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Archives for November 2010

The European rescue plan that dare not speak its name

Stephanie Flanders | 13:08 UK time, Tuesday, 30 November 2010

Should Germany leave the euro? Looking at the eurozone debt crisis unfold, many economists are warming to the idea, though I am told that the German chancellor emerged from this weekend's bail-out talks more determined than ever that the single currency remain intact.

Angela Merkel


Her plan, I'm told, is to honour the promise to proect senior creditors "in the breach". The current rules and protections will stand until 2013, but if there are individual bank failures before that time, she is going to try very hard to force private senior creditors to take a hit.

As one person put it: "the more this is about banks, the cheaper it is for Germany." It will be interesting to see whether this German offensive on debt is any more successful than the last one.

In the meantime, what about the rest of the eurozone? Could it benefit from getting rid of Germany, and maybe some of its neighbours?

As it happens, the European Commission provided some inadvertent support for the "dump Germany" idea in its latest European economic forecast. It predicts the euro area will grow by 1.7% this year and just 1.5% next year. But that average hides a lot of sins.

It sees growth for Germany of 3.7% this year and 2.2% in 2011, but in Spain the economy will have shrunk for a second year in 2010, and growth in 2011 is forecast to be a measly 0.7%.

Italy is the only country on the porcine periphery that is expected to grow by more than 0.5%, on a cumulative basis, over the course of 2010 and 2011. (And it's worth noting that the Commission doesn't think much of Ireland's forecast for growth of 1.75% in 2011. The European forecast is 0.9%.)

Today's employment numbers are the icing on the cake. The eurozone unemployment data out today shows German hiring intentions higher than they have been at any time since unification.

There's an undeniable buzz in Germany these days - you hear about it from every German you speak to. The official line is that some of that buzz is at last coming from the domestic market. Supposedly, the long-awaited re-balancing of German growth is at hand.

Well, maybe. Yesterday's forecast has German domestic demand growing by 2.3% in 2011, compared to a eurozone average of just 1%. But remember that a good part of that demand will be dedicated to serving German exporters. Private consumption is expected to grow at less than half that rate: not much faster than the Eurozone average.

German exports grew by nearly 15% in 2010, and investment in equipment and machinery is set to grow by roughly 10% in 2010 and 2011 - twice as fast as the Eurozone average.

Leaving the euro would test the proposition - often advanced by German officials at international meetings (see my posts from Seoul) - that Germany's trade surplus has nothing to do with having the same currency as Greece, Italy and Spain.

You never know, they might be right. Germany specialises in capital good exports, which are traditionally driven by external demand more than price.

We can say for sure that if Germany left the euro, the new German currency would go up, and the euro would probably go down. It's a fair bet that other big surplus countries, like the Netherlands, Austria and maybe Finland, would want to join them.

The huge advantage, to the periphery, would be that they would get a depreciation (albeit possibly a modest one), without having immediately to default or restructure their debt. If they left the euro themselves, their euro-denominated debt would soar in value, meaning some form of default was more or less guaranteed.

Of course, if the periphery is going to come out ahead, there would have to be losses for German creditors, notably banks, who could see the value of their euro debt fall sharply in domestic terms.

In a sense, that's what a currency appreciation is all about: long-term, it's supposed to make it less attractive to invest and export abroad, and more attractive for businesses and banks to focus on the markets at home. It's called re-balancing the economy. But the short-term hit to German lenders is yet another reason why Germany will not be abandoning the single currency any time soon. It doesn't want anyone else to leave either.

However, if the Euro continues in its current form, the chances are there will be need to be either a series of bail-outs, or a much expanded system of fiscal transfers between states, as the countries on the periphery discover that they can't make life in a single currency pay.

Knowing that it would have to bankroll both of these, Germany would rather have neither. That is why it is so keen to have private creditors pay for them instead. But remember that many of those creditors are German. In a twin-track eurozone, the big creditor nation ultimately has to choose between propping up the debtors, or losing a big chunk of the money that it has lent.

That sounds rather like a choice between Germany paying for the single currency crisis upfront - with a costly exit right now - or paying for it in installments, in perpetuity.

German voters won't be offered this choice, in so many words, by any senior German politician in the current group. But who knows what they would choose if they ever were?

Good news for Mr Osborne, but with a health warning

Stephanie Flanders | 14:00 UK time, Monday, 29 November 2010

The chancellor will find little to concern him in the latest forecast from the independent watchdog he created - and some important reasons to cheer, particularly in the labour market. But, as the Director of the Office of Budget Responsibility, Robert Chote is keen to stress he'd be mad to expect any of the forecasts in this report to turn out to be right.

As expected, the OBR has revised up this year's growth forecast, from 1.2% to 1.8%, but it does not think all of that growth is sustainable. The forecast for 2011 has been revised down, from 2.3% to 2.1%.

The biggest news is the big reduction in the job losses forecast in the public sector between now and 2014-15. The OBR now thinks the public-sector workforce will shrink by 330,000 over that period, not 490,000, though they expect another 80,000 to lose their jobs in the 2015-16.

Mr Osborne will be pleased by the very modest change in the borrowing forecasts, though the OBR expects tax revenues to be £2.4bn lower than forecast by 2015-16, and it now thinks that he will only save £9.6bn from the extra welfare cuts in the spending review, about £1bn less than he hoped.

Bad news for home-owners: the OBR thinks house prices will fall by 3.1% in 2011. Previously, it expected a small rise.

Update 1417: Robert Chote has just confirmed that the chancellor's spending review saved 130,000 jobs.

As I mentioned earlier, the forecast job losses in the public sector by 2014-15 have fallen by 160,000. Of that, around 30,000 is due to the OBR changing the way it makes the forecast, but the rest is down to Mr Osborne - notably the decision to cut welfare more, and departmental spending less.

As the report underscores, the news from the private part of the labour market has been even better in the past few months. In fact, the OBR is in the welcome position of finding that its forecast for the level of total UK employment in the middle of 2012 has already been met.

There has been a 350,000 increase in employment since the first quarter of 2010 - put it another way, around one fifth of the increase in employment the OBR expected by 2016 has happened in just the past six months.

On borrowing, Robert Chote says that the OBR now thinks there is a 70% chance that the government will meet its deficit target by 2014-15.

That's slightly better than in June, and better than the "more than 50% chance" that the fiscal mandate requires. But with so much of the report dedicated to the uncertainty surrounding all of the forecast, I don't expect the chancellor will be planning any spending sprees on the back of it.

Finally, it is interesting to note that it would be better for Mr Osborne if the economy did not re-balance, as we are all supposed to hope. The "rebalancing delayed" scenario in the report shows that a more consumption-led recovery would be good news for the public finances, with borrowing falling faster than expected. It might be good for the government's election chances as well, even if it was simply delaying the day of reckoning for household finances.

A new prayer for Mr Osborne could be "Lord, may Britain have more balanced growth, but please make it after the next election."

A good man, and a fox hole

Stephanie Flanders | 09:28 UK time, Friday, 26 November 2010

"If we stabilise Ireland, it may be possible to hold the eurozone as well." Interviewing the Irish finance minister yesterday, that was the line that jumped out at me. I had asked him whether he thought Ireland would be the last eurozone country to apply for emergency support.

