Monthly Archives: January 2013

Historically, the drive for tax reform in the US has focused on the individual income tax. The ideal, epitomised by the Tax Reform Act of 1986, has been to broaden the tax base and thereby reduce statutory tax rates in a revenue-neutral manner.

American observers, however, now believe that the so-called fiscal cliff deal that President Barack Obama and congressional Republicans agreed to on the first day of the year has in effect taken individual income tax reform off the table indefinitely.

The reason is that the fiscal cliff deal raised the top individual income tax rate from 35 per cent to 39.6 per cent and raised the maximum rate on dividends and capital gains from 15 per cent to 20 per cent. Having just expended enormous political capital to raise rates, it is exceedingly unlikely that Mr Obama would then turn round and agree to cut them again in some sort of tax reform.

Moreover, the improving but still large federal budget deficit means there is going to be continuing political pressure to raise revenues. Both Republicans and Democrats agree that higher rates are off the table and that new revenues must come from closing tax expenditures, which will make them unavailable to finance rate reductions.

Thus it appears that there is no potential for a tax reform deal in the traditional sense. But there is a growing need for it on the corporate side of the ledger that may yet become a vehicle for meaningful tax reform.

Members of both political parties are keen to reduce the statutory corporate tax rate from 35 per cent, which is high by international standards, to perhaps 25 per cent. The problem is that if revenue neutrality is demanded, no new revenue source such as a financial transactions tax is permitted, and the base-broadening is confined to the corporate side, there is a problem. There are not enough corporate tax expenditures available to finance the rate reduction that everyone thinks is necessary.

The Congressional Research Service has estimated that the lowest statutory corporate tax rate possible that is financed entirely by closing corporate tax expenditures is 29.4 per cent in the long run. And this is a very optimistic calculation because it would require the elimination of accelerated depreciation, a very popular tax preference that has long enjoyed bipartisan support.

Getting the rate that low would also require treating the large and growing unincorporated business sector the same way as traditional C corporations. Such companies are often assumed to be small businesses that are large job generators. Under current economic and political circumstances, it is highly unlikely that Congress would do anything deemed to raise taxes on small businesses.

The one big tax preference theoretically available to finance a rate reduction is deferral on foreign source income. Presently, the US taxes the income of foreign subsidiaries of US-based multinational corporations, but only when repatriated to America. Income remaining offshore is untaxed by the US.

This tax regime obviously makes it expeditious for multinational corporations to realise their profits offshore and keep them there, neither taxed by the US nor available to shareholders as dividends. This often involves legally dubious techniques such as selling intellectual property like patents to foreign subsidiaries at a price far below market value.

By borrowing in high-tax jurisdictions, thus maximising the deduction for interest expense, and realising profits in low-tax jurisdictions to the greatest extent possible, US-based multinational corporations can defer a vast amount of taxation indefinitely. Another Congressional Research Service report estimates that US-based multinationals realise about $1tn of profits a year in foreign jurisdictions.

The following chart from the CRS report illustrates the extent to which US-based multinational corporations have shifted their profits from relatively high-tax jurisdictions such as Australia, Canada, Germany, Mexico and the UK to low-tax jurisdictions such as Bermuda, Ireland, Luxembourg, the Netherlands and Switzerland.

Profits of US multinational corporations in selected country groups as a percentage of total profits reported abroad by American MNCs

American NMCs








Source: Congressional Research Service analysis of US Department of Commerce data

It is important to emphasise that little in the way of real economic activity, such as jobs or tangible investment, has shifted anywhere. All that has shifted is the tax base.

The Internal Revenue Service and the OECD have struggled for some years to deal with the problem of income shifting and tax avoidance, to little avail.

This makes the international tax regime a ripe target for reformers. Some type of one-off reform that lowers rates and eliminates deferral is theoretically achievable. The payoff would be taxation of the vast hoard of liquid assets estimated to be held in foreign accounts by US-based multinationals, estimated by the Pulitzer Prize-winning journalist David Cay Johnston at $3.4tn.

With reports of low domestic taxes paid by large profitable corporations such as Starbucks in the UK, the time may also be ripe for an international agreement to curb tax shifting. The US has recently implemented a law called the Extractive Industries Transparency Initiative that requires companies to disclose their payments to governments from oil, gas and mining assets. Allison Christians of McGill University argues that the expansion of such information reporting to the transfer pricing of all multinationals is the first step towards capturing the revenue now lost to the shifting of business costs to high-tax jurisdictions and revenues to low-tax jurisdictions.

There is growing evidence that corporations are sensitive to the public outcry when they are caught avoiding taxation excessively. Starbucks, for example, recently agreed to pay more taxes in the UK than legally required to quell the controversy over its virtually nonexistent tax bill. The same shaming technique may have broader application to multinationals generally.

As Justice Louis Brandeis of the US Supreme Court once put it, “publicity is justly recommended as the remedy for social and industrial diseases”.

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

Currency wars may be all the rage but they are merely a symptom of a much more deep-rooted problem. We are witnessing the return of economic nationalism. At the 2009 London Group of 20 summit, it seemed for a fleeting moment that nations had learnt how to work together to solve the world’s economic and financial problems. That dream no longer holds. Persistent economic stagnation has left our political leaders increasingly looking for national solutions to what have become deeply-entrenched international problems.

Their approach is hardly surprising. Politicians are accountable more to their own electorates – and their local media – than to anyone else. In the good old days, when globalisation appeared to deliver rising living standards for all, there was no conflict: our leaders could simultaneously support the architecture of globalisation while taking the plaudits for prosperity at home. That’s all changed. While globalisation has most certainly dragged millions of Chinese and Indians out of poverty and turned rich westerners into the super-rich, that is scant consolation for those millions of western citizens heavily in debt and without a pay rise for many years.

It is not so much that nations are becoming deliberately more protectionist. Rather, the cheerleaders for globalisation have gone into hiding. They can no longer so easily claim that the forces of internationalisation have brought benefits to all. Without those cheerleaders, however, the temptation to pursue economic nationalism becomes ever greater.

Economic nationalism, however, is riddled with contradictions. It might make sense for policy makers in one country alone to pursue currency devaluation, particularly if the evidence suggests a currency is significantly overvalued. But it cannot make sense for many countries to pursue devaluation policies all at the same time: they cannot all, simultaneously, have overvalued exchange rates. Similarly, it might seem reasonable for those countries with low levels of debt and “healthy” balance of payments positions to demand that others follow in their footsteps yet it simply is not possible for all nations to run current account surpluses, despite the wistful hopes of economic conservatives in Germany.

We cannot help but live in an interconnected world. Those connections, for good or bad, shape all our economic destinies. Economic nationalism, in effect, ignores those connections. It pretends that countries can be masters of their own destinies, marching to their own beat even as other nations head off in entirely different directions. It is, in truth, no more than a populist fiction: the ups and downs of the economic cycle in any one country are closely attuned to similar movements elsewhere; the success of currency devaluations depends on both the willingness of foreigners to buy bargain-basement exports and the extent of any increase in domestic inflation thanks to higher import prices; the benefits of quantitative easing will be attenuated if it leads to significantly higher commodity prices; and attempts to raise taxes to bring budget deficits under control may simply lead to an exodus of talent from, say, Paris to London.

Mohamed El-Erian is absolutely right to warn of the dangers to the eurozone associated with the easy monetary policies pursued elsewhere in the world. If the Japanese succeed in delivering a weaker yen, if the Americans continue to print money in an attempt to bring their unemployment rate well below 7 per cent and if a Mark Carney-led Bank of England pursues a new growth-friendly strategy with an air of relaxed detachment about price stability in the short term, the danger is that all the good work achieved by Mario Draghi in stabilising the eurozone monetary system last year will unravel. Labour costs in southern Europe are still too high; a much stronger euro will only serve to crush hopes of an eventual growth renaissance.

The consequences of such a failure would undoubtedly be painful. More than anything else, southern European countries need growth to enable them to soothe their fiscal positions. In the absence of growth, those fiscal positions will only get worse. Even with the contingent offer from the European Central Bank of outright monetary transactions, higher government debts would eventually trigger a crisis as much political as economic. For how long would the creditor nations of northern Europe be happy to support the uncontrollable debt trajectories of those in the south? And if support eventually waned, would the eurozone economy then, once again, be teetering on the brink of a recessionary abyss?

This danger reveals an underlying truth about economic nationalism. It too often leads not so much to faster growth but, instead, to an international redistribution of economic pain. We are witnessing a battle between the interests of international creditors and debtors. With levels of global output much lower than expected only a handful of years ago, creditors are incentivised to shift the burden of adjustment on to debtors, demanding painful austerity for those who have “sinned”. Debtors, meanwhile, are incentivised to pass the burden of adjustment on to creditors through currency devaluation, default and bailouts.

Faced with these competing incentives, it is no great surprise that we cannot return to the growth rates of old. Economic nationalism may offer near-term pain relief but, as a political response to economic failure, it only risks locking in that economic failure for the long term.

The writer is HSBC Group’s chief economist and the bank’s global head of economics and asset allocation research. His new book, ‘When the Money Runs Out: The End of Western Affluence’, is due to be published by Yale later this year

It is easier to make money than sense out of China’s banks. These big four state-owned commercial banks are huge profit centres, but many who see vulnerabilities in China’s economy think these banks are the problem when they actually reflect symptoms of distortions elsewhere. China’s banks are in fact too secure – and their performance could be improved by strengthening competition and breaking up the “too big to manage” entities.

Many critics cite inflexible interest rates that are deemed too low relative to inflation as the issue. Others point to excessive government interventions fomenting risks such as a property bubble. Still others remind us the state-owned banking behemoths are sitting on a mountain of household deposits that feed into temptations to misuse captive funds given lax governance safeguards.

But China’s interest rates are already relatively high in real terms compared with other major economies in a global monetary system flooded with liquidity. Its capital markets lack the depth for interest rates to be shaped by market forces and the dominance of the big four banks reduces the benefits of having more flexible rates. The emergence of a property bubble has more to do with capital controls that discourage investors from moving their savings abroad and thus encourage speculation in the domestic property market. And these huge deposits are a natural consequence of the massive savings in an economy with limited investment options.

More recently further concern has been caused by the emergence of new wealth management products and shadow banking that allow for higher returns to savers but at the cost of introducing riskier and unregulated instruments in an otherwise stultified system. These initiatives are broadly to be welcomed rather than discouraged. They provide more diversified options for savers and are shaking up a system that has relied too long on just channelling funds to state entities, leaving unmet the needs of potentially more dynamic private enterprises.

Some or many of the borrowers may not meet the criteria that one would wish for and there will be defaults and probably a mini-crisis or two. But these are part of the costs of learning in an otherwise regimented system. Greater transparency along with an appropriate regulatory framework will need to emerge but trying to regulate such activities prematurely could actually do more harm than good by stifling the learning process.

One is hard pressed to come up with indicators that would reveal an imminent banking crisis in China. After all, the big four commercial banks pay a steady stream of high dividends, their non-performing loan ratios are low (even if flawed conceptually), their control over an immense volume of household deposits would be the envy of any other banking system, their lending for mortgages is not highly leveraged, taking a US-style meltdown off the table, and since so much of their activity is geared to state entities or carry explicit or implicit state guarantees, the risks are ultimately less about the quality of the banks but the creditworthiness of the state which remains relatively strong compared with other major economies.

Then what is the problem with China’s banks?

Governance is the issue in a state-dominated activity that provides the glue for much of China’s economy. The incentives for prudent risk taking and adherence to commercial objectives are weak for these banks given their near monopoly position and government interventions. In this environment, admonitions for improved management can only go so far.

The challenge is to introduce more competition in a system that politically will continue to be dominated by the state and where vested interests are exceptionally strong. Given this reality, there are nevertheless actions that could help improve performance. One would be liberalising entry of foreign banks whose presence in China is miniscule at present. This would spur competition and innovation and, contrary to what is believed in China, strengthen rather than weaken the performance of state-owned banks.

A more radical action would be to confront China’s own version of the west’s problem of their banks being “too big to fail”. The counterpart for China is that the big four state-owned banks are “too big to manage”. Breaking them up into three regional banks each would be a powerful means to foster competition and improve governance. This has been a process that has worked well before when China split its national airline into numerous regional entities which then subjected to market pressures resulted in a manageable number of more efficient but still state-owned companies.

