The rise of the yuan: Turning from green to red

In Tokyo last week the bigwigs of international finance paid close attention to a speech by Ben Bernanke, chairman of America’s Federal Reserve. His speech urged them, in effect, to pay less attention. Many policymakers in emerging markets complain that Fed easing destabilises their economies, contributing to higher inflation and asset prices. Mr Bernanke pointed out that emerging economies can insulate themselves from his decisions by simply decoupling their currencies from the dollar. It is their habit of shadowing America’s currency, however loosely, that obliges emerging economies to ease monetary policy whenever he does.

Policymakers may heed Mr Bernanke’s words—freeing them to ignore his decisions—sooner than he thinks. In a (more thinly attended) speech on the same day, a deputy governor of China’s central bank pointed out that China no longer hoovers up dollar reserves with its past abandon. And according to a new study by Arvind Subramanian and Martin Kessler of the Peterson Institute for International Economics in Washington, DC, the dollar’s influence is waning in the emerging world. Currencies that used to shadow the greenback are no longer following it so closely. Some are floating more freely. But in other cases they are steadily falling under the spell of a different currency: the yuan.

Some inflation-prone emerging economies, such as Ecuador, have adopted the dollar as their official currency. Others, such as Jordan, peg their exchange rate to it. These official policies are one measure of the dollar’s international role. Messrs Subramanian and Kessler use a different measure, based on the way exchange rates behave in the market. They identify currencies that tend to move in sympathy with the dollar in its daily fluctuations against a third currency, such as the Swiss franc. This “co-movement” could reflect market forces, not official policies. It need not be a perfect correlation. It need only be close enough to rule out coincidence.

Based on this measure, the dollar still exerts a significant pull over 31 of the 52 emerging-market currencies in their study. But a number of countries, including India, Malaysia, the Philippines and Russia, appear to have slipped anchor since the financial crisis. Comparing the past two years with the pre-crisis years (from July 2005 to July 2008), they show that the dollar’s influence has declined in 38 cases.

The greenback has in the past played a dominant role in East Asia. But if anything, the region is now on a yuan standard. Seven currencies in the region now follow the yuan, or redback, more closely than the green (see chart). When the dollar moves by 1%, East Asia’s currencies move in the same direction by 0.38% on average. When the yuan moves, they shift by 0.53%.

Of course, the yuan does not yet float freely itself. Since June 2010 it has climbed by about 9% against the dollar, fluctuating within narrow daily bands. Its close relationship with the greenback poses a statistical conundrum for Messrs Subramanian and Kessler. How can they tell if a currency is following in the dollar’s footsteps or the yuan’s, if those two currencies are moving in close step with each other? In previous studies, wherever this ambiguity arose, currencies were assumed to be following the dollar. The authors relax this assumption, arguing that the yuan now moves independently enough to allow them to distinguish its influence. But some of the yuan’s apparent prominence may still be the dollar’s reflected glory.

Outside East Asia, the redback’s influence is still limited. When the dollar moves by 1%, emerging-market currencies move by 0.45% on average. In response to the yuan, they move by only 0.19%. But China’s currency will continue to grow in stature as its economy and trading activity grow in size. Based on these two forces alone, China’s currency should surpass the dollar as a key currency some time around 2035, Mr Subramanian guesses. By that point, the Fed chairman will be the one pulling in the smaller audiences.

Source: The Economist

Believe it or not, times are getting better.

At least that’s what the dry statistics keep telling us. Industrial production, G.D.P. — the kind of figures that Washington and Wall Street sweat over — suggest that the economy is on the mend.

Yet if we go beyond the Beltway and the Battery, to where most of American life is lived, the numbers don’t always add up. Yes, the Great Recession officially ended in 2009. But many millions of Americans are out of work or cannot find full-time jobs. Home prices are wobbly. The foreclosure crisis drags on. And the Occupy movement’s campaign against “the 1 percent” has underscored the ravages of income inequality.

It was, as always, a year of ups and downs in business. Washington said the nation’s AAA rating was safe, but Standard & Poor’s concluded that it wasn’t. Europe insisted that its currency was sound, but investors worry that it isn’t. Wall Street seemed perpetually on edge. After so many wild days, the American stock market ended 2011 about where it began.

