An out-of-control shadow banking system that's been barely reformed. A housing sector that's been booming but seems primed for a bust. And despite a recent election that seemed to make it clear who was in charge, gridlock and short-term thinking appear to be hobbling the country's political elite.
I'm talking, of course, about ... China. Well, not me so much as Fitch Ratings, which has turned just a bit bearish on Chinese debt. Why did Fitch downgrade their debt?
China's growth since the re-launch of market-based economic reform in 1992 has been globally as well as domestically transformative. However, the investment-led growth model faces tightening constraints as the share of investment in GDP approaches the level of domestic savings. The process of rebalancing the economy towards consumption could lead to the economy's performance becoming more volatile.
Some underlying structural weaknesses weigh on China's ratings. Average income at USD 5,988 in 2012 and the overall level of development remain well below 'A' medians despite China's phenomenal growth. Standards of governance lag 'A' range norms according to the World Bank's assessment framework....
Risks over China's financial stability have grown. Credit has grown significantly faster than GDP since 2009. China experienced the second-fastest expansion of credit in real terms, behind only Qatar, between end-2009 and end-June 2012. The stock of bank credit to the private sector was worth 135.7% of GDP at end-2012, the third-highest of any Fitch-rated emerging market.
Fitch believes total credit in the economy including various forms of "shadow banking" activity may have reached 198% of GDP at end-2012, up from 125% at end-2008. Only 55% of new social financing took the form of bank lending in the 12 months to February 2013, down from 76% in 2009. The proliferation of other forms of credit beyond bank lending is a source of growing risk from a financial stability perspective....
The ratings assume there is no significant deterioration of geopolitical risk, for example a conflict between China and Japan or an outbreak of war on the Korean peninsula.
China has faced concerns over debt levels since 2009 when state-owned banks unleashed a surge of loans to power the economy through the global financial crisis. The credit wave succeeded in keeping Chinese growth on track, but it led to bubbly housing prices and also saddled local governments with mountains of loans that they are still struggling to repay.
Beijing has spent the past three years trying to manage these problems. It has waged a long campaign to rein in the real estate sector, raising mortgage downpayments and barring people from buying second homes in the hottest markets. Partly as a result, China recorded its lowest annual growth rate for a decade last year.
Reuters tells a similar tale on China's shadow banking system.
China's banks are feeding unwanted assets into the country's "shadow banking system" on an unprecedented scale, reinforcing suspicions that bank balance sheets reflect only a fraction of the actual credit risk lurking in the financial system....
But the key question is no longer how much risk banks are carrying. Rather, it's how many risky loans have been shifted to the lightly regulated shadow banking institutions - mainly trust companies, brokerages and insurance companies.
The risk to the overall financial system is not clear, because of insufficient data about the quality of credit in the shadow banking sector.
To be fair to Chinese authorities, they're quite aware of what they're going through. Indeed, the entire China 2030 exercise, as well as last month's China Development Forum, is predicated on the notion that China's growth model needs to change. But as Martin Wolf notes in his column, as China enters "middle income trap" territory, there are significant problems with such reforms:
First, if expected growth falls from over 10 to, say, 6 per cent, the needed rate of investment in productive capital will collapse: under a constant incremental capital output ratio the fall would be from 50 per cent to, say, 30 per cent of GDP. If swift, such a decline would cause a depression, all on its own.
Second, a big jump in credit has gone together with reliance on real estate and other investments with falling marginal returns. Partly for this reason, the decline in growth is likely to mean a rise in bad debts, not least on the investments made on the assumption that past growth would continue. The fragility of the financial system could increase very sharply, not least in the rapidly expanding “shadow banking” sector.
Third, since there is little reason to expect a decline in the household savings rate, sustaining the envisaged rise in consumption, relative to investment, demands a matching shift in incomes towards households and away from corporations, including state enterprises. This can happen: the growing labour shortage and a move towards higher interest rates might deliver it smoothly. But, even so, there is also a clear risk that the resulting decline in profits would accelerate a collapse in investment.
I'd add only two things at this point. First, as far as I'm concerned, one of the great mysteries in comparative political economy is why it's so bloody difficult for countries like Germany, Japan, and China to change their growth models. High-saving export-oriented economies don't change their ways all that much. To be fair, neither do low-saving, high import countries like the United States. This could be a "varieties of capitalism" story, but that seems ... inadequate as an explanation.
Second, it's worth remembering that the conventional wisdom about China's government was that annual growth below eight percent a year would spell trouble for the government. The implicit contract over the past three decades was that the Chinese Communist Party would supply the growth in return for political quiescence. The end of high growth would imply that this social contract is in trouble.
Except that China's growth has been below that rate for the last two years and running. During that time, Beijing has weathered one major political scandal, a raft of minor political scandals, and a leadership transition without a hint of regime collapse. So while China's economy does seem to merit greater attention, I'm not sure that China's political economy will trigger the kinds of instability that have been predicted for so long.
What do you think?
So, after reading up on the Cyprus deal from the Financial Times, the Economist, and Quartz, I think I have a pretty good idea of what happened. Tyler Cowen isn't happy with the deal, and I can see why, but I don't think that means the deal won't stabilize things for a spell. My four quick takes:
1) I've been pretty insistent that the most surprising thing about the aftermath to the 2008 financial crisis is how much global policy norms haven't changed. By and large the major economies are still rhetorically and substantively committed to trade liberalization, foreign direct investment, and a constrained role for the state in the private sector. The one exception? Capital controls. The earth has moved here, and the fact that this deal will require fair amounts of financial repression and cross-border controls is just the latest sign of this fact.
From a normative perspective, I can't say I'm too broken up about this. It's not that I'm a huge fan of capital controls or anything. In the various policy trilemmas or unholy trinities that Dani Rodrik and others talk about, however, it strikes me that unfettered capital mobility is the policy preference with the least upside. And Cyprus does seem to be the fifth iteration of the lesson that countries that live by large unregulated offshore finance will die by large unregulated offshore finance.
2) If the FT's Peter Siegel and Joshua Chaffin are correct, then the political backlash in Cyprus from this deal won't be that great:
In Nicosia, political leaders generally greeted the deal as painful but necessary.
The city streets were quiet and peaceful, with most businesses closed for a public holiday.
Even before the agreement was clinched, most Cypriots had come to grips with the fact that the offshore financial business sector that has powered the economy since the Turkish invasion in 1974 would be but a shell of its recent self.
And as the Economist explains, the current Cypriot reaction is based on the fact that the new deal is a damn sight better for them than the previous deal:
On March 16th Cyprus’s president, Nicos Anastasiades, desperate to protect Cyprus’s status as an offshore banking model for Russians, had decided to save the two biggest banks and thus to spread the pain thinly. He would have applied a hefty tax to all depositors: 9.9% for those too big to be covered by the EU-mandated €100,000 deposit guarantee, and 6.75% for the smaller depositors.
But after a week of brinkmanship—including protests by Cypriots, the extended closure of banks to avoid the outrush of money, a failed attempt by Cyprus to throw itself at Russia’s feet, an ultimatum by the European Central Bank and an eleventh-hour threat by Cyprus to leave the euro zone—a different decision was made: to apply the pain much more intensely, but on a smaller number of large depositors.
Which leads me to....
3) So much for Russia as a counterweight to the European Union. Cyprus tried to realign itself closer to Moscow, but it didn't take. Furthermore, the new deal really puts the screws on the large deposits of Russian investors that have parked their money in Nicosia. As Felix Salmon explains:
In the Europe vs Russia poker game, the Europeans have played the most aggressive move they can, essentially forcing Russian depositors to contribute maximally to the bailout against their will. If this is how the game ends, it’s an unambiguous loss for Russia, and a win for the EU.
The Financial Times makes a similar point:
One Moscow businessman blamed the harsher haircut on the Kremlin, which he accused of failing to protect Russia’s interests, “thereby allowing the Germans to bully Cyprus and thousands of Russian depositors”.
“As soon as the EU saw that Russia was not going to protect its citizens, the confiscation of Russian money in Cyprus was pushed by the EU. All that was necessary for Russia to do was to provide €2.5bn secured by Cyprus’s nationalised assets,” he said.
With Xi Jinping's visit to Moscow, there's been a lot of chatter about "rise of BRICS" and "Russia turns East" and "SCARY!! SCARY!!" Bear in mind, reading all of this, that Moscow couldn't budge the ostensibly enervated EU from its position on the EU member with the closest ties to Russia.
[Can't Russia just mess with the Europeans on energy?--ed. Um... no. Sure, they could try to do that, but the long-run implications of that move for Russian exports ain't good. To paraphrase an old Woody Allen joke, Russia might find its economic relationship with the European Union to be totally frustrating and irrational and crazy and absurd... but Russia needs the eggs.]
4) What I said about Cyrprus last week still seems to hold for this week. So I guess this means Cyprus now falls under the "good enough" global governance category, with the caveat that this involves eurozone officials, so "good enough" here is defined down to mean "managed not to wreck the rest of the global financial system."
Am I missing anything?
Well, this sounds like very bad news for the global financial system:
A plan to rescue the tiny European country of Cyprus, assembled overnight in Brussels, has left financial regulators, German politicians, panicked Cypriot leaders and a disgruntled Kremlin with a bailout package that has outraged virtually all the parties.
In the end, a bailout deal that was supposed to calm a financial crisis in an economically insignificant Mediterranean nation spread it wider. Word of the plan unnerved markets across Europe, raised fears of bank instability in Spain and Italy and sent pensioners into the streets of the island’s capital, Nicosia, in protest.
As markets tumbled and the Cypriot Parliament fell into turmoil, salvos of blame were hurled back and forth across the Continent.
Officials scrambled to explain what went wrong and how best to control the damage of what Philip Whyte, a senior research fellow at the Center for European Reform, called a “completely irrational decision” to make bank depositors liable for part of the bailout. The deal flopped so badly that finance ministers who came up with it shortly before dawn on Saturday were on the phone to each other Monday night talking about ways to revise it.
Now, on the one hand, you would be hard-pressed to find anyone who will defend the Cypriot deal as it was announced on Saturday -- but it's pretty easy to find critics of the proposed deal across the political spectrum. So this seems like yet another data point confirming the truly mind-boggling stupidity of European governments and regulators. It's particularly galling that they did this during a time when global capital markets are still fragile from the 2008 financial crisis.
Oh, except, wait a minute, it turns out that those markets aren't as fragile as the perception suggests. If you burrow into the McKinsey Global Institute's latest report on global asset markets, it turns out that, excepting Europe, the rest of global finance has experienced a decent recovery from the 2008 crash. According to MGI:
With the pullback in cross-border lending, foreign direct investment from the world’s multinational companies and sovereign investors has increased to roughly 40 percent of global capital flows. This may bring greater stability, since foreign direct investment has proved to be the least volatile type of capital flow, despite a drop in 2012.
Of course, this was written before the Cypriot stupidity, so now markets are really roiled, right? Well... here's Business Insider's Joe Weisenthal's take early this a.m.:
Markets are down a bit in Europe although not dramatically so yet.
US futures were flat, and Asia was actually up nicely, with Japan gaining 2%.
That seems like a thoroughly appropriate reaction. And over at the New York Times, Andrew Ross Sorkin explains why that's the rational and appropriate reaction:
While the bailout of Cyprus is a fascinating case study and raises interesting theoretical questions about moral hazard for policy wonks and talking heads, here is the reality: It is largely irrelevant to the global economy. Cyprus is tiny; its economy is smaller than Vermont’s. And the bailout is worth a paltry $13 billion, the equivalent of pocket lint for those in the bailout game.
Even the larger issue about bailing out a country by taking money from depositors — which quickly created outrage around the world — seems overblown....
[I]n truth, the smart money knows that the bailout of Cyprus says very little about future actions.
“I would assume that anyone in Spain, Portugal or elsewhere who knows about the taxation of Cypriot depositors also would know that the Cypriot banking system is a very different animal than anywhere else in the euro zone,” Erik Nielsen, chief economist at UniCredit, wrote in a note to clients.
Mr. O’Neill of Goldman also acknowledged: “I am sure it will not set a precedent.”
Cyprus is unique. Besides being tiny, its banking system looks different from those in most other countries. Much of the big money deposited in its banks is from foreign investors, including Russians who have long been suspected of money laundering. Those investors had fair warning that Cypriot banks were troubled. The issue has been simmering for six months. But those investors left their money in the bank, in part because they were gambling that the banks would be bailed out at no cost to them. If the current plan is approved, depositors will have lost that bet.
Now this is a perfectly rational analysis. What's significant is that it seems like markets are making the same calculation. When financial markets are fragile, when there's a fear of financial contagion, they don't make the rational calculation -- they freak out. That hasn't happened with Cyprus.
