Date: 30-01-2012
Source: SPIEGEL

Europe’s politicians are losing touch with reality. Greece is broke, and yet Brussels wants to send the country billions in new loans, to which there is growing opposition within the coalition government in Berlin. Rescue efforts are hopelessly bogged down by bickering over who will ultimately step up.

Martial music booms from the loudspeakers as warlike images gallop across monitors. A short euro crisis film montage shows police officers being posted in front of the parliament building in Athens and the jostling of frantic reporters, then US investor George Soros uses grim words in an appeal to rescue the euro zone. „The alternative is just too terrible to contemplate,“ he says.
Speaking in a panel that follows the short film, German Finance Minister Wolfgang Schäuble, a member of Chancellor Angela Merkel’s center-right Christian Democratic Union (CDU), has a gloomy expression. It is last Friday when the global business elite were at the World Economic Forum in Davos, Switzerland, to discuss the „Future of the Euro Zone.“ It becomes quickly apparent that Schäuble would have preferred a different opening than the dark film for this event. The negotiations with Athens’ private creditors are going well, he says, and he points out that he is „quite optimistic“ Greece can be rescued.

But later European Union Economic and Monetary Affairs Commissioner Olli Rehn, standing next to the stage, imparts a very different message to reporters. He concedes that Athens needs money once again, but that he cannot yet reveal just how much. Nevertheless, he adds, it is „likely“ that the donor countries will have to come up with „a slightly larger contribution.“

Once again, Europe is arguing over a bailout for Greece, and it looks as though the result will be no different that it has been in the past. German Chancellor Angela Merkel opposed lending money to Athens in early 2010, and then the first bailout package for Greece was put together. A year later, she balked at further aid, and then came the second program. Now she is trying to protect the euro zone’s coffers once again, though no one in Berlin or Brussels is willing to bet that she will have more success this time around.

Europe’s politicians continue to battle reality. Everyone knows that Greece cannot repay its massive pile of debts, now at more than €350 billion ($459 billion). But instead of effectively reducing the financial burden, European politicians intend to approve new loans for the government in Athens and go on fighting debt with new debt. „If the country wants to remain in the euro zone, we should support it,“ says Austrian Chancellor Werner Faymann.

No Progress

Though the rescuers may be issuing calls for perseverance, resistance is growing in Europe. In Athens, political parties and citizens are fighting too keep austerity measures from transforming their economic downturn into a full-on crash. And in Germany, the main donor country, leading politicians within the two coalition parties, the CDU and the business-friendly Free Democratic Party (FDP), do not believe that a majority of parliamentarians will vote for additional aid to Greece. „Our position has not changed,“ says Horst Seehofer, the chairman of the CDU’s Bavarian sister party, the Christian Social Union (CSU). „There is no money for a standstill in reforms.“

The effort to rescue Greece is clearly moving in circles, and there is no evidence of any progress.

Ironically, only three months ago European leaders believed that things were already on the mend. Greece’s private creditors were supposed to abandon half of their claims, and the partner countries planned to contribute another €130 billion ($172 billion). These efforts were expected to bring the country’s debt level from more than 160 percent of gross domestic product (GDP) to a more tolerable 120 percent by 2020.

But these hopes were deceptive. The Greek economy is shrinking faster than European politicians believed was possible in autumn, and now the country is short on funds once again. The representatives of the so-called troika, consisting of the European Commission, the European Central Bank (ECB) and the International Monetary Fund (IMF), estimate the shortfall to be about €15 billion, meaning that Greece needs €145 billion instead of €130 billion. „We do not assume that the additional funds can be collected solely from private creditors,“ say sources within the troika.

The only other option is to redistribute the burden. Under the current program, the IMF is responsible for about one-third, and the Europeans for two-thirds of the costs. But obtaining cash is becoming increasingly difficult. A serious dispute over who will come up with the additional money has been raging behind the scenes for days — a dispute that resembles a game of Old Maid.

Politicians Bicker with Banks

The German government feels that the financial sector should bear much of the additional burden. If additional funds were needed, the banks would simply have to contribute more, the Germans argue. The countries involved are already pitching in €130 billion to the new bailout package, and Berlin feels that that ought to be enough.

The banks’ representatives disagree completely. They have already increased their contribution several times, and now they point out that it isn’t just private institutions that hold Greek government bonds. The European Central Bank, for example, holds up to €55 billion in Greek securities. Why shouldn’t the ECB participate in the write-downs, Deutsche Bank CEO Josef Ackermann asks himself?

But Europe’s monetary watchdogs indignantly reject such proposals. They only bought the bonds to maintain the money supply, say officials at ECB headquarters in Frankfurt’s Eurotower. Waiving some of their claims, they argue, would be tantamount to intervening in the fiscal policy of countries. „If we did that, we would be taking on a portion of a country’s debt,“ says a central banker. „And we are barred from doing that.“

With such arguments, the monetary watchdogs passed the unwanted baton back to politicians. Last Thursday, EU Economic and Monetary Affairs Commissioner Rehn conceded that the hole in the second bailout package could only be plugged with government funds. The German government was not amused. „Rehn is completely alone in his opinion,“ a senior government official in Berlin grumbled. Nevertheless, European leaders know that the countries in the euro zone will not be able to avoid coming up with the funds for new loans to Greece. If there are no other options, says Luxembourg Finance Minister Luc Frieden, „the public sector may have to provide more money.“

Europe is pursuing a Greece strategy of pressing on regardless of the potential cost. Meanwhile, it is becoming increasingly obvious that this method is not helping the country’s economy get back on its feet. Although the Athens government is spending €20 billion less this year than it did in 2009, the debt ratio is still climbing, because the Greek economy will shrink for the fifth year in a row in 2012. And almost all experts agree that the country will not be able to pull itself out of the crisis on its own.

The Dismal Greek Economy

The Greek economy is not productive enough to generate growth. Aside from olive oil, textiles and a few chemicals, there are hardly any Greek products suitable for export. On the contrary, Greece is dependent on food imports to feed its population.
„Greece has been living beyond its means for years,“ an unpublished study by the German Institute for Economic Research (DIW) concludes. „The consumption of goods has exceeded economic output by far.“

Especially devastating is the assessment that the DIW experts make about the condition of an industry that is generally seen as a potential engine for growth: tourism. According to the DIW study, the Greek tourism industry concentrates on the summer months, with almost nothing happening throughout the rest of the year. There is almost no tourism in the cities, which translates into low overall capacity utilization and high costs for hotel operators. By contrast, capacity utilization in the hotel sector is much more uniform in other Mediterranean countries.

According to the study, a key cause of the problem is the relatively poor price/performance ratio. In Mediterranean tourism, Greece has to compete with non-euro countries like Croatia, Tunisia, Morocco, Bulgaria and Turkey, which can offer their services at significantly lower prices. The per-hour wage in the hospitality industry was recently measured at €11.39 in Greece, as compared with only €8.49 in Portugal, €4 in Turkey and as little as €1.55 in Bulgaria. The study arrives at grim conclusions, noting that the drastic austerity programs will not only remain ineffective, but will also stigmatize the country as „Europe’s problem child“ for a long time to come.

Others in Europe are also noticing that the transformation of the Greek economy is not progressing. This translates into resistance within national parliaments against approving new aid for Athens.

