Why Obama’s India Trip Matters?

9. November 2010 by admin.

Why Obama’s India Trip Matters? President Barack Obama is on a high-profile diplomatic trip to India this week, furthering Obama’s goal of deepening U.S.-India ties and addressing a number of related issues. Since entering office, Obama has continued President George W. Bush’s emphasis on building a special relationship between the two countries, making Indian Prime Minister Manmohan K. Singh the guest of honor at Obama’s first official state dinner. Here’s what’s happening on the visit, why it matters, and what it could mean for the two countries and beyond.

• Why the U.S. and India Want to Be Best Friends  The New York Times’ Jim Yardley writes, “Both countries are eager to build on their improved ties and set up a unique, special relationship, given that together they represent the world’s richest and largest democracies. Faced with a rising authoritarian China, and an economically wounded Europe, a weakened United States is casting about for global partners. India would seem a nice fit.”

• …And Why That’s Proving So Difficult  Yardley explains the security disputes: “The Americans, at different times, have pushed the Indians to cut a deal with Pakistan over the disputed region of Kashmir, but the Indians have bristled at any interference. The Indians still want the Americans to sponsor India for a permanent seat on the United Nations Security Council. Not such an easy thing, the Americans reply, since America alone can’t do this and it creates issues between America and China. It has sometimes seemed like a relationship built around one country asking the other to do something it considers against its self-interest.” And the economic disputes: “High unemployment in America has renewed complaints that outsourcing to India hurts American workers. Indians complain that American protectionism is hurting Indian companies and that American export restrictions on technologies that can have both military and civil uses are outdated and unnecessary in a relationship between putative allies.”

• Obama’s Grand Gesture to India  The Associated Press’s Erica Werner reports, “President Barack Obama backed India for a permanent seat on the U.N. Security Council Monday, a dramatic diplomatic gesture to his hosts as he wrapped up his first visit to this burgeoning nation. Obama made the announcement in a speech to India’s parliament on the third and final day of his visit. In doing so, he fulfilled what was perhaps India’s dearest wish for Obama’s trip here. India has been pushing for permanent Security Council membership for years.”

• Can India Continue Moving Ahead?  Foreign Policy’s Arvind Panagariya notes that India is still “one of the poorest countries in the world,” but “the United States and many other countries are betting on India not because of where it stands today, but where they see it going in the next 15 years. … But none of this will matter if India fails to fulfill its economic promise. As the recent revelations about corruption and mismanagement of the Commonwealth Games dramatically showed, India’s government still has a long way to go — the country’s phenomenal success over the past two decades has come largely because its politicians and bureaucrats have gotten out of the way.”

• U.S. Must Choose Between Pakistan and India  The L.A. Times’ Selig Harrison warns, “A quiet crisis is developing in what seems, on the surface, to be an increasingly promising relationship between the world’s two largest democracies. … [India worries] that the United States can hardly be a strategic partner if it continues to build up the military capabilities of a hostile Pakistan that sponsors Islamist terrorists dedicated to India’s destruction. … the full potential of U.S.-Indian cooperation, including naval cooperation in the face of an increasingly ambitious China, will not be realized until Washington stops providing Islamabad with weaponry that can be used against India and takes a realistic view of the reasons for Indian-Pakistani tensions.”

• Get Indian Influence Out of Afghanistan  David Pollock writes in the Washington Post that their presence makes the war tougher. “India, of course, is an increasingly important regional and global partner for U.S. foreign policy. But it is in India’s self-interest to contain extremist pressures in Afghanistan and Pakistan - and one paradoxically clever way to do that is to lower India’s profile in Afghanistan. During his visit, Obama should drive home the point that such self-restraint would best serve our common interest in stabilizing the region.”

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Rise Of India and American Jobs

9. November 2010 by admin.

The other elephant

Barack Obama thinks that the rise of India will be good for American jobs. There is another side to the story

ON THE eve of the 2008 New Hampshire primary Bill Clinton finally gave vent to his fury with the Obama campaign. He dismissed Barack Obama’s message as “the biggest fairy tale” he had ever heard. (“Give…me…a…break,” he roared at the startled crowd.) And he denounced underhand tactics, particularly a description of Hillary Clinton as “the senator from Punjab”.

On November 5th Mr Obama, fresh from his humiliation in the mid-term elections, flies to India accompanied by an entourage of almost 250 businesspeople. His message for the folks back home will be that India could be a goldmine for American jobs. And he will clinch a succession of huge business deals with India—not least a $5.8 billion aircraft sale by Boeing.

Mr Obama’s win-win rhetoric is plausible enough. India is growing at about 8% a year at a time when America can barely manage 2%. It is also set to add 240m people to its working population by 2030. And America produces all sorts of things that Indians crave, from iPads to MBAs to fighter planes.

Yet the rise of new economic powers always brings problems as well as opportunities for incumbents. New companies displace old ones. New business models disrupt established ones. Comfortable workers in the rich world are forced to compete with hungrier ones in the poor world.

India is producing a legion of new global giants that are competing head-to-head with established American companies. Look at Arcelor Mittal and Tata Steel in steelmaking; Bharat Forge and Sundram Fasteners in car parts; Hindalco in aluminium rolling; and a host of companies, including Infosys, Tata Consulting Services (TCS), Cognizant and HCL Technologies, in information services. Twenty years ago India had no global companies worth mentioning. Today the Tata group earns 60% of its revenues abroad, and Indian companies ranging from natural-resource firms, such as Reliance Industries, to health-care companies, such as Pirmal Healthcare, have been snapping up American brands.

American companies are also setting up shop in India. Bangalore and Hyderabad have “electronic cities” crowded with America’s leading companies. In Bangalore Cisco spent $1 billion on its Globalisation Centre East and General Electric (GE) opened a swanky research centre. IBM employs more people in India than in the United States.

For American workers the most worrying thing about all this is the flight of brain-intensive jobs to India. Americans reconciled themselves to the loss of manufacturing jobs with the thought that they would keep the smart jobs. But they reckoned without two things: the power of the internet and the hunger of emerging-market companies.

India has long since turned itself into the world’s back-office—subjecting paper-processing hubs such as Kansas City to the same forces of competition that devastated former industrial cities such as Gary, Indiana. Now Indian-based companies are moving into an wider range of services: reading CT-scans and X-rays, processing legal documents and helping with animation. They are also moving into sophisticated niches. TCS and Infosys compete directly with IBM and Accenture in consulting. American companies are adding to the trend by moving more of their important operations to India: John Chambers, Cisco’s boss, has decreed that 20% of the firm’s leadership should be in Bangalore.

Companies in India are challenging American ones in an area that they have long considered their own—innovation. The Boston Consulting Group’s 2010 survey of innovation notes that the number of American companies on its list of top innovators is declining while the number of Indian companies is rising. It also points out that the Indian firms place a higher value on innovation than the American companies.

Most strikingly, Indian companies have produced a new type of innovation, variously dubbed “frugal”, “reverse” and “Gandhian”. The essence is to reduce the price of a product or service by a breathtaking amount—80% rather than 10%—by removing unnecessary bells and whistles. Tata Motors is selling its “people’s car” for $3,000; GE’s Indian arm offers a medical ECG machine for $400; Bharat Biotech sells a single dose of its hepatitis B vaccine for 20 cents and Bharti Airtel provides one of the cheapest wireless telephone services in the world. These frugal products are likely to disrupt established Western companies (including GE itself) by forcing them to engage in a bloody price war.

Luring them back

To add to this general turbulence Indian-based companies are also on a hiring binge. For decades America has gorged itself on a seemingly limitless supply of brilliant Indian PhD students and entrepreneurs. Half of Silicon Valley’s start-ups were either founded or co-founded by Indians. But these paragons are now returning en masse to the mother country (just as America makes life more difficult for immigrants). Why work for a sluggardly American firm when Infosys is growing at double digits? Why live in a flimsy bungalow in the Valley when an Indian company will provide you with a villa in a gated community, membership of a country club and a chauffeur-driven car?

There is an upside to these downsides. Frugal products will be a godsend for America’s pinched consumers. They may even prevent the American economy from being crushed by the health-care Godzilla. But Americans need to get back on the treadmill. In a recent speech Mr Obama told schoolchildren in Philadelphia that: “When students around the world in Bangalore or Beijing are working harder than ever, and doing better than ever, your success in school is not just going to determine your success, it is going to determine America’s success in the 21st century.” That is not a bad theme for the next two years of his presidency.

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Book Review: Mahabharata of Polyester (The Making Of World’s Richest Brothers)

7. November 2010 by admin.

The Ambani brothers

A durable yarn

A revealing account of India’s most colourful business family.

DHIRUBHAI AMBANI grew up in a two-room home with an earthen floor in the Indian state of Gujarat, close to the Arabian Sea. Later this month his eldest son, Mukesh (pictured, right), head of Reliance Industries and the world’s fourth richest man, will throw a party to show off his new home in Mumbai, a towering vertical palace with six floors of parking space, three helipads and a hanging garden.

