The Great Debate UK

from MacroScope:

The Law of Diminishing Greeks

The Law of Diminishing Returns  states that a continuing push towards a given goal tends to  decline in effectiveness after a certain amount of effort has been expended. If this weren't the case, Usain Bolt would be able to run the mile in  less than 2-1/2 minutes.

From an economic standpoint, this law now seems to be fully in force in Greece. The latest jobs figures from the twice-bailed out euro zone country paint a bleak numerical picture of the impact of unrelenting austerity in ordinary Greeks, regardless of whether it was self-inflicted or not. To wit:

More than one in five Greeks is unemployed.

There are more young people without a job than with one.

The record 1.08 million people  without work in January was a  47 percent tumble  in a year.

Putting aside for the moment the question of what such a condition means for political dissent, there is now the issue of whether any of this austerity-fueled pain is actually helping the Greek economy.

Austerity mixed with the inability of euro-tied Greece to devalue its currency  means  Greece is now in its fifth year of recession. As for job-creating small and medium -sized businesses, the latest projections are that more than a net 130,000 of them will have shut down over two years by the time 2012 is over.

The biggest example of the Law of Diminishing returns, however, is the impact all this is having on what ails Greece in the first place -- its budget.

Unemployed people offer no revenue to the government in terms of income tax and far less in sales tax than they would if they were working.

Germany should be happy to let Greece go

When the Greek crisis began, there was much talk of contagion as the greatest short-term risk. In my view, this worry is almost irrelevant because bondholders are in any case facing a haircut of over 70%, so the question of default or bailout is now merely a technical detail.

From a longer term perspective, there is also little reason for the Germans to panic over a Greek default, even if it ultimately leads to the disintegration of the euro zone. The line peddled by a number of commentators and politicians that Germany has “done very well out of the euro zone” begs the question of how well it would have done without the euro zone, a question to which I do not know the answer – but nor does anyone else.

The implicit or explicit claim is that, with floating exchange rates, German trade would have suffered as the DM appreciated against the currencies of its neighbours. This is nonsense, a case of how, in the world of popular economics – what one colleague famously called D-I-Y economics – exchange rates occupy a position of exaggerated importance (If those who study the subject were given the same importance, I’d have had a peerage by now).

If exchange rate appreciation were so damaging and depreciation so beneficial to a country’s trade, the Swiss would by now be the poorest country in Europe and the Italians the richest. The reality is that, while there may be short term dislocations, the effect of changes in the value of a currency are ephemeral. Devaluations are self-defeating because they push up costs until the country’s terms of trade are back where they started, and the opposite for appreciations: a rise in the value of a country’s currency makes its imports cheaper, reducing its inflation rate and restoring its competitiveness as time passes. The process of adjustment seems to take some six or seven years, which might seem a window of opportunity worth seizing for opportunistic devaluation. The fly in the ointment, however, is that the more rapidly a currency depreciates, the more agents in the economy wise up and start anticipating the next depreciation, speeding up the adjustment and thereby narrowing the window of opportunity for exporters.

In other words, exchange rate flexibility smoothes the road, but does nothing whatever to change the destination. Moreover, the effect of exchange rate changes is smallest for countries with the most efficient labour markets, which includes Germany ever since its reforms of ten years ago, so there is every reason to suppose that it would adjust quickly anyway, just as it did in the 1970’s and 1980’s when the DM rose in value almost continually without seriously damaging the country’s competitiveness.

As far as Greece is concerned, making it competitive inside the euro zone will require a so-called internal devaluation – mainly a reduction in wages – whereas outside the euro zone a relaunched drachma could be allowed to float downward. The only difference is that in the former case, Greek workers will have to get by on fewer Euros than they have been used to, whereas outside the euro zone they would be paid in devalued drachmas, which would mean a cut in their living standards of the same order of size (is there such a thing as a Hobson’s Choice between Scylla and Charybdis?).

For Germany (and for the rest of Europe, including Britain), the real danger is that euro zone disintegration might be followed by the collapse of the single market, the only truly valuable component of the EU edifice. As a nation very reliant on its external trade, Germany needs market access – no reasonable person wants to go back to a world of protectionism, quotas and  non-tariff  barriers to trade, but it is an ever-present threat as populist politics take hold in Europe. But even then, the German carmakers have demonstrated in the last couple of years how capable they are of compensating for sales lost in Europe by higher volume in the emerging markets of Asia and Latin America, and there is every reason to suppose that the formidable German capital goods sector will prove just as adaptable.

from Lawrence Summers:

It’s time for the IMF to step up in Europe

By Lawrence Summers The opinions expressed are his own.