I know I'm at the risk of pulling a Donald Luskin here, but what's happening in Cyprus right now primarily affects Cypriots, with a small concern about regional effects. It doesn't look like it's triggering the same kind of concerns of either the Lehman collapse or the Greek sovereign debt crisis. And anytime the abject stupidity of European financial statecraft can be confined to Europe, that's a very, very good thing indeed for the global financial system.
Am I missing anything?
One of the lasting effects of the 2008 financial crisis was the belief that the distribution of economic power had radically shifted. China rising, West fading, yadda, yadda, yadda. A minor key in this argument has been the notion that a new and important measure of economic power is the size of a country's official reserves. This has led to the occasional panicked article that "China is buying gold!!" or "Russia is hoarding gold!!" or "Germany is moving gold!!" as a first step towards pushing the dollar out as the world's reserve currency.
Which is just so much horses**t.
Here are three facts to remember whenever you read any story about a BRIC economy hoarding gold:
1) Buying gold would have been extremely savvy in 2008. Now it's just silly. The price of gold peaked at over $1900 in September 2011 -- and despite massive amounts of quantitative easing and numerous reports about central bank hoarding, it's fallen by $300 since and trending downward.
2) The BRIC economies did not have a lot of gold to begin with. As Bloomberg notes, "Russia’s total cache of about 958 tons is only the eighth largest [in the world]."
1. The United States (8,134 tons)
2. Germany (3,391 tons)
3. The International Monetary Fund (2,814 tons)
4. Italy (2,451 tons)
5. France (2,435 tons)
So, to sum up: To believe that gold holdings really matter in the global political economy, you have to be willing to assert that Italy is a great power in global finance. I, for one, am not going there.
Let's face it, Americans do not understand the current state of either macroeconomic policy or foreign policy terribly well. According to Bloomberg, only six percent of Americans know that the federal budget deficit is actually shrinking. According to Gallup, just a bare majority of Americans believe that the United States military remains "number one in the world militarily." In a world of these kind of epic media fails, where significant numbers of GOP legislators seem "more concerned about 2% inflation than 8% employment," it's important to to have recognized experts try to clear the air.
Nobel Prize-winning economist and unusually-pithy-writer-for-an-economist Robert Solow has an op-ed in today's New York Times to offer a primer on the implications of U.S. debt. Here, in brief, are the "six facts about the debt that many Americans may not be aware of," in Solow's words. Let me number them here:
1) Roughly half of outstanding debt owed to the public, now $11.7 trillion, is owned by foreigners. This part of the debt is a direct burden on ourselves and future generations....
2) The Treasury owes dollars, America’s own currency (unlike Greece or Italy, whose debt is denominated in euros)...
3) One way to effectively repudiate our debt is to encourage inflation...
4) Treasury bonds owned by Americans are different from debt owed to foreigners. Debt owed to American households, businesses and banks is not a direct burden on the future....
5) The real burden of domestically owned Treasury debt is that it soaks up savings that might go into useful private investment.
6) But in bad times like now, Treasury bonds are not squeezing finance for investment out of the market. On the contrary, debt-financed government spending adds to the demand for privately produced goods and services, and the bonds provide a home for the excess savings. When employment returns to normal, we can return to debt reduction.
Some foreign pollicy experts think that Solow is being too sunny. Take Council on Foreign Relations president Richard Haass:
With respect, I think Solow is actually being too pesssimistic, and Haass is being way too pessimistic.
The problem is that, contra Solow, I suspect Americans are keenly aware of his points 1-5. The United States owes a lot of money to China, but I'd wager that any poll of U.S. citizens would reveal that the public thinks we owe even more to China than we actually do. Similarly, much of the policy rhetoric coming from Washington focuses on fears of incipient inflation that have yet to pan out.
It's Solow's last point that is the one Americans need to hear more: in an era of slack demand, bulging coporate cash coffers, and recovering personal savings rates, it's actually pretty stupid to have U.S. government spending and employment contract so quickly. I fear, however, that excessive concern about Solow's first, third, fourth and fifth points will swamp out the rest of his op-ed.
As for Haass, I'm not exactly sure what "rising rates" he's talking about, as just about any chart you can throw up shows historically low borrowing rates for the United States government. Indeed, the U.S. Treasury is exploiting this fact by locking in U.S. long-term debt at these rates. As for foreign governments pressuring the United States, the fear of foreign financial statecraft has been somewhat hyped by the foreign policy community. And by "somewhat hyped," I mean "wildly, massively overblown."
The bias in foreign policy circles and DC punditry is to bemoan staggering levels of U.S. debt. This bias does percolate down into the perceptions of ordinary Americans, which leads to wild misperceptions about the actual state of the U.S. economy and U.S. economic power. I'd like to see a lot more op-eds by Solow et al. that puncture these myths more effectively.
Am I missing anything?
About six months ago, when the world's major central banks all started pursuing aggressive strategies of quantitative easing, I blogged that, "the international bitching and moaning about QE3 seems much less than the 'currency war' rhetoric that QE2 triggered."
With Japan's decision to unleash the monetary taps, the "currency war" meme has cropped up again, but in an odd way. To be honest, I'm reading a lot more essays that smack down the "currency war" claim than are making it. For recent and salient smackdowns, see Felix Salmon, Mario Draghi, Gavyn Davies, Philipp Hildebrand, Matthew Yglesias, and Paola Subacchi.
So this raises an awkward question -- who is claiming that there's a currency war and why? Is there a lobby that's agitating for an end to certain policies and using the guise of a "currency war" to try to make it happen? Who are these shadowy groups?
As near as I can determine, there are three interest groups with the motivated interest in doing this:
1) The Bundesbank. One can think of the eurozone crisis as one long, inexorable weakening of the Bundesbank's grip on European monetary policy. Bundesbank president Jens Weidemann set off the latest round of currency war puffery in a speech in which he bemoaned the "increased politicisation of exchange rates" and warned that central bank indepenence was eroding. Now I'm not a German-speaker, but it's possible that when Weidemann says central bank independence is "eroding" he means, "I don't have a veto over eurozone monetary policy like I used to and Draghi won't return my calls."
2) The bond funds. Bondholders aren't big fans of inflating currencies, which is the designed effect of this collective round of quantitative easing. Or, to put it more pithily, it's not a currency war unless someone at PIMCO is hyping it!! In this case, Mohammed El-Erian:
[T]here is a lot of scholarship demonstrating why such beggar-thy-neighbor approaches result in bad collective outcomes. Indeed, multilateral agreements are in place to minimize this risk, including at the International Monetary Fund and the World Trade Organization.
Yet, when push comes to shove, country after country is being dragged into abetting a potentially harmful outcome for the global economy as a whole. Worse, this process has not yet registered seriously on the multilateral policy agenda.
El-Erian needs to read the Financial Times a bit more often. The problem isn't that this isn't on the "multilateral policy agenda" -- it's that these global governance structures are less stressed about it than El-Erian:
The world’s largest developed nations reaffirmed their commitment not to target exchange rates in a statement on Tuesday aimed at addressing concerns over a fresh round of global currency wars.
In a move widely seen as an attempt to defuse tensions over recent rapid moves in the currency market, the Group of Seven countries -- comprising the US, the UK, France, Germany, Italy, Canada, and Japan -- said they would “consult closely” on any action in foreign exchange markets.
"We reaffirm that our fiscal and monetary policies have been and will remain oriented towards meeting our respective domestic objectives using domestic instruments, and that we will not target exchange rates,” the ministers and governors said.
This doesn't sound like the G-7 is all that troubled -- or, to put it more bluntly, not as troubled as El-Erian wants them to be.
3) The developing world. While the G-7 seems pretty copacetic with the combined quantitative easing, the G-20 is another matter.
The words “currency wars” are too blunt for a G20 communique, but that is what the world’s finance ministers will talk about when they meet in Moscow this week.
A new round of monetary easing in advanced economies is pushing down their currencies and prompting howls of protest from the developing world.
Indeed, the most cogent critiques of the developed world's combined QE strategy comes from officials and op-ed writers focused on the less developed world. And to be sure, the combined effect of developed country actions on the monetary front can create some policy problems in the developing world.
Again, though, what's striking isn't the vocal complaints about currency wars in 2013 but the relative absence of them compared to, say, the fall of 2010 after QE2. Which suggests that while there might be some mild grumbling among the advanced developing countries, they prefer the status quo to policies that cause the OECD economies to contract in size.
So, to sum up: when you read about someone voicing "grave concern" about currency wars, see if they are based in A) an export-dependent developing economy; B) a bond fund; or C) the German central bank. If they are, you can safely tune them out. It's when people outside those places start carping that I'll start getting concerned about a currency war.
Am I missing anything?
The Washington Post's Howard Schneider and Danielle Douglas have a story detailing the ways in which post-crisis global financial reform has allegedly ground to a halt:
Five years after the collapse of Lehman Brothers, a global push to tighten financial regulation around the world has slowed in the face of a tepid recovery and a tough industry lobbying effort....
the post-Lehman goal — of a global scheme that would immunize the financial system from another large-scale shock — remains incomplete. Big banks, insurers and other financial giants remain intact and arguably “too big too fail.” Tools to guard against dangerous bubbles in the value of property or other assets are not yet in place. There is no agreement on how countries should coordinate the failure of a globally important financial company. Implementation of basic banking rules in major nations has fallen behind schedule.
Finishing the job “is going to take many years,” International Monetary Fund chief economist Olivier Blanchard said last week. “It is conceptually very difficult, politically very difficult.”
In their effort to overhaul the global system, regulators have been confronted by a number of head winds. The world’s economy has been unexpectedly slow to recover, making governments leery of doing anything that might make banks cautious to loan and invest. The financial industry has pushed back hard, warning that aggressive regulation might undermine growth. And regulators are simply limited in their understanding of how modern finance can be made safe while still supporting economic activity.
The result: Some of the proposals once considered core to a safe, post-Lehman system have been delayed and weakened, and others have been played down, at least for now, as too politically complex.
Well, this sounds like a blow against my theory of "pretty good" or "good enough" global governance that I've been yammering about on the blog.... that is, until one starts reading the rest of the Post's story.
First of all, with the exception of one Jamie Dimon quote, there's not any real evidence in the story that industry lobbying is to blame. I'm not saying that this means that there was no industry lobbying, or that it was inconsequential -- merely that there's no evidence in the story to support the lede.
What there is evidence of, however, are two things that seem pretty consistent with "good enough" global governance. The first is that even in areas where there's been minimal global agreement, there have beern "patchwork" arrangements that look like they will work. For example:
There also is no comprehensive global approach for addressing bank failures. Individual members of the Basel committee, including the United States, have established resolution plans in case their own lenders become insolvent. And the United States and Britain in December released a set of guidelines to handle a major insolvency — a potentially important agreement between two world financial centers.
But determining how to coordinate the collapse of a major multinational bank is an area where the IMF and others have had limited success in pushing for a broader global agreement. The issue is important because a method to share the fallout of a bank failure across national borders would probably make countries more willing to let institutions go out of business, rather than propping them up with taxpayers’ money.
Again, in a perfect world one would like to see a comprehensive agreement. Given the center of gravity for the financial sector, however, an Anglo-American arrangement is actually pretty powerful and covers the biggest concerns.
Then we get to the implementation of the Basel III accords, designed to insure that banks have sufficient reserves of safe and liquid assets on hand to prevent a panic. As Schneider and Douglas note, the Financial Stability Board reports that only 8 of 27 nations are on track to implement these reforms on schedule.
Why is that the case? Here we find that interest group lobbying seems to matter less than... a recognition by regulators that life is not so simple:
[O]ther Basel proposals have been revised as regulators, bankers and officials have better understood how some of their major assumptions about finance and risk had been upended by events.
In Basel this month, regulators scaled back one key set of provisions that would force banks to keep the equivalent of larger levels of cash on hand to guard against a run on deposits or another fast-moving crisis.
Such highly liquid assets had been defined to include government bonds — which traditionally can be sold quickly and at close to their face value — and to exclude securities backed by residential mortgages, the bundled, complex assets that had triggered the financial crisis in 2007 when they proved difficult to sell other than at a steep loss.
The financial crisis in the euro zone showed a flaw in the approach when Greek, Portuguese and other government bonds plummeted in value. Smaller U.S. banks, meanwhile, argued that to completely exclude mortgages from the new “liquidity coverage ratio” would reduce their ability to make home loans.
When the final Basel rules on the issue were released this month, the required liquidity levels were reduced, mortgages were included in the tally and banks were given extra time to comply.
“Nobody set out to make it stronger or weaker as a standard but to make it more realistic... to make sure there was no impediment to financing recovery,” said Bank of England Governor Mervyn King, who chairs a Basel committee of central bankers and regulatory chiefs.
So, to sum up: after an initial burst of regulatory arrangements, progress has slowed down in some areas, and in other areas relies on a more patchwork arrangement. That said, there appear to be intrisically good reasons for the slowdown, and the patchwork covers the major financial centers.
Yeah, this is "good enough" global governance.
