Archive for the ‘Public Spending’ Category

Também publicado em Portugal Uncut

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Why does the Spanish government pay significantly more to borrow than the UK government – despite having a smaller deficit and lower overall debt? This column argues that the reason lies in the Eurozone’s fragility. Its members lose their ability to issue debt in a currency over which they have full control. The column discusses ways to deal with this weakness.

A monetary union is more than just a single currency and a single central bank. Countries that join a monetary union lose more than one instrument of economic policy. They lose their capacity to issue debt in a currency over which they have full control.

This separation of decisions – debt issuance on the one hand and monetary control on the other – creates a critical vulnerability; a loss of market confidence can unleash a self-fulfilling spiral that drives the country into default (see Kopf 2011). The economic logic of this is straightforward.

Suppose that investors begin to fear a default by, say, Spain. They sell Spanish government bonds and this raises the interest rate. If this goes far enough, the Spanish government will experience a liquidity crisis, i.e. it cannot obtain funds to roll over its debt at reasonable interest rates.1 The Spanish government cannot force the Bank of Spain to buy government debt and although the ECB could provide all the liquidity in the world, the Spanish government does not control that institution. This can be self-fulfilling since if investors think that the Spanish government might reach this end point, they’ll sell Spanish bonds in a way that turns their fears into a reality.

It doesn’t work like this for countries capable of issuing debt in their own currency. To see this, re-run the Spanish example for the UK. If investors began to fear that the UK government might default on its debt, they would sell their UK government bonds and this would drive up the interest rate.

After selling these bonds, these investors would have pounds that most probably they would want to get rid of by selling them in the foreign-exchange market. The price of the pound would drop until somebody else would be willing to buy these pounds. The effect of this mechanism is that the pounds would remain bottled up in the UK money market to be invested in UK assets.

Put differently, the UK money stock would remain unchanged. Part of that stock of money would probably be re-invested in UK government securities. But even if that were not the case so that the UK government cannot find the funds to roll over its debt at reasonable interest rates, it would certainly force the Bank of England to buy up the government securities. Thus the UK government is ensured that the liquidity is around to fund its debt. This means that investors cannot precipitate a liquidity crisis in the UK that could force the UK government into default. There is a superior force of last resort, the Bank of England.

This different mechanism explains why the Spanish government now pays 200 basis points more on its ten-year bonds than the UK government despite the fact that its debt and deficit are significantly lower than the UK ones. This contrast is shown vividly in Figures 1 and 2.

Figure 1. Gross government debt (% of GDP) – Spain and UK

Source: AMECO

Figure 2. 10-year government bond rates Spain and UK

Source: Datastream

Because of the liquidity flows triggered by changing market sentiments, member countries of a monetary union become vulnerable to these market sentiments. These can lead to “sudden stops” in the funding of the government debt (Calvo 1988), setting in motion a devilish interaction between liquidity and solvency crises. For the liquidity crisis raises the interest rate which in turn leads to a solvency crisis. This problem is not unique for members of a monetary union. It has been found to be very important in emerging economies that cannot issue debt in their own currencies. (See Eichengreen, et al. 2005 who have analysed these problems in great detail).

There are important further implications of the increased vulnerability of member-countries of a monetary union. (In De Grauwe 2011 these implications are developed in greater detail; see also Wolf 2011). One of these is that members of a monetary union loose much of their capacity to apply counter-cyclical budgetary policies. When during a recession the budget deficits increase, this risks creating a loss of confidence of investors in the capacity of the sovereign to service the debt. This has the effect of raising the interest rate, making the recession worse, and leading to even higher budget deficits. As a result, countries in a monetary union can be forced into a bad equilibrium, characterised by deflation, high interest rates, high budget deficits and a banking crisis (see De Grauwe 2011 for a more formal analysis).

