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Alvaro Espina 24 Noviembre de 2014 Entre 28 Septiembre y 7 de octubre ft.com Comment Opinion October 7, 2014 6:19 am Apple, the European Commission and Ireland By James Stewart A tax-based industrial policy will not produce an innovative economy, writes James Stewart

©Bloomberg Apple's campus in Cork, Ireland I rish tax policy has in recent years attracted considerable international criticism, but within Ireland it is seen as inviolable. Enda Kenny, the Irish prime minister, denies that the country has become a “brass plate location” where international corporations try to book their profits so as to benefit from low tax rates. He has described the country’s low tax rate as “a cornerstone of Irish industrial policy”. It is no doubt true that a sudden change of policy would hurt investment in the short term. What Ireland’s government seems not to be aware of, however, is the vast quantity of profits that are not subject to corporation tax anywhere in the world because of “double Irish” tax strategies. More ON THIS STORY// Apple braced for explosive Brussels probe/ Apple hit by Brussels tax finding/ Apple hits back over ‘bendgate’ furore/ Lex iPhone 6 – bent phone, firm margin/ New iPhones the verdict ON THIS TOPIC// Cork brushes off Apple tax claims/ Ireland under pressure over low tax rates/ Q&A Brussels tackles Ireland over Apple tax/ Watchdog warns Ireland over budget IN OPINION// Joe Studwell Focus on Hong Kong tycoons/ Amy Kazmin India’s clean-up drive/ Anjana Ahuja The fight against Ebola/ Dominique de Villepin Weapons of peace This ruse involves two Irish companies, one of which makes sales to customers and pays hefty royalties to the second, which is resident in a tax haven such as the Cayman Islands. The sliver of profit attributable to the first company is taxed at the Irish rate of 12.5 per cent. But the lion’s share, attributable to the second company, is barely tax ed at all. In May last year, finance minister Michael Noonan told parliament that it was impossible to know how many companies avoid paying tax in this way. In fact, we have some idea. In 2011, 19 subsidiaries registered in Ireland between them avoided paying tax on €33bn of profits in this way. (Apple’s was one of them.) That sum is equivalent to one- fifth of Ireland’s entire economic output for that year. Several more companies have similar arrangements, but their profits are excluded from the total because their legal structure means they do not have to file accounts. American companies can pay between 10 and 25 per cent tax on profits they make in the US, depending on what measure you use. But some pay almost nothing on profits they make outside the US, and Ireland has in some cases become central to these tax avoidance strategies. How did industrial policy in Ireland became so dependent on such a favourable corporate tax regime? Those with the best knowledge of the tax system will be the ones appointed to senior management jobs Tweet this quote Some clues can be found in the European Commission’s report on Apple and Ireland. The report says that at times there was extensive contact – which the commission describes as “negotiations” – between Apple’s tax advisers and the Irish tax authorities. There can be little doubt that other companies are engaging in similar talks. A tax-based industrial policy will not produce an innovative economy at the cutting edge of technology and research. Instead, it will lead to an emphasis on tax reduction. Those with the best knowledge of the tax system will be the ones appointed to senior management jobs. They lean in turn on tax advisers, whose prosperity brings them considerable influence in formulating tax policy and legislation. Meanwhile, those skilled in new product development, production expertise, logistics and marketing, are being sidelined. The tax regime for foreign direct investment in Ireland will probably have to change, not least because of the commission’s intervention. However, there is little reason to think that the underlying conduct will change much in the near future. The affected companies will seek other tax incentives to do business in Ireland. The prime minister has already spoken of the need to improve the competitiveness of the tax treatment available in the country for research and development expenses and intellectual property rights. It is time for countries to work together to fight abuses of the international tax system. An economy dominated by sliderules is scarcely better than one specialising in brass plates. The writer is an associate professor of finance at Trinity College, Dublin http://www.ft.com/intl/cms/s/0/bde702e4-4d5e-11e4-bf60- 00144feab7de.html#axzz3FMDPrdyo 2

ft.com Markets Capital Markets October 6, 2014 5:00 pm Eurozone inflation gauge hits record low By Ralph Atkins in London

©AP President of European Central Bank Mario Draghi walks in front of the ECB governing council prior to their meeting in Naples A closely watched gauge of inflation rates expected by financial markets has fallen to the lowest on record, dealing another blow to Mario Draghi, European Central Bank president. The eurozone inflation rate expected over five years starting in five years’ time fell to 1.88 per cent on Monday, according to Barclays data based on swaps prices. That was below the previous lowest close in October 2010 and the weakest since the euro inflation swaps market was developed a decade ago. More ON THIS TOPIC// The Short View Inflation outlook brings ECB QE into view/ Editorial Criticism of Draghi’s actions is misguided/ ECB to start asset purchases this month/ The World Mario Draghi’s press conference IN CAPITAL MARKETS// Investors weigh rising risks of EM assets/ Dollar rise gives Brevan Howard a boost/ Merck sale boosts Europe’s bond market/ First post-Argentina bond contracts Mr Draghi is battling to prevent low inflation rates tipping the eurozone into a damaging deflationary downswing. The “five year-five year” inflation measure gained attention after being cited by Mr Draghi in August at a gathering of central bankers in Jackson Hole, Wyoming. The sharp fall he noted then led to the ECB announcing in September an unexpected cut in interest rates and a private sector asset purchase programme. Mr Draghi’s focus on the measure has since backfired, however. Rather than rising on the ECB’s actions, it has continued to fall. September’s measures stopped short of full-blown “quantitative easing”, involving large scale purchases of government bonds, which many market strategists argue is needed in the eurozone, and Mr Draghi’s comments after last week’s ECB meeting suggested the central bank was no closer to taking such a step.

“It seems the bearish trend has continued,” said Khrishnamoorthy Sooben, Barclays analyst. “The reaction of the broader market to the ECB last week suggests there was some disappointment. Probably markets were expecting a bit more.” At last week’s press conference in Naples, Italy, Mr Draghi insisted the ECB monitored a broad range of information about inflation expectations. “We don’t use one single measure of inflationary expectations. We use a broad range of indicators,” he said. But the ECB president admitted that “our inflation expectations measures have gone down, especially on the short horizons” and that the falls were being watched, “definitely with great attention”. “Markets have been obsessed with these five year-five year rates since Draghi mentioned it at Jackson Hole. It is not as if [the inflation swaps market] is a perfect market to assess longer term inflation expectations,” said Peter Vanden Houte, chief eurozone economist at ING in Brussels. “It was probably a mistake for Draghi to mention it explicitly . . . Markets are now focused on this one indicator and when it moves it creates an anticipation of further easing.” By keeping inflation expectations in line with their targets, central banks aim to affect pricing behaviour and keep actual inflation rates under control. Although the eurozone inflation rates implied by swap markets appears in line with the ECB’s target of an annual rate “below but close” to 2 per cent, they have historically remained firmly above that level. Eurozone annual inflation fell in September to a five- year low of 0.3 per cent. In Naples, Mr Draghi warned of the danger of “a prolonged period of too low inflation” but argued steps taken by the ECB would “underpin the firm anchoring of medium- to long-term inflation expectations”. http://www.ft.com/intl/cms/s/0/57ec035e-4d63-11e4-8f75- 00144feab7de.html#axzz3FMDPrdyo

ft.com comment Columnists October 6, 2014 2:12 pm Why public investment really is a free lunch

By Lawrence Summers The IMF finds that a dollar of spending increases output by nearly $3 It has been joked that the letters IMF stand for “it’s mostly fiscal”. The International Monetary Fund has long been a stalwart advocate of austerity as the route out of financial crisis, and every year it chastises dozens of countries for their fiscal indiscipline. Fiscal consolidation – a euphemism for cuts to government spending – is a staple of the fund’s rescue programmes. A year ago the IMF was suggesting that the US had a fiscal gap of as much as 10 per cent of gross domestic product.

©AFP All of this makes the IMF’s recently published World Economic Outlook a remarkable and important document. In its flagship publication, the IMF advocates substantially increased public infrastructure investment, and not just in the US but much of the world. It asserts that when unemployment is high, as it is in much of the industrialised world, the stimulative impact will be greater if investment is paid for by borrowing, rather than cutting other spending or raising taxes. Most notably, the IMF asserts that properly designed infrastructure investment will reduce rather than increase government debt burdens. Public infrastructure investments can pay for themselves. Why does the IMF reach these conclusions? Consider a hypothetical investment in a new highway financed entirely with debt. Assume – counterfactually and conservatively – that the process of building the highway provides no stimulative benefit. Further assume that the investment earns only a 6 per cent real return, also a very conservative assumption given widely accepted estimates of the benefits of public investment. Then, annual tax collections adjusted for inflation would increase by 1.5 per cent of the amount invested, since the government claims about 25 cents out of every additional dollar of income. Real interest costs, that is interest costs less inflation, are below 1 per cent in the US and much of the industrialised world over horizons of up to 30 years. So infrastructure investment actually makes it possible to reduce burdens on future generations. In fact, this calculation understates the positive budgetary impact of well-designed infrastructure investment, as the IMF recognised. It neglects the tax revenue that comes from the stimulative benefit of putting people to work constructing infrastructure, as well as the possible long-run benefits that come from combating recession. It neglects the reality that deferring infrastructure renewal places a burden on future generations just as surely as does government borrowing. More ON THIS STORY// Editorial Bleak words from the IMF/ Markets Insight US midterms will have limited impact/ Global recovery is stalling, says index/ France tells Europe to focus on growth ON THIS TOPIC// IMF urges overhaul of sovereign bonds/ Rich nations urged to honour aid pledges/ Lagarde warns of ‘new mediocre’ era/ EM central banks’ euro holdings fall LAWRENCE SUMMERS// Reform as the answer/ Cost of second-term presidents/ US foreign policy/ The inequality gap It ignores the fact that by increasing the economy’s capacity, infrastructure investment increases the ability to handle any given level of debt. Critically, it takes no account of the fact that in many cases government can catalyse a dollar of infrastructure investment 5

at a cost of much less than a dollar by providing a tranche of equity financing, a tax subsidy or a loan guarantee. When it takes these factors into account, the IMF finds that a dollar of investment increases output by nearly $3. The budgetary arithmetic associated with infrastructure investment is especially attractive at a time when there are enough unused resources that greater infrastructure investment need not come at the expense of other spending. If we are entering a period of secular stagnation, unemployed resources could be available in much of the industrial world for quite some time. While the case for investment applies almost everywhere – possibly excepting China, where infrastructure investment has been used a stimulus tool for some time – the appropriate strategy for doing more differs around the world. While the case for investment applies almost everywhere, the appropriate strategy for doing more differs around the world The US needs long-term budgeting for infrastructure that recognises benefits as well as costs. Projects should be approved with reasonable speed. The government can contribute by supporting private investments in areas such as telecommunications and energy. Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps. This may be possible through the expansion of the European Investment Bank or more use of capital budget concepts in implementing fiscal reviews. Emerging markets need to make sure that projects are chosen in a reasonable way based on economic benefit. What is crucial everywhere is the recognition that in a time of economic shortfall and inadequate public investment, there is for once a free lunch – a way for governments to strengthen both the economy and their own financial positions. The IMF, a bastion of “tough love” austerity, has come to this important realisation. Countries with the wisdom to follow its lead will benefit. The writer is Charles W Eliot university professor at Harvard and a former US Treasury secretary http://www.ft.com/intl/cms/s/2/9b591f98-4997-11e4-8d68- 00144feab7de.html#axzz3FMDPrdyo

A Reporter at Large October 13, 2014 Issue The Empire of Edge How a doctor, a trader, and the billionaire Steven A. Cohen got entangled in a vast financial scandal. BY PATRICK RADDEN KEEFE

The federal investigation echoed tactics used for the Mob: get low-level workers to inform on those farther up the hierarchy.CREDIT ILLUSTRATION BY CONCEPCIÃ³N STUDIOS. CLOCKWISE FROM TOP: LOUIS LANZANO / BLOOMBERG VIA GETTY; SHANNON STAPLETON / REUTERS / CORBIS; LOUIS LANZANO/BLOOMBERG VIA GETTY; BRENDAN MCDERMID / REUTERS / CORBIS; SPENCER PLATT / GETTY; RONDA CHURCHILL / BLOOMBERG VIA GETTY As Dr. Sid Gilman approached the stage, the hotel ballroom quieted with anticipation. It was July 29, 2008, and a thousand people had gathered in Chicago for the International Conference on Alzheimer’s Disease. For decades, scientists had tried, and failed, to devise a cure for Alzheimer’s. But in recent years two pharmaceutical companies, Elan and Wyeth, had worked together on an experimental drug called bapineuzumab, which had shown promise in halting the cognitive decay caused by the disease. Tests on mice had proved successful, and in an initial clinical trial a small number of human patients appeared to improve. A second phase of trials, involving two hundred and forty patients, was near completion. Gilman had chaired the safety- monitoring committee for the trials. Now he was going to announce the results of the second phase. 7

Alzheimer’s affects roughly five million Americans, and it is projected that as the population ages the number of new cases will increase dramatically. This looming epidemic has added urgency to the scientific search for a cure. It has also come to the attention of investors, because there would be huge demand for a drug that diminishes the effects of Alzheimer’s. As Elan and Wyeth spent hundreds of millions of dollars concocting and testing bapineuzumab, and issued hints about the possibility of a medical breakthrough, investors wondered whether bapi, as it became known, might be “the next Lipitor.” Several months before the Chicago conference, Barron’s published a cover story speculating that bapi could become “the biggest drug of all time.” One prominent investor was known to have made a very large bet on bapi. In the two years leading up to the conference, the billionaire hedge-fund manager Steven A. Cohen had accumulated hundreds of millions of dollars’ worth of Elan and Wyeth stock. Cohen had started his own hedge fund, S.A.C. Capital Advisors, with twenty-five million dollars in 1992 and developed it into a fourteen-billion-dollar empire that employed a thousand people. The fund charged wealthy clients conspicuously high commissions and fees to manage their money, but even after the exorbitant surcharge investors saw average annual returns of more than thirty per cent. S.A.C. made investments in several thousand stocks, but by the summer of 2008 the firm’s single largest position was in Wyeth, and its fifth-largest was in Elan. All told, Cohen had gambled about three-quarters of a billion dollars on bapi. He was famous for making trades based on “catalysts”—events that might help or hurt the value of a given stock. Sid Gilman’s presentation of the clinical data in Chicago was a classic catalyst: if the results were promising, the stocks would soar, and Cohen would make a fortune. Gilman had not wanted to make the presentation. Seventy-six years old and suffering from lymphoma, he had recently undergone chemotherapy, which left him completely bald—like the “evil scientist in an Indiana Jones movie,” he joked. But Elan executives urged Gilman to participate. He was a revered figure in medical circles, the longtime chair of neurology at the University of Michigan’s medical school. In Ann Arbor, a lecture series and a wing of the university hospital were named for him. His C.V. was forty-three pages long. As a steward for the fledgling drug, he conveyed a reassuring authority. But soon after Gilman began his thirteen-minute presentation, accompanied by PowerPoint slides, it became clear that the bapi trials had not been an unqualified success. Bapi appeared to reduce symptoms in some patients but not in others. Gilman was optimistic about the results; the data “seemed so promising,” he told a colleague. But the investment community was less sanguine about the drug’s commercial prospects. One market analyst, summarizing the general feeling, pronounced the results “a disaster.” The Chicago conference was indeed a catalyst, but not the type that investors had expected. It appeared that Cohen had made an epic misjudgment. When the market closed the following day, Elan’s stock had plummeted forty per cent. Wyeth’s had dropped nearly twelve per cent. By the time Gilman made his presentation, however, S.A.C. Capital no longer owned any stock in Elan or Wyeth. In the eight days preceding the conference, Cohen had liquidated his seven-hundred-million-dollar position in the two companies, and had then proceeded to “short” the stocks—to bet against them—making a two-hundred-and-seventy-five- million-dollar profit. In a week, Cohen had reversed his position on bapi by nearly a billion dollars. Gilman and Cohen had never met. The details of the clinical trials had been a closely guarded secret, yet S.A.C. had brilliantly anticipated them. Cohen has suggested that his decisions about stocks are governed largely by “gut.” He is said to have an uncanny ability to watch the

numbers on a stock ticker and intuit where they will go. In the assessment of Chandler Bocklage, one of his longtime deputies, Cohen is “the greatest trader of all time.” But federal authorities had a different explanation for S.A.C.’s masterstroke. More than three years after the Chicago conference, in December, 2012, prosecutors in New York indicted a young man named Mathew Martoma, who had worked as a portfolio manager for Cohen. They accused him of using confidential information about bapi to engineer the most lucrative insider- trading scheme in history. According to the indictment, Martoma had been receiving secret details about the progress of the clinical trials for nearly two years and, ultimately, obtained an early warning about the disappointing results of the second phase. His source for this intelligence was Sid Gilman. In 1977, after completing medical school at U.C.L.A. and teaching at Harvard and Columbia, Gilman was recruited to run the neurology department at the University of Michigan. He moved to Ann Arbor with his first wife, Linda, and their two sons. Gilman’s marriage unravelled in the early eighties, and the older son, Jeff, developed psychological problems. Jeff committed suicide in 1983, overdosing on pills in a hotel room near campus. Gilman had experienced tragedy before: his father had walked out on the family when he was a boy, and his mother later committed suicide. After Jeff’s death, Gilman seems to have dealt with his despair by throwing himself into his job. “The man worked himself to distraction,” one of his many protégés, Anne Young, who went on to become the chief of neurology at Massachusetts General Hospital, told me. In 1984, Gilman married a psychoanalyst named Carol Barbour, but they never had children, and though his surviving son, Todd, attended the University of Michigan, they eventually became estranged, leaving him with no ties to his former family. Over the years, however, Gilman became a father figure to dozens of medical residents and junior colleagues. “Helping younger people along—that was a constant,” Kurt Fischbeck, a former colleague of Gilman’s who now works at the National Institutes of Health, told me. Gilman was “incredibly supportive” of younger faculty, Young said. “He would go over grants with us, really putting an effort into it, which is something chairs rarely do.” One day in 2002, Gilman was contacted by a doctor named Edward Shin, who worked for a new company called the Gerson Lehrman Group. G.L.G., as it was known, served as a matchmaker between investors and experts in specialized industries who might answer their questions. “It was kind of ridiculous that the hedge-fund business got so much information by asking for favors . . . when it would certainly pay,” the company’s chief executive, Mark Gerson, told the Times.

“You’re a little too niche.”BUY OR LICENSE » Shin proposed that Gilman join G.L.G.’s network of experts, becoming a consultant who could earn as much as a thousand dollars an hour. Gilman was hardly alone in saying yes to such a proposal. A study published in the Journal of the American Medical Association found that, by 2005, nearly ten per cent of the physicians in the U.S. had established relationships with the 9

investment industry—a seventy-five-fold increase since 1996. The article noted that the speed and the extent of this intertwining were “likely unprecedented in the history of professional- industrial relationships.” Gilman read the JAMA article, but disagreed that such arrangements were objectionable. In an e-mail to Shin, he explained that investors often offered him a fresh perspective on his own research: “Although remuneration provides an incentive, the most attractive feature to this relationship (at least for me) is the exchange.” Gilman’s university salary was about three hundred and twenty thousand dollars a year, a sum that went a long way in Ann Arbor. As he took on more paid consultations, he began supplementing his income by hundreds of thousands of dollars a year. Acquaintances did not notice any abrupt change in his life style: Gilman wore elegant clothes, but otherwise he and his wife appeared to live relatively modestly. “He was not a flashy guy who revelled in expensive toys,” Tim Greenamyre, a former student, who now runs the Pittsburgh Institute for Neurodegenerative Diseases, told me. Gilman counselled Greenamyre and other colleagues to avoid even the appearance of a conflict of interest in their professional dealings, and he made a point of telling people that he never invested in pharmaceutical stocks. The consulting, he later maintained, was simply “a diversion.” In the summer of 2006, Gilman received a call from Mathew Martoma, who explained that he had recently joined S.A.C. and was focussing on health-care stocks. They spoke about Alzheimer’s remedies, and specifically about bapineuzumab. Although Martoma had no medical background, he was attuned to the scientific intricacies at play. His mother and his wife, Rosemary, were physicians, and he had a long-standing interest in Alzheimer’s, dating back to his childhood, in Florida, when he volunteered as a candy striper at a local hospital. He and Gilman talked for more than two hours. Afterward, Martoma asked G.L.G. to schedule another consultation. S.A.C. was a notoriously intense place to work. Its headquarters, on a spit of land in Stamford, Connecticut, overlooking the Long Island Sound, are decorated with art from Cohen’s personal collection, including “Self,” a refrigerated glass cube, by Marc Quinn, containing a disembodied head sculpted from the artist’s frozen blood. It was nearly as frigid on the twenty-thousand- square-foot trading floor, which Cohen kept fiercely air-conditioned—employees were issued fleece jackets with the S.A.C. monogram, for keeping warm. The atmosphere was hushed, with telephones programmed to blink rather than ring, but a curious soundtrack could be heard throughout the building. As Cohen sat at his sprawling desk, before a flotilla of flat-screen monitors, and barked orders for his personal trades, a camera—the “Steve cam”—was trained on him, broadcasting his staccato patter to his subordinates. Cohen is not a physically imposing man: he is pale and gnomish, with a crooked, gap-toothed smile. But on the Steve cam he was Oz. When S.A.C. first approached Martoma about a job, he was ambivalent. He was living in Boston, working happily at a small hedge fund called Sirios Capital Management. He knew that careers at S.A.C. followed a starkly binary narrative. Portfolio managers were given a pot of money. If their investments were consistently profitable, they became very rich very quickly. If their investments lost money, they were out of a job. Contracts at S.A.C. contained a “down and out” clause, so it was prosper or die. Cohen likened his traders to élite athletes; for many years, he paid a psychiatrist who had worked with Olympic competitors to spend several days a week at S.A.C., counselling employees about mastering their fears. He hired high achievers who were accustomed to gruelling pressure. Martoma had studied bioethics at Duke, graduating summa cum laude. After a year working at the National Institutes of Health, where he co-authored a paper, “Alzheimer Testing at Silver Years,” in the Cambridge Quarterly of Healthcare Ethics, he was admitted to 10

Harvard Law School. He departed a year later, during the dot-com boom, and launched a startup. Next, he obtained an M.B.A. from Stanford. S.A.C. was another brand-name institution, a strong allure for someone like Martoma. After visiting the office in Stamford and spending a day shadowing Cohen on the trading floor, he accepted the job. S.A.C. relied on portfolio managers to devise novel investment ideas. In a marketplace crowded with hedge funds, it had become “hard to find ideas that aren’t picked over,” Cohen complained to the Wall Street Journal, in 2006. In the business, a subtle but crucial informational advantage was called “edge.” Richard Holwell, a former federal judge in New York who presided over high-profile securities-fraud cases, told me that, in order to evaluate a technology stock, hedge funds sent “people to China to sit in front of a factory and see whether it was doing one shift or two.” He added, “An edge is the goal of every portfolio manager.” When Cohen was asked about edge during a deposition in 2011, he said, “I hate that word.” But S.A.C.’s promotional materials boasted about the firm’s “edge,” and Cohen provided his employees with every research tool that might offer a boost over the competition. The eat-what-you-kill incentive structure at S.A.C. put a damper on collegiality. Employees with edge had no motivation to share it with one another. But every good idea was shared with Cohen. Each Sunday, portfolio managers sent a memo to an e-mail address known as “Steve ideas,” in which they spelled out their most promising leads, weighted by their level of conviction. Martoma had always been avid about research, and he was impressed by S.A.C.’s resources. At his disposal was a boutique firm full of former C.I.A. officers who could monitor the public statements of corporate executives and evaluate whether they were hiding something; S.A.C. also had a “buffet plan” with the Gerson Lehrman Group, giving Martoma unrestricted access to thousands of experts. From his first days in Stamford, he was interested in the investment potential of bapi. He contacted G.L.G. with a list of twenty-two doctors he hoped to consult, all of whom were involved in the clinical trials of the drug. Most declined, citing a conflict of interest; clinical investigators had to sign confidentiality agreements that constrained their ability to talk about the progress of the trials. But Sid Gilman accepted, noting, in his response to G.L.G., that he would “share only information that is openly available.” On the Sunday after the initial conversation with Gilman, Martoma sent an e-mail to Steven Cohen, suggesting that S.A.C. buy 4.5 million shares of Elan stock, and noting that his conviction level was “High.” Martoma was born Ajai Mathew Thomas in 1974, and grew up in Merritt Island, Florida. His parents had emigrated from Kerala, in southern India, during the sixties. They were Christian; the name Martoma, which the family adopted around the turn of the millennium, is a tribute to the Mar Thoma Syrian Church, an Orthodox denomination that is based in Kerala. Mathew’s father, Bobby, was a stern man with a sharp nose and a clipped mustache. He owned a dry- cleaning business, and placed enormous pressure on his son to succeed. Mathew obliged, excelling in school and starting a lawnmowing operation in which he outsourced the actual mowing to other kids. The oldest of three brothers, he seems to have taken naturally to the role of family standard-bearer. Childhood photographs show him grinning, with his hair neatly parted, in a tiny three-piece suit. When Martoma’s father first came to America, he was admitted to M.I.T., but he could not afford to attend. He retained a fascination with Cambridge, however, and prayed daily that his oldest son would go to Harvard. Martoma graduated from high school as co-valedictorian, but he ended up going to Duke. Shortly after Mathew’s eighteenth birthday, Bobby presented him with a plaque inscribed with the words “Son Who Shattered His Father’s Dream.” During college, Martoma volunteered in the Alzheimer’s wing of the Duke Medical Center, and developed an interest in medical ethics. Bruce Payne, who taught Martoma in a course on ethics and policymaking, remembers him as “creased and pressed—very pre-professional.” Payne wrote a recommendation letter for Martoma’s application to business school at Stanford,

praising his subtle readings of Sissela Bok’s “Lying” and Albert Camus’s “The Plague.” Martoma was unusually adept at cultivating mentors. “He was ambitious—he wanted to make something of his life,” Ronald Green, who supervised Martoma during his year at N.I.H. and is now a professor at Dartmouth, told me. “To some extent, I felt like Mathew was an adopted son.” At Stanford, Martoma was introduced to a young pediatrician from New Zealand named Rosemary Kurian. Strikingly beautiful, she was studying for her medical boards so that she could practice in the United States. She had grown up in a sheltered family and had never dated before. But she felt an immediate bond with Mathew: her parents were also from Kerala, and she, too, felt both very Indian and very Western. “I was just enamored with how lovely he was,” she told me recently. “And he seemed to be very respectful of my parents.” Her mother and father endorsed the relationship, and in 2003 Mathew and Rosemary were married, in an Eastern Orthodox cathedral in Coral Gables, Florida.

“It was your first day—why not give it another twelve years?”BUY OR LICENSE » By the time they moved to Connecticut, they had one child and Rosemary was pregnant with a second. She stopped working, but she was very involved in advancing Mathew’s career. “Mathew didn’t just do that job by himself,” she told me, with a smile. He worked perpetually. “It was heads-down, tails-up, twenty-four-seven kind of work.” Martoma rose at 4 A.M. to keep up with the European health-care markets, then worked until the market in New York closed. After spending a few hours with the children, he put in another shift, sitting in bed with his laptop while Rosemary fell asleep beside him. He had numerous investment prospects, but bapi was the most promising, and it became an obsession. “As a portfolio manager, you live by your ups and downs,” Rosemary said. “These stocks, they’re your babies, and you’re following them and you’re nurturing them.” The fixation became a running joke, and her conversations with him were often punctuated by the word “Bapsolutely!” Rosemary never met Sid Gilman, but throughout the fall of 2006 Martoma arranged frequent consultations with him about bapi. Much later, in court, Gilman recounted this phase in their relationship as a kind of intellectual seduction. They spoke for hours about the trials for various Alzheimer’s drugs. “Every time I told him about a clinical trial, he seemed to know a good deal about it,” Gilman testified. “The more I told him about each of the trials, the more he wanted to

know.” Gilman found himself wishing that his students in Ann Arbor were as bright and curious as Martoma. That October, Gilman had plans to visit New York on other business, and Martoma arranged to meet with him at S.A.C.’s offices in Manhattan. In an e-mail to G.L.G., Martoma specified that he wanted the meeting “to be with just me and dr. gilman alone.” The appointment was at lunchtime, and when Gilman was shown into the room he was pleased by a small courtesy—an array of sandwiches. Martoma walked in, broad-shouldered and genial, with close-cropped black hair and long eyelashes that gave his face a feline aspect. He was “very, very friendly,” Gilman recalled. Martoma complimented him on “the previous consultations we had.” According to G.L.G.’s records, Gilman and Martoma had forty-two formal consultations over two years. Gilman consulted with many other investors during this time, and Martoma spoke to many other doctors, but neither spoke to anyone else with nearly the same frequency that they did with each other. It seemed to Gilman that Martoma shared his passion for Alzheimer’s research, and regarded the efforts to create an effective drug as much more than a matter of financial interest. In e-mails, Martoma had a tendency to slip into the first-person plural, using “we” when discussing how medical professionals treated people with the disease. Gilman also got the impression that Martoma wanted to be friends. Martoma proposed that they have coffee after meetings of the American Academy of Neurology. He talked to Gilman about his family’s emigration from India, and about how he and Rosemary had had their children in rapid succession. In e-mails, he sent his best wishes to Gilman’s “better half.” Gilman called Martoma “Mat,” but, even when they were speaking almost daily, Martoma always addressed him as “Dr. Gilman.” Once, when Gilman was travelling in Istanbul, he forgot about a scheduled consultation. Unable to reach him, Martoma had his assistant make multiple calls to try to track the doctor down. Eventually, a hotel employee discovered Gilman by himself, reading, and alerted him to the calls. “I was in a foreign country, and he couldn’t find me,” Gilman testified. “It was touching.” Later, Gilman had trouble pinpointing just when his relationship with Martoma crossed into illegality. But he recalled a moment when Martoma asked, repeatedly, about the side effects that one might expect to see from bapi. “I didn’t quite recognize it for what I think it was, which was an attempt to find confidential information,” Gilman said. Initially, he offered theoretical responses, but Martoma “persisted in wanting to know what really happened,” and finally the answers “slipped out.” Gilman told him how many patients and how many placebo cases had experienced each adverse effect. While he was talking, Martoma periodically asked him to slow down, so that he could transcribe the numbers. In 1942, lawyers in the Boston office of the Securities and Exchange Commission learned that the president of a local company was issuing a pessimistic forecast to shareholders and then offering to purchase their shares. What the president knew, and the shareholders didn’t, was that earnings were on track to quadruple in the coming year. He had edge, which allowed him to dupe his own shareholders into selling him the stock at far below its real value. Later that year, the S.E.C. established Rule 10b-5 of the Securities Exchange Act, making insider trading a federal crime. At the time, one of the commissioners remarked, “Well, we’re against fraud, aren’t we?” In the ensuing decades, however, enforcement of this prohibition has been inconsistent. Some academics have suggested that insider trading is effectively a victimless crime, and should not be aggressively prosecuted. At least privately, many in the financial industry agree. But in 2009, when Preet Bharara took over as United States Attorney for the Southern District of New York, with jurisdiction over Wall Street, he made it a priority to curb this type of securities fraud. The problem had become “rampant” in the hedge-fund industry, Bharara told me, in part because of a prevailing sense that the rewards for insider trading were potentially astronomical—and the 13

penalty if you were caught was relatively slight. “These are people who are in the business of assessing risk, because that’s what trading is, and they were thinking, The greatest consequence I will face is paying some fines,” Bharara said. His strategy for changing their behavior was to throw a new variable into the cost-benefit equation: prison. Agents from the F.B.I. and the S.E.C. began asking investment professionals to identify the biggest malefactors. Peter Grupe, who supervised the investigations at the F.B.I., told me that all the informants were “pointing in the same direction—Stamford, Connecticut.” Rumors about insider trading had circulated around Steven Cohen since his first years in the business. As a young trader at a small investment bank called Gruntal & Company, he was deposed by the S.E.C. in 1986 about suspicious trades surrounding General Electric’s acquisition of R.C.A. Cohen asserted the Fifth Amendment and was never indicted, but, during the nineties, as his fund became extraordinarily profitable, observers and rivals speculated that he must be doing something untoward. Like Bernard Madoff’s investment firm, S.A.C. enjoyed a level of success that could seem suspicious on its face. “A lot of people assumed for years that S.A.C. was cheating, because it was generating returns that didn’t seem sustainable if you were playing the same game as everyone else,” the manager of another hedge fund told me. When Cohen was growing up, as one of eight children in a middle-class family in Great Neck, New York, his father, who owned a garment factory in the Bronx, brought home the New York Post every evening. Cohen read the sports pages, but noticed that there were also “these other pages filled with numbers.” In an interview for Jack Schwager’s book “Stock Market Wizards” (2001), he recalled: I was fascinated when I found out that these numbers were prices, which were changing every day. I started hanging out at the local brokerage office, watching the stock quotes. When I was in high school, I took a summer job at a clothing store, located just down the block from a brokerage office, so that I could run in and watch the tape during my lunch hour. In those days, the tape was so slow that you could follow it. You could see volume coming into a stock and get the sense that it was going higher. You can’t do that nowadays; the tape is far too fast. But everything I do today has its roots in those early tape-reading experiences.

“I discovered coffee!”BUY OR LICENSE » Cohen was never a “value investor”—someone who makes sustained commitments to companies that he believes in. He moved in and out of stocks quickly, making big bets on short- term fluctuations in their price. “Steve has no emotion in this stuff,” one of his portfolio

managers said in a deposition last year. “Stocks mean nothing to him. They’re just ideas, they’re not even his ideas. . . . He’s a trader, he’s not an analyst. And he trades constantly. That’s what he loves to do.” The business model at S.A.C., though, was based not on instinct but on the aggressive accumulation of information and analysis. In fact, as federal agents pursued multiple overlapping investigations into insider trading at hedge funds, it began to appear that the culture at S.A.C. not only tolerated but encouraged the use of inside information. In the recent trial of Michael Steinberg, one of Cohen’s longtime portfolio managers, a witness named Jon Horvath, who had worked as a research analyst at S.A.C., recalled Steinberg telling him, “I can day-trade these stocks and make money by myself. I don’t need your help to do that. What I need you to do is go out and get me edgy, proprietary information.” Horvath took this to mean illegal, nonpublic information—and he felt that he’d be fired if he didn’t get it. When Cohen interviewed job applicants, he liked to say, “Tell me some of the riskiest things you’ve ever done in your life.” In 2009, a portfolio manager named Richard Lee applied for a job. Cohen received a warning from another hedge fund that Lee had been part of an “insider- trading group.” S.A.C.’s legal department warned that hiring Lee would be a mistake, but Cohen overruled them. (Lee subsequently pleaded guilty to insider trading.) White-collar criminals tend to make soft targets for law enforcement. “The success rate at getting people to coöperate was phenomenal,” Peter Grupe told me. Most of the suspects in insider-trading investigations have never been arrested, nor have they contemplated the prospect of serious jail time. When Michael Steinberg was waiting for the jury in his trial to pronounce a verdict, he fainted in open court. So the authorities approached hedge-fund employees, one by one, confronting them with evidence of their crimes and asking them what else they knew. Because the suspects weren’t anticipating being under surveillance, the F.B.I. could tail them for weeks. Then one day, as a suspect headed into a coffee shop and prepared to place his usual order, an agent would sidle up and place the order for him. The tactics echoed the approach the F.B.I. had used to dismantle the New York Mob. The plan was to arrest low-level soldiers, threaten them with lengthy jail terms, and then flip them, gathering information that could lead to arrests farther up the criminal hierarchy. Over time, agents produced an organizational chart with names and faces, just as they had with La Cosa Nostra. At the top of the pyramid was Steven Cohen. In 2010, F.B.I. agents approached a young man named Noah Freeman, who had been fired by S.A.C. and was teaching at a girls’ school in Boston. Freeman became a key witness. Asked in court how often he had attempted to obtain illegal edge, he replied, “Multiple times per day.” According to an F.B.I. memo, “Freeman and others at S.A.C. Capital understood that providing Cohen with your best trading ideas involved providing Cohen with inside information.” When Martoma first came to S.A.C., his due-diligence report had noted his “industry contacts” and his personal “network of doctors in the field.” Through the fall of 2007, he acquired more and more Elan and Wyeth stock, and Cohen followed his lead, supplementing the money that Martoma was investing from his own portfolio with funds from Cohen’s personal account. That October, Martoma e-mailed Cohen that bapi was on track to start Phase III trials soon, and that they would make up “the MOST COMPREHENSIVE ALZHEIMER’S PROGRAM to date.” S.A.C. had a proprietary computer system, known as Panorama, which allowed employees to monitor the company’s holdings in real time. Employees checked Panorama incessantly, and many noticed the scale of the bet that Martoma, a relatively junior portfolio manager, was making, and the fact that Cohen was backing him. Because of the open plan in the Stamford office and the simulcast from Cohen’s desk, people could watch as Martoma approached the boss and murmured recommendations. A portfolio manager named David Munno, who had a

Ph.D. in neuroscience, was skeptical about bapi’s prospects. He didn’t like Martoma, and didn’t understand the source of his conviction. At one point, he wrote to Cohen, wondering whether Martoma actually knew something about the bapi trial or simply had “a very strong feeling.” “Tough one,” Cohen replied. “I think Mat is the closest to it.” It’s impossible to know exactly how Martoma buttressed Cohen’s confidence in bapi. Portfolio managers at S.A.C. often wrote detailed explanations to support trading recommendations, but, when it came to bapi, Cohen and Martoma preferred to talk. Martoma’s e-mails to his boss often consisted of a single line: “Do you have a sec to talk?” “Do you have a moment to speak when you get in?” Whenever Munno pressed Cohen on how Martoma knew so much about bapi, Cohen responded cryptically. “Mat thinks this will be a huge drug,” he wrote to Munno at one point. On another occasion, he explained simply that “Mat has a lot of good relationships in this area.” A second portfolio manager, Benjamin Slate, shared Munno’s concerns, suggesting, in one e- mail, that it was “totally unacceptable to bet ½ billion dollars on alzheimers without a real discussion.” In a message to Slate a month before the Chicago conference, Munno complained that Martoma was telling people he had “black edge.” In subsequent legal filings, S.A.C. has claimed that Munno and Slate coined the term “black edge,” as “humorous commentary.” But, according to subsequent filings by the Department of Justice, “black edge” was “a phrase meaning inside information.” Initially, Gilman may have “slipped” when he divulged secret details to Martoma, but as their friendship continued the malfeasance became more systematic. Whenever Gilman learned about a meeting of the safety-monitoring committee, Martoma scheduled a consultation immediately afterward, so that Gilman could share whatever new information he had obtained. Apart from consultation fees, Gilman did not receive any additional remuneration from Martoma, yet he slid into ethical breaches with an ease verging on enthusiasm. At one point, Gilman proposed outright deception, suggesting to Martoma that they supply the Gerson Lehrman Group with fraudulent pretexts for meetings, in order to deflect suspicion. On June 25, 2008, Gilman sent an e-mail to Martoma with the subject line “Some news.” Elan and Wyeth had appointed him to present the results of the Phase II clinical trials at the International Conference on Alzheimer’s Disease, in July. Martoma scheduled a consultation, informing G.L.G., inaccurately, that he and Gilman would be discussing therapies for multiple sclerosis. Up to this point, Gilman had been given access to the safety results of the trials, but he had been “blinded” to the all-important efficacy results. Now, in order to present the findings, Gilman would be “unblinded.” Two weeks later, Elan arranged for a private jet to fly him from Detroit to San Francisco, where the company had offices. He spent two days with company executives, crafting his conference presentation. When he returned to Michigan, an Elan executive sent Gilman an e-mail titled “Confidential, Do Not Distribute.” It contained an updated version of the twenty-four-slide PowerPoint presentation that would accompany his remarks. After downloading the slide show, Gilman received a call from Martoma. They spoke for an hour and forty-five minutes, during which, Gilman later admitted, he relayed the contents of the presentation. But the material was complicated—too complicated, perhaps, to convey over the phone. Martoma announced that he happened to be flying to Michigan that weekend; a relative had died, but he had been too busy to attend the funeral, so he was going belatedly to pay his respects. Could he swing by? “Sure, you can drop in,” Gilman replied. Two days later, Martoma flew from J.F.K. to Detroit, took a taxi to Ann Arbor, and met with Gilman for an hour in his office on campus. He flew back to New York that evening, without having visited his family. Rosemary picked him up at the airport.

The next morning, Sunday, Martoma e-mailed Cohen, “Is there a good time to catch up with you this morning? It’s important.” Cohen e-mailed Martoma a phone number, and at 9:45 A.M. Martoma called him at home. According to phone records introduced in court, they spoke for twenty minutes. When the market opened on Monday, Cohen and Martoma instructed Phil Villhauer, Cohen’s head trader at S.A.C., to begin quietly selling Elan and Wyeth shares. Villhauer unloaded them using “dark pools”—an anonymous electronic exchange for stocks—and other techniques that made the trades difficult to detect. Over the next several days, S.A.C. sold off its entire position in Elan and Wyeth so discreetly that only a few people at the firm were aware it was happening. On July 21st, Villhauer wrote to Martoma, “No one knows except me you and Steve.”

“I think I see your deadline approaching.”BUY OR LICENSE » Martoma said nothing to Gilman about the selloff, and a week later he flew to Chicago for the conference, bringing along Rosemary and their children, as he often did when he travelled. Gilman also did not know that Martoma had cultivated a second source connected to the clinical trials—Joel Ross, a New Jersey doctor who had been involved in the efficacy tests. Ross had plans to attend a dinner the night before Gilman’s presentation, at which he and other principal investigators would be shown the full data from the trials. Martoma met Ross in the lobby of the hotel immediately after the dinner. But Ross was mystified by their interaction. He was still moderately optimistic about bapi, having seen real improvements in the patients he was supervising, but Martoma was more skeptical. “He was always very detail-oriented,” Ross later testified. And, indeed, Martoma knew every detail of the results that Ross had learned at the dinner, moments earlier. Ross was unnerved: it was as if Martoma had been “in the room.” As Gilman made his presentation, the next evening, word of the ambiguous results hit the news wires. Tim Jandovitz, a young trader who worked for Martoma, watched in dismay as the news appeared on his Bloomberg terminal in Stamford. He checked Panorama, which showed that S.A.C. still held huge positions in Elan and Wyeth. Jandovitz believed that both he and Martoma had just lost more than a hundred million dollars of Steven Cohen’s money—and, along with it, their jobs. The next morning, he braced himself and went to the office. But when he consulted Panorama he saw that the Elan and Wyeth shares had vanished. Some time later, Martoma informed Jandovitz that S.A.C. no longer owned the stock. The two men had worked closely together, and Jandovitz was hurt that he had been left out of the loop. Martoma explained that the decision to sell had been kept secret on “instructions from Steve Cohen.”

People outside the firm were equally startled to learn that S.A.C. had turned a potential disaster into a windfall. “TELL ME MARTOMA GOT OUT OF ELAN,” a friend of Jandovitz’s, who worked at J. P. Morgan, said in an instant message. Jandovitz replied, “w/out getting into detail, wed and this week have been GREAT for us.” “I LOVE IT,” his friend wrote. Jandovitz agreed: “Stuff that legends are made of.” S.A.C., by dumping its shares in Elan and Wyeth and then shorting the stocks, made approximately two hundred and seventy-five million dollars in profit. That year, Martoma received a bonus of $9.3 million. The last time he saw Gilman—before the two men met again in court—was the day after the presentation, when Martoma invited Gilman to lunch at a Chicago hotel. “Did you hear about what happened to Elan stock?” Martoma said, adding that it had plummeted. The market does not like a drug that helps only half the people who receive it, he explained. Several months later, at the end of September, 2008, Gilman sent Martoma an e-mail with the subject heading “How are you?” Hi Mat. I haven’t heard from you in awhile and hope that all is well with you and your family. I hope that you have not been too terribly set back by the great turmoil in the markets plus the disappointing drop in Elan stock. . . . Anyway, no need to call, I have nothing new; I just wonder how you are faring. Martoma never responded. Regulators at the New York Stock Exchange monitor millions of transactions. Six weeks after the Alzheimer’s conference, investigators flagged the huge reversal by S.A.C. before Gilman’s presentation and alerted the Securities and Exchange Commission. In the summer of 2009, Charles Riely, an attorney at the S.E.C., and Neil Handelman, an investigator, began combing through hundreds of phone records, trying to identify a link between an insider at one of the drug companies and S.A.C. It took more than a year of investigation, but one day Riley and Handelman were looking through Gilman’s phone records and came across the cell-phone number of Mathew Martoma. Sanjay Wadhwa, who oversaw the S.E.C. investigation, told me, “That’s when we said, ‘This is probably the guy.’ ” By that time, federal authorities had been investigating Steven Cohen for years. But Cohen was a more elusive target than perhaps they had imagined. He described his firm as having a “hub and spokes” structure, with him at the center, pulling in information, while his specialized portfolio managers ran their accounts with a degree of autonomy. This meant that the authorities could arrest and flip low-level suspects who might describe the crooked culture of the place, but these employees would not necessarily be in a position to testify that Cohen knowingly traded on inside information. In the summer of 2009, the F.B.I. obtained a wiretap on Cohen’s home, a thirty-five-thousand- square-foot mansion in Greenwich, but the tap yielded no incriminating evidence. According to a person involved in the investigation, Cohen spent most of the month that it was operational in a house that he owned in the Hamptons. For a time, the agency wanted to place an informant in Cohen’s company, and groomed a stock trader who had once worked at S.A.C. to seek employment there again. But Cohen rejected the overture, explaining, in a 2011 deposition, that “rumors from people on the street” indicated that the trader was wearing a wire. In most white-collar cases, the authorities subpoena reams of internal communications, but this approach had limited utility with S.A.C., whose legal department warned employees not to

“compose or send any electronic communication, or leave any voice mail message, if you wouldn’t want it . . . read by regulators.” On one occasion in July, 2009, a new portfolio manager sent Cohen an instant message saying that he was going to short Nokia on the basis of “recent research.” He apologized for this oblique rationale but explained that he had just gone through S.A.C.’s compliance training—“so I won’t be saying much.” Any time a written exchange approached potentially incriminating territory, Cohen insisted on oral communication. “I am getting coffee on tues afternoon with the guy who runs north American generics business,” a colleague once informed him. Cohen’s reply: “Let’s talk later.”

“I’ll find you some candy, but first tell me how you got past the Secret Service.”BUY OR LICENSE » Even when there appeared to be ironclad evidence that Cohen had received and acted upon inside information, his lawyers went to impressive rhetorical lengths to challenge it. One day in 2008, Jon Horvath, the analyst, sent an e-mail to two colleagues about an upcoming earnings report from Dell. His source, he wrote, was “a 2nd hand read from someone at the company.” One of the colleagues forwarded the e-mail to Cohen’s personal research trader, who forwarded it to Cohen—and then telephoned him. Two minutes after the call, Cohen began liquidating his position in Dell, which was worth ten million dollars. Yet when this trade became a focus in the Steinberg trial Cohen’s lawyers argued that Cohen’s decision to sell Dell was independent: although the “2nd hand read” e-mail was sent to his inbox, Cohen “likely never read” it. He received a thousand e-mails each day, the lawyers elaborated; he sat at a desk with seven monitors, and it was on the far left monitor that his Outlook inbox appeared. Moreover, the Outlook window was behind two other programs, and the window was minimized, allowing Cohen to see only five e-mails at a time: “Cohen would have had to turn to the far left of his seven screens, minimize one or two computer programs, scroll down his e-mails, double-click into the ‘second-hand read’ e-mail to open it, read down three chains of forwards, and digest the information.” Steinberg was ultimately charged with insider trading in the Dell case and convicted; he is currently serving a three-and-a-half-year sentence. Cohen was never charged. In theory, Steinberg could have testified against his boss, but he might not have been able to produce any additional evidence that Cohen had knowingly traded on inside information. Moreover, Steinberg was an old friend of Cohen’s who had worked with him for more than a decade, and was therefore unlikely to betray him. Martoma had no such loyalty to Cohen. After receiving his enormous bonus in 2008, he lost money in 2009. In 2010—down and out—he was fired. In an e-mail, a former colleague disparaged him as a “one trick pony with Elan.” Martoma and his family moved to Boca Raton, where he and Rosemary bought a large house in a waterfront community, for $1.9 million. 19

Neither of them had a job, and they focussed instead on their kids (they had a third child in 2009) and on charity, establishing the Mathew and Rosemary Martoma Foundation and giving it an endowment of a million dollars. Martoma’s best friend from Duke, Tariq Haddad, who is now a cardiologist in Virginia, told me that Mathew has always been passionate about philanthropy. “He’s given ten per cent of his life savings away,” he said. “Over a million dollars, he’s donated.” On the evening of November 8, 2011, the Martomas returned home from running errands to discover two F.B.I. agents in their front yard. One of them, B. J. Kang, had been a key figure in the investigation of Steven Cohen. Kang has a buzz cut and a brusque demeanor, and he is known for carrying his service weapon—and several magazines of extra ammunition—with a regularity that may not be entirely necessary for an agent on the hedge-fund beat. “Get inside the house,” he told Rosemary. “This has nothing to do with you.” “I’m staying right here,” she replied. “Whatever you have to say to Mathew you can say to me.” Kang turned to Martoma. “Do you want to tell her or should I?” Martoma looked unsteady. Then he said, “You can go ahead and tell her if you like.” Rosemary was confused and terrified. She had no idea what this was about. According to Rosemary, Kang then said, “We know what you did at Harvard.” Martoma fainted. When Martoma was accepted at Harvard Law School, his father was so happy that he insisted on driving his son in a U-Haul all the way from Florida to Massachusetts. Martoma, who at the time was still using his birth name, did well in his first year. He was an editor of the Journal of Law & Technology, and he co-founded the Society on Law and Ethics. In the fall of his second term, he sent applications for judicial clerkships to twenty-three judges. But when a clerk for one of the judges scrutinized Martoma’s transcript, something looked off, and the clerk got in touch with the registrar at Harvard. On February 2, 1999, the registrar confronted Martoma. His transcript had apparently been doctored: two B’s and a B-plus had all been changed to A’s. (A remaining B-plus, an A, and an A-minus were left unchanged.) Martoma initially insisted that “it was all a joke.” But the school referred the matter to Harvard’s Administrative Board, which recommended expulsion. He fought the decision vociferously, hiring a lawyer and taking two polygraph examinations. There had been a misunderstanding, Martoma explained: he had altered his transcript not for the judges but for his parents. He brought the faked transcript home over winter break, and they were ecstatic. (The panel evaluating his case noted that Martoma was “under extreme parental pressure to excel.”) But, after showing his parents the transcript, Martoma continued, he had to leave town abruptly, so he asked one of his younger brothers to compile the clerkship applications that he had left out in his bedroom. Unwittingly, the brother picked up a copy of the forged transcript, and included it in the mailing for the judges. Martoma had discovered the mistake before being confronted by the registrar, he insisted, and had sent e-mails to the secretaries of two professors from whom he had sought recommendations, asking them not to send the letters, “as I am no longer looking for a clerkship.” The Administrative Board remained dubious, because the secretaries did not receive the e-mails until the night of February 2nd—hours after Martoma had been questioned by the registrar. The e-mails were time-stamped February 1st, and Martoma maintained that there had been some sort of server delay, because he had definitely sent them the previous day. His mother, father, and brother all testified before the board and backed his account. Martoma even turned over his laptop to a company called Computer Data Forensics, which produced a technical report for the Administrative Board analyzing the metadata of the e-mails in which he asked to withdraw the 20

recommendations. The firm found that the e-mails had indeed been sent on February 1st. Nevertheless, Harvard finalized the expulsion. While contesting his dismissal, Martoma had moved to an apartment complex in Framingham, Massachusetts, where he became friends with a young M.I.T. graduate named Stephen Chan. The two began eating dinner together and training in martial arts at a local gym. Eventually, they started a business. Martoma’s parents took out a second mortgage to assist the enterprise, and Martoma and Chan hired several employees. Martoma told the employees that he was a Harvard-trained lawyer. The name of the company was Computer Data Forensics. Martoma had supplied Harvard with a forensic report issued by his own company. The partnership between Martoma and Chan ended, acrimoniously, not long afterward, with Martoma taking out a restraining order against Chan, and Martoma’s parents were forced to mediate with disgruntled employees (who had not been paid). Bobby Martoma, incensed with his son, called him “a complete liability.” Later that year, Martoma applied to business school at Stanford. Soon after being accepted, he stopped calling himself Ajai Mathew Thomas and legally adopted his current name. Stanford surely would not have accepted him had it known of his expulsion from Harvard, but because Stanford will not comment on the case it is impossible to know whether Martoma mischaracterized his year in Cambridge or left it out of his academic history altogether. To Ronald Green, his former supervisor at the N.I.H., he explained his departure from Harvard by pointing to the entrepreneurial opportunities available at that time. “The way I understood it, he dropped out to start a business, and it was booming,” Green told me. When I asked Rosemary Martoma when she learned about the expulsion, she said that Mathew had confided it to her early in their relationship. “I’m a full-disclosure person,” she explained. But the incident was a source of humiliation for Martoma and for his family, and it became a closely held secret. Even his best friend, Tariq Haddad, always believed that Martoma dropped out of law school; he learned the truth only recently, after Martoma was indicted. Martoma always feared exposure of the Harvard incident, Rosemary said: “It was like a dagger that had been hanging over his head.” (S.A.C. performed background checks on prospective employees, but it is not known whether the firm detected this blemish in Martoma’s record. Of course, S.A.C. could have learned of it and hired him anyway; forging a law-school transcript and mailing it to twenty-three federal judges demonstrates impressive comfort with risk.) When Martoma regained consciousness, Agent Kang told him that the F.B.I. knew about “the trade in 2008.” Both Rosemary and Mathew immediately understood what he meant. The other agent, Matt Callahan, hung back, but Kang was aggressive. “Your whole life is going to be turned upside down,” he said. “You’re going to lose all your friends, and your children are going to grow up hating you, because you’re going to live your years in a jail cell.” According to Rosemary, Kang said that the government would “crush” Martoma unless he coöperated. “We want Steve Cohen,” Kang said. Martoma was not an ideal star witness: if Cohen’s lawyers could find a path of escape through a minimized Outlook window, imagine what they might do to Martoma’s credibility on the stand by bringing up his Harvard career. Then again, criminal kingpins are often convicted on the testimony of morally dubious underlings. The key witness who put away John Gotti was Sammy (the Bull) Gravano, who had confessed to nineteen murders. A rap sheet was practically a prerequisite to testify against Whitey Bulger. And Martoma clearly possessed a dogged instinct for self-preservation. His parents still called him by his birth name, Ajai, which in Hindi means “Undefeatable.” But then something surprising happened. Martoma refused to coöperate. Agent Kang had already paid a visit to Sid Gilman. At an initial meeting at the university, and in several subsequent conversations, investigators asked Gilman if he had supplied confidential

information about bapineuzumab to Martoma. Gilman repeatedly lied to them. “I was intensely ashamed,” he explained later. “I had betrayed my colleagues, myself, my university.” Kang told Gilman that he was a minor player in this saga—a “grain of sand”—and that the person the authorities were really after was Steven Cohen. Eventually, Gilman agreed to tell the government everything, in exchange for a promise not to prosecute him. Would Martoma flip next? In criminal cases where coöperation is a possibility, a defendant’s attorney goes to prosecutors with a “proffer,” explaining what the client might offer in exchange for lenient treatment. But, despite warnings from Agent Kang that if Martoma went to trial the F.B.I. would “ruin his life,” Martoma’s attorneys never broached the notion of a plea deal. Here was a hedge funder who might finally deliver Cohen and, because of his enormous profits from the bapi trade, would face extensive jail time if he didn’t. Yet Martoma was intransigent. Eventually, a team of F.B.I. agents returned to Boca Raton and, in front of the children, marched him out of his house in handcuffs.

