Official Monetary and Financial Institutions Forum Blog

A convoluted London affair

Huhne resignation further weakens Cameron’s European hold

By David Marsh

In European public life, there are some reassuringly fixed behavioural laws. If ministers or top officials in Germany or Switzerland have to resign, as recent examples have shown, it's nearly always about principle or money. In Britain, when such departures happen, sex is never far away. So it was on Friday when high-flying Liberal Democrat Chris Huhne, energy minister in David Cameron’s coalition, was forced to step down from the British cabinet. The action undermines the coalition’s cohesiveness, further weakens Cameron’s European credibility and will have at least an indirect impact on the UK’s contribution to resolving the euro sovereign debt crisis.

In the UK the slogan ‘cherchez la femme’ retains validity. The Huhne case revolves around two women. Had it not been for a convoluted illicit affair with a PR consultant, which last year sparked Huhne’s divorce from long-time spouse and well-known economist Vicky Pryce, the saga would never have sparked the politician’s fall from grace.

On the European stage, Cameron has lately cut a less convincing figure. Tory back-benchers are asking whether the prime minister’s attempted blockade against European Union treaty changes is worth the bother. Early successes chalked up by Italy’s new Prime Minister Mario Monti have weakened Cameron’s relative influence in European bargaining.

Now that Huhne has quit his job to defend himself against charges of attempting to pervert the course of justice, Cameron has lost an ardent pro-European just when he needs to burnish his European credentials in the eyes of foreign partners. Huhne – although often clashing with Cameron on European and party issues – has been an important component behind a fragile political balance. His authority in energy and climate change questions is widely recognised. Huhne’s departure reduces the general level of expertise and intelligence in a cabinet not renowned for extraordinary competence.

Before he moved over into politics, quick-thinking Huhne made his name and then his fortune first as a business journalist and then as co-founder of the IBCA rating agency, later sold to Fitch. The Liberal Democrat resigned from office after the public prosecutor announced he would be charged with persuading former wife Pryce to accept speeding points on his behalf. The politician’s slide began in 2010 after the allegations about the speeding points, dating back to 2003, appeared in the press soon after Huhne left Pryce for another woman. Scorned Pryce seems to have regretted her alleged earlier decision to cover up for her erring husband. Unfortunately for her, she will have to appear in court too.

Argumentative and irritating (especially for the Conservatives) though the former cabinet minister may be, as the European debt crisis drags on and Cameron considers how best to re-engage with Europe over bail-out mechanisms, the UK government could profitably use someone of Huhne’s experience and knowledge.

Germany enters French election campaign

Merkel’s go-for-Sarkozy gamble

By David Marsh

On the eve of yet another European summit to shore up the single currency, Germany has dramatically entered the campaign for the French presidential elections this spring.

French president Nicolas Sarkozy, in a televised interview last night, referred constantly to German economic prowess as the benchmark for France’s own performance. Both he and (in a separate TV debate on Thursday) François Hollande, the Socialist candidate in the April/May presidential poll, lauded Gerhard Schröder, the former German chancellor, who inaugurated unpopular but effective economic reforms to improve German competitiveness.

Sarkozy, trailing in the opinion polls, used his TV appearance to announce an increase in value added tax to 21.2% to help fund a cut in payroll taxes, as well as measures to boost productivity and competitiveness for French business. He had some good news: last year’s budget deficit might have been as low as 5.3%, down from the previously-estimated 5.7%. Appearing at times more like a presidential contender than the man who has been in the top job for 4 ¾ years, Sarkozy admitted a range of French economic defects and the need to catch up with its eastern neighbour. ‘France has 100,000 exporting companies, Germany 400,000,’ he said.

In a highly unusual move, Angela Merkel, the German chancellor, who has gained popularity on both sides of the Rhine during the euro crisis, will join the campaign for Sarkozy in France in coming weeks. Announcing this in Paris at the weekend, Hermann Gröhe, general secretary of Merkel’s Christian Democrat party, fiercely attacked Hollande for proposing ‘outdated concepts and left-wing dreams from the rag-bag of politics’ in his 60-point programme unveiled on Thursday. Instead of Hollande, ‘we need a strong France with a strong president at the helm,’ Gröhe said.

Merkel’s campaign entry is a double-or-quits strategy. By signalling her support for Sarkozy, a day ahead of a Brussels summit that will outline the new fiscal treaty intended to bind Europe together, Merkel will boost the president’s fortunes well before he has formally declared his candidacy. Both she and Sarkozy are banking on Hollande’s strong start petering out, a scenario repeatedly played out in French election campaigns, where early favourites often fade as polling day approaches.

Hollande says he would ‘renegotiate’ European leaders’ accord for a new fiscal treaty to reemphasise growth in Europe. He wants the European Central Bank to act more aggressively to damp down bond market speculation and favours governments mutualising borrowing through Eurobonds – measures that Merkel hitherto has sturdily opposed.

Merkel may have calculated that, if Sarkozy wins, his evident debt to her will make France more compliant to German policy requests. However, if Hollande maintains his early lead and triumphs in May, Germany can expect no favours from France. Such political calculations – as well as straightforward differences in party political allegiances – have normally prevented French and German leaders from joining national campaign trails in each other’s political backyards. Merkel’s status gives her the leeway to take risks that others would shun.

Meanwhile, one clear-cut result of the Merkel-Sarkozy alliance will be to sideline still further David Cameron, the UK prime minister. Always somewhat precocious in appearance, Cameron has taken on the air of an insufferably British schoolboy, taunting the straight-laced but thin-skinned teacher of home economics, Frau Angela Merkel. At the Davos conference last week, Cameron poured scorn on flaws in the euro currency system. He claimed France and Germany needed to adopt British precepts by taking ‘bold and decisive’ steps to solve the debt crisis. Exactly where Cameron gets his jaunty self-confidence is not clear. According to latest IMF figures, Britain’s fiscal deficit last year was 8.6% of GDP, against 10.4% in the recession year of 2009, whereas the deficit across the euro area was a much healthier 4.3% against 6.5% in 2009.

If Merkel’s go-for-Sarkozy gamble pays off, she will achieve a multiple victory: keeping a grateful incumbent in the Elysée Palace, strengthening the forces holding the euro together, and scoring points against her own domestic Social Democratic opposition. An additional bonus would be to wrong-foot the British prime minister by showing she can carry out her own policies in her own time without heeding advice from abroad. 

Starting French campaign, Socialist candidate Hollande pledges: ‘My adversary is finance’

‘Germany will not remain strong in a weak Europe, and it will not remain rich in a Europe that is poor’

François Hollande, the candidate for the Socialist party in France who is leading the opinion polls ahead of the presidential election on April/May, proposed on 22 January sweeping reforms of the European and French financial systems to combat speculation and restore growth. In particular, he suggested splitting the investment and commercial banking operations of French banks, similar to the recommendations of the UK Independent Commission on Banking last year.
 
In the opening speech of his election campaign, Hollande – addressing 10,000 supporters at Le Bourget north of Paris – declared his ‘real adversary’ in the poll was ‘the world of finance’. Although pledging a ‘new relationship of truth and equality’ with Germany, Hollande outlined many policies that counter the present line of the centre-right coalition government in Berlin, including common Eurobonds for euro members and new measures against speculation by the European Central Bank.
 
If Hollande wins the election, the stage is set for an intriguing re-run of tensions between France and Germany in May 1981 when François Mitterrand became the first Socialist president of the Fifth Republic with economic policies that put him on a collision course with Chancellor Helmut Schmidt in West Germany.

The following is a translation of a key passage on the economy and Europe from Hollande’s 105 minute speech.
 
‛The financial crisis has destabilised governments. The markets have gained universal rights, thanks to huge public debts. Europe cannot protect its currency against speculation. Our country faces record unemployment. It is sinking down into recession and austerity. Doubt is on the march. I see it every day. It weighs down Europe. It nurtures distrust of democracy itself. It spills over into indignation at injustice, at the limits of policy, at the indecency of the rich.

Before spelling out my project, let me tell you one thing. In this battle that is joined, I will reveal who is my opponent, my true adversary. He has no name, no face; he belongs to no party; he will never declare his candidature. He will not be elected, yet he governs. My enemy is the world of finance. Before our eyes, in the past 20 years, finance has taken over the economy, society, and even our lives. It is now possible, in a split second, to move astronomical amounts of money, threatening the very fabric of states.

What was once merely an influence has become an empire. And, far from being diminished, it has been strengthened further by the crisis spawned on 15 September 2008. Confronted by the force of finance, the pious promises of regulation, the incantations of ‘never again’ have come to nothing. Successive G20 meetings have produced no tangible results. In Europe, we have seen 16 ‘last chance’ summits, each postponing final resolution of the problem. Banks, rescued by the states, now eat the hand that fed them. Rating agencies, rightly criticised for not spotting the sub-prime crisis, determine the fate of leading countries’ sovereign debts, creating bogus justification for increasingly painful austerity. And the hedge funds, far from having disappeared, spread the spores of destabilisation attacking us all. Thus has finance been unleashed: freed from all rules, from all morality, from all control.

With this in mind, I can show no mercy to the five-year presidential term now coming to an end. But that is no longer the issue. The judgments speak for themselves. Started in torment, the presidency ends in turmoil. Weighed down by tax breaks for the wealthy, the term finishes with tax increases for everyone in France. Opened with a promise of return to full employment, it concludes with record numbers out of work. Not to mention the deficits, the debt, the de-industrialisation, the demolition of public services, including throughout our schools.

One word sums up this presidency: degradation. Everything has been downgraded. I’m not speaking just of the credit rating. I do not even speak of the public accounts. I'm talking about living conditions, about social behaviour, about the entire situation of the country. On top of injustice in choice and inconsistency in decision-making, we have endured seizure of power and collusion with the powerful, with the ultimate paradox that the desire for omnipotence has brought the most abject confession of failure. That is why I want to change not just a president, a government or a majority. We must go much further: we need to provide our country with a change of policy, a change of perspective and a change of dimension.

If finance is our enemy, then we must confront it with our own means, first of all on our own territory, tempered neither by weakness nor by lack of realism, believing it will be a long battle and a hard test, but one where we will demonstrate that we, too, are armed for the struggle.
 
Defeating the forces of finance will start with a law that will oblige banks to separate credit activities from speculative investment banking. No French bank will be allowed to operate from a tax haven. Toxic financial products that bear no relation to the needs of the real economy will be banned, pure and simple. Stock options will be cancelled, and we will bring in limits on bonuses. Finally, I propose a tax on financial transactions, not simply a restoration of stamp duty, which was removed a few months ago – so much for consistency! No, I will propose a real tax on financial transactions, along with those in Europe who stand ready to implement them with us. I propose, too, if we wish to avoid being judged by rating agencies of questionable legitimacy, that we set up, at a European level, a public rating agency.

The other point with respect to finance concerns Europe. The euro area is being dismantled before our eyes. France must recover, once again, the ambition to change the direction of Europe. We must convince and drive forward our partners. I am often asked: ‘But how will you persuade your allies in Europe to agree, when the outgoing president was unsuccessful?’ I answer: power to convince our neighbours will come from the power of the French vote. The destinies of Europe and France are linked; the grandeur of France cannot be separated from the force of Europe. We need Europe; but it should help us overcome the crisis, not impose endless austerity leading to a spiral of depression.
 
Discipline and commitment are needed for debt reduction. But it is growth that will get us there more surely. That’s why I will propose to our partners a pact of responsibility, governance and growth. I will renegotiate the European treaty stemming from the agreement of 9 December to forge the dimensions it lacks - regarding coordination in economic policies, in industrial projects, in reviving public works in energy, and in instruments to combat speculation: a European fund that will have the means to act in the markets with the intervention of the European Central Bank, ultimately serving the fight against speculation.
 
I will act to create Eurobonds to pool a portion of sovereign debt, to finance large projects. Because that is the meaning of the European project, I will defend a system of democracy that involves national and European parliaments in decisions affecting the states. I will propose a new trade policy in Europe that will prevent unfair competition, setting strict rules in matters of social affairs, the environment, and reciprocity. This will be complemented by an environmental tax on European imports. I will continue to act for a fair euro-dollar exchange rate. I will not accept that the Chinese currency remains inconvertible at a time when the country that is now the world’s biggest exporter registers surpluses without ever facing a revaluation.

Europe has many faults, I know. Yet, at the same time, it is our common good. We must defend it, because this is what Europe needs and deserves. I say this as a true-hearted European: What is lacking in Europe is movement, but not towards any kind of Europe. We need movement towards a Europe of growth, towards a Europe of solidarity, to a Europe of protection. It is France’s vocation to build that with Germany and with other countries willing to accompany us.

No major challenge facing Europe can be resolved without the pact of friendship in equality that the French and Germans have developed after the war. I therefore propose to our German friends a new relationship of truth and equality. In turn, they should show solidarity. Germany will not remain strong in a weak Europe, and it will not remain rich in a Europe that is poor: that is the truth. I know that many in Germany understand this. But, on our side, we must make efforts to increase competitiveness and to bring about fiscal justice. This is the covenant that we must forge to open a new cycle in Europe, one of cooperation in economics, industry and energy between our two countries. That is why, if I am awarded the mandate, in January 2013 – just a few months after the date of 6 May and half a century after De Gaulle and Adenauer’s founding dynamic act for both our countries - I shall propose to the Chancellor of Germany a new Franco-German Elysée Treaty.’

Germany sticks to stability

Policy in Berlin: ‘Keep calm and carry on’

By David Marsh

German Chancellor Angela Merkel will mount a stout defence of soundness, solidity and stability when she opens the Davos conference in Switzerland this week. Although sentiment on European bond markets improved last week, her statement represents only the tip of a very spiky iceberg towards which the monetary ship of the European single currency may still be steaming. The imbroglio around a barely-avoidable Greek sovereign default could soon take on a nightmarish hue. 

At  worst,  in a few weeks or months, part of economic and monetary union (EMU) may find itself in a legal and political limbo,  with one smallish but important country, Greece, hooked on the fiendishly difficult question of whether or not it is legally and constitutionally able to leave the euro. This would be the direst outcome of a Greek default. It is one that governments in most euro members (as well as, probably, most leading Greek politicians) desperately wish to avoid.  But, through a complex concatenation of events, such a result may be growing inevitable. 

While these matters are being played out, the German motto will be ‘keep calm and carry on.’ Another part of Berlin’s strategy will be to show maximum restraint and sensitivity towards France as the Paris government comes to terms with the setback of the Standard & Poor’s downgrade and Nicolas Sarkozy’s rocky ride in the opinion polls ahead of the April/May presidential elections. 