European leaders will meet today for yet another “historic” summit at which the fate of Europe is said to hang in the balance. Yet it is clear that this will not be the last convened to deal with the financial crisis.

If public previews from France and Germany are a guide, there will be commitments to assuring fiscal discipline in Europe and establishing common crisis resolution mechanisms. There will also be much celebration of commitments made by Italy, and a strong political reaffirmation of the permanence of the monetary union. All of this is necessary and desirable, but the world economy will remain on edge.

Given that Europe is the largest single component of the global economy, the rest of the world has a stake in helping to avoid major financial accidents. It also has a stake in aiding continued growth in Europe and ensuring that the European financial system supports investment around the world – particularly as cross-border European bank lending dwarfs that of banks from any other region.

Now is also a historic juncture for the International Monetary Fund. The focus of the policy response to the crisis must now shift from Brussels and Frankfurt to the IMF’s boardroom.

From the problems of the UK and Italy in the 1970s, through the Latin American debt crisis of the 1980s, the Mexican, Asian and Russian financial crises of the 1990s, the IMF has operated by twinning the provision of liquidity with strong requirements that those involved do what is necessary to restore their financial positions to sustainability. There is ample room for debate about the precise policy choices the fund has made in the past. But, the IMF has consistently stood for the proposition that the laws of economics do not and will not give way to political considerations. At key points the IMF has offered prescriptions, not just for countries in need of borrowed funds, but also for those whose success is systemically important for the global economy.

Christine Lagarde, the head of the IMF, highlighted the seriousness of problems in Europe to members of the international financial community assembled in Jackson Hole in August. She pointed to capital shortfalls in the European banking system and the need for adjustment to be carried on in ways that were consistent with continuing growth. Now, the IMF needs to speak and act on several fronts.

Why stasis on Capitol Hill should worry investors

By Kathleen Brooks. The opinions expressed are her own.

The markets have had to – grudgingly – get used to pricing in political risk in recent months. Instead of being moved by economic data and fundamental or technical factors, a large amount of recent price action has been driven by politicians, and that always spells bad news.

Firstly, we have had to listen to the machinations of Europe’s various branches of power as they try to muddle through to a solution to the euro zone debt crisis. This has done very little apart from cause excess amounts of volatility in the markets as politicians talk at odds to each other. The results are pathetic: more than 18 months since the Greek crisis first flared up not only is Athens still deep in its own sovereign crisis but contagion has spread to Italy and Spain and even threatens to engulf some of the core member states like France.

Although most of the focus has been on Europe, the spotlight may shift to the U.S. Republicans and Democrats have failed to agree on $1.3 trillion of cuts to the Federal Budget, which makes it unlikely that the bi-partisan Deficit Committee can come reach a debt deal by Wednesday’s deadline. The problem isn’t the cuts: if Congress can’t agree where the axe can fall then automatic cuts will be enforced. The problem isn’t even the repercussions of missing the deadline: these cuts wouldn’t be imposed until January 2013 and the missed deadline will not cause a default on U.S. debt or a government shut-down, unlike the impasse in Washington back in August.

Instead this suggests that the U.S. and Europe are in a chronic state of political partisanship. In the U.S. its two main political parties are pitted against each other and in the currency bloc the same thing occurs with inflation and austerity hawks in the North failing to bow to pressure to implement policies that could boost the financially weakened Southern states. Essentially the political stalemate is a bit like blocked plumbing since it disrupts the normal flow of things, which damages investor confidence and has the power to cause excess market volatility and a prolonged slump in the global economy.

Thus, the political impasse in the U.S. coming at the same time as outright political dysfunction in Europe is important for two reasons. Firstly, Presidential elections don’t take place for another 12 months in the U.S. so there could be more political brinkmanship and bi-partisan bickering for some time. This is likely to undermine risk sentiment even further since it shows a lack of fiscal resolve in the U.S., which creates uncertainty – and the markets hate uncertainty.  Secondly, the bitter dispute regarding deficit cuts has turned ideological, which could impact growth going forward.

Republicans want spending cuts and Democrats want to increase taxes for the wealthiest Americans to boost the revenue side of the U.S.’s enormous balance sheet. This is important since it makes an extension of the payrolls tax cut and emergency unemployment benefits much less straight forward. Both of these expire at the end of the year and are considered important to boost growth: payroll tax cuts help to encourage firms to hire and unemployment benefits can keep consumption levels stable during periods of high unemployment.

from The Great Debate:

The G20 summit should commit to growth

By Gordon Brown The views expressed are his own.