These systemic features of a monetary union have not sufficiently been taken into account in the new design of the economic governance of the Eurozone. Too much of this new design has been influenced by the notion (based on moral hazard thinking) that when a country experiences budget deficits and increasing debts, it should be punished by high interest rates and tough austerity programmes. This approach is usually not helpful in restoring budgetary balance.

In addition, a number of features of the design of financial assistance in the Eurozone as embodied in the European Stability Mechanism will have the effect of making countries even more sensitive to shifting market sentiments. In particular, the “collective action clauses” which will be imposed on the future issue of government debt in the Eurozone, will increase the nervousness of financial markets. With each recession government bondholders, fearing haircuts, will “run for cover”, i.e. selling government bonds, thereby making a default crisis more likely. All this is likely to increase the risk that countries in the Eurozone lose their capacity to let the automatic stabilisers in the budget play their necessary role of stabilising the economy.

A monetary union creates collective problems. When one government faces a debt crisis this is likely to lead to major financial repercussions in other member countries (see Arezki, et al. 2011 for evidence). This is so because a monetary union leads to intense financial integration. The externalities inherent in a monetary union lead to the need for collective action, in the form of a European Monetary Fund (Gros and Mayer 2010). This idea has been implemented when the European Financial Stability Facility was instituted (which will obtain a permanent character in 2013 when it is transformed into the European Stability Mechanism). Surely, when providing mutual financial assistance, it is important to create the right incentives for governments so as to avoid moral hazard. Discipline by the threat of punishment is part of such an incentive scheme. However, too much importance has been given to punishment and not enough to assistance in the new design of financial assistance in the Eurozone.

This excessive emphasis on punishment is also responsible for a refusal to introduce new institutions that will protect member countries from the vagaries of financial markets that can trap countries into a debt crisis and a bad equilibrium. One such an institution is the collective issue of government bonds (for recent proposals see Delpla and von Weizsäcker 2010, De Grauwe and Moesen 2009 and Juncker and Tremonti 2010). Such a common bond issue makes it possible to solve the coordination failure that arises when markets in a self-fulfilling way guide countries to a bad equilibrium. It is equivalent to setting up a collective defence system against the vagaries of euphoria and fears that regularly grip financial markets, and have the effect of leading to centrifugal forces in a monetary union.

A monetary union can only function if there is a collective mechanism of mutual support and control. Such a collective mechanism exists in a political union. In the absence of a political union, the member countries of the Eurozone are condemned to fill in the necessary pieces of such a collective mechanism. The debt crisis has made it possible to fill in a few of these pieces. What has been achieved, however, is still far from sufficient to guarantee the survival of the Eurozone.

Paul De Grauwe
10 May 2011


Arezki, R, B Candelon, and A Sy (2011), “Sovereign Rating News and Financial Markets Spillovers: Evidence from the European Debt Crisis”, IMF Working Paper, 11/69, March.
Calvo, Guillermo (1988), “Servicing the Public Debt: The Role of Expectations”, American Economic Review, 78(4):647-661
De Grauwe, P, and W Moesen (2009), “Gains for All: A Proposal for a Common Eurobond”, Intereconomics, May/June
De Grauwe, P, “The Governance of a Fragile Eurozone”,
Delpla, J, and J von Weizsäcker (2010), “The Blue Bond Proposal”, Bruegel Policy Brief, May.
Eichengreen, B, R Hausmann, U Panizza (2005), “The Pain of Original Sin”, in B Eichengreen, and R Hausmann, Other people’s money: Debt denomination and financial instability in emerging market economies, Chicago University Press.
Gros, D, and T Mayer (2010), “Towards a European Monetary Fund”, CEPS Policy Brief.
Juncker, J-C and G Tremonti (2010), “E-bonds would end the crisis”, The Financial Times, 5 December.
Kopf, Christian (2011), “Restoring financial stability in the euro area”, 15 March, CEPS Policy Briefs.
Wolf, M (2011), “Managing the Eurozone’s Fragility”, The Financial Times, 4 May.