On present opinion poll readings, Sarkozy will be dispossessed on 6 May by François Hollande, the Socialist challenger, who on Sunday 22 January – while ostensibly backing the European project – spelled out policies that in many fields directly counter the German government’s priorities. He called for more German measures to expand its economy and help hard-pressed neighbours, underlining: ‘Germany will not remain strong in a weak Europe, and it will not remain rich in a Europe that is poor.’ (See separate article - Hollande: ‘My Adversary is Finance’)

Germany is grimly aware that some of the issues that could propel Greece down a default-and-exit route, chiefly the hard-line stance taken by some Greek bond-holders in rescheduling negotiations, are outside the decision-making sphere of governments. The air in Berlin is thick with foreboding about the possible political effects of a Greek exit, including a spillover into Europe’s relations with Turkey, fragmentation in Nato and further destabilisation of North Africa. 

Although the Berlin government does not wish it to happen (and also doesn’t believe it would help Greece’s near-intractable problems), Germany knows it cannot rule out a Greek decision to quit the euro, a path for which, at the European level, there is no legally-valid mechanism. The Germans believe that, unless they have a ‘Plan B’ to deal with a possible Greek exit, they would be open to blackmail as Athens tries to extract additional concessions. 

If the dual development of a Greek default associated with a decision to leave EMU were to take place, Germany believes there is just enough ‘ring-fencing’ in the system to prevent such an outcome creating catastrophic contagion among other peripheral countries and destroying the single currency.

In the meantime, do not expect Angela Merkel or any other German representative to make any public concessions towards more money, more guarantees or more leeway for misbehaving states in EMU - least of all for Greece. Anyone speaking to senior German officials and parliamentarians in recent days will gain the impression that Germany is not prepared to bend from the iron-clad path of stringency. 

For three reasons. First, the Bundestag has already gone to the limit in extending funding and guarantees (important bits of which still have to be voted through by German legislators) for euro bail-out mechanisms. 

Second, Berlin believes the European Central Bank, with its purchases of €217bn worth of peripheral bonds (as of 13 January) and its enormous market operations to channel cheap three-year liquidity to hard-pressed banks, has already gone quite far enough in bending the rules of orthodox central banking behaviour. Both former German central bank president Axel Weber and former ECB executive board member Jürgen Stark resigned over the past 12 months because of the bond purchases. Spanish and Italian banks’ ability to take cut-price loans from the ECB, and then engage in profitable round-tripping by purchasing their own governments' bonds, is already attracting allegations of unfair competition from hard-pressed, partly German government-owned Commerzbank.

Third, the hard-line German approach is demonstrably working, shown by the successful application (so far) of Merkenomics by Italian Prime Minister Mario Monti or the espousal of German-style precepts in Madrid, Lisbon and Dublin. For all technocratic Prime Minister Lucas Papademos’ efforts, the Athens government’s poor progress in executing reforms, and Papademos’ manifest inability to enforce his will over a government composed mainly of party place-holders, are seen as marking Greece as a highly negative special case. 

In Rome, the Germans say things are different. If the Bundesbank had given into pressure and allowed the ECB to have carried out unlimited purchases of Italian bonds during the summer, Silvio Berlusconi would still be in charge.

Against this delicate background, the Germans are well aware that some of their demands may be unfulfillable. The threefold set of German requirements – that Greece continues with harsh structural reforms, that it agrees with private creditors to take much larger write-downs on their bond exposure to allow Greece to reduce its overall outstanding debt to 120% of GDP, and that Athens stays in the euro – may turn out to be an innately contradictory ‘Impossible Trinity’. In that case, a Greek euro exit may be the only way out. But, Berlin says, that could come as a solution only if it was decided and carried out by the Greek parliament and government, and not dictated by the Germans or anyone else.   

And then there were four…

After the French downgrade, things could start to go downhill in Europe: Five top-rated European countries outside EMU – and only four inside

By David Marsh

Seldom in monetary history will an event so frequently forecast and so intrinsically banal have triggered such far-reaching consequences. Standard & Poor’s downgrading of France from Triple A status is of monumental significance. From now on, things could start to go downhill in a big way.

Forget the ringing declarations of Franco-German solidarity, the ritual denunciation of rating agencies as Anglo-Saxon dark forces and the stalwart Parisian affirmations of 'business as usual'. Put to one side, too, any comparison with the US downgrade in August (since when American Treasury yields have been in free fall).

Developments in Europe are (and have been for 150 years) the result not of absolute rankings, but of relative positions, especially between Germany, Britain and France. Much will change as the result of Friday's S&P ratings drop for France and eight other countries. Probably, very little of it for the better.

The movie we're watching is actually an old one. Each country is reverting to type. S&P’s stripping  of France and Austria from the top notch list, the downgrading of Spain, Italy and five other members of economic and monetary union (EMU) and the maintained top credit rating for Germany and the Netherlands confirm the 'winner takes all' polarisation of the euro area. The Germans will become not more generous, but more self-righteous, because they fear that, if they stray from the path of orthodoxy, France's fate will be theirs.

There are now five top-rated European countries outside EMU – Denmark, Norway, Sweden, Switzerland and the UK – and only four within – Germany, Finland, Luxembourg and the Netherlands.  The first group (because of Germany’s preponderance) still has a higher population – 104m against 90m. All the same, at a stroke, EMU’s claim to represent the best of Europe in strength and stability has been washed away.

Turning the EFSF rescue fund into a useable financing vehicle will become immeasurably more challenging now that its Triple A rating is all but gone.  

Watching  from the side-lines, knowing that they may be caught up in the debacle but will not themselves be in the midst of the wreckage, the British and Americans raise supercilious eyebrows and say, 'Sorry, but we told you so.'

The strongest shockwaves are rippling across France, only slightly more than three months ahead of the presidential elections. Even though kindly old S&P made sure the news was not a surprise - two months ago it helpfully released a precursor of the downgrade announcement - the loss of the Triple A accolade brings to a halt France's decades-long effort to achieve sustainable parity in its monetary and financial relationship with Germany.

Germany is in the ascendancy - and looks like staying there. Up to the events of the last few days, recent developments looked relatively satisfactory. The new Spanish and Italian governments were knuckling down to austerity programmes. The European Central Bank was dispensing liquidity to problem-hit banks. Leading French officials openly welcomed the tilt to German-style discipline by Madrid and Rome, saying this could make Berlin more compliant in other areas of European policy. Now the room for optimism is fading fast.

Marine Le Pen, the leader of France’s ultra-right National Front and François Hollande, the Socialist candidate, slightly ahead of President Nicolas Sarkozy in the opinion polls, will reap considerable political capital from the S&P decision. As a result, the whole of French politics will move towards the nationalist end of the spectrum. Not good news for anyone who still thinks EMU can hold together without major disruptive changes in coming months.

Hildebrand does the right thing

A question of standards and judgment

By David Marsh

Philipp Hildebrand is an intelligent and resourceful man. Pleasant and thoughtful, too. He has done the right thing by departing as chairman of the Swiss National Bank. He has certainly demonstrated flaws. His resignation statements suggest he still doesn’t understand what he did wrong. I know and like Hildebrand. But, on his past days’ showing, I wouldn’t want him anywhere near my defence team if I got into a legal scrape.

At a time when central banks all over the world have become far more active and much more exposed to publicity as a result of the financial crisis and its aftermath, central bankers have to show almost superhuman probity in all their financial dealings. This, manifestly, Hildebrand did not do. Still more importantly, he made errors of judgment which, if transferred to larger spheres, would cast doubt on whether he has the right mind-set to make extraordinarily difficult and complex decisions in the world of finance.

One should leave aside for the moment whether or not the leaking of the Hildebrand family’s foreign exchange transactions was politically motivated. (Certainly, in its later and most destructive phases, it was). Beyond this, public officials – or indeed almost anyone in the public eye – have to ask themselves a constant question: If this particular deal became a matter of public knowledge would I be embarrassed or worse? If the answer is Yes, then the simple solution is: Don’t do it. The motivation for the leak is less important than the fact that Hildebrand did not live up to standards that reasonable people would expect.

There are some specific points, too. First, not realising that discussing and (tacitly) authorising a large transaction by his wife to buy dollars on 15 August at a time when the SNB must have been intensively discussing its own intervention policy shows lack of judgment and foresight.

Second, not closing out the transaction immediately, which would have limited the damage and prevented any large-scale profits or losses, was an error. The e-mails released by the SNB indicate that Hildebrand was discomfited by confirmation that the trade took place and was aware of the compliance implications.

Third, once the decision was made not to close the transaction immediately, why did the Hildebrands add insult to injury by closing out the trade in October (after announcement of the SNB’s policy of ‘limitless’ intervention to hold down the Swiss franc) rather than keeping it open, which would have at least meant that gains would not have been crystallised? One of the documents released by the SNB says that Hildebrand told his banker Felix Scheuber at Bank Sarasin that ‘any currency position in the account must be held for at least six months in line with our internal SNB rules on personal investments’. The dollar sale in October appeared to have breached this rule.

Fourth, arranging for e-mails allegedly to be used for his defence to be released, when in fact they helped to harden the allegations against him, demonstrates naiveté, carelessness or over-confidence – perhaps a combination. This is all the more puzzling because Hildebrand is well aware of the lack of care in separating personal from professional activities that helped bring down Ernst Welteke, the previous president of the Bundesbank, in a probably less-serious conflict of interest in 2004.

Fifth, it is clear from the e-mail correspondence that the Hildebrands have a significant and reasonably actively traded portfolio in Swiss quoted shares. It could be that none of these shares are held in the SNB’s own portfolio. But at the very least it appears incautious to be such an active personal player in equity markets when his own publicly-owned institution has also, under his stewardship, become a large owner of equities.

Hildebrand’s defence yesterday that his ‘dollar lifestyle’ made such dealings near-inevitable smacks of special pleading. The fact remains that (for totally different reasons) a lot of central bankers have resigned recently – Axel Weber from the Bundesbank and Jürgen Stark and Lorenzo Bini Smaghi from the ECB – because of the diverse pressures and burdens of office.

Hildebrand will, of course, be back. The best example for him to bear in mind is that of Rupert Pennant-Rea, the foreign editor of the Economist, who was catapulted in a remarkably unprepared way to the deputy governorship of the Bank of England under the John Major government and had to resign in 1995 over a somewhat lurid extra-marital affair. He had since rebuilt a successful career in private business.

Here you have the nub of the matter. British central bankers resign over sex, Swiss over money. At least some things are predictable these days.

In April, the cruellest month, France and euro may face crunch

Fatal political contradictions between Sarkozy and Merkel: French and German politics are moving in diametrically opposite directions

By David Marsh

The lesson of history is that French elections early in the year often coincide with financial unrest. Spring 2012 may prove to be particularly bloody. For France and perhaps for the rest of Europe, April may in fact be ‘the cruellest month’. Of the three principal candidates heading to fight the French presidential elections, the first round of which is on 22 April, the most pro-euro contender appears to be, somewhat astoundingly, the incumbent, Nicolas Sarkozy.
 
Ahead of a fresh meeting today in Berlin between Sarkozy and Angela Merkel to discuss euro rescue issues, there is a fateful, self-fuelling contradiction between the political positions of the French president and German chancellor. French and German politics are moving in diametrically opposite directions. The more Sarkozy – himself a strong doubter regarding fundamental questions at the heart of economic and monetary union (EMU) – gives in to German pressure for stronger external controls over the French economy (such as in budgetary matters), the less popular he will be in the election battle.
 
Strong French action, urged by the Germans, to bear down on the budget deficit in the face of a rapidly weakening economy will add to Sarkozy’s problems with the voters. All of this will increase the likelihood that the whole of France will shift in coming months towards an overtly nationalistic, anti-euro stance.
 
On the other hand, the more that Merkel makes concessions towards Sarkozy’s electoral sensitivities, in the hope that he remains in power after the second round of the election on 6 May, the more pressure she will herself face at home from growing euroscepticism in her own country. It is a convoluted tussle from which neither politician can emerge as a clear victor – and where both may lose.

None of this will make EMU supporters sleep easily as April approaches. Five years ago, as finance minister under President Jacques Chirac, Sarkozy candidly revealed his views about the historical experience of the ‘hard franc’ which laid the groundwork for France’s entry into EMU in 1999. 'With its exorbitant interest rates and over-valued exchange rate, the monetary policy of the 1990s penalised investment, lowered the competitiveness of French products and French labour, led to an explosion in unemployment and provoked recession. If France had practised the same monetary policies as England at the beginning of the 1990s, then our public debt would not be much more than theirs.’

Sarkozy wrote these lines – in his campaigning book ‘Ensemble’ – at a time when the bitter memory of running the French budget ministry in 1993-95 (under Prime Minister Édouard Balladur) was still on his mind. After Britain and Italy left the exchange rate mechanism (ERM) of the European Monetary System in September 1992, and other countries such as Spain and Portugal devalued, France was left with no means of escaping from triple predicament of high interest rates, an over-valued franc and an economic slowdown – prompting considerable budgetary strains that caused Sarkozy great political pain.
 
Sarkozy’s view in 2007 is unlikely to have changed over the past five years. If France had left the ERM and allowed the franc to float and interest rates to fall, then it would have been a great deal better off. Like many Frenchmen, Sarkozy saw EMU as the means for France to rescue itself from German domination after Germany’s reunification in 1990. Unfortunately, the sacrifice does not seem to have produced the desired results. While giving full rhetorical force in the past year or so to shoring up the edifice of the single currency, Sarkozy has been frustrated by EMU’s failure to allow France more leeway in its fraught relationship with an ever more economically potent Germany.

As campaigning gets under way, both François Hollande, the Socialist challenger, who is leading in the opinion polls, and Marine Le Pen, the National Front leader, have declared their hand as euro-sceptics. France’s economic vulnerability has been a central feature of the election campaign so far. Hollande has said he will renegotiate the euro rescue accord reached in Brussels as the pre-Christmas summit. He wants greater powers for the European Central Bank (ECB) and for member states to issue joint Eurobonds – measures to which Merkel is implacably opposed. Mme Le Pen, daughter of the populist National Front founder Jean-Marie Le Pen, and currently running No. 3 in the opinion polls after Hollande and Sarkozy, has said she would quit EMU altogether and return to the franc.