The build-up to the G20 summit has been dominated by the euro's failings. With Europe now the epicenter of the global crisis, its continued weakness will dominate the G20 discussions. Even now, uncertainties about Greece’s future -- and about the real strength of Europe’s commitment to its new stability fund -- has left little opportunity for a focus on the global economy as a whole.

But even if the state of the world economy has featured less than the euro in the preparatory work for the summit, the decisions world leaders will make on the global economy will dictate the mood of the coming two years. President Sarkozy has major global initiatives he will unveil to improve global food security, and may even force his plan for a global financial levy on the agenda. But there is a big choice the G20 must make. Either the world will come together and agree on a coordinated growth plan -- or we will retreat into a new, more acrimonious protectionism.

Already the head of the World Trade Organization is warning of a return to protectionism, and every day we find yet another new country following Brazil, Switzerland, Indian, Korea, and Japan in introducing either new tariffs, currency controls, or capital controls. In response, the draft G20 communiqué assumes a free trade world where each continent steps up what it is doing in order to achieve sustained growth.

But a G20 that was really working would take countries far beyond the current draft communiqué -- which is a set of bland statements about what each country is doing on its own to foster growth. Instead it would focus on coordinated  measures under which countries would agree to support and complement each other's contribution. If , under an agreed growth pact, China increased consumer spending and Asia opened its markets, and if this was balanced by America and Europe investing more in infrastructure,  then over a three year period -- as the IMF has suggested -- there could be 5 percent more growth and 25-50 million more jobs, with 100 million people taken out of poverty.

A ccordinated  approach is desirable because under current policies every country wants to export its way to growth and no one wants to import. But cooperation is not just an option; it is, in my view, a necessity because the world is precariously balanced between a west that consumes the most, and the rest of the world which now produces the most. For 150 years until now, Europe and America monopolized the world’s output, exports, manufacturing, investment and consumption. But in 2010 for the first time America and Europe were out-produced, out-exported, out-manufactured and out-invested by the rest of the world. Today they account for just 41 percent of output, 43 percent of manufactured goods, 47 percent of trade, and 40 percent of investment. But they account for 55 percent of consumption and, if we added other advanced economies, the figure would be 70 percent.

A better understanding between the consumer countries and the producer countries would make for more balanced and more sustainable growth. Indeed, if  China was confident its export market could be sustained then it might be more willing to increase domestic consumption, and if America was confident its export markets could flourish then we would have a more confident American consumer and more  private  investment at home. This was what was envisaged by the April 2009 summit of the G2O and then in the detail of the growth pact agreed to at the Pittsburgh summit in autumn 2009.  Unfortunately in 2010 the growth pact has descended into a dispute over currencies, with the American senate now calling China a currency manipulator. A brave attempt by Korea to break from the currency dispute and accelerate growth by putting ceilings on surpluses and deficits failed.

A 6-1 defeat is not a draw

Michael Gove trying to laugh off Monday’s rebellion by 81 backbenchers sounds like a United supporter arguing that 6-1 was more or less a draw. For all the excuses, he can’t hide the fact that the government’s position is full of contradictions.

On the one hand, the PM has added his voice to the chorus calling for the euro zone to turn itself into a monetary-and-fiscal union, a proposal which certainly goes with the grain of the crisis. The idea has the support of the Americans and would probably be warmly welcomed in Asia too. In fact, it has great appeal everywhere except in the euro zone itself, where the main protagonists themselves have got a severe attack of cold feet.

And no wonder – they are being asked to accept what amounts to full economic integration: a huge decision taken more or less on the hoof, in the space of a few weeks, whereas they are only too well aware that it took the best part of a decade of consultation, summits and referenda to overcome the opposition to monetary union – and in the end their victory really was almost a draw.

However, fiscal integration is by no means a done deal, nor is it remotely certain that fiscal integration will solve the immediate problem, given that the crisis has already reached France and is directly threatening Germany’s own creditworthiness. But if such far-reaching changes are afoot within the euro zone, you would expect the government to be putting forward a clear vision of where it sees Britain fitting into the new architecture, rather than merely providing unsolicited advice which is bound to be both ignored and resented.

If fiscal integration does go ahead, it will confirm the two-tier model of Europe, with an inner core of countries run by a single government controlling all aspects of macroeconomic policy (and most of microeconomic policy too), and an outer tier consisting of… of what exactly?

This is a real opportunity for Britain to reshape its place in Europe, as the largest of a bloc of countries mostly on the periphery that are part of the single market, but which retain full economic sovereignty – control not only of their own monetary and fiscal policies, and their own currencies (and hence interest rates), but also of their own tax rates and their own regulatory authorities too.

