ft world crisis

8/4/2019 FT World Crisis

1/6

WORLD ECONOMYFINANCIAL TIMES SPECIAL REPORT | Friday September 23 2011 Page 2

EurozoneLeading actorsin the dramacome under thespotlight

www.ft.com/world economy 2011 | twitter.com/ftreports

Inside this issueEuropeGreekdefaultfearsdeependebt crisisPage 2

Across the zone Memberstates finances dissectedPage 2

Public finances The truthbehind plans for deficitreduction differs fromappearances Page 3

Reforms An argument israging about how muchlenders should do toprotect themselves Page 3

Central banks Consensuson extra monetary stimulus

is lackingPage 4

Third armMacroprudentialpolicy has to

prove itsworth

Page 4

Markets Optimisticinvestors are in short

supply Page 4

Balance sheets Effects ofrecent measures to supplyliquidity assessed Page 5

Profile Mario Draghi takesover at the EuropeanCentral Bank at a time ofcrisis Page 5

Global growth Leadingcountries must findcommon ground Page 6

IMF Newhead isset for ashowdownwith EuropePage 6

On FT.com

World Trade OrganisationNations wait to move onafter Doha

Commodities Are high oilprices bad for the globaleconomy?

The world economy onceagain stands on a preci-pice. Finance ministersmight want to look

straight ahead, but investors areforcing them to peer down tothe abyss.

As advanced economies slowsharply and emerging econo-mies wonder whether inflationor recession is the greaterthreat, the need for finance min-isters to find a way to achievetheir ambition of strong, stableand balanced global growthhas rarely been more urgent.

A world expansion must bestrong enough to allow adjust-ment to the stresses that havebuilt in the past decade. It mustbe stable because any hitchesrisk an intensification of thecrisis. And it must be balanced,because simply putting off thenecessary restructuring willonly increase the strains caus-ing angst among investors and

politicians.The alternative is another

financial and economic crisis,worse perhaps than that of2008-09.

Those in positions of author-

ity are worried. ChristineLagarde, the new managingdirector of the InternationalMonetary Fund, has urged coun-tries make necessary adjust-ments to restore confidence.

I believe there is a path torecovery, much narrower thanbefore, and getting narrower. To

navigate it, we need strongpolitical will across theworld leadership over brink-manship, co-operation over com-petition, action over reaction,she said in a speech this month.

Tim Geithner, the US treasurysecretary, flew to Poland thismonth with the same messageto European finance ministersthat the time has come for polit-ical will to solve the eurozonecrisis and help put the worldeconomy on a stronger footing.

Governments and centralbanks have to take out thecatastrophic risks from mar-kets . . . [and avoid] loose talkabout dismantling the institu-tions of the euro, he said.

The scene is set for the discus-sions at the Group of 20 and theInternational Monetary Fundthis weekend to be as tense asthose in 2008.

Then, the post-Lehman eco-nomic crisis and deep recessionwere stemmed by a huge show

of force from global policymak-ing. Governments underwrotetheir banking systems. Interestrates across the advanced worldwere cut to negligible levels.Central banks turned to unor-

thodox measures both to pumpnewly created money into theireconomies and ease strains inmarkets that had frozen.

Governments allowed tax rev-enues to plummet without off-setting action and implementedsome stimulus. Commodityprices plunged, raising realincomes in oil-consumingnations. Emerging economies,particularly China, gave a hugeboost to domestic investmentwith direct spending and looserrestrictions on lending. Andvery few nations erected tradebarriers to impede the recovery

when it came in spring 2009.The policies worked in stem-

ming the crisis, but some havefallen into reverse. Commodityprices have risen to levels simi-lar to those in 2008, the equiva-

lent of a tax on oil-consumingcountries. Fiscal policy is beingtightened across the advancedworld. But the greatest problemin advanced economies is thatcompanies and households re-main cautious about spending.

Companies are hoarding cash.Households are reducing liabili-ties and governments, particu-larly in the eurozone, are realis-ing the limits of being the con-sumer of last resort. For them,the adjustment is far from com-plete.

Willem Buiter, chief econo-mist of Citi, says: The ad-

vanced economy slowdown isacross the board and countriesreinforce each other. We dontexpect a recession yet although we are close to it butthere is not enough growth

likely to stop unemployment ris-ing in the US.

Having revised their globaleconomic forecasts higher as therecovery initially seemed betterthan expected, internationalorganisations have becomemuch more gloomy.

The Organisation for Eco-nomic Co-operation and Devel-opment expects almost nogrowth in advanced economiesfor the rest of 2011 and the lat-est figures from the Interna-tional Monetary Fund this weekmark down global economicgrowth in 2011 from 4.3 to 4 per

cent, and from 4.5 to 4 per centin 2012, with advanced econo-mies facing the bulk of the fore-cast downgrade.

Rich countries no longer dom-inate the world economy. At

market exchange rates some 40per cent of global output comesfrom emerging economies and amuch greater share of growth.On the basis of the IMFs springforecasts, the combined size ofemerging economies wouldexpand 30 per cent between 2007and 2012, an average annualgrowth rate of 6 per cent. Foradvanced economies the growthrate over the same period islikely to be close to zero.

But becoming the dominantforce in global growth has nothelped emerging economies rideout the storm. Faced with twin

threats of global downturn andinflation, policymakers have notknown where to turn.

Some countries, Turkey and

Financial

institutionsstare into

the abyssThe need for concertedaction is greater thanever, as imbalancesacross the eurozoneare replicated globally,reports Chris Giles

Continued on Page 3


2/6

2 FINANCIAL TIMES FRIDAY SEPTEMBER 23 2011

World Economy | Eurozone

For Jean-Claude Tri-chet there will ben o g en tl e w in d-d ow n b ef or e h is

retirement. The eurozonedebt crisis has assumed ap unishing intensity inrecent months, stretchingthe skills of even veteransof financial market crisessuch as the European Cen-tral Bank president.

As he prepares to stepdown on October 31, thefuture of Europes mone-tary union remains unclear.Possibilities that even a fewmonths appeared slim areno longer ruled out.

German politicians specu-late openly about Greece

defaulting or even leavingthe eurozone. Financialmarkets fear a return of theparalysis that struck afterthe collap se of L ehmanBrothers in late 2008.

Europes economic inte-g ra ti on c ou ld a ls o b ethrown into reverse. Con-veying the drama of themoment, Angela Merkel,German chancellor, warnedthe Bundestag this monththat the eur o was mor ethan just a currency. Theeur o is a guarantor of aunited Europe, or put itanother way: if the eurofails, Europe fails.

For now, much lies in thehands of the ECB. With itstheoretically unlimited fire-power and ability to actrapidly, the ECB is the finalbackstop for the euro.

A s b ro ad er w or ri esemerge over the strength ofeurozone banks at a timewhen economic growth hasstalled across the region the ECB has become thesole institution capable ofcalming financial market

nerves. But the resignationthis month of GermanysJr gen Star k from theECBs executive board high-lighted internal divisionsover crisis management

strategy, especially theECBs controversial bond-buying programme.

Germanys conservativesfear the ECBs actions haveundermined its independ-ence by straying into fiscalpolicy, threatening its credi-bility and ultimately thebattle against inflation.

A turning point came inJuly. The debt problems ofGreece, which lay behindthe original outbreak of theeurozone debt crisis, hadintensified once more. Euro-zone political leaders agreedthat a fresh bail-out planwas needed, but Germanysuccessfully led a push forprivate-sector banks toshare some of the burden.Its principled point wasthat taxpayers should notfoot the bill entirely, eventhough credit rating agen-cies warned any signs of

coercion would result inGreece being deemed ind ef au lt a nd t he E CBwarned that it would send adisastrous signal to inves-tors in other eurozone

countries.At their July 21 summitin Brussels, eurozone lead-ers insisted their plan forGreece would be excep-

tional and unique. Theyalso took other steps to alle-viate its finance by slashingthe interest rate payable onbail-out loans and extend-ing their maturity. Similarhelp was given to Irelandand Portugal.

Nevertheless, investorst oo k f ri gh t. B y e ar lyAugust, the market borrow-

ing costs of Italy and Spainwere reaching worrying lev-e ls . T he E CB f ac ed adilemma. It wanted Rome totake bold action to addressthe crisis but feared a finan-

cial meltdown.After a tense weekend atwhat should have been theheight of the holiday sea-son, the government of Sil-vio Berlusconi announced aseries of structural and fis-cal reforms.

