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.

Euro zone finance officials voiced optimism on Friday that a deal to avert a disorderly Greek default was imminent and that key building blocks to resolve Europe’s sovereign debt crisis are gradually fitting into place.

Europe’s top economic official said an agreement between the Greek government and its private creditors on voluntary losses for bondholders would be complete within days and the euro zone was making progress on strengthening its financial firewalls.

„We are very close to a deal, if not today then over the weekend and preferably in January, not February. We are very close,“ European Economic and Monetary Affairs Commissioner Olli Rehn told the World Economic Forum in Davos.

The euro strengthened against the dollar and safe haven German bond futures fell back after Rehn’s comments. Italy’s six-month borrowing costs fell below 2 percent at an auction, their lowest since May, in another sign of easing bond market tensions.

German Finance Minister Wolfgang Schaeuble, speaking on the same panel as Rehn, said crafting a new rescue package for Greece was not easy because of past slippage in its performance, but it would be done in the coming days.

„We don’t expect a default in Greece,“ he said. However, he cautioned that Athens would have to meet commitments to economic and fiscal reform that it had not delivered over the past two years and warned against giving Greece the wrong incentives.

The emerging private sector bond swap deal seems set to leave a funding gap of 12-15 billion euros to bring Greece’s debt down to a level of 120 percent of annual output regarded by the IMF as sustainable, EU officials say.

Rehn and Jean-Claude Juncker, chairman of the 17 euro area finance ministers, have both said European governments and institutions may have to increase their support for Greece to make up the difference.

Spanish Economy Minister Luis de Guindos said the European Central Bank should not have to take a writedown on its holdings of Greek government bonds, bought at a discount to calm bond markets, since that could impair its monetary policy.

The ECB’s governing council is debating whether and how to contribute to a package for Greece and has not yet taken a decision. ECB sources said the bank opposes taking a haircut to avoid financing governments or setting a bad precedent, but many council members wanted to find a way to avoid making a profit on holding the bonds to maturity when others were taking losses.

MORE FIREPOWER

Rehn said leaders of the 17-nation currency area would decide in the coming weeks whether to combine a temporary rescue fund for countries in difficulty with a new permanent bailout fund to give Europe more financial firepower.

By combining the 250 billion euros left in the temporary European Financial Stability Facility, a planned 500 billion euros of the permanent European Stability Mechanism and an additional 500 billion euros sought by the International Monetary Fund, „you can calculate in which ballpark we are talking.“

IMF Managing Director Christine Lagarde, speaking to reporters in Davos, kept up pressure on the Europeans to boost their financial firewalls after making a strong plea in Berlin on Monday.

There were „big worries“ around the world about what the euro zone would do going forward, she said.

U.S. Treasury Secretary Timothy Geithner praised a series of steps the euro zone was taking to overcome the crisis but warned of the risk of austerity fuelling a recessionary spiral and said Europe needed a bigger firewall to avert future crises.

„I think the Europeans recognize that the unfinished piece in that framework is building a stronger and more effective firewall,“ he said at another Davos session.

The United States, China and other major non-European economies have said the euro zone should commit more of its own money to crisis management before any increase in the IMF’s fire-fighting resources.

If European countries committed to a more effective firewall, Geithner said he expected other economies in the IMF to act to support those efforts. Rehn said he hoped for progress at next month’s G20 finance ministers’ meeting in Mexico.

European ministers praised the ECB for flooding European banks with cheap, three-year liquidity last month to avert a looming credit crunch.

ECB lending had relieved pressure on euro zone banks and governments, but there is still much to do to spur growth, they said.

„The unlimited liquidity provided by the ECB’s three-year LTRO has reduced pressure on European banks and will help confidence to return … Now we have to think together about how we can support growth,“ French Economy Minister Francois Baroin said.

Baroin and De Guindos both said that in the longer term, the euro zone should issue joint bonds on behalf of its governments, once fiscal discipline had been more strictly enforced and gaps in member states’ economic competitiveness narrowed.

A Few Thoughts on LTRO

The ECB is taking almost any quality asset a European bank offers up and putting it on its balance sheet, as part of its long-term refinancing operation (LTRO). Basically, this allows a bank to post an asset at the central bank and receive 1% money, which they can turn around and use to either improve their own balance sheet and liquidity or buy European sovereign debt at, say, 6%. If the bank then makes 5% on the loan and leverages it up, it can “get whole” in a short time.

