Monthly Archives: February 2013

America’s newly minted top diplomat hasn’t yet finished his nine-country, 11-day swing through Europe and the Middle East, his first overseas trip as secretary of state, but the first tough reviews are already in print. It doesn’t help that John Kerry’s most widely reported comment thus far was a boast to German students that Americans “have a right to be stupid” or that, as if to prove his point, he seemed to create a new central Asian republic known as “Kyrzakhstan”. He’s “off to shaky start”, warned one headline. “Kerry hits a bumpy road in world diplomacy” announces another.

Let’s be fair: Mr Kerry is a shrewd and sophisticated analyst of international politics and a formidable Washington heavyweight. He has a tough act to follow in Hillary Clinton, but Mr Kerry’s hard work on behalf of the administration over the past four years made a significant contribution to some of her successes.

But beyond early assessments of whether Mr Kerry is up to the job, we must acknowledge that success as secretary of state depends increasingly these days on the ability of a skilled manager to do more with less. This president’s stated policy goals focus overwhelmingly on the domestic side, and when boasting of his first-term foreign policy achievements, Barack Obama speaks mainly of bringing soldiers home, reducing the leverage of US diplomats at international bargaining tables.

As for this first trip, it’s no surprise that Mr Kerry begins his work in Europe and the Middle East, the two regions he knows best. Friendships in London, Berlin, Paris, Rome, Ankara, Cairo, Riyadh, Abu Dhabi and Doha will serve him well. His challenge in Europe will be to keep the US involved in the process of eurozone reform without offering much direct material help and to create momentum behind a transatlantic trade pact that will take years to negotiate.

In the Middle East, the first step will be to try to stop the carnage in Syria and help prepare the ground for a capable new government. He scored an early apparent success by helping persuade opposition leaders to join talks on Syria’s future. Yet Mr Kerry knows well that here, as in other Middle East hotspots, Saudi Arabia, Turkey and Iran will have significant say in how a post-Assad Syria develops in coming years. Particularly given the “pivot” of more US resources and attention to Asia, America’s direct involvement will be more limited than in the past, and every government in the Middle East knows it.

Then there is Russia, a country with which Washington would like better relations, if only to make life easier in managing emerging challenges in Syria and Iran. Yet Vladimir Putin, Russia’s president, has made plain that he believes he can score more points at home by attacking the US and its foreign policy than by engaging its diplomats.

Mr Kerry’s most complicated test will be in Asia, where he must lead an administration effort to ensure that America’s heavier Pacific presence and US efforts to expand security and commercial relations with so many of China’s neighbours does not produce the sort of competition with Beijing that provokes direct conflict – in Asia’s waterways, in trade relations or in cyberspace.

Secretary Kerry, best of luck.

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’

To hear US President Barack Obama tell it this week, the budget sequestration – automatic spending cuts due to kick in on Friday March 1 – will decimate the government. Each party is blaming the other, as if something new and unexpected was about to begin. Many of the pending cuts are indeed ill-advised, but the surprising truth is that from the start of his presidency Mr Obama has planned a steep decrease in discretionary spending as a share of national income.

Each year he has put a budget on the table. Each year that budget has called for a sharp decline in discretionary spending as a share of gross domestic product in 2012 and later years. His rhetoric about increasing public investments in America’s future has always been contrary to the budgets he has presented, though most of his supporters have been unaware of this contradiction.

The administration is now vigorously blaming the Republicans for the pending cuts. Yet the level of spending for fiscal year 2013 under the sequestration will be nearly the same as Mr Obama called for in the draft budget he presented in mid-2012. In fact, so deep were the proposed cuts in discretionary spending that the budget narrative made the surprising point that the president’s plan would “bring domestic discretionary spending to its lowest level as a share of the economy since the Eisenhower administration”.

The squeeze on domestic programmes dates to the beginning of Mr Obama’s first term. In July 2009, he presented the details of his 10-year budget framework. In that plan, discretionary outlays (both defence and non-defence) would rise temporarily from 7.9 per cent of GDP in 2008, the final full year of George W. Bush’s presidency, to 8.8 per cent in 2009 and 9.8 per cent in 2010, mainly because of the stimulus spending and the surge in Afghanistan. But then discretionary outlays would decline to 8.7 per cent in 2011, 7.8 per cent in 2012, 7.4 per cent in 2013 and to just 6.3 per cent in 2019, the final year of the 2009 10-year budget framework.

These cuts are now taking hold, and they will indeed hurt. Mr Obama’s supporters will be very puzzled – many will doubt the basic fact that these cuts have long been ordained by the president, at least in general terms, though not exactly as they will now occur. Why would a progressive president plan for deep cuts in discretionary spending relative to GDP even as he advocates larger investments in health, education, infrastructure, clean energy, science and technology, job training, early childhood development and more?

There is a simple answer that is the key to American federal politics of our time. Mr Obama ran for office in 2008 and 2012 promising to make permanent the Bush-era tax cuts for almost all Americans. These tax cuts were unaffordable from the start and were scheduled to expire in 2010. But to say so honestly, while the Republicans were promising to make them permanent for everybody, would probably have cost Mr Obama both elections.

So he made a Faustian bargain. He would champion the permanent extension of the tax cuts except for a tiny number of rich Americans, and he would silently plan for deep cuts in discretionary outlays as a share of GDP to compensate for the lack of adequate budget revenues in later years. In effect, he would allow rising outlays on mandatory programmes such as Medicaid and Social Security and debt servicing to crowd out public investments that are vital for America’s long-term economic future. And indeed, on January 1, Mr Obama and Congress agreed to make the Bush-era tax cuts permanent for 99 per cent of American households.

Mr Obama probably hoped that when the moment of truth arrived, when the spending cuts started to bite, the American people would support higher taxes rather than the spending cuts long called for in his own budget proposals. And perhaps they will still do so. Yet he has never presented an alternative with more robust tax revenues in order to fund a higher sustained level of public investments and services.

So now the moment of truth has arrived: we are on the path of deep cuts in discretionary programmes relative to national income. The truth is that America needs higher public investments and it needs more tax revenues to fund them. Mr Obama is finally saying some of these things, though still without specific tax proposals.

Yet it is very late in the day. Now that the Bush tax cuts are permanent, Mr Obama lacks the political leverage to achieve a boost of revenues. After years of deflecting public attention from the coming budget squeeze, he will now preside over sharp cuts in public services and investments that are the opposite of his stated goals.

The writer is the director of The Earth Institute at Columbia University and author of ‘The Price of Civilization’

Credibility is seeping away from the Bank of England’s Monetary Policy Committee. The minutes of its latest meeting released last week revealed fundamental differences of view at best and muddle at worst within the committee. They showed that three of the nine votes cast were in favour of a change in policy.

Despite modestly positive news on the economy and inflation projected to remain above target for more than two years, two MPC members including the governor shifted their voting positions towards more quantitative easing. This was unexpected.

Sir Mervyn King’s vote seemed inconsistent with a recent speech that warned about the limitations of monetary policy. Paul Fisher, executive director of the bank, voted for £25bn additional gilt purchases, contradicting his previous view that such a small amount was “neither here nor there”.

While there is considerable debate among economists about the effect of QE on growth, there is virtual unanimity about its effect on the exchange rate. The split vote indicated a higher probability of future QE and sterling duly fell when the vote was announced. It fell even further later in the week when the credit rating agency Moody’s downgraded the UK’s rating from triple A to Aa1.

The Group of Eight countries solemnly maintain that they are not using their monetary policies to target their exchange rates. Yet coded references to the need to rebalance the British economy towards manufacturing and exports repeatedly crop up in MPC members’ speeches. Perhaps the support for more QE was a tactical ploy to weaken sterling without buying more gilts. If so, it succeeded.

However, it is more likely that the split reflects a strategic realignment within the MPC. The minority voters are stronger believers in the positive effects of QE – at least through the exchange rate channel – and less concerned about the persistence of inflation than are the majority.