On Sunday August 7, MrTrichet said the ECB wouldactively implement itsbond buying. Within hours,it had started the large-scale b uy ing of Italianbonds. Rome, however, hasyet to convince markets ofits commitment to reduc-i ng p ub li cd e b t ;I t a l y sposition asone of theeurozonesl a r g e s teconomiesm a g n i f i e sthe signifi-

cance of any p er ceiv eddefault risk.

Meanwhile, fears of a full-blown Greek default haveescalated, and worries oversovereign debt holdings

have fuelled fears about thefinancial strength of banksacross the continent.

Eurozone governments,meanwhile, have y et toimplement another stepagreed on July 21 boostingthe powers of the EuropeanFinancial Stability Facility,the bail-out mechanism setup a year ago.

As well as supp or tingcrisis-hit countries directly,the ECB is hoping the EFSFwill soon be able to takeover its role of interveningin eurozone bond markets.But cumbersome operatingprocedures and disputes

between national capi-tals could hamper its

effectiveness.T he re a re n ot

many bright spots.Whereas Greecehas failed to meettargets set under

its international bail-out,Portugals programme ap-pears to be on track, andIreland even shows signs ofmaking a comeback, helpedby export growth.

But overall, the eurozoneeconomic r ecovery hasstalled. In the second quar-ter, gross domestic productexpanded by just 0.2 percent compared with the pre-vious three months.

Gloom about global pros-pects, including in the US,as well as fiscal austeritymeasures and eurozonedebt woes have led to fallsin business and consumerconfidence. Forward-look-ing purchasing managersindices hold out little hopeof a growth rebound in thesecond half. Weaker growthwill hit the banks further.

T he E CB h as s o f araverted disaster. As well asits large-scale bond pur-chases, it has continued toprovided unlimited liquidityto eurozone banks. But it isp roving to b e a fatefulautumn for the eurozone.

Debt crisis deepens on Greek default fearsEurozone

The role of thecentral bank is

under increasedscrutiny, writesRalph Atkins

Crumbling empire:a united Europe issaid to depend onGreece staying inthe eurozone

The ECB hasbecome the soleinstitution capableof calming financialmarket nerves

GERMANYDomesticgrowthslowdowna worry

The future ofthe eurozone,

and the capacity ofthe 17-nation currency union torecover from the debt crisisamong its peripheral members,depends on the performance ofthe German economy morethan on any other in Europe.

Equally, Germanysprosperity is inextricablylinked with the success andsurvival of the single currency,with more than 38 per cent ofGerman exports going to itseurozone partners, and almost58 per cent to the 27 membersof the European Union. Thestability of the euro has been abig factor in the remarkablyswift recovery of the Germaneconomy from the economic

crash of 2008-09.Yet Angela Merkel, the

German chancellor, is facing anstruggle to persuade herelectors, particularly her ownsupporters in the centre-rightcoalition, to provide thefinancial guarantees needed totide over the most debt-ladeneurozone members.

For the past 18 months,German economic growth hasprovided the impetus for itspartners, but the rate ofgrowth has slowed appreciablyin recent months. After a 3.6per cent rise in gross domesticproduct in 2010, and 1.3 percent growth in the first quarterof 2011, the rate of increaseslumped to 0.1 per cent in thesecond quarter of the year.

Bullish business expectationshave also dropped off. Theclosely followed businessclimate index published by theIfo institute in Munich droppedfrom 112.9 in July to 108.7 inAugust, as companies scaledback their expectations for thesecond half of the year.

Ms Merkel still believes thatgrowth in the current year willbe closer to 3 per cent than2.5, and most analysts expecta soft landing.

The chancellors dilemma ishow to persuade her votersthey can afford to be moregenerous to their eurozonepartners in the short term, inorder to assure their continuedgrowth in the long run. Theworry for her partners is thatslower German growth will notprovide the stimulus they needto pull them out of recession.

Quentin Peel

FRANCEPublicspending a

weak pointNicolas

Sarkozy, thecharacteristic-

ally hyperactiveFrench president, repeatedlyinterrupted his August break todeal with the crisis engulfingthe eurozone.

An emergency meeting of hiscabinet and a Paris summitwith Chancellor Angela Merkelwere packed into the month asMr Sarkozy attempted topersuade sceptical markets thatthe eurozones politicalleadership was in command ofthe regions sovereign debtproblems, that Frances ownpublic finances were undercontrol and, not least, a fiercemarket assault on Frenchbanks was unmerited.

Mr Sarkozy has responded tothe Greek crisis by throwingFrance firmly behind theeurozones second bail-out planfor Athens agreed in July.France was the first eurozonemember to ratify the plan. The

president, in league with MsMerkel, is leading a push forcloser economic governancewithin the eurozone andregulatory action, such asreform of the rating agencies,in a bid to prevent arecurrence of the sovereigndebt problems.

Frances Achilles heel,however, is its public finances.Its debt is in excess of 80 percent of GDP and the budgetdeficit this year is projected at5.7 per cent of GDP.

Little surprise therefore, that,given the extra exposureFrance assumed to Greeceunder the July bail-out plan,financial markets put inquestion the countrys triple-Arating when Standard & Poorsdowngraded the US. The spreadbetween French governmentbonds and German Bundswidened as a result and Frenchbank shares took a dive.

Mr Sarkozys governmentreacted by introducing asupplementary budget package,made up of a variety of taxmeasures worth 12bn ($16.5bn)over this year and next, toensure the country remainedon track to reduce the deficitto 4.5 per cent of GDP in 2012

and return to the eurozonessupposedly mandatory level of3 per cent in 2013.

Frances fiscal task is madeharder by a slowing economy.Official projections are forgrowth of 1.75 per cent thisyear and the same in 2012.

Against this background, MrSarkozys opponents on the leftand right are queueing up toattack him over the economy.He faces a winter every bit astough as his turbulent summer.

Hugh Carnegy

SPAINPrudencestarts topay offIn May last

year, USpresident Barack

Obama made ahighly unusual telephone callto Jos Luis RodrguezZapatero, the Spanish primeminister, urging him to takeresolute action to fix Spainseconomy and save the countryfrom a bail-out by theInternational Monetary Fundand the EU.

Mr Zapatero, who hadpresided over an alarminglyhigh budget deficit of 11.1 percent of GDP in 2009, did whathe was told by his Americanand European colleagues,imposing an austerity plan thatis set to reduce the deficit toaround 6 per cent of GDP thisyear. Spain wants to stay inthe euro.

The US deficit has remainedstubbornly high and is forecastto be around 9 per cent of GDPthis year. Mr Zapatero whoseSocialist party is expected tolose power in a general electioncalled for November 20 hasso far wisely refrained fromtelling Mr Obama to fix hisown fiscal crisis.

Spain has not exactly beenrewarded by the financialmarkets for its determination,but bond market investorshave at least noticed thatItalys accumulated debt ismuch higher than Spains. InAugust according to theinterest rate spreads overGermanys benchmark Bunds they began to regard Rome asa greater risk than Madrid.

Both countries saw theirsovereign bond yields spike todangerous levels in the firstweek of August, and have sincebenefited from a controversialbond-buying programme by theEuropean Central Bank thatinitially cut yields from over 6per cent to around 5 per cent.

That support, however, cameat a price. At the insistence ofthe ECB, Mr Zapatero hurriedlyintroduced further reforms toliberalise the labour marketand amended the constitutionto enforce budgetary prudence

by law from 2020.The issue now is growth.

Neither this government, northe PP leaders likely to beelected in November, are surethey can continue to slashspending without tipping thecountry back into recession.

Victor Mallet

PORTUGALExports seenas thesaviourPortugals new

governmentexudes resolve.

The centre-rightcoalition is determined

to go beyond the requirementsof the countrys 78bn bail-outagreement with the EU andIMF by overshooting fiscaltargets and meeting reformdeadlines early.

The aim is to gain credibilitywith investors and Europeanpartners as an administrationthat can discipline publicfinances and run the economywith an efficiency that willallow the country to resumefinancing its debt in themarket by 2013.

Pedro Passos Coelho, theprime minister who took officein June, has set a target of

cutting the budget deficit from9.1 per cent of GDP last year to0.5 per cent in 2015.

Achieving this will requirethe biggest public spendingcuts in modern Portuguesehistory, reducing stateexpenditure by sevenpercentage points to 43.5 percent of GDP within five years.

