirements and anti-dumping measures. Small wonder that the Obama administration is actively pursuing the Trans-Pacific Partnership to the west and raising the prospect of a US-EU deal in the east.

The US finally seems to have realized that Europe’s economic heft is a strategic asset. Secretary of State Hillary Clinton said in a speech at the end of November that “America is not pivoting from Europe to Asia; we are pivoting with Europe to Asia.” The EU is the largest economy in the world; it is the US’s largest trade and investment partner and China’s largest trade partner. [Building a genuine transatlantic market reinforces the transatlantic political and military alliance and helps both the US and the EU coordinate policy toward different Asian countries.] It also creates a new set of possibilities in the Atlantic basin, improving ties to both Africa and South America and encouraging trade and investment between them. Finally, the EU could be an important market for increased US energy exports.

Expanded US trade and the symbolism of a new and enduring transatlantic agreement could be a political lifeline for embattled EU leaders who see nothing but austerity and political fights ahead. It gives them something new to offer their consumers and at least some of their producers. And it makes clear that the US is putting a long-term bet on the EU, just as it has done ever since 1958, That also has to mean a long-term bet on the survival and indeed expansion of the eurozone. All of which means that if European governments are ever to find the political will to face down the agricultural and other lobbies that have frozen previous efforts to achieve a US-EU trade agreement, the time is now.

Britain should be watching these developments with particular interest. If the US and the EU can agree to merge their markets, the cost of a potential British exit from the EU go way up. Britain would once again become an island economy, but one walled off from a transatlantic sea.

Look around the world and big risks abound. One or more countries may drop out of the eurozone. Violence may spread across the Middle East. The US Congress may yet drive the country off its fiscal cliff and into recession. An island dispute between China and its neighbours may flare up, provoking the US to intervene in the Pacific. But in my view, the single greatest risk is that one of these events or some other throws the world into another global financial crisis, a “GFC II”.

This is a possibility for three reasons. First, the world economy is still in fragile shape and only slowly recovering from the GFC of 2007-08. Households and governments are still struggling under heavy debt loads. Banks are still shrinking their balance sheets and uncertain over the evolving, but still vindictive, regulatory climate. Any new shock will add to their worries and cause further retrenchment.

Second, economic policy is maxed out. Both fiscal and monetary policy have hit their effective boundaries. The GFC created a balance sheet recession which means that Keynesian stimulus based on more government borrowing will be ineffective at best and counterproductive at worst. Central banks have held nominal interest rates near zero for an unprecedented length of time and pumped liquidity into their financial institutions through quantitative easing (QE). But the signs of a classic liquidity trap are everywhere. Banks find little demand for new loans and in any case the regulators tell them to build up their reserves. QE is helping to prop up the banks but it is not getting into the real economy, and the negative side effects for savers and pension funds are growing. If an external shock occurs, there is little that government policy can do to counteract it.

The third vulnerability is political weakness. Prolonged austerity is undermining political support for mainstream parties and encouraging the fringes, both left and right. The peripheral eurozone countries are at particular risk. A weak coalition in Italy after Spring elections or a separatist win in Catalonia could not only be the beginning of the end of the euro but the trigger for GFC II.

To mitigate this risk, international cooperation will be key. The objective should be economic surveillance to monitor crisis regions and, if necessary, economic containment. Contingency plans should be prepared to prevent the spread of financial crisis from one country to the rest of the global economy without retreating into protectionism. The G20 is the obvious place to coordinate this. Unfortunately it is Russia’s turn to lead the G20 next year. Yet another reason to worry.

The quarter-century leading up to the financial crisis saw a remarkable leap in globalisation. In particular, cross-border financial flows grew rapidly. Western investors piled into China and the other Brics. The new phenomenon of south-north flows emerged, as sovereign wealth funds from Asia and the Middle East acquired developed economy assets on a massive scale. But the fastest growth was in cross-border bank lending, much of it intermediated in London. Citibank’s ambition was to be seen on street corners from Manhattan to Manama; HSBC proudly told us, every time we got off a plane, that it was “the world’s local bank”.

Since the crisis that last trend has gone into reverse: cross-border lending has fallen sharply and the ambitions of major American and European banks have been scaled back. HSBC has withdrawn from a number of countries; Citibank and Barclay’s have other preoccupations. The continental European banks are struggling to strengthen their capital bases, and emerging market assets have been realised to bolster the parents’ balance sheets.

So are we entering a new age of financial deglobalisation? If so, should we care?

Some of the retrenchment was inevitable, so we may as well welcome it. Banks had become overextended. Their appetites exceeded the capacity of their digestive systems. We need not regret the retreat of Icelandic and Irish banks to their geysers and Loughs. But there are signs that some of the withdrawal may be traced to regulatory actions, and to a form of financial protectionism, which could be as dangerous as protectionism in the trade of physical goods.

In some cases, particularly in Europe, home state regulators have required their institutions to pull liquidity back from overseas markets to protect the parent bank. Host regulators are requiring pools of liquidity to be held in their jurisdiction, perhaps over-learning the lessons of the messy Lehman’s bankruptcy.

US regulators are pressing overseas banks to set up local subsidiaries, with separate capitalisation (as the Canadians have done for some time). Even in the EU, where banks have the legal right to operate across the union from one member state authorisation, they are being pressed to set up local subsidiaries. No-one wants a repeat of the Icelandic debacle, when the British and Dutch governments found themselves bailing out depositors in banks they had never authorised.

But these are not costless measures. They cause liquidity and capital to be trapped where they are not needed, and mean that capital is therefore not optimally used, which will increase the cost of credit. In response, banks withdraw from marginal markets, reducing competition. The local authorities respond by biasing their regulation in favour of domestic entities. A cycle of discrimination and domestication is established.

The Financial Stability Board is concerned about these trends, as is the IMF. They recognise the dangers. 2013 will be a decisive year. Will central banks and regulators embrace financial deglobalisation enthusiastically, in response to local political pressures, or will it be possible to find a new equilibrium, in which the crisis learnings are embedded in a new approach which preserves many of the benefits of open international financial markets? Finding the right answer to that question is crucial.

Last Friday 20 children and six adults were shot dead at an elementary school in Newtown, Connecticut. The same day a group of schoolchildren was attacked in China’s Henan province. There, the assailant wielded a knife and the result was injuries to 23 children and an adult but no deaths. This follows an established pattern. Like the US, China has experienced a spate of attacks on schoolchildren. But without easy access to guns, Chinese attackers seldom succeed in killing.

America’s inability to protect the public from gun violence is a case study in several of our democratic failures: the single-issue minority that overrides the weaker preference of the majority; the inbuilt rural bias of our politics; the entrenched power of a well-endowed lobby; and the runaway interpretation of certain politically congenial rights by a conservative Supreme Court majority. Because of the scale of these systemic obstacles, liberals like Barack Obama, who are naturally inclined to support sensible gun-control laws, have in recent years shied away from taking on the issue.


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If that is to change there are two possible paths to reform. The first is a civil rights, or moral model, along the lines of the campaign for gay marriage or the recent executive order ending deportation of illegal immigrants who were brought to the US as children. The other is a public-health model, used to curb smoking or promote seat belts, where better policy advances through regulation, litigation and incremental political change at multiple levels.