 1. Additionally, the investors who have acquired euros are likely to decide to invest these euros elsewhere, say in German government bonds. As a result, the euros leave the Spanish banking system. Thus the total amount of liquidity (money supply) in Spain shrinks.

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O recente agravamento da componente pública da dívida externa é em larga medida resultado do abrandamento da actividade económica, da consequente significativa diminuição da receita com impostos, do aumento da despesa com protecção social, de juros que se tornaram imorais e da socialização dos prejuízos no BPN. Em Portugal, o Estado pode e deve gastar melhor, mas não é a razão do impasse económico a que chegámos. A componente privada da dívida externa, recebendo muito menos interesse dos mesmos eternos comentadores que o sistema lhe oferece for free, é consideravelmente maior que a pública.

Como muitos previram, as medidas pró-cíclicas de austeridade afundaram a economia e aprofundaram a divergência europeia entre o centro e periferia. Mas o quadro, de qualquer modo, estava há muito criado. Moeda única concebida à imagem e segundo os interesses da economia mais forte num espaço económico altamente heterógeneo. Credo liberal segundo o qual uma moeda comum pode existir sem orçamento comum. Tudo isto com o aprofundamento da desregulação e privatização que hoje permite aos tais ‘mercados’ condicionar profundamente as decisões dos governos que elegemos.

Trichet e FMI dizem-nos que a solução é mais do mesmo.

A pressão é enorme. Mas, como se sabe, nas coisas humanas, excepto para o fim da vida, há sempre alternativa.

Stiglitz opõem-se a este tipo de solução para a Irlanda.

Krugman diz que é má ideia para Portugal.

Munchau afirma que a Europa deve recusar globalmente esta solução: “(…) a presente negociação gira à volta de 4 pilares: gestão da crise actual; o Mecanismo de Estabilidade Europeu; um novo pacto de estabilidade que inclua supervisão orçamental; e coordenação de políticas económicas e sociais. As negociações acerca dos financiamento do Mecanismo de Estabilidade Europeu têm avançado bem, assim como as discussões acerca do pacto de estabilidade. O menos robusto dos quatro pilares é a coordenção política. A Chanceler Angela Merkel insiste num pacto de competitividade como troca pela prontidão Alemã para disponibilizar garantias de crédito. Mas como devem responder os outros países? A minha resposta é: rejeitem. Eu recomendaria aos estados membros da zona Euro que vetassem o pacto de competitividade ainda que isso coloque em causa o pacote global. Se a Alemanha não pode garantir o seu lado nesta troca, não é claro para mim por que é que alguém aceitaria uma perda de soberania – que é o que efectivamente implicaria a coordenação de políticas (…)”.

Em Portugal mais razões há para dizer não; a remuneração do trabalho não tem cessado de minguar (parcela de retribuição do trabalho em percentagem do rendimento nacional diminuiu 10% entre 1975 e 2009) e a desigualdade de rendimentos é inaceitável.

Ao contrário de anuir com a imposição de injustas medidas austeritárias, precisamos de reclamar liberdade. É necessário defender o acesso universal ao serviço nacional de saúde, o subsídio de desemprego, as pensões de reforma e demais direitos do trabalho, para poder dizer não à coerção de senhores e patrões. Caso contrário, prepara-te, isso de tu não teres classe social é engano; um lugar de caixa, trabalho à noite e fins de semana e 400 eurinhos por mês estão à tua espera. Se te portares bem.

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By Paul De Grauwe

The crisis that started in Greece culminated into a crisis of the eurozone as a whole. It may find a temporary resolution. But even then, it will leave an important imprint on macroeconomic management within the eurozone. In particular, the crisis has made clear that the financial markets are dictating and will continue to dictate the speed with which the eurozone governments are reducing their budget deficits and debt levels. In other words, not the governments but the financial markets will force exit strategies in the budgetary field.

The believers in market efficiency are cheering. The markets are going to discipline profligate governments, forcing them back into orthodoxy. The reluctant governments failing to follow the market’s order will be punished with higher risk premia on their bonds. In the end the market will force them to return to the stable of budgetary orthodoxy.