Resistance Mounts in Berlin

This also applies to Merkel’s center-right coalition government in Berlin, in which the first Greece package and the European Financial Stability Facility (EFSF) bailout fund were already hotly contested. Since then, resistance to additional German aid for debt-ridden countries has only grown. „Greece would be the most difficult decision by far for the parliamentary group,“ says Florian Toncar, the FDP’s deputy parliamentary leader, who is a member of the party’s pro-European wing. It is already clear that significantly more parliamentarians will refuse to go along with their leadership in the future.

Bavarian FDP member of the Bundestag Erwin Lotter, for example, who has voted for all euro bailout packages until now, would no longer do so in the case of Greece. „I was of the opinion that the Greeks needed time,“ he says. „Now I assume that there will be a national bankruptcy, and that the problems cannot be solved with more money.“

There are also serious concerns within the CSU, which has only supported Merkel with great reluctance until now. „The CSU rejects new aid for Greece beyond the approved programs,“ says CSU Chairman Seehofer. The CSU wants to hold a European conference on Monday to discuss the subject of Greece. Seehofer has already set the tone: „If the Greeks do not implement the reform programs, there can be no further aid.“

Doubts are also growing within the CDU. „I will not vote for new aid to Greece,“ says CDU domestic policy expert Wolfgang Bosbach. „The Greeks don’t lack the political will, but they do lack the economic strength to get back on their feet.“ Anxiety is also spreading through the party’s European wing. „A great deal of irritation has spread through the party,“ says Gunther Krichbaum, the chairman of the CDU’s Europe committee. „All Greek parties must finally show the unconditional will to make fundamental changes.“

The displeasure at the party base has now reached the leadership of the coalition too. In a move designed to generate good publicity, CDU/CSU parliamentary group leader Volker Kauder has called for sending a European state commissioner to Athens. His FDP counterpart, Rainer Brüderle, is also not mincing his words. „Solidarity is not a one-way street. In this sense, the European Community must remain tough and demand the necessary structural reforms,“ says Brüderle. „Only if the Greeks also offer proof that they are serious, can and might we, as the European Community, come to their aid.“

Restructuring with a Crowbar

Perhaps the only purpose of the sharp tone being taken by the parliamentary leaders is to pave the way for the next aid payment. According to the deal these statements are trying to prepare for, Greece will receive new money if it bends to even stricter requirements and conditions. The country is to be restructured with a crowbar.

Experts believe that this recipe is just as unlikely to get the country’s ailing economy back on its feet as the other form of radical therapy currently being discussed: Greece’s withdrawal from the euro. „It is naïve to believe that the problems will be solved if Greece reintroduces the drachma,“ says Ansgar Belke, director of macroeconomic research at the DIW and a professor at the University of Duisburg-Essen. The country’s products would become cheaper, but at the same time, the turbulence caused by currency reform would send thousands of companies and banks into bankruptcy. Interest rates could rise, and a bankruptcy would also infect other countries. As a result, says Belke, „the problems of Greece and the euro zone could even become worse.“

Instead, economists recommend finally doing what is already unavoidable: sending the country into an orderly insolvency. Greece’s government creditors, which include the ECB and, most of all, the partner countries that have lent the country money until now, would have to abandon about half of their claims so that the country’s mountain of debt could be reduced to a tolerable level. Then the measures that can return the Greek economy to growth on its own can become more effective: reforms in the labor market, more competition in the service industries and foreign investment.

The majority of European politicians still refuse to recognize reality, though. This is understandable, given that abandoning portions of their claims against Greece would translate into substantial losses. But some government representatives are at least willing to approach the first warm-up exercises. When Luxembourg Prime Minister Jean-Claude Juncker was asked by German financial newspaper Handelsblatt last Friday whether the euro countries should also forgive Greek debts, he replied that such proposed solutions are „not entirely absurd.“

Date: 30-01-2012
Source: The Guardian

If the world economy was a video game, the central bankers and politicians have been struggling to master the controls – and remain stuck on the first level

There has been a lot of collateral damage since the economic war began some four years ago – not least in France, where S&P’s downgrade set off explosions under Sarkozy’s government

Imagine the world economy as a video game, one observer said. You have to complete a number of stages before you win, and the idea is to dodge all the bad stuff that can come at you at any moment. If you really get it wrong, you are zapped and you have to start all over again.

The game being played by the policymakers who assembled in Davos last week should be called Global Apocalypse. It now even has its own Super Mario figure in the shape of the president of the European Central Bank, Mario Draghi.

Sad to say, it is taking those in charge of the global economy a long time to master the controls. After four and a half years they have made it to the first level but are now stuck there. Missiles rained down on them in 2011 and by the year’s end there was a very real fear of a wipeout as the euro crisis deepened.

A bit of clever footwork from Super Mario has averted the immediate danger. The ECB has flooded Europe’s financial system with cheap money and that has prevented banks from going to the wall. Mark Carney, Canada’s central bank governor and chairman of the financial stability board, said on Saturday that the long-term refinancing arrangements meant there was no longer the risk of a repeat of the chaos that followed the collapse of Lehman Brothers in September 2008.

But as Churchill said after Dunkirk, wars are not won by retreats, however brilliantly executed, and getting beyond level one is still proving challenging, at least for the developed countries in the west, where it has taken unprecedented intervention from central banks to prevent it from being game over. Martin Wolf, of the Financial Times, aptly describes the current state of affairs as a contained depression.

In a sense, it should come as no surprise that victory has so far proved elusive. George Osborne is right when he says that recoveries from recessions are always more difficult when the downturns are caused by excessive debt, but this slump has been accompanied by two other shocks: a big technological shift from an analogue to a digital world and a big geographical shift that has seen the centre of gravity of activity move from Europe and North America to Asia. Companies such as Nokia that were viewed as world-beaters only a few years ago are finding out exactly what the economist Joseph Schumpeter meant by creative destruction, but that process also seems to be at work between countries and regions.

Even so, there is a way through the labyrinth provided policymakers avoid the obvious pitfalls and work methodically. One problem has been that they have tried to find short cuts over the past few years rather than work their way through the levels in the right sequence.

So, if getting to the first level called for urgent and aggressive action to ease monetary policy and shore up the financial system, the next phase should be to deal with the global imbalances that caused the problem in the first place. The fundamental issue in the years leading up to the 2007 financial crisis was not the number of US sub-prime mortgages or even the explosion in derivatives; it was the instability caused by one half of the world running massive current account surpluses and the other half running massive current account deficits.

What needs to happen now is that the surplus countries accept the need to increase domestic demand, thereby soaking up exports from the debtor countries, resulting in more balanced growth all round.

Once the global economy has enough demand to allow the resumption of solid growth, there will be the right environment to repair the damage to the banking system. Regulation needs to be improved; banks have to provide themselves with bigger capital and liquidity buffers, and a solution has to be found to the „too big to fail“ issue.

Stronger banks will reduce the risk of a second credit crunch, making it easier for private-sector firms to finance expansion or secure working capital. Higher investment by the private sector will mean that governments will no longer have to shoulder so much of the burden of growth. Once a vigorous private-sector recovery is under way, finance ministries can adopt tougher fiscal policies without the risk of pushing their economies back into recession.

By this stage, an end to the game is in sight. Governments can use the fruits of stronger growth to finance supply-side improvements to their economy, including extra spending on education, skills and infrastructure. Growth can be made sustainable by championing vibrant green technology sectors. Regulatory regimes can be tinkered with to prevent „irrational exuberance“.