This is the same principle (in theory) that Paul Volcker used in 1980 when he allowed US banks to carry the debt of defaulting Latin American countries at face value. Given enough time and interest-rate spread, a bank can work its way out of a problem. And it worked for Volcker. Eventually, US banks made enough money to be able to write off the bad debts.

While this is a band-aid, an attempt to cover up the real problem of banks that are basically bankrupt and sovereign countries that are either in default or at risk of default, it is so far proving to help. Germany has essentially thrown in the towel on keeping the ECB from printing money. While they still growl and bark, like any well-trained dog they stay in the yard. They are a big dog, and their barking makes you nervous as you walk past, but so far they are allowing the ECB to prop up banks throughout Europe. On that point at least, Sarkozy won.

As long as LTRO continues, it should postpone the problem of a true banking crisis – until Portugal has to default, and then all eyes turn to Italy and Spain. If the ECB is allowed to fund Italy and Spain, even through the back door, it will mean Germany has made its choice to keep the euro intact, no matter the cost.

Greek Exhaustion Syndrome

One of my very good friends had a small private dinner this week with the chairman of a major German bank, who remarked, with a sense of gallows humor, that he thought he could get his fellow German banks to chip in enough money to give to Greece to just make them go away. They really have Greek Exhaustion Syndrome.

He also thought Portugal would eventually would have to leave, and said he thought he would take a haircut on Irish debt. Italy and Spain will somehow make it. At least that is the view from the top of the German bank pyramid.

Portuguese interest rates are soaring. Without life support from Europe, they cannot keep up their borrowing at rates that will allow them to recover. While they are gamely trying to reduce their deficit, austerity is reducing their GDP and thus their tax revenues. They will have no choice but to default at some point.

The interesting case is Italy. They have room in their budget to cut, as I have outlined in prior letters. If the ECB subsidizes their debt (lowering the interest-rate cost) or an agreement is reached to lower the rate on their bonds, they theoretically could make it. But either path is default by another name. Maintaining the status quo is not possible. It will not be long before they are at 130% debt-to-GDP, if Europe falls into recession. The IMF has long maintained that 120% is the line in the sand.

It is just a matter of who pays and how the payment is made. But someone will pay.

And there’s this note for those who think austerity comes with few consequences. From the Centre for European Reform:

“Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability. Latvia, Estonia, Lithuania and Ireland prove that so-called “expansionary fiscal consolidation” works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating.

“What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.

“Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade. The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand.”

Portugal and Greece are on that path, if they do not opt out of the eurozone. Italy and Spain cannot avoid the sad results of too much debt without major European support, which means the ECB, as no country will offer that amount of help, as none has the money to do so. But that means a lower-valued currency and purchasing power, higher energy and commodity costs, etc. As I keep saying, it is not a matter of pain or no pain, it is simply a choice of which pain and how much of it you want to have.

It is interesting to watch the game being played with Greek debt (merely interesting, because I have no Greek debt). Private bond holders are now looking at only getting about 30% on the euro. They are now asking that the ECB share some of their pain, and the IMF seemingly agrees that the ECB should. The ECB is aggressively resisting any such notion. An interesting principle is being set here. If you do it for Greece, then the line will get much longer. The euro is on its way to parity with the dollar, as I have said for a very long time.

Those predicting the death of the dollar (at least against major world currencies) and hyperinflation do not understand the rather vicious nature of deflation and debt deleveraging. But that is a topic for a later letter.

Ah, but what do we have here, at 3:36 AM (via my London partner, Niels Jensen), but an article by Nick Doms on Examiner.com, asserting that, yes indeed, Greece will default:

“Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.

The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote ‘in as orderly a fashion as possible’ unquote….

“A Greek exit strategy will probably not be announced officially until early March when the EU finance ministers meet.”

Uncertainty about whether Greece will stay in the euro is crippling its prospects

THE banners at the entrance to the Bank of Greece museum in Athens promise a “fascinating journey through Greece’s modern economic and monetary history”. How could any passer-by resist? Inside the museum ranks of glass cases enclose an array of coins and old bank notes, as well as the paraphernalia used to make them. The bills range from 5 drachma up to 100m drachma, a reminder that Greece has had problems with inflation in the past. The end of history, at least for this exhibition, is 2001 when Greece adopted the euro. But the country’s present troubles suggest an important chapter to the story of Greek money is still to be written. Some reckon the drachma may roll off the presses again.