On this side of the Atlantic, aftershocks of the financial crisis of 2008-9 are still reverberating, though the worst has passed. Now, how Europe’s economic troubles play out may determine whether job growth here finally picks up enough to make up for all the lost ground — and whether that 401(k) is richer or poorer next Jan. 1.

Where to go from here? And how to face the challenges ahead? Sunday Business asked the six economists who write the Economic View column to do a little blue-sky thinking on issues as varied as the Fed, Europe and housing. You won’t find stock tips. But if 2011 was any guide, the best advice for 2012 may be this: Hold tight.

Dear Mr. Bernanke:

Please Tell Us More

N. GREGORY MANKIW A professor of economics at Harvard, he is advising Mitt Romney in the campaign for the Republican presidential nomination.

WHAT can we do to get this economy going?

That’s the question Ben Bernanke and his colleagues at the Federal Reserve must be asking. Officially, the recession ended a while ago. But with unemployment lingering above 8 percent, it still feels as if we’re mired in a slump.

The Fed’s typical response to lackluster growth is to reduce short-term interest rates. To its credit, it did that — quickly and drastically — as the recession unfolded in 2007 and 2008. Then it took various unconventional steps to push down long-term rates, including those on mortgages. Mr. Bernanke deserves more credit than anyone for preventing the financial crisis from turning into a second Great Depression.

Now, the key will be managing expectations. Financial markets always look ahead, albeit imperfectly. They not only care what the Fed does today but also about what it will do tomorrow. With official short-term rates already near zero, what the Fed does this year will be less important than what policy makers say they will do next year — or the year after that.

A crucial question is how quickly the Fed will raise interest rates as the economy recovers. So far, Fed policy makers have said they expect to keep rates “exceptionally low” at least until mid-2013. There has even been talk about extending that time frame by a year, to mid-2014.

But Charles I. Plosser, the president of the Federal Reserve Bank of Philadelphia, was right when he said recently that “policy needs to be contingent on the economy, not the calendar.” The key to managing expectations will be spelling out this contingency plan in more detail. That is, what does the Fed need to see before it starts raising rates again?

Unfortunately, economists don’t offer simple and unequivocal advice. Some suggest watching the overall inflation rate. Others say to watch inflation, but to exclude volatile food and energy prices. And still others advise targeting nominal gross domestic product, which weights inflation and economic growth equally.

Forging a consensus among members of Federal Open Market Committee, which sets monetary policy, won’t be easy. In fact, it may well be impossible. But the more clarity the Fed offers about its contingency plans, the better off we’ll all be in the years ahead.

Two Big Problems,

Two Ready Solutions

CHRISTINA D. ROMER An economics professor at the University of California, Berkeley, she was chairwoman of President Obama’s Council of Economic Advisers.

THE United States faces two daunting economic problems: an unsustainable long-run budget deficit and persistent high unemployment. Both demand aggressive action in the form of fiscal policy.

Waiting until after the November elections, as seems likely, would be irresponsible. It is also unnecessary, since there are plans to address both problems that should command bipartisan support.

On the deficit, the big worry isn’t the current shortfall, which is projected to decline sharply as the economy recovers. Rather, it’s the long-run outlook. Over the next 20 to 30 years, rising health care costs and the retirement of the baby boomers are projected to cause deficits that make the current one look puny. At the rate we’re going, the United States would almost surely default on its debt one day. And like the costs of maintaining a home, the costs of dealing with our budget problems will only grow if we wait.

We already have a blueprint for a bipartisan solution. The Bowles-Simpson Commission hashed out a sensible plan of spending cuts, entitlement program reforms and revenue increases that would shave $4 trillion off the deficit over the next decade. It shares the pain of needed deficit reduction, while protecting the most vulnerable and maintaining investments in our future productivity. Congress should take up the commission’s recommendation the first day it returns in January.

But we can’t focus on the deficit alone. Persistent unemployment is destroying the lives and wasting the talents of more than 13 million Americans. Worse, the longer that people remain out of work, the more likely they are to suffer a permanent loss of skills and withdraw from the labor force.

