The ECB’s outright monetary transactions are a game-changer. OMT’s soothing power stems from the fact that market participants in effect see them as a commitment to the mutualisation of liabilities across the eurozone: countries standing together behind the debts of the vulnerable. But in reality, the eurozone is far from such a stable position.

Lasting and credible burden-sharing – for example, through eurozone bonds – cannot be imposed by unelected central bankers. It will require political leadership and broad support from electorates. Crucially, it will need to be accompanied by further ceding of national sovereignty by the 17 members of the eurozone to limit any future buildup of national indebtedness. It will not be an easy process, as amply demonstrated by the slow and painful progress towards a banking union.

It has become conventional wisdom that little can happen before the German general election in September. But sooner or later, Europe will need to determine whether to make this fundamental change to the design of political and monetary union.

And one thing is already clear: Germany will not and should not go down this route if it is the only large healthy economy in the eurozone. That means Germany will need to be assured of two things. First, that France – the second largest eurozone economy – will also be among the strong. Second, that the French and German economies will be sufficiently aligned for the two countries to have broadly common interests as they jointly shape the terms and conditions of mutualisation and deeper political union in Europe.

History suggests that it is reasonable for Germany to expect such assurances. Data since 1980 — and indeed since re-unification — shows that the German and French economies have grown at the same rate, on average. Admittedly France ran slightly larger budget deficits than Germany. But until the financial crisis, that difference was small – less than half of one percentage point of their respective gross domestic products. The Germans rightly expect their French partners to stand shoulder-to-shoulder and be well aligned. What terrible timing it is, therefore, that these economies have diverged by more than at any time over the past 30 years.

Virtually every economic indicator tells the same unhappy story. France’s fiscal deficit stood at around 4.5 per cent of GDP in 2012, while Germany’s government balanced its budget. Despite weak domestic demand, France’s current account remains stubbornly in deficit, versus Germany’s huge surplus. And French unemployment is now around 5 percentage points higher than in Germany – the biggest difference for more than three decades (see chart below). Most shockingly, youth unemployment now stands at 26 per cent in France versus 8 per cent in Germany.

This dramatic divergence surely reflects a lack of reform in France over at least the last decade. During the same time, Germany realigned its economy to boost potential growth and reduce unemployment. As a result, France’s government currently spends around 56 per cent of GDP – more than 10 percentage points higher than the share in Germany. French labour cost growth has far outstripped that of Germany and German exports have grown three times as much as French exports over the past decade.

France and Germany are, of course, aligned in one arena – global bond markets. Both countries can borrow at record low interest rates. But while such low rates are extremely helpful for France in the short term, there is little sign they reflect optimism about the French economy. Rather, they stem as much from broader global monetary, liquidity and regulatory conditions, together with continued strong demand for French government bonds from a deleveraging domestic economy.

Therefore to give Germany the assurance it will need to agree to permanent burden-sharing, France needs to press on with reforms, and to do so boldly and visibly. It needs to reduce the size of the state, lower labour costs and so improve competitiveness and boost medium term growth prospects. Put bluntly, France needs to make its economy more German, and it needs to do so as quickly as possible.

Some of the necessary measures may prove painful to implement in the short term, particularly against a backdrop of slow growth and high unemployment. But France needs to recognize that if it is to achieve its long held goal of deeper union and mutualisation of liabilities then it too will need to cede some sovereignty.

There are promising signs that the French government and corporate elite now recognise that reforms are essential. For example, the government prompted French unions and business organisations to reach a labour market reform agreement that was more radical than many expected. The details of that agreement suggest that French unions may be making the journey towards becoming more German – increasing their focus on employment rather than wages. But that reform, which finally passed through the French parliament last month, is only a first step. France has much further to go.

The prize for France of deeper union and mutualisation of liabilities is still within its grasp. And it may turn out to be the only way to save the euro. But to make it possible for Germany to take this final step, France must itself give up some sovereignty, and press ahead with reforms to reverse the recent and ill-timed divergence of its economy from Germany’s.

Haruhiko Kuroda, the newly installed Bank of Japan governor, has offered the monetary equivalent of shock and awe. Under Mr Kuroda’s guidance, the BoJ now intends to hit a 2 per cent inflation target within the next two years; is committed to doubling the monetary base; is willing to buy bonds of all sorts of maturities; is accelerating its purchase of risk assets; and has gone considerably beyond already elevated expectations within financial markets.

In acting decisively, Mr Kuroda is following a well-trodden path: think of Paul Volcker and his battle against inflation at the beginning of the 1980s or Alan Greenspan and his tussle with equity markets in 1987. Moreover, there has been a willingness to learn from the excessive caution of the past. By buying bonds of more or less all maturities, the whole yield curve has come down. By openly committing to a higher inflation objective, it’s clear that monetary conditions will remain loose for a prolonged period of time. Meanwhile, Shinzo Abe, Japan’s prime minister, seems keen to avoid a UK-style inflation trap, emphasising that a healthy escape from deflation requires not just higher prices but also higher wages.

So far, so good. The commitment is most definitely there and the ambition has now been well-defined. Yet Japan is not yet out of deflationary trouble and, even in the event of the monetary equivalent of the Great Escape, it might still all end in disappointment.

The first – and most obvious – problem is that Japan’s difficulties do not reflect an absence of monetary and fiscal stimulus alone. Offshoring, ageing, the unproductive use of women in the workforce and an acutely cautious attitude towards immigration have all played their part in constraining Japanese growth during its two lost decades. A wave of the monetary magic wand cannot fix those problems.

The second difficulty relates to leakage in what is known as the carry trade, in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return. It may be that borrowing costs in yen are now remarkably low relative to Japan’s own history but, over the past two decades, they have always been low relative to interest rates elsewhere. Over that period, attempts to boost the Japanese economy have too often seen the benefits spilling over to other parts of the world, creating unwanted hot money inflows, overvalued currencies and unsustainable financial bubbles, even as the Japanese economy has remained trapped in a deflationary hole.

The third challenge relates to the performance of the yen and, more generally, the transmission mechanism of monetary policy. There’s a potential inconsistency between the Japanese view of monetary stimulus (it lifts domestic demand and rebalances the economy towards domestic consumption) and the – whispered – UK view (it lowers the exchange rate and rebalances the economy towards exports). In the UK’s case, the rebalancing never came to pass and, arguably, a lower level of sterling only led, via higher import prices, to a squeeze in real wages. In Japan’s case, previous experiments with QE – admittedly not on the same grand scale – mainly served to boost exports without any significant impact on domestic demand. In a world where other nations are struggling for growth, a yen-induced export-led Japanese economic recovery might not be enthusiastically received. And, despite Mr Abe’s hopes of higher wages, it may be that rising import prices ultimately only serve to squeeze real incomes.

Mr Kuroda has got to first base. He has yet to score a home run.

The writer is HSBC’s group chief economist. His new book, ‘When the Money Runs Out: The End of Western Affluence’, will be published by Yale in May

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 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”.



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

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

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

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

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

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

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

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

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

The new Energy Bill that the government has introduced into parliament appears to pass the main tests that will ensure that the UK’s electricity system keeps the lights on while also reducing its impact on our climate. The basic principles are sound and there is a clear and encouraging sense of direction.

However, it still sends worrying signs that the internal bickering within the government over the future direction of energy policy may continue, undermining the confidence of potential investors in the power sector.

On the plus side, the new “contracts for difference”, should provide greater certainty about the returns on investments in renewables, carbon capture and storage and nuclear power, at least up to 2020, particularly as a new government-owned company will act as a single counterparty to these contracts, and hence limit the risks for private companies.

(These contracts mean that if the market price of electricity drops below a “strike price” set by the government, investors will be compensated.)

The cost to consumers, capped by the “levy control framework“, should be modest and affordable, with the Department of Energy and Climate Change estimating that low-carbon investments will add £95, or 7 per cent, to the average household bill in 2020, an average increase of less than 1 per cent a year, compared with £20, or 2 per cent, in 2011. According to the energy regulator Ofgem, average electricity bills have risen by more than 10 per cent over the past four years, and there are, of course, understandable concerns about how rising energy prices affect the cost of living.

Consumers could be paying less in 2020 if the government’s energy efficiency measures have the desired impact on homes and businesses; and the advantages of alternatives to fossil fuels will be greater if the wholesale price of gas rises more quickly than in DECC’s projections.

This means that the Energy Bill provides the clarity which could underpin the scale of the investment in low-carbon power that is needed up to 2020 to provide affordable electricity while reducing emissions of greenhouse gases.

The guarantee of support for renewables, carbon capture and storage and nuclear means that the UK low-carbon electricity supply system should include a portfolio of technologies that is diverse and robust enough to deal with further development.

The creation of the power capacity market, to provide insurance against blackouts via financial incentives, with the first auction tentatively scheduled for 2014, should provide a greater security of supply. The pressures on capacity are strongly influenced by the level and pattern of demand and markets can play a strong role in their management.

The key elements of managing demand in relation to supply should involve time-of-day pricing and contracts for “interruptibility”, as well as, fundamentally, using energy efficiency measures to reduce overall electricity consumption.

Taking all these measures together, the package represents an encouraging move towards using markets to provide for the medium and long run, as well as the short run, in contrast to the current system, with its excessive focus on near-term competition. Fundamental to the markets doing their work for efficiency, flexibility and discovery will be a strong carbon price – already a government commitment.

All these measures provide a clear market-based framework that will encourage investment. Unfortunately, there are still some signals that may ultimately put off investors.

Over recent months, the coalition has appeared unclear about the direction of energy policy and its commitment to low-carbon electricity.

Last year, the government dithered over accepting the recommendations by the independent Committee on Climate Change about the cuts in emissions required by the mid-2020s, insisting that the carbon budget should be reviewed next year, with the possibility that it would be weakened.

In addition, some ministers and senior cabinet members have given the false impression that economic growth and environmental responsibility are not compatible, or exaggerated the costs and challenges of deploying renewables, particularly onshore wind farms.

As a result, the very sensible CCC recommended in September that the government should include in the Energy Bill a target to decarbonise the power sector by 2030, to try to re-establish clarity for investors.

But the government has fudged its response, only creating a provision within the Energy Bill to introduce such a decarbonisation target in 2016 during the next parliament. This is a clear sign that the simmering internal disagreements between ministers over energy policy have not been truly settled, creating an impression to the outside world of risks that policy may unexpectedly change direction in future.

So it remains to be seen how investors react not just to the contents of the bill, but also to its passage through Parliament. If they remain confident and optimistic about the UK’s power sector, they could invest billions of pounds, giving a much-needed boost to growth.

But if investors are unconvinced and uncertain about the Government’s intentions, households and businesses will find it increasingly difficult to gain access to affordable and secure sources of clean electricity.

President Morsi’s decree granting him more power has acted as a catalyst for widespread protests in Egypt and a rupture in relations between the executive and judicial branches of government. It has also placed Egypt’s allies in an awkward position. The renewed turmoil will also inevitably raise questions about the recent agreement with the International Monetary Fund, which many view as essential for the economy’s wellbeing.

Egypt has turned to the IMF not out of choice but of necessity. Its economy is yet to gain proper momentum. Unemployment is too high, especially among the young. Foreign exchange reserves have stabilised but show little sign of returning to prior levels. The budget deficit is under pressure. Local interest rates have risen. And foreign investors remain hesitant, adding to the financial rationing that is holding back the private sector’s considerable potential.

The political and social implications of Mr Morsi’s decision are potentially profound. Most importantly, the current situation impedes progress towards the important goal of the grassroots uprising of January 2011: to deliver greater social justice and broad-based economic improvement, as well as reorient institutions towards the common good and away from benefiting deeply-entrenched minority interests .

A derailment of the IMF’s support for Egypt would add to the country’s challenges. This institution is the only creditor able and willing to provide Egypt with fast, low cost financing. Its involvement would facilitate $10bn from other creditors, as well as the reported $4.8bn from the fund itself. The institution’s technocrats can support Egypt in the implementation of its own reform programme via a coherent economic framework

Getting broad-based local support for the IMF’s involvement was never going to be easy. Some Egyptians still view the institution as an arm of western domination. Many have no desire to return to the days of external dependency. And most worry that the fund’s involvement would complicate already-delicate measures to reform Egypt’s subsidy system and its bloated public sector.

Mobilising external support for a fund programme is also complex. With its involvement in Europe over the last three years, the IMF has sent confusing signals about programme standards, funding levels and the application of conditionality. Some countries expect the IMF to apply the same leniency to Egypt. Others worry that this would constitute yet another step down a very slippery slope.

For now these issues have been crowded out by the political turmoil. But they will soon return.

Once the country regains its footing, which will probably involve Mr Morsi rescinding parts of the recent decree, the government and the IMF will need to move quickly to anchor the agreement aimed at stabilising the country’s immediate economic situation and providing the basis for meeting the medium-term objectives of the revolution.

To this end, the IMF needs to be open and explicit about the trade-offs involved as Egypt attempts to move from a horrid past to a better and more inclusive future. For its part, the government will need to engage in broad discussions on any IMF programme.

This would inevitably involve lots of noise. Yet this is Egypt’s new reality. And fundamentally it is not such a bad one.

For the first time in a very long time, average Egyptians feel empowered and able to influence the destiny of a country that they now own. To outsiders, this comes across as loud and messy. And it is. But it is also an indication of Egypt’s new checks and balances and, more broadly, its bumpy journey towards a vibrant democracy.

Proper engagement with the IMF on an Egyptian-owned program could help the country progress on this important path. In turn, this would increase the likelihood that the Fund would go from being seen as an instrument of western colonialism to a supporter of Egyptians legitimately seeking greater social justice, inclusive growth and fairness.

A recent survey by the French Institute of Public Opinion (Ifop) showed that 68 per cent of the French are pessimistic about the future, a record for this early in a new presidency. This does not mean that France has become a dismal country to visit: the French rather enjoy gloom. They even have a word for it – morosite – which has no easy equivalent in English, though the sense is clear.

But while it is quite acceptable in Paris for a resident to be pessimistic, indeed it is almost de rigueur, the same indulgence is not granted to foreigners. The French have spent the last weeks shooting messengers. The rot set in at the end of October when the German news magazine Bild asked pointedly if France is about to be the new Greece. An Economist cover story described France as a time-bomb ticking at the heart of Europe. Then, to add insult to injury, Moody’s downgraded French debt, and left the country on negative watch.

This outbreak of Anglo-Saxon hostility has caused a degree of circling of wagons. The Prime Minister, Jean-Francois Ayrault, talked of sensationalism and the desire to sell papers. The right-leaning Le Figaro, no friend of President Hollande, the main target of the Economist article, charged the British press with “le French-bashing”. (The Financial Times is seen as an enthusiastic fellow-traveller of The Economist in this regard).

In fact the English language press is saying nothing that has not been said, more elegantly, and with more supporting analysis, by the Cour des Comptes, the French National Audit Office (though that pedestrian English term does not quite convey its grandeur) or in a report on competitiveness by Louis Gallois, the former boss of the European defence group EADS. Mr Gallois’ report raised the alarm, pointing in particular at high employment taxes and inflexible labour markets as impediments to growth.

But the recommendations, from a man with centre left credentials, were – to Anglo-Saxon eyes – a strange mishmash. He argued for a cut in labour taxes, funded by increased VAT, and some modest legal changes, but balanced by a set of measures to promote what we would call “industrial democracy”, with greater staff representation on works councils, whose impact on competitiveness is unclear and highly indirect, at best.

In response, the government set out a “competitiveness pact“, which included a promise to implement some of his 22 ideas. But French employers were underwhelmed, and it is unclear how committed the other social partners are to the pact. In any event, it is hard to see that it amounts to a Copernican revolution, as Finance Minister Pierre Moscovici characterised it. French policy remains built on an assumption that the sun will continue to circle France, and that investors will continue to look benignly on the state’s 56 per cent share of the economy.

So far, they are right. Markets have not reacted to the Moody’s’ downgrade: French borrowing costs remain very low. In relative terms, French credit looks secure. Though there have been rumblings from across the Rhine from German economists, and possibly from Finance Minister Wolfgang Schaueble himself (though that is denied) about France’s declining competitiveness, and unsustainable labour costs, the Germans still have greater worries further south, and no incentive to upset the applecart by questioning the soundness of their biggest partner.

Perhaps we should conclude, then, after a few weeks of Gallic angst, that it has been much ado about nothing, and all’s well that ends well. Life can go on as normal for the Normal President.

Perhaps, but the facts are inescapable. French unit labour costs have risen by 20 per cent more than German since the launch of the euro, and there is no sign of a change of trend. France’s public spending remains well above the EU norm, even five percentage points above Sweden’s. A present day Shakespeare might produce a bittersweet comedy under the title “If a thing can’t go on for ever it will probably end one day”. That day could dawn with little warning.

Below the surface, there are worries. At a dinner in Paris last week the conversation turned to the interesting question of who the French Mario Monti would be if a government of national unity were needed there. Pascal Lamy was the answer, now happily “au dessus de la melee” (above the battle) at the World Trade Organisation in Geneva. He knows the geography of the prime ministerial offices at Matignon quite well. Mr Ayrault should beware.

On Monday, Turkish Prime Minister Recep Tayyip Erdogan denounced Israel as a “terrorist state”. Whether you find yourself nodding or shaking your head in response, take a moment to consider those words.

This judgment did not come from predictable quarters: from Syria’s soldiers, Iran’s mullahs, or even Saudi royals. Turkey is a moderate Muslim democracy, a member of Nato, one that has traditionally protected constructive relations with Israel. And Mr Erdogan did not simply denounce a particular Israeli action, as he did in 2010 following an Israeli raid on a Turkish aid ship bound for Gaza.

He labeled Israel itself as a source of terrorism.

What’s truly new about Israelis and Palestinians exchanging fire? It isn’t Israeli politics. Early elections are on the way, and there are few signs that Prime Minister Benjamin Netanyahu faces a serious leadership challenge. Nor is it the increasing number and accuracy of rockets fired by Hamas and its Al-Qassam brigades.

It is the surrounding landscape that has changed. The immediate neighbors are the first worry. Egypt’s embattled civilian leaders have little incentive to give Israel any breathing room. The same can be said for Jordan, and Israel has very few friends on any side of Syria’s grinding civil war. In fact, governments in the Middle East, even those that are relatively stable, must worry about public opinion as never before. And outside the US, it’s getting hard to find a country in which public opinion remains on Israel’s side.

That’s why it is especially worrying that Israel is behaving as if none of this matters. For the near term, perhaps it doesn’t. Though Hamas has managed to stockpile a substantial number of increasingly sophisticated weapons, Israel plainly has the means to restore order-with brute force where necessary-and its “Iron Dome” anti-missile system will hold. Hamas will fight on knowing that its forces are overmatched.

But on the international stage, this conflict and the response it has provoked from moderate governments like Turkey’s are game-changers. There are no longer persuadable partners in the region.

Washington will defend its old friend. President Obama has made crystal clear that Israel’s operations in Gaza have his full support. Hillary Clinton, the US secretary of state, is expected to travel to the region today. Yet, the US is not the power looking to become more active in the Middle East in years to come. That country is China, a still-emerging power that has no cultural and ideological ties with Israel to protect as it looks to ensure the steady long-term flow of crude oil.

For all these reasons, it has never been more important for Israel’s long-term security for Israelis leaders to build and protect a workable peace with Palestinians. Sadly, after years of diplomatic inaction and now another surge of deadly violence, that peace looks more remote than ever.

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’

As the deadline to avert the fiscal cliff gets closer, US policy makers may want to learn some lessons from the way eurozone authorities managed their crisis. Let’s consider four.

