Trichet@LSE: EMU as Viable a Currency Area as US

Flashing sirens, extra security guards, financial journalists baying for blood, and the incessant chatter of students and faculty debating the virtues of "EU bonds" and "haircuts": Where else could it have been but at the LSE in eager anticipation of the ECB President Jean-Claude Trichet delivering an address? And so it was last Monday afternoon that Europe's Bulwark Against Market Pandemonium came to speak before our central London institution. With various commentators predicting the imminent breakup of currency union--or at least the removal of some of its more recalcitrant members alike Greece, Ireland, and Portugal--this talk was highly anticipated for followers of European integration. Given that nearly all of the world's major geographic regions are engaged in integration projects, certainly the fate of its most advanced project deserves attention.

While we await the LSE Events folks posting the video clip of Trichet's talk online, let us content ourselves with the presentation slides and the transcript from it. While he unsurprisingly gives a fairly optimistic view of EMU's progress to date, something that struck me was his argument that the EU represented no less an optimum currency area than the US based on measures of economic variation. Trichet compares the dispersion of annual inflation, real growth, and unit labour costs in explaining that differences in economic performance among EMU states are not wildly different from those of US states.

This being the IPE Zone, let us set aside the "international" and "political" aspects for now and consider the "economy" of European vis-a-vis American integration according to Trichet. Since you can read the rest for yourselves, I have chosen to focus on differences in unit labour costs (ULC), defined by the OECD as a "measure the average cost of labour per unit of output and are calculated as the ratio of total labour costs to real output." What follows is the chart for the EU:

And here is the equivalent chart for the US:

Both charts set the context for his argument that, well, economic conditions for using a single currency are not all that different across the Atlantic:

Let us go one step further and investigate the sources of this growth dispersion in the US and euro area economies. This reveals parallels even in the root causes of dispersion in economic performance. Both currency areas comprise regions that experienced a significant boom and bust cycle over the past decade. Both also contain regions that are facing significant structural challenges of a more long-term nature.

Nevada, Arizona, Florida and California in the United States, for example, experienced increases in house prices that outpaced the national average by a wide margin. Steep house price increases and the related strong performance of real estate, construction and financial services probably contributed to above average growth in these states.

Some other US states, particularly the former manufacturing powerhouses in the ''Great Lakes'' region, saw a long episode of below average growth at the same time. Below average performance of the region – and particularly weaker growth rates in the states of Michigan and Ohio – are related to strong reliance on manufacturing. Structural shifts in the US economy towards services have gradually reduced the value added of manufacturing relative to GDP, with implications for areas with a high concentration of companies in manufacturing industries other than information and communications technology.

The sharp fall in house prices in Florida and the south-western US states turned boom into bust. These states experienced the harshest recession among the US states. But GDP growth in the ''Great Lakes'' region, which was below average before the crisis, also remained below average during the crisis.

Some euro area countries experienced asymmetric boom-and-bust cycles similar to those just described in the United States. Several euro area countries had higher than average growth in the pre-crisis years, while a few have experienced growth below the euro area average for the past decade due to structural issues that could have been tackled with more determination.

The effect of the crisis on the different euro area economies follows a similar pattern to those of comparable US states. The countries in the euro area that have been hit hardest are those in which either large asset-bubble driven imbalances unwound or structural problems were left unaddressed before the crisis. More specifically, Ireland and Greece, in particular, remained in recession in 2010.

Those countries that have yet to implement more far reaching structural reforms also have relatively low growth prospects after the crisis. Just a few years ago, Germany was – entirely wrongly – labelled the “sick man of Europe”. Yet Germany is now an example of how big the dividends of reform can be if structural adjustment is made a strategic priority and implemented with sufficient patience.

And then he zeroes in on differences in labour cost as a yardstick for competitiveness:

The relatively low growth rates in some countries are linked to a deterioration of competitiveness, driven, for example, by persistent above average unit labour costs. Ahead of EMU, unit labour costs converged in the euro area. What is more – disregarding the most recent countries to join the euro area – dispersion both ahead of the crisis and during the crisis was very similar in the euro area and the United States.

At the same time, it is worth noting that both currency areas include regions with persistently above or below average growth of unit labour costs. Again leaving aside the most recent countries to join the euro area, here, Greece, Portugal and Ireland, in particular, have lost competitiveness vis-à-vis their main trading partners in the euro area. Germany, in contrast, has been able to lower relative unit labour costs over the same period.

Similar persistent losses and gains in competitiveness are also observed in the United States. Some states have experienced large or persistent increases in unit labour costs, currently exceeding the national average by as much as 20%. Other states, on the other hand, have been gaining competitiveness vis-à-vis the national average over the past decade.

In summary, these results suggest that those who are questioning the viability of the euro area as a single currency area on the grounds of economic heterogeneity are misguided. Over the past 12 years, this has been broadly similar in the euro area and the United States.

So divergences in economic performance among member states in the EMU and US may not be all that different, but then there are matters of international and political configuration. While American federalism may not bind states to the central government as tightly as in some other countries, its working principles for sovereignty are more worked out than those in the EU where supranational authority is still in question. What is Trichet's solution? Being a Frenchman at an institution modelled after the Bundesbank (the ECB), more central surveillance is his reply:

The existing economic governance framework has been incorrectly implemented and, more importantly, has proved to be insufficiently binding while lacking appropriate comprehensiveness.

Today’s reform of the governance framework has to take the current constitutional framework. We have to accept this situation as a given, at least for the foreseeable future, even if I am convinced that we have already to reflect upon further steps for economic governance in the longer term. Today, we have to empower the institutional arrangements that are already in place to the point at which they can really and durably inspire confidence.

The requirements for a very significant reinforcement of the fiscal surveillance of the Stability and Growth Pact and for the creation of a new surveillance of competitive indicators and macroeconomic policy have been discussed widely and in much detail.

As you may know, the ECB takes the strong view that there is the need for more speed and automaticity in the sanctioning mechanism, particularly in the Stability and Growth Pact, but also in the broader macroeconomic policy surveillance framework. The experience of the past months has vividly demonstrated the importance of a timely correction of internal and external imbalances.

Argue if you will with his logic, but it is very much in the "ever-closer union" vein to prevent future crises. Left to their devices, errant members will misreport macroeconomic data to paint a brighter picture of their national situations. To mitigate this "moral hazard," they must be more accountable to the centre. Surely it's a familiar if controversial notion, but that's roughly where the thinking of ECB powers-that-be lies at the current time.

Would Greece have been let into the EU if the true rottenness of its finances were known beforehand? Or, would Greece's situation have been addressed earlier had the magnitude of its problems been known at an earlier date? The ECB is keen on not losing any more sleep in the future over such counterfacturals through far more vigilant scrutiny.

Joseph Stiglitz On Rethinking Macroeconomics

In the wake of the global financial crisis, various economists have sought means to make macroeconomics and more specifically macroeconomic modelling more faithful simulations of the world economy instead of the other way around. That is, instead of trying to make the world behave more like neat economic models (the Procrustean bed of economic reductionism), several have tried to make macroeconomics resemble true-to-life phenomena more. However, reworking the assumptions of macroeconomics will be an awesomely huge task given how standard economic theory has permeated modern thought. Hence your behavioural economics, neuroeconomics, and all sorts of variations on a theme of making economics a more realistic discipline than assuming hyper-rational actors.

What are we to do with macroeconomics now? Although this theme has been given infinite variations in the wake of the global financial crisis, Stiglitz's spin may be worth considering. Among other things, Stiglitz suggests that we might return to the (good old?) days, presumably when building societies (in the UK) and savings and loan associations (in the US) dominated the home mortgage scene and were ultimately responsible for due diligence as well as risk bearing. That is, instead of passing off risk further down the line to ultimately no-one knows via relentless securitization, consolidating risk assessment and concentration at the traditional lender-borrower interface may be better.

Your mileage may vary; what follows are the abstract and policy implications. Unfortunately, dear readers, the LSE house journal Global Policy from which this excerpt has been taken has now been gated. (The associated PowerPoint slides are still available, though.) So the promotional period ends, but some of the world's leading thinker on global governance--whether you agree with them or not--still populate its pages:

Abstract

The financial crisis made obvious the deficiencies in the standard macroeconomic models, which not only did not predict the crisis, but also said that such events could not occur. While it has long been known that markets are not in general efficient, for example with imperfect information, standard models focused on special cases where the consequent problems did not arise. When market imperfections were introduced, it was done in ways that were ad hoc and/or did not adequately explain deep downturns, such as the Great Recession. This article charts the failures of the standard model, and relates policy failures in the lead-up to the crisis as well as its management to that model’s influence. The standard models focused on providing explanations of normal fluctuations, when what really matters is understanding what causes deep downturns, why shocks to the system get so amplified and why recovery from such events is so slow. (The standard models assumed that the economy was buffeted by exogenous shocks; most crisis shocks are, however, endogenous –‘manmade’.) Four hypotheses are presented about how the structure of the economy changed (sometimes as a result of policy) in ways that increased the likelihood of a large crash with a slow recovery. Finally, the article explains why, in the current context, the policy prescriptions derived from standard models are likely to be misleading.