Beset by high unemployment and low growth, Sarkozy seems likely, based on current opinion polls, to become the first single-term president of France’s Fifth Republic since Valéry Giscard d’Estaing in the 1970s. There are already a number of potential flash points in the 2012 world economic calendar, with the Easter weekend earmarked by some as a potential time for Greece to leave the euro and bring back the drachma. The combination of Greek strains and French elections could prove particularly inflammable. 

Beset by high unemployment and low growth, Sarkozy seems likely, based on current opinion polls, to become the first single-term president of France’s Fifth Republic since Valéry Giscard d’Estaing in the 1970s. There are already a number of potential flash points in the 2012 world economic calendar, with the Easter weekend earmarked by some as a potential time for Greece to leave the euro and bring back the drachma. The combination of Greek strains and French elections could prove inflammable. 

ECB reshuffle shows Draghi will be his own man

Key portfolios go to Cœuré and Praet

By David Marsh

As economic and monetary union (EMU) prepares for its most bruising year yet, the European Central Bank is battening down the hatches with personnel moves that underline President Mario Draghi’s determination to be his own man.

By turning down Germany’s request for the ECB economics portfolio to be handed to newcomer Jörg Asmussen, former state secretary at the Berlin finance ministry, the former Banca d’Italia chief is wisely breaking with the 13-1/2-year-old year tradition that the post should be held by a German.

Instead, Peter Praet, an experienced Belgian economist who was actually born in Germany, takes over the job, effective immediately. The post became free following the resignation of the previous incumbent, Jürgen Stark, the former Bundesbank deputy president who left at the end of 2011, above all in protest against ECB bond purchases of embattled countries’ debt.

Another key post, looking after the ECB’s payments infrastructure, which will come under great strain if there are changes in EMU’s membership in the coming period, goes to Benoît Cœuré, a former  top French finance ministry official. He took over on 1 January from the departed former Italian government and central bank official Lorenzo Bini Smaghi.

Asmussen will be responsible for international and European relations. He will be the ECB’s representative at key international meetings and attend with Draghi or his deputy Vítor Constâncio meetings of European finance ministers and heads of government. Asmussen will inevitably be in Draghi’s shadow for much of the time. But he is likely to support the ECB president’s newly-affirmed determination to ensure governments live up to their own responsibilities in healing EMU’s strains, rather than calling on the ECB to shore up problem-hit governments through bond purchases.

European bond markets will remain under pressure ahead of key debt auctions in coming weeks. Pantelis Kapsis, a Greek government spokesman, did not help matters when he said yesterday that Greece would leave the euro unless the latest hotly-contested Greek rescue package was agreed by all participants. This is yet another sign that the once taboo issue of a country leaving the single currency has now broken through to the surface.

By deciding against giving either France or Germany the key economics post, Draghi has watered down the former link between this position and the Bundesbank. However, the new Italian president has also underlined ECB independence by showing resistance to undue government interference.

Stark, who before he moved to the Bundesbank previously held the finance ministry state secretaryship vacated by Asmussen, was considered for the ECB chief economist post in 1998, when the ECB was set up. But the German government decided to recommend for the job then Bundesbank chief economist Otmar Issing, on the grounds that the ECB would otherwise have too strong a connection to the German government.

Intriguingly, by deciding that the chief economist post should now go to an experienced Belgian rather than a German, Draghi has demonstrated a similar desire for independence. But, with the emotional link between the ECB and the Bundesbank now less strong, Draghi has also made it easier for the Berlin government to take coming difficult decisions on the euro from a clear-headed economic rather than an overtly political point of view.

Inconvenient Euro-truths: Ten facts you need to know about Germany, Britain and EMU

As UK builds trade ties with EMU, Germany is integrating with non-euro area

By David Marsh

The welter of publicity about the latest European Union summit and the supposed ‘isolation’ of the UK from the rest of Europe demonstrates a lack of knowledge about some central features of economic and monetary union (EMU). British Prime Minister David Cameron’s refusal to agree a euro rescue plan built around a new European treaty, although important in UK political terms, is almost completely irrelevant to the longer-term discussions on the euro’s future.  

Below are 10 key facts on the present position of the euro that many people overlook. Perhaps the most salient point concerns the direction of trade flows - the opposite of what you might expect. A classic case of ‘man bites dog’. The UK, a resolute non-member of the euro, has been busy over the past decade building trade ties with EMU. Yet Germany, in whose name and with whose currency monetary union was built, has been successfully integrating with the non-euro area – with fast-growing states in non-EMU Europe and Asia – and is doing progressively less trade with the euro bloc. Germany’s relative trade links with the peripheral countries have fallen particularly sharply. Considering these countries’ financing requires so much treasure from the taxpayers of Germany and other creditor countries, the imbalance between falling trade and rising demand for finance is at the bottom of the growing reluctance of the creditor countries to pledge more money to solve the conundrum. Confused about all this? Now read on.  

1. The outline agreement achieved on Friday in Brussels towards greater fiscal discipline in the euro bloc is a step in the right direction but is neither necessary nor sufficient to bring calm to EMU. At the root of the euro upheaval is a balance of payment crisis caused by the cumulative effects of a 13-year-old one-size-fits-all monetary policy and a fixed exchange rate for a collection of disparate countries in very different stages of economic and structural development. The vicious circle joining low interest rates in peripheral countries (Greece, Ireland, Portugal etc.), higher growth and inflation, lower competitiveness, large payments deficits, high foreign borrowing, higher bond market interest rates and eventual market distress for these countries is (belatedly) well understood. How to break out of it is not.
2. Financing problem countries’ continued large-scale current account deficits and capital outflows is the most important task for the euro area, being accomplished principally by very large balance of payment financing organised by European central banks, led by the Bundesbank, which has now chalked up claims of nearly €500bn in balance of payments financing under the intra-EMU Target system. The weekend agreement had very little new to say about financing apart from moves to bolster International Monetary Fund resources and talk of more money next year for Europe’s two bail-out vehicles. That’s helpful but not enough.
3. In Brussels, President Nicolas Sarkozy pretended to be indignant at Cameron’s refusal to back a thoroughgoing euro treaty for fiscal discipline based on central control of budgets throughout Europe. In fact, Cameron has helped him out of a tight spot. In recent weeks, Paris has cold-shouldered Berlin’s proposals to use centralised Community institutions to police stringent fiscal rules. Over 50 years of on-and-off argument with Germany over European monetary arrangements, France has always favoured inter-governmental accords over binding rules set by supranational authorities. So the French president has every right to be pleased that Europe now looks headed towards a less rigid framework of fiscal coordination where sanctions against infringement are not truly automatic but are subject to national horse-trading. Furthermore, as a result of Cameron’s cack-handed negotiating tactics, Sarkozy can now cast Britain as the scapegoat for blocking a treaty he never wanted. Vive David Cameron! Give that man the Légion d’honneur! Cameron has walked right into a trap the French president has sprung for him. No wonder Sarkozy was smiling when he left Brussels.
4. Contrary to the popular mythology peddled above all by the German government, high budget deficits in the peripheral countries have not been the main cause of the euro malaise. In nearly all cases budget deficits have arisen in recent years as the result of economic imbalances in the private sector caused earlier on by unhealthily low interest rates and easy EMU-induced access to international capital. In the first nine years of EMU, from 1999 up to and including 2007 when the financial crisis broke, Italy registered an annual average general government deficit of 2.9% of GDP against 2.6% for France and 2.2% for Germany. Greece showed a worse-than-average 5.5% deficit but Portugal’s average was a relatively moderate 3.6%, while Ireland and Spain produced surpluses on average of 1.6% and 0.2% respectively. This relatively good performance continued right up to the moment the financial crisis broke. In 2007, both Ireland and Spain ran surpluses – and so would not have been subject to sanctions under the newly-outlined ‘fiscal compact’.
5. In all cases where countries faced borrowing foreign difficulties, a far more reliable early warning of forthcoming problems stemmed from burgeoning current account deficits. This was an indicator that the European Central Bank studiously ignored until well after the outbreak of the crisis. In August 2007, the ECB famously published a 12-page analysis of world current account imbalances. It didn’t mention with one word the burgeoning deficits ran up the previous year within the euro area (Greece 11.4% of GDP, Portugal 10.7%, Spain 9.0%, according to the OECD) as well as the large-scale surpluses (6.2% for Germany, 9.3% for the Netherlands). Despite the upheavals since 2007, and despite deep recession in the peripheral countries, the basic picture of intra-EMU current account imbalances remains in place, albeit in modified form. In 2011, according to the OECD’s latest forecasts, Germany and the Netherlands will run current account surpluses of 4.9% and 7.8% respectively, while Greece, Spain and Portugal will produce deficits of 8.6%, 4.0% and 8.0% respectively. As the French say: the more things change, the more they stay the same.
6. The UK is not part of the euro, under an opt-out agreed at the Maastricht summit 20 years ago – when Britain was also said to have been isolated. In the meantime, in spite of fast European trade growth with China, the UK has upheld its position as the most important trading partner of the euro bloc, with €187.4bn in total trade with the members of the single currency – visible goods, exports and imports - in the first half of 2011, against these countries’ €186.9bn of trade with China and only €118.7bn with the US, according to ECB figures. Despite the political rhetoric and undoubted strains resulting from the Brussels summit, in trade, at least, Britain is (and will probably remain) at the heart of Europe.
7. Britain’s trade with Germany since the single currency started in 1999 has risen disproportionately compared with Germany’s exports and imports with EMU members. In the first half of 2011, according to Bundesbank figures, the UK accounted for 7.2% of German exports and 5.9% of its imports. The equivalent figures for German trade with France were 9.4% and 7.4%; with Italy, 6.0% and 5.3%; with Spain, 3.3% and 2.6%. German exports to and imports from the UK both grew an annual average 7% during the period 1998 to 2011; German exports to France also rose 7% annually on average, but imports grew much more slowly, at only 4% a year.
8. Britain’s trading integration with Germany has been even more marked since Britain’s so-called isolation at Maastricht in December 1991, when UK Prime Minister John Major opted out of EMU. German exports to the UK between 1990 and 2011 grew 168%, while imports went up 215%. By contrast German exports to France increased 133%, with imports rising 177%.
9. At the same time as the UK has been stepping up its trading links with a currency bloc of which it is not part, Germany has been busily integrating in the other direction. The German move into the non-euro area reflects German companies’ heavy leaning towards globalisation as well as the beneficial effect of a relatively undervalued euro helping exports. Comparing 2011 with 1998, Germany’s exports to EMU members now make up only 40% of its overall foreign sales, against 47% before the euro was introduced. Exports to Asia and non-EMU Europe (headed, of course, by China but also including fast-growing countries in Europe like Poland, Russia and Turkey) have risen from 39% of total German exports before EMU was formed to 46% now. German diversification away from EMU trade has been even greater for imports, with Germany’s purchases from EMU countries now down to only 38% of the total import bill, against 46% of the total in 1998, while imports from Asia and non-EMU Europe have risen to 50% of the total from 40% in 1998.
10. Declining German trade ties within EMU, in particular with the now-low growth periphery, provides the single biggest reason why, in the long-running wrangles over EMU’s future, Chancellor Angela Merkel can dig in her heels about providing more aid to countries that are progressively becoming less creditworthy, more tiresome and less relevant. Within Europe, according to the Bundesbank, in the first six months of 2011, Germany carried out €103bn worth of total trade (exports and imports) with the five euro problem countries, Italy, Spain, Portugal, Ireland and Greece. Over this period, Germany registered nearly twice that trade volume - €189bn - with five big European trading partners outside EMU – the UK, Poland, Russia, the Czech Republic and Sweden. Germany’s trade ties with this latter group are likely to carry on rising at a higher pace than those with EMU countries. This is part of a general transition by German companies towards markets of the future which may well see not Britain but smaller uncompetitive euro members feeling progressively lonely in coming years.

Draghi, Weidmann fit the landscape

Central bankers have fallback in case things go wrong

By David Marsh

At a time of monumental transition in Europe’s 13-year-old experiment of economic and monetary union (EMU), the destinies of the two figures at the top of Europe’s most powerful central banks, Mario Draghi and Jens Weidmann, are inextricably intertwined. Draghi took over the presidency of the European Central Bank on 1 November, Weidmann at the Bundesbank on 1 May. 

As Chancellor Angela Merkel and President Nicolas Sarkozy meet in Paris today at the start of yet another crunch week for the single currency, Draghi and Weidmann appear to fit into the troubled monetary landscape better than their predecessors. 

Relations between the previous incumbents, Jean-Claude Trichet and Axel Weber, became frosty in the extreme. The two newcomers – the former a 64-year-old veteran of international central banking, the latter a 43-year-old wise-headed, young-shouldered freshman – have reconciled their views by speaking the same steely yet down-to-earth language and declining to cross the border line between central banking orthodoxy and high-level European politicking.

Thrust into their positions by the unpredictable currents of European history, the two central bank leaders are better-suited to shape events positively. Draghi was the former governor of the Banca d’Italia, Weidmann the economic adviser to Angela Merkel after an earlier spell as head of the Bundesbank’s monetary department. 

EMU is about to change decisively. Either in the direction of a much closer political and economic association of convergent, like-minded nations, or towards fragmentation between stronger and weaker members, with countries such as Greece manifestly unable to match up to exacting German-style standards likely to split off from the others. Probably the two trends will complement and overlap each other. As Draghi made clear in his appearance at the European Parliament on Thursday, the ECB  may be able to help cushion the transition with extra financial help for banking and bond markets – but only if governments do their job and come up with implementable, realistic plans for greater fiscal cohesion and discipline. 

Whatever the outcome, Draghi at the ECB and Weidmann at the Bundesbank can reset the ground rules at their central banks and  defend them against external and internal attacks. 

If, as a result of inevitable setbacks, a search for scapegoats starts, then neither Draghi nor Weidmann should find it too difficult to deflect blame from their respective institutions to those bearing the real responsibility for the mess, European politicians.

Despite the escalation of the crisis surrounding the over-borrowed peripheral countries, internal strains within the ECB and the Bundesbank are now ebbing, with fault lines among factions within the two institutions now much less exposed than before.

Trichet, a former head of the French Treasury and governor of the Banque de France, saw EMU as his own flesh and blood, an instrument for overarching political renewal in Europe, for which he had fought for many years. Draghi, Trichet's successor, is much less emotionally committed. He sees himself, and behaves, less like a missionary warrior, more as a manager employed to carry out a specific technocratic task as a non-elected civil servant, at the helm of an institution concerned exclusively with monetary policy that has no wish to extend itself unnecessarily into areas outside its responsibility or control.

