Europe: 'Dark clouds on the horizon'

Michael Klein, is the William L. Clayton Professor of International Economic Affairs at the Fletcher School, Tufts University, and a nonresident Senior Fellow in Economic Studies at the Brookings Institution. 

This weekend's meetings of the International Monetary Fund and the World Bank are overshadowed by "dark clouds on the horizon" that threaten the "light recovery blowing in a spring wind," according to Christine Lagarde, the managing director of the IMF.

The main source of the dark clouds is Europe, where recovery remains weak.

More than three years into the crisis, policy options in Europe are limited; fiscal stimulus is out of reach for many countries, and recent efforts by the European Central Bank provided only a temporary respite. In this environment, strong and sustained recovery depends upon rebalancing within Europe, whereby countries' trade imbalances are reduced.

But rebalancing is a two-sided affair. We have all heard the ongoing calls for some European countries to rebalance deficits through painful austerity measures.

Investors to ECB: 1 tillion euros not enough

 

These calls need to be balanced with demands that countries with surpluses also move to rebalance.

In particular, Germany must take advantage of its scope for fiscal expansion to bolster European recovery and to forestall its own slippage towards an economic slowdown.

There are those who argue that the German surplus reflects its productivity growth and labor market reform. These people argue that Germany could only rebalance by stifling its own economic dynamism.
There are three responses to this argument:

Shared rewards: Reforms have made labor markets more flexible in Germany. Innovative policies, such as the Kurzbeit, the short-time working policy, limited the unemployment effects of the crisis.

German unemployment briefly peaked at 8% in July 2009 while the U.S. unempoloyment rate spiked to 10% in October of that year. Despite the soft landing, workers have not fully shared in the benefits of the recovery, and trade unions have been demanding higher wages.

Higher wages for workers would raise their demand for consumer goods, including the products from other euro-area nations.

Shared consequences: German exporters, and German producers of import-competing goods, have benefited from the weak euro.

Since 2008, the German real exchange rate has depreciated by almost 9%, even while its economy recovered relatively strongly from the crisis and its economy was strongly in surplus.

In contrast, over this same period the Swiss franc appreciated 16% -- estimates suggest that had the German real exchange rate tracked the Swiss real exchange rates, German export growth would have been cut in half.

Another major surplus country, China, saw an appreciation of its real exchange rate by more than 10% over this period.

If Germany had a free-floating currency of its own, rather than one whose value is determined by the fate of the full set of euro members, it would have seen an appreciation that would have brought down its current surplus.

Shared experiences: Another surplus country offers a striking recent example of rebalancing: China. In 2007, China's surplus exceeded 10% of its GDP.

The IMF projects that the debt to GDP ratio will fall to 2.3% in 2012, well below the 6.3% forecast published in its World Economic Outlook last year. In contrast, the most recent IMF forecast of the 2012 German debt to GDP ratio, of 5.2%, exceeds last year's forecast of 4.6%.

As a member of the euro area, Germany will not see the natural forces of a currency revaluation bring about a reduction in its current surplus.

But the government has the tools available to rebalance, and foster growth both domestically and more widely in Europe, through a stimulative fiscal expansion.

Investing in Europe? Look north

 

There are other tools available as well, such as policies to promote female labor force participation (which is low relative to other industrial countries) and liberalizing retailing (which could help promote domestic demand), to raise growth and to widen its benefits among its citizens.

Rebalancing needs to occur for both deficit and surplus countries to support and sustain growth during these challenging times.


By Michael W. Klein @CNNMoneyMarkets April 21, 2012: 10:50 AM ET

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A choice for Americans: Spend more Borrow more? Spend less Tax more?

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Debt crisis: America faces a decision that will affect us all

The financial crisis will force the Obama administration to make a choice that will define its future - and ours. 

Wall Street blues: America's problem is political, not economic Photo: ALAMY By Jeremy Warner

To understand the origins of today’s stand-off between Republicans and Democrats over the US debt crisis, it is necessary to revisit an event which took place in Boston Harbour nearly 238 years ago. On December 16, 1773, a group of Massachusetts colonists boarded ships belonging to the East India Company and threw the entire cargo into the sea. There, in tax rebellion, began the American Revolution.

This iconic event in US history, the one from which the modern Tea Party takes its name, helped establish a national aversion to taxation that has remained at the heart of the American psyche ever since. For a people defined by the idea of rugged individualism, self-reliance and the frontier spirit, the presumption of low taxes – and correspondingly small government – is an article of faith as sacred as motherhood and apple pie.