Policy Implications

• The focus of monetary policy before the crisis – keeping inflation low and stable – clearly did not suffice to maintain real stability. In the future, monetary authorities need to focus more on the factors that affect the stability of the financial system and credit supply. The deadweight losses associated with the slight misalignment of relative prices associated with low or moderate inflation are miniscule compared to the losses associated with a deep recession.
• Central banks have at their disposal, in addition to interest rates, a wide range of regulatory instruments. Had they employed these properly, the bubble that caused the current crisis could have been dampened, and the economic consequences of its breaking mitigated. While there may be some costs associated with the use of these instruments, these pale in comparison to the costs of not using them – as the costs of the downturn in the US mount into the trillions.
• This will necessitate paying more attention to the behavior of the banking system – including tight supervision and regulations, designed to prevent excessive risk taking and excessive interconnectivity, and to encourage banks to focus on lending, especially to small and medium-sized enterprises, which typically do not have access to capital markets. Credit availability may be as important as or more important than interest rates in determining, for instance, investment, especially for SMEs.
• It is not a surprise that this crisis followed on from financial market liberalization measures taken by the US in recent years; financial crises frequently follow such liberalizations. Globally, financial and capital market liberalizations enabled the ‘made in America’ crisis to spread all over the world.
• Inherent problems in securitization of home mortgages mean that governments should not count on the restoration of that market – unless it is underpinned with what should be viewed as unacceptable government guarantees. Rather, there should be a return to more traditional mortgage systems (bank based, or the Danish mortgage system).
• Fiscal policies can be an effective mechanism for reducing unemployment and restoring growth, even in the presence of moderate levels of national debt. Well-designed programs can simultaneously reduce the debt over the long run. By contrast, with interest rates near zero, the contractionary effects of austerity policies cannot be offset by looser monetary policies.
• Many of the models that became standard in macroeconomics did not incorporate features that allowed them to forecast the downturn (they suggested that such events could not occur), to take actions to prevent such downturns or to respond to the crisis once it occurred. Much of macroeconomics was incoherent – using one set of models, with one set of strong assumptions, to advocate for capital and financial market liberalization, and another set of models to respond to the crises that often follow on from such liberalizations. Models estimated in periods in which firms and households do not face financial constraints and excessive leverage and where central banks are able both to raise and lower interest rates easily do not necessarily provide adequate guidance for behavioral responses in the midst of a deep downturn such as the current one.
• While it is important to ascertain dynamic responses to current government policies, a wider range of responses needs to be incorporated. Extended periods of unemployment and underinvestment in education and infrastructure can impact future growth and productivity.

PM Cameron to Block Gordon Brown Heading IMF?

The House has noticed the Prime Minister’s remarkable transformation in the last few weeks from Stalin to Mr Bean...Creating chaos out of order rather than order out of chaos - then-UK Shadow Chancellor Vince Cable on Gordon Brown in November 2007

Poor Gordon Brown. During the early years of New Labour, he was widely considered a master of public financial management. He famously coined the so-called golden rule of fiscal policy that over the economic cycle, the UK will borrow only to invest and not to fund current spending. In other words, net borrowing must be close to zero during an economic cycle. Of course, many pounced on this notion as problematic. How do you define an "economic cycle" being the most obvious question left unanswered.

The global financial crisis put paid to the golden rule rhetoric in a way that the later Blair years were already beginning to hint at. Tight-fisted control of the public purse? You must be joking. It's Brown's misfortune to come into office when a dramatic deterioration of public finances due to bailouts, eroded revenues, etc. began to take their toll. However, while Gordon Brown's reputation lies in tatters here in Britain, he may still be better received in Washington among the global financial elite. After once being mooted to be an IMF managing director, he still has not formally said "no" to the idea.

In the past day on the BBC's Today radio programme, current PM David Cameron was asked if he would endorse Gordon Brown as the next IMF managing director given that its current head, Domonique Strauss-Kahn (DSK), is widely believed to be heading home to France next year to be the Socialist Party's standard bearer against Nicolas Sarkozy.

I made a post sometime ago--Stupid European Tricks, I called it--on how this system works in Europe. Leaders here are often keen on allowing rivals from other parties to gain key posts in international institutions, thereby removing them from domestic politics. Think of Silvio "Bunga Bunga" Berlusconi allowing Romano Prodi to become the EU commissioner. Or, think of Nicolas Sarkozy encouraging the aforementioned DSK to become the IMF managing director.

Given that Gordon Brown is pretty much a spent force in the UK, we actually have PM Cameron discouraging the idea of Brown heading to Washington (not that he asked for it, but anyway.) With Brown more or less silent on the Westminster scene, there is no benefit for Cameron in giving a former rival a chance to rehabilitate his reputation elsewhere. Churlish? You decide. From the Evening Standard:

Gordon Brown's hopes of heading the International Monetary Fund were dealt a serious blow as David Cameron indicated he was ready to block his predecessor's appointment to the role. The Prime Minister said Mr Brown was not the "most appropriate person" to take over as managing director of the IMF because he failed to understand the dangers of excessive debt.

His intervention raised the prospect of a UK veto amid heightened speculation that Mr Brown is emerging as a leading contender to take over from Dominique Strauss-Kahn who is deciding whether to be the socialist candidate in the French presidential elections next year...

But, asked whether he would veto the move, Mr Cameron said: "I haven't spent a huge amount of time thinking about this but it does seem to me that, if you have someone who didn't think we had a debt problem in the UK when we self-evidently do have a debt problem, then they might not be the most appropriate person to work out whether other countries around the world have debt and deficit problems."

Encouragingly, Cameron is aware of the world economy's changing centre of gravity and says it's time we broke with the convention of choosing a European to head the IMF (and an American to do the same for the World Bank?):

Speaking on BBC Radio 4, the Prime Minister suggested that the IMF should look to "another part of the world" for its next leader in order to increase its global standing...If you think about the general principle, you've got the rise of India and China and South Asia, a shift in the world's focus, and it may well be the time for the IMF to start thinking about that shift in focus," he said.

"Above all what matters is: is the person running the IMF someone who understands the dangers of excessive debt, excessive deficit? And it really must be someone who gets that rather than someone who says that they don't see a problem."

To be sure, the Bretton Woods institutions have backed away from strict neoliberal strictures on fiscal prudence when the financial centres they came from went astray. Review IMF Chief Economist Olivier Blanchard when rich countries instead of poor countries ran into trouble during the global financial crisis. You know the excuses: their margin of error is higher, markets are more forgiving of them, their status as reserve currency issuing countries helps, the balance of risks today is different, etc.

So, in a post-crisis IMF, Brown's later American-style spending spree and implicit deficit denial may not be entirely out of place. Then again, how would you push the austerity message on others given his track record? At any rate, the FT avers that Brown is not even one of the top candidates for the predicted IMF job opening [1, 2] but a host of other European financial bigwigs. Christine Legarde? Too many French in international institutions IMHO.

It's too speculative for me at the moment, and I for one would fully endorse an LDC successor to DSK wholeheartedly. We can all hope, eh?

UPDATE: An audio clip of the interview is available from Auntie.

Bailout Fatigue, Casual Racism & EU Tea Parties

For obvious reasons, yours truly is particularly attuned to shifting political sentiment towards migration here in Europe. Earlier on, I had a post on the electoral gains made by parties with openly xenophobic agendas. Sour times breed sour sentiments; that much is obvious. While far-right parties are worrisome, I've previously thought that mainstream parties co-opting this message in a more offhand manner is actually more dangerous. Here in Britain, Prime Minister David Cameron is no stranger to stirring this particular pot. For instance, he like Germany's Angela Merkel has declared multiculturalism dead while not grasping what it means to begin with. Now, he his stated intention to reduce migration to the tens of thousands has prompted a rebuke by his Lib Dem coalition partner Business Secretary Vince Cable that Cameron risked inflaming extremism.