This exacting austerityprogramme will take a heavytoll on growth and manyeconomists question thelikelihood of a recovery asearly as 2013, when thegovernment predicts growth at1.8 per cent, after anaccumulated contraction of 4per cent in 2011 and 2012.

Exports, predicted by thegovernment to grow at morethan 6 per cent a year to 2015,are intended to lead Portugal

out of recession. But slowergrowth in Europe, whichaccounts for 74 per cent ofPortuguese exports, couldundermine a recovery.

Portugals ability to cutdebt at the same time asit makes the structuralreforms required for a

sustained export-led recoveryamounts to what Mr PassoCoelho describes as thecountrys toughest test in 37years of democracy.

Peter Wise

FINLANDEuroscepticssee surge insupportFinland used to

be consideredone of the EUs

most compliantmembers. These days it isemerging as a major stumblingblock to eurozone rescueefforts.

Finnish public opinion hasbeen turning progressivelymore eurosceptic with eachfresh bail-out for Greece andother crisis-hit euro members.

This was reflected in thesurge in support for a populist

anti-EU party in Aprils generalelection the True Finns wonnearly a fifth of the vote,

which has heaped pressure onthe ruling coalition to take atough line in Brussels.

Helsinki has demanded thatGreece provide collateral inreturn for any further Finnishloans, but this has sparked adispute with other euromembers who want similarguarantees from Athens. Thesquabbling has threatened toderail the latest rescuepackage.

Further tension seems certainover the planned overhaul ofthe European financial stabilityfacility to give the fund greatercrisis-fighting powers. JyrkiKatainen, Finlands staunchlypro-EU prime minister, faces astruggle to keep his politically

diverse government together onthe issue.

Finland holds a crucial roleas one of the six euro memberswhose triple-A credit ratingsallow the EU bail-out fund toborrow cheaply in internationalmarkets. Finns resent theircountrys hard-won fiscal

strength being used to prop upmore profligate countries.However, with 30 per cent ofFinnish exports going to theeurozone, Mr Katainen arguesit is in the countrys intereststo help out.

Andrew Ward

ITALYFight forcredibilitycontinuesA founding

member of theEU, Italy en tered

the single currency ready torelinquish a degree ofsovereignty in the hope that acompetent and honest Brusselswould curb the excesses of thecountrys own discreditedpolitical elite.

That this debt-burdenedcountry now risks plunging theeuro into a mortal crisis and

thereby dismantling the widerEuropean project comes as ashock to many Italians, who

have been repeatedly assuredby Silvio Berlusconi, centre-right prime minister, that Italyis safe from Greek contagion.

The billionaire entrepreneuradmitted that his governmentslatest austerity budget wasfoisted on him by the ECB anddrawn up in the space of fourdays in early August.

In the weeks that followed while the ECB propped upItalian bonds with purchases ofover 40bn Mr Berlusconiducked and weaved as he triedto water down the budgetprovisions, eroding Italyscredibility on the markets.

Two resolute pro-Europeans Giorgio Napolitano, head ofstate, and Mario Draghi,

governor of the Bank of Italyand the next ECB president played critical roles in gettingthe government to toughen upthe 54bn package that wasfinally passed by parliament onSeptember 14.

The stated goal ofeliminating the budget deficit

by 2013 has failed toreassure panicky investorsholding European peripherydebt. Mr Berlusconis authorityover his fractious coalition toput the budget into effect is indoubt, while weakeninggrowth prospects and risingdebt financing costsundermine confidence in itsprojections.

Already the focus is turningto further measures thegovernment needs to take toshore up its credibility. Theseinclude growth-promotionpolicies, a possibly sweepingwealth tax and perhaps asecond tax amnesty. MrBerlusconis promise not toput the governments hand inthe pockets of Italians isalready broken.

The prime ministers personalscandals raise serious doubtsover his ability to see out hisfull term until 2013. The

stirrings of an internal partyrevolt are likely to gainmomentum now that thecrucial budget package haspassed parliament.

Guy Dinmore

IRELANDPopularbacklash apossibility

Irelandsdramatic

property crash sawthe country follow Greece inhaving to seek a financialrescue from the EU and IMF.But, unlike Greece, Ireland haswon plaudits for sticking to theausterity plan the donors haveapplied.

A popular backlash has yetto materialise despite anti-EUbroadsides by all the mainpolitical parties ahead of thisyears general election inFebruary. But Irelands EUpartners recognise that themood in Ireland has changedafter Irish voters twice rejectedEU treaties in recent years only to be told to vote again. IfEurope now resorts to issuingeurobonds to tackle thecurrency areas debt crisis, asmooted, Ireland may berequired under its constitutionto stage another referendum.Few believe at this stage itwould pass.

Irelands short-term politicalstrategy is to implement theEU-IMF programme, whilecalling for more generousterms on the bail-out funds. Itsecured some relief in July andagain in September when theEuropean Commission agreedto reduce the interest rate andextend the maturities on theIrish borrowings.

But Irelands debtsustainability depends criticallyon an economic recovery that

is stuttering at best, with GDPforecast to rise by just 0.7 percent this year and 2.5 per centin 2012.

With bond redemptions andrepayments on the EU-IMFfunds ramping up from 2013,without a strong economicrecovery it is likely Ireland willcontinue to be dependent onofficial funding.

Certainly any chance thatthe government will be able toreturn to the private debtmarkets to fund the budget bythe end of next year, asenvisaged under the EU-IMFprogramme, now looks a longshot. Meanwhile, the fiscalcontraction that still has totake place is considerable.

John Murray Brown

NETHERLANDSEconomic

shifts bringanxietyOne of themost open and

trade-dependenteconomies in

Europe trade comes to 150per cent of GDP, against aeurozone average of 80 per cent the Netherlands was an earlybacker of European monetary

union and has done well by theeuro. Real GDP per capita is up10 per cent since 2000, againsta eurozone average of 6 percent. Unemployment has beenlow for a decade, and wasscarcely touched by thefinancial crisis; at 4.3 per cent,it is the second-lowest inEurope after Austria.

But with their Calvinistculture, triple-A credit ratingand low budget deficits, theDutch were always uneasy atthe prospect of monetary unionwith free-spending governmentsin southern Europe. Thepowerful far-right politicianGeert Wilders calls thecountrys support for Greecethrowing money over thedikes. Polls in August foundmost Dutch wish the countryhad never joined the euro.

The anxiety reflects deepeconomic shifts. Being an openeconomy has its costs, and

many companies that longdefined the Netherlands brandhave gone foreign. Shell,Unilever and Reed Elsevier areAnglo-Dutch condominiums.KLM has merged with AirFrance. ABN Amrosinternational bankingambitions collapsed after itsfailed merger with RBS andFortis.

The Netherlands economyrises or falls with its Europeantrading partners. Whether theDutch are willing to kick inmore money to keep thosepartners afloat is anotherquestion.

Matt Steinglass

GREECEPace ofreformraisesconcerns

Greeces debtcrisis has

plunged the countryinto its worst recession in 60years, while the lagging pace offiscal and structural reform israising doubts about whetherthe government will be able toavoid an eventual default.Opinion polls show anoverwhelming majority ofGreeks are opposed to leavingthe eurozone.

Yet Greece is struggling toachieve this years budgetdeficit target under the termsof its current bail-out by theEU and IMF.

Recent announcements of anew property tax aimed atraising 2bn by December,along with moves to sackmore than 20,000 workerswithin weeks, mark alast-ditch attempt by Athensto put fiscal consolidationback on track.

This may be enough tosecure the disbursement of the

next 8bn loan tranche. ButNicolas Sarkozy and AngelaMerkel, along with seniorCommission officials, havewarned George Papandreou,prime minister, that hemust accelerate the pace ofreform to ensure the secondrescue package goes ahead asplanned.

One worry is that anambitious 28bn privatisationprogramme included in thenew package is behindschedule. Another is that Greekbanks are in urgent need ofrecapitalisation after takinghaircuts of around 20 per centon their bond portfolios asa condition of the secondbail-out.

Yet Greek lenders areshowing reluctance to seekfunding from an IMF-backedbank stability facility becausethe state would become theirmajority shareholder.

But with the economy

projected to shrink this yearby 5.3 per cent and another2 per cent in 2012, andunemployment already at 16per cent, policymakers inAthens cannot afford furtherdelays in implementingreforms.