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Say this for Brian Lenihan - he doesn't go in for the kind of exaggerated statements of confidence that most finance ministers resort to when their backs are against the wall. I suspect his fellow European finance ministers would have preferred something less tentative. But that has never been his style.

I first interviewed him back in April, at the start of Britain's election campaign. If anything, he was more relaxed the second time around, though compared to today, April must now seem to him like the lull between the storms. Rightly or wrongly, at that time the markets were giving Ireland the benefit of the doubt.

Come to think of it, back then the markets were feeling pretty optimistic about the entire world. The IMF started talking about unwinding the many G20 stimulus programmes, and it looked as though the eurozone might not be in as much trouble as some had feared.

Not any more. Now, some of the worst fears that senior policy-makers have had about the eurozone and its crisis management capacity have been realised - or at least now look much more real than they did before.

On the vexed issue of Ireland's banks and their debt, Mr Lenihan confirmed to me that there would be sizeable haircuts for many, if not all, the junior creditors of Ireland's most troubled banks. He was pleased that Anglo Irish had reached an exchange agreement for its subordinated debt maturing in 2017, which values it at merely 20% of the face value. Expect more such deals.

But he was adamant, as ever, on the question of senior debt. I pressed him hard: he kept returning to the same, undeniable truth - that Ireland is not so different on this issue than anyone else.

Ireland has guaranteed the debt explicitly. But implicitly, the other European governments have been just as keen to reassure senior bondholders in their banks (with the possible, and unsurprising exception of Germany.) He said "there has been no question" of failing to service this debt in Ireland - but there hadn't been any question of it happening in Britain either.

We tend to think that the desire to reassure bondholders is driven by blind fear: no-one wants a repeat of Lehmans. But, after the interview, Mr Lenihan mentioned an intriguing, practical, objection to imposing haircuts on senior bondholders. Because, in European law, the senior bondholders in a bank have an equal legal standing to its depositors, he claims that it would be legally challenging, to say the least, to punish bondholders without punishing depositors as well.

I'd be interested to hear whether the legal experts agree. If true, most of Europe's politicians would consider it yet another reason why they don't want to go down this road.

But, as we saw this week, investors do not believe that governments will be able to hold the line. if senior bank debt isn't restructured, they expect that there will be some form of sovereign restructuring instead. The price for taxpayers is just too high - and their economies too weak.

Against this backdrop, Mr Lenihan's lukewarm vote of confidence sounds about right. "[I]f we stabilise Ireland, it may be possible to hold the eurozone" is a fair reflection of where we are.

Ireland's four-year recovery plan

Stephanie Flanders | 14:30 UK time, Wednesday, 24 November 2010

I am sitting in the press conference listening to Ireland's leaders explain their four-year plan. They are promising to protect health and education spending - as far as possible - from the four years of cuts outlined in the plan.

This is easier said than done - the report notes that these two account for 44% of current spending.

All workers in these sectors will be affected by the cuts to the public sector pay bill and staff numbers.

But, by my reckoning, Ireland is doing more to protect the education of its future workforce than the nation's health.

Staff numbers in the civil service and the health system will both fall by more than 10% (12% in the case of the civil service). There will be more than 10,000 fewer people working in the health sector by 2014.

Worst hit will be local authorities (sound familiar, Mr Osborne?) Their staff levels will fall by 14% by 2014.

But, numbers employed in the education sector will barely change - down by around 1% by 2014, according to the plan.

Ireland's pain: Multiply by 10

Stephanie Flanders | 12:20 UK time, Wednesday, 24 November 2010

In these days of financial crisis, we're bombarded by bad news with a lot of zeroes attached. Sometimes it's difficult to keep track of what it means for ordinary people - and the economy of which they are a part.

Ireland's crisis is a case in point. Now we know it's in line for an 85bn euros rescue package - conditioned, in part, on a 15bn euros programme of further budget cuts by the Irish government which we'll be hearing more about this afternoon.

If you live in Britain, you will understandably be wondering what these numbers actually mean. But here's a good place to start: take every number you hear later today from the Irish finance minister and multiply it by 10.

This year Ireland's national output, or GDP, will be around 160bn euros. As it happens, Britain's GDP will be about 1,600bn euros so that 15bn euros in cuts would be more like 150bn euros - or £126bn - if it was happening in the UK.

Put it another way: today's 15bn euros in cuts represents a tightening of just over 9% of Ireland's national output over four years. For reference, the UK government is planning to reduce structural borrowing by around 8% of GDP over five years from 2010.

So, you might say, this is not so different from Britain's own austerity. But remember, Britain is just starting its fiscal tightening. Ireland's "era of austerity" started more than two years ago.

The government here has already cut spending or raised taxes by 15bn euros in the past two years. In the teeth of the steepest recession in Europe (see chart below), it has already done more tightening in the past two years than the British government is planning to do in the next five. And now it is promising to do the same again, by 2014.

Chart showing output loss

In fact, it's even worse than that. In discussing Ireland, most economists - and certainly all international organisations like the IMF - tend to emphasis GNP, not GDP, because the earnings of foreign multinationals account for such a large share of Ireland's national output. So, whereas GDP this year will be around 160bn euros, GNP will be closer to 130bn euros. So that 15bn euros in cuts will feel more like 11% of national income than 9%.

It was a global curiosity when Brian Lenihan unveiled a major austerity budget in the spring of 2008, just as pretty much every other country in the world was lurching toward fiscal stimulus (remember the London G20?) The feeling was that Ireland's enormous banking woes had left it no choice.

But optimistic souls talked about the possibility of an "expansionary fiscal tightening" - the idea that budget cuts would do so improve Ireland's standing in global financial markets and the confidence of the private sector that they might actually support growth, and hasten the end of Ireland's recession. (Incidentally, George Osborne used to talk about it as well.)

You don't hear much of that talk today. The government is forecasting average growth of 2.75% a year between 2011 and 2014, but in their summer staff report, the IMF thought even that could be optimistic - and their forecasts back then did not take into account additional bank bailout costs in 2010 of 20% of GDP.

In that same report, the IMF suggested that of all the 30-odd countries it monitors closely, Ireland was most at risk of suffering from outright deflation (see chart below). That risk, too, must surely have intensified as a result of the events of the past few weeks.

Chart showing deflation vulnerability indicator

People here still believe in the euro. Certainly, being in the single currency area - with a "one-size-doesn't-really-fit-any" monetary policy - helped magnify Ireland's boom. As has been written many times here, it also made it easier for the rest of Europe to lend the Irish private sector an extraordinary amount (see chart at end of this post).

Now the euro is magnifying Ireland's bust, because to make an export-led recovery remotely plausible, prices and wages have to fall instead of the currency. Unemployment in Ireland has risen from 4% to more than 13%. The IMF don't expect it to fall much below 10% between now and 2015.

In today's FT, Martin Wolf argues [registration required] that Ireland's experience shows the "German" approach to monetary union is fundamentally misconceived. That is for others to judge. But it has certainly not been a recipe for "no more boom and bust". The currency has been stable - but very little else.

Having ridden the roller-coaster up, now Ireland has to ride it down. The official IMF assessment is that Ireland is embarked on a prolonged period of "internal devaluation" to rebuild competitiveness within a single currency. The clever economists at the Fund may be able to tell the difference between that and a Japan-style scenario of stagnant real incomes, high unemployment and deflation. I doubt that many Irish voters will.