Notice this is not a total retreat into a customs union. Apart from the fact that there is more – though not a lot more – to the EU than economics, it would still allow free movement of capital and, more controversially, of labour. Ending the latter would no doubt be popular, but stupid for a number of reasons. In the first place, most of the problems arising out of immigration are associated with arrivals from outside Europe. Secondly, in reality it is almost impossible to stop immigrants arriving, legally or illegally, even from outside Europe, let alone from, say, Poland or Slovakia. Thirdly, on purely pragmatic grounds, if we are ever to get what we want in Europe, we need all the support we can muster – and the Eastern Europeans will be far less supportive if we slam the door in their faces.

Geithner’s fudge won’t kill the euro zone debt Ouroboros

The frosty reception given to US Treasury Secretary Timothy Geithner at the ECOFIN meeting in Poland last week tells you all you need to know about what is wrong with the EU. The hostility was directed not at the feebleness of the advice he had to give, but at the right of an American passport-holder to offer any advice at all to the policymaking elite of Europe, who are so obviously capable of handling the crisis themselves without any outside assistance.

As far as I can tell, Geithner’s proposal amounts to leveraging the EFSF so that it can be inflated to a level sufficient to assure the markets that it has the resources to do the enormous job it has been given: bailing out Greece, Ireland, Portugal,  Spain, probably Italy and maybe even France at some point.

So, as ever, the American solution to the problem of excess leverage is… even more leverage. Financial wizardry is what Europe needs now – after all, it worked so well last time around… Risks? What risks? The additional borrowing will be guaranteed by the ECB, whose credit is cast-iron, so problem solved. Why did it take them so long to come up with an answer? If only it were so easy. Ask yourself: why is the ECB so creditworthy in the first place?

Not, in the final analysis, because its borrowing is backed by the governments of Greece or Portugal or Spain or Italy, nor even because it is backed by the Netherlands or Finland – however fiscally responsible they may be, they are simply too small to stand behind Europe’s central bank. In a crunch (and if we ever doubted that crunches happen, we know now that they do) even French support could be inadequate, given that it is currently running a sizeable budget deficit and faces a presidential election in a few months.

No: there are two meaningful levels of support that give the ECB its pristine credit status.

Firstly, the backing of the German government was, until recently, enough to preserve the ECB’s status as Son of Bundesbank. The trouble is that Germany itself has a debt-to-GDP ratio comparable to that of Britain, and the ratio would be a lot higher if it included commitments already made and about to be made to support weaker euro zone member governments. Moreover, even if they still have the capacity to do so, it is hard to see why the Germans would want to shoulder the bailout burden in this barely-camouflaged form when they are apparently so wary of entering into a more explicit transfer union (as they call the nightmare scenario of a Europe in which they are doomed to subsidise everyone else in perpetuity).

There is a second-level backstop for the ECB, and it is the one which I suspect will be called upon in the end. Although it is subject to all sorts of nominal restrictions on its freedom of action to reflect its multinational character, which have served to prevent it ever being free to behave like the Fed, the ECB is ultimately a central bank and, as such, it can always be given the green light to print Euros in whatever quantity is required to pay its debts or simply to cover the cost of more loans. The Geithner proposal amounts essentially to freeing the ECB from some of its existing constraints and preparing it to monetise Europe’s fiscal deficits, a policy similar to that which the Obama Administration itself has pursued vigorously so as to fund massive bailouts of Fannie Mae, Freddie Mac and other basket cases, with results that have been at best extremely mixed.

from Lawrence Summers:

The perils of European incrementalism

By Lawrence H. Summers The views expressed are his own.

In his celebrated essay “The Stalemate Myth and the Quagmire Machine,” Daniel Ellsberg drew out the lesson regarding the Vietnam War that came out of the 8000 pages of the Pentagon Papers.  It was simply this:  Policymakers acted without illusion.  At every juncture they made the minimum commitments necessary to avoid imminent disaster—offering optimistic rhetoric but never taking steps that even they believed offered the prospect of decisive victory.  They were tragically caught in a kind of no man’s land—unable to reverse a course to which they had committed so much but also unable to generate the political will to take forward steps that gave any realistic prospect of success.  Ultimately, after years of needless suffering, their policy collapsed around them.