While the UK is not as big on the European financial stage as Germany for the obvious reason of not being in the Eurozone, both share the burden of bailing out various ailing European nations. And so it has proven that these, alike many other countries asked to pony up emergency funds, are experiencing unrest among restless natives weary of bailouts. By not condemning migration baiting but actually giving it lip service when it suits, mainstream parties may be opening the door to the rise of extreme right outfits as what I call casual racism against immigrants is mainstreamed. The earlier diagram in the first link above aside, we may see the rise of extremism through the ostensibly "friendlier" guise of anti-EU sentiment:

Chroniclers of Europe’s populist fringe have long focused on the anti-immigration rhetoric of many of these parties, particularly the National Front in France and Mr Wilders’ Dutch Freedom party. But many, such as Mr Soini in Finland or Flemish nationalist Bart De Wever, have either shunned or played down their anti-foreigner roots and re-branded themselves for the economically angry mainstream. Softening her party’s hard-edge approach to race and immigration helped Marine Le Pen, the sunnier face of her father’s [Dominique Le Pen] angry French nationalism, woo white working-class voters disillusioned with Mr Sarkozy’s economic policies.

We are witnessing Europe’s own Tea Party moment. Like Barack Obama, US president, leaders of European nations with the might to rescue a continent from crisis are hamstrung by voters who have had enough bailing out others. Much like Mr Obama, these leaders are having a hard time figuring out how to win voters back. Angela Merkel, the German chancellor, has shown just enough solidarity to help the eurozone but her begrudging approach has only heightened popular resentment at profligate southerners.

I must admit it's getting pretty ugly out here in old Europe for us non-EU, non-white folks. While the LSE churns out among the most desirable of international graduates in the UK, persistent negativity about their contributions to the British economy as either students or workers later on is not encouraging. If the purported cream of the crop is being told to go, who'll remain?

As for me, it's probably time to move on.

Eurofighting: UK, Dutch Will Beat Iceland's Stuffing

The Eurofighter (Typhoon) is as sleek fighting machine as you can imagine; the very epitome of European aerospace know-how. Today, though, we won't be talking about the Eurofighter but about Eurofighting. What is Eurofighting, you ask? It is a rather sloppy quarrel involving two of the most subprime economies in Western Europe: those of Iceland and the UK, with the more competent Netherlands thrown in for good measure. I once described the UK v Iceland fight as the clash of the pygmies by two countries laid low by the financial crisis; it's now time we returned to the hostilities.

Most memorably, the British used anti-terror rules to freeze Icelandic assets in the UK insofar as the bust Icesave online bank was unable to insure British depositors. Having reimbursed them, the British authorities are now expecting payment from Iceland for their troubles. This didn't go down too well with Iceland's then-government and people, to say the least. Insofar as the Icelanders were now being made to pay for Icesave's offences to the tune of $5 billion, this tiny country has had mighty woes thrust upon it.

Now, Europeans--those of the EU variety at least--have a trick of asking for re-votes from wayward countries until they get their way. Think of subjecting the Irish to referenda until they voted for the Lisbon Treaty. The Irish voted it down once, but were not brave enough to do so again as it found itself in the teeth of a banking crisis. But here's the odd thing about the prickly Icelanders. Not only did they vote down paying the UK and Dutch once, but they have now done so again. Considering how much bigger their own opponents are, let's say the Icelandic folks are brave if perhaps foolhardy as the full force of the European heavyweights will soon be upon them:

Iceland faces more economic uncertainty and a drawn-out European court case after its voters rejected for a second time a plan to repay $5 billion to Britain and the Netherlands from a bank crash. The British and Dutch governments voiced disappointment with the result of Saturday's referendum, in which almost 60 percent of voters opposed the repayment deal.

"We must do all we can to prevent political and economic chaos as a result of this outcome," Prime Minister Johanna Sigurdardottir told state television. The issue will now be settled by the court of the EFTA Surveillance Authority (ESA), the European trade body overseeing Iceland's cooperation with the European Union. [Iceland is a member of the lesser-known and ever-shrinking EFTA and not the EU.] "My estimate is that the process will take a year, a year and a half at least, Finance Minister Steingrimur Sigfusson told a news conference.

The debt was incurred when Britain and the Netherlands compensated their nationals who lost savings in online "Icesave" accounts owned by Landsbanki, one of three overextended Icelandic banks that collapsed in late 2008, triggering an economic meltdown in the country of 320,000 people. Economists have said failure to resolve the issue means Iceland faces delays ending currency controls, boosting investment and returning to financial markets for funding.

But the centre-left coalition government said it would not resign despite the defeat. "The government will emphasize maintaining economic and financial stability in Iceland and continuing along the path of reconstruction which it began following the economic collapse of 2008," it said in a statement.

This behaviour hasn't gone down well with those trying to steady Iceland's situation, as you can imagine:

It said a fresh round of talks on further funding from the International Monetary Fund, which led a bailout for the island, would be delayed several weeks, but that it had enough foreign exchange reserves to cover debts maturing this year and next. The proposed deal at issue in Saturday's vote set a clear timetable for repaying the Dutch and the British, including interest. But voters rejected the idea that taxpayers should foot the bill for what they see as bankers' irresponsibility. "I know this will probably hurt us internationally, but it is worth taking a stance," Thorgerdun Asgeirsdottir, a 28-year-old barista, said after casting a "no" vote.

Dutch Finance Minister Jan Kees de Jager said: "This is not good for Iceland, nor for the Netherlands. The time for negotiations is over. Iceland remains obliged to repay. The issue is now for the courts to decide." Economists have said the court route could be much costlier. The government still hopes most of the debt will eventually be paid back from the estate of the bankrupt Landsbanki. Ratings agencies were following the vote closely. Moody's had said it might lower Iceland's rating in case of a 'no'. Standard & Poor's analyst Eileen Zhang said a 'no' vote "might possibly result in a lengthy legal process and further uncertainties regarding the ultimate fiscal cost".

Obviously this is a very unsavoury matter for the Icelanders to accept, but they've now set themselves on a harder path in the name of righteousness. Consider:

1. Their exit from IMF lending may be prolonged with all the stigmas attached to it;
2. Their credit rating may be downgraded further;
3. In light of (1) and (2), their return to international debt markets will likely be harmed;
4. They now have incurred the wrath of the lawyer-heavy UK and EU bigwigs the Dutch;
5. Their bid for joining the Eurozone to avoid currency-related issues in the future is probably mortally wounded as a consequence.

I understand that accepting a $5 billion liability would have been equivalent to its 320,000 population taking on $15,625 each in debt. Given the above, however, I wouldn't be surprised if the Europeans exact more than that much in grief. Sometimes you just have to give in--especially when you have no good bargaining chips like Iceland. The Icelandic leadership's inability to get that message across is regrettable. Some folks are just asking for it.

Like Greece & Ireland, IMF Shouldn't Help Portugal

Now I'm hopping mad! I know that I'm beginning to sound like a broken record on this, but in the interest of fairness, I will fight the good fight even if no one else will do so. Bravely I must soldier on in this bleak and unbearable world. Previously, I have argued that the IMF should not have bailed Greece out because its problems were primarily of the fiscal sort (accumulating a debt too large to service), not the balance-of-payments sort (having insufficient foreign exchange to pay for necessary imports like food and energy).

I've also said that bailing out Ireland was an indecent financial proposal since its woes stem primarily from the state guaranteeing its banks' solvency without fully realizing the magnitude of such commitments. Insofar as the IMF remains an institution dedicated to dealing with balance of payments problems, we have an identical main problem with IMF lending to Ireland and Portugal. While theirs are somewhat dissimilar woes, what they have in common with Greece is not having a BOP problem which would oblige the IMF to act according to its Articles of Agreement.

Even the IMF describes its activities in Ireland as support for recapitalizing nearly insolvent lenders which have, in turn, tested the solvency of the Irish state. Witness:

Ireland’s banks are at the heart of the current crisis. Massive lending during the boom years left banks heavily exposed to the Irish property market, which has yet to stabilize despite a steep fall in housing prices of 36 percent since the peak in 2008. At the height of the boom, the assets of domestic banks amounted to five times Ireland’s gross domestic product, with real estate loans making up close to 30 percent of all loans in 2006.

Such an oversized banking system is no longer sustainable, not least because of the ongoing weakness of the property market in Ireland. The problems have resulted in a loss of deposits and market funding, and have made Irish banks overly dependent on financing from the European Central Bank. The banking sector therefore needs to be restructured and recapitalized.

There isn't even an allusion to balance of payments woes, precisely because Ireland doesn't suffer from them.