There was little sign in Davos last week of this sort of strategy. In part, that’s because some of the measures taken by central banks to prevent catastrophe have had unintended consequences: the impact of quantitative easing on commodity prices and hence on inflation, for example. In part, it has been the result of „black swan“ events, such as Japan’s tsunami. But mostly, it has been due to inertia, complacency and error.

Policymakers have put the question of global rebalancing into a box labelled „too hard to deal with“, and have been dilatory in sorting out the problems of their financial sectors. Instead, whether through a misguided belief in financial orthodoxy or a fear of the bond markets, they have concentrated on heavy-handed and blanket austerity, something that should have come at the very end of the game.

The result has been sluggish growth in the west because every element of growth – public expenditure, consumer spending and investment – has been choked off simultaneously. If government is to retrench without causing recession, private demand has to rise, but the squeeze on real incomes and a reluctance to invest means this is not happening. The result is an unbalanced global economy, drifting towards a double-dip recession (in the west at least), a dysfunctional financial system and – a new ingredient in the toxic mix – a deeply disaffected public.

Christine Lagarde, the International Monetary Fund’s managing director, spent last week rattling the tin in the hope of getting contributions for a $2 trillion (£1.3tn) war chest. European policymakers were trying to put the finishing touches to a Greek debt deal. Draghi made it clear that providing liquidity to Europe’s banks would not be enough on its own to bring an end to the crisis.

What does it mean? It means that blanket austerity is not working, and. It means that what was originally a global response to a global crisis has become a series of national responses to national crises. It means that Europe is treating a three-dimensional problem (growth, banks, public finances) with a one-dimensional fix of deficit reduction. It means that the global economy is still struggling to get beyond level one of Global Apocalypse. And if policymakers don’t start showing a bit more skill, it will soon be Game Over and time to play Global Apocalypse 2.

Cautious optimism was the buzz among bankers at the World Economic Forum in Davos.
While discussion continues about a possible breakup of the euro zone, few now expect this to happen—at least not yet.

Bankers believe many people are still underestimating what a game-changer the European Central Bank’s offer of unlimited three-year loans to banks has been. The policy is part quantitative easing, part proto-euro bond and part backdoor recapitalization of the banks via the boost to profits, according to one bank chief executive. By removing the prospect of a systemic bank crisis, the ECB has bought the euro zone time.

This optimism will get a further boost if Greece reaches a deal with private-sector creditors in the coming days. The prospects for a deal have improved markedly following acknowledgments that Greece’s official lenders could also take losses if a deal with private-sector lenders fails to put the country’s debt on a sustainable basis. Any official sector burden sharing would take the form of lowering interest rates rather than debt forgiveness, European economic affairs Commissioner Olli Rehn told The Wall Street Journal. That makes it less likely Greece will be forced into a coercive default that inflicts substantial losses on the ECB’s estimated €45 billion ($59.5 billion) exposure, something that would likely precipitate Greece’s exit from the euro zone.  But the caution reflects concern that euro-zone governments won’t properly use the time that has been bought. The challenges are well understood. The current row over a possible loss of Greek economic sovereignty is a reminder that the risk of a political accident remains high. Italy and Spain need to press ahead with reforms to boost growth and restore competitiveness. Fiscal austerity and bank deleveraging will continue to take their toll on growth. The euro zone needs to increase the size of its bailout funds to create a more credible firewall to withstand contagion if other countries are shut out of funding markets. Portugal may yet need further support. Many believe only a clear commitment to fiscal transfers and euro-zone bonds can truly convince markets the euro will survive.

So long as these doubts remain, banks will continue to prepare for the worst. Many will use cheap ECB loans to buy domestic bonds, but most will continue to cut exposure to other governments. Similarly, they will continue to prioritize domestic lending as they deleverage and try to match cross-border assets and liabilities. Regulators are likely to encourage this process as they seek to ring-fence their domestic financial systems.

The euro zone’s challenge is to ensure that this fragmentation doesn’t ultimately become self-fulfilling. It still has work to do to turn cautious optimism into confidence.

29.01.2012 | 18:18 | CHRISTINA AUMAYR-HAJEK (Die Presse)

Der Außenauftritt von Bundeskanzler und Vizekanzler kennt zwei Strategien: Schweigen und Beleidigtsein.

Finance Minister Says Euro Zone May Refuse Athens a Fresh Bailout If Nation Can’t Enact Reforms

BERLIN—Germany’s finance minister issued an unusually blunt warning that the euro zone might refuse to grant Greece a fresh bailout, pushing Athens into default unless it persuades Europe it can overhaul its state and economy.

Finance Minister Wolfgang Schäuble is known as a believer in the euro and a guardian of Germany’s purse.

„Greece needs to decide,“ Wolfgang Schäuble said in an interview with The Wall Street Journal, when asked whether the euro zone would grant or withhold the second bailout package for the country since 2010, expected to be in excess of €130 billion ($172 billion).

Europe is „prepared to support Greece“ with the new loan package, Mr. Schäuble said, but he warned: „Unless Greece implements the necessary decisions and doesn’t just announce them…there’s no amount of money that can solve the problem.“

The remarks came as German officials last week floated the radical idea of appointing a European „budget commissioner“ with veto powers over Greece’s spending, partially suspending Greece’s national sovereignty over its budget, in return for aid.

„Perhaps we and our partners must look into ways to assist Greece in this difficult task in an even closer manner,“ Mr. Schäuble said, alluding to the German oversight proposal.

Germany’s proposal met with skepticism from other European policy makers and got an angry response from Athens. In a statement on Sunday, Greek Finance Minister Evangelos Venizelos said „bigger nations“ shouldn’t force Greece to confront a „dilemma of ‘economic assistance or national dignity.’ „

Greece’s deteriorating finances and ever-growing funding needs are leading to renewed political tensions in the euro zone that threaten to reignite the region’s debt crisis, which has shown tentative signs of stabilizing so far this year.

In Germany and other northern European creditor countries, frustration is rising with Greece’s perceived failure to get a grip on public spending, improve tax collection or free up its economy. Many lawmakers in German Chancellor Angela Merkel’s conservative-led coalition are unhappy about risking billions more on financially stricken Greece.

Berlin officials say their proposal for more-intrusive controls over Greece’s budget is one of several ideas being discussed, and that they are flexible about the specifics—but that something needs to be done about Greece’s slow compliance with the terms of its international aid.

Ms. Merkel is expected to discuss stronger enforcement of Greece’s reform measures with Greek Prime Minister Lucas Papademos in Brussels on Monday, when European leaders gather for a summit whose official agenda is how to improve economic growth in the 17-nation euro area.

Greece’s fiscal mess is increasingly taking center stage again, however, in a sign of how the euro zone has gone around in circles since the crisis began in Athens in late 2009.

Stubbornly high budget deficits mean that Greece is struggling to restore its solvency, despite an expected deal with bondholders that could reduce its private-sector debt by up to €100 billion. Many economists say euro-zone governments and the European Central Bank will also eventually have to forgive some of what Greece owes them.

Mr. Schäuble declined to rule that out, saying „we must see what the whole package will look like,“ and that the independent central bank would make its own decision.

The euro zone must decide by March whether to proceed with the second bailout deal for Greece, which some European officials say will require closer to €145 billion in international loans than the €130 billion agreed on in principle late last year.