The story of how the Ambanis moved from dusty provinces to city skyscrapers is a tale of pluck, guile and vaulting ambition. But telling it also requires courage and tenacity. Hamish McDonald, an Australian journalist who was posted to Delhi in the 1990s, brought out his first book on Ambani, The Polyester Prince, in 1998. Publication in India was scrapped after Reliance set its heart on legal action, but the book became required reading for anyone interested in Indian industry. In his new work, Mahabharata in Polyester, Mr McDonald brings the story up to date, adding chapters about Dhirubhai’s death in 2002 and the subsequent feud between his two sons, Mukesh and Anil.

The young Dhirubhai lacked money, but not charisma. He raised his first 100,000 rupees (now $2,250) from a second cousin’s father and was introduced to yarn trading by a nephew. His first ventures into textile-making were run by Gujaratis back from Yemen, where Dhirubhai had worked for a petrol company during the day while trading rice, sugar and other commodities in the souk after hours.

Indians complain that social connections trump hard work. But no one worked harder than Dhirubhai at forging connections. His philosophy was to cultivate everybody from the doorkeeper up, Mr McDonald remarks. With the help of these relationships, Reliance set about making the most of India’s famous License Raj.

At that time the government took a suffocating interest in a firm’s imports and output. In 1987, for instance, the Customs Directorate alleged that Reliance’s yarn factory had more than twice its permitted capacity and that it had evaded over 1 billion rupees of duty on imported machinery. Reliance denied breaking the rules and the charges were subsequently dropped. But the rules themselves were strangling Indian industry. In exceeding these limits, Reliance made the case for their removal, according to Arun Shourie, a journalist, former minister and one-time critic of Reliance who later made his peace with the company.

Some of those restrictions also worked to Reliance’s benefit. In 1982, for example, the government raised duties on imported yarn to over 650%, which allowed Reliance to charge high prices for its homespun polyester yarn. Later in the decade import restrictions on paraxylene, a petrochemical, forced India’s other big polyester-maker to buy the crucial ingredient from Reliance, its bitterest rival. Clumsy curbs on trade are bad for the economy, but they are not always bad for individual businesses.

Dhirubhai Ambani knew how to appeal to the people as well as the powerful. By the late 1980s, Reliance Industries boasted the widest shareholding in the world. Dhirubhai held annual meetings in football stadiums and scattered subscription forms for one debenture from a helicopter. His roguish side only added to his appeal. Like India’s most popular Bollywood stars, Dhirubhai was an anti-hero, cocking a snook at complacent and hypocritical guardians of privilege.

By the time Dhirubhai died, Reliance was one of India’s biggest companies. But it was not big enough for both his sons, who soon fell to squabbling. Their mother brokered a split of the family’s assets in 2005. Mukesh got the heavy industry (hydrocarbons, petrochemicals and polyester) with the rich cashflows. Anil got the weightless businesses (telecommunications and financial services) with their rich share valuations. Both had inherited a driving ambition from a father who did not let them rest on their laurels. Within hours of his final MBA exam, Anil left Wharton (where, among other things, he learned to cook and iron his clothes) to look after a textiles factory in Gujarat. Mukesh returned to set up a polyester factory even before completing his MBA at Stanford. Their father told them they could either command respect through their efforts, or be left vainly to demand respect from people who badmouthed them behind their backs.

Outsiders rarely have the patience to dig through the details of India’s corporate life. Mr McDonald is an exception. His book puts the reader in the thick of the sweatiest corporate wrestling matches. He cannot quite sustain that intensity in the later chapters, in part because they were written from a distance long after he left India, but also because less is at stake. Dhirubhai Ambani’s rise symbolised a struggle for the heart and soul of India. His sons squabbles seem petty by comparison, even if the sums involved are huge.

Mukesh’s new palace is in the same neighbourhood he lived in as a youngster. In the intervening years this middle-class address has become an exclusive neighbourhood for Mumbai’s rich and famous. Reliance has grown, but India has grown with it. The Ambani brothers are big fish and swimming in a much bigger pond.

Mahabharata in Polyester: The Making of the World’s Richest Brothers and Their Feud. By Hamish McDonald. UNSW Press; 432 pages; A$34.95Sent from my iPad

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Skilled immigration: Green-card blues

30. October 2010 by admin.

Skilled immigration: Green-card blues

 A backlash against foreign workers dims business hopes for immigration reform.BAD as relations are between business and the Democrats, immigration was supposed to be an exception. On that topic the two have long had a marriage of convenience, with business backing comprehensive reform in order to obtain more skilled foreign workers. That, at least, was what was meant to happen. In March Chuck Schumer, a Democratic senator, and Lindsey Graham, a Republican, proposed a multi-faceted reform that would toughen border controls and create a path to citizenship for illegal immigrants while granting two longstanding goals of business: automatic green cards (that is, permanent residence) for students who earned advanced degrees in science, technology, engineering or maths in America, and an elimination of country quotas on green cards. The quotas bear no relationship to demand, leaving backlogs of eight to ten years for applicants from China and India. Barack Obama immediately announced his support. But the proposal never became a bill, much less law. Mr Graham developed cold feet and withdrew his support; he was concerned that the Democrats were moving too quickly, as the economic misery that has turned Americans against foreign trade spread to dislike of foreign workers. Last year Congress made it harder for banks that had received money from the Troubled Asset Relief Programme to hire workers on H-1B visas, the most popular type for skilled foreign workers. In January the Citizenship and Immigration Service barred the use of H-1Bs for workers based on a client’s premises instead of their own company’s, a move aimed at outsourcing companies, many of them based in India. In August even Mr Schumer, needing to look tough on outsourcing, pushed through a bill sharply raising H-1B fees on firms that depend heavily on the visas. Perhaps the most naked election-year hostility to foreigners appeared during the debate in September over a Democratic bill in the Senate that would have rewarded companies for firing foreign-based workers and replacing them with Americans. Charles Grassley, a Republican senator, responded with a proposal to prohibit any company that had laid off Americans from hiring visa workers at all. The bill did not win enough votes to break a filibuster. Tightened restrictions, political aggravation and economic conditions seem to be having an effect. In 2009 the number of employment-based green cards and H-1B visas was the lowest in years (see chart). It took an unusually long time for the quota of H-1Bs for the fiscal year that ended on September 30th to be used up. Several Indian outsourcing companies have made a point of boosting local hiring at American facilities. This is partly the result of the recession, which has hurt demand for all types of workers. But in a recent report the Hamilton Project, a moderately liberal research group, notes that the number of foreign workers in America has been declining for some time. This might reflect America’s diminished appeal to the world’s most sought-after workers, as well as brightening prospects in their own countries. A survey for the pro-immigration Kauffman Foundation in 2007 found that only a tiny proportion of foreign students planned to stay in the United States. This almost certainly extracts an economic toll, since immigrants are more likely than others to start businesses or file patents. America’s immigration policies have long put a higher priority on family reunification than on employment. Legal immigrants to the country are more likely to have failed to finish high school than either native-born Americans or immigrants to other English-speaking countries. Immigrants to Canada are far more likely to have a college degree. Legislators from both parties have at various times advanced proposals that would smooth the way for skilled migrants, but they have usually foundered on the more intractable problem of dealing with illegal immigration. These two issues can and should be separate,” says Michael Greenstone of the Hamilton Project. We are giving up economic growth by putting the two issues together. Democratic Hispanic legislators oppose separating them for fear of losing business support for comprehensive reform. In principle, then, a Republican takeover of the House might increase the likelihood of a stand-alone bill on skilled immigration. That, however, is not the Republicans’ priority. Lamar Smith, the Republican who would probably become chairman of the House judiciary committee, is more focused on deporting illegal immigrants and strengthening the border.Still, it would be premature to write off the odds of immigration reform. If Mr Obama is to accomplish anything in the next Congress, he needs to find common ground with Republicans on something Business-friendly immigration reform might just qualify.

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And You Thought Things Were Bad Now…. Wait Until 2011!

18. August 2010 by admin.

In just six months, the largest tax hikes in the history of America will take effect.  They will hit families and small businesses in three great waves on January 1, 2011:

(N.B. This version of the document contains even more tax hikes than the original version did)