And so it is the case once more with Portugal. Sharing a common currency with its main trading partners in the Eurozone, the euro is also a standard global reserve currency that is second only to the US dollar in terms of reserve holdings. But Portugal may have trouble obtaining euros, you say? As late as February, the ECB had a facility for purchasing sovereign issuances which it used to help out Portugal. So, Portugal could have just issued more IOUs and sold them to the ECB:

The European Central Bank has intervened in eurozone bond markets for the first time in weeks, buying Portuguese debt amid fears that the country could yet seek an international rescue. The ECB returned to the market on Thursday as Portugal’s cost of borrowing on 10-year debt jumped to a euro-era high of 7.63 per cent, traders said. The ECB temporarily suspended its bond-buying programme in mid-January.

The real triggers for Portugal asking for help from the European Financial Stability Facility (EFSF)/IMF are a nuber of things. First, the outgoing PM Jose Socrates failed to pass austerity measures, displeasing powers-that-be in Brussels who had hoped Portugal could avoid another massive bailout episode. Absent political leadership (Socrates resigned and there will be parliamentary elections come June 5) and a credible plan for getting its fiscal woes under control, the ECB inevitably tired of purchasing Portugese debt as a lifeline and asked Lisbon to formally ask for help. Financially, servicing EUR 10B of maturities due in June is virtually impossible. Hence the cry for mercy.

My argument in the Portugese case is similar to the Greek one: In the main, fiscal woes--overindebtedness--is to blame, not BOP problems. Although the IMF may be giving its support to Eurozone countries to help quell systemic disturbances in the international monetary system, that isn't what it was tasked for as I keep repeating.

It's also a matter of fairness to LDCs. Most likely, poor countries aren't contributing to the IMF so that their funds will be used to bail out rich countries suffering not from BOP problems but from fiscal ones. So, not only is it a misallocation of funds, but also a miscarriage of global governance. By all means, let the Europeans help out one of their own--but without IMF funds.

The world is an unfair place, but it was like that long before I got here.

Is the US Really More £$%*ed Up Than the UK?

With the US heading towards a government shutdown by Friday lest they feed the whole unsavoury enterprise more scraps, let's just say that the UK at least has this one over its erstwhile wayward North American insurrectionists. (As if cutting a measly $73 billion from a trillion-plus dollar deficit helps much.) I have heartily endorsed the idea of US government shutdown [1, 2]. However, another less gung-ho opinion is that of Emma Duncan, deputy editor of The Economist. In her op-ed, she says that the UK is in the least of a political-economic pickle amongst the US and EU. For, the UK political system is not geared towards inherent intractability (American "checks and balances") or making a challenging economic compromise work politically (a single currency). Although I am not entirely in agreement, there are interesting points worth mulling here.

There's the obvious reference to free lunch economics where America is buying fleeting respite from tomorrow's inevitable misery as the US authors its own demise:

America's problems are quite different. Its government has been spending freely to pump demand into the economy, and its central bank, the Fed, has been keeping interest rates at rock-bottom and printing money like there's no tomorrow. At more than three per cent a year, America's growth rate is therefore, not surprisingly, rather healthy.

It's not so much economics as politics that's gone wrong in America. Washington is being torn apart by battles between the Democrats and Republicans. They cannot agree on a budget for 2011, despite many concessions offered by the Democrats, for the Republicans are being dragged further and further Right by a fervently anti-government Tea Party wing. If the two sides cannot reach an agreement before Friday, the government will run out of money, and civil servants and suppliers will stop being paid.

Sooner or later, of course, they will agree on a budget. But that will solve the short-term difficulty, not Washington's much larger, longer-term problem. The government's massive commitments on pensions, healthcare and the like, combined with a deep American reluctance to pay taxes, mean that the country is slowly going bust. It can keep borrowing for the moment, because the dollar remains the world's favourite currency and American treasury bonds have long been regarded as the safest place for companies and governments to put their money, but unless America can sort out its budget problems, that won't last.

And then there's her argument of why Britain is better placed to avoid American-style unreality:

In Britain, the Government has put together what sensible people in Washington can only dream of: a plan for getting the Government's finances under control. It isn't much fun. For the public sector, it means less generous pensions and fewer jobs. For the private sector, it means less revenue and less profit. For everybody, it means higher taxes - a VAT rise in January and a National Insurance increase this month. Growth is creeping along at a rate of around 1.6 per cent. But the markets are sufficiently impressed that, although our budget deficit rivals Greece's, our borrowing costs are barely above Germany's.

Britain is doing better than either America or Europe not because our politicians are cleverer but because the way our country is run makes sensible economic management easier. America is stuck because its political system is designed to put a brake on politicians' freedom of action. Power is shared between the President and the two houses of Congress. If they disagree, there is stalemate - and, as the Republican Party hares off to the Right, they disagree more and more.

British governments, by comparison, can turn on a sixpence. Lord Hailsham, the brilliant lawyer who became a Tory Lord Chancellor, called it an "elective dictatorship". It lets prime ministers do pretty much as they like, as quickly as they like. That's not always a good thing - but it's a great advantage when dealing with a crisis.

I certainly hope she's right...

Why I Still [Heart] Trade War, US Federal Shutdown

I've just come from an engaging talk by Martin Wolf at the LSE. In his take on one of Aesop's fables, China and other industries have been, in recent years, industrious "ants" busy saving up through thrift and industry. Meanwhile, the likes of the US and the UK have been loafing around, singing a happy tune. Making his own elaboration, he adds "locusts" or financial intermediaries we've come to know more than we would probably like in the aftermath of the subprime crisis who perform the task of intermediating between the "ant" and the "grasshoppers."

Depressingly, Martin Wolf lays out a global picture which is remarkably unchanged despite the aforementioned crisis (the podcast should be uploaded to the LSE Events site in the next few days for you to listen to). Various LDCs have now accumulated an unbelievable $9 trillion in reserves by his estimate after slowing down their rate of accumulation in the immediate wake of the US-manufactured debacle. Speaking of whom, the Americans have been acting like themselves in acting out the ol' "deficits don't matter tune"--lip service aside, no one has the political will in that dissipated land to do anything about it.

This brings me to something I wanted to ask of Wolf but ran out of time: We've been talking about global economic imbalances since 2003 or 2004 and how increasing savings in places alike the US (making them more "ant"-like) and increasing consumption in the surplus countries alike China (making them more "grasshopper"-like) should help mitigate these imbalances. Well, it hasn't happened. Despite the novel analogy, the facts remain largely unchanged.

It seems to me that we need to shake both parties out of their complacency. How can that happen? Again, I can think of two ways that global economic imbalances can be mitigated in one fell swoop:

First, a nice US-China trade war should solve the problem of capital flowing uphill from where there are more investment opportunities (the PRC) to where there are less (the US), hence investment in non-productive activities alike residential fixed investment. No capital flows, no imbalances, period. I've been quite keen on this confrontational approach of the US and China just cutting the crap and putting their money here their mouth is at for quite some time now.

Second, a newer idea is inspired by the current congressional budget impasse in Washington. While bickering over $61 billion worth of cuts is quite pointless insofar as the US will most likely run a deficit well over $1 trillion next year, look on the bright side: Republicans are threatening to stop drip-drip-drip feeding Washington and let the federal government shut down. In reality, of course, only a few government agencies will stop, leaving the diplomatic service and other apparatus of American influence running. Still, you can imagine a prolonged "starve-the-beast" episode where intractable differences drag on, causing massive hits to confidence in America's ability to run day-to-day.

Two attractive scenarios obtain here in the interest of solving global imbalances: (a) the US becomes unable to service its gargantuan debts and hence defaults on "AAA" Treasuries, causing massive investor panic among those dumb enough to hold such dollar-denominated detritus; or (b) investor fears over hampered debt service ability owing to significantly diminished revenue collection makes folks shun US sovereign debt in droves. Voila! Cutting off funding to the world's largest issuer of such instruments solves the problem of reserve overaccumulation overnight.

Wouldn't it be nice? Martin Wolf has been talking about the resolution of global economic imbalances for a very long time now, but to no avail. So, our American friends, write to your senators and congresspersons about how much a blanket tariff on all Chinese imports is necessary, or how a federal government shutdown is required to show the world conservatives mean business. Maybe the Tea Party won't be so bad if something along these lines pushes through.

Besides, ain't it about time we figured out who's got the biggest balls in today's global economy?