The alternative—a full-blown default by Greece on its debts in late March—could spark another round of panic in European government bond markets, threatening the access to credit of other euro members with rising debts, including Spain and Italy.

Fear of such contagion is the main reason Germany and other creditors view further aid for Greece as the lesser evil. But Berlin officials are growing exasperated with Greece’s political parties, which are seen as only half-heartedly behind the country’s painful reform program, and with a Greek public administration that has failed to turn reforms into reality.

Mr. Schäuble, a 69-year-old conservative and the second-most powerful member of Germany’s government after Ms. Merkel, is known as both a staunch believer in the euro and a steely guardian of Germany’s purse. In the interview, he defended Germany’s handling of the euro-zone crisis against recent international criticism.

At last week’s World Economic Forum in Davos, Switzerland, top global policy makers and business leaders called for Germany to relax its drive for pan-European austerity, do more to support growth, and build a bigger financial safety net to reassure markets struggling euro-zone governments will stay liquid.

Mr. Schäuble insisted Germany is taking the best possible steps to support economic growth in Europe’s biggest economy, and rejected calls for a significantly bigger euro-zone bailout fund.

„In the euro zone, we will regain the trust we have lost only through steady policies,“ rather than constantly revising decisions, Mr. Schäuble said. Germany’s cautious, step-by-step response to the euro-zone „isn’t that unsuccessful,“ he said, pointing to the relative financial calm in Europe since Christmas.

But while some analysts have suggested lately that the worst of the euro crisis might be over, Mr. Schäuble said it’s „too early to sound the all-clear,“ given the continuing uncertainties in Greece and other struggling euro members.

Dismissing the idea that Berlin should pursue a more-expansionary fiscal policy to support the euro-zone economy, Mr. Schäuble said last year’s 3% economic growth in Germany showed that careful budget consolidation is more effective.

„I don’t know how it’s best done in America, but in Germany it works like this: If you want more private demand, you have to take people’s angst away,“ he said.

Many German consumers are anxious about rising public debt and its implications for the state’s ability to pay for pensions and health care in an aging society. Mr. Schäuble cited the research of U.S. economists Kenneth Rogoff and Carmen Reinhart, who have argued high public debt is a drag on economic growth.

Germany’s economy has stalled this winter after two years of solid growth, however, adding to criticism of the government’s austerity focus. Mr. Schäuble said the slowdown is temporary. „A recession looks quite different from what’s happening in Germany right now,“ he said.

THE Associated Press reported last week that Fidel Castro, the former president of Cuba, wrote an opinion piece on a Cuban Web site, following a Republican Party presidential candidates’ debate in Florida, in which he argued that the “selection of a Republican candidate for the presidency of this globalized and expansive empire is — and I mean this seriously — the greatest competition of idiocy and ignorance that has ever been.”

When Marxists are complaining that your party’s candidates are disconnected from today’s global realities, it’s generally not a good sign. But they’re not alone.

There is today an enormous gap between the way many C.E.O.’s in America — not Wall Street-types, but the people who lead premier companies that make things and create real jobs — look at the world and how the average congressmen, senator or president looks at the world. They are literally looking at two different worlds — and this applies to both parties.
Consider the meeting that this paper reported on from last February between President Obama and the Apple co-founder Steve Jobs, who died in October. The president, understandably, asked Jobs why almost all of the 70 million iPhones, 30 million iPads and 59 million other products Apple sold last year were made overseas. Obama inquired, couldn’t that work come back home? “Those jobs aren’t coming back,” Jobs replied.

Politicians see the world as blocs of voters living in specific geographies — and they see their job as maximizing the economic benefits for the voters in their geography. Many C.E.O.’s, though, increasingly see the world as a place where their products can be made anywhere through global supply chains (often assembled with nonunion-protected labor) and sold everywhere.

These C.E.O.’s rarely talk about “outsourcing” these days. Their world is now so integrated that there is no “out” and no “in” anymore. In their businesses, every product and many services now are imagined, designed, marketed and built through global supply chains that seek to access the best quality talent at the lowest cost, wherever it exists. They see more and more of their products today as “Made in the World” not “Made in America.” Therein lies the tension. So many of “our” companies actually see themselves now as citizens of the world. But Obama is president of the United States.

Victor Fung, the chairman of Li & Fung, one of Hong Kong’s oldest textile manufacturers, remarked to me last year that for many years his company operated on the rule: “You sourced in Asia, and you sold in America and Europe.” Now, said Fung, the rule is: “ ‘Source everywhere, manufacture everywhere, sell everywhere.’ The whole notion of an ‘export’ is really disappearing.”

Mike Splinter, the C.E.O. of Applied Materials, has put it to me this way: “Outsourcing was 10 years ago, where you’d say, ‘Let’s send some software generation overseas.’ This is not the outsourcing we’re doing today. This is just where I am going to get something done. Now you say, ‘Hey, half my Ph.D.’s in my R-and-D department would rather live in Singapore, Taiwan or China because their hometown is there and they can go there and still work for my company.’ This is the next evolution.” He has many more choices.

Added Michael Dell, founder of Dell Inc.: “I always remind people that 96 percent of our potential new customers today live outside of America.” That’s the rest of the world. And if companies like Dell want to sell to them, he added, it needs to design and manufacture some parts of its products in their countries.

This is the world we are living in. It is not going away. But America can thrive in this world, explained Yossi Sheffi, the M.I.T. logistics expert, if it empowers “as many of our workers as possible to participate” in different links of these global supply chains — either imagining products, designing products, marketing products, orchestrating the supply chain for products, manufacturing high-end products and retailing products. If we get our share, we’ll do fine.

And here’s the good news: We have a huge natural advantage to compete in this kind of world, if we just get our act together.

In a world where the biggest returns go to those who imagine and design a product, there is no higher imagination-enabling society than America. In a world where talent is the most important competitive advantage, there is no country that historically welcomed talented immigrants more than America. In a world in which protection for intellectual property and secure capital markets is highly prized by innovators and investors alike, there is no country safer than America. In a world in which the returns on innovation are staggering, our government funding of bioscience, new technology and clean energy is a great advantage. In a world where logistics will be the source of a huge number of middle-class jobs, we have FedEx and U.P.S.

If only — if only — we could come together on a national strategy to enhance and expand all of our natural advantages: more immigration, most post-secondary education, better infrastructure, more government research, smart incentives for spurring millions of start-ups — and a long-term plan to really fix our long-term debt problems — nobody could touch us. We’re that close.

Date: 29-01-2012
Source: The Economist

THIS grotesque map of the world, depicting Europe as a bloated balloon, caught my eye this week, and powerfully illustrates one of the factors in Europe’s debt crisis. It depicts the countries of the world sized according to the amount of government spending*. that they spend on social protection, from pensions to health, education and unemployment benefits.

In the words of the World Bank, which published it in a report issued this week („Golden Growth: Restoring the lustre of the European Economic model“), Europe is the world’s “lifestyle superpower”. As opposed to America, which spends almost as much as the rest of the world put together on defence, Europe spends more than the rest of the globe combined on social policies.

http://web.worldbank.org/WBSITE/EXTERNAL/COUNTRIES/ECAEXT/0,,contentMDK:23074045~pagePK:146736~piPK:146830~theSitePK:258599,00.html

In many ways this is an admirable aspect of Europe’s economic model, which combines high living standards with high standards of social welfare. The trouble is, such spending is helping to bankrupt governments—not least because those very same caring policies ensure that Europeans live longer, requiring more expenditure on health care and the payment of pensions for more years.