Despite heated rhetoric to the contrary, the evidence that fiscal stimulus raises employment and lowers joblessness is stronger than ever. And pairing additional strong stimulus with a plan to reduce the deficit would likely pack a particularly powerful punch for confidence and spending.

The payroll tax cut for workers and employers and the extended unemployment insurance that President Obama proposed last September would help put people back to work.

But even better would be measures that increase employment today, while also leaving us with something of lasting value. Because many people worry about increasing the role of the federal government, why not give substantial federal funds to state and local governments for public investment? Tell them that the money has to be used for either physical infrastructure like roads, bridges and airports, or for human infrastructure like education, job training and scientific research. Then let the states, cities and towns figure out what would work best for their citizens.

Ronald Reagan once said that “there are simple answers — there just are not easy ones.” What needs to happen on fiscal policy is relatively straightforward. The hard part is getting politicians to do it.

Thickening Clouds

Over Europe

TYLER COWEN A professor of economics at George Mason University.

HOW, and when, will Europe get out of its mess?

The short answer is this: not anytime soon, and not without more pain. The longer that Europe’s troubles last, the worse and more insidious they become. Insolvent governments, troubled banks, divisive politics, painful austerity — the list of problems is formidable already.

The best-case outlook is that the euro zone will, in effect, grow its way out of this crisis. The European Central Bank is now extending unlimited loans to banks in the 17 nations of the European Union that use the euro, provided that those banks put up collateral. The loans don’t have to be paid back for three years, by which time it is hoped that steady growth will have returned.

In theory, these loans should ensure that Europe’s banks stay liquid. Some of these banks, in turn, are already lending money to their national governments, and others may be forced to. In the short run, this will help keep euro zone governments funded, too.

If the economy starts growing again before the loans are due, the central bank’s efforts to fix the Continent’s solvency problems will have succeeded. The plan will have relieved pressure in the money markets and on the banks, since they would be backed by wealthier, more credible governments. We would probably have to write off Greece, but, under this circumstance, other euro zone countries would avoid a major financial crisis.

There are, however, several darker possibilities. One is that the economies of some major euro zone nations will continue to stagnate. In per-capita terms, Italy is already poorer than it was 12 years ago, so maybe it’s stuck in a slow-growth mode. If that’s the case, more borrowing from the European Central Bank is simply stretching an unsustainable situation.

Eventually, the central bank would have to let it be known that it is not expecting its money back. In this case, banks in weak nations would probably be unable to raise funds from the private sector. Confidence would evaporate. Some countries would end up abandoning the euro and printing their own currency to keep their promises to bank depositors and bondholders. The consequences could be disastrous, not only for Europe, but for the global economy.

A second danger would arise in Europe if an election, probably in a smaller country, gave rise to a government that repudiated the euro. Then, too, all bets would be off.

My guess — and guess is the right word — is that odds of this ending well are about one in three. Otherwise, fasten your seat belts.

Why 2 Paychecks

Are Barely Enough

ROBERT H. FRANK An economics professor at the Johnson Graduate School of Management at Cornell University.

WHY do many middle-class families now struggle to get by on two paychecks, whereas most got by on just one back in the 1950s and ’60s?

The answer, according to “The Two-Income Trap,” by Elizabeth Warren and Amelia Warren Tyagi, is that many second paychecks today go toward financing a largely fruitless bidding war for homes in good school districts.

Parents naturally want to send their kids to good schools. But quality is relative. Because the best schools tend to be those serving expensive neighborhoods, parents must outbid 50 percent of other parents with the same goal just to send their children to a school of average quality.

How hard is that? I constructed a measure I call the toil index. It tracks the number of hours a median earner must work each month to earn the implicit rent for the median-priced house.

From 1950 to 1970, when incomes were growing at about the same rate for families up and down the income ladder, the toil index actually declined slightly. But since 1970 — a period during which income inequality has grown — the toil index has risen sharply.

The increase in two-earner households explains only part of it. The climb in the toil index was also driven by the easy credit that fueled the housing bubble, as well as by an expenditure cascade in housing caused by growing income disparities.