Unfortunately the MPC’s inflation forecasting model provides little help with such questions. It portrays inflation in the conventional way as the result of imbalances between demand and supply. The latest minutes show that the committee has side-stepped this problem by judging “that demand and effective supply were likely to continue to move reasonably closely together. That implied that some of the uncertainties around the outlook for GDP growth should have only limited implications for spare capacity and hence inflation.”

No wonder the markets are confused when the main communication vehicle of the MPC – its published inflation report – no longer provides guidance on the key issues it is debating.

When Mark Carney takes over as BoE governor in the summer, the strategic debate within the MPC is likely to intensify. At his confirmation hearings, Mr Carney repeatedly stressed the importance of good communication with the markets and his belief that a flexible inflation-targeting regime could be consistent with long periods of above-target inflation.

If sterling continues to fall on the expectation of further QE, the inflation provoked by the devaluation will present a tough communication challenge for the new governor, especially if the Treasury has launched a review of the monetary policy remit. Even undeclared currency wars carry big risks.

The writer is a former member of the Monetary Policy Committee of the Bank of England

Barack Obama might prefer to focus his energies on immigration, gun control and education. But it is the tax and spending wars that still paralyse Washington, and the US is on the verge of a dismal solution – the sequestration. Unless a new budget deal can be agreed within the next few days, almost all forms of so-called “discretionary” spending, departmental budgets that the US Congress sets each year, will be cut equally and indiscriminately – beginning next week.

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But cutting discretionary spending is like invading Iraq when the attack came from Afghanistan. Everyone knows that the federal spending problem involves the soaring cost of healthcare entitlements, which are not covered by the sequestration. The share of US gross domestic product consumed by Medicare alone is projected to rise from 3.7 per cent today to 6.7 per cent in 25 years. Meanwhile, discretionary spending is declining as a share of economic output, and it is already being subjected to a $1.1tn 10-year cut that was initiated in 2011.

The manner of the $1.2tn, nine-year sequestration, which also includes defence spending, is wrong-headed. Each area of the discretionary budget will be forced to share the cuts equally. How bad is this? Imagine a hospital deciding to cut every department by an equal amount. Oncology and cardiology would be reduced as much as cosmetic surgery. No medical institution would ever do this. Life-or-death areas would be cut last.


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Under the sequestration, nearly every defence category would be cut by 9 per cent this year, regardless of their importance to US national security. The Federal Aviation Authority would temporarily lay off 10 per cent of its workforce daily, causing airport delays throughout the country. Likewise, the Center for Disease Control and the FBI. There would be no prioritisation.

That is why, when the legislation that established the sequestration was passed in 2011, its impact was seen as so blunt that no one would accept it. The idea was to force Congress into a more reasonable approach to deficit reduction. But Democrats and Republicans are still miles apart on finding a substitute.

The looming sequestration reflects the fact that a true solution to the present giant budget deficit and record levels of federal debt has not yet been found. Yes, beginning in mid-2011, two bitterly fought Congressional deals have legislated $3tn of deficit reduction over 10 years. However, it is only half of the amount recommended by Erskine Bowles and Alan Simpson, the widely respected bipartisan duo whose analyses frame the debate on the national debt.

Increasingly ugly triggers and deadlines have been legislated for to try to force a solution – culminating in this sequestration. But if the current course is so foolish, why can’t the two sides find another? Because the Republicans want this $1.2tn of additional deficit reduction to come entirely from the spending side. No more tax increases, they say. In contrast, the Democrats demand that it come equally from new tax revenue and spending cuts.

Unblocking the impasse should follow three principles. First, further deficit reductions are necessary. Second, they must incorporate both reductions in entitlement spending, which is growing too quickly, and increases in tax revenue, which is growing too slowly. Third, they should be phased in to protect the still fragile economy.

These principles lead naturally to recommendations. First, immediately restructure the $85bn impact of the sequestration that would take effect this year. Convert it into $9bn in further annual cuts over the remainder of the sequestration. This would preserve the economic outlook for 2013 and the planned deficit reduction, give the Washington players more time to find a substitute approach, and keep up the pressure on them to do so.

The ultimate substitute should cut the deficit even further, incorporate both new revenue and reduced entitlement growth and leave discretionary spending where it is now. In terms of revenue, leaders on both sides have previously discussed reducing the value of tax deductions for high earners. Doing so would raise substantial revenue, promote tax fairness and avoid further increases in marginal tax rates. On the entitlement side, Mr Obama recently proposed $1tn in Medicare cuts, adjustments to cost of living indices, and other reductions. This is a sound approach.

The advent of this misguided sequestration is a low point for Washington, and that is really saying something. When all sides despise the path they are on, it is obviously time to change course. They will either see the light on their own, or the inevitable public outcry over this wanton sequestration will force them to see it.

The writer is founder and executive chairman of Evercore Partners and was US deputy treasury secretary in 1993-94

Stock markets responded nervously to Wednesday’s indications that America’s central bankers are getting more worried about the collateral damage of quantitative easing. But the implication is not that the US Federal Reserve will look to end its unconventional policy approach any time soon. Rather, it is that problems multiply when other policy makers and politicians fail to contribute to a balanced and comprehensive policy approach.

According to the minutes of its January meeting, the Federal Open Market Committee discussed – to use Fed chairman Ben Bernanke’s elegant formulation from August 2010 – the possibility that the expected “benefits” of QE could be offset by mounting “cost and risks”.

As I have argued in the Financial Times, including last week, this is part of a broader set of challenges facing most western central bankers – and an increasing number in emerging economies. As a result of varying degrees of political dysfunction, monetary institutions have been thrust into leadership roles for which they find themselves ill-equipped. As such, they are pursuing too many objectives using tools that are too few, too indirect and too imperfect.

The longer this persists, the greater the scope and scale of QE’s “costs and risks”. In the process, the Fed’s credibility and political autonomy will be questioned.

Because of this, some are interpreting the latest Fed minutes as signalling that the FOMC may seek an early end to QE. While possible, this is not probable for two reasons.

First, market reactions are unlikely to force the Fed to abandon QE. Unlike in other open economies, the US central bank does not alter policy course because of exchange rate movements. And while inflationary expectations may well increase over time, they are unlikely to do so at a highly alarming rate. This is especially so when an orderly rise in inflation, along with the Fed’s current regime of “financial repression” (where artificially low interest rates subsidise debtors at the cost of creditors), serve to gradually deleverage overextended segments of the economy.

Second, unlike the Bank of Japan, which is now succumbing to the political pressure applied by Prime Minister Shinzo Abe, America’s highly polarised politicians are in no position to force change on the Fed. Not only are they too busy with self-inflicted fiscal problems; I suspect they are also relieved that the Fed attracts so much of the economic policy focus.

The only way the Fed will abandon QE any time soon is if America’s growth rate and job creation reach “escape velocity”. For this to happen, Congress would need to encourage tailwinds rather than headwinds. Absent that, it will take some time for the economy’s ongoing endogenous healing to attain critical mass.

Since Congress doesn’t look to be getting its act together any time soon, the Fed will face an uncomfortable choice at every policy meeting in the next few months: either continue to use imperfect policy tools and risk greater collateral damage on a widening front; or stop and undermine the economy’s momentum.

Today’s world of dysfunctional politics is one that pushes central banks further away from their comfort zone and excludes the best possible responses. The resulting inconsistencies can only be resolved through a more comprehensive policy approach that deals directly with the west’s challenges of too little growth, too much debt and too polarised a political discourse. In the meantime, central banks will have no choice but to opt for what they perceive as the lesser of two evils – that of maintaining a visibly imperfect policy stance.