“I’m not actually doing anything—this is just punishment for not flossing.”BUY OR LICENSE » In financial and law-enforcement circles, many wondered why Martoma accepted the role of fall guy. One explanation suggested to me by numerous people was that a numbered account had been set up for the Martomas in some tropical banking haven. But this scenario struck me as unlikely. Suppose that Cohen did seek to witness-tamper in this way. Even if he did so in the billionaire’s fashion—through multiple intermediary layers of deniability—wouldn’t he be handing Martoma the ammunition for a lifetime of blackmail? If someone promised Martoma ten million dollars not to testify about securities fraud, what would stop him from renegotiating on the spot, by demanding twenty million not to testify about obstruction of justice on top of securities fraud? Even so, Cohen’s money was an inescapable factor in the case. After working briefly with a criminal-defense attorney named Charles Stillman, Martoma chose to retain Goodwin Procter, a major law firm with very high fees. But Martoma was not paying for his lawyers: S.A.C. was. So the attorneys advising Martoma on whether he should risk a jail sentence or testify against Cohen were sending their bills to Cohen’s company. After the U.S. Attorney’s office announced an indictment of Martoma, Cohen convened a company-wide meeting at S.A.C. and said that he was furious about the behavior of “a handful of employees.” Martoma was the eighth person who had worked for Cohen to be charged with insider trading—the largest number of individuals from any U.S. financial institution to be criminally charged in recent years. Even if Martoma didn’t turn on Cohen, the company was

clearly in trouble. In March, 2013, lawyers for S.A.C. agreed to pay six hundred and sixteen million dollars to the S.E.C. in order to settle civil insider-trading charges. Several months later, the S.E.C. launched a separate case against Cohen personally, charging him with “failure to supervise” subordinates, and alleging that he received “highly suspicious information that should have caused any reasonable hedge-fund manager . . . to take prompt action.” (That case is still pending.) Last summer, the Department of Justice announced a criminal indictment of S.A.C.—though not of Cohen directly—alleging that the company had become a “magnet for market cheaters,” and that Cohen had presided over insider trading “on a scale without known precedent in the hedge-fund industry.” Not long afterward, the firm pleaded guilty to the criminal charges, agreeing to pay a historic $1.8-billion fine. Cohen had always greeted allegations of impropriety at S.A.C. with bored disdain. When a lawyer asked him in a deposition in 2011 about Rule 10b-5—the federal regulation against insider trading—Cohen claimed not to know what it said. The lawyer pointed out that Cohen’s own compliance manual at S.A.C. spelled out the rule. Cohen responded that he didn’t know what the compliance manual said, either. The lawyer was incredulous: “You don’t know, sitting here today as the head of the firm, what your compliance manual says?” “That’s right,” Cohen said. “I’ve read it. But if you’re asking me what it says today, I don’t remember.” Not long after S.A.C. announced its settlement with the S.E.C., the news broke that Cohen had bought Picasso’s “La Rêve,” for a hundred and fifty-five million dollars—the second-highest price in history for a painting. While he was at it, he bought a new house in East Hampton, a waterfront property worth sixty million. The trial of Mathew Martoma began in January, 2014, and lasted a month. Blizzards had deposited huge snowbanks around the federal courthouse in downtown Manhattan, and every morning Mathew and Rosemary Martoma arrived in a chauffeured car and clambered, with their lawyers, over cordons of dirty snow. They had brought the children with them to New York and were staying at a midtown hotel. Mathew’s mother and father had come from Florida for the trial, and they sat in the front row, bundled in winter coats and scarves and looking solemn. Rosemary’s parents sat beside them. “Ladies and gentlemen, the case is not about scientific testing and it is not about trading,” the government’s lead lawyer, Arlo Devlin-Brown, told the jury. “The case is about cheating.” Martoma, wearing a dark suit, watched impassively as a parade of former S.A.C. colleagues testified; Rosemary smiled when she agreed with a witness and flared her nostrils when she didn’t. She wore eye-catching clothes, becoming an attraction for the tabloid photographers who clustered at the base of the courthouse steps. An article in Bloomberg Businessweek remarked on her poise in the courtroom and the defiant smile she maintained when she and Mathew walked in and out of the courthouse, hand in hand, “as if she’s walking a red carpet.” The government presented dozens of e-mails that Martoma sent to Cohen and other colleagues, and called on Joel Ross, the doctor from New Jersey, to recount how he shared inside information with Martoma. But the heart of the case was the testimony of Sid Gilman, who in the second week made his way, slowly, to the stand. Gilman had resigned from the University of Michigan, and administrators had scrubbed all traces of him from the institution: the wing of the hospital, the lecture series, the university’s Web site. His federal grant support disappeared, his former colleagues wanted nothing to do with him, and he was banned from the campus. He had lately been advising patients at a free clinic. “I had given a great deal to that university, and I am suddenly ending my career in disgrace,” he said. Gilman still dressed elegantly, his shirt and tie cinched tightly around his neck, 23

accentuating his large, round head. But he was eighty-one and visibly frail. During five days of testimony, he looked marooned in the witness box, a shipwrecked man. Several lawyers suggested to me that Martoma’s attorneys should never have let the case go to trial, because the evidence against him was so conclusive that he didn’t stand a chance. But his defense team, a pair of lean and intense litigators, Richard Strassberg and Roberto Braceras, relentlessly attacked Gilman’s credibility as a witness. He had apparently told prosecutors that he had e-mailed a copy of the PowerPoint presentation to Martoma. But, the defense team pointed out, the prosecutors had failed to find any trace of that e-mail. At times, Gilman just seemed confused. Asked about the population of Ann Arbor, he said that it was fifteen hundred. (The population exceeds a hundred thousand.) Some of Gilman’s colleagues speculated that, after decades of studying neurodegenerative disorders, he was now succumbing to cognitive decline himself. Of course, this may be a generous interpretation of actions that many who knew him found inexplicable. “Nobody could believe it,” Anne Young told me. “To jeopardize his career for a hundred thousand dollars or so is insane.” Martoma, Strassberg told the jury, was “the quintessential American success story,” whereas Gilman was a confused old man who had been coached by the government. When speaking to Gilman, Strassberg combined the elevated volume you might use to address a deaf person with the patronizing tone you might employ with a seven-year-old. If this was a strategy, it backfired. Every time Strassberg asked whether Gilman hadn’t heard or understood something he said, Gilman bristled. “You’re slurring your words,” he snapped at one point. Martoma’s lawyers suggested that the information Gilman shared with Martoma was already publicly available. “There is nothing nefarious or improper about trying to get edge,” Braceras argued. “That was the job.” The lawyers challenged the government’s narrative of a special relationship between Gilman and Martoma, observing that Gilman had consultations with scores of other investors. But former colleagues of Gilman told me that the government’s story was plausible. “Sid was a mentor to so many people, and enjoyed that role, and was good at it,” Tim Greenamyre said. “I could certainly see how, if someone was cunning and perceptive, they could pick up on that, and take advantage of it.” As Gilman answered questions on the stand, day after day, he looked, above all, lonely. His son Todd lived nearby, in New Haven, but they had hardly spoken for years. On his final day of testimony, Gilman was asked what set Martoma apart from the other investors he had dealt with. “He was personable,” Gilman replied. After a pause, he said, “And he, unfortunately, reminded me of my first son. In his inquisitiveness. His brightness. And, sadly, my first son was very bright also, and committed suicide.” One matter that was not illuminated at trial was the substance of the twenty-minute phone call that Martoma had with Cohen on the Sunday morning after his trip to Michigan. If Martoma took the stand, prosecutors would attack his credibility by introducing evidence of his expulsion from Harvard Law School, so he elected not to testify in his own defense. Steven Cohen wasn’t called to testify, either. In 2012, he had been asked about the phone call during his deposition with the S.E.C. He said only that Martoma was “getting uncomfortable with the Elan position.” Asked whether he inquired why Martoma had grown uncomfortable, Cohen said that he remembered having done so—but that he could not recall Martoma’s answer. A second theory about why Martoma didn’t flip on Cohen was that any conversation the two of them had that day would have been deliberately opaque. Cohen would never be so foolish as to sit and listen while a subordinate laid out the full provenance of an illegal tip. At some firms, Judge Holwell told me, there is an unwritten “don’t ask, don’t tell” policy, where the fact that a piece of information came from an insider would be conveyed not in so many words but with a facial expression, a tone of voice, or coded language (say, a conviction level of nine). The sociologist Diego Gambetta, in his book “Codes of the Underworld,” explains that people engaged in criminal conduct often evolve an elaborate semiotics to communicate with one

another, because they cannot speak openly about their plans. One federal official who has investigated S.A.C. told me, “In the Mob, sometimes it’s just an expression. One expression means ‘Kill him.’ Another expression means ‘Don’t kill him.’ How do you bring that to a jury?”

November 8, 2004“I’m self-published.”BUY OR LICENSE » After deliberating for three days, the jury convicted Martoma of two counts of securities fraud and one count of conspiracy. Rosemary wept as the verdict was read. The guidelines for his sentence would be based not just on the $9.3-million bonus he had received from S.A.C. in 2008 but also on the two-hundred-and-seventy-five-million-dollar profit that S.A.C. had made on the bapi trades. Yet Cohen was not charged with those trades, or even named as an unindicted co-conspirator. The judge, Paul Gardephe, went so far as to ask the attorneys to avoid discussing Cohen altogether, because he had not been charged with any crime. “General questions about how Steve Cohen conducted his trading, I think, are very dangerous,” he told them. “They represent a risk of opening the door to a broader examination of how Steve Cohen did business. . . . And I think we all agree that that is not a path we want to go down.” (In a subsequent ruling, Gardephe left little doubt about his own views, concluding that Cohen’s trades in July, 2008, “were based on inside information that Martoma had supplied.”) During the trial, Cohen was photographed at a Knicks game, sitting courtside with the art dealer Larry Gagosian. According to a recent article in New York, Cohen told his children that he felt betrayed by his subordinates. “People in the company have done things that are wrong, and they’re going to pay for what they did,” he said. “I didn’t do anything wrong.” Before Judge Gardephe delivered his sentence, Martoma’s family sent him a hundred and forty- three letters from friends and supporters, pleading for leniency. “We pressed him to excel until he maxed out,” Bobby Martoma wrote. “As a father, I wonder . . . whether I was wrong to dream as I did.” On September 8th, Gardephe sentenced Martoma to nine years in federal prison. Delivering the sentence, he invoked the deception at Harvard and suggested that there was a “common thread” between that transgression and this case: an “unwillingness to accept anything other than the top grade, the best school, the highest bonus—and the willingness to do anything to achieve that result.” A few days after the sentencing, I took an elevator to the twenty-sixth floor of a skyscraper on Forty-second Street to meet with Rosemary and Mathew Martoma. I walked into a glass-walled conference room that seemed to hover over midtown. Martoma was there, wearing a neat V- neck sweater. He shook my hand, smiled warmly, and thanked me for coming. But he did not want to talk. Rosemary explained that she would speak on his behalf. She was wearing a cream- 25

colored blouse, tan slacks, and a tiny gold crucifix around her neck, and after Mathew left the room we talked for nearly four hours. Things were looking dire for the Martomas. The government would likely take possession of their house in Boca Raton, and Judge Gardephe had ordered them to forfeit the millions of dollars that they have spread across several bank accounts, which would clear out their savings while still falling well short of the nine million dollars that they have been ordered to pay the U.S. government. When I consulted the tax returns of the Mathew and Rosemary Martoma Foundation, I discovered that the couple had not, in fact, given a million dollars to charity. Instead, after parking that sum in their tax-exempt nonprofit, they had given away smaller amounts to various charities. In 2011, they gave away only three thousand dollars; this included a check to the Florida chapter of the American Alzheimer’s Association, in the amount of two hundred and ten dollars. All the remaining money in the foundation will now go to the government. When I asked Rosemary why Mathew didn’t flip on Cohen, her answer did not match any of the prevailing theories. “He’s innocent,” she said. Martoma could not plead guilty to a crime he did not commit. Outside the courthouse, after the sentencing, Bobby Martoma had told me much the same thing, invoking the Ten Commandments and bellowing, “Thou shalt not bear false witness!” The government’s case was a fiction, Rosemary assured me. “At S.A.C., there’s an expectation that you’re using the resources to formulate a hypothesis, and that’s what he did,” she said. But Gilman had admitted to violating his own confidentiality agreement, I pointed out. He may have had “little mini brain infarcts, where he was slipping on things he shouldn’t have,” Rosemary said. But these were “irrelevant to Mathew’s trading.” Gilman had lost everything. Why would he lie on the stand about having committed these crimes? Because, Rosemary explained, when he was initially interviewed by F.B.I. agents, he lied to them, and at that point they had him on obstruction of justice. So the prosecutors could make him say anything they wanted. “His story was coerced,” she said. She told me about her grandfather, a lawyer in India who had worked alongside Mahatma Gandhi in the struggle for independence. British authorities threw her grandfather into prison, where he contracted cholera and other ailments, from which he never fully recovered. Rosemary noted the “parallels” between her grandfather’s martyrdom and her husband’s. Rosemary’s mother, in a letter to Judge Gardephe, elaborated: “Mathew has given Rosemary courage by reminding her of her grandfather’s suffering for a noble principle, and that he too is standing for a noble principle, that is sticking to the truth.” While Rosemary and I spoke, Mathew retreated to an inner room in the law offices where we were meeting. Periodically, Rosemary left me alone in the conference room and went to confer with him. It was a discomfiting interview scenario, with Martoma lurking in the wings like Polonius. People who maintain their innocence after a criminal conviction are often desperate to get their stories out, and, each time Rosemary disappeared to debrief Mathew on our conversation, I half-expected him to walk back in with her, and tell me that he had been railroaded by the feds. But he never came. They had arranged for a single chicken-salad sandwich to be delivered, and it sat on a sideboard, wrapped in plastic. Eventually, alone in the conference room, I ate it. When Rosemary returned, she spoke at length about the duplicity of Sid Gilman. “He’s a strange man, and he compromised his values to save himself,” she said. The notion that Gilman and Martoma had a special relationship was “farfetched”—a fabrication of the prosecutors that Gilman had parroted. “There is no relationship outside of a cordial consulting relationship,” she said, mocking the notion that Gilman was genuinely moved by Martoma having arranged lunch

at their initial meeting, in New York. She looked at me pointedly and said, “I mean, were you touched when we served a sandwich to you?” Throughout our conversations, Rosemary was quick, animated, and intelligent. But her account stood at odds with what I had witnessed during the monthlong trial and had encountered in my reporting. She stressed that, when Mathew visited Michigan that summer weekend before the 2008 Alzheimer’s conference, it was indeed because a relative had died.

April 25, 2011“He died after a long battle with me.”BUY OR LICENSE » “Did he see Gilman while he was there?” I asked. “I don’t think he has a specific memory of it,” she replied. Early in our conversation, I had asked if Martoma felt vindicated by his acceptance at Harvard Law School, having been denied admission at Harvard College. After one of her visits with him, Rosemary returned to the room and said that she needed to correct one point: “Mathew did get into college at Harvard.” “As an undergrad?” I asked. “Yeah,” she said. “He was admitted and chose to go to Duke instead.” This struck me as hard to believe. I asked why Martoma, the very opposite of a rebellious kid, might defy his father’s deepest wish. She responded, vaguely, that Duke “was Southern” and “felt a little bit more comfortable to him.” I wondered if, on this and other points, Rosemary was simply lying to me. But as our conversation progressed it became clear that she ardently believed in her husband. She reminisced about her medical residency in Boston, when she would be on call overnight and Mathew would sleep in the hospital with her so that she wouldn’t be alone. She pointed to the many letters written to Gardephe as evidence of the degree to which Mathew remained a beloved friend and a role model for his extended family. “Every Indian parent I’ve known, they take the weight of their children on their shoulders,” she said. “When you look into the eyes of all the four parents that are left behind, every single heart is broken.” Mathew’s mother had told him recently that she wished she could serve his prison sentence for him, Rosemary said. She added, “I’ve said that to him, too.” Within this close-knit family, it seemed crucial to maintain that Martoma was going to prison for a crime that he did not commit, and it occurred to me that there might be one final explanation for his unwillingness to accuse Cohen of criminality. In order to implicate Cohen in a conspiracy, Martoma would have had to plead guilty and admit to being part of that conspiracy himself. Could it be that Martoma was prepared to leave his wife and family and spend the better part of a decade in prison for the sake of preserving their illusion that he was an

honorable man? I thought of Gilman on the stand, abandoned by his friends and colleagues, while the first few pews in the courtroom were filled by Martoma’s extended family—by people who believed in him. Martoma is scheduled to begin his sentence, at a federal prison in Miami, next month. When I asked how Rosemary and the children would manage, she said, “I’m not sure.” The children are nine, seven, and five. “They understand Daddy’s going to jail,” she said. “I mean, as an adult, I’m having a hard time understanding it.” Neither side of the family has any savings to give them, she said, adding, “There is not, and never was, and never will be, any discussion of Steve Cohen taking care of us.” In April, S.A.C. ceased to exist, and Cohen’s company was rechristened Point72 Asset Management. Under an agreement with the government, it will be limited to investing Cohen’s personal fortune of roughly nine billion dollars. Cohen has announced that he will institute more robust compliance measures to prevent insider trading, and he has hired the Silicon Valley security company Palantir Technologies to monitor his traders. He has also reportedly banned certain kinds of instant messaging at the firm. When I asked Preet Bharara about the ultimate failure of his multi-year effort to catch Cohen, he responded, through a spokesman, that his office brings charges against “those for whom there is sufficient proof.” The S.E.C.’s lawsuit charging Cohen with “failure to supervise” will progress, as will a class-action lawsuit brought on behalf of hundreds of Elan and Wyeth shareholders who lost money when Cohen shorted the stocks. Insider trading may not be a victimless crime after all—at any rate, not when the victims sue you. In August, the litigants amended their suit to include a racketeering provision, which alleges that Cohen, like a Mob boss, sat on top of a criminal enterprise. After Martoma’s conviction, Stanford Business School rescinded its original offer of admission, effectively stripping him of his degree. “What to make of the early interest in ethics?” his professor from Duke, Bruce Payne, asked. “A hugely ambitious guy wanting to know the exact contours of the boundaries that might limit him? Or an anchor to the windward for self- protection by someone already willing to break the rules to his own advantage? If it was the latter, I was conned, and conned quite effectively.” When I asked Rosemary about the future, she cried. “I don’t have the answers, but you know it is my goal to find them,” she said. “And I do pray that America will give us a chance to survive. And to thrive.” ♦ http://www.newyorker.com/magazine/2014/10/13/empire-edge

How Turkey will not escape the middle- income trap Author: Emre Deliveli · October 5th, 2014 In the concluding statement of its 2014 Article IV Mission to Turkey, which was released on Oct. 3, the IMF noted that without structural reforms, Turkey was likely to be left in a middle-income trap as a result of slowing growth. Here is the introduction to my latest Hurriyet Daily News (HDN) column, where I discuss an op-ed by Turkish Finance Minister Mehmet Simsek, which was probably a response to the IMF document. You can read the whole thing on the HDN website. I have several points to make, but before I go on, a small clarification is in order: You may have noticed that the IMF document appeared on Friday, whereas Simsek’s op-ed was published on Wednesday. But government officials see (and approve; it is actually a very tedious process where they go over the statement line by line) these documents beforehand. Another clarification before I move on: I also did not want to overlook Turkey’s external vulnerability. On the contrary, last Monday’s HDN column was about how vulnerable Turkey was. And reports that have been published since then, for example those from the IMF that I mention in the column, as well as the IIF’s “Capital Flows to Emerging Markets”, have confirmed my worries. A different set of vulnerable countries comes out from each report, but Turkey is in all those lists, along with South Africa and Brazil. However, I argue here that lack of growth is more important than a one-off sudden stop crisis… OK, coming back to Simsek’s column: He has written similar pieces emphasizing the importance of structural reforms in the past, but I liked the way he identified the main problems of the Turkish economy this time: Education, labor market and innovation. I should say that none of this is original: Anyone who follows the Turkish economy a little bit would know that these consistently come as bottlenecks in academic studies. For example, here’s one I wrote about some time back. But it is good to see that government officials are at least aware of the problem. I would like to discuss each of these ares a bit, but before that I should add that I still do not agree with Simsek on the reasons behind Turkey’s past economic performance under the ruling Justice and Development Party (AKP). Turkish per-capita income did not rise to $10,807, from $3,492 in 2002, because of wide-ranging reforms as he is claiming- unless the Minister has macroeconomic reforms in mind. The impressive rise was due to capital flows and appreciating lira= as well as newly-gained macroeconomic stability. But Turkish real GDP only rose about 40 percent, and Turkey in fact grew less than peers during the second half of this period, as Dani Rodrik highlighted in a blog post last year: OK, coming to Simsek’s reform areas, I see the Turkish education problem as mainly as a skills-mismatch problem. For lower-level workers, their skills are just not enough for the needs of the private sector. But, as fellow HDN columnist Guven Sak emphasized in his latest column on Saturday, for high-skilled science and engineering grads, the problem is 29

the opposite; they cannot find jobs for which they trained. And here are a couple of columns of mine on Turkey’s education woes: Bad and unequal education & Bad and unequal education encore. As for the labor market, Simsek mentioned two issues, on both of which I wrote before: Labor market flexibility and and women’s labor force participation- actually I make it a point to cover women’s labor issue every year on international women’s day: 2014, 2013, 2012 and 2011: Last, but not the least, innovation… This is the one I have written the least about among the three, because for one thing, I believe that if you give incentives to innovate and have human capital able to support it, innovation will just follow. Here’s a column where I sketched those ideas. OK, time to move on. I would like to elaborate on Simsek’s motivations for writing his op-ed: For one thing, once the Fed starts raising its interest rates, the decade of easy money to EMs will be over, and foreign investors will have to be picky.They will choose countries that can continue to grow in this new world. That’s why Simsek, Mexico’s President and others are rushing to emphasize their zeal for reform, whether real or not…So is Simsek’s real? Probably yes. He and econ. czar Babacan (but not President Erdogan and his chief econ. adviser Brave Cloud) are well aware that Turkey cannot grow more than 3- 3.5 percent without structural reforms, which won’t be enough to absorb new entrants to the labor force and keep unemployment at bay- as he notes in his WSJ op-ed. However, he and Babacan should also know that they won’t be able to convince Erdogan on the need for structural reforms before the very important 2015 general elections- as Erdogan will try to get enough votes to change the Constitution. And if Babacan is a really a goner after the elections (if the AKP’s rules don’t change), I am not sure if Simsek will be able to push for reform himself- unless Erdogan Bulut suddenly realize that Turkey can not grow anymore without reforms. Therefore, a more realistic way of interpreting Simsek’s WSJ op-ed is to realize that he may be trying to buy time, as economist Murat Ucer underlined in the FT piece I hyperlinked in the column. I’ll quote him directly: “They [ministers] understand Turkey’s macro story is stuck but also say they cannot do these reforms quite yet. I wonder if investors are going to give Turkey the benefit of the doubt for another nine months” What do you think? Will they succeed in buying time? Finally, if you speak Turkish, I would recommend comments from main opposition Republican People’s Party’s (CHP’s) freshly-minted vice chairman in charge of economic policies Selin Sayek Boke on the middle income trap. Selin is a first-rate macroeconomist, with whom I had the privilege of working with at Ankara think-tank TEPAV almost a decade ago, but I have serious reservations about unbacked promises like creating a global brand every year. To repeat my point on innovation: If you create an environment conducive to creating global brands, you will end up getting global brands. It may not be one every year, but you will get them. But I will give her the benefit of the doubt for now- and will be waiting to see the CHP’s economic program, which should be revealed soon. With her at the helm, I have really high expectations. We’ll see… I know I already said “finally”, but if you made it this far, you deserve a little bit of fun. See the title state-run Anadolu Agency used in its article about the IMF report. :):) http://www.economonitor.com/emredeliveli/2014/10/05/how-turkey-will-not-escape- the-middle-income-trap/ 30

The Opinion Pages| Op-Ed Columnist |NYT Now Voodoo Economics, the Next Generation OCT. 5, 2014

Paul Krugman Even if Republicans take the Senate this year, gaining control of both houses of Congress, they won’t gain much in conventional terms: They’re already able to block legislation, and they still won’t be able to pass anything over the president’s veto. One thing they will be able to do, however, is impose their will on the Congressional Budget Office, heretofore a nonpartisan referee on policy proposals. As a result, we may soon find ourselves in deep voodoo. During his failed bid for the 1980 Republican presidential nomination George H. W. Bush famously described Ronald Reagan’s “supply side” doctrine — the claim that cutting taxes on high incomes would lead to spectacular economic growth, so that tax cuts would pay for themselves — as “voodoo economic policy.” Bush was right. Even the rapid recovery from the 1981-82 recession was driven by interest-rate cuts, not tax cuts. Still, for a time the voodoo faithful claimed vindication. The 1990s, however, were bad news for voodoo. Conservatives confidently predicted economic disaster after Bill Clinton’s 1993 tax hike. What happened instead was a boom that surpassed the Reagan expansion in every dimension: G.D.P., jobs, wages and family incomes. And while there was never any admission by the usual suspects that their god had failed, it’s noteworthy that the Bush II administration — never shy about selling its policies on false pretenses — didn’t try to justify its tax cuts with extravagant claims about their economic payoff. George W. Bush’s economists didn’t believe in supply- side hype, and more important, his political handlers believed that such hype would play badly with the public. And we should also note that the Bush-era Congressional Budget Office behaved well, sticking to its nonpartisan mandate. But now it looks as if voodoo is making a comeback. At the state level, Republican governors — and Gov. Sam Brownback of Kansas, in particular — have been going all in on tax cuts despite troubled budgets, with confident assertions that growth will solve all problems. It’s not happening, and in Kansas a rebellion by moderates may deliver the state to Democrats. But the true believers show no sign of wavering.

Meanwhile, in Congress Paul Ryan, the chairman of the House Budget Committee, is dropping broad hints that after the election he and his colleagues will do what the Bushies never did, try to push the budget office into adopting “dynamic scoring,” that is, assuming a big economic payoff from tax cuts. So why is this happening now? It’s not because voodoo economics has become any more credible. True, recovery from the 2007-9 recession has been sluggish, but it has actually been a bit faster than the typical recovery from financial crisis, despite unprecedented cuts in government spending and employment. In fact, the recovery in private-sector employment has been faster than it was during the “Bush boom” last decade. At the same time, researchers at the International Monetary Fund, surveying cross-country evidence, have found that redistribution of income from the affluent to the poor, which conservatives insist kills growth, actually seems to boost economies. Reagan was well liked, even by his adversaries, but he was an intellectual failure, he never learned how to think and his ideas were not the... First, voodoo economics has dominated the conservative movement for so long that it has become an inward-looking cult, whose members know what they know and are impervious to contrary evidence. Fifteen years ago leading Republicans may have been aware that the Clinton boom posed a problem for their ideology. Today someone like Senator Rand Paul can say: “When is the last time in our country we created millions of jobs? It was under Ronald Reagan.” Clinton who? Second, the nature of the budget debate means that Republican leaders need to believe in the ways of magic. For years people like Mr. Ryan have posed as champions of fiscal discipline even while advocating huge tax cuts for wealthy individuals and corporations. They have also called for savage cuts in aid to the poor, but these have never been big enough to offset the revenue loss. So how can they make things add up? Well, for years they have relied on magic asterisks — claims that they will make up for lost revenue by closing loopholes and slashing spending, details to follow. But this dodge has been losing effectiveness as the years go by and the specifics keep not coming. Inevitably, then, they’re feeling the pull of that old black magic — and if they take the Senate, they’ll be able to infuse voodoo into supposedly neutral analysis. Would they actually do it? It would destroy the credibility of a very important institution, one that has served the country well. But have you seen any evidence that the modern conservative movement cares about such things? http://www.nytimes.com/2014/10/06/opinion/paul-krugman-voodoo-economics-the- next-generation.html?_r=0

ft. com World Europe October 5, 2014 4:18 pm France tells Europe it must focus on growth rather than deficits By Hugh Carnegy in Paris

©ReutersThe EU must change policy to avert the threat of prolonged low growth and low inflation, including easing the tempo of deficit reduction, according to France’s finance minister. Defying heavy criticism of Paris for repeatedly missing its promises to meet EU budget deficit limits, Michel Sapin said Europe should soften the rhythm of deficit cutting and boost investment as the key ways to prevent Europe becoming stuck in Japanese-style stagnation. More ON THIS TOPIC// France defiant on missed deficit target/ Hollande warns France of spending cuts/ French unemployment number falls/ Valls demands end to Air France strike IN EUROPE// German factory orders tumble/ Suicide bomber kills 5 police officers/ Borisov ahead in Bulgarian poll/ Pro-Russian party comes first in Latvia “That is a risk we absolutely have to avoid, for Europe, not just France,” he said. “This has been very well analysed by foreign observers, especially in the Anglo-Saxon world, by the IMF and, above all, by the European Central Bank, which has taken good decisions,” Mr Sapin told the Financial Times in an interview. He insisted that conditions had changed since the eurozone sovereign debt crisis. Without naming Germany, he made clear France wanted a clear shift of emphasis away from the deficit reduction championed by Berlin, in a call that echoed those being made by Matteo Renzi, Italy’s prime minister. “Should nothing change? Should we carry on just as if we were still in the [previous] period when the risk was of explosion?” said Mr Sapin, a close friend of President François Hollande since they were students together at France’s elite Ecole Nationale d’Administration. “It is difficult because some in Europe are still following the logic of the last period. We have got to adapt to the current period. Europe has to get out and find the appropriate measures.” France’s insistence on a policy tilt has been weakened by its own economic malaise and repeated failure to meet the EU budget deficit limit of 3 per cent of national output. The 2015 budget proposal outlined by Mr Sapin last week ditched the twice-delayed target of meeting the limit next year, instead pushing it back to 2017.

He now faces tough negotiations with Brussels over the budget plan. But Mr Sapin said he was hopeful of persuading the incoming European Commission to accept the revamped schedule. As he spoke in his office overlooking the River Seine in Paris, a staffer brought him a copy of an interview given by Mr Renzo to the FT backing France’s stance. Mr Sapin nodded approvingly. “It is not about France. France is not in a situation like other countries that were caught by the throat. I have good hopes that things will move in a way that is in the global interest of Europe and especially the eurozone.” In depth Euro in crisis News, commentary and analysis of the eurozone’s debt crisis and its faltering recovery as it struggles with austerity and attempts to regain competitiveness// Further reading He was adamant that France was not abandoning budgetary rigour. The current plan to save €50bn over three years, cutting growth in public spending to 0.2 per cent a year in real terms, “has never been seen before” in France, Mr Sapin said. He rejected suggestions that, with overall public spending running at more than 55 per cent of gross domestic product, France should cut harder and faster. “Public spending is still money in the system. If you remove it, you can cause a shock. €50bn marks the balance between budget responsibility and causing too great a recessionary effect.” Mr Sapin said France’s proposals for boosting investment in Europe were focused on stimulating the private sector. Referring to German concerns about fiscal stimulus, he said: “It should not be confused with public spending. We need a good balance with that part of public investment that allows us to leverage new private investment.” He cited moves by the European Investment Bank to boost financing for small and medium sized companies and a potential for public-private partnerships, especially in transport and energy infrastructure. “I think Germany is ready for that,” he said. Mr Sapin jauntily dismissed as “clichés” recent criticism that France had become the unreformable “sick man” of Europe. Andy Street, chief executive of British retailer John Lewis, last week declared France “was finished”. On Monday, Manuel Valls, the prime minister, will visit London in an effort to persuade the City that the government is serious about change. Mr Sapin said the government, which is to cut €40bn in taxes on business over the next three years, was forging ahead with further reforms. Proposals are due this month on breaking up monopolies in the service sector. Negotiations are under way on easing labour regulations and restrictions on Sunday and late-night trading. Mr Sapin said business should get behind these moves. “We don’t expect business to support a socialist government, but what is indispensable is that business leaders recognise that things have changed in the way they wanted and take decisions [to invest and hire] that they would not take six months ago. It’s what you call confidence.” http://www.ft.com/intl/cms/s/0/e89df860-4c66-11e4-90c1- 00144feab7de.html#axzz3FMDPrdyo

ft.com comment Columnists October 5, 2014 7:20 pm Blinded EU can learn from one-eyed US

By Edward Luce If you listen to German officials, their philosophy is hard to distinguish from Tea Party Republicans

That noted economist, Groucho Marx, once said: “These are my principles. If you don’t like them, I have others.” Alas, Marx’s pragmatic sense of humour never crossed the Atlantic. Following years of “whatever it takes” firefighting by the Federal Reserve, the US economy is on the cusp of reasonable growth. Europe, on the other hand, is in danger of sinking beneath the waves. The cause of growing US-eurozone divergence is Marxian. Confronted by the failure of its principles, Europe insists it has no others. The US, on the other hand, has invented new ones as it goes along. Even the partially sighted can see the difference. Europe’s deepest problem is institutional. Mario Draghi, head of the European Central Bank, views the crisis in much the same way as Ben Bernanke or Janet Yellen, his successor at the Fed. More ON THIS STORY// Editorial Bleak words from the IMF/ Fed official calls for patience on rates/ Fink blames regulators for heated markets/ Lex US banks – stress reduction/ Martin Wolf Inequality is such a drag EDWARD LUCE// Obama’s Faustian pact/ Modi in Washington, via Mars/ Short-sighted US buyback boom/ Edward Luce War on terror by any other name Unlike the latter, however, Mr Draghi’s ECB lacks de facto independence. The Fed confronts as many critics in the US as Mr Draghi does in Europe. But it has a clear mandate to ignore them. For the past six years, US monetary hawks have warned of the coming tsunami of big inflation. Those jeremiads have redoubled after Friday’s strong US payroll numbers. Thankfully, Mr Bernanke was able to get on with his job. If he had listened to the scaremongers, America would not now be in recovery. But the battle is never won. Ms Yellen now faces a renewed chorus. Europe would be in a much worse state than it already is without Mr Draghi’s heroic efforts. Two years ago, he arguably saved the eurozone from breaking up by issuing his “whatever it takes” pledge to keep pumping liquidity into the markets. But the ECB’s actions came later, and were less aggressive, than they could have been. Mr Draghi is hemmed in by much the same constraints today. Surveying a Europe paralysed between a periphery that would reflate and a core that would restructure – when it should be both at the same time – the ECB remains the only game in town. Mr Draghi is once again

trying whatever he can. If it is allowed to go ahead, the ECB’s plan to buy up to $1tn of private asset-backed securities ought to be enough to keep the eurozone’s head above water. But it will still be too little. The second is political. At the key moment in the financial crisis, Capitol Hill squeaked through a majority in favour of an $847bn fiscal stimulus. The result was less than perfect. Economists are still debating whether the boost was enough – it passed in January 2009 after the US had contracted by almost 8 per cent on an annualised basis in the previous quarter. It was also poorly designed. Too much was frittered on thinly spread tax cuts and too little on game-changing infrastructure. With hindsight, it was also too small. But it was enough to turn a recession into an anaemic recovery. It is astonishing that Europe is still unable to follow suit. The US political edge was shortlived. It is America’s good fortune that the Tea Party had not yet gained a veto over the purse strings in 2009. US fiscal policy has hit an impasse since Republicans gained control of the House of Representatives in 2010. It is Europe’s misfortune that Germany, which is Europe’s equivalent to the Tea Party, has wielded a veto over eurozone budgetary rules since the start. It appears none the wiser today. If you listen to German officials, and their counterparts in other core eurozone economies, their philosophy is hard to distinguish from Tea Party Republicans. The Great Recession was a morality tale that we brought upon ourselves. We must pay for our sins by tightening our belts now. If you don’t like our principles, you can shove it. What will it take for Europe to heed America’s lessons? The circumstances are hard to picture. Europe is too politically divided, and too institutionally hidebound, to be able to duplicate the Fed’s rule book. The danger, in fact, is that the inspiration might be going the other way. Friday’s US jobs report has renewed calls for Ms Yellen to raise interest rates early next year. There are no signs of real wage growth and median incomes are still almost 10 per cent lower than before the recession. The US has caught Europe’s disease of declining labour force participation. Much of the drop in US joblessness is a result of people ceasing to look for work altogether. Though there is no evidence of inflation, the hawks want action to pre-empt it. Early tightening could stop America’s recovery in its tracks – and deal a further blow to Europe’s recovery prospects. Things being relative, Mr Draghi would swap his problems for Ms Yellen’s in a second. Viewed from outside of the west, however, the US and Europe share deep-seated problems posed by the rise of the rest of the world and a populist backlash against democratic norms. The US, at least, has clawed its way to a point where it can consider structural reforms, even if they are politically unrealistic. Europe is not even close to that. At a minimum, it should look across the Atlantic for how to restore growth. As that other noted economist, Albert Einstein, pointed out: the definition of insanity is to keep trying the same thing over and over and expect a different outcome. http://www.ft.com/intl/cms/s/0/2b3b3408-4997-11e4-8d68-00144feab7de.html#axzz3FMDPrdyo

ft.com comment Columnists October 5, 2014 7:46 pm Monetary policy: An unconventional tool By Martin Wolf The Fed’s quantitative easing raises questions about whether it has worked and its legacy

©Getty QE involves the creation of central bank money on a large scale. That makes it “quantitative”. It is one of a family of unconventional policies employed in the aftermath of a crisis that damaged the financial system and caused a deep recession. As the International Monetary Fund has noted, “central banks in advanced economies responded with unconventional tools to address two broad objectives: first, to restore the proper functioning of financial markets and intermediation, and second to provide further monetary policy accommodation . . . The two objectives, while conceptually distinct, are closely related.” More ON THIS STORY// ECB and BoJ face toughest challenges yet/ Dwindling US inflation casts shadow/ Treasury market cuts US inflation outlook/ ECB’s asset plan takes political hit/ ECB to start asset purchases this month ON THIS TOPIC// Emerging markets face ‘new normal’/ Trading Post Not all markets are ready for rate rises/ Tracking the US market benchmarks/ US banks braced for big deposit outflows IN THE BIG READ// Hong Kong Playing with fire/ Pimco ‘Bonds are meant to be boring’/ War on Isis Under fire/ Asset-backed securities Back from disgrace The Fed had to be particularly imaginative because the US financial system was more complex and more dependent on “shadow banking” – intermediation outside the

banking system – than were those of other advanced economies. Liquidity provision was extended to non-bank entities, for example, such as securities firms. In addition, central banks purchased assets outright. The purchase of private assets was expected to support markets and improve the impaired balance sheets of banks and other financial intermediaries. The purchase of government bonds was expected to persuade the holders to shift their portfolios towards riskier assets. Such large-scale asset purchases were an element in a set of policies aimed at restoring a degree of normality to financial markets and financial institutions. This has been called “credit easing”. Asset purchases are also designed to reinforce monetary policy. The justification has been the reduction of conventional central bank intervention rates to the “zero lower bound”. That is where the rates of the Fed and Bank of England have languished since 2009. It is where the European Central Bank has reluctantly placed its rates. The Bank of Japan’s rates have been near zero for two decades. Central bank asset purchases are a way to make monetary policy effective when short-term rates are already at the zero lower bound. Such QE is held to affect monetary conditions via a “scarcity channel”, a “duration channel” and a “signalling channel”.

By reducing the availability of assets, QE causes investors to shift towards assets deemed close substitutes. This should raise prices and lower yields. By limiting access to long-maturity financial assets, QE lowers the riskiness of investors’ portfolios. That should increase prices and lower yields for all maturities, not just those of the assets the central bank purchases. Finally, QE puts the central bank’s money where its mouth is, thereby reinforcing credibility. For this reason, it is a complement to another unconventional policy, namely “forward guidance” on future short-term interest rates. The pioneers The BoJ pioneered QE’s use as a tool of monetary policy in 2001, But it used it in a relatively limited way. In the present crisis, however, the Fed, the BoE and, from 2013, the BoJ have used it extremely aggressively. 38

From November 2008 to November 2009, the Fed purchased Treasuries worth $300bn, as well as debt of government-sponsored mortgage agencies valued at $175bn and mortgage-backed securities worth $1.25tn. This came to be called QE1. It was more credit easing than quantitative easing. The Fed put QE2 into effect from November 2010. It had purchased $600bn of Treasuries by June 2011.

The Maturity Extension Programme – commonly known as “Operation Twist” and worth $667bn – ran from September 2011 to December 2012. In this the Fed sold short- term Treasuries in return for longer-term ones. The final stage, QE3, began in September 2012. Initially, it focused on the mortgage-backed securities of government- sponsored enterprises. It followed up with purchases of Treasuries from December 2012. This had a predominantly monetary purpose: it was no longer to restore the financial sector to health. Its aim was to prevent excessively low inflation and restore the economy to health. In the UK, the BoE launched its first QE programme, worth £200bn, in January 2009, adding a second, worth £175bn, in October 2011. In both cases, the Bank bought only government bonds, or gilts. Its QEs, then, were monetary. The UK’s policy for credit easing was Funding for Lending, organised with the Treasury and launched in July 2012. The expansion of the BoE’s balance sheet, relative to the size of the economy, has been almost identical to that of the Fed. The BoJ introduced its “comprehensive monetary easing” in October 2010, intended to be worth Y76tn by the end of 2013. After the election of Shinzo Abe as prime minister, it launched its “quantitative and qualitative easing” (QQE), in April 2013. This aims to increase the monetary base by between Y60tn and Y70tn annually. The signalling channel Credit easing played a role in restoring US financial markets to health. But how far has QE worked? This question is hard to answer. QE is far from the only reason long-term interest rates have remained low. In the UK, for example, long-term rates stayed low after it ended. The explanation is the belief that the economy would stay weak and so the need for accommodative policies would prove long-lasting. 39

One authoritative survey, by John Williams, president of the Federal Reserve Bank of San Francisco, states: “First, although individual estimates differ, this analysis consistently finds that asset purchases have sizeable effects on yields on longer-term securities. Second, there remains a great deal of uncertainty about the magnitude of these effects and their impact on the overall economy.” Mr Williams concluded that $600bn of asset purchases tended to lower the yield on 10-year Treasuries by 15 to 25 basis points. That is roughly the size of the move in longer-term yields one would expect from a cut in the federal funds rate of ¾ to 1 percentage point. Similarly, the IMF concludes that: “In the US, the cumulative effects of bond purchase programs are estimated to be between 90 and 200 basis points (0.9 and 2 percentage points) . . . In the UK, cumulative effects range from 45 basis points to 160 basis points.” In Japan, purchases of government bonds under CME and QQE reduced 10-year yields by a little over 30 basis points.

The IMF also argues that the signalling channel was the most important, at least in the US, although the portfolio balance channel seems to be important in the UK, perhaps because markets are more segmented from one another. What effect has this had on economies? Economists largely agree that QE has raised asset prices, including equity prices, and affected economies positively. For this reason, the IMF has recommended aggressive QE, including purchases of government bonds, by the ECB. Moreover, there is some evidence that these effects, too, are strongest via the signalling channel, probably because QE was seen to cut off the tail risks of a still deeper slump QE has then proved itself to be a useful instrument under slump conditions. That is the view of most policy makers and academics. It is not universally shared: complete agreement on policy is impossible. One line of criticism is that QE works mainly by distorting asset prices, particularly those of long-lived assets, such as equities. But the distortions will necessarily unwind, so creating a new round of difficulties. The argument against this is that it is an objection to active monetary policies, not QE alone. 40

Another criticism is that buying bonds has adverse distributional consequences, benefiting rich owners but damaging subsequent returns on long-term savings. Yet, again, this effect is largely due to ultra-low interest rates. QE is just the icing on that cake. Moreover, if interest rates had been substantially higher, economies would have been far weaker, resulting in far more bankruptcies. That, too, would have created large losses, including for many savers. Keeping zombies alive A closely related line of criticism is that QE is preventing the deleveraging of the private sector and keeping “zombies” (both corporate and governmental) out of bankruptcy or default. More broadly, these policies are reducing the pressure for radical restructuring and reform necessitated by the unsustainable pre-crisis trends and post- crisis legacy. These are legitimate concerns. But, again, they are not about QE per se but rather about ultra-easy monetary policy. They amount to demanding still deeper depressions. Another line of criticism is that QE, particularly by the Fed, guardian of the world’s principal reserve currency, has disruptive global spillover effects. Emerging economies, notably Brazil and China, have made these complaints particularly strongly.

Again this is more a criticism of the entire stance of monetary policy rather than of QE in itself. But the most important point by far is that another great depression or even a far weaker recovery would have been much worse. The early interventions were unquestionably of benefit to everybody. Moreover, in a world of floating exchange rates, countries have to prepare themselves for changing monetary policies and fluctuating exchange rates elsewhere. One has to hope emerging economies are now properly prepared for the ending of QE. According to the IMF, QE1 did raise asset prices, including those of foreign currencies. Later ones seem to have had a smaller effect. But, in the US, the case for a weaker dollar and an adjustment in its external balance was strong. Nor does it make any sense to expect the US or other crisis-hit countries to stick in recession for the (often imaginary) sake of other countries.

Part of what lies behind this set of criticisms is a struggle over the balance of financial power. Creditor countries believe they are morally entitled to dictate to deficit countries. But they cannot dictate to the country that issues the global reserve currency. So the US was able to force adjustment upon others, including China, by pursuing policies that were in its own interests. Inside the eurozone, the creditors have far more power: this has not gone well. Wild accusations A far wilder, albeit popular, criticism is that QE must lead to hyperinflation or at least very high inflation. This misguided criticism is based on a mechanical application of the outmoded idea that bank lending is dictated by availability of banking reserves. QE is an extreme version of traditional open-market operations of central banks. So it does increase banks’ reserves. Yet no mechanical link exists between reserves and lending in a modern banking system. Institutions know the central bank will provide them with the money they need, to provide customers with cash or settle with other banks, so long as they stay solvent. The determinant of bank lending and so their creation of money is their perception of the risks and rewards of lending, not the size of their reserves. If these criticisms are mostly misplaced or exaggerated, QE still creates significant risks. Exit is the obvious one. Yet many ways of handling it exist. Interest rates can be increased, by raising rates paid on reserves. Term open-market operations (“reverse repos” or other liquidity absorbing instruments) can be used to drain excess reserves. Central banks do not have to sell the assets they have bought either: these can mature. The main risk is that raising rates from ultra-low levels might be disruptive. Central banks can also leave reserves permanently higher. This would turn QE into a form of “helicopter money”, retrospectively. By this is meant scattering money across the population, suggested by Milton Friedman. That option has not been employed. Yet, done on a suitably large scale, helicopter money would, as Willem Buiter, chief economist of Citi, argues, end deficient demand. In irresponsible hands it could also cause hyperinflation. But it need not do so. What of the immediate future? While the US and UK are thinking about exiting from ultra-easy policies, Japan is still struggling to banish deflation and the eurozone is fighting with itself on what sort of monetary policy to pursue, as risks of deflation rise. The ECB might yet find itself forced to buy large quantities of government bonds. The legacy of the crisis has included a wide range of experiments, of which QE is one. This tool would be used again if such times recurred. The alternative is to avoid getting into such straits again. That might mean something yet more unpalatable – a higher inflation target. Unconventional times call for unconventional remedies. That is the lesson we have learnt since the crisis. http://www.ft.com/intl/cms/s/0/22011490-4a30-11e4-8de3- 00144feab7de.html#axzz3FMDPrdyo

ft.com comment Columnists October 5, 2014 7:13 pm If Europe insists on sticking to rules, recovery will be a dream

By Wolfgang Münchau A euro devaluation would have to be extreme to have a big impact on, say, Italian exporters

©AFP IMF chief Christine Lagarde has called for action to improve the global outlook At the annual meetings of the International Monetary Fund and the World Bank in October 2013, the eurozone crisis was officially declared over. A year on we know that this optimism proved illusory: we have entered year seven of a depression that refuses to end. The timeline shows obvious parallels with the Great Depression in the US. It was declared over in 1936 when pre-crisis levels of economic activity were reached. Fiscal and monetary tightening led to a renewed recession in 1937 and 1938. In reality, these were not two consecutive recessions, just as there was no double-dip recession in the eurozone recently, or a trip-dip in the case of Italy. They were all long single depressions with interruptions. The eurozone depression started in 2008. What the world celebrated last year was the false dawn of one of these interruptions. More ON THIS STORY// Editorial Bleak words from the IMF/ Lagarde warns of ‘new mediocre’ era/ EM central banks’ euro holdings fall/ IMF urges shake-up of top bankers’ pay/ ECB to start asset purchases this month ON THIS TOPIC// Outlook Policy makers to focus on global outlook/ ECB and BoJ face toughest challenges yet/ ECB’s lack of detail on plan disappoints/ ECB’s asset plan takes political hit WOLFGANG MÜNCHAU// Germany’s eurosceptics/ Italian debt/Wolfgang Münchau Declining influence/ What Draghi must do next On many levels, our depression is worse than the one 80 years ago. It is not just a giant yo-yo. It leaves us permanently below the pre-crisis trajectory of economic output. Returning to that trajectory would require growth rates higher than those we enjoyed in 43

the previous decade. The good news is that democracy is not in danger. Political stability, however, nurtures complacency. Without a clear policy response, the depression is in danger of turning into a secular stagnation – measured in generations, not years. What ended the Great Depression was the fiscal expansion to finance preparations for Word War II – hardly a model to follow. As a monetary union happy to live without a central budget or transfer mechanism, the eurozone has no fiscal capacity of its own. Germany has some, but does not want to use it; France and Italy have none, but do want to use it. The sum total of this absurdity is a number fairly close to zero, accompanied by lots of noise. Any heavy lifting will have to come from monetary policy. This was also the message of the formidable Geneva report, compiled by a group of academics who see a real danger of a secular stagnation. Their recommendation is further monetary expansion, including quantitative easing, combined with a credible commitment to keep interest rates down for a very long time. Monetary policy works through numerous channels. I do not believe the exchange rate is the most important one. A euro devaluation would have to be quite extreme to have a big impact on, say, Italian exporters. It is only the exports outside the eurozone that would benefit. Over the past three months, the euro’s trade-weighted exchange rate fell by less than 4 per cent – and that shift already includes market expectations of future QE. Like the US, the eurozone is a large, relatively closed economy. The exchange rate is not completely irrelevant but not that important either. The main route through which QE could work is the so-called portfolio balance channel: when the ECB buys five-year sovereign bonds, the sellers will try to replace those bonds with securities of similar characteristics – say five-year corporate debt. If that happens, the price of the bonds would rise, the interest rates on them would fall, and companies will find it easier to raise money. There is more the eurozone can do. How about a programme of investments or tax credits, funded by the ECB? And while they are at it, they should also suspend the fiscal compact. There is no way that Italy or France will meet its stringent fiscal targets in the foreseeable future. Unfortunately, the discussion is going in the opposite direction. The big fear in Brussels is that the new European Commission may not be sufficiently strict in applying the deficit rules of the Maastricht treaty. It is depressing to see that the incoming commissioners offered no new ideas about how to make the euro sustainable during their confirmation hearings last week. The best chance, as ever, could come through pressure from abroad. I would advise global finance officials about to descend on Washington to question the eurozone’s strategy in some detail – if they can find one. http://www.ft.com/intl/cms/s/0/352e4edc-4997-11e4-8d68- 00144feab7de.html#axzz3FMDPrdyo

The Fed and the Secular Stagnation hypothesis Read more on secular stagnation//Monetary policy cannot solve secular stagnation alone/ Secular stagnation in today's economy. How can it be addressed?/ Review: The secular stagnation hypothesis/ Review: The natural interest rate framework - quite unnoticed, monetary policymakers have already revised their views about the long-run equilibrium interest rate by Jérémie Cohen-Setton on 6th October 2014

Asmus What’s at stake: Larry Summers made a big splash in late 2013 when he re-introduced the secular stagnation hypothesis to explain the disappointing recovery from the Great Recession. Experts have since debated whether we should worry about systemic saving- investment mismatches and what to do about them. But the extent to which monetary policymakers have already revised their views about the long-run equilibrium interest rate has remained quite unnoticed so far. The new secular stagnation hypothesis Barry Eichengreen writes that the idea that America and the other advanced economies might be suffering from more than the hangover from a financial crisis resonated with many observers. Coen Teulings and Richard Baldwin write that this ill-defined sense that something had changed was given a name when Larry Summers re-introduced the term ‘secular stagnation’ in late 2013. Tweet This/ Secular stagnation usually refers to a situation in which saving can only equal investment at a negative real interest rate

Juan F. Jimeno, Frank Smets and Jonathan Yiangou write that secular stagnation usually refers to a situation in which saving can only equal investment at a negative real interest rate – an equilibrium that cannot be achieved because of the zero lower bound (ZLB) constraint on interest rates and low inflation. Laurence Summers writes that the ‘new secular stagnation hypothesis’ responds to recent experience and the manifest inadequacy of conventional formulations by raising the possibility that it may be impossible for an economy to achieve full employment, satisfactory growth, and financial stability simultaneously simply through the operation of conventional monetary policy. Secular stagnation and the pace of policy normalization David Beckworth writes that the FOMC projections that are available show a pronounced downward trend in the "longer run" forecast of the federal funds rate. Alex Rosenberg writes that when it comes to what the markets ultimately care about in the short term—Fed policy—there's one thing nearly everyone can agree on: fresh concerns about secular stagnation are likely to make the Fed even more nervous about reducing accommodation too soon.

