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It happened the day after a controversial decision to subject sanctions to a political vote. I was sitting in the office of a well-known European central banker, who was jumping up and down. The eurozone would now not have any means to control fiscal profligacy, he said.

That was in 1998. Not much has changed. The French and the Germans have once again been discussing whether sanctions should be automatic or not. And central bankers are just as furious. For Jean-Claude Trichet to issue an official note of disagreement – after European Union finance ministers last week drafted a watered-down sanctions package – is extraordinary on several levels. The president of the European Central Bank had demanded a great leap forward. But the French and the Germans are not leaping. They go round in circles. Since the start of the euro, the world has suffered its worst financial crisis ever and the worst recession in 70 years – and the eurozone’s political leaders are still obsessed with the minutiae of the stability pact, which is supposed to police government debt and budget deficit levels.

The real irony is that the pact, in whatever form, is not even relevant to the eurozone’s future. This may be a shocking statement. But look at the evidence. Contrary to popular narrative, fiscal profligacy played only a minor role in the eurozone’s sovereign debt crisis. Successive Greek governments cheated, but on my information, this occurred with at least partial knowledge of the senior European officials involved in the process. They chose not to apply the pact for political reasons. When the full extent of the Greek deficit became public in the autumn of 2009, EU leaders did not want to impose sanctions on a newly elected government. Everybody wanted to give George Papandreou, the Greek prime minister, a last chance. That turned out to be a good decision.

As for Spain and Ireland, they did not breach the rules ever, and would thus never have been subject to sanctions, automatic or otherwise. Even Ireland’s shockingly large projected deficit of 32 per cent of gross domestic product this year will not be a breach. Ireland’s bank bail-out is considered an exceptional circumstance, and not subject to the pact’s sanctions procedure.

Portugal exhibited persistent bouts of fiscal profligacy, but the real problem, again, was the banks. In all three countries, the crisis was caused by private sector imbalances, which far outweigh the relatively small discrepancies between national budgets. Germany may appear a paragon of virtue, but its debt-to-GDP ratio is close to that of France. It is larger than Spain’s and only a little lower than Portugal’s. But Germany’s pre-crisis 8 per cent current account surplus and Spain’s 10 per cent current account deficit were large and real. They have improved, but on the projections I have seen, are deteriorating again.

So if you really want to fix the eurozone’s problem, the pact is not the place to start. Obsession with it does not come out of concern for the eurozone’s future, but from an inter-institutional battle in Brussels.

What about the various proposals on macroeconomic surveillance, including that of the task force chaired by Herman van Rompuy, president of the European Council? He is proposing an early warning system, in addition to the already agreed European Systemic Risk Board. At the very least, one would expect all those new rules and institutions to pass the hindsight test. Had they been there 10 years ago, would they have prevented the Spanish or the Irish housing bubble? I cannot see how. Would José Luis Rodríguez Zapatero, Spain’s prime minister, have really imposed bubble-bursting real-estate taxes, after receiving a high-level delegation from Brussels or Frankfurt? Of course not. There can be only two explanations for Mr van Rompuy’s hubris about his macroeconomic surveillance proposals. Either he is naive, or he has a different agenda.

What about the proposed crisis resolution mechanism? When Angela Merkel, the German chancellor, gave ground last week on automatic sanctions, she gained the concession from Nicolas Sarkozy, the French president, that he would support Germany on crisis resolution.So the €440bn European Financial Stability Facility, set up in May to support eurozone countries with funding difficulties, will not be renewed. In 2013, it will be replaced by a tough crisis resolution mechanism to address the logical inconsistency of a system that rules out exit, default, and bail-out. The Germans continue to support the no bail-out principle; and have accepted that you cannot force a state to exit against its will. This leaves default. Having been very pessimistic on the default-probability of eurozone states, global investors may now be too optimistic again. If Ms Merkel gets her way – and I think she will – this means the eurozone’s future crisis resolution mechanism will be based on default.

The eurozone thus ends up with tough rules, poor implementation, no effective framework to deal with private sector imbalances, and an officially instituted mechanism that encourages default. The crisis was obviously not big enough to bring about genuine policy change. If, or rather when, that next crisis comes, it will probably be too late.