The first is that policy authorities tend to act too late, after financial markets have lost confidence. This is because of a belief among policy makers that the unpopularity of decisions will diminish only when voters understand that the alternative is much worse. Only on the verge of disaster do citizens understand that unpalatable policies are necessary. But by that point, financial markets start questioning the determination and ability of policy makers to face the situation and tend to lose confidence. At that point, even more unpalatable actions may be required.

The eurozone experience has shown how costly such a strategy can be. For instance, finding a consensus in Germany for providing financial support for Greece became possible only when the crisis reached a peak, in May 2010, and the euro seemed at risk. But at that point the size of the overall package required to stabilise the markets had risen substantially.

If the US authorities follow the same path and wait for market pressure to force a compromise, the decision might be more acceptable to both sides, being the last resort, but the burden on the economy might be dear. The sooner a solution is found, the less costly it is.

The second lesson to be learned from the European experience is that open political brinkmanship fuels financial instability. Games of chicken are won by the party which convinces the other that it will not compromise, even if it makes everybody worse off. Negotiations should ideally take place confidentially, and the result would be known only when it is reached. This is obviously difficult to achieve in democratic systems.

In the eurozone, brinkmanship has been frequently used to convince the other party in the negotiation. In particular, eurozone authorities had at times to threaten openly that they would let Greece fall out of the euro, in order to make the Greek policy-makers understand that there was no room for compromising on conditionality. This might have been effective in convincing the Greek government to stick to their commitments, but it also scared the markets away from Greece, and the eurozone.

If the opposing parts in the US start negotiating in public, from their apparently uncompromising positions, the risk of catastrophe will increasingly be discounted by the markets, with negative effects on confidence.

The third lesson is that partial solutions may temporarily solve problems but ultimately a piecemeal approach requires more comprehensive action later on, generally much earlier than expected. The political cost of such a strategy has been quite high.

European summits have had less and less impact on market sentiment, as the prospected solutions appeared to be partial and lacking a comprehensive plan. For instance, markets reversed the initial positive reaction to the agreement on the ESM last June, when they understood that the agreement on the banking union and fiscal union was still vague.

In the US, much emphasis has been put recently on the need to avoid the fiscal cliff, but less so on how to achieve the result in a sustainable way. Confidence is likely to vanish if policy makers do not come up with a credible medium term plan, based on realistic assumptions about growth and interest rates.

The fourth lesson which can be drawn from the eurozone crisis is that fiscal and structural problems can ultimately be settled only by the respective policies. Monetary policy can only help buying time for the relevant political sphere to design and implement concrete solutions. Experience shows, however, that if the time is too long the authorities in charge tend to relax, thinking that favorable market conditions are there to last, and ignoring that these conditions are partly the result of a deliberately accommodative monetary policy.

Each time the ECB succeeded in calming the markets with extraordinary measures, either the Securities Market Program or the Long Term Refinancing Operations, the pressure eased on the eurozone political authorities to pursue the adjustment and complete the institutional framework underlying the euro.This is the reason why the ECB’s Open Market Transactions had to be made conditional on the political authorities’ signed commitment to do their part of the job. Acting without such conditionality would entail the risk of losing credibility and compromising the effectiveness of monetary policy.

If a central bank gives the impression that it stands ready to be the “only game in town”, it will end up being played. The other policy makers will have no incentive to take on their own responsibilities. This will ultimately drag the central bank into monetising the debt and lose its reputation.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Affairs and a former member of the ECB’s executive board

The minutes of the US Federal Reserve released on Wednesday are an essential read for those interested in a real time snapshot of the complexity of modern day central banking. They are also a cautionary note for all who believe that, acting on their own, today’s hyper-active central banks can engineer good economic outcomes.

While the Fed is already deep in experimental mode, the minutes confirm that officials there are already considering additional measures. There are two reasons for this. First, their baseline economic expectations remain subdued as more positive housing and consumption indicators are offset by slower business activity. Second, they recognise the “significant downside risk” to the baseline forecast due to the global economy’s synchronised slowdown and the possibility of further financial shocks, such as the US falling off the fiscal cliff.

The minutes also reveal considerable confusion as to what exactly the Fed should do next. With interest rates at zero and forward interest rate guidance already extended to mid-2015, policy is faced with a shrinking set of options. This includes evolving further its communication role by moving to “quantitative thresholds” (ie, specific targets for the unemployment rate and inflation or, alternatively, for a broader concept such as nominal GDP); and/or expanding the programme to purchase securities on the open market (or “QE3”) in order to change the private sector’s behaviour.

While many Fed officials appear to favour additional policy activism, the minutes cite the need “to resolve a number of practical issues” before taking another major step. That is not surprising. What the Fed is now considering is fraught with even greater operational complexity. And this applies to both components.

As regards communication, the challenges go well beyond the tricky specification of the quantitative thresholds. Should the Fed target actual or forecast levels? Should its policy reaction function involve a glide path or a step function? How conditional should its commitment be?

The Fed is also running against practical concerns when it comes to the possibility of more QE. Already, its large purchases have turned this traditional referee into a non-commercial player with influential ownership of many individual market issues. The Fed has imposed a sizeable footprint on the markets for US Treasuries and mortgages. In doing so, it has altered not only valuations but also the efficient functioning of markets. As such, it is also far from straightforward to expand the institution’s securities program without creating significant damage.

As real as these problems are, they pale in comparison to what is really at issue: the worrisome signal that – with other policymakers essentially missing in action and politicians again playing Russian roulette with the economy – influential members at the Fed feel that they have no choice but to do more using imperfect, untested, partial and, potentially, risky tools.

This policy dilemma is amplified by the fact that, until now, the Fed’s unusual policy activism has failed to deliver the growth and employment results that its policymakers expected. At best, Fed officials have provided more time for the system to heal, but at the risk of growing collateral damage and unintended adverse consequences.

Judging from the minutes, some Fed officials are worried, questioning “the effectiveness of current purchases.” Yet this will not stop the institution from implementing additional highly experimental policies – and not because it wants to but, rather, because it feels it has no choice but to do so. And it could happen as early as the December or January Fed policy meetings.

Expect the Fed to move to quantitative thresholds, announce additional outright purchases of securities, and reintroduce Treasuries to their list of targeted instruments. But unless (and until) politicians and other policy making entities step up to their responsibilities, this unusual policy activism will fail to deliver the economic outcomes that the country needs and deserves.

China’s change of leadership comes at a precarious time for the world economy. Europe is still trying to find a politically sensible solution to the eurozone crisis; the US is at the edge of the fiscal cliff. The adjustment in the developed world is likely to take many years, possibly the rest of this decade. For China, this means that fast export growth will be permanently sealed in the historical drawer.

Challenges inside China are no less demanding. The 18th Chinese Communist party congress pledged to double Chinese per capita income by 2020. This is a modest goal when judged against historical records. However, several factors may make it a challenging aim in the rest of the 2010s. Facing an export slowdown, China needs to enlarge its domestic market. However, there is no clear sign that household consumption will increase as a share of the economy, after more than a decade of decline. China’s labour force will peak in 2015; after that, China has to rely on technological progress and human capital to generate more growth. Manufacturing, China’s growth engine, will probably reach a peak in terms of its share in the economy sometime between 2015 and 2020. Change is afoot.

It seems that the new party leadership has noticed. The 18th congress has highlighted several reforms to address these challenges, among which the reform of the hukou system, or the household registration system, is the most significant. This system was introduced in 1958 to restrict labour mobility, especially migration from the countryside to cities. In effect, it confines a person’s legal residency to his birthplace. However, 240m people, including 160m with rural hukou, do not presently live in their birthplaces.

In fact, a new hukou policy was announced in February 2012. Through this new policy, migrants in small cities can apply for local hukou if they have a stable job and a place (including a rented home) to live. Migrants in medium-sized cities can do the same if they have worked and lived in the same city for three years in a row.

This policy, if it is implemented, will greatly boost domestic consumption for two reasons. First, rural migrants save much of their income because they have to prepare for going back home someday; giving them urban hukou will stabilize their expectations and allow them to consume more. A rough calculation shows that China’s household consumption would be increase by 4.2 percentage points as a share of GDP if the consumption level of rural migrants were increased to the average level of city-based Chinese.

Second, migrants will bring their children and parents to the city once they get the urban hukou. A larger urban population will provide a larger market for services, a sector very much underdeveloped and with the potential to fill the gap left by the falling share of manufacturing in the second half of this decade.

In China, leaders are not elected. But political cycles still exist. Market-oriented reforms between 1978 and 2002 had increased the efficiency of the Chinese economy, but also left the country’s social security system shattered and its countryside untended. In the last decade the Hu Jintao-Wen Jiabao government took serious steps to rebuild the social security system and to increase investment into the countryside, especially in its education system.

In a sense, this government has turned the country toward the left. It is thus reasonable to expect that the next government of Xi Jinping and Li Keqiang would go back to the reform track. The political report of the 18th congress did not mention the payroll reform, a mandate carried out by the current premier Wen Jiabao in the hope to correct China’s enlarging income inequality. Clearly, the next leadership does not want to continue the left-leaning policies of the current administration.

There are daunting challenges for the next leadership if it wants to carry out the reforms spoken of during the 18th congress. There is still no concrete plan to implement the hukou reform, eight months after its announcement. Both local governments and local residents are against the reform. Local governments believe that accepting the migrants would greatly increase the burden of local public finance, and local residents believe that migrants would endanger their children’s chances of education and shrink their already tight living spaces. Unlike previous reforms that brought clear gains to the society and only burdened isolated groups of people, the hukou reform does not bring immediate gains but poses clear and immediate threats to the interests of a majority of the population.

It will take great courage and political wisdom for the new leadership to gather proper supports for the reforms pledged by the 18th party congress. The motion has been set out; now we wait for real actions.

Mistakes happen, even in great news organisations such as the BBC. If they are bad enough, heads will probably have to roll. But what matters much more than the bloodletting is that lessons should be learnt from what went wrong, so that the error is not repeated. In the case of the most recent Newsnight affair, there are three main conclusions to be drawn.

The first is that the BBC’s news is always going to be held, very properly, to a much higher standard than the work of its commercial rivals. The whole point of a public service broadcaster is that its editors can be relied on to exercise sound news judgment, and to deliver accurate and authoritative information. That does not mean that they shouldn’t seek to break exclusive stories, or to undertake investigative journalism. On the contrary, it’s in the public interest that the BBC should be using its vast resources to take on challenging projects that are beyond the reach of other news organisations. But this is by its nature difficult work, and must be managed with great care.

In the first place, there need to be clear rules about sourcing, about giving individuals named in the story the right to respond ahead of publication, and about the authority that is required to approve the broadcasting of contentious material. Such stories need to be checked and rechecked, and never rushed onto the air. Above all, senior editors have to trust the journalists that are involved in projects of this kind, and be confident that they share the organisation’s values. Among other things, this means that work like this should never be subcontracted to outsiders, as appears to have happened at least in part with the inaccurate Newsnight story.

The second lesson is that the whole ethos and mission of the BBC must be different from that of commercial broadcasters. Its journalists should not be attempting to compete with their very different range of news priorities, or to build audiences in any other way than through the sheer quality of their work. And editors must be reminded that quality reporting is not boring – as a whole bunch of talented BBC people from Nick Robinson in Westminster to Mark Mardell in Washington demonstrate every day.

The final lesson is that when trouble comes, as sooner or later it very probably will, the Director General’s job will always be on the line whether or not he or she is called editor in chief. It follows that the overriding priority of the job must be to protect and enhance the organisation’s reputation for quality journalism. Since one person can only take direct oversight of a tiny fraction of the BBC’s immense news output, the Director General must have a series of trusted lieutenants with direct responsibility for specific areas of coverage. It’s also necessary to have colleagues with a remit to monitor the social media, in order to help inform the overall news judgment.

A set of clearly understood rules is also required to make sure that the most sensitive material crosses the Director General’s desk in a timely fashion. The priorities would change as the news agenda moved on, but would always apply to stories which could potentially involve big legal liabilities, or which could have serious political consequences. The inaccurate Newsnight story, which broke all the rules of sound journalism, would have been caught on both these counts. The Director General simply cannot afford to be blind-sided as he was in this case.

Its public service broadcaster is an invaluable asset for the UK and the wider world, and must be cherished as such. The present furore will eventually die away, but when it does it’s vital that these three lessons should remain etched in the BBC’s corporate memory

Pakistan and Afghanistan look on the spectacular landslide re-election of Barack Obama for a second term as US president with some trepidation. Pakistan has just come out of a nine-month breakdown of all talks with the US, the worst state the two countries relationship has been in for 60 years. Pakistan thinks the US under Mr Obama has no strategy, while the US thinks Pakistan lies as it continues to harbour extremists. Mr Obama has frequently called Pakistan his biggest headache but he has been unable to come up with a satisfying painkiller.

In Afghanistan, a war of words has persisted between Obama officials and President Hamid Karzai. Washington has in effect told the Afghan President to be quiet and be grateful for the sacrifices that the US is making. Mr Karzai keeps reminding everyone that he enjoyed better days with George W. Bush and that Mr Obama has tried to undermine him.

For leaders of both countries, Mr Obama’s first term has been the worst of all possible worlds, periodically using carrot or stick to drag Islamabad and Kabul into line, but often using threats without clear strategic goals. Moreover, acts declared as victories by the US such as the killing of Osama bin Laden, the start of the US troop withdrawal from Afghanistan or the refusal to provide the Afghan army with heavy weapons have been viewed with enormous suspicion by Pakistan and Afghanistan.

In Washington, the problems have been magnified by internal rivalries. Mr Obama had allowed the US military to run his policies towards Pakistan and Afghanistan – starting with the surge in Afghanistan in 2009 and then planning for the US withdrawal in 2014. More important political strategies such as talking to the Taliban, making sure free and fair elections are held in Afghanistan and Pakistan and trying to revive relations with Islamabad have been run by a weak state department, stymied by the lack of presidential support.

Now Mr Obama gets a chance to do things differently. What should he do?

Well, for starters, everything.

If the US withdrawal from Afghanistan in 2014 is high on his agenda than he should prioritise talks with the Taliban that would aim for a ceasefire between all sides before troops depart and before Afghan presidential elections are held in April of that year.

Many of the Taliban leaders have become advocates for a political settlement rather than a bloody power grab for Kabul that the Taliban know would prompt a civil war they cannot win.

Last year’s US-Taliban talks broke down, partly because the military and the CIA in Washington undermined them. Now US officials say all parts of the administration are on board. Mr Obama needs to swiftly compose a team of experts and diplomats and enlist the help of some European countries to talk to the Taliban with the aim of reducing violence in Afghanistan in a step-by-step process that could lead to a ceasefire. Another major diplomatic effort is also needed to revive talks with all neighbouring states, including Iran and Pakistan, about a non-interference regional pact that would protect Afghanistan.

Despite the country’s internal chaos, a clear US strategy to talk to the Afghan Taliban leaders based in Pakistan would be attractive to the warring military, judicial and political factions. That is especially so for the military, which is now feeling the heat from the growing threat posed by the Pakistani Taliban. A US dialogue to achieve a cease fire in Afghanistan that includes Pakistani participation may act as a glue to help bind the bickering Pakistani establishment.

The new Obama administration needs to re-engage with Pakistan on all fronts but particularly to help it deal with the growing internal jihadist threat and that includes helping Pakistan devise a comprehensive policy to disarm the anti-Indian extremist groups that inhabit the important province of Punjab. On its own and without financial help Pakistan is presently incapable of devising any such strategy. And if left out of any peace equation in Afghanistan, its intelligence agencies will be tempted to act as spoilers rather than healers.

At the beginning of his first administration Mr Obama took several positive steps to try and ease tensions between the US and the broader Muslim world but there was no follow through by the White House or the State Department. Events such as the Arab Spring, the civil war in Syria and the worsening relations with Iran overwhelmed those early initiatives. There was no effort to deal with the Israeli-Palestinian quagmire.

What is needed is a more consistent, more deeply engaged and well led political-diplomatic effort by the US in the broader Muslim world in which the newly elected President Obama is more involved in than what he has been in the past four years.

For a while in the small hours, even after the arithmetic of the electoral college had already doomed his campaign, it seemed Mitt Romney would not concede defeat. Karl Rove, whose perpetual air of self-satisfaction must for once have been tinged with chagrin, was muttering on air that Ohio would have to be recounted; that his home network of Fox had thrown in the towel prematurely. Hopes of a repeat of Bush-Gore were evidently still glimmering. But this was the last gasp emitted from the echo chamber of delusions within which the Republican elite have sealed themselves for years

Then Mr Romney came on stage in Boston to make his concession speech. It was gracious but less moving than John McCain’s speech four years ago, a concession so generous and imbued with a sense of the historical moment that it alarmed even his own Republican troops. But in his way, too, Mitt Romney for a moment dropped the mask. Behind it was a chastened man, for once slightly unkempt, the weariness visible. But not much else. Graceful good wishes to the victor, a prayer for the President and the country and then true Romney, a homily that teachers, investors, citizens of strong faith might lead us out of dire straits. And that was it.

Suddenly the man who had tried to be everything to everyone was nothing to anyone, except a tired private equity executive and former Governor of a state that had just repudiated him by a huge margin. In the last weeks of the campaign his strategists had imagined they might expand the “battleground map” into the industrial mid-West, concocting a fable – that Barack Obama had sent the auto industry into bankruptcy and was even now outsourcing jobs to China – so at odds with the truth that even MoTown executives were compelled to denounce it. Detroit, Milwaukee and Cleveland were not buying it, and so long before Pennsylvania was known to have turned the tide Mr Obama’s way, the Republicans had lost the presidency in the industrial heartland.

What bit the dust on Tuesday was the world of denial in which Republicans have immured themselves ever since the rise of the Tea Party in 2009. This is a universe in which the financial crash was caused by over-regulation; one in which, despite years of brutal drought and violent weather patterns, climate change is a liberal hoax; a country that can correct a vast structural deficit without ever raising additional revenue, while expanding the military budget beyond anything sought by the Pentagon; a belief system in which Mr Obama was the source of all economic ills rather than the steward of the most intractable crisis since the Depression. The mantra was that a business executive would, simply by virtue of that fact, effect a magical rejuvenation of the staggering American economy.

But the most obstinate fantasy to die in this election was that the greatness of the United States was somehow inseparably bound to the dominion of the white male. The most egregiously offensive candidates for the Senate, Richard Mourdock in Indiana, who proclaimed that post-rape conceptions must be part of God’s plan, and Todd Akin in Missouri, who spoke of “legitimate rape”, threw away Senate seats that were the GOP’s for the taking. Another illusion was that huge sums poured through Super- Pacs would tip the balance in competitive races. Linda McMahon, the professional wrestling tycoon, spent $100m in two elections attempting to become Senator for Connecticut and still head-locked herself into disaster.

Built into these assumptions was the conviction that non-white, non-male voters, especially Latinos, could not be mobilised, especially not with the same intensity or numbers they had shown in 2008. The long lines of people waiting hours to vote in Florida and many other places ended that narrow-minded complacency.

Of course the Republican party does not altogether turn its back on this new America. But the harshness of its policy on immigration is a slow-drip suicide for the Republicans, reducing them to becoming the Party of the confederacy and the mountain states of guns and God.