First Wave: Expiration of 2001 and 2003 Tax Relief In 2001 and 2003, the GOP Congress enacted several tax cuts for investors, small business owners, and families.  These will all expire on January 1, 2011: Personal income tax rates will rise.  The top income tax rate will rise from 35 to 39.6 percent (this is also the rate at which two-thirds of small business profits are taxed).  The lowest rate will rise from 10 to 15 percent.  All the rates in between will also rise.  Itemized deductions and personal exemptions will again phase out, which has the same mathematical effect as higher marginal tax rates.  The full list of marginal rate hikes is below: - The 10% bracket rises to an expanded 15%
- The 25% bracket rises to 28%
- The 28% bracket rises to 31%
- The 33% bracket rises to 36%
- The 35% bracket rises to 39.6% Higher taxes on marriage and family.  The “marriage penalty” (narrower tax brackets for married couples) will return from the first dollar of income.  The child tax credit will be cut in half from $1000 to $500 per child.  The standard deduction will no longer be doubled for married couples relative to the single level.  The dependent care and adoption tax credits will be cut. The return of the Death Tax.  This year, there is no death tax.  For those dying on or after January 1 2011, there is a 55 percent top death tax rate on estates over $1 million.  A person leaving behind two homes and a retirement account could easily pass along a death tax bill to their loved ones. Higher tax rates on savers and investors.  The capital gains tax will rise from 15 percent this year to 20 percent in 2011.  The dividends tax will rise from 15 percent this year to 39.6 percent in 2011.  These rates will rise another 3.8 percent in 2013. Second Wave: Obamacare There are over twenty new or higher taxes in Obamacare.  Several will first go into effect on January 1, 2011.  They include: The Tanning Tax.  This went into effect on July 1st of this year.  It imposes a new, 10% excise tax on getting a tan at a tanning salon.  There is no exemption for tanners making less than $250,000 per year. The “Medicine Cabinet Tax”  Thanks to Obamacare, Americans will no longer be able to use health savings account (HSA), flexible spending account (FSA), or health reimbursement (HRA) pre-tax dollars to purchase non-prescription, over-the-counter medicines (except insulin). The HSA Withdrawal Tax Hike.  This provision of Obamacare increases the additional tax on non-medical early withdrawals from an HSA from 10 to 20 percent, disadvantaging them relative to IRAs and other tax-advantaged accounts, which remain at 10 percent. Brand Name Drug Tax.  Starting next year, there will be a multi-billion dollar tax assessment imposed on name-brand drug manufacturers.  This tax, like all excise taxes, will raise the price of medicine, hurting everyone. Economic Substance Doctrine.  The IRS is now empowered to disallow perfectly-legal tax deductions and maneuvers merely because it judges that the deduction or action lacks “economic substance.”  This is obviously an arbitrary empowerment of IRS agents. Employer Reporting of Health Insurance Costs on a W-2.  This will start for W-2s in the 2011 tax year.  While not a tax increase in itself, it makes it very easy for Congress to tax employer-provided healthcare benefits later. Third Wave: The Alternative Minimum Tax and Employer Tax Hikes When Americans prepare to file their tax returns in January of 2011, they’ll be in for a nasty surprise—the AMT won’t be held harmless, and many tax relief provisions will have expired.  These major items include: The AMT will ensnare over 28 million families, up from 4 million last year.  According to the left-leaning Tax Policy Center, Congress’ failure to index the AMT will lead to an explosion of AMT taxpaying families—rising from 4 million last year to 28.5 million.  These families will have to calculate their tax burdens twice, and pay taxes at the higher level.  The AMT was created in 1969 to ensnare a handful of taxpayers. Small business expensing will be slashed and 50% expensing will disappear.  Small businesses can normally expense (rather than slowly-deduct, or “depreciate”) equipment purchases up to $250,000.  This will be cut all the way down to $25,000.  Larger businesses can expense half of their purchases of equipment.  In January of 2011, all of it will have to be “depreciated.” Taxes will be raised on all types of businesses.  There are literally scores of tax hikes on business that will take place.  The biggest is the loss of the “research and experimentation tax credit,” but there are many, many others.  Combining high marginal tax rates with the loss of this tax relief will cost jobs. Tax Benefits for Education and Teaching Reduced.  The deduction for tuition and fees will not be available.  Tax credits for education will be limited.  Teachers will no longer be able to deduct classroom expenses.  Coverdell Education Savings Accounts will be cut.  Employer-provided educational assistance is curtailed.  The student loan interest deduction will be disallowed for hundreds of thousands of families. Charitable Contributions from IRAs no longer allowed.  Under current law, a retired person with an IRA can contribute up to $100,000 per year directly to a charity from their IRA.  This contribution also counts toward an annual “required minimum distribution.”  This ability will no longer be there. Read more: http://www.atr.org/six-months-untilbr-largest-tax-hikes-a5171##ixzz0wuEeV0XS

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Germany After the EU and the Russian Scenario

29. May 2010 by admin.

Germany After the EU and the Russian Scenario

By George Friedman

Discussions about Europe currently are focused on the Greek financial crisis and its potential effect on the future of the European Union. Discussions these days involving military matters and Europe appear insignificant and even anachronistic. Certainly, we would agree that the future of the European Union towers over all other considerations at the moment, but we would argue that scenarios for the future of the European Union exist in which military matters are far from archaic.

Russia and the Polish Patriots

For example, the Polish government recently announced that the United States would deploy a battery of Patriot missiles to Poland. The missiles arrived this week. When the United Statescanceled its land-based ballistic missile defense system under intense Russian pressure, the Obama administration appeared surprised at Poland’s intense displeasure with the decision. Washington responded by promising the Patriots instead, the technology the Poles had wanted all along. While the Patriot does not enhance America’s ability to protect itself against long-range ballistic missiles from, for example, Iran, it does give Poland some defense against shorter-ranged ballistic missiles and substantial defense against conventional air attack.

Russia is the only country capable of such attacks on Poland with even the most distant potential interest in doing so, and at this point, this is truly an abstract threat. In removing a system that was really not a threat to Russian interests — U.S. ballistic missile defense at most can handle only a score of missiles, meaning it would have a negligible impact on the Russian nuclear deterrent — the United States ironically has installed a system that could affect Russia. Under the current circumstances, this is not really significant. While much is being made of having a few U.S. boots on the ground east of Germany within 40 kilometers (about 25 miles) of the Russian Baltic exclave of Kaliningrad, a few hundred technicians and guards are simply not an offensive threat.

Still, the Russians — with a long history of seeing improbable threats turning into very real ones— tend to take hypothetical limits on their power seriously. They also tend to take gestures seriously, knowing that gestures often germinate into strategic intent. The Russians obviously oppose this deployment, as the Patriots would allow Poland in league with NATO — and perhaps even by itself — to achieve local air superiority. There are many crosscurrents in Russian policy, however.

For the moment, the Russians are interested in encouraging better economic relations with the West, as they could use technology and investment that would make them more than a commodity exporter. Moreover, with the Europeans preoccupied with their economic crisis and the United States still bogged down in the Middle East and needing Russian support on Iran, Moscow has found little outside resistance to its efforts to increase its influence in the former Soviet Union. Moscow is not unhappy about the European crisis and wouldn’t want to do anything that might engender greater European solidarity. After all, a solid economic bloc turning into an increasingly powerful and integrated state would pose challenges to Russia in the long run that Moscow is happy to do without. The Patriot deployment is a current irritation and a hypothetical military problem, but the Russians are not inclined to create a crisis with Europe over it — though this doesn’t mean Moscow won’t make countermoves on the margins when it senses opportunities.

For its part, the Obama administration is not focused on Poland at present. It is obsessed with internal matters, South Asia and the Middle East. The Patriots were shipped based on a promise made months ago to calm Central European nerves over the Obama administration’s perceived lack of commitment to the region. In the U.S. State and Defense department sections charged with shipping Patriots to Poland, the delivery process was almost an afterthought; repeated delays in deploying the system highlighted Washington’s lack of strategic intent.

It is therefore tempting to dismiss the Patriots as of little importance, as merely the combination of a hangover from a Cold War mentality and a minor Obama administration misstep. Indeed, even a sophisticated observer of the international system might barely note it. But we would argue that it is more important than it appears precisely because of everything else going on.

Existential Crisis in the EU

The European Union is experiencing an existential crisis. This crisis is not about Greece, but rather, what it is that members of the European Union owe each other and what controls the European Union has over its members. The European Union did well during a generation of prosperity. As financial crisis struck, better-off members were called on to help worse-off members. Again, this is not just about Greece — the 2008 credit crisis in Central Europe was about the same thing. The wealthier countries, Germany in particular, are not happy at the prospect of spending taxpayer money to assist countries dealing with popped credit bubbles.

They really don’t want to do that, and if they do, they really want to have controls over the ways these other countries spend their money so this circumstance doesn’t arise again. Needless to say, Greece — and countries that might wind up like Greece — do not want foreign control over their finances.

If there are no mutual obligations among EU member nations, and the German and Greek publics don’t want to bail out or submit, respectively, then the profound question is raised of what Europe is going to be — beyond a mere free trade zone — after this crisis. This is not simply a question of the euro surviving, although that is no trivial matter.

The euro and the European Union will probably survive this crisis — although their mutual failure is not nearly as unthinkable as the Europeans would have thought even a few months ago — but this is not the only crisis Europe will experience. Something always will be going wrong, and Europe does not have institutions that could handle these problems. Events in the past few weeks indicate that European countries are not inclined to create such institutions, and that public opinion will limit European governments’ ability to create or participate in these institutions. Remember, building a super state requires one of two things: a war to determine who is in charge or political unanimity to forge a treaty. Europe is — vividly — demonstrating the limitations on the second strategy.

Whatever happens in the short run, it is difficult to envision any further integration of European institutions. And it is very easy to see how the European Union will devolve from its ambitious vision into an alliance of convenience built around economic benefits negotiated and renegotiated among the partners. It would thus devolve from a union to a treaty, with no interest beyond self-interest.

The German Question Revisited

We return to the question that has defined Europe since 1871, namely, the status of Germany in Europe. As we have seen during the current crisis, Germany is clearly the economic center of gravity in Europe, and this crisis has shown that the economic and the political issues are very much one and the same. Unless Germany agrees, nothing can be done, and if Germany so wishes, something will be done. Germany has tremendous power in Europe, even if it is confined largely to economic matters. But just as Germany is the blocker and enabler of Europe, over time that makes Germany the central problem of Europe.