Anybody who wants to understand the strengths and weaknesses of European economies in this time of crisis would do well to read the report.(the overview is here:)
http://siteresources.worldbank.org/ECAEXT/Resources/258598-1284061150155/7383639-1323888814015/8319788-1326139457715/fulltext_overview.pdf

First the strengths. Europe, say the authors, invented a unique “convergence machine” by admitting successive waves of poorer countries and quickly raising their standards of living. Convergence has been accelerated by the free flow of trade and capital within the European Union. As the report puts it:

Between 1950 and 1973, Western European incomes converged quickly towards those in the United States. Then, until the early 1990s, the incomes of more than 100 million people in the poorer southern periphery—Greece, southern Italy, Portugal, and Spain—grew closer to those in advanced Europe. With the first association agreements with Hungary and Poland in 1994, another 100 million people in Central and Eastern Europe were absorbed into the European Union, and their incomes increased quickly. Another 100 million in the candidate countries in Southeastern Europe are already benefiting from the same aspirations and similar institutions that have helped almost half a billion people achieve the highest standards of living on the planet. If European integration continues, the 75 million people in the eastern partnership will profit in ways that are similar in scope and speed.

Yet this convergence machine is spluttering, and deep reforms are needed. Much effort has been expended on explaining the nature of the financial crisis of the past two years. The sharpest and most concise analysis I know of is a recent policy brief by Jean Pisani-Ferry, director of the Bruegel think-tank in Brussels („The euro crisis and the new impossible trinity“, here). This argues that the problems are deeper than a lack of fiscal discipline: there is a flaw in the way the euro zone was designed, without a lender of last resort, without joint bonds and with a vicious feedback loop that weakens both sovereigns and their banks. There is a tendency in Brussels to think that, if only the euro zone were to make the leap to federalism, all would be solved. Far from it.

The effect is most alarming on the Mediterranean rim. These next two charts show that, as expected, in 2002 northern Europe was more productive than southern Europe, which in turn led the new member states of eastern Europe. But between 2002 and 2008 something strange happened. The convergence machine went into reverse for southern Europe. While the easterners were roaring ahead to catch up with the northerners, where the productivity in Mediterranean countries actually fell.

Part of the reason is contained in this chart (below). It shows how foreign direct investment was abruptly redirected from southern countries to the new member states in the east. Mediterranean members faced a triple challenge: they were hit hard by globalisation and the loss of low-tech industries such as textiles; they faced competition from cheaper labour in ex-communist members; and the adoption of the euro made it harder for them to adjust through devaluation. Yet Club Med has only itself to blame.

A premature adoption of the euro by southern economies is sometimes blamed for this reversal of fortune. Others say that letting the formerly communist countries into the European Union so soon did not give the south enough time to become competitive. But perhaps the most likely explanation is that of all the economies in Europe, the entrepreneurial structures of Greece, Italy, Portugal, and Spain were least suited for the wider European economy. For one thing, a sizable part of net output in southern economies is generated in small firms—almost a third of it in tiny enterprises (with fewer than 10 workers). This is not an entrepreneurial profile suited for a big market. Unsurprisingly, with the expansion of the single market in the 2000s, foreign capital from the richer economies of Continental Europe quickly changed direction, going east instead of south as it had done in the 1990s. Did the south need more time to adjust, or did it squander opportunities? The latter seems more plausible. Ireland has shown that EU institutions and resources can be translated quickly into competitiveness. The Baltic economies are now doing the same. The chief culprits for the south’s poor performance were high taxes and too many regulations, often poorly administered. While these mattered less when its eastern neighbors were communist and China and India suffered the least business-friendly systems in the world, they are now crippling southern enterprise.

All is not lost. Northern European states, especially Nordic countries, show it is possible to innovate, raise productivity and maintain generous social welfare at the same time. This is the World Bank’s explanation for their success:

What has the north done to encourage enterprise and innovation? Much of its success has come from creating a good climate for doing business. All the northern economies are in the top 15 countries of 183 in the World Bank’s Doing Business rankings; at 14th, Sweden is the lowest ranked among them. They have given their enterprises considerable economic freedom. Their governments are doing a lot more. They have speeded up innovation by downloading the “killer applications” that have made the United States the global leader in technology: better incentives for enterprise-sponsored research and development (R&D), public funding mechanisms and intellectual property regimes to foster profitable relations between universities and firms, and a steady supply of workers with tertiary education. Tellingly, Europe’s innovation leaders perform especially well in areas where Europe as a whole lags the United States the most. These features make them global leaders; combining them with generous government spending on R&D and public education systems makes their innovation systems distinctively European.

Even so, there are reasons to worry, even in northern Europe. For instance:

What has been more perplexing is Europe’s generally poor performance in the most technology-intensive sectors—the Internet, biotechnology, computer software, health care equipment, and semiconductors. Put another way, the United States, the Republic of Korea, and Taiwan, China, have been doing well in sectors that are huge now but barely existed in 1975. Europe has been doing better in the more established sectors, especially industrial machinery, electrical equipment, telecommunications, aerospace, automobiles, and personal goods. The United States has young firms like Amazon, Amgen, Apple, Google, Intel, and Microsoft; Europe has Airbus, Mercedes, Nokia, and Volkswagen.

The productivity gap is especially important in Europe, given that Europeans tend to work less than Americans, while spending more on social protection.

The hallmark of the European economic model is perhaps the balance between work and life. With prosperity, Americans buy more goods and services, Europeans more leisure. In the 1950s, Western Europeans worked the equivalent of almost a month more than Americans. By the 1970s, they worked about the same amount. Today, Americans work a month a year more than Dutch, French, Germans, and Swedes, and work notably longer than the less well-off Greeks, Hungarians, Poles, and Spaniards..

And on top of fewer working hours in the day, and taking longer holidays, Europeans have tended to retire earlier—even as they lived longer. By 2007, the French could expect to draw pensions for 15 years longer than they did in 1965. On current trends for immigration and participation in the workforce, says the World Bank, the 45 European countries in its study will lose 50m workers over the next 50 years. Which brings us to that spending bulge.

Europe’s states are not big spenders on either health or education. The variation among countries stems from a difference in spending on pensions and social assistance. Europe’s countries also differ how they tax these benefits; Northern European countries tax the social security benefits of people with high incomes more than others in Europe. After taxes are considered, the southern periphery is the biggest social spender in Western Europe. But the reason why Europe spends more than its peer on public pensions is the same in the north, center and south. This is not because Europe has the oldest population (Japan’s is much older) nor because of higher pension benefits (annual subsidies per pensioner are about the same in Greece as in Japan). It spends more because of easier and earlier eligibility for pensions.

So the outlook is gloomy. Even with greater productivity, even if governments can reduce unemployment and bring more women into the workforce, Europeans will have to stay in work for many more years. Even so, the workforce will decrease. So Europeans will have to rethink migration policies too.