Chart showing firms debt burden

Update, 12:30: I see the ratings agency Standard and Poor's has similar fears for Ireland's economy, which partly explains their decision to downgrade Ireland's sovereign debt, yet again. Here's a few nuggets from today's press release:

"As a consequence of the high overhang of private debt, fiscal austerity, and the uneven outlook for external demand in Europe, Standard & Poor's now expects close to zero nominal GDP growth for 2011 and 2012. We do not envisage GDP exceeding 2% a year in real terms before 2013."
"While export performance is forecast to remain firm over the medium term, we are of the further view that domestic demand will most probably stagnate, thwarting any immediate recovery in tax revenues.
"In our view, downside risks of deflation remain. These depend partly on the external environment and the speed with which the financial sector can recover sufficiently to contribute to the economy again. Meanwhile, uncertainties surrounding the timing and extent of imposed burden sharing by EU institutions have raised refinancing costs. In our opinion, these refinancing costs are likely to remain high until investors perceive the forecasts for primary fiscal balances as much improved."


Of course, the value of the assets sitting on the banks' balance sheets will be affected by the state of the property market and the overall economy. So will the state of the budget. It's a simple point but an absolutely crucial one. If the economy doesn't get better, then neither will the banks or the national budget. Right now, international markets don't seem to have much confidence in any of them.

Irish lessons for the eurozone

Stephanie Flanders | 12:43 UK time, Monday, 22 November 2010

Ireland has surrendered. All that now remains is the detail - and we may not get that for some time. But some broad lessons for the eurozone are already clear, and not encouraging.


The first lesson is that Europe is further than ever from a pragmatic approach to the debt mountain sitting on the balance sheets of Europe's more troubled banks.

Negotiators appear to have gone into the Irish negotiations with an assumption that senior creditors to Ireland's banks will not see their bonds restructured as part of the deal.

If so, the eurozone is pressing ahead with the same approach it has followed ever since the collapse of Lehmans set us on this path. That is: when in doubt, sign another blank cheque to private creditors, and try not to think about the money, or the moral hazard.

Jean-Claude Trichet

19 November: Jean-Claude Trichet at the European Banking Congress in Frankfurt

As we know, the Irish are furious that the German chancellor started talking about restructuring sovereign debt in future crises. Their anger is understandable: as the European Central Bank President Jean-Claude Trichet warned at the time, you shouldn't go public on that kind of discussion without a clear strategy for dealing with the inevitable market reaction. Apparently, Angela Merkel didn't have much of a plan at all.

But those who care about the future of the eurozone - and, incidentally, the global financial system - will also be angry that the issue was raised in such a cack-handed manner. It may well have left the system further than ever from addressing a problem that even investors would now like to see addressed.

At the start of this year (Thinking the Unthinkable), I considered whether what the world needs now is not just a mechanism to allow banks to fail in the future, but to allow sovereign governments to fail as well. Chancellor Merkel may be right to want to find one, but right now the eurozone looks weaker, not stronger, for her efforts. We don't have a reasonable way to talk about restructuring any senior debt at all.

The second lesson relates more to the real economy, and to the message that Ireland's failure sends to other countries in trouble.

In the case of Greece, a string of governments had borrowed and spent too much, and delayed the day of reckoning by hiding a good part of that debt from the rest of the eurozone. That is why, deep down, many in Europe see a kind of justice in what is happening to Greece and its economy. They broke the rules; now they have to pay. In a sense, the feeling is that they should be grateful for whatever help they can get.

That is less true of Ireland (and I don't think I'm saying that because Dublin is so much nearer to London). They did play by the rules. The government did not run large deficits during the boom years - quite the opposite. Even its current-account deficit was not so different from Britain's. And when the crisis hit, ministers made early and politically very difficult efforts to preserve market confidence and rebuild the country's competitiveness within the constraints of the single currency system.

Yes, the Irish authorities let the property market and the banking system get far out of control. In a sense, they let the whole country go slightly mad, high on rising property values and a tidal wave of cheap credit. But didn't they all?

Robert Peston is right to remind us that Britain's mistakes, in the boom years, were different in scale to Ireland's - but not in kind. The biggest difference is that we did not choose to join the euro.

This is what should be troubling Europe's leaders about Ireland. Greece is seen as a country that broke the rules and has to pay. Ireland has its faults, which European officials may choose now to play up. But, at bottom, it is a country that played by the rules of the euro and failed. Other countries striving to make a go of the single currency will reasonably ask whether the same fate awaits them.

The stages of Ireland's grief

Stephanie Flanders | 11:46 UK time, Thursday, 18 November 2010

They say governments in financial crises go through a process much like the stages of grief. This week Ireland's ministers have been going through them at record speed.

Customs Building, Dublin


On Tuesday morning on the Today programme, the European Affairs minister was still denying that the country had a problem. Then came anger. Now, we have widespread acceptance that a deal will have to be struck.

There are some question marks over the timing of a programme for Ireland's banks - and many more about the details. But the fact that there will be one is no longer in doubt.

For what it's worth, I'd expect us to have the broad outlines by Monday morning - if not before. (Talking to anyone in Dublin, they tell you these things "always happen on Sundays".)

But as any amateur psychologist can tell you, acceptance is not the same as forgiveness. There are two aspects of this crisis, in particular, that will be sticking in Brian Lenihan's throat.

The first is that they wouldn't be in this mess - or at least they wouldn't be in this mess right now - if the German chancellor hadn't insisted on leading the rest of Europe into a formal discussion of how sovereign debt in the eurozone might be restructured, in the event of crises after 2013 (see my post From 'competitive depreciation' to 'competitive miscommunication'). 2013 is not far away. Investors understandably wondered whether the debt they were holding right now could be in for a haircut as well.

In the market maelstrom that has followed, ministers have scrabbled to "clarify their position", insisting that only debt issued after 2013 would be affected.

But it doesn't much matter - at least to Ireland. The damage has been done. And of course, the concerns have the ring of truth. Germany and others really would like to punish bondholders before 2013 - if only the global financial system looked more able to take a sovereign debt restructuring in its stride.

Partly thanks to the German chancellor's efforts, the system may be even further from that point now than it was a few weeks ago.

The other thing that must seem so unfair to Ireland's ministers is that, of all the countries in the eurozone in trouble, Ireland has probably done the most to get past the economic disadvantages of being in the euro and move forward.

Unlike Portugal, Spain or Greece, it did not come into this with a massive current account deficit. And unlike them, it has made enormous progress in the past few years in restoring the countries' competitiveness.

Unit labour costs are a good rough guide to the competitiveness of a country's workforce in global markets. Like the other PIGS, Ireland's unit labour costs rose sharply relative to Germany's in the boom years. But unlike the others, Ireland has brought labour costs down sharply since the crisis began. Wages have fallen sharply, and so have prices.

In that sense, Ireland has played by the rules of the single currency system. As a result, you can see a growth path out of this for the Irish economy within the euro, that you can't see for Spain, Greece or Portugal. If only they could just get past that mountain of private bank debt.

But of course, that's no small detail. Indeed, it's that mountain of debt that has ultimately made Ireland's banks vulnerable to this kind of loss of confidence, and all that follows from it.