China Shows Its G-20 Might, Wins on Imbalances

In case you missed it, and I can't blame you if you did because it mostly consisted of theatrics as opposed to anything substantial, the G-20 convened a meeting on the question of global economic imbalances over the weekend in Paris and issued a tame communique. Instead of having a substantial bearing on such imbalances, however, it casts more insight on that perpetual question of "Hu's the daddy of the world economy?" Coming into this meeting, the Chinese position was already well understood on the matter of using indicators for imbalances. Which is to say that overall the lesser, the better. At the meeting proper, the PRC held firm in the face of near-universal clamour for using such indicators to prevent another 2008:

China is the only country blocking an agreement on a set of indicators to measure global imbalances, leaving deputies with a limited number of options to present to ministers on Saturday, a G20 official said. The official said G20 deputies had drafted a list of two sets of internal indicators--public debt and deficits and private savings--and two sets of external ones--the current account or trade account as well as reserve levels combined with real exchange rates.

"China is reticent, generally speaking," he said, noting Beijing preferred to include the trade balance rather than the current account. "And its position on reserves and the exchange rate is well known," the official said. China's opposition had left G20 deputies with limited options to suggest on Saturday: either accept the four indicators or reject them; introduce a hierarchy where some indicators count more than others or use a time delay for their gradual introduction, the official said.

Among the Europeans, the Germans were holding out for some Chinese hide:

Germany dug its heels in ahead of G20 talks on global economic imbalances on Friday, with a German source saying Berlin wanted nothing less than agreement on a full list of indicators used to tackle such mismatches, including exchange rates. G20 finance ministers meet in Paris on Friday evening and Saturday to discuss a series of indicators that could be used as benchmarks for judging when one of other of the world's economic powers should change economic policy.

Meanwhile, the Americans brought their usual sob story to the table [quick, bring me a hankie], albeit with some additional flourishes given the wider audience of G-20 member countries. They probably thought a message of "China hurts everyone including fellow LDCs" would have added resonance:

Treasury Secretary Timothy Geithner on Saturday pointed to the problems China's tightly controlled currency poses for other developing economies and said Beijing still had further to go to let its currency rise. Talks at a Group of 20 meeting in Paris centered round efforts, led by Germany and G20 presidents France, to persuade China to include its yawning current account surplus and undervalued currency in a list of measures aimed to start a process of rebalancing the global economy.

There was little public evidence that the United States itself had pushed Beijing hard on that issue, but Geithner reiterated that there was still some way to go in the steady appreciation of the yuan. "China's currency remains substantially undervalued, and its real effective exchange rate -- the best measure to judge its currency against all of its trading partners -- has not moved much in this latest period of exchange-rate reform," Geithner told a press conference after the meeting.

When all was said and done, let's just say China largely got its way at the G-20. Although not necessarily a positive outcome, it goes to show you how the PRC's influence now looms large at these international confabulations. Not only was there any mention of currency reserves in the final communique, but the rest of the terminology was watered down to the point of, well, being back to where we were before. There too was no mention of REER (real effective exchange rate) being used as an indicator as per Geithner's overtures:

The Group of 20 dropped currency reserves and provided compromise wording on other indicators in a list of measures it will use to assess global economic imbalances, a post-meeting communique showed on Saturday. The deal, struck after two days of deadlocked negotiations in Paris, gives ground to China, who had resisted the inclusion of reserves and the current account balance in the list [it favoured using the trade balance].

There was no mention of reserves and rather than the current account and real effective exchange rates, the group agreed to use "the external balance composed of the trade balance and net investment income flows and transfers, taking due consideration of exchange rate, fiscal, monetary and other policies."

Try and make that mishmash of weasel words stick. You can't identify transgressors as there are no hard and fast indicators of exchange rates, fiscal and monetary policies that would identify a nation due for adjustment. Again, read the communique and weep.

Bottom line: Why don't they just give China enough policy space to figure out what it already understands on its own? Attempts to gang-tackle it at international summits clearly haven't worked, and the latest G-20 gathering is no exception. In fact, my argument is that others bloviating about currencies and reserves only makes matters worse by raising Chinese resistance. Generally, states (except for the weakest ones) do not welcome the image of being cowed by foreign nattering nabobs of negativity. What more China?

Behavioural Economics? Try Biological Economics

By now, all and sundry should be familiar with behavioural economics. In contrast to homo economicus or rational economic man, real humans are subject to all sorts of foibles during decision-making processes. This body of work was most memorably crystallized in Kahneman and Tversky's prospect theory which won a Nobel Prize in Economics a few years back. If anything else, the idea of "bounded rationality" was visibly displayed by the easy fallibility of financial services workers of all stripes during the subprime crisis.

Although behavioural economics is now rightly drawing its share of adherents, there is yet another emerging field that may help our understanding of international finance in particular. No, I am not talking about neuroeconomics, though that too is an interesting area. Rather, we may be on the verge of mainstreaming what was previously esoteric in biological economics. Drawing on natural phenomena, there may be patterns in how financial markets operate that can be understood thusly. Instead of building models on faulty notions of homo economicus, how about building models drawing on nature? Lest you think this work is too high-faluting, the Bank of England has begun sponsoring work here. From Auntie:

Biology and the natural world are helping economists build new models to understand the dynamics of the financial sector and why the US sub prime loan crisis caused so much global damage. Could an understanding of ecology have helped prevent the credit crunch? It sounds unlikely, but a group of scientists working with the Bank of England believe banking has lessons to learn from biological science...

As the financial sector grew, so did the demand for talented, numerate graduates to create new and ever more sophisticated products. But the financial sector became too tangled and when the crash came, it threatened to bring down whole economies. "This was not something that our conventional models could make sense of," says Andrew Haldane, executive director of financial stability at the Bank of England. "Activity in every country around the world fell off a cliff," he says. But there was one group of people who could make sense of it.

Enter the biologists. Scientists and the Bank of England have begun to explore possible insights from the life sciences. Comparisons are being drawn between biological systems, with their complicated webs of interactions between all the different species, and with the interactions between different banks and financial institutions. "We need to think about the system as a system, rather than looking at this atom by atom, or node by node," says Andrew Haldane, admitting that pre-crisis, this had not been done. We didn't differentiate between the big and the small, we didn't really think hard about the joins between them," he says.

Until now, system-wide data collection in banking has been virtually non-existent. Regulators are hoping they can gather information to allow them to map the financial web, and spot fluctuations that could lead to an institution collapsing. Seeing banking as a biological system can also help explain why the financial world became so vulnerable.

Paradoxically, as banks grew bigger and more complex, the financial system as a whole ended up being more homogeneous. "It's rational for an individual bank to have sought to diversify its balance sheet," says Haldane. By taking on different functions, a bank spreads its risk - it is not putting all its eggs in one particular financial basket. But all the big banks were doing the same thing. "The quest for diversification by individual banks, led to the system as a whole rather lacking in diversity," Haldane says.

In biological science, a lack of diversity in a population equals a lack of robustness - and this has fuelled calls to break up the big banks following the credit crunch. Another approach is to look at the spread of disease through a population by drawing on the parallels between big banks, and the epidemiological concept of a "superspreader" - an individual who, through their contact with large number of other people, is responsible for the spread of an infection. Like the spread of an infectious or sexually transmitted disease, the crisis that struck the biggest banks had a knock-on effect to the other institutions connected to them.

"For the equivalent of the promiscuous, we have these big banks globally who have interconnections with all the other banks in the system," says Andrew Haldane. "What you need for those types of entity is a greater amount of protection up front," he says.

In banking terms, that protection requires that the interactions between institutions are kept from being so convoluted that when there is trouble, everything goes wrong at once. The challenge is how to do that in practice, streamlining interconnections and maintaining diversity.

Don't dismiss it out of hand. If it adds to our explanatory power of global financial machinations, then all the better.

When Basel III Met the Yankee Bubblemeisters

In German, weltmeister is the world champion in English. But, when it comes to inflating asset price bubbles, perhaps we can relax the rules of grammar and syntax and declare our American friends the global bubblemeisters. Not being content with one housing bubble and its demise, let's just say the US in its own inimitable way is trying to inflate another one via shenanigans such as the $600 billion Fed bond purchase programme.

Now we come to another conundrum of international organization in the form of the upcoming Basel III macroprudential banking regulations. Interestingly enough, some of its framers propose including a mechanism for various countries to report that asset bubbles are afoot at home. In theory, the others would then be able to raise financial firms' capital requirements to guard against troubles in the said country spilling across borders via this early warning device.

It sounds great in theory, but what if the world's largest economy is so magnificently distorted already by, say, still-historically elevated housing prices as to preclude rational analysis in neat and tidy Basel III frameworks? Beats me, and nobody should be surprised to see the bubblemeisters push back at the global negotiating table for Basel III:

Banking regulators have quietly taken a major step towards harmonised global regulation by agreeing to raise worldwide capital requirements whenever an individual country declares a credit bubble. Part of the larger “Basel III” banking reform package, the “countercyclical capital buffer” heralds a step change in the way national banking regulators interact and is the first concrete example of “macroprudential” regulation that seeks to moderate the economic cycle.