By Wolfgang Münchau

Published: October 24 2010 20:02

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One of the weirder experiences for anyone who lives in the eurozone is a visit to a German supermarket. I had the pleasure the other day, and found the general price level there to be a little over half of what it is in Belgium, Italy or Spain. This, of course, is just an unscientific guess. I also found price differences of some 30 per cent when comparing certain categories of goods on various Ebay sites in the eurozone.These differences go some way to explaining the eurozone’s divergent economic performance, and give a pointer as to what to expect in the future. The really intriguing aspect of the divergences is not how they happened, but why they are not correcting themselves. We know how they happened: Germany entered the eurozone at an uncompetitive exchange rate and embarked on a long period of wage moderation. Macroeconomists would say Germany benefited from a real devaluation against other members. But while real exchange rates tend to move around, one would not normally expect extreme misalignments to be persistent. In this case, one would expect Spanish and Italian consumers to abandon their expensive retail stores and swamp German internet sites with mail order purchases, especially for durable goods. Eventually there would be some price realignment.

It is not happening.

You would also expect some pressure for realignment from the labour market. As the German export sector returns to full capacity, one would expect wage costs to rise by more than the eurozone average.

This is not happening either.

The reason for the lack of demand-side adjustment is that Europe’s internal market is not fully functioning, certainly not at the consumer level. I spoke to an executive of one of Germany’s mail order companies and asked him why people in Belgium, where I live, cannot buy his extremely cheap products. He told me that national tastes were so different as to preclude a European-wide mail order service. My response was that the Belgians, and the Italians, probably share the Germans’ taste for low prices, and would probably shop if only given an opportunity. Despite some recent improvements it remains surprisingly hard to shop cross-border.

While adjustment of the product side is prevented by an imperfect single market, adjustment on the labour market side is prevented by a complete absence of market integration. You would expect German workers to seek higher wages outside the country. But this is not happening, as the European labour market remains almost perfectly fragmented. That means German wage moderation can persist uncorrected for a long time. Nominal wages are effectively frozen, and are set to rise by only small percentages in the next few years.

Taken together, this means the intra-eurozone imbalances will not only persist, but probably increase. This will make the economic adjustment for Spain, Portugal or Greece even more difficult than it already is. Those persistent imbalances, much more than the build-up of debt, are my deep cause of concern about the long-term health of the eurozone.

But from a German perspective, this strategy boosts growth in the short term. It is, of course, a beggar-thy-neighbour strategy. The improvement in Germany’s economic growth is driven not by productivity gains but by real devaluation.

So while I expect the German economy to perform better than the eurozone average, it is important to keep some perspective and not draw false inferences from the 9 per cent annualised growth rate during the second quarter. If you look at the period since the beginning of the financial crisis, Germany’s economic performance has been dismal. If you compare levels of gross domestic product between Germany and the US since the crisis, you find the US significantly outperformed Germany during that period. That situation may still be reversed if the US were to go into a double-dip recession. But the best judgment we can make now is that of Christine Lagarde, the French finance minister, in her recent interview in the Financial Times: Germany is recovering faster this year because it contracted faster last year, when GDP fell by 5 per cent. So far, this looks like classic dead-cat bounce.

Given its export-dependence, the performance of the German economy will ultimately depend on the global economy. As the US is heading for another downturn, it is hard to see how Germany can maintain its recent rates of growth. To do so would require a sudden increase in domestic demand. But I cannot see where that would come from.

The bottom line is that Germany’s economic performance will almost certainly improve relative to the eurozone average in the years ahead, but also that the current wave of enthusiasm is much exaggerated.

The real danger – to the eurozone, but ultimately to Germany itself – is the strains stemming from the policy of a real devaluation. I cannot see how southern Europe can ever fully reverse the misalignments in the real exchange rate. Nor are there any signs that the reforms in the EU’s product and labour markets will be sufficient to ensure that economic adjustment mechanisms can kick in. In other words, Germany’s economic strength is likely to be persistent, toxic and quite possibly self-defeating in the long-run.


via FT.com / Columnists / Wolfgang Münchau – Germany’s rebound is no cause for cheer.

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In this short RSA Animate, renowned philosopher Slavoj Zizek investigates the surprising ethical implications of charitable giving.

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Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.

Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.

We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.

And this third depression will be primarily a failure of policy. Around the world — most recently at last weekend’s deeply discouraging G-20 meeting — governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending.

In 2008 and 2009, it seemed as if we might have learned from history. Unlike their predecessors, who raised interest rates in the face of financial crisis, the current leaders of the Federal Reserve and the European Central Bank slashed rates and moved to support credit markets. Unlike governments of the past, which tried to balance budgets in the face of a plunging economy, today’s governments allowed deficits to rise. And better policies helped the world avoid complete collapse: the recession brought on by the financial crisis arguably ended last summer.