The view that financial markets are a reliable device forcing agents and institutions to be disciplined is popular again. This is surprising. After all, can’t we conclude from the recent past that, if anything, financial markets have failed dismally as a disciplinary device?

Before the subprime crisis, financial markets systematically underestimated risk, leading to excessively low risk premia which in turn gave wrong incentives to millions of investors who took on too much risk. Since the eruption of the crisis, risk premia have increased everywhere.

Are we so sure that the risk premia that the markets are now imposing are the right ones? If for years the markets could underestimate risk, can’t they also overestimate risk systematically afterwards? The answer is yes, of course.

It is even worse. The risk aversion that markets today exhibit vis-à-vis government debt creates a self-fulfilling dynamic that tends to increase the risk inherent in government debt. Let me elaborate on this.

First, it is important to keep in mind that the main source of the sudden increase in government debt in the eurozone (and elsewhere) is the preceding unsustainable explosion of private debt of households and even more so of financial institutions.

Since the eruption of the crisis, the private sector has been gripped by the need to improve its balance sheets by saving more and by deleveraging. Balance sheet improvement of the private sector, however, was made possible because governments made it possible. The fact that governments started saving less and took on more debt was the condition that allowed private sector agents to improve their balance sheets.

When financial markets today force governments of the eurozone (and elsewhere) to exit their strategies of budget deficits and debts, they cut the branch on which they are sitting. By forcing an early exit strategy, financial markets force private agents to intensify their attempts at reducing debt levels by saving more and by selling assets. This is likely to be self-defeating and to lead to a new recession. And as always, recessions lead to deteriorations of government budget deficits.

The vicious circle has come around. By forcing governments into early exit strategies, financial markets increase the risk that government budget deficits increase, raising the risk against which financial market participants wanted to protect themselves against.

There is a second self-fulfilling mechanism that will affect government budgetary policies in the eurozone. When investors start dumping, say, Spanish government bonds, they raise the interest rate on these bonds and force the Spanish government to reduce its budget deficit.

This is likely to produce a downturn in Spanish economic activity which in turn affects Spain’s trading partners. The latter see their exports to Spain decline, leading to a decline in their national production. Through this channel government budget deficits increase in the countries that trade a lot with Spain. Thus by selling Spanish government bonds investors also increase the riskiness of the government bonds in other countries of the eurozone. Investors start selling these bonds also.

The essence of the problem is that investors who sell government bonds of one country do not take into account the spillover effects these sales have on the riskiness of the government bonds of the other countries. This problem of risk contagion is high in the eurozone because member countries trade intensely with each other. Investors trying to avoid risk, create more risk elsewhere in the eurozone.

In addition, by forcing an early exit strategy on one member country of the eurozone, other countries that need not exit are also forced to do so. The probability of a new recession in the eurozone increases. There is only one way to solve this problem. This consists of the governments of the eurozone coordinating their budgetary policies better. Unfortunately, there is very little prospect for this to happen soon. As a result, financial markets, that are ill-suited to do so, will continue to dictate budgetary policies in the eurozone.

Paul De Grauwe is professor of economics at the Catholic University of Leuven and associate fellow at the Centre for European Policy Studies.

Related reading:

Greece: It’s not all tragedy Michael Burda, Vox
Spain’s woes and Germany’s export model come mean double dip Edward Harrison, Naked Capitalism
FT Alphaville
FT Money Supply

March 15, 2010 2:55pm in Crisis, Eurozone, Greece

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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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By George Soros. Published: June 24 2010.

Germany used to be at the heart of European integration. Its statesmen used to assert that Germany had no independent foreign policy, only a European policy. After the fall of the Berlin Wall, its leaders realised that German reunification was possible only in the context of a united Europe, and they were willing to make some sacrifices to secure European acceptance. Germans would contribute a little more and take a little less than others, thereby facilitating agreement.