@JCSBruegel During the latest FOMC press conference, Steven Beckner pointed out that the Summary of Economic Projections assessments of appropriate funds rate levels show the funds rate getting up to that 3.75 percent normal level at the end of 2017. If you look at the SEP projections of unemployment, inflation, and so forth, they seem to get back to those mandate-consistent levels by the end of 2016, if not much sooner. So what is the justification for waiting that much longer to get back to normal? 46

In her response, Janet Yellen said that the story is […] not that the Fed is behind the curve in failing to return the funds rate to normal levels when the economy is recovered. It is rather that, in order to achieve such a recovery in 2016 or by the end, that it’s necessary and appropriate to have a somewhat more accommodative policy than would be normal in the absence of [several] headwinds. [A] common view on this is that there have been a variety of headwinds resulting from the crisis that have slowed growth, led to a sluggish recovery from the crisis, and that these headwinds will dissipate only slowly. How to model secular stagnation? Paul Krugman writes that if you look at the extensive theoretical literature on the zero lower bound since Japan became a source of concern in the 1990s, you find that just about all of it treats liquidity trap conditions as the result of a temporary shock. Tweet This Something – most obviously, a burst bubble or deleveraging after a credit boom – leads to a period of very low demand, so low that even zero interest rates aren’t enough to restore full employment Something – most obviously, a burst bubble or deleveraging after a credit boom – leads to a period of very low demand, so low that even zero interest rates aren’t enough to restore full employment. Eventually, however, the shock will end. The idea that the liquidity trap is temporary has shaped the analysis of both monetary and fiscal policy. Simon Wren-Lewis writes that a basic idea behind secular stagnation is that the natural real rate of interest might become negative for a prolonged period of time. A simple way to model this would be to allow the steady state real interest rate to become negative. But that cannot happen in basic representative agent models since the steady state real interest rate is pinned down by the discount factor of the representative agent. Gauti Eggertsson and Neil Mehrotra write that in representative agent models the natural rate of interest can only temporarily deviate from this fixed state of affairs due to preference shocks or some similar alternatives. Changing the discount rate permanently (or assuming a permanent preference shock) is of no help, since this leads the intertemporal budget constraint of the representative household to ‘blow up’ and the maximization problem of the household to no longer be well defined. Moving away from a representative savers framework to one in which households transition from borrowing to saving over their lifecycle can, however, open up the possibility of secular stagnation. The key here is that households shift from borrowing to saving over their lifecycle. If a borrower takes on less debt today (due to the deleveraging shock), then tomorrow he has greater savings capacity since he has less debt to repay. This implies that deleveraging will reduce the real rate even further by increasing the supply of savings in the future. http://www.bruegel.org/nc/blog/detail/article/1450-the-fed-and-the-secular- stagnation- hypothesis/?utm_source=Bruegel+economic+blogs+review&utm_campaign=dcdc 8a65a8-Bruegel+BEBR&utm_medium=email&utm_term=0_14a9e32a9c- dcdc8a65a8-277483461 47

Tim Duy's Fed Watch Saturday, October 04, 2014 Is There a Wage Growth Puzzle? Is there a wage growth puzzle? Justin Wolfers says there is, and uses this picture:

to claim: This puzzle isn’t entirely new, as the usual link between unemployment and the rate of wage growth has totally broken down over recent years. The recent data have made a sharp departure from the usual textbook analysis in which a tighter labor market leads to faster wage growth, and subsequent cost pressures feed through to higher inflation. But has the link between wage growth and unemployment "totally broken down"? Eyeball econometrics alone suggests reason to be cautious with this claim as the only deviation from the typical unemployment/wage growth relationship is the "swirlogram" of fairly high wage growth relative to unemployment through the end of 2011 or so. But is this a breakdown or a typical pattern of a fairly severe recession? While, it might seem unusual if you begin the sample at 1985 as Wolfers did, so let's see what the 1980- 85 episode looks like: 48

Same swirlogram. Compare the two recessions:

Fairly similar patterns, although in the 80-85 episode there was more room to push down the inflation expectations component of wage growth. It would appear that in the face of severe contractions, wage adjustment is slow. Now consider the 1985-1990 period (graph below): Notice that wage growth is stagnant until unemployment moves below 6% - past experience thus suggests that we should not expect significant wage growth until we move well below 6% (you could argue the response actually began at 6.5%). Thus, it is premature to believe that there has been a breakdown in this relationship. So far, the response of wages is exactly what you should have expected in light of the 1980's dynamics. Which leads to two points: 1. I am no fan of Dallas Federal Reserve President Richard Fisher. That said, he did not pick 6.1% out of a hat when he said that was the point at which wage growth has tended to accelerate in the past. That number fell out of his staff's research for a reason and surprises me not one bit. 49

2. There is a reason the Fed picked 6.5% unemployment for the Evan's rule. There was absolutely no chance that that would be a meaningful number as far as labor market healing is concerned.

Consider now the sample since 1990:

Note four points: 1. Notice the minor "swirlogram" associated with the early-90's recession. Again, not a breakdown. 2. After 1992, wage growth tends to move sideways until unemployment sinks below 6%. 3. Since 2012, the relationship is as traditional theory would suggest, a point that is actually evident on Wolfer's chart as well. The R-squared on the regression line is 0.75. Although notice that again, as wage growth moves into that 2.5% range, it appears to once again move mostly sideways. No mystery - nothing we haven't seen before.

4. Clearly, there is some noise in the relationship. You should be able to extract away from the noise and recognize that there is no sudden acceleration in wage growth. Now let's take another step and consider the relationship between unemployment and real wages (note that the series ends in 2014:8 - we don't have the September PCE price data yet):

The period of the Great Disinflation was generally associated with negative real wage growth. The period of the mid-90s to the Great Recession was generally associated with positive real wage growth. The swirlogram of the Great Recession is again evident, but notice that as unemployment approached the bottom end of the black regression line (R- squared = 0.65), real wage growth actually accelerated before returning to trend. I now have additional sympathy for firms that have complained in the past two years that they could not push wage growth through to higher prices. It does appear that real wage growth was faster than might be expected given the pace of economic activity and, by extension, the level of unemployment. Oh - and real wage growth has reverted to the pre-Great Recession trend - pretty much exactly where you would expect it to be given the level of unemployment. Honestly, this one surprised me. Which suggests that labor market healing has progressed much further than many progressives would like to admit. Many conservatives as well. Which also means a lot of people are not going to like this chart. And before you complain that the all-employee average wage data holds some great secret that is not in the production and nonsupervisory wage series (I have trouble taking seriously any sweeping generalizations of the business cycle dynamics of a series we only have through one business cycle), here is that version:

Same swirlogram. Pretty much the same idea with wage growth heading right back to where you would expect prior to the great recession. Bottom Line: Be cautious in assuming that this time is different. The unemployment and wage growth dynamics to date are actually very similar to what we have seen in the past. Low wage growth to date is not the "smoking gun" of proof of the importance of underemployment measures. There very well may have been much more labor market healing that many are willing to accept, even many FOMC members. The implications for monetary policy are straightforward - it suggests the risk leans toward tighter than anticipated policy. Posted by Tim Duy on Saturday, October 04, 2014 at 05:00 PM | Permalink http://economistsview.typepad.com/timduy/2014/10/is-there-a-wage-growth- puzzle.html

vox Research-based policy analysis and commentary from leading economists Thinking the unthinkable: The effects of a money-financed fiscal stimulus Jordi Galí 03 October 2014 Many unconventional policies adopted by central banks in response to the Crisis failed to boost the economy. This column discusses the effects of a temporary money-financed fiscal stimulus. When a more realistic model is allowed, such a stimulus can have a strong effect on output and employment, and a mild effect on inflation. Related// Deflation, debt, and economic stimulusRichard Wood//Must fiscal stimulus policies put a burden on the future?Max Corden “The prohibition of money financed deficits has gained within our political economy the status of a taboo, as a policy characterised not merely as in many circumstances and on balance undesirable, but as something we should not even think about let alone propose.” Lord Turner (2013) The recent economic and financial crisis has reminded us of the limits to conventional countercyclical policies. The initial response of the monetary and fiscal authorities to the decline of economic activity – through rapid reductions in interest rates and substantial increases in structural deficits – left policymakers without ammunition well before the economy had recovered. Policy rates hit the zero lower bound at a relatively early stage of the Crisis, while large and rising debt-GDP ratios forced widespread fiscal consolidations – still underway in many countries – that have likely delayed the recovery and added to the economic pain. What is more, and leaving aside its likely contribution to the stability of the financial system (and the profitability of banks), the kind of unconventional monetary policies adopted by the main central banks have failed to provide a sufficient boost to aggregate demand and bring output and employment rates back to their potential levels, especially in some of the countries hit hardest by the financial crisis. Against this background, there is a clear need to think of policies that could stimulate the economy without relying on lower nominal interest rates (unfeasible) or further rises in the stock of government debt (undesirable, given the historically high – and growing – debt ratios). The option of an increase in government spending financed through higher taxes is not an appealing one either, given the high tax rates prevailing in many countries and the likely self-defeating effects of higher taxes. On the other hand, proposals focusing on labour cost reductions or structural reforms have been recently called into question by several authors on the grounds that their effectiveness at raising output hinges on a simultaneous loosening of monetary policy, an option no longer available.1

Money-financed fiscal stimulus In a recent working paper (Galí 2014), I study the effects of an alternative policy intervention aimed at reviving the economy – a temporary increase in government purchases, financed entirely through money creation. As the above quote by Turner suggests, such a policy is viewed in policymaking circles as ‘unspeakable’, nothing short of a ‘taboo’. But as academics, we should not feel bound by such conventions. It is our responsibility to explore the consequences of any policy that may help attain widely shared social goals (e.g. full employment and price stability), and to let our findings be known (though always with the necessary caveats). • A central message of my recent work is that the implications for output and inflation of a money-financed fiscal stimulus are highly model-dependent. Thus, when that fiscal intervention is analysed in the context of an ‘idealised’ classical monetary economy with perfect competition in all markets and fully flexible prices and wages, the money-financed fiscal stimulus has a very small effect on output and employment and a huge, frontloaded impact on inflation. Private consumption declines. A desirable effect, on the other hand, lies in the implied reduction in the debt ratio resulting from the erosion of the debt’s real value caused by the initial spike in inflation. All things considered, a money-financed fiscal stimulus is clearly unappealing if one takes such an idealised classical model as a reference framework.2 I conjecture that it is that kind of ‘classical’ reasoning that has shaped the widespread prejudice against money-financed fiscal expansions. But such judgments may not be entirely justified. As I show in my recent paper, when I deviate from an ideal classical world and use instead a more realistic model allowing for imperfect competition and nominal wage and price rigidities to evaluate the impact of a money-financed fiscal stimulus, the effects are very different. • Such an intervention is predicted to have very strong effects on economic activity with relatively mild inflationary consequences spread over several years. The large increase in activity is due to a crowding-in of private consumption and investment, caused by the persistently lower real interest rates due to higher expected inflation. • The debt-GDP ratio is also predicted to go down over time, largely as a result of the lower interest rates. • Finally, if output is sufficiently below its efficient level, a money-financed fiscal stimulus is shown to raise welfare even if based on purely wasteful government spending. A fiscal stimulus programme that focuses on productivity-enhancing public investment projects would likely have even more desirable effects. The previous predictions contrast with the experience with quantitative easing and other unconventional monetary policies, which do not affect aggregate demand directly and which, as a result, have failed to jumpstart the depressed economies of many countries, especially in the Eurozone. An additional advantage of a money-financed fiscal stimulus, particularly relevant for a monetary union, is that the associated increase in

government purchases may be targeted at the regions with higher unemployment and lower inflation (or higher risk of persistent deflation). The time may have come to leave old prejudices behind and come to terms with the urgent need to increase aggregate demand in a more foolproof way than tried up to now, especially in the Eurozone. The option of a money-financed fiscal stimulus should be considered seriously. References Eggertsson, G, A Ferrero, and A Raffo (2013), “Can Structural Reforms Help Europe?”, Brown University, mimeo Galí, J (2013), “Notes for a New Guide to Keynes (I): Wages, Aggregate Demand and Employment”, Journal of the European Economic Association, 11(5), 973-1003. Galí, J and T Monacelli (2014), “Understanding the Gains from Wage Flexibility: The Exchange Rate Connection”, CREI working paper. Galí, J (2014), “The Effects of a Money-Financed Fiscal Stimulus”, CEPR Discussion Paper 10165, September. Footnotes 1 See Eggertsson et al. (2013), Galí (2013) and Galí and Monacelli (2014), among others. 2 In the model, implementation of such a policy reduces households’ utility unambiguously. http://www.voxeu.org/article/effects-money-financed-fiscal-stimulus

The world economy Wealth without workers, workers without wealth The digital revolution is bringing sweeping change to labour markets in both rich and poor worlds Oct 4th 2014 | From the print edition TECHNOLOGICAL revolutions are best appreciated from a distance. The great inventions of the 19th century, from electric power to the internal-combustion engine, transformed the human condition. Yet for workers who lived through the upheaval, the experience of industrialisation was harsh: full of hard toil in crowded, disease-ridden cities. The modern digital revolution—with its hallmarks of computer power, connectivity and data ubiquity—has brought iPhones and the internet, not crowded tenements and cholera. But, as our special report explains, it is disrupting and dividing the world of work on a scale not seen for more than a century. Vast wealth is being created without many workers; and for all but an elite few, work no longer guarantees a rising income. In this section//The Party v the people//Wealth without workers, workers without wealth//Don’t let history repeat itself//The rise of the Vallenzi//A plea for change Related topics//China Computers that can do your job and eat your lunch So far, the upheaval has been felt most by low- and mid-skilled workers in rich countries. The incomes of the highly educated—those with the skills to complement computers—have soared, while pay for others lower down the skill ladder has been squeezed. In half of all OECD countries real median wages have stagnated since 2000. Countries where employment is growing at a decent clip, such as Germany or Britain, are among those where wages have been squeezed most. In the coming years the disruption will be felt by more people in more places, for three reasons. First, the rise of machine intelligence means more workers will see their jobs threatened. The effects will be felt further up the skill ladder, as auditors, radiologists and researchers of all sorts begin competing with machines. Technology will enable some doctors or professors to be much more productive, leaving others redundant. Second, wealth creation in the digital era has so far generated little employment. Entrepreneurs can turn their ideas into firms with huge valuations and hardly any staff. Oculus VR, a maker of virtual-reality headsets with 75 employees, was bought by Facebook earlier this year for $2 billion. With fewer than 50,000 workers each, the giants of the modern tech economy such as Google and Facebook are a small fraction of the size of the 20th century’s industrial behemoths. Third, these shifts are now evident in emerging economies. Foxconn, long the symbol of China’s manufacturing economy, at one point employed 1.5m workers to assemble electronics for Western markets. Now, as the costs of labour rise and those of automated manufacturing fall, Foxconn is swapping workers for robots. China’s future is more Alibaba than assembly line: the e-commerce company that recently made a spectacular debut on the New York Stock Exchange employs only 20,000 people. The digital transformation seems to be undermining poor countries’ traditional route to catch-up growth. Moving the barely literate masses from fields to factories has become harder. If India, 56

for instance, were to follow China’s development path, it would need skilled engineers and managers to build factories to employ millions of manufacturing workers. But, thanks to technological change, its educated elite is now earning high salaries selling IT services to foreigners. The digital revolution has made an industrial one uneconomic. Bridging the gap None of this means that the digital revolution is bad for humanity. Far from it. This newspaper believes firmly that technology is, by and large, an engine of progress. IT has transformed the lives of billions for the better, often in ways that standard income measures do not capture. Communication, knowledge and entertainment have become all but free. Few workers would want to go back to a world without the internet, the smartphone or Facebook, even for a pay increase. Technology also offers new ways to earn a living. Etsy, an online marketplace for arts and crafts, enables hobbyists to sell their wares around the world. Uber, the company that is disrupting the taxi business, allows tens of thousands of drivers to work as and when they want. Nonetheless, the growing wedge between a skilled elite and ordinary workers is worrying. Angry voters whose wages are stagnant will seek scapegoats: witness the rise of xenophobia and protectionism in the rich world. In poor countries dashed expectations and armies of underemployed people are a recipe for extremism and unrest. Governments across the globe therefore have a huge interest in helping remove the obstacles that keep workers from wealth. The answer is not regulation or a larger state. High minimum wages will simply accelerate the replacement of workers by machines. Punitive tax rates will deter entrepreneurship and scare off the skilled on whom prosperity in the digital era depends. The best thing governments can do is to raise the productivity and employability of less-skilled workers. That means getting rid of daft rules that discourage hiring, like protections which make it difficult to sack poor performers. It means better housing policy and more investment in transport, to help people work in productive cities such as London and Mumbai. It means revamping education. Not every worker can or should complete an advanced degree, but too many people in poor countries still cannot read and too many in rich ones fail to complete secondary school. In future, education should not be just for the young: adults will need lifetime learning if they are to keep up with technological change. Yet although governments can mitigate the problem, they cannot solve it. As technology progresses and disrupts more jobs, more workers will be employable only at lower wages. The modest earnings of the generation that technology leaves behind will need to be topped up with tax credits or wage subsidies. That need not mean imposing higher tax rates on the affluent, but it does mean closing the loopholes and cutting the giveaways from which they benefit. In the 19th century, it took the best part of 100 years for governments to make the investment in education that enabled workers to benefit from the industrial revolution. The digital revolution demands a similarly bold, but swifter, response. From the print edition: Leaders http://www.economist.com/news/leaders/21621800-digital-revolution-bringing- sweeping-change-labour-markets-both-rich-and-poor

Economic reform in Europe The rise of the Vallenzi The leaders of France and Italy have a window to pursue genuine reforms, but it is only a narrow one Oct 4th 2014 | From the print edition

IN THE smouldering economic landscape of the euro zone, the future is riding on two men. In France Manuel Valls (pictured, right) is leading the most reformist government in years (see article). In Italy, whose economy is in even worse shape than France’s, Matteo Renzi (the hugger on the left) is also talking of change. Both have been in office for barely half a year and have a promising Blairite agenda. But the Vallenzi are also open to the same criticism: that as far as reform goes, they are all mouth and no trousers. France and Italy pose a grave threat to the single currency. They are the euro zone’s second- and third-largest members. Growth in France is flat and unemployment stuck at over 10%. The budget has not been balanced for 40 years, and public spending takes 57% of GDP—far the highest in the euro zone. Italy is no better. It is in recession, and its debt is over 130% of GDP. In this section// The Party v the people// Wealth without workers, workers without wealth// Don’t let history repeat itself// The rise of the Vallenzi//A plea for change They are also laggards in reform. Whereas Spain has started to get to grips with its structural problems, France’s Socialist president, François Hollande, has not even tried. Instead of reducing taxation, he has raised it. Instead of encouraging business, he has

added to its burdens. Instead of promoting reforms, he has avoided them. In Italy, a series of well-meaning prime ministers have been unable to overcome the formidable vested interests that see reforms as a threat to the special deals they have carved out. This combination of size and lassitude is dangerous, because France and Italy are at once too big to fail and too big to bail out. But the two countries’ governments now offer reason for hope. Mr Renzi has overseen constitutional change that should make it easier to force through reforms, and promised a “revolution” to speed up justice and promote investment. Hollande’s only hope Mr Valls has reshuffled his government to dump its most leftist anti-reformers. He sounds pro-business and promises to cut spending, reform welfare and the labour market and open up protected professions. The 35-hour working week is being made more flexible, and the top tax rate of 75% will lapse next year. Until now Mr Hollande’s unpopularity has been a weakness, but as the least-popular president in the history of the Fifth Republic, backing Mr Valls may be his only chance. After two years of failure, French voters seem to understand that there is no alternative to reforms: they are now even in favour of working on Sundays. Mr Valls may also get most Socialist deputies to accept change by threatening fresh elections if they do not. Two things could help the Vallenzi: more public investment to boost demand in the euro zone (see article) and a longer time-frame in which to cut their deficits. Other member states may be unwilling to give them that much leeway. Eastern European countries whose people suffered through the imposition of tight fiscal discipline immediately after the crisis see little reason why richer member states should be indulged, especially since previous relaxations of discipline have been followed by backsliding. Their misgivings are understandable. Thus the discipline the European Commission imposes should be eased only if the Vallenzi implement reforms as well as promising them. But Angela Merkel, the German chancellor, should get on with raising public investment. Germany itself is again on the brink of recession, and if the euro zone cannot somehow regain its zip, it may not be only budget-deficit ceilings that are broken: it may be the single currency itself. http://www.economist.com/news/leaders/21621785-leaders-france-and-italy-have-window- pursue-genuine-reforms-it-only-narrow

Hong Kong protests

Oct 4th 2014 The Party v the people The Communist Party faces its toughest challenge since Tiananmen. This time it must make wiser decisions

OF THE ten bloodiest conflicts in world history, two were world wars. Five of the other eight took place or originated in China. The scale of the slaughter within a single country, and the frequency with which the place has been bathed in blood, is hard for other nations to comprehend. The Taiping revolt in the mid-19th century led to the deaths of more than 20m, and a decade later conflict between Han Chinese and Muslims killed another 8m-12m. In the 20th century 20m-30m died under Mao Zedong: some murdered, most as a result of a famine caused by brutality and incompetence. China’s Communist Party leaders are no doubt keen to hold on to power for its own sake. But the country’s grim history also helps explain why they are so determined not to give ground to the demonstrators in Hong Kong who want to replace the territory’s fake democracy with the real thing (see article). Xi Jinping, China’s president, and his colleagues believe that the party’s control over the country is the only way of guaranteeing its stability. They fear that if the party loosens its grip, the country will slip towards disorder and disaster. In this section//The Party v the people//Wealth without workers, workers without wealth//Don’t let history repeat itself//The rise of the Vallenzi//A plea for change Related topics//Arab Spring//Egyptian Protests//North African Politics//Egyptian politics//War and conflict 60

They are right that autocracy can keep a country stable in the short run. In the long run, though, as China’s own history shows, it cannot. The only guarantor of a stable country is a people that is satisfied with its government. And in China, dissatisfaction with the Communist Party is on the rise. Bad omens Hong Kong’s “Umbrella revolution”, named after the protection the demonstrators carry against police pepper-spray (as well as the sun and the rain), was triggered by a decision by China in late August that candidates for the post of the territory’s chief executive should be selected by a committee stacked with Communist Party supporters. Protesters are calling for the party to honour the promise of democracy that was made when the British transferred the territory to China in 1997. Like so much in the territory, the protests are startlingly orderly. After a night of battles with police, students collected the plastic bottles that littered the streets for recycling. For some of the protesters, democracy is a matter of principle. Others, like middle-class people across mainland China, are worried about housing, education and their own job prospects. They want representation because they are unhappy with how they are governed. Whatever their motivation, the protests present a troubling challenge for the Communist Party. They are reminiscent not just of uprisings that have toppled dictators in recent years from Cairo to Kiev, but also of the student protests in Tiananmen Square 25 years ago. The decision to shoot those protesters succeeded in restoring order, but generated mistrust that still pervades the world’s dealings with China, and China’s with its own citizens. In Hong Kong, the party is using a combination of communist and colonial tactics. Spokesmen have accused the protesters of being “political extremists” and “black hands” manipulated by “foreign anti-China forces”; demonstrators will “reap what they have sown”. Such language is straight out of the party’s well-thumbed lexicon of calumnies; similar words were used to denigrate the protesters in Tiananmen. It reflects a long-standing unwillingness to engage with democrats, whether in Hong Kong or anywhere else in China, and suggests that party leaders see Hong Kong, an international city that has retained a remarkable degree of freedom since the British handed it back to China, as just another part of China where critics can be intimidated by accusing them of having shadowy ties with foreigners. Mr Xi, who has long been closely involved with the party’s Hong Kong policy, should know better. At the same time, the party is resorting to the colonialists’ methods of managing little local difficulties. Much as the British—excoriated by the Communist Party—used to buy the support of tycoons to keep activism under wraps, Mr Xi held a meeting in Beijing with 70 of Hong Kong’s super-rich to ensure their support for his stance on democracy. The party’s supporters in Hong Kong argue that bringing business onside is good for stability, though the resentment towards the tycoons on display in Hong Kong’s streets suggests the opposite. Yet the combination of exhortation, co-option and tear gas have so far failed to clear the streets. Now the government is trying to wait the protesters out. But if Mr Xi believes that the only way of ensuring stability is for the party to reassert its control, it remains possible that he will authorise force. That would be a disaster for Hong Kong, and it would not solve Mr Xi’s problem. For mainland China, too, is becoming restless. 61

Party leaders are doing their best to prevent mainlanders from finding out about the events in Hong Kong (see article). Even so, the latest news from Hong Kong’s streets will find ways of getting to the mainland, and the way this drama plays out will shape the government’s relations with its people. The difficulty for the Communist Party is that while there are few signs that people on the mainland are hungering for full-blown democracy, frequent protests against local authorities and widespread expressions of anger on social media suggest that there, too, many people are dissatisfied with the way they are governed. Repression, co-option and force may succeed in silencing the protesters in Hong Kong today, but there will be other demonstrations, in other cities, soon enough. A different sort of order As Mr Xi has accumulated power, he has made it clear that he will not tolerate Western- style democracy. Yet suppressing popular demands produces temporary stability at the cost of occasional devastating upheavals. China needs to find a way of allowing its citizens to shape their governance without resorting to protests that risk turning into a struggle for the nation’s soul. Hong Kong, with its history of free expression and semi- detached relationship to the mainland, is an ideal place for that experiment to begin. If Mr Xi were to grasp the chance, he could do more for his country than all the emperors and party chiefs who have struggled to maintain stability in that vast and violent country before him. http://www.economist.com/news/leaders/21621803-communist-party-faces-its- toughest-challenge-tiananmen-time-it-must-make-wiser

vox Research-based policy analysis and commentary from leading economists Deflation, debt, and economic stimulus Richard Wood03 March 2011 The US, Japan, and Ireland are threatened by the spectres of deficient private demand, rising debt, and a tendency to deflation. This column questions current monetary policy directions, i.e. quantitative easing, and argues that printing money to directly finance fiscal stimulus may be a better option. The US, Japan, and Ireland are suffering from deficient private demand, rising debt, and a tendency to deflation. This column asks what can be done about it. We begin by assuming that relevant authorities have decided that new money creation is necessary to work against deflationary tendencies and to stimulate the economy. The central issue explored here then is how should such new money creation best be deployed to create the required economic stimulus? Policy A: Further quantitative easing Under Policy A the central bank creates new currency to purchase government bonds on the secondary market. The principal purpose is to finance a rise in bond prices and lower interest rates and, thereby, stimulate private investment. Considerable risks and side-effects could arise from the continued application of this policy in the current environment of historically low interest rates. If the consumption/investment preferences of bond holders are unchanged, then, under Policy A, bondholders may simply purchase new domestic bonds (or other close substitutes) with the newly created currency received from the central bank, or they may purchase higher yielding foreign bonds/assets offshore. On this basis, the additional money supply would not go directly, if at all, to domestic consumers, wage-earners, the unemployed, or to non-finance businesses – the areas where it is most needed to generate widespread domestic demand growth. Additional reductions in interest rates will further lower interest incomes of state and local governments, mutual funds, and pension funds etc., including the incomes of the elderly, retirees, and savers, which could, in turn, impact adversely on consumption expenditure. As well, at some point the return for not hoarding becomes too low, and with uncertainty high, and financial and borrowing fears elevated, economic agents may prefer to hold cash (and safe currencies) as a store of value. In other words, the liquidity trap could be strengthened (Krugman 1999). As medium- to longer-term nominal lending interest rates fall toward their lower bounds, the margin between borrowing and lending rates may come under downward pressure, making difficulties for banks in extending credit. As these interest rates fall, insurance companies, heavily reliant on low-risk bond interest income, may be adversely impacted, potentially damaging their effectiveness.

Beyond some point, further rises in bond prices could set the stage for a sell-off of US government bonds, particularly when quantitative easing bond purchases are completed, resulting in potential disruption to financial and exchange rate markets. Working toward an artificially flat yield curve based on a near-zero interest rate (through excessive quantitative easing), could impart misleading information about underlying risk structures, distort time-dependent investment/purchasing/selling decisions, encourage banks to take on higher-risk positions to maintain profitability, and artificially create illusory, “bubble-like”, share market gains. To the extent that quantitative easing is successful in reducing longer-term interest rates, there will be an increased incentive for “carry trade” and other cross-border capital flows. The likely effect on capital outflows, and the exchange rate, could be relatively large in open economies where medium-term interest rates approach their lower bound. Foreign jurisdictions may be disadvantaged as domestic inflation there could increase, asset price bubbles could develop, and local exchange rates could rise. This could complicate global economic adjustments and international policy coordination. The effectiveness of Policy A is highly uncertain. No one knows how much new money needs to be created, and how many government bonds need to be purchased, to force the sought after reduction in business and personal borrowing interest rates. When the time comes to raise interest rates, from their artificially low levels, public debt will increase. The Fed is limited to holding no more than 35% of any single issue of US Treasury bonds. These limits are rapidly being approached as the second phase of quantitative easing unfolds and may, if maintained, preclude further rounds. Policy B: New money financed budget deficits The alternative approach involves the central bank printing new money to directly finance fiscal stimulus. This neglected policy option – apparently largely overlooked by officials during the global economic crisis – is likely to be appropriate for countries where prices are falling (or inflation drops toward zero), private demand is deficient, interest rates are already too low and where public debt is excessive. Policy B provides a capacity to: • finance budget deficits without raising public debt levels further; • simultaneously stimulate private demand; and • retreat from deflation. In order for the central bank to expand the monetary base (the liability side of its balance sheet), there must be a matching expansion on the asset side. This would have to be matched by a liability on the central government’s balance sheet. This involves the central bank purchasing newly created bonds from the ministry of finance, thereby creating new intra-governmental debt, which, nevertheless, would normally need to be serviced and repaid. The interest outflows to the central bank would, over time, be returned as budget revenue to the government, and taxpayers would, on that account, accumulate no liabilities.

In relation to the redemption value, the government could either refinance the debt in the market or else pay down the debt. Paying down the debt would create a liability for taxpayers when the redemption date is reached. In extraordinary times the government’s liability (the bond) could be issued as “perpetual” debt (i.e., it would provide no set maturity date). This approach would leave a long-term liability on the government’s balance sheet and a long-term asset on the balance sheet of the central bank. There is no effective increase in the overall net debt of the government (considered broadly), and taxpayers would not incur taxation liabilities to finance the deficit. Policy B would be appropriate if domestic demand is deficient, excess productive capacity exists, unemployment is high, inflation is low or negative, and there is a desire to apply fiscal stimulus without raising the level of publicly-held debt. These prior conditions exist in different degrees in the US, Japan, and Ireland, and potentially in some other European countries. Policy B directs new money creation to locations in the economy where the marginal propensities to consume, and to invest in real productive assets (as distinct from financial assets under quantitative easing), are the highest. Policy B, therefore, could be expected to impact relatively favourably on consumption and investment spending and provide the time, increased incomes, suitable inflation rates, confidence, and appropriate interest rates needed to work-out of liquidity traps. Policy B would be wound-down as sustainable economic recovery is established. Both Policy A and Policy B involve new money creation and, if taken too far, may eventually lead to rising inflation and excess liquidity that may, possibly, later need to be withdrawn by raising bank reserve requirements, asset and mortgage sales, or sales of government bonds. The policy change and its implications The application of Policy B to Ireland (a country without its own sovereign currency) could be challenging at the political level, but not necessarily precluded by policy design. The European Central Bank could conceivably directly finance budget deficits of selected small countries, addressing growing “debt” problems at their source. Attempting to resolve debt-crises, as is currently the case, by generating even more (relatively high interest) debt seems counter-intuitive and self-defeating – especially where early economic recovery is unlikely. There are not endless shots left in the policy armoury. Great care needs to be taken so as not to fire-off the remaining monetary policy shot in the wrong direction. Each creation of new money is not costless, as eventually it could result in a higher rate of inflation than is desirable, and may, therefore, need to be withdrawn from the economy, reducing the scope for more constructively applied money creation in the interim. If monetary policy is considered on its own then there could be a case for terminating current quantitative easing programmes. This would steer Japan and the US away from the shoals of triple jeopardy (Leijonhufvud 2011). Quantitative easing could be replaced with a policy of printing new money with an explicit objective to assist in the financing of future budget deficits (see suggested money-financed tax cut: Bernanke 2002 and analysis by Corden 2010). The deployment

of new money creation in this manner would take some pressure off the need for severe fiscal austerity measures (at a time when continued stimulus is still required); minimise further increases in public debt; provide clear signals of policy intent (in relation to interest rate objectives, the method of financing deficits and the approach to delivering economic stimulus); and be more effective, have fewer adverse side-effects, and deliver stronger economic stimulus than further quantitative easing. Countries experiencing a deflationary tendency and deficient private demand that introduced laws in times of high inflation which preclude the printing of new money to finance budget deficits, and the ability of central banks to lend directly to Ministries of Finance, could consider repealing them. The views expressed in this private paper are those of the author alone and may not be shared by his employing agency, the Australian Treasury. References Bernanke, Ben (2002), “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, Remarks before the National Economists Club, Washington DC, 21 November. Corden, Max (2010), “The Theory of the Fiscal Stimulus: How will a Debt-Financed Stimulus Affect the Future”, Oxford Review of Economic Policy, 26(1):38-47. Krugman, Paul (1999), “Thinking About the Liquidity Trap”, December. Leijonhufvud, Axel (2011) “Nature of an Economy”, CEPR Policy Insight 53, February. http://www.voxeu.org/article/deflation-debt-and-economic-stimulus

ft.com/markets THE SHORT VIEW October 2, 2014 7:32 pm Inflation outlook brings QE into view for ECB By James Mackintosh Mario Draghi’s April plan has so far been followed exactly, but further action may be needed

©Bloomberg Mario Draghi, president of the European Central Bank Investors have learnt to listen to central bankers. In Europe, perhaps, they have not listened carefully enough. On Thursday, the message from Mario Draghi, European Central Bank president, was not what markets wanted to hear. He started out well, saying purchases of asset-backed securities and covered bonds would “generate positive spillovers to other markets”. In the vernacular, that translates to “fill yer boots”. More ON THIS STORY// ECB to start asset purchases this month/ Editorial Criticism of Draghi’s actions is misguided/ ECB’s lack of detail on plan disappoints/ Video Draghi treads cautiously/ Global Insight Germany refuses to budge on fiscal rigour ON THIS TOPIC// The World Mario Draghi’s press conference/ Protesters clash with police in Naples/ Lorenzo Bini Smaghi Only a weak euro can save the ECB now/ Audio How much lower can the euro go? THE SHORT VIEW// Investors to face true test of courage/ Carry trade and junk bonds feel the squeeze/ HK investors – keep umbrellas to hand/ Bet on the dollar but beware bad news Unfortunately, Mr Draghi then laid out a plan with more caveats than hoped, including a demand that Greece sign up to a new European supervision scheme when its bailout expires this year. Worse, he refused to confirm that a €1tn expansion of the balance sheet, which had become accepted wisdom on dealing floors, was a target. The ECB will start buying bonds later this month, but the immediate spillovers to other markets were not what Mr Draghi might have hoped. Far from thinking that falling inflation would soon be reversed, investors were unimpressed about likely economic impacts. The euro had its best day against the dollar since its long fall was

briefly interrupted in early August. Italian and Spanish bond yields rose a little, too, as they were seen as riskier. Owners of what the ECB calls the “monetary transmission channel” – banks – were deeply disappointed. Eurozone bank shares fell 3.8 per cent to have their second-worst day of the year, more than giving up their gains from when the ABS scheme was announced a month ago.

There should be hope, though. In April Mr Draghi set out how the ECB would react to three scenarios. The first two led to negative interest rates, new long-term loans and ABS purchases. Only the third possibility he laid out would lead to full-blown quantitative easing: a worsening of the inflation outlook, for example through weaker demand. This now seems to be under way, and when pushed Mr Draghi reluctantly mentioned weak demand as one explanation for last month’s surprisingly low core inflation. German politics makes full QE (buying government bonds) hard for Mr Draghi to discuss, and markets anyway want action, not words. But his April plan has so far been followed exactly. If there are no signs soon that inflation will pick up, QE is next on the list. http://www.ft.com/intl/cms/s/0/c1cff688-4a4b-11e4-bc07- 00144feab7de.html#axzz3F4JDCIFL

ft.com/global economy EU Economy October 2, 2014 6:55 pm Draghi’s lack of detail on measures disappoints By Claire Jones in Naples The tight security and street protests in one of the poorest regions of a country mired in its third recession in seven years underlined the extent of the task facing the eurozone’s monetary policy makers in Naples on Thursday. The European Central Bank was in southern Italy to give the details of its latest attempt to rid the region of the threat posed by stagnant growth, weak inflation and unemployment so high that it has left more than half of young people in the region without work More ON THIS STORY// The Short View Inflation outlook brings ECB QE into view/ ECB to start asset purchases this month/ Editorial Criticism of Draghi’s actions is misguided/ Video Draghi treads cautiously/ Global Insight Germany refuses to budge on fiscal rigour ON THIS TOPIC// ECB’s asset plan takes political hit/ Markets Insight Falling commodities flash global warning/ Hawkish Plosser to stand down from Fed/ Gillian Tett Emerging markets brace for a bumpy ride IN EU ECONOMY// France defiant on missed deficit target/ Tax probe widens to include Gibraltar/ Eurozone’s manufacturing recovery slows/ Ireland under pressure over low tax rates Analysts had mixed views on whether the details of the ECB governing council’s plans to buy bundles of loans repackaged as asset-backed securities and covered bonds would provide some succour for Europe’s citizens. The ECB has cast its net wide in terms of the assets it will consider buying. But the lack of a hard figure from the ECB for the size of the purchases and the perception that Mario Draghi, its president, had backtracked on a signal that the central bank would expand its balance sheet by up to €1tn fuelled disappointment. Information on the size of the programme was vague, the central bank saying only that it would have a “sizeable” effect on its balance sheet. The ECB president also played down the focus on recent remarks that the governing council would inject enough liquidity to match levels last seen in early 2012, when the balance sheet topped €3tn. At the moment, the balance sheet is about €2tn. Mr Draghi said the “ultimate yardstick” of success was keeping expectations of inflation well anchored. Beat Siegenthaler, of UBS, said: “The impression was that Draghi and the more dovish side of the governing council would have wanted to be bolder [in giving a specific figure] but were held back by the more hawkish side.”

Ken Wattret, economist at BNP Paribas, said: “Without the quantum being known, the concern is that the ECB will fall miles short of reversing the shrinkage of the balance sheet.” But if the size of the two-year programme was unclear, its scope appeared to be broad. Mr Draghi said the so-called “universe” of assets eligible for purchase would be worth €1tn, though he stressed that did not mean the ECB would buy them all. A trillion euros implies the ECB would buy the safest, so-called “senior”, slices of eurozone asset-backed securities and covered bonds. If the ECB secures guarantees from governments on riskier, mezzanine tranches, the universe would expand. Yet, while a decision is not expected before November, early signs are that Germany and France will not back the riskier purchases. Importantly, the ECB will consider buying ABS and covered bonds retained by the banks that have created them. The retained ABS make up more than half the European market, and are often used as collateral in exchange for the ECB’s cheap loans. The ECB would also purchase the safer slices of loan bundles from all eurozone member states, including Greece and Cyprus, for which even the senior tranches carry subinvestment grade, or “junk”, ratings. “We want to be as inclusive as possible but with prudence,” the ECB president said. To mitigate the risk of investing in Greek and Cypriot bundles, the ECB will insist that both countries remain in EU reform programmes. To the protesters outside, enraged, in part, by the austerity inflicted under those reform programmes, Mr Draghi acknowledged they had some cause for complaint But the ECB, he said, was not “the guilty actor”. It had launched countless exceptional measures to stave off financial meltdowns and economic stagnation. Mr Draghi maintained once again that it was a lack of economic reforms, particularly in Italy and France, that was blunting the effect of the ECB’s measures. Frederik Ducrozet, an economist at Crédit Agricole, said the details of the central bank’s latest effort had made him “cautiously optimistic” that monetary policy makers would continue to do all they could to fix the economy. “If something goes wrong, then I firmly believe that the ECB would prove to be flexible enough to do more, including widening the scope of the programme to include riskier assets,” Mr Ducrozet said. http://www.ft.com/intl/cms/s/0/66aca742-4a50-11e4-b8bc- 00144feab7de.html#axzz3F4JDCIFL

ft.com Comment The A-List

Lorenzo Bini Smaghi October 2, 2014 Only a weak euro can save the ECB now

(Ralph Orlowski/Getty Images) Most of the news which has come out since the European Central Bank’s last governing council, in early September, has made life more difficult for Mario Draghi. On the economic front, eurozone inflation continues to fall, dangerously approaching the zero bound. Inflation expectations have plunged back below the trough recorded in the summer. Hard and soft indicators all point to a slowdown in economic activity, now affecting also the core of the monetary union. Concerning the effectiveness of monetary policy, the results of the targeted longer-term refinancing operations (TLTRO) have been much lower than expected, and concentrated on the periphery, which may create new stigma and discourage further drawings in future. The size of the ECB’s balance sheet continues to shrink, while money and credit aggregates are still disappointing. Finally, the political and institutional environment for the conduct of monetary policy has become more complicated. Governments have excluded the possibility of guaranteeing the non-senior tranches of the asset-backed securities to be purchased by the ECB. Criticisms have emerged in some political quarters about the ECB’s decision to expand the balance sheet by buying risky assets. The economic slowdown makes fiscal consolidation more difficult to implement in some countries. To sum up, while the underlying economic fundamentals call for a further easing of monetary conditions, in particular by accelerating the unconventional measures given that interest rates are now at zero, the instruments left to implement such a policy have become increasingly limited and controversial. It is practically impossible to bring

the size of the ECB’s balance sheet back to 2012 levels without directly purchasing non-senior tranches of ABS and government bonds. The only variable which has moved in the right direction is the euro exchange rate, which has fallen by about 4 per cent against the dollar and 2 per cent in effective terms since September 3. Part of this move is due to the deterioration of economic conditions in the eurozone. It is also partly due to the better than expected US economic recovery, which may bring forward the timing of the first Federal Reserve rate hike. But a substantial part of the euro depreciation is predicated on the expectation that the ECB will implement further non-conventional measures in order to bring inflation back towards the 2 per cent ceiling, as announced. However, if these expectations were disappointed, the depreciation of the euro could slow down, or even reverse. This would be quite damaging. In current circumstances the exchange rate is the most effective channel left for monetary policy to influence the real economy. Only a weaker euro can raise inflation to a level consistent with price stability and provide a short term stimulus to the eurozone. We know that the exchange rate is not an objective of the ECB’s monetary policy. But it is certainly more than just one of the many indicators to follow. It should be a prompt for the ECB to bite the bullet — and accept that QE is the only answer left. http://blogs.ft.com/the-a-list/2014/10/02/only-a-weak-euro-can-save-the-ecb-now/

3 ottobre 2014 Bce, mercati insoddisfatti del piano di Mario Draghi. E tra i grandi investitori cresce l'impazienza per Renzi Flavio Bini Pubblicato: 02/10/2014 22:09 CEST Aggiornato: 02/10/2014 23:03 CEST L’incantesimo si sta rompendo per entrambi. Per il primo, Mario Draghi, la bocciatura dei mercati alle parole prudenti e assai poco dettagliate sul piano di acquisto di Abs e covered bond annunciato oggi è stata lampante e rumorosa, con Piazza Affari caduta quasi di quattro punti percentuali. Per il secondo, Matteo Renzi, dietro gli applausi raccolti nella platea di investitori e banchieri riuniti alla Guildhall, a Londra, il malessere è più sotterraneo, ma lo rileva con assoluta precisione chi, proprio in quella sala, lo ha ascoltato per quasi due ore: “La luna di miele degli investitori con Renzi è finita. Ora dopo gli annunci tutti attendono i fatti”, commenta Alberto Gallo, responsabile della strategia sul credito in Europa per Royal Bank of Scotland. Piccolo passo indietro, ore 17.30. Il sismografo finanziario della borsa di Milano registra in chiusura una delle sedute più difficili da molte settimane a questa parte, con il Ftse Mib a quota -3,92%, sceso per la prima volta dal 22 agosto scorso sotto quota 20 mila punti. È la traduzione numerica di una giornata molto difficile per il numero uno dell’Eurotower. L’uomo che, poco più di due anni fa, con tre parole (“Whatever it takes”) era riuscito a condurre l’Europa fuori dalla crisi del debito, oggi si è dovuto scontrare con il mal di pancia dei mercati per le misure descritte dall’ex governatore di Bankitalia. Il giudizio degli analisti è pressoché unanime: la delusione "si sarebbe diffusa per la mancanza di un punto di riferimento chiaro ed esplicito sull'ammontare di asset acquistati dalla Bce”, rileva Vincenzo Longo, market strategist dell'ufficio studi ig interpellato da Radiocor. Per Marco Valli, capo-economista per l'eurozona di Unicredit, Draghi è "rimasto piuttosto sul vago in merito al volume della prevista espansione di bilancio" attraverso i piani di acquisto di Abs e Covered Bond. Mettere in vetrina l’arsenale, come Draghi ha fatto negli ultimi mesi elencando tutti gli strumenti messi in campo dall’Eurotower, rischia di non bastare più: occorre cominciare a sparare. “Oggi è mancato un elemento fondamentale – spiega ancora Gallo ad Huffpost -, i dettagli. E non averli forniti oggi rappresenta senz’altro un segnale negativo. Dimostra la difficoltà ad implementare le misure annunciate, dovute alla mancanza di consenso intorno agli interventi della Banca Centrale e al freno che alcuni governi, come quello tedesco, stanno mettendo alle iniziative di Draghi”. La strada quindi, è strettissima. “La Bce in questo momento sta cercando di prendere tempo, ma anche a questo c’è un limite”.

Lo stesso tempo che gli investitori rischiano di non concedere più al premier, che poco più di sei mesi dopo un incontro analogo organizzato nella City, si è ripresentato a Londra per rilanciare la propria agenda di governo. Ma il clima, da allora, è cambiato molto. Non solo il peggioramento del quadro economico, che ha visto in poco più di un semestre ribaltare le stime di crescita del governo in un cupo -0,3% previsto per la fine dell’anno. Ma anche i grandi capitali, malgrado gli endorsement pubblici dei top manager più di bandiera che di sostanza, rischiano di cominciare a guardare l’orologio. Tanti annunci non si sono ancora concretizzati in tante riforme. Oggi, proprio nella sala londinese, il premier ha fissato due altre importanti scadenze. La prima, sul Jobs Act, che “sarà possibile fare entro un mese”. La seconda, sull’intero pacchetto di riforme, il cui percorso si potrà concludere “entro sei mesi”. “È una scadenza molto ambiziosa – conclude Gallo – effettivamente non è facile implementare tutti questi cambiamenti in così poco tempo. Forse ci vorranno più di sei mesi di tempo, ma non so se il mercato potrà aspettare più a lungo di così”. http://www.huffingtonpost.it/2014/10/02/mario-draghi- bce_n_5922950.html?utm_hp_ref=italy

Paolo Ferrero Segretario nazionale del Partito della Rifondazione Comunista – Sinistra Europea Sul deficit seguire la Francia e non lasciarla isolata, come successe nel 1998 Pubblicato: 01/10/2014 18:21 CEST Aggiornato: 01/10/2014 18:22 CEST

Per la prima volta da molti anni un governo europeo adotta una decisione sensata dal punto di vista economico e sociale. Sto parlando della decisione del governo francese di allungare unilateralmente e senza l'accordo con la Commissione europea il piano del 74

rientro del deficit. Si tratta di una decisione del tutto insufficiente perché non viene messo in discussione l'impianto di fondo delle politiche europee ma per la prima volta si va nella direzione giusta. A questo punto gli alibi del governo Renzi sono caduti: se Renzi vuole effettivamente cambiare le politiche europee non ha che da seguire la Francia sulla strada tracciata: dica chiaramente che l'Italia aumenterà il deficit di un paio di punti per avere le risorse per mettere al lavoro un milione di persone in tempi rapidissimi: dal riassetto idrogeologico del territorio, al rifacimento degli acquedotti-colabrodo, alla manutenzione degli edifici pubblici, alla messa a valore del patrimonio storico e archeologico fino al superamento delle liste di attesa in sanità. Non c'è che l'imbarazzo della scelta perché in questa folle austerità tanti, troppi, sono i lavori assolutamente utili e necessari che non sono stati fatti con la scusa che non c'erano soldi. I soldi al contrario ci sono e le banche private li hanno a gratis (0,05% di interesse) mentre i trattati europei condannano gli stati a fare tagli su tagli. Renzi ha una ulteriore carta dalla sua: è il presidente di turno dell'Unione e ha quindi l'autorevolezza e la condizione per rafforzare la scelta francese e puntare a generalizzarla. Fino ad oggi la presidenza italiana dell'europa non ha prodotto nulla: è l'occasione giusta. Non si dica che non è corretto disobbedire unilateralmente ai trattati, che bisogna discutere ma rispettare i patti. Per come funziona l'Unione Europea, per il numero incredibile di stupidaggini codificate nei trattati, la modifica dell'indirizzo economico dell'Unione attraverso il consenso di tutti è impossibile da ottenere. Si possono battere i pugni sul tavolo di Bruxelles forte - come vuole Renzi - o fortissimo - come vuole Grillo - il risultato è identico: nulla di nulla. L'unica strada per cambiare l'Europa prima che deflagri in un disastro epocale a causa delle politiche di austerità, è quella della disobbedienza unilaterale, della pratica dell'obiettivo, del consapevole perseguimento di un indirizzo diverso da quella che piace alla Merkel. Renzi ci dirà quindi nelle prossime ore se vuole veramente uscire dalle politiche di austerità oppure se è solo uno scaltro teatrante che ogni giorno sbraita ma quando ne ha l'occasione nulla fa. Non è più il tempo delle lamentele, dei mugugni, è il tempo dei fatti! Non sarebbe la prima volta che l'ignavia del PD e dei suoi recenti antenati condanna l'Europa al disastro. Alla fine degli anni '90 il governo Jospin aveva fatto la legge sulle 35 ore in Francia, conquistate a sua volta dall'IG metal - per via sindacale - in Germania. In Italia c'era il governo Prodi e noi di Rifondazione Comunsita chiedemmo giustamente di fare anche in Italia una legge sulle 35 ore. Se questo fosse avvenuto la storia dell'Europa sarebbe cambiata e invece delle politiche di austerità e della deregulation del mercato del lavoro messa in campo negli anni successivi in Germania sarebbe stato possibile imboccare un'altra strada, centrata sulla redistribuzione del reddito e del lavoro invece che sulla compressione dei diritti e dei salari. La storia ci racconta come andò a finire: Prodi traccheggiò un anno ma scelse la via liberista, Rifondazione giustamente uscì dalla maggioranza e fece cadere il governo, Jospin restò isolato e in Germania la linea neoliberista di Scroeder ebbe la meglio sull'impianto socialdemocratico di Lafontaine. 75

Oggi la storia ripropone un bivio nella vita dell'Europa. Noi comunisti, noi di sinistra, siamo per imboccare con nettezza la strada dell'uscita dalle politiche neoliberiste. Anche perchè peccare umanum est, perseverare diabolicum. http://www.huffingtonpost.it/paolo-ferrero/deficit-fare-come-francia-non- lasciare-isolata-_b_5914260.html?utm_hp_ref=italy

The ECB’s ABC of ABS is missing a few letters - size unknown, political constraints still unresolved and new issues popping up by Silvia Merler on 3rd October 2014

LHF Graphics After the ECB last month announced a programme of private sector assets purchases, all eyes were directed at Frankfurt yesterday. As expected, the ECB unveiled further details of its new ABS and covered bond purchase programmes, revealing that important issues remain unresolved (while others may soon become thorny). Tweet This Draghi was rather vague about whether the TLTRO and ABS programme are mutually reinforcing or rather conflicting with each other in banks’ eyes There was still no figure quoted for the programme. Draghi reiterated his September point saying that it is hard to give a figure because there are several interactions between ABS purchases, Covered Bond purchases and the TLTRO. He insisted that the overall impact should be such as to bring the ECB’s balance sheet back to the size it had 76

at the beginning of 2012. Draghi was rather vague about whether the TLTRO and ABS programme are mutually reinforcing or rather conflicting with each other in banks’ eyes (something I previously addressed here). Further measures are not ruled out. At the eve of the meeting, pressure had been mounting for the ECB to “do more” on the back of weak data. Perhaps in the attempt to counteract the scepticism that seemed to be growing after the disappointment of the first TLTRO auction, Draghi spelled out somewhat more clearly than usual that “despite the measures already taken, the Governing Council still stands ready to take additional measures”. This – by now, usual – statement, is hardly an indication that a full QE should be expected in a near future, considering how much reputational capital the ECB has put at stake in marketing the TLTRO and ABS programmes over the past months. Details on the ABS and Covered bond programme (CBPP3) were unveiled. In both cases, purchases will be conducted in both primary and secondary markets, as it was the case for the two previous CBPP. The third Covered Bond Programme (CBPP3) differs significantly from the two previous waves (2009 and 2011), and the ECB has evidently tried to make it look more open-ended. No target amount was revealed on announcement; there is no eligibility requirement related to the issue volume of a covered bond (it needed to be 300 million during the second and no less than 100 million during the first programmes); there is no maximum residual maturity on covered bonds accepted and fully retained securities are eligible. Purchases of covered bonds will start in mid October 2014 that – as we already pointed out in a paper and a post – is a tricky timing. Banks will in fact have to deal with the aftermath of the ECB’s supervisory assessment – including but not limited to possible capital needs identified. The ECB’s involvement in the business of buying banks’ bonds could put the Central Bank in an uncomfortable position and raise questions of incompatibility with the supervisory function that is carried out by the same institution – although supposedly behind Chinese walls. Tweet This The eligibility criteria for guaranteed mezzanine tranches of ABSs – has not been disclosed yet. This most likely signals that ECB has not yet found the way around the opposition it faces on this politically (highly) sensitive point Concerning the ABS Purchase Programme (ABSPP), the programme will last for at least 2 years and both senior and guaranteed mezzanine tranches of asset-backed securities (ABSs) will be purchased. This is something that ECB’s President Draghi has been strongly fighting for in recent weeks, but the most important detail – i.e. the eligibility criteria for guaranteed mezzanine tranches of ABSs – has not been disclosed yet. This most likely signals that ECB has not yet found the way around the opposition it faces on this politically (highly) sensitive point. The purchases of ABS will however not start until the fourth quarter of 2014. One issue on which the ECB’s official position was much awaited was the credit rating of the instrument that the programme would be targeting. Last week, the FT had reported that the ECB would announce derogations from the rating criteria set for ABS in the collateral framework, in order to broaden the pool of targeted securities. At present, in fact, the minimum grade for marketable assets to be eligible as collateral in

ECB’s lending operations is BBB-. Currently, ABS rating is strictly linked to the rating of the sovereign, which acts as a cap. In the case of Greece and Cyprus, a strict application of this principle would rule out purchases of ABS issued in these countries. The ECB confirmed today that the Eurosystem’s collateral framework will be the guiding principle for deciding the eligibility of assets to be bought under the ABSPP and the CBPP3, but there will be some adjustments. Draghi clarified that the rules governing eligibility for the asset purchase programmes are inspired by the fact that: 1 The Eurosystem will apply an issue share limit of 70% per ISIN, except in the case of ABSs with underlying claims against non-financial private sector entities resident in Greece or Cyprus and not fulfilling the CQS3 rating requirement; for those ABSs, a corresponding limit of 30% per ISIN will be applied. 1. Outright purchases differ from lending against collateral (because in the second case the asset is only temporarily pledged on the Central Bank’s balance sheet); 2. The asset purchase programme is focused on lending to SME, so the ECB will not buy structured ABS; 3. The general aim is to be “as inclusive as possible, but with prudence”. In practice, the ECB’s view of “prudence” means that assets bought should be “risk equivalent”. This has two major implications. The first one is operative: while ABSs and covered bonds from Greece and Cyprus – which are currently not eligible as collateral for monetary policy operations – will be included, the Eurosystem will buy relatively fewer of them1. The second implication is instead more philosophical. Answering to a specific question, Draghi hinted to the fact that derogation would require the country to be under a programme to be applicable. He actually did a little bit more than hinting at it, as he even came up with a catchy phrase such as “no programme, no purchase” (and this is how e.g. Reuters also reported it). In fairness, this sounded striking, because it would be hard to see the rationale of subjecting a country to a programme before implementing a monetary policy measure that would be explicitly targeted at private sector assets. Tweet This Draghi hinted to the fact that derogation would require the country to be under a programme to be applicable The issue is in fact considerably more vague in the two technical documents issued by the ECB after the press conference. The ABSPP one for example states that “for ABSs with underlying claims against non-financial private sector entities resident in Greece or Cyprus […], a derogation […] will be applied for as long as the Eurosystem’s minimum credit quality threshold is not applied in the collateral eligibility requirements for marketable debt instruments issued or guaranteed by the Cypriot or Greek governments”. After their sovereign ratings were slashed to the lowest levels during the crisis, the ECB decided to suspend the usual minimum rating criteria for the programme countries, so as to allow banks in these countries to pledge government bonds as

collateral (which would not have been possible otherwise). This is still the case for Greece and Cyprus, and the ECB seems to be saying that the derogation in ABSPP will be applied to them “for as long as” the minimum credit quality threshold is suspended. And when is the minimum credit quality threshold is suspended? The ECB itself decided in 2012 that this will be the case for all countries “eligible for Outright Monetary Transactions or under an EU-IMF programme”. So, putting the pieces together in a slightly more linear way, it looks like the ECB will buy Greek and Cypriot securities derogating from rating requirements, for as long as the minimum credit threshold is suspended, and the minimum credit threshold will be Suspended for as long as the countries will be under a programme. While being overly convoluted, this does look significantly less strong than Draghi’s own language. The ECB will most certainly be asked to clarify what the correct interpretation is. Tweet This What would happen to these ABS after a country like Greece were to exit the programme, if their rating were not upgraded? But more importantly, what would happen to these ABS after a country like Greece were to exit the programme, if their rating were not upgraded. Would they be offloaded? And if so, how would that be justified? This point is definitely too important – especially for a country like Greece that is approaching the end of the second programme and is surrounded by rumours about the opportunity of a third one – to be left lost in the translation of central bank jargon. http://www.bruegel.org/nc/blog/detail/article/1448-the-ecbs-abc-of-abs-is- missing-a-few- letters/?utm_source=Bruegel+Fact+of+the+Week&utm_campaign=360fd4ff18- Bruegel+Fact&utm_medium=email&utm_term=0_397314f092-360fd4ff18- 277671613

Fact: The World still fears fiscal crises (and much else) - how the world has changed in respondents’ eyes and concerns by Silvia Merler on 10th September 2014 92292229

Ollyy Last week, the World Economic Forum (WEF) published its Global Risk Report for 2014/15. The report is an exercise conducted by the WEF since 2006, but this year’s issue is particularly interesting because it adopts an historical perspective, offering very interesting insights on how the world has changed in respondents’ eyes and concerns. The Global Competitiveness Report (GRR) assesses risks that are global in nature and have the potential to cause significant negative impact across entire countries and industries if they take place. A “global risk” is defined - for the purpose of the GRR’s exercise) - as “an occurrence that causes significant negative impact for several countries and industries over a time frame of up to 10 years”. 31 such risks are identified in the report and grouped under five categories – economic, environmental, geopolitical, societal and technological. • Economic Risks include fiscal and liquidity crises, failure of a major financial mechanism or institution, oil-price shocks, chronic unemployment and failure of physical infrastructure on which economic activity depends. • Environmental Risks encompass both natural disasters and man-made risks such as collapsing ecosystems, freshwater shortages, nuclear accidents and failure to mitigate or adapt to climate change.