Ireland can't blame that on the German chancellor, or any other government. True, the rest of the system was complicit in allowing the liabilities of the Ireland's banking system get so far out of line with the size of its economy. But ultimately, the responsibility for this crisis lies with the Irish themselves. That's a hard pill for ministers to swallow as well.

Tough choices: Devolved, and deferred

Stephanie Flanders | 08:17 UK time, Thursday, 18 November 2010

Scotland and Wales produced their new budget plans on Wednesday, less than a month after Chancellor Osborne told them how much money he had to give them between now and 2014-15.

George Osborne


Particularly in Scotland, politicians in the devolved nations have tended to say they have the worst of the cuts. The Treasury insists that they have only had their fair share. The answer is that they are both right.

Overall, the chancellor in the spending review decided that departmental spending across the UK was going to be cut by 11% in real terms by 2014-15. Another way to think about that is that it is just a bit better than a cash freeze. The real cut in the block grant for Wales and Scotland is also 11%, with the cut for Northern Ireland only slightly lower: 10%.

As we know, the Westminster government made a decision not to distribute the pain equally. Far from it. The NHS in England and overseas development will get real increases - albeit very small ones in the case of the NHS. That means unprotected departments are looking at a cut of 19%. The schools budget and defence are doing much better than that, meaning really eye-watering cuts for, among other things, higher education and housing.

The Welsh and Scottish governments also had to decide how to distribute that 11%. But arguably, they had less room for manoeuvre than Mr Osborne, because there have fewer places to distribute it. In that sense, things are a little harder for them. Health and education between them account for around two-thirds of spending by the Scottish government. They account for an even larger share of the Welsh budget. .

You can see the difference this makes in the cuts in capital spending which the Treasury pencilled in for Scotland and Wales at the time of the Spending Review. Across the UK, there will be an average 29% real cut in capital spending by departments by 2014-15 - but the cut for Scotland and Wales is close to 40%. The Scottish government tried to lessen that cut slightly today, but it did not have room to do much.

In this draft budget, Wales is going it alone in suggesting that everyone - and every department - should take their fair share of pain. If passed by the Assembly, the budget would cut health spending by nearly 8% in real terms, with similar cuts for education and local government.

If devolution is supposed to be about nations having the freedom to go their own way, this may be the most striking example yet. It will be interesting to see if they manage to hold the line, if and when the difference in health spending between Wales the rest of the UK starts to become obvious to voters.

The Scottish government played it differently - displaying, in many ways, similar priorities to the chancellor in Westminster. As in England, health is being protected, while universities, prisons and housing are being hit. There is also the obligatory public sector pay freeze and talk of sweeping efficiency savings.

However, George Osborne did at least bother to come up with spending totals through to 2014-15. Today's Scottish budget only covers 2010-11. It's easy to see why the other years have been left blank: there is the small matter of a Scottish election in May. But it does mean that a lot of the tough decisions have been kicked down the road.

The implausible in pursuit of the indefensible?

Stephanie Flanders | 12:32 UK time, Tuesday, 16 November 2010

When Ireland explicitly guaranteed all the liabilities of the Irish banking system just over two years ago, the finance minister, Brian Lenihan, said it was "the cheapest bank bailout in the world."

It is turning out to be very expensive, not just for Ireland but for the whole of the eurozone. The European ministers meeting in Brussels today know that they have also made promises to the markets that they will find hard to keep.

Let me explain. Ever since this crisis began, the response by European policy makers has been centred around a promise that bondholders would be compensated in full for their investments - and a hope that this proposition would never seriously be tested.

Now that promise is being tested, in Ireland, which probably has the greatest mountain of problematic bank debt, relative to its economy, of any eurozone economy.

European investors and taxpayers look at Ireland, and they start to see what that promise to bondholders actually entails, not just for Ireland but for rest of the zone. And what started out as implausible, begins to look downright indefensible.

I've been banging on about the ECB role in the saga for months (see, for example Greek sovereign debt: Exit closed? and Ireland: A problem soon to be shared). Robert Peston provides a very useful reminder of the numbers involved in his two latest posts (How big is Europe's crisis? and Will the ECB pull the plug on Ireland?)

By providing cheap and unlimited liquidity to banks, the ECB has effectively found itself filling the gap between what the European governments had promised to the bond markets, and what they can actually afford.

Graph showing ECB support to banks

It has, to put it mildly, not been comfortable with playing this role. And in recent months senior ECB figures have been making their reservations felt, pressing governments to decide exactly how much they were going to support troubled economies like Ireland, and on what terms.

This has combined with the German chancellor's understandable - but deeply inconvenient - desire to send a message to German taxpayers and the markets that the promise to always and everywhere bail out bondholders has a use-by date. Come 2013, anyone buying eurozone sovereign debt should expect to pay the price for their mistakes (see my post From 'competitive depreciation' to 'competitive miscommunication').

As a result, this looks very like crunch time for eurozone ministers.

As I said on the Today programme this morning, perhaps the biggest flaw at the heart of the eurozone system was its version of the "Three No's": there would no exit, no bail-outs, and no default. That's possible in a perfect world where no country ever gets into trouble.

In the real world, when countries have crises, at least one of these rules will inevitably be broken. The founders planned for success, and didn't make much provision for failure.

In those fateful weeks of April and May, the eurozone governments decided to suspend the ban on bailouts right now, with a quiet promise (to Germany and others) that the "no default" rule would be lifted in future, when the crisis was past. But even here, they were planning for success without really preparing for failure.

Looking at the sovereign borrowing of all of the peripheral economies, and the debts of their banking systems, no serious investor expects every penny of that money to be repaid.

Even if it were possible politically, I doubt there are many people who think it would be healthy for Europe's economy or its democracy to transfer all of those obligations to the public balance sheet, to be financed by repeated rounds of fiscal austerity.

In reality, as we see in Ireland, transferring all of those obligations tends to make a much more damaging sovereign default that much more likely.

Understandably, European governments are desperate to avoid a conversation about how - and how far - the debts of European banks or countries might be restructured. So they keep promising that governments will stand by their banks, and the eurozone system will stand by their governments.

But investors ought to be asking themselves which would be more damaging to the long-term value of eurozone assets: governments breaking their promises to eurozone private bondholders, or governments trying to keep them?

PS You can hear me discussing the consequences of Ireland's economic woes on the rest of Europe with the BBC's political editor Nick Robinson on the Today programme:

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When the G20 stopped feeling like the G8-plus

Stephanie Flanders | 22:07 UK time, Sunday, 14 November 2010

Western officials should have realised this summit would be different when they arrived in Seoul to find their smartphones didn't work. The problem was that Korea's nationwide 4G network was too advanced. On early negotiating missions, key UK officials found themselves communicating with London via e-mail, on rented phones.


President Obama in Seoul

That was never a problem in Pittsburgh, or in Toronto. But as George Osborne liked to point out, this was the first G20 summit not hosted by a G8 country - and, he might have added, the first where G8 countries didn't call the tune.

As we know, there was vanishingly little progress on the debate of the hour - the question of global imbalances. China is going to open its economy and take on more of the burden for sustaining the world economy. But it's going to do it in its own time, in its own way. And that includes raising the international value of its exchange rate.