Kerin Hope

Faded star: the future of Europes monetary union remains unclear AP


3/6

FINANCIAL TIMES FRIDAY SEPTEMBER 23 2011 3

World Economy | Recovery

Brazil in particular, feel thetime has come when theyshould worry less about

inflation and cut interestrates to underpin expan-sion. Others, includingChina, are playing a wait-ing game. And India is soconcerned about inflationthat its central bank raisedinterest rates in September.

Two things are creatingthe turbulence in the globaleconomy. First is the euro-zone, which is strugglingwith a conflict between itsrelatively healthy economicfundamentals if it were aunified country and the factthat it is a combination of17 economies with oftendivergent interests.

Given that the eurozonesaggregate fiscal position isbetter than all other largeadvanced economies theUS, Japan and the UK theeuro crisis could be solvedwith greater pooling of taxreceipts and policy.

Replacing national sover-

eign debts with eurobondswould solve the immediatecrisis. But the more solventnorth Germany, the Neth-e rl an ds a nd F in la nd would have to accept to adegree the liabilities of thesouth Greece, Ireland,Portugal, Spain and Italy.

That would be an enormouspolitical step, as would theperipherys resultant loss ofsovereign policy-making.

Without a shift in this

direction, the euro mightnot be able to survive, espe-cially if the public begin tobelieve a split is possible.

As professor Larry Sum-mers of Harvard Universityand former chief economicadviser to Barack Obama,said this week: Now, whenthese problems have thepotential to disrupt growtha ro un d t he w or ld , a llnations have an obligationto insist that Europe find aviable way forward.

The eurozone woes arereplicated at a global level.Huge trade surpluses in oilproducers, in China, Ger-many and Japan are financ-ing deficits, predominantlyin the US. With US politi-cians unable to agree on astimulus to keep thesetrade patterns going, thealternative is that the glo-bal economy rebalances at alower level of output, the

depression everyone hasworked so hard to avoid.

The stakes could not behigher as the G20 meets inWashington. A solution tothe numerous contradic-tions in the world economyis not needed immediately.

But time is running out.

Finance ministersstare into abyss

After faint hopes last year of a sus-tained global economic recovery, it isclear that a second leg of the financialcrisis, three years after the first onepeaked, is dispelling hopes of any-thing better than stagnation for theyears ahead.

At the centre of that dynamic arethe worlds banks the cause of thewoes of 2007 and 2008 and now, inlarge part, victims of a feedbackloop, as the cost to governments offunding state bail-outs compoundsunderlying economic woes. With somuch of that now shaky-looking gov-ernment debt in the hands of banks,particularly in the eurozone, a viciouscircle has developed that is provingall but impossible to break.

The surprise is that after more than12 months of fairly sustained pressureon the weakest parts of the eurozone

periphery, more banks have not col-lapsed. Aside from a part-nationalisa-tion of the Irish banking system, mostbanks have survived.

Regulators midway through im-plementation of reforms drafted in thewake of the 2008 crisis are adamantthat without the drive to toughencapital and liquidity requirementsthere would have been more victims.

But a r ow is r aging about howmuch further banks need to go to pro-tect themselves from the latest woes.Is this the time to beef up buffers? Or,in the midst of a crisis, should regula-tors be letting banks eat into reserves the so-called counter-cyclical strat-egy. The markets are clearly torn.Credit Suisse, for example, had out-

performed rivals on the stock marketthanks to strong capital buffers, buthas slumped recently, as fears mountthat generating sufficient returns on

those higher equity levels will betough.Yet, at the same time, Frances

banks became the butt of the sell-offof eurozone banks, because of a com-bination of relatively high exposure tothe Greek economy, compounded byslimmer capital buffers than mostEuropean rivals.

Christine Lagarde, the new manag-ing director of the International Mone-tary Fund, made waves when she saidthere should be urgent recapitalisa-tion of European banks, to allow themto take the proper writedowns on thevalue of troubled eurozone debt, inpreparation for possible defaults.

Within a fortnight, Jamie Dimon,chief executive of JPMorgan, hadadded his polar-extreme view, describ-ing as anti-American the new BaselIII global rule book on capital andliquidity. The US should consider pull-ing out of the agreement, he said.

Yet it seems certain that banks eve-rywhere will have to hold higher lev-els of capital and liquidity slashingprofitability from the pre-crisis normof 20-30 per cent return on equity tomore like half that, at best.

But regulators should go further,says Andrea Enria, head of the Euro-pean Banking Authority, the over-sight regulator for the EuropeanUnion. [Extra capital] is extremelyimportant, he told a recent Financial

Times breakfast debate on the Futureof Banking. But its important thatwe strengthen supervision. I think wehave a major task ahead in dealing

with [systemic risk].The concerns apply as much to theso-called shadow banking environ-ment of hedge funds and money mar-ket funds as to banks themselves, astougher rules for lenders push busi-ness into less regulated institutions.

Some countries are going furtherthan the baseline global norms set bythe Basel Committee of regulators. OnSeptember 12, the UKs government-appointed Vickers Commission recom-mended sweeping changes to thestructure of the countrys banks. In areport backed by the government,with legislation promised by 2015 andimplementation by 2019, so-called uni-versal banks operating in Britain with retail and investment operationsunder one roof will have to separatethose businesses with a ringfence.

The idea is that barring the use ofhigh-street deposits to back invest-ment banking will make the busi-nesses safer. At the same time, it willremove in the UK the kind of implicitgov er nment guar antee that hasexisted in many countries since insti-

tutions from Northern Rock to Com-merzbank were bailed out three tofour years ago.

Most bankers and regulators believethe structure will remain a Britishpreserve, with other countries adopt-ing their own reforms.

More regulation is coming, though,with the Basel Committee yet to ruleon the exact liquidity requirementsthat banks should hold for the shortterm, and also on the maximum mis-match that should b e allowablebetween short funding terms and longlending commitments. Everyone hastheir fingers crossed that Europesbanks can make it through the cur-rent malaise without those additionalsafety measures in place.

Banks locked in vicious circle asregulators debate tougher rulesReforms

A debate is raging about

how much lenders shoulddo to protect themselves,writes Patrick Jenkins

At the Toronto sum-mit in June 2010,l ea der s o f t heGroup of 20 leading

nations thought they hadsettled the vexed issue ofthe d egree and p ace ofbudgetary consolidationafter the economic crisis.

Everyone signed up to theproposal that advancedeconomies (except Japan)

would halve their budgetdeficits by 2013.

The pledge was designedto inspire confidence thatgovernments had a grip onpublic finances and wouldlower borrowing as recov-ery continued. It was them om en t t he a dv an ce dworld moved from stimulusto austerity and the propos-als had widespread support.

No longer.A year later, fiscal policy

is again in flux. The USscraped a political deal toincrease its debt ceilingbefore the worlds largesteconomy descended intolikely default in August.Standard & Poor s, thec re di t r at in g a ge nc y,alarmed by the politicaldamage caused by the debtceiling fight, downgradedthe US triple-A rating, send-ing markets into a tailspin.

Internationally, the dis-putes over fiscal policy,which characterised thesupposedly harmonisedr esponse to the 2008-09financial and economic cri-sis, restarted as the globalrecovery stalled.

Germany is under pres-sure to loosen its fiscal tiesagainst its will. Christine

Lagarde, the new managingdirector of the InternationalMonetary Fund, has urgedcountries with the means toslow their austerity drives.The Organisation for Eco-nomic Co-operation andDevelopment trod the samepath in its September rec-ommendations.

But Germany is puttingstrong pressure on the restof the eurozone to cut defi-c it s q ui ck ly , a s s to rmclouds gather over Italy,Spain and Greece. It is dis-mayed that Barack Obama,US president, announced a

jobs plan, cutting taxes andincreasing spending at arate that would make USc om pl ia nc e w it h t he

Toronto agreement difficult.What once appeared a

straightforward process ofd elivering what many

thought was a reasonablebudget deficit reductionplan amid a gradual recov-ery has suddenly becomefraught with rancour andrisk.

By the time the Group ofSeven finance ministers andcentral bank governors metin Marseilles this month,there was ill-disguised frus-tration with the fiscal plansof other countries.

But the truth behind allthese d isputes is muchmor e comp lex than theheadline tensions suggest.Hidden behind claim andcounter-claim are surprisingstarting points from whicheach country was adjustingpolicy this autumn.