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

On Friday the European Commission releases its latest economic outlook. It will almost certainly confirm that several eurozone countries will miss their fiscal targets. In the previous round of forecasts, published in November, France was expected to record a budget deficit of 3.5 per cent of gross domestic product in 2013, in excess of the 3 per cent limit set down by the Maastricht treaty. Overruns are also expected for Belgium and Slovakia, while the forecast for the Netherlands’ deficit was a not-so-safe 2.9 per cent. The eurozone economy performed poorly during the end of 2012: there are reasons to fear a worse forecast for 2013. Jean-Marc Ayrault, France’s prime minister, has already declared that the 3 per cent target will be missed.

When he presents the forecasts on Friday, should Olli Rehn, the commission’s vice-president, coerce governments in France and other countries into further adjustment to ensure they meet their 2013 deficit targets? Or should he give them more time? It is a difficult balancing act.

The case for being tough rests on an argument about credibility. In 2003, France and Germany built a coalition to rebut the commission’s recommendations on deficits and put the stability and growth pact “in abeyance”. Over the past decade, France has been a serial breaker of the rules outlined in the pact. Today, the situation is worse. The 0.8 per cent growth forecast underpinning the French 2013 budget was already questionable on the day it was announced. A soft stance vis-à-vis Paris would certainly lead many in Europe and beyond to question the credibility of the new fiscal framework. If Brussels is not able to discipline France, then will anyone take it seriously?

On the other hand, the case for being flexible rests on an economic and on a political argument. Immediate fiscal adjustment in countries that have kept access to capital markets is not what Europe needs. According to the commission’s November calculations, France in 2013 will be cutting its deficit by 1.3 per cent of GDP in structural terms, though the government claims it is doing more. This is significant for a country whose output has been flat for almost two years. Further tightening would entail more serious economic damage than if applied in a recovery. Furthermore, it could elicit political resistance. The electoral debate in Italy, where GDP is below its 2009 trough, shows that austerity fatigue has set in. Fiscal consolidation is a marathon; the commission should not push the runners into political exhaustion.

So what to do? First, Mr Rehn should tell France than any spending over-run with respect to the budget adopted at end-2012 should be entirely offset in 2013 already. Hard times should not serve as an excuse for slippages.

Second, the commission should request from Paris a serious plan for public spending cuts in the years to come. The French 2013 adjustment was mostly based on tax increases. The government has announced that further consolidations would come from public spending cuts and it has pencilled in €60bn of those. This is, however, a rather weak commitment because President François Hollande has not spelt out precise priorities, let alone targets. So the commission should condition flexibility for 2013 on a decision by Paris on the targets, timetable and process for a comprehensive public spending review. It is not enough to say that some government spending will be cut. France must say which and when.

If these conditions are met, Mr Rehn should accept that revenue shortfalls attributable to a lower GDP do not need to be offset in the course of this year. And it should apply the same approach to other countries in similar situations. After all, the new fiscal treaty that entered into force on January 1 relies on structural, rather than headline, targets. Firmness on the former and flexibility on the latter would be in full accordance with the philosophy of the treaty.

The writer is a French economist and director of Bruegel, a Brussels-based think-tank focusing on global economic policy making

The US and Nato are more earnestly than ever trying to speed up peace talks between them, the Afghan and Pakistani governments and the Taliban. But they will falter again, just as they have done in the past until the US is prepared to make a radical break with the past format of negotiations and understand the importance of mediation.

For the last three years talks to end the war, before the 2014 deadline when US and Nato forces leave Afghanistan and to conclude a political power sharing-settlement between Kabul and the Taliban, have floundered on severe divisions of opinions within all the relevant players.

There were acute divisions within the first Obama administration, with a testosterone-driven military undermining peacemaking attempts by the state department, while Pakistan’s military refused to end its support of the Taliban. President Hamid Karzai’s ambivalent, contradictory and ultimately self-defeating approach towards the peace process was also a major hindrance. Taliban moderates who led the 2010-12 talks in Germany and Qatar with the Americans had to take abuse and threats from their own hardline rank and file. Meanwhile, other important regional players such as Iran, the central Asian states, India and Russia were ignored.

Now renewed hope is being generated by a changed US landscape. The dream team of John Kerry and Chuck Hegel at the state and defence departments see eye-to-eye on the need for talks to bring peace to Afghanistan. And Pakistan’s military is finally concerned enough about the state’s own possible collapse to speed up the peace process in Afghanistan, which could help reduce the threat from the country’s own extremists. Finally, although the Taliban are still deeply divided on the need for a 2014 peace deal, more and more of them do not want to continue fighting once the Americans leave.

But what we have seen in the on and off talks between the US and the Taliban is essentially that Washington acts as both the most powerful party in the conflict and as a mediator. The result has been that Kabul, Islamabad, the Taliban and others have put demands on the table which they expect the US to reply to as the lead party, but they also expect America to mediate each others’ demands so that both sides can reach a compromise and move forward.

It is time Washington woke up and realised that the US cannot bring peace in Afghanistan by mediating by itself. America cannot be both an occupying force in Afghanistan trying to kill Taliban commanders on night raids and firing drones into Pakistan, but also be a convincing mediator between all the protagonists to broker a peaceful conclusion to the war.

The obvious choice for such a mediator role is the UN, which brokered the Soviet Union’s withdrawal from Afghanistan in 1988 and tried many times to mediate an end to the civil war in Afghanistan between 1992 and 2001. However secretary-general Ban Ki-moon has run the organisation into the ground and the UN does not boast of a single authoritative renowned negotiator, who could muster global support for the task. (Even the UN mediation in Syria is being conducted by retired UN officials.)

There are two countries that could possibly carry out the task – Germany and Norway. Germany started the US-Taliban negotiations in November 2010 and has retained a good relationship with the Taliban despite still having troops in the country as part of the Nato force.

Out of all the countries in the world the Taliban first approached Germany to send messages to the Americans. The Taliban have trusted the Germans and so it seems does Mr Karzai. It was a serious mistake by the state department to dump the Germans once direct US-Taliban talks started – which quickly floundered as the US continued to play its double role of player and mediator.

Norway has also established excellent relations with the Taliban over the years and recently has been used by the US to try to get peace talks restarted. Oslo’s diplomatic corps is the world’s most renowned for pre-emptive and conflict resolution diplomacy. It is small enough and neutral enough not to upset the egos of the bigger players and despite its small contingent of troops in Afghanistan, Norway is also trusted by the Taliban.

The real advantage is that both these countries have had the humility to realise that they are not brokering peace for themselves or their national egos, but essentially for their American, Afghan and Pakistani allies. Only without hubris can true mediation be realised.

Messrs Kerry and Hegel need a non-American partner that can do some of the heavy lifting of mediating terms and conditions with a difficult, stubborn Mr Karzai and divided Taliban, who can talk to neighbouring states such as Iran which the US cannot do, who can offer an non-American perspective to the Pakistani intelligence services and who would have a clean record when the time comes to muster adequate funding to sustain a peace process and keep Afghanistan solvent for the next few years.

President Karzai also needs to realise that he cannot do this on his own as there are too many regional complications which Afghanistan is too weak to address and his regime is too discredited. He needs a mediating partner just as the Americans do. Pakistan too would probably welcome a neutral partner for mediation and there could be the start of a dialogue with Iran on the peace process.

This US administration needs to take a settlement in Afghanistan seriously if Barack Obama is to have a legacy as a peacemaker in four years’ time. Afghanistan needs to be up there in importance alongside handling the crisis in Syria and with Iran, but America also desperately needs a mature partner if it is to succeed and not end up failing again because it is trying to mediate by itself.

The writer’s latest book, ‘Pakistan on the Brink: The Future of America, Pakistan, and Afghanistan’, is now available in paperback. He is the author of four other books

The leaders of the Group of Seven and Group of 20 largest economies have recently tried to talk down the risk of a currency war. This will not necessarily be sufficient to avoid one. The reason is that there is no longer a shared view across leading industrial countries about the role monetary policy should play in the current environment.