Mr Obama’s instinct so far has been for the moral model. He gives a powerful speech, like the one he delivered in Newtown on Sunday night, announces that the time for change has finally come, and calls on Congress to act. This is the classic and preferable model of reform. It is transparent, persuasion-based, employs the democratic process and doesn’t smack of the nanny state. At this point, however, we would do well to acknowledge that America’s gun problem is not amenable to that kind of change.

At best, the moral model yields a halting, one-step-forward, two-steps-back type of reform. In the wake of a horrific 1989 school massacre in Stockton, California, Congress passed a ban on assault weapons, which Bill Clinton signed in 1994. A decade later, after lobbying by the National Rifle Association, that ban was allowed to expire. Even in the wake of the Newtown shooting, it is unrealistic to expect Congress to pass any kind of comprehensive gun-control legislation.

Michael Bloomberg, New York City mayor, has been the exemplar of the alternative, paternalistic model, in which government uses any regulatory, legal, or political power at hand to protect its citizens from harm, self-inflicted or otherwise. The case study is smoking, where in 2002 Mr Bloomberg championed an initially unpopular ban on smoking in bars and restaurants. In a few short years it became a national and even global norm. Combined with punitive taxes and a programme of supportive services for people who wish to quit, New York has reduced smoking rates, which had been stagnant for years, from 22 per cent to 14 per cent over a decade. Teen smoking has gone from 19 per cent to 7 per cent in the same period. Mr Bloomberg has recently been trying a similar approach with unhealthy fast food.

With guns, a public-health approach would begin by highlighting the legal anomaly that federal agencies can regulate devices meant to keep people alive but not those designed to kill them. When it created the Consumer Product Safety Commission in 1972, Congress gave itself the power to regulate toy guns but not real ones. The logic was that weapons were covered by the Treasury Department’s Bureau of Alcohol, Tobacco, and Firearms. But ATF has authority only to enforce existing criminal laws, not to apply new health and safety standards. The most important change Mr Obama could undertake would be pressing Congress to give ATF the same power over guns that the National Highway Traffic Safety Administration has over cars.

The other big change has to do with liability law. After state lawsuits forced tobacco companies to contribute billions towards public health costs, trial lawyers around the country trained their sights on gunmakers. In response, the NRA in 2005 got its minions in Congress to pass a bill that shielded firearms manufacturers and dealers from negligence suits. Mr Obama should try to have this decision reversed.

Regulation and tort law are not ideal ways to make public policy. But there is little rationale for treating guns as a uniquely special and protected class of manufactures. What gun-control advocates need is simple parity.

The writer is chairman and editor-in-chief of The Slate Group and author of ‘The Bush Tragedy’

For more than 30 years, from the mid-1970s to 2008, Keynesian demand management was in intellectual eclipse. Yet it returned with the financial crisis to dominate the thinking of the Obama administration and much of the UK Labour party. It is time to reconsider the revival.

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The rebound of Keynesianism, led in the US by Lawrence Summers, the former Treasury secretary, Paul Krugman, the economist-columnist, and the US Federal Reserve chairman Ben Bernanke, came with the belief that short-term fiscal and monetary expansion was needed to offset the collapse of the housing market.

The US policy choice has been four years of structural (cyclically adjusted) budget deficits of general government of 7 per cent of gross domestic product or more; interest rates near zero; another call by the White House for stimulus in 2013; and the Fed’s new policy to keep rates near zero until unemployment returns to 6.5 per cent. Since 2010, no European country has followed the US’s fiscal lead. However, the European Central Bank and Bank of England are not far behind the Fed on the monetary front.

We can’t know how successful (or otherwise) these policies have been because of the lack of convincing counterfactuals. But we should have serious doubts. The promised jobs recovery has not arrived. Growth has remained sluggish. The US debt-GDP ratio has almost doubled from about 36 per cent in 2007 to 72 per cent this year.


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The crisis in southern Europe is often claimed by Keynesians to be the consequence of fiscal austerity, yet its primary cause is the countries’ and eurozone’s unresolved banking crises. And the UK’s slowdown has more to do with the eurozone crisis, declining North Sea oil and the inevitable contraction of the banking sector, than multiyear moves towards budget balance.

There are three more reasons to doubt the Keynesian view. First, the fiscal expansion has been mostly in the form of temporary tax cuts and transfer payments. Much of these were probably saved, not spent.

Second, the zero interest rate policy has a risk not acknowledged by the Fed: the creation of another bubble. The Fed has failed to appreciate that the 2008 bubble was partly caused by its own easy liquidity policies in the preceding six years. Friedrich Hayek was prescient: a surge of excessive liquidity can misdirect investments that lead to boom followed by bust.

Third, our real challenge was not a great depression, as the Keynesians argued, but deep structural change. Keynesians persuaded Washington it was stimulus or bust. This was questionable. There was indeed a brief depression risk in late 2008 and early 2009, but it resulted from the panic after the abrupt and maladroit closure of Lehman Brothers.

There is no going back to the pre-crisis economy, with or without stimulus. Unlike the Keynesian model that assumes a stable growth path hit by temporary shocks, our real challenge is that the growth path itself needs to be very different from even the recent past.

The American labour market is not recovering as Keynesians hoped. Indeed, most high-income economies continue to shed low-skilled jobs, either to automation or to offshoring. And while US employment is rising for those with college degrees, it is falling for those with no more than a high school education.

The infrastructure sector is a second case in point. Other than a much-hyped boom in gas fracking, investments in infrastructure are mostly paralysed. Every country needs to move to a low-carbon energy system. What is the US plan? There isn’t one. What is the plan for modernised transport? There isn’t one. What is the plan for protecting the coastlines from more frequent and costly flooding? There isn’t one.

Trillions of dollars of public and private investments are held up for lack of a strategy. The Keynesian approach is ill-suited to this kind of sustained economic management, which needs to be on a timescale of 10-20 years, involving co-operation between public and private investments, and national and local governments.

Our world is not amenable to mechanistic rules, whether they are Keynesian multipliers, or ratios of budget cuts to tax increases. The UK, for example, needs increased infrastructure and education investments, backed by taxes and public tariffs. Therefore, spending cuts should not form the bulk of deficit reduction as George Osborne, UK chancellor, desires. Economics needs to focus on the government’s role not over a year or business cycle, but over an “investment cycle”.

When the world is changing rapidly and consequentially, as it is today, it is misguided to expect a “general theory”. As Hayek once recommended to Keynes, we instead need a tract for our times; one that responds to the new challenges posed by globalisation, climate change and information technology.

The writer is director of the Earth Institute at Columbia University

Last week’s summit of European leaders as well as finance ministers marks an important step in completing the eurozone architecture. At the same time, the summit’s results fall short of what could have been hoped for.

Start with banking union. When launched on 29 June, the project was widely and rightly interpreted by markets to indicate that Europe’s leaders had changed their assessment of the euro crisis. Until then eurozone heads of state had behaved as if a mere tightening of the existing budgetary provisions could suffice to restore confidence in the euro. But in June they recognised that the arrest of financial flows within the euro area had deeper roots. Banking union was designed as the first component of a systemic response to a systemic problem. Together with the announcement by the European Central Bank of a new bond-purchase facility, it was instrumental in convincing markets that the worst was not certain.