If Germany is the key decision maker in Europe, then Germany defines whatever policies Europe as a whole undertakes. If Europe fragments, then Germany is the only country in Europe with the ability to create alternative coalitions that are both powerful and cohesive. That means that if the European Union weakens, Germany will have the greatest say in what Europe will become. Right now, the Germans are working assiduously to reformulate the European Union and the eurozone in a manner more to their liking. But as this requires many partners to offer sovereignty to German control — sovereignty they have jealously guarded throughout the European project — it is worth exploring alternatives to Germany in the European Union.

For that we first must understand Germany’s limits. The German problem is the same problem it has had since unification: It is enormously powerful, but it is far from omnipotent. Its very power makes it the focus of other powers, and together, these other powers can cripple Germany. Thus, Germany is indispensable for any decision within the European Union at present, and it will be the single center of power in Europe in the future — but Germany can’t just go it alone. Germany needs a coalition, meaning the long-term question is this: If the EU were to weaken or even fail, what alternative coalition would Germany seek?

The casual answer is France, as the two economies are somewhat similar and the countries are next-door neighbors. But historically, this similarity in structure and location has been a source not of collaboration and fondness but of competition and friction. Within the European Union, with its broad diversity, Germany and France have been able to put aside their frictions, finding a common interest in managing Europe to their mutual advantage. That co-management, of course, helped bring us to this current crisis. Moreover, the biggest thing that France has that Germany wants is its market; an ideal partner for Germany would offer more. By itself at least, France is not a foundation for long-term German economic strategy. The historic alternative for Germany has been Russia.

The Russian Option

A great deal of potential synergy exists between the German and Russian economies. Germany imports large amounts of energy and other resources from Russia. As mentioned, Russia needs sources of technology and capital to move it beyond its current position of mere resource exporter. Germany has a shrinking population and needs a source of labor — preferably a source that doesn’t actually want to move to Germany. Russia’s Soviet-era economy continues to de-industrialize, and while that has a plethora of negative impacts, there is one often-overlooked positive: Russia now has more labor than it can effectively metabolize in its economy given its capital structure. Germany doesn’t want more immigrants but needs access to labor. Russia wants factories in Russia to employ its surplus work force, and it wants technology. The logic of the German-Russian economic relationship is more obvious than the German-Greek or German-Spanish relationship. As for France, it can participate or not (and incidentally, the French are joining in on a number of ongoing German-Russian projects).

Therefore, if we simply focus on economics, and we assume that the European Union cannot survive as an integrated system (a logical but not yet proven outcome), and we further assume that Germany is both the leading power of Europe and incapable of operating outside of a coalition, then we would argue that a German coalition with Russia is the most logical outcome of an EU decline.

This would leave many countries extremely uneasy. The first is Poland, caught as it is between Russia and Germany. The second is the United States, since Washington would see a Russo-German economic bloc as a more significant challenger than the European Union ever was for two reasons. First, it would be a more coherent relationship — forging common policies among two states with broadly parallel interests is far simpler and faster than doing so among 27. Second, and more important, where the European Union could not develop a military dimension due to internal dissensions, the emergence of a politico-military dimension to a Russo-German economic bloc is far less difficult to imagine. It would be built around the fact that both Germans and Russians resent and fear American power and assertiveness, and that the Americans have for years been courting allies who lie between the two powers. Germany and Russia would both view themselves defending against American pressure.

And this brings us back to the Patriot missiles. Regardless of the bureaucratic backwater this transfer might have emerged out of, or the political disinterest that generated the plan, the Patriot stationing fits neatly into a slowly maturing military relationship between Poland and the United States. A few months ago, the Poles and Americans conducted military exercises in the Baltic states, an incredibly sensitive region for the Russians. The Polish air force now flies some of the most modern U.S.-built F-16s in the world; this, plus Patriots, could seriously challenge the Russians. A Polish general commands a sector in Afghanistan, something not lost upon the Russians. By a host of processes, a close U.S.-Polish relationship is emerging.

The current economic problems may lead to a fundamental weakening of the European Union. Germany is economically powerful but needs economic coalition partners that contribute to German well-being rather than merely draw on it. A Russian-German relationship could logically emerge from this. If it did, the Americans and Poles would logically have their own relationship. The former would begin as economic and edge toward military. The latter begins as military, and with the weakening of the European Union, edges toward economics. The Russian-German bloc would attempt to bring others into its coalition, as would the Polish-U.S. bloc. Both would compete in Central Europe — and for France. During this process, the politics of NATO would shift from humdrum to absolutely riveting.

And thus, the Greek crisis and the Patriots might intersect, or in our view, will certainly in due course intersect. Though neither is of lasting importance in and of themselves, the two together point to a new logic in Europe. What appears impossible now in Europe might not be unthinkable in a few years. With Greece symbolizing the weakening of the European Union and the Patriots representing the remilitarization of at least part of Europe, ostensibly unconnected tendencies might well intersect.

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Geopolitics of European Monetary Union

19. May 2010 by admin.

The Geography of the European Monetary Union

As we consider the future of the euro, it is important to remember that the economic underpinnings of paper money are not nearly as important as the political underpinnings. Paper currencies in use throughout the world today hold no value without the underlying political decision to make them the legal tender of commercial activity. This means a government must be willing and capable enough to enforce the currency as a legal form of debt settlement, and refusal to accept paper currency is, within limitations, punishable by law.

 

The trouble with the euro is that it attempts to overlay a monetary dynamic on a geography that does not necessarily lend itself to a single economic or political “space.” The eurozone has a single central bank, the European Central Bank (ECB), and therefore has only one monetary policy, regardless of whether one is located in Northern or Southern Europe. Herein lies the fundamental geographic problem of the euro.

Europe is the second-smallest continent on the planet but has the second-largest number of states packed into its territory. This is not a coincidence. Europe’s multitude of peninsulas, large islands and mountain chains create the geographic conditions that often allow even the weakest political authority to persist. Thus, the Montenegrins have held out against the Ottomans, just as the Irish have against the English.

Despite this patchwork of political authorities, the Continent’s plentiful navigable rivers, large bays and serrated coastlines enable the easy movement of goods and ideas across Europe. This encourages the accumulation of capital due to the low costs of transport while simultaneously encouraging the rapid spread of technological advances, which has allowed the various European states to become astonishingly rich: Five of the top 10 world economies hail from the Continent despite their relatively small populations.

 

Europe’s network of rivers and seas are not integrated via a single dominant river or sea network, however, meaning capital generation occurs in small, sequestered economic centers. To this day, and despite significant political and economic integration, there is no European New York. In Europe’s case, the Danube has Vienna, the Po has Milan, the Baltic Sea has Stockholm, the Rhineland has both Amsterdam and Frankfurt and the Thames has London. This system of multiple capital centers is then overlaid on Europe’s states, which jealously guard control over their capital and, by extension, their banking systems.

 

Despite a multitude of different centers of economic — and by extension, political — power, some states, due to geography, are unable to access any capital centers of their own. Much of the Club Med states are geographically disadvantaged. Aside from the Po Valley of northern Italy — and to an extent the Rhone — southern Europe lacks a single river useful for commerce. Consequently, Northern Europe is more urban, industrial and technocratic while Southern Europe tends to be more rural, agricultural and capital-poor.

 

Introducing the Euro

Given the barrage of economic volatility and challenges the eurozone has confronted in recent quarters and the challenges presented by housing such divergent geography and history under one monetary roof, it is easy to forget why the eurozone was originally formed.

The Cold War made the European Union possible. For centuries, Europe was home to feuding empires and states. After World War II, it became the home of devastated peoples whose security was the responsibility of the United States. Through the Bretton Woods agreement, the United States crafted an economic grouping that regenerated Western Europe’s economic fortunes under a security rubric that Washington firmly controlled. Freed of security competition, the Europeans not only were free to pursue economic growth, they also enjoyed nearly unlimited access to the American market to fuel that growth. Economic integration within Europe to maximize these opportunities made perfect sense. The United States encouraged the economic and political integration because it gave a political underpinning to a security alliance it imposed on Europe, i.e., NATO. Thus, the European Economic Community — the predecessor to today’s European Union — was born.

 

When the United States abandoned the gold standard in 1971 (for reasons largely unconnected to things European), Washington essentially abrogated the Bretton Woods currency pegs that went with it. One result was a European panic. Floating currencies raised the inevitability of currency competition among the European states, the exact sort of competition that contributed to the Great Depression 40 years earlier. Almost immediately, the need to limit that competition sharpened, first with currency coordination efforts still concentrating on the U.S. dollar and then from 1979 on with efforts focused on the deutschmark. The specter of a unified Germany in 1989 further invigorated economic integration. The euro was in large part an attempt to give Berlin the necessary incentives so that it would not depart the EU project.

 

But to get Berlin on board with the idea of sharing its currency with the rest of Europe, the eurozone was modeled after the Bundesbank and its deutschmark. To join the eurozone, a country must abide by rigorous “convergence criteria” designed to synchronize the economy of the acceding country with Germany’s economy. The criteria include a budget deficit of less than 3 percent of gross domestic product (GDP); government debt levels of less than 60 percent of GDP; annual inflation no higher than 1.5 percentage points above the average of the lowest three members’ annual inflation; and a two-year trial period during which the acceding country’s national currency must float within a plus-or-minus 15 percent currency band against the euro.