In a nutshell, it works this way:

The agreement, struck last month, says that if a country decides its economy is overheated – based on the ratio of credit to gross domestic product – it can require banks within its borders to hold extra capital against potential losses. Regulators in every other country would have to follow suit and impose a proportional surcharge on their own banks, based on the size of those institutions’ exposure to the bubble country.

However, there are operational problems in verifying that the concerned developed countries apply these measures equally. There's a particularly large one that may feel it's being unfairly targeted based on its recent economic history. Its excuse is that their geographical spread is so large that so-called bubbles may be localized as to render such measures impracticable (as if Michigan compensated for Nevada circa 2007, but I digress):

Banking groups said they were concerned some nations would impose buffers more readily than others, creating an uneven playing field. They are also sceptical that once buffers are imposed, they will become permanent, either because regulators never cut them or investors react badly to a reduction.

“A country would have significant disincentives to impose the countercyclical capital buffer [because] ... the impact would likely be greater on its economy than on the banks,” said Greg Lyons, a US partner at law firm Debevoise. The US is said to be particularly reluctant because it would have to declare a country-wide bubble, even though there might be large variations between regions.

In essence, what if certain countries deliberately encourage such bubbles for short-term gain alike certain folks whose, ahem, "forward-looking perspectives" incorporate nearly infinite discount rates?

PIGS? With Belgian Breakup, Perhaps PIGS-FW

Here's something that may have been overlooked in all the current brouhaha over troubled eurozone peripheral economies Portugal, Ireland, Greece, and Spain. With two bailed out (Greece and Ireland) and one allegedly being forced to feed at the trough (Portugal), there may be another in dire straits. You see, longstanding differences between the Fleming (Dutch) and Walloon (French) sides of Belgium's--how should I describe it--conurbation have been pronounced as of late, with neither side able to establish a majority in an impasse which threatens to surpass the crusader paradise of Iraq for the longest period on record after general elections without a government of 234 days. Such political strife is causing yields on Belgian sovereign debt to begin mirroring the fate of its unfortunate neighbours. The telltale signs are there, including pricier credit default swaps. From Bloomberg:

Belgium’s political leadership cast about for solutions to the impasse that has left the country without a full-time government and pushed up the costs of servicing Europe’s third-highest debt burden. Belgian bonds fell for a third day as the failure to restart seven-party [count 'em!] talks to form a government almost seven months after inconclusive federal elections heightened the risk of a downgrade in the country’s sovereign-debt rating.

“We’re back into a serious crisis,” Elio Di Rupo, head of the French-speaking Socialists, the second-biggest force in parliament, told RTBF television late yesterday. “People have really had enough -- this situation is intolerable.” The constitutional feud between the Dutch-speaking north and Francophone south leaves Belgium with a caretaker administration to confront the budget deficit as concern mounts that Europe’s sovereign-debt crisis will escalate.

Belgian 10-year bond yields rose 7 basis points to 4.14 percent at 6 p.m. in Brussels, pushing the extra yield over German bonds up by 11 basis points to 126 basis points. The spread, a gauge of the risk of investing in Belgium, has risen from 79 basis points on election day June 13.

King Albert II was pondering how to pick up the pieces two days after two parties in Flanders, the richer northern region, rejected a compromise designed to lessen federal powers and restart coalition talks that broke down on Sept. 3. The author of the compromise, Johan Vande Lanotte, a Flemish Socialist, yesterday asked to give up his role as political troubleshooter. The king declined to let him go, saying in an e-mailed statement that the next royal move is “on hold” until the mediator is summoned back to the palace on Jan. 10. “There isn’t sufficient readiness to start the negotiations,” Vande Lanotte told reporters in Brussels late yesterday. “You can lead a horse to water, but you can’t make it drink.”

Standard & Poor’s Ratings Services said last month that the longest-ever post-election stalemate in Belgium -- now at 208 days, surpassing the 194-day marathon of 2007 -- may lead to a cut in the country’s AA+ credit rating. Belgium’s debt was 98.6 percent of gross domestic product in 2010, trailing only Greece’s 140.2 percent and Italy’s 118.9 percent among the 17 countries using the euro, according to European Commission estimates.

Political leaders began considering new formulas for forging a governing coalition, including by widening the circle of parties involved in how to manage the linguistically split country of 10 million people that is home to European Union and North Atlantic Treaty Organization headquarters. The clash boils down to “who’s in favor of the end of Belgium,” Jean-Michel Javaux, co-leader of the French-speaking Greens, said on RTBF.

Bart De Wever, head of the Flemish nationalist N-VA party, the top vote-getter in the June election, sought a face-to-face showdown with Di Rupo, whose Socialists are the dominant force in the French region. “The moment has come for the leading actors to sit together and agree on a path forward,” De Wever said on VRT television. He said he isn’t calling for new elections or the breakup of Belgium. For his part, Di Rupo offered to include representatives of the French-speaking or Dutch-speaking Liberal parties in the quest for a compromise, meeting a longstanding demand by the Flemish nationalists. “We are open to every form, every formula for a coalition of democratic partners,” Di Rupo, who led the first failed bid to corral the seven parties into a coalition, told RTBF.

Flanders has gradually gained more clout in five constitutional overhauls in four decades, as its growing wealth surpassed the sunset industries that concentrated power in the French region for more than a century after Belgium’s founding in 1830. Home to companies such as Anheuser-Busch InBev NV and the Antwerp port, Flanders generates annual output per person of 31,067 euros, according to 2009 figures. Wallonia, the French- speaking south, is weighed down by the legacy of coal and steel industries, with output per person of 22,868 euros.

The immediate focus is on how Belgium will save an additional 1.8 billion euros ($2.3 billion) to meet an EU target of cutting the deficit to 4.1 percent of GDP in 2011 from an estimated 4.8 percent last year. De Wever rejected the setup of an emergency cabinet, saying it would be nothing more than “minding the shop.”

The deadlock made it more expensive for investors to insure holdings of Belgian bonds. The cost of insuring Belgian debt against non-payment for five years, using credit-default swaps, climbed 14 basis points to a record 249 basis points today, according to CMA prices in London. A basis point on a contract protecting $10 million of debt is equivalent to $1,000 a year.

So, to recap:

• The Flemish side wants increased political clout commensurate with their growing economic power compared to their Walloon brethren;
• The royals want this over and done with (to keep Belgium and the throne intact), but the multitude of parties don't want to play along just yet;
• The top vote-getting party, the New Flemish Alliance, may yet doggedly pursue its electoral pledge of independence;
• And if Belgium does break up, who'll pay for previously issued Belgian sovereign debt?

It's very interesting stuff and comes on top of similarly unsettling developments elsewhere. All I can say is that they'd all probably be better off papering difficulties for now while a bond crisis is in full effect in Europe. With a debt load about equal to GDP, the margin of error is slight. What goes around comes around: it used to be the French side that looked down on the poorer Dutch, so in the interest of historical accommodation, the latter may now have to accommodate the former.

Markets Ponder China Bailing Out Europe (Again)

OK, OK, so I am using the term "bailing out" in a very loose sense: For instance, China has not quite said that its continued patronage of US debt in the wake of the financial crisis is specifically to bail out America. Rather, it's always couched in diplomacy-speak such as preserving "stability" in the global financial system as a certain Yankee diplomat-beggar would put it.


I almost missed the clip above of LSE IDEAS' very own Niall Ferguson arguing that the Chinese should help bail out China on Fareed Zakaria's GSP programme. (Despite what our school paper says, he does work here.) This theme has been a continuing one: former IMF Chief Economist Simon Johnson even went so far as to suggest its headquarters should be in Beijing if and when the Chinese become the largest shareholders. Somewhat less far-fetched, China has indeed voiced support for the idea of diversifying its holdings by purchasing sovereign debt of troubled eurozone members (which ares still denominated in euros).

So it is that newswires are abuzz with news that the Chinese are once again making noises to similar effect:

China has promised to take further “concerted action” to support European financial stabilisation, including continuing to buy the bonds of countries at the centre of the sovereign debt crisis, according to senior European officials. The officials, who declined to be named, said Wang Qishan, a Chinese vice-premier, had given assurances that China would step up support for European stabilisation efforts “if necessary”. Mr Wang made the pledge during the third annual China-EU High Level Economic and Trade Dialogue, held in Beijing on Tuesday...