Contrary to received wis-

dom, the US did not havethe loosest fiscal plans ofadvanced economies. In fact,with tax cuts due to expireat the end of 2011, beforethe presidents speech, theadministration was plan-ning the deepest austerityd rive in 2012 of any G7country. It was seeking toclose its underlying deficitby 1.4 percentage points ofnational income in 2012.

If Mr Obama can get hisproposals through Congress a b ig if the US wouldonly slightly r elax itsbudget deficit by 0.4 per-centage points of nationalincome in 2012, according toGoldman Sachs, a movethat har dly counts as a

large fiscal stimulus.In contrast, while Ger-

many preaches austerity tothe rest of Europe, it hasthe loosest plans for fiscalconsolidation in the G7 for2012. According to the IMF,its underlying deficit wasset to fall only 0.6 percent-age points, albeit from a lowlevel to one even smaller.

The challenge now is toset fiscal policy at a time ofdeep uncertainty over twovital variables.

First, it remains unclearwhether p rivate-sectord emand is so weak thatgovernment is the only eco-nomic actor willing tospend.

Second, people can onlyguess the effects of fiscalconsolidation at a timewhen every leading econ-omy is trying to get borrow-ing down simultaneously.

G lo ba l f is c al p ol ic yremains unresolved and theG7 was reduced to emptystatements in Marseilles.When ministers call forgrowth-friendly fiscal con-solidation, as they did inMarseilles, their objective isevident, but their policiesa nd l ik el y r ea ct io n t oshocks are undefined.

W ith the b ig issues influx, countries are enshrin-ing their existing deficitreduction programmes inlegislation in an attempt toconvince markets that theirresolve is strong.

If the world economy con-tinues to slide, fiscal policywill not be set by legislationbut by the altogether moreunpredictable whims of thewider global recovery.

Austerity drive slides

into rancour and riskPublic finances

German and USmoves keep fiscalpolicy in flux,writes Chris Giles

Fiscal fix: Barack Obamas jobs plan will make US compliance with the Toronto deal on deficits difficult Bloomberg

Germany is puttinghuge pressure onthe rest of theeurozone to cutdeficits quickly

Jamie Dimon,head of JPMorgan,described thenew Basel III

global rulebookon capital andliquidity asanti American

Continued from Page 1

ContributorsChris GilesEconomics Editor

Ralph AtkinsFrankfurt Bureau Chief

Quentin PeelChief Correspondent, Germany

Hugh CarnegyParis Bureau Chief

Victor MalletMadrid Bureau Chief

Peter WiseLisbon Correspondent

Andrew WardNordic Bureau Chief

Guy DinmoreRome Bureau Chief

John Murray BrownDublin Correspondent

Matt SteinglassAmsterdam Correspondent

Kerin HopeAthens Correspondent

Patrick JenkinsBanking Editor

Claire JonesEconomics Reporter

Robin HardingUS Economics Editor

Norma CohenEconomics Correspondent

Alan BeattieInternational Economy Editor

Rohit JaggiCommissioning Editor

Steven BirdDesigner

Andy MearsPicture Editor

For advertising,contactCeri Williamson +44 (0)20 7873 6321,email [email protected]


4/6


World Economy | Central Banking

If investors expectations oftomorrow are what drivemarkets today, many ofthe worlds developedeconomies face a roughride in the months ahead.

At the start of 2011,stock and bond marketswere near their high pointof recovery since the

darkest days of therecession in the firstquarter of 2009, and formuch of the first half ofthis year prices mostlymoved sideways.

But from about June and coinciding with arising drumbeat of weaker-

than-expected economicreadings from manydeveloped markets and therevelation that the USrecession had been deeperthan thought stabilityevaporated.

Moreover, equity anddebt strategists say, thereis no end in sight to thecurrent turmoil. This timeits different, says GrahamSecker, equities strategistat Morgan Stanley.

Since the start of theyear, the S&P 500 index isdown 4.3 per cent, theFTSE 100 off by 10.9 percent, the Eurofirst 300 hasfallen 18.3 per cent and the

Nikkei is down 14.7 percent.

In particular, there aredeepening concerns aboutthe stability of Europeanbanks, whose holdings ofsovereign debt issued bythe most fiscally fragile ofeurozone governments

Greece, Portugal, Irelandand possibly even Spainand Italy lookfrighteningly large, giventheir relatively thin capitalcushions. Those fears havefed on themselves, aslenders to the banks USmoney market funds inparticular withdraw theirshort-term loans.

Mr Secker says: Therehas been a structuraldeterioration in theoutlook for stocks, giventhe relapse in growth andfurther escalation in theeurozone debt crisis. Webelieve developed marketeconomies are now at the

end of their debtsupercycle.

Only concerted action bycentral banks to shore upfragile economies is likelyto reverse the trend. EvenGermany, the powerhouseof Europe, saw its grossdomestic product grow

only 0.1 per cent betweenthe first and secondquarters of 2011.

Equity investors, MrSecker says, are likely toremain sellers of stocksuntil three things happen:first, large-scale purchasesof securities from theEuropean Central Bank(quantitative easing);second, new fiscalstrategies from developedeconomies aimed atproviding short-termstimulus while laying outconcrete plans to cut long-term expenditure; and,third, the writing down ofdebts to levels that reflect

the likelihood that partialdefaults may occur.

Not everyone is aspessimistic. Nick Nelson,equities strategist at UBS,notes that markets are notnecessarily accuratepredictors of economictrends: Our central

Optimistic investors in shortsupply as volatility continuesMarkets

The euro crisis andUS recession are hitting confidence,says Norma Cohen

The third arm Macroprudential policy

There is little left in officialsmonetary and fiscalarmoury. But fear not. AndyHaldane, the executivedirector for financialmarkets at the Bank ofEngland, says the only thingwe have to fear is fear itself.

Why? With fortuitoustiming, there is a new tool

in the box, a third arm ofmacroeconomic policy, MrHaldane said in August. Thethird arm is, of course,macroprudential policy.

Macroprudential policy isnot in fact new. The phrasehas been around since thelate 1970s, when it wascoined by the CookeCommittee, the forerunnerof the Basel Committee onBanking Supervision. It hasbeen used, with varyingdegrees of success, bypolicymakers in Asia andSpain for many years.

But only since the crisisexposed the deficiencies ofrelying on existing policies,and market discipline, tocurb the excesses of creditand liquidity cycles, has itbecome a buzzword.

The policy countersdangers to the financialnetwork as a whole. It doesso by regulating the

availability of credit andmanaging liquidity.

In contrast to monetarypolicy, which for the mostpart relies on interest ratesas the sole policy tool, anumber of instrumentscount as macroprudential.

Tools can be split in twotypes: the countercyclical,which counter the peaksand troughs of credit cycles,and the structural, whichlimit the fallout of a firmsfailure.

Policymakers agree thatcountercyclical buffers,loan to value ratiosand liquiditycoverage ratiosshould be in thetoolkit. But they aresplit on what elseshould count asmacroprudential.

Brazil to the chagrinof policymakers elsewhere has said its decision to

impose capital controls inthe form of a tax on foreigninvestments was made onmacroprudential grounds.

Such divergence is likely tobecome part and parcel ofthe policy strand.

Various measures canhelp to promote financialstability, but only some areclearly macroprudential.Countries priorities differ onwhat the most importantsources of financial stress

are, so macroprudentialpolicy will differ from jurisdiction to jurisdiction.

Asian policymakers use ofmacroprudential tools hasfocused on loan to valueratios, which limit theamount a mortgage holdercan borrow against thevalue of the property.

Research by NataliaLechmanova at StandardChartered Bank suggeststhat the use of such ratiosby several Asian economies including Hong Kong,Singapore, Korea and China has been more effectivewhen coupled with monetarypolicy. Monetary policyalone is not sufficient toprick asset price bubbles,neither is macroprudentialregulation. They complementrather than substitute forone another, she says.

The research points outthat in Hong Kong and

Singapore, despite tighteningof macroprudentialmeasures, property pricescontinue to rise. But inSouth Korea wheremacroprudential measureshave been coupled withtight monetary policy house prices have stabilised.

Rising property pricesmay indicate macroprudentialmeasures can only do somuch if monetary policy isincorrect, she says. ThatSpains implementation of a

countercyclical capitalbuffer

counteracted by low interestrates in the eurozone failed to stave off recessionwould also point to this.

