Daily Archives: March 17, 2013

Europe’s economic situation is viewed with far less concern than was the case six, 12 or 18 months ago. Policy makers in Europe far prefer engaging the US on a possible trade and investment agreement to more discussion on financial stability and growth. However, misplaced confidence can be dangerous if it reduces pressure for necessary policy adjustments.

There is a striking difference between financial crises in memory and financial crises as they actually play out. In memory, they are a concatenation of disasters. But as they play out, the norm is moments of panic separated by lengthy stretches of apparent calm. It was eight months from the South Korean crisis to the Russian default of 1998, six months from Bear Stearns’ demise to Lehman Brothers’ fall, and there were several 30 per cent stock market rallies between 1929 and 1933.


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Lawrence Summers

Is Europe out of the woods? Certainly a number of key credit spreads, particularly in Spain and Italy, have narrowed substantially. But it is far from clear that market conditions have improved. Investors are still limited. Restrictions limit the ability of pessimistic investors to short European debt. Regulations enable local banks to treat government debt as risk-free. This allows them to access funding from the European Central Bank on non-market terms. And there is the suspicion that, in extremis, the central bank would come in strongly and bail out bond holders. Remissions are sometimes followed by cures and sometimes by relapses.

A worrisome indicator in much of Europe is the tendency of stock and bond prices to move together. In healthy countries, when sentiment improves stock prices rise and bond prices fall, as risk premiums decline and interest rates rise. In unhealthy economies, as in much of Europe today, bonds are seen as risk assets, so they move just like stocks in response to changes in sentiment.

Perhaps it should not be surprising that Europe still looks to be in serious trouble. Growth has been dismal, with eurozone gross domestic product still below its 2007 level. Forecasts predict little, if any, growth this year.

For every Ireland, where there is a sense that a corner is being turned, there is a France, where the sustainability of current policy is increasingly questionable.

The controversy surrounding the decision by European authorities to conduct a bail-in that imposes levies on Cypriot bank depositors gives an indication of the degree of fragility in Europe. The idea that converting a small portion of deposits into equity claims in an economy with a population barely over 1m could be a source of systemic risk suggests the current situation rests on a hair trigger.

All of this is compounded by political uncertainty. Italy’s election was inconclusive even by its own standards. Scandals and staggeringly high unemployment are taking their toll in Spain. France is much calmer about its situation than are many outside observers. And Germany’s primary concern is avoiding turmoil before federal elections in September. There is little doubt that, given a choice, all eurozone countries would prefer almost any kind of macroeconomic unorthodoxy to the breakdown of monetary union. But this is insufficient. There is the serious risk that as nations pursue parochial concerns, the political and economic situation will deteriorate to a point that is not remediable.

Structural reform in the most troubled economies is essential, and the work of building a stronger institutional foundation for monetary union must go on. But the key to success will be the recognition that in economic policy – as in life – what is good for one is not good for all.

It is true, as German policy makers constantly point out, that fiscal consolidation and structural reform were key to Germany’s rise from being the “sick man of Europe” to its current position of strength. What they do not recognise is that there cannot be exports without imports. Germany’s export growth and huge trade surplus were enabled by borrowing by the European periphery. If the debtor countries of Europe are to follow Germany’s path without economic implosion there must be a strategy that assures increased external demand for what they produce. This could come from a German economy that was prepared to reduce its formidable trade surplus, from easier monetary policies in Europe that spurred growth and competitiveness, or from increased deployment of central funds such as those of the European Investment Bank.

Invocation of necessity is not a strategy. As any student of Germany’s experience of the 1920s knows, requiring a nation to service large debts by being austere in a context where there is no growth in demand for its exports is far from being a viable strategy.

European policy makers, the International Monetary Fund and external policy makers with a stake in the European outcome need to recognise that the history of financial crises is a history of missed opportunities. New business is always more exciting than unfinished business. And where matters are controversial, forced moves are easier for policy makers than unforced moves because they can be portrayed as moves of necessity rather than choice. So outsiders avoid confrontation and insiders embrace drift. The consequences could be grave.