The traditional view is that monetary policy should be aimed at stimulating growth and employment as long as price stability is ensured. On the proviso that inflation expectations are well anchored and the central bank’s inflation projections are within target, interest rates can be kept as low as possible to foster consumption and investment. The exchange rate is determined by financial markets as a result of the different monetary policy stances across countries, which are in turn determined by different cyclical positions.

In such an environment, currency wars do not exist because the weakness of some countries’ exchange rates reflects the weakness of their fundamentals. There would be no point in complaining about the low level of the exchange rates of countries with a relatively depressed economy. It is the task of monetary policy to try redress the situation; the exchange depreciation is only the consequence.

The real world has become a bit more complicated.

First, exchange rates do overshoot compared with the levels that are consistent with underlying fundamentals. This is not only because financial markets adjust faster than goods markets, as the German-born economist Rüdiger Dornbusch explained more than 35 years ago, but also because of the self-fulfilling nature of investors’ expectations, and the herd behaviour that influences aggregate market developments. Overshooting is the rule rather than the exception, and is very difficult to mitigate. Indeed, exchange rate interventions are ineffective unless they are co-ordinated between the monetary authorities of both the appreciating and depreciating countries. Such a co-ordination is very hard to achieve, however, because of the asymmetric benefits that exchange rate movements produce.

Second, and more important, is the fact that monetary policy has become less effective in the current crisis at supporting growth. Despite interest rates at record lows in all advanced countries, economic activity has been disappointing. The reason is that economic agents are burdened by an accumulation of too much debt. Even with low interest rates, they have no incentive, or no possibility, to borrow more. They first need to deleverage and return to more sustainable levels of debt.

In order to restart rapid growth, the amount of debt in the economy should be reduced. This requires a redistribution of wealth from lenders to borrowers. This is not easy to achieve, especially in a democracy. A restructuring of all debts would hurt savers and institutional investors, with potentially destabilising effects on financial stability. It would also fuel moral hazard. An increase in public debt to compensate for the losses of savers and investors, and to avoid market instability, would be as unpopular, even if it were feasible for countries that struggle to issue new debt in the markets. It would be hard for any government to find a parliamentary majority in favour of bailing out those who borrowed excessively at the expense of creditors or of future generations.

A smart idea, which does not require parliamentary approval, is for the central bank to do the job. By intervening directly in the markets, the central bank can reduce the amount of risky assets in the system in exchange for cash, and decrease interest rates with a view to encouraging economic agents to start borrowing again.

If such an intervention is of temporary, to counter portfolio shifts generated by liquidity shortages or fears of major market disruptions, it has no lasting impact on the supply of money nor on the distribution of wealth between borrowers and lenders. If instead the intervention is permanent, accompanied by a commitment to maintain low interest rates for a prolonged period, the policy is very close to what Carmen Reinhart and Kenneth Rogoff have called “financial repression”. By holding risky assets and keeping interest rates very low, even lower than the rate of inflation, potential losses are absorbed by the central bank and spread out to future generations, in the expectation that they will be in better shape to absorb the losses. This decision is not the result of an explicit democratic choice but of the central bank being given the task, and accepting, of doing whatever it takes to stimulate growth, even if it entails wealth redistribution. By implementing financial repression, the central bank conducts covert fiscal policy.

The reaction of investors is to try to escape from being financially repressed, including by purchasing foreign assets, especially of countries where such repression is opposed by the political system or prohibited by the central bank statutes. The outflow of capital leads to an excessive depreciation of the currency in the former countries and an appreciation in the latter, compared with underlying fundamentals.

At that point, a currency war can be avoided only if the latter start acting like the former, and also repress holders of financial assets. The most likely outcome of the currency peace which would result from a global attempt by central banks to repress holders of financial assets would be a new bout of risk taking all over the world. And, sooner or later, a new financial crisis.

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

What do Europe’s economic crisis, Syria’s civil war and global warming have in common? No one seems to have the power to stop them.

All three are part of a growing global trend: problems that no country can solve by acting alone. As globalisation has intertwined nations, communities, and businesses ever more tightly, the number of problems that cannot be solved by any one country – not even a superpower – on its own has soared.

Today, finance ministers and central bank governors of the Group of 20 nations will meet in Moscow to tackle some of these kinds of problems. Their agenda includes usual suspects: how to co-ordinate policies to restore growth, contain indebtedness and strengthen financial regulations. These problems are as critical as their solutions have proved elusive.

The reality is that, despite many commitments by national leaders, the capacity of nation-states to co-ordinate their responses has dwindled. Problems may have gone global but the politics of solving them are as local as ever. It is hard for governments to devote resources to problems beyond their national borders and to work with other nations to address these challenges – while painful problems at home remain unsolved.

The changing landscape of global politics also plays a role. As the number and the interests of those sitting at the tables where agreements are negotiated have increased, the opportunities for consensus and concerted action have shrunk. Emerging powers such as the Brics (Brazil, Russia, India, China and South Africa), new international coalitions, and influential nongovernmental players are now demanding a say in the way the world handles its collective problems. Inevitably, when all these disparate and often conflicting interests need to be incorporated into any agreement, the resulting solutions fall short of what is needed to solve the problem.

This is why global multilateral agreements in which a large number of countries deliver on co-ordinated commitments have become increasingly rare. When was the last time you heard that an agreement with concrete consequences was reached by a large majority of the world’s nations? I think it was 13 years ago – the Millennium Development Goals. Since then, almost all international summits have yielded meagre results, most visibly those seeking to advance the global agendas on trade liberalisation and curbing global warming.

This gap between the growing need for joint international action and the declining ability of nations to act together may be the world’s most dangerous deficit.

In economics, when demand outstrips supply prices go up. In geopolitics the inability of nations to satisfy the demand for solutions to problems that transcend national boundaries results in dangerous instability. Pirates hijacking ships off the coast of Somalia, financial crashes that spread internationally at great speed, overfishing, the exploitation of the rainforest and nuclear proliferation are just a few well-known examples on the long list of problems that need international co-operation.

What to do? One possible way forward is “minilateralism”.

Minilateralism consists of gathering the smallest number of countries necessary to make a major change to the way the world addresses a particular issue – for instance, the 10 largest polluters, the 20 largest consumers of endangered fish stocks, the 12 major countries involved in aid to Africa as donors or recipients, and so on.

Minilateralism can serve small countries too, when it takes the shape of alliances of the few that have a greater chance of succeeding, but also of not being shut down by dominant powers. Inevitably, the countries left out of these negotiations will denounce these agreements as exclusionary and undemocratic as they run against the one-country, one-vote rule that is a pillar of multilateral institutions. And they surely have a point and it is indeed a problem. But perhaps it is a better problem to have than the catastrophes that loom ahead as a result of inaction.

In 2002, Yoriko Kawaguchi, then Japanese foreign minister, was dispatched to Moscow to discuss ways of improving her country’s relations with Russia. During that visit, she told President Vladimir Putin that Japan and Russia had the most troubled relations of any two Group of eight leading economies, and that it should not be so. She argued that a dispute over a set of Pacific islands claimed by both countries was needlessly blocking potential progress in other areas. Mr Putin agreed. This was a problem that both governments had inherited from decades-old wartime hostilities, he said, and both countries should benefit from improved economic ties.

In the years since that meeting, tensions over the islands have flared from time to time, but they have not prevented the two countries from steady improvements in their commercial relations, particularly on the Japanese import of Russian energy.

This is the approach Japanese Prime Minister Shinzo Abe should now take with China. It is clear that relations between China and Japan, the world’s second and third largest economies respectively, have more tension and less trust than any other in the entire G20. That is not good for China – but it’s much worse for Japan, a country that has not diversified its trade partnerships nearly as effectively as China, and continues to depend heavily on access to China’s consumer market for the buoyancy of its economy and the health of some of its largest companies.