Since 1970, the top 1 percent have captured most of the income growth in the nation. Like everyone else, the rich spend more on housing when they have more money. High-end houses become bigger and fancier. That shifts the frame of reference for the near rich, and so on down the income ladder. Because the median hourly wage, adjusted for inflation, has been falling, there’s really no other way to explain why the median new house built in the United States in 2007 was about 50 percent larger than its counterpart in 1970.

The increase in the toil index has been spectacular. From a postwar low of 41 hours a month in 1970, it rose to more than 100 hours in 2005. Although it has fallen since the housing bubble burst, the middle-class squeeze persists.

Growing income disparities don’t just make the 99 percent angry. They also raise the cost of achieving basic goals.

A Tax Credit to Fix

A Housing Mess

ROBERT J. SHILLER A professor of economics and finance at Yale.

WE used to talk a lot about helping homeowners in trouble.

Instead, the bankers were bailed out — and now we hardly talk at all about aiding ordinary Americans.

Yet the problems facing homeowners today are even bigger than they were in the dark days of the financial crisis. According to the S.& P./Case-Shiller 20-city Home Price Index, home prices have fallen 13.2 percent since Lehman Brothers collapsed in September 2008. Over the same period, of course, unemployment has climbed.

In other words, more homeowners are underwater on their mortgages — and more Americans are out of work. And home prices are still falling.

So we need to overcome the sense that real help is impossible — and to think about approaches that might be politically feasible. Despite concern over our national debt and a general distaste for spending taxpayer dollars on people who may have been less responsible, there are some potential solutions.

Prof. Richard K. Green, director of the Lusk Center for Real Estate at the University of Southern California, has proposed changing the tax system so that it offers stronger, more targeted encouragement for homeownership by focusing on people who might be giving up the dream of buying any home at all. The current mortgage interest deduction, Professor Green argues, based on his work with Prof. Andrew Reschovsky of the University of Wisconsin, is mostly an incentive for relatively wealthy people to build bigger houses, rather than for people of modest means to buy a home. It also provides a strong incentive only for people in high tax brackets, who benefit more because of their higher marginal tax rates, and who tend to itemize because the standard deduction is less advantageous for them.

Professor Green wants to offer more help for lower-income taxpayers. He suggests creating a refundable tax credit as a percentage of mortgage interest payments, one that could be used even by those who take the standard deduction. This credit, presumably with some dollar limit, would be available to all homeowners. (That is in contrast to the HARP 2.0 mortgage refinancing program from the Obama administration; it is available, arbitrarily, only to those with Fannie Mae and Freddie Mac mortgages.) Professor Green proposes paying for this change by gradually phasing out the existing mortgage interest deduction.

Homeownership fosters citizenship, builds stronger families and communities, encourages active participation in the economy and, ultimately, bolsters economic confidence. Professor Green’s proposal is an example of a change that wouldn’t smack of a bailout, but would help vulnerable people who are losing hope in the American Dream.

The Answer Starts

With a Salad Bar

RICHARD H. THALER A professor of economics and behavioral science at the Booth School of Business at the University of Chicago.

IN case you’ve forgotten, we have a crisis in health care spending. But employers can help us deal with it — and save themselves some money — with a few nudges.

The thesis of “Nudge,” which Cass R. Sunstein and I wrote in 2008, is that “choice architects” can often help people achieve their goals simply by making the necessary steps easier. As choice architects, employers can do a lot to improve their workers’ health. That, in turn, can lead to more productive workers who have fewer sick days and cost less to insure.

Where to start? First, make it easier to eat well while at work. That doesn’t mean limiting the cafeteria menu to tofu and cauliflower. It means offering various healthful, tasty options that are featured prominently. Put an attractive salad bar including some healthy proteins before the burger line, for instance, and subsidize the healthy food.

Second, make it easier to get some exercise during the workday. Walking just 30 minutes a day provides noticeable health benefits. Some ambitious companies have installed treadmills with workstations, but there are lower-cost solutions. Even a small to midsize business can probably arrange a discount at a health club.