America isn't helpless in this battle. Far from it. The US controls the only truly global currency. And its central bank will print a lot of it, if it has to, to keep the American economy going. But, as I said last month, this battle over the Chinese exchange rate may be the closest we have seen to a fair fight between America and another nation for a very long time.

China has spent $2 trillion in the past decade keeping its exchange rate at a competitive level, and there's plenty more where that comes from.

It wasn't just currencies. The development agenda tilted eastwards at this summit as well. As far as China, India, or Korea are concerned, no-one ever got rich following the old-style Washington Consensus of the World Bank and IMF: Africa, least of all. The way they see it, Asia is where the really big falls in poverty have all been achieved - and that didn't happen by playing Western rules.

The Washington Consensus has been dead for a while, or at least under serious review. But the "Seoul Consensus" that the G20 signed up to this week made it official. And there were Asian fingerprints all over it.

In the communique, the leaders also agreed that "innocent victims" of the currency wars - countries whose exchange rates were getting pushed up for no good reason - might be right to impose formal capital controls. That's the final nail for another G8 taboo.

I remember back in the Asian financial crisis, in the late 1990s, when Malaysia resorted to widespread capital controls to protect their economy. It became a pariah - at least in IMF circles. But most of the fast-growing Asian economies have limited capital inflows for years - and after this latest turbulence, they're planning to regulate more in future, not less. Like it or not, the IMF and the G20 are catching up with reality.

It's too soon to call the end of America's hegemony over international summits. The US will be the largest economy in the world for a few years yet. I suspect US presidents will continue to set the agenda, long after it slips to second place - if only to give the others something to pick apart.

But this may go down as the summit where China said no to the US - and where the G20 stopped feeling like the G8-plus.

Like the global economy, this new G20 has a different balance of power. It's more diverse. More fractious. And it's not a little disconcerting to the old guard. Just don't expect Nicolas Sarkozy to admit it, when he chairs the G20 next year.

From 'competitive depreciation' to 'competitive miscommunication'

Stephanie Flanders | 17:45 UK time, Friday, 12 November 2010

Seoul: They say it's difficult to prevent the next crisis while the last one is still going on. Eurozone leaders have been learning that one the hard way.

In recent days they have almost single-handedly brought on a mini-panic over European sovereign debt which has sent bond yields on the periphery to new highs, and leaves the euro about two cents lower against the dollar than when the leaders got on a plane to Seoul.


The German chancellor talks about the evils of "competitive depreciation". Maybe President Obama should start laying into the Europeans for their "competitive miscommunication" to financial markets.

How did they get here? Cast your mind back to the summer, when the eurozone leaders bailed out Greece, and set up an emergency safety net for other eurozone countries. That is supposed to last for three years. But ministers know that investors will take even more risks next time, if they think governments are always going to bail them out.

To prevent the next crisis, the Germans, in particular, think that anyone buying a eurozone government bond after the three years are up should know they are doing so at their own risk. After all, if investors had been a bit more cautious in lending to Greece, the government probably wouldn't be in the mess it's in now.

It's called moral hazard, and Angela Merkel, reasonably enough, wants to reduce it. After all, Germany was the one that wanted a no-bailout clause written into the Maastricht Treaty when the euro was created. If there are no bailouts, and no exits from the single currency, it follows logically that governments must, in extremis, restructure their debt.

Arguably, it was the refusal to acknowledge this basic logic that allowed the imbalances in the eurozone to become so large. Investors concluded there was not much difference between lending to Greece and lending to Germany.

That is why last month Angela Merkel pressed her fellow leaders to support a mechanism for restructuring - or writing down - sovereign debt, if there's another crisis in the Eurozone down the road.

But that's about preventing a future crisis. To keep a lid on today's one, investors need to keep faith that they're not going to lose money holding on to Irish debt, or that of any other European government.

If you start talking about restructuring debt at some time in the future, investors will naturally worry that you are about to do it next week.

Talking to European officials here in Seoul, it's fair to say they now understand this point better than they did a few weeks ago. Privately, they admit that the whole thing could have been better handled.

But that's not much consolation to Ireland, whose cost of borrowing at one point today rose to 8%. Or to Portugal. In Brussels they remember the painful lesson of Greece - that it's dangerous to get behind the curve. They would be quite happy to mount a rescue package for Ireland. If the Irish government would only ask for one.

The mere existence of that special bailout facility was supposed to give so much reassurance to investors that governments would never actually have to use it. But that was before they started talking about how, and when, they would take that safety net away.

Funny thing about financial markets - it doesn't take much to turn a long-term solution into a short-term fiasco.

You can hear a version of this post on today's edition of PM.

The expectations game

Stephanie Flanders | 06:56 UK time, Friday, 12 November 2010

G20 leaders always try to beat expectations when they produce their final communiqué - and the expectations for today's final agreement, recently released, had been set very low indeed.

In the early hours of last night, negotiatiors made just enough progress on the vexed subject of exchange rates and global imbalances for all sides to declare victory.

The US can say they got some numbers attached to the language about limiting imbalances - but those numbers are dates. And even those are not very specific The question of whether countries will ever be - even nominally - committed to particular current account targets has been kicked down the road, for the finance ministers to sort out (or fudge) in the first half of next year.

The US President has had a tougher ride here than at any previous G20 Summit - and it's hard to miss the frustration on the American side at how their policies, and their position at this Summit has been portrayed. On the US version of events, the idea of hard targets was abandoned weeks ago, after the finance ministers' meeting. There is also consternation at the response to last week's decision by the Fed.

If these were different times - we'd be paying more attention to the development piece of this Communique. It sets a new tone in this area, with Asian members of the group pushing back against the traditional, Western approach to foreign aid and growth.

After days of complaint about the US and its cheap dollar policy, Eurozone leaders might take comfort from the fact that the dollar has been rising in recent days - and the Euro has been going down.

But they will not welcome the cause: growing concern about the safety of Irish and Portugese government debt. Once again, at this Summit, the leaders find themselves working to prevent the next crisis -while the aftershocks of the last one are still being felt.

G20: No brackets, and no cigar

Stephanie Flanders | 18:06 UK time, Thursday, 11 November 2010

Seoul: The hard-working officials at these summits - those much-put-upon sherpas - always try to agree as much as possible in advance. Only the thorniest issues are left in brackets, for the leaders to thrash out amongst themselves.

When they went into their working dinner tonight, I'm told the latest drafts of the communique still had brackets around the key references to exchange rates and trade imbalances.

President Obama wants the others to agree on clear rules of the road for reducing big trade surpluses and deficits - and a stronger promise from China that it would allow its currency to go up soon, not at some vague point in the future.

US officials expect to make some headway on these issues in the coming hours.

But China and Germany will not be signing up to any hard numbers or targets. And the Chinese are very unlikely to commit to anything on the exchange rate that goes beyond the agreement between the finance ministers last month.

As I discussed earlier, that is partly because the US has been weakened by international criticism of the Fed and its QE2. But some non-US officials I've spoken to here say the US Treasury Secretary should also take some of the blame, for mishandling the negotiation with China when they were in the final strait.

These critics say he overplayed his hand when he publicised the idea of having hard numerical targets for current-account imbalances, in the days before that finance ministers' meeting in early October.