Last week finance ministers agreed on the first important step towards banking union: the establishment of a single supervisory mechanism (SSM). The compromise they have reached seems to be a good one. The ECB will be in a strong position and responsible for the overall functioning of the SSM. It will have direct oversight of eurozone banks in a differentiated way depending on size. The size threshold of €30bn means that perhaps 85 per cent of assets and more than 180 banks in the eurozone will be under direct oversight of the ECB. The press communiqué suggests that ECB will also have the right to scrutinize banks below the threshold, which will reduce banks’ incentives to fall below or above the threshold. This is important to avoid competitive distortions but also to prevent major problems among small banks, which taken together are still large. Moreover, when financial assistance is given, the ECB will be the supervisor which allows extending the coverage to a number of Spanish Cajas that are smaller in size than €30bn. The compromise also appropriately allows non-eurozone countries to participate in the SSM.

That first step was, however, the easiest of the three steps towards an integrated financial framework. Establishing a common resolution framework will be harder, because it implies giving a European authority the power to distribute losses among shareholders and creditors in several countries, close down banks and lay-off employees. Still, heads of state and government made quite some progress on this front. They explicitly acknowledge that a single resolution mechanism is required and call for the mechanism to be finalised before the European elections in 2014. They also wish the resolution mechanism to be based on resources from the financial sector itself and there is an acknowledgment that a fiscal backstop is needed.

So which principles should the single resolution mechanism be based upon? First, given the distributional choices and the fiscal resources needed, the resolution task should be completely distinct from the new supervisor at the ECB as otherwise there will be a temptation to use monetary policy to reduce the fiscal burden. Second, bank resolution should be exercised by an independent authority. This authority should be guided by clear rules and it should be politically accountable ex-post. However, the actual decisions should be done at arm’s length from the fiscal authorities to avoid excessive politicisation of decisions. Third, the authority should rely on an appropriate fiscal backstop. A clear decision-making framework is needed to determine under which conditions aid can be requested. Defining those conditions will be controversial, because budgetary decisions are always the most acrimonious. Furthermore, agreeing on banking regulation that proves appropriate for reducing fiscal costs will also be controversial. The next steps to be taken for the completion of banking union are therefore clearly on the table but far from easy to achieve.

As regards fiscal union, the summit is a disappointment. The founding fathers of the euro were aware of the need to complement monetary with fiscal union but put off difficult choices to future decision makers. The time has come to address a series of unanswered questions. Should there be a proper euro-area budget? Should a new system be conceived as an intergovernmental transfer scheme? Or should sovereigns’ ability to borrow be restored through some form of mutual guarantee? What should be the degree and type of conditionality? What does a euro area fiscal union mean for the EU as a whole? It was evidently too early to take any decision now, yet a reflection process should have been initiated. Hermann Van Rompuy, the President of the European Council, was willing to conduct it. By giving him a mandate, the European leaders would have shown that they are able to think strategically, not only to respond to market pressure.

The writer is director of Bruegel, the economic think tank. This paper is co-authored by Guntram Wolff, Bruegel’s deputy director

Sooner or later the American tax code will be reformed. Probably sooner. Raising revenue will be the main motivation, but at a time of sharply increasing economic polarisation issues of fairness will be prominent too. There are also legitimate concerns about the complexity of current tax rules and their adverse effects on the economy.

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So far, the debate has focused on scaling back provisions of the tax code that have favoured activities traditionally deemed to be valuable. For example, there is talk of reducing reliefs for charitable contributions, taxes paid to state and local governments, home mortgages, employer-provided health insurance and many less important provisions.

There are reasonable arguments to be made in each case. But taking only the “limit tax incentives” approach to tax reform has several major defects.

First, if reform is designed to avoid perverse outcomes, such as the crushing of charitable contributions or more pressure on state budgets, then it will raise limited amounts of revenue.


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Second, this approach will address very little of the complexity in the code and is not likely to do much for recovery, since it will do little to increase demand.

Third, it will do little to address concerns about fairness: the richest taxpayers actually make relatively little use of deductions and credits.

What is needed is an additional element, one that has largely been absent to date: the numerous exclusions from the definition of adjusted gross income that enable the accumulation of great wealth with the payment of little or no taxes. The issue of the special capital gains treatment of carried interest – performance fee income for investment managers – is only the tip of a very large iceberg. There are far too many provisions that favour a small minority of very fortunate taxpayers. Because these provisions effectively permit the accumulation of wealth to go substantially underreported on income and estate tax returns, they force the federal government to consider excessive increases in tax rates if it is to reach any given revenue target.

All parties – whether their primary concern is preserving incentives for small businesses, closing prospective budget deficits or protecting the social safety net – should be able to come together around the idea that it should not be possible to accumulate and transfer large fortunes while avoiding taxation almost entirely. Yet this is all too possible today.

Here are some issues the Obama administration and Democrats and Republicans in the US Congress should consider given the magnitude of prospective deficits and the extraordinary good fortune of those at the top of the income distribution.

Why do current valuation practices built into the tax code make it possible for investment partners to end up with $50m or more in entirely tax-free individual retirement accounts when the vast majority of Americans are constrained by a $5,000 annual contribution limit?

A simple calculation shows that the US estate tax system is broken. Assets that are passed to relatives or other personal relations are often badly misvalued relative to what they cost on an open market. The total wealth of American households is estimated at more than $60tn. It is heavily concentrated in very few hands.

A conservative estimate given the lifespans of Americans would be that 2 per cent ($1.2tn) is passed down each year, mostly from the very rich. Yet estate and gift taxes raise less than $12bn, or 1 per cent, of this figure each year.

If a family’s home rises in value by more than a $500,000 exclusion over the course of its dwelling, then it pays capital gains tax on the difference between the value now and the value at purchase. But real estate investment operators, who sell properties whose value is measured in the hundreds of millions if not the billions of dollars, are able to take tax deductions for “depreciation” on their properties. And they are then able sell these properties at an appreciated price while avoiding capital gains tax through what is known as a “like kind exchange” – but is in fact a sale.

Why should international companies be able to locate the lion’s share of their foreign income in small, low-tax jurisdictions such as Bermuda, the Netherlands and Ireland, and avoid paying taxes?

There are sound arguments for a preferential rate on capital gains. But is there any real justification for allowing those who do not need to sell their assets to finance retirement to avoid capital gains taxes entirely by including them in their estates?

These tax rules, which permit the taxes of the most fortunate Americans to be far less than commensurate with their good fortune, have the virtue of being relatively comprehensible. There are many others, involving issues such as derivative accounting, pooled interests and leveraged leases, that are neither easily explainable nor easily justified.

The failure to tax capital gains at the point of death costs the federal government about $50bn a year. Since its removal would both raise money in the future, and induce earlier and greater realisations of capital gains in the short term, its removal would likely add well over $500bn during a 10-year period. I believe it is plausible to raise $1tn over the next 10 years by going after provisions that cause what adds to wealth and spending not to be regarded as income.

It has been observed that the greatest scandals are not the illegal things that people do but the things that are fully legal. This is surely true with respect to a tax code in urgent need of reform.

The writer is Charles W. Eliot university professor at Harvard and a former US Treasury secretary

America’s biggest economic problem is lack of good jobs and insufficient growth. And our principal goal must be to revive both.