The mere fact of Mr Obama’s re-election ought, if the Republicans have an eye for their long-term preservation, give them pause before venturing on the usual manic conspiracy theories or denouncing their nominee for being insufficiently conservative. But you might also hope they listened to his victory speech, which was, for a candidate who has at times been startlingly disengaged from the persuading element of the presidency, one of the great moments in his political career. For after generously thanking two generations of Romneys for public service, Mr Obama went on to defend democracy itself on one of its climactic days: not in the airy philosophical terms to which he often resorts, but by painting a picture of ordinary people ennobled by the democratic process. In vivid words he painted a picture of countless people knocking on doors, queueing to vote notwithstanding all the obstacles placed in their way by institutions or Mother Nature; living their American identity through these acts of engagement. Politics, the President said, can sometimes seem, small or “silly” (amen to that) before insisting that in the majesty of the multitudes it was as big as anything can get. Then he sounded a theme that has been too often muted in his first term: that the US is a republic in which mutual obligations matter as much as the assertion of rights. And where did America’s true exceptionalism lie? In its unique diversity, which his own person embodies and which might at last be seen as the sign not of its enervation but of its rejuvenated redemption.

The writer is an FT contributing editor

The absence of a discussion on climate change in the three debates between Barack Obama and Mitt Romney is a sign of how the topic has fallen off the US policy agenda since the financial crisis. This is a sad gap and one the next president must address.

Looking globally, however, there is some cause for hope. Last week, the board of the Green Climate Fund, a very important but little known international institution, decided to locate the fund permanently in South Korea. This was a good move. South Korea has been a global leader in promoting the important concept of “green growth”: economic growth combined with reduced greenhouse gas emissions.

The Green Climate Fund, agreed by the 191 countries that are signatory to the UN Framework Convention on Climate Change, is the key global instrument for enabling poor countries to undertake investments in renewable energy and climate change adaptation (that is, making the economy more resilient to the climate change that is already underway). The Green Climate Fund has been given a daunting assignment: to raise $100bn per year for low-income countries by 2020.

Rich countries need to finance poor countries for three reasons.

First, they owe it to the them. Around 75 per cent of the greenhouse gas emissions to date have come from the rich countries, but it is the poor countries, notably in the tropics, that are reeling from the brunt of human-induced climate change. If we had global tort law, the poor countries would sue the rich countries for damages in destroying their climate. Instead, we have an agreement on compensation.

Second, the world has rightly accepted that climate change action must be addressed within the overall context of development, meaning that poor countries must not be hampered by the costs of low-carbon energy and the burdens of climate-change adaptation.

Third, the world has accepted a pragmatic reality: without incremental climate financing, poor countries simply can’t afford a development strategy that combines low-carbon energy with universal access to electricity. They will be forced to choose the lower-cost, carbon-intensive energy systems.

Yet the rich countries have not yet accepted a formula to meet their $100bn-a year pledge. Those who have participated in the backroom negotiations know that it is the US above all other countries that has resisted a clear and accountable financing mechanism. This is par for the course. The US these days resists almost all calls for sharing the financial burdens of sustainable development. As a striking example, the US official development assistance budget, though large in absolute terms, is the lowest share of GDP of any advanced economy, just 0.18 per cent of national income.

The basic principles of financing the Green Climate Fund should be clear enough. Polluters should pay for the damages they are causing, so contributions should be linked to carbon emissions. Payments should be graduated in terms of ability to pay (and implicitly, as least, historical responsibility). And the use of the funds should be directed to the low-income countries, those in need of the climate financing.

Here is a straightforward way to reach $100bn that abides by these principles. The world would adopt a base assessment rate of $5 per ton of CO2 emitted by each country. The high-income countries would pay the full $5 per ton on their emissions. Upper-middle income countries would pay half-fare, that is, $2.5 per ton. Lower-middle income countries would pay half of that, $1.25 per ton. The low-income countries would not pay into the GCF, but would be the recipients. The World Bank’s country-classification scheme would be used to categorize countries by income.

Using the 2010 emissions by country reported by the International Energy Agency, we find that a $5-per-ton base levy would lead to combined assessments of $101bn. The largest assessment would be on the US, at $27 billion, equal to roughly 0.18 per cent of GDP. This reflects the U.S. 5.4bn tons of CO2 emitted in 2011. The second largest contribution would come from China, at $19bn and equal to roughly 0.17 per cent of GDP, reflecting China’s 7.7 billion tons assessed at $2.5 per ton.

Suppose that countries cover these assessments through carbon levies that are passed along to the consumer at the petrol pump and the home electricity bill. A tax of $5 per ton of CO2 emission would amount to roughly 1.1c per litre, or 4.4c per gallon of petrol. Similarly, that same carbon levy on the electricity produced by a coal-fired power plant would amount to roughly 0.5c per kilowatt-hour.

The advantage of this approach to the GCF is fairness – as it is based on the “polluter-pays” principle adjusted by ability to pay – and its simplicity, transparency, and predictability. There are no other financing proposals on the table that have these properties, nor are there likely to be. The US has been resisting such a simple formulation precisely because it would then be held accountable for the scale of its emissions and its ability to pay, if not for its historical responsibility in bringing the planet to the current state of climate instability.

Another advantage, clearly, is that such a global carbon-based levy would push countries to the right kind of domestic policy intervention: setting a social cost of carbon emissions to be collected through a carbon tax or the sale of carbon emission permits. Interestingly, the US has actually set a social cost of carbon of $21 per ton of CO2 for purposes of cost-benefit analyses by US regulatory agencies, but the government has not yet taken the next obvious step, of introducing that social cost of carbon into market transactions through corrective taxes or permits. The move to a global carbon levy for the CGF would nudge it and other governments to do just that, thereby promoting the market-based transition to low-carbon energy.

On Thursday, CNN released a revealing poll. It asked people this question: “Do you think the policies of Barack Obama and the Democrats or George W. Bush and the Republicans are more responsible for the country’s current economic problems?”

Remarkably, 54 per cent of “likely voters” put primary blame on Mr Bush and the Republicans versus only 38 per cent who blame Mr Obama and the Democrats. Among registered voters, the disparity is even larger, with 57 per cent blaming Mr Bush and only 35 per cent Mr Obama.

Among subgroups, those under age 50 are much more likely to blame Mr Bush than Mr Obama; those over 50 are more inclined to blame Mr Obama, although a majority still blames Mr Bush. Those with low incomes are more inclined to blame Mr Bush than those with high incomes; those in the Northeast or in cities are more inclined to blame Mr Bush than those in the Midwest or in the suburbs. But again, majorities blame Mr Bush.

Indeed, every subgroup blames Mr Bush more than Mr Obama with the obvious exceptions of Republicans and conservatives. However, even among these groups, a significant percentage blame Mr Bush—15 per cent of Republicans and 36 per cent of conservatives. Perhaps most importantly, from an electoral point of view, 53 per cent of independents blame Mr Bush while only 37 per cent blame Mr Obama.

The CNN poll results are not unique. An August ABC News/Washington Post poll asked people, “Who do you think is more responsible for the country’s current economic problems – Barack Obama or George W. Bush?” Mr Bush was held responsible by 54 percent of respondents, with 32 percent blaming Mr Obama.

An August impreMedia/Latino Decisions poll that tracks only Latinos, a critical voting group for both parties, found 68 per cent of them primarily blame Mr Bush for the economic downturn of the last few years, with only 14 per cent blaming Mr Obama.

In July, a CBS News/New York Times poll found 48 per cent of voters blame Bush “a lot” for the economic downturn, a third blame him “some” and only 18 per cent don’t blame him at all. Regarding Obama, 34 per cent blame him a lot, 30 per cent some, and 35 per cent don’t blame him at all.

I don’t know if these results are unprecedented, but they are certainly remarkable given that Mr Obama has now been president for almost four years. One would think that as the years have gone by memories of Mr Bush would have faded, and as Mr Obama’s policies were implemented that he would in essence “own” the economy.

At least in my lifetime, new presidents have tended to get blamed for economic conditions unreasonably quickly, well before their policies really had a chance to take effect. That was certainly true for Ronald Reagan in the early 1980s.

Why so many people continue to blame Mr Bush long after he left office is intriguing. It suggests that they are far more sophisticated about the impact of presidents on the economy than is generally believed. It may also be the price Republicans are now paying for obstructing Mr Obama’s agenda in Congress.

Voters, more so than pundits, seem to know that our current economic difficulties began during the Bush administration. According to the National Bureau of Economic Research, the recession began in December 2007, while Bush was president, and ended in June 2009. However, polls show that the vast majority of people think the recession never ended. A Fox News poll released on Wednesday found that 80 per cent of voters believe the economy is still in recession, with another 10 per cent believing that while the recession is over another is on the way.

During the Democratic convention, former president Bill Clinton argued strenuously that the economic mess Mr Obama inherited was so severe that no president could fix it in just four years. Apparently, this is a message that resonates with many voters—and also reminds them that the seeds of our economic problems were sown during the previous administration.

Republicans clearly know that Mr Bush is an albatross around their necks, which is why he is almost never mentioned and wasn’t even invited to appear at the Republican convention last month. Mr Bush himself seems to keep out of sight as much as possible. On the other hand, Democrats haven’t done much to exploit peoples’ aversion to their last president. Perhaps they feel it is unnecessary and might engender sympathy for him.

In any event, the Bush presidency is important subtext for this year’s presidential election. Given Mr Obama’s now-solid lead in the polls, it appears that voters are more willing to give him another four years, despite a generally poor economy, than take the risk of turning the White House over again to the party of Bush.

Through both its actions and what it refrained from doing, the Federal Reserve confirmed on Thursday that it is operating in policy purgatory: incapable of delivering the good economic outcomes it desires, yet unable to exit from an experimental policy stance that risks a widening array of collateral damage and unintended consequences.

To grasp the Fed’s policy dilemma, we must first discuss the why and what of additional unconventional Fed measures.

Three realities anchor the case for additional measures, notwithstanding the fact that the results of prior policy interventions actions have consistently fallen short of policymakers’ own expectations.

First, the FOMC reiterated concerns about the country’s economic prospects, and rightly so. It echoed Chairman Ben Bernanke’s speech at Jackson Hole on August 31. There he cited America’s “daunting economic challenges,” including the “grave concern” of a stagnant labour market where high unemployment – even if predominantly cyclical in nature as Mr Bernanke believes – would get embedded in the structure of the economy were it to persist for long.

Such worries were accentuated in the last week by the disappointing August employment report, as well as the more recent high frequency jobless claim data released earlier on Thursday. Both confirm weak job dynamics. They come at a time when long-term and youth unemployment is way too high, Americans are dropping out of the labour force, poverty is on the rise, and income inequality is widening.

Second, the Fed is not helped by the fact that it is the only entity properly engaged in addressing America’s challenges. Others, including those paralysed by deep congressional splits, are standing on the sidelines even though they have better suited policy instruments.

Then there are the unusual “tail risks” facing the economy and additional policy insurance they appear to warrant – from the threat of the European debt crisis to the self-inflicted fiscal cliff in the US and mounting political risks in the Middle East. If even one were to materialise, America would soon find itself again in a recession which would accentuate economic, financial, political and social fragilities.

With this in mind, Fed officials decided to experiment even more. They extended forward guidance, stating that policy rates are expected to stay exceptionally low “at least through mid-2015”. Importantly, they also committed to additional, open-ended purchases of mortgage-backed securities (what will likely be labeled “QE3”).

History and detailed analyses of the problems underpinning America’s prolonged economic malaise suggest that these well-intentioned measures will again fail to secure a much better economic situation. This is also behind the widening gap between economists urging the Fed to do even more and those favouring less.

In refraining from going beyond forward guidance and QE3, the Fed is seeking to balance these two competing views. It thus refused to cut the interest it pays on excess reserves (IOER) despite some arguing that this would induce banks to lend more to the real economy and thus encourage greater economic activity. It also declined to move from an intermediate policy target (boosting asset prices) and time commitment (mid 2015) to specific economic targets (including nominal GDP).

With both options having been discussed by Fed officials, their revealed preference speaks to important considerations that will grow in the months ahead.

They signaled growing recognition of the “costs and risks” of unconventional policies – from undermining the functioning of certain market mechanisms to hampering entire segments that provide financial services to citizens (such as money market accounts, life insurance products and pension coverage). For example, a cut in the IOER would have dealt an even bigger blow to the money market industry. They also reinforced Mr. Bernanke’s earlier view that “monetary policy cannot by itself [deliver] what a broader and more balanced set of economic policies might achieve.”

Like the ECB, its Frankfurt-based European counterpart, the Fed cannot by itself secure the results that so many desire – high growth, robust job creation and financial stability. At best, it can keep buying time in the hope that other government entities will get their act together. Until this happens, the Fed will remain in policy purgatory.

Mario Draghi’s bond buying plan has restored some control over interest rates in those parts of the eurozone which, it seemed, were in danger of becoming detached from the European Central Bank mothership. While many in the private sector harbour doubts, the ECB president has to be fully signed up to the euro’s survival. It can therefore justify purchasing assets that others might regard as untouchable. And with yesterday’s qualified ratification of the EU bailout programmes by the German constitutional court, the ECB can look back on an effective week.

Yet problems remain. To get their hands on the ECB’s largesse, countries have to sign up to austerity and structural reform programmes. That’s entirely understandable. No one – least of all, the Bundesbank – wants to see the ECB writing unconditional cheques to renegade governments with dubious fiscal ambitions. However, no government will want to sign up for blank cheques if the cost ends up being excessive austerity and political downfall – one reason why Mariano Rajoy, Spanish prime minister, nervously looking at Catalonian protests, has yet to buy into the ECB’s plan.

Imagine that a country volunteers for the ECB’s deal. Once the European Financial Stability Facility or the European Stability Mechanism buys in the primary market, the ECB buys bonds in the secondary market at the short-end of the yield curve, ensuring relatively low interest rates.

There are then two risks. The first is the danger of fiscal backsliding. If the country fails to deliver – perhaps because the regions are recalcitrant or because the electorate is uneasy – does the ECB, doubtless prompted by the EFSF/ESM, withdraw support? The answer surely should be “yes”. In the eurozone, however, failure in one country has a nasty habit of infecting others.

The second, more worrisome challenge, is the possibility that even with low interest rates, economies may still end up slipping into recession, thanks to a combination of fiscal austerity and losses of competitiveness. We surely know by now that monetary policy has its limitations. The Bank of England, for example, has been able to deliver remarkably low interest rates, quantitative easing and a much weaker currency, yet the benefits of these policies have not been good enough to prevent a return to – admittedly shallow – recession.

Let’s say that Spain or Italy stays in recession – or, worse, that their current recessions deepen – despite the help provided by the ECB. Budget deficits might then end up spiralling out of control even if governments were sticking to austerity measures pre-agreed with the higher powers. The European Commission rightly focuses only on “structural”, not “cyclical”, deficits but disentangling one from the other in the midst of ongoing stagnation has become nearly impossible. A cyclical deficit is only cyclical if there is eventually recovery.

The Stability and Growth Pact, the EU’s fiscal rulebook, allows for delays in fiscal consolidation if the excess deficit “results from a negative annual GDP volume growth rate or from an accumulated loss of output during a protracted period of very low annual GDP volume growth relative to potential”. Importantly, however, “the excess … shall be considered as temporary if the forecasts provided by the Commission indicate that the deficit will fall below the reference value (3 per cent of GDP) following the end of the … severe economic downturn.” This is a another way of saying that there is a risk of fiscal tightening at the wrong time, locking in recession and stagnation for the long term.

The “circuit breakers” – allowing countries to postpone the day of fiscal reckoning – do not seem to be flexible enough. In contrast, for example, under the Gramm-Rudman-Hollings law, US deficit reduction was to take place each and every year in the late-1980s and early-1990s but the process would be automatically suspended in the event of a recession or weak growth: there was a bias against pro-cyclical fiscal tightening. But in the eurozone, this type of bias is hard to find.

What if such a bias was introduced in the eurozone? It might be a good thing for growth but, to the extent that fiscally-weak countries would then become even more dependent on handouts. it would only serve to emphasise the limits beyond which monetary policy cannot go. Ultimately, successful monetary unions are invariably successful fiscal unions too. Mr Draghi’s actions, the German Constitutional Court ruling, or the Dutch election do little to change that conclusion.

With its decision of September 6 the European Central Bank has taken a large part of the “convertibility risk”, i.e. the risk of a break-up of the eurozone, off the table. Spreads have come down substantially in the following days, especially in Spain and Italy. Today’s decision by the German constitutional court to allow ratification of the bailout programmes should see those spreads come down further still.

The question now is whether countries will decide to activate the ECB’s intervention.

Requesting such programs entails costs and benefits.

The cost is mainly political, due to the stigma attached to any type of IMF or EU support. By asking for support, a government implicitly admits that its previous policies have not succeeded in convincing the markets. The negotiation of an adjustment program and the regular monitoring by the so-called troika (IMF-EU-ECB) is considered to entail a loss of sovereignty. Any government accepting intervention also fears losing political support. And the tougher the conditions attached to a programme, the higher the political cost associated with it.

The benefit consists mainly in the reduction of interest rates, especially at the low end of the yield curve, obtained by the ECB’s intervention, which reduces the cost of adjustment and alleviates tensions in financial markets. The lower the yield targeted by the ECB, the larger the benefit for the country to enter into a programme.

The reduction in interest rates that followed the ECB’s announcement may have temporarily reduced the incentives to request financial support. Furthermore, the assessment of the respective costs and benefits is still unclear. On the one hand, there are uncertainties about what the IMF or EU programmes will imply for the various countries, especially in terms of additional policy measures, although this will probably be clarified bilaterally over the coming days. On the other hand, the ECB has not – and will probably not – indicate any target for the level of Government bond yield it intends to achieve, making the benefit for governments uncertain.

Two scenarios may thus develop over the coming weeks and months.

A positive scenario would see financial markets continuing to react positively to the ECB’s announcement, achieving a permanently lower level of interest rates throughout the maturity curve. Under these conditions countries might not even need to apply to any program and the ECB’s threat for action would not have to be implemented.

However, in a negative scenario, the ECB’s announcement would have short lived effects as financial markets would not be convinced that countries can manage on their own. Rates would soon start rising again, amid renewed financial turbulence, forcing countries to apply to an IMF/EU program. The political costs of such a move would then be even higher, as countries would be perceived as being forced into a programme, rather than autonomously choosing to request one. The ECB would have to intervene, as indicated, starting however from a much higher level of interest rates and thus with much larger amounts.

The likelihood of the two scenarios depends on a series of factors.

The first is the reaction of governments and parliaments to the improved market conditions that have resulted from the ECB’s announcement. If national authorities take the opportunity of the renewed calm in financial markets for strengthening their reform programs aimed at increasing growth prospects, and adopt further measures, in particular privatisation, to accelerate the reduction of the debt, the likelihood of a positive scenario might increase .If instead the euphoria that followed the ECB’s announcement leads to a relaxation of the reform effort, or even to question some of the measures, the negative scenario would become more likely.

The second factor is the prospects for economic recovery in the various countries. Any unexpected cyclical improvement, which would contribute to ease the adjustment of the budget deficits and debts, could consolidate market confidence and make the virtuous scenario more likely. If, on the contrary, the general deterioration of economic conditions continues, with further downward revisions of growth prospects and upward revision of unemployment prospects, the risks of a negative outcome increase.

A related factor concerns the correlation between sovereign and banking risk. The improvement in government bond markets observed after the ECB’s announcement has been accompanied by a spectacular recovery in bank stocks. This suggests that the correlation is still strong. It may even increase if the process for bank restructuring and recapitalisation is delayed and if non-performing loans continue to rise as a result of a further slowdown of economic activity and weakness of the housing market. This could contribute to a worsening of the scenario.

The third factor is the development of monetary conditions in the eurozone, compared in particular to those in other major currency areas, which determine the external competitiveness of the euro. An improved competitiveness of the whole eurozone would contribute to support economic growth and tilt the balance towards the virtuous scenario.