• Geopolitical Risks cover politics, diplomacy, conflict, crime and global governance. These risks range from terrorism, disputes over resources and war to governance being undermined by corruption, organized crime and illicit trade. • Societal Risks are intended to capture risks related to social stability – such as severe income disparities, food crises and dysfunctional cities – and public health, such as pandemics, antibiotic-resistant bacteria and the rising burden of chronic disease. • Technological Risks covers major risks related to the centrality of information and communication technologies to individuals, businesses and governments (such as cyber attacks, infrastructure disruptions and data loss). The objective of the report is to map the risks - by means of a survey - according to the level of concern they arouse, their likelihood and their potential impact. Additionally, the GRR also looks at the perception of interconnections between risks and the strength of their potential systematicity. The survey for this edition was conducted between October and November 2013 among respondents from business, government, academia and non-governmental and international organizations. Note: From a list of 31 risks, survey respondents were asked to identify the five they are most concerned about.

Global Risks Perception Survey 2013-2014 Table 1 show the top-10 of risks for respondents in the GCR 204/15. Economic issues dominate the lists. The possibility of fiscal crises in key countries appears to be the concern that kept everybody awake at night, followed by post-recession structurally high unemployment or underemployment and concerns of severe income disparity. These concerns appear to be well-substantiated if one looks at the current situation in the euro area (even though the GCR unfortunately does not give a country or region breakdown of the responses).

Environmental concerns are also high-ranked, with failure to mitigate/adapt to climate change rank in the top-5 as well as water crises, whereas geopolitical risks are low in the ranking. This is most likely due to the timing of the survey (October-November 2013), which was conducted before the escalation in the Ukrainian crisis and the conflicts in the Middle East (which were in the top-5 back in 2008). Health issues - which disappeared from the list in 2011 - are also likely to come back next year, as the world struggles to manage the Ebola outbreak in Africa. Figures below show the ranking of risks in terms of both likelihood and impact separately, for 2014 as well as for the previous 7 years. It has to be stressed that the exact definition of these risks has been changed by the WEF over the years, but the insights are many and interesting. Tweet This Economic risks are recurrently perceived as highly likely risks and as those having the strongest impact Economic risks are recurrently perceived as highly likely risks and as those having the strongest impact. But it is very interesting to see how the economic concerns have changed over the years, following the developments in the global financial crisis first and of the euro sovereign crisis later. In 2008-10, the most dangerous economic risk in the perception of respondents was most naturally asset price collapse. In 2011, following the emergence of a sovereign crisis in Europe, fiscal crises climbed on top of the list. As the sovereign-banking troubles intensified during 2011/12, the risk of major systemic financial failures gained relevance. Now, as the emergency phase of the crisis is over but we are left to face its legacy of high debt burdens and economic slack, the focus has shifted to fiscal crises and structurally high unemployment as the high impact economic risks. It is also interesting to see that the risk of growing income disparity has been ranking first in terms of likelihood since 2012 (well before the whole Piketty’s debate started) but does not seem to be considered a high-impact risk (even though the question asked explicitly clarifies that “impact” is “to be interpreted in a broad sense beyond just economic consequences”). The risk of a major systemic financial failure appears less pressing than it was two years ago, but it still remains in the top-10, perhaps signalling that at the time the survey was conducted there was still significant uncertainty about the ongoing process of financial sector assessments in Europe and about banks’ possible capital needs in the near future (as we mentioned here). Note: Global risks may not be strictly comparable across years, as definitions and the set of global risks have been revised with new issues having emerged in the 10-years horizon. For example, cyber attacks, income disparity and unemployment entered the set of global risks in 2012. Some global risks were reclassified: water supply crisis and income disparity were reclassified as environmental and societal risks, respectively, in 2014.

Global Risks reports 2007-2014, World Economic Forum Another interesting part of the GCR exercise concerns the mapping of perceived interconnectedness across risks. Fiscal crises are perceived to be strongly connected with structural unemployment and underemployment, which in turn feed back social risks e.g. rising income inequality and political and social instability. The central node to the map of risk interconnectedness is represented by the risk of failure in global governance, from which a cascade of economic and socio-political risks would spill over. Tweet This The recent history of the Euro area proves perhaps better than any other case studies the existence of risk interconnectedness The recent history of the Euro area proves perhaps better than any other case studies the existence of such interconnectedness. The financial turmoil of 2008-09 evolved into a sovereign-banking crisis with fiscal consequence, which in turn left behind a legacy of high unemployment and dissatisfaction vis à vis Europe, with the risk of increased social malaise and political instability. Governance played a great role in shaping the developments over the last five years and it will have to play a (perhaps even bigger)

role in dealing with what will hopefully be a normalisation, over the next five years. In our recently published EU2DO list of memos for the new EU leadership, we try to offer some advice in view of this enormous challenge.

Global Risks Perception Survey 2013-2014 http://www.bruegel.org/nc/blog/detail/article/1431-fact-the-world-still-fears-fiscal- crises-and-much- else/?utm_source=Bruegel+Fact+of+the+Week&utm_campaign=360fd4ff18- Bruegel+Fact&utm_medium=email&utm_term=0_397314f092-360fd4ff18- 277671613

October 2, 2014 4:08 pm Lagarde warns of ‘new mediocre’ era By Robin Harding in Washington

©AFP The world economy is threatened by a mediocre era of low growth for a long time, warned Christine Lagarde as she signalled cuts to the global outlook for 2015. Ms Lagarde, managing director of the International Monetary Fund, said in a speech on Thursday that the global economic recovery is “brittle, uneven and beset by risks”. More ON THIS STORY//EM central banks’ euro holdings fall/IMF urges shake-up of top bankers’ pay/ECB to start asset purchases this month/The Short View Investors to face true test of courage/EM currencies letting them slide ON THIS TOPIC//IMF urges overhaul of sovereign bonds/Lawrence Summers Public investment/Rich nations urged to honour aid pledges/Benn Steil Brics bank is a feeble strike IN GLOBAL ECONOMY//Global recovery is stalling, says index/Interactive Brookings-FT Tiger Index/Dwindling US inflation casts shadow/IMF warns of global imbalances risk Her remarks highlight a steady weakening of the global outlook in recent months as emerging economies, in particular, suffer a slowdown that threatens to damp already sluggish growth in advanced countries as well. “Overall, the global economy is weaker than we had envisaged even six months ago,” Ms Lagarde told an audience at Georgetown University. “Only a modest pickup is foreseen for 2015, as the outlook for potential growth has been pared down.” The IMF’s most recent forecasts in July called for global growth of 3.4 per cent this year and 4 per cent in 2015, but those numbers are likely to be slashed when the Fund releases its new estimates next week. Among advanced economies, Ms Lagarde said she expected the strongest growth in the US and the UK, and the weakest expansion in the eurozone. She said that emerging economies would remain the main source of global growth but at a slower pace than before.

“Six years after the financial crisis began, we see continued weakness in the global economy,” she said. “Countries are still dealing with the legacies of the crisis, including high debt burdens and unemployment.” In contrast to some of her past remarks, however, Ms Lagarde did not single out particular actors such as the European Central Bank. Only a modest pickup is foreseen for 2015, as the outlook for potential growth has been pared down - Christine Lagarde Tweet this quote She said one of the biggest threats to the global economy is a sustained period of slow growth that feeds on itself as weak output becomes a self-fulfilling prophecy. “If people expect growth potential to be lower tomorrow, they will cut back on investment and consumption today,” she said. The IMF has recently published research noting an unprecedented and synchronised slowdown in growth for emerging economies. She called for countries to move slowly when cutting their budget deficits, take steps to help women into the workforce, open professions such as law to greater competition and cut energy subsidies. She urged countries to invest more in infrastructure, saying that investment is 20 per cent below its pre-crisis trend, with transport and energy bottlenecks holding back growth. “The global economy is at an inflection point: it can muddle along with subpar growth – a ‘new mediocre’ – or it can aim for a better path where bold policies would accelerate growth, increase employment, and achieve a ‘new momentum’,” said Ms Lagarde. In a chapter of its World Economic Outlook published on Tuesday, the IMF argued that infrastructure spending could “pay for itself” if done correctly, because interest rates are so low. “Debt-financed projects could have large output effects without increasing the debt-to- GDP ratio, if clearly identified needs are met through efficient investment,” it argued. That assertion remains highly contentious, however. ------Letter in response to this article: October 3, 2014 9:55 pm Lagarde’s U-turn on the UK leaves me wondering Sir, Your report “Lagarde warns of ‘new mediocre’ era” (October 3) made no mention of the fact that just 16 months ago Christine Lagarde was heavily criticising the UK’s austerity policy and now she apparently chooses to pick out the UK again, but this time for exactly the opposite reason, as a growth economy. I am left wondering, exactly how useful are the IMF’s prescriptions?//Hamish Brewer, Aptos, CA, US// http://www.ft.com/intl/cms/s/0/2bfa11d6-4a44-11e4-8de3-00144feab7de.html#axzz3FMDPrdyo 86

CAPITOL REPORT IMF chief Lagarde warns of ‘new mediocre’ era October 2, 2014, 11:52 AM ET IMF's Lagarde: To revise down 2015 global growth forecast (again) next week from current forecast of 4%:

https://twitter.com/IanTalley/status/517692303738433536/photo/1

International Monetary Fund chief Christine Lagarde said Thursday that she worries the global economy has entered a new era, that of the “new mediocre.” In a speech at Georgetown University in Washington, D.C., Lagarde said that, unless policymakers find new ways to work together to spur growth beyond slashing short- term interest rates to zero, the global economy risks entering an era of lackluster growth. “Monetary policy cannot suffice. Moreover, the longer easy money policies continue, the greater the risk of fuelling financial excess,” Lagarde said, saying this will be her main message to the finance ministers and central bankers from 188 countries who will gather in Washington on Oct. 11-12 for the IMF’s annual meetings. Lagarde called the global recovery brittle and uneven, and warned of the many dark clouds gathering on the horizon, like divergent monetary policies, possible financial imbalances and an opaque and growing shadow banking sector. These dark clouds can be delayed if policymakers aim higher and work together, Lagarde said. “There has to be a new momentum… in order to avoid the risk that the world gets stuck in the new mediocre,” Lagarde said. The IMF chief said that growth in 2014 has been disappointing and that only a modest pickup is forecast in 2015. While the U.S. is leading the pack, Japan and Europe are lagging behind. And Asia and China are set to slow, she said. http://blogs.marketwatch.com/capitolreport/2014/10/02/imf-chief-christine- lagarde-warns-of-new-mediocre-era/

ANTONIO FATAS ON THE GLOBAL ECONOMY WEDNESDAY, OCTOBER 1, 2014 The permanent scars of fiscal consolidation The effect that fiscal consolidation has on GDP growth has probably generated more controversy than any other economic debate since the start of the 2008 crisis. How large are fiscal multipliers? Can fiscal contractions be expansionary? Last year, Oliver Blanchard and Daniel Leigh at the IMF produced a paper that claimed that the IMF and other international organizations had underestimated the size of fiscal policy multipliers. The paper argued that the assumed multiplier of about 0.5 was too low and that the right number was about 1.5 (the way you think about this number is the $ impact on GDP of a $1 fiscal policy contraction). While that number is already large, it is possible that the true costs of fiscal consolidations are much larger. In a recent research project (draft coming soon) I have been looking at the effects that fiscal consolidations have on potential GDP. Why is this an interesting topic? Because it happens to be that during the last 5 years we have been seriously revising the level (and in some cases the growth rate) of potential GDP in these economies. And while there might be good reasons to do so, the extent to which we have done this is dramatic and one gets the sense by analyzing the data that what is really happening is that the cyclical contraction is just leading to a permanent revision of long-term GDP forecasts (I wrote about this in my latest post). To prove my point I decided to replicate the analysis of Blanchard and Leigh but instead of using the forecast error on output growth, I used the forecast error on potential output changes. Here are the details, which follow Blanchard and Leigh as close as I can: I take the April 2010 issue of the IMF World Economic Outlook and calculate: - The predicted fiscal consolidation over the next two years (2010-11) - The expected change in potential output over the next two years (2010-11). I then look at the actual change in potential output during those years (2010-11) as presented in the April 2014 IMF World Economic Outlook. Comparing this figure to the forecast done back in April 2010, we can calculate for each country the forecast error associated to potential output growth. Most models assume that there should be no correlation between these two numbers. Fiscal consolidations affect output in the short run but not in the long run. But under some assumptions (hysteresis or growth effects of business cycles) cyclical conditions can have a permanent effect on potential output (I have written about it here). So what is the evidence? If we include all European countries that are part of the Advanced Economics group as defined by the IMF we get the relationship depicted in the graph above. There is a 89

strong correlation between the two variables: fiscal consolidations have led to a large change in our views on potential output. The coefficient (strongly significant from a statistical point of view) is around -0.75.

Just for comparison, and going back to the original work of Blanchard and Leigh, the coefficient using output growth (not potential) is around -1.1. Because the forecast for output growth already included a multiplier of about 0.5, Blanchard and Leigh's interpretation was that the IMF had been underestimating multipliers and instead of 0.5 the true number was 1.6. In my regression, the theoretical multiplier built into the IMF model must be zero, which means that the true long-term multiplier is just the coefficient on the regression, about 0.7. But this number is very large and it provides supporting evidence of the arguments made by DeLong and Summers regarding the possibility of fiscal contractions leading to increases in debt via the permanent effects they have on potential output. There are many interesting questions triggered by the correlation above: What are the mechanisms through which potential output is affected? Is potential output really changing or is just our perception about long-term growth that is changing? These are all interesting questions that I hope to address as I translate the analysis into a proper draft for a paper. To be continued. Antonio Fatás POSTED AT10/01/2014 09:35:00 PM http://fatasmihov.blogspot.com.es/2014/10/the-permanent-scars-of-fiscal.html

« Do Unemployment Benefits Expirations Help Explain the Surge in Job Openings? | Main*// October 01, 2014 Cross-Country Evidence on Transmission of Liquidity Risk through Global Banks Claudia M. Buch, James Chapman, and Linda Goldberg Over the past thirty years, the typical large bank has become a global entity with subsidiaries in many countries. In parallel, financial liberalization has increased the interconnectedness of banking systems, with domestic banking systems becoming more exposed to shocks transmitted through foreign banks. This globalization of banking propagated liquidity risk during the global financial crisis and subsequent euro area crisis. Unfortunately, little is known about how cross-border operations of global banks transmit liquidity shocks between countries. The seminal work by Peek and Rosengren (1997, 2000) provides early examples of how bank-level data can help identify the specific transmission channels. There are, however, two limitations to conducting this line of research. First, there is a lack of public data on the balance sheets of global banks. Second, it is difficult to compare the results of different research projects that use sensitive supervisory data collected by banking supervisors and central banks. Together with other scholars, we established the International Banking Research Network (IBRN) to overcome these limitations. In its first full project year of 2013, the IBRN brought together researchers from a dozen central banks: Austria, Australia, Canada, France, Germany, Hong Kong, Ireland, Italy, Poland, Spain, the United Kingdom, and the United States, along with International Monetary Fund and Bank for International Settlements representatives. The goal of the IBRN is to conduct coordinated research using bank-level data to analyze issues pertaining to global banks. IBRN participants agree on a common research question and appropriate econometric specifications. Each central bank research team uses its respective micro-data (including supervisory data) to answer the common question, with scope for individualized applications. The purpose of this approach is to facilitate cross- country comparisons. The transmission of liquidity shocks in lending and through balance sheet exposures of domestic and global banks was the first project chosen and completed by the group, resulting in a series of research papers with authors from the participating countries. The work conducted by the IBRN uses a methodology based on the work by Khwaja and Mian (2008) and Cornett, McNutt, Strahan, and Tehranian (2011), and extended as described in Buch and Goldberg (2014). Among the starting points for understanding the effects of liquidity shocks is the observation, underscored in the charts below, that different categories of lending—domestic lending, foreign lending, and net intrabank lending—followed quite distinct trajectories across countries.

Each of twelve country teams estimated a panel regression of the domestic banks (both globally active and purely domestic). The variables of interest were the change in various measures of bank balance-sheet line items that could affect the response of lending to liquidity measures such as foreign loans by the bank or net-due balances from foreign affiliates. The independent variables included various (lagged) controls such as the bank’s capital ratio, proxies for size, and various measures of liquidity risk. The risk metrics included a country-specific Libor-OIS spread to measure market liquidity as well as measures of official liquidity support during the crisis.

Buch and Goldberg (2014) conduct a meta-analysis on the individual countries results. Several results are observed: • The common methodology better explains cross-sectional differences in lending by internationally active banks than lending by purely domestic banks. • The channels of transmission of liquidity shocks to bank lending differ across banks. Deposit funding matters more for the domestically oriented banks. In contrast, internal liquidity management strategies and official liquidity support matter more for the banks with foreign affiliates. • The common empirical model explains more of the cross- sectional and time-series variation in domestic lending than in net-due-to (such as intrabank lending) or foreign

lending. This finding suggests higher stability of domestic lending. At the same time, we see cross-border lending growth is more sensitive to liquidity risk in relation to the balance sheet characteristics of the banks. An interpretation is that cross-border lending tends to be subordinated to domestic lending activity as stress conditions change.

The individual country studies conducted by the IBRN represent the first systematic look at individual banks across countries using a common methodology. This initial effort provides insights that contribute to the debate about appropriate regulatory responses to liquidity risks and other shocks. More information about the IBRN activities and relevant studies can be found on its website and at the Halle Institute for Economic Research’s International Banking Library

Claudia M. Buch is a deputy president of the Deutsche Bundesbank. James Chapman is an assistant chief in the financial stability department at the Bank of Canada.

Linda Goldberg is a vice president in the Research and Statistics Group of the Federal Reserve Bank of New York. http://libertystreeteconomics.newyorkfed.org/2014/10/cross-country-evidence-on- transmission-of-liquidity-risk-through-global-banks.html#.VCyhh-dN0xl

vox Research-based policy analysis and commentary from leading economists The who and how of disappearing routine jobs Matias Cortes, Nir Jaimovich, Christopher J. Nekarda, Henry Siu02 October 2014 As routine tasks are increasingly automated, middle-wage jobs are becoming rarer. This column documents the changes in labour-market dynamics behind this polarisation, and investigates which workers are affected by it. Flows into middle-wage routine jobs are declining (rather than flows out increasing). Interestingly, routine cognitive workers – who tend to be educated women – are benefiting from this hollowing-out by moving up the occupational ladder. Related//Job polarisation and the decline of middle-class workers’ wages Michael Boehm Labour markets around the world have experienced a profound polarisation in recent decades. The share of employment in middle-wage jobs has declined, while employment in high- and low-wage jobs has increased. In the US, this ‘hollowing out of the middle’ has been linked to declining per-capita employment in occupations with a high content of routine tasks – activities that can be performed by following a well- defined set of procedures and are therefore relatively easy to automate (Autor et al. 2006, Goos et al. 2014). To put this in perspective, as recently as the late-1980s more than one in three American adults was employed in a routine occupation; currently, that figure stands at about one in four. To design appropriate policy responses, it is important to understand who the disappearance of routine employment is affecting the most, and how the process is playing out. For example, if the decline in routine employment is mainly accounted for by changes in the occupational choices of young workers entering the labour market, the appropriate response would be different than if the decline is due to increasing exit rates from the labour force of prime-aged workers. Our current research investigates the labour-market changes that underlie the disappearance in middle-wage, routine jobs (Cortes et al. 2014). • We find that there has been a marked decline in the rate at which workers transition into routine employment. This change is particularly pronounced among the young. • Women and those with higher education levels have found it easier to adjust to these changes. They have become more likely to move into higher-paying, non-routine cognitive (‘brain’) jobs. • This is not the case for men and those with less education, who tended to work in blue-collar occupations. The loss of routine jobs among these individuals has been offset by transitions into other jobs that also have a high content of routine tasks (such as clerical and 94

administrative work), or transitions into lower-paying, non-routine manual (‘brawn’) jobs. Declining flows into routine employment To better understand the polarisation phenomenon, we analyse the changes over time in the flows of workers into and out of routine occupations. The key factor accounting for the decline in routine employment is the fact that fewer workers are transitioning into routine jobs. Since the 1980s, unemployed workers – particularly those working in a routine occupation before becoming unemployed – have become less likely to find employment in a routine job. Similarly, the probability that an individual who is out of the labour force transitions into a routine job has also fallen. Figure 1.

On the other hand, changes in the rate at which workers quit or are dismissed from routine jobs account for very little of the decline in routine employment. There have been slight increases in the exit rates from routine employment to labour force non- participation. However, these changes are much less important than the fall in the inflow rates in understanding the overall decline, particularly in recent years. • Our results also show that these changes in transition patterns cannot be attributed to changes in the demographic composition of the US economy, such as population ageing or the increase in the number of people going to college. Instead, they reflect behavioral changes for individuals with given demographic characteristics. We also find that young workers – those aged between 16 and 34 – have experienced the largest decline in the likelihood of transitioning into routine jobs. Across all demographic groups, this change is the most important in accounting for the aggregate decline of routine, middle-wage employment. Figure 1 illustrates this. The blue solid 95

line displays the evolution of per-capita employment in routine occupations from 1976 to the end of 2012. The green hatched line displays how this series would have evolved if the key transition rates that we identify had remained at their pre-polarisation levels for all demographic groups. More than half of the fall in routine employment is mitigated under this scenario. Finally, the red hatched line displays the evolution of routine employment when only the transition rates of the young are held constant to pre- polarisation levels. Much of the total mitigating effect is driven by the young. Where do they go? Given our finding that an important driver of polarisation is the fall in the rate at which unemployed routine workers return to routine jobs, we ask the natural question: where are these unemployed workers going instead? Are they switching into high- or low- paying non-routine occupations? Do they remain unemployed or leave the labour force? To answer this, we distinguish between two subsets of routine occupations that differ markedly in terms of their demographic composition. This first subset, routine manual jobs, includes occupations such as machine operators and other blue-collar jobs that tend to employ men with relatively low education levels. The second subset, routine cognitive jobs, includes occupations such as clerical and administrative support jobs that are generally female-dominated with higher levels of education. Unemployed workers from both of these subsets have experienced falls in the rates at which they return to their previous occupation group. However, the way in which workers in these categories have responded is markedly different. Figure 2a. Change in transition rates from URM: 12−month horizon (Relative to 1976−79 expansion)

The top panel of Figure 2 displays the change in the job finding rate during each expansionary or ‘boom’ period since the 1980s for unemployed workers who used to hold a routine manual job. The first four clusters of bars illustrate the change in the rate at which they find employment in routine manual, routine cognitive, non-routine cognitive, and non-routine manual occupations, respectively. The rightmost cluster illustrates the change in the rate at which they find employment in any job. Relative to the pre-polarisation period, the leftmost cluster shows the fall in the rate at which unemployed routine workers return to a routine manual job. As we will discuss further, this fall has been particularly strong since the Great Recession. Prior to this latest episode, the rate at which they switched into other occupational groups increased. However, this occupational switching was not directed towards high-paying non-routine cognitive jobs, but rather towards middle-wage, routine cognitive jobs (which are also in decline) and low-paying non-routine manual jobs (such as food-preparation workers and home-care aides). Figure 2b. Change in transition rates from URC: 12−month horizon (Relative to 1983−90 expansion)

On the other hand, the bottom panel of Figure 2 displays analogous changes for unemployed routine cognitive workers. These workers have also become less likely to return to their old occupation. However, here we see an increase over time – even after the Great Recession – in the rate at which these workers transition into high-paying non-routine cognitive jobs (such as managers and financial analysts). Thus, workers in these occupations (who tend to be women and have higher levels of education) have been better able to cope with the disappearance of routine employment – by moving up the occupational ladder.

Changes since the Great Recession The period since the Great Recession has been characterised by a precipitous fall in the rate at which unemployed routine workers return to routine employment (what we refer to as the ‘return job finding rate’). Interestingly, as Table 1 shows, the analogous changes for the unemployed from non-routine occupations since the Great Recession were much less pronounced. Whereas the return job finding rate was nearly halved for unemployed routine workers between the pre-polarisation era and the post-Great Recession era, the fall for non-routine workers was relatively mild, at around three percentage points. Table 1. URM → ERM URC → ERC UNRM → ENRM UNRC → ENRC Pre-polarisation expansion 23.12% 15.80% 13.98% 14.80% 2009-2012 expansion 13.87% 7.91% 11.30% 11.68% Difference -9.25% 7.89% -2.68% -3.12% Conclusions To fully understand the phenomenon of employment polarisation and design appropriate policy responses, it is crucial to understand the changing labour market transition patterns of different demographic groups in the economy. Our findings indicate that an important factor behind the decline in employment in middle-wage, routine jobs is the substantial fall in the transition rates of young workers into such jobs. In addition, while routine cognitive workers (who tend to be women with more education) have had some success in moving up the occupational ladder, routine manual workers have not. Editors’ note: The analysis and conclusions set forth in this article are those of the authors and do not indicate concurrence by other members of the research staff or the Board of Governors of the Federal Reserve System References Autor, D H, L F Katz, and M S Kearney (2006), “The Polarization of the US Labour Market.” American Economic Review, 96, 189-194. . Goos, M, A Manning, and A Salomons (2014), “Explaining Job Polarization: Routine- Biased Technological Change and Offshoring.” American Economic Review, 104, 2509- 2526. http://www.voxeu.org/article/disappearance-routine-jobs

10/02/2014 11:15 AM The Merkel Effect What Today's Germany Owes to Its Once-Communist East By Dirk Kurbjuweit East Germany ceased to exist following the 1989 revolution and the fall of the Berlin Wall. But did the former communist country help shape today's Germany? The answer is yes, and Chancellor Merkel is a big reason why. The West will assimilate the East and transform the fruits of its revolution into profits for its companies. Nothing will remain of the German Democratic Republic (GDR), and its citizens will have to submit to a foreign lifestyle. The East is taken over, an event the revolutionaries welcomed with open arms -- but it's a hostile takeover, an obliteration and eradication of what the eastern part of Germany once was. West Germany will simply expand, and that will be that. Such were the expectations after the euphoria of the revolution -- the elation that prevailed when the Berlin Wall came down on November 9, 1989 -- had dissipated. Even worse, some even feared that a newly expanded Germany would regress into a reincarnation of a former empire of evil. In February 1990, author Günter Grass said: "The gruesome and unprecedented experience of Auschwitz, which we shared with the people of Europe, speaks against a unified Germany." Grass favored a confederation, and if it did turn into a unified state, after all, "it will be doomed to fail." But Germany did not follow this advice. Unless we are completely mistaken, the failure predicted by Grass was avoided. But what about the other suspicions, the fears of takeover and commercialization of the revolution? Were the courageous citizens of East German cities like Leipzig and Halle merely added to the army of consumers, without bringing any political change to their new country? A revolution has two goals: to put an end to everything that preceded it and to create something new. The revolutionaries of 1989 achieved the first goal when the GDR ceased to exist as a country. But the second goal was a different matter. The Federal Republic, as West Germany was (and today's Germany is) formally known, enveloped the former East Germany, and the new entity was something familiar, at least at first. The West had expanded eastward. But now, 25 years after the fall of the Berlin Wall, it is clear that this is not the whole story. The revolution also created the conditions for something new, a different Germany. The institutions haven't changed and the West German economy continues to dominate, but something has also flowed in the opposite direction. Could it be that the Federal Republic of Germany, which has been gazing westward since 1949, has become more eastern in the last few years?

Quieter in Germany Nothing has contributed more to this change than the chancellor from the east, Angela Merkel. She is a democrat and a champion of freedom, and she hasn't created an expanded GDR. Nevertheless, there are aspects to the way she runs the country that are reminiscent of the former East Germany. A dictatorship fears open discourse and conflict, and it thrives on the fiction of unity. The ruler or the ruling party claims that it is executing the will of the people, and because that will is supposed to be uniform, everyone is under forced consensus. Silence in the country is treated as approval. Merkel grew up in this system. Elements of it are reflected in her political style. She despises open dispute, she does not initiate discourse and she feels comfortable when silence prevails. She prefers to govern within a grand coalition, because it enables her to create broad consensus within small groups. Things have become quieter in Germany. Many people in the country like that. Eastern Germans are used to it. Even in the past, the Anglo-Saxon model, with its dualisms and heated conflicts, was suspect to most West Germans. Even the French argue more heatedly than the Germans. Merkel has enabled Germans to find themselves. Merkel's center-right Christian Democratic Union (CDU) and the center-left Social Democratic Party (SPD) have been forged into a new kind of SED, a more social- democratic one, one which generously funds the social consensus, providing money for families and retirees, as well as a minimum wage. The only party that managed to show some sympathy for Anglo-Saxon capitalism, the Free Democratic Party (FDP), has all but disappeared. While Merkel brings the East German element of silence instead of discourse into federal German politics, President Joachim Gauck, also an East German, provides an audible dissidence. As a pastor in the northeastern city of Rostock, Gauck was no resistance fighter, yet he was a civil rights activist. He injects his energetic approach to freedom into German politics, along with the message that freedom must be fought for or defended, with armed force, if necessary. Germany's New Center He has encountered the most resistance from a party whose roots are also in the GDR, the Left Party. For the most part, it emerged from the Party of Democratic Socialism (PDS), the successor party to the SED, and later joined forces with left-wing defectors from the SPD. The Left Party is so strong that a leftist majority could not be assembled without it. But so far the SPD has refused to entertain the idea of a coalition government with the Left Party at the national level. As a result, an eastern German party is responsible for the fact that an eastern German chancellor has managed to stay in power so long, at the head of a government with an eastern German imprint. It would, in short, be difficult to claim that Germany has retained the character of the old federal republic after the fall of the Berlin Wall. This diagnosis depends heavily on Merkel and could therefore be ephemeral. But the nation itself has also changed. It has discovered a new center.

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Until 1945, Germans had only lived in a shared country for 74 years. Perhaps that was why it was so easy for the western part of the nation to abandon the idea of unity. Konrad Adenauer (CDU), the first West German chancellor, believed that the Western powers represented the salvation of his federal republic. He didn't take the Stalin Note seriously, which held out the prospect of German unity for the price of neutrality in the early 1950s. As a result, the eastern Germans were left high and dry. West Germany took the westward path, and by the 1970s, most people were using the concept of "brothers and sisters" in the two Germanys in an ironic sense. A sense of foreignness did exist, but it was also manufactured. Many West Germans wanted to see themselves as Europeans first and Germans second, primarily out of shame for the Nazi past. Many West Germans were fond of nonchalantly saying that they felt closer to a Briton or a Frenchman than to an East German. Over the years, those on the more comfortable side of the Berlin Wall began to look askance at those on the other side. They were viewed as great athletes (who used performance-enhancing drugs, of course) who were nevertheless small-minded and smug, people who never drove faster than the speed limit on the autobahn, surrounded by informants, dressed in those oddly faded jeans, people with the misfortune to be locked up behind the death strip, and yet who were also there somewhat voluntarily. The West Germans created images of East Germans who were so foreign that it would be impossible to be reunited with them. In doing so, they overlooked the fact that varying levels of consumption and freedom have little effect on deeper-seated mentalities, and certainly cannot change everything in 40 years -- the blink of an eye, historically speaking. 'Social Monarchy' The citizens of East Germany had not alienated themselves as strongly from their counterparts in West Germany, despite encouragement from the SED. The country bordering theirs to the west remained a place of aspirations and hopes -- for more freedom and a higher level of consumption. The step they took following their revolution was in fact not a step into a completely alien world. Despite the separation, citizens in the eastern and western parts of Germany retained a similar political mentality. Germans value a strong social welfare state. In the GDR, it provided total care at a low level. While it isn't as comprehensive in the federal republic, it also offers a better standard of living. Both the east and the west have a tendency toward anti-capitalism. It was an established part of the system in the GDR, while in West Germany it developed in a special form called the Rhenish model of capitalism, which was less permissive than the Anglo-Saxon model and allowed for more government influence. The recently deceased historian Hans-Ulrich Wehler found that a desire for a "social monarchy" already existed in 19th-century Germany. Citizens pinned their hopes on a strong state and not the individual. This is the key difference between Germans, on the one hand, and the British and Americans, on the other.

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Germans have a pacifist strain that developed on both sides of the border after the disaster of World War II. Especially active peace movements arose in both East and West Germany. Despite their fascination with all things American, the Germans indulge in anti- Americanism. It was imposed by the state in the GDR, and yet citizens there knew that US missiles would destroy their country if a war erupted. In West Germany, the love- hate relationship with the American big brothers became mixed with anti-capitalist and pacifist elements. It is interesting that these four basic positions -- the affection for the social welfare state, pacifism, anti-capitalism and anti-Americanism -- correspond to the aims of the Left Party, making it the quintessentially German party. Still, it cannot achieve majorities nationwide because it defends its position with a radical, un-German approach. Deeper Roots Nevertheless, Sahra Wagenknecht, a member of the German parliament and a Left Party leader, has managed to become a media star with her radical critique of capitalism. During the financial crisis, she gained the support of people who would otherwise have had little to do with the Left Party. Wagenknecht also represents a strong eastern element in German politics. Of course, many East Germans had initial difficulties in dealing with the free market economy. And perhaps the food in their restaurants still isn't very good, at least judging by the complaints of West Berliners returning from weekend outings to the surrounding state of Brandenburg. But that will disappear over time. Fundamentally, eastern and western Germans are not that different. In terms of mentality and values, East Germany would have had a much more difficult time uniting with Great Britain. But the same holds true of West Germany. At the time, West Germans felt closer to the British, and yet at their core they were as German as Germans can be. Because anti-capitalism and the love of the social welfare state have even deeper roots in the eastern German population than in western Germany, these movements have become stronger overall in united Germany. Together, all four basic positions form an image of a nation that remains romantic and wants to keep its distance from the squabbles and hardships of a cold world. Merkel is the right chancellor for the job, because of her protective instincts, and because she usually does what her country expects her to do. In its late phase, the revolution of 1989 was also a national revolution, just like the revolution of 1848, a time when citizens also associated notions of freedom and democracy with German unity. They failed because the Prussian king was unwilling to lead a democratic Germany. The proliferation of small states known as Kleinstaaterei lasted for another 20 years. The revolutionaries of 1989 achieved their goal on October 3, 1990, which has been a national holiday ever since, the Day of German Unity. After that, the question was

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whether the fears of intellectuals like Günter Grass would come true, fears of a return to nationalism and militarism, and of German dominance over Europe. Devoid of Nationalism When it comes to nationalism, one of the things the West Germans managed to learn from the East Germans was flag-waving. It was part of every parade in the GDR, whereas West Germans only waved their flags in stadiums, during international sports competitions, and did so with some degree of reticence. The 2006 soccer World Cup, on the other hand, became a festival wrapped in the colors of the German flag, black, red and gold. The Germans celebrated as Germans, but they also celebrated Togo and Brazil. The act of waving the flag was not hollow the way it was in the past, but happy. We have become a nation almost devoid of nationalism. There are pockets, of course. And deeply sick ones at that, such as the NSU terrorist group, which murdered immigrants. This excessive xenophobia emerged from the former East Germany as did the renaissance of the far-right National Democratic Party of Germany (NPD). But western Germany can't exactly claim to be overly welcoming to immigrants, either. In fact, mentalities in the east and the west were fundamentally similar on this issue. On the issue of militarism, the peaceful 1989 revolutionaries would probably have been the last ones to predict that they would pave the way for Germany's participation in future wars. But that was exactly what happened. Once the Germans were united, their NATO allies saw them as a normal country, a nation with normal obligations. The expectations of military commitment grew and continue to grow, especially given the current state of global affairs. The German military, the Bundeswehr, has thus far completed two major combat missions: in the Balkans and in Afghanistan. But regardless of one's stance on these missions, they have not triggered militarism or a new Prussianism. The Bundeswehr has remained a cautious army, one that lawmakers deploy in scrupulous ways. Finally, when it comes to fears of German domination over Europe, probably the most breathtaking change has occurred in its position toward the European Union. Former Chancellor Helmut Kohl fought for the euro and a United States of Europe, and he felt that the Germans stood to benefit from every deutschmark that went to Brussels. West Germany did not see itself as a complete entity, which it wasn't, but as a part of larger entities, like Europe and NATO. It was because of this attitude that Kohl had no objection to the notion of allowing his country to dissolve into the EU. Merkel learned policy in a united and therefore complete Germany, a large country that has become more self-confident. She pays closer attention to what is in Germany's interest, and in her view this doesn't always include solidarity with other nations, especially in financial matters. A New Sensation Germany dominates Europe because it is so strong economically. It is also highly self-reliant in other ways. It is no longer an obedient part of the West. When NATO launched air strikes in Libya, Merkel isolated her country from all the leading Western powers, including the United States, Great Britain and France.

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When Vladimir Putin took over the Kremlin, he discovered many sympathizers in Germany. All things considered, a dialectic movement emerged from the revolution. The federal republic made Germany's eastern parts western by incorporating it, but it also became less western, perhaps even more eastern in the process -- because of its top politicians and their understanding of political culture, and because of a reinforcement of old tendencies like anti-capitalism and a love of the social welfare state. "The Long Road West," the title of a book by historian Heinrich August Winkler, has been interrupted. In fact, we have even taken a few steps back recently. Germany is not as western European in 2014 as it was in 1989. This isn't necessarily a bad thing, because the West itself is no longer as solid an entity as it was in 1989. As long as the underpinnings -- freedom, peacefulness, democracy, the constitutional state and the social market economy -- remain untouched, Germany also has a right to its own path within its alliances, the EU and NATO. Perhaps the 1989 revolutionaries didn't have many of these developments in mind. But they didn't just remove the GDR from maps; they also changed Germany as a whole. Revolutions arise from obstinacy. People are dissatisfied with what they are told and they develop new ideas. That was how it was in 1989, in Leipzig and elsewhere. Perhaps it's just a coincidence, but 25 years later we are now living in an obstinate country, which is a new sensation for Germans in the postwar era. Translated from the German by Christopher Sultan URL: • http://www.spiegel.de/international/germany/how-east-germany-influences- modern-day-german-politics-a-994410.html Related SPIEGEL ONLINE links: • Burger Blues: Ailing Fair a Measure of German-American Ties (08/14/2014) http://www.spiegel.de/international/germany/the-woes-of-a-fair-for-germany-and- america-a-985876.html • The Bearable Lightness of Being: How Germans Are Learning to Like Themselves (07/17/2014) http://www.spiegel.de/international/germany/football-championships-help-boost- german-image-at-home-and-abroad-a-981591.html • Germany's Choice: Will It Be America or Russia? (07/10/2014) http://www.spiegel.de/international/germany/as-us-scandals-grow-germans-seek- greater-political-independence-a-979695.html • How Western Is Germany? Russia Crisis Spurs Identity Conflict (04/09/2014) http://www.spiegel.de/international/europe/conflict-with-russia-raises-buried- questions-of-german-identity-a-963014.html

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10/02/2014 09:55 AM The Sand Thieves World's Beaches Become Victims of Construction Boom By Laura Höflinger Sand is becoming so scarce that stealing it has become an attractive business model. With residential towers rising ever higher and development continuing apace in Asia and Africa, demand for the finite resource is insatiable. It's during the few hours when the sea retreats and reveals its underlying treasure that the people come. At first they appear like ants, small dots on the mountain slope, but the group, perhaps 100, quickly draws closer. The men carry shovels, and the women, buckets. They've come to steal Cape Verde's sand. A young man jumps into the ocean and wades a few meters out. The water rises up to his chest. He dives under, and when he returns to the surface, his sludgy bounty drips from his shovel. He energetically shovels the mass into a bucket held by a woman waiting next to him. As she lifts the heavy bucket onto her head, she pauses for a moment, closing her eyes. A wave hits from behind and rolls over her. Once it passes, she clenches her teeth as she wades back to shore. The sand robbers are in a hurry. The ebb here lasts six hours and they can only mine the sand during low tide. Very few of the people here can swim, and the task can be life- threatening even at low tide as the waves break over their heads and the currents tug at their legs. They rush back and forth. Some are still youthful, but others are over 50. A heavily pregnant woman climbs out of the water, another grabs her hand to help her along. They come here every day, they say. "Except Sundays. On Sundays we go to church." Disappearing Sands The sand has long since disappeared from the high-tide shorelines at beaches like this, with only dirt and stones left to mark the coastline. Once the sand disappeared on the shore, the people began venturing into the water to find it. They've since been mining away their island's sand, one bucket at a time. Diminutive Cape Verde, located around 600 kilometers (373 miles) west of Senegal, is comprised of nine inhabited islands in the Atlantic Ocean formed by volcanoes. It's a beguiling land, one where papayas, mangos and pineapples grow between canyons. The sun shines year-round, the waters of the Atlantic foam on its shores and rare turtles bury their eggs on beaches. Cape Verde is considered one of the safest and most stable regions in Africa. It would be a dream destination for tourists if it weren't for the fact that the Cape Verdeans are hard at work destroying their beaches.

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Of course, there are still intact shorelines on Cape Verde -- places where luxury hotels serve guests from Italy, Germany and Portugal. But in other areas, the beaches are disappearing. From a distance, it looks like gophers have dug their way through the beaches, with piles of sand stacked up, still dark from the wetness. Between them, stones are scattered, having been separated from the sand. And there are several pits, some as deep as two meters. A Global Problem The phenomenon of disappearing beaches is not unique to Cape Verde. With demand for sand greater than ever, it can be seen in most parts of the world, including Kenya, New Zealand, Jamaica and Morocco. In short, our beaches are disappearing. "It's the craziest thing I've seen in the past 25 years," says Robert Young, a coastal researcher at Western Carolina University. "We're talking about ugly, miles-long moonscapes where nothing can live anymore." The sand on our ocean shores, once a symbol of inexhaustibility, has suddenly become scarce. So scarce that stealing it has become attractive. Never before has Earth been graced with the prosperity we are seeing today, with countries like China, India and Brazil booming. But that also means that demand for sand has never been so great. It is used in the production of computer chips, plates and mobile phones. More than anything, though, it is used to make cement. You can find it in the skyscrapers in Shanghai, the artificial islands of Dubai and in Germany's autobahns. 'Sand Is Like Oil, It Is Finite' In 2012, Germany alone mined 235 million tons of sand and gravel, with 95 percent of it going to the construction industry. The United Nations Environment Program (UNEP) estimates global consumption at an average of 40 billion tons per year, with close to 30 billion tons of that used in concrete. That would be enough to build a 27-meter by 27- meter (88.5 feet) wall circling the globe. Sands are "now being extracted at a rate far greater than their renewal," a March 2014 UNEP report found. "Sand is rarer than one thinks," it reads. At times, the paucity of sand has even forced workers to put down their tools at construction sites in India and China. It has also halted fracking-related drilling in the United States because the process requires that sand be mixed in with the water pumped into the ground in order to keep open the fissures from which gas is extracted. "Sand is like oil," explains Klaus Schwarzer, a geoscientist at Germany's University of Kiel. "It is finite." Western Carolina University's Young adds, "If we're not careful, we'll run out of sand." Difficult Lessons in Cape Verde The people of Cape Verde are already learning the hard way what can happen when the sand starts to disappear. In Ribeira da Barca, the small town where the sand thieves come from, fishermen store their boats in the streets. A pack of dogs snoozes in the shadows. A few steps further, 106

town official Jerónimo Oliveira stands at the shore, his hands clasped behind his back. He tries to explain how the situation could have progressed this far. When he was around six years old, Oliveira recalls, he could still play on the beach. Today, though, the black sand has been replaced by ocean. The remains of a wall jut out between the waves. "One day, one of the houses collapsed," he says, its foundation having become instable. "It probably won't be the last," he adds. The sand had protected the town from the water like a dike. But once the beach began to shrink, the ocean devoured the remaining sand at an ever faster pace, taking a little more with each wave and passing storm. Today the surf gnaws at the foundations of homes, with the climbing sea level and erosion intensifying the effect. As the problem began to grow, residents asked the government for help. Now, a wall runs along the shoreline -- made of concrete. Oliveira shakes his head. Although he says he doesn't want to defend the sand thieves, he also doesn't want to condemn them. He explains that 4,000 people live in the town and that not even 20 have steady jobs. Even though Praia, the capital of Cape Verde, is booming, Ribeira da Barca is an impoverished town. The rule of thumb here is that those who have money buy sand. Those who do not sell it. The same applies in Hong Kong, Singapore, Indonesia and Cambodia. And, as geologist Harald Dill of the University of Hanover says: "Small city-states have a tendency to dig away the coasts of weaker countries." Efforts to Stop Illegal Mining Fail In 2012, the environmental organization Global Witness released satellite images showing how Singapore has expanded its territory by 22 percent over the past 50 years. The group provided evidence that the sand used to enlarge Singapore came from neighboring countries like Vietnam, Indonesia and Malaysia and had, in some instances, been extracted illegally. One country after the other then issued a ban on mining sand. Singaporean dredging vessels responded by setting course for Cambodia. Phnom Penh responded by likewise banning exports of the resource. Prospecting for sand has also been prohibited in Cape Verde since 2002 and the military does in fact patrol parts of the coastline for illegal mining activity. Sometimes they even arrest sand thieves, but the punitive measures have thus far done little to stop illicit trade. Clarisse Tavares Borges, who goes by "Dita," has herself been detained for sand theft. She spent 24 hours in jail with five other women. She is sitting on a plastic chair in her home with the curtains billowing in the wind. The crashing of Atlantic waves can be heard in the distance. There's china in a cabinet on the wall and the floor has been swept clean. The 38-year-old apologetically says she can't get up because she's suffered from back pain for years now. Bending down to get the sand and lifting the buckets is becoming more difficult for her, Dita says. Her older boys, aged 18 and 11, are perched in front of the house and her 18-month-old toddler is sleeping in the double bed shared by the family. Dita says she dreams that each will one day have their own bed to sleep in.