Yet the news coming out of Washington these days is all about avoiding January’s so-called “fiscal cliff” – some $500bn in tax increases and spending cuts that automatically kick in if Democrats and Republicans don’t come up with a long-term plan to reduce the federal budget deficit.

Why is Washington so obsessed with reducing the federal budget deficit rather than creating jobs and restoring growth? Because so many Americans have come to believe that the way to get jobs back and restore growth is to “get our fiscal house in order.”

That’s been the Republican Party line for over two decades. And even though Republicans lost November’s presidential election and saw their numbers dwindle in both the House and Senate, this view continues to prevail.

It’s dead wrong.

Exhibit A is the “fiscal cliff” itself. It’s dangerous to the economy – the Congressional Budget Office and many private economists believe going over it will tip the United States into recession next year – precisely because it requires too much deficit reduction, too quickly. It would suck too much demand out of the economy.

As it is, America suffers from inadequate demand. Consumers, whose spending comprises 70 per cent of economic activity in the US, aren’t buying nearly enough to boost the economy. Businesses won’t expand and hire unless consumers spend more. This means government has to spend more to make up for the shortfall.

In reality, the best way for America to reduce future budget deficits is through more jobs and faster growth. More jobs and faster growth will shrink the deficit as a proportion of the overall economy.

Recall the 1990s, when the Clinton administration balanced the budget ahead of the schedule it had set with Congress. That was because of faster job growth than anyone expected — creating more jobs and bringing in more tax revenues than anyone had forecast.

Europe offers the same lesson, but in reverse: Its deficits are growing because its austerity policies have caused its economies to contract. Sure, Greece had to pull in its belt. But Britain and Spain were doing fairly well before they began cutting public spending. Now they’ve pulled so much demand out of their economies that unemployment has risen and tax revenues have dropped.

Policymakers need to understand that when unemployment is high and workplaces are idle, the way to generate jobs and growth is for the government to spend more, not less. And for taxes to stay low, or become even lower, on the middle class.

Higher taxes on the rich don’t slow economic growth because the rich spend a much smaller portion of their earnings than does the middle class. And they’ll continue to spend even if their tax rates rise. They’re already taking home a near record share of America’s total income and have a record share of total wealth.

Why have so many Americans – including politicians and media – bought into the narrative that our economic problems stem from an out-of-control budget deficit? And why are they repeating this hokum even now, when we’re staring at a fiscal cliff that illustrates just how dangerous deficit reduction can be? Because an entire deficit-cutting industry has grown up in recent years, bent on selling this false story.

It began with Ross Perot’s third party in the 1992 election and continued through Peter Peterson’s institute and other think tanks funded by Wall Street and big business. It was embraced in the late 1990s and earlier this century by the government-haters in the Republican Party and the eat-your-spinach deficit hawk crowd among Democrats.

And it culminated in the Simpson-Bowles Commission that President Obama created in order to appease the hawks but which only legitimised them further.

Deficit mavens routinely warn that unless the deficit is trimmed, we’ll fall prey to inflation and rising interest rates. But there’s no sign of inflation anywhere. The world is awash in underutilised capacity. As for interest rates, the yield on the 10-year Treasury bill is now lower than it’s been in living memory.

In fact, if there was ever a time for America to borrow more in order to put our people back to work repairing our crumbling infrastructure and rebuilding our schools, it’s now.

Public investments that spur future job growth and productivity shouldn’t even be included in measures of government spending to begin with. They’re justifiable as long as the return on those investments — a more educated and productive workforce, and a more efficient infrastructure, both generating more and better goods and services with fewer scarce resources — is higher than the cost.

America should be enlarging these investments, not cutting them. No sane family equates spending on vacations with investing in their kids’ education. Yet that’s what we do in our federal budget.

Finally, the biggest driver of future budget deficits in the United States is the rising cost of health care — that same phenomenon that’s causing headaches for individuals, families and businesses. America’s wildly inefficient balkanised health-care system is already taking a far larger share of the total economy than that of every other rich nation (18 per cent), and yet our health outcomes are worse.

Instead of fighting over how to cut the budget deficit, Democrats and Republicans should be having a constructive conversation about how to use government’s bargaining power through Medicare and Medicaid to hold down health-care costs, and then use the Affordable Care Act as a stepping stone toward a single-payer health-care system.

The current Washington obsession about future budget deficits is distracting America’s attention from what the nation should be obsessing about — regaining jobs, restarting growth, and making America’s health-care system far more efficient.

The writer is the chancellor’s professor of public policy at the University of California at Berkeley, and former US Secretary of Labor under President Bill Clinton.

As the fighting season winds down in Afghanistan for the winter months, the four major players in the Afghan imbroglio – the US, Pakistan, the Afghan government and the Taliban – are involved in a complex game of political and military manoeuvring ahead of what is expected to be a decisive round of peace talks in the spring.

With the withdrawal of US troops approaching and the Afghan President Hamid Karzai’s tenure nearing an end, for once all all four parties appear to have an interest in talks.

Even while waiting for a new Secretary of State to be appointed, US diplomats have been visiting the region, talking to allies and urging them to try and bring the Taliban back to peace talks in Qatar that were suspended by the Taliban last March.

Those talks are critical because they hold out the promise of a Taliban front office in Qatar and the possibility that the US could free five senior Taliban commanders from Guantanamo Bay a confidence building measure. The Taliban have insisted on talking first to the Americans before they hold any dialogue with the Kabul regime.

A game changer in recent months is the Pakistan military’s surprising shift of attitude. It has freed Taliban prisoners it has been holding. It has reportedly now told the Taliban and Kabul that it will actively help the process of reconciliation and has been urging both parties to start talking to one another.

The army’s change of heart is premised on the hope that reconciliation between the Afghan Taliban, the Americans and the Kabul regime will lead to a reduction in the violence being perpetrated by the Pakistani Taliban in north west Pakistan.

Taliban commanders and fighters have had a sanctuary in Pakistan since 2002 and have been allowed to raise recruits, funds and logistics through Pakistani allies. But now the Pakistani army and its Interservices Intelligence (ISI) are faced with crippling violence at home that has claimed several thousand lives this year. The government and the army are finding it difficult to cope with two insurgencies, mayhem in Karachi, a moribund economy and a political crisis with elections to be held next May.

However even Pakistan cannot force the Taliban to the table, nor can it change their insistence on wanting to talk to the Americans first. Thus for Islamabad also, restarting the Qatar talks is vitally important if its own initiative of reconciliation is to succeed.

For the Afghan government, which in 2014 faces a withdrawal of US and NATO forces and presidential elections, it is paramount to achieve a ceasefire with the Taliban before that date. A war with the Taliban absent NATO support would overburden the fledgling Afghan army and put the survival of the government at risk.

Thus Afghanistan’s High Peace Council, which is tasked with negotiating with the Taliban, has met several times with Pakistan army chief General Ashfaq Kiyani in order to work out a common road map that both can pursue to bring the Taliban to the table. The Council also works closely with the Americans.

In mid-November Pakistan freed nine Taliban officials it had been holding, releasing them to the Afghan High Peace Council saying it would soon free more Taliban prisoners. The ISI is holding at least 100 Taliban leaders and foot soldiers but is expected to eventually free them all.