You don’t have to leave work to get some exercise. A good place to start is on the stairs. Walking a few flights several times a day is a good start on that 30 minutes. To entice workers, companies should make their stairwells attractive and fun. Add music, murals or graffiti contests. Or try lotteries with a chance to win any time you walk up or down one flight. Finally, better align health insurance incentives with behavior. One of the biggest health care problems is that patients don’t keep up with their medications, even those that might save their lives. Why charge people who’ve had heart attacks a co-payment when they fill prescriptions that reduce the chance of another attack? Instead, make those prescriptions free and use technology to remind them to take their medicine, either with a text message or a pillbox that starts beeping if you forget to take your pills.

And here’s a practice we should use more often: Offer insurance discounts to reward healthy behavior. Saving $500 on a premium is a good incentive to quit smoking or lose some weight.

My New Year’s resolution is to take at least two walking meetings a week. How about you?

Source: New York Times

Overview

It is crunch time for the Group of 20. If things go well, the Cannes summit will mark the moment the “premier global economic forum” acts to defuse the economic risks being run in the world. The alternative is to allow them to fester, contributing towards another destructive financial and economic crisis.

Underlining the urgency, the International Monetary Fund declared in mid October: “The immediate risk is that the global economy tips into a downward spiral of increased uncertainty and risk aversion, dysfunctional financial markets, unsustainable debt dynamics, falling demand, and rising unemployment”.

Three challenges stalk the global economy.

Most pressing is the declining prospects for growth, which have become evident in the weeks following the IMF annual meetings in late September. Then, the IMF had already downgraded its economic forecasts and warned of further risks, but most emerging economies were still growing rapidly and had experienced little fallout from the slowdown in almost all advanced economies.

Six weeks on the world outlook seems darker notwithstanding the eurozone agreement a week before the G20 summit. As the Organisation for Economic Cooperation and Development outlined on Monday, “Uncertainties regarding the short-term economic outlook have risen dramatically in recent months.”

The OECD significantly downgraded its 2012 growth forecast for the world economy and for advanced economies, cutting the forecast from 2 to only 0.3 per cent and its US forecast from 3.1 to 2 per cent.

A rapidly cooling global economy is both the consequence and cause of the eurozone sovereign debt crisis. As the second challenge – one which has frayed investors’ nerves and knocked business and consumer confidence since the summer – fixing the existential crisis of the European single currency is a pre-requisite for a safer global economy next year.

The crisis has many dimensions, ranging from the insolvent Greek economy, through a dip in confidence in the peripheral sovereign debt of Italy and Spain increasing their borrowing costs substantially, and to a weakness in the balance sheets of European banks sitting on these assets. The issues are inextricably linked and must be addressed as a whole, as recognised by both the French and German government’s commitment to a “comprehensive plan”, the outlines of which were revealed last Thursday morning.

If the eurozone crisis was not difficult enough, deep trade imbalances are the third challenge facing the G20. According to the IMF, current policies on trade and exchange rates suggest that enormous current account surpluses in China, Japan, Germany and relatively poor oil exporters are set to continue, forcing ever more capital to flow to finance deficits elsewhere which must balance the surpluses.

Since well before the crisis, individuals and governments in surplus countries enjoyed building claims on deficit countries, but much of this capital ended up financing increasingly risky activity at cheap rates – sub-prime mortgages and peripheral eurozone sovereign debt – adding to the risks that these investment flows would end in crisis and huge losses.

As Mervyn King, governor of the Bank of England, said recently: “From the very beginning of the global crisis there has been a reluctance by governments to face up to the underlying solvency problems generated by apparently unending trade deficits with no mechanism, whether flexible exchange rates or some other means, for correcting these disequilibria”.

In short, the task for the G20 summit is to accelerate solutions to the latter two challenges so as to mitigate the slowing global economy and set it on a path towards the G20’s long-standing ambition of “strong, stable and balanced” global growth.

France, the chair of the G20 in 2011, is well aware of what needs to be done. Speaking to the United Nations a week before the summit, Jean-David Levitte, the diplomatic advisor on the G20 to French president Nicolas Sarkozy, recognised the original agenda of the summit must be torn up and replaced with a coordinated response, because “no one is immune from the economic crisis”.

“France is calling on all G20 countries to adopt measures adapted to the situation and on all countries that don’t belong to the G20 to support the collective efforts that will be undertaken to restore confidence,” he said.