 

As cracks have begun to show in both the political and economic support for the eurozone, however, it is clear that the convergence criteria failed to overcome divergent geography and history. Greece’s violations of the Growth and Stability Pact are clearly the most egregious, but essentially all eurozone members — including France and Germany, which helped draft the rules — have contravened the rules from the very beginning.

 

Mechanics of a Euro Exit

The EU treaties as presently constituted contractually obligate every EU member state — except Denmark and the United Kingdom, which negotiated opt-outs — to become a eurozone member state at some point. Forcible expulsion or self-imposed exit is technically illegal, or at best would require the approval of all 27 member states (never mind the question about why a troubled eurozone member would approve its own expulsion). Even if it could be managed, surely there are current and soon-to-be eurozone members that would be wary of establishing such a precedent, especially when their fiscal situation could soon be similar to Athens’ situation.

 

One creative option making the rounds would allow the European Union to technically expel members without breaking the treaties. It would involve setting up a new European Union without the offending state (say, Greece) and establishing within the new institutions a new eurozone as well. Such manipulations would not necessarily destroy the existing European Union; its major members would “simply” recreate the institutions without the member they do not much care for.

 

Though creative, the proposed solution it is still rife with problems. In such a reduced eurozone, Germany would hold undisputed power, something the rest of Europe might not exactly embrace. If France and the Benelux countries reconstituted the eurozone with Berlin, Germany’s economy would go from constituting 26.8 percent of eurozone version 1.0’s overall output to 45.6 percent of eurozone version 2.0’s overall output. Even states that would be expressly excluded would be able to get in a devastating parting shot: The southern European economies could simply default on any debt held by entities within the countries of the new eurozone.

With these political issues and complications in mind, we turn to the two scenarios of eurozone reconstitution that have garnered the most attention in the media.

 

Scenario 1: Germany Reinstitutes the Deutschmark

The option of leaving the eurozone for Germany boils down to the potential liabilities that Berlin would be on the hook for if Portugal, Spain, Italy and Ireland followed Greece down the default path. As Germany prepares itself to vote on its 123 billion euro contribution to the 750 billion euro financial aid mechanism for the eurozone — which sits on top of the 23 billion euros it already approved for Athens alone — the question of whether “it is all worth it” must be on top of every German policymaker’s mind.

This is especially the case as political opposition to the bailout mounts among German voters and Merkel’s coalition partners and political allies. In the latest polls, 47 percent of Germans favor adopting the deutschmark. Furthermore, Merkel’s governing coalition lost a crucial state-level election May 9 in a sign of mounting dissatisfaction with her Christian Democratic Union and its coalition ally, the Free Democratic Party. Even though the governing coalition managed to push through the Greek bailout, there are now serious doubts that Merkel will be able to do the same with the eurozone-wide mechanism May 21.

 

Germany would therefore not be leaving the eurozone to save its economy or extricate itself from its own debts, but rather to avoid the financial burden of supporting the Club Med economies and their ability to service their 3 trillion euro mountain of debt. At some point, Germany may decide to cut its losses — potentially as much as 500 billion euros, which is the approximate exposure of German banks to Club Med debt — and decide that further bailouts are just throwing money into a bottomless pit. Furthermore, while Germany could always simply rely on the ECB to break all of its rules and begin the policy of purchasing the debt of troubled eurozone governments with newly created money (“quantitative easing”), that in itself would also constitute a bailout. The rest of the eurozone, including Germany, would be paying for it through the weakening of the euro.

 

Were this moment to dawn on Germany it would have to mean that the situation had deteriorated significantly. As STRATFOR has recently argued, the eurozone provides Germany with considerable economic benefits. Its neighbors are unable to undercut German exports with currency depreciation, and German exports have in turn gained in terms of overall eurozone exports on both the global and eurozone markets. Since euro adoption, unit labor costs in Club Med have increased relative to Germany’s by approximately 25 percent, further entrenching Germany’s competitive edge.

Before Germany could again use the deutschmark, Germany would first have to reinstate its central bank (the Bundesbank), withdraw its reserves from the ECB, print its own currency and then re-denominate the country’s assets and liabilities in deutschmarks. While it would not necessarily be a smooth or easy process, Germany could reintroduce its national currency with far more ease than other eurozone members could.

The deutschmark had a well-established reputation for being a store of value, as the renowned Bundesbank directed Germany’s monetary policy. If Germany were to reintroduce its national currency, it is highly unlikely that Europeans would believe that Germany had forgotten how to run a central bank — Germany’s institutional memory would return quickly, re-establishing the credibility of both the Bundesbank and, by extension, the deutschmark.

 

As Germany would be replacing a weaker and weakening currency with a stronger and more stable one, if market participants did not simply welcome the exchange, they would be substantially less resistant to the change than what could be expected in other eurozone countries. Germany would therefore not necessarily have to resort to militant crackdowns on capital flows to halt capital trying to escape conversion.

Germany would probably also be able to re-denominate all its debts in the deutschmark via bond swaps. Market participants would accept this exchange because they would probably have far more faith in a deutschmark backed by Germany than in a euro backed by the remaining eurozone member states.

 

Reinstituting the deutschmark would still be an imperfect process, however, and there would likely be some collateral damage, particularly to Germany’s financial sector. German banks own much of the debt issued by Club Med, which would likely default on repayment in the event Germany parted with the euro. If it reached the point that Germany was going to break with the eurozone, those losses would likely pale in comparison to the costs — be they economic or political — of remaining within the eurozone and financially supporting its continued existence.

 

Scenario 2: Greece Leaves the Euro

If Athens were able to control its monetary policy, it would ostensibly be able to “solve” the two major problems currently plaguing the Greek economy.

First, Athens could ease its financing problems substantially. The Greek central bank could print money and purchase government debt, bypassing the credit markets. Second, reintroducing its currency would allow Athens to then devalue it, which would stimulate external demand for Greek exports and spur economic growth. This would obviate the need to undergo painful “internal devaluation” via austerity measures that the Greeks have been forced to impose as a condition for their bailout by the International Monetary Fund (IMF) and the EU.

If Athens were to reinstitute its national currency with the goal of being able to control monetary policy, however, the government would first have to get its national currency circulating (a necessary condition for devaluation).

The first practical problem is that no one is going to want this new currency, principally because it would be clear that the government would only be reintroducing it to devalue it. Unlike during the Eurozone accession process — where participation was motivated by the actual and perceived benefits of adopting a strong/stable currency and receiving lower interest rates, new funds and the ability to transact in many more places — “de-euroizing” offers no such incentives for market participants:

• The drachma would not be a store of value, given that the objective in reintroducing it is to reduce its value.

• The drachma would likely only be accepted within Greece, and even there it would not be accepted everywhere — a condition likely to persist for some time.

• Reinstituting the drachma unilaterally would likely see Greece cast out of the eurozone, and therefore also the European Union as per rules explained above.

   

The government would essentially be asking investors and its own population to sign a social contract that the government clearly intends to abrogate in the future, if not immediately once it is able to. Therefore, the only way to get the currency circulating would be by force.

The goal would not be to convert every euro-denominated asset into drachmas but rather to get a sufficiently large chunk of the assets so that the government could jumpstart the drachma’s circulation. To be done effectively, the government would want to minimize the amount of money that could escape conversion by either being withdrawn or transferred into asset classes easy to conceal from discovery and appropriation. This would require capital controls and shutting down banks and likely also physical force to prevent even more chaos on the streets of Athens than seen at present. Once the money was locked down, the government would then forcibly convert banks’ holdings by literally replacing banks’ holdings with a similar amount in the national currency. Greeks could then only withdraw their funds in newly issued drachmas that the government gave the banks to service those requests. At the same time, all government spending/payments would be made in the national currency, boosting circulation. The government also would have to show willingness to prosecute anyone using euros on the black market, lest the newly instituted drachma become completely worthless.

 

Since nobody save the government would want to do this, at the first hint that the government would be moving in this direction, the first thing the Greeks will want to do is withdraw all funds from any institution where their wealth would be at risk. Similarly, the first thing that investors would do — and remember that Greece is as capital-poor as Germany is capital-rich — is cut all exposure. This would require that the forcible conversion be coordinated and definitive, and most important, it would need to be as unexpected as possible.

Realistically, the only way to make this transition without completely unhinging the Greek economy and shredding Greece’s social fabric would be to coordinate with organizations that could provide assistance and oversight. If the IMF, ECB or eurozone member states were to coordinate the transition period and perhaps provide some backing for the national currency’s value during that transition period, the chances of a less-than-completely-disruptive transition would increase.

 

It is difficult to imagine circumstances under which such support would not dwarf the 110 billion euro bailout already on the table. For if Europe’s populations are so resistant to the Greek bailout now, what would they think about their governments assuming even more risk by propping up a former eurozone country’s entire financial system so that the country could escape its debt responsibilities to the rest of the eurozone?