 The Problem

Few would contest the manifold economic success that these principles have delivered. They are the very foundation of the American economic model, and helped to make the US the richest and most powerful nation the world has ever seen. But here’s the problem. In recent times, both government and its spending commitments have been getting a whole lot bigger. Taxation, on the other hand, has failed to keep pace. On the contrary: under George W Bush, America reduced its tax burden even as its spending escalated. Since President Obama came to power, spending has run further out of control, with no compensating tax increases.

Hard as it is to believe in some of its states, America as a whole remains a low-tax economy in comparison with most other “rich” nations. Yet its government spending is approaching the heroic levels seen in Europe. For the time being, the gap is filled by borrowing from foreigners, a plainly unsustainable and humbling path – made all the more worrying by the fact that there are huge spending pressures still to come from the needs and demands of an ageing population. Something has to give. Either America must spend less, or tax more.



Misconceptions

But before analysing the significance of this choice, we need to lay a couple of misconceptions about the nature of the current crisis to rest. From President Obama to Larry Summers, the former treasury secretary, to Christine Lagarde, the managing director of the IMF, to our own Vince Cable, the airwaves have been ringing with apocalyptic warnings about the likely consequences for the world economy should Congress fail to break the impasse over the debt ceiling by the August 2 deadline. Any American default, Summers has warned, would be like “Lehman on steroids… it’s gonna be financial Armageddon”.

Lagarde has wagged her finger at the US and urged action similar in its “courageousness” to that taken last week by the eurozone, which she somewhat optimistically seems to think has now largely solved its problems. Meanwhile, the Business Secretary, in an extraordinary and ill-advised outburst, accused “a few Right-wing nutters” in Congress of posing a bigger threat to the world economy than the trials and tribulations of the euro.

To heap the blame for America’s indecision on a particular ideology is to misunderstand the nature and importance of the debate – yet Mr Cable seems determined to accuse President Obama’s opponents of holding the world to ransom.

Are any of these warnings valid? Well, if America were to default, it would indeed be a seismic upheaval of shattering dimensions. In reality, it’s not going to happen. What’s being played out here is not, at this stage at least, an existential event, but a political charade.

Distress signs

There have been signs of distress in financial markets in recent days, but in the main, investors have displayed a remarkable lack of concern, with US Treasuries still trading at yields close to their historic lows.

They are right to be sanguine. The bottom line is that Mr Obama is not about to go down as the first president in history to default – which in any case would be to breach the Constitutional amendment stating that “the validity of the public debt of the United States shall not be questioned”.

Much as he would like to blame Republicans for such a calamity, he would not be able to escape responsibility. It is the President’s job to find solutions. The buck ultimately stops with him.

If, by some outside chance, the President does petulantly decide to throw himself off the cliff, it will be an unnecessary and surreal type of default. America is not insolvent, in the same way that some of the peripheral economies of the eurozone plainly are. It’s simply that it cannot agree on the correct balance between spending and tax. The crisis is political, not economic – which makes it quite unlike the situation in the eurozone, where it is both.

The immediate problem of the deficit – and possibly of the longer-term demographic challenges, too – could easily be solved with a single measure, the imposition of a European-style federal sales tax, akin to VAT. Yet hell will freeze over before such an abomination is agreed.

With characteristic wit, Mr Summers has summarised the issue thus: Democrats are against VAT because they see it as a regressive tax which would hit the poor, while Republicans are against it because they see it as a money machine that would entrench high state spending. Perhaps if Democrats came to appreciate its qualities as a revenue generator, and Republicans its regressive characteristics, they might actually be able to agree.

The parties have produced several rival plans for fiscal consolidation, but there’s little merit in getting into the minutiae: to the outside world, they all look as flawed and implausible as each other.

And the detail of the argument is, in any case, almost irrelevant compared to the titanic battle for the heart and soul of America’s future that underlies it.

Staying loyal

Does the US economy stay loyal to its low-tax, libertarian traditions, or does it retreat into serene, low-growth, European-style old age by reinforcing its social welfare programmes and charging citizens the taxes necessary to pay for them? Not since the Civil War has the nation been so polarised. If it were possible to split the US in two, and for each half to go its own way, it might provide some kind of a solution. But, ultimately, one voice must triumph over another.

For the US to forsake the principles that have underpinned its economic success for more than two centuries would be a disaster not just for the country, but for the world. European experience teaches that rising taxes almost invariably entrench higher spending. Once a culture of entitlements – a cushy, cradle-to-grave welfare state – becomes established, it’s very difficult to remove. When a choice then has to be made between spending on welfare and productive investment in the nation’s future – education, defence and so on – the latter is always culled first.