These split-up banks would be headquartered in various provinces rather than in Beijing and thus less influenced by politically driven mandates but more by the real needs in their localities. They would not be restricted to operating only in their originating regions but could expand elsewhere and eventually develop a national presence. But they would need to become more commercially oriented and efficient to survive. In this process, some of them would be motivated to seek external partners, as has happened with the airlines, and this would help open the door for increased foreign participation and provide support for further liberalisation.

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

I was reminded recently that there is an important distinction between a problem and a dilemma. A problem has a solution while a dilemma must be continuously managed. The euro’s situation has evolved from being a severe problem to posing a dilemma for eurozone countries seeking to grow and secure debt sustainability.

Six months ago, stress on the European financial system led to existential questions about the euro. The financial system was fragmenting, deposits were pouring out of the weaker countries, and high interest rates were converting liquidity problems into solvency ones, adding to the regional headaches caused by countries already in vicious debt cycles.

Bold policy reactions stopped this dynamic – so much so that, today, several investors are again emphasising rate convergence for many eurozone bond markets. And while harmful credit rationing persists, especially for small- and medium-sized companies in peripheral economies, banks are less fragile.

The immediate solution to the euro’s existential problem came in the form of the European Central Bank’s “outright monetary transactions“. The ECB was supported by the progress made by governments in agreeing to reinforce monetary union with greater fiscal union, political integration and banking union.

Having solved its urgent problem, the eurozone needs to deal with a new dilemma: that of an appreciating currency. There is a growing number of countries seeking to weaken their own currencies. Indeed, in the last six months, the euro has appreciated by 11 per cent against the US dollar and by 8 per cent in nominal trade weighted terms. It has appreciated by a lot more against the Japanese yen.

With growth already sluggish, the eurozone can ill afford a stronger currency. Sharp appreciation undermines economic activity – not only for export powerhouses such as Germany but also for countries such as Spain where, for the past eight quarters, the contribution of net exports has been positive.

With budgetary concerns continuing to dominate mindsets, few countries are able and willing to stimulate their economies by loosening national fiscal policies. As a result, the number of unemployed citizens – which is 6m higher than at the outset of the global financial crisis – remains alarmingly high, and especially so among the young.

Given what other countries are doing around the world, European politicians need to significantly accelerate policy reforms if they wish to maintain competitiveness in a safe and orderly fashion. This involves quickly moving from the design to the implementation of key measures.

At the regional level, productivity-enhancing structural reforms need to accompany a renewed push on fiscal union, banking union and political integration; and, for starters, politicians should not wait for the June summit to press ahead with the “four presidents” report.

But, having averted an existential financial problem, politicians seem more interested to bask in their success than deal with remaining challenges. This understandable desire to savour the moment – and with it, the illusion of stability – is inevitably strong in the run-up to several key elections this year.

With politicians failing to manage the dilemma directly, it is only a matter of time until they again look to the ECB for help.

Expect the ECB to be pressed hard to join other central banks in actively seeking to depreciate the currency – by cutting the policy rate (currently 0.75 per cent) and quantitative easing of the type pursued by the Bank of England, the Bank of Japan and the US Federal Reserve.

This is not a road that the ECB will embark on easily. And if it does, it would seek to address a regional dilemma by adding to a global one.

Being a relative price, all countries cannot simultaneously weaken their exchange rates (except against gold, real estate and other “real” assets). And should the ECB feel forced to join collective attempts to do the impossible, the risks of a global currency war and related beggar-thy-neighbor outcomes would increase meaningfully.

As the new year begins, it may seem hard not to be pessimistic about the global battle to manage the huge risks of climate change, a defining challenge of this century.

The most recent UN climate change summit in Doha made only modest progress. In addition to confirming a second commitment phase of the Kyoto protocol, now based mostly on action by the EU only, it set work programmes ahead of the 2015 summit at which a global deal will be attempted for a post-2020 framework with a unified legal structure.

Doha made crystal clear that the pace of international action is not consistent with the scale and urgency of the challenge the world faces. Evidence mounts that our planet is heating up, and prospects of us preventing dangerous climate change, which all countries have agreed should be avoided by limiting warming to no more than 2C, seem to be receding by the day. Indeed, current projections may imply possible warming of 4C or more to temperatures that probably have not been seen on Earth for tens of millions of years, with consequences that could be catastrophic.

Given this backdrop, it is not hard to see why there is so much pessimism. However, far from this being the hopeless situation some assert, we believe that we may be reaching a point when the tide could decisively turn.

Why the reason for retaining optimism amid so much apparent gloom? If one takes a step back and examines what is happening at national and provincial levels, a wholly different picture is emerging.

In contrast to the pace of international negotiations, domestic laws to address climate change are being passed at an increasing rate. In the past year alone, as described in a new report published on January 14 by Globe International and the Grantham Research Institute, 32 of 33 surveyed countries have introduced or are progressing significant climate or related legislation and regulation.

This is nothing less than a “game-changing” development, taking place across all major continents. Cumulatively, it represents a crucial and vastly under-appreciated change.

For example, China passed its first sub-national legislation last year in order to control greenhouse gases in Shenzhen and is developing a national climate change law. Moreover, Mexico passed a ground-breaking General Law on Climate Change, legislating for a quantified emissions reduction target of 30 per cent below “business as usual” by 2020.

Meanwhile, South Korea passed legislation to begin a nationwide emissions trading scheme by 2015; Bangladesh passed the Sustainable and Renewable Energy Development Authority Act; and Kenya approved its climate change national action plan and its parliament is debating the climate change authority bill. Other important advances have been made by Ethiopia and South Africa and embodied in their medium-term planning frameworks.

One key finding of the report is that developing countries, which will provide the motor of global economic growth in coming decades, are leading this drive. Many, including China, are concluding it is in their national interest to reduce greenhouse gas emissions by embracing low-carbon growth and development, and to better prepare for the impact of climate change.

They see that expanding domestic sources of renewable energy not only reduces emissions but also increases energy security by reducing reliance on imported fossil fuels. Reducing energy demand through greater efficiency reduces costs and increases competitiveness. Improving resilience to the impacts of climate change also makes sound economic sense.

Many governments and companies have recognised that a green race has started, and they are determined to compete. They also recognise that, over time, those that produce in “dirty” ways will be increasingly likely to face “border adjustment mechanisms” which take account of the subsidy associated with their taking advantage of any unpriced pollution.

While progress has generally been slower among the richer nations, some are showing leadership, such as the UK through its 2008 Climate Change Act. In the US, existing environmental regulations are being used to tackle climate change, and states are moving more quickly, such as California, where trading started this month in its new carbon market.

It follows, therefore, that advancing domestic legislation on climate change, and experiencing the co-benefits of reducing emissions, is a crucial building block to help create the political conditions to enable a comprehensive, global climate agreement to be reached. Domestic laws give clear signals about direction of policy, increasing confidence and reducing uncertainty, particularly for the private sector which can drive low-carbon economic growth.

With negotiations on a post-2020 global deal scheduled to conclude in 2015, it is very unlikely that an agreement, with the necessary ambition, will be reached unless more of these domestic frameworks are in place in key countries. Sound domestic actions enhance the prospects of international action, and better international prospects enhance domestic actions.

The clear implication is that more emphasis should be placed on bilateral and regional activities to encourage the advance of domestic legislation between now and 2015. That means greater engagement, primarily, between legislators and parliaments, a constituency that has long received too little attention within the environment and sustainable development agenda.

Taken overall, despite the recent slow pace of the international response to climate change, we are therefore encouraged by the domestic action being taken, particularly by developing countries. To be sure, this is just a beginning and much remains to be done. But there are grounds for real optimism if momentum for action to tackle climate change at the national level continues to build ahead of a strong international agreement in 2015.

Lord Stern of Brentford is chair of the Grantham Research Institute on Climate Change and the Environment and I.G. Patel Professor of Economics and Government at London School of Economics and Political Science, and was formerly chief economist at the World Bank. This article was co-written with Lord Deben (John Gummer), who is president of the Global Legislators’ Organisation (Globe International), a former UK secretary of state for the environment and chairman of the UK’s statutory committee on climate change.

David Cameron made a well-received intervention here in Davos on his priorities for the Group of Eight, which he chairs this year, but inevitably the focus of attention has been the speech he made about Europe, before leaving London.

He was wise to lay his egg at home, as it would have been in the lead balloon category here. Davos Man, and his fur-clad trophy wife, are europhiles, almost to a fault. The eurosceptic tendency is very thin on the ice. You might think that there would be a natural constituency in the alpine confederation, but the Swiss who show up in Davos are typically those who bemoan their lack of influence in the councils of Europe and wish their compatriots weren’t, well, so damned Swiss about it all.

Even the London mayor Boris Johnson, a ubiquitous presence this year, was on his best behaviour, supporting the British prime minister’s careful line, emphasising the positive side, and also referring from time to time to his impeccably eurocratic father. The Duke of York, who genially hosted the British bash, might have his own private views on the European Commission’s working time directive, but they were undisclosed, and it would be inappropriate to speculate on them in a family newspaper.

With these isolated exceptions the spectrum of views here on the prospect of a British referendum on EU membership ran across the range from iffy to bonkers. Those at the iffy end emphasised the time it would take, thought it might be possible to negotiate a face-saving list of concessions, and if all else failed took refuge in the Micawber doctrine, that “something might turn up” to stave off the worst. The “bonkers” crowd took the view that no good could possibly come of it, that the UK would be crazy even to think of leaving the EU, and no foreign company would ever again invest a penny anywhere from Land’s End to John O’Groats.

At a dinner of what we like to call opinion-formers on Thursday night, the attendees were asked for their views on how likely it is that the UK will leave. The host was a hedge fund, so we were asked to price a derivative which would pay out $100 if the UK leaves the EU within five years, and $0 if it did not. The guests included a former US Treasury secretary and a former Bundesbank president, so not all of them had political acumen. The answer was that the average bid price was $40.

This struck me as on the high side, and I immediately enquired about the opportunity to take a short position against the room, but the hedgies did not seem comfortable with their price formation methodology and declined to trade. At my end of the table we concluded that there is about a 66 per cent chance that a referendum will take place (the Tories may lose the election, which lowers the probability, but Labour may also be forced into a referendum commitment, which raises it). If a referendum is held there is, we thought, a 33 per cent chance of a No (the Tories may recommend Yes if they achieve a renegotiation; Labour may recommend Yes, anyway). So the correct price on this assessment is $22 (a third of two-thirds).

The more important conclusion was that it will be Germany’s Angela Merkel who decides the outcome. The referendum is most likely to happen if Mr Cameron achieves a majority after the next general election. He will then seek a new deal with his partners. Will they be prepared to grant him enough leeway to say he has negotiated a new settlement which he can recommend to the nation, as was done with Harold Wilson in 1975? (No one, incidentally, can recall anything of what Wilson is supposed to have secured then, so the detail hardly matters.) Or will he be told that it is the menu touristique or nothing, and that Europe à la carte is not on offer.

For what it is worth, our largely German table took the latter view. They are sick and tired of us Brits. If we want to sling our collective hook, that is fine by them.

I wonder whether that will be their considered view, even if it is the way they now feel. They should certainly not offer concessions now, pour encourager les autres. But the calculation may be different if the choice is between supporting a prime minister who wants a deal he can recommend and UK withdrawal, with all its awkward consequences for the oft-proclaimed inevitability of the European project. That prime minister will, however, need an absolute majority to reach a favourable negotiating position.

In the meantime, $22 is your answer to any question on this vexed topic. Buy below, and sell above. The Treasury is always looking for clever ways of funding the deficit by appealing to diverse investor preferences. I know a hedge fund who can construct them an instrument that will tap the surplus funds of Davos Man. It would save the lives of many small furry creatures too.

The writer is a former chairman of the Financial Services Authority, former deputy governor of the Bank of England and former director of London School of Economics. He is now a professor of practice at Sciences Po in Paris

In London, the G20 has rather faded from view since Gordon Brown’s great event in Docklands in the spring of 2009, when a $1tn global stimulus was announced. (We await a final audit of this figure). It is hard to bring to mind any solid achievements to which it can claim credit since then. But in Davos, where Gs x & y are part of the currency of debate over breakfast, it is still alive and kicking. Indeed one reason why there is such a large Russian presence here is that Russia holds the presidency this year. They will be followed by the Australians in 2014. After digesting that recherché fact, who dare suggest that one does not learn interesting things in the Swiss mountains?