One of this blog's
annoying tics persistent themes has been its insistence that the 2008 financial crisis did not, in fact, doom the United States to a future of inevitable decline. Indeed, there are many reasons to be optimistic about America's future, and there are many reasons to be skeptical about claims that China will be able to exercise leverage over the United States.
Now, one of the counterarguments to this thesis over the past five years has been the explosion of U.S. debt and Washington's need for Beijing to continue to buy that debt to finance America's current expenditures. This was a running theme of financial writers in 2009. Four years ago, there was a particular concern that "China is also trading long-term Treasuries for short-term notes." If the United States could only borrow overseas by issuing more short-term debt, that ostensibly gave China some kind ov leverage as Washington needed to continually roll over those debt obligations.
I bring this up because Daniel Altman highlights a fascinating data point in his Foreign Policy essay about the shifting composition of the federal government's debt:
In the past several years, the national debt of the United States has undergone a tremendous change. Long-term securities -- those with maturities of seven years or more -- have gone from about 30 percent of the debt in 2009 to about 40 percent today. By 2018, according to the Treasury's own estimates, they'll make up 50 percent of the debt, a proportion the Treasury expects to maintain from then onward. The United States is doing what any smart borrower would do: locking in low rates for the long term. As a result, its probability of default for any given level of debt has dropped.
Huh. So it turns out that desite a surge in borrowing by the U.S. government and China's desire to keep the arrangement on a short-term basis, Washington has managed to borrow in a relatively efficient manner at historically low interest rates.
Oh, and by the way, how has China altered its purchases of U.S. debt? Well, besides a general slackening of such purchases (which partially explains the appreciation of the yuan) and a general lack of complaint in response to QE3, it has also changed the composition of those U.S. debt purchases:
China has actually decreased its short term U.S. bond holdings by 5.1%. China holds $US 3.7 billion short term U.S. paper. On June 2011 China held $US 4.9 billion of short term U.S. paper. So basically all the debt that China holds are long term treasuries now. Interesting to know, China had $US 200 billion in short term U.S. debt in May 2009. So they divested all short term paper to long term paper.
In other words, contrary to the fears of debt hawks in 2009 -- including, it should be noted, Hillary Clinton -- China has not exercised an iota of influence over the United States via its debt holdings. Indeed, the shifting pattern of their debt purchases strongly suggests that the Chinese have recognized the futility of such an approach.
While Beijing has recognized this truth, certain Very Serious People who write Very Serious Columns persist in being afraid of China's mythical debt leverage. So, on occasion, as a public service, this blog will continue to remind its readers that U.S. remains clothed in immense financial power.
The Wall Street Journal has two great stories on the Federal Reserve's decision to go for QE3 -- a third round of quantitative easing. First, Jon Hilsenrath documents how Fed chairman Benjamin Bernanke built a consensus among the Federal Reserve governors:
For weeks, Mr. Bernanke made dozens of private calls on days, nights and weekends, trying to build broad support for an unusual bond-buying program he wanted approved during the Fed's September meeting, according to people familiar with the matter....
Fed officials described the Fed chairman's phone calls as low-pressure conversations. Mr. Bernanke sometimes dialed up colleagues while in his office on weekends, catching them off guard when their phones identified his private number as unknown. He gave updates on the latest staff forecasts, colleagues said. He asked their thoughts and what they could comfortably support, they said.
The calls helped Mr. Bernanke gauge how far he could push his committee. It also won him trust among some of his fiercest opponents, officials said. Nearly all of Mr. Bernanke's colleagues described him as a good listener.
"Even if you disagree with him on the programs, you know your voice has been heard," said [Dallas Fed President Richard] Fisher, one of his opponents. "There is no effort to bully."
So Bernanke did a lot of hand-holding, a lot of listening... to the key Fed decision-makers. What's equally important is who he didn't talk to -- namely, other central bank heads in the rest of the world.
I bring this up because some of these central bank officials are pretty pissed. QE3 has caused the yuan to hit its all-time high against the dollar, for example. Which leads us to the other interesting Wall Street Journal story. Aaron Back and In-Soo Nam document how South Korea and China have reacted to QE3:
Chinese and South Korean central-bank officials criticized the U.S. Federal Reserve's latest easing efforts and advocated reducing Asia's dependence on the U.S. dollar.
The comments Thursday, at a joint seminar in Beijing by the two central banks, are the clearest indication yet of a rising backlash in Asia against U.S. monetary policy, suggesting it could speed up the search for alternatives to the dollar as the main global currency.
"The rise in global liquidity could lead to rapid capital inflows into emerging markets including South Korea and China and push up global raw-material prices," said Bank of Korea Gov. Kim Choong-soo. "Therefore, Korea and China need to make concerted efforts to minimize the negative spillover effect arising from the monetary policies of advanced nations."
Chen Yulu, an academic adviser to the People's Bank of China, said Asia needs a "regional core currency" to reduce its dependence on the dollar. China's ultimate goal is for the yuan to be as important as the euro or the dollar, he said.
Whoa, this sounds pretty bad... until you get to the next paragraph:
But [Chen] acknowledged that will be a slow process, saying it would be possible for the yuan to be fully convertible by 2020, and that the overall yuan-internationalization process may last until 2040. China strictly controls its currency, though it has made small moves to broaden its use globally in recent years and has also allowed a little more flexibility in its movements (emphasis added).
Furthermore, it's worth noting that the international bitching and moaning about QE3 seems much less than the "currency war" rhetoric that QE2 triggered. Why? Based on my half-assed blog analysis I'd speculate that there are three reasons:
1) The global economy is in a more sluggish state in 2012 than in 2010, so it's hard to argue that expansionary monetary policy is inappropriate now.
2) The United States was not the only major economy to go the quantitative easing route in the past few months. Both the European Central Bank and the Bank of Japan have made similar -- if uncoordinated -- moves.
3) The central bank heads have learned frrom QE2 that the bitching and moaning won't accomplish anything. It didn't stop QE2 and it won't stop QE3.
Am I missing anything?
Hey, remember when I said that China's debt holdings did not pose a serious threat to the United States? And remember when I banged my head against the desk because Very Serious People continue to insist otherwise?
I bring this up because, according to Bloomberg's Tony Capaccio and David Kruger, the Department of Defense has my back:
China's holdings of more than $1 trillion in U.S. debt and the prospect that it might “suddenly and significantly” withdraw funds don’t pose a national security threat, according to a first-ever Pentagon assessment.
“China has few attractive options for investing the bulk of its large foreign exchange holdings out of U.S. Treasury securities,” given their extent, according to the report dated July 20 and obtained by Bloomberg News
China is the second-largest holder of U.S. government debt after the Federal Reserve. Acting at the direction of Congress, the Defense Department studied the rationale behind the investments and whether “the aggressive option of a large sell- off” would give China leverage in a political or military crisis. China’s debt holdings have been cited as a sign of U.S. vulnerability by Republicans in this year’s election campaign....
“Attempting to use U.S. Treasury securities as a coercive tool would have limited effect and likely would do more harm to China than to the United States,” according to the report, which was sent to congressional committees by Defense Secretary Leon Panetta. “As the threat is not credible and the effect would be limited even if carried out, it does not offer China deterrence options” in a diplomatic, economic or military situation, the Pentagon found....
China decreased its Treasury holdings last year with little apparent impact in the market, Treasury data show. The world’s most populous country reduced its position in Treasuries in the first yearly decline since Bloomberg began tracking the data in 2001.
The holdings declined 0.7 percent, or by $8.2 billion, to $1.15 trillion last year. The decline was much steeper in the second half of the year when China’s stake plunged 12 percent, or by $163 billion, from an all-time high of $1.31 trillion in July 2011, the data show.
During that period, 10-year Treasuries rallied as the U.S. credit rating was reduced by Standard & Poor's to AA+ from AAA and the European sovereign debt crisis worsened, pushing the yield to 1.88 percent from 2.80 percent.
Foreign investors held 50.3 percent of the $10.52 trillion in outstanding Treasuries as of June, government data show. That’s down from April 2008, when they reached 55.7 percent of the $4.64 trillion in U.S. marketable debt....
The Pentagon said in its report that the Fed also is “fully capable of purchasing U.S. Treasuries dumped” by China and “reducing the economic impact.”
A Chinese move to “suddenly and significantly” reduce its Treasury holdings “would fundamentally change the international finance and business community’s perception of China as a reliable and respected economic and financial partner,” the Pentagon said.
This report isn't going to end the silly campaign rhetoric or the Niall Ferguson/Tom Friedman foreign policy community talking point, of course. But I thought it was worth posting here so I can link back to it the next time I need to bang my head against a desk.
If you're an American and want o worry about China, don't focus on the debt -- focus on the apparent disappearance of China's next leader.
I should be really pleased with Thomas Friedman's column today. Entitled "In MItt's World," Friedman pens a substantive column criticizing Romney's foreign policy rhetoric to date and wishing that Romney displayed the same analytic acumen about foreign policy that he displayed as CEO of Bain Capital.
So I should be happy, except that I passed out from banging my head against my desk after reading the first two paragraphs:
Mitt Romney has been criticized for not discussing foreign policy. Give him a break. He probably figures he’s already said all that he needs to say during the primaries: He has a big stick, and he is going to use it on Day 1. Or as he put it: “If I’m president of the United States ... on Day 1, I will declare China a currency manipulator, allowing me to put tariffs on products where they are stealing American jobs unfairly.”
That is really cool. Smack China on Day 1. I just wonder what happens on Day 2 when China, the biggest foreign buyer of U.S. debt securities, announces that it will not participate in the next Treasury auction, sending our interest rates soaring. That will make Day 3 really, really cool.
No. No, no, no, no, no, and no.
To elaborate a bit further:
First, it wouldn't be enough for China to stop buying Treasuries -- as Joe Weisenthal showed with some fun charts a few weeks ago, China has pared back its Treasury purchases intermittently over the past few years -- with zero appreciable effect on U.S. interest rates. (see non-panda-hugger Paul Krugman on this point as well). No, for China to have the effect that Friedman envisions, they would also have to actively dump most of their holdings of U.S. debt as well.
So what if they do? Well, second, while Romney's stated China policies border on the destructive, the "labeling" move is bone-headed rather than truly calamitous. China wouldn't dump its debt unless things got really bad between the two countries. Not even Stephen Roach thinks this would be the initial Chinese response -- and I think Roach is being way too gloomy about Sino-American relations under Romney.
The reason China won't respond with the nuclear option of dumping all its U.S. debt holdings is that -- to repeat a theme -- this move would hurt China way more than it would hurt the United States. The far more likely response by China would be to retaliate with trade measures. This would not be good, as China is now the third largest export market for the United States. Beijing can hurt a Romney administration by reducing its American imports far more adroitly than trying to trigger another financial crisis.
Now, for the record, I don't think Romney should label China as a currency manipulator on day one, and I think Friedman makes some trenchant observations on Romney's consequences-free foreign policy statements later in his column. But this Niall Ferguson-lite version of Sino-American relations is bad international relations theory and really bad economics -- and yet Very Serious People keep trotting it out.
I really, really wish this would disappear from public discourse. But it won't. So, most likely, my desk is gonna get dented a few more times before Election Day.
Well, given this morning's headlines, I can't think of a better week for Foreign Policy to put excerpts of my interview with C. Fred Bergsten online. Bergsten is the founder of the hugely influential Peterson Institute for International Economics. At the end of this year, he will be stepping down as president of that institute.
Sometime this week I will post the full interview transcript. In the meanwhile, I found this answer to be particularly interesting:
They were not very literate then, and they're not very literate now. The problem is that the individuals who are at the top of the foreign-policy hierarchy, both at State and at the National Security Council, tend to be less than sophisticated, shall we say, about economic issues. It's not part of their DNA to think about economic topics when they go about their business with Syria or Iran or Russia, not to mention Europe or China.
This observation is ironic, given recent reports that Tim Geithner suggested Hillary Clinton replace him as Treasury Secretary last year. Still, I think Bergsten's proposition has held for quite some time. I don't think it will be able to hold for much longer, however.
While I was on the road last week, I see that Greek elections managed to accomplish two things:
1) A requirement for yet more Greek elections; and
Sooo ... what happens then? The Financial Times has a useful article that asks the appropriate big questions while providing some useful information. Particularly interesting is the emerging belief that the eurozone now has erected the necessary firewalls to prevent contagion from Greece to the rest of the southern Med and Ireland:
[W]ith a new, permanent €500bn rescue fund backed by the strength of an international treaty with multiple tools to buy sovereign bonds on the open market and inject capital into eurozone banks, some officials believe the contagion could be contained -- much as it was after Athens finally defaulted on private bondholders last month.
"Two years ago a Greek exit would have been catastrophic on the scale of Lehman Brothers,” says a senior EU official involved in discussions about Greece’s future. “Even a year ago, it would have been extremely risky in terms of contagion and chain reaction in the banking system. Two years on, we’re better prepared."