European style

Paradoxically, although moving to a European-style tax base would provide all the revenues the country needs, it would inevitably mark the start of America’s long retreat from military and economic hegemony.

Economic might is as much to do with confidence and perception as reality. The spectacle of a nation so lacking in credible political leadership that it cannot resolve its differences, threatens to default on its debts, and would rather print money than face up to its underlying economic challenges, is already perilously close to breaking the spell. America needs to wake up, before it’s too late.

IMF - Lagarde’s Challenges

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Raghuram Rajan

CHICAGO – Now that the dust has settled over the selection of the International Monetary Fund’s managing director, the IMF can return to its core business of managing crises. Christine Lagarde, a competent and well-regarded technocrat, will have her hands full with three important challenges.

The first, and probably easiest, challenge is to restore the IMF’s public image. While the criminal case against Dominique Strauss-Kahn on sexual-assault charges now seems highly uncertain, the ensuing press focus on the IMF suggests an uncontrolled international bureaucracy with unlimited expense accounts, dominated by men with little sense of restraint.

Fortunately, the truth is more prosaic. Top IMF staff face strict limits on their allowable business expenses (no $3,000 per night hotel rooms, despite reports in the press), and are generally underpaid relative to private-sector executives with similar skills and experience.

The IMF, like many organizations where workers spend long trips together, has its share of intra-office romances. But the environment is professional, and not hostile to women. A previous incident in which Strauss-Kahn was let off lightly for an improper relationship with a subordinate clearly suggests that the Fund needs brighter lines for acceptable behavior and tougher punishment for transgressions. But other organizations have dealt with similar issues; the IMF needs to make the necessary changes, and, equally important, get the message out that the DSK incident was an aberration, not the tip of the proverbial iceberg.

Mess in Europe

The second, and perhaps most difficult, challenge facing Lagarde, is the mess in Europe, where the IMF has become overly entangled in eurozone politics. Typically, the IMF assesses whether a country, after undertaking reasonable belt-tightening measures, can service its debt – and lends only when it is satisfied that it can. The entire objective of IMF lending is to help finance the country while it makes adjustments and regains access to private borrowing. This also means that a country with too much debt should renegotiate it down before getting help from the IMF, thereby avoiding an unsustainable repayment burden.

Perhaps swayed by promises of eurozone financial support (and Europe’s desire to prevent default-fueled financial contagion from spreading to countries like Spain and possibly Italy), the IMF took a rosier view of debt sustainability in countries like Greece than it has in emerging markets. But this has not “helped” such countries, for the availability of soft credit from the eurozone or the Fund only enables a greater accumulation of debt.



Ultimately, debt can be repaid only if a country produces more than it spends. And the higher the debt, the less likely it is that the country will be able to achieve the mix of belt-tightening and growth that would enable it to generate the necessary surpluses. Delayed restructuring eventually means more painful restructuring – after many years of lost growth.

If troubled eurozone countries, especially Spain, start growing rapidly again, there is still a “muddle-through” outcome that might work. With too-big-to-save countries like Spain in the clear, the debt of highly-indebted peripheral countries like Greece could be written down through interest waivers, maturity extensions, and debt exchanges. The eurozone – and the European Union – could survive its fiscal crisis intact.

Significant haircut

But having failed to insist on an up-front restructuring, the IMF will face problems. With private investors reluctant to lend more or even to roll over existing debt, the bulk of Greek debt at the time of any restructuring (or whatever it is euphemistically called) will be from the official sector. How the resulting losses imposed on debt holders will be divided between the various eurozone institutions and the IMF is anyone’s guess. For the first time in its history, the Fund might have to take a significant “haircut” on its loans, and it will have to prepare its non-European shareholders for it.

 Being independent

A greater dilemma will emerge if the muddle-through strategy does not seem to be working. At some point, the IMF’s strategy, which should be focused on the distressed country’s citizens and its creditors, should depart from that of the eurozone, which is more willing to sacrifice individual countries’ interests for the larger interest of the monetary union. Lagarde’s challenge will be to chart a strategy for the IMF that is independent of the eurozone’s strategy, even though she has been intimately involved in formulating the latter.

The third challenge for Lagarde concerns the circumstances of her election. It is not inconceivable that a number of emerging-market countries will get into trouble in the next few years. Will the Fund require the tough policy changes it has demanded of countries in the past, or will Lagarde’s need to show that she is not biased towards Europe mean that future IMF interventions will become more expansive and less demanding? A kinder, gentler Fund is in no one’s interest, least of all the distressed countries and the world’s taxpayers.