Draghi uses fewer words than Trichet, will make fewer speeches, and is no friend of presidential pretension and protocol. He is unlikely to repeat Trichet’s tiresome practice of publicly rebuking politicians, either past or serving, for errors, omissions and misdemeanours. 

A similar development is underway at the Bundesbank. Had former Bundesbank president Weber not (wisely) decided, first, to renounce the opportunity to succeed Trichet at the ECB, and, then, to step down early from his Bundesbank post, Weidmann would not have moved so quickly into his present position - and Draghi not at all.

Draghi benefits from a powerful unstated benefit. Had Weber become ECB president, the German would have been hailed, in a reckless over-exaggeration of his actual potential, as a deus ex machina who would put the EMU world to rights. Draghi, as an Italian from a state undergoing enormous challenges within EMU, is on the whole underestimated. A less exalted advance billing can be of great advantage.

Similarly, Weidmann has refused to make much noise in public and offers quiet leadership rather than sound-bites. Insiders say that despite his mild appearance, this is a monetary wolf who will defend traditional Bundesbank policies with greater insistence and staying power than Weber. As in the ECB, where Trichet’s polarising and hectoring style led to internal confrontations, Weidmann now heads a more cohesive and united Bundesbank board.   

Weidmann and Draghi, in different ways and from different standpoints, will play their roles as guardians of monetary and fiscal discipline. They are prepared to go down fighting if the politicians don’t play ball. Draghi and Weidmann will live up to their responsibilities better if they do not seek to over-extend them into areas where central bankers have no place.

ECB may be ‘last one standing on a field of ruins’

By David Marsh

Who will blink first? In games of chicken on railway lines, at least one chicken ends up decapitated. The triple stand-off between the European Central Bank, European governments and the financial markets is building up to fever-pitch.  We appear to be heading for a re-run of the fateful times nearly 20 years ago – at the height of the September 1992 exchange rate mechanism crisis – when President François Mitterrand browbeat Chancellor Helmut Kohl into urging the Bundesbank, after much tergiversation, to defend the French franc. If the Bundesbank had its way in remaining on the sidelines while the markets sold down the franc, Mitterrand told Kohl, the Bundesbank would be ‘the last one standing on a field of ruins.’

Expect, therefore, at some stage in the dramatic days ahead, another confrontation between these two latter-day standard-bearers of Franco-German cooperation, President Nicolas Sarkozy and Chancellor Angela Merkel. This will no doubt come in the run-up to the next EU summit on 9 December, where optimism is rising that a package of measures on economic surveillance, European treaty changes, steps to fiscal union and IMF aid for Italy will encourage the ECB to loosen its euro purse strings.

As Sarkozy, Merkel and newly-annointed Italian premier Mario Monti made clear at their meeting in Strasbourg on Thursday, there’s no way that European governments can give instructions for the ECB to defend peripheral countries’ bond markets. Such pressure would be counter-productive, as even Sarkozy must recognise now. The cleverest action the politicians can take is to refrain from pressure on the ECB – and wait for events to take their toll.

The ECB, meanwhile, like a thin red line of Victorian soldiers under attack from Zulu hordes, is standing firm – yet remains ready to counter-attack when and if the going gets better. No one who has visited the ECB in recent days, however, can be unaware of the central bank’s immense irritation at the incapacity of European politicians to assemble sufficient firepower to defend monetary union at an earlier stage. In an ever more bitter blame game, the ECB is determined to avoid responsibility for the potential breakdown of Europe’s emblematic integration project.

The ECB feels it has done enough – and that politicians have been negligent in not responding energetically and quickly enough to numerous stopgap measures implemented by the central bank in the last 18 months to shore up the euro’s peripheral members.

The ECB formally warned European finance ministers a year ago that it could not guarantee European financial stability unless governments at least doubled the size of the EFSF rescue fund.

The message to finance ministers late in 2010, outlined by Nout Wellink, the former president of the Dutch central bank in a book published in the Netherlands, was placed on the agenda of a meeting of euro finance ministers under Jean-Claude Juncker, the Luxembourg prime minister, attended by Jean-Claude Trichet, then ECB president. Trichet angrily reported to the ECB’s decision-making council that the letter made no impression.

All this shows why ECB action to buy Italian and Spanish bonds has been relatively small-scale, pretty ineffective in stemming the rise in yields to unsustainable levels around 7%. As Italy and Spain are driven ever deeper in to the vicious circle territory of debt deflation, the ECB has some remedial measures up its sleeve. And these are all the more likely to be taken if Monti, as everyone hopes, prevails on the Italian parliament to decide fresh deficit cuts. As the most likely alternative to massive selective purchases of trouble-hit members’ bonds, the ECB has discussed broadly-based US- and UK-style quantitative easing in recent months. In this case, the ECB would purchase government bonds across monetary union in proportion to member countries’ GDP – meaning that German and French buying would prevail over Italian. That might bring some respite to monetary union’s weeks of turmoil – but no one knows whether it would be sufficient to steer Europe towards a solution.

As Euro dream turns sour, single currency may divide into two

Not more Europe, but 'more Euro' is the answer

By David Marsh

Technocrats in Europe must show they can act - and communicate

By David Marsh

T-Time in Europe. It's time for technocrats.  Lucas Papademos has become caretaker Greek prime minister. Mario Monti, the former European commissioner and president of Bocconi University, has been asked to form a government in Rome after the unlamented departure of Silvio Berlusconi.  Jürgen Stark and Lorenzo Bini Smaghi, important personalities on the board of the European Central Bank, are both leaving at end-December, well before expiry of their terms. Who knows whether some form of political office beckons for them? We will no doubt see and hear more of them in the New Year.
 
What do these erudite people have in common? They understand and enjoy speaking to the financial markets and economists. They’re good at formulating wise and sometimes witty sentences on monetary policies. Monti has steel as well as brains, as anyone can attest who had anything to do with him while he was taking on the German government over the state-owned Landesbanks during his time as Competition Commissioner.

Yet they're not very good at speaking to ordinary citizens. That’s not what they have been asked to do up to now. Well, at least for some of them, that’s now changing.
 
Lucas Papademos, a former governor of the Bank of Greece and vice-president of the European Central Bank, now has one of the most difficult jobs in world politics without experience in political office. Could a technocrat’s lack of a common touch be, to coin a phrase, his Achilles heel?
 
Anyone who expects technocrats to work miracles must ponder an essential fact. Economic and monetary union has been above all a “top down” project dreamed up by political and business leaders and pushed through without undue consultation or communication with the people. Establishing governments under technocratic leadership can therefore be no more than an emergency stop-gap pending the appointment of leaders with a democratic mandate to force through necessary reforms – or, otherwise, to face a future outside EMU.
 
Papademos is a delightful man, scholarly, pleasant, self-effacing, courteous, engagingly shy, a benign companion and an excellent listener (something he had to do a lot while Jean-Claude Trichet was giving press conferences). He has an excellent academic pedigree, especially in America. He has worked at the Federal Reserve Bank of Boston. His colleagues at the European Central Bank had only good words to say about him. The trouble is that he has no track record at actually getting things done in the political arena.
 
In his airy office at the European Central Bank four years ago, Papademos spelled out to me on two occasions in great detail and with considerable plausibility all the things that countries like Greece were doing wrong. He was particularly strong on the shortcomings of the ECB’s communications policy. The Greeks had not understood, he said, that, with entry into monetary union, the framework for their actions had fundamentally changed because they could no longer devalue the currency. Adjustment would have to take place in other ways.
 
I asked him: How much of his job was spent speaking Greek? How many times a month did he address his countrymen, in either large or small circles, to relay the important message that he was giving me in the comfort of his office? He didn’t do that at all, he replied. The ECB vice president’s rule was not to go to Greece on work-related occasions. He preferred to leave to his successor at the Bank of Greece the task of lecturing his countrymen on how they needed to improve their economy.

The problems stemming from this lack of communication were spelled out with unusual bluntness in a speech in Berlin last Thursday by Jürgen Stark, who announced his resignation from the ECB board in September but opted to stay on until the end of the year. 
 
In Berlin he was on excoriating form, lambasting the “political elites” for their failure to “communicate what needs to be done” and warning that the west faced a grave crisis from new alliances among the emerging market economies that are now the main creditors and engines of growth.
 
Now that the technocrats are in charge, at least temporarily, they'll have to show they're a bit better at communicating the need for unpopular measures than the failed political professionals they have replaced.

Clash of civilizations and the collapse of European credibility

By David Marsh in Singapore

Ten pieces of advice for Mario Draghi

By David Marsh

Mario Draghi, the urbane and experienced former governor of the Banca d’Italia, takes over today as president of the European Central Bank at a crucial time. The resolution of the Greek debt crisis has turned a corner after last week’s Brussels deal. This puts the spotlight firmly on Italy.  Here are ten pieces of advice for the incoming boss.

1. Take to heart Clausewitz’s (paraphrased) doctrine: “Monetary union is the continuation of war by other means.” Adopt a military-strategic approach to your job. Be stealthy. Don’t forget that Clausewitz learned a lot from Machiavelli.

2. Leave politics to others – at least in your public statements. In your contacts with governments, inform; neither lecture nor cajole. During meetings with presidents and prime ministers when others are present, do not interrupt; speak only when you are spoken to. Don’t even try to be charismatic. You have profited from advance billing as a well-controlled central banking technocrat who is a canny operator, understands financial markets and has no love lost for Silvio Berlusconi – a feeling we understand is fully reciprocated.  Playing, in an understated way, to these strengths, should get you through your first 100 days. After that, it may get much better – or much worse.

3. Give no media interviews in your first months of office, pleading pressure of work. (Off-the-record journalistic conversations - so long as they are just that – may however be useful for you.) In your statements, press conferences and speeches, whether in words or in mannerisms, be as boring as possible. The Germans, your main constituents, expect central bankers to be like that. They will be pleased. In due course, they may even forgive you for not being Axel Weber. Many expected the former Bundesbank president to get the job. He turned it down partly because he sensed that his temperament and beliefs would be out of kilter with his duties. You can show you’re different.

4. Don’t be swayed by commentators who, for a variety of reasons, are urging the ECB to buy vast quantities of Italian government bonds as a “lender of last report”. How on earth will you exert leverage over Mr Berlusconi if you agree a policy that frees him from the constraints of financial markets? Whatever happens, keep repeating that the whole ECB council decides policy on bond purchases, not simply the president. It’s up to the EFSF now to take the strain! Make the ECB’s decision-making processes on bond purchases sound as complicated as possible.  If everything ends badly, you can plead collective responsibility.

5. Learn who your friends are on the ECB council. You will need them. Make special efforts to get on well with the Bundesbank, at all levels.  History shows that, if things get tough, you will need to know where you stand with the German central bank.

6. Keep your statements at press conferences short and factual. If you don’t have an answer to any particular question, say so, without explanation. Do not give flowery answers that may be open to different interpretations.  You are a technician, not a poet. Train yourself to speak slowly in short, precise and rather uninteresting sentences.

7. Allow your deputy Vítor Constâncio, a former governor of the Bank of Portugal and also (in the 1970s) Portuguese finance minister, to answer questions at press conferences. Jean-Claude Trichet, your predecessor, very seldom did that. You can do things differently. Try to make sure that, on the big issues, Mr Constâncio agrees with you, but expresses his opinion in a slightly different way. This a) brings modest variation to these showpiece events, b) allows you to speak less, c) furthers the doctrine of collective responsibility.

8. Don’t say things you may regret later. Mr Trichet displayed a leaning for political and economic statements that seemed to go beyond the realms of monetary policy.  Life’s already full enough of complications without having to add to them.

9. Don’t introduce Italian as the official language of the ECB, in spite of the fact that both you and Lorenzo Bini Smaghi hail from the same country.  Don’t let staff see you and Lorenzo speaking too often together in the corridors in Italian. Don’t introduce Italian delicacies on to the ECB canteen menu.

10. Work hard behind the scenes to find a solution to ease Mr Berlusconi out of office in the next six months.  If his government were replaced by an interim technocratic leadership, that would be good news for Italy and for the euro. Doing nothing to prevent Italian bond yields from remaining above 6% might be helpful to that end. Don’t, of course, let anyone in the outside world know what you’re doing. Central bank governors are not supposed to dispossess their country’s prime ministers.  It has happened before, though. The history of the Bundesbank and its relationships with post-war German governments shows that, for such actions, Frankfurt is not a bad place to be. Make the most of your new home.

European debt rescue could pave way for renminbi borrowing

By David Marsh in Beijing

In the wake of last week’s new deal on European debt, China is serving up a steely reminder to Europe: you may have to start borrowing in renminbi to gain a sympathetic hearing from the world's largest creditor.

Already officially enshrined as bankers to the world’s biggest debtor, the US, the Chinese have no wish to become, too, a last-ditch lender to the Europeans. The idea of renminbi borrowing has been put forward by Beijing advisers and officials as a way of lowering Chinese foreign exchange risks caused by further exposure to Europe - and also of using the Europeans’ latest discomfiture to advance China's international monetary policy agenda.

If European borrowing in the Chinese currency became a reality, it might pave the way for the US Treasury eventually to issue renminbi-denominated paper – a momentous milestone in world monetary history.

Klaus Regling, the head of Europe’s EFSF rescue fund, was in Beijing at the end of last week to explain the latest bail-out efforts. Significantly, Regling did not rule out renminbi funding in future.

The Chinese have shown impatience with Europe’s stop-start approach to solving the debt crisis. Like other large investors throughout Asia, they are surprised that travelling Europeans expect them to buy bonds from hard-pressed European governments when the institution they have expected to be the lender of last resort, the European Central Bank, balks (for whatever reason) at intervening to stem the rise in Italian bond yields.

In a telephone call on Thursday to discuss this week’s G20 summit in Cannes, President Nicolas Sarkozy explained the latest bail-out measures to President Hu Jintao. The Chinese leader told him he hoped the measures would ‘help Europe stabilize financial markets’. The state Xinhua news agency was lukewarm, saying, ‘While China and other emerging countries indicated they won't be bystanders of the eurozone crisis, it would be unfair to ask them to shoulder the same responsibility as those directly responsible for the crisis. Emerging economies should not be seen as the EU's Good Samaritans – in the end, the EU has to pull itself out of the crisis.’

Chinese officials say that, rather than considering further bilateral lending to Europe through the byzantine assortment of additional EFSF instruments, China is far more likely to agree to funding Europe via additional multilateral agreements with the International Monetary Fund. These would provide the Chinese with more leverage over conditionality, expose them to fewer risks and also allow the emerging market economies as a bloc to lay down the law more effectively with regard to the western nations that still dominate the Fund.