For the G20 to play a part in any solution to the eurozone woes, non-members of the single currency area made it clear at a finance ministers’ meeting in Paris in mid-October that the euro nations first had to demonstrate they had a “decisive” plan to save the single currency.

That plan – the outlines of which were agreed at a eurozone summit a week before the G20 summit – included a comprehensive recapitalisation of European banks, a 50 per cent voluntary write-down of Greek debt leaving the beleaguered country with more sustainable debts, a beefed-up fund to prevent contagion spreading from Greece to other eurozone economies and medium-term reforms to the governance of the eurozone to prevent a recurrence of fiscal and trade imbalances within the zone.

The enhanced European Financial Stability Facility will have two elements in a package with more than €1,000bn of firepower: limited insurance for sovereign debt of peripheral countries and a new leveraged fund to buy debt outright.

Underpinning the details is the idea that medium-term German and French finance for peripheral eurozone countries will be balanced by German and French control of economic policy across the eurozone, in what Angela Merkel, German Chancellor, euphemistically calls a “stability union”.

Once these elements of a package are agreed, the French hosts hope that non-eurozone countries will boost the credibility of the plan at the G20, either through additional bilateral or IMF support. The aim would be to provide overwhelming firepower behind the eurozone and stop traders betting on a eurozone break-up.

G20 finance ministers made clear in Paris that such a deal was a possibility, though it is far from a certainty in Cannes.

Speaking in a similar vein to many non-eurozone finance ministers, Tim Geithner, US treasury secretary, said: ”The IMF has a substantial arsenal of financial resources, and we would support further use of those resources to supplement a comprehensive, well-designed European strategy alongside a more substantial commitment of European resources.”

In contrast to hastily devised plans to defuse the eurozone crisis, the G20’s progress in reducing global imbalances inches forward at glacial speed. The added difficulty, as Mr Levitte makes clear, is that unlike in 2009, there is no unifying theme for action needed to foster a stronger and more balanced global economy.

He says: “The message from Cannes will have to be more diverse; some nations need to focus on measures to boost their economy, others on consolidating their public finances, and still others on rebalancing their economic models to promote domestic consumption.”

On past experience, gaining agreement on general themes and objectives will be easier than specific changes in domestic policies of any G20 member.

In addition, France is still keen to be seen to have made some progress on Mr Sarkozy’s original ambitions for the 2011 G20 agenda on reforming the international monetary system.

It is expecting specific agreements on rules governing the management of international capital flows – allowing countries in limited circumstances to impose capital controls.

France also hopes to increase the range of IMF credit lines available to help well managed countries that are exposed in a crisis, co-ordinating these flows with those of Europe and Asia.

And it hopes to continue discussion on exchange rates, particularly that of the renminbi, although it acknowledges there will be no breakthrough in Cannes.

But the problem for world economic governance is that it still faces a deep collective action problem.

Policy changes that would foster the common good are seen as counter to individual countries’ domestic interests. This obstacle has forced France to scale back its longer-term ambitions for Cannes.

The potential for the summit to make progress in fighting the immediate eurozone crisis is therefore something of a boon for Mr Sarkozy as he prepares for Cannes. Without the crisis, the potential achievements of the summit were looking extremely limited.

Source: Financial Times Special Report

To judge from this week’s summit between Germany’s Angela Merkel and France’s Nicolas Sarkozy, the answer is no. The two came together in the holiday season partly because the markets had moved on from an assault on Italy to attack France, a core AAA-rated euro member. Investors were hoping for a deal to expand the euro zone’s bail-out fund, the European Financial Stability Facility (EFSF), or to start issuing mutually guaranteed Eurobonds. Instead the two leaders did little beyond repeating previous accords, promising stronger euro-zone economic governance and putting up such distractions as a financial-transactions tax, harmonised corporate taxes and constitutional commitments to balance budgets—along with more euro-zone summits in future (see Economist article).

The markets were unimpressed. A day later the European Central Bank was again buying Spanish and Italian government bonds, having spent €22 billion ($32 billion) the previous week. The latest shockingly low growth figures for the euro zone in the second quarter may partly reflect fiscal austerity, but they also suggest that it will be harder than ever for troubled economies to grow out of their debt burdens.