The new eurozone firewall -- now backed with additional resources for the IMF -- is not the only reason some officials are becoming increasingly sanguine about losing Greece. Spain and Italy, they say, have taken huge steps to put their economic houses in order, enabling them to bounce back quickly if credit markets suddenly dry up and their banks wobble.
Still, uncertainty over how Europe’s banks would be affected has continued to be the primary concern.
Paul Krugman is somewhat more pessimistic. Sketching out the possible endgame, he posits that Spanish and Italian banks would experience massive capital flight, triggering the key decision faced by Germany:
4a. Germany has a choice. Accept huge indirect public claims on Italy and Spain, plus a drastic revision of strategy -- basically, to give Spain in particular any hope you need both guarantees on its debt to hold borrowing costs down and a higher eurozone inflation target to make relative price adjustment possible; or:
4b. End of the euro.
And we’re talking about months, not years, for this to play out.
Krugman has been predicting Greece's exit from the euro for some time now, but in this case I do think he's correct about the choice posed by Germany -- as yet more signals accrue about Merkel's declining political strength.
Now, actually, I suspect that Greece stays in the eurozone for longer than anyone suspects. That said, based on my two empirical observations during the past two years -- namely, eurogoggles and the Merkel Algorithm. Here is how I would game out the "Grexit" scenario:
1. Greece's departure is announced at the same time as an EU summit announces a boost to its new rescue fund and modest pro-growth German policies. Markets initially react to this news favorably.
2. Within 48 hours, negative news about the Spanish and Italian economies, combined with a second wave of stories revealing that the rescue fund isn't as big as anyone thought it was, rattles financial markets and triggers the behavior described by Krugman.
3. The ECB does nothing, calling on
MerkelEuropean political leaders to take "decisive action."
4. After a week or two of agnonizing non-action, Germany announces half-measures that end the immediate panic gut set up Spain for more stagnation and a new crisis in 2013.
Am I missing anything?
In my experience, pundits tend to be risk-averse in calling out a very rich person on their economic or financial analyses. There's a couple of intuitive logics at work here:
1) Most pundits don't know much about economics, and so are leery of entering those waters;
2) The really rich person likely became really rich because they demonstrated a shrewd understanding of the markets -- therefore, who is the low-six-figure-or-less-earning pundit to challenge such high-yielding wisdom;
3) Most pundits refuse to admit that they don't understand something that reads like gobbledgook, because they're afraid this makes them look like an idiot.
Well, your humble blogger has never been afraid of looking like an idiot... which brings me to PIMCO's Bill Gross. I'll occasionally read his monthly newsletter when a link to it pops up in my Twitter feed. Every time, I'm amazed at the florid, rambling, not-really-related-to-his-main-point way he opens these little essays. Sometimes I find the analysis afterwards useful, sometimes I find it eerily similar to what someone says after spending too much time with Tom Friedman. I gather he's had better years as an analyst than he did in 2011, but everyone has down years and bad predictions.
Here's the thing, though -- I can't understand a word of his latest Financial Times column: Here's how it opens:
Isaac Newton may have conceptualised the effects of gravity when that mythical apple fell on his head, but could he have imagined Neil Armstrong’s hop-skip-and-jumping on the moon, or the trapping of light inside a black hole? Probably not. Likewise, the deceased economic maestro of the 21st century – Hyman Minsky – probably couldn’t have conceived how his monetary theories could be altered by zero-based money.
Things get a little clearer towards the end of the op-ed... but not much. His February 2012 newsletter appears to be an expanded version of this op-ed (plus the usual wacky opening), so let's go there to see what he's trying to say:
[W]hen rational or irrational fear persuades an investor to be more concerned about the return of her money than on her money then liquidity can be trapped in a mattress, a bank account or a five basis point Treasury bill. But that commonsensical observation is well known to Fed policymakers, economic historians and certainly citizens on Main Street.
What perhaps is not so often recognized is that liquidity can be trapped by the “price” of credit, in addition to its “risk.” Capitalism depends on risk-taking in several forms. Developers, homeowners, entrepreneurs of all shapes and sizes epitomize the riskiness of business building via equity and credit risk extension. But modern capitalism is dependent as well on maturity extension in credit markets. No venture, aside from one financed with 100% owners’ capital, could survive on credit or loans that matured or were callable overnight. Buildings, utilities and homes require 20- and 30-year loan commitments to smooth and justify their returns. Because this is so, lenders require a yield premium, expressed as a positively sloped yield curve, to make the extended loan. A flat yield curve, in contrast, is a disincentive for lenders to lend unless there is sufficient downside room for yields to fall and provide bond market capital gains. This nominal or even real interest rate “margin” is why prior cyclical periods of curve flatness or even inversion have been successfully followed by economic expansions. Intermediate and long rates – even though flat and equal to a short-term policy rate – have had room to fall, and credit therefore has not been trapped by “price.”
Even if nodding in agreement, an observer might immediately comment that today’s yield curve is anything but flat and that might be true. Most short to intermediate Treasury yields, however, are dangerously close to the zero-bound which imply little if any room to fall: no margin, no air underneath those bond yields and therefore limited, if any, price appreciation. What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount. Duration risk and flatness at the zero-bound, to make the simple point, can freeze and trap liquidity by convincing investors to hold cash as opposed to extend credit (emplases in original).
And... sorry, I still don't get it. I get why zero interest rates are bad for bondholders like PIMCO. I get that flat yield curves + high amounts of economic uncertainty = cash hoarding. What I don't get is that:
A) Gross himself acknowledges that the yield curve ain't flat;
B) Low interest rates allow for private-sector deleveraging, which is a prelude to stimulating market demand;
C) Low interest rates prevent today's government binge from being even more expensive than it would be in normal times (by keeping financing costs down);
D) If uncertainty is decreasing -- and that appears to be the case with the U.S. economy -- then low interest rates should spur greater entrepreneurial investments.
So, at the risk of threatening my status in the International Brotherhood of Serious Global Political Econmy Bloggers That Talk Seriously About Economics, I hereby ask my commenters to explain Bill Gross' concerns to me. Because I don't get it -- and I'm beginning to wonder if I'm not the only one.
It's been a busy week for Iran-watchers. The European Union is mulling a phased-in oil embargo, prompting Iranian officials to label the move as "an economic war" against Iran. Now Iran's Asia customers are trying to diversify away from Iranian oil. These expectations of future cutoffs, combined with pre-existing sanctions, are taking their toll on the Iranian economy in the form of dollar-hoarding and a free-falling national currency. Fareed Zakaria sums up the current state of play nicely:
[T]he real story on the ground is that Iran is weak and getting weaker. Sanctions have pushed the economy into a nose-dive. The political system is fractured and fragmenting. Abroad, its closest ally and the regime of which it is almost the sole supporter -- Syria -- is itself crumbling. The Persian Gulf monarchies have banded together against Iran and shored up their relations with Washington. Last week, Saudi Arabia closed its largest-ever purchase of U.S. weaponry.…
The Obama administration has put tremendous pressure on Iran on a variety of fronts -- far more pressure than the Bush administration was ever able to muster. This is, in part, because the pressure has been brought to bear, wherever possible, with other countries. The United States does not buy oil from Iran. But European nations, Japan and South Korea do, and if they go along with a new round of sanctions, Iran faces the real prospect of an economic freefall.
Iran's response to these moves has been a mixture of tough talk, empty gestures, backtracking on threats, and an acknowledgment of economic difficulties. It's therefore no wonder that the Washington Post reports, "U.S. officials are increasingly confident that economic and political pressure alone may succeed in curbing Iran's nuclear ambitions." Walter Russell Mead observes that, "public opinion in Iran does not seem to be rallying behind its unpopular government as the economic storm intensifies."
At the same time, however, Iran is trying to demonstrate that its uranium enrichment will continue unabated. Trita Parsi argues that overconfidence in the sanctions track will cause the Obama administration to rebuff any negotiated breakthrough on the nuclear issue. This leads to the obvious question: What's the endgame in Iran? Will sanctions "work"?
To get Clintonian, this depends on your definition of "work." One could argue that the current and projected actions taken by the EU and Pacific Rim might have been a wake-up call to Tehran that it's more isolated than it had previously thought. Iran is not merely facing the United States; it's facing a multilateral coalition that's growing stronger, not weaker. Unless potential benefactors like China take proactive steps to function as a "black knight," these sanctions really will cripple Iran's economy. The alienation of Iran's bazaari from the leadership in Tehran would ... let's say complicate the domestic situation in Iran.
That said, I'm skeptical that it will push the current regime toward making a substantive accommodation on its nuclear program. Based on how the leadership has treated domestic unrest, it seems clear that the top leadership is perfectly comfortable following The Dictator's Handbook approach to staying in power. More-powerful sanctions will therefore simply lead to more-powerful crackdowns. If Iranian elites view the nuclear program as the key to preventing outside attempts at forcible regime change, there's no way they'll compromise.
So would negotiation work? I'm skeptical here too. In part the problem is determining whether the Iranians are capable of negotiating in good faith. I don't mean that Tehran will act duplicitously; I mean whether the fractious regime can act in a coherent manner. Its behavior over the past week or two suggests otherwise. So does Zakaria:
The Obama administration seems to have concluded that the Iranian regime is not ready or able to make a strategic reconciliation with the West. The regime is too divided and Ayatollah Ali Khamenei, the ultimate authority, the Supreme Leader, is too ideologically rigid. So for now Washington wants to build pressure on Iran in the hopes that this will force the regime into serious negotiations at some point.
I suspect the Obama administration's hopes are more ambitious. They want the sanctions to be so crippling that Khamenei's ultimate authority comes under challenge, to the point where factional divisions open up space for a substantive change in the regime.
This might work, but I'd put the odds of this happening at less than 1 in 3. Still, this is the thing about instances in which economic sanctions are deployed. Even if their prospects don't look great, they're usually employed because the other options have even worse odds. For the next, say, six months, pursuing this course of action makes sense. It weakens Iran at a key moment in the Middle East, and it might lead to some positive developments down the road. That said, even if the sanctions work in crippling Iran's economy, they likely won't work at altering Iran's objectionable nuclear policies -- the expectations of future conflict are too great. At that point, the United States is going to need to consider whether it's prepared to pursue a longer-term containment strategy or alter course.
What do you think?
Yesterday, in commenting on the eurozone crisis, Barack Obama said the two words all political scientists hate to see:
"Europe is wealthy enough that there's no reason why they can't solve this problem," Obama told reporters at the White House.
"If they muster the political will, they have the capacity to settle markets down, make sure that they are acting responsibly and that governments like Italy are able to finance their debt." (emphasis added)
By and large, political scientists hate the concept of political will. As I've said numerous times on the blog, "political will" is usually tantamount to saying, "if only politicians would completely ignore short-term political incentives and do the right thing!" Or, to put a finer point on it, "if only politicians stopped acting like politicians!" Because we as a profession tend to focus on structural forces and immutable preferences, "leadership" as a variable often (though not always) falls by the wayside.
Looking at the latest EU summit/eurozone machinations, however, I'm beginning to wonder if we need to think about "first image" explanations for what just happened. As the Wall Street Journal, Felix Salmon, Financial Times, Paul Krugman, and Economist are all reporting, it was pretty friggin' disastrous. Salmon provides the most complete autopsy -- here's a snippet:
[A]nother half-baked solution is exactly what we got. Which means, I fear, that it is now, officially, too late to save the Eur ozone: the collapse of the entire edifice is now not a matter of if but rather of when.
For one thing, fracture is being built into today’s deal: rather than find something acceptable to all 27 members of the European Union, the deal being done is getting negotiated only between the 17 members of the Euro zone. Where does that leave EU members like Britain which don’t use the euro? Out in the cold, with no leverage. If the UK doesn’t want to help save the euro — and, by all accounts, it doesn’t — then that in and of itself makes the task much more difficult.
But that’s just the beginning of the failures we’re seeing from European leaders right now. It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.
The fundamental problem is that there isn’t enough money to go around. The current bailout fund, the European Financial Stability Facility, is barely big enough to cope with Greece; it doesn’t have a chance of being able to bail out a big economy like Italy or Spain. So it needs to beef up: it needs to be able to borrow money from the one entity which is actually capable of printing money, the European Central Bank.
But the ECB’s president, Mario Draghi, has made it clear that’s not going to happen. Draghi is nominally Italian but in reality one of the stateless European technocratic elite: a former vice chairman and managing director of Goldman Sachs, he’s perfectly comfortable delivering Italy the bad news that he’s not going to lend her the money she needs. He’s very reluctant to lend it directly, he won’t lend it to the EFSF, and he won’t lend it to the IMF. Draghi has his instructions, and he’s sticking to them — even if doing so means the end of the euro zone as we know it.