But future historians will tell us that this wasn’t the end of the third depression, just as the business upturn that began in 1933 wasn’t the end of the Great Depression. After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.

In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.

As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy, by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.

Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around the edges of Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. On the contrary: Greece has agreed to harsh austerity, only to find its risk spreads growing ever wider; Ireland has imposed savage cuts in public spending, only to be treated by the markets as a worse risk than Spain, which has been far more reluctant to take the hard-liners’ medicine.

It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.

So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.

And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.

Op-Ed Columnist – The Third Depression – NYTimes.com.

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Thank God for José Luis Rodríguez Zapatero, the Spanish prime minister. For the first time in the three years since the outbreak of the financial crisis, a European leader has done something intelligent and surprising. Spain’s unilateral decision to publish the stress tests of its banks has bounced the European Union – at a summit in Brussels last Thursday – into following a Spanish lead, and to accept an uncharacteristic degree of transparency.

Does this mean that we are about to get on top of this wretched crisis? Well, so far, the EU has agreed to publish the stress tests of only 25 banks. They are not the main problem banks in the eurozone. There is a good chance that governments will extend those tests to other banks. But it is no reason to get too excited.

The fundamental problem is that governments are still fighting the wrong crisis. Global investors have recognised a fundamental truth, that this is not a sovereign debt crisis at heart, as Germany and the European Central Bank keep on telling us, but a banking crisis and a crisis of policy co-ordination failures.

Since the banks are guaranteed by their respective governments, most private debt is ultimately public debt. The European Central Bank and the newly created European Financial Stability Facility – the €440bn ($545bn, £368bn) special purpose vehicle to stabilise the European bond markets – will absorb billions of euros of junk debt which, on default, would trigger a massive redistribution of income from northern Europe to southern Europe. So far, this crisis has cost European taxpayers nothing. But that would change if, or when, some of the Greek debt gets restructured. That will not happen for three years. But, by then, most of that Greek debt would wind up in the hands of the EFSF and the ECB. A default at that point would confront the EU with a binary decision: either to go for fiscal union, or to break up. The investors do not know which way the EU will jump. Nobody does.

One conceivable strategy for getting out of this mess is to remove the lingering doubts about the banking sector. Except for Greece, the sovereign debt situation is under control everywhere. The problem is not the actual government debt, but the contingent debt, most of which is located in the banking sector. If there is more transparency about the banking sector, the situation would be eased.

If the publication of the stress tests would lead to a process of bank recapitalisation, we would be well on the way. But I do not see it. Germany’s bad bank scheme is so incredibly unattractive that hardly any banks have taken it up. Yet, the German government is in no position to force the banking sector to accept new capital. The Landesbanken – probably the biggest financial toxic waste dumps on earth – are controlled by the state governments.

The situation is not much better in Spain, where the Bank of Spain is already pushing hard for a consolidation of the cajas, the local savings banks. We will no doubt get a lot more bad news from the Spanish banking sector, as Spain goes through the adjustment. Having been sceptical about Mr Zapatero’s willingness to do what needs to be done, I am a touch more optimistic now. His recently decreed labour market reforms are a step in the right direction, but probably insufficient.

Elsewhere in the eurozone, there are several other trouble spots. France also has its share of poorly capitalised banks, and so do Austria and Belgium.

Uncertainty will persist, until we have a reliable estimate of the remaining toxic waste in bank balance sheets, and some resolution trajectory. The only information that was ever leaked in Germany was a worst-case estimate by the banking regulator a year ago of a total write-down volume of €800bn, about a third of Germany’s annual gross domestic product. I have no idea what the number would be today.

To resolve this crisis, we need to know those numbers and a lot more. Most importantly, the EU must set up a workable system of economic policy co-ordination, including a strategy to deal with resurgent internal imbalances. On that point, we are actually regressing.

The decision to publish the stress tests masked an otherwise disappointing European summit. After months of debate, all the European Council had to show was another stability pact and another Lisbon agenda – a now defunct growth initiative. One of the lessons of the early stability pact – from 1999 until 2003 – was that sanctions do not work, because they cannot be applied in the real world. The revised stability pact, agreed in 2005, moved away from an emphasis on sanctions to incentives. The idea was sound, but ultimately failed because of insufficient policy co-ordination. The decision to revert to the original sanctions-based approach is silly. If sanctions do not work, then surely, lots of sanctions are not going to work either. As for the Lisbon agenda, it is now called Agenda 2020, and it is just as hopeless.