 

The European Dilemma

Europe therefore finds itself being tied in a Gordian knot. On one hand, the Continent’s geography presents a number of incongruities that cannot be overcome without a Herculean (and politically unpalatable) effort on the part of Southern Europe and (equally unpopular) accommodation on the part of Northern Europe. On the other hand, the cost of exit from the eurozone — particularly at a time of global financial calamity, when the move would be in danger of precipitating an even greater crisis — is daunting to say the least.

 

The resulting conundrum is one in which reconstitution of the eurozone may make sense at some point down the line. But the interlinked web of economic, political, legal and institutional relationships makes this nearly impossible. The cost of exit is prohibitively high, regardless of whether it makes sense.

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The U.S.’ Eurozone Problem

15. May 2010 by admin.

The U.S.’ Eurozone Problem

Authors:

Ashraf Laidi, Chief Market Strategist, CMC Markets Adolfo Laurenti, Deputy Chief Economist and Managing Director, Mesirow Financial Carmen Reinhart, Research Associate, National Bureau of Economic Research; and Vincent Reinhart, Resident Scholar, American Enterprise Institute Uri Dadush, Director, International Economics Program, the Carnegie Endowment Ron Sloan, Chief Information Officer, Invesco Anna Gelpern, Associate Professor of Law, American University

May 14, 2010

 

The debt crisis that began in Greece and spread to other eurozone countries has served as a painful reminder of the risks associated with high public debt in a globalized financial system. The threat of contagion to countries outside Europe has divided experts on what the impact will be on the U.S. economy–whose debt is expected to rise to 90 percent of GDP by 2020. Some economists argue the U.S. economy will benefit from the eurozone crisis, since the euro’s continued weakness will secure the U.S. dollar’s status as a global reserve currency. Others say the U.S. debt problem will escalate if bloated entitlement programs go unaddressed. Some analysts argue the greater impact of the crisis will be on U.S. growth, which relies on market confidence and exports to Europe.

 

CMC Markets’ Ashraf Laidi, Mesirow Financial’s Adolfo Laurenti, the National Bureau of Economic Research’s Carmen Reinhart and the American Enterprise Institute’s Vincent Reinhart agree that the crisis buys the U.S. government time to tackle its debt–for better or worse. Of greater concern is the impact of the crisis on U.S. market confidence and growth, say the Carnegie Endowment’s Uri Dadush and Invesco’s Ron Sloan. Finally, American University’s Anna Gelpern says the crisis heightens the need for strong financial reforms that can “shield banks–and by extension the public–from government failure.” –Roya Wolverson, Staff Writer on Economics, CFR.org

Ashraf Laidi, Chief Market Strategist, CMC Markets

The most common arguments against a destabilization of the U.S. economy by the eurozone sovereign debt crisis are 1) the activism of the U.S. federal government in mobilizing another TARP-like aid package for U.S. banks, 2) a compliant Federal Reserve willing to reopen the liquidity taps by buying (again) U.S. government bonds, and 3) the sole ability to print a currency in which globally held U.S. debt is denominated. These measures–enacted in 2008 and 2009–effectively restored confidence in U.S. and global financial markets. The 60 percent surge in equity markets since March 2009 offered a jolt of confidence, while government-stimulus programs helped cap the unemployment rate and revived the role of consumers in lifting the U.S. economy out of recession.

To be sure, these solutions came at a cost. The Federal Reserve balance sheet swelled to a record $2.29 trillion as a result of purchasing government debt, while the U.S. debt ceiling was raised to $14.3 trillion, nearly triple the level of 2001. Currency and bond markets took notice. The U.S. dollar lost more than 20 percent of its value, and U.S. bond yields doubled throughout the stimulus period. Yet, as debt concerns escalated in the eurozone, the U.S. dollar benefited from flows exiting risky European currencies into the safety of U.S. treasury paper.

Today, German and French banks are exposed to as much as $900 billion in Greek and other eurozone countries’ debt. This exposure could bolster speculative attacks on U.S. equities on the rationale that a deteriorating European economy could quash the recovery of the Chinese economic engine as well as the U.S. consumer. Under such a scenario, a double dip U.S. recession is a stark possibility. Yet, as long as the corroding euro retards the process of global currency diversification away from the greenback, the United States will have little difficulty continuing to finance its debt from overseas lending. The power of printing its own currency will deflect credit agencies’ scrutiny from the United States, as they focus on more pressing cases in the eurozone and Britain.

 

Adolfo Laurenti, Deputy Chief Economist and Managing Director, Mesirow Financial

The 750 billion euro stabilization package implemented in the eurozone was instrumental in stopping the panic and restoring some semblance of order in increasingly volatile financial markets.

Nonetheless, upon closer scrutiny, the plan doesn’t fix the structural fiscal imbalances that impair countries like Greece, Spain, Portugal, and to a lesser extent, Italy and Ireland. The massive aid package only buys time for these embattled states to execute much-needed corrective policies. In order to bring government spending under control, additional measures of fiscal tightening must be adopted.

The eurozone plan also buys some time for the United States. The sovereign debt crisis in the eurozone has reasserted the position of the dollar as the world’s reserve currency. Yet the flight to safety out of Europe and the resulting strong demand for Treasury bonds should not be an excuse to delay action on our own weak fiscal position.

The concern is twofold. In the short run, we need to pay for the cost of bailouts and stimulus policies that followed the financial crisis and the “Great Recession.”

More importantly, long-term demographic trends make the burden of Social Security and Medicare unsustainable. Within a decade, American public finances will be under severe pressure to keep up with the exploding costs of our entitlement programs. Unless Congress resolves to undertake prompt and profound revision of the federal budget, the country may face dire consequences from our current profligate spending attitudes.

Thus, fiscal complacency is a major threat to the economic outlook for the United States. A slowdown in Europe will reduce our exports across the Atlantic, but the overall effect on the U.S. economy will be negligible when compared to the potential damage that a fiscal crisis may produce on our economy–if we let the opportunity to reduce our deficit and debt slip by.

The European malaise has given us some precious, borrowed time. We’d better not waste it.

 

Carmen Reinhart, Research Associate, National Bureau of Economic Research; and Vincent Reinhart, Resident Scholar, American Enterprise Institute

Recent weeks have shown that, although Greece may have a small footprint on global economic output, it casts a long shadow on financial markets. These funding difficulties have mostly resonated in the United States as a morality play. Borrowers with dubious prospects of repayment will ultimately be confronted by angry lenders.

The message has taken hold with such force domestically because our own fiscal path seems unmoored. While the current debt stock relative to national income, at 85 percent, does not directly trigger alarms, fiscal deficits run at 10 percent of income. More worrisome, public confidence that there are enough political leaders with the courage to arrest the process seems at a low ebb.

All true. But there was another message from Europe with equally profound implications. This was quieter and directed to an elite group controlling the official foreign exchange reserves of about a dozen sovereign governments, mostly located along the Asian Pacific Rim. Greece’s funding problems and the continent’s contagion established that the euro is not ready to be a reserve currency.

The economies in the world that are growing faster than the rest–China, India, and Korea, among others–are also saving more. After the Asian Crisis of 1998–a devastatingly deep but localized predecessor to what the world just went through–those countries have been directing a good-sized share of that saving to building up foreign exchange reserves.

Reserve managers, however, do not buy foreign currencies. They buy the safest assets, government securities, denominated in those foreign currencies. Buying safe dollar-denominated assets is easy; they are called U.S. government securities. Buying safe euro-denominated assets has been revealed to be patently more difficult. Many gilt-edged bonds have an embossed “€” somewhere, but their repayment prospects differ according to where they were printed, say, in Germany or Greece. Simply put, U.S. government securities satisfy a need as a reserve asset that is less likely to be satisfied by those from Europe, at least for some time.

In these circumstances, any noble exhortation based on the European experience is likely to fall flat. As long as reserve managers are buying U.S. government securities, U.S. politicians will not be pressed to change their ways by financial markets. A benefit, but perhaps only for a time. Politicians who are not disciplined are not likely to show discipline on their own. Thus, the faltering of the euro as an asset class because of the bad behavior of some may enable bad behavior for longer here at home.

 

Uri Dadush, Director, International Economics Program, the Carnegie Endowment

The United States has a vital interest in assuring that the euro crisis is controlled. The EU represents 20 percent of U.S. exports. More than 50 percent of U.S. overseas assets are held in Europe, while close to 40 percent of Europe’s foreign assets invested in the United States.

 

In fact, the euro crisis has already had a significant impact on the U.S. economy: Since late November, the euro has lost 17 percent of its value vis-à-vis the dollar, making U.S. exports less competitive, even as the Obama administration’s goal is to double exports in five years. U.S. exports are also adversely affected by Europe’s sluggish recovery–in the first quarter, European GDP was up only 0.3 percent on the same quarter a year before, compared to a 2.5 percent rise in the United States and 11.9 percent in China. U.S. investors in Europe should expect to take large balance sheet and income translation losses due to the lower euro.

But the most important effects of the euro crisis on the United States will operate not through the real channels of trade and foreign direct investment, but through broader effects on confidence and banks. Stock market volatility (as measured by the VIX index) has more than doubled in the last two months, and the confidence that banks have in lending to each other–measured by the TED spread (the difference between three-month inter-bank lending rate and the yield on Treasury Bills) was as wide as 30.8 basis points at the end of last week, a nine-month high, up from this year’s low of 10.6 basis points in March.