Those days are over. The euro is in crisis, and Germany is the main protagonist. Germans don’t feel so rich any more, so they don’t want to continue serving as the deep pocket for the rest of Europe. This change in attitude is understandable, but it has brought the European integration process to a halt.

By design, the euro was an incomplete currency at its launch. The Maastricht treaty established a monetary union without a political union – a central bank, but no central treasury. When it came to sovereign credit, eurozone members were on their own.

This fact was obscured until recently by the European Central Bank’s willingness to accept the sovereign debt of all eurozone members on equal terms at its discount window. As a result, they all could borrow at practically the same interest rate as Germany. The banks were happy to earn a few extra pennies on supposedly risk-free assets and loaded up their balance sheets with the weaker countries’ government debt.

The first sign of trouble came after the collapse of Lehman Brothers in September 2008, when the European Union’s finance ministers decided, at an emergency meeting in Paris that October, to provide a virtual guarantee that no other systemically important financial institution would be allowed to default. But German chancellor Angela Merkel opposed a joint EU-wide guarantee; each country had to take care of its own banks.

At first, financial markets were so impressed by the guarantee that they hardly noticed the difference. Capital fled from the countries that were not in a position to offer similar guarantees, but interest-rate differentials within the eurozone remained minimal. That was when countries in eastern Europe, notably Hungary and the Baltic states, got into trouble and had to be rescued.

It was only this year, when financial markets started to worry about the accumulation of sovereign debt, that interest-rate differentials began to widen. Greece became the centre of attention when its new government revealed that its predecessors had lied about the size of the 2009 budget deficit.

European authorities were slow to react, because eurozone members held radically different views. France and other countries were willing to show solidarity, but Germany, traumatised twice in the 20th century by runaway prices, was allergic to any build-up of inflationary pressures. (Indeed, when Germany agreed to adopt the euro, it insisted on strong safeguards to maintain the new currency’ s value, and its constitutional court has reaffirmed the Maastricht treaty’s prohibition of bail-outs.)

Moreover, German politicians, facing a general election in September 2009, procrastinated. The Greek crisis festered and spread to other deficit countries. When European leaders finally acted, they had to provide a much larger rescue package than would have been necessary had they moved earlier. Moreover, in order to reassure the markets, the authorities felt obliged to create the €750bn European Financial Stabilisation Facility, with €500bn from the member states and €250bn from the International Monetary Fund.

But the markets have not been reassured, because Germany dictated the terms of the rescue and made them somewhat punitive. Moreover, investors correctly recognise that cutting deficits at a time of high unemployment will merely increase unemployment, making fiscal consolidation that much harder. Even if the budget targets could be met, it is difficult to see how these countries could regain competitiveness and revive growth. In the absence of exchange rate depreciation, the adjustment process will depress wages and prices, raising the spectre of deflation.

The policies currently being imposed on the eurozone directly contradict the lessons learnt from the Great Depression of the 1930s, and risk pushing Europe into a period of prolonged stagnation or worse. That, in turn, would generate discontent and social unrest. In a worst case scenario, the EU could be paralysed or destroyed by the rise of xenophobic and nationalist extremism.

If that were to happen, Germany would bear a major share of the responsibility. Germany cannot be blamed for wanting a strong currency and a balanced budget, but as the strongest and most creditworthy country, it is unwittingly imposing its deflationary policies on the rest of the eurozone. The German public is unlikely to recognise the harm German policies are doing to the rest of Europe because, the way the euro works, deflation will serve to make Germany more competitive on world markets, while pushing the weaker countries further into depression and increasing the burden of their debt.

Germans should consider the following thought experiment: withdrawal from the euro. The restored Deutschemark would soar, the euro would plummet. The rest of Europe would become competitive and could grow its way out of its difficulties but Germany would find out how painful it can be to have an overvalued currency. Its trade balance would turn negative, and there would be widespread unemployment. Banks would suffer severe losses on exchange rates and require large injections of public funds. But the government would find it politically more acceptable to rescue German banks than Greece or Spain. And there would be other compensations; German pensioners could retire to Spain and live like kings, helping Spanish real estate to recover.

