Daily Archives: December 19, 2013

Flags of the EU member states fly in front of the European Parliament in Brussels

For a few years now, I have felt as if I live intellectually in the Alps. In the European Council, I used to translate the virtues of discipline into Mediterranean languages, while also interpreting for northern countries the difficulties felt by southern Europe.

A mutual learning process is now essential. The south, as it adapts to the social market economy, must be more determined in pursuing fiscal discipline and structural reforms. Likewise the north, Germany in particular, must appreciate that such efforts by the south are unlikely to generate sustainable improvements unless Europe’s policy framework becomes more growth-friendly.


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When the EU acknowledged in May that Italy, after two years of tight fiscal policy, no longer needed to be under the EU’s “excessive deficit procedure”, it was seen in the country like a release from prison. Although the exit reduces interest rates, and so has a favourable effect on the budget, this interpretation was mistaken. Some in Italy even saw the decision as an EU admission that it had been too tight-fisted to start with. Others jumped straight into discussions on new ways to spend money, as if freed from budgetary constraints intended to safeguard stability and protect future generations.

In fact, achieving stable and sustainable budgetary conditions will require southern countries to make cultural adjustments. In particular, people must accept that budgetary discipline pays. Policy makers will need to persuade people that fiscal discipline is not a forced tribute paid to gods residing in more northern parts of Europe. It is simply appropriate economic behaviour.

Northern Europe must also give something: a deeper understanding of the role of investment in economic activity. The Maastricht treaty did not distinguish sufficiently between public expenditure for consumption and for investment. Consequently, many European countries have achieved budgetary discipline through disproportionate cuts in public investment, which is usually politically less painful – though more damaging – than cutting public current expenditure.

Of course, it is not easy to distinguish among different sorts of public investment – whether productive investments or pseudo-investments (as when a government transfers funds to state-owned companies to cover their current losses). Definitions and measurement need serious work. Yet this alone does not justify assuming that all public sector investment is essentially like consumption, or lacks any economic merit and productive purpose, which is what is done if the pact is taken at face value.

Now that the south is moving closer to the economic and fiscal concepts of central and northern Europe, it is encouraging to see that the European Commission and the European Council – and perhaps even Germany – are more willing to enforce the pact more meaningfully.

But what about structural reforms? Although they have come to be recognised as a top priority, more nations have succeeded in adjusting their budgets than in reform. There are two reasons for this.

The first concerns the game of pitting government against organised interest groups. The task of government is harder when reforms directly affect the interests of well-organised groups, businesses, professionals or public sector employees. Such steps will usually inject competition into a market, wiping out comfortable rents for specific groups. The effects of budgetary measures such as tax rises are, by comparison, more diffuse.

The second reason is that Europe provides less help on the more important task: structural reforms. The focus of European monetary union has been on obtaining budgetary discipline.

Ultimately, this boils down to a simple rule of thumb: if you meet stronger opposition to structural reforms domestically, and receive less of a push from Europe on this than on budgetary consolidation, the likelihood is that you will make less progress on structural reforms.

That is why I welcome the recent reorientation of EU policy – not away from fiscal discipline but towards emphasis on country-specific recommendations on structural reforms, for example to make labour markets more flexible. When I was a member of the European Council, I favoured the idea of contractual arrangements between the commission and individual countries on specific reforms as the way forward. This strengthens the influence of the EU on governments and strengthens the hand of each government in relation to domestic organised groups, all in the interest of achieving structural reforms.

Coupled with mechanisms to facilitate the financing of the reforms in countries that still face high borrowing costs but are pursuing the policies recommended by the EU, these arrangements may help to push Europe towards further reforms to promote growth and employment. The European Council of December 19-20 will, I hope, endorse this.

The writer is former Italian prime minister and chairman of the Berggruen Institute on Governance’s Council for the Future of Europe

Job done, at least for now. Ben Bernanke and his colleagues at the Federal Reserve will be delighted at the market reaction following their monetary “pincer movement” on Wednesday. The Fed will taper its asset purchases by $10bn a month in January – down from $85bn to $75bn a month – with a strong hint that further tapering will occur as 2014 progresses.