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In the village where Dita lives, sand mining is women's work. The men either work as fishermen or imbibe grog at the bar. Virtually all the women here, including Dita, are single mothers. They survive by selling vegetables or mining sand. Each morning the women and their daughters hike the stony path down to the ocean. Dita says they are well aware that their work is damaging to the village. She's even noticed that the drinking water now tastes saltier and that the mango and papaya trees are shrinking because of saltwater seepage. "We thought the sand would last forever," she says. It's Not Just Cape Verde Sand is similar to fossil fuels like natural gas, coal or oil: It takes thousands of years to form -- for rock to be naturally ground down into sand with rivers washing, grinding and breaking up stone on their long journeys to the sea. But the global population is growing, and since the start of the economic booms in Asia and Africa, sand doesn't even make it to the oceans anymore in some places. It often gets fished out before getting there. The Ganges River stretches for 2,300 kilometers (1,429 miles) across India. It runs from high in the Himalayas down toward Bangladesh and the Bay of Bengal. It passes through Indian cities like Kolkata (Calcutta) and Kanpur, which are growing quickly and have voracious appetites for sand. "The only thing that still reaches Bangladesh is a mixture of clay and silt," says geologist Dill. "People even fish for stones." With laws prohibiting the extraction of sand from rivers in many places, it has become a black market good. Hardly a day passes without Indian newspapers reporting on the dealings of the "sand mafia". "We only hear of the consequences when a textile factory collapses in Bangladesh," Dill says. "People aren't building on sand there anymore," and without sand, the ground isn't stable enough. Not all types of sand are identical. For microchips, lenses and glass, pure quartz sand -- of the type found in Germany for example -- is required. The construction industry also uses gravel, which by definition has grains measuring between 2 and 63 millimeters (0.07 inches to about 2.5 inches). It is mixed with cement and water to make concrete. In reality, there is plenty of gravel in the world. It's just not always where construction companies need it most. A Dearth of Sand in the Desert One might think that the Arab Peninsula, with its high sand dunes, would have the largest reserves, but desert sand isn't suitable for every purpose. It contains a surfeit of chalk, clay and iron oxide. And while the countries have considerable amounts of marl, quality sand is also necessary to produce cement. Paradoxically, then, the desert region is suffering a shortage of sand. The Arab Emirates want to continue growing -- both vertically, with their massive skylines, and in area. Construction crews in Dubai, Qatar and Bahrain are all busy erecting the world's tallest residential towers and massive airports. Dubai reclaimed land using 385 million tons of sand for its Palm Island project, which was then followed by a second one. Now work is continuing on another artificial archipelago project called The World. Nearby Saudi Arabia possesses sand reserves, but it has repeatedly restricted 108

supplies to neighboring countries -- forcing construction cranes to come to a grinding halt. Even Germany, a country with a wealth of sand, imports the natural resource. Officials at the country's Federal Institute for Geosciences and Natural Resources in Hanover say Germany has enough sand supplies to last for thousands of years. The problem is that the sand on hand isn't always available -- it might be in a conservation area, in forests or located near municipalities. "It's a bit like wind turbines," Dill says, nobody wants a gravel pit in their backyard. Sand Mining Leaves Scars in Germany In Germany, too, firms have begun mining sand from the ocean floor. Using dredgers the size of aircraft carriers, they trawl the North and Baltic seas, with gigantic suction heads vacuuming the grains from the sea floor. Nature conservation organizations fear the dredging could disturb the habitat of harbor porpoises and seals and that sustained damage is being done to the ocean floor ecosystem. "Anything that gets sucked in is killed," says Kim Detloff of Germany's Nature and Biodiversity Conservation Union (NABU). Klaus Schwarzer of the University of Kiel has conducted diving expeditions at the sites of sand dredging in the Baltic Sea. Off the coast of the island of Rügen in Germany, he discovered deep chutes dating back to East German times that still haven't returned to normal even after decades. "It's astounding how long marine regions take to recover," he says. But in some places where the suction heads left holes behind, they filled in again within half a year. "We need to do a good job of reviewing where and how much we dredge," Schwarzer says. One of the problems is that the sediment is only a few meters deep in some spots. The northern state of Schleswig-Holstein, for example, has been importing sand from Denmark to spread across its coasts for years because it has run out of its own. Norway also sells sand to Germany. "We can't just keep taking and taking," Klaus Schwarzer says. "At some point we will run out." Depletion Control Happens Too Late In the eastern part of Hamburg, one can still see what many places in the area used to look like. There, a small forest gives way to a clearing and your feet begin sinking deep into the sand, as in a desert. The Boberger Dune is Hamburg's last remaining shifting sand dune. All other such deposits in the region were consumed as the city grew. The same phenomenon can currently be seen on the Canary Islands and in India, Brazil and China -- even on the small Cape Verde islands. But these days, the process goes much faster. Clementina Furtado leans against a bench in front of the Universidade de Cabo Verde in Praia. Having studied in both Belgium and France, she is part of the new generation in her country, one that is educated, multilingual and cosmopolitan. "By the time we began trying to control the depletion, it was already too late," she says. "We had already taken too much." The beach in her hometown has long since been depleted. Huge puddles full of garbage stand where the sand once was. Turtles used to live on the beach, but they have long 109

since disappeared. "The crazy thing," says Furtado, "is that sea sand isn't even particularly good." Before such sand can be used in construction, the salt has to be carefully washed out of it, otherwise it dissolves in water and corrodes the steel reinforcement rods. That explains why, for example, work has been temporarily suspended on China's tallest skyscraper in Shenzhen. The property developers responsible for the construction of 15 buildings purchased cheap sea sand, likely from illegal sources. "In reality, there is enough sand in the world," says Harald Dill. "We just want to have it cheaply." Researchers are already looking into possible alternatives, including using ground up glass or building structures using different materials entirely. On Cape Verde, they have begun crushing volcanic rock, but that costs more than sand produced by sand miners. "As long as there are people offering sand more cheaply, and then even more cheaply, it won't stop," says Furtado. Meanwhile, there's only one reason that the Boberger Dune still exists in Hamburg: In 1927, an agreement couldn't be reached on what its sand should cost. URL: • http://www.spiegel.de/international/world/global-sand-stocks-disappear-as-it- becomes-highly-sought-resource-a-994851.html Related SPIEGEL ONLINE links: • Photo Gallery: 'Sand Is Rarer than One Thinks' http://www.spiegel.de/fotostrecke/photo-gallery-sand-is-rarer-than-one-thinks- fotostrecke-119613.html • A Tangle of Conflicts: The Dirty Business of Palm Oil (05/02/2014) http://www.spiegel.de/international/world/indonesian-villagers-driven-from-villages- in-palm-oil-land-theft-a-967198.html

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The Growth economics Blog This blog takes Robert Solow seriously Re-basing GDP and Estimating Growth Rates Posted on October 1, 2014 by dvollrath Leandro Prado de la Escosura recently posted a voxeu column about splicing real GDP series after re-basing. Re-basing of real GDP means adopting a new set of reference prices to value output in each year. Think of what Nigeria did last year, when they re- based from 1990 prices to using 2010 prices, and all of the sudden measured real GDP was about twice as big. de la Escosura’s point is that when we re-base and “retrocast” real GDP numbers to past years, we may obscure evidence of rapid economic growth. You should go read his post, and his associated paper, to understand his point in full. But let’s use the Nigerian 2013 re-basing to get the basic idea. Let’s say that in 1990 Nigeria produced 1000 units of food, and zero motorcycles. In 2010 Nigeria produced 1000 units of food again, but produced 200 motorcycles. So there clearly is real growth in output. In 1990, the price of food was 1 naira per unit and motorcycles were 500 naira. 1990 real GDP in 1990 prices is 1000(1) + 0(500) = 1000. 2010 real GDP in 1990 prices is 1000(1) + 200(500) = 101,000. This is a dramatic growth rate of real GDP (10,100% actually). After re-basing, what do we get? In 2010 the price of food was 2 naira per unit, and motorcycles were 100 naira each. So 1990 real GDP in 2010 prices is 1000(2) + 0(100) = 2000. 2010 real GDP in 2010 prices is 1000(2) + 200(100) = 22,000. Still a lot of growth, but only 1100%. The growth rate of real GDP between 1990 and 2010 went from over 10,000% to about 1100%, an order of magnitude drop. Growth looks much slower in Nigeria after re-basing. Why? Because with dramatic economic growth came dramatic changes in relative prices. Motorcycles dropped severely in price, while food went up slightly. Combined, this makes food look more valuable compared to motorcycles by 2010. So valuing 1990 output in 2010 prices tends to make 1990 look pretty good, because in 1990 they had lots of food relative to motorcycles. de la Escosura’s argument is that in 1990, for sure, the 1990 prices are the right way to value real GDP. Similarly, in 2010, for sure, the 2010 prices are the right way to value real GDP. So leave those years priced in their own prices. For the nineteen intervening years, 1991-2009 inclusive, compute their real GDP in both 1990 and 2010 prices. Then average those two estimates depending on how far from each year we are. So for 1991, let real GDP be (1991 GDP at 1990 prices)(18/19) + (1991 GDP at 2010 prices)(1/19). For 1992, let real GDP be (1992 GDP at 1990 prices)(17/19) + (1992 GDP at 2010 prices)(2/19), and so forth. For de la Escosura, this better captures the growth in real GDP over time. For our example, 1990 real GDP in 1990 prices is 1000,

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and 2010 real GDP in 2010 prices is 22,000, and the growth rate is 2,200%. It essentially splits the difference of the two different benchmarks, preserving some of the rapid growth seen using the 1990 prices. This isn’t necessarily a new concept. Johnson, Larson, Papageorgiou, and Subramanian discuss this issue in their paper on the Penn World Tables. Their suggestion for a chained PWT price index amounts to a similar suggestion. The big point is that by re-basing you are necessarily screwing with the implied growth rate of real GDP because you are screwing with the value of real GDP in the first year (1990 in our example). If there has been a lot of economic growth and relative prices have changed, then almost certainly the first year will have a higher measured real GDP when we re-base. With a higher initial level of GDP, the growth rate will necessarily be smaller. If your worry about computing growth rates, then this is an issue you have to worry about a lot, and something like de la Escosura’s method or the Johnson et al suggestion is what you should do. If you worry about comparing income levels across countries, then this critique is not crucial (although you have other things to worry about). http://growthecon.wordpress.com/2014/10/01/re-basing-gdp-and-estimating-growth- rates/

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vox Research-based policy analysis and commentary from leading economists Mismeasuring long-run growth: The bias from spliced national accounts Leandro Prados de la Escosura27 September 2014 As demonstrated by the dramatic upward revision of Nigeria’s GDP for 2013, the choice of a benchmark year matters when computing GDP statistics. This column explains how the replacement of benchmark years creates an inconsistency between new and old national accounts series, and how different ways of resolving this inconsistency yield very different estimates of historical GDP levels and growth rates. When used to evaluate the relative historical performance of Spain and France, the interpolation procedure for splicing national accounts produces more plausible results than the conventional ‘retropolation’ approach. Related// Using happiness scales to inform policy: Strong words of caution Timothy N. Bond, Kevin Lang/ GDP measurement: Accounts, surveys and lights Maxim Pinkovskiy, Xavier Sala-i-Martin//More to do on measuring hunger Joachim De Weerdt, Kathleen Beegle, Jed Friedman, John Gibson/ Measuring economic progress Diane Coyle// A new measure of US GDP S Borağan Aruoba, Francis X. Diebold, Jeremy J Nalewaik, Frank Schorfheide, Dongho Song In April it was made public that Nigeria’s GDP figures for 2013 had been revised upwards by 89%, as the base year for its calculation was brought forward from 1990 to 2010 (Financial Times, 7 April 2014). As a result, Nigeria became the largest economy in sub-Saharan Africa. Though spectacular, this is not an exceptional case. Ghana (2010), Argentina (1993), and Italy (1987) also experienced dramatic upward revisions of their GDP. How should this revision affect GDP time series and, consequently, the country’s relative position? Should the existing historical series be re-scaled in the same proportion? Official national accounts are only constructed in a homogeneous way for short periods, and are usually available from mid-20th century onwards, but often only for the latest decades. Thus, when a homogeneous long-run GDP series is required, various sets of national accounts using different benchmark years and often constructed with dissimilar methodologies need to be spliced. The alternative choice of splicing procedures to derive a single GDP series may result in substantial differences in levels and growth rates and, hence, in significant biases in the assessment of economic performance over time. Angus Maddison (1991) addressed the issue of inadequate splicing while researching Italy’s long-term economic performance. Unfortunately, Maddison’s warning about a serious risk of mismeasuring growth over the long run did not receive much attention.

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Benchmark years in GDP statistics National accounts rely on complete information on quantities and prices in order to compute GDP for a single benchmark year, which is then extrapolated forward on the basis of limited information for a sample of goods and services. To allow for changes in relative prices and, thus, to avoid that forward projections of the current benchmark become unrepresentative, national accountants periodically replace the current benchmark with a new and closer GDP benchmark. The new benchmark is constructed, in part, with different sources and computation methods. Often far from negligible differences in the new benchmark year between ‘new’ and ‘old’ national accounts stem from statistical (sources and estimation procedures) and conceptual (definitions and classifications) bases. Once a new benchmark has been introduced, newly available statistical evidence would not be taken on board to avoid a discontinuity in the existing series. Thus, the coverage of new economic activities partly explains the discrepancy between the new and old series. As a result, a problem of consistency between the new and old national account series emerges. Is there a solution to this inconsistency problem? The obvious option would be computing GDP for the years covered by the old benchmark with the same sources and procedures employed in the construction of the new benchmark. However, this option is beyond the resources of an independent researcher. The challenge is, then, establishing the extent to which conceptual and technical innovations in the new benchmark series hint at a measurement error in the old benchmark series. In particular, whether the discrepancy in the overlapping year between the new benchmark (in which GDP is estimated with ‘complete’ information) and the old benchmark series (in which reduced information on quantities and prices is used to project forward the ‘complete’ information estimate from its initial year) results from a measurement error in the old benchmark’s initial year estimate. The ‘retropolation’ approach A simple solution, widely used by national accountants (and implicitly accepted in international comparisons), is the ‘backward projection’, or ‘retropolation’, approach, that accepts the reference level provided by the most recent benchmark estimate (YT) and re-scales the earlier benchmark series (Xt) with the ratio between the new and the old series for the year (T) at which the two series overlap (YT/XT). Underlying this procedure is the implicit assumption of an error level in the old benchmark’s series whose relative size is constant over time (de la Fuente 2014). In other words, no error is assumed to exist in the old series’ rates of variation that are, hence, retained in the spliced series YRt. Official national accountants have favoured this procedure of linking national accounts series on the grounds that it preserves the earlier benchmark’s rates of variation. Usually the most recent benchmark provides a higher GDP level for the overlapping year, as its coverage of economic activities is wider. Thus, the backwards projection of the new benchmark GDP level with the available growth rates – computed at the previous benchmark’s relative prices – implies a systematic upwards revision of GDP levels for earlier years. This one-sided upward revision effect on the levels of spliced GDP series is hardly noticeable when discrepancies between the new and old benchmarks are small for the overlapping year and the considered time span is short. 114

However, as the time horizon expands and earlier series are re-scaled again and again to match newer ones, the gap tends to deepen significantly. The interpolation approach An alternative to the backward projection linkage is provided by the interpolation procedure that accepts the levels computed directly for each benchmark year as the best possible estimates, on the grounds that they have been obtained with ‘complete’ information on quantities and prices, and distributes the gap or difference between the ‘new’ and ‘old’ benchmark series in the overlapping year T at a growing rate. Contrary to the retropolation approach, the interpolation procedure assumes that the error is generated between the years 0 and T. Consequently, it modifies the annual rate of variation between benchmarks (usually upwards) while keeping unaltered the initial level – that of the old benchmark. As a result, the initial level will be probably lower than the one derived from the retropolation approach. Choosing between the two approaches The choice of linkage procedure makes a significant difference for GDP levels and growth rates. When the levels for earlier years are re-scaled upwards with the retropolation procedure, the country in question becomes retrospectively richer. Alternatively, interpolating each original benchmark tends to raise the economy’s rate of growth and, hence, implies a lower initial GDP level. Which method is preferable? A practical answer may be derived by analysing the experience of Spain – a country that went through a process of deep structural change during the second half of the 20th century. Figure 1. Ratio of spliced interpolated series to retropolated series, 1954–2013 (GDP at current prices)

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Figure 1 presents the GDP levels resulting from splicing national accounts through non- linear interpolation relative to the levels derived through extrapolation. It can be noticed how the over-exaggeration of GDP levels cumulates over time when the extrapolation method is used. Differences between the results of the interpolation and retropolation procedures appear much more dramatic when placed in a long-run perspective, that is, when the spliced national accounts are projected backwards into the 19th century with volume indices taken from historical accounts series. This is due to the fact that most countries grew at a slower pace before 1950, so a country’s per capita GDP level by mid-20th century determines its earlier relative position in country rankings. Thus, the choice of splicing procedure can result in far from negligible differences in the relative position of a country in terms of per capita income over the long run. As an illustration I present Spain’s relative position to France derived with retropolation and interpolation splicing methods (Figure 2). According to the retropolation splicing procedure, by mid-19th century, real per capita GDP in Spain would have been similar, if not superior, to that of France. If, alternatively, the interpolation splicing procedure were used, Spain’s real per capita GDP would have been 80% of that of France. When the period 1850–1913 is considered, Spain would match France’s real income per head, according to the retropolated series, and reach only four-fifths if the interpolated series are employed. These proportions hardly alter if the period under comparison is extended to 1935. It can be concluded that whatever the measurement error embodied in the interpolation procedure may be, its results appear far more plausible than those resulting from the conventional retropolation approach. Figure 2. Spain’s real per capita GDP (France = 1), alternative splicing results (2011 EKS $)

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Concluding remarks The bottom line is that splicing national accounts must be handled with extreme care, especially when countries have experienced intense growth and deep structural change, as there is a risk of biasing their income levels upwards and, consequently, their growth rates downwards. A systematic revision of national-accounts splicing in fast-growing countries over the last half-century using the interpolation approach would most probably reduce their initial per capita GDP levels while raising their growth – with the result of a more intense and widespread catching-up to the core countries. References de la Fuente Moreno, A (2014), “A Mixed Splicing Procedure for Economic Time Series”, Estadística Española, 56(183): 107–121. Maddison, A (1991), “A Revised Estimate of Italian Economic Growth 1861–1989”, Banca Nazionale del Lavoro Quarterly Review, 177: 225–241. Prados de la Escosura, L (2014), “Mismeasuring Long Run Growth. The Bias from Spliced National Accounts”, CEPR Discussion Paper 10137. http://www.voxeu.org/article/mismeasuring-long-run-growth

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Argentina president claims US plotting to oust her Cristina Fernández de Kirchner alludes to alleged plot against her by local businessmen and ‘foreign help’ in televised speech Uki Goñi in Buenos Aires The Guardian, Wednesday 1 October 2014 18.36 BST

Argentina President Cristina Fernandez de Kirchner was accused of being ‘out of touch with reality’ by Argentinian opposition politicians. Photograph: Justin Lane/EPA Argentinian opposition politicians have accused the country’s president, Cristina Fernández de Kirchner, of being “completely out of touch with reality” after she gave a rambling televised address in which she claimed the US may be behind a plot to overthrow her government and possibly even assassinate her. “If something should happen to me, don’t look to the Middle East, look to the North,” Fernández said during the address on Tuesday night, in which she alluded to an alleged plot against her by local bankers and businessmen “with foreign help”. Fernández had previously claimed to have received death threats from Islamic State (Isis) because of her friendship with Pope Francis. In last night’s speech, however, she seemed to suggest the threats against her, received in three emails to Argentinian security officials, had come from the US. Her claim comes in the wake of a rapid deterioration of Argentina’s already rocky relationship with the US after the country went into default in August.

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Argentina has rejected paying $1.3bn (£990m) awarded by New York Judge Thomas Griesa to “vulture fund” investors who refused to accept a “haircut” on Argentinian bonds from the country’s previous default in 2001. “I’m not naive, this is not an isolated move by a senile judge in New York,” said Fernández. “Because vultures look a lot like the eagles of empires,” referring to the bald eagle, the national symbol of the US. Fernández almost threw out the US embassy chief of mission Kevin Sullivan for saying “it is important Argentina get out of default” to a local newspaper. Fernández claims that despite its debt crisis, Argentina is not in real default and Sullivan was called in for a reprimand by the Argentinian foreign ministry for using the “default” word. With economic stagnation, Argentina’s peso currency in free fall and an alarming rise in crime levels, Fernández has seemed increasingly beleaguered in the last few weeks. There is also increasing uncertainty within her Victory Front party regarding who Fernández will back as presidential candidate in 2015. Fernández’s second term ends next year, and she is unable to stand for re-election, though her 37-year-old son Máximo Kirchner could be a candidate to replace her. Elisa Carrió, the presidential candidate of the centrist opposition UNEN party, said President Fernández was “completely out of touch with reality”. “Since she doesn’t resist reality, with unemployment, high inflation, the rising dollar, she says it’s no longer Isis trying to kill her, but the US,” said Carrió. “She’s inventing conspiracies.” The president’s mental wellbeing was previously questioned by Hillary Clinton in 2010. “Is she taking medication?”, Clinton asked in a diplomatic cable leaked to the press while she was US secretary of state. “How does stress affect her behaviour toward advisers and/or her decision-making?” the memo added. http://world.einnews.com/article_detail/227006617/yjO_BGvzCSqt- 2bF?afid=777&utm_source=MailingList&utm_medium=email&utm_campaign=Breaki ng+News%3A+world818-Thursday

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Bloomberg Businessweek Markets & Finance http://www.businessweek.com/articles/2014-10-02/what-now-for-bill-gross-after- pimco-exit Bond King Bill Gross Departs for Realm of the Unknown By Sheelah KolhatkarOctober 02, 2014

Photograph by J. Emilio Flores/Corbis Even for observers accustomed to surprises from Bill Gross, the news that he had suddenly quit Pacific Investment Management Co. and agreed to join Janus Capital Group (JNS) was a shock. Pimco and Gross have been in turmoil since the departure last January of Mohamed El-Erian, Gross’s deputy and expected successor. Reports that El-Erian was driven away by Gross’s difficult personality had deeply hurt Pimco’s chief investment officer and co-founder, who was convinced that the reasons for El-Erian’s decision were more complex. “Gross is an autocrat, a dictator,” is how Gross described the way he felt he was being portrayed when he spoke with Bloomberg Businessweek in April. “Whenever I read the newspaper, I say to myself, ‘At least my wife loves me.’ ” Pimco would have preferred that its founder keep quiet and carry on. But Gross was never one to censor himself, and that’s a large part of the reason he’s been so successful, as both a fund manager and a financial celebrity. He was seen as an eccentric genius

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whose quirks were central to his brand. In the end, though, some of the same qualities that helped him earn the title Bond King led to his sudden departure.

The exit shook Pimco and the markets. The stock of Pimco’s owner, Allianz (ALV:GR), fell, while Janus stock went up, and investors scrambled to pull money out of Pimco funds. Gross’s flagship, the Pimco Total Return Fund, saw $23.5 billion leave in September. The prospect of Pimco selling holdings to meet customer demands for cash caused a selloff in Treasuries, inflation-protected bonds, and the Mexican peso. “Asset managers do change, but usually it is orderly and planned,” says Scott Burns of Morningstar (MORN). “This wasn’t very orderly, it wasn’t very telegraphed, it wasn’t very planned. That is very disruptive for investors.” Pimco Chief Executive Officer Douglas Hodge says the company was ready for client redemptions. He quickly named three managers to replace Gross at Total Return and promoted Deputy Chief Investment Officer Daniel Ivascyn to be the new CIO. “Our institutional client base, which is a vast majority of our assets, and a number of our retail clients understand that it’s still the firm that it was last Thursday, minus one man,” Edward Devlin, a Pimco fund manager, said at an investor conference. During a call with investment analysts, Michael Diekmann, the CEO of Allianz, the German insurance conglomerate that bought a majority of Pimco in 2000, said Allianz remained “committed” to Pimco. Gross co-founded Pimco in 1971 and built it into one of the largest investment firms in the world, managing $2 trillion of pension, endowment, and retirement money. In addition to proving himself as a skilled navigator of the bond markets—his Total Return Fund earned an average 7.9 percent since its launch in 1987—Gross had an intuitive grasp of his role as a brand ambassador and media figure. He catapulted himself into the public eye, appearing frequently on TV to discuss the global economy, interest rates, and Treasury yields, often speaking in his own lexicon of pop culture references, song

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lyrics, and investment jargon. He sported a shaggy haircut, wore his tie flung over his shoulder, and invited reporters to sit in on his yoga routine. Gross always had a knack for a surprising metaphor—“You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels, and a ‘tramp stamp,’ ” he wrote in 2007, commenting on risky securities getting high grades from the ratings firms. In contrast to the bland investor letters coming out of most mutual fund companies, Gross’s monthly investment outlook has referenced his cat and Mad Men and offered dating advice. His flair for self-promotion made him the closest thing to a household name in an industry that produces very few of them. There’s Peter Lynch, manager of the Fidelity Magellan Fund from 1977 to 1990, and Bill Miller, whose star rose when he beat the Standard & Poor’s 500-stock index 15 years in a row at his Legg Mason Value fund and faded quickly after the streak dried up. The power of Gross’s personality to dazzle investors is particularly evident when he’s compared with Dan Fuss of Loomis Sayles. While Fuss’s performance numbers are as impressive as Gross’s, if not more so, he keeps a lower profile—and manages far less money. Pimco’s biggest growth spurt came after the financial crisis. Gross had helped Pimco sidestep most mortgage bonds, leaving it in a strong position in 2008, when the real estate collapse devastated the market. The public rushed out of stocks and into bond funds. According to Morningstar, $101 billion of fresh cash flowed into Total Return from 2008 to 2012, and the fund almost doubled. With that much money to deploy, even Gross found it hard to move nimbly, and the fund’s returns started to fall off—as the old joke goes, it’s hard to beat the market when you are the market. He built his portfolio to profit when interest rates rose and then suffered losses when they stayed near historic lows, which didn’t make investors happy. This year, Total Return saw its five-year performance ranking drop to the 62nd percentile, according to data compiled by Bloomberg. As of Oct. 1, the fund had seen 17 straight months of investor withdrawals. Other Pimco executives became increasingly unhappy with Gross in recent months. “Ever since the Mohamed departure, the knives were out for Bill,” says Kurt Brouwer, chairman of advisory firm Brouwer & Janachowski, who’s invested in Pimco funds since the 1980s. Gross’s former colleagues, some of them executives he had hired and helped promote, started to talk about the possibility of firing him, and Pimco’s executive committee met to see whether there were enough votes to oust him, according to a person with knowledge of the firm who declined to be identified because the deliberations were private. “I made these people rich,” Gross said of Hodge and other top executives, according to the person. “While we are grateful for everything Bill contributed to building our firm and delivering value to Pimco’s clients,” Hodge said in a statement, “over the course of this year it became increasingly clear that the firm’s leadership and Bill have fundamental differences about how to take Pimco forward.”

Gross’s exit was unlike any other star fund manager’s, which is probably just how he wanted it. “I look forward to returning my full focus to the fixed-income markets and investing, giving up many of the complexities that go with managing a large, complicated organization,” Gross said in a statement. He declined to comment for this 122

story. At Janus he’ll be managing a much smaller pool of money—as of May, its Global Unconstrained Bond Fund had just $13 million in assets—so he may find it easier to generate above-average returns.

The question now is what remains for Gross to prove—and why he still would feel the need to prove anything. He’s 70 and, after having built one of the world’s premier financial institutions, is worth more than $2 billion. He’s an active philanthropist, frequently donating the profits from his stamp collecting hobby to charity. But some combination of ego, injury, and a compulsive need to control the narrative appears to be driving him. That and an obsession with beating the bond market.

Story: Pimco's Bill Gross Picks Up the Pieces Story: Bill Gross Returns to His First Love Video: How Important Was Bill Gross to Pimco? Story: Bill Gross Takes a Big Step Down Story: Bill Gross’s Investing Secret: A Rising Market and Extra Risk

The bottom line: Averaging 7.9 percent a year at Pimco Total Return, Gross helped build Pimco into a $2 trillion money manager.

With Mary Childs

Kolhatkar is a features editor and national correspondent for Bloomberg Businessweek. Follow her on Twitter @Sheelahk.

http://www.businessweek.com/articles/2014-10-02/what-now-for-bill-gross-after- pimco-exit

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Bloomberg Businessweek Markets & Finance http://www.businessweek.com/articles/2014-10-02/what-being-poor-is-really-like- linda-tirados-hand-to-mouth Books Poorsplaining: What It's Really Like to Be Poor in America By Peter CoyOctober 02, 2014

Poor people are more likely than rich people to smoke. To get fat. To get into hassles with cops and creditors. To have children despite no visible means of support, to lurch from one crisis to another, and sometimes to have very bad attitudes. But before you judge them, just try being poor yourself. Linda Tirado has been poor, and she doesn’t judge. Hand to Mouth: Living in Bootstrap America, which goes on sale Oct. 2, is her unapologetic explanation for why she and other poor people do what they do. It’s funny, sarcastic, full of expletives, and most of all outrageously honest. For Tirado, being poor has meant walking miles to jobs because she didn’t have money to fix her car. Stacking boxes and cleaning toilets. Suffering chronic pain from rotten teeth she can’t afford to have cared for properly. Getting treated like human garbage by customers, bosses, doctors, and landlords. And then, after all that, being asked why she’s not smiling on command. She writes: I get that poor people’s coping mechanisms aren’t cute. Really, I do. But what I don’t get is why other people feel so free in judging us for them. As if our self-destructive behaviors therefore justify and explain our crappy lives. Newsflash: It goes both ways. Sometimes the habits are a reaction to the situation. The genesis of Hand to Mouth was something she wrote last year on an online forum responding to a person who asked why poor people do things that seem so self- destructive. “Poverty is bleak and cuts off your long-term brain,” she wrote, while enumerating various things she’s done that might not seem particularly foresighted. Her impromptu essay was picked up by the Huffington Post, the Nation, and Forbes and generated, she says, “thousands” of e-mails. Barbara Ehrenreich wrote the foreword. Ehrenreich is a professional writer who took a series of low-wage jobs just to see what it was like and produced a best-selling 2001 book, Nickel and Dimed. Writes Ehrenreich of Tirado: “She makes all the points I have been trying to make in my years of campaigning for higher wages and workers’ rights: That poverty is not a ‘culture’ or a character defect; it is a shortage of money.” One obvious objection to Tirado’s book is that it paints all poor people alike, and Tirado is the first to admit that she’s not speaking for everyone. For instance, she writes, “There are poor people who would never dream of doing anything as déclassé as using 124

drugs.” It’s true, too, that Tirado didn’t grow up in poverty, if that makes a difference to anyone. She left home at 16 for college, became estranged from her family for over a decade, suffered health problems, and had everything she owned destroyed in a flood. “I slid to the bottom through a mix of my own decisions and some seriously bad luck,” she writes. “I think that’s true of most people.” Considering how depressing the subject matter is, Hand to Mouth is a quick read because Tirado has a way with words that’s somehow both breezy and blunt. The section on her teeth alone is more persuasive than a stack of think-tank treatises on poverty. She lost a bunch of teeth and damaged her jaw when a drunk driver hit the car she was riding in. The dentist who fitted her for a denture kept lecturing her not to do meth, even though Tirado told her that she had damaged her teeth in an accident. The denture snapped two years later. She can’t eat with it. “I usually eat alone, at night, tearing off bits of food and bolting them down without chewing,” Tirado writes. She doesn’t smile, either, so she refuses to join group photos. “They will cajole and wheedle and bring the whole group photo to a screeching halt until you finally, shamefully, admit that you can’t, that you don’t want a picture of you like this to exist.” And that is what it’s like to be poor in “bootstrap America.” Story: Here Are the Parts of the U.S. With the Most Income Inequality Story: College Is More Valuable Than Ever, and That's Driving Income Inequality

Coy is Bloomberg Businessweek's economics editor. His Twitter handle is @petercoy. http://www.businessweek.com/articles/2014-10-02/what-being-poor-is-really-like- linda-tirados-hand-to-mouth#r=lr-sr

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ft.com/global economy EU Economy Last updated:October 1, 2014 5:04 pm France and Italy push for fiscal leniency By Hugh Carnegy in Paris and James Politi in Rome

©Bloomberg The Elysee palace, Paris France and Italy have stepped up their defiance of EU budget targets, as the two countries face critical talks in coming weeks with their European partners over their wayward public finances. Confirming that the budget deficit will now not fall within the EU-designated target of 3 per cent of national income until 2017, Michel Sapin, France’s finance minister, insisted ahead of negotiations with Brussels that France’s position was “legitimate and [well] argued”. Mr Sapin’s comments came only hours after the Italian government delayed its projection for a balanced budget until 2017, a sign of how the deteriorating economic outlook is adversely affecting its difficult fiscal position. More ON THIS STORY// Sylvie Goulard France’s magical thinking/ Hollande warns France of spending cuts/ French unemployment number falls/ France warns on budget deficit target ON THIS TOPIC// Valls demands end to Air France strike/ Housing fall highlights Hollande’s woes/ A French revolution in work at O2/ Global Insight Hollande’s mood frays over economy IN EU ECONOMY/ Tax probe widens to include Gibraltar/ Eurozone’s manufacturing recovery slows/ Ireland under pressure over low tax rates/ EU-US trade deal could drop arbitration The move by the eurozone’s second- and third-largest economies to relax their deficit targets is likely to meet resistance in Berlin. Angela Merkel, German chancellor, warned on Wednesday that the EU’s credibility depended on member countries fixing their own budgets. “We are not at the point where we can say the crisis is fully behind us. Therefore, it is now important for everyone to fulfil their commitments and obligations in a credible way,” Ms Merkel said before a German business audience. “This can only be done by the member states themselves.” 126

But in a defence of France’s economic policy, Mr Sapin issued a clear call to Germany to do more to boost the eurozone’s weak recovery. He said that, while France was “facing up to its responsibilities”, surplus countries that had already had “the courage to reform” needed to “pose the question” of what more they needed to do to recover growth. According to the socialist government’s 2015 budget, published on Wednesday, the deficit will rise this year to 4.4 per cent, before falling to 4.3 per cent next year and 2.8 per cent in 2017. France has already missed two extensions granted by the European Commission, which had set a renewed date of 2015 for hitting the 3 per cent target. Mr Sapin argued that the government’s latest projections were “extremely realistic” given unexpectedly weak growth in France and across Europe and the low level of inflation. Growth in France is now forecast at 1 per cent in 2015, rising to 1.9 per cent in 2017, well below previous projections. The country’s high council for the public finances nonetheless cautioned that the new estimates were based on “overly favourable tenets”. On Tuesday night, Rome also slashed its economic forecasts, and is now projecting that gross domestic product will contract 0.3 per cent in 2014, a big markdown compared with expectations of 0.8 per cent growth in April. Italy is expected to skate along the edges of the EU’s budget rules this year, with a deficit of 3 per cent of gross domestic product, according to the government. The debt to GDP ratio, meanwhile, is expected to rise from 131.6 per cent in 2014 to 133.4 per cent next year.

Referring to the government’s pledge to shave €50bn from public spending over the next three years, including €21bn in 2015, Mr Sapin said: “France has never made an effort of that size before.” The cuts include, for the first time, real reductions in social welfare such as family benefits, prompting President François Hollande to warn on Tuesday of “painful” reforms.

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But the government rejected calls for bigger cuts in its outsized public spending bill. “The French will not be asked to make an additional effort because while the government is committed to budget responsibility to restore the country, it rejects austerity,” the budget statement said. Mr Sapin insisted that Germany and other European partners “appreciated” that the government should also persist with a programme of €40bn in tax cuts for business despite the deficit slippage, as a means to restore French competitiveness and growth. The budget also included more than €3bn in tax cuts for households next year in an attempt to assuage strong public anger over big tax increases imposed in recent years in preference to spending cuts. The French budget came a day ahead of confirmation hearings in the European Parliament for Pierre Moscovici, Mr Sapin’s predecessor who is due to take over as EU economic commissioner in joint charge of vetting national budgets. He is set to face tough questioning on his own role in France’s deficit slippage. Sylvie Goulard, a French MEP who heads Liberals in the European parliament’s economic committee, said the controversy surrounding the budget was likely to infect the confirmation hearings. “At the least, it is not very wise to take a decision the day before you want someone confirmed . . . I don’t know whether that is a strategy or just a mess.” Ms Goulard said the Hollande government had lost credibility in Brussels by repeatedly insisting that they did not want leniency in the Commission’s adjudication of its new budget – while saying publicly that they need more time to hit deficit targets. An important element in negotiations with the commission, which will give its verdict on the French budget later this month, will be the reduction in the structural deficit, which excludes short-term cyclical effects. Brussels and Berlin have made clear their concern that Paris has not done enough to date to push through structural reforms.

Mr Sapin conceded that the rate of structural deficit reduction would also slow, falling from 2.4 per cent of gross national product this year to 2.2 per cent in 2015. But he said

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this was the lowest level since 2001 and the slowdown was due to lower growth and inflation projections, not a relaxation of spending cuts. The budget showed growth in France’s public debt, which exceeded €2tn for the first time in the first half of this year, would not now peak until 2016, at 98 per cent of GDP. Public spending, the second highest in the EU, is now set to peak at 56.5 per cent this year, falling to 54.5 per cent in 2017. Likewise, the government said the tax burden on the economy, a factor in the record low approval ratings of President Hollande, would peak this year at 44.7 per cent of GDP. But it will only fall to 44.4 per cent by 2017, when Mr Hollande faces re-election. Additional reporting by Peter Spiegel in Brussels and Stefan Wagstyl in Berlin http://www.ft.com/intl/cms/s/0/2de40808-493b-11e4-9d7e- 00144feab7de.html#axzz3EnXyN5sD Content recommended for you Related articles • France to sharply overshoot EU budget deficit target • Hill woos Brussels doubters with help from bard • France remains in a state of magical thinking • Cameron’s last conference speech gives voice to party optimism • Poland on course for battle on new EU climate change targets • New York and London vie for crown of world’s top financial centre • Transcript: Interview with Turkey’s finance minister • The (early) Lunch Wrap • Hollande warns France of tough spending cuts • Peugeot Citroën and Renault call for speedier economic reforms

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ft.com Comment Opinion October 1, 2014 5:58 pm France remains in a state of magical thinking By Sylvie Goulard The economic taboos remain – the best-off are being protected, writes Sylvie Goulard

©AFPFrançois Hollande, left, and Manuel Valls S hould the rest of Europe once again accept that France is not keeping its word? The French government on Wednesday said its deficit would reach 4.4 per cent of gross domestic product this year, and that it would not reach the EU-designated target of 3 per cent until 2017. That is two years later than President François Hollande and his then finance minister Pierre Moscovici had promised as recently as last summer. “We are not asking,” Manuel Valls, the prime minister, declared before the National Assembly earlier this month. “France makes its own decisions.” It is legally hazardous. He should perhaps reread the law. Since joining the euro Paris has shared its economic and monetary sovereignty. The Lisbon treaty, of which it is a signatory, states that economic polices are “a matter of common concern” that must be co-ordinated with the European Council. In almost the same breath, Mr Valls asked Germany to “shoulder its responsibilities”. If each country makes its own decisions, why did he expect Berlin to listen? This mutual surveillance of budgetary policies has been strengthened since 2011. The European Commission now examines each country for economic imbalances – and in France’s case, identified problems concerning pensions, labour costs, taxation and regulated professions, among others. It was in return for assurances that these would be addressed that France was granted two years’ respite. Paris gave its word. More ON THIS STORY// France defiant on missed deficit target/ Hollande warns France of spending cuts/ French unemployment number falls/ France warns on budget deficit target ON THIS TOPIC// France to adopt plain cigarette packaging/ Hollande rules out further spending cuts/ Simon Kuper France – the way the French see it/ France warns of budget overshoot IN OPINION// Hans-Werner Sinn Draghi’s meddling/ Benn Steil Brics bank is a feeble strike/ Chandran Nair Modi’s challenge/ Huw van Steenis Flexible funding needed

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Countries that break the rules are expected to pay the price. The only way to escape fines is to secure the consent of other countries. This is unlikely to be forthcoming. The commission has been especially flexible towards France. The law is not the only area in which Mr Hollande’s team has succumbed to magical thinking. It is also in denial about the state of the French economy. The government argues it is victim to a difficult economic cycle. It claims to be confronting “exceptional circumstances” of very weak growth combined with very low inflation. (Both figures are close to 0.5 per cent.) The downturn is indeed worse than expected, and it is also affecting Germany and Italy. But it is not without precedent. But the root of France’s problem is structural. The country is uncompetitive in international markets. That is hardly surprising. Public expenditure amounts to 55 per cent of GDP. The country’s hands are tied. French authorities claim to be aware of the challenges. Yet they do not hesitate to flatter recalcitrant spirits. Mr Valls has again assured people that the 35-hour working week will not be touched. Nor will the government relax constraints on employers that make it difficult to fire workers. The minimum wage is sacrosanct. Civil servants will keep their cushy terms. The circumstances might be “exceptional” but the taboos remain. The government’s priority is to defend those who are already best protected. Those who are excluded can wait. The prime minister told MPs that the French social model was not out of date. This is a system that leaves one-in-six young people without any qualifications. Millions of long- term unemployed have no realistic prospect of finding a job. Too many of them are illiterate. This hardly deserves to be called a social model. Yet the French political class is not in the mood for sacrifice. Many European countries have embarked on drastic policies. Meanwhile, Paris plans to shave €50bn off public spending, equivalent to 4 per cent of the total. It is not in any hurry; making the savings will take three years. Reforms in EU member states must be combined with action at the European level that supports productive investments as well as measures to fight deflation. The European Central Bank is playing its part but it cannot replace national governments. If there is something exceptional in France it is the attitude of denial into which all of the political parties have lapsed: denial about shared sovereignty in Europe, denial about the weakness of the national economy, denial about the hard and far-reaching reforms that the country badly needs. France has incredible potential. Instead of defending an unfair status quo, which increases social inequalities, this is the time to support positive reform, which will enable the nation to regain its credibility in Europe. France needs to pull itself together – and to keep its word, at all costs. The European Commission should stand firm. //The writer is a French MEP and member of the liberal ALDE parliamentary group// http://www.ft.com/intl/cms/s/0/4d909502-496f-11e4- 8d68-00144feab7de.html#axzz3EnXyN5sD

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Germany’s malaise shows eurozone can’t cut its way to prosperity The experiment – German designed, German engineered and German exported – with austerity has failed, writes Larry Elliott Wednesday 1 October 2014 18.54 BST

Frankfurt stock exchange. The snapshot of German manufacturers shows that for the first time in more than a year industry is contracting rather than expanding. Photograph: Stringer/REUTERS Europe has a problem and it is called Germany. The crisis that has bedevilled the single currency area for the past five years started with the smaller countries on the eurozone’s periphery: Greece, Ireland, Portugal. Then it moved to the bigger countries of Southern Europe: Spain and Italy. Next the malaise spread to the second biggest economy: France. All the time, though, the sense was that Germany – the powerhouse of the eurozone – was immune. Exports from the factories of Bavaria and North Rhine-Westphalia were booming. Business confidence was high. Growth was solid. While the core of the eurozone remained secure, there was nothing really to fear. That was then. The story today is of waning confidence and drooping factory orders. The snapshot of German manufacturers shows that for the first time in more than a year industry is contracting rather than expanding. A temporary blip caused by the tension in Ukraine? In part, yes. Sentiment has clearly been affected by fears that Russia could decide to annexe eastern Ukraine, while sanctions have affected exports. But that’s not the whole story. German exports were falling even before the escalation of the Ukraine crisis, and that was mainly due to falling demand from the rest of the eurozone. At Berlin’s insistence, domestic demand has been squeezed across Europe. Everybody has been urged to cut costs, become more competitive and adopt the German model of export-led growth. 132

But if Spanish, Italian and Portuguese consumers lack spending power, they can’t afford a spanking new BMW or a Miele washing machine. That means weaker German exports, lower German growth and in turn less demand for Spanish, Italian and Portuguese exports. All of which explains the current state of the eurozone: a faltering recovery that poses the risk of a triple-dip recession and deflation. Growth stagnated in the second quarter this year and is on course to be no better in the third. Inflation, according to the flash estimate published this week, stands at 0.3%. The experiment – German designed, German engineered and German exported – with austerity has failed. The eurozone is not cutting its way back to prosperity. It is cutting its way towards being the new Japan. If policymakers in Berlin were willing to accept this, they might be prepared to see the sense in easing up on the spending cuts and wage reductions. They might even see virtue in a modern Marshall Plan for Europe, under which Germany would run down its budget surplus in order to boost spending not only in its own economy but in the rest of the eurozone. But that is not going to happen. Instead, Germany will belatedly and begrudgingly drop its opposition to the European Central Bank using full-strength quantitative easing – buying government bonds to create money – to try to kickstart growth. Expect hints of QE to emerge from the ECB on Thursday. http://eurozone.einnews.com/article/226857832/3VUKs9f3n9Wml5S3

British and German factories see sharp slowdown in manufacturing Stock markets fall across UK, Europe and US as sluggish eurozone and global conflict hit economies Angela Monaghan and Phillip Inman The Guardian, Wednesday 1 October 2014 21.18 BST

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Work on the Royal Navy's aircraft carrier at Govan, Glasgow, where BAE Systems is to build a new order of navy patrol vessels. Photograph: Simon Dawson/Bloomberg/ Getty Images Factories in Britain and Germany suffered a sharp slowdown in September, raising fears that economic recovery is losing momentum against a backdrop of global political turmoil and the flagging eurozone economy. In the UK growth in manufacturing activity was the slowest in 17 months as demand for British goods waned at home and abroad. In Germany, long the powerhouse of the eurozone, the sector shrank for the first time in 15 months, hit by Russian sanctions over the Ukraine crisis and general malaise across the economies of the currency bloc. Stock markets fell in Britain, across Europe and in the US, after investors took fright at the weak manufacturing reports and the first confirmed Ebola case in the US. The FTSE 100 fell 69 points or 1% to 6,553.99. In the US the Dow Jones was down 218 points by mid afternoon in New York. “The world economy is still performing reasonably well, but there are signs that growth is softening,” said Andrew Kenningham, senior global economist at Capital Economics. The pound fell to a two-week low of $1.6164 against the dollar after the weak UK data was published by Markit/CIPS. It was the lowest level against the dollar since the eve of the Scottish referendum vote, although the pound recovered some of its losses later in the day. The headline index on the Markit/CIPS UK purchasing managers’ index (PMI) combines output, orders, employment and prices. It fell to 51.6 in September from 52.2 in August (a reading above 50 indicates expansion). It was the slowest rate of growth since April last year and the third monthly drop in the index, disappointing City forecasters who said the surprise fall took any remaining prospect of an imminent rise in interest rates definitively off the table. James Knightley, an economist at ING, said: “This is a 17-month low and further diminishes the prospect of Bank of England policy tightening in November. One possibility is that the uncertainty generated by the close polls in the lead-up to the Scottish independence referendum made business cautious and therefore led to a delay in orders.” Germany had recovered all but 0.1% of its peak manufacturing output in July but the UK was 7.9% down in the same month, though revised national accounts show British manufacturing output down by only 4.5% from its highest point. New UK export orders have barely grown, putting growth at the slowest rate in almost 18 months, further frustrating George Osborne’s aim to rebalance the economy away from consumer spending and financial services and towards manufacturing and exports. Rob Dobson, an economist at Markit, said the UK manufacturing sector was losing momentum. “The strong upsurge in the UK manufacturing sector at the start of the year appears to have run its course. Inflows of new work slowed in domestic and export

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markets. Overseas demand was reined in mainly by the ongoing lethargy of the eurozone and the appreciation of sterling against the euro.” The contraction in Germany’s manufacturing sector shocked economists who were expecting a small increase in activity. The headline index fell to 49.9 in September from 51.4 in August. Oliver Kolodseike, an economist at Markit and author of the report, said it painted a worrying picture for German manufacturing.“Surveyed companies reported that a weakening economic environment, Russian sanctions and subdued growth in key export destinations, were behind the disappointing reading.” New factory orders fell to their lowest level since the end of 2012, boding ill for the immediate future. The situation also deteriorated for the sector in the wider eurozone, where manufacturing growth almost came to a halt in September. The PMI dropped to a 14-month low of 50.3 from 50.7 in August. Kenningham said the weak performance made it more likely that the European Central Bank would announce more radical stimulus measures for the eurozone economy. “There has been no let-up in the flow of bad news from the eurozone. We expect [ECB president Mario] Draghi to hint strongly at [today’s] ECB meeting that a large-scale government bond purchase programme is on its way.” Some countries in the single currency bloc fared better. Where Germany joined Austria, Greece and France as those seeing contractions, the most rapid growth was in Ireland and Spain – although in both countries it was slower than in recent months. While Spain’s manufacturing sector is starting to recover, July’s data showed output was still nearly a third below its peak in 2008. Madrid has worked hard to put a positive gloss on recent growth, but much of the sector was wiped out in the financial crash and has yet to return. Italy’s manufacturing sector also had a colossal fall in output in the wake of the financial crisis and was 26.6% below its peak in July. Growth in the US manufacturing sector slowed slightly in September but remained strong, with the PMI index edging down to 57.5 from 57.9 in August. http://eurozone.einnews.com/article/226857832/3VUKs9f3n9Wml5S3

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Austerity has been an utter disaster for the eurozone All of the suffering in Europe – inflicted in the service of a man- made artifice, the euro – is even more tragic for being unnecessary, writes Joseph Stiglitz

Joseph Stiglitz The Guardian, Wednesday 1 October 2014

Austerity has been an utter and unmitigated disaster, which has become increasingly apparent as European Union economies once again face stagnation, if not a triple-dip recession. Photograph: Vladimir Rys/Getty Images “If the facts don’t fit the theory, change the theory,” goes the old adage. But too often it is easier to keep the theory and change the facts – or so German chancellor Angela Merkel and other pro-austerity European leaders appear to believe. Though facts keep staring them in the face, they continue to deny reality. Austerity has failed. But its defenders are willing to claim victory on the basis of the weakest possible evidence: the economy is no longer collapsing, so austerity must be working! But if that is the benchmark, we could say that jumping off a cliff is the best way to get down from a mountain; after all, the descent has been stopped.

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But every downturn comes to an end. Success should not be measured by the fact that recovery eventually occurs, but by how quickly it takes hold and how extensive the damage caused by the slump. Viewed in these terms, austerity has been an utter and unmitigated disaster, which has become increasingly apparent as European Union economies once again face stagnation, if not a triple-dip recession, with unemployment persisting at record highs and per capita real (inflation-adjusted) GDP in many countries remaining below pre-recession levels. In even the best-performing economies, such as Germany, growth since the 2008 crisis has been so slow that, in any other circumstance, it would be rated as dismal. The most afflicted countries are in a depression. There is no other word to describe an economy like that of Spain or Greece, where nearly one in four people – and more than 50% of young people – cannot find work. To say that the medicine is working because the unemployment rate has decreased by a couple of percentage points, or because one can see a glimmer of meager growth, is akin to a medieval barber saying that a bloodletting is working, because the patient has not died yet. Extrapolating Europe’s modest growth from 1980 onwards, my calculations show that output in the eurozone today is more than 15% below where it would have been had the 2008 financial crisis not occurred, implying a loss of some $1.6 trillion this year alone, and a cumulative loss of more than $6.5 trillion. Even more disturbing, the gap is widening, not closing (as one would expect following a downturn, when growth is typically faster than normal as the economy makes up lost ground). Simply put, the long recession is lowering Europe’s potential growth. Young people who should be accumulating skills are not. There is overwhelming evidence that they face the prospect of significantly lower lifetime income than if they had come of age in a period of full employment. Meanwhile, Germany is forcing other countries to follow policies that are weakening their economies – and their democracies. When citizens repeatedly vote for a change of policy – and few policies matter more to citizens than those that affect their standard of living – but are told that these matters are determined elsewhere or that they have no choice, both democracy and faith in the European project suffer. France voted to change course three years ago. Instead, voters have been given another dose of pro-business austerity. One of the longest-standing propositions in economics is the balanced-budget multiplier – increasing taxes and expenditures in tandem stimulates the economy. And if taxes target the rich, and spending targets the poor, the multiplier can be especially high. But France’s so-called socialist government is lowering corporate taxes and cutting expenditures – a recipe almost guaranteed to weaken the economy, but one that wins accolades from Germany. The hope is that lower corporate taxes will stimulate investment. This is sheer nonsense. What is holding back investment (both in the United States and Europe) is lack of demand, not high taxes. Indeed, given that most investment is financed by debt, and that interest payments are tax-deductible, the level of corporate taxation has little effect on investment.

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Likewise, Italy is being encouraged to accelerate privatisation. But prime minister Matteo Renzi has the good sense to recognise that selling national assets at fire-sale prices makes little sense. Long-run considerations, not short-run financial exigencies, should determine which activities occur in the private sector. The decision should be based on where activities are carried out most efficiently, serving the interests of most citizens the best. Privatisation of pensions, for example, has proved costly in those countries that have tried the experiment. America’s mostly private health-care system is the least efficient in the world. These are hard questions, but it is easy to show that selling state-owned assets at low prices is not a good way to improve long-run financial strength. All of the suffering in Europe – inflicted in the service of a man-made artifice, the euro – is even more tragic for being unnecessary. Though the evidence that austerity is not working continues to mount, Germany and the other hawks have doubled down on it, betting Europe’s future on a long-discredited theory. Why provide economists with more facts to prove the point? • Joseph E. Stiglitz, a Nobel laureate in economics, is University Professor at Columbia University. His most recent book, co-authored with Bruce Greenwald, is Creating a Learning Society: A New Approach to Growth, Development, and Social Progress. Copyright: http://www.project-syndicate.org/commentary/joseph-e--stiglitz-wonders- why-eu-leaders-are-nursing-a-dead-theory 2014. http://eurozone.einnews.com/article/226857832/3VUKs9f3n9Wml5S3

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ECONOMICS Your Debt, Our Nation's Headache

42Oct 1, 2014 10:10 AM EDT By Barry Ritholtz On this day 56 years ago, the U.S. economy began to undergo a momentous change. It was Oct. 1, 1958, and the company known best for its Travelers Cheques introduced a new product: The charge card. Although American Express technically wasn't the first company to introduce a charge card, it was the first to make its cards ubiquitous, and in the process changed the concept of where and how credit could be used. The nation hasn't been the same since. From those humble beginnings, the use of credit spread throughout the county. The Depression-era generation was loath to become indebted to any bank or lender after seeing what could happen in a credit crisis. It's no coincidence that the widespread use of credit didn't occur until a new generation came of age. Along with that new generation came the birth of the suburban bedroom community. Homes were bought with mortgages and furnished with revolving debt. Cars purchased with dealer financing were the glue that held the edifice together. All of these items were out of reach for the average family, unless purchased with credit. This is no small matter. As you can see from the Federal Reserve’s most recent Flow of Funds report, the total indebtedness of U.S. households is a staggering $14 trillion dollars. What makes the unstoppable rise of credit so significant is the role it played in the 2007-09 financial crisis, and the subsequent recovery. Credit crunches are different from ordinary recessions. Not only are they more severe, as Carmen Reinhart and Ken Rogoff have documented in "This Time Is Different: Eight Centuries of Financial Folly," but their character is significantly different. Consider an ordinary recession: The economy begins to heat up as wages rise and consumers borrow and spend. The Fed, concerned about increasing inflation, raises interest rates. As credit becomes more expensive, sales slow, putting the economy at risk of slipping into a recession.