 

This is against a backdrop of a crisis largely confined thus far to Greece, a country accounting for a mere 2.6 percent of the eurozone GDP. Imagine what would happen if the crisis spread to Spain or Italy, countries five or six times larger. Though the exposure of U.S. banks to the most vulnerable countries in Europe is limited–about $176 billion, or 5 percent of their total foreign exposure–the indirect exposure is much larger, since U.S. banks do business with all the large international banks, which are themselves exposed to these vulnerable countries.

A spreading euro crisis would hurt U.S. interests in two other ways. First, although U.S. government debt may increase in popularity initially due to a safe haven effect, a spreading crisis would likely eventually place the spotlight on rising U.S. debt as well, aggravating the country’s unstable debt dynamics.

 

Ron Sloan, Chief Information Officer, Invesco

The 2009 private sector debt crisis has morphed into the 2010 sovereign debt crises, as the private debt was swapped into government debt. In fact, the pea was just moved under a different shell in a replay of this classic scam. Deleveraging on this scale is going to take a long time, and not everyone has the patience for this. Hence, rioting in Greece.

The eurozone crisis begs the question of what will fuel the growth that an increasingly export-driven developed world needs. We can’t all export to the smaller emerging world, and we can no longer count on significant growth within the developed world as new austerity measures become the rule of thumb throughout much of Europe. Once inventory restocking is finished, sustainable growth assumptions will have to move lower in the debt-laden developed world, and an emerging world that is increasingly moving to tighten its own fiscal and monetary policies.

The eurozone crisis is really a growth crisis. Debt-laden companies and countries–including those in the United States–will lose many reinvestment/growth options. Without growth, social instability and economic volatility will follow. The euro is certainly at risk in its current configuration. Southern European countries are looking to revalue their way out of their crisis, and German and French citizens are becoming more resistant to the austerity measures required to save the euro. The developed world has absorbed two decades (the ’80s and ’90s) of social and economic tailwinds–driven by low interest and tax rates, inflation, and increasing consumption and leverage–that are now turning into headwinds. Deleveraging will be a long and messy process.

 

Anna Gelpern, Associate Professor of Law, American University

The crisis in Europe reinforces the central message of the past two years: Governments and financial institutions are locked in a dysfunctional loop. When banks and shadow banks go under, they draw in governments to protect credit flows, payment systems, and people’s savings. When governments go under, they sink their creditors–banks, pension funds, insurance companies. Financial reform is essential not only to shield people from bank failure, but also to shield banks–and by extension the public–from government failure.

Greek banks and pension funds hold more than a quarter of Greek government debt. If Greece defaults, it wipes out popular savings and freezes credit essential to recovery. Elsewhere, European banks, pension funds, and insurance companies hold over half of Greek debt. Thus default threatens the broader European financial system, needed to finance Greek growth. This is the same system that nearly collapsed in 2008 from the U.S. housing bust, and was deeply shaken by the failures of Lehman Brothers, Fortis and Dexia, and the Icelandic banking crisis. But it is also the system that benefited from the U.S. government support for AIG, which had sold credit derivatives to European banks, absorbing their risks so they could hold less regulatory capital.

This leads to a paradox: Even if Greek debt is deeply unsustainable, and even if Greek debt contracts contain relatively few barriers to restructuring, uncertainty about the effects of default on the financial systems threatens to reduce or eliminate the benefits of debt reduction. To be sure, links between governments and financial institutions were central in the crises of the 1980s and 1990s as well, but now no part of the global financial system can be presumed immune.

In the past, we had thought that the best way to ensure a timely and orderly sovereign debt restructuring was through reforming sovereign debt contracts, or sovereign bankruptcy. One lesson from Greece is that stronger financial reforms–on both sides of the Atlantic–may be the surest way forward to manage sovereign distress. That means boosting capital so firms can absorb losses, comprehensive resolution so conglomerates may die in peace, and transparent derivatives markets to reveal the true risks of default.

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The Eurozone: Looking For Solutions

9. May 2010 by admin.

The Eurozone: Looking For Solutions

 

After an all-night meeting on the Greek debt and eurozone crisis, the eurozone members have preliminarily announced an emergency fund in an attempt to prevent the crisis from deepening.

 

So far there are no details on the size or scope of the emergency fund. All that has been released is that the EU’s central authorities will gain the ability to issue bonds to pay for currency protection programs, or bailouts. Supposedly, such debt will be guaranteed by eurozone members, but there are no details as yet as to how such debt would be paid back. The EU has no independent fund-raising capacities, suggesting that this is somewhat akin to cosigning for an open line of credit for a college student with no independent income.

 

We assume that is not precisely what they have in mind — in addition to being fiscally…questionable, the eurozone countries have already put forward all of the spare cash they will likely be able to independently generate for the next several months to pay for Greece’s bailout thus far — but we are waiting along with everyone else to see what the real deal is. It is highly likely that there will be some sort of an implied role in the process for the European Central Bank. Full details of the plan will be announced just before the Asian markets open Sunday May 9.

What we can say is that the Europeans do seem to be moving toward a plan with considerable speed, and we are not referring just to this emergency summit. European summits that run into the early morning hours are commonplace — one downside of a “consensus-based” governing system — but something else happened Saturday May 8 that is unprecedented.

 

Germany’s constitutional court rejected a case asserting that the Greek bailout announced just a few days ago was unconstitutional. It is not so much that the court rejected the case, but that it rejected it so quickly. The case was only filed last week, and the court rejected the case May 8 (a Saturday!) so that Berlin would have the needed legal cover to move immediately on this new crisis fund. Normally EU policy is hashed out over years. Now it is being done in hours, and Berlin is taking charge.

 

Something big is coming, and something big needs to come considering the scope of problems that the Greek crisis has imposed. The Greek crisis is clearly spreading to other eurozone members. Investors are beginning to shed the debt of a host of other eurozone states, Spain most notably, and unlike tiny Greece, there is no financial force in Europe — or the world — that can possibly bail out these larger states. The Greek bailout has not been sufficient to calm the markets. There is also fear — whether grounded in reality or not — that Europe’s problems could also spread to the United States and other global markets.

 

If the European Union — normally known for expansive, poorly enforced legalisms — is going to sequester the damage, it needs to do it fast. The EU is not known for speed, which is why a fast solution would be unprecedented in and of itself. And that may be exactly what Berlin and other eurozone capitals are thinking, that shocking the markets at this point is no longer about money, but rather the scope and speed of a European response.

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The Global Crisis of Legitimacy

6. May 2010 by admin.

The Global Crisis of Legitimacy

 

 

Financial panics are an integral part of capitalism. So are economic recessions. The system generates them and it becomes stronger because of them. Like forest fires, they are painful when they occur, yet without them, the forest could not survive. They impose discipline, punishing the reckless, rewarding the cautious. They do so imperfectly, of course, as at times the reckless are rewarded and the cautious penalized. Political crises — as opposed to normal financial panics — emerge when the reckless appear to be the beneficiaries of the crisis they have caused, while the rest of society bears the burdens of their recklessness. At that point, the crisis ceases to be financial or economic. It becomes political.

 

The financial and economic systems are subsystems of the broader political system. More precisely, think of nations as consisting of three basic systems: political, economic and military. Each of these systems has elites that manage it. The three systems are constantly interacting — and in a healthy polity, balancing each other, compensating for failures in one as well as taking advantage of success. Every nation has a different configuration within and between these systems. The relative weight of each system differs, as does the importance of its elites. But each nation contains these systems, and no system exists without the other two.

Limited Liability Investing

Consider the capitalist economic system. The concept of the corporation provides its modern foundation. The corporation is built around the idea of limited liability for investors, the notion that if you buy part or all of a company, you yourself are not liable for its debts or the harm that it might do; your risk is limited to your investment. In other words, you may own all or part of a company, but you are not responsible for what it does beyond your investment. Whereas supply and demand exist in all times and places, the notion of limited liability investing is unique to modern capitalism and reshapes the dynamic of supply and demand.

It is also a political invention and not an economic one. The decision to create corporations that limit liability flows from political decisions implemented through the legal subsystem of politics. The corporation dominates even in China; though the rules of liability and the definition of control vary, the principle that the state and politics define the structure of corporate risk remains constant.

 

In a more natural organization of the marketplace, the owners are entirely responsible for the debts and liabilities of the entity they own. That, of course, would create excessive risk, suppressing economic activity. So the political system over time has reallocated risk away from the owners of companies to the companies’ creditors and customers by allowing corporations to become bankrupt without pulling in the owners.

 

The precise distribution of risk within an economic system is a political matter expressed through the law; it differs from nation to nation and over time. But contrary to the idea that there is a tension between the political and economic systems, the modern economic system is unthinkable except for the eccentric but indispensible political-legal contrivance of the limited liability corporation. In the precise and complex allocation of risk and immunity, we find the origins of the modern market. Among other reasons, this is why classical economists never spoke of “economics” but always of “political economy.”

