Archive for the ‘Sustainability’ Category

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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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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21 hours

The vision

Moving towards much shorter hours of paid work offers a new route out of the multiple crises we face today. Many of us are consuming well beyond our economic means and well beyond the limits of the natural environment, yet in ways that fail to improve our well-being – and meanwhile many others suffer poverty and hunger. Continuing economic growth in high-income countries will make it impossible to achieve urgent carbon reduction targets. Widening inequalities, a failing global economy, critically depleted natural resources and accelerating climate change pose grave threats to the future of human civilisation.
A ‘normal’ working week of 21 hours could help to address a range of urgent, interlinked problems: overwork, unemployment, over-consumption, high carbon emissions, low well-being, entrenched inequalities, and the lack of time to live sustainably, to care for each other, and simply to enjoy life.

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crazy consumption and really gross domestic product

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I guess it had to happen this way. The greatest social menace of the new century is not terrorism but drugs, and it is the poor who will have to lead the revolution. The global trade in illicit narcotics ranks with that in oil and arms. Its prohibition wrecks the lives of wealthy and wretched, east and west alike. It fills jails, corrupts politicians and plagues nations. It finances wars from Afghanistan to Colombia. It is utterly mad.There is no sign of reform emanating from the self-satisfied liberal democracies of west Europe or north America. Reform is not mentioned by Barack Obama, Gordon Brown, Nicolas Sarkozy or Angela Merkel. Their countries can sustain prohibition, just, by extravagant penal repression and by sweeping the consequences underground. Politicians will smirk and say, as they did in their youth, that they can “handle” drugs.No such luxury is available to the political economies of Latin America. They have been wrecked by Washington’s demand that they stop exporting drugs to fuel America’s unregulated cocaine market. It is like trying to stop traffic jams by imposing an oil ban in the Gulf.

No such luxury is available to the political economies of Latin America. They have been wrecked by Washington’s demand that they stop exporting drugs to fuel America’s unregulated cocaine market. It is like trying to stop traffic jams by imposing an oil ban in the Gulf.

Push has finally come to shove. Last week the Argentine supreme court declared in a landmark ruling that it was “unconstitutional” to prosecute citizens for having drugs for their personal use. It asserted in ringing terms that “adults should be free to make lifestyle decisions without the intervention of the state”. This classic statement of civil liberty comes not from some liberal British home secretary or Tory ideologue. They would not dare. The doctrine is adumbrated by a regime only 25 years from dictatorship.

Nor is that all. The Mexican government has been brought to its knees by a drug-trafficking industry employing some 500,000 workers and policed by 5,600 killings a year, all to supply America’s gargantuan appetite and Mexico’s lesser one. Three years ago, Mexico concluded that prison for drug possession merely criminalised a large slice of its population. Drug users should be regarded as “patients, not criminals”.

Next to the plate step Brazil and Ecuador. Both are quietly proposing to follow suit, fearful only of offending America’s drug enforcement bureaucracy, now a dominant presence in every South American capital. Ecuador has pardoned 1,500 “mules” – women used by the gangs to transport cocaine over international borders. Britain, still in the dark ages, locks these pathetic women up in Holloway for years on end.

Brazil’s former president, Fernando Henrique Cardoso, co-authored the recent Latin American Commission on Drugs and Democracy. He declares the emperor naked. “The tide is turning,” he says. “The war-on-drugs strategy has failed.” A Brazilian judge, Maria Lucia Karam, of the lobby group Law Enforcement Against Prohibition, tells the Guardian: “The only way to reduce violence in Mexico, Brazil or anywhere else is to legalise the production, supply and consumption of all drugs.”

America spends a reported $70bn a year on suppressing drug imports, and untold billions on prosecuting its own citizens for drugs offences. Yet the huge profits available to Latin American traffickers have financed a quarter-century of civil war in Colombia and devastating social disruption in Mexico, Peru and Bolivia. Similar profits are aiding the war in Afghanistan and killing British soldiers.

The underlying concept of the war on drugs, initiated by Richard Nixon in the 1970s, is that demand can be curbed by eliminating supply. It has been enunciated by every US president and every British prime minister. Tony Blair thought that by occupying Afghanistan he could rid the streets of Britain of heroin. He told Clare Short to do it. Gordon Brown believes it to this day.

This concept marries intellectual idiocy – that supply leads demand – with practical impossibility. But it is golden politics. For 30 years it has allowed western politicians to shift blame for not regulating drug abuse at home on to the shoulders of poor countries abroad. It is gloriously, crashingly immoral.

The Latin American breakthrough is directed at domestic drug users, but this is only half the battle. There is no rational justification for making consumption legal but not the supply of what is consumed. We do not cure nicotine addiction by banning the Zimbabwean tobacco crop.

The absurdity of this position was illustrated by this week’s “good news” that the 2009 Afghan poppy harvest had fallen back to its 2005 level. This was taken as a sign both that poppy eradication was “working” and that depriving Afghan peasants of their most lucrative cash crop somehow wins their hearts and minds and impoverishes the Taliban.

The Afghan poppy crop is largely a function of the price of poppies compared with that of wheat. The only time policy has disrupted this potent market was in 2001, when the old Taliban responded to American pressure by ruthlessly suppressing supply. Since the Nato occupation it has boomed, inevitably polluting Kabul politics and plunging western diplomats and commentators into hypocrisy over Hamid Karzai’s corrupt regime. What did they think would happen?

The crop has shrunk because the wheat price has risen and the recession has dampened European demand. It will rise again. The policy of Nato and the UN’s economically illiterate drug tsar, Antonio Maria Costa, of treating Afghan opium as the cause of heroin addiction, not a response to it, means trying to break supply routes and stamp out criminal gangs. It has failed, merely increasing heroin’s risk premium. As long as there is demand, there will be supply. Water does not flow uphill, however much global bureaucrats pay each other to pretend otherwise.

The trade in drugs is a direct result of their unregulated availability on the streets of Europe and America. Making supply illegal is worse than pointless. It oils a black market, drives trade underground, cross-subsidises other crime and leaves consumers at the mercy of poisons. It is the politics of stupid. The incarceration (pdf) of thousands of poor people (11,000 in England and Wales alone) also deprives economies of a large labour pool.

As the Brazilian judge pointed out, the tide of violence associated with any illegal trade will not abate by only licensing consumption. The mountain that must be climbed is licensing, regulating and taxing supply, thus ending a prohibition now outstripping in absurdity and damage America’s alcohol prohibition between the wars.

From the the deaths of British troops in Helmand to the narco-terrorism of Mexico and the mules cramming London’s jails, the war on drugs can be seen only as a total failure, a vast self-imposed cost on western society. It is the greatest sweeping-under-the-carpet of our age.

The desperate politicians of Latin America have at last found the courage to grasp the nettle. Will Britain? According to the UN, it has the highest number of problem drug users in Europe. I imagine Gordon Brown and David Cameron agree with the Argentine supreme court, but they are too frightened to say so, let alone promise reform. In all they do they are guided by fear.

I sometimes realise that, if Britain still had the death penalty, no current political leader would have the guts to abolish it.

Simon Jenkins | Comment is free | The Guardian

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