Of course, this is purely hypothetical because, if Germany were to leave the euro, the political consequences would be unthinkable. But the thought experiment may be useful in preventing the unthinkable from actually happening.

The writer is chairman of Soros Fund Management

FT.com / Comment – Germany must reflect on the unthinkable.

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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 great German physicist Max Planck remarked that “science advances one funeral at a time.” The situation is worse in economics, which is subject to regress, as happened when the valuable but imperfect insights of Keynesianism were supplanted by the ideological blinkers of neo-liberalism.

The effects of this regress have again been on display in the confused discussions and policy responses to Europe’s sovereign debt crisis. The fact is that countries which borrow in their own currency and control their money supply will never default because they can always issue the money needed to repay their debts.

For such countries, central banks should respond to speculative debt crises with “bear squeeze” tactics that have them buy existing debt. In this fashion, countries can buy back debt below par value, in effect repaying it on the cheap. It is what the European Central Bank should have been doing on behalf of its member countries.

Not only does a bear squeeze assist debt reduction, it also punishes speculators and lowers interest rates, enabling countries to refinance on favourable terms. In a sense, this is what the Bank of England and the Federal Reserve have been doing on behalf of their respective governments by buying gilts and treasuries. Though such policy does increase the money supply, this is desirable at a time of big demand shortage and excess capacity when inflation is a distant danger.

The eurozone has cheated itself of these benefits because of the neo-liberal design of the ECB. That design ignores the fact that having central banks act as the government’s banker and to help manage the national debt was one of the original reasons for the establishment of central banks. This is no accident as neo-liberalism intentionally aimed to sever the fiscal – monetary policy link, but in doing so it discarded an essential tool of macroeconomic management.

The most damaging aspect of the crisis is the global boost it has given to the arguments of those advocating fiscal austerity. That is a cure which will almost certainly kill the patient by causing deep recession that lowers tax revenues and aggravates budget difficulties, while also causing bankruptcies that threaten an already weakened banking sector.

Governments cannot limitlessly increase debt and the money supply without cost. If such policies were continued, once the economy was back to normal there would eventually be a price to pay in the form of higher inflation and reduced confidence in money as a store of value. That means there is need to design policies and institutional arrangements that guard against such an outcome. But that is a wholly different proposition from saying governments and central banks should not use their powers to create money to addressing problems of excessive debt, speculation, financial panic and deep recession.

Central banks were slow to adopt quantitative easing (QE) to address the run on the financial sector in 2008 when money markets froze and banks could not refinance. That cost the global economy dearly. Now, the mistake is being repeated in the eurozone with the slow embrace of QE to address the run on public debt.

Europe, and perhaps the global economy, again confronts the possibility of a run for liquidity. In such circumstances there is only one thing for central banks to do: supply it. Keynes wrote of this in his masterful General Theory:

“Unemployment develops, that is to say, because people want the moon; — men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off. There is no remedy but to persuade the public that green cheese is practically the same thing and to have a green cheese factory (i.e. a central bank) under public control.”

Yet, policy continues to respond with too little, too late, and then goes on to compound the damage with inappropriately timed austerity and doubling-down on policies of wage suppression that have already wrought such havoc.

The root problem is the dominance of flawed neo-liberal economic thinking. This problem is particularly acute in the ECB and European finance ministries which are dominated by economists trained in Chicago School neo-liberal macroeconomics. Ironically, social democratic Europe has been much more virulently infected by this strain of thinking than the US where politicians’ pragmatism has moderated economists’ extremism.

The Great Recession may have lowered economists’ public standing but it has not yet changed their thinking or swept away the top policy appointees who have failed so disastrously. When it comes to economics, Max Planck was too optimistic about scientific progress.