Another riveting factoid is that the G20 has spawned subsidiary creatures. There is the B20- a group of business leaders from the member countries, and indeed the L20, made up – you guessed it- of Labour unions from the same. Maybe there is a P20 composed of Professors (I would hate to discover that existed and I had not been invited), and even an H20 for journalists?

So what will the Russians do with their new toy? That was the topic of a long session full of Russians and Australians, and notably empty of Americans and Europeans. Both have always been suspicious of the G20, in which their influence has been notably reduced, by comparison with the precedent G7.

Kevin Rudd, the ex-prime minister, and ex-everything else in Australia, spoke well in support of the group’s achievements, though they were described as in the nature of: “Meaningfully moved forward the ongoing agenda on eliminating bad things and supporting really nice ones”. Amen to that. He argued strenuously for a new effort to revive the Doha round of trade talks, beginning with a new trade facilitation agreement, which he said would produce an immediate cost reduction of 10 per cent on trade of $22tn. One senses there must be some catch here. It sounded like one of those emails you get telling the lucky winner she has won the lottery, if only she first deposits a sizeable sum in an account in the Cayman Islands. Even Pascal Lamy, the WTO director-general sitting discreetly in the audience, looked a touch sceptical.

And it was downhill from there. A Chinese professor argued for a clear G20 statement in favour of nuclear power. I can just see Angela Merkel signing up to that. The International Labour Organization wanted new and tougher labour standards and a collective commitment to reduce unemployment. Others wanted the G20 to be an “advocacy organisation”. Advocating to itself, one presumes, as it is made up of governments.

The Russians listened to all this agenda-setting with polite indifference. For their part they showed some interest in pressing the US finally to agree to implement International Accounting Standards, which would indeed be a fine thing: the SEC has been stalling shamefully for years. Even that modest aim will cause big trouble with the absent hegemonic power. They also plan to have a look at dangerous trends in the deglobalisation of finance, as banks retreat to home base under regulatory pressure.

But it is hard to see any game-changing moves in prospect. The G20 seems condemned to drift along, unloved and unremarked, until the next crisis, when world leaders will no doubt touch a different G-spot in search of instant gratification.

David Cameron’s speech on Europe was predominantly tactical. So, too, are the reactions from Berlin and Paris. But the British prime minister’s speech raises questions of broad significance for the whole of the EU. Should it be redefined as a permanently two-level edifice? And if so, how?

These are not new questions. In fact they were raised two decades ago when Britain, and later Sweden, decided against joining the European Monetary Union. They were discussed later in the 1990s in the context of EU enlargement, until it became clear that eastern Europeans had no appetite for second-class citizenship. And they were put back on the agenda when it was realised that eurozone members had to integrate further, because a viable currency required more than a common central bank and a set of fiscal rules.

The EU’s response has so far been to act as if all members shared the same goal but were travelling at different speeds. So the euro is legally the currency of the whole EU, but some members benefit from “derogations” and can issue their national currency. In the same way, the prevention of excessive deficits applies in principle to all EU countries, but strong enforcement tools can only be used with eurozone members.

This unity has become a fiction. A set of rules, institutions and instruments is being built for the current and future participants in the euro. These involve a mutual assistance fund, revamped fiscal discipline rules, and a common supervision and resolution regime for banks. There are talks of a specific eurozone budget, or at least of a common “fiscal capacity”, and of financial support for reform efforts. Further steps could include joint external representation in international forums. This endeavour raises issues of political legitimacy, which will need to be solved one way or another.

So, an “EU-plus” is in the making.

But if an EU-plus is being built, why not an EU-minus, as Mr Cameron suggests? If the euro members strive to define how much integration they need to make their currency union effective and resilient, why not ask how much integration is needed to ensure the effectiveness and resilience of what Britain regards as the key reason for participating in the EU, namely the single market? If the goal is to stop there, why not strip out some EU rules or policies that are merely intended to pave the way to further steps of integration?

The question is what this could mean concretely. The PM’s speech is remarkably short of specifics. He refers to the treaty provision committing EU members to an “ever closer union”, suggesting that the UK should be freed from it. This would be of limited consequence: whoever thought that Britain was really bound by this commitment was the victim of a dangerous optical illusion.

So what could Mr Cameron hope to strip out? Labour regulations are repeatedly mentioned by British critics of the EU. But regulations on health and safety, equality in the workplace or working time are not there to pave the way for an ever closer union, rather because, together with product and environmental regulations, they are considered an integral part of the single market. So the question here is not whether to limit integration to what is needed for an effective single market. Rather, the dispute is what an effective single market must encompass. Britain’s partners have strong views in this respect and they are unlikely to concede to British demands.

Finally the UK government is concerned by EU financial services legislation. It is a very natural concern that stems from London’s status as the offshore financial centre of the eurozone. How to avoid mission creep in the operation of supervision and resolution at eurozone level and how to avoid the eurozone turning into a caucus that would command an automatic majority of financial regulation matters are real issues and both sides must agree on principles to deal with them. But again, the forming of an EU-minus union around the single market would not solve any of these problems.

Another prime candidate for reform would be the EU budget. The problem with the budget, however, is not that it is too big (it amounts to a little less than 1 per cent of EU gross domestic product) or too integrationist. It is that it is a relic of the late 20th century that does not correspond to today’s policy priorities. It is not a matter for dispute between pro-Europeans and eurosceptics, but between the advocates of change and those with a vested interest in the status quo.

So it is to be hoped that the predominance of tactics will not prevent discussion on the issues raised in Mr Cameron’s speech. But it is not certain that this will do much to alleviate British angst over Europe.

Though the Swiss army troops on security detail tend to bark instructions in Schweizerdeutsch if you stray off-piste, inside the Congress Centre the Davos language is English. A few visiting leaders insist on their own language – Prime Minister Dmitry Medvedev is dispensing bromides in Russian as I blog – but all the debates are in English, which might be thought to give talkative Brits a competitive advantage.

There is some truth in that, and the UK chattering classes are probably over-represented. We outpunch our gross domestic product. But the Davos language is not quite the English one finds on the pink pages, or indeed in Prime Ministerial speeches.

At a session on the crisis of confidence in business the moderator told us that after the initial presentations there would be plenty of time “for your interrogatives”. As the presenters talked movingly of the crucial need for businesses to communicate clearly and fully with their stakeholders, I had the leisure to ponder why the word “question” has become somehow too blunt and vulgar to use in polite company.

When we got round to the interrogatives, it turned out that “answers” are also out of fashion. After a rather penetrating initial interrogative from the floor, the CEO of NYSE Euronext was asked: “Do you want to log on to this?” Duncan Niederauer speaks Davosian like a native, and responded without a moment’s hesitation. He knew what to do at the end of the session, too, when the panelists were asked for a “headline benediction”, which means a “closing comment”, I think. Certainly no one took it literally and swung a thurible around the platform.

Between the interrogatives and the benediction the speakers worried aloud about the decline of trust in business leaders, which the FT reported last week. New polling in the US shows that only 18 per cent of those surveyed believe that business leaders tell the truth in a difficult situation, slightly fewer than those who trust politicians. They are trusted much less than the institutions they represent.

This is a bit of a blow to the well-meaning Davos crowd. How can it be? An American produced a list of conspicuous failures over the past year or two, which he thought contributed to bad headlines and damaged reputation. The list included Bernie Madoff, Bo Xilai and George Entwistle, which seemed a bit harsh on the ex-DG. His BBC tenure may not have been glorious, but even the Daily Mail has not argued that he has real blood on his hands.

By contrast, the list of good guys, showing the rest of us the way to better corporate social responsibility, included Howard Schultz of Starbucks, which I guess shows that news doesn’t travel as fast as we might think across the Atlantic, or that the US concept of CSR doesn’t necessarily include paying tax.

What is the answer? How can business leaders become loved and revered again? “Profit with purpose” was the favourite headline benediction. Log on to that.

Howard Davies will be writing from Davos for the FT A-List throughout the week. Click here to read previous entries.

David Cameron is making three assumptions in seeking to change the basis of Britain’s EU membership and then put this “new settlement” to an in-out referendum. That our partners want Britain in at any price. That they will negotiate a new treaty in which Britain’s demands can be easily accommodated. And that the British government will be able to determine the timetable. All these assumptions are highly questionable.

First, what “new settlement” are other member states likely to agree as the condition for Britain’s continued membership? Without doubt, nobody wants the UK to leave. Minus Britain, both the EU and Britain itself would be diminished in weight and global influence. Most member states value the influence of Britain’s outward-looking global instincts and networks, and they recognise the importance of the global financial hub we provide in the City of London.

But this will not mean accepting Britain at any cost, especially if it involves unpicking the rules of the single market. No doubt Britain could find allies for a range of measures that strengthen the EU’s accountability and competitiveness and reduce its regulatory burden. But the EU is approaching the outer limit of its flexible geometry, the patchwork quilt of different opt-ins and opt-outs enjoyed by member states across the EU’s activities. Britain already opts out of the single currency and the union’s cross border migration arrangements and is proposing to quit justice and policing, including the European arrest warrant. If Mr Cameron were to seek exemption from employment and social policy regulation as well, while retaining the trade and investment privileges of the single market, others would say “sorry, with rights come obligations – you cannot treat the EU as a cafeteria service in which you arrive with your own tray and leave with what you want”.

What is Mr Cameron’s answer to this? I do not see that he has leverage over other major players, notably Germany and France. In public these countries will be polite but for years to come their overriding priority will be fixing the eurozone and securing the single currency. Britain’s demand for legitimate protection of the position of member states outside the euro against discrimination is reasonable. But if a Cameron government were to say to them “we’ll only help you fix the euro if you agree to our opt out demands elsewhere”, I think there would be a very dusty reply.

What of a future treaty negotiation which could be used as the vehicle to agree Britain’s “new settlement”?

At one stage a new treaty was planned to overhaul the eurozone’s governance – firewalls and stability mechanisms, fiscal co-ordination and transfers, banking union – but the idea has lost support. The markets’ seeming implacable demand for such clarity has abated since the ECB’s intervention calmed nerves. Market pressure might return and, with it, fresh talk of a treaty. But, for now, there is a preference for carrying out the necessary changes in stages, within existing treaties, rules and protocols, or by means of very tightly drawn new treaties which can be approved by parliaments rather than highly risky national referendums.

Mr Cameron should look to the precedent offered by one of his predecessors, Labour premier Harold Wilson. When Wilson “re-negotiated” Britain’s accession to the European Community in 1974, he did so by finessing the agreement and not by re-opening the accession treaty itself. This, he knew, would be a bridge too far for other heads of government and Mr Cameron will soon discover the case will be the same for him.

So, if the prime minister wins the next election and embarks on this venture, how will he bring it to a close? It will be very difficult to start negotiating at a time of his sole choosing, let alone conclude in any meaningful way at a time of his choice. Mr Cameron may still be bargaining in five years from now, creating huge uncertainty for investors and their access to Europe’s single market.

And what of the subsequent British referendum he says will determine acceptance or not of his putative “new settlement”? Mr Cameron might find himself in the worst of all worlds: starting a negotiation he cannot quickly end, on eventual terms that satisfy neither pro- nor anti-Europeans, with voters probably bored by the process and using the ballot to express their views on any number of unrelated issues. Whether you regard Mr Cameron’s Europe gamble as a sincere attempt to reform and improve Europe or a cynical ploy to head off party opposition to his leadership, he does not seem to be a man with a plan.

Davos ought not to succeed. Why on earth should the world’s business and financial community, with a leavening of politicians and princes, trek up a mountain to an overpriced resort, to spend much of their time sitting in an Audi (the official car) traffic jam, where the only interest lies in distinguishing the A8s from the A4 Quattros? (Aston Martins can’t fit the snow tyres, I am told, or the Russians would take theirs along).