A fourth factor is the management of pending critical eurozone issues, from the Greek adjustment program to the design of the longer term integration process, starting with the forthcoming discussion on the banking union. Negative developments in any of these areas could produce contagion effects that would push towards the negative scenario.

The balance between the two scenarios is not entirely in the hands of policy makers. But their actions can make a difference. We have already experienced in the past situation in which the improvements in market conditions, resulting for instance from the measures implemented by the ECB (for instance, last year’s 3-year LTRO), led to a relaxation of the adjustment process and a slowdown in the joint effort for improving the institutional framework supporting the euro. Restarting the effort again, once markets have deteriorated, proved each time to be much more difficult.

Regaining the confidence of the markets, once it has been lost, is extremely demanding. Regaining the confidence of the people is nearly impossible.

The question at the core of America’s upcoming election isn’t merely whose story most voting Americans believe to be true – Mitt Romney’s claim he can pull it out of its stall because he’s a businessman who has turned around failing companies, or Barack Obama’s claim the economy is slowly mending from the worst downturn since the Great Depression because his approach is working.

If that were all there was to it, Friday’s report from the Bureau of LaborStatistics showing that the economy added only 96,000 jobs in August,would appear to bolster Romney’s assertion that the economy is in a stall. Since January, the United States has added an average of only 139,000 jobs a month, compared to last year’s average of 153,000 a month. Second quarter growth was a weak 2.2 percent, down from 4 percent last year. In other words, the economy isn’t improving.

The deeper question is what should be done starting in January to boost a recovery that by anyone’s measure is still anaemic — and on this neither candidate has offered specifics.

At last week’s Republican convention in Tampa, Florida, Romney produced nothing more than a vague and predictable set of Republican bromides: cut taxes, reduce the budget deficit, and get government out of the way. On Thursday night at the Democratic convention in Charlotte, North Carolina, President Obama provided little more, but from an opposing perspective: reduce the deficit by increasing taxes on the wealthy rather than cutting programs the middle class and poor depend on (such as Medicaid), give tax incentives to companies that create jobs in the United States, and invest in education.

The lack of detail about how to reignite the economy is understandable. Political reality militates against specificity. Winning depends more on firing up likely supporters with rhetoric they want to hear than convincing the very few who haven’t made up their minds that you’ve got the better detailed plan. Besides, bold new ideas at this stage are only likely to provide fodder for opponents eager to show why they won’t or can’t work, or are downright dangerous.

But another explanation for why neither candidate has come up with a concrete plan is profound disagreement even among experts about what’s gone wrong, and a paucity of credible ideas for righting it. Keynesians want more government spending but can’t come up with a convincing scenario for what happens after the pump is primed. The big stimulus in 2009 and 2010 had a positive impact but hardly enough to rescue the economy. Some Keynesians call for more spending, but how much more before credit markets begin to scream? Some want the Fed to keep interest rates near zero, but it’s kept them near zero for almost three years – along with two rounds of “quantitative easing” – with little to show for it.

So-called supply-siders want lower taxes and fewer regulations but can’t come up with a convincing argument for why American businesses would hire more workers under those circumstances. After all, much of their current profitability has come from cutting payrolls — either by substituting computers and software or outsourcing the jobs abroad. Why would they hire additional workers, especially when American consumers – whose spending is 70 per cent of the nation’s economic activity – are holding back? Deficit hawks, meanwhile, want to raise taxes and reduce public spending but have no idea how to do this without bringing on another recession as long as private spending remains in the doldrums. And if the economy contracts, the government debt only worsens in proportion. Markets are already spooked by next January’s “fiscal cliff”.

Noticeably absent from this interminable debate is the damage to the economy from America’s increasingly concentrated income and wealth at the very top. Mr Obama alluded to this Thursday night when he said the “basic bargain” that once rewarded hard work and gave everyone a fair shot had come undone. But, notably, he did not say, as he did last December 6, in Osawatomie, Kansas, that that basic bargain had eroded because “fewer and fewer of the folks who contributed to the success of our economy actually benefited from that success” while “those at the top grew wealthier from their incomes and investments than ever before.”

Neither Keynesian pump-priming nor any other remedy is likely to work if the vast middle class doesn’t have enough income to keep the economy going. As Mr Obama said last December, “this kind of inequality – a level we haven’t seen since the Great Depression – hurts us all” because “middle class families can no longer afford to buy the goods and services that businesses are selling.” He noted then that “countries with less inequality tend to have stronger and steadier economic growth over the long run”.

But Thursday night in Charlotte, the President made no mention of inequality. Perhaps he and his advisors thought the topic too provocative to raise nine weeks before Election Day. That may be the case. But if he’s reelected, Mr Obama will have to tackle the problem head on if the United States is to return to the robust growth it once enjoyed — when the “basic bargain” linking wages and productivity was still at the core of the American economy.

This year, the critical question in Europe has changed from whether policymakers could find the required policy instincts – they have – to whether they are moving fast enough to get ahead of the deleveraging by the private sector.

By announcing a new conditional bond purchase program on Thursday, the European Central Bank took a major step to close what, at one time, seemed a near-insurmountable deficit in this race. It now needs the support of other policymaking bodies to fully eliminate the gap.

European policymakers and politicians were very slow in 2009-10. Insufficient understanding of regional debt dynamics, together with widespread denial that Europe could be on the receiving end of a typical “emerging market crisis,” made it even harder to coordinate policy in a monetary union with very different initial conditions among its 17 member countries. The longer this persisted, the more policies fell behind the exiting of private capital.

As the regional crisis deepened in 2011,  governments and the ECB adopted a policy approach more commensurate with the complexity of the crisis. Namely, seeking to break the link between sovereign credit deterioration and banking sector weakness, trying to change the policy mix for struggling countries and, at the regional level, addressing design flaws in the original monetary union through banking and fiscal unions and closer political integration.

But words came easier than actions. As implementation lagged, private capital outflows broadened and accelerated. Outflows took two distinct forms. Firstly, out of an expanding universe of peripheral eurozone countries and to a very small inner eurozone core. Secondly, out of the eurozone as a whole to the rest of the world, in particular Switzerland and the US.

These outflows did more than increase market volatility, raise financing costs for struggling economies and ration funds to their governments and (especially) companies. They also put in place the seeds for a fragmentation of the single financial market, threatening  structural damage to the very idea of investment in Europe.

The danger to the single financial market and the related increase in “convertibility risk” were cited in the historic remarks made by Mario Draghi, in London on July 28th. They set the stage for a much bolder policy response that, after a summer of intense work and  consultation aimed at reconciling debtors’ demand for financing and creditors’ emphasis on policy conditionality, culminated in what the ECB announced on Thursday.

According to MrDraghi, the ECB will start buying short-dated (up to three-year maturity) bonds issued by government subjecting themselves to appropriate policy conditionality. It will do so with no pre-specified limit, thereby seeking to sustainably lower borrowing costs while removing concerns about these countries’ refunding prospects. According to preliminary information, the policy component of this more transparent new programme will strike a better balance between conditionality and financing – one that, critically, may be more agreeable to both creditor and debtor countries.

Returning to the race analogy, Thursday’s ECB actions can significantly close the gap between private capital outflows and what, until now, have been lagging official policy reactions. They would reduce the tail risk of immediate fragmentation. But it remains to be seen whether this latest policy sprint can totally eliminated the gap, thus putting in place conditions for a reversal in capital outflows.

Our analysis of the underlying drives of financial flows suggests that policy still needs a further nudge to get ahead of the de-leveraging. Specifically, exploiting the window offered to them by bold ECB actions, national and regional policy entities need to implement – rapidly, comprehensively and simultaneously – the list of corrective measures that have been widely discussed in official circles but languish on the drawing board.

If they fail to do so, the ECB will find that it has mis-timed its impressive sprint. Within a few months, policies will again fall further behind the de-leveraging process, and the credibility of Europe’s policymaking process will be dented further. This is a possibility that should be avoided – not just for Europe’s sake but also for that of the global economy.

Having recently declared that I am not likely to vote this year here in the Financial Times, I should have added that that is just how I feel now. I am certainly open to persuasion and my feet are not set in concrete.

Last week’s Republican convention did nothing to encourage me to vote for Mitt Romney. All of the speakers simply recited well-worn conservative talking points that won cheers from true believers in the convention audience, but did nothing to win over the undecided.

Polls universally show that Romney got no “bounce” from the convention and did much worse than John McCain four years ago. Moreover, television ratings for the 2012 Republican convention were well down from those in 2008, suggesting that only party loyalists watched the proceedings.

Thus far, the Democratic convention, which has been meeting in Charlotte, North Carolina since Tuesday, has bested both the Republican convention and Democrats’ expectations. The only Republican speech that was memorable was a rambling, incoherent monologue by the actor Clint Eastwood.

By contrast, Democrats are raving about the speeches by Michele Obama, former president Bill Clinton and other party luminaries. When Barack Obama speaks tonight, I as an undecided voter am primarily looking for one thing: Will the next four years be different than the last four? If so, how? And what reasons do I have for thinking that they will be better?

Obviously, Obama has to walk a fine line between admitting failure in certain respects and talking about the need for change. After all, it is his administration’s own policies are the ones that need changing. At the same time, he must avoid sounding like he is whining about bad luck—of which he has certainly had more than his share in terms of the economy—and all the nasty things Republicans have done to frustrate his policies and ensure their failure.

It is not necessary to remind Democrats that the Republican leader in the Senate, Mitch McConnell of Kentucky, said publicly back in 2010, “The single most important thing we want to achieve is for President Obama to be a one-term president.” Ironically, this may give him an opening for Republicans to work with him in a second term— something independents want to hear. The Constitution limits presidents to two terms, so Obama will be not be able to run again. Therefore, Republicans have no reason to go out of their way to make him into a failure.

Indeed, it may be in their interest to get some of the messy work of fixing the budget accomplished while there is a Democratic president to share the blame for any political pain that will be required. Mr Obama should talk about bringing new leadership into the government. His Treasury secretary, Tim Geithner, has already announced plans to leave after the election. And in any case, a second term is an appropriate opportunity to clean house and bring in fresh blood.

Mr Obama might also talk about opportunities presented by the so-called “fiscal cliff” that will result from automatic tax increases and spending cuts already programmed into law to take effect on Jan. 1. And the expected pullout of all American troops from Afghanistan by 2014 will create new opportunities and challenges for American foreign policy that deserve discussion and will contrast Obama from the unpopular sabre-rattling of the Republicans. In short, there are plenty of ways Obama can promise something different and something better in another term. I, for one, will be listening for them.

The release last month of the Congressional Budget Office’s update to the budget and economic outlook for the next decade rightly draws attention to the “fiscal cliff” – the large tax increases and spending cuts that are currently scheduled for January 1. But there’s more to the CBO report than its analysis of what may happen in the next few months.

The CBO analysed the consequences for deficits and debt over the next decade of keeping tax and spending policy on autopilot. Relative to the agency’s baseline, deficits would increase by almost $8tn over the next decade. And debt held by the public would reach about 90 percent of gross domestic product; its highest level since the second world war.

Elevated federal spending is the source of the widening deficits over the next decade. The CBO estimates that revenues as a share of GDP would average about 18 per cent, roughly their 40-year average. Federal spending at 23 per cent of GDP would at stand about 10 per cent higher than its 40-year average, 21 per cent.

Higher debt levels crowd out private investment. And they reduce household and business spending on account of higher expected future taxes to close the budget gap. The debt problem that the CBO identifies will get worse after the next decade with large and growing shortfalls in Social Security and Medicare. It is not an understatement to observe that the challenge of avoiding a high-debt, low-growth economy is the key domestic policy issue.

So what are the approaches of Governor Mitt Romney (who I advise) and President Barack Obama (who speaks tonight at the Democratic convention) to this central challenge?

Mr Romney’s budget (for which I wrote the foreword) focuses on reducing debt burdens and enhancing economic growth through spending restraint and tax reform. Mr Romney proposes to reduce federal spending as a share of GDP to 20 percent by 2016 and gradually reduce the growth in Social Security and Medicare spending, particularly for more affluent households. The GOP candidate would reform the corporate and individual income taxes, reducing marginal tax rates by just under one-third for the corporate tax and by 20 per cent for the individual income tax, while broadening the tax base to make up lost revenue. The Romney plan addresses the deficit and debt challenge comprehensively, though both spending restraint and tax reform pose political challenges.

Mr Obama has proposed to continue current elevated levels of federal spending, while raising taxes on higher-income households and businesses to reduce the deficit and debt consequences of higher spending.

Indeed, Larry Summers, the president’s former chief economic adviser,  recently argued in the Financial Times that reducing federal spending as a share of GDP is not achievable. Mr Summers pointed to demographic change (population aging), higher interest payments on the large public debt (which has increased substantially in the past few years) and increases in the relative price of health (a significant component of government spending). This view is consistent with Mr Obama’s budget, which assumes elevated levels of spending over his presidency and thereafter.

In contrast with Mr Romney’s plan, the president’s plan does not address medium-term and long-term deficit and debt problems. Taken at face value, the Obama plan will require acceptance of the costs of much higher levels of deficits and debt or substantial tax increases on all Americans. The CBO’s report shows the consequences for deficits and debt over the next decade of such continued budget inaction.

But the president is proposing higher tax burdens on certain households and businesses. Will those tax changes close the budget gap? No.

The president says he will raise marginal tax rates on upper-income workers and business owners (against the grain of tax reform efforts over decades, including his own Fiscal Commission, which argued for lower marginal tax rates financed by broadening the tax base). His proposed revenue increases include the “Buffett rule” (effectively a new alternative minimum tax on high-income taxpayers), tax increases on dividends and capital gains, plus raising the top income tax rate to its pre-2001 level.

What are those tax increases? The Buffett rule imposes a minimum effective tax rate on taxpayers with annual incomes over $1m (most of whom already face a higher tax rate). For higher taxes on saving and investment, the president would raise taxes on capital gains to 20 per cent from 15 per cent and on dividends to 39.6 per cent from 15 per cent. Next, the president calls for restoring the pre-2001 tax rates for high-income individuals, including increasing the top marginal income tax rate to 39.6 per cent from 35 per cent. In addition, the president’s budget also calls for phasing out exemptions and lower-bracket tax rates for higher-income taxpayers, raising marginal tax rates further. And the president would limit certain tax deductions for individuals with incomes over $200,000.

Adding up the proposed tax increases on upper-income taxpayers should raise $148bn per year in additional revenue, according to US Treasury department estimates. Viewed next to proposed additional spending by the president of roughly $500bn per year, Mr Summers’s claim that federal spending will remain high, or this year’s federal budget of $1.1tn, the president faces an arithmetic challenge.

Assuming the Obama administration wanted to close the budget gap – to be comparable with the lower deficits in the Romney plan – what additional tax increases would be required? To begin, let’s call the maximum additional revenue from upper-income taxpayers $148bn per year, as the administration has not identified more tax increases on those taxpayers.

To close the budget gap, one could raise additional revenue by broadening the tax base. But the president’s proposals already accomplish much of that for upper-income taxpayers. Additional tax base broadening would be required for middle-income taxpayers. Of course, the administration could propose an increase in marginal tax rates. Unless, though, the administration wants to raise marginal tax rates further on high-income individuals, marginal tax rates would have to be raised – and substantially – on middle-income taxpayers. Of course, the deficit and debt could simply be allowed to rise, not a sustainable long-term solution for the country.

The choices of the size of government and how we pay for it are fundamental ones. They are also the ones we should be analysing and debating. Mr Romney has proposed a plan of fiscal consolidation and tax reform. Accomplishing it will require reducing the growth of federal spending and broadening the tax base. These changes will not be easy. Mr Obama proposes a larger government with explicitly higher taxes on high-income taxpayers but, by the arithmetic of higher spending levels, eventually higher taxes on all Americans.

The increasing role that monetary policy has acquired in addressing the current financial crisis is raising concerns for the independence of central banks. Such independence is protected by the statutes of central banks, which specify, among other things, the mandate, the way in which the members of the decision-making bodies are nominated or can be dismissed, the length of the term of office, the kind of operations which can be conducted. Central banks must also be accountable.

The way in which central banks account for their policies varies across countries. In the US and the UK, for instance, the minutes of central bank meetings are made public – albeit with some delay – and individual members of the decision-making bodies are required to disclose their votes and explain their views. In the eurozone there are no detailed minutes of the meetings and only the view of the whole European Central Bank Governing Council is disclosed. In the US and UK, central bank accountability is individual; in the eurozone, accountability is collegiate.

The difference depends on the underlying political structure. In fully integrated political systems, like the US or the UK, accountability is exercised and monitored by the entirety of the country’s public opinion, media and political system. A central banker suspected to act under the pressure of a political party or interest group would be publicly criticised throughout the country. The reputation of the political body which nominated him would be seriously undermined. This represents a strong incentive for nominating independent personalities and for the latter to act independently in an open way.

The eurozone is based on a yet imperfect political integration. The governors of the 17 National Central Banks, out of the 23 members of the ECB Governing Council, are nominated by their respective national authorities (while the six members of the Executive Board are nominated by the European Council) but are expected not to be influenced by their nationality when they express their views. They cannot be called by their national parliaments to give account of their votes, given that they are supposed to take decisions for the interest of the whole eurozone.

National politicians, media and the wider public have not yet fully understood that the ECB Council members do not represent the interests of their respective countries. They often associate the names of the members with their nationality, forgetting that each member participates in the ECB Council on a personal basis. The exercise of accountability in a collegiate way aims to protect the ECB Council members from the possible pressure coming from their own countries. As a result, the discussions – sometimes quite animated – take place within the ECB Council, but only the decision is made public. The members of the ECB Council are expected to loyally support and defend in public whatever decision is taken.

This system has served the ECB well for many years. Even when decisions were not unanimous, there was little public interest in understanding the nationality of the dissenting voices.

Things changed in Spring 2010, when dissenting views were publicly expressed on specific policy measures, in particular concerning the purchase of government bonds on the secondary market.

The departure from collegiate accountability and the expression of dissenting views on important policy issues has not strengthened the independence of the ECB. It might have actually seriously undermined it.

The expression of a dissenting opinion, especially when the opinion coincides with the view of a large part of the population of the respective country, generates the impression that discussions within the Governing Council are politicised, and that all members reflect national views. This may encourage pressures by national constituencies on the different ECB Council members to act on the basis of national interests, rather than the broader European ones. It may also encourage some national central banks to publicly express views on monetary policy issues, which is against the letter and the spirit of the Treaty because monetary policy is not anymore a competence of the NCBs but only of the ECB. The Treaty clearly states that the ECB Council members should not be influenced by any national or European institution, not even their own central bank.

The breach of collegiate accountability has led to requests for modifying the statutes of the ECB with a view to better reflect nationalities. An example is the recent call by some German politician and academics to change the currentone-man-one-vote ECB voting system to one based on national weights. This would certainly end the independence of the ECB.

Finally, in the current environment characterised by high uncertainty, not only in financial markets but also in the population at large, uncoordinated communication adds to instability. It ultimately undermines the credibility of the central bank and reduces the effectiveness of its policies. Central banks are expected to send clear messages, explaining the reasons for their actions, possibly also the risks, including the risks of non-action.

Preserving the independence of the ECB requires that personal considerations, even when well-founded, remain subordinated to the pursuit of the common good. If this cannot be achieved, there is only one way out.

What should one make of the indicators coming out of Beijing that have regularly fallen short of market expectations; the most recent being an August PMI — further revised downwards this morning – showing manufacturing intentions hitting a nine-month low?

GDP growth for this year could fall short of Beijing’s target of 7.5 per cent, which would be a two-decade low. At one extreme, bears foresee a long-anticipated collapse while others feel that a more benign landing is underway. Some argue for letting this cycle play itself out, rather than risk incurring distortions from another stimulus. Yet another group is focused on long-standing concerns about rebalancing the economy.