By Thomas Palley who is Schwartz Economic Growth Fellow at the New America Foundation

FT, May 23, 2010

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The British political classes are going through one of their occasional bouts of masochism, with party leaders vying with each other on the theme of who can cut public spending faster and more effectively. Spice is added by talk of leaks and secret plans; and ideology by arguing about the balance between tax increases and spending curbs. My own bottom line is that all this is in response to a largely imaginary budget crisis. If we have a normal economic recovery the red ink will diminish remarkably quickly. If we don’t, it won’t and won’t need to.

All the secrecy and conspiracy-mongering is quite unnecessary and would soon disappear if ministers read the documents to which they attach their names and if opposition leaders, instead of searching in rubbish bins, did the same thing.

I hope readers will forgive me if I follow the official practice of talking in terms of percentages of gross domestic product. Even the most inveterate number-crunchers must have become dizzy with all the figures in billions and trillions of pounds and dollars launched on the world since the credit crunch.

The key document is the 260-page Treasury publication with the sensational title Budget 2009 (popularly known as “the Red Book”). The key table – surprise, surprise – is Table 1.1. You will see here the famous or infamous pledge to halve the Budget deficit in four years. Public sector net borrowing is projected to reach a peak of 12.4 per cent of GDP in the current financial year, declining gradually to 5.5 per cent by 2013-14. This is based on the assumption that GDP itself recovers by a modest 1 per cent next year but returns to an above-trend rise of 3¼ per cent by 2011. The Red Book even shows the tax take (defined as net taxes and national insurance contributions) rising over the period by 2.3 percentage points of GDP, of which 1 percentage point is accounted for by an increase in the income tax take. This is before the slash and burn offensive hinted at by one opposition party or the “progressive austerity” by another.

The Treasury is understandably coy about giving more details about how the fiscal tightening is to be achieved. The Institute of Fiscal Studies estimates that, allowing for expenditure not under immediate government control, departmental spending would have to be cut by an average of 2.9 per cent a year in real terms to achieve official objectives; and in practice the axe would fall particularly severely on Labour’s beloved public investment.

Suppose we turn our attention from annual deficits to public sector debt. The Red Book shows it rising from about 30 per cent of GDP at the beginning of this decade to 65 per cent in the current financial year. The pace of increase begins to slow down in the coming decade; but debt is put at 76 per cent and still rising slowly in 2013-14. The Treasury is of course well aware of the hazardous nature of these projections and how they depend on all sorts of guesses about interest payments, social security spending and many more unknowables. But it believes that is erring on the side of caution in what it presents to ministers. The debt projections look horrifying internationally only if we look at rates of increase. The ratios themselves, as projected by the International Monetary Fund, show Britain well below the US and only slightly above France and Germany. UK official estimates will change slightly in the pre-Budget report, due out in a couple of months, but are unlikely to be radically different from those in the last Budget.

Debt ratios of this size are historically far from unprecedented. In the early Victorian period the ratio was nearly 200 per cent and almost reached that level again in the early 1920s. In 1956 it was just under 150 per cent. Harold Macmillan, who was chancellor at the time, quoted the historian Lord Macaulay: “At every stage in the growth of that debt it has been seriously asserted by wise men that bankruptcy and ruin were at hand; yet still the debt kept on growing, and still bankruptcy and ruin were as remote as ever.” In fact the debt was gradually reduced from the peaks mentioned above without any heroic gestures.

The danger of premature tightening was illustrated in the US in 1936-37, when the ending of a war veterans’ bonus and the introduction of social security taxes helped push the US back into recession when recovery from the Great Depression was far from complete.

The big error of the current discussion is to confuse the budget balances of individuals and companies with the government budget balance, which needs to be in deficit so long as attempted savings exceed perceived investment opportunities. Gordon Brown more or less understands this, and I wish he would use his talents to explain such fundamentals instead of stirring up an outdated class war.

FT.com / Columnists / Samuel Brittan

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