Up until then, it seems that China had been edging - with the help of South Korea - towards a more fundamental approach to the problem of imbalances, which might have pleased both sides, by focussing on the root causes of current-account surpluses, not just the exchange rate.

That wouldn't have had many hard numbers attached either, if any. Germany had not yet signed up to anything at that point, and it is even more opposed to numerical targets than China is - partly because they don't think the idea makes much sense.

As the Germans say, with some justification, we have a much better idea of what an "excessive" current account deficit looks like, relative to the size of the economy, than an "excessive" surplus.

Tim Geithner - and John Maynard Keynes - would say that makes their point. It's part of the inherent bias of the system that we only think about the domestic risks of running a deficit, not the external costs of running a large surplus.

Of course, the Germans don't think their 5% of GDP (higher than China) current-account surplus is related to any concrete policy action on their part. And they don't think it's "excessive". It's simply down to German companies' innate competitive edge.

Some might say their success might also have a tiny bit to do with sharing an exchange rate with the likes of Portugal and Greece.

But, you don't have to buy Germany's own explanation to accept that any numerical ceiling or target would have to carry endless exceptions - for example, for commodity exporters like Norway, say, or very small open economies. An exception here, a bit of special pleading there, and the number would pretty quickly lose its value.

As they negotiate into the small hours, officials say the leaders might well end up broadly where they would have ended up a few weeks ago - before all the talk of currency wars and before all talk of numerical targets.

But it would have seemed like a larger achievement, had there not been so much huffing and puffing about concrete numbers along the way.

The leaders will have a final communique before they go home. They always do. There will be some steps forward on development policy in this Seoul agreement, and on regulation of systematically significant banks.

There will also be hard-ish language about monitoring imbalances - and bringing them down.

But the world's largest economies will still go away with rather different views on the best way forward for the global recovery.

G20: Obama on the back foot

Stephanie Flanders | 09:35 UK time, Thursday, 11 November 2010

Seoul, South Korea: The global economy looks stronger now than it did at the G20 Summit in London last spring. But the will to cooperate looks a lot weaker - and so does President Obama.

President Obama


Even a few weeks ago, there was talk of China being forced into a corner at this meeting - signing up to a significant appreciation of its currency against the dollar. There was even the possibility that Treasury secretary Geithner would get his way in having concrete current account guidelines for countries in the G20.

But talking to officials here, it's striking how much the results of the US congressional elections, and surprisingly widespread criticism of the Fed's new round of quantitative easing, has changed the mood. To many leaders gathered here, Mr Obama no longer looks like the coming man.

Bizarrely, now it's the US that is on the defensive for manipulating its currency. The only concrete "deliverable" the US delegation had been hoping for from this Summit was the Korea-US free trade agreement. On the basis of the two presidents joint press conference earlier today, it seems they are not going to get even that.

Sooner or later, the pendulum will swing back again. But for the moment, the Chinese can scarcely believe their luck. With the German chancellor, the Brazilian finance minister and others all joining China in criticising the US, a debate about global imbalances and China's role in reducing them, has somehow turned into a debate about the evils of US monetary policy.

That is quite a turnaround. Especially when you consider that the US is one of the handful of countries in the G20 that does not fix its national currency, or directly intervene in the markets to change its value. Of course, a weaker dollar is one of the channels through which QE ought to work. But they are not intervening to fix the dollar at any given level. Unlike China. And many other countries in the G20

The dollar has fallen against most currencies since the summer. But most estimates still suggest it is somewhat overvalued. And it is actually slightly stronger today against the pound and the euro than it was at the start of the year. Last week's move by the Fed did not produce a major slide: in fact, thanks to more worries about eurozone debt, against the euro, the dollar has gone slightly up.

US officials are optimistic that China will budge a little on the exchange rate tomorrow, but the change in the balance of power means that the move will be less immediate, and probably more vague than Mr Obama would have wanted.

Instead of Mr Geithner's current account targets, they are holding out hope for a weak be a weak agreement on trade "tripwires" or guidelines, with the IMF reviewing countries that reach a certain level of current account deficit or surplus. Possibly 4%. But for the Germans, anything with a number attached is a hard sell.

In Washington last week, President Obama was deemed insufficiently penitent in his response to last week's election results. Supporters said he didn't apologise because he didn't think he had anything to apologise for. In fact, he looked for all the world like a man who thought the voters ought to be apologising to him - for giving him so little credit for averting a depression.

Rightly or wrongly, Mr Obama probably thinks the G20's harsh verdict on US policies is equally unjust.

Update, 09:57: When I discussed these issues on Today this morning Jim O'Neill, Goldman Sachs' economic supremo, said - with some justice - that I was focussing excessively on the problems of the West. You can listen to what we said and decide for yourself.

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Low and high expectations - for growth and the G20

Stephanie Flanders | 17:21 UK time, Wednesday, 10 November 2010

Seoul, South Korea: Mervyn King has a very clear idea of what should happen at the G20 meeting in Seoul over the next two days. He's a lot less certain about what will happen in the UK.

Mervyn King


But if the nine members of the MPC can't agree on the best path for the UK, I wonder whether it's fair to expect the G20 to agree on the best path for the world.

Watching the Bank of England quarterly press conference from my Seoul hotel room, I can say the governor's message to the G20 leaders came through loud and clear.

Time and again, he urged them to recognise their "shared interest" in agreeing a path for unwinding global imbalances. They didn't need to agree dates, or detailed exchange rate targets, he said, but there had to be a "collective recognition" that global imbalances are a pressing problem, and broad agreement on what the path of adjustment would be.

Such an agreement was possible, he suggested, and could produce a "win-win" for the global economy. But failure was also a possibility - and that would be a "lose-lose".

It sounds so simple. You'd think the G20 would be able to knock this off in a couple of days. It's not like they have much else to do here.

Except, they have already agreed that global imbalances are a problem. Many, many times. A "collective recognition" of the problem has been a staple of G20 and G8 Communiques since long before the crisis.

Indeed, at last month's meeting of G20 Finance ministers meeting in Korea last month, officials were falling over themselves to declare their common interest in finding a way through:

"....given the high interdependence among our countries in the global economic and financial system, uncoordinated responses will lead to worse outcomes for everyone. Our cooperation is essential. We are all committed to play our part in achieving strong, sustainable and balanced growth in a collaborative and coordinated way."

Everyone agrees on the "shared interest" in finding a solution to global imbalances. The disagreement is over how - and how quickly.

Part of the argument comes down to differing long-term growth strategies. For example, Germany measures its economic success by its exporting prowess. That is not going to change any time soon, even though German workers - and households - have not seen much benefit from that success in the past 10 years.

For China, it's not just about hanging on to an export-led growth strategy, it's about keeping control. China's leaders know the economy needs to change but - understandably - they fear the consequences of changing too fast - social and political.

But at the heart of the latest talk of "currency wars" is also a basic disagreement about the short-term macro-economic outlook, which Governor King will recognise from recent meetings of the MPC.

As in the Bank, it all comes down to how fast you think the US and other advanced economies can grow, in the wake of this crisis - and how much scope you see for policy makers to speed things up.

In effect, the ECB - and the senior German officials who were sounding off about the US this weekend - have an Andrew Sentance view of the world. They think the recovery we're seeing in Europe and the US is more or less the best on offer, for countries emerging from a major financial crisis.