Tokyo’s move in the middle of last year to assert ownership over the Senkaku islands (known in China as the Diaoyu) in the East China Sea predictably triggered anti-Japanese outrage in China, and Beijing allowed popular protests to swell longer than usual. Chinese demonstrators launched boycotts of Japanese companies and badly damaged a number of Japanese stores and products. In September alone, Toyota and Honda’s year-on-year sales in China fell 49 per cent and 41 per cent respectively.

This episode provides yet another reminder for Japan’s new government that it must hedge its bets on trade with China by forging new partnerships elsewhere in Asia. Mr Abe wisely began the year with trips to Singapore, Australia, the Philippines, Brunei, and Myanmar. And, just as South Korea now enjoys free trade agreements with the US, EU and the Association of South East Asian Nations, Japan must develop new trade ties further afield. Joining talks for the trans-Pacific Partnership, a trade pact involving governments in both Asia and the Americas, is a vitally important step in this direction.

But this is not enough. The need for better relations with Beijing can no longer be avoided. In recent days, Japan has dispatched fighter jets to intimidate non-military Chinese planes away from the islands. China has sent fighters of its own to “monitor” the Japanese. While this pointless posturing is bad for both countries and the entire region, it will take a heavier toll on Japan’s economy than any other.

Mr Abe wants to expand US-Japanese security ties, but Washington can’t protect Japanese companies from the fallout that flows from growing friction in Chinese-Japanese relations – a much greater threat to Japan’s future than any posed by the People’s Liberation Army Navy. And the US must safeguard its own relations with China.

To protect its popularity, Japan’s newly elected Liberal Democratic party government wants to project strength by talking and acting tough on China. A significant segment of the public demands it. Yet, there is nothing Japan’s people want more from their elected leaders than the restoration of a dynamic, growing economy, and that’s why picking needless fights with China is such a bad idea. The best way to “project strength” is by actually building the country’s strength – by bolstering its economy – not by sabre-rattling.

This is why Japan should do what it can to rebuild trust with China, not by giving ground on the islands but by agreeing to put the issue on the shelf for the time being. The dispute will not be resolved this year. Better to focus on restoring a relationship that can strengthen both economies – and, by extension, the domestic credibility of both governments.

It won’t be easy. Just as tensions still flare occasionally over Japan’s territorial disputes with Russia, so there will be incidents of various kinds that test the patience and wisdom of leaders in Tokyo and Beijing. But restrained, skilful management of these issues can help accelerate the process of confidence-building between leaders. The challenge will be greater than with Russia, in part because the history of relations between China and Japan are much more troubled and because both governments have new leaders who are only now taking their seats – leaders looking for shortcuts to make themselves more popular. Yet the fact that the task will be difficult does not make it any less important for Japan’s future.

In the meantime, there are specific steps Japan’s leaders can take to start moving things in the right direction. First, there is a series of actions that Japanese leaders know will aggravate tensions in east Asia, such as visits to the Yasukuni shrine, a controversial war memorial that has been the focus of anger in China. Avoiding acts that destroy trust between governments is the bare minimum Tokyo can do to cool the temperature.

In putting the island issue aside to concentrate on other business, Mr Abe could at least acknowledge that there is a dispute over ownership. In admitting Beijing and Tokyo disagree on boundaries, he need not give any ground on Japan’s claim. More constructively, he could offer a plan that extends fishing rights around the islands to Chinese and Taiwanese fishermen – and open talks on joint development of hydrocarbon deposits in the East China Sea.

None of these steps would come without a political price, but in a country that has passed through seven prime ministers in six years, there can be no substitute for restoring economic vigour. That’s not possible if leaders are repeatedly stumbling into confrontation with China.

Barack Obama campaigned and won re-election without anything much resembling a second-term programme. On the campaign trail, he called for greater tax fairness, more jobs and doing something or other about immigration. Seeking refuge in an even greater vagueness, Mitt Romney was in no position to call him out.

Since the election, however, the president has been steadily filling in the missing pieces, asserting his renewed mandate on behalf of an ambitious, liberal agenda. As for Tuesday’s State of the Union address, no one can accuse Mr Obama of lacking specifics. His proposals were many, detailed, and in a few instances quite unexpected. His speech was a deliberate effort to move the national conversation away from an endless budget battle that threatens to overshadow his second term. Looking beyond what he was right to call the “manufactured” fiscal crisis that continues to preoccupy Washington, Mr Obama offered a new programme that was broader and more comprehensive than his first term’s.

This includes the night’s biggest surprise, a rise in the minimum wage of nearly 25 per cent, to $9 an hour, which would lift millions of workers out of poverty. The speech also proposed major new investments in infrastructure and early childhood education, a path to citizenship for illegal immigrants, marriage equality for homosexuals, voting reform, gun control, a US-EU free-trade zone, comprehensive tax reform, market-based rules on greenhouse gas emissions, national energy conservation goals, more research into clean energy technology, an accelerated troop drawdown in Afghanistan, and more.

Most of this won’t even come up for a vote, of course. While a few Republicans have signaled flexibility on immigration, the current House leadership is unlikely to take up a minimum wage law or new spending programmes. Mr Obama knows that and has incorporated the obstructionism he expects into his political strategy. His big speech set what he hopes will become a lose-lose trap for Republican legislators: accede to his agenda or face his mobilised supporters in 2014. In his first term, Mr Obama’s message to the GOP was: “I will meet you halfway.” They refused to budge. For his second term, his message is: “Compromise or pay the political price.”

To the public, the implicit message was: “If you want any of this, I’m going to need a Democratic Congress next time.” When Republicans won control of Congress in 1994, Bill Clinton responded with a long list of small-bore initiatives: gun safety locks, school uniforms, mobile phones for citizen patrols, and so forth. Mr Clinton wanted to show that he was still relevant and that he could still accomplish something even with a divided government. Mr Obama, by contrast, has little appetite for legislative hors d’oeuvres. His programme is designed to show not what he can do with a Republican Congress, but what he can’t do with one.

The impossibility of getting much done at present lends itself to expansiveness, at least at the level of presidential rhetoric. Talking about what he would like to do, rather than what he can do, Mr Obama is able to offer a broad agenda around the themes of equality and fairness that framed his second inaugural speech. At the same time, Mr Obama must avoid the charge that he is relapsing into old-school liberalism. Thus he framed his proposals on Tuesday evening as “smarter government” rather than bigger or more government.

This framing is telling. Where Mr Obama may be overreaching is in assuming away fiscal problems that are still very much with us. The American economy is in recovery mode and tax receipts are rising, but a vast structural deficit remains. Absent the kind of grand bargain Republicans are loath even to discuss, federal insolvency will pre-empt the kinds of investments Mr Obama talked about on Tuesday night. To the delight of his base, the president has finally found his progressive voice. Only in a context of fiscal rectitude can he use it bring back government activism.

The US’s foreign policy “pivot” to Asia is designed to balance China’s influence in the region. However, it has so far caused more agitation than calm.

Until the mid-2000s, the byword of US policy towards China was “engagement”. Even the Tiananmen Square incident in 1989 and the end of the cold war did not change this policy. The expectation behind it was that China would “become more like us” if the country was brought into the international community.

Professor Joseph Nye of Harvard University believes that the US had a pivot-like strategy of “integrate but hedge” even in the 1990s. He might be right (he served in Bill Clinton’s administration) but no American official at the time openly talked about this strategy.

After the 2008-09 financial crisis, the US suddenly found that it had to face a more confident – or in many Americans’ eyes, more arrogant – China. Beijing used to be a student of the American system; Chinese delegates used to be silent in international conferences. But after the crisis, China began to ask Americans this question: “Why have you, our teacher, done wrong?” Some Chinese even began to publicly speak out about the advantages of the Chinese system. Military spending by Beijing has grown by double-digit rates. All these developments taught American policy makers that China was moving away from them. The idea of pivot is not new – the Bush administration probably would have done the same if there had not been the September 11 2001 attacks – but its implementation was definitely accelerated by the US’s perception of a more assertive China.