This is no longer just a fantasy of diehard sceptics about the euro in Britain and Germany. Even Greeks concede that the big problem afflicting the economy, now in its fifth year of recession, is the uncertainty about whether Greece can stay in the euro and get its act together. Savers are anxious that their cash might be forcibly converted to a new Greek currency. By November the Greek banking system had lost a quarter of the deposits it had two years earlier. To fill the gap, the banks have borrowed €43 billion ($56 billion) of emergency funds from the Greek central bank on top of €73 billion of secured loans from the European Central Bank (ECB). Credit remains in short supply because banks have had to cut loans and raise borrowing costs. Informal credit arrangements between firms are breaking down. Foreign suppliers now demand cash payment upfront, making liquidity even scarcer.

Few investors or businesses are brave enough to make long-term bets on the Greek economy in these conditions. The stockmarket has fallen steeply (see chart 1). “You can buy good companies for pocket money,” says one business chief. Assets are cheap but they would become cheaper still were Greece forced out of the euro. Capital spending is down by almost half from four years ago; house building has fallen by two-thirds. The one bright spot is tourism: visitors to Greece were up by 10% last year, in part because tourists steered clear of the unrest in north Africa.

There are hopes that the economy might recover next year if Greece’s place in the euro is confirmed. Agreement on a big new support package from the euro zone and the IMF would put some minds at rest. But a deal on new money cannot be thrashed out until the IMF in particular is sure that Greece’s public finances are on a sustainable path.

That depends, among other things, on private-sector creditors signing up to a bond-exchange deal that will see half of the face value of their Greek paper written off. A deal is proving elusive. Bondholders think Greece’s European rescuers should share in the pain. The ECB has purchased around €40 billion of Greek government bonds, at a discount to their face value, as part of its programme to stabilise bond markets. It stands to make a profit on them, which riles private bondholders. They also want a higher interest rate on the new bonds than officials are willing to sanction. Until a deal is done, Greece is stuck.
 From bad to worse

The ever-gloomier diagnoses of Greece’s economy and public finances further complicate negotiations. An IMF report published at the end of last year said that a 50% write-down on private-sector bonds, a target set at an EU summit in October, together with €130 billion of extra official financing at low interest rates would give Greece a decent chance of getting its public debts down to 120% of GDP by 2020.

But that assessment already looks too sanguine. The headwinds facing the economy are proving much stronger than had been forecast. Greece’s GDP probably fell by 6% last year, far more than expected. A weaker economy has made it harder for Greece to meet its fiscal targets. Softer growth in the rest of the euro-zone economy has not helped. But the depth of last year’s slump owes much to a shortage of liquidity, an influence which most economic models ignore, says Yannis Stournaras of IOBE, an Athens think-tank.

The Greek central bank’s figures show that bank credit to households and private firms fell by 2.4% in the year to November. Banks suffering a drain of deposits have had to husband their liquidity. Official lending figures do not reflect the drying up of other sorts of credit. An informal system by which firms used postdated cheques to pay for supplies has broken down, in part because banks are warier of taking them as collateral for short-term loans. Firms complain that the government is slow to pay value-added-tax (VAT) rebates, making the liquidity shortage worse. Few foreigners will supply Greek customers on the basis of a credit guarantee from a Greek bank. So Greek importers, however solid, usually have to pay cash upfront.

Some firms are finding ways round the stigma of being a Greek enterprise and the credit troubles that brings. The headquarters of Aquis, a firm that runs hotels and resorts in Greece, was recently moved to London by its founder, Ioannis Kent. It is now a UK holding company with a British bank account into which the firm’s revenues are paid. Other firms have delayed payments to suppliers and employees.

A necessary fiscal squeeze is adding to the downward spiral and risks becoming self-defeating. The sorts of public spending that are likeliest to induce other economic activity, such as roadbuilding, have been cut, says Mr Stournaras. Big tax increases are not a sure-fire way of raising revenue in a country where taxes are routinely avoided. The rate on restaurant meals was raised from 11% to 23%; such a sharp jump seems almost an invitation to cheat for cash-strapped small businesses. The IMF says a shortfall in VAT receipts suggests some firms are not complying. A hike in car taxes prompted many drivers to hand in their licence plates.

With so many uncertainties, the Greek economy cannot hope to attract the investment it needs to spur recovery. Until a deal on private-sector losses is finalised and implemented, investors cannot rely on a second bail-out package that will keep Greece in the euro. Even if a deal on losses is agreed in principle, a substantial number of holdout creditors could force the Greek government to implement a coercive restructuring. That might further unsettle bond markets and depositors. Banks will also have to be recapitalised after taking losses on their Greek bonds; no one is sure whether they will remain in private hands.