Chinese observers make the point that the Beijing government is under much more pressure than ever before from an alert internet-savvy public to resist cash appeals from errant European governments when millions of ordinary Chinese are still struggling with worrisome social, economic and environmental conditions and, in some cases, abject poverty. So renminbi borrowing – even though it could expose Europe to problems if the Chinese currency rises – could provide an appropriate compromise acceptable to both sides.

OMFIF ANALYSIS OF DEPARTING ECB PRESIDENT’S SPEECHES

Trichet’s vocabulary displays adaptability to changing financial moods

By David Marsh and Fredrik Kinell

Jean-Claude Trichet, who steps down on 31 October after eight adventurous years atop the European Central Bank, has shown himself a supremely flexible master of monetary phraseology, ably adapting his statements to shifting financial market moods. 

A central banker who in the first four years of his mandate praised the role of the ECB in generating jobs and extolled European financial integration as a force for stability has virtually dropped those terms from his vocabulary.

Instead, in the harsher times since the financial crisis erupted in August 2007, Trichet now places much greater emphasis on previously underplayed buzzwords such as “governance”, “imbalance” and “risk”.

A textual analysis of Trichet’s formidable array of public speeches (278 over eight years) reveals a pronounced emphasis of themes in line with prevailing financial sentiment.

A charge of verbal opportunism - Trichet would probably prefer the description “dexterity” - is not the most welcome accolade for a man hugely attentive to his legacy. The retiring ECB president departs with his head held high after the latest Brussels summit deal to resolve the debt crisis around Europe’s single currency.

Trichet would like to go down in history as an unbending adversary of inflation and a constant upholder of central banking independence, caring little for fluctuating political or economic whims. The truth is somewhat less heroic. Like a football manager looking back at a turbulent match, Trichet can reflect that his eight year mandate has been a game of two halves.

Why the creditors don’t want to join the EMU debt club

By David Marsh

Time to set up the Non-Eurogroup

A new way to preserve European unity

By David Owen and David Marsh

Bernanke is fighting the wrong battle

By David Marsh

Hurdles lie ahead on EFSF leveraging

By David Marsh

Gold standard test looms as Greek debt worries swirl at IMF meeting

David Marsh in Washington

Euro has become a political football for US, Chinese

By David Marsh

Geithner’s imperial strictures, meanwhile, had no discernible effect on Europe’s crisis-solving ability. He put forward a number of solutions including “leveraging” the EFSF rescue fund to give the Europeans more firepower to fight financial markets.

Stark’s departure: an historic step for German central banking

By David Marsh

Swiss National Bank declares war on foreign exchange market

By Marina Shargorodska

However, we are quite bearish on the Euro’s prospects. If the crisis reaches new heights, as we expect,  it will undoubtedly increase pressure on the CHF to appreciate. The stakes will be high if the SNB really delivers on it’s promise to provide unlimited liquidity. The loss potential would far outweigh the capital base of the bank and require urgent and massive recapitalizations by the kantonal governments who are the majority shareholders. This would make the interventions a very public affair at the worst of moments. In Switzerland, there is a long history of direct democracy with numerous propositions being voted on by the entire voting populace. It is not inconceivable to see propositions that would limit the ability to implement “hedge fund like” strategies that are financed by the Swiss taxpayers. (Previous interventions have already been characterized this way.) One of the main lessons of the crisis still to be learned conclusively is that in the end it’s the people who decide. We’ve seen people on the streets in Greece and riots in the UK. Don’t expect anything so emotional in Switzerland. But if the SNB suffers loses on its intervention policy we may eventually see a striking example of people power at work.

Collective leadership for ECB

By David Marsh

During the past two years of euro-crisis escalation, the European Central Bank  generally has won high marks for competence. Yet the picture has darkened since early summer. So it’s time for the ECB to appear in public with collective leadership and a more cohesive voice.

Up to a few months ago, the ECB benefited from the failure of European politicians to recognise the scale of the euro’s  difficulties and tackle them with the right firepower. The ECB was Europe’s sole fully functioning crisis manager.

Now those days are over —  because of evident disagreement on monetary policy within the ECB’s Governing Council. With his ‘no’ to ECB purchases of southern member states’ government bonds, Bundesbank President Jens Weidmann has admitted that, in the euro’s central decision-making body, Germany is now in a structural minority. Christian Wulff, the German president, who is supposed to be above day-to-day politics, added his voice to the controversy last week, saying the central bank’s bond purchases were illegal.

Weidmann has stepped up the opposition shown by his predecessor Axel Weber who — once he displayed his initial dismay about bond purchases in May 2010 — tried reasonably hard not to rock the ECB boat with too much discord. By contrast, Weidmann now fully articulates his resistance within the ECB Council.

The ECB’s fragmentation is a dangerous sign of dislocation. How long can this state of affairs drag on? A partial solution might be available in coming weeks. The retirement of President Jean-Claude Trichet on 31 October could bring a new beginning.

His successor, Bank of Italy Governor Mario Draghi, like Trichet a former Treasury chief, faces multiple challenges, against a background of progressively more sceptical public opinion – especially in Germany, where he will now have to spend a good deal of his time.  Draghi may be a shrewd personality on the global central banking scene and a respected policy authority in his Italian homeland. But it’s exaggerating to say he’s an  international superstar. He  lacks a firm hold on the Governing Council and has no great experience with the international media. Rather counter-productively, he has apparently lately been turning down chances to meet the international press.

Draghi has to overcome these obstacles. The sooner the better. Trichet has always practised an imperial style — accentuating the pattern of predecessor Wim Duisenberg. My suggestion is that Draghi should bring in collective leadership. From 1 November, he should appear before large audiences only with other members of the ECB’s executive board. Above all, Draghi should insist that at the ECB’s monthly press conferences he is accompanied by an appropriate number of board colleagues.

Not only, as happens up to now, Vice President Vitor Constancio should appear before the media. In addition, board member Jürgen Stark, an ex-Bundesbank official who backs Weidmann’s tough line on state bonds, should be there — and Draghi should allow his colleagues actually to speak. Trichet’s current press rituals embody the absurd theatre that his experienced, well-respected deputy Constancio (who held the office of Portuguese finance minister as long as 33 years ago) sits lamely next to him during press conferences but hardly makes any comments.

A new communication style would best reflect the ECB’s difficult external circumstances as well as its increased internal plurality. It would side-step the considerable threat to Draghi that he could be made the sole scapegoat for future setbacks. Trichet-era autocracy has to end. The answer is collective leadership. This will not be a permanent fix for the euro’s woes — but it’s a good way for the ECB to overcome its obvious fragility and mount a more effective public presence.

As the Germans prepare for unpalatable decisions, the EMU virus is closing in on Berlin

By David Marsh

Sending in the water cannon

ECB calls in the riot squad

David Marsh

When legendary New Zealand mountaineer Sir Edmund Hillary was asked why he’d climbed Mount Everest, the highest peak in the world, in 1953, he gave a laconic Kiwi reply: ‘Because it was there.’ Similarly, a young English hooligan told a BBC reporter why he had looted shops during last week’s English riots: ‘Because no one stopped me.’

In both episodes, logical openings paved the way for certain actions. In the first case, heroic; in the second case, criminal. Opportunities presented themselves. They were taken.

Same in banking and finance. When trust, credibility and consent break down, anything can happen. If everyone queued up every day to get their money out of banks, finance would go bankrupt. If everyone wanted to smash windows all at once, no police force in the world could stop them.

When English police allowed the rioters to gain the upper hand in London and other cities a week ago, lawlessness spread with self-feeding force. Only when the police got over their feeling of defensiveness — New York–style zero tolerance, here we come — and escalated countermeasures, did criminal activity come under control.

Which brings us to the European Central Bank. In the week before last, a bubble and a vacuum were building up in the market for Spanish and Italian government bonds. In thin markets, selling reached pandemic levels. As a result of a hastily arranged telephone conference, the ECB council decided to apply its restarted bond purchases to the third- and fourth-largest economies of the euro area.

Similar to the police commanders sending in more personnel and telling them to wield their batons, the action calmed. Admittedly, on oversold markets. At least temporarily, the measures brought down bond yields to slightly more acceptable levels.

Even the vocabulary is similar. British Prime Minister David Cameron has been declaring he will ‘do everything necessary’ to stem unrest. That’s just what President Nicolas Sarkozy and Chancellor Angela Merkel have been saying about the euro.

Oddly, the outbursts have not affected the British government’s creditworthiness. The interest-rate differential between 10-year British and German government securities fell by the end of last week to just 0.2 percentage points.

But even the unlined features of Cameron creased slightly when he revealed that Britain was considering using water cannons to fight the tumult. For euro members, the equivalent would be agreeing to euro bonds — debt instruments under which Germany would effectively take over the debt of Greece. And possibly lose its AAA rating in the process. Which will come first? Water cannon or euro bond? The next few weeks may bring some answers.

Picking a fight with the Bundesbank can be dangerous for ECB health

Dissent at the ECB

By David Marsh

Asia torn between European incompetence and American cynicism

By David Marsh

Europe’s convergence game – between the Cold War and the euro

The Cold War and the euro are, when you come to think of it, more or less the same thing.

By David Marsh

When the European single currency was introduced in 1999, German Chancellor Helmut Kohl hyped it as “a question of war and peace.” Given the parallels, it’s hardly surprising that politicians and central bankers throughout the euro crisis have frequently turned to the language of “mutually assured destruction” to try to get their way.

The idea is simple. To persuade others to avoid certain courses of action that would allegedly provoke awful consequences. So it’s back to the Cold War. The presumption was, if either the Soviet Union or the U.S. launched a nuclear strike, this would automatically trigger a deadly blow to the assailant. Neither side wished to snuff itself out. So a nuclear attack was never unleashed. Nuclear deterrence gained the upper hand.

We see the same principles today. The Greek central bank governor told his country’s parliamentarians a couple of weeks ago that rejecting EU and IMF austerity measures would amount to “suicide.” Hey presto, Greece desists (for the moment) from saying “No” and nods the measures through. Similarly, feisty European Central Bank board member Lorenzo Bini Smaghi tells any wayward euro member thinking of debt restructuring that such an initiative would bring “political suicide.” So far they haven’t done it.

Such arguments are advanced, too, to convince European bankers to extend further loans to insolvent states. Otherwise we’ll all be down the drain. In the same way, a senior German government official told me some time ago that staying in monetary union was the only way for Greece to stave off a new military dictatorship. Angela Merkel and Nicolas Sarkozy use every opportunity to protest that dismantling the euro would ruin Europe. Merkel’s pet phrase is: “If the euro fails, Europe fails.” A throwback to the classic language of superpower conflict.

Such imagery may be superficially helpful. It gets politicians, technocrats and bankers to pass certain decisions and “gains time.” But such language is certainly not healthy. A number of hasty decisions in the last 15 months, aimed at staving off what were imagined to be catastrophic outcomes, have brought little in concrete results apart from weakening the status and credibility of the institutions that carried them out. I mean the ECB, the IMF, the Brussels commission and the German government. Quite a list.

Threats that unorthodox action would cause Armageddon are running increasingly thin. No one thinks, for example, that if Greece did default on its debts, the ECB really would refuse to accept all Greek paper as collateral. And Jan Kees de Jager, the Dutch finance minister, admitted a few days ago that “a short-term rating event” ensuing from a mandatory Greek debt restructuring would not be such a bad outcome.

The outcome is that major institutions dealing with the euro crisis can no longer be trusted. For coping with future upheavals, this is extremely bad news.

Germans start euro retreat

By David Marsh

The big loser from Euro wrangling is EMU’s overall credibility

By David Marsh

Pound clutches to third spot

Pound remains rather than re-emerges as a major reserve currency

By Marina Shargorodska

Much has been made of currency diversification among central banks. Will the Chinese dump dollars and promote use of the Yuan? Will SDR’s become a true reserve currency? What about bringing Gold back into the mix?

All of these questions will take time to answer. Several things are clear. While reserves are being accumulated rapidly the USD has been slightly declining as a share of importance. But interestingly enough the EUR has not been gaining here. Other currencies, which are largely emerging market currencies have been gaining share rapidly. And what about the other forgotten majors? Central banks have been actively accumulating JPY which was the world’s third largest reserve currency in the 1990’s through to 2004. Reserves have risen from 92bn in 2000 to 195bn USD in 2010. However, Sterling reclaimed the third spot in 2005 and has maintained its lead since then. Reserves have grown from 42bn to 203bn USD over the same period. Interestingly the JPY strengthened over the period sharply while the GBP was close to unchanged. This is surprising for two reasons, first the reserves are measured in USD so the depreciation of the pound would have reduced the measured reserves substantially while the measured JPY reserves would have risen substantially even if central bank holdings were unchanged. Second, central banks, like other investors, tend to follow the market and invest in the recent winners. Alas, it seems that the time of greatest accumulation of GBP was at the height of its overvaluation in 2006 and 2007 when it reached 2.1 to the USD. But remarkably perhaps, the rate of GBP accumulation has continued apace.

Are countries switching to GBP? Most likely not. Seemingly, countries which strategically hold GBP’s have increased their relative pace of reserve accumulation as compared to those that do not. Rather than being the result of a shift towards GBP, this most likely represents a shift in accumulation towards a specific group of countries. Indeed, a closer look at the data shows that much of the GBP's relative rise has been due to the emerging and developing economies, many of which have historically maintained GBP as a reserve currency. So while those who are looking for the reemergence of Sterling as a major reserve currency may be somewhat disappointed, they are probably still quite pleased that 65 years after the end of World War II, the GBP continues to clutch the third spot in the list of global reserve currencies.

Trichet’s European debt to Houdini

Retiring ECB chief: the master escapologist

By David Marsh

Horse-trading over IMF post intensifies

By David Marsh

Greece and Bundesbank: an intriguing combination

By David Marsh

Osama bin Laden’s “economic war”

By Marina Shargorodska

Weidmann dons hawkish plumage

By David Marsh

BRICS move to downsize dollar

By David Marsh

Axel Weber's lack of "solidarity"

By David Marsh

It’s never a good idea if a major difference of opinion between the government and the central bank emerges into the public eye. But that is what is happening in Germany, as the result of a critical behind-the-scenes tussle between Chancellor Angela Merkel and Axel Weber.

Last week was a tough time for Merkel, framed by the massive setback for her Christian Democrat party. She made it worse last Thursday by launching an unmistakable broadside at Weber in a landmark speech at a high-profile banking conference in Berlin, indirectly accusing the Bundesbank chief of a lack of “solidarity” with other European states over the future of Economic and Monetary Union. Although she did not mention Weber by name, the object of her remarks was clear.