One of the purposes of the pivot is presumably to hedge China’s military encroachment on its neighbours. It should be noted, though, that the growth of China’s military spending has been largely a result of its economic growth. Military spending is measured in nominal terms and the nominal size of China’s economy has been growing by double-digit rates.

To the average Chinese, the US is once again showing its nature as a hegemon that wields its power wherever it likes to, reinforcing the long-held Chinese view that “being backward is to invite bullies”. If the pivot has any effect on China, it must be that it has pushed Beijing to accelerate its military build-up.

Americans like to say that the pivot is a response to China’s more aggressive claims on some of the islands and reefs in the South China and East China Seas. Informed Chinese would not agree with this view. But regardless of the sequence of the events, the result presented to the world is that the American pivot has escalated tensions in the region. It has been taken as an encouragement by China’s neighbours; in the meantime, it has forced China to take more assertive actions.

The more constructive part of the pivot should have been the Trans-Pacific Partnership. But even on this count, the US has caused more suspicion than goodwill in China. The TPP was designed for like-minded countries to form, in President Barack Obama’s words, “a platinum” free-trade agreement for the Asia-Pacific region. It was the result of both America’s agony with the ineffectiveness of the Asia-Pacific Economic Co-operation forum and the White House’s political strategy to please those on both the right and the left – it expands free trade, so Republicans are happy; but it also requires member countries to meet labour, environmental and even human rights standards, so Democrats are happy.

To most Chinese, however, the TPP is one of America’s intentional moves to exclude China. For one thing, there is no way for China to meet its conditions in the medium term. For another, the TPP will not bring significant gains to the US, precisely because China, the US’s largest trading partner in the region, is not going to join.

More importantly, China was not part of the design process. To China, the TPP is a club set up solely on American will; China can knock on the door, but can be rejected. Ten years ago, when China applied to join the World Trade Organisation, this would not be a problem. Today, China feels differently: it has become reluctant to accept something if it does not feel ownership.

In a sense, all Chinese history since the mid-1800s has involved China trying to become as equal as other world powers. Today, China’s leaders and the Chinese people are increasingly feeling that point is coming. Yet the existing powers, noticeably, the US and EU, may have different ideas about equality. To them, China will only be treated as “one of us” after China is fully transformed politically and socially. This discrepancy of beliefs will be a major source of tension between China and existing powers in the coming years.

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

A simple observation last week by the Bank of England’s Monetary Policy Committee speaks volumes to the historic evolution of modern central banking – a process that is consequential, unprecedented and inadequately covered in traditional “money and banking” texts.

In its February 7 statement, the MPC stated that, due to a sluggish UK economy facing fiscal contraction, it is “appropriate to look through the temporary, albeit protracted, period of above-target inflation”. And it sure has been “protracted”; and will remain so.

The last time UK inflation came in below target was November 2009. If official projections are accurate, inflation will stay above target until the third quarter of 2014 – or a divergence of more than 50 consecutive months. To quote Mike Amey, my Pimco colleague, the target has become a “loose reference tool”.

The BoE is not the only central bank coping with inconsistencies. The European Central Bank has repeatedly been forced to react in ways once deemed contrary to its philosophy and practices. Under pressure from the new government, the Bank of Japan is in the midst of a historical U-turn.

Emerging economies are also struggling to respond. Some subordinate domestic objectives to the unusual activism of western central banks. Others experiment with “heterodox” measures. And yet others flip-flop in their search for the right policy mix.

Then there is the global dimension, including the risk of a currency war that has less to do with trade tensions and more with unconventional monetary policy. Just last week, Felipe Larrain, Chile’s minister of finance, warned in the Financial Times that “by seeking relief at the expense of other economies, [quantitative easing] is, in its essence, a globally counterproductive policy”.

To many, including politicians itching to interfere, central banking is stuck between a conundrum and incoherence. So here are a few pointers on where the debate stands, and where it should go.

With many other policy makers essentially missing in action, central banks find themselves in leadership roles not out of choice but necessity. Given imperfect tools, their involvement entails, to use the US Federal Reserve chairman Ben Bernanke’s phrase, “benefits, costs and risks”. They believe that macroeconomic benefits will outweigh the collateral damage; and they hope that they will buy sufficient time for others to respond properly and for economies to heal endogenously.

The dilemma of modern central banking was captured well last week by incoming BoE governor Mark Carney in his testimony to the UK House of Commons Treasury committee. While recognising the risks of further QE, the current Bank of Canada chief argued that central banks should act to avoid sluggish growth raising the natural unemployment rate via hysteresis.

The fundamental problem is that central banks are pursuing too many objectives with too few instruments. That is why outcomes consistently fall short of their expectations; and also why talk of exit is repeatedly shelved.

Absent better support from other policy makers, central banks will be dragged deeper into policy experimentation. Meanwhile, with incentive structures failing to align properly, perverse reactions are clear – from persistent (and, in Europe’s case, increasing) policy complacency elsewhere to distorted market functioning leading to potentially harmful resource allocations.

Then there is the biggest issue of all: the effects of unconventional monetary measures are likely to become volatile and highly binary if a growing number of central banks around the world feel they have no choice but to join the current western policy stance.

A larger global shift to expansionary monetary policy would enhance the probability of triggering “wealth effects” and “animal spirits”: the two channels through which policy-bolstered asset prices translate into better economic fundamentals. With that, the greater the likelihood of a pivot from “supported growth” to “genuine growth”.

However, relative pricing channels, including currency relationship, would be crippled if too many central banks were to opt for the same policy. Harmful beggar-thy-neighbour effects would amplify damage from artificial surges in asset prices that encourage irresponsible risk taking, fuel “bad inflation” and worsen the risk of disorderly economic and financial deleveraging.

Neither historical experiences nor analytical studies point convincingly to how the systemic effects will ultimately tip. What is clear, however, is that the probability distribution could be significantly improved if central banks were to get stronger support from those who touch more directly productivity and demand, as well as from multilateral institutions mandated with global policy co-ordination. This is where both debate and advocacy should focus.

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

The US, France, UK and other European countries are engaged in a widening arc of military activities across Africa, the Middle East, western Asia and central Asia, some visible and some surreptitious. France’s incursion into Mali last week was a notable short-term success. Other actions have been costly failures. It is important to understand why.

Let us distinguish two main kinds of targets. The first are oil states, including Algeria, Iraq, Iran, Libya and Sudan. For these countries, the west’s oil interests are the principle drivers of action. The US and UK overthrew Iran’s democracy in 1953 to block the nationalisation of Iran’s oil reserves owned by British interests (today’s BP). The west sided with Algeria’s generals in blocking a democratically elected Islamist parliament in 1992. The US overthrew Iraq’s Saddam Hussein in 2003 and Libya’s Muammer Gaddafi in 2011 in part because they were viewed as threats to western energy security. The west is now deploying economic and political instruments to destabilise the regimes in Iran and Sudan. The west is also targeting the Syrian regime, partly to curb Iranian influence in the region, and as a result finds itself in the company of jihadists also trying to bring down the regime.

The second kind of target are failed states, generally non-oil states in the region characterised by extreme poverty, hunger, massive population growth due to unchecked fertility rates, and extreme ethnic and clan divisions. These states include Afghanistan, Mali, Niger, Somalia and Yemen. The western attention to these impoverished countries rise when they become staging grounds for paramilitary groups and terrorist cells.

The purposes of western actions in the oil states are, of course, routinely obscured. Since oil interests are not an acceptable reason for regime change, other reasons are put forward. In Iraq, the ostensible reason for the US invasion was weapons of mass destruction, which of course did not exist. In Libya, the claim was that Nato was helping Libya’s freedom fighters. These freedom fighters were in fact a congeries of local militias largely created and armed by the west.

The result of western attempts at regime change in the oil states has been a trail of destruction that is remarkable in its scale, duration and futility. Western strategists are more or less satisfied with the results – the oil keeps flowing – yet they fail to realise that the oil would have kept flowing anyway. Every regime that they have toppled was eager enough to sell oil and grant concessions to western companies.