Each year, the invited and the salon des refuses compete to be as dismissive as possible about what they are, or are not, going to do. Will Hutton kicked off this season with a bitter piece in the Observer, condemning Davos Man and all his works. He knows whereof he speaks, as a 20-year veteran. I shall be sorry not to see him leave the hotel for the slopes on non-filing days – four out of five for a Sunday journalist. But George Soros, who is here as usual, told me he “hates it”, but always attends.

His argument is that the “network effects” dominate all the other inconveniences. It is the same phenomenon that sustains the City. Banks are there because the others are. One day this will change, just as Babylon ceded its place as the world’s financial centre, but for now the position of Davos seems fairly secure: indeed the event has got bigger and bigger.

One sustaining dynamic is the existence of several tiers of participation, reflected in the colour of your conference badge. Whether intentionally or not, Klaus Schwab – the original begetter and still in charge – has borrowed from Scientology, where initiates rise through the ranks in an attempt to attain that mysterious state of being “clear”. So every time you think you have reached the “access all areas” roadies’ nirvana, you discover there is another, yet more privileged layer of membership. For a while, I thought the top level was known as IGWEL, the Informal Group of World Economic Leaders, with its own lounge and coffee machines. How proud I was to have a special badge with a hologram where the Davos logo normally sits.

But as in the best computer games, there is always a “next level” to which to aspire, just when you think you have seen off the competition.

I must renounce these ambitions today. I have cascaded down to the “faculty” grade. We are the gadflies – not members exactly, and certainly not Igwellians. We prod and provoke. We question and challenge, but nicely and politely. A few orthogonal opinions may help the digestion, but not too many facts. Facts can be quite antisocial at a convivial gathering, as every London dinner party host or hostess knows. Idees recues are much better companions for a long evening.

So we prepare to harness our horsepower to the cause of “resilient dynamism”, this year’s chosen theme. It will be tough, with only fondue and fendant (an amusing Swiss white wine) to sustain us through the week.

Howard Davies will be writing from Davos for the FT A-List throughout the week.

In the two and a half months between the election and this week’s inauguration of President Barack Obama, America’s public policy debate has been focused on prospective budget deficits and what can be done to reduce them.

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The concerns are partly economic – there is a recognition that debts cannot be allowed to grow indefinitely faster than incomes and the capacity to repay them. Then there is a moral dimension in terms of not unduly burdening our children. There is also the global and security dimension, with the concern that the excessive build-up of debt would leave the US vulnerable to foreign creditors and without the flexibility to respond to international emergencies.

Economic forecasts are, of course, uncertain. Yet there is a great likelihood that, in the next 15 years, debts will rise relative to incomes in an unsustainable way if no action is taken beyond the 2011 budget deal and the end-of-year agreement to prevent the nation tumbling over the “fiscal cliff”. So even without the risk of self-inflicted catastrophes – failure to meet debt obligations or government shutdown – it is entirely appropriate to focus on reducing prospective deficits.


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Those who argue against a further concentration on prospective deficits on the grounds that – contingent on a forecast that assumes no recessions – the debt to gross domestic product ratio may stabilise for a decade counsel irresponsibly. Given all uncertainties and current debt levels, we should be planning to reduce debt ratios if the next decade goes well economically.

Reducing prospective deficits should be a priority – but not an obsession that takes over economic policy. This would risk the enactment of measures such as pseudo-temporary tax cuts that produce cosmetic improvements in deficits at the cost of extra uncertainty and long-run fiscal burdens. It could preclude high-return investment in areas such as infrastructure, preventive medicine and tax enforcement that would, in the very long term, improve our fiscal position.

Economists have long been familiar with the concept “repressed inflation”. When concern with measured inflation takes over economic policy, and drives the introduction of price controls or subsidies to hold down prices, the results are perverse. Measured prices may not rise, so the appearance of inflation is avoided. But shortages, black markets and enlarged budget deficits appear. The repression is unsustainable and, when it is relaxed, measured inflation explodes as in the case of the Nixon price controls during the early 1970s.

Like repressing inflation, repressing budget deficits can be a serious mistake. Yet – just as corporate managements judged only on a single year’s earnings take perverse and ultimately harmful steps – government officials in the grip of a budget obsession repress rather than resolve deficit problems.

When arbitrary cuts are imposed, agencies respond by deferring maintenance, leading to greater liabilities later. Or compensation is provided in the form of promised retirement benefits that are less than fully accounted for, with the ultimate burden on taxpayers increased. Or measures such as the recent Roth Individual Retirement Arrangement legislation are enacted, encouraging taxpayers to accelerate their tax payment while reducing present value.

As important as avoiding the repression of the budget deficit is ensuring that focusing on it does not come at the expense of other, equally real deficits. Interest rates in the US and much of the industrialised world are now remarkably low. Indeed, in real terms the government’s cost of borrowing has been negative for as long as 20 years. No one who travels from the US can doubt that we have an enormous infrastructure deficit. Surely, even leaving aside any possible stimulus benefits, current economic conditions make this the ideal time to renew the nation’s bridges and roads. Such investments, borrowed at near-zero real rates of interest, need not increase debt ratios if their contribution to growth raises tax collections.

Infrastructure deficits are only the most salient of the deficits facing the US. Nearly six years after the onset of financial crisis, we are living with substantial jobs and growth deficits. Consider this: an increase of just 0.15 per cent in the growth rate maintained over the next 10 years would reduce the debt to GDP ratio in 2023 by about 2.5 percentage points. That is an amount equal to the much-debated end-of-year tax compromise. Increasing growth also creates jobs and raises incomes.

By all means, let us address the budget deficit. But let us not obsess over it in counterproductive ways – nor lose sight of the jobs and growth deficits that will ultimately have the greatest impact on the way this generation of Americans lives and what they bequeath to the next.

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

Four years ago, Barack Obama took his oath of office against a backdrop of huge expectation and great peril. Here was a figure of inspiration and societal change taking the stage amid the worst financial crisis in 70 years. In that context, the question of the president’s fundamental view of government’s role seldom arose. An emergency simplifies the job of a chief executive. For any president of either party, the agenda in January 2009 would have been largely the same: keep the economy from falling into another Depression, save the auto industry, restore the flow of credit and get Americans back to work.

Having accomplished all that, and passed national health insurance into the bargain, Mr Obama now faces the problem of what to do for an encore. He takes his oath for the second time with greatly diminished personal promise, a far healthier economy and facing no special peril. After some eloquent words today, he seems likeliest to keep on governing like a Dwight Eisenhower or George H.W. Bush — a moderate, effective problem-solver with limited aspirations. The word Mr Obama has used more than any other to describe himself is “pragmatist.” By continuing in this mode for another four years, he stands to leave a legacy as a fine decision-maker and manager in troubled times. Unless he raises his sights, however, he is unlikely to live up to his promise as a transformational leader.

To say that President has yet to develop a broad, coherent vision of government is not the same as saying he lacks an agenda. Mr. Obama’s second term programme has already begun to emerge: gun control, immigration reform and protecting the core of the federal safety net: Medicare, Medicaid, and Social Security. But this agenda comes largely as a response to events and political opportunity: gun control because the Sandy Hook shootings, immigration because of the rising power of Latinos, a defense of entitlements against the House Republican Jacobins.

With an agenda defined mostly by reacting and defending, Mr Obama and the Democrats face a long-term hazard. The danger is slipping into a purely reactionary liberalism – one that stands for spending programmes with powerful constituencies rather than for basic principles.

The obstacle that prevents liberals from thinking more ambitiously about government’s role is the swelling cost of entitlement spending, which is turning the Democrats into the party of transfer payments and taking any new ideas that cost money off the table. Under budget caps the President and Congress have already agreed to, non-defense, discretionary spending is set to fall over the next decade to below three per cent of GDP, its lowest level in fifty years. This decline is offset by growth in entitlement spending and interest on the national debt. The paradox is that without doing some of what Republicans want when it comes to reducing the long-term costs of entitlements, Democrats can’t do much of anything else. Restoring long-term fiscal stability has again become a prerequisite for government taking on new problems.

What might a more ambitious and activist liberalism try to accomplish in the coming years? More than anything else, I would argue that it means taking on the problem of inequality. Since the 1970s, the fortunes of wealthier Americans have diverged dramatically from the middle and bottom, producing a more class-bound society and undermining common institutions of all kinds. But Democrats remain wary of taking on this problem directly for two reasons. The first is that beyond national health insurance and higher taxes on the wealthy, they really don’t know what to do about it. The second is their underlying fear that equality has fallen in the hierarchy of American values.

So long as Republicans continue to marginalize themselves, Democrats can win politically by standing still. If he would be a great president, however, Mr Obama needs to frame his signature first-term achievement of health care reform around the larger idea of social equality, and provide a bookend accomplishment, such as a guaranteed right to higher education, in his second. The president retains a chance to leave his stamp on American liberalism as Franklin Roosevelt, Lyndon Johnson, and Bill Clinton did in their various ways. To join that pantheon will require leading his party beyond reactionary liberalism to another re-imagining the American social contract.

America isn’t working. The grim reality of today’s US economy is that 24m people who want to work cannot get a job. That is an astounding number. We won the second world war with fewer people: a total of 16m Americans served in the US armed forces. Five million of the new army have been idle for six months or more, 3m have for more than a year. That is a level of long-term unemployment that has not been seen since the Great Depression. Furthermore, if the labour participation rate had not dropped from 65.7 per cent in June 2009 to the historically low 63.5 per cent today, the jobless rate would still be just a shade under 10 per cent.

What we have become good at is creating more part-time jobs, not full-time jobs. Many of the part-timers are in low-wage jobs instead of middle-class jobs. Manufacturing jobs have been replaced by new jobs in healthcare, warehousing and retail, many of which don’t even allow workers to rack up enough hours to earn healthcare benefits let alone break out of poverty. Eight and a half million workers are stuck in part-time jobs because their hours were cut back or they were unable to find full-time positions. Part-time work has increased for it allows employers to reduce costs through diminished benefit packages or none at all in a weak economy. In the retail sector, employers want an on-call workforce that they can hire when demand is high and release when business is slower. Full-time workers used to comprise more than 70 per cent of the American retail workforce; now at least 70 per cent are part-time. The retail and wholesale sector has cut a million full-time jobs since 2006 while adding more than 500,000 part-time jobs. It is hard to believe that after the 20th-century labour struggles for the 40-hour work week, the 21st-century battle is a fight for enough working hours to make a living.

The consequences of the weak employment market are manifold. One is that hundreds of thousands of workers who have exhausted their unemployment benefits are no longer counted in the labour pool. They have vanished into that other army, the almost 9m who have become disability claimants despite the general pattern of healthier Americans. On any month now it is a toss-up whether more Americans are qualifying as disabled than are finding jobs.

Another consequence of the lamentable jobs market is that young people have been stopped in their career track, sinking not soaring. An estimated 41 per cent of those unemployed are aged 30 or under, in contrast to their share of the labour force of 27 per cent. The reason is simple: older workers, understandably, have become much less inclined to retire. The better-paying jobs held by experienced older people are not becoming vacant so the younger segment of the workforce has a diminished opportunity to get ahead. Talk about a lost generation who had the misfortune to start their working lives at the worst possible time since the end of the second world war.

But here is the paradox. Twenty-four million can’t find work and hundreds of thousands of employers can’t find workers. The vacancy signs persist month after month because the vacancies are for workers with skills they don’t have. Too many Americans in the army of the unemployed lack the necessary science, technology, engineering and mathematics skills companies seek. Education means skills. Skills bolster productivity. Productivity is the key ingredient to economic success. The greater the skills, the higher the wages and the higher the employment ratio. This shortfall in education is the economic equivalent of a permanent national recession, for those with less education and fewer job-related skills experience especially high rates of job loss and higher extended periods of unemployment.

Low-wage industries have created more than 43 per cent of net employment growth, while better-paying industries such as construction, manufacturing, finance and insurance have not grown enough to make up for recession losses. The manufacturing sector remains about 1.8m jobs below pre-recession levels. And deep cuts in state and local governments hit mid- and higher-wage occupations the most. The question now is whether we are going to become a low-wage, part-time employment nation at a time when an uncertain economic climate makes it safer for companies to take on people on a part-time basis.