Sorting through this morass of advice, one is reminded that China’s slowdown is a mix between a longer-term structural transition and a frenetic cycle of expand-contract-expand policies in the wake of the 2008 financial crisis. This all began with the $600bn stimulus program four years ago, followed by tightening policies to curb an overheated economy and, over the past half-year, mildly expansionary policies to cope with the eurozone difficulties and a lacklustre US recovery.

But China’s longer-term structural transition involves moving to a more sustainable growth model appropriate for a maturing economy – one that is more innovative and less resource-intensive. The structural transition should have begun much earlier but China’s 2008 stimulus pushed growth back into unsustainable double-digit levels when it should have nurtured a gradual decline to around 8 per cent.

This transition is characterised by two interconnected rebalancing processes. The first is a spatial rebalancing in commercial activity from the coast to the interior and from rural to urban areas. The second is a macroeconomic rebalancing from foreign to domestic demand, of which the gradual shift from investment to consumption within domestic demand is but one aspect. This two-fold rebalancing should not be seen as objectives in their own right. Comparative experience tells us that imbalances are often associated with successful growth processes and their role and duration will vary.

The spatial rebalancing is the result of the increasing demand for services and goods from China’s rising middle class and an aging population in the midst of rapid urbanisation. These trends are ratcheting-up domestic demand relative to foreign. The central provinces with improved transport connectivity will gradually play a more important role as the bridge between a trade-driven coast and a consumption-driven interior. With lower wages and property costs than in the coastal areas, serving both the domestic economy and even some export industries from the central region is becoming attractive.

Aspects of the spatial rebalancing are well underway. China’s inland regions have been growing more rapidly than along the coast after three decades during which the opposite happened. Less well known provinces like Inner Mongolia, Hunan, Sichuan, and Guizhou all grew by 14 per cent or better last year, while the headlines from China’s powerful manufacturing centres along the coast are of declining orders.

This two-speed path is what intrigues foreign investors seeking a continuation of their 20 per cent returns as the coastal mega cities mature. Provinces like Henan and Hunan would rank among the top 20 globally in population size as individual countries, while the municipality of Chongqing is as large as Venezuela or nearly six times the size of Singapore.

The macro rebalancing from external to domestic demand has taken place sooner than expected, as the massive 2008 stimulus absorbed much of the excess savings that had generated the large trade surpluses during 2005-8. This resulted in a sharp decline in China’s trade surplus from over 8 per cent five years ago to around 2 per cent last year.

The concern over the apparent imbalance between low consumption and high investment as shares of GDP within domestic demand, however, is overdone. This is partly because of distorted expenditure statistics – including undervaluation of housing services in personal consumption and inflated investment figures. So consumption as a share of GDP may be underestimated by as much as 10 percentage points of GDP. It is overdone also because personal consumption has continued to grow at an unmatched 8-9 per cent annually through one global crisis after another.

As the abnormally high investment from the 2008 stimulus fades, the consumption-investment shares will moderate. Expenditure rebalancing is also being supported by the spatial rebalancing, since the inland regions have a higher consumption to GDP share than the coastal. But this will be a decade-long process as urbanisation accelerates.

So what, if anything, should China do about all this?

The reality is that depressed foreign demand and inventory adjustments necessitated by the slowdown have cut growth prospects by at least 1 percentage point more than anticipated last year. Mildly expansionary policies carry little risk now that inflation has moderated but are less effective in these circumstances.

Major adjustments in headline exchange and interest rates are not realistic options since they would run counter to longer-term objectives although recent reforms to introduce more flexibility are positive steps. More can be gained, however, in supporting spatial rebalancing through affordable housing and liberalising labour migration policies.

Cushioning the impact of the current recessionary pressures through fiscal reforms that would strengthen social services also make sense. So would more support for the private sector through diversified sources of financing and freer entry into state dominated activities. Such actions would contribute to the desired structural transition.

There is great interest in the annual symposium of central bankers that starts tomorrow, and rightly so. Whether it is in Europe or the US, central bankers continue to carry most of the policymaking burden, and do so deep in experimental territory. There is no better place to discuss central banking than Jackson Hole, in Wyoming.

Many people are eager to hear more about the framework that underpins the thoughts and actions of Ben Bernanke, US Federal Reserve chairman. Some are even hoping for another policy leap. (Similar expectations for Mario Draghi, the president of the European Central Bank, were dashed by Tuesday’s announcement that he was cancelling his panel participation – more on this later.)

We have been spoiled in recent years as Mr Bernanke has used Jackson Hole to share insights on the what and the why of unconventional monetary policy. In the process, he has provided us with a better understanding on how it supplements the diminished impact of traditional monetary policy, especially with interest rates long floored at “exceptionally low levels” and forward guidance extended substantially.

During his tenure as Fed chairman, Mr Bernanke has supplemented academic (2006-07) and historical (2008-09) perspectives with forward looking ones. In 2010, he laid the ground for the second stage of quantitative easing, or QE2 – the direct purchase by the Fed of Treasury securities in order to push investors out the risk spectrum and target macroeconomic outcomes (rather than just QE1’s normalization of financial markets).

In 2011, he took another step, providing us with the context for “the twist” – the combination of security purchases and sales aimed at flattening the yield curve. In addition to inducing further risk-taking, this sought to reduce borrowing costs in the economy without impacting the size of the Fed’s balance sheet (though it did change the risks facing the balance sheet).

Throughout, Mr Bernanke indicated that exceptional Fed activism is not the metaphorical slam dunk. It involves, to use his elegant characterisation, a delicate balance of “benefits, costs and risks”. Indeed, one of the first things that will be looked at on Friday is his assessment of this trio’s historical evolution.

There will also be interest in Mr Bernanke’s characterisation of policies that fall outside his purview, particularly fiscal. Over the last few months, the Fed chairman has increasingly visited this political territory. And not just to warn about the dangers of the fiscal cliff. This also relates to whether he is sufficiently comfortable to push his Fed colleagues to a nominal gross domestic product target, especially when congressional polarisation limits the scope for proper fiscal policy coordination.

Such a move, from an intermediate policy target (asset prices) to a more-narrowly defined macro-economic one, is part of the policy leap that some are urging Mr Bernanke to make on Friday. It certainly would be viewed by markets as a favorable development as a GDP target would effectively re-price the “Fed put.” And to maximize effectiveness, hyper-activists also want him to follow the Bank of England in pursuing credit easing.

A policy leap of this nature is a possibility but far from a high probability, at least not as of yet. Rather than push out the policy envelope again, Mr. Bernanke is likely stick to the content of the FOMC minutes released last week, listing future options and re-iterating the general commitment to do more if needed.

Which brings us to Mr. Draghi. According to an ECB spokesperson, his trip was cancelled due to a “heavy workload.” This sounds right given extensive preparations ahead of important European decision points in September. But there is also something else.

With some people pushing him to put meat on the new policy bone announced at the last meeting of the ECB three weeks ago – including specifying a band for yields on Italian and Spanish bonds – Mr Draghi would have faced significant risks. Jackson Hole is neither the place nor the time for him to preview new ECB policy proposals; and this is before factoring in the differences with Germany’s central bank. Accordingly, his most probable course of action, that of reiterating Europe’s recent policy progress and the ECB’s vigilance, would have been met with disappointment from those who wrongly believe that the institution, by itself, can (and should) solve Europe’s crisis.

Having used brilliantly-crafted words to buy a few weeks of market tranquility, the last thing central bankers want today is to use Jackson Hole to prematurely signal the difficulties of implementing on their own sufficient follow-up actions.

Amid all the hoopla surrounding the choice of Paul Ryan as the Republican candidate for vice president, and Senate candidate Todd Akin, let us not forget the still significant matter of Mitt Romney’s tax returns and what they say about the sorry state of US tax policy.

On that front, Mr Romney remains unrelenting in his refusal to release more than two years of filings, causing political opponents and cynics to continue to mutter darkly about what awfulness they might contain.

Should Mr Romney eventually yield, I believe that at a minimum, we will see nauseatingly more of the same: an immensely wealthy businessman who stretched every crack in the tax code to the breaking point and possibly beyond.

Like Mr Romney, I have labored in the private equity vineyards and am familiar with many of the loopholes available to practitioners of that art. But Mr Romney unearthed crevices that I never knew existed and worked the tax code to greater advantage than I’ve ever heard of a private equity executive doing.

Not all of Mr Romney’s manipulation was arcane; his headline tax rate of 14 per cent results largely from the dramatic cuts in taxes on capital gains and dividends engineered by former president George W. Bush.

Since becoming known, that low rate has been a source of irritation not only to less fortunate Americans (famously, Warren Buffett’s secretary pays more) but often also to highly paid wage slaves whose salaries and bonuses are fully taxed at a top rate of 35 per cent.

And that’s far from the only way that Mr. Romney has kept his payments to Washington so low for someone with $20.9m of income last year.

For one thing, what is considered capital gains for Mr. Romney and taxed at 15 per cent – the well-known“carried interest” received by private equity and hedge fund managers –would be considered wages in a more rational world and taxed at 35 per cent.

But Mr. Romney has even elasticized this provision. He left the private equity business in 1999 and yet continues to claim the 15 per cent rate, at best a grey area under Internal Revenue Service rules.

And that’s just the beginning. Like most Americans, Mr. Romney has an individual retirement account (known popularly as an IRA or a 401k). Unlike most Americans, Mr. Romney’s IRA contains as much as $100m, notwithstanding the relatively low ($30,000 at present) limit on annual contributions to these accounts.

We don’t know how Mr Romney shoveled so much into his IRA; my guess is by “selling”Bain investments at substantial discounts or carried interest at nominal valuations.

What we do know is that he is deferring paying taxes on income earned by these funds, an interest free loan from the US government worth millions of dollars a year.

Then there’s the matter of inheritance taxes. Notwithstanding strict limits on tax free gifts to heirs, Mr. Romney has managed to put aside as much as $100m for his descendants, probably using the same mechanisms as he did with his retirement plans, thereby potentially postponing death duties of roughly 35 per cent of the value of the trusts for multiple generations.

That’s not all. By structuring these vehicles as “grantor trusts,” taxes on the income from the investments are paid by Mr Romney rather than by the trusts, which allows the assets of the trusts to accumulate faster, thereby obviating still more inheritance taxes.

Much has been made of Mr Romney’s offshore accounts, including a now-closed Swiss bank account. Tempted as I am to pile on Mr. Romney for those, unless he engaged in patently illegal tax evasion, which strikes me as highly unlikely, I mostly can’t figure out how they have helped him avoid US taxes.

With one exception: Mr. Romney appears to have taken advantage of the ability of hedge fund managers (Bain had hedge funds as well) to defer indefinitely taxes on carried interest profits attributable to investors in their offshore entities. While now closed for new deferrals, Mr. Romney is (once again) receiving an interest-free loan potentially worth millions each year.

Beyond the prurient interest in a rich man’s finances and the more high-minded question of Mr Romney’s character, the presumptive Republican nominee’s successful efforts to minimize his taxes speak volumes about the Swiss cheese nature of America’s tax code.

Ironically, Candidate Romney himself has served up tax cut proposals that would only lighten further his already featherweight tax burden.

High on the agenda for the next President – whoever it might be – should be a long overdue wholesale revamping and simplification of the revenue code.


The Republican party, like all political parties, is not monolithic; it is a coalition of people who may or may not agree with each other on many issues but are willing to support each other on those the others care about for mutual benefit. But from time to time, one issue comes along that makes holding a party’s coalition together very difficult.

The classic example is slavery. In the 1850s, the Democratic party in the north essentially collapsed, as northern Democrats could no longer support their members in the south, who were adamantly opposed to compromise on slavery. The other major party at that time, the Whigs, tried to straddle the fence – not defending slavery, but fearful of condemning it forthrightly, lest they lose votes in the South.

As abolitionist sentiment rose in the north, the Republican party came into existence on an explicitly anti-slavery platform. The Whig party disappeared.

The closest analogy to slavery in modern American politics is abortion; indeed, anti-abortion forces often make an explicit connection between the denial of “personhood” to both slaves and unborn fetuses.

The issue has been an important issue in American politics since at least 1973, when the Supreme Court decided that the right to an abortion is guaranteed by the Constitution. Previously, abortion was not a federal issue but one that the states decided for themselves.

In the years since, those who would prefer to return to the status quo ante have largely coalesced in the Republican party. As their support within that party has grown, anti-abortion forces have pressed ever harder for it to take an absolutist position on the issue – no legal abortions whatsoever even in cases of rape or incest.

According to polls, this is an extreme position not shared by most Americans. By and large, the Republican strategy has been to pay lip service to anti-abortion extremists – lots of rhetoric, little legislative action. This is necessary because many Republicans, especially middle class women, strenuously oppose the extremist position and would abandon the party on that issue if they thought it would actually attempt to ban abortion altogether.

The fault line has long been an exception for rape and incest, which most people consider reasonable. But the extremists cannot abide that. To them, abortion is murder and making any exception means sanctioning murder.

On 19 August, Congressman Todd Akin of Missouri, who is the Republican party’s nominee for the US Senate this year, focused attention on this fault line by stating in a television interview that abortion should be prohibited even in cases of forcible rape, which he foolishly called “legitimate rape.”

On August 21, the Republican Party’s platform committee, which is meeting in Tampa, Florida, in advance of next week’s party convention, adopted a plank endorsing an amendment to the Constitution that would ban all abortions without exceptions.

These events will almost certainly make abortion a major issue in the presidential campaign. Clearly, this will be to the disadvantage of Republicans, who would prefer to continue their practice of appealing to anti-abortion extremists without endangering the votes of women and other members of the party likely to bolt if forced to accept the extremist position.

The attention on abortion also prevents Republicans from focusing the campaign on the economy, which is Barack Obama’s weakness. But given the power of anti-abortion extremists within the Republican Party, it may be impossible to finesse the issue that matters most to them this year and could tilt the election toward Mr Obama.

For the third time in three years the Europeans’ stance on Greece is economically inconsistent.

The first time was in 2009-2010 after then prime minister George Papandreou indicated that he would need to file for assistance from the International Monetary Fund. The European response was to reject the principle of IMF intervention while not offering an alternative to it. It took several months until an agreement was found, in May 2010, to combine European and IMF conditional support.

The second time was in 2010-2011 when Greece’s solvency became the urgent issue at hand. Two camps emerged. One advocated swift debt restructuring, emphasising that Greece was a unique case and that markets could be convinced that no other European country would follow suit. The other one stressed the adverse spill-over effects of a default and favoured keeping Athens afloat through cheap loans. The compromise was to lend at penalty rates while letting markets expect that restructuring would perhaps come, but at a later date. Each of the two positions was internally consistent but the compromise was not. It took more than a year, until the second half of 2011, to recognise this contradiction.

The third time is now. Again, Europe is divided. One camp, well represented in northern Europe, considers that Greece should leave the eurozone because it is not fit for purpose either economically or politically. This view is actually held by both eurosceptics (who want to demonstrate that exit is possible) and europhiles (who hope to win over opposition to further integration). The latter camp, more vocal in France and southern Europe, is adamant that the integrity of the eurozone must be preserved, because Greece’s departure would have adverse contagion effects on other southern countries.

Each of these positions is also internally consistent. But it is not consistent to urge an exhausted country to make all possible efforts to meet the targets of the IMF/euro area programme, while fuelling anticipations of a forced exit. For domestic agents, the risk of the financial disruptions an expulsion would cause acts as an incentive to export capital or hoard cash. For foreign investors, including overseas Greeks, it is an incentive to refrain from investing in the country in the hope of future bargain acquisitions. In such conditions one should not wonder why investment in the first quarter of 2012 was only 46 per cent of its level four years previously (in fact one may wonder why it was still so high). But without investment and a return of confidence, Greece is bound to remain caught in a vicious circle of recession and whatever its efforts, it is unlikely to meet its creditors’ demands.

European leaders should choose. If they really think they would be better off with Greece out they should offer it an exit package. Evidently, an exit will cost them dearly because the sharp currency depreciation that is certain to take place will force the country to default on its euro liabilities. Also, Athens will remain in need for financial support, if only because it is still far from having returned to budgetary and external balance.  The credibility of the euro will suffer and other countries will have to be protected from contagion. And finally the EU cannot forget Greece because whatever its fate in the EU, it will remain in Europe and will matter for the whole continent. So on closer examination the option looks less attractive and more dangerous than seems at first sight. But at least it has an internal logic.

If the Europeans accept that a Greek exit is not in their interest, they should recognise the efforts made and give it a real chance to adjust further and recover within the euro. Obviously they cannot remove the redenomination risk entirely but they can at least make speculation of exit a less-assured bet. Beyond a reasonable extension of the assistance programme, this means giving clear signals that Europe believes in a possible success. One possibility, which is certainly not without difficulty, would be a conditional relief on the debt to official creditors, what the jargon calls official sector involvement. Another one would be to foster public and private equity investment, through debt-equity swaps, investment by international financial institutions (such as what the European Bank for Reconstruction and Development has done in eastern Europe), or a revival of the too quickly derided Eureca plan for the pre-privatisation once proposed by Roland Berger, the consulting firm. The key is that private agents can only believe in the revival of Greece if the Europeans themselves invest in it.

When Prime Minister Samaras meets with fellow European leaders later this week, he should offer them a small gift for late summer reading: a copy of Alfred de Musset’s play, A door must be either open or shut. It is short and inspiring.

On the surface, it seems strange: Spain is offered large loans at below-market interest rates, coupled with significant additional support by a regional central bank willing to buy the country’s government debt on the secondary market. Yet the government is reluctant to officially request this help.

However, Spain’s reluctance is rational, rather than a reflection of stubborn national pride or a misunderstanding on the part of the government. It is a well-founded hesitation to follow others in becoming a ward of the eurozone. Until the continent’s leaders fix these contradictions, the euro crisis will continue to pose a threat to Europe’s historic regional integration efforts.

In theory, there are four immediate upsides to the assistance offered to struggling members of the eurozone: it provides direct, cheap and sizeable financing to facilitate a country’s implementation of comprehensive reform measures; it unlocks financing from the International Monetary Fund, also at below-market rates; it indirectly lowers the cost of government debt by shifting liabilities from the private to the public balance sheets; and it reduces some of the obstacles facing credit-rationed companies and households.

Together, these advantages offer recipients the ability to minimise crisis-induced losses in output and jobs. Yet, judging from the first three years of European financial packages (for Greece, Ireland and Portugal), theory is yet to translate into practice.

Rather than crowd-in private funding, the packages have signalled the end of a recipient country’s access to private capital markets. With that, borrowing costs have remained too high and access to new credit severely limited. Not surprisingly, growth and new employment have repeatedly fallen short of objectives.

Two major factors speak to this contrast between theory and practice.

First, the official financing packages have served to subordinate private loans. Due to this subordination, private creditors have shown no appetite to co-finance with the official “troika” of the European Central Bank, the European Union and the International Monetary Fund. Instead, they have used the availability of official financing to exit.

To make things worse, some of this exiting has been accompanied by structural changes that make it highly unlikely that capital will return any time soon. Just witness investment guideline changes that exclude peripheral European economies from the permissible investment universe, and the related credit rating downgrades.

Second, the underlying programmes are yet to strike that delicate balance between budgetary austerity and growth-enhancing measures, including competitiveness-enhancing reforms. This does more than limit countries’ ability to generate future income and be in a stronger position to repay debt. It increases domestic popular resistance to European financial packages, serving also to encourage capital flight by residents (including large withdrawals from bank deposits).