“Solidarity,” Weber said, was a term used for assistance “requested by countries which have infringed the rules [of EMU] from those which have applied them.” Without naming Portugal, Ireland, Italy, Greece or Spain (the so-called PIIGS), he said individual countries now appeared to be departing from “fundamental principles” governing EMU. Rather than requesting assistance that would create “false incentives,” they needed to take responsibility for their own plight and to get back to the core concepts behind monetary union of running sound fiscal and economic policies designed to maintain competitiveness.

Weber said he was not unduly worried about the widening of credit spreads on government bonds in EMU, arguing that this was a return to norms that had existed around 1995. What was far more worrying, he said, was the contraction of yields in 2000-06, which had seen Greek and German spreads fall to only about 10 basis points — an unjustified degree of harmonization, which, he said, had laid bare diverging economic trends.

Weber, the head of the Bundesbank since 2004, will be replaced by Jens Weidmann, Merkel’s economic adviser since 2006. He is the first German government official to make a direct transition to the No. 1 Bundesbank post. At least at the beginning of his tenure, Weidmann is expected to keep his head down and avoid any confrontation with his old boss. Merkel, beset by problems on many fronts, is no doubt looking forward to a break with Bundesbank skirmishing.

Angela Merkel's tenuous hold on power

By David Marsh

Sunday’s regional election results in Germany – paving the way for the anti-nuclear Green ecology party to take control of the traditionally conservative industrial stronghold of Baden-Württemberg – lower further Chancellor Angela Merkel’s tenuous hold on power  and will harden Germany’s bargaining line over economic and monetary union (EMU).

In particular, the fresh blow to Merkel’s standing with the German electorate may encourage the Berlin government to dig in its heels over selecting the new president of the European Central Bank during the summer. This may weaken the chances that Mario Draghi, the respected head of the Banca d’Italia, will take over from Jean-Claude Trichet in November. Draghi had been regarded as front-runner following last month’s withdrawal from the race of Axel Weber, the president of the Bundesbank.

The Green surge in Germany in the wake of the Japanese atomic disaster ended 60 years of rule of Merkel’s conservative Christian Democrat party in the key southwestern bastion of iconic corporations like Daimler, Porsche and Bosch.

Over EMU, Germany’s primary tactics for dealing with the sovereign debt crisis are rapidly losing traction.  Waiting until difficulties affecting the peripheral Euro members become intolerable, and then, with the utmost reluctance, agreeing credits under punitive interest rates and extreme austerity-generating conditions, is palpably not producing the right results.  The collapse of the Portuguese government and the emergence of a power vacuum in Lisbon represent a further twisting of the screw. This heightens the likelihood that Lisbon will turn to the EFSF rescue fund which again would ratchet up the probability, under the domino-like effects  that run through financial markets, that Spain would be next in line.

At last week’s Brussels summit, an expected deal to lower the interest rates on Ireland’s rescue loans did not materialise.  Creation of a permanent €500bn fund to be put in place in 2013 to replace the EFSF was incomplete, reflecting last-minute opposition in Germany to the new fund’s structure.

Germany’s introspective mood has sparked new anxieties  that German political  decision-making is becoming random and unpredictable.  In 1828, one of Germany’s most celebrated poets, the famously soul-searching Heinrich Heine,  wrote that his countrymen found find the wide world “too wide” and wished for nothing more than to “sit between the old familiar walls”, light the stove and read the local newspaper. A strange existence for the world’s second largest exporter that  profits hugely from globalization. But Heine’s words seem an apt  description of the economically powerful yet curiously rudderless state of Germany today.

The Fed opens the door a little further

By Malan Rietveld

The Federal Reserve has taken another big step towards modern best practice in central bank communication and transparency.

Starting 27 April, the Fed chairman will, on four occasions every year, brief the press on the central bank’s thinking, particularly around the changes to its forecasts. In truth, the move is overdue - the Fed was the only G7 central bank that did not provide direct, scheduled discussions of its forecasts.

The latest move is part of a longer process that Ben Bernanke, who has been chairman of the Federal Reserve since 2006, initiated to enhance communication with the public – or at least make it more routine.

Under the chairmanship of Alan Greenspan the markets elevated each and every word uttered by “the Maestro” to Delphic levels. Greenspan’s words moved markets, arguably causing unwanted volatility.

Bernanke’s view is that communication should be much more structured and routine, helping to carefully mould public opinion and expectations. It is also clear that he views transparent communication as part of the Fed’s commitment to accountability.

Of course, the Fed will have its work cut out in “managing the process” around the first two or three forecast briefings it conducts this year. But before long, the markets will take these events in their stride and the entire exercise will promote stability.

The only real question then around the Fed’s decision to open the door a little further is: “what took them so long?”

Is peripheral Europe being pushed to its limit?

By Marina Shargorodska

The decision to raise interest rates by the ECB seems directed at least in part at the German people who are, theoretically, to be tempted into some form of greater economic union with the rest of the Eurozone. It shows that European institutions can be counted on to preserve German ideology regarding financial markets. Greater economic integration could eventually set the stage for the issuance of Eurozone bonds,  which would allow weaker countries to leverage off of the fiscal strength of the Germans. Trying to conciliate the Germans makes some sense, since any long term improvement in the functioning of the Eurozone will require them to support measures which might be thought of as representing a bailout to the peripheral countries. However, we should remember the maxim often quoted by Ken Rogoff, former chief economist of the IMF: “Countries don’t default because they cannot pay their bills, rather they default because they choose to default”.

Forgive me for being a skeptic of the grand schemes for greater integration, but they look increasingly unlikely to materialize before one or more of the peripheral countries tires of their strong medicine. The people of Ireland and Greece can’t help but notice that rising interest rates are far from appropriate for their economies, which are operating with output gaps at or above 5% and rising. Though Portugal’s output gap is smaller, I doubt they are much happier. Their comrades in the Eurozone have so far failed to support them other than through monetary policy and the granting of loans basically at the market interest rates which prevailed at the time they were granted. Now monetary policy looks to be tightened despite the costs to their economies.

While there is nothing to say that a debt restructuring of any of the peripheral nations is imminent, we may nevertheless be approaching the beginning of the end. If we see the three interest rate rises that markets are now expecting, banks funding costs will rise immediately. We’ve seen that the rating agencies are prone to downgrade the peripheral countries as their banks position weakens. This is a process that has further to go. It’s about to get interesting … again.

Germany on ECB’s mind as it pushes ahead towards tighter money

By David Marsh

It’s happening quicker than I thought. Last Thursday’s stronger-than-expected statement on inflation from Jean-Claude Trichet, the European Central Bank (ECB) president, paves the way for Europe to start monetary tightening next month, compared with the timing of May or June that I predicted last week. Yet my forecast last week was well ahead of the earlier market consensus view that the ECB would wait until the summer before starting to return to a semblance of monetary normalcy. What has happened to speed everything up?

A series of factors are combining to produce a new environment for monetary rate-setting. Occupancy of the 23-person ECB governing council’s key seats on – held by Trichet and Bundesbank president Axel Weber –  is due to change in coming months. Trichet will be replaced from November by an as yet unknown successor, with odds shortening that he will be Mario Draghi from the Banca d’Italia.

Weber will be succeeded at the end of next month by Jens Weidmann, up to now Chancellor Angela Merkel’s economic adviser. Getting an unpopular interest rate move out of the way before the new chiefs arrive may be a sage decision, to avoid piling up pressure on freshly-anointed incumbents.  And Weber, who is quitting the Bundesbank and the ECB leadership race because his hawkish views are out of kilter with many others, may be glad to stamp his imprint on the ECB’s policies before he moves on.

The increase in the projected euro area inflation rate to well beyond the 2% limit that Trichet has been so proud to maintain in the euro’s first 12 years is the single biggest direct factor behind the ECB’s signal. Higher growth in Germany than in the rest of monetary union is making the Germans not wildly happy but nervous about rising inflation.

And there is another strongly political element behind the momentum now building towards monetary tightening.

The prospective improvements in Europe’s policy governance will fall well short of the wishes of either the ECB itself or the German government. The much-trumped “pact for competitiveness” put forward by Merkel and French president Nicolas Sarkozy has been watered down almost out of existence by the blunt refusal of most member states to have European decision-making intruding into their own budgetary or labour market instruments.

At a time of grave disparities in the European economy, the prospective ECB interest rate rise shows that the euro area is dancing to the tune set by the creditor economies and not the debtor states. That is arguably the way it should be, but it will certainly lead to unpopularity, above all in Trichet’s French homeland.

Germany can profit from package deal over Draghi nomination

Interest rates must rise sooner rather than later in euro area

By David Marsh

In recent months it became reasonably obvious that nominating a German as head of the European Central Bank (ECB) was not going to work. Above all, this would not have served Germany’s own interests. By pulling out of the race earlier this month, Bundesbank president Axel Weber has behaved consistently and honourably.  Although she may not have realised it straight away, he has done German Chancellor Angela Merkel a favour.

The way is now open for the ECB to return to the path of monetary normalcy quicker than expected. The package deal in view is for the ECB to raise interest rates in May or June in return for an understanding that front-runner Mario Draghi, the governor of the Banca d’Italia, will take over when ECB chief Jean-Claude Trichet retires at end-October.

Finding the right person is no small matter. The new leader must run the 23-member Governing Council in a consensual but also well-disciplined fashion, and persuasively present policy (and warnings) to the outside world. At the same time, in view of the threat of rising inflation especially in the heartland of Germany, the ECB needs as quickly as possible to raise interest rates from their abnormally low 2009-2010 level and end  excessive liquidity provision to euro area banks.

How can these two goals be combined? By nominating to the top job Draghi – the best-qualified ECB candidate now that Weber has stepped down – and linking this to an early interest rate rise. 

This opens the way to a package deal. The reality is this: had Weber been about to climb into the ECB hot seat, an interest rate correction would have been  impossible, as Europe would have looked as if it were dancing to the German tune. The corollary applies too. Draghi can only be appointed if ECB interest rates are firmly on an upward trend – to dispel doubts in Germany and other northern countries that selection of a southerner from a heavily-indebted state irretrievably puts Europe on the path of perdition.

Trichet during his remaining months at the ECB should start tightening in the early summer, with the compliance of leading European governments. He will then have performed one more service to the cause of monetary union.

Will the shadows lift from Libyan Investment Authority?

By Malan Rietveld

A number of sovereign funds have taken steps in recent year to increase transparency about their motives, objectives and investments. The Libyan Investment Authority (LIA) is not one of them. Could this change if Muammar Gaddafi's reign comes to end?

Weidmann marks tide of change for Bundesbank

French-speaking prowess may build bridges with Paris

By David Marsh

The appointment of Jens Weidmann as president of the German Bundesbank from 1 May as the successor to Axel Weber marks a significant change in the politics and psychology of central banking in Europe. But not principally for the reasons the critics say.

Commentators make much of Weidmann’s closeness to Angela Merkel, the German Chancellor, and claim this could diminish the Bundesbank’s vaunted independence. However, more importantly, he is the youngest-ever Bundesbank president. And he is the first one to speak French.

Weidmann has been Chancellor Merkel right-hand-man as chief economic adviser and ‘sherpa’ at international summits. He has been centrally involved in Germany’s efforts to overcome the financial crisis, the ensuing recession and now sovereign debt turbulence within monetary union.

Criticism that his promotion weakens the Bundesbank’s statutory freedom from political influence misses the point. The Bundesbank is no longer the institution it once was. Creation of Europe’s monetary union in 1999 was a deeply political act with deeply economic consequences.  Inevitably, the German central bank has been part of a much more politicised regime of monetary management for the past 12 years. The Bundesbank is subsumed within a 17-strong European system of central banks. The interplay with governments – whatever the statutes say about the supreme independence of the European Central Bank - is a fact of life.

The attempts by Merkel and Nicolas Sarkozy, the French president, to install some form of ‘economic government’ in Europe to accompany the purely monetary aspects of economic integration confirm how the world has changed. The mistakes and miscalculations of the last 12 years show how monetary union has to be part of a more united political system in Europe. Merkel now seems to understand that vital point. Weidmann will do his best (against considerable odds) to help her implement it.  That is not loss of independence. That is political and economic reality.

Surprise – what surprise? Axel Weber’s departure was inevitable

Merkel has made a mess of the ECB succession – but don’t blame the Bundesbank for that

By David Marsh

Axel Weber’s departure combined with his self-exclusion from the ECB presidential selection process has been labelled a surprise. It should not be one. Weber is an academic who was not the previous German government’s first choice when the Bundesbank presidency became vacant in 2004. He can hardly be criticised for seeking to resume life outside central banking. It was not a secret that, as an arch-defender of Bundesbank-style monetary orthodoxy, he was displeased with the ECB’s growing politicisation, and had no wish to take part in the horse-trading that forms part of an ECB chief’s job. 

Weber’s opinion is legitimate, consistent and frequently articulated. The German government was well-informed about it. Thus the much greater surprise is why Chancellor Angela Merkel stuck to her guns on placing a German at the helm of the ECB.  It was clear all along that this would not be in Germany’s best interests.

As I pointed out publicly six months ago (e.g. in OMFIF July Monthly Bulletin and in Financial Times on 2 August 2010 ‘Weber would be a bad choice as EU’s top banker’), putting a German in charge would inflame Europe’s north-south divisions and hamper Germany’s chances of enforcing stability-minded policies.

The likelihood of debt rescheduling by some of the euro’s problem members is rising. So are the complexities of Europe’s two-speed economics:  austerity in the south, export-led recovery in the north. With inflation rising in Germany, the ECB will have to tighten credit in coming months at an unpropitious time for the southern states.

One lesson from the Bundesbank’s history is that new presidents often have to take highly unpalatable decisions to raise interest rates that get them into political hot water. The same prospect faces whoever takes over at the ECB in the autumn when Jean-Claude Trichet retires.

It is still not entirely certain that a non-German will be the next ECB boss. Jürgen Stark, the ex-Bundesbank deputy president who is at present the ECB’s chief economist, could take over, but his eight year non-renewable term on the ECB board runs only to 2014, so he would be no more than an interim president. Klaus Regling, the present head of the EFSF bail-out fund, could get the job – but he would confirm the shift in the ECB’s mandate to become a political institution in charge of rescuing errant euro states.

Whatever happens, it will be complicated.