What must be done to avoid a descent to a low-wage, part-time America? There are a whole raft of programmes:

  • invest in infrastructure and high-speed internet connections;
  • multiply the government funds for training programmes and tie them to unemployment;
  • increase investment on education especially vocational training and post-secondary education;
  • strengthen science, technology, engineering and maths (STEM) in high schools and recruit and train teachers to broaden access to computer science in high school;
  • create an additional supplementary category of 20,000 annual visas for foreigners with the science and technology skills that are in short supply;
  • improve the attractiveness for foreign companies to locate here through a simplification of regulation.

The writer is editor-in-chief of US News & World Report and chairman, chief executive and co-founder of Boston Properties, a leading US real estate group

One month from the vote, Italy’s election campaign is running at full speed. The leaders of the main political parties blame each other for the country’s state of disarray. However, none of them is proposing measures that will solve Italy’s real problems.

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There has been a collective failure by politicians, academics, journalists, and the public at large to understand the origins of Italy’s crisis. Only when under pressure from financial markets or international institutions has Italy tackled causes rather than symptoms.

The steps taken by Italy’s leaders to address its crisis have focused on reducing its budget deficit and its public debt, mainly by raising revenues. Spending cuts and structural reforms were postponed until a “second phase”, the so-called “growth phase”. But by that time, the pressure of the markets had vanished, and the required urgency had evaporated.

As a result, since the start of the eurozone crisis, Italy’s economy has suffered more than any other, save for Greece. Gross domestic product has fallen 7 per cent since 2008, more than Portugal (5.5 per cent), Ireland (5 per cent) and Spain (4 per cent). Per capita income has fallen back to levels last seen in the mid-1990s.


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The election debate continues to focus on fiscal measures: property taxation and ways to boost aggregate demand. State intervention is seen as the only way to increase employment, and to protect ailing companies.

The missing word is competitiveness. Italy’s economy has lost competitiveness over the past decade or so. Internal labour costs have grown at a faster pace than productivity, and faster than in most of the rest of the world. Since the creation of the euro, Italy’s unit labour costs have risen by about 30 per cent more than the currency area average.

Other indicators of international competitiveness, such as tax rates, costs of starting a business, market flexibility, layers of bureaucracy, research and development investment, and transparency, show Italy as a laggard. The result? Stagnant productivity.

This explains why Italy’s current account has moved from surplus at the start of monetary union to a deficit of about 4 per cent of GDP in 2010. Italy’s external competitiveness has not even improved since the start of the crisis, unlike in Spain, Ireland and even Greece, where “internal devaluation” has occurred. The current account adjustment has taken place largely through a reduction of imports of goods and services (by 7 per cent in 2012), while exports have recovered (increasing by 1 per cent), but at a slower pace than the eurozone average.

Weak competitiveness has depressed growth, which in turn has worsened the public finances. The measures to tackle the latter have further reduced competitiveness and growth, creating a vicious circle. The only way to escape is to adopt measures to improve competitiveness and increase Italy’s growth potential. However, these measures require the determination to fight the opposition of multiple interest groups, which protect privileges and so-called “acquired rights”.

In this respect, the main obstacle resides in a traditional tendency in the Italian political system to avoid confrontation and to decide by consensus. Since the mid-1970s, governments have become used to taking decisions in concert with all sorts of unions and interest groups, representing labour, employers, commerce and banks, with the aim of achieving social cohesion.

During the 1970s and 1980s, the cost of inflexibility was shifted on to the public budget and on to the value of the currency, which was devalued several times. The debt burden doubled in a decade, from 60 per cent of GDP in 1980 to 120 per cent in 1992. The Italian lira went from 250 to the Deutschemark in the mid-1970s to 990 before joining the euro.

Since the start of monetary union, no room was left for inflation or the state budget to pick up the bill. As a result, Italy stopped growing. In these conditions social cohesion is unlikely to last. The new government will be confronted with tough decisions. Unless it wants to try to revert to the policies of the 1970s and 1980s, which cannot be done within the eurozone, it will have to start taking decisions without waiting for all social partners to sign up. (France’s recent decision to press ahead with labour market reform might be a good model.) This action might be politically costly, but will be unavoidable.

Election campaigns are surely not the right time to send tough messages to the public. But each of the candidates for prime minister should at least show that they are aware of the challenges and that they are willing to change how the country is governed. They have one month left to do so. There is no time to waste.

The writer is a former member of the ECB’s executive board

The hostage drama in an Algerian gas field is a brutal reminder of the perils of western intervention. A French military operation in Mali, a country whose difficulties were largely unknown to broader public opinion until a few days ago, seems to have tipped the world back towards a dangerous confrontation with radical Islam.

The lessons are many but the first is that whereas 60,000 civilian deaths in Syria’s civil war still leaves the international community divided and hesitant to intervene militarily, the harsh Islamic rebel order that has been imposed in northern Mali prompted no such hesitancy, although there has been no comparable toll in lives. Even if this is the first much of the world has heard about it, diplomats and defence officials in Paris, Washington and at the UN in New York have been talking intervention for months. Indeed, the French action has provided a substitute for a much more leisurely Security Council -approved UN deployment of neighbouring African peacekeeping troops. The rebels seemed to be about to advance on the Malian capital, Bamako: Mali’s beleaguered Government and the French felt an immediate intervention had become necessary.

So the first lesson is a rueful reminder for many of us that national security interests still trump humanitarian need when it comes to intervention. While the world dithers, and the Russians veto when it comes to the complex horrors of current Syria, the Security Council approval and international community support quickly falls into place when an al-Qaeda-linked movement threatens the stability of states.

Thereafter though, the parallels for Mali are Afghanistan not Syria. The French operation risks following the same trajectory of early honeymoon and apparent success followed by a long, bitter and losing engagement with no clear exit strategy.

The French with their own bitter experience in neighbouring Algeria’s colonial war are well aware of the risks. President François Hollande’s campaign commitments to avoid African entanglements means he will not have entered into this adventure lightly whatever the temporary fillip to his poll numbers. Beyond rightly feeling circumstances left them no choice, he and his advisers have pulled off the first phase of the operation with a very French aplomb that we British or Americans can only marvel at. Planners in Washington had been contemplating drone attacks which would be a much more problematic response than this combination of air power and ground troops. It may be lower tech (one of two British loaned C17 transport planes apparently quickly broke down) but it’s better politics.

France’s network of contacts in Francophone West Africa remains unrivaled and therefore Hollande’s team has been able to accelerate the deployment of ground troops from neighbours as anxious as the West to contain an expansion of revolutionary Islam. In doing so France will keep the region’s governments if not all of its People on side.

While the hostage crisis and the vulnerability of the growing number of foreign-operated oil and gas facilities across Africa seems likely to bring early rain on the French parade, the real dangers lie ahead. First, that the loosely networked al-Qaeda brand will avoid pitched battles with the French and melt back into the desert, as the Taliban did in Afghanistan, regroup and begin an insurgency against a logistically stretched occupier mounting attacks not just in Mali but back home in France through Islamic sympathisers. Second, the suddenness of the intervention risks aborting a political process to encourage the regime in Bamako to broaden its legitimacy and authority so that it can offer credible national leadership. Coups and political confusion have created the weak local partner that has dogged interventions of this kind from Vietnam to Afghanistan.

Without a credible government to hand back control to there could be no easy exit for France and its allies from a military occupation that may over time seed its own backlash as liberators become occupiers. There is a further critical point. The troubles began with a mildly Islamic Tuareg ethnic secessionist movement in northern Mali that has been hijacked by jihadists. The former need to be got back on side. This will require deep local knowledge of politics and culture which the French no doubt have but which tends in these crises to be pushed aside in a military driven operational planning process.

The French have given refreshingly firm leadership to a needed intervention but as the stand-off around the Algerian gas field shows it is already starting to get harder. The need to find a political solution to Mali’s divisions is even more important now than it was before French boots hit its desert ground.

The Bundesbank, Germany’s central bank, has decided to move part of its gold holdings from the Federal Reserve Bank in New York and other central banks such as the Banque de France to Frankfurt. This unusual and highly-visible decision is sure to trigger an explosion of media commentary relating both to motivation and implications – especially since Germany joins Iran, Libya and Venezuela in making such a move.

I suspect that Germany’s motivation is purely domestic: officials are responding to growing internal pressures ahead of elections later this year.

Since the start of the European debt crisis in 2009-10, citizens have gotten increasingly concerned about other countries’ ability to access their income. It is one thing for Germany to commit to a one-off loan to Greece. It is another for it to be part of recurrent bailouts, both direct and indirect, for a potentially expanding set of European countries.

Germans also realise that the more loans they make to struggling economies, the less likely they are to get fully repaid. Already, there is — understandable and realistic — talk that official creditors will have no choice but to forgive part of their financial claims on Greece.

It is not unusual for concerns about open-ended income transfers to evolve into broader worries about the integrity of the nation’s wealth and well-being. After all, German citizens are still paying a tax to cover the politically-driven decision just over 20 years ago to unify at parity the currencies of both East Germany and West Germany.

Over the last few months, there has been a debate in Germany about the safety of the country’s gold stock held in other countries – amplified by recognition that the historical case for holding the gold abroad is no longer as valid.

So, as I see it, domestic factors explain most of the motivation for Germany’s highly-visible and unusual decision. As much as conspiracy theorists may wish otherwise, this is not about the safety of the US Federal Reserve, nor is it about the state of German-US relations. And the backdrop of growing EU-UK tensions has nothing to do with all this either. After all, Germany is also repatriating gold from Paris.

Yet the systemic significance of Germany’s unusual announcement does not end here.

We are living in a world of growing multilateral economic tensions. As an illustration, witness the number of references in the media to “currency tensions” and “currency wars”. See also the extent to which many foreign governments have already expressed their displeasure about policy approaches adopted by the US Federal Reserve and Congressional dysfunction.

Given all this, Germany’s domestically-driven decision carries international risk.

In the first instance, it could translate into pressures on other countries to also repatriate part of their gold holdings. After all, if you can safely store your gold at home — a big if for some countries — no government would wish to be seen as one of the last to outsource all of this activity to foreign central banks.

If developments are limited to this problem, there would be no material impact on the functioning and wellbeing of the global economy. If, however, perceptions of growing mutual mistrusts translate into larger multilateral tensions, then the world would find itself facing even greater difficulties resolving payments imbalances and resisting beggar-thy-neighbor national policies.

The most likely outcome right now is for Germany’s decision to have minimum systemic impact. But should this be wrong and the decision fuel greater suspicion – a risk scenario rather than the baseline – the resulting hit to what remains in multilateral policy cooperation would be problematic for virtually everybody.

British savers and pensioners are among the biggest losers from the Bank of England’s long-running programme of quantitative easing. This is because the main way QE affects the economy is by holding long-term interest rates below market levels. Annuities are based on long-term rates and, for a 65-year-old man, the income from an average annuity fell by almost 12 per cent in 2012.

The Bank has claimed that such loss of retirement income is offset by the stimulus QE provides to the stock and bond markets in which pensions are invested. However, the extent of this offset is limited for funds that are in deficit and for many people with personal pensions and savings who have been advised to shift their resources out of volatile assets and into fixed-interest accounts. Retirees and others who are living off their savings will continue to suffer financial repression as long as interest rates are held down. They receive a double whammy if inflation remains high, pushing real interest rates further below zero.

Fortunately there is an easy and politically attractive way that the chancellor of the exchequer could counteract this negative byproduct of QE. In his next Budget he could instruct National Savings and Investments to issue an inflation-linked “pensioner bond” available for purchase only by individuals over 60 or for younger people within their pension wrapper to grow in value until they retired. Institutional pension providers would not be eligible as purchasers. The real interest rate could be fixed at 2.5 per cent, the current estimate of the economy’s potential growth rate, plus recorded inflation over the previous 12 months, as measured by the consumer price index.

With inflation today standing at 2.7 per cent, these pensioner bonds would have a highly attractive yield of 5.2 per cent compared to less than 1 per cent on most savings accounts. To avoid giving an extra advantage to those in high tax brackets, interest payments would be taxed as income when received and total purchases could be capped at, say, £100,000 a person. This would be high enough to meet the needs of most savers but not so high as to crowd out the bulk of other investments in the personal pension pots of wealthier people.