Much the same process has played out in Europe over the last two years.  At every stage from the first signs of trouble in Greece to the spread of problems to Portugal and Ireland, to the recognition of Greece’s inability to pay its debts in full, to the rise of debt spreads in Spain and Italy, the authorities have played out the quagmire machine.  They have done just enough beyond euro-orthodoxy to avoid an imminent collapse, but never enough to establish a sound foundation for a resumption of confidence. Perhaps inevitably, the gaps between emergency summits grow shorter and shorter.

The process has taken its toll on policymakers’ credibility.  As I warned European friends quite some time ago, authorities who assert in the face of all evidence that Greece can service on time 100 percent of its debts will have little credibility when they later assert that the fundamentals are sound in Spain and Italy, even if their view is a reasonable one.  After the spectacle of stress tests that treat assets where credit default swaps exceed 500 basis points as riskless, how can markets do otherwise than to ignore regulators assertions about the solvency of certain key financial institutions.

A continuation of the grudging incrementalism of the last two years risks catastrophe, as what was a task of defining the parameters of too big to fail becomes a challenge of figuring out what to do when key insolvent debtors are too large to save.  There are many differences between the environment today and the environment in the Fall of 2008 or any other historical moment.  But any student of recent financial history should know that breakdowns that seemed inconceivable at one moment can seem inevitable at the next.

To her very great credit, new IMF managing director Christine Lagarde has already pointed up the three principles any approach to Europe’s financial problems must respect.  First, Europe must work backwards from a vision of where its monetary system will be several years hence.  The reality is that politicians have for the last decade dismissed the widespread view among experienced monetary economists that multiple sovereigns budgeting and bank regulating independently will over time place unsustainable strains on a common currency.  The European Monetary Union has been a classic case of the late Rudiger Dornbusch’s dictum that “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”  So it has been with the buildup of pressures on the Euro system.

There can be no return to the pre-crisis status quo.  It is now clear that market discipline within monetary union is insufficiently potent and credible to assure sound finance, and equally apparent that when banks and sovereigns do not have access to lender of last resort financing the risk of self fulfilling confidence crises becomes substantial.  The respective responsibilities of the ECB, financial regulatory authorities and EU officials can be defined in different ways.  But there must simultaneously be an increase in the central financial commitment to the financial stability of member states and reduction in their financial autonomy if the common currency is to survive.

from Breakingviews:

Euro zone crisis may be close to resolution

By Hugo Dixon The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

DAVOS, Switzerland -- The euro zone crisis may be close to resolution. There is certainly optimism among policymakers at the World Economic Forum in Davos that a comprehensive deal -- involving more discipline by peripheral nations and more help from rich nations -- could be put together in coming weeks. If so, the hot phase of the crisis could be over and even Greece would have a fighting chance of getting out of the woods.

There is still no deal. But the stars seem to be coming into alignment. Germany, the zone's paymaster, clearly realises that it has a strong interest in the single currency holding together -- and will do what is needed to make that happen. Peripheral nations also seem to be willing to go an extra mile to give Berlin enough air cover to sell further help to the German people.

The basic bargain would involve more generous terms for loans to indebted countries, especially Greece, balanced by hard-and-fast promises not to run up debts in the future. The countries are discussing some form of "debt brake", a provision embedded in the German constitution which forces it to balance its budget in the medium term. Such self-denial could, indeed, be a healthy mechanism for all countries to adopt.

Meanwhile, two changes could be made to make even Greece's debt burden -- which is officially forecast to peak at just under 160 percent of GDP -- more bearable. The first would be to buy back chunks of its debt in the secondary market at a discount and pass the benefit onto Athens. If, say, a quarter of its debt could be acquired at a 20 percent discount, the peak ratio would fall by 8 percentage points. Not huge, but helpful. More importantly is the idea of cutting the interest rate on the debt. If the country was able to fund itself at below 5 percent, the annual interest payment would be below 8 percent of GDP.

Even with such a package, Greece would still face a massive uphill struggle to boost its competitiveness. It would still need to push through aggressive moves to tackle rampant tax evasion. And it would still need to punish those who have looted the public purse in recent years -- otherwise, the general population will not be willing to endure the years of hardship ahead. But there is a narrow path the country could tread back to long-term health.

It will also be important to stop further dominoes falling, especially Spain. Madrid had a golden opportunity earlier this week to draw a line in the sand by coming up with its own comprehensive solution for its troubled savings banks, the cajas. It flunked it by saying that a maximum of 20 billion euros would be needed -- significantly less than the market consensus. But it is not too late to remedy the error. Spain's euro zone partners should pressurise it to make crystal clear that there is more money if needed. If a proper clean-up of the region's troubled banks is also part of a comprehensive solution, the euro zone will indeed be able to look forward to better times.