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But fear not! After six months or so, the Fed then lowers rates, unleashing all that pent- up demand. Consumers and businesses begin spending again, folks get hired and the entire virtuous cycle begins anew. That approach is what we have seen in the 15 or so post-World War II recession- recovery cycles. An overheating economy leads to rising rates leads to a slowdown leads to falling rates. Rinse, lather, repeat. That isn't what occurs after a credit crisis such as the Great Recession. Assets purchased with cheap and widely available credit become worth significantly less once the bubble bursts. But the debt remains. All of that leverage used to purchase all of those assets -- regardless of whether it's subprime mortgages or dot-com stocks -- sticks around. Hence, a post-credit-crisis recovery is dominated not by the release of pent-up demand, but by massive corporate, household and government deleveraging. Even before the financial crisis, Reinhart and Rogoff were detailing how and why recoveries from such events were such slow, protracted and painful affairs. Until recently, most Wall Street analysts and economists misunderstood this. They used the wrong data set, looking at post-World War II recession recoveries as their frame of reference instead of post-credit-crisis recoveries. This is why their forecasts for the present recovery have been so wrong. How wrong have they been? Aside from their usual bad predictions, having the wrong frame of reference means they are unaware of what is typical, what is likely, and where this economy differs from the norm. A perfect example can be seen in the jobs data and the stock market. Ask most economists how these two indicators are doing, and you will get an answer along the lines of “The stock market is doing great, but unfortunately, the jobs data has been very soft.” That statement is true, if your frame of reference is the ordinary post-recession recovery. But if you are using the correct data set as your basis of analysis -- as we seen in this set of post-credit-crisis recoveries -- you reach a very different conclusion. Compared with the average recovery from the past 15 credit crises, this stock market’s performance is subpar. And surprisingly, the jobs recovery is better than average. Credit is a tool, one that can be used wisely or foolishly. No one held a gun to our collective heads and forced us to borrow and spend; the decision to live beyond our means was a choice too many of us made, both as individuals and collectively. That doesn’t mean we have to like it. Nor should we remain ignorant about the impact of credit’s use and abuse. This is why we now find ourselves in a slow and unsatisfactory recovery. The deleveraging process continues, and each passing quarter brings us closer to a more normal environment. Just don’t expect Wall Street economists to recognize this until long after the fact. http://www.bloombergview.com/articles/2014-10-01/your-debt-our-nation-s- headache

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Public Infrastructure Investment: IMF v. Mankiw Wednesday, October 1, 2014Abdul Abiad, David Furceri, and Petia Topalova report on a new analysis and sensibly state: Many advanced economies are stuck in a low growth and high unemployment environment, and borrowing costs are low. Increased public infrastructure investment is one of the few remaining policy levers to support growth. In many emerging market and developing economies, infrastructure bottlenecks are putting a brake on how quickly these economies can grow. Greg Mankiw responds: The IMF endorses the free-lunch view of infrastructure spending. That is, an IMF study suggests that the expansionary effects are sufficiently large that debt-financed infrastructure spending could reduce the debt-GDP ratio over time. Certainly this outcome is theoretically possible (just like self-financing tax cuts), but you can count me as skeptical about how often it will occur in practice (just like self-financing tax cuts). The human tendency for wishful thinking and the desire to avoid hard tradeoffs are so common that it is dangerous for a prominent institution like the IMF to encourage free-lunch thinking. Did Mankiw miss the memo? We are far below full employment and monetary policy alone has not restored full employment. Even if fiscal stimulus is not self financing, the IMF case is still solid. Funny how times change. Back in 2001 Mankiw was endorsing all sorts of budget busting fiscal stimulus on the grounds that we were below full employment. And back then we were not in a liquidity trap so using monetary policy alone was a more viable option. Posted byProGrowthLiberalat8:12 AM http://econospeak.blogspot.com.es/2014/10/public-infrastructure-investment-imf- v.html

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vox Research-based policy analysis and commentary from leading economists Re-discovering the Phillips curve László Andor01 October 2014 Negative real interest rates imply redistribution from savers to debtors. This column, by the EU Commissioner for Employment, Social Affairs and Inclusion, argues that such redistribution would benefit the whole economy. It would strengthen aggregate demand – including investment demand – at a time when such a boost is clearly needed. As a contribution to the EU’s institutional transition, a conference entitled “Labour Economics after the Crisis” took place in Brussels on 18-19 September 2014. The aim was to draw lessons from Europe’s protracted jobs crisis and from the experience of the Barroso II Commission as regards macroeconomic and employment policies.1 My key ‘handover’ message was that Europe needs to re-discover the Phillips Curve and pursue higher inflation if the EU is to make progress towards the 75% employment rate target of the Europe 2020 Strategy.2 The European labour market is currently adversely affected by three key macroeconomic developments: • First, there is a persistent gap between effective aggregate demand and potential output in most Member States – combined with high unemployment, a large overhang of private debt, low inflation and nominal interest rates close to their lower bound. The shortage of demand (for both consumption and investment) is related to demographic trends, but also to rising inequalities and an increase in savings which are not channelled to the real economy but parked in financial instruments or metropolitan real estate. • Second, there is an unprecedented polarisation in economic and employment outcomes across the Eurozone. This is linked to the incomplete character of the monetary union, notably the lack of aggregate demand management and absence of a shared fiscal capacity. The Eurozone’s design has, up till now, forced macroeconomic adjustment to unfold predominantly through internal devaluation. • Third, Europe struggles to reap the full job potential of structural changes under way, such as technological progress and further globalisation. The reason is that our labour market institutions, but also product markets, financial sector and public investment agencies are not capable of reallocating labour and capital in a flexible but secure way towards activities with a strong job-creation potential. The bottom line is that secular stagnation, permanently depressed employment and rising inequalities may well become reality if Europe’s economy continues to be

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characterised by a large overhang of private debts from the past and at the same time low inflation (see Teulings and Baldwin 2014). How does inflation matter for monetary, fiscal and structural policies? Many years ago the Phillips curve used to encourage macroeconomic policy-makers to pursue full employment by using monetary and fiscal policies at their disposal. Today, the inverse relationship between unemployment and (wage or price) inflation may appear as controversial in Europe. After all, we live in an era of financial capitalism and two decades ago we established a monetary union geared towards price stability more than full employment. Figure 1. The textbook Phillips Curve and its outward shift due to the oil price shocks and resulting stagflation of the 1970s

Source: Wikipedia.org (http://en.wikipedia.org/wiki/Phillips_curve#mediaviewer/File:NAIRU-SR-and-LR.svg) In 1958, William Phillips highlighted the inverse relation between unemployment and nominal wage inflation in the UK in the previous century. A lot of similar empirical research followed and Samuelson and Solow soon re-stated the “Phillips curve” as an inverse relationship between unemployment and inflation. The policy implication of the Phillips curve is that increasing aggregate demand through monetary and/or fiscal policies is considered sufficient to increase labour demand and thereby bring unemployment down, provided that we accept the higher inflation that goes with it. 143

In the late 1960s, however, Milton Friedman claimed on the basis of empirical evidence concerning the USA that “inflation is always and everywhere a monetary phenomenon”, i.e. that inflation rates are proportional to the growth of the money stock. Furthermore, in the early 1970s, economists like Robert Lucas argued that only unanticipated inflation developments would create temporary deviations from equilibrium, given that rational economic agents take all available information into account when setting prices and wages. According to this school of thought, output and unemployment are essentially independent of inflation and expansionary fiscal policy is useless since economic agents will respond to it by reduced consumption in anticipation of higher future taxation. It was also concluded as part of this critique that in the long term, the Phillips curve becomes vertical: the economy reaches a so-called natural rate of unemployment which depends only on structural factors. Accordingly, policy-makers’ focus shifted to structural reforms which would bring down structural unemployment. The critique of the Phillips curve was warranted by developments in the 1970s and 80s, namely the supply-side shocks of the oil crises, which understandably drove up inflation (including wages), without reducing unemployment. But let us have a look at what actually happened since then. The Phillips curve has become more horizontal, not vertical We can start with the example of France because it is so close to the European average in many ways. Figure 2. The (original) Phillips curve for France, 1970-2013

Source: European Commission, DG EMPL.

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Throughout most of the period from 1970 to 1990 in France, increases in unemployment were associated with falls in nominal wage growth, just like the traditional Phillips curve would suggest. • The years after the 1973 and 1979 energy crises, when both unemployment and wage inflation increased, were notable exceptions. • Starting in the mid-1990s and especially more recently, the relationship between unemployment and wage inflation has flattened out. • In other words, while unemployment rose further, there was only a slight decrease in wage inflation. In the case of Spain we can observe a similar but more clear-cut pattern. • The relationship between unemployment and wage growth since has basically flattened out since the onset of the crisis in 2008. • Wage inflation has been low and unemployment grew. Figure 3. The (original) Phillips curve for Spain, 1970 - 2013

Source: European Commission, DG EMPL. Developments in Germany since unification also suggest that the Phillips curve holds. Decreases in unemployment in Germany in recent years have been associated with (slightly) rising wage levels. All three cases display an inverse relationship between unemployment and wage growth, like the original Phillips curve. However, we nowadays observe relatively major differences in unemployment rates, while inflation remains rather low and stable. • What all three cases show is that the Phillips curve has not become vertical as the monetarists had predicted; it is much closer to being horizontal in recent years. 145

Why has the Phillips curve flattened? One obvious explanation is that inflation in Europe has simply been very low in the last 20 years. This can be associated with the establishment of the euro where the ECB has price stability (not full employment) as its primary objective and where convergence towards low inflation rates represents one of the key accession criteria. Figure 4. The (original) Phillips curve for Germany, 1992 - 2013

Source: European Commission, DG EMPL. Adjustment to economic shocks in the Eurozone tends to occur not through expansionary fiscal or monetary policies that would drive up inflation and reduce unemployment, but through internal devaluation which leads to low inflation or outright deflation, accompanied by high levels of unemployment. Moreover, wage-inflationary pressures are much less likely nowadays than in the 1970s or 1980s because labour-union density has decreased considerably and collective bargaining has become more decentralised and easy to opt out from. In many countries, such as Spain or Germany, the nominal unit labour cost has also been rising less than overall prices, due to deliberate wage constraint or inefficient product markets. The result has been a further compression in aggregate demand and a more pronounced impact on unemployment. What should we learn from the Phillips curve? In short, empirical evidence suggests that the Phillips curve continues to be relevant, only it has been perhaps neglected in macroeconomic policy. We rightly pursue structural reforms aiming at reducing the long-term structural rate of unemployment, such as the Youth Guarantee3 or investments in education. But we may have forgotten that the way to the long term leads via several episodes of the short term.

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Since 2010, we have allowed aggregate demand in Europe to drop and unemployment to shoot up. Today we see that this has negative impact on medium-term growth prospects. • A protracted period of low or negative growth causes hysteresis (decline in human and fixed capital), in turn undermining the growth potential. • Unemployment caused by a cyclical downturn becomes structural in its consequences if the downturn is not tackled. Figure 5. Unit labour cost and GDP price deflator (net of indirect taxes and subsidies) in France, Spain and Germany since 2000

Source: European Commission, DG EMPL. Conclusions In conclusion, assuming that we take the EU’s objective of full employment seriously even with low projected GDP growth, we need to embrace negative real interest rates. Nominal interest rates should be kept at very low levels and inflation expectations need to rise. Economic agents (and especially the savers among us) need to accept the idea that very low or even negative returns on their capital are necessary for the sake of the whole economy’s growth. Conditions for borrowing need to become more favourable, especially as regards young people and SMEs. In practice, a negative real interest rate means some form of redistribution from savers to debtors. It can take many forms, such as debt relief, ‘helicopter money’ or simply increased taxation of capital gains or wealth and greater fiscal support to lower-income

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groups. Greater redistribution would benefit the whole economy at the current juncture as it would strengthen aggregate demand, including demand for investment. In any event, higher inflation expectations and lower unemployment cannot be achieved on the basis of only fiscal or only monetary policies, nor only through structural changes like wage increases in surplus countries. Concerted action through fiscal, monetary and structural policies is needed, as in the concept of “Abenomics” and as recently argued also by the President of the European Central Bank.[4] References Andor, László (2013). "Can we move beyond the Maastricht orthodoxy?", VoxEU column, 16 December 2013. Council of the European Union (2013), "A recommendation on establishing a Youth Guarantee". Teulings, C and R Baldwin (2014), Secular Stagnation: Facts, Causes and Cures, VoxEU e-book, 15 August 2014, . Footnotes 1 The conference papers are available at http://ec.europa.eu/social/main.jsp?langId=en&catId=88&eventsId=993. 2 This article elaborates on part of a speech presented at the EU conference on "Labour Economics after the Crisis" under the title "Towards a European Labour Model" (18 September 2014, http://europa.eu/rapid/press-release_SPEECH-14- 605_en.htm?locale=en) 3 The Youth Guarantee is a structural reform aiming to ensure that all people under the age of 25 receive a good-quality offer of a job, continued education, apprenticeship or traineeship within four months of becoming unemployed or leaving school. A recommendation on establishing a Youth Guarantee was adopted by the Council of the European Union in April 2013; cf. http://ec.europa.eu/social/main.jsp?catId=1079. 4 The recent speech of Mario Draghi in Jackson Hole emphasised the need for more accommodative monetary policies and a more expansionary aggregate fiscal stance of the Eurozone, so that Europe can implement structural reforms without risking further short-term contraction in GDP and further deflationary pressure. Draghi, M., "Unemployment in the euro area", speech at the Annual central bank symposium in Jackson Hole, United States, 22 August 2014, http://www.ecb.europa.eu/press/key/date/2014/html/sp140822.en.html http://www.voxeu.org/article/re-discovering-phillips-curve

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10/01/2014 05:43 PM Bridge to Nowhere Are EU Subsidies for Andalusia Well Spent? By Christoph Pauly No other region in Spain receives as much European Union funding as Andalusia. But do the projects being funded make sense? Questions are mounting about the efficacy of the subsidies -- and about their potential for feeding corruption. Teófila Martínez Saiz is to be envied, and not just by other mayors. For the last 19 years, the 66-year-old has governed Cádiz, one of Spain's most beautiful cities. She resides in a palace with elegant columns, ancient statues, opulent murals and a view of the sea. What's more, she is popular, not least for her ability to mobilize external money for local projects. Currently, a five-kilometer-long (3.1 mile), €500 million bridge is under construction which will stretch from the island city of Cádiz to the mainland. It is to be the highest such structure in Europe and will also have a middle section that can be opened to allow megaships of the future to sail into the bay. The bridge isn't the only such publically funded project in Cádiz. The European Union also helped the city -- population 123,000 -- build a new wastewater treatment plant, Martínez notes, as well as providing money for continuing workforce education, reindustrialization projects, the expansion of the harbor and more. In mid-September, the EU earmarked an additional €135 million for a tram line between nearby Chiclana and Cádiz. Brussels is also paying for a new bicycle path above the beach. Yet despite the windfall, the economy in the city and the surrounding Andalusia region is in disastrous shape. More than a third of the adult population is unemployed and the youth jobless rate in the Cádiz Province is over 57 percent, the highest in all of Spain. Young people in Andalusia prefer to head overseas for work if possible. Those who cannot, stay at home with mom. The economic difficulties are a problem for the region, but also for the European Union and the European Investment Bank (EIB), which has proffered €6.7 billion worth of development loans to the region in the last 10 years to little effect. The projects funded in and around Cádiz, after all, have been accompanied by waste and a not insignificant amount of corruption. This summer, the situation even resulted in the resignation of IEB Vice President Magdalena Álvarez Arza. A Time of Crisis Andalusia receives more EU money than almost any other region in Europe. The EU, together with money made available by Spain, made a total of €14 billion available to the province between 2007 and 2013. Some €2.3 billion from the European Social Fund was provided for training programs for unemployed Andalusians. But Spanish anticorruption officials believe that many of the registered vocational training courses never actually took place.

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Currently, millions of euros are being spent in the Cádiz port, with the construction of a new, 500-meter-long wharf underway. The port director says that the quay will provide more room for container ships from overseas to load and unload their cargos. The terminal's capacity is to more than double, from 160,000 units to 350,000 units per year. The expansion, though, is coming at a time of crisis for global shipping. Indeed, only cruise ships are doing well, and Cádiz, with its baroque beauty from the 17th and 18th century is already a regular stop on the Mediterranean voyages of many such vessels. Nevertheless, the EU approved €60 million from its Structural Funds for the expansion of the container terminal on the edge of the historic city center. A further €60 million is to come from the EIB in the form of a development loan. The money earmarked for the project is even more than the €118 million estimate for the total costs. Even locals are critical of the project. "We are fighting for the industrial port to be moved from the city to the mainland," says Teresa Vassalo Varela, a co-founder of the citizens' initiative El Caso Cádiz. It makes no sense, she says, to expand the port on the island, with its historic old town, when there are more suitable sites on the mainland that would be cheaper to develop. In 2011, the small initiative filed a formal objection to the EU subsidies. The European Anti-Fraud Office (OLAF) has also stepped in. "Cádiz is one of these places where European structural aid was converted into a business model for the benefit of people who never were, or will be, in need of aid," the initiative wrote to the European Commission in 2013. Need for a New Bridge? The activists from El Caso Cádiz see a connection between the giant bridge across the inlet and the container terminal. The six-lane highway only makes sense, they argue, if it is intended to provide trucks from the port access to the mainland. The city itself doesn't really need the bridge; there is already a three-lane span stretching across the narrow end of the inlet which is perfectly adequate. Indeed, the tight city center isn't able to handle any more vehicle traffic than it already has. Had the expensive new bridge been included in the price tag for modernizing the port, it seems unlikely that the European Commission would have approved the subsidies. The costs would have massively exceeded the expected benefits of increased container traffic. Brussels has consequently continued to insist that the two projects are unrelated. The new bridge, the EU wrote in a letter to the citizens' initiative, is not necessary "for the full operational effectivity of the container terminal." The document notes that the Spanish state is financing the bridge and that it is being built to improve the city's connection to the mainland. But even EU officials appear to be uncomfortable with that line of argumentation. Funding earmarked for the port expansion has still not been definitively released, pending the outcome of the El Caso Cádiz objection. Nevertheless, the state-owned port authority has moved ahead with construction on the strength of loans and advance payments from the European Commission. The Port of Cádiz, however, isn't the only terminal in the region currently undergoing expansion. The one in Sevilla is also being improved. As part of the project, the EU and

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the EIB are also financing the construction of new locks, which will be Europe's largest when completed. Because the Andalusian capital is located 100 kilometers from the seaside, the Guadalquivir River, which connects Sevilla with the Mediterranean, must be dredged to a depth of seven meters (23 feet). Funding from Brussels is going to pay for the additional dredging of the river, much of which flows lazily through a nature reserve. The 2007 to 2013 EU budget had also included funding for improvements to the Sevilla container port, but environmentalists, including some within the European Commission, have thus far been able to prevent that money from being dispersed. Meanwhile, there have long been suspicions that there might be more behind the vast quantities of EU funding for Andalusia than meets the eye. Former EIB Vice President Àlvarez Arza, for example, has been accused of being part of an illegal system for the dispersal of aid money. In 2001, Andalusia established a fund to help workers hit by layoffs, but some of the money was allegedly misappropriated. Álvarez Arza has denied all accusations of wrongdoing and posted €30 million in bail to avoid pre-trial detention. World-Class Highways and Ports There are images showing Álvarez Arza in 2005, when she was still minister of public works, at the signing of the EIB loan for the gigantic lock in Sevilla. A picture from 2007 shows her looking proudly at a model of the gigantic bridge spanning the Cádiz inlet. "It will be higher, longer and wider," she gushed happily. She was also present at the signing of the EIB loan agreement for the Cádiz container terminal. Today, the EIB has a problem. When El Caso Cádiz began questioning the role played by Álvarez Arza in 2011, the investment bank brushed aside their concerns. "Following an investigation by the independent complaint department of the EIB, no violations of EIB rules were found," the bank wrote in a statement provided to SPIEGEL. The final decision to provide the loans was not made by the managing board, but by the administrative council, which is made up of representatives from all EU member states, the statement continued. Recent checks of projects Álvarez Arza was involved in likewise found no irregularities. Inge Grässle, however, has her doubts. She is the chair of the Budgetary Control Committee in the European Parliament. In early September, she submitted a parliamentary question to the Commission reading in part: "What role did Ms Álvarez Arza play in the authorization and negotiation of a financing agreement with the Cádiz Bay Port Authority? What did the agreement say, and what funds have been granted by the EIB and the Commission for the construction of the port terminal, the building of the bridge in Cádiz, and links connecting it with industrial estates in and around Cádiz?" Cádiz Mayor Martínez is not discouraged. Though work on the bridge has been temporarily halted due to renewed cost overruns, construction on the structure and on the other projects has progressed far enough that, she believes, there is no turning back. Only the future sometimes fills her with trepidation. "We are going to have world-class highways, train lines and ports," she says. "What will we do if nobody wants to use them in the end?" 151

Laura Leon/ DER SPIEGEL

Does Cádiz really need this massive new bridge to the mainland?

URL: • http://www.spiegel.de/international/europe/questions-mounting-about-eu- development-aid-for-andalusia-in-spain-a-994844.html Related SPIEGEL ONLINE links: • German Central Bank Head Weidmann: 'The Euro Crisis Is Not Yet Behind Us' (09/24/2014) http://www.spiegel.de/international/business/interview-with-bundesbank-head-jens- weidmann-on-euro-crisis-and-ecb-a-993409.html • V for Victoria: Catalans Want Independence Too (09/10/2014) http://www.spiegel.de/international/europe/catalonia-seeks-independence- referendum-despite-madrid-rejection-a-990632.html • Pilgrims Inc.: Soul Searching and Commerce on the Way of St. James (08/07/2014) http://www.spiegel.de/international/europe/more-popular-than-ever-way-of-st-james- still-offers-enlightenment-a-983670.html

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OECD News Today Income Inequality Worldwide Reaches All-Time High: OECD Chief STRASBOURG, October 1 (RIA Novosti), Daria Chernyshova – Income inequalities worldwide have reached an all-time high, the head of the Organization for Economic Co-operation and Development (OECD) Angel Gurria said Wednesday speaking at the Parliamentary Assembly of the Council of Europe (PACE). "We have growing inequalities; inequalities have never been as high as they are today," Gurria said. "How bad is inequality? It is 9.5 times – the income of the 10 percent of the poorest in the OECD only – can fit 9.5 times income the 10 percent of the richest," Gurria stressed. "It was 6 times when the crisis started. That means we are going in the wrong direction very fast." He continued by saying that in the United States the inequality is even higher and is 14- 15 times, in Mexico and Chili – 25-26 times, in Brazil – 50 times, in some African countries – 100 times. The Parliamentary Assembly's fall session takes place in Strasbourg from September 29 to October 3, 2014. http://oecd.einnews.com/article/226785984/JN8_d03knhxORHCJ

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wsj Fed Sep 29, 2014

Key Inflation Reading Slips Further Below Fed’s 2% Target

By Eric Morath

Consumer prices held flat in August from a month earlier, resulting in a closely watched annual inflation gauge slipping further below the Federal Reserve’s target.

The price index for personal consumption expenditures—the Fed’s preferred inflation measure—advanced just 1.5% in August from a year earlier, the Commerce Department said Monday. August was the 28th straight month the inflation reading undershot the Fed’s 2% target.

Excluding volatile food and energy prices, so-called core prices also advanced 1.5% year over year.

The pace of overall price gains decelerated compared with July’s 1.6% pace, while the core price reading held steady for the fourth straight month.

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The data broadly indicates inflation pressures remained at bay. The Fed aims to set monetary policy so that prices will increase 2% a year. Consistently undershooting that target suggests slack remains in the economy, shown in part by weak wage growth and not enough demand for businesses to pass along price increases to customers.

Weak inflation gives the Fed leeway to maintain its low-interest rate policy without causing the economy to overheat. The central bank’s benchmark interest rate has been pinned near zero since late 2008. The Fed intends to complete its bond-buying program this fall, turning policy makers’ attention to raising rates.

The central bank will likely maintain low-interest rates for a “considerable time … especially if projected inflation continues to run below [policy makers’] 2% longer-run goal, and longer-term inflation expectations remain well anchored,” Fed Chairwoman Janet Yellen said at a press conference earlier this month.

Forecasts released following a September meeting showed most Fed officials expect the first rate increase will occur sometime next year. A majority of economists surveyed by the Wall Street Journal expect the first increase to occur in the second or third quarter of 2015.

Price increases measured by the PCE index slowed to a 1% annual pace late last year before accelerating during the spring and then plateauing this summer.

A separate measure also shows inflation is largely in check. The Labor Department’s consumer-price index rose 1.7% in August from a year earlier. That was a marked slowdown from the better-than-2% pace recorded the previous four months.

The CPI historically runs about half a percentage point higher than the PCE price index, which employs different statistical methods. http://blogs.wsj.com/economics/2014/09/29/key-inflation-reading-slips-further- below-feds-2-target/?mod=marketbeat

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Why inequality is such a drag on economies Martin Wolf Last Updated: Wednesday, October 1, 2014, 10:21 When should growing inequality concern us? This is a moral and political question. It is also an economic one. It is increasingly recognised that, beyond a certain point, inequality will be a source of significant economic ills. The United States – both the most important high-income economy and much the most unequal – is providing a test bed for the economic impact of inequality. The results are worrying. This realisation has now spread to institutions that would not normally be accused of socialism. A report written by the chief US economist of Standard & Poor’s, and another from Morgan Stanley, agree that inequality is not only rising but having damaging effects on the US economy. According to the Federal Reserve, the upper 3 per cent of the income distribution received 30.5 per cent of total incomes in 2013. The next 7 per cent received just 16.8 per cent. This left barely over half of total incomes to the remaining 90 per cent. The upper 3 per cent was also the only group to have enjoyed a rising share in incomes since the early 1990s. Since 2010, median family incomes fell, while the mean rose. Inequality keeps rising. The Morgan Stanley study lists among causes of the rise in inequality: the growing proportion of poorly paid and insecure low-skilled jobs; the rising wage premium for educated people; and the fact that tax and spending policies are less redistributive than they used to be a few decades ago. Thus, in 2012, says the Organisation for Economic Co-operation and Development, the US ranked highest among the high-income countries in the share of relatively low- paying jobs. Moreover, the bottom quintile of the income distribution received only 36 per cent of federal transfer payments in 2010, down from 54 per cent in 1979. Regressive payroll taxes, which cost the poor proportionally more than the rich, are projected to raise 32 per cent of federal revenue in fiscal year 2015, against 46 per cent for federal income tax, the burden of which falls more on higher earners. Relative pay of executives Also important are huge increases in the relative pay of executives, together with the shift in incomes from labour to capital. The Federal Reserve’s policies have also benefited the relatively well off; it is trying to raise the prices of assets which are overwhelmingly owned by the rich. These reports bring out two economic consequences of rising inequality: weak demand and lagging progress in raising educational levels. The argument on demand is that, up to the time of the crisis, many of those who were not enjoying rising real incomes borrowed instead. Rising house prices made this possible. By late 2007, debt peaked at 135 per cent of disposable incomes. Then came the crash. Left with huge debts and unable to borrow more, people on low incomes have been forced to spend less. Withdrawal of mortgage equity, financed by 156

borrowing, has collapsed. The result has been an exceptionally weak recovery of consumption. It makes no sense to lend recklessly to those who cannot afford it. Yet this suggests that the economy will not become buoyant again without a redistribution of income towards spenders or the emergence of another source of demand. Unfortunately, it is not at all clear what the latter might be. Government spending is constrained. Business investment is curbed by weak prospective growth of demand. It is also unlikely to be net exports: everybody else wants export-led growth, too. American education has also deteriorated. The US is the only high-income country whose 25- to 34-year-olds are no better educated then its 55- to 64-year-olds. This is partly because other countries have caught up with the US, which pioneered mass college education. It is also because children from poor backgrounds are handicapped in completing college. The S&P report notes that for the poorest households college graduation rates increased by only about 4 percentage points between the generation born in the early 1960s and that born in the early 1980s. The graduation rate for the wealthiest households increased by almost 20 percentage points over the same period. Yet, without a college degree the chances of upward mobility are now quite limited. As a result, children of prosperous families are likely to stay well-off and children of poor families likely to remain poor. Unfulfilled talents This is not just a problem for those whose talents are not fulfilled. The failure to raise educational standards is also likely to impair the economy’s longer- term success. Some of the returns to education may just be the reward to obtaining a positional good: the educated do better because they have won a zero- sum race. Yet a better-educated population would also raise everybody to a higher level of prosperity. The costs to society of rising inequality go further. To my mind, the greatest costs are the erosion of the republican ideal of shared citizenship. As the US supreme court seeks to bend the constitution to the will of plutocrats, the peril is to the politically egalitarian premises of the republic. Enormous divergences in wealth and power have hollowed out republics before now. They could well do so in our age. Yet even for those who do not share such concerns, the economic costs should matter. The “secular stagnation” in demand, to which Lawrence Summers, the former US treasury secretary, has referred, is related to shifts in the distribution of income. Equally, the transmission of educational disadvantages across the generations is also a growing handicap to the economy. A debt-addicted economy with stagnant levels of education is likely to fare ill in future. – (Copyright The Financial Times Limited 2014) © 2014 irishtimes.com http://business.einnews.com/article/226708378/J- 1Y5ba7atQOzEAA

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vox Research-based policy analysis and commentary from leading economists Helicopter money: The best policy to address high public debt and deflation Biagio Bossone, Thomas Fazi, Richard Wood01 October 2014 High debt and deflation have afflicted Japan, the Eurozone, and the US. However, the implemented so far monetary and fiscal policies have been disappointing. This column discusses the importance of helicopter money in the form of overt monetary financing in addressing these problems. The overt money financing is the policy with highest impact in raising demand and output without increasing public debt and interest rates. Related// Unconventional monetary policies revisited (Part II) Biagio Bossone/ Unconventional monetary policies revisited (Part I) Biagio Bossone/ Helicopter money as a policy option Lucrezia Reichlin, Adair Turner, Michael Woodford/ Helicopter moneyStephen Grenville The G20 leaders may well endorse a higher ‘growth target’ at their November meeting in Australia, but they will be incapable of agreeing to the monetary/fiscal policy combination that is required to substantially lift aggregate consumer demand and economic growth. Fiscal and monetary policy coordination is required for economic recovery The IMF is reportedly examining 900 structural/infrastructure policies, and more will be needed to reach growth targets. However, the required locomotive power to substantially lift consumer demand is far and away beyond that which can be harnessed from supply-side policies. However, a mere handful of well-chosen, coordinated macroeconomic policies could ensure success. Current policies are not working Germany is now running both a budget surplus and a large current account surplus, thus providing none of the powerful locomotive potential it could provide to revive the Eurozone block. There are also growing concerns ─ including at the Bank of International Settlements and the Financial Stability Board ─ that the ultra-low interest rate policies adopted by Japan and the US are creating large risks in the form of the mispricing of risk, asset overvaluation, downward price dynamics, and a new financial crisis. Quantitative easing (QE) has raised asset prices, but the new money has failed to stimulate spending and inflationary expectations to the extent that was originally anticipated. Helicopter money and overt money financing As provocatively discussed by Friedman (1969), helicopter money is a policy whereby new money is created by the central bank and provided directly to households and

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private businesses. Grenville (2013) notices that central banks have no mandate to give money away (they can only exchange one asset for another), and that such decisions need to be backed by the budget-approval process. In most countries, therefore, central banks cannot conduct helicopter money operation on their own -- helicopter money must essentially involve fiscal policymaking.1 Buiter (2014) focusses on the application of helicopter drops through overt monetary financing, whereby the central bank creates new money to finance a fiscal stimulus. He identifies the conditions under which such a helicopter drop increases aggregate demand. One of these conditions is the irreversibility of the new money base stock creation, which constitutes a permanent addition to the total net wealth of the economy, which is made possible by the (‘fiat’) money base being an asset for the holder but not a liability for the issuer (Buiter 2004). Such irreversibility can be attained if overt monetary financing operations are executed by either of two routes. • The first is by having the government issue interest bearing debt, which the central bank would buy and hold in perpetuity, rolling over into new government debt when the existing debt on its balance sheet reaches maturity. In this case, the government would face a debt interest servicing cost, but the central bank would make an exactly matching profit from the difference between the interest rate it receives on its debt and the zero cost of its money liabilities, and would return this profit to the government. • A second route is by having the central bank buy government securities which are explicitly non-interest bearing and never redeemable. In terms of the fundamentals of money creation and government finance, the choice of these two routes would make no difference (Turner 2013). Note that the irreversibility condition has nothing to do with the fact that, at any future date, the central bank might decide to withdraw part or all of the liquidity injected in the system by selling its own bonds. In this case, the holders of liquidity would exchange it for the bonds sold by the central bank, but the total net worth of the economy would not change, only its composition would (shifting from more to less liquid assets). The addition to the economy’s net worth originally operated through the overt monetary financing would not be undone by any new open market operation. Note that where overt money financing operations are run by the Treasury, without involving the central bank (see below), none of the two routes above is necessary, since the Treasury directly finances the budget by issuing money or a money-like instrument. Overt money financing In relation to overt money financing, we claim the following: • First, it is the combination of monetary and fiscal policy that has the greatest impact in raising demand and output (McCully and Pozsar 2013, Turner 2013). • Second, overt money financing is most likely to turn deflation into inflation in the shortest time. Unlike QE, it flows to households with a relatively high marginal propensity to consume ordinary goods and services. Hence, demand 159

and consumer goods prices both rise relatively early under overt money financing. • Third, overt money financing does not trigger Ricardian Equivalence effects (in contrast with conventional bond financing) since the intertemporal budget constraint of the state is permanently relaxed by the corresponding new money stock. • Fourth, it creates no rise in interest rates and hence there is no crowding-out. • Fifth, it always increases demand (Buiter 2014). • Finally, and most importantly, overt money financing involves no increase in public debt, whereas conventional bond financing does. Central banks and public debt Government bonds held by the central bank are usually counted as part of general government debt (public debt). Indeed, this might be considered an anachronism since the central bank, as well as the Treasury, are both organs of the state. Conceptually, in a consolidated public-sector balance sheet there would be no new debt creation if the government received new money from the central bank to finance the state budget. However, this is not quite the case in reality, for a number of possible reasons. Where central banks are partly privately owned by commercial banks, there is a justifiable separation. Another justification may be that many central banks are ‘independent’ agencies, and separable from government influence. A third reason is that financial markets ‘see through’ the consolidated public-sector balance sheet and recognise that a central bank may sell government bonds to the private sector at any time. Not all helicopter drops are created equal Except for the case where the central bank creates money to finance the budget in exchange for new government bonds, helicopter drops do not cause the public debt to increase. This equally holds when: • New helicopter money flows from the central bank directly into the private bank accounts of individuals and businesses (see, for instance, Kimball 2012). • Overt money financing operations are implemented under the two routes above (Bossone and Wood 2013) • The Treasury (not the central bank) issues new money and uses it to finance its own budget (Wood 2012). • The Treasury (not the central bank) issues a pseudo-money instrument to finance tax cuts (Bossone et al. 2014). The first two cases require a great deal of coordination between a (possibly) independent central bank and the Treasury, implying that they have to come to an agreement in order to engineer an overt money financing operation. On the other hand, the third and fourth cases do not involve the central bank, thus simplifying overt money financing execution; yet, the government needs to exert a great sense of fiscal discipline in order to avert the risk of abusing the money financing. Why is all this important? 160

The issues discussed in this article are important for a number of reasons. First, if the above taxonomy is not clearly understood, then the policy of overt money financing could be misinterpreted, and its significance not appreciated, including by key policymakers who have, to date, seemingly turned a blind eye to it. Second, QE has failed to deliver what was promised and is likely to be disruptive as ‘normal’ interest rates are restored. A new approach to monetary policy needs to be developed to impact consumer demand much more rapidly. Third, as the case of Japan -- where the public debt level is very large – shows, successive rounds of QE and bond-financed budget deficits do not prove effective. Fourth, the afflicted countries just survived the global financial crisis. However, with public debt already at danger levels, they are currently incapable of responding to any new crisis that may emerge by using large-scale conventional bond financed deficit spending. Fifth, Eurozone countries are again sliding into depression and deflation. Current policies need to be radically altered to create the requirements for widespread and strong economic recovery. Finally, there has been much conjecture about whether or not some advanced countries have entered an era of ‘secular stagnation’ (Teulings and Baldwin 2014). Overt money financing offers the most effective monetary and fiscal policy response to secular stagnation. References Bossone B (2013), “Unconventional Monetary Policies Revisited (Part I)”, VoxEU.org, 4 October. Bossone B (2013), “Unconventional Monetary Policies Revisited (Part II)”, VoxEU.org, 5 October. Bossone B, M Cattaneo and G Zibordi (2014), “Which Options for Mr. Renzi to Revive Italy and Save the Euro?” Economonitor, 3 July. Bossone B and R Wood (2013), “Overt Money Financing: Navigating Article 223 of the Lisbon Treaty”, EconoMonitor, 22 July. Buiter W H (2004) ‘Helicopter Money: Irredeemable Fiat Money and the Liquidity Trap’, NBER, Working Paper 10163. Buiter W H (2014), “The Simple Analytics of Helicopter Money: Why it Works – Always”, Economics, Vol. 8, 2014-28. Friedman M (1969), “Optimum Quantity of Money”, Aldine Publishing Company. 1969. p. 4. Grenville S (2013), “Helicopter Money”, VoxEU.org, 24 February. Kimball M (2012), “Getting the Biggest Bang for the Buck in Fiscal Policy”, Confessions of a Supply-Side Liberal, May 29, 2012. McCulley P and Z Pozsar (2013), “Helicopter Money: Or How I Stopped Worrying and Love Fiscal-Monetary Cooperation”, Global Society of Fellows, 7 January. 161

Teulings C and R Baldwin (eds.) (2014), “Secular Stagnation: Facts, Causes, and Cures”, A VoxEU.org eBook, 10 September, CEPR Press. Turner A (2013), “Debt, Money and Mephistopheles: How Do We Get Out of This Mess”, Cass Business School Lecture, 6 February. Wood R (2012), “The Economic Crisis: How to Stimulate Economies Without Increasing Public Debt”, CEPR Policy Insight No.62, August. Footnote 1 Buiter (2014) considers the ECB as one possible exception in particular circumstances. http://www.voxeu.org/article/helicopter-money-today-s-best-policy-option

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ft.com Comment The Big Read September 30, 2014 6:47 pm Asset-backed securities: Back from disgrace By Christopher Thompson and Claire Jones The ECB is pinning its hopes on a discredited symbol of pre-crisis financial engineering to kick-start growth

©Reuters Back in the swing of things: Mortgage-backed securities account for about two-thirds of the ABS market When Ian Bell visited the European Commission in the dark days after the global financial crisis to lobby for “high-quality” asset-backed securities, the veteran financial analyst was given short shrift. The packages of loans that were sliced and diced and sold off to investors had become one of the symbols of the type of financial engineering that brought on the worst economic crisis since the Great Depression. “They would listen politely and say, ‘thanks for coming – don’t call us, we’ll call you’,” says Mr Bell, the head of the Prime Collateralised Securities secretariat, a body set up in London to monitor the quality of ABS after the crisis. More ON THIS STORY// Hans-Werner Sinn Draghi’s meddling/ Euro drops as inflation hits new low/ Markets Insight Draghi brings out ABS rocket boosters/ ECB to press ahead with ABS-buying plan/ Eurozone recovery stutters in September

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ON THIS TOPIC// Global Market Overview Euro tumbles on ECB easing speculation/ Huw van Steenis Flexible funding needed/ Draghi pushes ECB to take ‘junk’ loan bundles/ Outlook Focus switches to eurozone data IN THE BIG READ// End of the Iron Age/ Race for Brazil’s driving seat/ Alibaba Weapons of mass ecommerce/ Russia Putin’s power politics By late 2013, however, the policy makers were inviting him back to Brussels. “When I arrived they were sitting in a room with pads and pens saying, ‘high-quality securitisation – how can we make it work?’” The reason for the volte-face is simple enough: two years on from the promise by Mario Draghi, president of the European Central Bank, to do“whatever it takes” to save the euro, Europe is teetering on the brink of economic stagnation and a triple-dip recession.

Mr Draghi gave the eurozone a much-needed respite, pushing euro borrowing costs for banks and governments to record lows. But as concerns have grown in recent months about deflation, Mr Draghi has realised that more radical intervention is needed. He says a reinvigorated ABS market will allow banks to start lending again to struggling small- and medium-sized businesses. The ECB is expected to announce details on Thursday in Naples of an ambitious plan to buy hundreds of billions of euros of repackaged debt in order to kick-start bank lending. “Assets only recently branded as toxic are being heralded as potential saviours,” says Andrew Jackson, chief investment officer at Cairn Capital. Supporters say a revival in the eurozone’s moribund ABS market would allow banks to trim their bloated balance sheets and free up capital for lending. This would allow smaller companies to borrow money to invest in their businesses. But it would also entail unprecedented levels of credit exposure for the ECB. Mortgage-backed securities account for about two-thirds of the ABS market. “The ECB is taking a bet on the credit market and, by opening to mortgage-backed purchases, especially the housing market, which has potentially powerful fiscal implications for the eurozone area,” says Carlo Altomonte, a professor of economics of

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European integration at Bocconi University in Milan. “But with the ECB having used many of its other tools, with arguably little effect, the question is whether it is a risk worth taking?” The plan has powerful critics. Last week, Wolfgang Schäuble, Germany’s finance minister, voiced his unease. “I am not particularly happy about the debate started by the ECB about the purchase of securitisation products,” he told the Bundestag. Since mid-2012, as ABS volumes flatlined, eurozone banks have tried to shrink their balance sheets by cutting lending. Loans to non-financial corporations fell by 8.5 per cent collectively, or by €400bn, over the period, according to ECB figures. The ECB and Bank of England consider a revival of the market as a way of transforming European finance from a system based on bank loans to a US-style system weighted more in favour of capital markets. Europe’s bank dependence is stark: banks account for nearly 80 per cent of corporate loans compared with about 50 per cent in the US. With a greater variety of non-bank sources of finance, businesses’ access to credit is not solely tied to the fortunes of their high street bank. Proponents of the plan point to the US programme of asset purchases as evidence that it can work in Europe. The US Federal Reserve has $1.7tn in mortgage-backed securities on its balance sheet as a result of its buying programme since 2009, leading to a sharp rebound in US ABS volumes. The ability to sell historic debts has given banks more lending capacity. Commercial and industrial loans, for example, have risen by 45 per cent to $1.74tn since late 2010, according to Federal Reserve figures. BlackRock, which has worked for the New York Federal Reserve and the central banks of Ireland and Greece, is helping the ECB design the programme. “The key takeaway [from the US] is ‘build it and they will come’,” says Jim Caron, managing director at Morgan Stanley Investment Management. “There were many questions about who would invest and would it work. But once the government started to buy [MBS] it kick-started other forms of lending and moved collateral away from banks to non-banks.” There is also evidence that Europe’s inventory of ABS is in better condition than that of the US, where default rates were much worse. Of more than 9,000 European ABS notes issued during the past decade, only 2 per cent have defaulted or are likely to realise future losses, according to Moody’s Investors Service, compared with about a fifth of US ABS. European ABS tend to have long maturities and thus underlying loan values benefited from economic stabilisation in the aftermath of the crisis. . . . Nevertheless, Mr Draghi said the ECB would only buy products that were “simple, transparent and real”. The ECB president wants to use the purchases in tandem with his bank’s offer of cheap four-year loans to expand its balance sheet by up to €1tn during the next two years.

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In part this is because new ABS issuance has fallen so sharply since the crisis – from an annual peak of $539bn in 2006 to $75bn last year, according to Dealogic – that there are questions as to whether the ECB could buy enough to make a difference. The ECB could start with ABS backed by SME, consumer and car loans, of which there is €300bn outstanding, according to Royal Bank of Scotland. Expanding to include mortgage- backed ABS, which are “simple and transparent”, means a market of €850bn. “It’s the spark which should kick-start the market,” says Alberto Gallo, head of European macro credit at RBS. “The programme could start small with purchases over many quarters of both existing and new ABS.” Most existing ABS are held by banks as collateral in exchange for ECB loans. If the ECB included all banks’ outstanding loans and mortgages that could be feasibly packaged, the potential ABS could be €3tn, according to estimates by Prof Altomonte and Patrizia Bussoli, an asset manager at Fideuram. But there are doubts over whether banks will take the ECB up on its offer. The central bank has already injected more than €1tn of cheap liquidity into banks since 2011 to stave off another financial crisis, and last month it offered an additional €400bn in cheap four-year loans. Only €82bn was taken up. “What difference will it make replacing one source of cheap liquidity with another? It’s just left pocket to right pocket,” says a London-based ABS banker. “Banks are already flush with liquidity but they still have to lend it on.” The picture is further complicated by new regulations in the wake of the financial crisis, which mandate steep capital charges – the amount of capital retained in order to cover potential losses – for ABS relative to other assets. The riskier the ABS tranche, the higher the corresponding capital charge. This discourages banks from packaging ABS – and also deters investors. For example, under proposed rules, insurers that invest in even the safest ABS have to put aside more than double the amount of capital than for an equivalent corporate bond. As a result, demand for ABS has slumped. Yves Mersch, a member of the ECB’s executive board, likens the regulation to “calibrating the price of flood insurance on the experience of New Orleans for a city like Madrid”.

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A crucial plank of the purchase programme is the ECB’s pledge to buy the riskier “mezzanine” tranches, albeit only with a government guarantee. Mr Draghi has signalled the central bank will not take too much risk on to its balance sheet without the backing of lawmakers. Without finance ministers’ agreement to guarantee any losses on purchases of the mezzanine slices, the ECB would be confined to buying only the safest senior tranches. The snag for banks is that the senior tranches are so safe that the ECB’s purchases of them would do little to free up space for more lending.

“ You need a plan to deal with the riskiest ABS tranches that provide the most capital relief,” says Mr Bell. “If the ECB just buys senior tranches the programme simply becomes another tool for funding – and arguably a less attractive one than the alternative programmes the ECB have in place.” Early indications are that Germany and France will reject calls for guarantees for the riskier slices of the loans. In a leaked paper from Paris and Berlin, both governments rejected calls for governments to stand behind the ECB’s purchases. Such an intervention would, the paper argued, be “problematic”. “Investors could be tempted to rely on the guarantee rather than to conduct their due diligence by examining the transaction and underlying assets, and it would be very difficult for the public sector to disengage without undermining the market,” the paper said. . . . If the aim is to stimulate commercial lending to SMEs, the ability to package and resell the riskier tranches of ABS is crucial, analysts say. Owing to the variety of sectors in which they operate and their vulnerability to economic downturns, such loans are generally considered riskier than mortgages, for example. Given the battering smaller companies took during the crisis, their balance sheets have lower-quality collateral, says Mr Altomonte. “Moreover, the quality of financial information reported in balance sheets is in general less regular and accurate, and different across member states, implying a more complex assessment of the probability that loans will be repaid.” 167

Mr Draghi has made clear he wants to do more to support struggling eurozone economies but he appears to be running out of options. “ABS is not a quick fix but there isn’t much else left for Draghi to choose from,” said Mr Gallo. ------Historic loans: From Frederick the Great to the Bowie Bond In their most basic form, asset-backed securities – in which the debt is backed by a specific underlying pool of revenue-generating assets – originated in Europe more than 200 years ago. In the late 18th century, following the devastating seven years war, Frederick the Great introduced the pfandbriefe system, which issued bonds backed by revenues from land estates to ease a contemporaneous credit crisis among Prussia’s nobility. Modern ABS originated in the US mortgage market in the 1970s when the government, through its agency known as Ginnie Mae, guaranteed the first mortgage securities that passed through the mortgage principal and interest payments to investors rather than banks. This “pass through” mechanism allowed banks to pool mortgages and loans that could be sold on, freeing up their balance sheets and minimising their exposure to rising interest rates. By allowing mortgages to be packaged and sold, bolstered by official guarantees, the US government wanted to encourage banks to increase mortgage credit to consumers and boost home ownership. Annual issuance of US mortgage-backed securities rose from zero in 1970 to $1.2tn in 2006. In the process issuers also sliced ABS packages into different tranches based on the underlying risks of particular loan pools. The safest tranche was termed “senior” and investors could expect to be paid first in the event of default. Behind senior lay “mezzanine” and then “equity”, which reflected the riskiest loans but paid the highest interest rates. The asset class expanded to package revenues from other loans, including corporate loans, student loans, car purchase loans and credit card borrowings. In 1997 the singer David Bowie helped launch one of the first ABS backed by intellectual property when he bundled royalties from his albums to issue a “Bowie bond”. However, the market’s spectacular growth came to an abrupt end when, in 2008, heavy losses in complex and opaque ABS, mostly backed by US subprime mortgages, triggered financial panic. http://www.ft.com/intl/cms/s/0/7d9d25f0-4729-11e4-ba74- 00144feab7de.html#axzz3EnXyN5sD

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ft.com Comment Opinion September 30, 2014 4:59 pm Europe needs a more flexible financial market By Huw van Steenis Europe needs to channel non-bank funding to businesses and infrastructure, writes Huw van Steenis The European Central Bank’s plan to inject €1tn into the eurozone’s ailing economy may provide a welcome boost, but it will not fix the structural flaws in Europe’s financial system. The problem is an over-reliance on lending by banks, whose balance sheets remain four times the size of the currency zone’s gross domestic product – far larger than elsewhere in the west. Jean-Claude Juncker, president-elect of the European Commission, has given full- blooded endorsement for the idea of creating a “capital markets union”. This slogan – shorthand for financing more of Europe’s economy using markets rather than banks – could become an important spur to growth. More ON THIS STORY// Asset-backed securities Back from disgrace/ Hans-Werner Sinn Draghi’s meddling/ Euro drops as inflation hits new low/ Markets Insight Draghi brings out ABS rocket boosters/ ECB to press ahead with ABS-buying plan ON THIS TOPIC// Global Market Overview Euro tumbles on ECB easing speculation/ Draghi pushes ECB to take ‘junk’ loan bundles/ Outlook Focus switches to eurozone data/ Investors shun eurozone equity funds IN OPINION// Chandran Nair Modi’s challenge/ Philippe Lamberts Juncker’s jokers/ Martin Feldstein Spend more to beat Isis/ Lilia Shevtsova Putin in the corner Making this a reality will be one of the most important tasks facing Lord Hill should he be confirmed as the EU commissioner overseeing Europe’s financial sector. We need to find new ways to channel non-bank finance to businesses and infrastructure projects which will require some significant changes to Europe’s market plumbing as well as the approach of policy makers to markets. Mid-sized companies need to be able to tap long-term savings via a new private placement market that gives them access to long-term cheap finance. In the US, 80 per cent of long-term company finance is provided by investors; in the eurozone it is 30 per cent. It is not just about providing cheaper debt. Europe’s growing companies also need access to the equity market, from venture capital through to stock exchanges. The commission should also lay out plans for project bonds for infrastructure, perhaps along the lines of North American municipal bond markets. Banks have traditionally played a major role in funding infrastructure, but new Basel rules strongly disincentivise this. Given the EU itself estimates it may need €1tn to finance such projects by 2020, a strong focus is needed to develop the right bond structure, transparency and tax treatment. 169

Enabling banks to sell small business loans directly to investors could also provide a boost to lending capacity, but post-crisis rules make this far more difficult. Thoughtful recalibration of the regulations, along lines that the ECB and the Bank of England are already investigating, could give banks more capacity to lend to SMEs. There must also be a reconsideration of regulatory barriers that constrain investors from providing long-term finance. It is unfortunate that new rules imposed on insurers and pension funds, Europe’s largest pool of long-term savings, have discouraged them for funding the real economy. For example, Solvency 2, the new rule book for insurers, makes it economically unappealing to fund an infrastructure project or buy a package of small business loans. The accounting treatment of longer-term assets poses further problems. Lord Hill should also consider a regulatory framework that enables specialist lenders, such as peer-to-peer lending, to grow. To reduce the cost of funding for countries in southern Europe, the new commissioner should also focus on clearing some of the roadblocks that hold up flows of credit. An obvious one would be to narrow the massive differences in bankruptcy procedures where it can take five-10 years to recover bad debts in the Italian courts. (In some other countries, the same work can be completed in two years.) The ECB’s actions to unclog eurozone lending through stress-testing banks and offering cheap loans need to be reinforced with structural reforms. Allowing investors to help finance Europe’s growth directly could be far more transformational in fuelling the eurozone’s recovery. The writer is head of European financial services research at Morgan Stanley http://www.ft.com/intl/cms/s/0/7b43a8ee-3f5c-11e4-984b- 00144feabdc0.html#axzz3EnXyN5sD

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vox Research-based policy analysis and commentary from leading economists Offshoring and skill-biased technical change Daron Acemoglu, Gino Gancia, Fabrizio Zilibotti30 September 2014 Offshoring of production can have a deep impact on the wages and welfare of workers with different abilities through its effect on technological progress. This column argues that, when labour is sufficiently cheap abroad, firms have incentives to offshore low- skill tasks and invest in skill-biased technologies at home. Over time, however, offshoring raises foreign wages. This increases demand for all firms and makes innovations complementing low-skill workers more profitable. As a result, offshoring can eventually lead to higher wages for everybody and less inequality. Related// Offshoring and innovation in emerging economies Ursula Fritsch, Holger Görg/ Offshoring firms innovate more: Evidence from European manufacturers Bernhard Dachs, Bernd Ebersberger, Steffen Kinkel, Oliver Som/ Effects of offshoring on jobs and skills: Evidence from Japan Yasuyuki Todo/ Services offshoring increases wage inequality Holger Görg, Ingo Geishecker, Christiane Krieger-Boden Offshoring, the demand for skill, and biased innovations The rapid rise of offshoring has been one of the most visible trends in the US labour market over the last three decades. Despite its prevalence, the implications for wages and skill premia are still debated (see, for instance, Grossman and Rossi-Hansberg 2008 and Baldwin and Robert-Nicoud 2014). The production structure of Apple’s iPod illustrates some of the potential effects. Like many other high-tech products, the iPod is designed in the US and is made of components produced all over the world and assembled in China. Though most production jobs are offshored, a significant number of high-skill engineering jobs and low-skill retail jobs are created in the US, and more than 50% of the value added of the iPod is captured by domestic companies. With more limited offshoring, some of the production jobs may have stayed within the US borders, increasing the demand for the services of low-skill production workers. But this would have also increased the cost and price of iPods, reducing employment not only in engineering and design occupations but also in retail and other related tasks. In Acemoglu et al. (2014), we study the impact of offshoring on wages of high- and low-skill workers through its effect on technological progress. Returning to the example of Apple products, the variety of iPods may not have been profitable to introduce and develop if labour costs were higher – as they would have been without offshoring. More importantly, iPods and other products may have been designed differently in the face of these different labour costs.

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To study these issues, we build a model where an advanced country (the ‘West’) invests in innovation to boost the productivity of either high-skill or low-skill workers, and can pay an offshoring cost to relocate part of production to a skill-scarce, low-wage country (the ‘East’). Offshoring, innovation, and the skill premium: An inverted-U relationship As in models of directed technical change (e.g. Acemoglu 2002, 2007), the effect of offshoring on the factor-bias of innovation works through price and market-size effects. By lowering the cost of tasks performed by low-skill workers, offshoring opportunities increase the relative price of skill-intensive products. This price effect tends to spur innovation in the skill-intensive sector. Counteracting this, however, offshoring opportunities expand the market for technologies used by low-skill labour. This market- size effect tends to induce innovations in less skill-intensive sectors. Our key finding is that which force dominates depends on the level of offshoring. In the most plausible scenario, for low levels of offshoring (i.e. when offshoring is initially expensive), the price effect dominates, so that greater offshoring opportunities initially induce skill-biased technical change. If the level of offshoring is already high (i.e. when the offshoring cost is sufficiently low), however, the opposite pattern obtains. Thus, the inequality-promoting effect of offshoring is greatest at the beginning. The reason for this switch in the direction of technological progress is that more offshoring increases the demand for labour abroad and thus wages in the East. In turn, the closing of the wage gap between countries mutes the price effect that was fuelling skill-biased innovation. The impact of offshoring on technology yields new implications for the evolution of the skill premium. Not surprisingly, offshoring first increases wage inequality in the West. However, as offshoring continues, technical change eventually changes direction and may even lower the skill premium. Under mild conditions, the same pattern can hold in the East as well. But which scenario is more plausible? To address this question, we calibrated the model to roughly match wages and offshoring in the US and China. The results of our simulations suggest that, during the period 2000–2008, offshoring may have increased the skill premium by 10% and marginally eroded the real wage and welfare of US low- skill workers. Conclusion The predictions of our model are broadly consistent with the available evidence. The first wave of offshoring in the 1980s coincides with a sharp decline in the real wages of US low-skill workers, but as offshoring continues to expand in the late 1990s and 2000s, unskilled wages stabilise and begin rising (e.g. Acemoglu and Autor 2011). Moreover, the finding that offshoring may have triggered skill-biased technical change, thereby raising wage disparities, is consistent with recent findings that imports from China encouraged investments in information technology (Bloom et al. 2011) and reduced US employment (Autor et al. 2013). According to the theory, however, the implications of offshoring are very different once its volume reaches a critical level. If wages in China keep rising at current rates, further offshoring may soon induce innovation in less skill-intensive sectors. Thus, the future distributional effects of offshoring could be quite different from its past impact. 172

References Acemoglu, D (2002), “Directed Technical Change”, Review of Economic Studies, 69: 781–809. Acemoglu, D (2007), “Equilibrium Bias of Technology”, Econometrica, 75: 1371– 1410. Acemoglu, D and D Autor (2011), “Skills, Tasks and Technologies: Implications for Employment and Earnings”, in Handbook of Labor Economics, 4: 1043–1171. Acemoglu, D, G Gancia, and F Zilibotti (2014), “Offshoring and Directed Technical Change”, American Economic Journal: Macroeconomics, forthcoming. Autor, D, D Dorn, and G Hanson (2013), “The China Syndrome: Local Labor Market Effects of Import Competition in the United States”, American Economic Review, 103: 2121–2168. Baldwin, R and F Robert-Nicoud (2014), “Trade-in-goods and trade-in-tasks: An integrating framework”, Journal of International Economics, 92: 51–62. Bloom, N, M Draca, and J Van Reenen (2011), “Trade Induced Technical Change: The Impact of Chinese Imports on Innovation and Productivity”, NBER Working Paper 16717. Grossman, G and E Rossi-Hansberg (2008), “Trading Tasks: A Simple Theory of Offshoring”, American Economic Review, 98: 1978–1997. http://www.voxeu.org/article/offshoring-and-skill-biased-technical-change

Acemoglu, D, G Gancia, and F Zilibotti (2014), “Offshoring and Directed Technical Change”, American Economic Journal: Macroeconomics, forthcoming, version previa en: http://www.crei.cat/people/gancia/Acemoglu_Gancia_Zilibotti_June24_2014.pdf

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Now Is a Good Time to Invest in Infrastructure

Posted on September 30, 2014 by iMFdirect By Abdul Abiad, Davide Furceri, and Petia Topalova Infrastructure is the backbone of well-functioning economies. Unfortunately, that backbone is becoming increasingly brittle in a number of advanced economies. For example, there has been a decline in the overall quality of infrastructure in the United States and Germany (Figure 1; see the FT 2014 and ASCE 2013 for more in infrastructure in the U.S., and Der Speigel 2014 and Kunert and Link 2013 for Germany). In many emerging market and developing economies, the expansion of the backbone has not kept pace with the broader economy, and this is stunting the ability of these economies to grow.