Pakistan, Afghanistan and the US are already working closely together through meetings of what is called the core group. However now Pakistan and Afghanistan want to see a much clearer American indication of where the talks should lead before they offer any more concessions to the Taliban.

The key question in everyone’s mind in the region is whether in his second term President Barack Obama will get serious about promoting a political settlement in Afghanistan.

Although he authorised a political process in his first term he never really gave it presidential support. The key question now is who becomes Secretary of State and who is appointed to lead a new team that will deal with AfPak talks and peace making. Most officials in the region are rooting for Senator John Kerry as Secretary of State simply because they know him and he knows the region and its myriad of leaders and warlords well.

However the core group still faces an overwhelming problem: none of the players trust each other. US-Pakistan relations have deteriorated over the past two years largely because of Afghanistan. They are only now being mended. US officials are still deeply sceptical about whether the ISI and the military are genuinely changing policy towards the Taliban.

Mr Karzai has been at odds with the US over a range of issues including whether the US should have a long term presence in Afghanistan, whether it should hand over all Afghan prisoners to Afghan authorities, and how to map out a common process for peace talks and curbing corruption within the government. Mr Karzai still finds it easier to lambast the US in his speeches than to admit to any faults of his own or to improve governance.

The Taliban of course trust nobody. They blame the Americans for the shut down of the Qatar process and now face tumultuous internal disagreements over whether those talks should be revived or not. The Taliban are dependent on the Pakistanis but loathe the ISI for its past micro management of their affairs and they consider Mr Karzai a worthless American puppet.

Time is now of the essence. Any talks will need months, possibly years, but everyone – even the Taliban – would like to see a ceasefire in the war before 2014 so that the Americans can withdraw and a new political process start in Kabul. Mr Karzai cannot be a candidate for presidential elections in 2014, which offers the opportunity for a new and invigorated Afghan leadership, which the Taliban could accept as a negotiating partner.

The Americans in particular need to appoint a heavyweight diplomat to take the AfPak process forward and Mr Obama needs to personally get engaged. NATO countries need to play less of a waiting game and be more proactive in pushing the US to speed up the talks. Above all the Afghans who have battled outsiders and each other for 34 years need to show maturity and seek a peaceful resolution to their wars.

The writer is the author of ‘Pakistan on the Brink – The Future of Pakistan, Afghanistan and the West.’

The Syrian endgame has begun. The insurgents are digging into the outskirts of Damascus; large swathes of northern Syria are in rebel hands; when President Bashar al-Assad’s helicopters and jets venture out against rebel strongholds, they get shot down. Mr Assad now faces the prospect of dying at the hands of the rebels or of his own supporters if he tries to flee.

The agonised questions the international community has been asking for the last 18 months are becoming irrelevant. Do we arm the rebels? They are already armed. Do we provide them with safe havens? They have them already. Can we stop the killing? Not anymore.

As endgame approaches, the real question is whether, having done so little to secure the rebels’ allegiance, Western governments have any leverage to shape their conduct now that they are winning. The US will soon anoint the Syrian opposition as “the” legitimate representative of the Syrian people, but the militias inside the country who have done the fighting will not surrender power to these ‘outsiders’ without a struggle.

If nearby Iraq is any guide, outsiders will be swept aside by insiders and the transition from violence to politics will be bloody.

When the regime eventually falls, pent-up forces of vengeance will be unleashed. The Alawite, Kurdish, Christian and Druze minorities have reason to fear the day the Sunni majority takes Damascus. Sectarian warfare may break out in a country littered with unsecured chemical weapons.

The challenges facing any post-Assad Syrian leadership will be daunting: securing these weapons, protecting minorities from revenge massacres and preventing the Syrian state from disintegrating altogether into warring sectarian enclaves.

The armed groups who come out on top in the struggle will seek outside help, and each outside actor, whether it be the Qataris, the Saudis, the western governments or the Russians, will struggle for influence over a chaotic situation.

There is still reason to believe that the worst can be avoided. No matter how virulently the UN Security Council disagreed about intervention while the civil war was raging, they have a strong motive to come together now that it approaches its end. The Russians, Americans, Saudis and all of Syria’s neighbours, including the Israelis, have an interest in preserving the integrity of the Syrian state, keeping weapons of mass destruction out of the hands of terrorists and ending sectarian blood-letting that could further destabilise Jordan and Lebanon.

It’s not unimaginable to see the Russians and Americans co-operating in a joint UN mandated force to secure weapons stockpiles; or to see them jointly promoting a strong UN political mission to channel the factions of Syria towards constitution making and elections. The reason that erstwhile antagonists like Russia and the US might co-operate in a UN mandated transition in Syria is paradoxical: each has lost something by doing nothing in Syria, and all might gain something if they act together to secure an end to bloodshed there. This is the outcome most devoutly to be wished for in 2013.

The writer is a former Canadian politician, now teaching at the University of Toronto

The US heads toward 2013 fearful of the fiscal cliff. President Obama and congressional Republican leaders are arguing over tax burdens on the well off and the correct balance between revenue increases and spending reductions. As the President’s economic advisors surely know, economic evidence points to fiscal consolidations being overwhelmingly about spending restraint, rather than revenue increases. But the battle at the cliff is political rather than economic and can best be analysed as such. Next year will bring a forced discussion of political choices.

Three observations shape this intellectual meal in the new year.

First, the principal decision is about the size and scope of government. This is less about defining a percentage of gross domestic product government should account for than about what role government should play. We want to secure our defence and invest in physical and human capital. What, though, of the welfare state? If we seek social insurance for the least well off, the size of government relative to the economy need not change much from historical norms. If middle-class entitlements are our goal, the size of government will increase.

Second, a larger government will require higher taxes — on everyone. After a New Year’s Eve policy hangover, we will realize that a larger government cannot be paid for simply by ‘taxing the rich.’ All of the tax increases on upper-income households currently proposed may be as much as 1 per cent of GDP. While a significant sum, deficits in the near term –and, more important, in the long term — are an order of magnitude greater. If in 2013 the public accepts a vision of a large government, a tax system that can raise much more revenue from many more people will be needed. Industrial economies with much larger welfare states than the United States typically pay for that largesse with less progressive, broader-base tax systems.

Third, there is little chance of escaping a fiscal trap of high debt and crushing tax burdens without a resumption of more salutary economic growth. Faster growth raises living standards, of course, but also reduces debt burdens relative to the size of the economy, easing the pain of needed fiscal consolidation.

These observations point to two paths, one in policy, the other in process. First, a shift toward consumption taxation to reduce distorting corporate and individual income and payroll taxes can raise economic growth and more revenue. There have been many recent proposals from economists for progressive consumption taxes — some of which can be implemented with not too many changes from our present tax structure. Nor do we have to change all at once. Twenty years ago this month, then US Treasury Secretary Nicholas Brady outlined in a speech at Columbia Business School a plan to use a modest consumption tax to decrease the elements of the income tax most harmful to growth – particularly taxes on business income and payrolls. A shift toward consumption taxation is a pro-growth support for a smaller government; it would be all the more necessary for financing a larger one.