It is understandable that Mrs Merkel, in particular, should be loth to embrace bold new rescue plans. She is cautious by nature, more a follower than a leader. She recognises the deep hostility of her voters to big fiscal transfers to weaker, more profligate euro-zone countries. She is already finding it hard to persuade her coalition partners to support in parliament the deal she struck in July to expand the EFSF’s powers and let it buy up government debt. She is mindful that the Bundesbank is vociferously against a big ECB programme to buy government bonds (the ECB has already spent €100 billion). And she fears that her country’s constitutional court may rule all euro zone bail-outs to be illegal.

Yet Mrs Merkel needs to be mindful of something else as well: that the current rescue plan for the euro is just not working. The markets continue to price in default by Portugal as well as Greece (though the third bailed-out country, Ireland, is looking a bit healthier). The attempt to limit the trouble to these three and stop contagion spreading to Spain has manifestly failed: instead Italy and now France, both of which seem to be solvent, have been infected. A year ago it was said that the euro zone could take care of two or three small countries but that Spain was too big to fail. Today, with Italy and even France looming into the picture, the very survival of the euro is coming into question.

A break-up of the euro may not be unthinkable, but it would certainly be damaging, painful and very expensive. This is most obvious for debtor countries whose banks and governments would go bust; but Germany and other creditors would also pay an extremely high price. And the consequences would be scarily unpredictable: Europe’s single market, and even the European Union itself, might be at risk.

Mrs Merkel must know that it is worth paying a lot to avoid all this. That means, at minimum, a large expansion of the EFSF, to at least €1 trillion, though there is a limit to how much bigger it can get without denting some creditor countries’ ratings. It is likely to require further large-scale bond-buying by the ECB. It involves accepting bigger restructuring of Greek and maybe other debt. In the end, it may even necessitate mutually guaranteed Eurobonds (see Economist article).

Honesty is the best policy

Any or all of these measures have three things in common: they involve stronger countries giving more support to weaker countries; to offset this, they require intrusive outside control of national fiscal policies. They thus constitute a step towards political union. That is what airy labels like “economic government” or “deeper integration” actually mean.

The problem is that most governments have no mandate from voters to move in this direction. Politicians therefore need to start explaining to their electorates the choices they face, and the consequences of those choices. If Europe’s leaders sign up for a level of integration deeper than voters want, the backlash could split the EU apart—exactly the outcome they are trying to avoid.

Source: The Economist

Economist interactive guide to Europe’s troubled economies

The IMF has published the 2011 edition of its World Economic Outlook

The recovery is gaining strength, but unemployment remains high in advanced economies, and new macroeconomic risks are building in emerging market economies. In advanced economies, the handoff from public to private demand is advancing, reducing concerns that diminishing fiscal policy support might cause a “double-dip” recession. Financial conditions continue to improve, although they remain unusually fragile. In many emerging market economies, demand is robust and overheating is a growing policy concern. Developing economies, particularly in sub-Saharan Africa, have also resumed fast and sustainable growth. Rising food and commodity prices pose a threat to poor households, adding to social and economic tensions, notably in the Middle East and North Africa. Oil price increases since January 2011 and information on supply, including on spare capacity, suggest that the disruptions so far would have only mild effects on economic activity. An earthquake in Japan has exacted a terrible human toll. Its macroeconomic impact is projected to be limited, although uncertainty remains elevated. Overall, with the recovery stronger on the one hand but oil supply growth lower on the other, projections for global real GDP growth in 2011–12 are little changed from the January 2011 WEO Update. But downside risks have risen.

World real GDP growth is forecast to be about 4½ percent in 2011 and 2012, down modestly from 5 percent in 2010. Real GDP in advanced economies and emerging and developing economies is expected to expand by about 2½ percent and 6½ percent, respectively. Downside risks continue to outweigh upside risks. In advanced economies, weak sovereign balance sheets and still-moribund real estate markets continue to present major concerns, especially in certain euro area economies; financial risks are also to the downside as a result of the high funding requirements of banks and sovereigns. New downside risks are building on account of commodity prices, notably for oil, and, relatedly, geopolitical uncertainty, as well as overheating and booming asset markets in emerging market economies. However, there is also the potential for upside surprises to growth in the short term, owing to strong corporate balance sheets in advanced economies and buoyant demand in emerging and developing economies.