 

The state both invents the principle of the corporation and defines the conditions in which the corporation is able to arise. The state defines the structure of risk and liabilities and assures that the laws are enforced. Emerging out of this complexity — and justifying it — is a moral regime. Protection from liability comes with a burden: Poor decisions will be penalized by losses, while wise decisions are rewarded by greater wealth. Because of this, society as a whole will benefit. The entire scheme is designed to increase, in Adam Smith’s words, “The Wealth of Nations” by limiting liability, increasing the willingness to take risk and imposing penalties for poor judgment and rewards for wise judgment. But the measure of the system is not whether individuals benefit, but whether in benefiting they enhance the wealth of the nation.

 

The greatest systemic risk, therefore, is not an economic concept but a political one. Systemic risk emerges when it appears that the political and legal protections given to economic actors, and particularly to members of the economic elite, have been used to subvert the intent of the system. In other words, the crisis occurs when it appears that the economic elite used the law’s allocation of risk to enrich themselves in ways that undermined the wealth of the nation. Put another way, the crisis occurs when it appears that the financial elite used the politico-legal structure to enrich themselves through systematically imprudent behavior while those engaged in prudent behavior were harmed, with the political elite apparently taking no action to protect the victims.

 

In the modern public corporation, shareholders — the corporation’s owners — rarely control management. A board of directors technically oversees management on behalf of the shareholders. In the crisis of 2008, we saw behavior that devastated shareholder value while appearing to enrich the management — the corporation’s employees. In this case, the protections given to shareholders of corporations were turned against them when they were forced to pay for the imprudence of their employees — the managers, whose interests did not align with those of the shareholders. The managers in many cases profited personally through their compensation system for actions inimical to shareholder interests. We now have a political, not an economic, crisis for two reasons. First, the crisis qualitatively has moved beyond the boundaries of a cyclical event. Second, the crisis is rooted in the political-legal definitions of the distribution of corporate risk and the legally defined relations between management and shareholder. In leaving the shareholder liable for actions by management, but without giving shareholders controls to limit managerial risk taking, the problem lies not with the market but with the political system that invented and presides over the limited liability corporation.

 

Financial panics that appear natural and harm the financial elite do not necessarily create political crises. Financial panics that appear to be the result of deliberate manipulation of the allocation of risk under the law, and from which the financial elite as a whole appears to have profited even while shareholders and the public were harmed, inevitably create political crises. In the case of 2008 and the events that followed, we have a paradox. The 2008 crisis was not unprecedented, nor was the federal bailout. We saw similar things in the municipal bond crisis of the 1970s, and the Third World Debt Crisis and Savings and Loan Crisis in the 1980s. Nor was the recession that followed anomalous. It came seven years after the previous one, and compared to the 1970s and early 1980s, when unemployment stood at more than 10 percent and inflation and mortgages were at more than 20 percent, the new one was painful but well within the bounds of expected behavior.

 

The crisis was rooted in the appearance that it was triggered by the behavior not of small town banks or third world countries, but of the global financial elite, who took advantage of the complexities of law to enrich themselves instead of the shareholders and clients to whom it was thought they had prior fiduciary responsibility.

 

This is a political crisis then, not an economic one. The political elite is responsible for the corporate elite in a unique fashion: The corporation was a political invention, so by definition, its behavior depends on the political system. But in a deeper sense, the crisis is one of both political and corporate elites, and the perception that by omission or commission they acted together — knowingly engineering the outcome. In a sense, it does not matter whether this is what happened. That it is widely believed that this is what happened alone is the origin of the crisis. This generates a political crisis that in turn is translated into an attack on the economic system.

 

The public, which is cynical about such things, expects elites to work to benefit themselves. But at the same time, there are limits to the behavior the public will tolerate. That limit might be defined, with Adam Smith in mind, as the point when the wealth of the nation itself is endangered, i.e., when the system is generating outcomes that harm the nation. In extreme form, these crises can delegitimize regimes. In the most extreme form — and we are nowhere near this point — the military elite typically steps in to take control of the system.

 

This is not something that is confined to the United States by any means, although part of this analysis is designed to explain why the Obama administration must go after Goldman Sachs, Lehman Brothers and others. The symbol of Goldman Sachs profiting from actions that devastate national wealth, or of the management of Lehman wiping out shareholder value while they themselves did well, creates a crisis of confidence in the political and financial systems. With the crisis of legitimacy still not settling down after nearly two years, the reaction of the political system is predictable. It will both anoint symbolic miscreants, and redefine the structure of risk and liability in financial corporations. The goal is not so much to achieve something as to create the impression that it is achieving something, in other words, to demonstrate that the political system is prepared to control the entities it created.

The Crisis in Europe

We see a similar crisis in Europe. The financial institutions in Europe were fully complicit in the global financial crisis. They bought and sold derivatives whose value they knew to be other than stated, the same as Americans. Though the European financial institutions have asserted they were the hapless victims of unscrupulous American firms, the Europeans were as sophisticated as their American counterparts. Their elites knew what they were doing.

 

Complicating the European position was the creation of the economic union and the euro by the economic and political elite. There has always been a great deal of ambiguity concerning the powers and authority of the European Union, but its intentions were always clear: to harmonize Europe and to create European-wide solutions to economic problems. This goal always created unease in Europe. There were those who were concerned that a united Europe would exist to benefit the elites, rather than the broader public. There were also those who believed it was designed to benefit the Franco-German core of Europe rather than Europe as a whole. Overall, this reflected minority sentiment, but it was a substantial minority.

 

The financial crisis came at Europe in three phases. The first was part of the American subprime crisis. The second wave was a uniquely European crisis. European banks had taken massive positions in the Eastern European banking systems. For example, the Czech system was almost entirely foreign (Austrian and Italian) owned. These banks began lending to Eastern European homebuyers, with mortgages denominated in euros, Swiss francs or yen rather than in the currencies of the countries involved (none yet included in the eurozone). Doing this allowed banks to reduce interest rates, as the risk of currency fluctuation was pushed over to the borrower. But when the zlotys and forints began to plunge, these monthly mortgage payments began to soar, as did defaults. The European core, led by Germany, refused a European bailout of the borrowers or lenders even though the lenders who created this crisis were based in eurozone countries. Instead, the International Monetary Fund (IMF) was called in to use funds that included American and Chinese, as well as European, money to solve the problem. This raised the political question in Eastern Europe as to what it meant to be part of the European Union.

 

The third wave is represented by crisis in sovereign debt in countries that are part of the eurozone but not in the core of Europe — Greece, of course, but also Portugal and possibly Spain. In the Greek case, the Germans in particular hesitated to intervene until it could draw the IMF — and non-European money and guarantees — into the mix. This obviously raised questions in the periphery about what membership in the eurozone meant, just as it created questions in Eastern Europe about what EU membership meant.

 

But a much deeper crisis of legitimacy arose. In Germany, elite sentiment accepted that some sort of intervention in Greece was inevitable. Public sentiment overwhelmingly opposed intervention, however. The political elite moved into tension with the financial elite under public pressure. In Greece, a similar crisis emerged between an elite that accepted that foreign discipline would have to be introduced and a public that saw this discipline as a betrayal of its interests and national sovereignty.

 

Europe thus has a double crisis. As in the United States, there is a crisis between the financial and political systems. This crisis is not as intense as in the United States because of a deeper tradition of integration between the two systems in Europe. But the tension between masses and elites is every bit as intense. The second part of the crisis is the crisis of the European Union and growing sense that the European Union is the problem and not the solution. As in the United States, there is a growing movement to distrust not only national arrangements but also multinational arrangements.

 

The United States and Europe are far from the only areas of the world facing crises of legitimacy. In China, for example, the growing suppression of all dissent derives from serious questions as to whom the financial expansion of the past 30 years benefits, and who will pay for the downturns. It is also interesting to note that Russia is suffering much less from this crisis, having lived through its own crisis before. The global crisis of legitimacy has many aspects worth considering at some point.

 

But for now, the important thing is to understand that both Europe and the United States are facing fundamental challenges to the legitimacy of, if not the regime, then at least the manner in which the regime has handled itself. The geopolitical significance of this crisis is obvious. If the Americans and Europeans both enter a period in which managing the internal balance becomes more pressing than managing the global balance, then other powers will have enhanced windows of opportunities to redefine their regional balances.

 

In the United States, we see a predictable process. With the unease over elites intensifying, the political elite is trying to stabilize the situation by attacking the financial elite. It is doing this to both demonstrate that the political elite is distinct from the financial elite and to impose the consequences on the financial elite that the impersonal system was unable to do. There is precedent for this, and it will likely achieve its desired end: greater control over the financial system by the state and an acceptable moral tale for the public.

 

The European process is much less clear. The lack of clarity comes from the fact that this is a test for the European Union. This is not simply a crisis within national elites, but within the multinational elite that created the European Union. If this leads to the de-legitimization of the EU, then we are really in uncharted territory.

 

But the most important point is that almost two years since a normal financial panic, the polity has still not managed to absorb the consequences of that event. The politically contrived corporation, and particularly the financial corporations, stands accused of undermining the wealth of nations. As Adam Smith understood, markets are not natural entities but the result of political decisions, as is the political system that creates the allocation of risk that allows markets to function. When that system appears to fail, the consequences go far beyond the particular financials of that event. They have political consequences and, in due course, geopolitical consequences.

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