So, what explains this mess -- the inexorable structural problems of the European Union, or the lack of political leadership? At this point, I'm genuinely uncertain. For example, the facile explanation for British Prime Minister David Cameron's rejection of an EU treaty is catering to his domestic interests -- namely the British financial sector. Then, however, we get to this bit from the Economist:
After much studied vagueness on his part about Britain's objectives, Mr Cameron's demand came down to a protocol that would ensure Britain would be given a veto on financial-services regulation (see PDF copy here. The British government has become convinced that the European Commission, usually a bastion of liberalism in Europe, has been issuing regulations hostile to the City of London under the influence of its French single-market commissioner, Michel Barnier. And yet strangely, given the accusation that Brussels was taking aim at the heart of the British economy, almost all of the new rules issued so far have been passed with British approval (albeit after much bitter backroom fighting). Tactically, too, it seemed odd to make a stand in defence of the financiers that politicians, both in Britain and across the rest of European, prefer to denounce....
Britain may assume it will benefit from extra business for the City, should the euro zone ever pass a financial-transaction tax. But what if the new club starts imposing financial regulations among the 17 euro-zone members, or the 23 members of the euro-plus pact? That could begin to force euro-denominated transactions into the euro zone, say Paris or Frankfurt. Britain would, surely, have had more influence had the countries of the euro zone remained under an EU-wide system.
As for Merkel, well, my take on her leadership style has been documented already. She's dealing with an opposition that is castigating her for not taking swifter and more drastic action to resolve the eurocrisis. In response, she's pushing for changes that will take months, if ever, to accomplish -- and, if they are accomplished, have no guarantee of actually solving the problem. It doesn't seem like the eurozone has that time.
As for Draghi, well, one could attribute his range of half-hearted measures to his excessively cautious leadership -- after all the ECB is an ostensibly independent institution, so presumably Dragh has the greatest amount of autonomy. It's not that simple, however -- Draghi wouldn't have been selected as the new ECB head unless he demonstrated the kind of policy traits that made him acceptable to Germany in the first place. Oddly enough, although Draghi currently has the most freedom of action, the structures that ensured he would become the new ECB head ensured he would be the least likely person to exploit that freedom.
So, stepping back, there appears to be a role for the quality of political leadership as an explanatory factor for the current eurozone crisis. Properly defining that role, however, is beyond the capacity of this blog post.
What do you think?
Hey, remember when about ten days ago I blogged that things were getting so bad in Europe that it was legitimate to bring up the 1930's? What's happened since that seemingly hyperbolic warning?
As Felix Salmon blogged earlier this week, the European banking system is headed towards a full-blown liquidity crisis. Yields on Spanish and Italian debt are hovering around the 7% mark, which was the tipping point that forced Greece, Ireland and Portugal to seek assistance from the European Financial Stability Facility and the IMF. Multiple European countries, including France, have had difficulty completing bond auctions this week.
So it would seem that the European Central Bank needs to do something. The New York Times, Wall Street Journal, and Financial Times all have lead stories today pointing out the enormous pressures that are being put on the European Central Bank this week. We'll excerpt the non-gated NYT story to set things up:
Only the fiercely conservative stewards of the European Central Bank have the firepower to intervene aggressively in the markets with essentially unlimited resources. But the bank itself, and its most important member state, Germany, have steadfastly resisted letting it take up the mantle of lender of last resort....
At issue is whether the bank has the will — or the legal foundation — to become a European version of the Federal Reserve in the United States, with a license to print money in whatever quantity it considers necessary to ensure the smooth functioning of markets and, if needed, to essentially bail out countries that are members of the euro zone.
Traditionally, and according to its charter, the European bank has viewed its role in much narrower terms, as a guardian of the value of the euro with a mission to prevent inflation. But as market unease has spread over the past two years, critics say the bank’s obsession with what they say is a phantom threat of inflation has stifled growth and helped bring the euro zone to the edge of a financial precipice.
With events threatening to spin out of control, the burden now rests on Mario Draghi, an inflation fighter in the president’s job at the bank barely two weeks who surprised many economists by immediately cutting interest rates a quarter point.
This morning, however, in his first speech as the head of the ECB, Draghi pivoted and redirected the pressure back at the politicial stewards of the EU:
National economic policies are equally responsible for restoring and maintaining financial stability. Solid public finances and structural reforms – which lay the basis for competitiveness, sustainable growth and job creation – are two of the essential elements.
But in the euro area there is a third essential element for financial stability and that must be rooted in a much more robust economic governance of the union going forward. In the first place now, it implies the urgent implementation of the European Council and Summit decisions. We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?
The truly scary thing is that, given the state of the Italian and Spanish bond markets, even the full EFSF won't be enough to calm markets down.
And so the pressure gets redirected back to Germany, as the most powerful actor in the ECB and EU. As Matthias Matthijs and Mark Blyth explain in Foreign Affairs, however, Germany has not been reading its Charles Kindleberger:
In order to guarantee the strength of any international economic system, Kindleberger explained, a stabilizer -- only one stabilizer -- needs to provide five public goods: a market for distress goods (goods that cannot find a buyer), countercyclical long-term lending, stable exchange rates, macroeconomic policy coordination, and real lending of last resort during financial crises. The United States did not supply these things in the 1930s. Germany fails the test on all five items today.
First, rather than providing peripheral countries with a market for their distress goods, the Germans have been enthusiastically selling their manufactured goods to the periphery. According to Eurostat, Germany's trade surplus with the rest of the EU grew from 46.4 billion euro in 2000 to 126.5 billion in 2007. The evolution of Germany's bilateral trade surpluses with the Mediterranean countries is especially revealing. Between 2000 and 2007, Greece's annual trade deficit with Germany grew from 3 billion euro to 5.5 billion, Italy's doubled, from 9.6 billion to 19.6 billion, Spain's almost tripled, from 11 billion to 27.2 billion, and Portugal's quadrupled, from 1 billion to 4.2 billion. Between 2001 and 2009, moreover, Germany saw its final total consumption fall from 78.5 percent of GDP to 74.5 percent. Its gross savings rate increased from less than 19 percent of GDP to almost 26 percent over the same period.
Second, instead of countercyclical lending, German lending to the eurozone has been pro-cyclical. Indirectly (through buying bonds) and directly (by spreading its exchange rate through the euro), the country has basically given the periphery the money to buy its goods. During the economic boom of 2003-2008, Germany extended credit on a massive scale to the eurozone's Mediterranean countries. Frankfurt did quite well for itself. "European Financial Linkages," a recent IMF working paper, reveals that in 2008, Germany was one of the two biggest net creditors within the eurozone (after France). Its positive positions were exact mirrors of Portugal, Greece, Italy, and Spain's negative ones. Of course, as the financial crisis began to escalate in 2009, Germany abruptly closed its wallet. Now Europe's periphery needs long-term loans more than ever, but Germany's enthusiasm for extending credit seems to have collapsed.
And what about the third public good, stable exchange rates? By definition, the euro gives the countries that choose to join it a common external float, the credibility that comes with banking in a potential global reserve asset, and the credit rating of its strongest member. This is both true and where the problems begin. At the core of the eurozone lies a belief that, if countries adhere to a set of rules about how much debt, deficit, and inflation they can have, their economies will converge, and the same exchange rate will work for all members. This is true in theory, but only so long as countries obey the rules. And, despite being the author of many of those rules, Germany showed a singular lack of leadership and responsibility when it came to following them. When it broke the Stability and Growth Pact (SGP) in 2003, it sent the signal to the smaller countries that fiscal profligacy would go unpunished. The result was heightened public sector borrowing and increased public spending. Germany's enthusiastic lending to the periphery only exacerbated the problem.
Fourth, economic health requires the stabilizer to coordinate macroeconomic policy within the system. In this domain, Germany failed spectacularly, by insisting that the rest of the world follow its peculiar ordoliberal economic philosophy of export-oriented growth. By ignoring long-established ideas such as the Keynesian "paradox of thrift" or the "fallacy of composition," Germany is advocating a serious dose of austerity in the European periphery without even a hint of offsetting those negative economic effects with stimulus or inflationary policies at home. German growth, after all, was partially fueled by demand in Southern Europe (made possible by excess German savings). By the iron logic of the balance of payments, one country's exports are another country's imports and one country's capital inflows are another's capital outflows. So, the eurozone as a whole cannot become more like Germany. Germany could only be like Germany because the others countries were not. Insisting on ordoliberal convergence is guaranteed to produce economic instability, not stability.
Finally, Kindleberger would want Germany -- or, rather, the ECB, which is dominated by Germany -- to act as a lender of last resort by providing liquidity during the current crisis. Germany instead insisted on IMF conditionality for the bailout countries and on severe fiscal austerity measures in exchange for limited liquidity, thus failing Kindleberger's final test. The most obvious example is German obstinacy against letting the ECB play the role that the Federal Reserve played in the United States in 2008 and 2009. By lending heavily, the Fed was able to arrest the United States' slide into despair. Only a couple of days ago, Jens Weidmann, the president of Germany's powerful Bundesbank, flat-out rejected the idea of using the ECB as "lender of last resort" for governments, warning that such steps "would add to instability by violating European law." It is hard to see how yet one more violation of European code will add significantly to the already horrendous levels of instability, when brushing democracy aside is considered good for the euro.
It looks as if there's a plan in the works for the ECB to do a legal end-around by loaning money to the IMF and then having the Fund loan to the GIIPS economies. If that happens, however, it won't be announced until next month. And the way credit markets are playing out right now, I'm not sure the eurozone has that much time.
Now is usually the point in the post at which the instinct to provide some sweeping narrative about the state of the eurozone -- a la David Brooks -- is very compelling. What's the point, however? The eurozone is in contagion mode right now, which means it doesn't matter which countries were virtuous and which countries weren't during the last decade of binge borrowing. They're all on the same sinking ship, and the Merkel Algorithm seems to be playing out again.
Developing.... in a way that truly scares the living crap out of me.
I swear, I wasn't going to watch tonight's CNBC debate on economic policy. I'd had a long day, I was tired, and Wednesday night at the Drezners we watch The Middle and Modern Family. But since neither of those shows were on the air tonight, I switched over to the debate.
While Rick Perry's major league gaffe will command all the headlines, I thought the most reealing answers were given to the first question of the night -- what to do about Italy? Here are the responses of the co-frontrunners:
HERMAN CAIN: "There's not a lot that the United States can directly do for Italy right now, because they have -- they're really way beyond the point of return that we -- we as the United States can save them."
MITT ROMNEY: "Well, Europe is able to take care of their own problems. We don't want to step in and try and bail out their banks and bail out their governments. They have the capacity to deal with that themselves."
The responses by Ron Paul, Rick Perry and Jon Huntsman were similar in tone and content.
Now, philosophically, there's a logic to these answers, avoiding moral hazard and all. But recall how earlier this week conservatives were castigating Barack Obama for giving Western Europe the cold shoulder? I believe Michael Goldfarb phrased it as a problem of Obama "abandoning allies."
I raise this because, if the eurozone actually did need American help, the response by the GOP candidates for president would be to... abandon America's allies.
One of Richard Nixon's saltier lines on foreign economic policy was, "I don't give a f**k about the lira." I think it's safe to say that the current GOP doesn't give a f**k about the euro.
The National Journal's Jim Tankersley frames this exactly right:
Europe’s problems should absolutely terrify anyone who cares about the American economy; its sovereign debts could infect banks around the world, potentially triggering a new wave of financial crisis, and a European recession would drag on already slow U.S. growth.
But the candidates who assembled at the CNBC debate in Detroit treated those threats as a far-away nuisance, like famine in Africa or an earthquake in Mongolia: very serious, very sad, not our problem....
It’s stunning that a Republican field that includes a former ambassador, a former House speaker and two successful former businessmen – and which, to a candidate, gushed over the virtues of markets throughout the debate – so casually brushed aside the struggles of the world’s largest collective economy (the Eurozone is bigger, economically, than the United States) and America’s largest trading partner.
You don’t have to believe America should bail out Italy, Greece or the entire Eurozone – a straw-man concept that no one in Washington is even floating, but several candidates took pains to denounce on Wednesday night – to recognize that the United States has a role to play in averting another global financial crisis. At the very least, you should expect lawmakers, and presidential candidates, to be making plans for how to respond if the European crisis escalates.
There were no such plans to be found on the debate stage on Wednesday.
At 8:30 this morning U.S. Secretary of State Hillary Clinton will give "a major address on the role of economics in our foreign policy." This speech is the culmination of a series of Clinton speeches and papers over the past few months, including her July remarks in Hong Kong, her essay on America's Pacific Century in the pages of FP, and her remarks on global leadership earlier this week.
A key precept in Clinton's effort is addressing a kind of cultural lag in the sprawling Washington bureaucracy. Lead policy makers may recognize the pivotal role that economics plays in global diplomacy--but in many ways, the diplomatic bureaucracy needs to catch up. Clinton's planned speech will be in large part a call to her own agency's ambassadors, diplomatic staff and analysts to shift their thinking.