On this view, further efforts to pump up activity - for example, with further quantitative easing - would be futile, at best. More likely, they will fuel inflation and/or unwelcome asset price bubbles and distortions (including, in the Fed's case, unwelcome swings in the value of the dollar.)

The US, it is fair to say, is rather more optimistic about the potential for growth. Indeed, there has been no formal recognition by the Administration or the Federal Reserve that US productive potential has been permanently hit at all by the crisis.

Nor is there much acceptance that the heavy burden of household and corporate debt will make this recovery slower than the recoveries of the past.

When you listen to Administration officials this week, remember that their official growth forecast for 2011 is still a gloom-defying 4%. And they are not just optimistic about potential growth; they're also optimistic about the central bank's capacity to bring it about. (Whether they would be so optimistic if it were not also the only policy tool available is a moot point.)

As I discussed at length in my last post, that is why they see looser US monetary policy as a win-win for the US and for the world - even if others fear it will be a lose-lose.

Like Adam Posen, in the MPC, Administration officials think the greatest risk facing the global recovery is not inflation, or distorted asset markets, but a tyranny of low expectations, where low estimates of potential growth become a self-fulfilling prophesy, and we all end up like Japan.

Perhaps thanks to the lively debates among Posen, Sentance, and the rest, the MPC has ended up somewhere between the two poles: moderately pessimistic about UK growth, but fairly optimistic about the Bank's capacity to force the pace, if necessary.

The Bank's average growth forecast for 2011 and 2012 of just over 2.5% looks optimistic to some (especially those who ignore the skewed distribution of risks, and focus only on the modal forecast of around 3%.)

But, as the Inflation Report acknowledges, this would be weaker than the second and third year of recent recoveries, and could still leave the economy with a significant amount of spare capacity and unemployment.

An interesting nugget from the report: if this recovery behaved like the recoveries of the 80s and early 90s, national output would be back to its pre-crisis peak by the middle of 2011. The Bank thinks there's only a one in three chance of that happening. On their forecast, there's even a chance it could be more than three years before we get back to that point.

However, the Bank's cautious and caveat-laden forecast for the UK looks positively upbeat when you compare it to the midpoint of the ECB's latest growth forecast for the euro area in 2011, which is just 1.4%.

Such is the pessimism about the euro area's potential growth rate, the ECB's economists think even this modest growth rate would make a dent on the region's spare capacity. There are no plans to loosen policy - far from it.

Expectations for this Summit are also pretty low. But if Mervyn King is right, the stakes could be very high indeed.

Beggar my neighbour - or merely browbeat him?

Stephanie Flanders | 17:37 UK time, Thursday, 4 November 2010

This week's statement by the Federal Reserve has achieved all that Ben Bernanke might have hoped it would achieve; stocks are up, the dollar is down, and so are most US bond yields. We can't say for sure that it will "work", but all of these developments ought to be net positive for the US economy. The question I raised yesterday was whether it would be expansionary for the rest of the world.

Ben Bernanke


After all, the US is supposedly engaged in competitive devaluation. At the very least, it is pursuing a policy of "active dollar neglect". Talk of competitive devaluation conjures up visions of the 1930s, the iconic example of a time when countries beggared each other with depreciation and protectionism as they fought over a diminishing global pot of economic demand.

Is that what is happening today? Is the US simply exporting its demand shortage to the rest of the world?

As I said yesterday, the answer depends, in part, on how other countries respond. The big problem in the 1930s was not so much the depreciation itself, as the way it took place: through domestic price levels, rather than the exchange rate. Because most of the countries "competing" were locked into the gold standard, the only way they could make their goods cheaper overseas was by forcing down domestic prices (and demand). Once you have a lot of countries doing that, you have the ingredients for a shrinking global economy and a lot of beggaring, not just of your neighbours but of your own country as well.

To be clear: that is not the kind of competitive depreciation that the US is after. When you talk to people in the administration, they don't think they are trying to beggar anyone. Far from it. They think that they're trying to get as much growth as possible for the US economy - and if their cheap money (and currency) policies encourage others to do things which expand their own domestic demand, well, isn't that what they should be doing anyway?

Is that what's going to happen as a result of the Fed's move? That depends on whether other countries have a fixed exchange rate or a flexible one. For countries with completely fixed exchange rates, the economic would suggest that more QE by the Fed would be expansionary, because the domestic authorities have to loosen domestic monetary conditions by a similar amount to keep the currency at the same rate.

This is (sort of) what should happen in China - but not if the Chinese authorities have anything to do with it. As I discussed at length a few weeks ago, China's quasi-communist financial system means it has more ability than most both to fix its exchange rate, and to do what it wants to domestic monetary conditions.

But what about the many countries that do not fix their exchange rate? At first glance, for them the Fed's move will be clearly contractionary: their currency will go up, meaning less demand for their exports and tighter conditions at home.

However, America's economic heft makes a difference to the calculation: rising US stock prices and lower US interest rates should push global equities up and interest rates down, as they have today. That would offset the tightening effect through the currency. Also, if central banks don't want demand to go down in their economies, they can and will act to offset the Fed's move, and push their currencies back down again.

That, in a sense, is why the US sees 'competitive depreciation' of the dollar as a win-win. If other countries, with flexible countries, don't respond with QE2 of their own, then their currencies will strengthen, and demand for US goods in those economies will (theoretically) go up. If they do respond, with more easing to counteract the rise in the currency, then global demand goes up, and the US is once again better off.

Put that way, it sounds like a no-brainer. But all of this assumes that the Fed's policy is actually effective, over the medium-term, in lowering US real interest rates and raising US real demand. (It  also depends, incidentally, on the policy raising inflation. Critics seem to to think it can be both ineffective and inflationary. That is simply a contradiction in terms, at least when it comes to the US.)

If the policy doesn't work, the calculation shifts: in that case, QE2 won't cause inflation in the US, but it might simply fuel asset price bubbles in emerging market economies without doing much good at home.

It's an open question whether that is contractionary or expansionary for the rest of the world in the short term. But note that it does very little to re-balance the global economy. Re-balancing is supposed to mean increasing consumer demand in the emerging economies, not increasing the amount of hot money invested in domestic real estate.

Charles Dumas, of Lombard Street Research, takes the gloomiest possible view in a paper he has just put out. He thinks the only positive effects from QE2 will come through the lower dollar. (Notably, he doesn't think it will do anything to support house prices in the US, because the Fed is not buying houses or even mortgage-backed securities, as it did in the first rounds of QE.) And that positive effect, in terms of net exports, will happen slowly, if at all.

But, in the Dumas view, the negative impact of QE2 on the US will be significant, and operate much more quickly. A weaker dollar will hit real incomes by raising the cost of food and energy; he also thinks that rising inflation expectations at the 30-year end of the US bond market could actually push mortgage rates up as a result of the Fed's move.

His bottom line? If anything, QE2 will make deflation in the US more likely over the next year or so - and raise the chance that the Chinese will slam on the brakes domestically to curb inflation there. If true, that would be well and truly the worst of all worlds: no inflationary impact in the country that wants inflation, and a deflationary impact in the country where the US most wants to see strong domestic demand.

Now you see why the Fed is playing for such high stakes. And you can see why countries resent the US putting its interests first. If QE2 does what the US central bank wants it to do, it will almost certainly do more good to the global economy than harm. But if it doesn't, some of the biggest harm might be done overseas.