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

Having stressed publicly that Greece was an exception and that no other rescue would impose losses on senior private creditors, European officials embarked this weekend on a controversial path for Cyprus. They did so for understandable reasons, which they will argue are unique. Yet the specifics of the rescue will bring implementation challenges that will undermine its effectiveness and may lead to negative side-effects.

Early Saturday morning, European officials stunned Cypriots by announcing that part of the burden of rescuing the country would be borne by bank depositors. When banks reopen on Tuesday, all account holders will have their savings reduced by 6.75 per cent to 9.9 per cent, depending on the size of their deposits. In exchange, they will receive an out-of-the-money equity claim on banks.

This constitutes a notable expansion in the EU’s application of PSI (private sector involvement).

In addition to committing €10bn of bilateral and multilateral assistance to support a new austerity package, officials went beyond the Greek precedent of restructuring government bonds (and in isolated cases wiping out junior and subordinated bank bond holders) and extended burden-sharing further.

I can think of at least four reasons that led influential European countries to impose on Cyprus what they previously deemed as improbable if not unthinkable.

The scale of the problem and its concentration in the banking system: Like Ireland a few years ago, Cyprus has been brought to its knees by irresponsible banking. In entrusting funds to Cypriot institutions, depositors (and especially foreign depositors) inadvertently funded the over-extension of the banking system, both domestically and abroad. Now they are being forced to contribute to the bail out.

Lax banking regulation: At a time of renewed emphasis on sound banking worldwide, officials have questioned publicly whether Cypriot banks have intermediate funds with dubious origins. By killing once and for all the notion that Cyprus is a safe and lax offshore haven, the levy serves to limit such intermediation in future.

The alternatives seemed worse: As explained in a frank statement by the Cypriot government, the country had run out of easy options. Impossibly tough choices had to be made among local constituents, including pensioners, wage earners, companies and, of course, depositors.

Countering moral hazard: European hardliners have been increasingly worried about the complacency that has spread in struggling countries following the dramatic involvement of a “whatever it takes” European Central Bank. This weekend’s decision serves as a wakeup call to other struggling European economies, which wrongly believe that the solution to their problems has been outsourced to the ECB.

These are all valid reasons. As such, I am puzzled less by the decision to extend PSI to depositors and more by how it has been done. Specifically:

By choosing to include all deposits and not just the large ones, thus penalizing all segments of the population, officials opted for a highly regressive approach that also undermines the traditional construct of deposit insurance schemes around the world.

By limiting the levy on large accounts to just 9.9 per cent, officials will raise insufficient funds for Cyprus while encouraging remaining deposits to flee the country, thus increasing the likelihood of a second PSI down the road.

If this is correct, the specifics of this weekend’s agreement risk becoming part of the problem rather than a solution for Cyprus.

In Cyprus, they would fuel a private liquidity implosion and more acute credit rationing. They would also risk triggering a disruptive political backlash and social unrest.

In Europe, they could well undermine the recent tranquil behavior of depositors and creditors in other vulnerable European economies – in particular Greece, Italy, Portugal and Spain. Despite assurances from European officials that Cyprus is “exceptional” and the measures are “unique,” this weekend’s actions have increased the risk premium. They will also add to the disillusionment of an increasing of Europeans with the traditional political order and parties.

More generally, the actions will test the faith that global investors place in central banks’ ability to offset political surprises and, thus, enable and protect an endogenous process of economic and financial healing. Since this comes at a time when many risk markets’ assets appear technically over-bought, they could also prompt pullbacks in asset prices.

European officials were right to look for a bold approach for Cyprus. But in compromising excessively on critical design elements, they risk ending up in the disruptive muddled middle: not going far enough to solve the country’s problems, and not being sufficiently careful in containing potential negative externalities.

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