Second, the fiscal dysfunction that rings in the new year is less an economic problem (its solution for any likely desired size of government is not beyond our grasp), but a political one. Modern deficits and debt, in contrast to historical budget patterns, are less about debt build-ups in war and pay-downs in peace than about the unchecked rise of the welfare state. As a consequence, the new Congress will talk about process. One adaptation would be to place on the explicit budget increases in accrued liabilities of entitlement programs, with such increases requiring higher taxes or offsetting decreases in other spending. If the sirens’ song is still too tempting, a mast of a constitutional requirement for budget balance over a multi-year period must be considered.

These thoughts suggest clear tasks for President Obama and congressional Republican leaders. Given his vision of more generous social insurance and a larger government, the president needs to articulate a path of tax increases for all Americans – higher income taxes or a new consumption tax. While they have articulated the case for tax reform, GOP leaders must define more clearly the size and scope of government they seek. This definition should focus on a safety net version of Social Security and Medicare, with declining generosity for high-lifetime-income individuals.

So what will happen at midnight before the new year? U.S. leaders should agree on a 10-year deficit targets with revenue and spending components, but then quickly adopt a new year’s resolution of a real debate about the role of government and how it will be paid for. With the next election in 2014, 2013 will be the last opportunity for awhile for big change – watch closely.

The writer is dean of Columbia Business School and former chairman of the Council of Economic Advisers under President George W. Bush

We must be cautious of drawing firm conclusions from Friday’s US job report, given the impact of Hurricane Sandy. But when placed in the context of all of this year’s monthly data releases, a much clearer picture emerges of the state of the labour markets.

America’s employment situation has steadily improved in the course of 2012. This progress, while very important, is unlikely to constitute as yet the critical mass required to fundamentally alter the underlying dynamics of the economy. As such, more needs to be done by policymakers and politicians in Washington – particularly to reduce the risks of durable impairments to the functioning of the labour market, and the potential threat that this poses for growth and income distribution.

While still high, both in historical terms and relative to what is desirable and attainable, the unemployment rate has trended down for most of the year. At 7.7 per cent, this widely-followed headline number ends the year well below its starting level of 8.7 per cent (and well below the 10 per cent of October 2009). This year’s monthly average for the unemployment rate is now almost a full percentage point lower than the monthly average for 2011. A prominent part of the reduction has come in internationally-competitive sectors, led by manufacturing. Meanwhile those with jobs have seen a modest increase in their earnings in 2012. Average hourly earnings have risen by 25 cents to $19.84 while hours worked increased by just under 2 per cent.

These are welcome indications that the labour market continues its gradual healing after the extreme trauma and severe dislocations inflicted by the 2008 global financial crisis. But these improvements have to be accelerated if America is to fully overcome an unemployment crisis that weakens social cohesion and aggravates inequalities of income, wealth and opportunities. Otherwise, the healing process will plateau, leaving joblessness too high and the labour market too exposed to disruption from exogenous factors, be they domestic or global.

Concerns about the persistent fragility of job creation reflect three realities:

First, the decline in the headline unemployment rate overstates the amelioration in the employment as a whole. About half of the improvement is statistical rather than fundamental: it is due to Americans dropping out of the labour force as opposed to getting new jobs. Indeed, the labour force participation rate ends the year at 63.6 per cent, compared to 64 per cent a year earlier.

Second, with 4.8m Americans unemployed for more than six months now, insufficient progress has been made in 2012 to reduce long-term joblessness. As such, the country still faces too high a risk of skill atrophy and lower labour mobility.

Third, youth unemployment has remained a troubling issue throughout the year. Almost a quarter of the 16 to 19 year-olds in the labour force are yet to secure employment, an alarming dynamic which stubbornly has not changed much all year. Some are at high risk of becoming unemployable as the rank of those looking for work for the first time is bolstered each year by new school leavers.

These realities should be front and centre in Washington given both their immediacy and their long-term consequences. They are not. Instead political “interactions” focus almost entirely on creating, and then addressing, homemade problems, which then play Russian Roulette with the economy – the latest being, of course, the fiscal cliff.

Washington’s bickering sure makes for good theatre and gripping drama. Sadly, it also crowds out efforts to design, implement and sustain the more responsible and visionary economic policymaking that the US desperately needs and should be able to deliver.

Friday’s employment report is yet another reminder that the human cost of Congress’ political dysfunction is real, and its incidence risks spreading to the next generation as well.

Mr Carney, your adopted country needs you! That, it seems, is the main message from the Chancellor of the Exchequer’s Autumn Statement.

If George Osborne’s fiscal plans are ever to add up, he will need all the help he can get from the Bank on the other side of London. The chancellor of the exchequer’s austerity measures in themselves will do little, if anything, to support growth yet he desperately needs growth to make his fiscal numbers add up.

Thankfully, according to the Office for Budget Responsibility (OBR), the UK still has plenty of spare capacity. The output gap – the difference between actual and “potential” levels of gross domestic product – will increase to 3.5 per cent in 2013 and, even with an assumed recovery in economic growth in later years, will still stand at a whopping 1.9 per cent in 2017.

From the chancellor’s point of view, these projections are more than a little handy. He can claim that, despite a still-uncomfortable headline fiscal position, the cyclically-adjusted path is not so bad. Indeed, within the Autumn Statement, the cyclically-adjusted deficit magically disappears by 2016-17.

Chancellors of the exchequer typically assume an air of omniscience unbecoming in mere mortals. By doing so, they can assume their fiscal problems away. It was a strategy pursued with some considerable success by Gordon Brown before things went rather horribly wrong. Mr Osborne is in danger of following the same well-trodden path.

He can claim his forecasts come from the independent OBR, of course, but his fiscal numbers only make sense if the UK economy eventually bounces back. He’s used that approach for a number of years now. Unfortunately, it’s not working.

To see why, consider the forecast errors made by the OBR since its first foray into the predictions business in the middle of 2010. Back then, it projected growth of 2.3 per cent in 2011 followed by gains of 2.8 per cent, 2.9 per cent and 2.7 per cent over the following three years. By 2015, it thought output would be only 0.9 per cent below potential. Thanks to these gains and, alongside them, a dose of austerity, the cyclically-adjusted balance on the current budget was supposed to be in surplus to the tune of 0.3 per cent of GDP by 2014-15.

We now know, of course, that these projections were hopelessly optimistic. Over the last two years there has been hardly any growth. The OBR is now a little less gung-ho about the future. Yet, despite this new-found caution, and despite a much bigger than expected level of public sector net borrowing in future years, the Chancellor still has no difficulty meeting his medium term target for the cyclically-adjusted current surplus. True, the surplus turns up two years later than originally planned but, nevertheless, it’s still there. Yet we have an economy that has gone from bad to worse.

Mr Osborne is able to generate a surplus only because the OBR assumes that the continued growth shortfall is mostly cyclical in nature: near term losses will be offset by longer-term gains. Yet while the output gap charade works perfectly well as a device to keep Mr Osborne’s cyclically-adjusted deficit on track, it totally fails to deal with what is fast becoming a relentless increase in government debt as a share of GDP.

Imagine that the OBR’s forecasts over the next two or three years prove to be as excessively optimistic as they have been in the recent past. Under those circumstances, the debt to GDP ratio would be heading through 90 per cent of GDP, 20 percentage points above the estimates provided in 2010. Borrowing would also be significantly higher. The only way to make the numbers “add up” would be to assume – again – that all the weakness was cyclical. The OBR would have to claim that the output gap was getting bigger in each and every year.