Again, the US isn't trying to export its weak recovery to the rest of the world. It wants a strong recovery, for itself and everyone else.

However, it is possible - some would say likely - that a strong recovery is not available at any price in the US today, especially while the most important dollar exchange rate is set in Beijing. If that is true, the American authorities could end up simply exporting the negative side-effects of a futile expansion effort, while doing very little to raise growth at home. Let's hope it's not.

Why the Fed matters more

Stephanie Flanders | 08:21 UK time, Wednesday, 3 November 2010

Exit bears, pursued by the Federal Reserve. That is what Ben Bernanke would like to be today's story. If the US central bank does announce a second round of quantitative easing, it will be a more important event for the global economy than the mid-term elections.

Federal Reserve building


Congress is a dysfunctional institution at the best of times. As I've argued in the past, this election result will make it that much harder for the US to pursue the fiscal strategy that many would like it to follow - supporting the economy short-term but fixing the hole in the budget long-term. Most likely, it will do exactly the opposite. That makes the Fed and its remaining policy tools that much more important.

There are two sides to what happens today: what it means for the US recovery, and what it means for the dollar.

On the first, the latest figures show the US economy growing at an annual rate of 2% - well below the long-term trend. Inflation is hovering close to 1% a year. Unemployment is at a 25-year high, and, perhaps most troubling, US house prices are falling again - raising the fear that even more Americans will lose their homes and the banks will have more bad mortgages sitting on their books. (If you want things to worry about, incidentally, worry about the implications for UK banks if another round of big losses for US banks once again causes global bank funding to dry up.)

The Federal Reserve Chairman, Ben Bernanke, has made clear that he wants to do more - which means another round of QE. The best guess is that the figure mentioned today will be in the region of $500bn (£312bn), but economists from the HSBC and Goldman Sachs reckon that it could have to spend $2trillion before this round is done. That is what they calculate is needed to make up for the inability to lower the official interest rate below zero.

If the Fed can lower the cost of borrowing for firms and households, it may be able to put a floor under house prices and, by extension, the economy. That, at least, is the hope. Again, given the size of the deficit and the divisions between the parties, they don't have many other options.

Hope for a stronger US recovery would be good news for the rest of the world. But of course, many will be even more focused on what happens to the US currency.

As I said on the Today programme, for all the talk of "debasing the currency", it's possible that today's move will push the dollar up. QE2 has been "in the price" for some time. If the Fed is perceived to have exceeded market expectations in a way that will make the policy more effective at supporting the economy, the dollar could strengthen, at least short-term.

But, of course, the overall strategy is not to push up the dollar. To re-balance the economy and feed the massive demand for jobs and income, the US needs a weak dollar - and stronger exchange rates in the East.

Is that expansionary for the world economy - or contractionary? That is the question I will answer in my next post. For the moment, let me just say that it depends on how other countries respond to the Fed's decision.

The key tension at the heart of the "currency wars" is that the US has a global currency - but a national monetary policy. For Ben Bernanke, the US recovery must come first - but the entire world must live with the consequences.

Shocking advice for the MPC

Stephanie Flanders | 10:40 UK time, Tuesday, 2 November 2010

If the Bank of England were really serious about helping the economy, it would be trying to tank the housing market. That is not quite how the economists at Fathom Consulting would put it, but it's a key implication of their latest report on UK monetary policy. The Monetary Policy Committee are unlikely to follow their advice - or not directly, anyway. But the policy paper will make for sobering reading as they prepare for the start of their November meeting on Wednesday.

How, you might ask, could a sharp fall in house prices possibly help the economy? It would help because it would get it over with. Like many economists, the authors of the report, Danny Gabay and Erik Britton, believe that the British economy will not truly put the crisis behind it until it has fixed the banking system and dramatically lowered the amount of private sector debt weighing on the economy. Unlike some of their peers, they think that a correction in house prices is a crucial part of that process in Britain, and it has barely begun.

There is a lot of meat in the report. Here's what I found most interesting.

First, the authors highlight a recent study from the Bank of International Settlements [145KB PDF]. Based on data from 27 countries, this finds that financial crises tend to be followed by a long period of drawing down debt in the private sector. Nothing new there, you might say, but the numbers are interesting: on average, total private sector debt, as a share of GDP tends to fall by 38 percentage points, and the process takes 10 years.

In the US, private sector debt has fallen by about 11% of GDP in the past few years. You could say that their correction is broadly on course (even if that course is painfully slow). But in the UK, private sector debt has barely fallen at all since the Bank of England came to the economy's rescue with a bank rate of just 0.5% (see chart below).

Chart showing household debt

"Zombie companies" always feature prominently in cautionary tales about Japan. Instead of forcing companies to recognise their losses, the authorities kept them alive on a drip-feed to nearly free cash. By seeking to ease the pain of adjustment, they actually made it a lot worse.

If you buy the Fathom view, policy-makers in the US and UK are making exactly the same mistake, only we're creating zombie households instead, who can only stay afloat because the cost of servicing their mortgage has fallen through the floor. As a result, banks don't have to face the fact that their mortgage-based assets are worth much less than they were at the peak of the boom - and the country can't move on.

Isn't it possible that UK houses are worth that much after all? Perhaps. Certainly, we didn't have a mad housing construction boom like the US or Spain, which has left parts of those economies with a large overhang of excess supply. But you don't find many forecasters expecting a significant rise in house prices over the next few years. Indeed, many expect a fall.

It is all but impossible now to obtain a mortgage worth more than 75% of the current value of the house. You can call that extreme risk aversion, or you can read it as a forecast of further house price falls by the lenders themselves.

Robert Peston has written frequently about the funding needs of the banks over the next few years. The Fathom economists calculate that, if recent house price declines continue over the next couple of years, the banks will once again have a £180bn funding gap by 2012, when the Bank of England's Special Liquidity Scheme for the banks is due to end.

We like to think that by recognising bank losses early and injecting fresh capital, Britain and the US have avoided Japan's mistakes. Instead, according to Fathom, we have made the same mistakes, in a slightly different way.

Where do we go from here? Fathom says it's time for a UK version of TARP, funded, at first, by more magical money creation by the Bank of England.

Briefly, the way this would work would be that the Treasury would set up a "bad bank" to buy troubled mortgage-backed assets from banks, paid for by issuing a special bond, which could be bought by the Bank as part of QE2.

Is there any chance this would happen - and would it work? I suspect we will not find out the answer to the second question, because the answer to the first is no. At least for the foreseeable future.

But you can reject the specific policy conclusion while still paying attention to the arguments that have led them there. Like many other critics, Fathom thinks the Bank of England weakened the effect of QE by spending nearly all of the money on buying government bonds. More of the same, in their view, would be at best counter-productive and possibly downright harmful. Many around the table at the MPC's meeting this week will be harbouring similar doubts: after all, just how low can the gilt yield go?

The Fathom economists are also looking at a country where average house prices are not now much lower than they were at the peak in 2007 and the ratio of household debt to disposable income is also close to its historical peak - and concluded this is not a country, or an economy, which is ready to put the debt crisis behind it. They are not alone.

PS. Here is Danny Gabay talking to Evan Davis on the Today programme earlier.

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