What has become clear in the last few months is that Herman Van Rompuy, the president of the European Council, is not providing sufficient leadership to move the process forward. Without a plausible end game in sight, I would expect investors to continue to place bets on the eurozone’s demise.

via FT.com / Columnists / Wolfgang Münchau – We need the figures on Europe’s toxic banks.

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The aim of the rescue package agreed for Greece cannot conceivably have been to prevent a default. For all the daunting austerity and structural reform it requires, the numbers do not add up. The main purpose I can detect is to reverse the rise in Greek bond yields and stop contagion.

We should not knock this deal from Athens. The eurozone might not have survived otherwise. This column would have been an obituary. I am also glad to note that those in charge gave a positive answer to a question I posed last week, which was whether the authorities would ever get ahead of the situation. They did, and they deserve credit.

But in spite of the readiness to accept extreme austerity, Greece will not get by without some form of debt forgiveness. I can understand why the International Monetary Fund and the European Union did not want to open that can of worms at this point. It would have prolonged the negotiations. In the middle of an acute bond market crisis one has to manage expectations very carefully.

A debt restructuring will eventually be necessary, however, because Greece’s debt to gross domestic product ratio is going to rise from its current 125 per cent to about 140-150 per cent during the adjustment period. Without restructuring, Greece will end up austere, compliant, and crippled.

The decision to take Greece out of the capital markets for three years will prevent immediate ruin but has only a marginal impact on the country’s future solvency. The underlying assumption of the agreement is that Greece can sustain austerity beyond the time horizon of the accord, without falling into a black hole. The latter is particularly optimistic. Standard & Poor’s, the rating agency, last week estimated that Greece would not return to its 2009 level of nominal GDP until 2017.

Last week gave us an inkling of the vicious circles at play in such a crisis. First, a country’s financial situation deteriorates. Then a rating agency downgrades the debt, which in turns triggers a rise in market interest rates. That leads to a further financial deterioration.

Another such loop goes via the banking sector. If a government’s solvency is in doubt, so is the solvency of the banks, whose liabilities are guaranteed by the government. Last week, the banking sector in large parts of southern Europe was in effect cut off from the capital markets.

Angela Merkel and her inexperienced economic advisers have no idea about the dynamics of sovereign crises. They never bothered to look at the experience of other countries, notably Argentina. Waiting until the moment a country is about to fail – which is how the German chancellor interpreted the political agreement she accepted in February – constitutes an abrogation of leadership that is bound to end in financial ruin. It means that everybody, Germany especially, has to pay billions of euros more than would have been the case if the EU had sealed this in February.

On my estimate, the total size of a liquidity backstop for Greece, Portugal, Spain, Ireland and possibly Italy could add up to somewhere between €500bn ($665bn, £435bn) and €1,000bn. All those countries are facing increases in interest rates at a time when they are either in recession or just limping out of one. The private sector in some of those countries is simply not viable at those higher rates.

As I have argued before, three things are required if the eurozone is to survive in the medium term: a crisis resolution system, better fiscal policy co-ordination, and policies to reduce intra-eurozone imbalances. But this is only the minimum necessary to get through the next few years. Beyond that, the eurozone will almost certainly need both an embryonic fiscal union and a single European bond.

I used to think that such constructions would be desirable, albeit politically unrealistic. Now I believe they are without alternative, as the experiment of a monetary union without political union has failed. The EU is thus about to confront a historic choice between integration and disintegration.

Germany can be relied on to resist every one of those measures. In the meantime, European leaders will treat each new crisis with the only instrument they have available: an injection of borrowed liquidity. But this instrument has a finite lifespan. If it is not blocked by popular unrest, it will be blocked by constitutional lawyers.

On one level, I agree with those lawyers. There can really be no doubt about what the “no bail-out” rule was intended to mean. It meant that Greece should not be supported. The EU had to resort to some unseemly legal trickery to argue that advancing junior loans at a massive scale to an effectively insolvent country does not constitute a bail-out. The clause – Article 125 of the Lisbon treaty – is irresponsible. If you follow it, you end up breaking the eurozone. So far, the choice has been to break the clause instead, and now would be the right moment to change it.

So what is the endgame of the eurozone’s multiple crises? For Greece it will be debt restructuring, a polite term for negotiated default. The broader outcome is more difficult to predict: it will either be deep reform of the system or a break-up.

Wolfgang Münchau, FT, May 2 2010

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