In addition, Klaus Regling, the head of the eurozone’s €440bn ($577bn) bail-out fund, said China had shown enthusiasm for bonds issued by his agency, tasked with raising a sizeable chunk of the funding for the €85bn Irish bail-out. The EU is China’s biggest export market, with two-way trade valued at $434bn in the first 11 months of this year, and Beijing has a strong interest in supporting regional stability. “From the European point of view we appreciate the support of China for the European and international effort to safeguard financial stability in Europe,” said Olli Rehn, European Commissioner for Economic and Monetary Affairs.

Two things, however: so the Chinese have already voiced support for troubled eurozone economies, but that hasn't done much to reduce their interest rate differentials over that of German debt. Also, further support is likely to be tied to the EU moving on two longstanding grievances China holds with the West over lifting its designation as a "non-market economy" earlier than 2016 as agreed to in its WTO accession and limitations to its purchases of European arms:

Mr Wang’s comments boosted the euro’s value against the US dollar, but China’s public support for Greece and Portugal over recent months has not prevented their bond yields remaining near record highs. European officials said that although China had not explicitly linked its bond purchases to any specific issues, Beijing asked in the talks for the EU to grant it “market economy” status and lift a long-standing arms embargo.

That said, I gather that market commentators are taking somewhat increased risk appetite as a result of expectations for China to backstop Europe. Once more, it's interesting how much market participants now attribute to China's actions despite limited evidence of it buying distressed euro-denominated sovereign debt.

Maybe LDCs Aren't Being Inundated w/ Capital (Yet)

The general impression you get from certain developing countries is that easy money policies emanating from reserve currency-issuing ones like the unbelievably profligate United States are driving up their exchange rates and threatening to inflate various bubbles. It may be some surprise that, in 2009 at least, this scenario did not really happen as capital flows to the developing world fell from 2008 according to a just-released World Bank report:

Net global capital flows to developing countries fell 20 percent in 2009 to $598 billion (3.7 percent of gross national income [GNI]), from $744 billion in 2008 (4.5 percent of GNI) and were a little over half the 2007 peak of $1.11 trillion. This according to a new comprehensive dataset launched by the World Bank today on international capital flows titled “Global Development Finance 2011: External Debt of Developing Countries,” which reveals the impact of the financial crisis on 128 developing countries.

Global private flows (debt and equity) declined by 27 percent in 2009 despite a rebound in bond issuance, portfolio equity flows, and (mostly trade-related) short-term debt flows. Foreign direct investment (FDI) inflows across the globe fell 40 percent, to $354 billion - their sharpest drop in 20 years. All the largest recipients of FDI saw net inflow declines in 2009. Net debt flows from private creditors dropped by 70 percent from $182 billion in 2008 to $59 billion the following year, driven by the collapse in medium-term commercial bank lending to public and private borrowers.

Reflecting increased support to developing countries during the crisis, net capital inflows (loans and grants) from official creditors increased by 50 percent to $171 billion in 2009. This was driven by a sharp rise in gross disbursements on new loans extended by the international financial institutions. These rose to $98 billion (from $61 billion in 2008) in calendar year 2009, of which $31 billion came from IBRD and IDA, the highest in the history of these institutions.

It will be interesting to study the implications here when the 2010 figures come around: Did repatriation flows to distressed Western firms temporarily reduce capital flows to the developing world? Or, did the effects of free money policies kick in after a lag--especially once everyone recognized that countries like the US had no intention of shaping up anytime soon?

Can Count Dracula Save Romania's Economy?

The title is more apropos than you would think. When we last talked about Romania, it was in the clutches of an IMF standby agreement as one of the Soviet satellite countries that ran into a bad balance-of-payments situation in June of 2009. The recently Economist featured a downcast article on Romania's economic prospects going forward. In some respects, it's a matter of "political risk" being an unsettled matter in the country:

Nor are foreign investors queuing up to take advantage of Romania’s fertile soil and beautiful scenery or its flexible, cheap and multilingual workforce. Services are particularly underdeveloped. “This could be the back office of Europe,” says a foreign banker, who tries hard to stay optimistic. It could also be a regional hub for companies interested in smaller neighbouring countries. But investors like certainty, not the murky, jerky decision-making that typifies Romanian politics.

Aside from the difficulties attracting foreign investors due to political shenanigans, there's the matter of promoting tourism. For better or worse, Romania is associated with Vlad Basarab Tepes, also known as Vlad the Impaler or "Count Dracula" as immortalized in fiction. In scenic Snagov Lake lies the island of Snagov, whose monastery contains his grave. Despite his global renown (or notoriety depending on your perspective), this site should be of at least as much historical interest as Lenin's Tomb or the Mausoleum of Mao Zedong. Yet, despite the picturesque location, efforts to make it into a tourist destination have been haphazard at best:

A good example of good intentions but poor results comes from Snagov, an island monastery where the real-life Dracula, a prince called Vlad Tepes, is supposedly buried. With much fanfare, the authorities have built a bridge across the lake, a beauty spot, in the hope of attracting tourists. That is welcome: past governments perversely shunned Romania’s most famous son. The new tourism minister, Elena Udrea (a vivacious and wealthy blonde), wants him to take centre stage. She will lead foreign ambassadors on a “Dracula tour” of his castles in the summer. But for humbler visitors, finding the unsignposted way to Snagov is hard. The ill-built bridge is an eyesore. A rough-spoken monk demands a hefty fee and refers to local gypsies (Roma) as “scum”.

It's not quite a Disneyfied attraction just yet. Call it a regrettable metaphor for lack of progress -

Once I had the rarest rose
That ever deigned to bloom
Cruel winter chilled the bud
And stole my flower too soon

IMF's Strauss-Kahn on Progress in Saving Greece

There's an interesting interview of IMF Managing-Director Dominique Strauss-Kahn (DSK) that recently appeared in the Greek newspaper Kathimereni. Protestations that this is a kinder, gentler, less Washington Consensus-style lender aside, the emphasis is still very much on the old triad of liberalization, privatization, and deregulation. Elsewhere, DSK is quite diplomatic and in the process avoids questions about Portugal and Spain, preferring to point out that neither has approached the IMF for help. (He usefully points out as well that the problems facing Greece and Ireland differ significantly.) Moreover, Strauss-Kahn avers that the current episode is not an existential threat to the euro, two-speed economies and everything else. Yet the usually smooth DSK stumbles a bit when asked which industries he sees growth coming from. It kind of beats me, too...

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Q: What specific moves are needed in the next couple of months in order for the fourth installment of the loan to Greece, in March, not to be endangered?

DSK: As the recent assessment of the EC, ECB, and IMF made clear, the program is broadly on track. There has been good progress in a number of key areas--notably in reducing the fiscal deficit and in completing a landmark pension reform. Now, the program is at an important crossroads. The overriding issue--as I reiterated during my visit to Athens--is to get growth going again. Growth--and the jobs that come from it. To achieve this, fundamental structural reforms are needed. For example, opening up services, trade, and the professions; streamlining state enterprises; and improving the climate for business and investment. In short, unlocking the potential of Greek industry and the Greek people. This is not easily done, but if Greece can maintain the momentum of reform, investors will come to realize the country's commitment to change and confidence will grow. I am optimistic Greece can do it.

Q: The IMF has repeatedly noted the need for political consensus. The leader of the main opposition party, who voted against the program, has said he is willing to show solidarity, provided there are changes to the program. Is that something you would accept?

DSK: I met with the leadership of the Opposition during my visit to Athens. I think we agreed that Greece is at a defining moment in its history and that the country can only succeed if there is the broadest possible support for the changes that are needed. That said, it is not up to the European partners or the IMF to make decisions on policy changes--that is the government's prerogative. So ideas for policy changes should, first and foremost, be discussed with the government. What the IMF does is advise on policy options and their feasibility based on our global experience.

Q: Is today's crisis the sole fault of the previous government, or is there enough blame to go around, given that the spreads skyrocketd during the first six months that Papandreou came to power?

DSK: Playing the "blame game" is not helpful. What matters is how to get out of the crisis. To that end, the government is implementing an ambitious program that aims at restructuring broad parts of the economy to make it more competitive, create jobs, and put it on a path of sustainable growth. At the same time, the government is trying to do this in a way that is fair, socially balanced, and protects the most vulnerable groups. So let's look forward instead of backwards--that's what is important now: to support the reform effort and realize the country's true potential.

Q: In that context, did Mr Papandreou take too long to request assistance from the EU/IMF last Spring?

DSK: When the crisis deepened last year, the government took the necessary steps to consult its partners and seek help. Don't forget also that the government had already begun to implement substantial measures to lower the deficit and stabilize the situation--long before the Europeans or the IMF came in. When the pressures increased to unsustainable levels, the government did the right thing and sought assistance.