Many old policy challenges remain unaddressed even as new ones come to the fore. In advanced economies, strengthening the recovery will require keeping monetary policy accommodative as long as wage pressures are subdued, inflation expectations are well anchored, and bank credit is sluggish. At the same time, fiscal positions need to be placed on sustainable medium-term paths by implementing fiscal consolidation plans and entitlement reforms supported by stronger fiscal rules and institutions. This need is particularly urgent in the United States to stem the risk of globally destabilizing changes in bond markets. The U.S. policy plans for 2011 have actually switched back from consolidation to expansion. Efforts should be made to reduce the projected deficit for fiscal year 2011. Measures to trim discretionary spending are a move in this direction. However, to make a sizable dent in the projected medium-term deficits, broader measures such as Social Security and tax reforms will be essential. In Japan, the immediate fiscal priority is to support reconstruction. Once reconstruction efforts are under way and the size of the damage is better understood, attention should turn to linking reconstruction spending to a clear fiscal strategy for bringing down the public debt ratio over the medium term. In the euro area, despite significant progress, markets remain apprehensive about the prospects of countries under market pressure. For them what is needed at the euro area level is sufficient, low-cost, and flexible funding to support strong fiscal adjustment, bank restructuring, and reforms to promote competitiveness and growth. More generally, greater trust needs to be re-established in euro area banks through ambitious stress tests and restructuring and recapitalization programs.

Moreover, reform of the global financial system remains very much a work in progress. The challenge for many emerging and some developing economies is to ensure that present boom-like conditions do not develop into overheating over the coming year. Inflation pressure is likely to build further as growing production comes up against capacity constraints, with large food and energy price increases, which weigh heavily in consumption baskets, motivating demands for higher wages. Real interest rates are still low and fiscal policies appreciably more accommodative than before the crisis. Appropriate action differs across economies, depending on their cyclical and external conditions. However, a tightening of macroeconomic policies is needed in many emerging market economies.

• For external surplus economies, many of which manage their currencies and do not face fiscal problems, removal of monetary accommodation and appreciation of the exchange rate are necessary to maintain internal balance––reining in inflation pressure and excessive credit growth––and assist in global demand rebalancing.
• Many external deficit economies need to tighten fiscal and monetary policies, possibly tolerating some overshooting of the exchange rate in the short term.
• For some surplus and deficit economies, rapid credit and asset price growth warn of a threat to financial stability. Policymakers in these economies will need to act soon to safeguard stability and build more resilient financial systems.
• Many emerging and developing economies will need to provide well-targeted support for poor households that struggle with high food prices.

Capital flows to emerging market economies resumed remarkably quickly after the crisis. However, as policy rates in advanced economies rise from their unusually low levels, volatile flows may again exit the emerging market economies. Depending on country specific circumstances, and assuming appropriate macroeconomic and prudential policies are in place, measures designed to curb capital inflows can play a role in dampening the impact of their excessive volatility on the real economy. However, such measures are not a substitute for macroeconomic tightening.

Greater progress in advancing global demand rebalancing is essential to put the recovery on a stronger footing over the medium term. This will require action by many countries, notably fiscal adjustment in key external deficit economies and greater exchange rate flexibility and structural reforms that eliminate distortions that boost savings in key surplus economies.

There is broad agreement on the contours of the policy responses sketched here. However, with the peak of the crisis now past, the imperative for action and willingness to cooperate among policymakers is diminishing. It would be a mistake for advanced economies to delay fiscal adjustment in the face of a difficult political economy at home. Additionally, while the removal of distortions that boost saving in key external surplus economies would support growth and help achieve fiscal consolidation in key advanced economies, insufficient progress on one front should not serve as an excuse for inaction on the other front. It would also be a mistake for emerging market economies to delay exchange rate adjustment in the face of rising inflation pressure. Many emerging market economies cannot afford to delay additional policy tightening until the advanced economies undertake such tightening themselves. The task facing policymakers is to convince their national constituencies that these policy responses are in their best economic interests, regardless of the actions others are taking.

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