Our study—Chapter 3 in the October 2014 World Economic Outlook— examines the macroeconomic effects of public investment in a large number of countries and finds that in the current global environment of sub-par growth, there is a strong case for increasing public infrastructure investment in countries where conditions are right.

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A crumbling backbone The evolution of the stock of public capital—the most widely available proxy for infrastructure—suggests rising inadequacies in infrastructure provision. Public capital has declined significantly as a share of output over the past three decades in both advanced and developing countries (Figure 2). In advanced economies, public investment was scaled back from about 4 percent of GDP in the 1980s to 3 percent of GDP at present (maintenance spending has also fallen, especially since the financial crisis). In emerging market and developing countries, sharply higher public investment in the late 1970s and early 1980s raised public capital stocks, but since then public capital relative to GDP has fallen.

Road to prosperity Does investing in infrastructure really pay off? In our study, which uses a combination of empirical analysis and model simulations, we find that increased public infrastructure investment can have powerful effects on the macroeconomy. It raises output in the short term by boosting demand and in the long term by raising the economy’s productive capacity. In a sample of advanced economies, a 1 percentage point of GDP increase in investment spending raises the level of output by about 0.4 percent in the same year and by 1.5 percent four years after the increase (Figure 3, panel 1). In addition, the boost to

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GDP a country gets from increasing public infrastructure investment tends to offset the rise in debt, so that the public-debt-to-GDP ratio does not rise (Figure 3, panel 2). In other words, public infrastructure investment could pay for itself, if done correctly.

But the benefits depend on a number of factors. We find that the positive effects of increased public infrastructure investment are particularly strong if certain conditions are in place. • First, the short-term boost to output is substantially larger when public investment is undertaken during periods of economic slack and monetary policy accommodation, with the latter limiting the increase in interest rates in response to the rise in investment (Figure 4, panels 1 and 2). • Second, the output effects are bigger in countries with a high degree of public investment efficiency—where additional public investment spending is not wasted and is allocated to projects with high rates of return (Figure 4, panels 3 and 4). • Finally, public investment that is financed by issuing debt has larger output effects than when it is financed by raising taxes or cutting other spending (Figure 4, panels 5 and 6).

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A golden opportunity In this context, current conditions present a golden opportunity to increase public infrastructure investment in countries with infrastructure needs. In many advanced economies there is still substantial economic slack and interest rates are at historic lows—which means a bigger bang for the buck for such investment.

Now is also a good time for many emerging market and developing countries to boost infrastructure investment. Many of these economies may not have the economic slack as in advanced economies, and their public investment processes tend to be less efficient. As a result, increased infrastructure investment may lead to a smaller boost to output, and may even come at the cost of higher public debt. But if infrastructure bottlenecks have been constraining growth—which is the case in Brazil, India, the Philippines, and South Africa, just to name a few—the gains are still likely to be large. Clearly, the scope for investment and the efficiency of such investment differs across countries. However, our study finds that infrastructure investment can provide a powerful impetus for economic activity and jobs in countries So our bottom line?

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Now is a good time to invest in infrastructure. But invest well, where there is a clear need, and invest efficiently. Productive and efficient investment will provide a much- needed boost to output, both today and in the future. http://blog-imfdirect.imf.org/2014/09/30/now-is-a-good-time-to-invest-in- infrastructure/ Uneasy Money

Commentary on monetary policy in the spirit of R. G. Hawtrey

David Glasner I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual

Explaining the Hegemony of New Classical Economics

Published September 30, 2014 Keynes , microfoundations , New Classicals , New Keynesians , rational expectations , wage stickiness6 Comments Tags: Don Patinkin, Edmund Phelps, Mark Thoma, Paul Krugman, Robert Waldmann, Simon Wren- Lewis

Simon Wren-Lewis, Robert Waldmann, and Paul Krugman have all recently devoted additional space to explaining – ruefully, for the most part – how it came about that New Classical Economics took over mainstream macroeconomics just about half a century after the Keynesian Revolution. And Mark Thoma got them all started by a complaint about the sorry state of modern macroeconomics and its failure to prevent or to cure the Little Depression. Wren-Lewis believes that the main problem with modern macro is too much of a good thing, the good thing being microfoundations. Those microfoundations, in Wren- Lewis’s rendering, filled certain gaps in the ad hoc Keynesian expenditure functions. Although the gaps were not as serious as the New Classical School believed, adding an explicit model of intertemporal expenditure plans derived from optimization conditions and rational expectations, was, in Wren-Lewis’s estimation, an improvement on the old Keynesian theory. The improvements could have been easily assimilated into the old Keynesian theory, but weren’t because New Classicals wanted to junk, not improve, the received Keynesian theory. Wren-Lewis believes that it is actually possible for the progeny of Keynes and the progeny of Fisher to coexist harmoniously, and despite his discomfort with the anti- Keynesian bias of modern macroeconomics, he views the current macroeconomic research program as progressive. By progressive, I interpret him to mean that macroeconomics is still generating new theoretical problems to investigate, and that attempts to solve those problems are producing a stream of interesting and useful publications – interesting and useful, that is, to other economists doing macroeconomic research. Whether the problems and their solutions are useful to anyone else is perhaps not quite so clear. But even if interest in modern macroeconomics is largely confined to practitioners of modern macroeconomics, that fact alone would not conclusively show 178

that the research program in which they are engaged is not progressive, the progressiveness of the research program requiring no more than a sufficient number of self-selecting econ grad students, and a willingness of university departments and sources of research funding to cater to the idiosyncratic tastes of modern macroeconomists. Robert Waldmann, unsurprisingly, takes a rather less charitable view of modern macroeconomics, focusing on its failure to discover any new, previously unknown, empirical facts about macroeconomic, or to better explain known facts than do alternative models, e.g., by more accurately predicting observed macro time-series data. By that, admittedly, demanding criterion, Waldmann finds nothing progressive in the modern macroeconomics research program. Paul Krugman weighed in by emphasizing not only the ideological agenda behind the New Classical Revolution, but the self-interest of those involved: Well, while the explicit message of such manifestos is intellectual – this is the only valid way to do macroeconomics – there’s also an implicit message: from now on, only my students and disciples will get jobs at good schools and publish in major journals/ And that, to an important extent, is exactly what happened; Ken Rogoff wrote about the “scars of not being able to publish stick-price papers during the years of new classical repression.” As time went on and members of the clique made up an ever-growing share of senior faculty and journal editors, the clique’s dominance became self-perpetuating – and impervious to intellectual failure. I don’t disagree that there has been intellectual repression, and that this has made professional advancement difficult for those who don’t subscribe to the reigning macroeconomic orthodoxy, but I think that the story is more complicated than Krugman suggests. The reason I say that is because I cannot believe that the top-ranking economics departments at schools like MIT, Harvard, UC Berkeley, Princeton, and Penn, and other supposed bastions of saltwater thinking have bought into the underlying New Classical ideology. Nevertheless, microfounded DSGE models have become de rigueur for any serious academic macroeconomic theorizing, not only in the Journal of Political Economy (Chicago), but in the Quarterly Journal of Economics (Harvard), the Review of Economics and Statistics (MIT), and the American Economic Review. New Keynesians, like Simon Wren-Lewis, have made their peace with the new order, and old Keynesians have been relegated to the periphery, unable to publish in the journals that matter without observing the generally accepted (even by those who don’t subscribe to New Classical ideology) conventions of proper macroeconomic discourse. So I don’t think that Krugman’s ideology plus self-interest story fully explains how the New Classical hegemony was achieved. What I think is missing from his story is the spurious methodological requirement of microfoundations foisted on macroeconomists in the course of the 1970s. I have discussed microfoundations in a number of earlier posts (here, here, here, here, and here) so I will try, possibly in vain, not to repeat myself too much. The importance and desirability of microfoundations were never questioned. What, after all, was the neoclassical synthesis, if not an attempt, partly successful and partly unsuccessful, to integrate monetary theory with value theory, or macroeconomics with microeconomics? But in the early 1970s the focus of attempts, notably in the 1970 179

Phelps volume, to provide microfoundations changed from embedding the Keynesian system in a general-equilibrium framework, as Patinkin had done, to providing an explicit microeconomic rationale for the Keynesian idea that the labor market could not be cleared via wage adjustments. In chapter 19 of the General Theory, Keynes struggled to come up with a convincing general explanation for the failure of nominal-wage reductions to clear the labor market. Instead, he offered an assortment of seemingly ad hoc arguments about why nominal- wage adjustments would not succeed in reducing unemployment, enabling all workers willing to work at the prevailing wage to find employment at that wage. This forced Keynesians into the awkward position of relying on an argument — wages tend to be sticky, especially in the downward direction — that was not really different from one used by the “Classical Economists” excoriated by Keynes to explain high unemployment: that rigidities in the price system – often politically imposed rigidities – prevented wage and price adjustments from equilibrating demand with supply in the textbook fashion. These early attempts at providing microfoundations were largely exercises in applied price theory, explaining why self-interested behavior by rational workers and employers lacking perfect information about all potential jobs and all potential workers would not result in immediate price adjustments that would enable all workers to find employment at a uniform market-clearing wage. Although these largely search-theoretic models led to a more sophisticated and nuanced understanding of labor-market dynamics than economists had previously had, the models ultimately did not provide a fully satisfactory account of cyclical unemployment. But the goal of microfoundations was to explain a certain set of phenomena in the labor market that had not been seriously investigated, in the hope that price and wage stickiness could be analyzed as an economic phenomenon rather than being arbitrarily introduced into models as an ad hoc, albeit seemingly plausible, assumption. But instead of pursuing microfoundations as an explanatory strategy, the New Classicals chose to impose it as a methodological prerequisite. A macroeconomic model was inadmissible unless it could be explicitly and formally derived from the optimizing choices of fully rational agents. Instead of trying to enrich and potentially transform the Keynesian model with a deeper analysis and understanding of the incentives and constraints under which workers and employers make decisions, the New Classicals used microfoundations as a methodological tool by which to delegitimize Keynesian models, those models being insufficiently or improperly microfounded. Instead of using microfoundations as a method by which to make macroeconomic models conform more closely to the imperfect and limited informational resources available to actual employers deciding to hire or fire employees, and actual workers deciding to accept or reject employment opportunities, the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption, portraying it as nothing more than the consistent application of the rationality postulate underlying standard neoclassical price theory. For the New Classicals, microfoundations became a reductionist crusade. There is only one kind of economics, and it is not macroeconomics. Even the idea that there could be a conceptual distinction between micro and macroeconomics was unacceptable to Robert Lucas, just as the idea that there is, or could be, a mind not reducible to the brain 180

is unacceptable to some deranged neuroscientists. No science, not even chemistry, has been reduced to physics. Were it ever to be accomplished, the reduction of chemistry to physics would be a great scientific achievement. Some parts of chemistry have been reduced to physics, which is a good thing, especially when doing so actually enhances our understanding of the chemical process and results in an improved, or more exact, restatement of the relevant chemical laws. But it would be absurd and preposterous simply to reject, on supposed methodological principle, those parts of chemistry that have not been reduced to physics. And how much more absurd would it be to reject higher-level sciences, like biology and ecology, for no other reason than that they have not been reduced to physics. But reductionism is what modern macroeconomics, under the New Classical hegemony, insists on. No exceptions allowed; don’t even ask. Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment. UPDATE (11:43 AM EDST): I made some minor editorial revisions to eliminate some grammatical errors and misplaced or superfluous words. http://uneasymoney.com/2014/09/30/explaining-the-hegemony-of-new-classical- economics/

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ft.com Comment Opinion September 29, 2014 5:20 pm Merkel has a duty to stop Draghi’s illegal fiscal meddling By Hans-Werner Sinn The ECB is overstepping its mandate with anti-deflationary measures, writes Hans- Werner Sinn

©EPA Despite the Bundesbank’s protests, the European Central Bank is giving Europe’s banks a leg-up. To make them fit enough for the proposed banking union, the ECB proposes to relieve them of some of the potentially toxic loans they have extended to the private sector, which will be bundled into asset-backed securities and taken on to the central bank’s balance sheet. The ECB’s preference is to purchase the better tranches of these securities and leave the junk for the European Investment Bank. But since politicians are not playing along, the ECB will have to hold its nose – and complete its conversion into a bailout agency. The ECB began as a central bank that carried out monetary policy, providing liquidity for domestic uses. But when the financial crisis hit in 2008, banks in Ireland and southern Europe faced a dearth of foreign loans, on which they had come to depend. The ECB allowed national central banks in these countries to end the drought by lending even more money against ever-weaker collateral. This exercise in money creation went beyond what was needed to ensure domestic liquidity; €1tn in central bank credit was created out of thin air to settle foreign bills. The citizens of the six countries that were indulged in this way used the money to pay off their foreign debts and to purchase foreign goods. More ON THIS STORY// Wolfgang Münchau Germany’s eurosceptics/ Outlook Focus switches to eurozone data/ ECB’s asset plan takes political hit/ Draghi’s new weapon in war on deflation ON THIS TOPIC// Global Market Overview Euro tumbles on ECB easing speculation/ Euro drops as inflation hits new low/ Huw van Steenis Flexible funding needed/ Draghi pushes ECB to take ‘junk’ loan bundles IN OPINION// Chandran Nair Modi’s challenge/ Juncker’s pack of jokers needs reshuffle/ Martin Feldstein Spend more to beat Isis/ Lilia Shevtsova Putin in the corner 182

The ECB went on to instruct national central banks to grant crisis-afflicted states credit totalling €223bn under the so-called Securities Markets Programme. Mario Draghi, the ECB president, moreover offered unlimited protection for their government bonds, formalising his vow to do “whatever it takes” to save the euro under the rubric of “outright monetary transactions”. This lowered the interest rates at which overstretched eurozone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge. As comprehensive as these measures seemed, they may pale in comparison to what is now being considered. By directly granting credit to the private sector the ECB will enter a far larger arena. Mr Draghi has said that, as a first step, he intends to expand the ECB’s balance sheet by €1tn. The end of the property boom has left many private borrowers in southern Europe close to bankruptcy. The ECB’s plan to purchase their debt could end up transferring dozens if not hundreds of billions of euros from eurozone taxpayers to the creditors of these hapless individuals and companies. As UBS chief executive and former Bundesbank president Axel Weber has noted, the ECB is turning into a bad bank. The ECB says these unorthodox measures are needed to combat looming deflation. Given that prices are still rising (albeit slowly – core inflation stands at 0.9 per cent) this seems little more than a fig leaf. Anyway, deflation is not a danger for southern Europe but an essential precondition for restoring competitiveness. This is nothing less than a fiscal bailout – something the ECB has no right to undertake, as the German constitutional court implied when it declared OMT unlawful. Yet politicians may again keep their mouths shut about the ECB’s transgressions. Eurozone governments might even be thankful that the ECB is doing by stealth something for which they would otherwise have to seek permission from tight-fisted parliaments. Mr Draghi would never have dared to promise to do “whatever it takes” without the backing of the government heads of the day, and especially of German chancellor Angela Merkel. Mario Monti, Italy’s former prime minister, said as much this month. But Germany’s constitutional court has expressly prohibited the German government from sitting back while the ECB oversteps its mandate. If politicians do nothing, any German citizen can petition the court and force them to act. The writer is president of the Ifo Institute for Economic Research http://www.ft.com/intl/cms/s/0/09b1d31c-47c8-11e4-ac9f- 00144feab7de.html#axzz3EnXyN5sD

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Revisiting the Lehman Brothers Bailout That Never Was

By JAMES B. STEWART and PETER EAVIS SEPT. 29, 2014 Inside the Federal Reserve Bank of New York, time was running out to answer a question that would change Wall Street forever. At issue that September, six years ago, was whether the Fed could save a major investment bank whose failure might threaten the entire economy. The firm was Lehman Brothers. And the answer for some inside the Fed was yes, the government could bail out Lehman, according to new accounts by Fed officials who were there at the time. But as the world now knows, no one rescued Lehman. Instead, the firm was allowed to collapse overnight, a decision that, in cool hindsight, let problems at one bank snowball into a full-blown panic. By the time it was over, nearly every other major bank had to be saved. Why, given all that happened, was Lehman the only bank that was not too big to fail? For the first time, Fed officials have offered an account that differs significantly from the versions that, for many, have hardened into history. Related Coverage Fed Misread Crisis in 2008, Records ShowFEB. 21, 2014// Holding Off Disaster: The Race to Save LehmanOCT. 20, 2009// Tales From Lehman’s CryptSEPT. 12, 2009// Times Topic: Lehman Brothers Holdings Inc. Ben S. Bernanke, the Fed chairman at the time, Henry M. Paulson Jr., the former Treasury Secretary, and Timothy F. Geithner, who was then president of the New York Fed, have all argued that Lehman Brothers was in such a deep hole from its risky real estate investments that Fed did not have the legal authority to rescue it.

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Richard S. Fuld Jr., center, chief of Lehman Brothers, was heckled by protesters after testifying to Congress in October 2008 about the collapse.Credit Susan Walsh/Associated Press But now, interviews with current and former Fed officials show that a group inside New York Fed was leaning toward the opposite conclusion — that Lehman was narrowly solvent and therefore might qualify for a bailout. In the frenetic events of what has become known as the Lehman weekend, that preliminary analysis never reached senior officials before they decided to let Lehman fail. Understanding why Lehman was allowed to die goes beyond apportioning responsibility for the financial crisis and the recession that cost millions of ordinary Americans jobs and savings. Today, long after the bailouts, the debate rages over the Fed’s authority to bail out failing firms. Some Fed officials worry that when the next financial crisis comes, the Fed will have less power to shield the financial system from the failure of a single large bank. After the Lehman debacle, Congress curbed the Fed’s ability to rescue a bank in trouble. Whether to save Lehman came down to a crucial question: Did Lehman have enough solid assets to back a loan from the Fed? Finding the answer fell to two teams of financial experts at the New York Fed. Those teams had provisionally concluded that Lehman might, in fact, be a candidate for rescue, but members of those teams said they never briefed Mr. Geithner, who said he did not know of the results. “My colleagues at the New York Fed were careful and creative, and as demonstrated through the crisis that fall, we were willing to go to extraordinary lengths to try to protect the economy from the unfolding financial disaster,” Mr. Geithner said Monday in a statement to The New York Times. “We explored all available alternatives to avoid a collapse of Lehman, but the size of its losses were so great that they were unable to attract a buyer, and we were unable to lend on a scale that would save them.” Continue reading the main story Mr. Bernanke and Mr. Paulson said in recent interviews with The Times that they did not know about the Fed analysis or its conclusions. Interviews with half a dozen Fed officials, who spoke on the condition they not be named, so as not to breach the Fed’s unofficial vow of silence, suggest some Fed insiders believed that the government had the authority to throw Lehman Brothers a lifeline, even if the bank was nearly broke. The Fed earlier came to the rescue of Bear Stearns, after doing little analysis, and only days later saved the American International Group. The government subsequently saved the likes of Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. Ultimately, whether Lehman should have gotten Fed support was a judgment call, not a matter of strict statute, these people said. http://www.nytimes.com/2014/09/30/business/revisiting-the-lehman-brothers- bailout-that-never- was.html?hpw&rref=business&action=click&pgtype=Homepage&version=HpHed ThumbWell&module=well-region®ion=bottom-well&WT.nav=bottom- well&_r=1

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The new normal of monetary policy

- the Fed announced a revised plan for the mechanics of how it will raise interest rates from near zero despite large excess reserves by Jérémie Cohen-Setton on 29th September 2014

olegator What’s at stake: Since 2008, the asset purchases made under QE have increased drastically the aggregate level of bank reserves, thereby weakening the control of the Fed's federal funds rate. On Wednesday 17 September 2014, the Federal Reserve announced a revised plan for the mechanics of how it will raise interest rates from near zero despite large excess reserves. Tweet This The primary tool for moving the fed funds rate will be the interest rate the Fed pays on the money, called excess reserves Real Time Economics writes that as part of the so-called exit strategy, the Fed will continue to rely on its benchmark federal funds rate, an overnight interbank lending rate, as the key rate used to communicate Fed policy. But the primary tool for moving the fed funds rate will be the interest rate the Fed pays on the money, called excess reserves, that banks deposit at the central bank. The Fed also will use an interest rate it pays on trades called reverse repurchase agreements, or reverse repos, to help ensure the fed funds rate stays in its target range. The old way of raising rates Michael Woodford writes that it will be an interesting experiment in monetary economics because the Fed will be attempting to control short-term interest rates in a situation where almost certainly its balance sheet is going to be unusually large. That means that there are going to be extraordinary quantities of excess reserves in existence, and this means that Fed control of short-term interest rates will not be 186

achievable in the way that it always was in the past: through rationing the supply of reserves. The Fed would maintain a fairly small supply of reserves, small enough that there was indeed an opportunity cost of reserves, and it could adjust that opportunity cost fairly precisely through relatively small changes in the supply of reserves. John Cochrane illustrates in the figure below the standard story for monetary policy, and one option for the Fed when it wants to raise rates. In this story, the Fed controls interest rates by rationing the amount of non-interest-paying reserves. Banks must hold reserves in proportion to their deposits. If the Fed sells bonds, taking back reserves, the banks must get along with fewer reserves. They bid up the Federal Funds rate they pay to borrow reserves from each other. Treasury rates and other rates rise by arbitrage with the Federal Funds rate. So all interest rates rise.

John Cochrane The new way of raising rates Tweet This Attention turned to an alternative approach to monetary policy implementation by effectively “divorcing” the quantity of reserves from the interest rate target Todd Keister, Antoine Martin, and James McAndrews writes that recently, attention has turned to an alternative approach to monetary policy implementation by effectively “divorcing” the quantity of reserves from the interest rate target. The basic idea behind this approach is to remove the opportunity cost to commercial banks of holding reserve balances by paying interest on these balances at the prevailing target rate. Under this system, the interest rate paid on reserves forms a floor below which the market rate cannot fall. The Reserve Bank of New Zealand adopted a particular version of the “floor-system” approach in July 2006.

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NY Fed Todd Keister, Antoine Martin, and James McAndrews writes that the key feature of this system is immediately apparent in the exhibit: the equilibrium interest rate no longer depends on the exact quantity of reserve balances supplied. Any quantity that is large enough to fall on the flat portion of the demand curve will implement the target rate. In this way, a floor system “divorces” the quantity of money from the interest rate target and, hence, from monetary policy. This divorce gives the central bank two separate policy instruments: the interest rate target can be set according to the usual monetary policy concerns, while the quantity of reserves can be set independently. Policy "normalization” principles and plans In its press release, the FOMC writes that during normalization, the Federal Reserve intends to move the federal funds rate into the target range set by the FOMC primarily by adjusting the interest rate it pays on excess reserve balances. During normalization, the Federal Reserve intends to use an overnight reverse repurchase agreement facility and other supplementary tools as needed to help control the federal funds rate. Real Time Economics writes that since the authority to pay interest on reserves does not extend to other participants in short-term rate markets, such as government-sponsored enterprises and money market funds, the central bank has developed so-called overnight reverse repurchase agreements that allow it to withdraw liquidity from the system even from non-banks. Tweet This

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The Fed should stop referring to "normalization” when it talks about reducing the size of its balance sheet The FOMC writes that it intends to reduce the Federal Reserve's securities holdings in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the SOMA. John Cochrane writes that the Fed should stop referring to "normalization” when it talks about reducing the size of its balance sheet. The Fed may discover that a huge balance sheet, reverse repos for everyone, and even near-zero rates and zero inflation are a permanent and healthy policy configuration. If you've called tiny reserves that don't pay interest "normal," it's going to be awfully hard to accept that the "new normal" is just fine. http://www.bruegel.org/nc/blog/detail/article/1442-the-new-normal-of-monetary- policy/

Record world debt could trigger new financial crisis, Geneva report warns Concerted effort required to tackle economic woes as slow growth and low inflation cause global debts to balloon Phillip Inman, economics correspondent The Guardian, Monday 29 September 2014 15.32 BST

The Geneva economists are particularly worried about a borrowing binge in China and its long- term impact on the global economy.Photograph: Carlos Barria/Reuters Global debts have reached a record high despite efforts by governments to reduce public and private borrowing, according to a report that warns the “poisonous combination” of spiralling debts and low growth could trigger another crisis. 189

Modest falls in household debt in the UK and the rest of Europe have been offset by a credit binge in Asia that has pushed global private and public debt to a new high in the past year, according to the 16th annual Geneva report. The total burden of world debt, excluding the financial sector, has risen from 180% of global output in 2008 to 212% last year, according to the report. The study by a panel of senior academic and finance industry economists accuses policymakers in many countries of failing to spur sustainable growth by capitalising on historically low interest rates while deterring exuberant lending. It called for Brussels to write off the debts of the eurozone’s worst-hit countries and urgently embark on a “sizeable” programme of electronic money creation or quantitative easing to push down long-term interest rates. It said unless policymakers kept a lid on risks in the financial system, especially overvalued property and stock markets, a trend for investing in assets with borrowed money could run out of control. The Geneva report, which is commissioned by the International Centre for Monetary and Banking Studies, follows a study earlier this year by the Bank of International Settlements (BIS), which diagnosed the same problem, but said risky borrowing could only be discouraged by higher interest rates. The Geneva report instead argued a concerted effort to tackle the after-effects of the crisis was needed to mitigate a “poisonous combination of high and rising global debt and slowing nominal GDP [gross domestic product], driven by both slowing real growth and falling inflation”. Arguing that the European central bank had taken several mis-steps in efforts to orchestrate a broader revival, it said: “Further procrastination in implementing these by now urgent policy measures would risk, in the medium term, the resurgence of pressures on the sustainability of the eurozone itself. “Contrary to widely held beliefs, the world has not yet begun to de-lever and the global debt to GDP ratio is still growing, breaking new highs.” A lack of sustainable growth dates to the 1980s, according to the Geneva economists, who document the rise of debt-fuelled household and government spending over the past 30 years. After the financial crisis, debts increased dramatically in the west, but efforts to reduce them have been outstripped by a rise in borrowing across Asia. Similarly to an earlier BIS report, the Geneva economists are particularly worried by a borrowing binge in China, which they said Beijing should reduce, though this would slow growth and have a negative knock-on effect on global recovery. Luigi Buttiglione, co-author of the report and head of global strategy at the Brevan Howard hedge fund, said: “Over my career I have seen many so-called miracle economies – Italy in the 1960s, Japan, the Asian tigers, Ireland, Spain and now perhaps China – and they all ended after a build-up of debt.” A mix of moderate debt reduction, low interest rates and huge monetary stimulus in the UK and US were praised in the report, though with a health warning that increased

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central bank debt and a reliance on rising household indebtedness could undermine the recoveries. The International Monetary Fund, which meets in Washington next week, has aligned itself with the thinking behind the Geneva report. It has advocated that governments maintain low interest rates and embark on fiscal stimulus where necessary to maintain growth and prevent deflation. However, it is expected to voice concerns that public sector borrowing in China, mainly by local authorities and state enterprises, has reached unsustainable levels. Chistine Lagarde, the IMF’s director general, is expected to warn that slowing global growth could encourage investors to take bigger, riskier bets to maintain their income, undermining the stability of the recovery. http://eurozone.einnews.com/article/226857832/3VUKs9f3n9Wml5S3

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ft.com comment Columnists September 29, 2014 11:51 am Federalism fit for a kingdom

By Quentin Peel A system that works for America and for Germany would for Britain, writes Quentin Peel

The outcome of the Scottish referendum has left Britain’s political establishment in a state of alarm and confusion. Although the Yes side lost the vote for independence, the outcome was, to misquote the Duke of Wellington after the battle of Waterloo, “a damn near-run thing”. On a remarkably high turnout, 45 per cent voted for independence. Only a flurry of last-minute promises persuaded a majority to stick with their 300-year- old union with their English neighbours. Yet in spite of their narrow escape, Westminster’s political leaders seem determined to ignore the obvious way to resolve their dilemma: how to reconcile their pledges of more devolution with their determination to preserve a United Kingdom. More ON THIS STORY// Osborne pins UK recovery hopes on North/ Cameron furious at second Ukip defection/ UK could find itself tied to EU rules but with no say/ Wolfgang Münchau Germany’s eurosceptics ON THIS TOPIC// Markets Insight Cameron opens up fiscal ‘Pandora’s Box’/ Welsh politicians seek more powers/ Tour success prompts call for Yorkshire’s Grand Départ/ Editorial Towards a federal future QUENTIN PEEL// Putin misread Merkel/ Cameron overplays Juncker opposition/ Berlin talks agree consensus on EU A new federal constitution is the logical way forward, a negotiated division of political powers between the central government and the rest of the country. It is the sort of constitution that works perfectly well in the US, Canada, Australia and Germany. Indeed, British ideas were instrumental in drafting all their federal constitutions. But in the UK today, across the political spectrum, all sorts of half-baked compromises that fall short of federalism are being advanced as sensible. Some Conservatives want an English parliament. Others want English votes for English laws within the Westminster parliament. Labour wants to strengthen the powers of city councils.

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It is as if the very concept of the “F-word” is anathema. Why are the British – or at least the English – so frightened of the idea? It is as if they think federalism is only fit for foreigners. Part of the problem is that the word has been misused in the poisonous British political debate on the EU. Anyone who dares to argue in favour of strong EU institutions is dismissed as a “federalist”. That was the word used by the spin doctors of Downing Street, and their obedient adherents in the British media, to denounce candidates they did not like for the job of president of the European Commission. In the minds of British eurosceptics, the word “federal” appears to mean an excessive centralisation of power. That is why they denounce the Brussels bureaucracy. Yet in reality a federal system is a means to decentralise power – which is exactly what the UK needs, with far too much economic and political power centred on London. The more substantial trouble with federalism is that the most obvious solution – with the four “national” states of England, Scotland, Wales and Northern Ireland forming the constituent federal states of the UK – is hopelessly lopsided. England makes up 84 per cent of the total population and would dominate the federal parliament at Westminster. Indeed John Curtice, professor of politics at Strathclyde university, says that is the reason the English have no interest in federalism: they see the Westminster parliament as being, in effect, an English parliament – so why duplicate the exercise by having another English parliament? Prime Minister David Cameron’s answer is to have some sort of hybrid system whereby only English members of parliament would vote for English laws. Not only would it be extremely difficult to define what are purely “English” laws but it would also create two classes of MPs at Westminster. An English parliament, favoured on the right of the Tory party and in the UK Independence party, would emasculate the existing House of Commons. Indeed, it would probably sound the death knell for the UK, just as an assertive Russia, with Boris Yeltsin as president, led to the destruction of the Soviet Union: the mother country destroyed its own empire. Westminster blog

From the corridors of Westminster: Jim Pickard and Kiran Stacey blog on the UK’s political scene The obvious answer in the UK is to create English regional assemblies to complement the national assemblies in Scotland, Wales and Northern Ireland. Eight already exist – largely for the collection of statistics – including the North East, North West, East Midlands and West Midlands. London is a separate region, and so is Yorkshire and

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Humberside. The last two are the South East and South West. But they are relatively artificial and inspire little sense of identity. Does that matter? When the German federal republic was set up by the victorious Allies after the second world war, most of the new Länder (federal states) were artificial, partly to ensure that there was no dominant Prussian state. New creations such as Baden-Württemberg in the southwest, and North Rhine-Westphalia centred on the industrial Ruhr, inspired little common sense of identity. Yet today no one seriously questions their existence. Does German federalism work? Yes, although it is not particularly efficient, and can be infuriatingly slow moving. It means that the central government in Berlin is often forced to work by consensus and compromise: the 16 states represented in the Bundesrat, the second chamber of the German parliament, often have a different political majority to the Bundestag. That is no bad thing. A similar federal chamber representing 11 separate states in the UK could happily replace the strange anachronism that is today’s House of Lords, and call the Westminster government to account. It would be more democratic and more representative than the present upper house. It would give a much stronger voice to the nations and regions of the British Isles. What chance logic will prevail? Not much. The two main parties seem petrified at the prospect, even as their power dwindles and the proliferation of more narrowly focused interest groups (from the Scottish National party to Ukip and the Greens) makes coalition government the new normal. Only if the English decide that they too want more devolution from Westminster might a sensible federal system emerge. By then it might be too late for the survival of the union. http://www.ft.com/cms/s/0/77b50e90-4577-11e4-9b71- 00144feabdc0.html#axzz3EnXyN5sD

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EurActiv EU News & policy debates, across languages Juncker rejects UK push for independent scrutiny of EU laws Published: 26/09/2014 - 08:12 | Updated: 29/09/2014 - 09:20

Business Minister Baroness Neville-Rolfe was canvassing support for reform in Brussels yesterday. [Department of Business, Innovation and Skills] EXCLUSIVE: The new European Commission has rejected the UK Government's call to set up an independent body to scrutinise EU regulation and impact assessments before and after legislative proposals are adopted by the executive. Jean-Claude Juncker's spokeswoman, Natasha Bertaud, told EurActiv that impact assessments would remain an internal matter before proposals were adopted. Frans Timmermans, Juncker's choice for the new post of vice president in charge of better regulation, would ensure their quality, she said, after pointing to EU treaties governing Commission procedures. Currently research on the impact of regulation is looked over by an internal Commission department. It is then usually appended to a communication, white paper or proposal, which is then put out for public consultation. An independent body would also review any proposal again if it was significantly changed during negotiations between the Council of Ministers and the European Parliament, according to the UK plan. 195

But Juncker's spokeswoman said: "External review of an impact assessment can always be done after adoption by the Commission of its proposal – the Parliament already conducts such scrutiny now and this is welcomed." "External advice could play a role in advising the Parliament and the Council on the impacts of their proposed amendments, which are not systematically impact assessed today, if they wish to seek it." UK Business Minister Baroness Lucy Neville-Rolfe told her EU counterparts in the Competitiveness Council in Brussels yesterday (25 September) that the Commission should carry out “meaningful consultation” on draft assessments before suggesting new EU rules. “Legislation is too often produced without fully understanding the likely impact on businesses and consumers or whether action at EU level is strictly necessary,” a document circulated to embassies, MEPs, the EU institutions, and ministers, said. The executive should commit to slashing a set percentage of EU red tape to reduce regulatory administrative and compliance costs for businesses, it argued. Failing to do so would mean higher prices for consumers and the EU losing ground to international rivals. A report by the EU's High Level Group on Administrative Burdens will propose a 10% target. The UK points to Commission figures that show a 25% cut could increase Eu GDP by 1.4%. The ideas are part of a series of single market reforms involving energy security, climate change, trade, financial services and the digital economy that the UK is pushing for. The British are keen to be seen as engaging positively - and improving - the incoming executive's agenda. Securitisation The paper also called for action to promote “transparent, well-regulated” securitisation, where bank loans are packaged and sold on the market. Opaque and complex securitisation was blamed for the US subprime mortgage crisis, which some argue spurred the global financial crisis. It backs Juncker’s plans for a “capital markets union” to lessen European businesses’ dependence on bank funding. That source of finance has dried up since the crisis. The ECB and a number of other member states are in favour of securitisation, which could create €300 billion of financing for companies and infrastructure, according to Juncker. But others believed to be wary of the plans because of the poor reputation of securitisation post-crisis. The UK’s Jonathan Hill is set to take over the financial stability, financial services and capital markets union portfolio in the new Commission. But today’s diplomatic effort is not directly linked to Hill’s hearing before MEPs at the European Parliament on Wednesday, 1 October.

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Instead, it is geared towards securing broad support for UK policies to increase competitiveness ahead of Juncker’s team taking power in November. “I don’t think there’s a better time to talk about the EU’s future agenda for business," said Baroness Neville-Rolfe. “The UK wants to see real ambition from the EU and that’s why we’ve pulled together these ideas on how to reform the single market,” she added. Trade The UK explicitly backs the hotly-debated EU-US trade deal, the Transatlantic Trade and Investment Partnership (TTIP), another free trade agreement with Japan and calls for similar negotiations with China to be launched. “We need to place free trade at the heart of our agenda,” the document said. The Commission should also propose targeted laws to remove barriers to trade within the EU, starting with the construction and business services sectors, the document said. Barriers to lending across borders and to SMEs also need to be broken down in order to get the economy moving again, it said. Rules stopping e-commerce such as those around labelling rules, sales promotion and unreliable parcel delivery services, needed to be ditched, according to the UK. EU regulation was not keeping up with the pace of change in the digital world, the document said. The UK in the paper reiterates its support for the EU’s proposed 40% greenhouse gas reduction as part of its 2030 climate and energy framework. Those targets will be discussed at October’s meeting of EU leaders. The 40% target would encourage investment in “urgently needed” low carbon infrastructure, according to the UK. The internal market for energy could only be completed with new infrastructure, including cross-border interconnectors, the document said. Wider reform The suggested changes are part of a wider drive for EU reforms that UK Prime Minister David Cameron is campaigning for. While that does include controversial moves over freedom of movement, it also calls for the EU to scale back its regulation unless absolutely necessary. How the full set of Cameron’s EU reforms is received could have a direct impact on the UK’s continued membership of the Union. The success of the Eurosceptic UK Independence Party has upped pressure on Cameron to be tougher with the EU, especially after the humiliation of his failed attempt to block Juncker’s appointment as Commission president. Council conclusions The competitiveness council adopted conclusions aimed at integrating industrial competitiveness issues into relevant EU policy areas, such as environment, climate, 197

energy, trade, competition, state aid, with a view to creating a stronger industrial base for the EU economy, according to a press release. It also debated the mid-term review of the Europe 2020 strategy for growth and jobs. Watch the press conference after the meeting below. Positions: Jean-Claude Juncker's spokeswoman said, "Under the Treaty, the Commission initiates legislation and is responsible for the quality of its proposals and their supporting impact assessments, which provide the evidence base upon which the College's decisions are based. Mr Timmermans, as first vice president, in charge of Better Regulation, Inter-Institutional Relations, the Rule of Law and the Charter of Fundamental Rights, will ensure that the Commission's impact assessments are of high quality and comprehensive. "External review of an impact assessment can always be done after adoption by the Commission of its proposal – the Parliament already conducts such scrutiny now and this is welcomed. External advice could play a role in advising the Parliament and the Council on the impacts of their proposed amendments (which are not systematically impact assessed today) if they wish to seek it." http://www.euractiv.com/sections/eu-priorities-2020/juncker-rejects-uk-push- independent-scrutiny-eu-laws-308731 Background The EU is still struggling to recover from the financial crisis. One way to speed up the recovery is by increasing the competitiveness of the single market. The United Kingdom has suggested some changes to help boost the EU's competitiveness and spur growth and jobs. The UK wants to cut red tape and encourage the European Commission to only propose EU-wide rules when absolutely necessary. Setting targets for cutting regulatory burdens and setting up an independent body to scrutinise analysis of the impact of EU laws, should be considered by the new Commission.

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ft.com comment Columnists September 28, 2014 7:29 pm Germany’s eurosceptics sow the seeds of turmoil

By Wolfgang Münchau The AfD only needs to create doubt to upset economic equilibrium

©Getty Bernd Lucke, leader of Alternative für Deutschland Should we be worried by the Alternative for Germany? In federal elections held last year barely six months after the eurosceptic party was founded, the AfD came within a whisker of claiming 5 per cent of votes cast – the threshold it needed to cross to win representation in the Bundestag. In European elections held this May, the AfD won 7 per cent, and in the three state elections that have been held since then, it has done even better. The answer is: yes, we should be worried. But the reasons are not all that obvious. True, the AfD advocates a German departure from the eurozone; but that is easier said than done. Its leader, Bernd Lucke, a professor of economics, has been one of the loudest critics of the German government’s efforts to rescue the eurozone. He is also scathing in his criticism of Mario Draghi, president of the European Central Bank. As the only avowedly anti-euro party in Germany, the AfD is filling a niche in the political spectrum. In itself this is not a worry. A recent opinion poll put the party’s potential support at 22 per cent. Its rise has coincided with the decline of the liberal Free Democratic party, whose support collapsed in last year’s federal elections and has not recovered since. Among the FDP’s traditional supporters were conservative nationalists. Many of them have defected to the AfD because it has clearer conservative credentials. More ON THIS STORY// Global Insight Eurosceptics outflank moderate Merkel/ Comment Europe must keep populist right at bay/ Germany’s anti-euro AfD extends its electoral gains/ German eurosceptics win Saxony seats ON THIS TOPIC// Germany under fire over military mishaps/ Critics turn on German pension plans/ Bavaria’s conservatives lose in Munich/ Comment Germany needs a lead role WOLFGANG MÜNCHAU// Italian debt/ Wolfgang Münchau Declining influence/ What Draghi must do next/ An astute ECB step The AfD’s attraction goes beyond its advocacy of a euro exit. In recent regional state elections, the euro has hardly been an issue. The party succeeded this time by embracing conservative values. It advocates an end to immigration, more support for families and

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less social spending. This poses a danger to Angela Merkel, the chancellor, and her Christian Democrats. Unlike other postwar rightwing parties, the AfD’s appeal extends well beyond the fringe. The party has, by and large, managed to keep a distance from extremists. It is always possible that it will implode; there has been much infighting over the past year. But so far Mr Lucke has held it together. There is no chance of the AfD becoming a junior partner in government. Ms Merkel has ruled out any coalition with it, as have all the other parties. But senior CDU politicians are worried. The AfD is already influencing policy. It is no coincidence that the German government is once again talking tough with the rest of the eurozone. Last week we heard that Wolfgang Schäuble, finance minister, had criticised the ECB’s programme of private-sector asset purchases. He rejected the central bank’s suggestions that governments should guarantee asset-backed securities – financial instruments that transform loans into tradable paper. He rejected a proposal that would have diverted funds that were originally intended to prevent financial speculators from attacking the bonds of eurozone governments, releasing them for the broader purpose of boosting investment. Markus Söder, finance minister of the conservative-run state of Bavaria, was even more outspoken, arguing that an EU investment programme would end up stimulating support for the AfD. The German government is reverting to its previous habit of saying “Nein, Nein, Nein” to its eurozone partners. At least in part, this is because the AfD is breathing down its neck. The AfD is biding its time. It believes, probably correctly, that the euro crisis is likely to return, at which point it will press for Germany’s departure from the eurozone. None of this has yet arrived on the radar screen of international investors, who have reverted to the pre-crisis habit of treating all eurozone debt as equivalent. They take the ECB’s conditional guarantee that it will act as a lender of last resort – which is subject to a legal dispute – as a permanent and unconditional bailout guarantee. One reason for the current stability in financial markets is the high degree of what you might call constructive ambiguity regarding Germany’s willingness – and the ECB’s ability – to bankroll the system. The AfD will bring some unhelpful clarity about the limits of Germany’s engagement. The rest of the eurozone might be in for a shock. One place where trouble might strike is the sovereign bond market. I am hearing increasingly the view that we should ignore debt ratios, notably that of debt-to-gross domestic product, as a metric for debt sustainability. We should instead focus on affordability – debt service costs as a ratio of fiscal revenues. At present these are quite low, because bond yields are low. Those who tell us not to worry about debt ratios are telling us that good times will go on forever. The AfD only needs to create doubt to upset this equilibrium. It does not need to win an election or become part of a government. Its strategy will be to test the limits of Germany’s commitment. That strategy stands a fair chance of success. And when that happens, it will wreak havoc. http://www.ft.com/intl/cms/s/0/aa6dc99c-44de-11e4-ab0c- 00144feabdc0.html#axzz3EnXyN5sD 200

European Commission//Economic and Financial Affairs// Economic databases and indicators// Business and Consumer Surveys

European Commission

September 2014: Economic Sentiment decreases in the euro area and the EU In September the Economic Sentiment Indicator (ESI) decreased in both the euro area (by 0.7 points to 99.9) and the EU (by 1.0 point to 103.6). The euro-area indicator fell slightly below its long-term average of 100, which it had surpassed only in December 2013. The negative developments in the EU and the euro area indicator mainly reflect more cautious views of consumers and the retail trade sector.

The Directorate General for Economic and Financial Affairs (DG ECFIN) conducts regular harmonised surveys for different sectors of the economies in the European Union (EU) and in the applicant countries. They are addressed to representatives of the industry (manufacturing), the services, retail trade and construction sectors, as well as to consumers. These surveys allow comparisons among different countries' business cycles and have become an indispensable tool for monitoring the evolution of the EU and the euro area economies, as well as monitoring developments in the applicant countries.

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Sparse Thoughts of a Gloomy European Economist Francesco Saraceno's Blog Draghi the Euro Breaker? September 29, 2014 Update (9/30): Eurostat just released the September figures for inflation: Headline: 0.3%, Core, 0.7% Hans Werner Sinn did it again. In the Financial Times he violently attacks Mario Draghi and the ECB. To summarize his argument (but read it, it is beyond imagination): 1. The ECB gave too much liquidity to banks in peripheral EMU countries since 2008, thus fueling a spending boom. 2. Then, with the SMP and the OMT programs it “lowered the interest rates at which overstretched eurozone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge” 3. Finally, “The ECB’s plan to purchase [private borrower's] debt could end up transferring dozens if not hundreds of billions of euros from eurozone taxpayers to the creditors of these hapless individuals and companies.” 4. Last (but not least!!) he claims that deflation is necessary in EMU peripheral countries to restore competitiveness I am shocked. Let me start from the last point. Even assuming that competitiveness only had a cost dimension, what would be required is that the differential with Germany and core countries were negative. Deflation in the periphery is therefore only necessary because Germany stubbornly refuses to accept higher inflation at home. And no, the two things are not equivalent, because deflation in a highly leveraged economy increases the burden of debt, and triggers a vicious circle deflation-high debt burden-consumption drop-deflation. I refuse to believe that a respected economist like Hans Werner Sinn does not see such a trivial point… As for the rest, the spending binge in peripheral countries began much earlier than in 2008, and it is safe to assume that it was fueled by excess savings in the core much more than by expansionary monetary policies. Further, does Sinn know what a lender of last resort is? Does he know what is “too big to fail”? Where was he when European authorities were designing institutions incapable of managing the business cycle, while forgetting to put in place a decent regulatory framework for banks and financial institutions? And finally, does Mr Sinn remember what was the situation in the summer of 2012? Does he remember the complete paralysis of European governments that were paralyzed in front of speculative attacks to two large Eurozone economies? Does he realize that were it not for the OMT and the “whatever it takes”, today Spain and Italy would not be in the Euro anymore? Which means that probably the single currency today would not exist? Maybe he does, and he decided to join the AfD… http://fsaraceno.wordpress.com/2014/09/29/draghi-the-euro-breaker/ 203

George Osborne aims at tax credits and benefits in new squeeze on working poor Chancellor gambles on austerity in speech to Conservative conference outlining plans which will hit 10m households Patrick Wintour, political editor The Guardian, Tuesday 30 September 2014

George Osborne gives his conference speech, in which he also announced a public-sector pay freeze until 2017. Photograph: Peter Macdiarmid/Getty Images George Osborne took a calculated political gamble on Monday when he spurned the chance to ease austerity and instead announced that a re-elected Tory government would hit 10m households with a two-year freeze on benefits and tax credits. The chancellor’s move, which will cut £3bn a year from the welfare budget, is designed to cement the Conservatives’ reputation as the party willing to take tough long-term economic decisions, even at the cost of hitting more than 5m families characterised as working poor.

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But the political danger in promising to keep working-age benefits unchanged in the two years after an election is that Osborne alienates blue-collar workers already attracted either by Ukip or Ed Miliband’s promise to ease the living standards crisis. The freeze will hit the poorest third in society most and see in-work families with children lose as much as £490 a year in child benefit and tax credits. The average loss will be £300 a year per household but will vary greatly. Spurning the temptation to offer a traditional pre-election bribe, Osborne also announced that he was continuing with a freeze on public sector pay until 2017, meaning public sector workers will have seen their pay held back below inflation for seven years. In his speech to the Conservative party conference in Birmingham, Osborne said he was levelling with the British people that now was not the time to ease up on cutting the deficit. “The problem for Britain is not that it taxes too little – it spends too much.” Conservative strategists made the calculation that candour about the difficult spending choices ahead will gain Osborne political kudos and outweighs the risk of reinforcing a reputation for putting the burden of deficit reduction on to the backs of the poor. But there was a nervousness among some senior Tories that Osborne had abandoned the last vestige of compassionate Conservatism and bet the farm on such an unflinching approach to the deficit. “And I tell you in all candour that the option of taxing your way out of the deficit no longer exists if it ever did,” the chancellor said. Osborne balanced the tough message by announcing he was going to tackle technology companies such as Apple and Google, which have been accused of going to extraordinary lengths to offshore profits to avoid corporation tax. Apple’s tax deals will come under further scrutiny this week amid a threat that the European Union will impose a multi-billion pound fine this week for its decades-long deals with the Irish government. Tory officials said detailed measures would be announced in the autumn statement, but hundreds of millions of pounds would be saved from the multinational clampdown on corporate tax avoidance. The two-year working-age benefits freeze takes £3.2bn a year off the welfare bill by 2017-18, the first step of the chancellor’s commitment to wipe £12bn more from the annual welfare bill. This leaves Osborne still to find a further £9bn in welfare cuts in the first two years of the next parliament. Osborne also said he would cut general departmental spending by a further £13bn in the first two years of the parliament – enough, alongside growth, to put the overall budget in surplus by 2018. He said the latest Treasury estimate calculated £25bn was needed overall to eliminate the deficit, a figure that some government sources said might now be an underestimate. After the speech, Osborne’s aides tried to flush out how quickly the shadow chancellor, Ed Balls, would cut the deficit if he would not match Osborne’s welfare cuts. But Labour stressed it would make different choices, including raising taxes on the wealthiest. Osborne also took aim at the Labour leader’s failure to mention the deficit: “Did you hear that speech last week? Ed Miliband made a pitch for office that was so 205

forgettable he forgot it himself. Well, I have to tell you in all seriousness that forgetting to talk about the deficit is not just some hapless mistake of an accident-prone politician, it is completely and totally a disqualification for the high office he seeks.” The chancellor’s proposals have also caused tension in the coalition, with the Liberal Democrats indicating that they were opposed to the widespread benefits freeze. A Lib Dem source said: “We have consistently blocked Conservative attempts to freeze benefits for the working-age poor just as they have blocked our attempt to cut benefits for the wealthiest pensioners. It speaks volumes about the priorities of the Conservative party that they see benefit cuts for the working poor as a crowd-pleasing punchline for a conference speech.” The detailed plan will see all the main working-age benefits, including child benefit, frozen at their post-election levels rather than being uprated in line with inflation. Conservative officials said a working couple with one child, with each earning £13,000 a year, would lose £44 a year in child benefit and £310 a year in tax credits. A household with a single earner and two children would lose £75 a year in child benefit and £420 in tax credits. In 2012 Osborne imposed a 1% cap on most benefits, but the new proposed two-year total freeze for the first time includes housing benefit. The officials justified the freeze by arguing that earnings have grown by 14% since 2007 while most working-age benefits have been uprated by 22.4%. Due to the two- year freeze and the 1% cap on increases announced in the autumn statement, the gap between earnings and working-age benefits will have been eradicated by 2017, the sources said. Osborne had given himself little political room for manoeuvre by, in effect, ruling out any tax rises to cut the deficit. “I tell you in all candour that the option of taxing your way out of the deficit no longer exists if it ever did,” he told delegates. “In a modern global economy where people can move their investment form one country to another at the touch of a button and companies can relocate jobs overnight – the economics of high taxation are a thing of the past.” The move came a day after Osborne said a Tory government would cut the maximum benefits a household could claim in a year from £26,000 to £23,000. Osborne also said he would seek to end youth unemployment by giving unemployed 18 to 21-year-olds six months to find work or training before their jobseeker’s allowance would be withdrawn. http://www.theguardian.com/politics/2014/sep/29/george-osborne-benefits-tax-credits- conservative?CMP=EMCNEWEML6619I2

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TRANSPARENCY TWITTER@ANTICORRUPTION CORRUPTION PERCEPTIONS INDEX 2013

FACTS & FIGURES: SPAIN

* POPULATION (2010): 46.1 MILLION * GDP (2010): $1.41 TRILLION * INFANT MORTALITY RATE (PER 1,000 LIVE BIRTHS - 2010): 3.9 * LIFE EXPECTANCY (2009) 81.48 YEARS * LITERACY RATE (2009) 97.7% Corruption challenges Government and politics The Spanish legislative branch lacks efficient democratic processes due to the strong influence of political party leaders within parties. High-ranking party leaders decide if MPs are to remain on the party’s lists, not the constituents. MPs therefore have more incentive to be loyal to their party leaders than to their constituency – limiting MPs’ independent vote and deterring whistleblowing. Closed and blocked voting lists also favour a system in which the party leaders maintain strong control over the representative bodies on the national, regional and local level. Executive accountability is also limited. The Spanish Court of Audit is the only supreme body responsible for auditing government accounts and financial management. It also regulates the financing of political parties and the electoral processes. Although the agency is legally independent, in practice it is influenced by the two major political parties. The institution has sufficient resources, but is not very effective in controlling the efficiency and effectiveness of the public sector. Access to information Spain has no dedicated right to information legislation. A 2012 study found that more than half of the requests for public information in the country go unanswered. And only 20% of answered requests provide the requested information. As of July 2012, parliament is drafting an access to information law. The draft is currently online, but the law awaits passage from parliament as of December 2012. Judicial independence Judicial independence is explicitly recognized in the Spanish Constitution and legally guaranteed. However, research has shown that there are concerns about the 207

politicization of the judiciary because members of the higher courts are appointed with political influence. The same study has also shown that the courts are challenged by a lack of sufficient resources to cope with their high workload. Political and campaign financing In Spain political parties on the national, regional and local level, receive more than 90% of their funding from the State. The strength of such a system is that by relying primarily on public funds, parties can operate more independently and remain detached from private funders‘ agenda. However, the parties have over time indebted themselves and used bank loans to cover additional expenses. A 2010 survey indicates that citizens perceive that political parties is the institution most affected by corruption. Political actors have an excessive reliance on the financial sector, which has caused serious damage to the national economy. Savings banks (Cajas de Ahorros) have been politicized by the political parties in order to ensure funding and this, together with the risky investment policies of these entities, has caused bankruptcy and the need to bail some of them out. The strong links between the two major parties and the banking sector in party financing is a concern for political capture. Commercial loans given to parties are poorly controlled due to a combination of the lack of human and financial resources as well as increased workload facing the Court of Audit. Lobbying There is currently no lobbying regulation in Spain. In March 2012, a proposal was submitted to Congress to register and control lobby activities. However, the proposal was rejected. The code of good governance – applicable to members of government and political appointees in the central government – also lacks adequate lobbying guidelines, allowing officials to go on ill-informed on how to deal with lobbyists. Positive developments Foreign Bribery A 2010 Penal Code amendment makes the bribery of a foreign public official a punishable crime. The new regulation increases penalties to two - six years imprisonment, fines and extends the statute of limitation period to 10 years. Preventing money laundering Passed in 2010, the Anti-Money Laundering and Counter Financing of Terrorism Act Law aims to tackle money laundering and terrorist financing. The law transposes the European Directive 2005/60/EC (the Third Money Laundering Directive). It also unifies the preventive systems for money laundering and terrorist financing, previously split under the Anti-Money Laundering law and the law on Counter Financing of Terrorism. Under the new system, the Executive Service of the Commission for the Prevention of Money Laundering and Monetary offences (SEPBLAC by its initials in Spanish) is responsible for compliance supervision. Sanctioning powers lie with the Ministry of Finance.