The German government has certainly made a mess of the ECB succession, but Weber departs with an untarnished reputation for straight thinking and straight talking. He leaves the future direction of the euro zone cloudier than ever. But that is not his fault – and soon will no longer be his problem.

Different planet?

Fed: Made in USA inflation remains low

By Darrell Delamaide

As oil and food prices shoot upwards around the world, markets have grown nervous about inflation. Federal Reserve officials, however, serenely assure the US public that it’s not a problem.

“Are the Fed and the public on different planets?” Atlanta Fed president Dennis Lockhart asked not so rhetorically in a speech this week in Alabama, noting a number of headlines worrying about inflation.

In Congress, as Fed chairman Ben Bernanke made his first appearance in the House of Representatives since it came under Republican control, one lawmaker anxiously waved a Wall Street Journal with the headline “Inflation worries spread.”

Bernanke easily parried the implications for Fed policy by noting that the story was mostly concerned with emerging markets like China and Brazil, where central banks have raised their rates to dampen inflation.

“In the United States, inflation made here in the US is very, very low,” Bernanke said.
 
The confusion lies, Lockhart told his Alabama audience, in equating inflation with increases in certain costs of living. Yes, food and gasoline prices have risen, but that doesn’t mean there has been an overall loss in the purchasing power of the dollar, he explained.

The Fed can deal with generalised inflation, but is powerless to influence the cost of living. “We do not produce oil,” Lockhart said. “Nor do we grow food or provide health care. We cannot prevent the next oil shock, or drought, or a strike somewhere – events that cause prices of certain goods to rise and change your cost of living.”

Monetary policy is too blunt an instrument to target specific markets, Lockhart argued. It affects the value of the dollar across the board, so that any targeted item would still be expensive relative to income and to everything else.

Despite these comments, market analysts now see it as much likelier that the Fed will start raising rates before the year is out. Improved economic data suggest the Fed will not extend its asset purchases beyond their planned end in June and may raise the federal funds rate target, frozen near zero since December 2008, in December of this year.

Labour’s pugilist may turn out to have exaggerated Britain’s economic woes

By David Marsh

Ed Balls, the UK opposition Labour Party’s great new hope for a revival in its fortunes, is the man behind two clear choices which positively marked the economic policies of the Labour-run governments between 1997 and 2010. These were the decisions to give the Bank of England operational control of British interest rates and to keep the UK out of the euro after it was introduced in 1999.

Unfortunately, he is also the person who – as economic adviser to Gordon Brown during his 10 years as Chancellor of the Exchequer - did much to encourage his former boss to inflate public spending. This helped generate the ballooning budget deficits that have been one of the principal British legacies of the financial crisis.

Harvard-educated Balls’ record overshadows his current actions now that his appointment as shadow Chancellor at the end of last month has shaken up British politics. Balls’ Keynesian principles and pugilistic instincts have driven his fierce criticism of Prime Minister David Cameron and George Osborne, the Chancellor in the Conservative-Liberal Democrat coalition, for cutting back the budget deficit allegedly too rapidly for the good of the creaking British economy.

The jury is still out on whether Balls or Osborne has it right. An unexpected drop in Britain’s gross domestic product (GDP) at the end of last year appeared to confirm Balls’ scepticism on whether the UK was resilient enough to stand up to draconian budget cuts. However, other economic data seems to indicate that the economy can take the medicine. Last week the closely-watched purchasing managers’ index showed a formidable rebound in the services sector, helping to adjust the pessimism touched off a week earlier by the GDP figures. 

Rumours of sterling’s imminent demise against the euro and other leading currencies have been – like reports of Mark Twain’s death – much exaggerated. Two fundamental factors underpinning the pound have been the two key elements of Balls’ period at the Treasury, sterling’s non-membership of the euro (which would have been a disaster for the UK and Europe) and the policy credibility of the Bank of England.

Many observers believe a gigantic political battle is now in store between Balls and Osborne. The reality may be less dramatic, for two reasons. First, although Balls has carefully cultivated his image as a street-fighter, his ferocity is neither as intense nor as effective as popularly supposed.

Second, I believe that Balls has exaggerated the woes likely to afflict the British economy as a result of Osborne’s attack on the deficit. If the economy does show reasonable resilience despite the spending cuts, then Balls will tone down his doom-laden rhetoric. But he will be clever enough to claim that the reason why the economy is doing better is because Osborne listened to his advice and went easy on the spending cuts. 

Dollar über alles?

Egypt crisis highlights US currency role as safe haven

By Darrell Delamaide

With the fate of Hosni Mubarak hanging in the balance, investors took a new look at the attractiveness of US assets, giving a firmer touch to the dollar despite general worries about financing America's budget and current account deficits.

Renewed evidence of the dollar's appeal as a 'haven currency' formed a backdrop to the continuing discussion about the dollar’s future as a reserve currency. For instance, Israeli central bank governor Stanley Fischer, who held a US passport much of his life, said on a panel at Davos last week that his country is diversifying its reserve currencies and others are likely to be doing the same. “I'm more optimistic about the euro gaining strength as a potential reserve currency,” he said.

MIT professor Simon Johnson, a former chief economist at the IMF, told those attending a meeting in Denver earlier this month that the Chinese renminbi would be the world’s main reserve currency within 20 years. But another former IMF chief economist at that same meeting, Raghuram Rajan, demurred; saying that Asian economies will not enjoy a straight upward trajectory and the US will remain “the biggest mover” for a long time yet.

The Federal Reserve’s policy of quantitative easing has fuelled the new round of debate. Not surprisingly, current and former Fed officials tend to pooh-pooh the notion that this policy is affecting the dollar’s role. A group of ex-officials interviewed by the Wall Street Journal, including former Fed vice chairman Donald Kohn, saw the dollar maintaining its role for lack of alternatives. “The dollar will continue to be a reserve currency for decades to come,” Kohn was quoted as saying.

Those who forecast that the US will run into trouble financing its deficit, for instance, because it will no longer be the world’s reserve currency have got it backwards. Rather, the dollar is the de facto reserve currency because investors worldwide, including central banks, consider US government debt the safest investment – by far. It also offers the widest and most liquid market in the world.

This was the point driven home by Richmond Fed president Jeffrey Lacker recently when the question came up at a meeting of risk managers even in the sleepy state capital of Virginia. No one needs to tell managers of foreign official institutions how to manage their assets, he said in response to a question from the audience. They will do whatever is best for their accounts.

“The dollar has met a market test as an international reserve currency,” Lacker said. “We didn’t force it on anyone.” He said he was optimistic that the dollar would retain “a fairly strong position” as a reserve currency. In any case, he concluded: “If that were to erode – if our share of the international reserve currency market were to erode – I don't think it would cause any material problem for us.”

Crisis communications: playing the cards you’re dealt

By Malan Rietveld

Will Rising Food Prices Threaten Future Investments?

By Marina Shargorodska, OMFIF Advisory Board

My 6th Annual World Economic Forum in Davos, which unofficially ended on Sunday, was marked by two prevailing topics: inflation in China and the unrest in Egypt.

Of course, the interest in these topics goes far beyond the meeting rooms and presentation halls in Davos. Governments around the world seem on the verge of panic as they watch global food prices surging at the same time as they see helicopters circling in the skies above Cairo. The link has not been lost on them. Higher food prices are driving inflation and increasing dissatisfaction with governments. So it comes as no surprise that there have been reports of binge buying of wheat in Algeria and Saudi Arabia. Despite reasonable supplies, rice prices have been on the rise lately, and binge buying appears to be taking hold in this market as well. Bangladesh now says it intends to double its imports this year while Indonesia recently ordered four times as much as would be expected in a typical single order.

The correlation between fear of one’s own citizenry and the desire to stockpile foodstuffs seems fairly high – no? Of course, high food prices also have good effects: they stimulate production by attracting investment in agricultural resources. As the UK Science Commission noted in January, this is a long term problem and real food prices (i.e. adjusted for economy wide inflation) are set to rise by between 50% and 100% over the coming 40 years.

This reminds me of another event I had attended recently: the African Ambassadors New Year’s reception in Berne thrown by the Swiss African Business Council and where the universal theme has been focused on attracting investment into Africa’s agriculture sector. In terms of all factors that can lead to increased production: a) the availability of arable land b) improved use of irrigation c) increased use of fertilizers and d) advanced seed and machine technologies, it is Africa that can offer the largest gains.

The irony then is that rising food prices are likely to make investors more wary of geopolitical risks and less likely to make the very investments that are needed to prevent an even more vicious circle from developing.

Germany is treading a thin dividing line between solidarity towards errant states in the euro area – and solidarity towards its own citizens

By David Marsh

President Nicolas Sarkozy and Chancellor Angela Merkel both announced in Davos that the euro will not fail. The French and German finance ministers have proclaimed that the euro has turned a corner. European leaders are preparing a ‘grand bargain’ on the future of the European Financial Stability Fund.

But on whose terms will the bargain be? The sceptical tones in Germany are unmistakable: from the anti-inflationary sabre-rattling of German representatives on the Governing Council of the European Central Bank, through to profile-seeking Ministers from the junior coalition partners, the Free Democratic Party plugging a populist ‘hard euro’.

In addition, the debate over extended German rescue operations is still heavily influenced by judicial process on various Maastricht treaty lawsuits brought by anti-euro plaintiffs to the Federal Constitutional Court. 

Indeed, the observed drying up of ECB purchases of weaker countries’ government bonds in the last few days – despite a further rise in Portuguese yields – may have something to do with ECB fears that it is contravening constitutional niceties.

Germany’s position over euro rescues is at once terrifyingly simple and terrifyingly complex.  A clear commitment by Berlin to widen and deepen the rescue umbrella for troubled states, coupled with an ‘economic government’ for the euro area (as regularly urged by the French) could end up saving taxpayers  a lot of money. As in the Cold War, a potential assailant has to be deterred with the threat of massive retaliation.

But the problem is obvious. The earlier and the more generous such offers of assistance, the lower the willingness of the countries concerned to pursue persistent reforms that will end up changing matters for the better. So if Germany as the largest euro creditor shows too much German solidarity with the errant states, that could be counter-productive.

Equally, too much solidarity with Germany own electorate could encourage citizens in problem states to rise up against the lenders and their credit terms – as is already starting to happen in Ireland ahead of early elections later this month. An almost insoluble dilemma – and one that will probably loom ever larger during the euro’s 2011 year of destiny.

Documenting an ‘avoidable’ crisis

US panel fixes blame for financial crisis on Wall Street, regulators

By Darrell Delamaide

It hasn’t been a great time for bipartisan commissions in the US, given the political polarisation in Washington. The deficit commission late last year failed to reach a consensus that would have required Congress to take action and President Obama’s passing reference to its recommendations in his State of the Union speech will probably be the last we hear of them.

Now the Financial Crisis Inquiry Commission is releasing its massive 576-page report this week with the endorsement of only the six Democratic members of the 10-member panel. According to press leaks, the report, based on 19 days of hearings with more than 700 witnesses, concludes that the financial crisis was avoidable.

“The crisis was the result of human action and inaction, not Mother Nature or computer models gone haywire,” press reports quote the commission as saying. “The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble.”

Following what would appear to be a consensus in public opinion regarding the crisis, the report blames wildly imprudent mortgage lending, exotic instruments on Wall Street, malfeasance by credit rating agencies, and dereliction of duty by regulators, notably the Federal Reserve and the Securities and Exchange Commission.

The Republican members of the commission, after fancifully voting in December that the words “Wall Street” should be excluded from the report, are crafting dissenting reports. One Republican member, Peter Wallison, will issue a third report all his own, based on his obsession of many years about the evils of government-sponsored mortgage lenders Fannie Mae and Freddie Mac.

None of the commission members has any political heft. The chairman, former California Treasurer Phil Angelides, reached his high-water mark in losing disastrously against former Governor Arnold Schwarzenegger when he ran for re-election in 2006. One of the Republican members, Douglas Holtz-Eakin, was chief economic adviser to John McCain during the 2008 presidential campaign – responsible for the issue which cost McCain his last shred of credibility as a candidate.

While its conclusions are hardly surprising, the very sweep of the FCIC’s documentation should have an impact. Backing up the overall message, the late release of transcripts from the 2005 meetings of the Federal Open Market Committee, the Fed panel that determines monetary policy, showed indeed that officials at the central bank were aware of a potential housing bubble, but grossly underestimated its potential impact.

The commission report specifically faults both former Fed chairman Alan Greenspan for negligence with regard to “the flow of toxic mortgages” and his successor, Ben Bernanke, for his failure to foresee the developing crisis.

China's dollar Achilles heel

By David Marsh

‘The current international currency system,’ President Hu Jintao said portentously last week, ‘is the product of the past.’  The statement made headlines around the world.  However, as always, it was difficult to discern exactly what Hu was driving at.
 
China wants to modify the present currency arrangements under which the dollar is still by far the dominant international money. But Beijing remains remarkably vague about what it wishes to put in its place.

In the last couple of years, China has enacted a series of steps for enhancing the renminbi’s global role.
 
China’s Achilles heel is this: if the world monetary system is outdated, then shouldn’t the People’s Bank be lowering the volume of reserves held in dollars?

China remains officially tight-lipped about the proportion held in the greenback. China's foreign exchange reserves rose to a record $2.85 tn by the end of last year, an 18.7% increase year-on-year, according to the People's Bank. Yi Gang, vice-governor, has admitted that the reserves increase ‘will be increasingly challenging China's asset management.’

Officially, the proportion of reserves held in dollar is a state secret. However, there seems to be increasing awareness that this opacity doesn’t make much sense. We know (courtesy of Reuters) that China Securities Journal, an official newspaper, citing unnamed reserve managers, said a few months ago the reserves composition is in line with ‘the global average’: 65% in dollars, 26% in euros, 5% in pounds and 3% in yen.

China could make a further step by communicating the currency reserve breakdown to the International Monetary Fund. The IMF’s latest release, at the end of December, states that overall world foreign exchange reserves at the end of September 2010 totalled $8,986 bn against $8,421 bn at the end of the second quarter and $7,880 bn a year earlier.

However the ‘allocated reserves’ – basically the reserves for which member countries give the IMF a currency breakdown, a list which excludes China and some other mainly developing countries – were  ‘only’ $4,999 bn – leaving a $4,000 bn  ‘black hole’ of unallocated reserves.  Of the ‘allocated reserves’, 61% are in dollars and 27% are in euro. China would do everyone a service if it started communicating its holdings to the IMF, so that the aggregate figures became more meaningful. If we are to regard the world’s largest reserve holder as serious about revamping the future of international money, then it should at least give us a bit more information about the status quo.