Goodwill hunted

Slow progress on freeing up the economy and cutting the deficit has cast doubt on the ability of Greece’s leaders to implement reforms. Last year the country moved up one place (to 100th) in the World Bank’s rankings of 183 countries for ease of doing business. Businessfolk call for something more radical to demonstrate the country’s commitment to reform.

One suggestion is immediately to shut down lossmaking or underutilised public entities. Another is to tackle the corruption and inefficiency of the tax system by outsourcing the job to foreign tax officials or to a private-sector tax consultancy. That would speed up much-needed use of centralised computer records and stop the face-to-face contact between tax collectors and taxpayers that begets bribery. A signal that banks would operate at arm’s length to the state would also reassure potential investors. So would a high-profile assault on a closed industry.

But Greece’s economic problems are too big to be fixed quickly. Despite a jobless rate that has risen to 18%, Greece still has a current-account deficit of 10% of GDP (see chart 2). For an economy to have so much slack and yet consume more than it produces is a sign of chronic uncompetitiveness. The IMF has said it will take more than a decade for Greece to become competitive. Some reckon it would be easier for Greece to regain its edge by going back to the drachma and devaluing than by keeping the euro and suffering grinding wage deflation. The short-term disruptions would be outweighed by long-term gains.

Most businesspeople see little merit in devaluation. “The empirical evidence is against it,” says Efthymios Vidalis of SEV, Greece’s main business federation. “Greece had two devaluations after joining the European Union and the benefits were short-lived before inflation eroded them. It didn’t work.”

There is another way. When the crisis struck, Apostolos Vakakis, the founder of Jumbo, a Greek retailer, faced a choice: cut costs by 20% or raise productivity by that amount. He chose to improve productivity. In return for a pledge not to cut jobs or wages, Jumbo’s employees agreed to work harder. Each store is now staffed with fewer workers, allowing the firm to open outlets at a faster rate.

Many stress the importance of greater competition in bringing business costs down. In contrast to devaluation, the benefits from opening up professions and industries to competition are permanent, says Mr Stournaras of IOBE. “It is the ‘doing business’ sort of competitiveness that matters,” he says. Greek executives point to the lack of competition in trucking, where no new licences have been issued since 1971, as an example of an industry that raises costs for other Greek firms.

Public opinion also still favours the euro: more than 70% of Greeks say they want to stay in the single currency. But if Greece is to have the breathing-space it needs to right its economy, it has to convince its rescuers that they are not throwing good money after bad. A deal on private-sector losses is only a first step; it seems likely that the euro zone will also have to stump up more money than expected to keep Greece going. It will be a while before the drachma printing plates on display in Athens can truly be confined to history.

Greece may need more money.

Greece is struggling to reach an agreement on debt relief with its private-sector creditors. But even if it ultimately does, the country may need vastly more funding than has been envisioned so far. German commentators on Friday say it’s time for a bit of honesty from Europe’s leaders.

Greece needs more money. That would seem to be the growing consensus in Europe as negotiations over debt relief between Athens and the private sector drag on. On Friday, Jean-Claude Juncker, who chairs meetings of euro-zone finance ministers, became the most recent European politician to sound the warning bell.

„If Greece’s ability to sustain debt is proven and there is an overall understanding with the private sector, the public sector will also have to ask itself whether it will not provide help,“ he told the Austrian daily Der Standard in an interview published Friday.  The talks between Greece and the Institute of International Finance, which is representing the country’s private creditors in the haircut negotiations, have proven difficult as the two sides have been attempting to come up with an interest rate on the new bonds that will be issued to current debt holders. European politicians have said that this rate should be as low as possible so as to give Greece a shot at meeting its goal of reducing its sovereign debt to 120 percent of its economic output by 2020. Institutional bond holders, however, are holding out for a higher rate and resisting any agreement that could push their losses beyond the 50 percent they had originally agreed to.

A successful conclusion to the negotiations is necessary before a final agreement can be reached on a second bailout package for Greece. With Greece facing €14.5 billion in bond redemptions in March, time is of the essence. The European Central Bank is also currently considering whether to accept losses on the Greek bonds it holds.