The advantages of such a proposal are that it is easily understood; it could be closely targeted as it is based on age and already defined pension wrappers; its impact on the public finances would be minimal because of its targeting and it would reinforce the incentive to save for retirement rather than relying on the state. The disadvantages are that it could divert savings from alternative investments – which the financial services industry would not like – and it would cost the Treasury more to fund a portion of its debt as market rates on inflation-linked government bonds have recently fallen below zero. This extra cost to the exchequer could be limited by capping the size of individual holdings of pensioner bonds.

There could also be an unexpected macroeconomic benefit. The over-60s account for a growing share of the total population and they are generally net spenders, not savers. They own more than a quarter of household wealth in the UK and naturally they are concerned about its erosion through inflation or market turbulence. Providing them with the security of a known, inflation-proof income could stimulate their spending on leisure services such as travel and entertainment. Among Japanese economists there has long been a renegade school of thought that low interest rates for long periods have depressed, rather than stimulated, consumption because of the high proportion of older households who base their spending on interest income. If this is even partially true, then augmenting today’s low interest rates for younger borrowers with high rates for older savers could provide a new “operation twist” to complement the monetary policy stimulus from QE.

The writer is chairman of Chatham House and a former member of the Monetary Policy Committee of the Bank of England

Business leaders are starting to make their voices heard about Britain’s role in the EU, and about time too.

As the prime minister prepares for this month’s critically important speech on the subject, there is growing pressure on him to promise a referendum after the 2015 election of a kind that could lead to Britain’s exit. Such a commitment would yield tactical benefits at home. It would take the wind out of the sails of the UK Independence party, seen as a growing threat in the Conservative party’s heartland. It would help to change the mood of at least some troublesome backbenchers. And it would appease the Europhobe media, which should be natural Tory allies but which have become increasingly offensive about his leadership.


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These gains would come at a cost, however. The government rightly insists that all policy initiatives should be tested against their potential impact on growth. And it is hard to see how more than three years of uncertainty about Britain’s position in its biggest marketplace would do anything but damp the overall pace of economic activity.

Private sector investment has a central part to play in building recovery over the medium term. In its latest forecast, the independent Office for Budget Responsibility says that worries about the outlook for global and domestic demand have led companies to postpone spending decisions. But it is forecasting brisker expansion by 2015 and 2016, with business investment rising at an annual rate of more than 10 per cent, more than offsetting the impact on growth of the continuing squeeze on government consumption.

Is this likely to happen at a time when the UK might be locked into its most important, hotly contested political battle in decades?

Japanese and South Korean investors are already asking about the implications of a possible British exit from Europe. And foreign direct investment would not be the only growth engine that could stall. UK companies, too, might well decide to hold back until Britain’s place in the European economy became clearer. Safer, perhaps, to continue pushing new investment into Asia’s emerging economies than to take the risk that the UK’s position could be changed by a referendum decision.

Other questions could also start to trouble potential investors. For example, science budgets are under increasing pressure. One result is that Britain’s top universities, which are a powerful magnet for inward investment, have become increasingly dependent on European research funding – one estimate suggests that 10-20 per cent of their research income now comes from this source. What would happen to the UK’s science base if this money were to disappear, and would the taxpayer be willing to plug the gap?

Of course, the UK remains an attractive destination for inward investors. One of the best pieces of news in recent weeks was Nissan’s decision to manufacture its new premium vehicle at the Sunderland plant in the northeast of England for export worldwide, bringing with it sizeable investment and hundreds of jobs.

This is one of the most productive assembly plants in the world, and it makes sense for Nissan to build on its success. But as Honda made clear this weekend, Japanese carmakers would be alarmed by the prospect of substantial changes in the relationship between Britain and the EU. And they are not alone.

Most corporate leaders want to steer well clear of politics. But the prime minister is having to take a path towards what will be one of his most critical decisions at a time when one side of the argument has been dominating the debate.

If businesses feel it is better to keep their political options open at a time of such uncertainty for the UK and for Europe, and if they believe a prolonged period of wrangling is more likely to damage than enhance job creation and economic recovery, they should say so – preferably in public.

The most powerful voices would come from countries that have a big stake in the UK economy, and therefore a real interest in its performance. This means, above all, US businesses, which remain by far the largest source of foreign investment. It is time they followed the lead of their country’s diplomats and put their heads above the parapet.

The writer is a senior independent adviser at Deutsche Bank, Chancellor of Warwick University and a former FT editor

Barack Obama’s most cherished illusion during his first term was the possibility of co-operation with Republicans. Time and again, the president came to Congress bearing pre-emptive concessions – on his original economic stimulus package, his healthcare plan, and the 2011 debt ceiling fight – only to have the door slammed in his face by an obstructionist Republican party that viewed politics as a zero-sum game. Because Mr Obama has long seen himself as a conciliator, he was unwilling to let go his faith that if he only hewed to the path of moderation, his opponents would eventually have to meet him there.

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The president’s efforts at compromise yielded him little. He won almost no Republican votes for any of his major initiatives. Being left hanging with his hand outstretched made Mr Obama look weak and ineffectual during much of his first term, despite major legislative accomplishments. It disappointed his liberal base, which would have preferred more stridency to match the GOP. The one advantage of Mr Obama’s relentless reasonableness was that it rendered him immune to Republican charges of ruthlessness and extremism in the past election. Through the long, deep recession, Mr Obama’s approval rating never fell lower than the forties. Congress’s rating bottomed out at 12 per cent, where it remains today.

Republicans are not revaluating their obdurate approach for reasons of ideology and individual self-interest (compromisers get “primaried” by well-funded true-believers). In recent weeks, however, we have seen the tentative emergence of a quite different second-term Obama: one shorn of his fantasies about compromise, contemptuous of his opponents, and almost eager to stand on principle. Obama II may be no more likely to get more legislation passed than Obama I. Politically, however, he is a bolder and more appealing figure: less the hostage, more the reluctant gunslinger of the classic Western.


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During the year-end fiscal cliff negotiations, liberals feared Mr Obama would once again cave to economic blackmail by acceding to the extension of George W. Bush’s tax cuts, as he did in 2010, or caving on debt ceiling concessions, as in 2011. Instead, it was Mr Obama who stood his ground and House Speaker John Boehner who blinked. Bolstered by his new mandate, Mr Obama, stood firm and got the first tax agreement in two decades tilted in favour of the middle class rather than the wealthy.

What Mr Obama did not get was a grand bargain covering the pending “sequester” on spending or another increase on the debt ceiling, America’s statutory debt limit, which is shortly to expire again. This time, however, the president is resolved to handle the conflict differently; his cower has turned to swagger. “I will not have another debate with this Congress over whether or not they should pay the bills that they have already racked up through the laws that they passed,” he declared on New Year’s day, laying down a clear marker.

The president is similarly spoiling for a fight with his nomination of Chuck Hagel to be secretary of defence. Conservative foreign policy hawks who remember the former Republican senator’s opposition to the Iraq war consider him too reluctant to challenge Iran, insufficiently supportive of Israel, and too eager to cut military spending. At the ceremony to announce the nomination this week, Mr Obama almost dared them to take on their former colleague, presenting Mr Hagel as a wounded and decorated Vietnam veteran who “bears the scars of war”. It went without saying that he also bore the scars of the moderate Republican, a species hunted to near-extinction.

On a range of other issues, such as gun control, the president’s new tone suggests that he prefers going it alone to beating his head against a wall of ultraconservative opposition. This means either proceeding unilaterally with more limited executive orders or forcing the Republicans to stand up and be counted in opposition. There is probably some political strategy here. The GOP continues to control the House only because turnout in midterm elections is smaller, older, and whiter than in presidential years. Picking fights on social issues is probably the best way for Mr Obama to turn out the Democratic base in 2014.

Recapturing control of Congress in his final two years remains a distant dream. The real reason we are seeing the emergence of a different Barack Obama is simply the late-dawning realisation that compromise is impossible with the enfeebled Mr Boehner and his perfervid rank-and-file. Lacking a partner for peace, war has become the president’s only option.

The writer is chairman of the Slate Group

Whether they like it or not, central bankers are being dragged into the political fray. It is not so much an issue of whether independence is good or bad. Rather, monetary policy itself is no longer a job for technocrats.

Pre-crisis, it was assumed the achievement of price stability would keep everybody happy. Yes, central bankers would have to nudge interest rates in one direction or the other, making some of us better off and others worse off. Across an economic cycle, however, these effects would even out. In that sense, monetary policy could be regarded as politically neutral.


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No longer. Since the recession, developed world economies have stagnated and central bankers have had little choice but to keep rates close to zero and to pursue increasingly unconventional monetary policies in the hope that they will trigger a robust recovery.

Monetary policy today carries big political connotations. In the UK, for example, the most obvious sign is the Bank of England’s willingness to tolerate a rate of inflation far above the target set by parliament. While there is a reasonable justification – far better, surely, to squeeze all workers’ wages in real terms than to have a Depression-style rise in unemployment – it is not at all obvious that it is a decision to be made by the high priests of the central banking community alone.

There are less obvious effects that also warrant greater scrutiny. Quantitative easing may make it easier for governments to raise funds cheaply; but, by increasing the net present value of pension funds’ future liabilities, it creates problems for those funds already running deficits. That, in turn, means either bigger pension contributions for workers; lower prospective pension benefits; or, in the case of some public sector pensions, tax increases or spending cuts to make the numbers add up. Meanwhile, some of the biggest beneficiaries of QE are those already asset-rich and relatively old who prefer to sit on their windfall gains rather than spend them.

Put another way, monetary policy is doing more to redistribute income and wealth than to trigger a rebound in economic activity. Central bankers are making decisions that are more political than economic.

So it should come as no surprise that central bank independence is under threat. Nowhere is this more obvious than in Japan, where Shinzo Abe’s new government is planning both to appoint a new Bank of Japan governor and to refine the bank’s price stability mandate. The BoJ is likely to find itself under pressure to hit an inflation rate of 2 per cent rather than the current 1 per cent objective, bringing it into line with central banks elsewhere.

It seems a reasonable ambition. But announcing an ambition does not necessarily imply it will be met. Supporters of struggling Aston Villa, for example, surely hope their team will one day win the English Premier League. On current form, however, the chances seem remote. Likewise, even if the BoJ hoped to hit a 2 per cent target, would it have the tools to do so?

Imagine it does not. The obvious thing would be to send for the monetary helicopters, namely a big increase in the budget deficit to be funded through sales of newly issued government bonds to the central bank. At that point, the bank’s politicisation would be more or less complete: it would be no more than an agency of government.

We cannot know how the Japanese public would behave under those circumstances. Would they view a helicopter drop as a logical extension of unconventional policies, leading to a modest rise in inflation? Or would they take the view that the BoJ was now a passive agent of fiscal policy, no longer able to offer monetary discipline? If so, it surely would not be long before they dumped their yen, triggering a shift from excessively low to excessively high inflation.

I know it is hard to imagine, particularly in a country dogged by deflation. But following two decades of central bank independence, we have to face facts. They can no longer be properly “independent” because their policies are creating both winners and losers. They are making decisions that are inherently political. Once politicians recognise this they will surely be tempted to take over the reins. At that point, monetary stability, for good or bad, can no longer be guaranteed.

The writer is HSBC Group chief economist and global head of economics and asset allocation research

As the redesign of Europe churns along in 2013, some still fear that one or more eurozone states will take its leave. Others warn that individual European states will soon crack from within, as less familiar flags appear in places such as Catalonia, Scotland and Flanders. There are separatist pressures building within Spain and the UK, and Belgium’s unity remains fragile as well. But, at least for 2013, there is less to these warning signs than meets the eye. In fact, European separatism is one of 2013’s most important red herrings. There is virtually no chance that any of these independence movements becomes a full-blown phenomenon – at least this year.

Catalonia will move toward referendum, but any vote will probably be a 2014 event. Between now and then, a new fiscal deal with Madrid could even mitigate the push for autonomy. In November last year, a new centre-left coalition came out of regional elections as the incumbent Convergence and Union (CiU) and the Republican Left (ERC) found common ground: they both want a referendum for Catalan self-determination. But the two parties don’t see eye to eye on much else. The centrist CiU wants austerity; the ERC is staunchly opposed. This friction leaves the coalition weak and potentially unstable – and this friction will shape the contours of any deal with Madrid.