1. Die alten Industrieländer auf der Spitze eines irrsinnigen Schuldenberges

Die meisten Menschen können sich keine Vorstellung machen, wie unglaublich hoch der Schuldenberg inzwischen geworden ist, auf dessen Spitze viele der alten Industrieländer mühsam ballancierend vom Absturz bedroht sind. Zur Erläuterung greift meine Analyse teilweise auf ein
Papier der Boston Consulting Group zurück. Das Verhältnis von privater und öffentlicher Schuld zu Wirtschaftsleistung (BIP) der 18 Kernländer der OECD stieg in den 30 Jahren zwischen 1980 und 2010 von 160 % auf mehr als das Doppelte, nämlich 321 %. Darin stieg real nach Inflation die Verschuldung der Wirtschaftsunternehmen um 300 %, der Regierungen um 425 % und der privaten Haushalte um 600 % (Abb. 16730).

Hinzu kommen noch einerseits steigende Kosten für die Sozialversorgung der zunehmend alternden Bevölkerungen, was beispielsweise in Deutschland die Staatsverschuldung von 87 % auf 505 % bringen würde, wenn man die schon begründeten, aber noch nicht in der Rentenversicherung angesparten Versorgungslasten
einbeziehen würde. Andererseits laufen die Finanzsektoren auf einer in der Vergangenheit nie beobachteten Hebelung ihres Eigenkapitals über eine gigantische Kreditaufnahme.den gesamten Artikel lesen: http://www.jjahnke.net/wb/wb95-1733.pdf

THE buzzword in Brussels these days is “growth”. Perhaps the looming recession across much of Europe is concentrating minds. Or leaders may realise that the prospect of years of austerity is stirring bad blood. Unless the debt crisis was resolved and growth recovered, said Christine Lagarde, the IMF’s head, Europe and the world risked reverting to the 1930s. At their next summit on January 30th, European Union leaders will solemnly talk of boosting output, tackling youth unemployment, supporting small firms and much else. They might even commit money to job creation, for example by recycling unspent EU funds through the European Investment Bank.

Do not be fooled by such pieties. Everybody has different ideas about growth and they often reflect longstanding prejudices. For Germany, fostering growth is not about spending more money, but about fiscal discipline and structural reforms in weaker countries. For France, the priority is to curb “disloyal” competition, by harmonising taxes to stop low-tax states (eg, Ireland) taking business away from high-tax ones (eg, France), or stopping Britain from imposing tougher rules on its banks that might make them seem safer than French ones. For the British, Dutch, Swedes and other north Europeans, growth should come from the boost to competition from deepening the single market and pursuing free-trade agreements. For ex-communist countries in the east, the secret is the vital role of EU transfers.

Beyond papering over such disagreements with official verbiage, the main business of the summit will be to push ahead with the “fiscal compact”. This requires the signatories to adopt balanced-budget rules. “They are going to sign a treaty that makes Keynesianism illegal,” comments one diplomat. Mrs Lagarde, for her part, seems to lean the opposite way. Her recommendations for growth include easing monetary policy; relaxing deficit-cutting in surplus countries, such as Germany, that can afford to boost demand; and ensuring that banks keep lending. She is also urging the euro zone to increase the size of its rescue fund. And she makes the case for a Europe-wide system to support banks and for the mutualisation of some sovereign debt.

Mrs Lagarde’s words will fall on deaf ears in the country that most needs to hear them, Germany. So is Europe doomed to paralysis? A World Bank report on Europe, launched this week, tries to sound optimistic. As the report’s main author, Indermit Gill, puts it, “America has taken in poor immigrants and turned them into high-income individuals. The European Union has taken in poor countries and turned them into high-income countries.” Its economic model is valid, even if it needs reform.

Two problems stand out. One is the scale of European public spending. If America is a defence superpower, spending almost as much on defence as the rest of the world combined, Europe is a “lifestyle superpower”, spending more than the rest of the world put together on social protection. Big governments tend to slow growth, says the World Bank, unless they are as effective as Sweden’s. Ageing will add to the burden. For Mr Gill, Europeans can still choose to work shorter days and take longer holidays than Americans, but they can no longer afford to retire early.

It would help if Europe were more productive. But this is the second area of concern. Having almost closed the productivity gap with America in the mid-1990s, Europe is again being left behind. This trend is most alarming in southern Europe, where productivity has actually dropped. A simple explanation is that Mediterranean countries enjoyed easy “catch-up” growth by importing technology. New growth needs the harder graft of innovation and enterprise. Southern economies with cumbersome regulation, poor administration, overreliance on tiny family businesses and an over-protected labour force are bad at this. Fixing that will be the work of a generation, not a summit.

Even without its Mediterranean headache, Europe produces too few high-tech start-ups in areas such as IT and biotech. The causes are varied. One is poor synergy between industry and universities. Another is the fragmentation of the single market, making it harder for new firms to expand. Even the internet is filled with frontiers, as anyone who tries to shop across EU borders online can attest.

Patently absurd

One emblematic problem is the decades-old quest for a common EU patent. Europeans can pay five times more than Americans to protect their ideas, because they need to lodge separate patents and translate documents in each country. The cost of litigation is similarly multiplied. A simple one-stop shop would encourage innovation and cut costs. Yet the common patent was long blocked by linguistic chauvinism. English, German and French are the obvious choices. But Spain and Italy wanted their languages recognised too, or to have an English-only patent system (the cheapest option). The logjam seemed to be broken last year, when 25 countries agreed to push ahead without Italy and Spain under “enhanced co-operation”. Despite lawsuits, a deal was within reach last month.

But this is now being blocked by a fresh dispute, over whether the main patent court should be in London, Paris or Munich. Some money is at stake (a court creates a market in legal services), but the row is mostly about prestige. As Europe’s biggest issuer of patents and host to the registration office, Germany thinks it should also have the court. Britain and France are in no mood to yield to each other after December’s bust-up over the planned new treaty. But if the big countries cannot agree on a small but obvious step to enhance growth, what are the chances of the EU opening up the entire market in services? No wonder the rest of the world and the markets are losing faith in Europe.

Author: Jacob Funk Kirkegaard · January 27th, 2012 · Peterson Institute

Events remain unsettled in the euro area in 2012 in spite of some recent progress toward stabilizing the fiscal and financial outlook. To begin with, negotiations between the Greek government and private creditors represented by the Institute for International Finance (IIF) have been suspended as they enter the final critical phase, with each side considering their final “red lines” before the EU Summit on January 30, 2012.

The Struggle over Debt Restructuring

As always in such negotiations, the impasse is over who gets stuck with a bill that keeps getting bigger as the Greek domestic economy deteriorates. Last October, it was evident that the first 20 percent debt write-down negotiated the previous July would not deliver debt sustainability for Greece. Accordingly, the haircut on the debt principal was raised to 50 percent. Today, it seems obvious that while the 50 percent reduction in debt principal remains sacrosanct, the reduction in the net present value (NPV) of privately owned Greek debt will have to exceed 50 percent if Greece is to achieve debt sustainability. Moreover, private investors must participate in the “voluntary bond swap” at essentially 100 percent to reach that goal, according to the International Monetary Fund (IMF).

That is unsurprisingly proving to be a tough circle to square. As more investors oppose the “voluntary transaction,” the lower the bond coupon (e.g., lower NPV) for the new Greek debt becomes. Investors then become more likely to take their chances in an “involuntary bond restructuring” triggering sovereign credit default swaps (CDS). Financially, it comes down to the price of Greek debt that private investors paid or value on their books, as well as the price and payout of potential CDS protection and the NPV of the new replacement Greek bonds. Politically, however, for the Greek government and the euro area, the threat of “Greek contagion” will decide the outcome.