Western analysts ask why Arab countries do not create democracies. Perhaps the main reason is that the west has routinely overthrown those that have tried because democracy has produced governments not to the liking of the western powers, either because they are too nationalist, too Islamic or both. The best lesson about western-led regime change is not to try it: it is a cynical and violent manoeuvre almost surely that will go awry.

The western achievements in the region’s failed states are equally dismal. The first point to note is that these impoverished countries are rarely the source of crisis; they are too poor for that. Instead, they have been drawn into the vortex of the regional wars. Mali’s crisis results from armed paramilitaries that infiltrated that country after having been pushed south from Algeria and Libya. Mali, in short, is a blowback from the oil wars. Afghanistan and Somalia are also the roadkill of the waning days of the cold war, when the US and Soviet Union battled blindly in these impoverished regions.

The overwhelming problem in these failed states is their extreme poverty. They have become victims of the region’s wars because of their extreme vulnerability. Western military, diplomatic and economic strategists generally have no feel and even less care for the desperate poverty in these countries, and therefore believe that a quick political patch-up or reconciliation of political forces at western gunpoint will set them on their way. This is foolhardy, cynical and profoundly immoral. Millions have died in Afghanistan, Somalia and elsewhere because the west does not bother to note the realities of people clinging to the margins of survival.

These failed states share a number of characteristics. They are arid or hyper-arid, meaning that they are extremely vulnerable to drought and famine, which have been intensifying due to long-term climate change. They are high-fertility countries, with soaring populations and an absence of family planning and contraception. Their population has increased approximately four times since 1950. Several countries – including Afghanistan, Mali, Niger and Chad – are landlocked and all lack basic infrastructure. Death rates are high and literacy rates low. Most have substantial pastoralist populations, with unmet needs for veterinary care, livestock improvement, regional supply chains, and education and health systems attuned to low-density, semi-nomadic lifestyles.

In short, these are failed states for deep structural reasons that require attention and investments. Yet while no amount is too great to spend on wars – trillions of dollars expended in Iraq and Afghanistan – no amount has been too little to deny the impoverished countries caught up in these regional conflicts. The US has taken great pride in its hard-headed determination not to get involved in “nation building”. Loosely translated, the US has announced that it cares not a whit for the people involved, only for US national security. In budget terms, the US military outlays in Afghanistan have outpaced development spending by roughly 100 to 1.

Yet economic and social development is the only path to stability. The tools for that are far more powerful than even a decade ago. Mobile connectivity has created new models for health and education. Low-cost solar power has created new pathways for irrigation, livestock management and small business development. Ubiquitous information allows for local public service provision even in remote regions. Livestock can be quickly made healthier, hardier and more productive. There is a huge unmet demand for family planning services. Even a thousand drone missiles will not accomplish a single one of these goals.

The writer is the director of The Earth Institute at Columbia University, a special adviser to Ban Ki-moon, UN secretary-general, and author of ‘The Price of Civilization’

The speech this week by Britain’s chancellor of the exchequer on the “Reform of Banking” delivered a clear and forceful message: there is still energy and determination to reform the banking system, to make it healthier and safer. The speech is part of a broad agenda of reform in the UK, which has suffered grievously from the financial crisis. This reform agenda has been championed by many. In particular, it has benefited from the wisdom and dogged determination of Sir Mervyn King, Sir John Vickers, Lord Adair Turner and the chancellor himself.

However, I am still left with a sense of unease about the direction that reform of the banking system is currently taking, both in the UK and also internationally.

The chancellor’s speech comprised 3,600 words and contained important and sensible plans for change. But one word was sorely missing. Nowhere, at any point in the speech, was there an appearance of the word “capital”.

The speech, as with much of the current regulatory and reform agenda, focused largely on structures. On the one hand the future structure of banks themselves, and on the other, the structure of the regulatory apparatus that will provide banking oversight. In that context, what received most attention was the chancellor’s proposal to “electrify” the ringfence between retail and investment banks.

There is nothing wrong with an effective ring fence. But as energy and attention is channelled towards such structural issues, it risks being channelled away from the issues of excessive leverage and insufficient capital – the fundamental causes of the crisis. Adequate capital is crucial for building confidence in the banking industry. It is capital that enables banks to absorb the losses that are inevitable as financial cycles run their course. Despite the progress made on capital in the context of the Basel III reforms, the apparent move away from focusing on capital constitutes, I believe, a cause for serious concern.

In the years before the crisis, banks benefited by rapidly expanding their balance sheets and taking on enormous risks. Indeed, from a regulatory perspective they were incentivised to do so. To justify the risk they pointed to demanding targets for return on equity, which in the short term is boosted by high leverage. But return on equity is a deeply flawed measure of the performance of banks, as we discovered when the cycle turned, losses materialised, and society and taxpayers were left to bear the costs. That was, of course, long after bankers had taken much of the rewards of high risk-taking for themselves.

Unfortunately, structural reforms, no matter how thoughtfully designed and carefully implemented, will offer only limited defence for society if banks are allowed to become overly leveraged again. No matter the charge of the electrical current running through a ringfence, banks may still find ways under, around or over it. And even if the ringfence holds, the failure of a large bank, whether purely retail or purely casino, risks having destabilising, systemic effects. The core and unavoidable truth is that if banks are not sufficiently well-capitalised, they will always be vulnerable. And if they are large or interconnected enough, they will be potentially dangerous.

This means that politicians and regulators need, collectively, to have the courage to continue to focus on, and be tough on, the issue of capital. Inevitably, that will be in the face of intense lobbying from those bankers who hope to return to the days of high leverage, high return on equity and high compensation. But politicians and regulators need to maintain a focus on capital, and set simple, clear and transparent rules that force banks to hold enough. Market forces will then take care of much of the rest.

Much of this debate may only seem relevant for some far-off day when economies have healed and bankers’ appetite to take on excessive risk has returned. If only, you might be thinking. But I believe this debate has relevance for today, too. One of the tragedies of the eurozone’s continuing travails is that, more than five years after the beginning of the crisis, there is still a lack of clarity on whether eurozone banks have sufficient capital to make it through the hard days ahead. That restricts banks’ ability to fund themselves in the market. And it stops them from lending enough to encourage and sustain economic recovery. It contrasts sharply with the experience in the US, where credible stress tests for banks, and subsequent recapitalisation where necessary, returned the banking sector towards health. That difference is likely to be one reason why bank lending is now recovering in the US, but stagnating, at best, in the eurozone (see chart).

It is heartening to see that there is continuing appetite and energy for banking reform. But no amount of focus on structures should be allowed to obscure the most important element of that reform. Whatever their structure, we need above all else to ensure that all banks hold sufficient capital. That is the only way to deliver a safe, healthy financial system, capable of delivering the lending that economies need without endangering the public. It is the only way to ensure that, in Mr Osborne’s own words, “when mistakes are made, it’s the banks and not the taxpayer that picks up the bill”.



European leaders have started a discussion on German-inspired “contracts for competitiveness and growth”. To implement structural reforms in eurozone member states, the European Commission has proposed to negotiate with selected countries contracts underpinned by financial support.

The idea, to put it bluntly, is to bribe reluctant governments into economic change. Instead of exhorting governments in vain (the Lisbon agenda was a depressing example of such behaviour) and before a country reaches the point where there is no choice but to dispatch the troika of international lenders – the European Central Bank, European Commission and International Monetary Fund – the EU would support its reforms with temporary conditional transfers. It would agree with the government on a policy agenda and give grants in exchange for its implementation.