With interest rates likelyto remain the predominantpolicy tool, the findings aresignificant to policymakerselsewhere. However, thelessons that can be drawn

from Asias experience arelimited by differences in thepolitical climate. The Bankof Israels attempts to usemacroprudential measuresto damp the countryshousing bubble have metwith anger in the media,with claims that themeasures favour foreigninvestors over first timebuyers. This is likely toresult in policymakers in thewest opting for measureswhich less obviously favourany segment of society.

Another problem is a lackof evidence for policymakersto draw on in settingmacroprudential policy.

Richard Barwell, a RoyalBank of Scotland economist,said in a research note: Incontrast to the situationwhere the Bank was givenindependence for monetarypolicy in 1997, very little isknown about how to do

macroprudential policy. TheFinancial Policy Committeewill not . . . be able to drawon decades of research.

Implementingmacroprudential policy, willbe a case of trial and error,as officials are well aware.

Mr Haldane said in aninterview with CentralBanking Journal last year:The authorities will besailing in largely unchartedwaters in a new boat with anew crew. Against thatbackdrop, it is perhapsunderstandable that some

pessimists have predictedan imminent shipwreck.

From invisible handsto third arms,policymakers espousal

of macroprudentialpolicy is

characteristic of alack of faith in

markets. Thepolicy, though,

may not provethe complete answer.

Claire Jones

Three years after thep ea k o f t he G re atRecession, the worlds

central bankers are like awalking party that has set

off for a very long trip inthe mountains and remainsfar from its destination.

Despite trillions of dollarsof quantitative easing, hugeliquidity operations and arange of experiments incentral bank communica-tion, the legacy of the finan-cial crisis has not yet beenovercome.

In the US, households arestill burdened by high lev-els of d eb t held againsthomes that continue to fallin value. In Europe, mean-while, government debtburdens have led to a par-ticularly corrosive financialmalaise. Both are holdingback growth.

There is some fatigue andgrumpiness among the cen-tral b anking group andp lenty of d issent aboutwhat to do next.

One group well repre-sented by a European Cen-tral Bank that has raisedinterest rates in two stepsthis year from 1 to 1.5 percent wants to get down offthe mountains and takeshelter.

It thinks that slogging onwith extra monetary stimu-lus involves large risks inreturn for little benefit.

Another group includ-ing academic economistssuch as Paul Krugmanalong with central bankerssuch as Adam Posen at theB an k o f E ng la nd a ndCharles Evans of the Chi-cago Fed thinks that thereal danger is that the partyhas not been moving fastenough.

They argue, in essence,

that central banks shouldcast aside some of their bag-gage, take a little more riskand strike out hard for thedestination of full employ-

ment.Both the UK and the glo-

bal economy are facing afamiliar foe at present: pol-icy defeatism, said MrPosen in a recent speech.

H is s ol ut io n i s m or equantitative easing, whichmeans buying assets in aneffort to drive down long-term interest rates, and aneffort to transmit that effectvia a state-backed bank tochannel credit to smallbusinesses.

Mr Evans, by contrast,has become the first UScentral banker to counte-nance the idea that tempo-rarily higher inflation couldbe an effective way to easepolicy. If people expecthigher inflation, they havea stronger incentive tospend or invest their moneynow, he says.

The latest formulation ofMr Evans ideas is an ele-gant trigger strategy thatputs his goal in a way thatis easy to communicate. Hesuggests the Fed pledges tohold interest rates excep-tionally low until unem-ployment has fallen from itscurrent level of 9.1 to 7.5p er c en t, as l on g a smedium-ter m inflationstays below 3 per cent.

For now, however, mostof the central bankers onthis long walk are inclinedto press doggedly onwards.

They will not counte-nance the risks of aggres-sive action, nor will theylay down their burden oftrying to ensure low butstable rates of inflation.

The Bank of Japan, which

has been dealing with stag-nant prices for longer thanany other central bank, hasslowly r atcheted up itsasset p ur chases and its

attemp ts to p ush d ownlonger-term interest rates.

The Fed er al Reser ve,while setting a very highbar for a QE3 round ofa ss et p ur ch as es , h asreturned to efforts at easingpolicy.

In August, it said thatconditions were likely towarrant keeping interestrates close to zero at leastthrough mid-2013.

The general idea behindthese moves is that the ben-efits of further monetarypolicy easing are limited;the risks mainly in terms

of the credibility of the cen-tral banks promise not tofinance government spend-ing increase the furtherthe easing goes.

Monetary policy can doan enormous amount ofharm by trying to withdrawliquidity at a time whenbanks, firms and house-holds have a very strongdesire to be as liquid asthey can possibly be, saysNeal Soss, chief economistof Credit Suisse in NewYork.

The benefits of furthereasing, however, are muchsmaller. It is an extremelyasymmetric challenge, hesays.

As Neil Williams, chief

economist at Hermes FundManagers in London, putsit: If consumers still cantrepair their balance sheetwhen the true monetary

policy rate [adjusted forq uantitative easing] isminus 3 per cent it is hardto be too optimistic aboutthe outlook or the effects offurther easing.

Taking a step back fromtheir immediate policy con-cerns, the broad questionthat central banks have toanswer is whether it ismore damaging to suffer along period of high unem-ployment that would marka failure of the whole eco-nomic policy apparatus, orwhether to take risks thatcould lead to failure ontheir own specific responsi-b ilities of inflation andfinancial stability.

For M r Soss, it is thefinancial sector that will bein greater peril if monetarypolicy remains very easyfor a long time. Inflation, hesays, is unlikely, so long asconsumers prefer cash intheir pockets to consump-tion.

As long-term interestrates are driven ever lower,banks, insurers and pensionfunds are left with onlylow-calorie assets thatyield a couple of per cent ayear, says Mr Soss.

Yet the liabilities theyhave left over from the pastare pretty high-calorie, headds, so an eventual rise ininterest r ates would b epainful.

For the central banks,there is still a lot of groundto cover before they cantake their hot bath and coldb eer at the end of their

journey b ack from theGreat Recession.

The path to recovery provesto be a long and painful one

Central banks

There is still no

consensus on therisks of extramonetary stimulus,says Robin Harding

Monetary policycan do enormousharm by trying towithdraw liquidity

Lost in the hills: central bankers are undecided on whether to press ahead or run for cover Alamy Images


5/6

FINANCIAL TIMES FRIDAY SEPTEMBER 23 2011 5

World Economy | Central Banking

economic view is that we

will avoid the recessionnext year, but thatmarkets are getting aheadof themselves. While thereare multiple challenges the sovereign credit crisisin Europe, politicalparalysis in the US hestill expects some modestgrowth.

More worrying, he says,is that markets appear tobe pricing in a biggerslowdown in corporateprofit growth. The surge torecord nominal prices forgold and in the Swiss francindicate wider panic aboutthe stability of the system.

Indeed, the unusualvolatility in world stockmarkets comes ascompanies appear to haveweathered the recessionbetter than many couldhave imagined. Companycost-cutting in 2009 wasvery successful, Mr

Nelson says. The averagenet debt/equity ratio ofdeveloped markets is now40 per cent, about as lowas it has been at any timein the past 12 years. Profitmargins on earnings beforeinterest and tax, with theexception of the financial

sector, are about 13 percent, a 30-year high.

If anything, companiesare hoarding cash as neverbefore, a trend Mr Nelsonsays is a function of theemotional scarringmanagements received in

2008. Nevertheless,investors are pessimistic.

Bond markets, it seems,are little better. GaryJenkins, head of creditstrategy at EvolutionSecurities, says certainindices that are bellwethersof risk were remarkably

stable until the start of

summer. Corporates havebeen a haven, he says.

Until late May, theiTraxx Crossover Index ofcredit default swaps onlower-rated corporatebonds was stable.

But in recent weeks, thathas changed. For example,a subcomponent of theindex that tracks thesubordinated debt securitiesof financial institutions ispricing credit default swapsfor the sector at 560 basispoints ($560,000 to insure$10m of bonds againstdefault). In 2008, followingthe collapse of LehmanBrothers, the sector cost300bp to insure. The bondmarket is sending veryworrying signals, he says.

On the other side of thecoin are debts of strongersovereigns such as the USand Germany. In theformer, yields on 10-year

Treasuries have fallenbelow 2 per cent a recordlow while yields onbunds of a similarmaturity are not muchhigher. Either people arevery scared and seeking ahaven or are expectingdeflation, Mr Jenkins says.