And as Clinton lays out that vision in more detail, she will stress two main bulwarks. First, she will highlight the need to advance relations with the wider world as part of the effort to revive the American domestic economic order. And second, she will stress that State Department diplomats and foreign policy thinkers need to work harder to understand how market forces are driving first-order national security challenges in hot spots such as Afghanistan, Iraq and Iran.
Now, as I noted last week, my full disclosure here is that I've seen multiple draft versions of this speech and might have made a modest suggestion or two (because you, dear readers, know how gentle I am with the red pen). Last week, I was pretty pessimistic about the effect of this kind of initiative:
I fear that the State Department is fighting through hurricane-level winds on this front to make a difference. First, the trade deals just sent to Congress are the last ones we're going to see for a while. Doha is dead, the Trans-Pacific Partnership still hasn't materialized, and all of the momentum on trade policy is to move towards
futile gesturesclosure. The dynamic, growing economy is not looking so dynamic, and those deep capital markets are getting extremely jittery.
And this week? Oddly, I find myself more on the "glass half full" side, for a few reasons. First, Congress finally cleared the decks on the three outstanding trade deals, so that looks a bit less embarrassing. Second, there does appear to be genuine enthusiasm inside the administration for the Trans-Pacific Partnership, and a recognition that this would be a neat-o deliverable for the upcoming APEC summit in Honolulu. Third, my own conversation with State Department officials suggest that they've got a decent read on which geographic regions should be the focus of which initiatives. Fourth , dwindling resources doesn't mean no resources -- the U.S. still has some formidable foreign economic policy arrows in its quiver.
The most important reason I'm more optimistic, however, is that the Secretary will be doing two things with this speech that speeches can actually accomplish. A speech can act as a form of reassurance to other countries that the United States gets it -- economics is a vital component of foreign policy, and Washington is ready to play.
A speech can also signal to the foreign policy bureaucracy that there's a shift in priorities, and they had better get on the train if they want to
get promoted make a difference. If foreign service officers see that a familiarity with economics is a key for advancement, then the United States will develop a diplomatic corps that doesn't run away screaming in terror seem distracted if the words "exchange rates" or "geographic indicators" are uttered.
Watch the speech yourself -- it will be webcast at 8:30 AM -- and let me know what you think in the comments.
While Occupy Wall Street has been garnering many headlines with outrage about the financial sector, the Bank of International Settlements just released a paper that's likely to have more actual impact on said financial sector. The paper is an effort to estimate the costs and benefits from requiring global systemically important banks (G-SIB's) to increase their capital buffers. From the executive summary:
[R]aising capital requirements on the top 30 potential G-SIBs by 1 percentage point over eight years leads to only a modest slowdown in growth. GDP falls to a level 0.06% below its baseline forecast, followed by a recovery. This represents an additional drag on growth of less than 0.01 percentage points per year during the phase-in period. The primary driver of this macroeconomic impact is an increase of lending spreads of 5-6 basis points. Soon after implementation is complete, growth is forecast to be somewhat faster than trend until GDP returns to its baseline. The aggregate figures conceal significant differences across countries, which reflect differences in the role of G-SIBs in the domestic financial system and in current levels of bank capital buffers. International spillovers are also important, and in some countries are likely to be the dominant source of macroeconomic effects.
The overall results are robust to variations in key assumptions. Using a longer list of banks, scaling by assets rather than lending, shortening the implementation period, or limiting the ability of authorities to offset slower growth with monetary or macroprudential policy were all found to increase the growth impact, but not markedly.
What will be the effect of the full package of the Basel Committee's proposals for stronger capital requirements - the set of buffers that will be required of all banks under Basel III, combined with the additional buffers to be carried by G-SIBs? The impact of the Basel III proposals, using the end-2009 global capital levels as a starting point, was calculated by the MAG [Macroeconomic Assessment Group] in 2010. On top of this, we assume for illustrative purposes that the top 30 G-SIBs will need to raise their capital ratios by an additional 2 percentage points, and that both parts of the reform are implemented over eight years. Adding together these two components, we find that the impact is again quite small, with GDP at the point of peak impact forecast to have fallen 0.34% relative to its baseline level. Roughly 0.04 percentage points are subtracted from annual growth during this period, while lending spreads rise by around 31 basis points. As before, different assumptions lead to different effects, with faster implementation or a weaker monetary policy response increasing the impact on GDP.
The benefits of the G-SIB framework relate primarily to the reduction in the exposure of the financial system to systemic crises that can have long-lasting effects on the economy. The LEI estimated the benefits of Basel III by multiplying the degree to which it reduces the annual probability of a systemic crisis, by an estimate of the overall cost of a typical crisis in terms of lost output. Drawing on the [Basel Committee Long-term Economic Impact Study's] results, the MAG estimated that raising capital ratios on G-SIBs could produce an annual benefit in the order of 0.5% of GDP, while the Basel III and G-SIB proposals combined contribute an annual benefit of up to 2.5% of GDP - many times the costs of the reforms in terms of temporarily slower annual growth.
Let me just translate how the BIS would put this to a lay audience:
Hey, you know how Jaime Dimon and all the other bankers who contribute to the Institute for International Finance, American Bankers Association, and Financial Services Forum keep saying that raising their capital requirement is "anti-American" and will lead to catastrophic economic consequences? Yeah, well, they don't know what the f**k they're talking about. Raising their capital requirements causes a extremely small dip in expected growth -- and by small we mean less than one tenth of one percent of GDP. This is massively outweighed by preventing the expected lost output that would result from recessions triggered by another financial crisis.
Now, it's not terribly surprising that global regulators will say that they're right and the banks are wrong. One would expect that the interest group power of Wall Street, however, would have the upper hand. What is surprising, as the Wall Street Journal's Sara Schaefer Munoz notes, is that the banks seem to be losing their battle with regulators:
The tug-of-war between banks and regulators over post-crisis financial rules has so far moved in the watchdogs' favor with banks largely failing to upend the tougher proposals in the U.S. and Europe....
Even before Monday's report, regulators didn't seem responsive to the industry's arguments. In the U.S., lawmakers have already determined that the country's big banks must hold more capital, but haven't yet specified how much.
The Dodd-Frank financial overhaul law, enacted more than a year ago, mandated many new restrictions on banks but left it to regulatory agencies to write the rules. Wall Street and the financial industry have spent millions of dollars lobbying to shape the rules, with little success so far.
They lost in their efforts to block new limits on the fees they can charge merchants when consumers use debit cards. Regulators are expected to vote Tuesday to issue a proposed "Volcker Rule," a part of the Dodd-Frank law designed to curtail trading activities at bank. Now they appear likely to fail in their efforts to block or water down a rule requiring them to hold extra capital.
In 2010, securities and investment firms spent a record $101.6 million on lobbying, up from $92.3 million in 2009, according to the Center for Responsive Politics. Through early October 2011, the firms had shelled out $49.5 million.
There are plenty of ways in which large banks can continue to fight the suggested rules, particularly on the implementation side. Still, this is not how open economy politics traditionally works. Traditionally, bank preferences are communicated to national governments, which then get expressed in BIS/Basle Committee meetings. This certainly happened in the actual Basel III negotiations. This kind of back and forth, in which regulators appear to trump the arguments of the financial sector, is highly unusual.
I confidently predict that this post will not generate the kind of comments that, say, an Occupy Wall Street post has in the past week. That's kind of a tragedy, because this ongoing tug of war between the BIS and IIF will likely have more far-reaching consequences than anything those protestors achieve.
Yesterday FP alum Laura Rozen detailed the State Department's push to have economic statecraft to the front and center of U.S. diplomacy:
[I]n many ways, Hillary Clinton's diplomatic portfolio is increasingly indistinguishable from many of the leading challenges in global economic policy. Trade issues obviously have a direct impact on America's efforts to emerge from the present economic downturn--from the battles over the national debt to the the need to stimulate job growth. But economic issues also shape other less-noted features of the American foreign-policy agenda, be it the effort to contain fallout from Europe's debt crisis, to the rise of major economic powers such as China, Brazil, Turkey and India—all of whom come bearing their own foreign policy ambitions....
So Hillary Clinton has been working hard to beef up the economic bench strength of the State Department, while also mounting a bid for State officials to play a more decisive role in determining U.S. global economics policy. Aides expect her to lay out what they are calling the "Clinton doctrine on economic statecraft" early this month, likely in a speech in New York. Timing and venue for the address are still being worked out, her aides say.
"This is coming from a sense that we are seeing the lines between national security and economic security blur as emerging powers are doing more to advance their economic power, and fitting their national security strategy is more about economic interest," the State Department adviser told the Envoy Friday....
"As we pursue recovery and growth, we are making economics a priority of our foreign policy," Clinton said at the International Institute for Strategic Studies-Shangri La conference in Hong Kong in July. "Because increasingly, economic progress depends on strong diplomatic ties and diplomatic progress depends on strong economic ties. And so the United States is working to harness all aspects of our relationships with other countries to support our mutual growth."
Full disclosure: State Department officials have reached out to your humble blogger
in a sign of true desperation to talk about ways in which economics should be integrated into American foreign policy. Don't panic -- I know that they're talking to smarter people than I as well.
Economic statecraft is only as useful as the economic power that fuels such statecraft -- namely, the attraction of possessing a large, dynamic, growing economy for imports, deep capital markets, provisions for foreign assistance, and a model of economic development that looks attractive to others. Now, getting Congress to vote on negotiated-long-ago trade deals is certainly a step in the right direction. Talking about Russian entry into the WTO is also constructive.
On the other hand.... I fear that the State Department is fighting through hurricane-level winds on this front to make a difference. First, the trade deals just sent to Congress are the last ones we're going to see for a while. Doha is dead, the Trans-Pacific Partnership still hasn't materialized, and all of the momentum on trade policy is to move towards
futile gestures closure. The dynamic, growing economy is not looking so dynamic, and those deep capital markets are getting extremely jittery.
Finally, there's foreign aid -- which brings us to this New York Times front-pager by Steven Lee Myers:
America’s budget crisis at home is forcing the first significant cuts in overseas aid in nearly two decades, a retrenchment that officials and advocates say reflects the country’s diminishing ability to influence the world....
The financial crunch threatens to undermine a foreign policy described as “smart power” by President Obama and Secretary of State Hillary Rodham Clinton, one that emphasizes diplomacy and development as a complement to American military power. It also would begin to reverse the increase in foreign aid that President George W. Bush supported after the attacks of Sept. 11, 2001, as part of an effort to combat the roots of extremism and anti-American sentiment, especially in the most troubled countries.
Given the relatively small foreign aid budget — it accounts for 1 percent of federal spending over all — the effect of the cuts could be disproportional. (emphasis added)
It's striking to see Myers be that blunt in his assessment of the effects of these budget cuts. Look, foreign aid is far from a panacea, but one has to think of these forms of economic statecraft as spending on preventing rather than curing ailments in American foreign policy. As a general rule, the former is far cheaper than the latter. The latter also tends to involve a much greater allocation of blood and treasure. I know why foreign aid is the first item on the chopping block -- unlike military spending, it doesn't go to Congressional districts -- but let me go on record as saying this is a stupid own-goal by both Democrats and Republicans in Congress. Even if one buys the need for fiscal austerity, there's a lot more waste in the Pentagon than the State Department.
So American economic power looks set to wane, and the Amerian model of political economy seems broken. On the one hand, this is not a strong foundation upon which to build a more effective economic statecraft. On the other hand, this is precisely the moment during which policymakers need to think about how to be more efficient with America's still-impressive reservoirs of economic strength.
Consider the comments below as a suggestion box -- what would you recommend the State Department do to improve upon American economic diplomacy?
After last night's stunningly useless set of speeches, I'd put the odds of the U.S. not raising the debt ceiling by August 2nd at 1 in 2. Like many other observers, I'm finding it increasingly difficult to envision a deal that would get through the Senate while attracting a majority of House Republicans [You meant a majority of the House of Representatives, right?--ed. No, I meant a majority of House Republicans. I'm pretty sure that Boehner and the rest of the House GOP leadership will refuse to pass any debt ceiling plan that relies too much on House Democrats.]
So, it's gonna be a fun few weeks for those of us who study the global political economy. Let's start by thinking the unthinkable -- what will happen if there is a default?
I've expressed my feelings on the matter already, and I'm hardly the only one. That said, I've also
hedged my bets been flummoxed by the lack of market reaction to the DC stalemate. The lack of market reaction to date has emboldened House GOP members to stand fast. Could they be right?
Tom Oatley, who pooh-poohed my fears of the debtpocalypse last week, makes an interesting point about the composition of U.S. debt-holders:
By these figures, about 63% of US government debt is owned by central banks (foreign and domestic) and/sovereign wealth funds. Most of these entities are American friends and allies. Another 4% is owned by US state and local governments. That leaves 33%--about $4.8 trillion--in private hands. Of this, the financial institutions with the most restrictive regulations regarding asset ownership (depository institutions) own only 2% of the total ($290 billion). Mutual Funds, who may or may not have to dump downgraded debt, hold another 9% ($1.35 trillion).