Marcus' quagmire - a common tale

By Malan Rietveld

‘A lot of money’. That’s how Gill Marcus, the governor of the South African Reserve Bank, this week described the central bank’s $53bn currency purchases in 2010 as part of a largely ineffectual attempt to stem the appreciation of the local unit.

US ready to take off gloves with China

Currency dispute could brim over to trade confrontation

By Darrell Delamaide

The US is losing patience with China’s intractability on the currency issue and is moving closer to a full-fledged confrontation over trade.

At issue as President Hu Jintao conducts a state visit in the US is not only what Washington views as currency manipulation to keep down the value of the renminbi but also a host of other protectionist measures that apparently flout international trade rules.

President Hu’s plan to assuage American anxieties by promising new Chinese investment in the US won’t be much of a sop to increasingly restive lawmakers and business leaders. After all, building a plant in the US to assemble wind turbines will hardly make up for the job losses from China’s aggressive moves to protect and nurture a wind turbine industry that now has some 50% of the global market.

Wind turbine subsidies are the subject of a US complaint in December to the World Trade Organisation, seeking consultations regarding a Chinese fund that appears to contravene WTO rules. Washington is mulling a similar complaint with regard to solar cells, which, like the wind power issue, goes back to a petition filed last September by the United Steelworkers.

The Chinese moves in green energy technology are particularly galling to US policymakers because the industry was supposed to be one of the pillars of a US manufacturing renaissance. As it is, much of the stimulus money spent by the federal government on green energy actually went to creating Chinese jobs.

The New York Times documented in a recent series of articles how China is using local-content requirements, low-interest government loans and preferential contracts to favour domestic producers, which can now use their economies of scale to capture global market share – including in the United States.

Nor is it likely that the US will have much more patience with China’s shell game of shutting down a subsidy fund – as it did with two wind turbine funds named in the USW petition – or temporarily suspending implementation of a protectionist measure when challenged – as it did with an “indigenous innovation” initiative requiring local R&D.

The motives behind China's euro purchases

Beijing factors in power politics, economic self-interest

By David Marsh

China and Japan are turning into the euro’s best friends. Beijing is conducting a charm campaign over purchases of government bonds from the hard-up southern states of Greece, Portugal and Spain. Relatively small amounts, of course — but good public relations. For its part, Japan, the second largest owner of foreign exchange reserves after China, says it wants to acquire more than 20% of planned bond issues of the European bail-out fund as a means of boosting market confidence.

This is all part of a natural desire to maintain diversified stocks of currencies by the world’s biggest dollar holders. Especially in the case of Japan, which has built up its non-dollar stocks on a more regular basis than the Chinese over the years, technical and financial reasons have been the decisive factor behind the declaration in favour of European bonds.

The Beijing leadership is pursuing a more diverse mix of objectives. Behind its bond-market buying for peripheral euro states lies a goodly portion of political power play.

First, China wants to show the Europeans and Americans who’s boss on the currency scene when things get rough. China certainly has no plans — at least not now — to establish hegemony over the financial markets. But at a time when the Chinese face continued American pressure on revaluing the renminbi, a gentle reminder of who’s king of the currency castle cannot come amiss.

China is guided, too, by pure self-interest in its international trade relations. The European Union is now China’s most important trading partner. Given the likelihood of further upward pressure on its own currency, Beijing wants to do everything to oppose a further fall in the euro and avoid negative consequences on its own exports.

The rivalry with America extends, too, to hearts and minds. China wants to win respect, if not affection, by demonstrating how it can work in partnership to support economic reforms in other parts of the world. A bid to show themselves more interested in promoting stability than the Americans may win the Chinese significant plus-points over the longer term. Diverting international attention from overheating in its own economy is an additional bonus.

Finally, building a relationship with the most powerful country in the European Union, Germany, plays a key role. Visitors in Beijing’s monetary parlours in recent months have been left in no doubt about Chinese dismay over shortcomings of some European countries in terms of debt, fiscal consolidation and so on. China stands four square behind German efforts to corral the euro area toward more discipline.

With its announcements on European government bond purchases, the Chinese appear to be helping the nations on the brink of the monetary abyss. In reality, however, Beijing is showing solidarity with the strongest but also the most potentially vulnerable member of the single currency, Germany — which has most to give in contributions to failing states, and most to lose if monetary union were to collapse.

The Chinese are no doubt thinking that, whatever the final outcome of the euro saga, the German position will prevail. China can only buttress its longer-term political position in Europe if, by siding with the weaker peripheral states, it actually aids the strong one at the core.

Central banks in the money

By Malan Rietveld

It seems a bit passé at this stage of the financial crisis to state that central banks have never been as critical to functioning of the global financial system as right now.

But just this week two news items served to remind of this fact. Both stories spoke to simple one fact: central banks, quite literally, are in the money.

A rising tide lifts all vessels

Why we should be optimistic about euro's 2011 prospects

By Krafft Holtz

The Westerwelle factor

Merkel's coalition partner weakens hand in euro crisis

By Darrell Delamaide

Angela Merkel’s task in navigating the shoals of the euro crisis hasn’t been made any easier by the leak sprung in her coalition with the plummeting popularity of the Free Democrats and their leader, Guido Westerwelle.

Westerwelle is something of an anomaly. He is a deputy chancellor and party leader with little knowledge or interest in economics in the midst of an economic crisis. He is also a foreign minister with little knowledge or interest in foreign affairs. The US ambassador described the FDP leader in one of the Wikileak-ed cables as “incompetent, vain and critical of the United States.”

Westerwelle is now the least popular major politician in Germany and in opinion polls the FDP has sunk below the 5% threshold for parliamentary representation. The expectation is that trend will be confirmed in state elections in Baden-Württemberg in March, jeopardising CDU control in Stuttgart and perhaps enabling an SPD-Green coalition to take power.

Long gone are the days when the FDP under Hans-Dietrich Genscher could get away with taking Germany from a centre-left government to a centre-right government without an election, simply by switching coalition partners. As it is, Westerwelle is not expected to survive as the party’s leader if the FDP fails to surmount the 5% threshold in the March state election.

Already the FDP travails have weakened Merkel’s political leverage at home. Westerwelle has pledged German support for the euro but has been unbending on bailing out or guaranteeing “profligate” spending in euro area countries.
 
He backs Merkel in rejecting joint euro bonds as a solution. In a series of interviews last month, he argued that Germany needs to keep control of its own finances and cannot accept a “transfer union” that would give other governments few incentives to save.

For now, however, Westerwelle’s main contribution to the deliberations in Berlin is the drain his presence creates on the government’s political support.

At its annual conference last week, the FDP swept its leadership crisis under the rug for the moment. But it is sure to resurface at the time of the Baden-Württemberg elections, with further debilitating effect on Merkel’s government, exacerbated by the prospect of six more state elections later in the year.

And who knows just where the euro roller coaster will be then?

The reconversion of Otmar Issing

Former ECB chief economist veers again towards pessimism on European single currency

By David Marsh

Otmar Issing, the former chief economist of the European Central Bank and the German Bundesbank, is a genial number-cruncher who believes in the overall benefits of European integration but is genuinely open to others’ views. He is a key bellwether for Germany’s stance on the euro. In his 75th year, nearly five years after he retired from the ECB, he is still someone to watch; particularly now he has turned virulently pessimistic over the European single currency. In a marked change from his relative sanguinity during his eight years at the ECB, he terms member countries’ unreliability on economic policies ‘a basic design flaw of monetary union.’

And he unashamedly says – in an essay in the January OMFIF Bulletin to be published this week – the days of the single currency may be numbered. ‘The present seemingly unstoppable process towards further financial transfers will generate tensions of an economic and especially political kind.  The longer this process is characterised by unsound conduct of individual member countries, the more these tensions will endanger the existence of EMU.’ 

In the period before he was appointed in spring 1998 to become the ECB’s first board member in charge of economics, Issing won his spurs as a steadfast sceptic on European monetary integration.  Chancellor Helmut Kohl grumbled about his finance minister’s recommendation to appoint Issing to the ECB board, pointing out: ‘He has never said a good word about the euro.’ Theo Waigel, Kohl’s wily finance minister, convinced the Chancellor that Issing’s well-known euro doubts would help convince ordinary Germans that the future of the single currency lay in safe hands.

During his eight years at the ECB before he retired in summer 2006, Issing never went over to the side of die-hard pro-euro enthusiasts, insisting that the single currency remained an ‘experiment.’ And he pointed out the dangers that imbalances could lead to a constant flow of funds from better- to worse-off EMU states that could disastrously undermine political and economic confidence.  But he suspended his previous disbelief. In a speech in March 2006,  shortly before he retired (and took a part time job with Goldman Sachs), Issing said monetary union could succeed without political union, stressing that ‘Euro area countries already share important elements of state formation which are also key to the functioning of monetary union.’  He was confident that the euro’s rules-based system would produce stability and declared: ‘Monetary union is and will remain one of [the EU’s] major success stories.’

Even after leaving office, when he wrote a book on EMU (published in English in 2008), Issing’s scenarios remained largely benign, and his glass was half-full, not half-empty.  He regarded the build-up in current account imbalances among euro members not as a source of weakness but as a sign of strength, on the grounds that financial integration among disparate member states allowed worse-off countries to put aside previous constraints on growth.

Now, however, after the large increase in risk premia on deficit countries’ debt and the recourse to official European bail-out schemes during 2010, Issing writes, ‘The present scenario does not come as a surprise… This was a crisis that in many ways had been pre-announced. The seeds were sown some time ago… The euro members in no way represent a politically unified entirety, but they form a single currency. At the outset, and also after the start, politics failed to create the right conditions for it to work optimally.’

Cynics might say that ratcheting up euro rhetoric is all part of a German strategy to enforce tougher economic conditions on bail-outs. All this makes life more difficult for the deficit countries – but by pointing out plaintively that Europe is on the way to a ‘transfer union’, Issing may actually be helping to prepare the German public to accept more bail-outs.

When models are worse than useless

By Malan Rietveld

The three deadly sins of the euro protagonists

Much burden-sharing still lies ahead

By David Marsh in Berlin

André Szász, long-time board member of the Dutch central bank responsible for international monetary affairs, has witnessed all the major ups and downs of European money during a career that started in the 1970s.  Referring to the treaty that set down the path towards economic and monetary union (EMU), he once opined:  ‘Not one of the politicians who agreed the Maastricht treaty in 1991 understood what they were doing.’

Szász, who retired in the early 1990s, has a point. Confronted with the plethora of challenges piling up around the euro, Europe’s politicians have looked overwhelmed for some time.

What were the cardinal errors – the deadly sins?  Let me list three decisive miscalculations, all ultimately self-reinforcing, all contributing to the slow-burn euro crisis.

First, the belief that the ‘one size fits all; monetary policy would lead to a symmetrical distribution of pain and gain turned out to be illusory. It was clear that faster-growing countries with above-average inflation and low interest rates at the beginning of EMU would gain transitory benefits – but would suffer negative effects through reduced competitiveness that could no longer be offset by devaluations. The hope was that compensation would come from the disadvantage faced by low-inflation, low-growth countries such as Germany, which was held back at the beginning of the 2000s by interest rates that were too high for its own economic situation. We now know that the distribution has been asymmetric.  At the start of monetary union, Germany used years of subdued growth to strengthen fundamentally its economic structure, and is now reaping the rewards. Other countries enjoyed low interest rates and short-lived expansion without addressing structural reforms - and are now paying the bill.

The second error related to the distortions in competitiveness that inevitably build up in a fixed exchange rate system uniting countries with different developments in prices and productivity.  The idea was that these distortions could be reversed relatively easily. Not so. According to OECD statistics, Germany’s competitiveness measured by unit labour costs has improved by 10% globally since the start of EMU, whereas countries like Spain and Italy have suffered losses of 20%. As a consequence of austerity in the southern countries, and the present above-average growth in Germany, the competitive gap between the better- and worse-performers will fall – although nothing like fast enough to  make good the disparities advantages. Those who look to higher inflation in Germany to rescue the south will end up disappointed.

Third mistake: that trouble-free financing could be arranged in perpetuity for EMU members’ extreme current account surpluses and deficits caused by these competitive variations.  Politicians and technocrats knew EMU would be immune to currency crises. Yet they overlooked that the system could be prone to credit crises, as lenders demanded higher interest rates on debt  perceived to be increasingly higher risk - even (and especially) after years of apparent convergence on the bond markets.

We should not expect too much from the self-healing power of economic developments. Large imbalances between creditor and debtor nations are falling, but they are still there, and they still need to be financed. The OECD estimates that in 2012 Germany and the Netherlands will still be running current account surpluses amounting to 7% of GDP, Spain, Greece and Portugal will have deficits between 5 and 8% of GDP. Taxpayers in creditor countries are right to be wary. A great deal of burden-sharing lies ahead.

Europe's woes provoke soul-searching on African monetary union

By David Marsh, Co-chairman

For many years, the legacy of the colonial past and their own exemplary economic performance after the Second World War gave the Europeans cult status in money matters across Africa.

Now, with deep strains gnawing away at economic and monetary union (EMU), could all this be about to change? Quite a turnaround here. A continent that for decades has been a byword for grandiose economic mismanagement is now starting to ask whether Europe's governance problems make it the right model to follow.

These reflections have been prompted by a week of discussions with central bankers and economists from African countries. In the wake of the great changes wrought by the demise of the Soviet Union and the transition to post-apartheid South Africa in the early 1990s, it was natural that the Africans turned to Europeans for direction – and in particular the new dynamic EMU model led by Germany and France.

All the greater recently has therefore been the consternation of African economists and technocrats at the increasing difficulties in the euro area. The path towards EMU for several states in Africa looks less straightforward than imagined.

From central bankers across the region, I was asked many questions. How can better-off states in monetary union protect themselves from contagion risk by less well-managed members? Doesn't a fiscal union need to be brought in at the same time as monetary union? How do African politicians not at all used to sharing power intend to handle the losses of sovereignty inevitable in EMU?

There is a positive side. Developing countries now have a ringside seat to analyse the successes and shortcomings of the European monetary experiment and learn appropriate lessons.

Many building blocks for African Monetary Union -- improved fiscal performance, enhanced trade integration with neighboring countries, modernization of financial markets -- are necessary requirements for future growth. So Africa's EMU drive can catalyse useful developments in economic policy that need to be done anyway.

African EMU needs to come only after proven economic convergence: what the Europeans used to call the ‘coronation theory.' European tenacity needs to be combined with African patience.