At the same time, however, the Fed has strengthened its “forward guidance” message. Simply put, America’s central bank is promising low interest rates for longer. If the Fed’s forecasts are to be believed, rates will now be 25 basis points lower than previously projected at the end of both 2015 and 2016. Mr Bernanke has even managed to ease some of the tensions that had muddied the Federal Open Market Committee’s message over recent months. Those members who had previously offered a more hawkish view on interest rates appear to have had their talons trimmed.

We have, thus, shifted from one course of monetary drugs to another. The side effects from quantitative easing were becoming troublesome: the Fed’s rapidly-expanding balance sheet was raising eyebrows in Congress; financial assets were becoming ever-more expensive even as the pace of economic recovery remained lacklustre; and hot money flows globally were reigniting imbalances in parts of the emerging world. The Fed recognised much of this earlier in the year but, at that stage, hadn’t quite worked out a strategy to avoid the onset of post-QE cold turkey. With the imposition of forward
guidance, Mr Bernanke has prescribed the economic patient a new set of monetary pills.

But just as QE came with side-effects, might we eventually discover that forward guidance also has its problems? After all, it only really works if members of the public believe the central bank’s view of the future and if those members of the public believe that other members of the public also believe the central bank’s view of the future (in other words, it works on the basis of Keynes’ beauty parade). At the very least, then, forward guidance is a fragile exercise in second-guessing.

Guessing, however, is not a good foundation for monetary policy. Despite the Fed’s best efforts, however, it’s difficult to see how guesswork can be removed altogether. Before the financial crisis, central banks were keen to offer maximum monetary “transparency”. Forward guidance and transparency, however, are not happy bedfellows.

The opaque nature of forward guidance relates in part to time and economic reality. Is forward guidance a promise not to raise interest rates until a certain date or, instead, is it a promise not to raise interest rates until certain economic conditions are met? The Fed’s statement suggests the latter. Defining those conditions, however, is hardly straightforward. We now learn that the 6.5 per cent unemployment rate threshold is only a “soft” target, with the FOMC judging that “it likely will be appropriate that to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 per cent, especially if projected inflation continues to run below the Committee’s 2 per cent longer-run goal”.

That all sounds very dovish. What the Fed has not clarified, however, is the causal relationship between unemployment and inflation, a relationship that depends on the nature of the western world’s post-financial crisis economic funk. Typically, we tend to think that inflation is a lagging indicator relative to unemployment: demand picks up,
the jobless rate falls, wages accelerate and prices eventually rise. On that basis, a big drop in unemployment is an early warning sign of higher inflation in the future, leading markets to anticipate a tightening of monetary policy.

In a post-financial crisis world, however, the causality may be reversed. Weak credit growth – reflecting either a weak banking system or persistent deleveraging – pushes inflation below target which, in turn, raises real interest rates (at the zero rate bound), pushes up real levels of debt and triggers further deleveraging. Under those circumstances, a fall in unemployment might be merely a cyclical accent within a story of underlying structural decline. This, after all, was the Japanese experience in the mid-1990s, when a modest economic recovery did nothing to prevent deflation from taking hold.

Which of these stories is relevant for the US is, at this stage, unclear. And that, ultimately, is the weakness with forward guidance. The Federal Reserve can’t make convincing promises because, like the rest of us, it doesn’t have a perfect crystal ball. But if those promises aren’t convincing, it’s not clear whether the real economy risk aversion which has
limited the pace of recovery in the US will go away any time soon.

The writer is HSBC’s chief global economist and author of When the Money Runs Out

As on past occasions, the agreement reached by eurozone finance ministers on the single resolution mechanism will officially be saluted as a big step towards a fully-fledged banking union. But many will be disappointed because the agreement falls short of expectations.

The mechanism is unsatisfactory from several viewpoints. The decision-making process is cumbersome and involves too many bodies. The funds are insufficient to tackle a big banking problem. The ability of the mechanism to borrow in the markets is still unclear. The period of transition to the final system is too long, at least compared to the frequency of banking crises. Overall, the separation between banking and sovereign risk – which was the main goal of the union – has not been achieved.

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