What's the point? The discussion about the impact of US default revolves around the market response to default. Useful to recognize that most of the US government debt is held by public-sector agents who are much less sensitive to balance sheet pressures and regulatory constraints. These public sector agents are also substantially more sensitive to "moral suasion" and direct appeal than private financial institutions. The structure of ownership of US debt might dampen the negative impact of any default that does occur.
This is pretty interesting. Oatley focuses on "moral suasion," but there's also a national-interest motive for many U.S. debtholders. Most of the official holders of U.S. debt have a strong incentive for a) the value of their holdings not to plummet; and b) the United States economy to continue to snap up other their exports. If China, for example, is buying up U.S. debt to sustain its own growth, then neither a technical default nor a ratings downgrade should deter China or other export engines from continuing to buy U.S. debt even if there's a spot of trouble.
So it appears that complex interdependence will force America's rivals to continue to hold U.S. debt even after the debtpocalypse!! The United States in the clear, right?
Not so fast. Here are five "known unknowns" I can think of that might complicate Oatley's analysis:
1) What if the creditors form a cartel? In my 2009 paper, this was the one scenario that gave me the heebie-jeebies, because it's the one scenario under which creditors can wring geopolitical gains from debtor states. Any kind of default can act as a focal point moment in which U.S. creditors decide it's time to apply a haircut to American power and influence.
I don't think this is going to happen, because the national interests of American debtholders remain divergent. That said, if U.S. allies interpret default as a signal of U.S. unreliability in times of crisis, then all bets are off.
2) What about the economic nationalism of China? China is the largest foreign debtholder, which gives it a certain agenda-setting power in moments of crisis. There are a lot of compelling reasons why China would decide to try to minimize the economic disruptions . On the other hand, there's a lot of resentment on Chinese Internet boards already about the Chinese purchases of U.S. debt. During a period in which the CCP is already concerned about domestic instability, one could envision a scenario whereby they try to mollify nationalists at home by acting out against the United States.
3) What would be the effect of a mild market reaction on the House of Representatives? The less the markets react, the less that the House GOP will feel a need to do anything. There will come a point, therefore, when official debtholders might need to signal to the House that, in IPE lingo, "s**t needs to get done." That signal would in and of itself roil markets, not to mention the effects the current uncertainty is already having on the real economy.
4) What is the fiscal shock from a default? There are two causal mechanisms through which a default could affect the global economy. The first is through panic and uncertainty roiling financial markets. The second, however, is from a dramatic fiscal contraction due to limited government spending. Given the lackluster state of the current recovery, it wouldn't take much to tip the United States back into recession.
5) What if there's another AAA bubble? FT Alphaville's Tracy Alloway provided another interesting chart earlier this month on the distribution of AAA securities:
As Alloway warns:
[W]atch what starts happening from 2008 and 2009.
The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply. The turmoil of 2008 shunted some investors from ABS into safer sovereign debt, it’s true. But you also had a plethora of incoming bank regulation to purposefully herd investors towards holding more government bonds, plus a glut of central bank liquidity facilities accepting government IOUs as collateral. Where ABS dissipated, sovereign debt stood in to fill the gap. And more.
It’s one reason why the sovereign crisis is well and truly painful.
It’s a global repricing of risk, again, but one that has the potential for a much largerpop, so to speak.
We know that a downgrade of U.S. Treasuries would likely lead to a downgrade of state and municipal bond ratings as well. We also know that the ripple effects from the collapse of asset-backed securities were much larger than anticipated before the 2008 crisis. This is why the possible knock-on effects of downgrade so many AAA asserts makes me itchy. Even if banks and other financial institutions have minimal exposure to U.S. Treasuries, I don't think it's possible for them to have minimal exposure to all U.S.-based AAA sovereign debt.
These are just the five known unknowns that I could think of in the past hour -- there are probably many, many more. Readers are strongly encouraged to add them in the comments.
For those readers not keeping close tabs on the debt ceiling negotiations currently under way in Washington, here's how each participant views them:
There's been a lot of online debate about this question. Business Insider's Joe Weisenthal thinks this is just a matter of re-election motives, but I don't think it's that simple. As Nate Silver points out, "there is a larger ideological gap between House Republicans and Republican voters than there is between Republican voters and Democratic ones." Furthermore, many of the House GOP freshmen were elected in swing districts, so it's not as if they're representing only ultraconservative portions of the country.
I'd attribute the strategy of the House GOP caucus to two factors. The first is rhetorical blowback. It's simply impossible for elected representatives to say "we're not going to raise the debt ceiling, we're not going to raise the debt ceiling, we're not going to raise the debt ceiling..." and then actually raise the debt ceiling. And they really can't agree to the Mitch McConnell plan of "raise the debt ceiling with no concessions and then blame Obama." They can't agree to any "grand bargain" on austerity because any such bargain would have to include tax increases and there's that darn pledge not to. Politicians do occasionally go back on flat-out pledges not to do something. The example of George H. W. Bush to current GOP House members is not a good one, however. With blowback, it doesn't matter whether a member of Congress really and truly believes what they're saying or whether they can't reverse course without exposing their political backside. They're just as screwed.
The second factor is even simpler: to date the current Tea Party strategy of "no retreat, no surrender" has worked like political gangbusters. Recall that the conventional wisdom in Washington in early 2009 was that the GOP was going to have to be in the wilderness for a couple of election cycles before moderating their positions and winning at the polls again. The exact opposite of that scenario has occurred (see Erick Erickson on precisely this point). The Tea Party movement has been built on uncompromising hardline positions, and has led to significant electoral and political victories. As Joshua Green explains, even the exception proves this rule for Tea Partiers:
Unless and until the Tea Party wing of the GOP pays a political price for its positions, they have zero incentive to change their strategy.
Am I missing anything?
For the past two years, staunch monetarists and economic conservatives have warned about the evils of massive deficit spending and quantitative easing. They have argued that such policy measures are inevitably inflationary and will debase the currency and raise nominal interest rates. By and large, supporters of Keynesian policies have responded by loudly pointing to the data on core U.S. inflation and the dollar's performance as falsifying the conservative argument. And, by and large, they have a point. If inflationary concerns really were prominent, the dollar should have depreciated in value an awful lot, and nominal interest rates should have soared. Neither of these things have happened. Point for Keynesians.
Right now, however, markets are providing a pretty powerful data point for Tea Party supporters who argue that hitting the debt ceiling is not the end of the world. Last week Moody's issued the following warning:
Moody's Investors Service said today that if there is no progress on increasing the statutory debt limit in coming weeks, it expects to place the US government's rating under review for possible downgrade, due to the very small but rising risk of a short-lived default. If the debt limit is raised and default avoided, the Aaa rating will be maintained. However, the rating outlook will depend on the outcome of negotiations on deficit reduction. A credible agreement on substantial deficit reduction would support a continued stable outlook; lack of such an agreement could prompt Moody's to change its outlook to negative on the Aaa rating.
Although Moody's fully expected political wrangling prior to an increase in the statutory debt limit, the degree of entrenchment into conflicting positions has exceeded expectations. The heightened polarization over the debt limit has increased the odds of a short-lived default. If this situation remains unchanged in coming weeks, Moody's will place the rating under review.
Make fun of the ratings agencies all you like, but this was front-page news last week. One would think that markets would be pricing in the possibility of institutional investors diversifying away from dollar-denominated debt, a collapse in the dollar, skyrocketing interest rates, a drastic reduction in nominal GDP, dogs and cats living together, and so forth. Or, as Tim Geithner put it, "catastrophic economic and market consequences."
And yet.... last week, the yield on 10 year Treasuries fell below three percent. Maybe markets are underestimating the likelihood that a debt ceiling deal won't happen, maybe they are underestimating the damage caused by hitting the debt ceiling, or maybe they think the Chinese will continue to buy dollar-denominated debt no matter what happens on the debt ceiling (though read this). Or... maybe the Tea Party activists have a point.
So, my question to readers, investors, and experts on the global political economy -- why aren't markets freaking out more about the rising probability of hitting the debt ceiling?
With all the doings in the Middle East, it's easy to miss developments elsewhere. Let's take a look at Eastern Europe, shall we? Like Belarus, in which the latest developments suggest a uniquely Belarusian path to misery.
The Financial Times' Jan Cienski notes that Greece and Portugal aren't the only European countries looking for a bailout:
Away from frantic negotiations over how to save Portugal and Greece, another peripheral European country is scrambling for a bail-out. But Belarus is looking not to the European Union or the International Monetary Fund but to a grouping of ex-Soviet republics led by Russia.
Vladimir Putin, Russia’s prime minister, flew to Minsk on Thursday to offer Belarus about $3bn in loans over three years from the Eurasian Economic Community, in return for undertaking economic reforms and privatising state companies – which could see Russia take controlling stakes in strategic assets such as oil refineries and pipelines.
“It will help to improve investor sentiment,” said Anastasiya Golovach, an analyst with Renaissance Capital. “But Belarus will definitely have to pay something for this and Beltransgaz [operator of the east-west pipeline shipping Russian natural gas to the EU] will be the price.”
Moscow is relishing Alexander Lukashenko’s discomfort, as the authoritarian leader of Belarus, who has long had a prickly relationship with Russia, endeavours to calm the growing panic surrounding the Belarusian economy.
Belarus has plunged into a balance of payments crisis, with the current account deficit soaring to 16 per cent of gross domestic product and currency reserves dwindling to a month of import cover. The central bank has introduced multiple exchange rates, seeing a collapse in the rouble’s black market rate....
The outlook is gloomy. “We are heading in the direction of Zimbabwe here,” said a foreign diplomat stationed in Minsk.
Note to the Belarusian government: anytime your country is compared to Zimbabwe, you are in Very Big Trouble.
As the article notes, Lukashenko has managed to box himself into a corner. After flirting with the West for a time, a domestic crackdown that intensified in December of last year alienated Germany and the United States, leaving Russia as Lukashenko's only lifeline.
Russia is, not surprisingly, exploiting the situation in a manner remarkably consistent with trends I wrote about in The Sanctions Paradox oh so many years ago. As a scholar, it's always nice to see a model demonstrate its durability. In this case, there's the added frisson of seeing Russia tell others to enact policies that Moscow steadfastly rejected about a decade ago in order to advance Russian interests. And there's something oddly comforting about watching Belarus continue to make policy misstep after policy misstep -- it's the IR equivalent of rooting for the San Diego Clippers.
The downsides are that it prolongs Belarusian misery -- and makes the Visegrad states just a wee bit more jittery.
Your humble blogger has not been
contributing to the Osama-a-thon here at FP blogging all that much, because he was busy being a moosehead attending the 2011 Estoril Conference. Many Important topics were covered at this conference, including:
1) The eurozone crisis;
2) The global governance crisis;
3) The crisis in the Middle East;
4) Other global security challenges;
5) The life and times of Larry King.
It was that kind of conclave.
Actually, that really doesn't do it justice. Here's a link to the opening video. Even that doesn't do it justice -- the opening ceremonies featured a sporano suspended 50 feet in the air, a gospel choir, a drum corps, and what I can only assume are the backup dancers for Lady Gaga's music videos.
For a rundown of what the Big Cheeses said at the conference, check out my Twitter feed. The major substantive takeaway I got from the conference is that Portugal would like to do a serious hurt dance on Fitch, Moody's, and Standard & Poor. Half of the conference presenters were Portuguese, and most of the audience was as well. Here is a sampling of the questions the Portuguese asked anyone talking about anything remotely related to economics:
"Why do the bond rating agencies still influence markets after they failed so badly in 2008?"
"Shouldn't the bond-rating agencies be punished for their malfeasance last decade?"
"Aren't the bond-rating agencies to blame for everything bad that has happened since 2008?"
"What do you think of the idea of creating a European standard-ratings agency?"
"Say, has anyone thought about taking the heads of the bond-rating agencies and putting them in a duffel bag?"
OK, I made that last one up, but not the others.
Obviously, the Portuguese have very good reasons to be stressed out. And the bond-rating agencies deserrve an awful amount of flack. Still, the idea that they -- and they alone -- triggered both the 2008 financial crisis and Europe's sovereign debt crisis is absurd. They are far more the symptom than the cause of the crisis.
More blogging after
my eyes adjust to not seeing Lady Gaga's backup dancers everywhere I turn the weekend.
Last week Reuters' Emily Flitter filed quite the story, entitled "China flexed its muscles using U.S. Treasuries ," about China's financial power over the United States. Here's the opening:
Confidential diplomatic cables from the U.S. embassies in Beijing and Hong Kong lay bare China's growing influence as America's largest creditor.