I suspect that these two factors will be at the top of the agenda of Mariano Rajoy, Spain’s prime minister, when he travels to Germany. He has likely been encouraged by recent remarks by ECB and German officials which suggest greater recognition among critical European decision making. But translating this into effective changes on the ground will not be easy.

In a press conference last month, Mario Draghi, the ECB president, indicated that he would look for ways to minimise the subordination problem. This would involve a relaxation of the central bank’s preferred creditor status. But doing so would risk undermining the standing and credibility of an institution that needs safeguards as, almost by definition, it is expected to lend into highly stressed credit conditions.

Shifting the policy balance of the underlying packages is no easy feat either given the time inconsistency between immediate austerity measures and the growth side of the adjustment equation. In addition to complex design issues, this requires even more external assistance at a time when official creditors (and many of their political constituents) are wondering whether they are simply pouring taxpayer money into a deep hole.

European leaders will thus have to work hard to find innovative and imaginative solutions to both these issues. We should all hope that they are successful. If not, Spain’s hesitation will be followed by two new twists in Europe’s crisis: within a few weeks, a significantly larger economy would join three other eurozone members in becoming a ward of the European state; and Italy, an even bigger economy, would risk slipping to where Spain is today.

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


This much you have to give Mitt Romney: by choosing Paul Ryan as his running mate he has made it impossible to avoid turning the presidential election into a genuine and long overdue debate on the nature, extent and responsibilities of American government. By doing that, whatever the outcome, he will have rendered a service to the American people, who deserve to be drawn into an all-out contest of principles rather than the usual beauty-pageant cum pratfall-watch that consume most autumn campaigns.

Because Mr Ryan (unlike the top of the ticket), is in the habit of actually attaching numbers to his budget proposals, there is a faint possibility that the debate between Americans who want to retain the institutions of the New Deal and the 1960s (such as Medicare) and those who believe that under Franklin Roosevelt and Lyndon Johnson the country took a fatal step towards collectivism, will actually have to consider evidence rather than collapse into the usual exchange of uninformed abuse that gets confused with argument.

Is there, for example, any evidence (rather than a kind of religious optimism) that by slashing tax rates on corporations and individuals without considering revenue at all, you won’t actually make the deficit that Ryan-Romney says it wants to tackle catastrophically worse, rather than better? The ancient mantra of “closing loopholes and ending fraud and abuse” has been chanted at least since Reagan and somehow there never seems enough loophole-closing to make up the sudden fiscal shortfall. Is there any evidence at all that the voucher system with which Ryan wants to replace Medicare will actually keep pace with the rising costs of insurance, rather than expanding the numbers of those shut out from care and thus increasing rather than decreasing costs incurred from habitual resort to emergency rooms? Why was it that Paul Ryan voted for George W Bush’s bail-out of the automobile industry in the autumn of 2008? Could it be that there was not a hope in hell of the usual sources of credit being made available for the restructuring Mr Romney has said he wanted unless the federal government stepped in. Why not ask the voters of Mr Romney’s father’s home state what they think about that? Someone probably will.

A “Ryanised” debate will – one hopes – force Americans to think in first principles about what they really expect from the federal government and how it should be funded. Does a majority of Americans want the federal government to get out entirely from education, even though the evidence is that the US is falling woefully behind Asian and other countries in the proficiency of exactly the skills – scientific and technological – with which the future has to be won? Does a majority of Americans want the federal government to abandon responsibility for monitoring public health – clean air and water and in the age of fracking, the price that ought or not to be paid for the securing of domestic energy sources? Are Americans perfectly happy, as the Republican position now presupposes, to end the mortgage deduction from income tax returns, and were that to happen would it have a positive or negative effect on the tender shoots of recovery in the housing market? Is a society of widening, or narrowing, income inequality, more likely to be economically dynamic?

Behind all these particular issues lies a much bigger, general one, first rehearsed in the election of 1800 fought between the government minimalist Thomas Jefferson (who won) and the likes of John Adams and Alexander Hamilton who refused to see the federal government as a threat to democracy. That debate was joined again, not so much in 1932 when Roosevelt obscured his true predilection for aggressive intervention to save the shattered economy, but in 1936 when he was unrepentant about his New Deal.

What Roosevelt, and later Johnson, powerfully argued was the authentic American-ness of what they had done; that the establishment of Social Security, the prudence of Glass-Steagall, later the creation of Medicare and Medicaid, was rooted in a long tradition of American mutualism; looking out for each other as much as oneself. Ayn Rand, the atheist libertarian who accepted no god other than the individual, and devotion to whom seems to constitute most of the claims that Mr Ryan is “an intellectual”, on the contrary, argued that those reforms represented a plot against American liberty; a stealth enslavement. Fine, let’s have a spirited exchange of views about what a Randised America would look like.

But of course Barack Obama, who is no slouch at defending the American authenticity of the New Deal, Medicare and the rest, will not be debating Mr Ryan in the autumn, more’s the pity. Which raises the fascinating possibility that what is being hailed as a “game changer” on Mr Romney’s part may end up dragging him into a game he actually doesn’t want to play. Unless he supplies the kind of detailed, data-loaded plans for what he would have in mind after the Affordable Health Care Act is repealed, he will be stuck with Ryan-vouchers and the replacement of federal obligation to helping the poor and sick with those block grants, a “solution” which amounts to kicking the problem of costs down the road to Nevada, or Alabama by the very people who make an awful lot of their indignation against can-kicking.

Over and again Mr Romney will be asked whether he supports Ryanism. If he says yes he looks like the bottom, not the top, of the ticket. If he says no, he reinforces rather than ends the impression, already taking hold of independent voters, that he is a shifty opportunist who will do whatever it takes, say whatever has to be said, co-opt whomever it takes, to change the furnishings at 1600 Pennsylvania Avenue. If he asserts himself by neutering Mr Ryan, he will incur the wrath of the very hardcore Tea Partiers he is now so eager to appease. So while the political choice for Americans has overnight become dramatically clearer, for Mitt Romney the autumn may turn into the Be Careful What You Wish For campaign.

Syria’s civil war is deepening. Rebel forces have struck in the heart of Damascus, killing defence and security officials within both the regime’s inner circle and Bashar al-Assad’s family. Sanctions are in place, and the number of high-level defections is growing. Even former UN Special Envoy Kofi Annan now says that al-Assad “must leave office.” Has the conflict reached its endgame?

Would it were so. True, Mr Assad has few reliable friends outside his entourage and arms suppliers. His country has endured enough economic damage and his government lost enough credibility with Syria’s commercial elite, its armed forces, and the country’s majority Sunnis that his days are almost certainly numbered.

But that number is not as small as many think, because his willingness to use heavy artillery to pound his people into submission and the fear among minority Alawite core supporters that only he stands between them and a dark future keeps the killing in motion.

In short, short of a targeted assassination or some other form of quick decapitation strike by the rebels, we have a worst-case scenario: A regime that can’t win but won’t quit—and an outside world willing to do little more than watch.

Yes, Syria’s increasingly battle-tested rebels can expect more help. Local friends like Turkey, Saudi Arabia and Qatar will supply them with weapons while Americans and Europeans continue to squeeze al-Assad’s government. Yet, the regime still has the heavy weapons, and fears that survival depends on absolute victory ensure the state’s willingness to use them.

Only active intervention by outsiders could quickly tip the balance in the rebels’ favor. Last week, as the regime prepared its current assault on Aleppo, Syria’s second largest city and commercial capital, a US State Department warned that a “massacre” was in the works. That’s the same word deployed to justify last year’s NATO intervention in Libya. Fearing that Muammar Gaddafi army stood ready to slaughter the civilians of Benghazi, western governments used an Arab League invitation and a UN Security Council mandate to bomb government forces and boost rebel prospects.

Yet, that won’t happen in Syria. First, this time there will be no such institutional license to kill. Russia’s government will continue to veto UN resolutions that authorise force—not just because Mr Assad is a long-time friend and arms client, but because the west’s willingness to interpret the UN mandate as broadly as possible in Libya left Moscow feeling impotent and foolish. In addition, this conflict will play out not in the Libyan desert but in the heart of Syrian cities.

Second, Americans and Europeans aren’t exactly spoiling for another fight. Syria’s armed forces are far more capable than Gaddafi’s, and Syria is much more complicated than Libya. The Obama administration wants to minimize risks in the run-up to November’s elections, and though US voters are not focused on foreign policy, a failed effort to use US airpower and weapons to tip the balance in the conflict would certainly have an impact on the president’s standing. That’s why Washington will stick with covert support and humanitarian assistance. European leaders remain fully occupied with the fate of the Euro. Sanctions must suffice. Even if the Russians and Chinese decide that Mr Assad is bound to lose eventually, they are less than eager to endorse regime change to unseat an authoritarian government—and the precedent it might create.

There is also the (entirely reasonable) fear that the “controlled demolition” of Assad’s government now under discussion in the west will leave a potentially explosive vacuum of power inside yet another complex, multi-sectarian country at the heart of a volatile region and the intersection of its many rivalries.

That’s why US defense secretary Leon Panetta recently asserted Syria’s need to “maintain as much of the military and police as [possible], along with security forces” after Mr Assad is finally gone in order to help “transition to a democratic form of government.” That’s a pre-requisite for post-Assad stability—and it’s also intended to persuade the men with guns that their future is not tied to their president’s. Yet, no one should believe that building and maintaining a delicate political balance in a country plagued with scores to settle among minority Alawites and majority Sunnis—to say nothing of introducing genuine multiparty democracy—can make progress quickly or without conflict.

Instead, Syria can expect more slow-motion tragedy. Mr Assad will cling to power for some time to come, and the bombardment of Syrian cities will continue. The government and rebels will probably establish their respective strongholds. Neighbors like Lebanon and Jordan will feel the shockwaves as refugees seek safety.

When Mr Assad’s core supporters finally switch sides, outsiders will calculate how little they can do to help re-establish order. The country will then become an open arena in which Saudi Arabia, Iran and Turkey use proxies to protect their interests and play out their rivalries.

This week’s meeting of the FOMC, the Federal Reserve’s monetary policy committee, speaks volumes to the policy dilemma facing highly activist central banks. Let us hope other policymakers and, even more importantly, their political bosses are listening.

In the run up to the meeting, there seemed to be enough data to warrant additional policy measures – from weakening economic activity (domestically and around the world) to more subdued inflation. Along with European financial fragility, this led analysts to speculate about additional measures. Equity markets rallied, as did other risk assets, helped also by signals out of the European Central Bank. Yet, when push came to shove on Wednesday, the Fed was restrained, and understandably so.

For several years now, the Fed has been leading the policy parade. The initial focus (2008-09) was to counter market failures, system fragmentation and technical contagion that erupted in the midst of the global financial crisis. And it delivered, helping to avoid a global depression.

Fed officials did not stop there. Bolstered by their successes and, more importantly, feeling they must compensate for the paralysis of other US government entities, they shifted in 2010 to a more direct targeting of economic outcomes. Here, however, they have repeatedly disappointed – both in absolute terms and relative to their own expectations.

While some would have favored even greater policy activism, the Fed’s measures have been unprecedented – from flooring policy rates virtually at zero for quite a while (and also providing forward guidance until the end of 2014) to ballooning its balance sheet in an attempt to counter the de-leveraging of the private sector and induce it take more risk. In the process, it transitioned from completing dysfunctional markets to dominating some of their functioning; and it is sowing the seeds of possible policy complications down the road while exposing itself to greater political intrusion, undermining the price discovery process, and distorting asset and resource allocations.

So while markets have been conditioned to expect ever greater central bank intervention whenever the data weakens or sovereign spreads spike in Europe, the cost-benefit equation within the Fed has gotten considerably trickier. There is now much greater appreciation that the policy response, no matter how imaginative, can do little on its own to address decisively America’s challenges of too little growth and employment, too much long-term debt and too great a political polarisation.

So, this time around, the Fed decided to talk the talk but not walk the walk. It is unwilling to do anything now, also reflecting a desire to keep dry whatever policy ammunition remains in the event that Washington is unable to deal with the fiscal cliff and Europe takes another turn for the worse. And while it signaled a willingness to do more should conditions deteriorates, I suspect that it wishes this to be in support of other policy measures rather than substituting for them.

The Fed’s attempt to overcome its policy dilemma has little chance of succeeding given the degree of political dysfunction in Washington. It is only a matter of weeks until, once again, Fed officials will feel compelled to act, and despite full knowledge that their measures will have limited effectiveness in delivering desired outcomes.

Most fundamentally, what is being illustrated again in all this is that what the US faces today is as much a political problem as it is an economic one. Until the political system steps up to its strategic leadership challenge, America will risk the trap of policy purgatory.

Among the oddities of the US system of government is the vice president. The position was created by the Constitution, but the founding fathers neglected to give him anything to do. His only constitutional role is to preside over the US Senate and break ties; he can’t even speak except to deliver vote totals and make the occasional parliamentary ruling; and the vast majority of the time his function is fulfilled by random members of the majority party who serve as president pro tempore of the Senate.

Of course, the vice president becomes president in the event that the president should die in office or resign. Of the 43 men who have served as president, nine achieved the office this way. Additionally, the vice presidency is often a stepping stone to the presidency, with five vice presidents later being elected president in their own right. George H.W. Bush is the most recent to do so.

Therefore, a third of American presidents became president directly or indirectly through the vice presidency. It is a decision to which great thought should be given.

Unfortunately, this is often not the case. The vice president is often chosen to satisfy some political need within a party. For example, Ronald Reagan thought he needed Mr Bush to balance his ticket and soften his image as a hardline conservative.

Ideally, presidential nominees would like to find a vice president who can deliver a big state that he would not otherwise carry. The classic example is John F. Kennedy’s choice of Lyndon Johnson in 1960. He undoubtedly carried the state of Texas for him and helped throughout the South.

Since it is rare for there to be a potential vice president who can carry a key state, presidential nominees often look for vice presidents who appeal to certain interest groups. Mr Bush chose Dan Quayle in large part because he thought his youth would appeal to younger Americans.

The key constraint in terms of using the vice president for purely political purposes is that he or she really does have to be capable of becoming president. Nominating someone who is manifestly unqualified can drag a candidate down to defeat.

It is widely believed that John McCain’s choice of Sarah Palin as vice president in 2008 doomed him to defeat, as it became clear during the campaign that she had neither the minimum knowledge nor temperament to be president.

Consequently, much of the discussion about who Mitt Romney should name has centered on those considered safe choices—people clearly qualified to be president who won’t pull the ticket down.

Current speculation has centered on 5 men: Ohio Senator Rob Portman, former Minnesota Governor Tim Pawlenty, Florida Senator Marco Rubio, Louisiana Governor Bobby Jindal, and South Dakota Senator John Thune. Last week there was also some speculation about former Secretary of State Condoleezza Rice.

Mr Rubio and Mr Jindal clearly are long shots because of their youth and relative inexperience. Some Republicans believe Rubio, who is of Cuban heritage, would help with the fast-growing Hispanic vote, although there is no evidence of this in polls. Mr Jindal, whose parents were born in India, would showcase the party’s inclusiveness.

Political professionals, however, think Mr Romney will probably pick one of the “boring old white men”: Mr Portman, Mr Pawlenty or Mr Thune. Each is qualified to be president and would be unlikely to cause controversy. But none would measurably strengthen the ticket except possibly Mr Portman, who may help Romney carry a state, Ohio, he needs to win.

Some scholars have long been troubled by the common practice of allowing a party’s presidential nomination to have the sole say-so in naming his running mate. Although the party’s convention nominally names the vice president, in practice it merely rubber-stamps the presidential nominee’s choice.

I think it would be a good idea to give parties a bigger role in choosing the vice president. Perhaps nominees could provide the party convention with a slate of acceptable choices and let them sell themselves to party delegates. At least it would add some excitement to an event that is otherwise almost entirely devoid of substance in an era when presidential nominees are chosen by state primaries long in advance of party conventions.

Related link:
US elections 2012 – FT

With global demand seemingly in free fall, both the US and China see increased foreign direct investment as a possible cushion. But despite the US and China having the world’s largest bilateral trade flows, Foreign Direct Investment flows between the two are surprisingly negligible.

During the so-called US – China Strategic and Economic Dialogue, a meeting of respective honchos from both countries, the most heated discussions involve China complaining about US security restrictions on direct investment and America arguing that China is too fixated on promoting “indigenous innovation.” Differences in culture certainly play a role as well, but mismatched motivations in intentions pose an even greater challenge.

Contrary to popular belief, the US accounts for only a few percent of FDI into China. This is puzzling given the prominent role that such investments played in jumpstarting China’s economy, making it among the top two destinations globally, second only to the US. FDI from European countries also has been much higher than from the US, mirroring their stronger export presence in higher end machinery and consumer products compared with the US whose top two export lines are food grains and recycled waste products, which do not warrant supportive FDI.

American affiliates in China also played a surprisingly minor role in mediating the contentious export growth of Chinese-made but American-branded products. US companies have found that retailing is more profitable than production. Thus most of the high valued components are produced elsewhere and only assembled in China, and even then often by overseas firms such as Foxconn (Taiwanese) in the case of Apple. In areas where prominent US brands stand out—fast food and hotel chains—the major costs are on the books of local partners while US multinationals benefit from franchise fees.

These days, American firms entering China are primarily driven by the desire to tap a huge consumer market. But Beijing does not need more capital; it wants technology that is unavailable locally.

No wonder US FDI in China is so trivial.

And going the other direction, even though China’s outward direct investment only became significant recently, a mere 1 per cent so far has gone to the US. Can America create a more receptive climate for China’s inflows given the hostility experienced by Japan decades ago when it was already a US ally?

Chinese companies seeking opportunities abroad are now primarily motivated by the search for resources with showcase examples in Africa and Latin America and a notable victim of politics being Cnooc’s pursuit of Unocal in the United States. That failure contrasts with the Cnooc’s attempted $15bn acquisition of Nexen’s oil and gas assets, which if approved by the Canadian Government could represent a landmark shift in how Canada views the US and China.

Collaboration on clean energy technologies offers such an opportunity. China’s rise to dominance in the manufacturing of solar energy equipment and wind turbines reflects its push to make clean energy a growth industry. Combining state support with acquired technical advances, the resulting scale economies have reduced energy costs to a fraction of what they were only recently.

From the US perspective, however, China’s emergence is yet another example of not playing by the rules. Public attention is dominated by the anti-subsidy cases filed against China by a small group of US clean energy manufacturers even though they run counter to the wishes of the larger numbers involved in distribution.

The politically charged scrutiny of bankrupt Solyndra’s access to US loan guarantees confirms that the clean energy business is risky. But given the environmental and energy security benefits, most countries provide subsidies. Without the technical improvements and volumes to lower costs, commercially viable approaches will remain unrealised. As the two biggest carbon emitters globally, the US and China have the most to gain.

Beneath all the sparring, however, investors from both countries are starting to make deals. China concentrates in relatively low margin hardware and assembly while American firms focus on niche, higher valued-added upstream production or more profitable downstream installation. Rising labour costs in China combined with the benefits of proximity to technology centers and more sophisticated markets are starting to generate proposals to produce more in the US. This provides an option similar to the relocation of Japanese auto plants to the US which helped to ameliorate tensions.

With US funding for clean energy drying up and pressures to develop lower cost approaches mounting, both sides should channel their political capital into encouraging mutually beneficial arrangements rather than entering into protectionist battles.

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

By assigning to the European Central Bank the task of “defining and implementing the monetary policy of the Community”, the EU Treaty implicitly considers that there should be only one monetary policy for the entire euro area. Yet, looking at a variety of indicators – from short or long term interest rates on a wide variety of assets to the flow of money and credit to the private sector – it is difficult to conclude that monetary conditions are currently uniform across the union.