There is a case for such an approach. Reforms, even the most beneficial ones for society as a whole, are often opposed because they erode rents. Those enjoying rents, for example because the market for their product is kept closed, have all reasons to fight against change. Those who would benefit from reform are not organised, and they are also uncertain that they will in the end see the positive effects of it, so they do not fight for it. To overcome resistance, buying off the rents may be an advisable option (as advocated some years ago by the economists Jacques Delpla and Charles Wyplosz). However, countries in need of reform generally also suffer from too weak public finances to consider the option. Hence, the idea of relying on other countries’ money.

From the partners’ point of view it may also be better to pay a bit now rather than a lot later. Lack of reform hinders growth and competitiveness and is likely to end up creating troubles. Investing in the partners’ reform may be a valuable investment, if it helps avoid resurgence of financial tensions down the road.

Yet there are objections. Buying off rents may be very costly. Furthermore, and importantly, the politics of the proposal are awful. To negotiate domestic policy with foreign partners or international bodies is a humbling experience no government is likely to be keen on, unless forced to do so by markets. At any rate the partisans of the status quo would no doubt be quick to picture the reforms as foreign-inspired rather than homegrown, and the government as Brussels’ lackey. The whole endeavour could backfire terribly.

There is a better option. Instead of telling governments what they should do, the EU should decide what it wants to do and it should spend for it wherever needed, via new contributions from member countries if necessary. But it should also state clearly that it cannot spend money for certain goals if the national government’s policies make its spending ineffective. So it should make spending for a given goal in a given country conditional on national policies not hindering the achievement of the goal.

Here is an example. Assume the EU wants to foster employment of senior workers by supporting retraining and re-employment schemes. It could for instance introduce special grants to national employment agencies to help them enrol unemployed people in their 50s in dedicated training and placement programmes. These would primarily benefit countries where the employment rate of senior workers is low. But it would be absurd to support employment of older workers if national legislation discourages it (through, for example, early retirement programmes or overly generous disability benefits). So it would be fully justified for the EU to make access to its scheme conditional on the country reforming the provisions that discourage senior employment.

The same approach could be applied to other EU schemes, for example to foster labour mobility across regions and countries, unskilled employment or the improvement of university curricula. In each case the EU scheme should be accessible to all member states, conditional on the policy environment not being adverse to the fulfilment of the scheme’s goals.

The difference with the competitiveness contract would be threefold. First, the EU would not be telling governments what is good for them. It would set its own goals and pursue them. Second, a scheme would not single out a priori particular countries. De facto, the choice of priorities would imply a focus on some of them (as a scheme intended to remedy long-term unemployment would necessarily target countries where long-term unemployment is high), but de facto only. Third, conditionality would not consist in a comprehensive laundry list, rather it would in each case be targeted at significant roadblocks to the achievement of specific EU goals.

Such an approach would have defined goals and its effectiveness could therefore be assessed. And it would be more palatable politically than patronising contracts.

The writer is a French economist and director of Bruegel, a Brussels-based think-tank focusing on global economic policy-making.

Washington’s gamesmanship over the fiscal cliff raises a critical question: Does the US have budget rules and processes that are adequate for the nation’s looming crisis?

It does not — but today’s 100th anniversary of the 16th amendment to the US Constitution offers a reminder that the republic was designed to adapt to such challenges.

The 16th amendment, which blessed the taxation of income, opened a fiscal Pandora’s box. From that emerged a small but hungry federal government, initially taking no more than 7 per cent of the annual income of multi-millionaires. One hundred years later, it is taking 40 per cent from the incomes of citizens who will never be millionaires.

Proponents of the income tax amendment in 1913 justified its passage in terms of fairness. Tariffs had historically been the federal government’s main revenue source, and those taxes on international trade fell disproportionately on the consumption of lower-income Americans. Incomes, growing most rapidly for the highest earners in the late 19th century, remained untaxed.

Today’s budget debate should raise important concerns about fairness, too. High and rising national debt levels will sap future economic growth and portend sharply rising tax burdens and/or reductions in basic public goods such as defence, infrastructure, and scientific research. Our budget rules don’t account for short-sighted politicians, an omission that can easily be fixed.

Economists have long worried about unbalanced budgets. These warnings, coupled with countless plans to fix the budget, have been ignored while debt has piled up. A decade from now, under the Congressional Budget Office’s alternative (i.e. realistic) scenario, the debt-to-gross domestic product ratio is set to rise above its second world war level. And what the CBO calls the “explosive path of federal spending” will add the equivalent of 3 per cent of GDP to the national debt each year this decade, followed by 4 to 5 per cent per year in the next.

The federal government has resolved six major debt build-ups over the course of the nation’s history. Putting aside the Great Depression, debt spikes were driven by war — the revolutionary war, war of 1812, American civil war, and the two world wars. In contrast, today’s debt has been building up for decades and cannot be pinned on a singular event.

The US is facing is an entitlement crisis, which strains its out-of-date budget processes and raises serious questions of inter-generational fairness.

In 1973, the federal government spent 17.6 per cent of the nation’s GDP. Of these funds, 3.7 per cent of GDP went to Social Security spending, 1.1 per cent was for health care, leaving 9.9 per cent for discretionary spending (including defence).

This year will be quite a contrast. The federal government is projected to spend 21 per cent of the nation’s GDP, not counting interest payments on the debt. Of that spending, 5.1 percent of GDP will go to Social Security, 5.6 percent will be for health care entitlements, leaving only 7.8 per cent for discretionary spending.

This trend – entitlements crowding out other government responsibilities – is projected to continue. The rising cost of Washington relative to nation’s economy darkens the debt picture considerably.

While on this much nearly everyone agrees, Washington has not made serious progress towards bridging the fiscal gap. Making progress is essential, and it requires rethinking the rules; not simply the policies.

The broken budget process cries out for reform. An important step would be to use accrual accounting, as opposed to cash accounting to highlight the consequences of escalating entitlement spending. Accrual accounting counts up the cost of new long-term obligations in the year the obligation is made, not the year in the distant future when it will be paid. Changes in accrued liabilities of entitlement programs, in particular, should be assessed on budget each year. The US Congress and the president would then be required each year to consider offsetting those increases with revenue increases and/or with cuts elsewhere.

A broad-based consumption tax offers a potent tool here. Revenue from such a tax could be used to offset all revenue from the income tax, or at least the most distorting parts of it – high marginal tax rates on corporate and other business income that reduce investment, productivity, and employment. Analysis by economists of this tax reform suggest substantial economic gains on the order of 0.5 per cent of GDP each year for a decade.

While my preference would be for budget imbalance to be addressed entirely by reducing the growth of federal spending, a consumption tax also provides a means for raising additional revenue if the political process supports a larger government. A democracy should not be constrained in its use of revenue increases or spending reductions to achieve balance. But the use of the consumption tax ensures that all Americans know they are paying for the rising cost of broad-based entitlement programs. As with the case made for the 16th amendment, the US Congress could retain a modest wage tax for high earners to promote fairness.

The use of a consumption tax would not imply that the US Congress is required to support higher rates of consumption taxation to pay for rising entitlement spending. On the contrary, the US Congress – and by extension the public at large – would be compelled to choose among reducing entitlement spending (say, by slowing benefit growth for more affluent households), reducing discretionary spending (say, on defence and education), or increasing taxes in response to higher projected spending.

The adjustments could take place over several years to avoid amplifying the business cycle. And Congress would have to decide whether to initiate the new process at current levels of federal deficits and debt or, in addition, to reduce the debt-to-GDP ratio from its present level.

The centennial of the 16th amendment is a time to reflect on the income tax and on the need for tax reform. The roots of the income tax as a revenue raiser and tool to increase fairness could be better met with a reformed tax code raising the bulk of federal revenue from consumption taxation, while imposing a progressive labor income tax on high earners for fairness.

But this discussion should not crowd out as even more important one of how to restore budget discipline before both economic growth and fairness to future generations are irrevocably compromised. The combination of a revised budget process and the introduction of a broad-based tax as an instrument offer a way to reset the nation’s fiscal course while there is still time to do so.

This post was co-authored by Tim Kane, chief economist at the Hudson Institute


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