Currently markets seem to expect a voluntary deal between the IIF and the Greek government. I tend to support this view. In the end, a lower coupon on new bonds will be acceptable for the IIF, provided there is sufficient security and “upside participation” in the new bonds. The new bonds, for example, could be governed by the United Kingdom rather than Greek domestic law, preventing the Greek parliament from changing the rules in the future. There could also be a GDP-linked coupon, permitting a higher payment for investors in the future if the Greek economy recovers from its current slump. Another incentive for the deal is the potentially significant hidden cost to the entire euro area from a Greek default.

Yet, this outcome is not guaranteed. For one thing, while it may be the Greek government that is negotiating, in the end it is the euro area that will decide! Euro area leaders will thus establish the price they are willing to pay to avoid an involuntary restructuring resulting from a default and an unknown potential for fresh contagion. The IMF has been clear in its demands that the euro area make up for any financial shortfall from the Greek bond swap.

Assume that the IIF accepts a deal that leaves Greece €30 billion short of an estimated target for debt sustainability, for example. Such a deal would require the euro area official sector to contribute to financing Greece in the future. Euro leaders would also take into account their estimate of the scale of any market contagion to sovereign bonds issued by Ireland, Portugal, Spain, and Italy and the debt held by euro area banks. If you believe that the European Central Bank’s new three-year Long-Term Refinancing Operation (LTRO) is more than adequate to shore up euro area banks, and that new reform measures announced by Prime Minister Mario Monti of Italy and Spanish Premier Mariano Rajoy are adequate, and that Ireland and Portugal will continue to adhere to their current IMF programs, then that €30 billion is not worth paying.

On the other hand, it is clear that a coercive restructuring of Greece would have other costs to the euro area. Much is being written about the unfairness of the European Central Bank (ECB) not participating in any restructuring of the Greek debt it holds, as private debt holders are doing. This argument is patent nonsense, as it overlooks the ECB’s role as part of the official sector participating in the Greek bailout in ways that the private sector does not.¹ But there are valid questions regarding the ECB holdings of Greek bonds, as the bank is currently the single largest individual holding of an estimated roughly €45 billion.

Whatever happens, the ECB itself will not take any financial losses from an involuntary restructuring. Instead, any losses will be borne by the owners of the ECB, namely euro area governments. The ECB Governing Council will surely and successfully demand to be made whole in the name of safeguarding its institutional independence. Since the July 21, 2011 agreement [pdf], in which the ECB first secured credit guarantees from the euro area governments to enable acceptance of Greek collateral in its repo transactions, it has been clear that the ECB is a politically senior Greek creditor to the euro area governments and the European Financial Stability Facility (EFSF).

Because of the retroactive writing of coercive collective action clauses into all Greek government bonds, an involuntary Greek restructuring could legally force the restructuring of ECB holdings of Greek sovereign bonds. This restructuring would take the form of the Greek bonds being swapped at par (or at the ECB purchasing price) with new EFSF bonds. The arrangement would transfer the entire financial loss from any euro area official holdings of Greek sovereign debt on to the EFSF, leaving the ECB’s balance sheet intact. Such a swap of perhaps €45 billion of ECB-owned bonds could easily cost the EFSF two-thirds of the original sum, or €30 billion.

Such a transaction would amount to a backdoor recapitalization of the ECB. But the process through which it occurs will matter tremendously in political and policymaking terms. Simply put, Chancellor Angela Merkel of Germany would prefer the political poison of an ECB-EFSF bond swap over the political outcry in Germany from a required direct recapitalization of the ECB after a Greek default, which would quite likely require a separate approval of the Bundestag.

Losses from insolvent countries will therefore be borne by the euro area fiscal authorities, rather than the monetary ones. Without ironclad assurances and the removal of impaired assets before losses are recognized, the ECB would likely become more hesitant in assisting illiquid euro area members in the future.

An ECB-EFSF swap of Greek bonds in danger of default would send a powerful signal to private sector investors in other euro area debt markets. Such investors might fear the precedent effect on Spanish and Italian bond markets derived from the ECB enjoying an IMF-like super-preferred creditor status protecting it from losses in a Greek restructuring. Private investors might also fear that as the ECB increases bond purchases, the remaining private sector investors will become more and more subordinated as creditors. Ironically, the result might lead them to demand higher interest rates as ECB holdings expand.

Such fears, however, are misguided. They stem from erroneous and oversimplified market assumptions by private investors that protecting the ECB from direct credit losses leaves only private investors to suffer losses. The institutional setup in Europe is more complicated. The ECB is not a lonely island unto itself. It is one of several European official sector institutions with different capacities to absorb credit losses. Since late 2010, when the first stealth fiscal transfer was granted to Greece in the form of aligning its higher interest rates and shorter maturities with the lower terms offered to Ireland [pdf] in return for Greek compliance on austerity, the EFSF has been able to take NPV losses on loans ahead of private investors. Outright credit losses on Greek government bonds would certainly be politically trickier for the EFSF than under-the-radar concessions to Greece. Such a strategy would make it harder to argue that support for Greece is a one-off. Faced with the alternative of inflicting direct credit losses on the ECB, something under the radar would be feasible, however.

On the other hand, these concerns over how the euro area official sector “socializes” its credit losses is frankly secondary. What matters is the precedent of the EFSF (and its successor, the European Stabilization Mechanism (ESM), which comes into being later this year) taking credit losses pari passu with (if not ahead of) the private sector, even if the ECB itself is protected.

Another potential hidden cost for the euro area from an involuntary restructuring of Greek debt is the weakening of assurances that Greece is indeed a unique case. There will probably have to be an explicit financial commitment beyond the existing political commitment to “continue providing support to all countries under programs until they have regained market access, provided they fully implement those [IMF] programs.” [pdf] (This assurance has applied to Ireland and Portugal.) If Greek debt is coercively restructured, markets are unlikely to take such rhetorical commitments at face value. To regain market access, Ireland and Portugal might require new de facto fiscal transfers, perhaps in the form of a refinancing of high-yield Irish National Asset Management Agency (NAMA) bank bailout notes with lower cost EFSF debt. Ironically, Ireland and Portugal could thereby benefit from an involuntary Greek default.

All these considerations add up to the conclusion that a last-minute accord between Greece and its private creditors looks likely to be reached. But a bond swap deal would not guarantee a newly revised IMF program with Athens. A much more important obstacle is the newly indicated inability of Greece’s new unity government led by Prime Minister Lucas Papademos to implement any meaningful part of Greece’s structural reform program. This reform vacuum was severely criticized in the latest IMF program review [pdf]. Without a dramatic change in the political gridlock in Athens, an imminent bond swap deal with private creditors may only postpone an inevitable Greek economic collapse by a few months. A new revised IMF program would be impossible to negotiate in the face of continued Greek non-delivery of required reforms.

A delayed Greek collapse would have different implications for the rest of the euro area. The consequence of a deal with a 60 percent or more haircut for creditors, and new bonds governed by English law, would effectively eliminate the private sector as creditors to Greece. Greece would essentially become a euro area domestic problem, a complete ward of the state/euro area for all practical purposes. The IMF would remain the preferred official sector creditor. In that scenario, any private sector contagion from a subsequent Greek domestic economic collapse could be less acute, since most private financial losses will already have been allocated.