This is where Mr Carney comes in. Mr Osborne has been at pains to emphasise that plan A is still intact. He is promising continued austerity, at least for those at the top and bottom ends of the income scale, even if the middle isn’t being squeezed quite so much. Yet he also desperately needs growth. If fiscal policy can’t do the trick, he’ll have to rely on monetary policy instead.

That, at least, is the theory. In practice, however, it hasn’t been quite so easy. The OBR’s relative optimism in 2010 was conditioned on the idea that quantitative easing would work reasonably well. So far, however, despite a near-doubling of QE since then, the results have been disappointing. The hoped-for recovery hasn’t materialised. Moreover, some in the Bank of England now fretting about the emergence of “zombie” companies and banks are wondering whether QE is all it’s cracked up to be. Others, meanwhile, might be wondering whether QE is merely a device to allow the government to miss its fiscal targets without having to face the prospect of higher yields thanks to a perceived increase in credit risk.

Underneath all this is a much more serious problem. It may simply be that our supposedly cyclical problems are, in fact, structural in nature. The credit system isn’t working well. Productivity is in decline. We export too much to the stagnant eurozone and not enough to more dynamic parts of the world. Despite all the austerity, the public sector still absorbs a huge chunk of GDP.

If so, despite his undoubted skills, Mr Carney will struggle to fix Mr Osborne’s problems. Indeed, if he disagrees with the OBR’s assessment of the output gap, Mr Carney may be wise to deny he has the necessary magical powers.

Shintaro Ishihara, the former governor of Tokyo, recently unveiled a new political party which, he says, will help build a “stronger and tougher Japan”. This is the same Shintaro Ishihara who recently provoked an increasingly bitter row with China over control of a string of islands in the East China Sea. As Mr Ishihara and other leading Japanese politicians strike a more strident foreign policy tone and a more aggressive attitude toward China, they should consider the recent history of a quite different country in a quite different region.

When Mikheil Saakashvili rode Georgia’s Rose Revolution to power in 2004, the international community lauded the small nation’s transition to democracy. Mr Saakashvili quickly reached out to Washington and the Bush administration, eager to build a new strategic friendship in the region, reached back. But US officials worried aloud that Mr Saakashvili, convinced that US support offered him a shield, might stumble into conflict with Russia, Georgia’s hostile neighbour to the north. Four years later, exactly what happened.

Georgia’s young president, eager to score patriotic political points by standing up to the superpower bully next door, sent tanks into the breakaway region of South Ossetia, giving Moscow the opening it needed to push the Georgians almost all the way back to Tbilisi, Georgia’s capital. The US remained on the sidelines, reminding Georgia’s president that it had warned him about poking the bear. As then Secretary of State Colin Powell had warned him, the United States would not go to war with Russia over a breakaway province in the southern Caucasus.

There is a lesson here for Japan as tensions build over a string of contested islands in the East China Sea. Japan calls these rocks the Senkaku Islands, China calls them the Diaoyu Islands, and both countries claim ownership. When Japan recently moved to assert its claim, anti-Japanese protests surged through Chinese cities, and the Chinese government let them burn a bit longer than usual before dousing the flames.

Chinese demonstrators destroyed many Japanese stores and products and called for boycotts of Japanese companies, inflicting serious damage in a market that is increasingly important for Japanese corporations. In September Toyota and Honda’s sales in China were respectively 49 per cent and 41 per cent down on the same month last year. Some Japanese firms are rethinking their expectations of sales in China and reluctantly looking toward other countries for a larger share of exports and supply chains.

In addition, China is becoming more assertive in the contested waters between the two countries. In the East China Sea, China has moved ships into Japanese territory almost every day for the past month. Beijing’s message to Tokyo is clear: “Don’t push your luck.”

The concern in Washington is that Tokyo isn’t listening. Despite both the commercial and security dangers, some Japanese officials have lately tried to score points at home with an aggressive posture abroad, including in dust-ups with China. Old arguments about the 1930s are stiffening spines in both countries. The growing prominence of leaders like Toru Hashimoto, the mayor of Osaka, who has built another new nationalist party, and men like Mr Ishihara who have actively brought Japan and China closer to commercial and political conflict, has raised temperatures across the region. It was Mr Ishihara who provoked the Senkaku spat by threatening to use municipal funds to buy the islands.

Japan’s Liberal Democratic Party may well return to power following upcoming elections—elevating party leader and former prime minister Shinzo Abe back to his old job. He will have to move quickly to build his popularity with voters—this is a country that has burned through 17 prime ministers in 24 years—if he is to earn enough public confidence and political capital to extend his rule. He has offered conciliatory comments toward Beijing, but an October visit to the Yasukuni Shrine, resting place of men that Japan’s neighbours consider war criminals, suggests he might be willing to push things a bit further with China when his poll numbers slide.

Japan is not Georgia, a small country that must lie in Russia’s long shadow and make friends where it can. Georgia is a developing country with crumbling infrastructure and a host of fundamental economic challenges. Japan, for all its problems, remains the world’s third largest economy. It is a stable industrialised democracy and home to some of the world’s most dynamic multinational companies.

That said, Japan should learn from Georgia and avoid a confrontation with its neighbour. China still needs access to Japanese markets. It wants to welcome Japanese companies and investments, and gain more access to Japanese technology. But it doesn’t need any of these things as much as it did five years ago, and the trend is not good for Japan. As China signs deals with new partners in the region, as Chinese customers in the US and Europe recover more of their purchasing power, and as Chinese consumers are able to afford more Chinese-made products, Japan’s importance for China will continue to diminish.

China’s leaders are just as likely as Japan’s to try to build their popularity by demonising an often threatening neighbour. In Georgia Mr Saakashvili hoped to boost national pride with a quick win, but it was Vladmir Putin who came away looking like a winner. Japan’s leaders should keep that lesson in mind.

Finally, Japanese Defence Minister Satoshi Morimoto called last week for a revision of Japan’s security alliance with the US to put greater emphasis on the Chinese maritime threat. Talk of historic partnerships is one thing, and US-Japanese relations are vitally important for both sides. But though Washington can and will come to Japan’s defence if China tried to take the Senkaku islands, it cannot defend Japanese companies that are sure to take a beating in Chinese markets. That’s the true battlefield.

The best way for Japan to meet the challenge posed by rising China is to rebuild the dynamism of Japan’s economy from within and to build new commercial ties–in Asia and beyond. That will require wisdom, patience and political will. If the country’s next generation of leaders is up to the task, they will discover that success is the best defence of national interests.

The writer is the president of Eurasia Group, a political risk consultancy, and author of ‘Every Nation for Itself: Winners and Losers in a G-Zero World’

Since April the Democratic Republic of Congo has been engulfed in civil strife. In recent weeks a rebel group, M23, has made striking gains, capturing Goma, capital of the DRC’s North Kivu region, where fighting has displaced tens of thousands of people.

The M23 rebels are widely believed to be backed by Rwanda, a country which borders the DRC. What appears to be an internal African conflict, involves western government. Britain is a major donor to both the DRC and Rwanda, where British bilateral aid trails only the US. Rwanda’s budget is heavily aid dependent.