Last year, EU leaders agreed that the second bailout fund for Greece — coming on the heels of the €110 bailout package assembled in the spring of 2010 and now all but used up — would have to be worth €130 billion. But, with Greece’s financial situation having gotten worse since then, Juncker is not the only one who thinks this figure might have to be enlarged. European Economic and Monetary Affairs Commissioner Olli Rehn said on Thursday at the World Economic Forum in Davos that, even if Greece receives the envisioned €100 billion in debt relief from its private creditors, it still wouldn’t be enough. His spokesperson in Brussels added that experts were currently in the process of calculating Greece’s true needs.

Germany has consistently refused to consider throwing more money at Athens, but it may back down under increasing pressure.

The EU has also made the new bailout package dependent on Greek reform efforts. Several EU leaders have expressed frustration at how announced austerity measures have been implemented and insisted that there will be no aid without further belt-tightening.

The topics and tropes fall faster than snowflakes here in Davos, where several thousand of the world’s leading business people, politicians and policy makers gather once a year for an annual think-fest. And with literally hundreds of panels, debates, interviews, workshops and symposia taking place, it would be impossible to capture all of the ideas competing for attendees’ attention. But, still, as in any complex system, patterns start to emerge. With three of  the event’s four days almost over, here are some early bets on what may go down as the major themes of this year’s convocation.

Capitalism needs a fundamental overhaul. That capitalism is somehow broken has become one of Davos’ most persistent themes. Indeed, “Is 20th Century Capitalism Failing 21st Century Society,” was the topic of TIME’s own panel, which kicked off the proceedings here on Wednesday. Since then, no fewer than three other panels have been devoted to some variation of “fixing capitalism” or “remodeling capitalism.” No one here is arguing that capitalism should be scrapped wholesale, of course. Instead, the most rational arguments have pointed out that not only is capitalism the best system yet devised for enhancing the well being of the greatest number of people, but that it is also immensely supple and flexible. In 200 years, capitalism has already gone through several major iterations. But what, practically speaking, will a global capitalism retooled for the 21st century look like? More regulation? Or less? State Capitalism, like that practiced by China, Russia and many countries in the Middle East? Well, no one has quite figured that one out yet. But a surprising number of attendees (and these are the world’s most direct beneficiaries of the current system) seems to agree that something is wrong. And that in itself is remarkable.

The Arab Spring must end happily. Representatives from the revolutionary movements that recently toppled regimes in Tunisia, Egypt and Libya are among the stars of this panel. Many of them are wearing the hallowed holographic badges, which means that they have been invited to some of the very highest-level meetings usually reserved for heads of state, ministers of finance and their ilk. This indicates that the powers at the very core of the World Economic Forum are interested in the Arab Spring as a matter of paramount global importance. (That said, among the regular attendees, the Eurozone is of far more interest. At one panel discussion I attended on “The Future of North Africa,” the auditorium was about 10% full. For a “Future of the Eurozone” panel taking place immediately after, it was standing room only. This is worrying on several levels.)

The Eurozone crisis will continue to muddle along, but muddling may be enough. The European finance ministers in attendance are all staying on message: Eurobonds are not happening, austerity measures are the way forward now, greater fiscal union is the end goal, and Greece will not default or leave the Eurozone. Interestingly, for the first time in a long time, most of the policital/policy/media hive mind is cautiously optimistic that the Eurozone may actually be starting to heal itself. (Note that UK Prime Minister David Cameron, who sharply criticized the euro rescue plans yesterday, is a spectacular exception.) Much credit is being given to Mario Monti, the unelected technocrat Prime Minister of Italy, who has been widely praised as walking the fine line between implementing reforms that will bring results gently enough not to incite mass revolt by Italian society.

China is still the star. Brazil has come to Davos in a big way. As has Mexico, and India, and Azerbaijan. But the panels on China are packed, and everybody wants to talk about China, and while the cult of the Chinese technocrat has long been on the rise, we are now reaching the full flower of absolute reverence. American business people speak in hushed tones about the new generation of Chinese leaders as if they are supermen: They are well-educated, worldly, wise, and compared to the haplessness and paralysis that western governments have demonstrated over the past two years, they are paragons of good governance. They glide over a lot of complexities, of course, but they can’t help it. They are in love.

Americans and Europeans are pointing fingers at each other. Why is the global economy not in full recovery? The Europeans complain that none of this would have happened if the Americans had not taxed the global financial system when its housing bubble burst. To which, the Americans respond that that may be true, but they claim to have put their house in order and the only thing that’s holding America’s economy back now is European uncertainty. Then, arguments commence.