The central bank typically implements its monetary policy by setting the rate of interest at which it lends to the banking system. Such a rate, which influences asset prices and affects the savings and investment decisions of the private sector, is determined with a view to achieve price stability. A key assumption underlying this operational framework is that financial markets are efficient and support a smooth flow of funds across the union. In other words, the transmission mechanism of monetary policy is expected to be stable and predictable.

This assumption is far from being satisfied. The euro area financial market, in all segments and maturities – including the very short term money markets – does not function properly, as banks deposit their excess liquidity with the central bank instead of lending to other banks. Cross-border banking flows have dried up. Households and firms across the union borrow at rates that depend more on the respective sovereign risk – just look at Spain, today, for example – than on their intrinsic creditworthiness. Interest rate decisions made by the central bank are not able to affect monetary conditions in the desired way in a large part of the euro area.

There are two ways to address the issue. The first is that the central bank adopts measures aimed at circumventing the prevailing disruptions to the transmission mechanism of monetary policy. Over the past two years the ECB has taken several actions in this direction, such as the provision of unlimited long term refinancing to banks, at a fixed rate. These measures have been effective, at least for some time, and there is probably room for more, but the transmission mechanism of monetary policy has remained impaired.

The second way is to repair the transmission mechanism. But who’s task is it? Central bankers tend to think that the responsibility lies primarily with national governments and supervisors, given that the malfunctioning of the financial markets is mainly due to the heightened banking and sovereign risk. Governments, on their part, contend that they have already taken strong actions and have committed to more but markets are too slow to recognise progress. Only the central bank has sufficient firepower to push markets towards a sustainable equilibrium.

Both are right, to some extent. But there can be no viable solution without actions being taken at the same time by governments and the central bank, each in their own field of competence. In allocating responsibilities, the euro area can build on the experience gained by the International Monetary Fund in dealing with crises for more than 40 years. First, strong conditionality is needed to ensure that governments consistently implement their adjustment programmes over time. Second, liquidity has to be provided in sufficiently large amounts so as to catalyse private financial flows and convince market participants that the system is stable.

To be effective, the solution requires confidence and trust between the policy authorities. The central bank has to be reassured that the conditionality adopted by the member states is sufficiently stringent, lasting and irreversible. In this respect, the experienced which followed last Summer’s ECB’s intervention in the secondary market for Spanish and Italian government debt has left a sour aftertaste. Governments, on their side, have to be reassured that the tough measures that they have committed are supported by the provision of sufficient liquidity to guarantee success over time. To be sure, the fiscal adjustments, which are being implemented, have little chance of succeeding unless the interest rates prevailing in these countries are rapidly brought down more in line with the rest of the euro area. This can hardly be done without the direct involvement of the central bank.

The strategy is successful if market participants are convinced that policy makers stand ready to do all that is needed to solve the crisis. Communication is key, and needs to be consistent with this requirement. In this respect, focusing on what the central bank should not do or does not intend to do, rather than what it might eventually do, if necessary, in order to address the problem, can be counter-productive. For example, repeatedly raising concerns in the public about the size and the risks of the central bank balance sheet, about the dimension of the cross-border payment imbalances (Target2 balances) or about the limited ability of monetary policy to solve all problems may fuel doubts among market participants about the determination of the monetary authorities. In a fiat money system, even the slightest doubt that the central bank may face constrains in ensuring the convertibility of the currency can fuel bank runs and generate financial turmoil.

The euro area crisis may have reached a point in which it can hardly be resolved unless the policy authorities are determined to take bold actions. This may require that the member states further strengthen their policy commitments, concerning in particular the structural reforms aimed at improving competitiveness and growth, and make these commitments irreversible, consistently with their membership of the euro area. It also requires that the central bank takes more drastic measures to ensure that there is a single monetary policy throughout the euro area, consistently with its mandate. Price stability is not in danger right now. The euro might be.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Affairs and a former member of the ECB’s executive board

Ben Bernanke, chairman of the Federal Reserve, delivered on Tuesday a remarkably timid policy statement to Congress. This may reflect a hesitation to front run the FOMC, his policy-making committee, which next meets on August 1st. But the main culprit is probably elsewhere. The Fed increasingly finds itself in a large and deepening policy dilemma.

Mr Bernanke devoted almost the entirety of his written statement to recent economic and financial developments. Though he did not go far enough, he rightly emphasized what is now more than evident in recent data releases, including Monday’s retail sales numbers: America’s already inadequate recovery is weakening in the context of an increasingly synchronized global economic slowdown.

Look for the Fed in the next few weeks to go further in revising down its job, growth and inflation forecasts for 2012. Given the institution’s dual mandate of price stability and maximum employment, this will inevitably raise expectations of additional policy activism.

Having exhausted long ago the effectiveness of traditional monetary policy tools, the Fed has no choice but to consider another mix of unconventional measures – specifically, additional purchases of securities, a lower interest rate on excess reserves, an even more aggressive communication policy, and enhanced access to the discount window.

But, more of the same will not have a durable beneficial impact, especially if other policymakers remain missing in action. Indeed, the advantages of another round of unusual Fed activism are declining while the risk of both collateral damage and unintended consequences is material and growing.

The Fed is stuck in a widening dichotomy between the need for a policy response and an increasingly impotent tool kit. I suspect that Bernanke and his colleagues recognize that their policy effectiveness is waning. Yet, understandably, they are unwilling to stand idle given the paralysis in virtually every other part of the economic policy apparatus.

In the meantime, too many politicians seem willing to maintain the myth that the Fed can lead the domestic economy out of its current malaise. It cannot. The best it can do is slow a de-leveraging that, in the absence of proper growth dynamics, eats away at the traditional resilience and entrepreneurship of the US economy.

Recognising this, Congress should be doing much more to awaken other policymakers from their deep slumber. This requires the type of constructive political interaction that has eluded the US for almost the duration of the current term of congress. And there is little to suggest that this will change any time soon, and certainly not before the November elections.

It should therefore come as no surprise that, in their meeting with Mr Bernanke on Tuesday, members of congress showed little interest in internalizing their need to respond quickly to economic priorities. Instead, they diverted the discussion to other issues that, while topical and important, do little to advance the policy agenda and improve the outlook for hundreds of millions of Americans.

So, was Bernanke’s trip to Congress a complete waste of time? No. Hopefully, members of Congress will take seriously his attempt to humanize the risks associated with an urgent policy challenge – that of America avoiding going over the fiscal cliff.

Citing the Congressional Budget Office, Mr Bernanke noted that Congress’s failure to deal with the full range of programmed and blunt tax increases and expenditure cuts would lead to a “shallow recession” next year and, most importantly, “1 ¼ million fewer jobs … created in 2013.”

Given global connections and Europe’s persistent crisis, even this Mr Bernanke warning may be too sanguine. The last thing the US needs is another blow to an unemployment rate that remains way too high, and that involves a damaging component of long-term joblessness in the context of overly-stretched social safety net.

It’s not easy being a former president. The old joke is that ex-presidents are like Chinese vases: everyone says they are very valuable but no one knows what to do with them. Some, like Bill Clinton, continue with a frenetic flurry of activity, others such as Vladimir Putin, do not actually relinquish power while those such as Silvio Berlusconi seem to treat their post-presidential time as a hiatus before running for office again.

Recently, the two best known former presidents of Brazil took part, almost simultaneously, in events that clearly illustrate very different ways of living the ex-presidential life. Fernando Henrique Cardoso won the Kluge Prize, one of the world’s most important awards in the social sciences. This $1m prize is awarded by the Library of Congress of the United States and has a nomination and selection process as rigorous as that of the Nobel prizes.

The jury emphasised that the award recognised Mr Cardoso’s intellectual achievements. Before entering politics he was an internationally recognised sociologist who made pioneering contributions on the relationship of inequality and racism to under-development. He was also the father of the once popular “dependency theory”, which holds that under-development is partly caused by the richest countries as a result of the exploitative relations they established with poor countries. This idea is no longer in favour and Mr Cardoso himself recognises that the world has changed and that its conclusions are no longer valid.

About the same time that Mr Cardoso was being feted at the US Library of Congress,  Luiz Inácio Lula da Silva spoke by video conference to the participants of the Sao Paolo Forum who were meeting in Caracas. The Forum is a gathering of Latin American leftist organisations that meets periodically since it was launched by Mr Lula’s political party, the PT (The Workers Party) back in 1990.

In his televised address Lula said, “Only thanks to [Hugo] Chavez’s leadership, the people have had extraordinary achievements. The poor were never treated with such respect, affection and dignity. These achievements should be preserved and consolidated. Chavez, count on me, count on the PT, count on the solidarity and support of every leftist militant, every democrat and every Latin American. Your victory is our victory. ”

It is perfectly legitimate for Mr Lula to express his affection and admiration for Mr  Chavez. Affects – like love – are blind and deserve respect. But it is not legitimate for Mr Lula to intervene in another country’s elections. That’s not what democrats do. And Mr Lula knows it. Or he should know it. But he seems oblivious to this and in fact it is not the first time that he bluntly intervenes in Mr Chavez’s favor during a Venezuelan election. In 2008, on the eve of a critical referendum, he also intervened in the process, claiming that Mr Chavez was “the best president the country has had in 100 years”.

Nor is it legitimate to distort, as Mr Lula did, the Venezuelan reality – especially that of the poor. Mr Chavez has had a devastating effect on Venezuela and the poor are the main victims. It is they who pay the consequences of living in one of the world’s most inflationary economies; they are the ones having to make ends meet with a real wage that has fallen to its 1966 level (yes, 1966). It is they who cannot get jobs unless it is in the public sector and only if they are deemed loyal to the revolution and are willing to display publicly and often their unwavering support for el comandante. It is they who see their sons and daughters killed at one of the highest rates of homicides in the world.

No wonder, therefore, that in the last parliamentary elections in 2010 more than half of the votes were against Mr Chavez. In Venezuela it is impossible to reach that percentage without the votes of millions of the poorest – the very people that according to Mr Lula are doing better than ever thanks to Mr Chavez. And, finally, it is not legitimate for Lula to applaud and encourage in another country public policies that are diametrically opposite to those he implemented with great success as Brazil’s president.

In this sense, perhaps Lula would be well advised to do as former president what he did as president: follow Mr Cardoso’s example. After all, Mr Lula knows that his success as president owed a great deal to his decision to continue and even expand his predecessor’s economic and social policies. Mr Lula should take his post-presidential clues from Cardoso and understand that a true democrat does not use his prestige and influence as a former president to improperly intervene in another country’s elections.

We are now a year and a half into what many persist in calling the Arab Spring even though there is no end in sight to the turbulence and it is hardly certain to have a happy ending.

Nowhere is this more the case than in Egypt, the most populous and by many measures the most important country in the Middle East.

On one hand, there are elements of continuity. The military is predominant, having awarded itself most of the president’s traditional powers. There is no constitution; there is no parliament.

But there are also important changes. The old president is on his deathbed, far removed from power. Sitting in what was his ornate office is Mohamed Morsi, a popularly-elected member of the long-banned Muslim Brotherhood.

Egypt only arrived at this juncture by dodging a bullet. Namely, by allowing the Muslim Brotherhood to assume the presidency in the wake of elections. Had the military tried to foist its own candidate on the public there would have been massive protests that forced the military to either shoot into the crowds or back down. The generals would have forfeited their legitimacy whichever path they might have chosen.

By avoiding such a choice, General Tantawi and his colleagues have delayed the day of reckoning, but not permanently. The current co-habitation between a politicised military and a much-diminished president cannot last. Indeed, it may already be heading toward an end over the question of whether the parliament is to be restored now rather than after a new constitution is drafted and agreed on.

That said, de facto power sharing may linger for a time, if only because both sides have little appetite for making the hard economic decisions confronting the increasingly indebted country. Both the military and the Muslim Brotherhood fear alienating the people if they impose the necessary austerity. But the subsidies cannot go on. Egypt is akin to a start-up company that is burning its capital faster than revenues and investment are coming in. As the economist Herb Stein famously said in another context, that which cannot go one forever will not.

It is quite possible the military and the Brotherhood will agree on some necessary reforms, all the time pointing the finger at the other. But at some point the Brotherhood will tire of the imbalance of real power and force a showdown, and when it does, Egypt’s military is more likely to back down than not. The generals may fancy themselves in the mould of their Turkish counterparts who managed to “guide democracy”, but it is unlikely they will have the opportunity. Egypt is not Turkey, and even today’s Turkey is not the Turkey of old. Times have changed.

But what then? The honest answer is we have no idea. Many of the people running Egypt (or who soon will) were in the shadows only a year ago. But what is unknown to us and conceivably to them is how they will govern. What is to be the balance between the executive and rest of government? The balance between the public and private sector? The balance between government and society? For these and other reasons it is the debate over the constitution that will matter most.

In the end, the test of any individual or party is not a willingness to contest and win elections but rather the willingness to lose them. This is turn requires not just an honest count of the votes but a level playing field in terms of access to televison, the right to meet and organise, and the ability to raise money. We will learn if the Brotherhood is committed to democracy as a tactic or a principle.

What should outsiders do? For the US and Europe, interests are greater than influence. But this is not the same as having no influence. Economic and military assistance should be made conditional on behaviour — on moving in the direction of genuine democracy, respecting the rights of minorities and women, on fighting terrorists and honouring the peace treaty with Israel. Those running Egypt have the right to make their own choices, but they should understand those choices have consequences.

By any objective standard, Friday’s US jobs report was a poor one. Last month saw only 80,000 net new jobs, bringing the three month total to only 225,000. That is one third of the job creation rate of early 2012 and the weakest quarter in 2½ years. Once again, it confirms that the most noteworthy aspect of this economic recovery is how weak it is.

While the unemployment rate remained constant at 8.2 per cent, that is a misleading gauge of labour market health. Yes, this rate has fallen from the 10 per cent level of 2009. But, much of this improvement reflects shrinkage in the size of the labour force, rather than true employment gains. Broader measures of employment have not improved. The labour participation rate, which simply measures the percentage of working age adults with a job, just fell further to 63.8 per cent. That is a 27-year low.

These dismal job ratios reflect a fundamental lack of economic growth. Three full years have now passed since the trough of the recession. But, the US grew at only 1.9 per cent and an estimated 1.5 per cent for the first and second quarters of this year, respectively. For the full year, the consensus estimate is only 2 per cent. Such figures, well below the economy’s long run growth potential, are just not good enough to offset population growth and improve labour markets.

The obvious question is: why such a weak recovery? The answer traces back to the catastrophic 2008 credit market collapse. Namely, that the financial damage which it inflicted on consumers, lenders and homeowners has not been fully remedied. And, therefore, each of these three, broad sectors is struggling.

American households lost 20 per cent of their net worth during the collapse, as home values and financial assets plunged. So far, they have only recovered a bit more than half of this. As a result, they are financially cautious, for example saving nearly 4 per cent of their income, as compared to negligible, pre-crisis levels. This explains why consumer spending, which accounts for 70 per cent of GDP, remains relatively weak.

Then we all know the huge losses which so many lenders incurred in 2008 and 2009. It is no surprise that they, too, are hesitant. Total US commercial and industrial loans outstanding total $1.4tn, still well below 2007 levels. Lending criteria are tighter now, and marginal borrowers often cannot finance themselves.

Finally, millions of delinquent and underwater mortgages continue to depress the giant US housing market. New home construction is still running more than 50 per cent below its pre-crisis level. And, sales of existing homes, while slightly better, also have not seriously recovered.

The 2008 collapse and these resultant headwinds are not President Obama’s fault. They preceded him, and he has largely taken the right steps to counter them, i.e., fiscal stimulus, bank recapitalisations, and the like. And, the US economy is at least moving up, unlike Europe. Furthermore, he has consistently sought the right next step. Namely further stimulus now coupled with $3-4tn of long-term deficit reduction, beginning around 2014. But, the current economic weakness is the overarching election issue this year, and it portends a close outcome in November.

It feels like one more throw of the dice for central bankers stuck in the Last Chance Saloon. Last week’s rate cuts from the European Central Bank and gilt purchases by the Bank of England were certainly better than nothing. We shouldn’t kid ourselves, however, that they’ll provide the answer to life, the universe and everything. Our economic and financial problems are too big to be fixed with a simple flick of the interest rate switch or an extra £50bn of quantitative easing.

Yet, until now, the puppet masters who pull our economies’ strings have persuaded themselves they know how to deliver us to the Promised Land. Central bankers have persistently provided forecasts for economic growth which, in hindsight, have proved to be far too optimistic.

In the summer of 2010, for example, the sages of the Federal Reserve thought US economic growth would be between 2.9 per cent and 3.8 per cent in 2010 and between 2.9 per cent and 4.5 per cent in 2011. The actual outcomes were 3.0 per cent and 1.7 per cent respectively. The BoE was similarly optimistic, believing that the most likely outcome for UK growth in 2011 was around 3 per cent, a view conditioned on £200bn of asset purchases. The actual outcome was a rather more modest 0.7 per cent.

Does this mean monetary policy has lost its capacity to have any influence on economic outcomes? That, I think, is too pessimistic a conclusion. As the Bank for International Settlements notes in its 2012 Annual Report, the policy stimulus on offer post-Lehman was far greater than anything provided during the Great Depression. As a result, the economic outcome has been far superior: the overall peak-to trough decline in US GDP this time around was 5.1 per cent compared with a whopping 30 per cent or so in the early-1930s.

The problem, then, is not so much that policy hasn’t worked but, instead, that we expect too much from it. Stagnation is a lot better than Depression but there are still plenty of people out there who believe that, with a bit more effort and a few more macroeconomic policy wheezes, the good times will return – despite the evidence of persistent “optimism bias” in official forecasts based on no more than blind faith in the potency of policy.

For those who seem addicted to stimulus, the answer to monetary impotence is more fiscal stimulus. This, apparently, costs nothing (unless you happen to be unfortunate enough to be living in the eurozone). As part of the correspondence generated by their original provocative article (“A manifesto for economic sense“, 27 June 2012), Paul Krugman and Richard Layard argued that “If public sector deficits were increased, interest rates would rise little, especially if, as is desirable, the extra government debt was largely purchased by the central bank” (Letters, 1 July 2012).

It would be a cheap shot to mention the Weimar Republic or Zimbabwe in this context. Nevertheless, Messrs Krugman and Layard are making a highly-suspect assumption about the response of nominal activity to this kind of unconventional stimulus. Quantitative easing was supposed to boost UK growth but, instead, the UK ended up with higher inflation, squeezing real take-home pay and making debt repayment a lot more difficult. This was totally unexpected and thus provides a significant challenge to those who continuously demand even more stimulus. Can we be sure that the stimulus will affect real economic activity and not, even if indirectly, the price level?

Krugman and Layard’s manifesto stated that “today’s government deficits are a consequence of the crisis, not a cause.” Tautologically true (how could today’s deficits have caused the failure of Lehman?), the authors conveniently ignore the fact that fiscal positions had already deteriorated a great deal pre-financial crisis. During the good times, fiscal policymakers simply hadn’t been sufficiently frugal. Their subsequent firepower was, as a result, necessarily diminished.

The OECD estimates that, at the end of the 1990s, both the US and the UK were running cyclically-adjusted budget surpluses of around 3 per cent of GDP, excluding interest payments on existing debt. Long before the financial crisis, however, these 3 per cent surpluses had turned into 3 per cent deficits, thanks to big tax cuts and spending increases (the US) and spending increases alone (the UK). The subsequent collapse in economic activity obviously made fiscal positions far worse. Today’s fiscal predicament, however, stems in part from a lack of budgetary control during the good times. The convenient assumption was always that the good times would roll, a reflection yet again of a built-in “optimism bias”.