Contagion risks from Greece could well subside following a deal on debt restructuring, eliminating any real leverage Greece has vs. its euro area partners. A deal with private creditors is only the first, and arguably the easiest, political hurdle ahead for Athens. As the odds grow smaller for contagion from a Greek meltdown after such a deal, Athens’s ability to extract political concessions from the euro area diminish. In this scenario, Greece might find itself at the mercy of euro area hardliners seeking to protect themselves and the EFSF—with little regard for what happens to the Greek economy (or to Greek citizens). If a debt restructuring deal is implemented with the private sector creditors and Greece still does not deliver on structural reforms, notions of European solidarity will truly be tested. Ultimately, the political question will be asked in the euro area: can the common currency have a member that remains unwilling or incapable of economic reform?

Standard and Poor’s Roils the Water

The other main recent event in Europe was the downgrade of the sovereign debts of several euro area countries and the EFSF in early January. Unlike a potentially imminent coercive Greek restructuring, however, the rating action was largely anticipated and had little impact on market prices. Indeed, it is easily established from looking at market prices of debt and sovereign CDS rates that the new S&P ratings merely reflect existing market realities. The agency, for example, simply bowed to the reality that euro area countries whose 10-year bonds trade more than 100 basis points above AAA-rated Germany cannot themselves be AAA rated.

It is possible, however, that the downgrade of Portugal to grade BB will cause its bonds to lose liquidity as they are dropped from various industrialized country/investment grade sovereign bond indices. (Cyprus may also suffer in this way.) Like other ratings that might affect the size of ECB haircuts or the status of downgraded bonds as repo collateral, the Portugal downgrade indicates nothing about the informational value of the rating. Instead, markets movements merely reflect their own dysfunctional reliance on credit ratings in many standard financial contracts and regulations. This is true even though the two other large credit rating agencies, Moody’s and Fitch, have not followed S&P’s actions.

The principal effect of the downgrading action will therefore be political rather than financial. The biggest unknown is likely to be the impact on the French presidential election. The loss of AAA status for France could be a serious blow to President Nicolas Sarkozy, but French voters may on the other hand take the loss of the top rating as a sign of the seriousness of the plight of France. If economic credibility subsequently becomes a theme in the election, it might strengthen Sarkozy and weaken the Socialists, with their baggage of favoring a 35-hour work week and retirement at 60 years of age now being carried by the party’s candidate, François Hollande.

A closer look at S&P’s justification for its downgrade betrays a stereotypical view of the euro area political economy—and, for a credit rating agency, a surprisingly cavalier attitude to the political sequencing of economic policymaking. The key explanations offered by S&P are the following:

Today’s rating actions are primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone. In our view, these stresses include: (1) tightening credit conditions, (2) an increase in risk premiums for a widening group of eurozone issuers, (3) a simultaneous attempt to delever by governments and households, (4) weakening economic growth prospects, and (5) an open and prolonged dispute among European policymakers over the proper approach to address challenges.

The outcomes from the EU summit on Dec. 9, 2011, and subsequent statements from policymakers, lead us to believe that the agreement reached has not produced a breakthrough of sufficient size and scope to fully address the eurozone’s financial problems. In our opinion, the political agreement does not supply sufficient additional resources or operational flexibility to bolster European rescue operations, or extend enough support for those eurozone sovereigns subjected to heightened market pressures.

We also believe that the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone’s core and the so-called “periphery.” As such, we believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.

The relevant sequence in the first paragraph is the second, which mentions that market price signals have already moved and that S&P ratings need to catch up. The last paragraph is most revealing of the analytical capacity of S&P. Few will dispute the dangers of fiscal profligacy. But since the beginning of the global financial crisis, external deficits in peripheral countries (except for latecomer Italy) have declined while Germany’s current account surplus is basically flat. Therefore it cannot be said that euro area external imbalances are rising.²

Then there is the claim that the euro area reform process is “based on a pillar of fiscal austerity alone.” This assertion is blatantly misleading. It ignores the structural reform progress (admittedly disappointing in Greece) under way across the periphery, which will generate growth in the longer term if implemented successfully. Without significant structural reform progress, the lack of peripheral competitiveness cannot be credibly addressed inside a common currency.

Initial ECB and European Commission support for the bizarre doctrine of expansionary fiscal consolidation—the idea that crisis stricken governments can cut the fiscal deficit without any adverse effects on growth—has fortunately disappeared in the face of overwhelming empirical evidence. But the question remains as to whether a similar fallacy exists (and can surprisingly be discerned in the S&P explanation) on the other side of the European austerity-vs.-stimulus debate. That would be the fallacy of asserting the existence of a “consolidating fiscal expansion,” i.e., the idea that indebted governments can stimulate growth without any adverse effects on the debt-to-GDP ratio.

It is important here to differentiate between the experiences of United States, with its overhang of debt now a political issue in the presidential campaign, and those of most European countries. Everyone is understandably in favor of more growth. But unlike the United States, Europe faces growth impediments that are overwhelmingly structural in nature. In the United States, more and properly structured stimulus spending (not just tax cuts for the rich) might well spur sustainable economic growth, such steps are less likely to be effective in most European countries in the absence of liberalizing labor and product markets and the role of euro area institutions. Germany’s opposition to fiscal stimulus can be debated. But it is much less likely that stimulus spending will produce a sustainable burst of growth in Italy, France, or Spain without such a regulatory overhaul.

As Premier Monti of Italy points out, the euro area must pursue a path towards a more fiscally integrated euro area before any introduction of eurobonds is considered. But austerity in the euro area has been unavoidable and should not be reversed until the peripheral and euro area institutional structural reforms agenda is further progressed. The simple European political economy fact is that such reforms are politically the toughest thing to implement. Contrary to what S&P states, euro area austerity is neither “a lone pillar” or “self-defeating.” It must come with a necessary shift in policy.

Fortunately, the S&P downgrade of the EFSF looks unlikely to increase the cost of its raising capital for Greece, Ireland, and Portugal. Indeed an AA+ rated EFSF looks likely to be able to raise capital on basically the same terms—e.g., trading roughly at the level of France—as an AAA-rated EFSF until it is replaced by the ESM as early as June 2012.

Since the ESM will likely be an AAA-rated entity because of its paid-up capital structure (making it less reliant on sovereign guarantees), a lower rated EFSF might even have a better political chance of being kept alive alongside the ESM after June 2012. Euro area leaders might then have a new political option to expand its financial bailout vehicles in the name of increasing “policy flexibility.” They could do so by deploying both AAA and slightly lower rated bailout vehicles at their disposal. Such an EFSF existing alongside the €500 billion ESM might well be scaled back from its current €440 billion capacity for political reasons, reducing the size of EFSF guarantees proportionally granted by all euro area members in the process. If a smaller EFSF were nonetheless allowed to coexist with the AAA-rated ESM, their partnership would amount to progress in establishing a credible and sufficiently sized euro area firewall.

Notes

1. The expansion of the ECB balance sheet, continued acceptance of Greek collateral, etc. comes to mind, just as the ongoing concessionary lending to Greece by euro area governments for years to come does.

2. It is obvious that continuing if declining deficits adds up to increasingly negative external stocks, but adopting the line that net external investment positions cannot continue to rise in the short-term is akin to stating that even Latvian style shock therapy is too tepid.