Flight to safety: panic buyingof gold and Swiss francs

Mario Draghi Set to inherit an ECB in crisis

The challenges facing Mario Draghi, whenhe takes over as European Central Bankpresident on November 1, could hardly begreater, writes Ralph Atkins.

In the midst of the biggest crisis sincethe euros launch in 1999, the Italian centralbanker has to shore up investor confidencein the regions stability, avert financialmeltdown and steer its economy backtowards sustainable growth. He will also beaware of the ECBs stated main objective:controlling inflation.

But the terrain is not unfamiliar to MrDraghi, an experienced crisis manager. Inthe early 1990s, he headed Italys treasuryat a time when the public sector deficit hadsoared to more than 10 per cent ofeconomic output, inflation was nearly indouble digits and homegrown terrorism wasstill a threat. It was a situation that wascertainly worse than one could ever imaginetoday, he recalled in an interview with theFinancial Times last year. Mr Draghi helpedimplement a strict fiscal austerity plan andcatastrophe was averted.

After that formative experience, Mr Draghiworked at Goldman Sachs, the USinvestment bank, which appointed him vice chairman and managing director in 2002.Three years later, he took over as governorof the Bank of Italy, replacing the disgracedAntonio Fazio.

Born in 1947 into a middle class family inRome, Mr Draghi was orphaned as ateenager and for a while was brought up byan aunt. His rigorous education at RomesJesuit school instilled a cautious approachto the world. He also had extensive trainingas an economist. Under Franco Modigliani, aNobel economics laureate, he became thefirst Italian to gain a doctorate at theMassachusetts Institute of Technology.

Mr Draghi then taught economics andfinance at Italian universities and was aWorld Bank director for six years.

Mr Draghi is disciplined and sometimesenigmatic useful attributes in a centralbanker. Recently, he has kept a low profile,taking care not to undermine the authorityof Jean Claude Trichet, incumbent ECBpresident, with any hints of dissent.

Those familiar with his thinking report

that his career has taught him the virtuesof pragmatism. Thus he has supported theECBs adoption of extraordinary measuresto tackle the eurozone debt crisis, including

its controversial bond buying.Nevertheless, Mr Draghi has cultivated the

image of a monetary policy hawk orhardliner which explains why he was ableto win support, eventually, for hisnomination as ECB president from AngelaMerkel, the German chancellor. The way forhis selection became clear in February,when Axel Weber, Germanys Bundesbankpresident, withdrew from the contest citingdifferences with other eurozonegovernments on ECB strategy.

Germans fear that Mr Draghi will be softon fiscally imprudent southern Europeancountries. The fear in Italy, however, is thatan early desire to win German support for

the ECB will increase further the pressureon Rome. He has joined with Mr Trichet inpiling pressure on Silvio Berlusconi, Italysprime minister, to implement fiscal andstructural reforms. If you look at his recordon the Italian government, he is one of thecentral bankers who has taken the tougheststance, says Elga Bartsch, Europeaneconomist at Morgan Stanley.

In practice, Mr Draghi will only be able toact with the backing of the ECBs 23 stronggoverning council, comprising central bankgovernors of the 17 eurozone countries andsix Frankfurt based executives. That willrequire him to become expert at consensusbuilding. Less passionate in public than MrTrichet, he is nevertheless also likely to beactive behind the scenes in lobbyinggovernments into taking action to avertimmediate crises and secure the eurozoneslonger term stability.

Draghis image as amonetary policyhardliner helped winGerman chancellorAngela Merkelssupport for hisnomination asECB president

It is a fundamental tenet ofcentral banking, enshrinedin Walter Bagehots fabled

Lombard Street, t ha t i ntimes of crisis the worlds mone-tary guardians lend abundantlyagainst good collateral for anonerous fee.

Central banks have indeedprovided ample liquidity to mar-kets, playing a vital role in stav-ing off a financial meltdown.More contentiously, they haveaccepted collateral that eventheir most ardent defenderswould struggle to label good.They have also bought govern-ment bonds and other securitiesfrom investors under quantita-tive easing.

All of which is reflected in theexpansion of advanced-economycentral banks balance sheets.

Only after Lehman Brothers

failed did balance sheets expandsharply, as funding pressuresintensified though in the earlystages of the crisis the composi-tion of assets shifted as the cen-tral banks broadened theirrange of eligible collateral toaccount for funding strains inthe markets for all but the saf-est instruments.

Since October 2008, the Fed-eral Reserve has purchased$2,150bn of assets, of which$1,250bn were mortgage-backedsecurities, and $900bn treasur-ies. The Bank of England hasbought 200bn of assets, thebulk of them gilts. More quanti-tative easing may soon follow

on both sides of the Atlantic.The European Central Bank hadbought, as of September 12,143bn ($197bn) in Irish, Greek,Portuguese, Spanish and Italiangovernment debt.

Most of these measures arenot without their critics, whocontend that such actions ham-per monetary authorities inde-pendence. Jean-Claude Trichet,the ECBs president, this monthfelt moved to defend the central

bank by saying its balance sheethad expanded by only 77 percent since the crisis, against 226per cent for the Federal Reserveand 200 per cent for the Bank ofEngland.

Two dangers are that theexpansion could stoke inflationor result in losses that coulderode central banks slim capitalbuffers. Both could have impli-cations for their independence.

Inflation expectations, for

now, remain well anchored. Andone need only look at Japan tosee that an incr ease in theamount of cash swilling roundan economy does not necessar-ily result in price pressures,especially after a banking crisis.

Hitting back at oft-heardbarbs that the Bank of Japandid too little to combat its bank-ing crisis, Masaaki Shirakawa its current governor has saidthat the ratio of the central

banks balance sheet rose tosome 30 per cent of GDP in 2005.Speaking last September, hesaid: That is twice as large asthat by Federal Reserve, theECB, and the Bank of Englandin the recent crisis.

Six years on, Japan remainslocked in if not deflation, theninflation so low it offers littleincentive to spend now.

Central banks willingness totake on riskier assets could net

a tidy profit. The Fed declared arecord payment to the Treasuryfor 2010 of $80.9bn, most of itfrom interest earned on the risk-ier assets it now holds. Thatcould easily be reversed, produc-ing big losses which could erodecentral banks capital buffers.

Owing to their ability to profitfrom note-printing and their tra-ditional aver sion for r isk yassets, central banks capitalbuffers are understandably

minute. The Feds buffer is$26bn against a balance sheet of$2,800bn less than 1 per cent.Even after an increase of 5bnlast December, at 10.76bn, theECBs is an even smaller propor-

tion just half a per cent of its2,070bn balance sheet. TheBank of Englands is 2 per cent 4.4bn against its balancesheet of 225bn. It has alsoincreased its capital buffer from1.86bn in 2007.

T he B an k h as , h ow ev er ,ensured that its quantitativeeasing programme and its spe-cial liquidity scheme are struc-tur ed in a way that the UKTreasury would pick up the tab.

The Fed also has a similararrangement for the first chunkof losses on some of its crisis-fighting facilities and changedits accounting rules this year soit could defer its weekly pay-ments to the US Treasury wereit to incur losses.

Central bank losses are neverideal. But it is preferable for theloss to be the result of actionthat has an explicit governmentindemnity.

There is no such indemnityfor the ECBs securities markets

programme. In the event thatthe ECB were to make a loss sogreat that it eroded its capitalbuffer, it would first go to thenational central banks of allEuropean Union members.

I f t he y l ac ke d a de qu at eresources, the national centralbanks would have to ask theirgovernments for support.

That central bank s haveinflated balance sheets and holdriskier assets is far from ideal.Yet Mr Shirakawa is still havingto defend the Bank of Japanagainst claims they did not doenough. It is a difficult tightropethat the worlds monetaryguardians tread.

Central banks walk a monetary tightropeBalance sheets

Claire Jones looks at the risks and rewards

of recent measuresto supply liquidity

How central bank balance sheets have grown

Source: Thomson Reuters Datastream

Balance sheet size (rebased)

2007 08 09 10 11

50

100

150

200

250

300

350

Bank of England

Federal ReserveEuropean Central Bank

Casting the net wider

and diversified their holdings

Federal Reserve balance sheet assets ($000bn)

2007 08 09 10 11

0

0.5

1.0

1.5

2.0

2.5

3.0

US Treasury securities

Federal agency debt securities

Mortgage backed securities

Maiden Lane and AIG related holdings

Term Auction credit

Central bank liquidity swapsOther

Under fire: Jean Claude Trichet defended ECB balance sheet Bloomberg


6/6


World Economy | International Institutions

O n J ul y 5 , C hr is ti neLagarde became the 11thsuccessive European andfifth French head of theInternational MonetaryFund since the organisationstarted operations in 1946.