Promising a pot of gold at the end of the policy rainbow is all very well, but the public is surely now cottoning on to the fact that a succession of post-Lehman policy wheezes hasn’t delivered a sparkling recovery. Maybe they have recognised that, in a heavily-indebted world, there are limits to what policy can actually achieve. Yes, it can prevent the worst outcome but, no, it cannot take us back to “business as usual”. There is, of course, an obvious reason for that: business as usual would require a continuously-inflating housing boom, a persistent increase in household indebtedness and, as it turns out, ongoing fiscal stimulus. We won’t be returning to those conditions any time soon. Those who think we can must, then, be suffering from optimism bias.

Friday’s disappointing employment report out of the US is unsettling even for those of us that have consistently worried, and warned about the country’s weak job picture. It comes at a time when many people are understandably giving up hope of any major policy initiative out of Washington. And it confirms that this closely-watched release should be interpreted beyond its traditional role as a lagging indicator; these days, it is also a leading indicator for economic and political issues, both domestic and global.

It is not so long ago that a string of relatively strong reports – including monthly job gains averaging over 200,000 in the three months ended February this year – were fueling a bullish narrative about America’s prospects. After all, companies were sitting on lots of cash to finance new hiring and investment in plant and equipment; they were tapping into buoyant demand overseas, including in rapidly expanding emerging economies; and they had stretched their existing productive resources to the limit, thus setting the stage for a sustainable expansion.

This narrative got dismantled by successive monthly reports that did more than reduce average monthly gains to below 100,000. They also reinforced the fear that America’s labour market was risking structural impairment and, therefore, be much harder to fix.

Friday’s report adds to these concerns. Job gains were limited to just 80,000, again undershooting consensus expectation. The unemployment rate remained at 8.2 per cent, with a stunning 41.9 per cent of the 12.7m Americans out of work being long-term unemployed. The employment-population ratio stayed at the unusually low level of 58.6 per cent. And an alarming 23.7 per cent of teenagers in the labour force cannot find jobs.

The weak employment snapshot is consistent with other recent data releases, virtually all of which came in a lot worse than consensus expectations. It speaks to more than a subpar US recovery. It also illustrates the synchronized weakening of a global economy beset with limited policy effectiveness and adverse feedback loops – not just among individual countries, but also between economic fragility and political dysfunction and, especially in Europe, weak banks and deteriorating sovereign creditworthiness.

Economists who traditionally treat employment data as constituting lagging indicators – reflecting influences that have already played out in the economy – now need also to treat them as signals of future developments. And the consequences extend beyond America’s borders.

Worried about the reliability of their future income and given an already low household savings rate, consumers will spend less aggressively in the months ahead. Financial investors will also become more cautious. And companies will invest and hire less robustly.

A less buoyant American economy will amplify the pressures imposed on the global economy by Europe’s endless and still-expanding crisis. And do not look to policy makers in Europe and the US for effective offsets. Central banks are already in full experimentation mode, having stretched their traditional tools to the limit. The threat of a potentially disruptive fiscal cliff is looming ever larger. Policy responses are undermined by political bickering and dithering. And polarisation will only increase as the weak economy boosts those looking to unseat incumbents, especially in the run-up to the November elections in the US.

The notion that the world can rely on its pockets of healthy balance sheets to do the heavy lifting is theoretically correct but practically unlikely. Given the disappointing multilateral policy coordination, emerging economies will not fully compensate for prolonged weakness in Europe and the US. They too will slow, and are already slowing.

I hate to say it, especially as it sounds so fatalistic, but it is the unfortunate reality for now: Friday’s weak job report does more than confirm the prospects of a sub-2 percent growing US economy with unusually high and stubborn unemployment; it also signals even greater fragility ahead for both the country and the global economy.

This report will make households and companies less optimistic about their future, accentuate political dysfunction, and increase the cost of inadequate policy responses and poor global coordination. Until all this serves as enough of a wake-up call for short-sighted politicians in congress, it will make people like me worry even more about the wellbeing of both current and future generations.

François Hollande has had the kind of month most politicians enjoy once in a lifetime. After an unexpectedly large victory in the Presidential election, his troops followed up with a remarkable triumph in the legislatives, delivering him an absolute majority in the Chambre des Deputes, without the need to compromise with the Left Front or the Communists. The Socialists now control the Chambre, the Senate, and almost all the regions. It is “La Vie en Rose” across the political landscape, for the first time under the Fifth Republic.

Even the well-publicised spat between his current and former partners has not seriously damaged his triumph. After all, Mr Hollande claimed in the campaign that he would be a “normal” President, and it is normal for there to be a hint of domestic trouble at the Elysee Palace.

In Europe, things are not quite so well-ordered. The all-important Franco-German relationship has stuttered, and there seems to be little positive chemistry between him and Angela Merkel. But Mr Hollande nonetheless seems to be on the right side of the argument about what needs to be done to save the euro and stave off recession. He will surely get some response to his call for a growth agenda.

That may well, however, be as good as it gets, and he should bask in his success while it lasts. Because dark clouds are gathering, and the honeymoon is likely to be very short-lived.

The first major domestic problem will be the deficit. The Cour des Comptes, which audits the government’s books, is reviewing the state of the public finances and is expected to deliver its post-election verdict on 2 July. There are strong rumours that it will identify a ten billion euro gap in 2012-13, and an even bigger one the following year, if France is to meet its deficit reduction commitments.

By British or American standards that may seem small beer. In Washington, $10bn can get lost in a pork barrel. But in France cutting public spending is exceedingly difficult, and tax revenues are not buoyant. Furthermore, Mr Hollande was elected on a programme which involves recruiting an additional 60,000 teachers, and reducing the retirement age to 60 for some public servants.

The cost of that latter commitment is not high, but it is a symbol of the French left’s resistance to spending cuts and labour market reform. As French commentators put it, their Socialist party has never embraced “Schroederisation”. (Blairism is “vieux jeu”, if indeed it ever played at all in France). Hollande’s supporters, and indeed the French nation as a whole, are mentally unprepared for the kind of belt-tightening that will soon be needed. So far he has announced an increased tax on dividend payments, but additional business taxes, while popular with his own supporters, are risky. There will be red carpets all over Europe, not just in London, if French corporate taxation gets seriously out of line.

Nor is there widespread public understanding of France’s unfavourable economic trends –- though the Ministry of Finance is well aware of them. The share of manufacturing output in French GDP is in fact slightly below the UK’s, but almost no French politician can believe that, fed as they have been on a diet of French national champions, with Britain portrayed as an offshore financial centre — a kind of Greater Guernsey .

The comparison that matters more, given the constraints of eurozone membership, is with Germany. A decade ago, French GDP per head was 94.5 per cent of Germany’s; in 2011 it was 89.7 per cent. In the same period, and in spite of the effects of the crisis, Spanish GDP per capita continued to catch up. France has a problem of competitiveness, and of industrial capacity, and one which is getting worse.

Mr Hollande, and his new government, will need to spell out these realities, and set a new course. That will not be easy, as the ground has been ill-prepared. With a powerful mandate, and a solid parliamentary majority, he can afford to make some tough decisions. We will find out very soon whether he has the will to do so.

Related links:
France’s bling bling era is nearing its end – Howard Davies
What to expect from François Hollande – Philippe Aghion

To stop the doom spiral that threatens the eurozone, European leaders must now repair the serious flaws in the design of monetary union that have been revealed by the crisis. At the very least, at this week’s summit of European leaders, they should recognise them, name them, agree on directions for reform, and set a timetable for decisions.

Banking union — the move to a common regime for supervision, deposit insurance and resolution — has emerged as a key component of such a repair strategy. The idea makes sense because it addresses the feedback loop between sovereign weakness and banking weakness. The concept has been endorsed by several eurozone governments (including France who used to be lukewarm about it), by the European Central Bank and the European Commission, by the UK (provided it is not asked to take part) and by the International Monetary Fund. Germany has reservations, but they do not seem to be absolute.

There is however distance from concept to realisation. A banking union entails many choices.

First, who should participate? The EC wants a banking union for the whole of the EU but it is not going to happen. The case for it may exist, but it is overwhelming only for the participants in the euro. Transitional arrangements should be found for countries that intend to join the common currency, such as Poland.

Second, which banks should it cover? It would be simpler to limit it to systemic banks with cross-border activities. But the Cajas at the core of the Spanish crisis are small and domestic. For the banking union to alleviate the fiscal risk, it must be broad in coverage, possibly universal.

Third, who should supervise? Different countries have relied on different models, but there is a strong case for centring supervision at the ECB, which has both legitimacy and effectiveness.

Fourth, what resolution authority should be granted? Bank resolution involves allocating losses between stakeholders. These are intrinsically political choices that cannot be assigned to a central bank. It would be best to create a resolution authority under the umbrella of the European Stability Mechanism.

Fifth, what sort of deposit insurance? A benefit of banking union would be the pooling of insurance. Again, however, there are various ways of doing it, from complete federalisation like in the US to the reinsurance of national systems by a common fund.

Sixth, what sort of fiscal backstop? Banking crises are costly – sometimes horribly so. Even if losses are imposed on shareholders and creditors, they can easily exhaust insurance funds. It is important to make sure that when the accident happens, money is not only theoretically but actually available. There is therefore a need for a fiscal backstop – in other words some degree of fiscal union.

Seventh, what form of governance and accountability? A banking union is an off-balance sheet fiscal union and as such it needs to be underpinned by a form of political union. Taxpayers cannot be asked to commit to put up potentially large amounts of money in the absence of institutions that provide legitimacy.

Moving to a common banking union is a delicate transition. As soon as the possibility arisis to mutualise future losses, states will have an incentive to conceal problems. Here, clarity should prevail: the transfer of supervisory competence to the European level should be preceded by a comprehensive, thorough and intrusive screening of banks conducted by a special task force. All legacy costs uncovered in this assessment should be taken on by current authorities, unless they are or are at risk of being fiscally unable to bear them. In this case, but in this case only, there will be a case for mutualising risks in the form of direct capital injection by the ESM.

The writer is director of Bruegel, the economic think tank. This piece is based on a joint Bruegel report with André Sapir, Nicolas Véron and Guntram Wolff.

Related links:
A real banking union can save the eurozone – Wolfgang Münchau
Germany’s reticence to agree threatens European stability – George Soros

Between the end of the primaries and the start of the conventions presidential campaigns are message wars. Both sides test slogans and proposals, while trying to frame their opponents in memorably unfavorable ways. In this phase, Barack Obama has been the clear winner.

Mr Obama has used the element of surprise, taken risks that seem to be paying off and has put his opponent on the defensive. He first seized the initiative in May, when he endorsed gay marriage, changing his longstanding position. Even some on the Right praised the president for acting on principle when the politics seemed against him.

But the politics of that issue may actually be on Mr Obama’s side. Taking a moral stance on an issue of civil rights reanimated liberal voters who had drifted into disaffection, especially young voters that were crucial to his 2008 victory. Mitt Romney, who didn’t expect the move, found himself in awkward position. With his radical Republican challengers dispatched, conservative positions on social issues were the last thing Mr Romney wanted to emphasise. At a press conference, he called his own opposition to gay marriage “my preference” and declined to criticise Mr Obama for changing his position or pandering to a Democratic special-interest group. Mr Romney’s response was essentially a tactical surrender that underscored the inevitably of liberal victory on the issue.

This same dynamic was at play last week, when Obama issued an executive order that allows illegal immigrants who were brought to the US as children to remain in the country. Mr Obama’s unanticipated move aligned sound policy with good politics, re-awakening Latino supporters who had lost heart over his failure to get a more comprehensive reform of immigration laws through Congress. The decision will play particularly well in swing states such as Florida, Colorado and New Mexico, where Hispanic turnout can be decisive.

With his immigration surprise, Mr Obama showed his ability to act without help from the recalcitrant Republican-led Congress that is likely to remain in place even if he wins a second term. He again stole a march on Mr Romney, who was in the midst of figuring out how to “evolve” from the insincere, hardline anti-immigration stance he adopted in the primaries to something friendlier. On the CBS programme “Face the Nation,” Mr Romney was asked several times whether he would overturn the president’s decision. Each time, he dodged the question and refused to say. A week later, he remains stuck on the issue – reluctant to attach himself to his party’s anti-immigration absolutists, unwilling to concede that the president is right and with no apparent position of his own.

The president has seldom been a risk taker; he has operated within the boundaries of the possible, avoiding postures that yield no results. But he and his campaign have cleverly recognised that Mr Romney’s slow-footedness and lack of imagination presents an opportunity for them to shine in contrast. They have reversed the usual dynamic of reelection campaigns, highlighting the challenger’s stodginess while making Mr Obama’s into a nimble incumbent.

These stratagems show every sign of paying off. Mr Obama’s positions convey a Reaganesque sense of optimism about social change, while associating Mr Romney’s views with fear and the past. Mr Romney, whose approach to politics has always been to rearrange his views in relation to the next election, has thus far been stymied by this rabbit-punching. He has been on the defensive, landing few blows of his own and failing to come up with any memorable proposals. His strategy seems to be to trumpet increments of bad news about the economy. That is not only a risk-averse strategy, but also a sour one. This week, Mr Romney’s campaign reportedly asked Florida’s Republican governor to stop trumpeting his state’s economic recovery, lest the credit accrue to his opponent.

Mr Romney’s likely vice-presidential choices point further in the direction of playing it too safe for his own good. Taking the wrong lesson from John McCain’s reckless choice of Sarah Palin, Mr Romney is by various accounts looking to a boring Midwestern white man such as Minnesota governor Tim Pawlenty or Ohio senator Rob Portman to be his running mate. These choices would generate minimal excitement for a campaign that badly needs some.

Pity Ben Bernanke and his colleagues on the Federal Reserve’s main policymaking committee. Once again they felt compelled to do something to be seen as countering a renewed slowing of the domestic economy that is compounded by a deepening European crisis and less buoyant emerging economies. But in continuing to act on its own, all the Fed will do is buy some time that will again be wasted by the country’s politicians. Meanwhile, collateral damage will mount, making the next policy steps even more excruciating.

It is not so long that the Fed was discussing how to exit the unconventional policy phase initiated in the midst of the 2008 global financial crisis. Instead, and having already ballooned the balance sheet to 20 per cent of US gross domestic product, it will now exchange even more of its short-term Treasury holdings (up to 3 year maturities) for longer-dated (6-30 year) bonds. This extension of “operation twist” has, as an intermediate objective, repressing market interest rates to push investors to assume more risk, trigger the wealth effect and reignite animal spirits. The ultimate objective is, of course, to promote non-inflationary growth.

While the Fed has been able to normalise market functioning and boost valuations, it has repeatedly failed to deliver on its desired economic outcomes. Unfortunately, there is little to suggest that things will be any different this time around.

Whether you are worried about insufficient demand or the economy’s sluggish supply response, it is hard to argue that what ails the US is in the domain of Fed tools. The most it can do is buy time while trying to inform and —  at the margin — influence steps that can only be taken elsewhere.

The Fed can again try to slow the inevitable deleveraging of over-indebted parts of the private sector. But, given the liquidity trap, it won’t meaningfully counter lower government spending, consumers’ debt overhang and less dynamic export markets. It cannot get congress to agree on fiscal reform, nor will it remove the housing inventory, revamp housing finance, boost infrastructure, and enhance labour retraining and retooling.

What this continued Fed activism will do is to continue altering the functioning of markets, contaminate price discovery and distort capital allocation. Already, the viability of several segments – from money markets to insurance and from pension provision to suppliers of daily market liquidity, all of whom provide financial services to companies and individuals – has been undermined. The Fed has also conditioned many market participants to believe in a policy put for both equities and bonds. And other government agencies are relieved to have the policy spotlight remain away from their damaging inactivity.

Yet, judging from Wednesday’s decision, the Fed remains undeterred. This is not due to a lack of recognition of the increasingly unattractive balance between what Chairman Bernanke called in August 2010 the “benefits, costs and risks” of unconventional policies. Instead, I suspect that Fed officials feel a moral obligation to act when others won’t; they worry that their flexibility will erode as they get closer to the November elections; and the last thing they want is to inadvertently contribute to a sluggish US economy that would accentuate the synchronized slowing now taking holding of the global economy.

The Fed also remembers last summer when political brinkmanship over the debt ceiling took the country to the edge of a technical default and contributed to the loss of a triple-A sovereign rating. Now, due to the serial postponement of key congressional decisions, the US faces the menace of an end-year fiscal cliff – a disorderly contraction of some 4 per cent of GDP through arbitrary spending cuts and across-the-board tax increases – at a time when the economy as a whole is on course to deliver at best just 2 per cent in annual growth.

Wednesday’s decision signals that America is falling further behind its first best policy responses. And while the Fed should be commended for trying to deliver a second best, net benefits will prove even more difficult to secure. In the process, look for greater distortions that will take years to resolve.

Pakistan’s President Asif Ali Zardari is unlikely to challenge the Supreme Court’s decision to dismiss his Prime Minister Yusuf Raza Gilani and deprive him of being a member of parliament for five years. However Mr Zardari’s attempt to avoid a confrontation with the courts that could result in country-wide violence and the return of the army stepping, could also open the door to his own judicial dismissal.

For four years there has been a steady and increasing rise in conflict between Chief Justice Iftikhar Chaudry and the ruling Pakistan’s Peoples party. The courts have failed to try and dismiss Mr Gilani and Mr Zardari. Mr Gilani was convicted on April 26 for protecting Mr Zardari in a corruption case, but also for refusing to accept the court’s interference and jurisdiction in the constitution. Pakistan’s parliamentary democracy and constitution gives the power of sacking a prime minister to parliament — not to the courts.

Given the economic, social, foreign policy and political crises faced by the government, Mr Zardari and the PPP have decided not to block this second attempt by the Supreme Court to sack Mr Gilani. There have been three days of widespread rioting in the Punjab province due to massive cuts in electricity just as summer temperatures are soaring, there is a severe economic crisis, a state of civil war in Balochistan province and the continued terrorist actions by the Pakistani Taliban. Meanwhile Pakistan’s relations with the US and its Nato allies are not improving.

What happens next? In these dire circumstances a confrontation between the courts and the government over whether Mr Gilani should resign or not, in which ultimately the courts call upon the army to intervene on their behalf could easily lead to the country’s fifth martial law. Mr Zardari may be trying to avoid that by calling upon his party to show calm and quickly nominating a new prime minister from the PPP, who will easily get sworn in by Parliament because the PPP and its political allies hold the majority.

However that is unlikely to satisfy the opposition parties — led by politicians such as Imran Khan and Nawaz Sharif — who are demanding early general elections (these are due in spring 2013 but could be bought forward to the end of 2012). The opposition has broad support for its demand because of the multiple failures of the government. It may be Mr Zardari’s best bet to agree to early elections and take his party to the hustings as a martyr in the cause of the democracy. It would keep the army in its barracks and sustain the democratic process despite its heavily tainted appearance right now.

If the PPP wishes to fulfil its full term until 2013 there are likely to be more bruising conflicts between the courts and Mr Zardari. One issue that is hanging over Pakistani heads is the so called Memogate affair in which a judicial commission formed by the Supreme Court found former Ambassador to the US Hussain Haqqani guilty of treason. Mr Haqqani, who now lives in the US, vehemently denies the allegations. That judgement is now in the hands of the Supreme Court, which is likely to send it for a full trial in the weeks ahead. If that happens the case will also try and implicate Mr Zardari and other government figures for treason. Avoiding such an outcome would be best for everyone and early elections is the only possible way that Pakistan could get back on the rails.

Related links:
Pakistan coverage – FT
Waking up to war in Balochistan – Ahmed Rashid (BBC News)

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