Finally, there is a challenge that seems to be pressing, but is not. In her campaign for the position, Lagarde emphasized the need for diversity among the IMF’s top management. But what is really needed is the selection and promotion of the best people, regardless of national origin, sex, or race.

Clearly, the IMF’s existing culture and history will bias its selection and promotion of staff towards a certain type of person (for example, holders of PhDs from US universities). That commonality in backgrounds among IMF personnel allows the Fund to move fast in country rescues, not wasting time in endless debate. In the long run, more diversity is needed. But if it is attempted too quickly, in order to paper over the fact that a European is in charge once again, the Fund risks jeopardizing its key strength.

The IMF is perhaps the central global multilateral economic institution at a time when such institutions are needed more than ever. Lagarde arrives to lead it at a difficult time. We all have a stake in her success.

Raghuram Rajan, a former IMF chief economist, is a professor at the University of Chicago’s Booth School of Business.

Why the US is the greatest threat to Lagarde at the IMF?

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"It's a victory for France," President Nicolas Sarkozy said of Christine Lagarde's appointment as the new head of the International Monetary Fund.

Christine Lagarde leaves a private TV studio after appearing on prime time news in Boulogne Photo: REUTERS

By Richard Blackden, US Business Editor

It should come as no surprise that the unpopular French leader is trying to put a positive spin on losing his highly-regarded finance minister. And, in one sense, Sarkozy is spot on.

Lagarde becomes the IMF's fifth French leader, and her appointment ensures that the Gallic republic keeps a powerful voice at an institution that has made a comeback thanks to the financial crisis. But Lagarde won't have appreciated her former boss airing his sentiment in public. The 55-year old will start her first day in the job next Tuesday with three question marks hanging over her appointment.

The first and least troublesome one is some inevitable concern within the IMF that she's not an economist. Lagarde trained as a lawyer and spent 25 years working at US law firm Baker & McKenzie before moving into politics in 2005. Some of this will be intellectual snobbery, but some will be legitimate concern over whether she's qualified for the job. She's regarded as highly intelligent and the fund already has an army of economists that matters can be delegated to.

The second is whether her selection was a stitch up. And it was. Europe still wields a disproportionately large amount of votes at the IMF's top table - a gift from history that the continent is understandably reluctant to relinquish. There's nothing she can do about that, and Lagarde has already pledged to make changes to the voting system so it better reflects the shifting balance of economic power in the world.

The third is by far the most serious. As the French finance minister intimately involved in Europe's debt crisis during the last 12 months, will she be able to give the IMF an independent voice and protect the interest of its creditors? Lagarde certainly thinks so. During her job interview last week she told the IMF's Executive Board that "I will not shrink from the necessary candour and toughness in my discussions with European leaders." Adding that "there is no room for benevolence when tough choices must be made."

The former lawyer spent much of the past month visiting China, India and Brazil to assure them that she will not throw good IMF money after bad to solve Europe's debt dilemma. The fund, which means its donors, is supplying about a third of the €110bn that was pledged to Greece as part of the first bail-out in May, 2010. Such assurances appear to have won over those three economic heavyweights, who declared for her rather than Agustin Carstens, the head of Mexico's central bank, and Lagarde’s only rival.

Victory, though, only came when the Obama administration threw its weight behind Lagarde this week. US Treasury Secretary Tim Geithner sang the praises of his former counterpart and new neighbour in Washington DC. But it's politicians in the US capital, rather than Beijing, Delhi or Sao Paulo, that pose the greatest threat to Lagarde.

Despite the warm and no doubt genuine words from Geithner, The White House is increasingly frustrated at Europeans' handling of their own debt debacle. Its latest flaring comes as the US economic recovery is losing momentum, and Obama is trying to wrestle back the political initiative from a Republican party emboldened by the recent US slowdown. The irritation was likely behind an unusual public rebuke to European leaders from Geithner last week when he said it would be better if they could speak with one voice.

A still bigger threat comes from Congress. The Obama administration struggled to push through an extra $108bn in funding for the IMF in June 2009. If bail-out was a toxic word in Washington then, it has only become more so since. So far the contributions from the IMF, where the US is the biggest single donor, have raised relatively few heckles in the House of Representatives or Senate. But with Republican candidates currently vying for the right to challenge Obama next year, the chances are that will change. And any money required from the IMF for Greece's second bail-out will receive far more political scrutiny in the country that will have to dig deepest into its own pockets.

It's to her new neighbours in Washington, more than anyone else, that Lagarde needs to prove that her appointment is no victory for France.