Q: Is the fact that the IMF and EU will assist Ireland helpful or detrimental to Greece's effort, and how? And should the repayment plans for the two countries be the same?

DSK: Greece and Ireland are very different cases. While Greece was mainly affected by mounting public debt in an uncompetitive and relatively closed economy, Ireland, which has a very open and dynamic economy, faced mainly a crisis in the banking system that became a heavy burden on state finances. These differences mean that the economic programs supported by the European partners and the Fund need to be tailored to those specific circumstances. Regarding the repayment period for Greece, we are--as you know--advocating an extension and we will work with our European partners on a solution to give Greece some further breathing room.

Q: Should Portugal, and even Spain, opt for the EU/IMF mechanism in the near future?

DSK: Neither country has requested help from the IMF, and there is no point to speculate about hypotheticals.

Q: Do you find the idea of issuing Eurobonds helpful, or even necessary at this stage, and can it materialize given Germany's opposition which brings to mind its delay in agreeing with the mechanism for Greece last year?

DSK: The situation in Europe is serious and economic recovery sluggish-- and there is no silver bullet to fix it overnight. What the Eurozone needs is a comprehensive solution. Just as the resolution of the global financial crisis two years ago required a global approach, a European approach is now needed to resolve the problem of low growth in the Eurozone.

Q: What is your view on the potential for the members of the Eurozone going back to their national currencies, or the introduction of a two-speed Europe with a stronger euro for the North, and a weaker one for the South?

DSK: As I said, the situation in Europe is serious, but it is not a threat to the euro. The Eurozone's system and institutions worked well during the "good times" over the past decade. Now they need to be strengthened so as to better deal with crises. I am confident this will happen.

Q: The global crisis demands a globally coordinated response, but how helpful is the fact that Germany is following a tight policy while the Obama Administration has opted for expansionism?

DSK: Again, every country's circumstances are different and the response needs to be customized accordingly. What is important is that national policies do not create or exacerbate global imbalances. That's why we are advocating, within the framework of the G20, the Mutual Assessment Process to help countries monitor and coordinate policy responses that invariably affect their neighbors, regions, and the world. No doubt the world can do better on this point, but we are getting there--one step at a time.

Q: Are you worried that the crisis in Southern Europe could spread to the whole continent and negatively affect growth?

DSK: Clearly, the plight of some European countries affects growth in neighboring countries and across the region. All countries in Europe should be concerned about the slow pace of growth. Looking at the bigger picture, Europe risks faling behind other regions of the world and needs to become more innovative and competitive. Europe has done this before, and it can do it again. A growing and dynamic Europe, of course, is also good for the rest of the world.

Q: At a press conference during the Annual Meetings, I asked you about the difficulty Greece faces in achieving growth in the present world economic environment. Can you please tell us where growth can come from in the case of Greece?

DSK: Well, I pointed to some of the potential areas for growth in my previous answer. Among the sectors that offer strong potential growth are tourism, and the energy and transport sectors, and I am also convinced that liberalization and opening up of closed professions will spur the retail and service sector. The key is for Greece to restore its competitiveness in Europe and beyond. If Greece can implement the reforms in the program, we project growth returning in the latter half of next year or early in 2012. This depends, of course, on there being a positive economic environment in the rest of Europe and in the global economy--because we are all connected now. That is true for Greece as it is for every other country.

Q: How would you describe your personal relationship with PM Papandreou and FM Papaconstantinou?

DSK: Excellent. PM Papandreou and FM Papaconstantinou, as well as other government officials, are showing great resolve in getting the country back on track under very difficult circumstances. Political will and leadership are essential for any economic program to succeed.

Q: How do you assess the lack of coordination among ministers and would the personal involvement of the PM be neded?

DSK: The government is committed and fully engaged. Otherwise an ambitious reform program such as this wouldn't go anywhere.

Q: Finally, may I ask you for your reaction, both on a personal level, as well as head of the IMF, to the demonstrations against you?

DSK: Demonstrations are part of any healthy democracy. It is only natural that some people are unhappy about the changes that need to be made. I understand that. This is a very difficult situation for the Greek people and I do not underestimate the efforts they are making. In fact, I commend them on those efforts--as I believe the rest of the world also is beginning to do. I would only emphasize this point again: when you have to make tough decisions and take difficult measures, it must be done in a socially just manner. From the beginning, we--and the government--have stressed the issue of fairness. Ordinary workers and pensioners have done their part. Now, others in Greek society--including the high-income earners--must do their part too. That is why, for example, strengthening tax administration, and coming down hard on tax evasion, is so important. Yes, this will help increase needed revenues but, more than this, it will help enhance fairness. I believe that,ultimately, people will support reforms--even very difficult reforms--if they feel they are in the best interest of their country and if everyone is contributing their fair share.

Indecent Financial Proposal: IMF Lending to Ireland

No, no, I'm not talking about further dalliances by IMF Managing Director Dominique Strauss Kahn with his underlings which have spawned a bestseller in France on his alleged penchant for indecent proposals. However, I am still talking about Europeans abusing power at the international lender of last resort. (Even with a rather timid redistribution of voting shares away from European countries to fast-growing Asian ones, the impression remains that the Fund is dominated by Western voices--especially since it's still customary that the Europeans get to choose its head and the Americans its first deputy managing director.) A few days ago, I read former IMF Chief Economist Simon Johnson repeat an entirely legitimate criticism of the IMF being asked to help bail out Ireland in an FT article by Alan Beattie:

The Irish case shows how far the fund has drifted from its original purpose. Some officials say it needs to hold a debate about its role. Originally set up to administer the post-war system of fixed exchange rates, the IMF was constructed to tide over countries suffering balance of payments problems while the governments returned to solvency by cutting spending or raising taxes.

With rescues to countries such as Greece and Ireland, inside a monetary union, the emphasis has shifted. “It is strange for the IMF to be lending to a region which has a reserve currency and no balance of payments problem,” Johnson says. One G7 official says: “If the IMF is going to expand its mission to include lending to promote financial stability, we need to revisit exactly what its function is.”

To understand what Johnson means is very simple. Consider the plight of the countries in question. In the IMF Articles of Agreement, the purposes laid out say nothing about assisting countries with essentially fiscal rather than BOP woes alike Greece and Ireland. Rather, lending is supposed to occur when a country has a balance of payments problem. That is, it doesn't have enough foreign exchange to pay for its imports, especially necessities such as food or fuel. A BOP problem can occur in any number of ways, commonly a lack of export receipts that help earn a country much-needed foreign exchange.

Here are the pertinent clauses discussing when the IMF should provide such assistance:

(v) To give confidence to members by making the general resources of the Fund temporarily available to them under adequate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.

(vi) In accordance with the above, to shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members.

Previously, I discussed my belief and those of several others that the IMF isn't supposed to lend to Greece since its didn't really have problems availing of euros (since it can simply issue debt and exchange it at the ECB for euros under the ECBs emergency arrangements), the currency most of its imports from neighbouring EMU countries are denominated in. True, it is of course arguable that allowing Greece to go would have posed systemic risks to the international monetary system according to the third clause. You can also argue an IMF seal of approval lends confidence to others EU countries that Ireland will eventually find its footing. However, such lending could have been done through arrangements that didn't involve the use of IMF funds. And again, Ireland's particular woes stem largely from guaranteeing its banks' solvency in a manner which ultimately undermined its own solvency--it's a fiscal and not a monetary issue. In any event:

(iii) To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation.

In percentage terms, Greece's external deficit remains fairly large, making it arguable to some that Greece does have a BOP problem. However, few would probably argue that this external deficit has been a more important driver of its woes than its fiscal deficit. Turning to Ireland, it shares the same, internationally accepted reserve currency as Greece. Moreover, while Ireland did run a fairly sizeable current account deficit a few years ago, its external imbalance is now quite manageable. In fact, the IMF estimates that it will have a current account deficit of less than 3% this year. Click on the following table for a larger image; it is taken from the October 2010 World Economic Outlook:

Once more, it's an issue of fairness. Developing countries have put in their hard-earned foreign exchange at the IMF. Presumably, they are interested in seeing their contributions used towards alleviating troubles they themselves are likely to encounter like FX shortages as per the IMF's Articles of Agreement. How can you justify using poor countries' contributions meant for addressing BOP problems for rich countries' fiscal woes? It's something IMF brass hasn't really clarified, and this inaction does nothing to reduce the impression that the Fund remains a rich country club. (Think about that before asking LDCs like China to put in more money there.) Why it's...downright indecent.

UPDATE: The IMF's contribution amounts to EUR 22.5 billion