The Catalan president Artur Mas needs to champion the referendum to keep his coalition intact. But Spanish Prime Minister Mariano Rajoy has the capacity to offer economic concessions to Mr Mas in separate negotiations concerning funding for the autonomous communities. In the process, he could set a wedge between the Catalan coalition partners. If Mr Mas can save face with a better fiscal deal for Catalonia, it could even put off a referendum altogether.

In Belgium in October, the New Flemish Alliance (NVA) won big in local elections. The party president Bart De Wever declared: “We not only do as well as our monster score of 2010 [in the national elections]. We do even better.” The rise of the separatist NVA puts pressure on the federal government and complicates negotiations regarding finances and further devolutions. But even if talks go south and ultimately break down, it is still unlikely to result in partition of the country. The other two Flemish parties in the six-party federal government can deliver an alternative to the separatist agenda, provided it meets popular Flemish demands. Clearly these talks – and the need to maintain budgetary control to meet deficit targets – are challenges to the Belgian government. However, short of an early election stemming from government collapse, the next real threat to the country’s territorial integrity will probably be federal elections in 2014.

Debate surrounding Scottish independence from the UK will intensify in 2013. But even if it drives headlines and sells newspapers, the issue is a 2014 story: Scotland’s referendum on independence will not happen this year. Furthermore, any eventual verdict is by no means clear-cut. In fact, polls show that a majority of Scots are actually opposed to voting “Yes” because, among other concerns, they would face tough negotiations over defence and oil revenues with the UK. The post-independence path could prove even more of a deterrent, as a newly independent Scotland could be forced to reapply for EU membership and move towards euro adoption. That’s an integrative step fundamentally at odds with the original separatist push and it wouldn’t sit well with the public.

Across Spain, the UK and Belgium, separatist storm warnings are real, but don’t expect a downpour in 2013.

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’

The last-second deal to avoid America’s fiscal cliff has been criticised by budget experts, the business community and the press. In the face of deficits still exceeding a breathtaking $1tn annually, they had hoped for a “grand bargain” – namely, a long-term, multitrillion-dollar package of revenue increases and spending cuts that would truly fix the debt problem. That did not happen. Instead, the deal is seen as too small and unbalanced, as it raises only modest amounts of revenue and cuts no spending. Outside Washington, no one has a good word for it.

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Critics are transfixed by the bitter negotiations, however, and are missing the big picture. It may be happening in stages, but the US is making real progress towards reducing deficits and stabilising its debt. Indeed, according to the Committee for a Responsible Federal Budget, a Washington-based non-profit organisation, the federal debt to gross domestic product ratio – the critical measure of financial health – will be stable at about 73 per cent for the next decade. That is because annual deficits are now on track to be halved and, therefore, the debt level will not continue to grow faster than the economy. Yes, this ratio is still too high, but stabilising it will be a crucial achievement.

But with all the weeping over deficit and debt, how is this possible? The answer is that, in two months, a course for $3tn of deficit reduction over 10 years will be set. That is about three-quarters of the amount the much-praised bipartisan Simpson-Bowles presidential commission recommended in December 2010. And, using consensus assumptions on economic growth, it is enough to stabilise America’s debt ratio. Without it, the ratio would reach nearly 100 per cent, analogous to Italy’s. Yes, after 2022, it will worsen again – reflecting the ageing population and related health costs – and more fiscal tightening will be necessary. But 10 years is enough to find those additional solutions.


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Many will be sceptical that near-term deficit reduction will reach this $3tn total. So let’s break it down. First, recall the bitter struggle between President Barack Obama and congressional Republicans in mid-2011 over raising the federal debt ceiling. The result was legislation that launched two critical deficit reduction processes. It imposed a cap on discretionary spending, reducing this category by $1.1tn through to 2021. And it ordered Congress to pass another $1.5tn in deficit reduction legislation by the end of 2011. Otherwise, cuts in discretionary spending of $1.2tn would occur automatically. Indeed, Congress did fail to act, and this spending “sequester” was to be triggered at the start of 2013. So $2.3tn of deficit reduction was legally mandated by that 2011 legislation.

Then, a week ago, we all watched the fight over the fiscal cliff, whose result again was more deficit reduction. This time, the new legislation raised taxes on high-earning Americans, generating $740bn of such reduction over 10 years. It also delayed briefly the sequester until March 1 2013. Ominously, that is when the debt ceiling must be raised again.

This sets up a third and huge budget battle for the next few weeks. Republican Congressional leaders again are demanding $1 of fresh spending cuts for every $1 increase in the debt limit. Apparently, they are prepared to take America to the very edge of default to obtain these cuts.

But Mr Obama is adamant that he will not negotiate again. That stance is correct because it is grossly irresponsible to risk financial catastrophe over political demands. The president’s position should ultimately prevail, raising the debt ceiling unconditionally.

But that outcome would also make certain the $1.2tn of deficit reduction inherent in the sequester. This is scheduled, by law, to begin in two months, and only new legislation can change that. By definition, any such change to the sequester would require approval by the House of Representatives, which is controlled by Republicans. Even though the sequester would also cut defence spending, which Republicans dislike, their assent to a change is unlikely in today’s partisan circumstances. Therefore the ultimate deficit reduction will total $3tn.

A better approach for all parties, however, would be to replace this sequester with a larger, more balanced package of deficit reduction actions. They should negotiate now towards legislation that would contain: further revenue, perhaps through capping the value of deductions and such reforms; and the types of reduction in entitlement spending the president proposed three weeks ago. After all, entitlements represent the real spending problem, not discretionary spending.

Either way, these rounds of deficit reduction are gradually solving the debt problem. Yes, it is a halting process because that is the way big change occurs in America. And, yes, more reductions will eventually be required. But surprising progress is being made.

The writer, who served as US deputy Treasury secretary from 1993 to 1994, founded and chairs Evercore Partners

Two upcoming elections will be critical for the future stability of south and central Asia and for the continuing success in the struggle to defeat Islamic extremism.

The first are the parliamentary elections in Pakistan scheduled for next spring to elect a new government. In the next few weeks President Asif Ali Zardari and the opposition have to agree to a neutral caretaker government that would be in place for three months and would be responsible for holding the elections.

However, the country faces widespread violence and mounting casualties every day – an Islamic terrorist movement to overthrow the state in the northwest by the Pakistani Taliban, a separatist insurgency in Baluchistan province and mounting ethnic and mafia violence in the commercial capital Karachi. Some fear that as the violence escalates and the state loses control of large areas, the elections may not be held or held piecemeal.

These elections are also vital for the economy which faces a balance of payments crisis, high inflation, unemployment and massive corruption scandals but Mr Zardari has proved unwilling to tackle major economic reforms as demanded by the International Monetary Fund and the international community. Such reforms would now be left to the next government.

The elections – which have to be held at the latest by May 2013 – are unlikely to produce a clear winner and the next government is also likely to be a coalition of political parties. The significance of the elections is that it will be the first time in the country’s history that one elected government which has seen out a full term will transfer power to another elected government. At the same time, despite the series of crises in the country there is no threat of a military intervention that could disrupt the democratic process.

Afghanistan will face a presidential election in early 2014 but much of the spade work for that election has to be carried out this year, especially as 2014 is also the year when the US and Nato will complete their troop withdrawal from Afghanistan.

It will be up to President Hamid Karzai in early 2013 to finalise the composition of the election commission and the rules for the elections. He is also likely to announce a candidate or raft of several candidates whom he would support to become the country’s next president. Mr Karzai is illegible to stand again having served two presidential terms already.

It will be important that he stabilises the fraught political situation in the country by next spring and take steps that ensure a free and fair election – a key demand from 17 opposition parties and groups who have all demanded that he soon announce an electoral timetable and does not support his favoured candidate with government machinery or money.

It is vital for the west which is presently preoccupied with the military transition taking place by 2014, to focus more effectively on the political transition that will also take place that year and for which preparations must start as soon as possible.

At the same time there has been a renewed boost to the possibility of peace talks between the Americans, the Afghan government and the Taliban with the recent change in Pakistan’s policy towards the Taliban, which it is now encouraging to seek a political settlement with Kabul. This makes the preparations for the elections in 2013 that could include long and complicated talks with the Taliban and the holding of them in 2014 even more important. Afghanistan needs a safe and secure political transition from Mr Karzai to the next man and from dependency on the west to greater self-reliance.

The writer is best-selling author of several books about Afghanistan, Pakistan and central Asia, most recently ‘Descent into Chaos’

A great advantage of predictions is usually that only the author remembers them and then can portentously pull from the hat the one or two which challenged conventional thinking and were proved right. The other bold, but flawed, ideas can be discretely forgotten. So with that premium on shock value, here goes …

Financial opinion, including this newspaper, is visibly breathing a sigh of relief and declaring the corner turned on the eurozone crisis. Mario Draghi is the FT’s Person of the Year and Angela Merkel, one of its Women of the Year. But the fundamentals of southern Europe’s austerity trap and the intractable levels of low growth, unemployment and the social crisis it is creating, are unabated. Greece continues to slip towards ungovernability. Now France looks set to tip economically into the southern European camp. It seems unlikely that Central Bank brinkmanship can hold off economic and political fundamentals indefinitely. The euro remains holed below the water line.

It is hard to argue with the conventional wisdom on the Middle East: It will be a rough year that will trip up President Obama’s much vaunted pivot towards Asia. But beneath the surface of that consensus is even more unpleasant news: the Assad regime in Syria seems to be slipping towards its end but that is likely to lead to more chaos. This is because a military resolution, as opposed to a diplomatic one, will mean a raw and violent power struggle and subsequent period of sectarian retribution. The omens are similarly inauspicious in Iraq and Libya where there seems a high likelihood of increased instability, power struggles and a growing anti-western sentiment.

This is likely to drag the focus of western diplomacy back to the unfinished business of these three struggling countries and away from any renewed concentration on the Israeli- Palestinian conflict or Iran’s nuclear programme. On the latter, those who have declared that one way or another the Iranian nuclear issue would be brought to a head this year may therefore be disappointed.

The IMF has like others jumped on the band wagon of the African growth story noting that ten of the 20 countries in the world likely to have the highest annual growth rates in the next five years are African. It is certainly a more useful lens to look at Africa through than that of poverty and aid failure but it disguises some of the challenges ahead. At least a quarter of Africa’s growth will come directly from energy and minerals and a lot more still from their impact on other sectors. Across the continent, governments and those decent oil and mineral companies with a long term mindset are struggling to contain the dangers of corruption. This resource boom could make, or unmake, the continent.

Across Asia, the economic revolution of recent decades is beginning to turn on its own children. Demographic pressures are fanning old border disputes. Internal income inequalities are exploding leading to widespread social protest. Consumer and dietary changes along with urban growth are aggravating water and food scarcities. The propensity for a natural disasters is growing along with that for man made conflicts.

In Latin America, Hugo Chavez may be on the way out but Chavismo is doing better than Washington commentators hoped. From his Cuban hospital bed he has just won provincial elections. Narcotics and inequality are still undermining the dream of many both in the continent and its US neighbour for a more stable middle class and democratic politics.

Let’s hope these predictions are wrong enough to be soon forgotten by all but their author. In which case may I wish the FT’s readers a Happy and Prosperous New Year.

The writer is chairman of global affairs at FTI Consulting and author of ‘The Unfinished Global Revolution’. He is a former UN deputy secretary-general and vice-chairman of the World Economic Forum

Governments’ policies will lag economic reality – this is the easy part of the prediction for this year. The more difficult is whether policymakers will be forced to deliver better outcomes for citizens, or be able to delay big decisions as was the case in 2012.

As a result of political failure, central banks remained highly activist this year, unveiling measures that would have been deemed unthinkable only a few years ago. Both the US Federal Reserve and the European Central Bank made bold interventions that were critical to maintaining financial stability and fostering some growth, albeit not a lot.

Yet there is only so much they can do. And for two distinct reasons.

First, the tools available to central banks were ill-suited given the enormity of the task at hand. As much as they would like to, central banks could not meaningfully stimulate aggregate demand in economies stuck in liquidity traps. They had no means to improve productivity and competitiveness in economies that, for years, underinvested in their people and infrastructure. And they could not safely deleverage so many over-indebted segments, particularly those lacking direct access to their financing schemes.