Judging the ‘overall evidence of Rwandan involvement with M23 in the DRC to be credible and compelling’, last Friday the International Development Secretary Justine Greening justifiably took the decision to cut £21m of direct UK government support to Rwanda.

That action should on the face of it have an impact. More than 48 per cent of Rwanda’s budget is funded by donors. The European Union, the US, Germany, the Netherlands and Sweden have already suspended aid to Rwanda – the World Bank will not put forward further requests for money to its board, fearing it is financing the rebellion. Whatever Rwanda’s government says about being able to manage, this will have consequences for a country still recovering from the 1994 genocide.

But the main impact will be felt by Rwanda’s poor. Britain will restrict aid that has contributed to lifting 1m Rwandans out of poverty in the past five years. Cutting back on aid is less likely to materially change the direction of Rwanda’s involvement in the neighbouring DRC.

Aid is being used to as an attempt to put Paul Kagame on the political rack and force him to withdraw support for M23. Instead we are likely to see the limits of the influence of aid as a tool of influence. The Kivus represent a new and unsettling kind of political economy in Africa where the scramble to control mineral and energy resources amidst weak and failing states is creating much more powerful imperatives than aid flows. The region is poor, under-governed and far away from the country’s capital Kinshasa yet rich in minerals like tin, gold, cobalt and most importantly colombo-tantalite or coltan, which is vital for mobile phones. The DRC is home to between 60 and 80 percent of the world’s coltan reserves. The Kivus are a microcosm of the crisis that mineral wealth is inflicting upon Africa.

The province of North Kivu has been the epicentre of war in the DRC. It has generated over two dozen armed groups over the past decades, often controlled by local elites in Kigali and Goma seeking to further their business and political interests. In the case of M23, their links to Rwanda and particular have been well documented by the UN Group of Experts report, which uses everything from satellite footage of foot trails used by militia roaming across the Congo-Rwanda border, to variations in local language to reveal soldiers’ true identities.

Yet the ultimate aims of M23 remain inscrutable. The exact nature of their ongoing relationship with Rwanda is unclear. And it is not just Rwanda, which has an active interest in this conflict; Uganda, Zimbabwe and Angola are all also involved. Whatever the guilt of Rwanda the broader issue is how to make the Eastern Congo a viable prosperous and well governed entity rather than a honey pot of mineral wealth amidst a power vacuum that all sorts of chancers will always try to fill.

After each of the four major Rwandan linked incursions into the DRC since the 1990s there has been talk of an economic development plan and indeed some kind of loose open market that allows the free movement of goods and people. This seems the only way to channel the demographic pressures of an overcrowded Rwanda on the edge of the half empty Kivus, that is a mining and gem dealing magnet for the region, away from conflict to commerce.

It also might allow a political stability to to take hold which would reduce the risk of disgruntled Hutu rebels reorganising in order to take the fight back into Rwanda against a regime they still oppose. Only when the vacuum of governance in the Kivus is solved will Rwandan meddling end. In the meantime aid suspension is a bit of a sideshow except for those in Rwanda’s schools and hospitals who will quickly feel its absence.

When the Bank of England was made independent in 1997 it had to surrender its power to supervise the banking system. Parliament used two main arguments to justify this. The first was that there is a conflict of interest between monetary policy and the conduct of banking supervision. The second was that banking supervision cannot be as independent as monetary policy, and therefore needs to be much more accountable to the political authorities.

Both arguments proved wrong, not only in theory but also in practice. And not only in England.

Rather than a conflict of interest between monetary policy and bank supervision, the opposite has turned out to be true in recent years. The lack of information on the solvency of the banking system made it much more difficult for central banks, such as the BoE, to interpret market developments and to provide liquidity to sound institutions only. National supervisors had the tendency to paint a rosy picture of their financial system, which enabled banks to easily qualify as counterparties for central bank operations.

It is also unlikely that independent central banks that are accountable for their monetary policy objective, in terms of price stability, would seek to use monetary instruments for other reasons. Trying to address banks’ solvency problems by extending central bank liquidity support is not very effective over time. Furthermore any attempt to manipulate monetary policy for other purposes would become apparent if there were sufficient transparency of central banks’ operations.

The conflict of interest argument might have been an issue in the old days of politically dependent and non-transparent central banks. It is less relevant today. The opposite may actually be true. Without bank supervision powers the central bank may nevertheless be induced to use monetary policy to resolve problems created by ineffective bank supervision out of fear that those problems might impact on financial stability and, as a consequence, on price stability.

The argument that the prudential supervision of banks requires a “different type” of accountability – in other words less independence – than monetary policy, because taxpayers’ money is at stake is also flawed. The taxpayers’ money argument could also be valid also for monetary policy. A decision to raise the policy rate or cut it at the wrong time might cost the economy – and thus the taxpayers – even more than rescuing a failed bank.

Bank supervisors should apply regulations and take early action, presenting the political authorities with the available options in case of bank resolution, at an early enough stage that the appropriate solution can be taken, with a view to minimise the burden on taxpayers. The Basel principles on banking supervision state that independence is essential in order to perform such a task properly.

Bank supervisory authorities that are not sufficiently independent, and are too closely associated with the political authorities, are generally under pressure to delay the identification of insolvent banks, for the fear that taxpayers would get upset. The problem thus tends to be postponed, and the cost to the taxpayer rises. The experience of the recent crisis has shown that taxpayers have paid most in countries where supervision was less independent and where the political authorities are most closely associated with the banking system.

So why, in spite of this evidence, and the lack of serious analysis, are these arguments still used, for instance in the discussion about the attribution of supervisory powers to the ECB? Why are the proposals which have been put on the table so insistent on the separation between monetary policy and supervisory activity?

Being slave of some defunct economist –to paraphrase Keynes – might be part of the answer. A more likely reason is the fear of creating a too powerful institution at the heart of Europe, with both monetary policy and bank supervision powers, that “nobody can control”. Every time a campaign has started to move responsibilities to the European level, opposite forces mobilised to water down the effort and try retain some powers in the hands of the national authorities.

When the euro was created, several academics and commentators suggested that a single currency and a single market required a single regulator. The issue was analysed by European Finance ministers at least twice over the last few years, on the basis of the Lamfalussy report in 2001 and the De la Rosière report in 2009. The reform process was each time slowed down by the argument that the existing, decentralised system had worked well and would continue to work well, possibly strengthened by some form of enhanced cooperation. The underlying attitude was: “If it ain’t broke, don’t fix it”.

The crisis has shown that the system is indeed broken.

Had there been a single supervisor from the very start of the euro, independent like the ECB, the truth about some of the most problematic banks would probably have come out earlier. The excess leveraging accumulated in some countries would not have been tolerated for so long. The stress tests conducted since the start of the crisis would have been applied seriously, in a homogeneous way across countries. The cleaning up of banks’ balance sheet would have started earlier.

A single supervisor would probably have confronted several governments at an early stage of the crisis with clear-cut decisions aimed at ensuring an adequate capitalisation of their banking systems, as happened in the US. Maybe that’s what some actually did not want. But that’s what the eurozone needs in order to solve the crisis and avoid new ones in the future.

The author is Visiting Scholar at Harvard’s Weatherhead Center for International Affairs and at the Istituto Affari Internazionali

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