As the U.S. Federal Reserve grappled with the aftershocks of financial crisis, the Chinese, like many others, suffered huge losses from their investments in American financial firms -- from Lehman Brothers to the Primary Reserve Fund, the money market fund that broke the buck.
The cables, obtained by WikiLeaks, show that escalating Chinese pressure prompted a procession of soothing visits from the U.S.Treasury Department. In one striking instance, a top Chinese money manager directly asked U.S. Treasury Secretary Timothy Geithner for a favor.
This story generated a lot of interest across the mediasphere. FT Alphaville called it "Diplomacy by US Treasuries." AFP reports that the "sensitive cables show just how much influence Beijing has and how keen Washington is to address its rival's concerns."
As someone who's published on this question, you'd think I'd be very happy at the attention this issue is receiving. And Flitter deserves kudos for going through the cables to find clear efforts by Chinese officials to use its financial muscle to get what it wanted from the United States.
The thing is, the reportage is framed to suggest that China not only asked for concessions, but the United States granted them. And Flitter's own story suggests that very little in the way of concessions actually happened.
Here are the portions of Flitter's story that discusses U.S. responses to Chinese pressure:
On Chinese requests to halt/restrict arms sales to Taiwan: Flitter records no response. These concerns were voiced in late 2008 and the arms sales went ahead in early 2010, so there doesn't appear to be much influence here. AFP suggests that this pressure led the U.S. to not sell F-16's to Taiwan, but I don't think that option was ever in the cards.
On Chinese demands that they be provided guarantees for Chinese re-entry into the U.S. repo market:
The U.S. government does not appear to have offered the Chinese a special setup guaranteeing U.S. banks. Instead, the cables show, American diplomats reassured the Chinese by pointing out that Washington had infused banks' balance sheets with $700 billion in fresh capital, effectively propping up the banking system.
On Chinese demands for providing explicit U.S. government guarantees of Fannie Mae and Freddie Mac debt:
To defuse the situation, the Treasury Department sent Undersecretary for International Affairs David McCormick to Beijing for two days in October 2008. The gesture went over well.
"All of Undersecretary McCormick's counterparts appeared to appreciate his willingness to come to Beijing in the midst of a financial crisis," Piccuta wrote in a cable dated October 29, 2008. "Interlocutors stressed that unless leaders' concerns about the viability of banks and U.S. government-sponsored enterprises (GSEs) are assuaged, lower-level officials will be constrained from taking on greater counter-party risks."
The cables show McCormick trying to reassure the Chinese. "In each meeting, Undersecretary McCormick emphasized that even though the U.S. government did not explicitly guarantee GSE debt, it effectively did so by committing to inject up to $100 billion of equity in each institution to avoid insolvency and that this contractual commitment would remain for the life of these institutions," [Deputy Chief of Mission at the U.S. Embassy in Beijing Dan] Piccuta wrote.
On Chinese protests regarding Federal Reserve purchases of Treasuries and agencies in March 2009: Flitter has no response, though the fact that the Fed went ahead with QE2 suggersts that Chinese pressure didn't deter the Federal Reserve.
On responses to Chinese requests that CIC be allowed to participate in bidding on Morgan Stanley's new equity issuance:
There's no record in the cable of how Geithner responded, but it was only a day later, on June 3, that CIC announced plans to purchase $1.2 billion in Morgan Stanley shares.
A spokesperson for the Fed said in the instance of the June 3 CIC investment, no application for an exemption was made to the Federal Reserve Board.
On the general dynamic of Chinese financial pressure:
The cables also indicate a high level of confidence among the Americans that China can't entirely stop buying U.S. debt, a sentiment shared by most economists who describe the dynamic as a form of mutually assured financial destruction.
So, to sum up, the Chinese maybe got a small break on being able to particupate in the Morgan Stanley auction. Beyond that, all of these efforts led to the dilomatiic equivalent of hand-holding and not much else. And, hey, what do you know, that's pretty much consistent with what I wrote about this back in late 2009. So, contrary to some deep-seated fears of mine, the Wikiliaks cables appears to buttress rather than contradict prior scholarship.
Flitter deserves credit for making explicit what had only been inferred, but I'm worried that commentators are drawing the wrong lessons from her article. The big reveal here is not that China tried to exercise its financial muscle. The big reveal is that these efforts generated next to nothing in the way of U.S. concessions. China's financial might does give it the ability to deter U.S. pressure -- but to China's growing frustration, it doesn't yield much else.
Your humble blogger is taking a brief break from teaching and
zombie book-whoring publicizing recently-released research to start work on new research. This requires me to be in Europe for the week. So, for some local color, it's worth asking how things are in the land of the euro, the eurozone, and the eurocracy.
Last year, during the epth of the Greek crisis, I argued that, "When going backwards isn't an option, and muddling through is no longer viable, the only thing left to do is move further along the integration project."
Last week, it seemed that France and Germany had come to the same conclusion. The Guardian's John Palmer provided a cogent summary on the deal that was being negotiated at Friday's European leaders' summit:
Angela Merkel, Nicolas Sarkozy and the other EU chiefs will sound out the parameters of a breakthrough deal which could take the euro area – at the heart of the EU – towards a de facto economic government. The deal will offer massive financial support for countries under the currency market cosh in return for governments accepting that national economic policy in future will first have to secure the broad approval of the rest of the euro area.
[You must be feeling sooooo vindicated right now!!--ed.] Oh, you betcha, got this one right on the money... wait, what's this Financial Times story by Peggy Hollinger and Peter Spiegel saying?
New cracks emerged at a summit of European leaders on Friday, as the prime ministers of several countries raised strong objections to a Franco-German plan that would commit all 17 users of the single currency to co-ordinating their economic policies....
[T]heir initiative triggered a backlash from other European Union leaders anxious to defend their national economic, labour and welfare policies.
In the summit’s concluding communiqué, European leaders also appeared to back off a commitment to give the eurozone’s €440bn bail-out fund new tools to help shore up struggling “peripheral” economies.
An initial version of the conclusions committed the EU to giving the fund more “flexibility” – a code word for new authorities such as buying sovereign bonds of struggling countries on the open market. After extensive debate, that language was taken out, however, and now only binds members to give the fund “necessary effectiveness”, a clear watering-down.
What happened? The Wall Street Journal's Irwin Stelzer explains:
Most countries profess broad agreement of the need for reforms along the lines Germany is demanding. Yet when confronted with the German-French package—the French have always favored some form of centralized economic management of the EU, including strict regulation and heavy taxation of the financial services sector that is centered in Britain—they balked.
Austria, with one of the lowest effective retirement ages in the euro zone, won't go along with an increase in the retirement age. Portugal won't buy into the end of wage indexation with inflation because it wants to offer a sop to public-sector workers whose wages have been cut by 5%. Neither will Belgium, Spain and Luxembourg. All in all, almost 20 countries at Friday's EU summit objected to the Germanization of their countries for one reason or another. So Germany refused to sign on to an increase in the size of the euro-zone bailout fund. "It was truly a surreal summit," commented Yves Leterme, Belgium's prime minister.
Stezler goes on to predict that there will be yet more Euro-muddling as a result of this deadlock. I'm sticking to my original prediction, however. As much as the European periphery dislikes the proposed grand bargain, some form of it will likely be accepted because the alternative outcomes seem even more unappetizing.
According to Bloomberg, Brazilian Finance Minister Guido Mantega would like the real to stop appreciating and for the rest of the world to cooperate on currency matters:
Brazil's real dropped the most in two weeks after Finance Minister Guido Mantega raised taxes on foreign inflows for the second time this month to prevent appreciation and protect exports from what he called a global "currency war."
Brazil, Latin America’s largest economy, raised the so- called IOF tax on foreigners' investments in fixed-income securities to 6 percent from 4 percent. It also boosted the levy on money brought into the country to make margin deposits for transactions in the futures market to 6 percent from 0.38 percent…
"This currency war needs to be deactivated," Mantega told reporters. "We have to reach some kind of currency agreement.” …
Mantega cited the Plaza Accord of 1985, when governments agreed to intervene to devalue the U.S. dollar against the yen and the German deutsche mark, as the kind of agreement that might be required. International policy makers failed to narrow their differences on intervention in currency markets during the International Monetary Fund’s annual meeting this month.
Hey, you know, I bet the G-20 would be a decent forum for Mantega to foster this kind of cooperation. It's a good thing that there's a G-20 Finance Ministers meeting this weekend in Seoul.
Brazilian Finance Minister Guido Mantega will not attend a meeting of Group of 20 member-country finance officials in South Korea this week, a Finance Ministry spokesman said Monday.
The spokesman said Mantega would remain in Brazil while the government studies possible introduction of foreign exchange policy measures to curb the strengthening of the country's currency, the real.
Brazil's government will be represented at the meeting by Finance Ministry International Affairs Secretary Marcos Galvao and Central Bank International Affairs Director Luiz Pereira.
Is this rank hypocrisy by Mantega? Not entirely. It's something worse -- a judgment by Brazil's policy principals that more will be accomplished by staying in Brasilia to stem the tide of inward capital flows than to go to Seoul to seek a multilateral solution to the current lack of macroeconomic policy coordination.
There's plenty of blame to go around on this, but if Brazil thinks the G-20 is not going to accomplish much… then the G-20 is a dead forum walking.
Europe's debt crisis is not going away anytime soon, which means that the crisis over European monetary union won't be going away either. As it turns out, the European Commission is on this, proposing things like "excessive deficit procedures" and the like.
Will this work? Well … let's go to the Economist's explanation for why the previous set of rules failed to prevent this from happening:
The “stability and growth pact” was supposed to limit each country’s budget deficit to 3% of gdp and public debt to 60% of GDP. It failed, in part because France and Germany refused to abide by it -- and even rewrote the rules when they breached the deficit limit.
In contrast, the problems that arose because different economies responded differently to the zone’s common monetary policy were underestimated. The sudden drop in real interest rates on joining the euro in Greece, Ireland and Spain fuelled huge spending booms. (Portugal had enjoyed its growth spurt in the late 1990s in anticipation of euro membership.) Rampant domestic demand pushed up unit-wage costs relative to those in the rest of the euro area, notably in Germany, hurting export competitiveness and producing big current-account deficits.
The euro allowed these internal imbalances to grow unchecked and now stands in the way of a speedy adjustment, because euro-area countries whose wages are out of whack with their peers’ cannot devalue.
So, what is to be done? In the past, European integrationists have been quite adroit at using periods of crisis and malaise to jumpstart further integration efforts. It's possible that this could happen again.
In this case, however, integration efforts are going to be very costly. The Economist explains:
[T]here are three ways for a country to restore competitiveness: devaluation (which reduces wages relative to those in other exporting countries), wage cuts or higher productivity. In the euro area, the first option is out. The other two rely on easing job-market rules so that pay matches workers’ efficiency more closely, and workers can move freely from dying industries and firms to growing ones.
I'm thinking unions will
develop breakout nuclear capabilities aren't going to be big fans of that second option. The third option seems like the ultimate political dream, except it involves eliminating regulations that likely benefit a lot of entrenched interest groups.
Another possibility is greater fiscal centralization. The Economist is not keen on this, but that's besides the point -- as Mary Sarotte points out at Foreign Affairs, there's a Very Important Country that's not going to go along with the move:
The challenge now is governance reform, not expulsion of member states. Reverting to national currencies would drive the values of reissued southern currencies into the ground and the deutsche mark into the sky, thereby undermining Germany's export competitiveness and job market, to say nothing of the collateral damage to the European Union and the single market. The eurozone crisis should not signal the end of the euro but rather the start of a long-overdue overhaul. The idea of a European Monetary Fund, endorsed by Wolfgang Schäuble (an elder statesman from the days of German unification and now a subordinate of Merkel), faded after Merkel dismissed it but deserves broader support. Germany also needs to reconsider its calls for painful fiscal discipline on the part of the weakest countries until their economies regain footing. Ideally, but perhaps not realistically, Merkel should return to previous German form and spearhead a revision of the Maastricht Treaty, leading a fresh effort to do for political union what Kohl and Mitterrand did for monetary union.
The unlikelihood of such a move exemplifies a fundamental problem within the whole European Union: there exists a built-in tension between the lofty goals of integration and member states' collective unpreparedness to think through the consequences of their ambitious project. The great achievement of the past has been to reconcile these contradictory impulses by focusing on practical agreements. It is time to do so once again and realize that the necessary consequence of monetary union is greater political union.
In some ways, what happens from here on out will be an excellent test of whether economic interdependence really alters national incentives. As I blogged a few months ago, "When going backwards isn't an option, and muddling through is no longer viable, the only thing left to do is move further along the integration project."
Of course, the European have spent the past few months muddling through some more. Given current trends, however, that option is going to disappear sooner rather than later.
Daniel W. Drezner is professor of international politics at the Fletcher School of Law and Diplomacy at Tufts University.