Second, the responsiveness of other policymaking entities with much better tools was hampered by politics. Despite some progress, European politicians were unable to converge on a common analysis of the past and a credible vision of the future. This amplified the problems of countries, such as Greece, saddled by growing popular rejection.

In the US, congressional polarisation slowed the basic elements of economic governance, including a three-year failure to approve an annual federal budget. This was aggravated by uncertainties over the fiscal cliff, a self-inflicted wound.

The lack of new policy is why unemployment remains too high in most advanced economies; why debt and deficits are yet to regain medium-term sustainability in several countries; and why income and wealth disparities are excessive.

The urgency and importance of the potential turning point will rise markedly in 2013.

Absent meaningful policy changes, central bank policies will be increasingly associated with mounting collateral damage and unintended consequences. Meanwhile, inadequate growth and high unemployment will stubbornly persist.

Most analysts expect policymakers to do no better in 2013 than in 2012 – namely, defence with only the occasional burst of ineffectual offence. This is a reasonable yet unfortunate expectation.

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

This past September, the environmental community (especially in the US) marked the 50th anniversary of the publication of Rachel Carson’s Silent Spring. That book highlighted the threats to human health and natural systems posed by unregulated industrialization—and did so in such a compelling way that it sparked a major popular movement across Europe and North America.

Next March, the environmental community (but especially in India) will mark the 40th anniversary of the birth of the Chipko Andolan, a movement of Himalayan peasants against unregulated felling by timber contractors. Politicians and intellectuals in the developing world had tended to see environmentalism as a “full stomach phenomenon”: a rich man’s fad irrelevant to their concerns. Chipko changed all that. It demonstrated that degradation hurt the life chances of peasants, tribals, pastoralists and fisherfolk too.

Long before Chipko—and Carson—a certain Mohandas K. Gandhi had warned of the unsustainability, on the global scale, of Western patterns of production and consumption. “God forbid that India should ever take to industrialisation after the manner of the west”, he said in 1928. ‘The economic imperialism of a single tiny island kingdom [England] is today keeping the world in chains. If an entire nation of 300m took to similar economic exploitation, it would strip the world bare like locusts.”

Gandhi was ignored then, but the questions he posed in the 1920s came once more to the forefront in the 1970s and 1980s. Silent Spring was followed by such influential books as the multi-authored The Limits to Growth; Chipko was followed by other articulations of the environmentalism of the poor, such as Chico Mendes’s rubber-tappers movement in Brazil and Wangaari Mathai’s tree-planting campaigns in eastern Africa. These books and struggles spawned a wider debate on the meanings and dimensions of what was now being called “sustainable development”.

Rachel Carson had identified two reasons for the lack of attention to environmental abuse. ‘This is an era of specialists’, she wrote, “each of whom sees his own problem and is unaware of or intolerant of the larger frame into which it fits. It is also an era dominated by industry, in which the right to make a dollar at whatever cost is seldom challenged”. Carson (and Chipko) offered the integrative science of ecology as a corrective to specialized approaches, while outlining the costs to ordinary people of the state always privileging the demands of industry.

By the late 1980s, however, there was a backlash against sustainability. In the US, the Reagan administration dismantled environmental laws and safeguards. In China, and soon afterwards in India, the motto of “get rich quickly” led to the interests of miners, developers and industrialists being placed above those of those who lived on (and by) the land. Environmentalists were, once more, dismissed as party-poopers, or as agents sent by the west to keep the Motherland backward.

The environmental (and social) costs of unregulated development are now increasingly visible. Hurricane Sandy has brought climate change back into public debate. At a more everyday level, hundreds of millions of people struggle with the consequences of rampant air and water pollution, the depletion of groundwater aquifers, the decimation of forests and the decline of biodiversity. In India and China, in Nigeria and Mexico, villagers battle townsfolk who dump untreated garbage on their lands. Farmers fight other farmers for access to a shrinking water table. Fishermen protest at the gates of a factory that pollutes their river and destroys their fish. Everywhere, infants in cities are treated with steroids to combat pollution-induced asthma, while infants in villages die because of water contaminated by chemicals.

Next year, and in the years to follow, these and other such conflicts will slowly make their way back into the mainstream of public discourse. The disparagement of environmentalists by the “End of History” wallahs, the gung-ho free-marketeers, the “what is good for the Ambanis is good for India” ideologues, has and must run its course. Otherwise, we are on the way to collectively stripping the world bare like locusts.

In Britain, the fate of the coalition government continues to hang on what happens to the economy. The prospect of a sustained recovery is forecast by some. This, it is assumed, will lift the country’s mood and the coalition parties’ poll ratings. Equally, others believe that UK growth won’t be looking much different in a year’s time, notwithstanding the rise in employment. In which case the gossip of last summer that George Osborne, UK chancellor will be reshuffled in a straight swap with William Hague at the Foreign Office could become reality. While if things continue to look sticky for Nick Clegg you could see the pressure mounting on him to stand aside for Vince Cable.

Both moves would represent earthquakes for the coalition. A shift sideways by Mr Osborne, as well as signaling a failed economic strategy and the need for alternative policies,would severely test his close relationship with the Prime Minister. David Cameron would be seen to be sacrificing his chancellor in order to protect himself. In my view, it would make an already vulnerable Mr Cameron shakier still. The two of them succeed or hang together.

Of course, Labour would enjoy the mayhem. And a Cable succession, too, would strengthen the prospect of Labour co-operation with the Lib Dems. Would Clegg allow himself to be evicted so easily? He is a reasonable man, more public servant than grasping politician, so he might do the decent thing. On the other hand, he might want to hang on until the decision on Britain’s next European Commissioner is taken in mid-2014. I am not sure his wish would be fulfilled. The Conservatives have nothing to gain electorally by helping Mr Clegg out of his job, and the anti-Europeans in the party (i.e. almost all of them) would be appalled at promoting such a europhile into the influential Brussels post.

But, for Labour, what if the economy did show definite signs of revival during 2013? This could work one of two ways. It would either vindicate the coalition’s no gain without pain policies and put Labour sharply on to the back foot; or it would encourage the public to forget and forgive Labour’s alleged past economic mistakes and see it as the party, now that better times were returning, best placed to bring greater fairness and decent public services. Nonetheless, voters would still need to have confidence in the two Eds’ economic responsibility. Lowering trust in Labour’s fiscal credentials remains the Tories’ main aim. Removing this target will be Labour’s chief objective in 2013.

Looking beyond Britain, the Tories will harden their anti-Europe stance, the Lib Dems will struggle to stop this being translated into coalition policies and Labour will resist a dutch auction in euroscepticism. In 2013, the political battle lines will be drawn over Britain’s continued EU membership.

At the last European Council summit of 2012, politicians decided to go ahead with the banking union while ending their reflections on fiscal union they had initiated in June, a time of acute market stress. The message: banking union is needed; the rest is not.

This behaviour confirms that the eurozone has little appetite to think about its own future. Like negligent or impecunious homeowners who only contemplate repairs when the roof threatens to collapse, their overriding motivation is to avoid imminent disaster. As market expectations of break-up have abated, even a discussion on whether integration initiatives would make the currency area more resilient or more efficient seems superfluous.

There are several reasons for this stance.

First, few leaders still have ambitions for Europe. Most are disillusioned. Fighting the crisis in the eurozone has already proved divisive. The less further initiatives they take, the less they risk political problems at home.

Second, there is no agreement about what is desirable. Most observers in southern Europe and France regard systemic reforms to governance as necessary but most in Northern Europe consider the crisis has resulted from national economic policy failures.

Third, mutual trust among eurozone countries has been dented. Cultural prejudices about the lazy south and the arrogant north are back in force.

Fourth, governments in Europe have limited respect for the European institutions (with the possible exception of the European Central Bank) and they are very reluctant to transfer competences and powers to Brussels.

This does not mean that the euro will not survive. The creation of a financial firewall, the new fiscal treaty and banking union are three significant developments. At any rate, projects for a fiscal capacity, common bonds or the creation of a European treasury are still sketchy and far from being implementable. But by consciously avoiding to discuss which reforms would make participation in the euro less risky and more beneficial for all, the European leaders have missed an opportunity to signal that the harsh economic adjustment which will continue to dominate the policy agenda in 2013 is not an end in itself.

2013 will be remembered as the year China became a more “normal economy”. What does normality mean for China? Soon-to-depart Premier Wen Jiabao’s oft-cited quote that China’s growth is “unbalanced, unsustainable and uncoordinated” is a good place to start.

China was an abnormal economy with its state-led capitalist approach that produced double-digit growth rates, no major financial crises and average wage increases of 12 per cent annually for decades. But the drivers of this impressive economic transformation will no longer be available to the new leadership. Beijing cannot simply open the monetary floodgates to stimulate the economy as was done in previous downturns.

Rates of growth in the 7-8 per cent range will become the norm and the key question is whether growth will be of higher quality – more balanced, sustainable and coordinated?

China is in fact already rebalancing – internally, externally and spatially. Internally, if consumption continues to increase at 9 per cent annually and investment growth declines from over 15 per cent to 6-7 per cent, the consumption and investment shares of the economy will become more “normal”. Externally, the current account balance will also continue to moderate as domestic demand increases with urbanisation and investors diversify by shifting more of their funds abroad. China will also become spatially more balanced as the interior will grow much faster than the coast and urbanisation will accelerate.

China’s growth can also be more financially and environmentally sustainable with further reforms. Actions to strengthen the banking sector are already underway but its fiscal system needs to be transformed to take on more responsibility for channeling resources. And China’s Five Year Plan provides a platform to achieve environmental sustainability by sharply increasing energy efficiency and curbing pollution.

In a normal market-driven economy, coordination is less about the state managing all key activities but more about strengthening its regulatory role to give the private sector room to spur innovation and efficiency.

But as a normal economy, China also becomes more vulnerable to business cycles. It can no longer maintain stability by controlling key economic prices such as interest and exchange rates and limiting capital movements. Its vested interests will be grounded less in the links between the Communist party and the state-owned banks and enterprises but as in the west China will become more vulnerable to private interests and “crony capitalism”.

Without state-led investment taking the lead, the economy will be susceptible to Keynesian risks of lack of demand. Corporate profits will be squeezed by higher interest rates and rising wages. Efficiency will be more important than capacity in the future.

Normality will also undermine the authoritarian nature of the old model which served China well when the priority was simply to push out more infrastructure investment and ensure that the requisite resources were available. China will now need a less heavy-handed administrative system that will promote entrepreneurship All this will call into question the existing governance system and may well prove to be the catalyst for far-reaching political reforms.

The November election had many consequences, but few may be as profound as its impact on the likelihood of immigration reform.

Why? It has a good deal to do with domestic politics. One out of every six Americans is of at least some Hispanic heritage. The Republican party will not continue to be a national party able to compete successfully in presidential elections unless it embraces a more open approach toward immigrants and immigration. It doesn’t hurt that two potential Republican nominees in 2016 — former Florida governor Jeb Bush and current Florida senator Marco Rubio — are strong advocates of just such change.

Understanding the consequences of immigration reform for the US requires unpacking the issue into its three essential components. The first, illegal entry, has largely been resolved, the result of increased vigilance at borders, a slowed economy that offers fewer jobs, and smaller family sizes in Mexico that leaves fewer young men wanting to come to the US.

The second dimension is the most controversial: the state of the 11m people who entered or have remained in the country illegally. Forcing them to leave or “self-deport” as Mitt Romney put it is not a serious option. But forcing these men, women,and children to live in the shadows is inhumane and limits what they can contribute to US society.

Increasingly being talked about is a path to normalisation or even citizenship in which individuals — especially those who have jobs and some education, pay their taxes and have no criminal record — could, over the course of a decade or two, be able to stay legally and possibly become full citizens. Those doing public service could get there even sooner.

The third dimension of immigration is the least talked about but the most important for the country’s future: legal immigration. What is being sought is increasing the number of people with advanced degrees and required skills who can enter and remain in the US. American competitiveness would surely benefit. Seen this way, immigration is less of a problem than it is a strategic instrument.

The arguments for reform are strong, but they have been for some time. What is new is the politics. Immigration reform is back on the agenda of the country of immigrants.

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