M s L ag ar de , F re nc hfinance minister before herappointment, took overfrom her compatriot Domin-ique Strauss-Kahn, who isgenerally remembered atthe IMF for his wor k inrestoring its relevance tointernational crisis manage-ment, rather than the man-ner of his leaving the fund.

After a decade in which abooming global economyand confident investorsdiminished the demand foremergency rescue lendingfor crisis-hit countries, thefund looked like an organi-sation in search of a mis-sion.

It attempted to insertitself into or gave way toUS pressure to enter debates about misalignedexchange rates and rebal-ancing the global economy,which produced little butt he u su al s ta le ma tebetween Washington andBeijing over the renminbi.

Mr Strauss-Kahn seized

the chance presented by theglobal financial crisis, par-ticularly when it entered itssovereign debt phase in late2008.

First in a string of centraland eastern European coun-tries and then in Greece,Ireland and Portugal, MrStrauss-Kahn overcamereluctance from the Euro-pean Central Bank and oth-er s t o h av e t he I MFinvolved.

But with its involvementcame risks to its financesand its reputation, whichMs Lagarde has now inher-ited. Unusually, the fundhas provided a minor shareof the money for the Greek,Irish and Portuguese res-cues, with most comingfrom two other parts of thetroika the EuropeanCommission and the ECB.

The first Greek rescueprogramme, launched inMay 2010, was criticised bymany economists for over-optimism on growth andfailing to include a write-down of G reeces huge

sovereign debt owed to theprivate sector.

The second iter ation,s ke tc he d o ut i n a d ea lannounced in Brussels onJuly 21, made some modestmoves in the latter direc-tion and was praised byMs Lagarde for showing

Europe uniting to seize con-trol of the situation but itfailed to impress the finan-cial markets.

As much of the privatesector in this context com-prises western European

banks, particularly Frenchand German ones, it is alltoo easy for dissenters toconstruct an argument thata Europe-dominated IMF despite reforms, a third ofthe votes on the fundsexecutive board are held byEuropean countries, quiteapart from the tradition ofappointing a Eur opeanmanaging director isgoing easy on Europeancountries and banks.

Indeed, in an unusualmove in the usually dis-creet, not to say secretive,IMF, some emerging marketr epr esentatives on thefunds board have openlycriticised the Greek pro-gramme and said it wouldpr esent a challenge toMs Lagarde to distance her-self from her European ori-gins.

Ms Lagarde has dismissedthose criticisms as rub-bish and has distanced her-self from European policy-makers by warning thatwestern European banks arelikely to need more recap-italisation, a suggestion thatarouses wrath at the ECBand the Commission.

But while the IMF has alegitimate advisory role onbank capital, its main busi-ness is crisis lending, andhere Ms Lagarde may face adifficult decision aboutwhat to do with Greece.

The proposed comprehen-sive second r escue pro-gramme, which the Julymeeting envisaged havinghappened by now, is boggeddown. Greece has failed tomeet budget deficit targetsunder the current lendingprogramme and those whower e sceptical it wouldgrow enough to claw itselfout from under its debt bur-

den have been vindicated.The current indications

are that Greece will receivethe next tranche of lendingunder the programme afteragreeing to impose a prop-erty tax to close a 2bn($2.7bn) hole in its budget.

But unless growth picksup and the higher taxesa re s et , t he h ar de r i tbecomes for the economy toexpand quickly enough itmay soon become clear thatGreece will need a hugeamount of extra moneyand/or a substantial write-down in its sovereign debt.

This will not be an easydecision, not least becauseit may mean Ms Lagardebreaking with her Europeanformer counterparts, whoare more likely to want tokeep the money coming.

Ms Lagarde is a lawyer,not an economist a factthat has raised eyebrows in

the economics profession and having the confidenceto mak e a big call thatturns on a judgment of thesustainability of a complexeconomic situation mayinvolve almost as muchboldness as disagreeingwith fellow Europeans.

Lagarde facestough baptismover Greek debtIMF

The new head isset for a showdownwith Europe,writes Alan Beattie

ChristineLegarde hasdistancedherself fromEuropeanpolicymakers

Grand ambitions were theo rd er o f t he d ay w he nFrance took over the presi-dency of the G roup of 20

leading economies and the Group ofEight in January.

Gone was South Koreas low-keychairmanship of the worlds premierforum for international economic co-operation, to be replaced by show-manship from Paris.

Nicolas Sarkozy, French president,launched his 2011 G20 mission withthe vision of creating a new interna-tional monetary system. We live in anew world, so we need new ideas, hesaid. The proposal sought to tame vol-atility in currency and commoditymarkets, damp global capital flowsand solve global trade imbalanceswhich he said were caused by inter-national monetary disorder.

Some of the plan was more evolu-tionary than revolutionary and MrSarkozy insisted he did not want to

usurp the status of the dollar. Yet heshowed his desire for change by say-ing the dollar could not act as theworlds sole reserve currency. The

emergence of new economic powerswill lead to the emergence of newinternational currencies, he said.

While the grandiose language wasnever to the taste of most G20 coun-tries, the first step on the journey to anew international monetary systemwas the implementation of previousG20 agreements to create a strong,stable and balanced global economy.

In mid-February, G20 finance minis-ters gathered in Paris for what turnedout to be a harbinger of the chal-

lenges that have beset the French G20presidency ever since. The meetingwas supposed to be routine, withfinance ministers agreeing a set of

indicators that might be used toassess whether their economies andpolicies fostered balanced global eco-nomic growth.

Far from France undermining themeeting with excessive ambitions,countries struggled to agree even themost basic steps to a more stableworld economy.

A countrys current account surplusor deficit is the accepted measure ofbalance in its relations with othercountries, but the Chinese arrived in

Paris in intransigent mood. Theirnegotiators refused to let the G20 usethe current account as an indicator ofbalance. After an all-night session, the

absurd compromise China acceptedwas that countries were allowed toassess every component part of acountrys current account, but theterm current account was banned.

That ended the French presidencyslofty plans. From then on, limitedgoals became the order of the day, ashift that has been reinforced as theyear has progressed.

The slide into stagnation, the euro-zone sovereign debt crisis, the USdebt ceiling crisis and the re-emer-

gence of currency wars with the Swissdecision to cap the value of its franchave ensured that efforts to revivegrowth in the world economy will

form the centrepiece of the Frenchpresidency for the rest of the year.

We are now back in the world ofimmediate issues, not how to redesignthe monetary system for the next 50years, says one G20 official close tothe discussions.

An exhausting round of meetingsstarted in mid-September when thefinance ministers and central bankgovernors of the Group of Seven lead-ing advanced economies gathered inMarseilles. Markets were swooning

and, as the meeting started, newscame in that Jrgen Stark, the hawk-ish German board member of theEuropean Central Bank, had resigned

in disgust at the ECBs purchases ofhuge amounts of Spanish and Italiangovernment debt.

The G7 meeting did not augur wellfor the G20 summit in Cannes inNovember. The G7 failed to come up

with a co-ordinated plan; agreed todisagree on many important matters;and resolved that every countryshould do what was right for it.

Of the original French ambitions,little is left. But presidencies of theG20 are never allowed to come awayfrom a year of hard graft with noth-ing. There are still areas on whichhopes are high of agreement at theCannes summit.

Some specific and limited globalregulations are likely in commoditymarkets. There is still effort in secur-ing agreement on the controls coun-tries are allowed to impose on capitalflows. Efforts are also continuing infinding new lending facilities for theInternational Monetary Fund. Andcountries will again have to face up todiscussions over strong, stable andbalanced growth, even if they find itdifficult to agree anything specific.

One carrot being offered to China isthe inclusion of its currency, the ren-minbi, in the calculation of the IMFssupranational money, the specialdrawing right. If the regime accepts

and China offers concessions on itscurrency and domestic spending toearn the prize, Mr Sarkozys G20 presi-dency will be judged a success.

Uphill battle for French G20 presidencyGlobal growth

The leading economiesneed to find common

ground, says Chris Giles

Talking heads: leaders of G20 countries will again have discussions on strong, stable and balanced growth, even if they find it difficult to agree on specifics AFP/Getty

ft world crisis

Documents