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Transparency in political party financing In 2012, Spain passed a new law on political party financing which represents a modest improvement over the existing law. It reduces the amount of public funding for the functioning of political parties and clarifies sanctioning mechanisms for non- compliance with the law. The law’s impact on curbing corruption will depend on how effective its implementation is. Recommendations Stronger political financing regulations and more resources for monitoring mechanisms are needed. The electoral system needs to be modified. Reforms should include unlocking the closed voting lists and improving proportionality. Neutralizing political party internal control, and stimulating its internal democracy is also needed. For example, the primaries should be open to the people. To improve integrity in the judiciary, de-politicisation of the supreme bodies of the judicial power and the Constitutional Court are needed. Access to information reforms are needed to ensure the transparency of public institutions. The government should also adopt a strategic plan to improve responses, accessibility, as well as citizen participation and collaboration in public affairs. It is necessary to pass a law protecting whistleblowers in both the public and private sector. More recommendations can be found here. http://www.transparency.org/country#ESP

Ehttp://www.transparency.org/cpi2013/results

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CORRUPTION REMAINS A GLOBAL THREAT The Corruption Perceptions Index 2013 serves as a reminder that the abuse of power, secret dealings and bribery continue to ravage societies around the world. The Index scores 177 countries and territories on a scale from 0 (highly corrupt) to 100 (very clean). No country has a perfect score, and two-thirds of countries score below 50. This indicates a serious, worldwide corruption problem. Hover on the map above to see how your country fares. The world urgently needs a renewed effort to crack down on money laundering, clean up political finance, pursue the return of stolen assets and build more transparent public institutions. Rank Country Score Surveys Used CI: Lower CI: Upper 2012 SCORE 1 Denmark 91 7 87 95 90 1 New Zealand 91 7 87 95 90 3 Finland 89 7 86 92 90 3 Sweden 89 7 85 93 88 5 Norway 86 7 82 90 85 5 Singapore 86 9 82 90 87 7 Switzerland 85 6 81 89 86 8 Netherlands 83 7 80 86 84 9 Australia 81 8 79 83 85 (-4) 9 Canada 81 7 77 85 84 (-3) 11 Luxembourg 80 6 75 85 80 12 Germany 78 8 74 82 79 12 Iceland 78 6 73 83 82 (-4) 14 United Kingdom 76 8 74 78 74 15 Barbados 75 3 63 87 76 15 Belgium 75 7 71 79 75 15 Hong Kong 75 8 71 79 77 15 Belgium 75 7 71 79 75 15 Hong Kong 75 8 71 79 77 18 Japan 74 9 70 78 74 19 U S of America 73 9 66 80 73 19 Uruguay 73 6 71 75 72 21 Ireland 72 6 65 79 69 (3) 22 The Bahamas 71 3 69 73 71 22 Chile 71 9 68 74 72 22 France 71 8 67 75 71 22 Saint Lucia 71 3 70 72 71 26 Austria 69 8 64 74 69 26 U. A. Emirates 69 7 61 77 68 28 Estonia 68 9 64 72 64 (4) 28 Qatar 68 6 56 80 68 30 Botswana 64 7 61 67 65 31 Bhutan 63 4 59 67 63 31 Cyprus 63 5 57 69 66 (-3)

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33 Portugal 62 7 57 67 63 33 Puerto Rico 62 3 52 72 63 33 S. Vinc.& Gren 62 3 53 71 62 36 Israel 61 6 58 64 60 36 Taiwan 61 7 54 68 61 38 Brunei 60 3 43 77 55 (5) 38 Poland 60 10 56 64 58 40Spain 59 7 51 67 65 (-6) 43 Lithuania 57 8 51 63 54 (3) 43 Slovenia 57 9 51 63 61 (-4) 45 Malta 56 5 52 60 57 46 South Korea 55 10 51 59 56 47 Hungary 54 10 48 60 55 49 Costa Rica 53 5 46 60 54 49 Latvia 53 8 47 59 49 (4) 53 Turkey 50 9 46 54 49 57 Croatia 48 9 43 53 46 57 Czech Republic 48 10 43 53 49 61 Slovakia 47 8 39 55 46 63 Cuba 46 4 39 53 48 63 Saudi Arabia 46 5 35 57 44 66 Jordan 45 7 41 49 48 (-3) 67 Macedonia FYR 44 6 36 52 43 67 Montenegro 44 4 40 48 41 69 Italy 43 7 39 47 42 69 Kuwait 43 5 37 49 44 69 Romania 43 9 38 48 44 72 Bosnia Herz. 42 7 37 47 42 72 Brazil 42 8 36 48 43 72 Serbia 42 7 36 48 39 (3) 72 South Africa 42 9 37 47 43 77 Bulgaria 41 9 36 46 41 77 Tunisia 41 7 38 44 41 80 China 40 9 35 45 39 80 Greece 40 7 33 47 36

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Liberty Street Economics « The FRBNY DSGE Model Forecast | Main | Do Unemployment Benefits Expirations Help Explain the Surge in Job Openings? » September 29, 2014 Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks Kenneth D. Garbade From time to time, and most recently in the April 2014 meeting of the Treasury Borrowing Advisory Committee, U.S. Treasury officials have questioned whether the Treasury should have a safety net that would allow it to continue to meet its obligations even in the event of an unforeseen depletion of its cash balances. (Cash balances can be depleted by an unanticipated shortfall in revenues or a spike in disbursements, an inability to access credit markets on a timely basis, or an auction failure.) The original version of the Federal Reserve Act provided a robust safety net because the act implicitly allowed Reserve Banks to buy securities directly from the Treasury. This post reviews the history of the Fed’s direct purchase authority. (A more extensive version of the post appears in this New York Fed staff report.) Federal Reserve Banks actively used their “direct purchase authority” during World War I and for a decade and a half afterward. Direct purchases typically occurred when Treasury cash balances ran low shortly before a tax payment date or the settlement of a public securities sale. The Fed would then purchase a one-day certificate of indebtedness, rolling over the investment one day at a time until Treasury’s coffers had been replenished and the debt could be retired. In 1935 Congress acted to prohibit direct purchases of Treasury securities by Federal Reserve Banks. Treasury officials were not happy with the prohibition. In a letter to the chairman of the Senate Banking Committee, Under Secretary of the Treasury T. J. Coolidge questioned “whether in times of emergency it might not be important to permit a direct loan. This might have been the case in the bank holiday in 1933 had there been a sizeable note issue coming due when the banks were closed. It might be the case in time of war.” The historical record does not provide a clear explanation for the prohibition. In the 1940s, Marriner Eccles, the Chairman of the Board of Governors of the Federal Reserve System, suggested that the prohibition might have been intended to prevent excessive government expenditures or chronic budget deficits. W. Randolph Burgess, a past Manager of the System Open Market Account, suggested that it might have been intended to limit expansion of Reserve Bank balance sheets. (The Glass-Steagall Act of 1932 provided, for the first time, that Federal Reserve notes could be backed by Treasury securities as well as by gold and commercial paper.) However, neither explanation is particularly plausible because Congress did not concurrently limit the authority of the Federal Reserve to purchase Treasury securities in open market 212

transactions.

Following the entry of the United States into World War II, Congress—anticipating a long struggle that would require unprecedented expenditures and concomitant financings and that would present novel cash management problems—provided a $5 billion wartime exemption to the prohibition on direct purchases. Acting on the basis of that exemption, the Fed purchased certificates directly from the Treasury during the war much as it had during the 1920s and early 1930s: to replenish Treasury cash balances on a day-to-day basis before taxes were received or securities were issued. Following the conclusion of the war, Congress renewed the $5 billion exemption for three years and continued to renew it from time to time thereafter, until 1981. The lapse of the exemption in 1981 was attributable to two innovations in Treasury cash management. The first was the introduction of short-term cash managements bills (CMBs) in August 1975. The initial offering was $1 billion of eighteen-day CMBs and was followed with four more issues before the end of the year. The new program— which showed that Treasury could access the public markets for short-term funding on as little as one or two days’ notice—soon displaced most direct sales of Treasury debt to Federal Reserve Banks. In 1979, Federal Reserve Governor J. Charles Partee testified that “the direct [purchase] authority . . . has come to be used only infrequently,” because “the Treasury now often relies on short-dated cash management bills to cover low points in its cash balance prior to key income tax payment dates.” The second innovation was a 1978 overhaul of the Treasury Tax and Loan (TT&L) system that allowed Treasury to earn interest on TT&L balances at commercial banks. The overhaul materially reduced the cost of maintaining deposits at those banks, allowing Treasury to maintain a larger cash buffer against fluctuations in its receipts and expenditures.

Short-term CMBs and larger TT&L balances were not perfect substitutes for direct issuance to the Fed. Both required notice of at least a day or two, while a direct sale to the Fed could be arranged within a matter of hours. Additionally, of course, CMB issuance required that the public markets be open and functioning. Assistant Secretary of the Treasury Paul Taylor noted in 1979 that “If a market were disrupted, it might be very difficult to consummate [an offering]. If the market were already disrupted because there had been an earthquake because the San Andreas Fault had broken up and down California, or if war had been declared, or if some major event of that kind had occurred, you might find the market would not be functioning very well.” Taylor’s warning gained credibility following the terrorist attacks on September 11, 2001, when Treasury was forced to cancel a four-week bill auction, and as a result of disorderly market conditions on August 21, 2007, when an auction offering of four-week bills very nearly failed. In June 1979, Congress renewed (for two years) the $5 billion exemption to the prohibition on direct purchases, but limited the exemption to “unusual and exigent circumstances” and required approval by a super-majority (five members) of the Board of Governors of the Federal Reserve System. The conditions suggest that Congress believed that the combination of short-term CMBs and larger TT&L balances provided an adequate safety net for virtually all Treasury operations and that authority for direct 213

purchases could reasonably be limited to highly exceptional circumstances.

Treasury never issued securities directly to the Federal Reserve under the terms of the 1979 renewal, and the exemption was not renewed in 1981. Since that time, the Treasury has lacked a robust safety net that would allow it to meet its obligations in the event of an unforeseen depletion of its cash balances. Disclaimer The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York, or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

Kenneth D. Garbade is a senior vice president in the Federal Reserve Bank of New York’s Research and Statistics Group. http://libertystreeteconomics.newyorkfed.org/2014/09/direct-purchases-of-us- treasury-securities-by-federal-reserve-banks.html#.VClvxedN0xk

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Nobody Could Have Predicted, Bill Gross Edition September 29, 2014 11:57 amSeptember 29, 2014 11:57 am87Comments Gillian Tett feels sorry for BIll Gross, who was caught unaware by the sudden shift in bond market behavior. Who could have predicted that interest rates would stay low despite large budget deficits? Um, how about Pimco’s own chief economist, Paul McCulley? The truth is that the quiescence of interest and inflation rates was predicted by everyone who understood the obvious — that we had entered a liquidity trap — and thought through the implications. I explained it more than five years ago. When central banks have pushed policy rates as low as they can, and the economy is still depressed, what that tells you is that the economy is awash in excess desired savings that have nowhere to go. And as I wrote: So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap. So no crowding out, no reason interest rates should rise. And Paul McCulley understood all this really well (pdf): [I]n the topsy-turvy world of liquidity traps, these textbook orthodoxies do not apply, and acting irresponsibly relative to orthodoxy by increasing borrowing will do more good than harm. … Crowding out, overheating and rising interest rates are also not likely to be a problem as there is no competition for funds from the private sector. For evidence, look no further than the impact of government borrowing on long-term interest rates in the U.S. during the Great Depression, or more recently, Japan. Really, this wasn’t and isn’t hard. Or maybe it is. Strikingly, Tett’s version of what went wrong with Gross’s predictions makes no mention of deleveraging and the zero lower bound; it’s all a power play by central banks, which have been “intimidating” bond investors with unconventional monetary policy. This is utterly wrong, and in fact Gross’s own mistakes show that it’s wrong: one of his big failures was betting that rates would spike when the Fed ended QE2, which they predictably didn’t. 215

As an aside, whenever I hear people explaining away the failure of interest rates to spike as the result of those evil central bankers artificially keeping them down, I want to ask how they think that’s possible. Surely the same people, if you had asked them a few years ago about what would happen if the Fed tried to suppress interest rates by massively expanding its balance sheet, would have predicted runaway inflation. That didn’t happen, which should make you wonder what exactly they mean by saying that rates are artificially low. Oh, and Tett ends the piece by citing the Bank for International Settlements as a voice of wisdom. That’s pretty amazing, too; the sadomonetarists of Basel have a remarkable track record of being wrong about everything since 2008, but always finding some reason to call for higher rates. The thing is, Tett is a smart observer who talks to a lot of people in finance; seeing her present a discredited theory as obviously true, without so much as mentioning the kind of analysis that has been worked all along, says bad things about the extent to which anyone who matters has learned anything. http://krugman.blogs.nytimes.com/2014/09/29/nobody-could-have-predicted-bill- gross-edition/?_php=true&_type=blogs&_r=0

Mr. Krugman and the Classics (Trivial and Self-Indulgent)

September 29, 2014 3:29 pmSeptember 29, 2014 3:29 pm

http://krugman.blogs.nytimes.com/2014/09/29/mr-krugman-and-the-classics- trivial-and-self-indulgent/

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Liberty Street Economics

« Connecting “the Dots”: Disagreement in the Federal Open Market Committee | Main | Direct Purchases of U.S. Treasury Securities by Federal Reserve Banks » September 26, 2014 The FRBNY DSGE Model Forecast Matthew Cocci, Marco Del Negro, Stefano Eusepi, Marc Giannoni, and Sara Shahanaghi Fifth in a five-part series This series examines the Federal Reserve Bank of New York’s dynamic stochastic general equilibrium (FRBNY DSGE) model—a structural model used by Bank researchers to understand the workings of the U.S. economy and provide economic forecasts. The U.S. economy has been in a gradual but slow recovery. Will the future be more of the same? This post presents the current forecasts from the Federal Reserve Bank of New York’s (FRBNY) DSGE model, described in our earlier “Bird’s Eye View” post, and discusses the driving forces behind the forecasts. Find the code used for estimating the model and producing all the charts in this blog series here. (We should reiterate that these are not the official New York Fed staff forecasts, but only an input to the overall forecasting process at the Bank.) The model predicts that economic growth will continue to be sluggish as the headwinds from the financial crisis dissipate at a very slow pace. In addition, the negative shocks that have buffeted the economy will continue to restrain investment spending and further slow the recovery. These negative shocks have been offset in the past by expansionary monetary policy, but the positive effects of this policy are set to fade. Because of the still relatively weak economy, inflation remains below the Fed’s long- term objective, with the gap between inflation and the objective closing over the forecast horizon. The chart below presents quarterly forecasts for real output growth and the core personal consumption expenditures (PCE) inflation rate over the 2014-17 horizon. These forecasts were generated with data available at the end of July 2014. More specifically, we use data for real GDP growth, core PCE inflation, and the growth in total hours released through the second quarter of 2014, as well as values for the federal funds rate and the spread between BAA corporate bonds and ten-year Treasury yields up to July 30, 2014. The black line represents released data, the red line is the forecast, and the shaded areas mark the uncertainty associated with our forecasts at 50, 60, 70, 80, and 90 percent probability intervals. Notice that the uncertainty around the forecast is minimal for the third quarter of 2014, partly because some of the data used are available for that period of time. Output growth and inflation are expressed in quarter- to-quarter percentage annualized rates.

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The model projects a slow recovery with average output growth in the neighborhood of 2 percent throughout the forecast horizon. Moreover, the risks to the forecasts are skewed to the downside: it is more likely that GDP growth will turn out to be below our forecast rather than above. The main reason for this outcome is the zero lower bound on the federal funds rate, which constrains the Fed’s ability to respond appropriately to negative shocks. There is a sizable degree of uncertainty, however, around the real GDP forecast. For example, the model puts at 70 percent the probability that GDP growth (expressed in a Q4/Q4 basis) will be between 1.0 percent and 2.2 percent in the current year, and between -1.3 percent and 4.2 percent in 2015. Concerning the core PCE inflation forecast, the model predicts an average inflation rate between 1.3 percent and 2.0 percent over the forecast horizon, reaching the long-run Federal Open Market Committee (FOMC) objective of 2 percent only by the end of 2017. Forecast uncertainty is smaller for inflation than it is for output growth. In the near term, the model places high probability on inflation realizations being below the long-run FOMC target, but risks are balanced in the longer term. Market participants’ expectations about monetary policy are a key determinant of the model’s forecast as they affect the evolution of long-term interest rates. In order to capture the effects of forward guidance, or more generally of the Fed’s communication, the forecast is conditioned on financial market expectations available on July 30, 2014, of the path of the federal funds rate through 2015:Q2. Financial market participants anticipate a federal funds rate liftoff (that is, the first time in which the federal funds rate will be above 25 basis points) as happening in 2015:Q2. (Our working paper provides more details about the implementation of forward guidance in the model.) After the second quarter of 2015, we let the model set the path of the policy rate according to the “historical” interest rate rule, the one that we estimated over the pre- zero-lower-bound period. Of course, monetary policy might end up behaving differently from what is suggested by the estimated historical rule, but historical behavior is a

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reasonable starting point for a forecast. Under the current forecast, the model predicts the federal funds rate to return very slowly to its long-run level. As explained in the third post in this series, the model provides a narrative of the driving forces behind economic events, using the “shock decomposition” technique. The next chart shows that U.S. economic performance since the Great Recession has been driven primarily by two factors: headwinds hindering aggregate demand and monetary stimulus. Tight credit (in purple) and other factors restraining investment demand (in light blue) abated only very gradually, contributing to a holding back of the economy during the recovery. The persistent slack in the economy results in a rate of inflation coming in below the Fed’s long-run target. Looking ahead, the negative effect of the credit shocks (in purple) that generated the Great Recession are expected to wane. In fact, these shocks start to support growth starting in early 2014, consistent with the significant reduction in perceived risks and the ensuing compression in credit spreads observed recently. However, after the recession the economy has continued to be buffeted by negative shocks restraining investment (in light blue). The cumulative impact of these shocks on the level of output has not yet reached its full brunt, and consequently they still exert a negative impact on growth.

These negative shocks have been offset by expansionary monetary policy. In particular, forward guidance about the future path of the federal funds rate has played an important role in counteracting headwinds and has lifted output and inflation. The orange bars in the chart above show that the cumulative impact of policy accommodation, as measured by the current level of the federal funds rate in deviation from what is implied by the estimated historical rule. Through the first half of 2014, monetary policy provided substantial policy stimulus to the output growth. However, the positive effect of this policy accommodation on the level of output begins to wane at the end of 2014 and

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onward, as illustrated by the negative contribution of monetary shocks to output growth, even though it continues to maintain the policy rate lower than it would otherwise be. Why is that? In the model, monetary policy has no real effects in the long run, consistent with a long tradition in macroeconomics dating back to the so-called expectations-augmented Phillips curve of Friedman and Phelps. Therefore, monetary policy shocks can only have temporary effects on the level of output. If they push output up today, providing a positive contribution to its growth rate, then sooner or later that positive contribution must be reversed, so that output can ultimately return to its original level. Note that the chart shows only the most important shocks that have buffeted the U.S. economy in recent years. The chart omits in particular price markup shocks which capture short-term movements in inflation, such as those due to changes in commodity prices. Over the past few years, these shocks have driven some of the fluctuations in inflation, especially during the Arab Spring crisis (as discussed in yesterday’s post, “An Assessment of the FRBNY DGSE Model’s Real-Time Forecasts, 2010-13”). However, in this model, the impact of these shocks is short-lived and hence does not affect the medium- and long-term movements in inflation. (See this paper for an in-depth discussion of this issue.) In conclusion, the FRBNY DSGE model, at this point, predicts a continued gradual recovery in economic activity with a progressive return of inflation toward the FOMC’s long-run target of 2 percent, as the negative effect of the Great Recession continues to dissipate. This forecast remains surrounded by significant uncertainty, with the risks slightly skewed to the downside for output growth because of the constraint on policy imposed by the zero lower bound. http://libertystreeteconomics.newyorkfed.org/2014/09/the-frbny-dsge-model- forecast.html

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« A Bird’s Eye View of the FRBNY DSGE Model | Main | An Assessment of the FRBNY DSGE Model's Real-Time Forecasts, 2010-13 »

September 24, 2014 Developing a Narrative: The Great Recession and Its Aftermath

Andrea Tambalotti and Argia Sbordone

Third in a five-part series This series examines the Federal Reserve Bank of New York’s dynamic stochastic general equilibrium (FRBNY DSGE) model—a structural model used by Bank researchers to understand the workings of the U.S. economy and provide economic 220

forecasts.The severe recession experienced by the U.S. economy between December 2007 and June 2009 has given way to a disappointing recovery. It took three and a half years for GDP to return to its pre-recession peak, and by most accounts this broad measure of economic activity remains below trend today. What precipitated the U.S. economy into the worst recession since the Great Depression? And what headwinds are holding back the recovery? Are these headwinds permanent, calling for a revision of our assessment of the economy’s speed limit? Or are they transitory, although very long- lasting, as the historical record on the persistent damages inflicted by financial crisis seems to suggest? In this post, we address these questions through the lens of the FRBNY DSGE model.

DSGE models are a particularly suitable tool to look under the economy’s hood and illuminate its inner workings. Their structure allows us to decompose the evolution of the key macroeconomic variables that we can measure—such as GDP and inflation—in terms of their underlying driving forces, which are unobserved. In terms of the automotive metaphor, with a model of the car/economy in hand, we can trace back its observed behavior—direction and speed, say—to its fundamental determinants, such as the conditions of the road and the actions of the driver on the accelerator and the brakes. The key difference of course is that the economy is much more complicated than a car, and does not have one driver behind the wheel. Therefore our model can only provide a simplified, and in many cases imperfect, account of its workings. Even with these simplifications, however, the model provides useful insights.

The FRBNY DSGE model attributes the observed movements in macroeconomic variables to several fundamental disturbances, as explained in the previous post in this series and in more detail in our staff report. As it turns out, only four of these shocks account for the bulk of the movements in GDP and inflation since the Great Recession.

• A shock to total factor productivity (TFP), which affects the overall ability of the economy to produce output from any given amount of labor and capital inputs. A positive TFP shock results in higher GDP and, at the same time, in lower costs of production and hence lower inflation. In our model, shifts in TFP have a permanent effect on the economy’s productive potential. They capture a whole range of “structural” factors that will affect the growth trajectory of the economy for the foreseeable future. • A financial (or spread) shock stemming from increases in the perceived riskiness of borrowers, which induces banks and other intermediaries to charge higher interest rates on loans, thereby widening credit spreads. An increase in perceived risk (a positive realization of this shock) leads to a large increase in the cost of capital for entrepreneurs, which depresses investment demand and hence GDP growth. As a result of the lower demand, inflation also falls. Although the spikes in spreads associated with this shock tend to be relatively short-lived, as they were during the crisis, their effects can linger well past the most acute phase of market disruptions, with persistently tight credit conditions depressing demand, and hence output and inflation, for several years. Unlike the TFP shocks, however, these financial disturbances are not permanent, and their effects will ultimately dissipate, returning the economy to its pre-crisis growth trajectory. 221

• A shock to investment demand, whose negative realizations persistently depress capital formation, leading to lower growth and lower inflation. This shock has very similar macroeconomic effects to the risk shock we just described, with the crucial difference that it does not move credit spreads. Therefore, this disturbance can be thought of as capturing financial and other factors that do not manifest themselves in higher spreads, but that nonetheless affect firms’ willingness or ability to invest. Examples of such factors are a reluctance to lend by banks that does not lead to higher interest rates on loans, but for instance to a rationing of credit to certain borrowers, as well as the perception by firms of a particularly uncertain outlook, which delays their investment decisions. • Shocks to monetary policy, capturing changes in the monetary policy stance not reflected in the policy rate, such as the introduction of forward guidance.

The two charts below present the contributions of these four factors to the evolution of past observed and future projected GDP growth and inflation between 2007 and 2018. The variables are in deviation from their sample mean. Released data are represented by the black line. The projections for the rest of 2014 and beyond, captured by the red line, come from the model, as explained in more detail in the last post in this series. The colored bars represent the contribution of the corresponding driving force to the observed (or projected) outcome at any given point in time.

The first feature of this decomposition that we want to highlight is the paramount importance of spread shocks (in purple) during the recession. Starting at the end of 2007, the economy experiences a sequence of large shocks to credit spreads, driven by an increase in the perceived riskiness of borrowers. This progressive increase in risk is accompanied by deteriorating credit conditions, culminating in two spikes in spreads in the third and fourth quarters of 2008 with the failure of Lehman Brothers. These abrupt

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increases in the cost of credit account for a decline in quarterly GDP growth of more than 5 percentage points (annualized), which is about half of the total drop in output growth at the nadir of the recession. Inflation is also significantly affected by these shocks, which account for about three quarters of the decline in inflation in the second half of 2008.

The other half of the decline in GDP growth in 2008 stems from significant declines in TFP (the red bars). As we already pointed out, TFP shocks have permanent effects on the productive capacity of the economy in our framework, suggesting that the recession caused some lasting damage. However, the negative shocks of 2008 are followed by positive shocks, with the red bars primarily contributing to GDP growth. As a result, the level of TFP, and hence of potential output in our model, emerges largely unscathed at the present time.

As 2008 unfolds and the recession quickly worsens, the only force pushing against the fast deterioration in economic conditions is monetary policy. The orange bars— monetary policy shocks—do not represent the overall reaction of monetary policy to economic developments, which includes changes in the policy rate, but rather the extent to which this reaction exceeds what “normal,” historical reaction patterns would imply. Therefore, the large contributions of the orange bars suggest that the Federal Reserve was particularly aggressive in fighting the crisis early on, deploying several tools that went beyond its conventional weaponry. According to our model’s accounting, this extra effort is worth 2 to 3 percentage points of annual GDP growth in the middle of 2008, for a total boost to GDP of roughly 2 percent for 2008 as a whole. And this estimate does not even include the effects of the many credit and liquidity programs the Fed engaged in to ameliorate conditions in financial markets at the height of their stress.

Moving on to the recovery phase, which according to NBER dating starts in the middle of 2009, we can see that shocks to investment demand (in light blue) are the main 223

headwinds holding back the economy. As credit spreads return to normal, the effect of financial risk shocks (in purple) dissipates, even though their overall effect continues to be a drag on growth and inflation. At this point, however, investment shocks start taking on a very large negative role in pushing down both GDP growth and inflation. The key feature of these shocks is the persistence of their effect on both variables, which remain depressed throughout the recovery phase, and into the forecast horizon. Admittedly, the fundamentals of investment shocks are harder to characterize than those of the spread or TFP shocks, representing any factor unrelated to credit spreads that might still restrain investment demand. Many such factors have been identified over time as playing a role in the sluggish recovery, including an overall reluctance of banks and other intermediaries to expose their balance sheets to risk, regardless of the pricing of that risk, and the tendency of firms to delay projects in the face of unusually uncertain prospects. Either way, our model squarely points to investment demand shocks as playing a fundamental role in retarding the recovery, consistent with the view that weak investment, more than consumption, has been behind the slow pace of growth and subdued inflation.

Monetary policy remains on the other side of the ledger over the recovery period, serving to counteract the negative effects of the shocks weighing on the economy. Even with the policy rate against its zero lower bound, monetary policy continues to lift economic activity and prevent inflation from falling too far below target, as demonstrated by the positive orange bars in the chart. In the model, this stimulus is achieved through forward guidance, whose effect on expected future policy rates, and hence on long-term rates, is explicitly taken into account in the model estimation.

The model’s forecast for the evolution of the economy over the next few years (the red lines in both charts) remains persistently subpar, with GDP growth about half a percentage point below its mean and inflation recovering very slowly—scenarios that will be discussed in more detail in the last post in this series. Decomposing the forecasts into their determinants highlights two main features. First, the headwinds represented by tight credit and the other factors holding back investment demand abate only gradually, contributing to restrain the economy over the medium term. Second, monetary policy starts representing a drag on growth and inflation over the forecast horizon, even though the policy rate remains lower than it would otherwise be. The reason is that, in the model, monetary policy has no long-run effects on the real economy, so monetary policy shocks can only affect the level of output temporarily.

In conclusion, this analysis finds little evidence of the permanent structural damage to the economy’s productive potential that many commentators see as the main culprit for the subpar recovery from the Great Recession. Instead, our decomposition is quite supportive of the narrative popularized by Reinhart and Rogoff and more recently by Mian and Sufi, according to which a slow recovery is what we should have expected owing to the very persistent damage inflicted by the financial crisis on the real economy. In the FRBNY DSGE model, this damage manifests itself as a sequence of negative shocks to investment demand—shocks that capture many of the headwinds often mentioned as an impediment to a more robust recovery. At the same time, our model suggests that monetary policy played an important role in cushioning the blow from the financial crisis and in sustaining the recovery, which could have been 224

significantly more disappointing without the aggressive actions undertaken by the Fed.

Andrea Tambalotti is an officer in the Federal Reserve Bank of New York’s Research and Statistics Group.

Argia Sbordone is a vice president in the Bank’s Research and Statistics Group.

Early papers: http://libertystreeteconomics.newyorkfed.org/2014/09/a-birds-eye-view-of-the-frbny- dsge-model.html http://www.newyorkfed.org/research/staff_reports/sr647.html http://libertystreeteconomics.newyorkfed.org/2014/09/an-assessment-of-the-frbny-dsge- models-real-time-forecasts.html

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09/24/2014 01:00 PM German Central Bank Head Weidmann 'The Euro Crisis Is Not Yet Behind Us' Interview by Armin Mahler and Anne Seith An extended period of calm on the bond markets has led many to conclude the euro crisis is over. But German central bank head Jens Weidmann says in an interview that the coast still isn't clear and that there is still great need for reforms. SPIEGEL: Mr. Weidmann, you are notorious for being a tough critic of European Central Bank President Mario Draghi. But the euro crisis seems to be over, largely thanks to ECB intervention. Has he not been proven right? Weidmann: It's not about being right or a personal confrontation. When it comes to extremely important monetary policy decisions, the ECB Governing Council does its utmost to find the correct path. And the decisions are so difficult because the crisis is not yet behind us, even if the current calm on the financial markets might suggest as much. SPIEGEL: Yet Spain, once wracked by the euro-zone crisis, can today borrow money more cheaply than ever before in the history of the monetary union. Do you not think that is a consequence of Mario Draghi's 2012 pledge to save the euro "whatever it takes"? Weidmann: You shouldn't mistake the thermometer for the illness. I have never disputed that the ECB could impress and move the markets with the announcement that it would make massive purchases of sovereign bonds if necessary. But such measures focus on the symptoms and don't cure the causes of the crisis. As such, the current calm is misleading and even dangerous, because it takes pressure off of the governments to implement badly needed reforms. If they are not undertaken, investors could quickly change their risk evaluations. SPIEGEL: But if the ECB hadn't intervened, the euro zone patient may well have died from its 2012 fever. Weidmann: I don't believe that is the case. In reaction to the crisis, policymakers established a multibillion euro bailout fund to assist the crisis countries in exchange for their adherence to certain stipulations. That was the correct, democratically legitimate path. Even more so given that the bailout fund can also purchase sovereign bonds. The central bank in the euro zone, by contrast, is forbidden from providing credit to countries and from purchasing sovereign bonds on the primary market. By making targeted bond purchases on the secondary market, the ECB opened itself to accusations of skirting this ban. SPIEGEL: Since the beginning of the financial crisis, the European Central Bank has injected liquidity into the markets at decreasing intervals. It is a bit reminiscent of a junkie who has to continually up the dosage to have the desired effect. Weidmann: It is certainly true that after each loosening of monetary policy, the public immediately begins speculating about what might come next. 226

SPIEGEL: Most recently, in early September, the ECB Governing Council reduced the already low interest rate of 0.15 percent to 0.05 percent. What will that accomplish? Weidmann: That wasn't the only measure taken. After a controversial discussion, agreement was reached on a purchasing program for covered bonds and asset-backed securities (ABSs) and the effect of the entire package must be evaluated. No matter what one's views on the content of the package, the ECB council has demonstrated that monetary policy is prepared to go far and break new ground. SPIEGEL: The focus was more on the message sent rather than the real economic effects? Weidmann: There isn't necessarily a contradiction between the two. Monetary policy signals can be used to influence the expectations of consumers, investors and companies. The focus is no longer just on stimulating the credit markets, but also on pumping money directly into the economy if need be. That is why the most recent decisions made by the ECB council, in my estimation, mark a critical juncture and an incisive change in the ECB's monetary policy. SPIEGEL: Are there even sufficient securities in circulation for the ECB to spend several hundred billion on their purchase? Weidmann: If we want to avoid highly risky securities and keep away from buying out an entire market, it is questionable. For the program to have an effect, the purchases would have to completely rejuvenate the market for new securities. SPIEGEL: Which is why it is likely only a matter of time before the ECB begins buying large quantities of both sovereign and company bonds. Would you agree to such a program? Weidmann: I don't think much of speculating on what other actions might be added immediately following the introduction of new measures. Those who feed such speculation call into question the effects of those just introduced. My position on sovereign bond purchases is well known and has not changed. SPIEGEL: Low inflation in the euro zone has also been presented as a justification for such measures. What is so bad about the fact that prices are not increasing? Weidmann: From the perspective of the public, nothing at first. On the contrary, they are able to buy more for their money than they would if inflation were higher. But there are good reasons why the ECB council strives for an inflation rate of under, but close to, 2 percent, thus maintaining a safety margin from the zero line. An average inflation rate of zero in the euro zone would mean that prices and nominal wages would climb in some countries whereas they would have to fall in other countries. Experience shows that such a situation is difficult to manage. Even under the intense pressure to reform, nominal wages in crisis countries have, at least, not fallen. In addition, without a safety margin monetary policy reaches its limits more quickly, from which it can no longer furnish interest-policy stimulus. The prime rate cannot, after all, be reduced too far below zero. SPIEGEL: How realistic is the danger of deflation in the euro zone?

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Weidmann: The probability of a problematic deflationary development is very low. The decline of the inflation rate is largely due to sinking energy and commodity prices. As a central bank, we don't have any direct influence on that and the effects on the inflation rate are only temporary insofar as, for example, companies and trade unions don't react with their wage agreements. In addition, adjustment processes in the crisis countries are behind the development. During the adjustment period, not only economic growth, but also price pressures will be dulled. Rapidly overcoming this phase is another reason structural reforms must be resolutely implemented. SPIEGEL: Is not the ECB taking advantage of deflation fears to push through instruments that it shouldn't really be using? Weidmann: If a central bank is in danger of missing its inflation target in the near future, its credibility demands that it consider unconventional instruments within its mandate. Which doesn't mean that each of these instruments is equally appropriate. SPIEGEL: But you just said that the low inflation rate is the result of normal factors. Why should it then be combatted? Weidmann: We can't change the current rate of inflation. Our monetary policy targets future developments. For their future planning, households and corporations have to be able to depend on mid-term prices climbing at an annual rate of almost 2 percent, in accordance with our announcements. SPIEGEL: Nevertheless, you would have preferred that no action were taken at the last ECB council session. Weidmann: It was very much possible to have a different assessment regarding the need to take action, particularly given that new ECB forecasts have not changed the inflation rates expected for next year and the year after. As ECB President Draghi said in the press conference, we had divergent views as to whether it was absolutely necessary to introduce far-reaching purchasing programs and regarding the risks and side effects the recent resolutions might have. Especially in light of the fact that the liquidity measures announced in June hadn't even been initiated. SPIEGEL: Christian Noyer, head of the French central bank, said that the new measures are also aimed at pushing down the euro exchange rate. Is that the task of the ECB? Weidmann: Absolutely not, and I believe that Christian Noyer was misunderstood. Of course our decisions have an influence on the height of the exchange rate which then has an effect on the development of inflation. But we are not pursuing a monetary policy that targets the exchange rate. Policies aimed at intentionally weakening one's own currency would also not be consistent with G-20 agreements. More than anything, a weak currency is not a good way to ensure lasting growth. SPIEGEL: Via its ABS purchase program, the ECB balance sheet will soon include bank loans in the form of securities. Would that not threaten to turn it into Europe's bad bank? Weidmann: That depends on what is purchased and at what price. If at all, the ECB should only buy low risk securities -- and only after careful evaluation. More than anything, the ECB should not pay higher prices than a private investor would. What's 228

clear is that if the ECB does take on risky securities or pays inflated prices in order to reach the targeted purchase volume, it ultimately burdens taxpayers. Which is why it is important to limit the program's risks and ensure complete transparency regarding the purchases. SPIEGEL: Does the course currently being followed by the ECB mean that the collectivization of debt, a process opposed by Berlin, is being introduced through the back door? Weidmann: Depending on how the program is designed, there is a danger that banks might be freed from risks on the backs of taxpayers. But that is surely not the function of the ECB. It would also contradict the current regulation efforts aimed at making shareholders and creditors liable. That is why it is decisive that the purchasing program does not take on appreciable risks either from financial institutions or countries. SPIEGEL: That will be difficult. ABSs are primarily issued in the Netherlands, Italy, Spain and France, countries where banks have many questionable loans on their books. What is the point at which you say you can no longer support the course charted by the ECB? Weidmann: If I am unable to support a specific measure, I don't vote for it and I energetically throw my support behind a different course of action. Only in that way is it possible to influence decisions, sometimes to a greater degree than others. But I am certain that, without the influence of Germany's central bank, important decisions would be made differently. SPIEGEL: You wouldn't be the first German to leave the ECB in frustration. Weidmann: When I took office, we were already in a difficult monetary policy phase. I was aware of the conflicts that might be facing me. I do not wish to, nor will I, run away from them. SPIEGEL: You are seen as the great doubter while Draghi is celebrated as Europe's savior. Does that bother you? Weidmann: Such generalizations miss the point and are not helpful. Mario Draghi has also repeatedly pointed out that monetary policy alone isn't enough to save Europe. I am convinced that a central bank that allows itself to be pressured by politics risks its independence. If a central bank compensates for a lack of political action, the pressure to do so over and over again will constantly increase and it runs the risk of losing sight of its price stability targets. SPIEGEL: Supporters of this course of action say that the ECB has to do something because politicians are abdicating their responsibility for finding a solution. Are they not right? Weidmann: The view of democracy that informs this question is not one that I share. If elected politicians don't take action for fear of voter dissatisfaction then a small circle of central bankers, who are not elected and who don't have a mandate for economic policy, should not allow themselves to be seduced into taking on the role of policymakers. Such a procedure is not a sound foundation for the collective European house.

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SPIEGEL: Just as you are largely isolated in the ECB, German Chancellor Angela Merkel is largely alone when it comes to European policy. Most countries are demanding that austerity be loosened. What is wrong with giving crisis countries more time to solve their problems? Weidmann: I don't see Germany as being isolated. Precisely those countries that have implemented far-reaching reforms in recent years and consolidated their budgets against political opposition are now calling on larger member states to conform to the rules. Furthermore, we shouldn't forget that the sovereign debt crisis was triggered by doubts about the stability of the public budgets of some euro-zone member states. If we want to address the causes, a credible course toward stable state finances must be charted. Reaching agreements when the pressure is on only to scrap them when pressure drops cannot be part of that course. SPIEGEL: Still, the goals must be realistic. Is there not a danger of strangling the economy via austerity? Weidmann: We are far away from that. In some countries, the deficits have been over 3 percent for years and this year too will see six euro-zone countries transgress the deficit limit. The danger I see is that the necessary budget consolidations will be delayed and that the trust that has been lost won't be built up again quickly enough. Solid budgets, furthermore, are a precondition for, not a contradiction to, sustainable economic growth. SPIEGEL: Draghi, though, wants to stimulate the economy. Among other measures, he is gathering support for an investment program worth more than €300 billion. Weidmann: Before that can happen, it must be seen how the program, proposed by incoming European Commission President Jean-Claude Juncker, is to be financed. In any case, it cannot lead to the abandonment of consolidation. And each project must be examined to determine if the investment carries benefits for the economy in its entirety. The past has shown that not all public investments were sensible, neither in the crisis countries nor here in Germany. SPIEGEL: What is your recipe for increased growth? Weidmann: Growth and jobs are ultimately produced by private companies. That is where investment must take place. To promote that, the public sphere must create the necessary framework. I believe that the improvement of administration structures in many crisis countries, for example, is much more important than reflexively demanding that new streets and bridges be built. If you have to wait months for an operating or construction license, that doesn't promote the willingness to become active as an entrepreneur. In addition, public budgets must be consolidated, labor markets must be made more flexible and banks must be stabilized as promised so that loans can once again be made. And there has been progress on those issues. SPIEGEL: But not in France and not in Italy. Weidmann: There too governments have realized that there is a need to act. The examples of Spain and Ireland show that structural reforms are worthwhile. The governments of both those countries were recently able to make significant upward adjustments to their growth forecasts. SPIEGEL: What if France and Italy continue on as they have? 230

Weidmann: The longer these two large countries refrain from creating the conditions for growth and stability, the longer the euro zone's weakness will continue -- and with it, the pressure on monetary policy. SPIEGEL: Would you rather see the euro fail than abandon your principles? Weidmann: That isn't the question. The ECB contributes to the success of monetary union by keeping monetary value stable. That is our legal mandate. Member states, for their part, have to make their economies fit for the common currency. Those are the rules of the game that all have agreed to. SPIEGEL: Mr. Weidmann, we thank you for this interview. URL: • http://www.spiegel.de/international/business/interview-with-bundesbank-head- jens-weidmann-on-euro-crisis-and-ecb-a-993409.html Related SPIEGEL ONLINE links: • France and Friends: Merkel Increasingly Isolated on Austerity (09/03/2014) http://www.spiegel.de/international/europe/the-anti-austerity-camp-is-growing-as- merkel-becomes-more-isolated-a-989357.html • Weapon of Last Resort: ECB Considers Possible Deflation Measures (04/23/2014) http://www.spiegel.de/international/europe/ecb-prepares-measures-to-combat- possible-deflation-a-965636.html • Out of Ammo? The Eroding Power of Central Banks (04/16/2014) http://www.spiegel.de/international/business/central-banks-ability-to-influence- markets-waning-a-964757.html

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EurActiv EU News & policy debates,across languages Germany’s economic mirage Published: 23/09/2014 - 15:24 | Updated: 30/09/2014 - 19:03

Philippe Legrain Germany’s economy needs an overhaul. Policymakers should focus on boosting productivity, not “competitiveness,” with workers being paid their due, writes Philippe Legrain. Philippe Legrain, a visiting senior fellow at the London School of Economics’ European Institute and a former economic adviser to the president of the European Commission, is the author of European Spring: Why Our Economies and Politics are in a Mess – and How to Put Them Right. For 60 years, successive German governments sought a more European Germany. But now, Chancellor Angela Merkel’s administration wants to reshape Europe’s economies in Germany’s image. This is politically unwise and economically dangerous. Far from being Europe’s most successful economy – as German Finance Minister Wolfgang Schäuble and others boast – Germany’s economy is dysfunctional. To be sure, Germany has its strengths: world-renowned companies, low unemployment, and an excellent credit rating. But it also has stagnant wages, busted banks, inadequate investment, weak productivity gains, dismal demographics, and anemic output growth. Its “beggar-thy-neighbor” economic model – suppressing wages to subsidize exports – should not serve as an example for the rest of the eurozone to follow.

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Germany’s economy contracted in the second quarter of 2014, and has grown by a mere 3.6% since the 2008 global financial crisis – slightly more than France and the United Kingdom, but less than half the rate in Sweden, Switzerland, and the United States. Since 2000, GDP growth has averaged just 1.1% annually, ranking 13th in the 18 member eurozone. Written off as the “sick man of Europe” when the euro was launched in 1999, Germany responded not by boosting dynamism, but by cutting costs. Investment has fallen from 22.3% of GDP in 2000 to 17% in 2013. Infrastructure, such as highways, bridges, and even the Kiel Canal, is crumbling after years of neglect. The education system is creaking. The number of new apprentices is at a post-reunification low, the country has fewer young graduates (29%) than Greece (34%), and its best universities barely scrape into the global top 50. Hobbled by underinvestment, Germany’s arthritic economy struggles to adapt. Despite former Chancellor Gerhard Schröder’s labor-market reforms, it is harder to lay off a permanent employee in Germany than anywhere else in the OECD. Germany languishes in 111th place globally for ease of starting a business, according to the World Bank’s Doing Business rankings. Its largest firms are old and entrenched; it has produced no equivalent of Google or Facebook; and the service sector is particularly hidebound. The government has introduced fewer pro-growth reforms over the past seven years than any other advanced economy, according to the OECD. Average annual productivity growth over the past decade, at a mere 0.9%, has been slower even than Portugal’s. The brunt of the stagnation has been borne by German workers. Though their productivity has risen by 17.8% over the past 15 years, they now earn less in real terms than in 1999, when a tripartite agreement among the government, companies, and unions effectively capped wages. Business owners might cheer, but suppressing wages harms the economy’s longer-term prospects by discouraging workers from upgrading skills, and companies from investing in higher-value production. Wage compression saps domestic demand, while subsidizing exports, on which Germany’s growth relies. The euro, which is undoubtedly much weaker than the Deutschmark would have been, has also helped, by reducing the prices of German goods and preventing France and Italy from pursuing currency depreciation. Until recently, the euro also provided booming external demand in southern Europe, while China’s breakneck industrial development raised demand for Germany’s traditional exports. But, with southern Europe now depressed, and China’s economy decelerating and shifting away from investment spending, the German export machine has slowed. Its share of global exports fell from 9.1% in 2007 to 8% in 2013 – as low as in the “sick man” era, when Germany was struggling with reunification. Because cars and other exports “made in Germany” now contain many parts produced in central and eastern Europe, Germany’s share of global exports is at a record low in value-added terms. German policymakers pride themselves on the country’s vast current-account surplus – €197 billion ($262 billion) as of June 2014 – viewing it as a sign of Germany’s superior competitiveness. Why, then, are businesses unwilling to invest more in the country?

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External surpluses are in fact symptomatic of an ailing economy. Stagnant wages boost corporate surpluses, while subdued spending, a stifled service sector, and stunted start- ups suppress domestic investment, with the resulting surplus savings often squandered overseas. The Berlin-based DIW institute calculates that from 2006 to 2012, the value of Germany’s foreign portfolio holdings fell by €600 billion, or 22% of GDP. Worse, rather than being an “anchor of stability” for the eurozone, as Schäuble claims, Germany spreads instability. Its banks’ poor approach to lending their surplus savings inflated asset-price bubbles in the run-up to the financial crisis, and have imposed debt deflation since then. Nor is Germany a “growth engine” for the eurozone. In fact, its weak domestic demand has dampened growth elsewhere. As a result, German banks and taxpayers are less likely to recover their bad loans to southern Europe. Given how bad wage compression has been for Germany’s economy, foisting wage cuts on the rest of the eurozone would be disastrous. Slashing incomes depresses domestic spending and makes debts even less manageable. With global demand weak, the eurozone as a whole cannot rely on exports to grow out of its debts. For struggling southern European economies whose traditional exports have been undercut by Chinese and Turkish competition, the solution is to invest in moving up the value chain by producing new and better products. Germany’s economy needs an overhaul. Policymakers should focus on boosting productivity, not “competitiveness,” with workers being paid their due. The government should take advantage of near-zero interest rates to invest, and encourage businesses – especially start-ups – to do likewise. Finally, Germany should welcome more dynamic young immigrants to stem its demographic decline. This would be a better economic model for Germany. It would also set the right example for the rest of Europe. Copyright: Project Syndicate http://www.euractiv.com/sections/eu-priorities-2020/germanys-economic-mirage- 308648

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Wolfgang Schäuble

From Wikipedia, the free encyclopedia Jump to: navigation, search

Wolfgang Schäuble ([ˈvɔlfɡaŋ ˈʃɔʏblə] born 18 September 1942) is a German politician of the Christian Democratic Union (CDU) who has served as Germany's Federal Minister of Finance in the second and third Merkel cabinets since 2009.

From 1984 to 1991 he was a member of Helmut Kohl's cabinet, first as Federal Minister for Special Affairs and Chief of the Chancellery and then as Federal Minister of the Interior. Between 1991 and 2000, he was chairman of the CDU/CSU group in the parliament, and from 1998 to 2000 also CDU party chairman. He served again as Federal Minister of the Interior in the First Merkel cabinet from 2005 to 2009. Contents

• 1 Early life and education// 2 Career// 3 Member of Parliament// 4 Public office • 5 Political views// 5.1 Criticism// 6 Assassination attempt// 7 Personal life// 8 Selected works// 9 References// 10 External links Early life and education[edit]

Schäuble was born in Freiburg im Breisgau, as the son of a tax finance advisor. After completing his Abitur in 1961, Schäuble studied law and economics at the University of Freiburg and the University of Hamburg, which he completed in 1966 and 1970 by passing the First and Second State Examinations respectively, becoming a fully qualified lawyer.

In 1971 Schäuble obtained his doctorate in law, with a dissertation called "The public accountant's professional legal situation within accountancy firms". Career[edit]

Schäuble entered the tax administration of the state of Baden-Württemberg, eventually becoming a senior administration officer in the Freiburg tax office. Subsequently he became a practising registered lawyer at the district court of Offenburg, from 1978 to 1984. http://en.wikipedia.org/wiki/Wolfgang_Sch%C3%A4uble

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Uneasy Money

Commentary on monetary policy in the spirit of R. G. Hawtrey

David Glasner I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual Temporary Equilibrium One More Time Published September 23, 2014 expectations , intertemporal equilibrium , IS-LM , J. R. Hicks , Paul Krugman , rational expectations , temporary equilibrium1 Comment Tags: IS-LM, J. R. Hicks, Keynes, Krugman, temporary equilibrium, Value and Capital

It’s always nice to be noticed, especially by Paul Krugman. So I am not upset, but in his response to my previous post, I don’t think that Krugman quite understood what I was trying to convey. I will try to be clearer this time. It will be easiest if I just quote from his post and insert my comments or explanations. Glasner is right to say that the Hicksian IS-LM analysis comes most directly not out of Keynes but out of Hicks’s own Value and Capital, which introduced the concept of “temporary equilibrium”. Actually, that’s not what I was trying to say. I wasn’t making any explicit connection between Hicks’s temporary-equilibrium concept from Value and Capital and the IS-LM model that he introduced two years earlier in his paper on Keynes and the Classics. Of course that doesn’t mean that the temporary equilibrium method isn’t connected to the IS-LM model; one would need to do a more in-depth study than I have done of Hicks’s intellectual development to determine how much IS-LM was influenced by Hicks’s interest in intertemporal equilibrium and in the method of temporary equilibrium as a way of analyzing intertemporal issues. This involves using quasi-static methods to analyze a dynamic economy, not because you don’t realize that it’s dynamic, but simply as a tool. In particular, V&C discussed at some length a temporary equilibrium in a three-sector economy, with goods, bonds, and money; that’s essentially full-employment IS-LM, which becomes the 1937 version with some price stickiness. I wrote about that a long time ago. Now I do think that it’s fair to say that the IS-LM model was very much in the spirit of Value and Capital, in which Hicks deployed an explicit general-equilibrium model to analyze an economy at a Keynesian level of aggregation: goods, bonds, and money. But the temporary-equilibrium aspect of Value and Capital went beyond the Keynesian analysis, because the temporary equilibrium analysis was explicitly intertemporal, all agents formulating plans based on explicit future price expectations, and the inconsistency between expected prices and actual prices was explicitly noted, while in

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the General Theory, and in IS-LM, price expectations were kept in the background, making an appearance only in the discussion of the marginal efficiency of capital. So is IS-LM really Keynesian? I think yes — there is a lot of temporary equilibrium in The General Theory, even if there’s other stuff too. As I wrote in the last post, one key thing that distinguished TGT from earlier business cycle theorizing was precisely that it stopped trying to tell a dynamic story — no more periods, forced saving, boom and bust, instead a focus on how economies can stay depressed. Anyway, does it matter? The real question is whether the method of temporary equilibrium is useful. That is precisely where I think Krugman’s grasp on the concept of temporary equilibrium is slipping. Temporary equilibrium is indeed about periods, and it is explicitly dynamic. In my previous post I referred to Hicks’s discussion in Capital and Growth, about 25 years after writing Value and Capital, in which he wrote The Temporary Equilibrium model of Value and Capital, also, is “quasi-static” [like the Keynes theory] – in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes. As I read this passage now — and it really bothered me when I read it as I was writing my previous post — I realize that what Hicks was saying was that his desire to conform to the Keynesian paradigm led him to compromise the integrity of the temporary equilibrium model, by forcing it to be “quasi-static” when it really was essentially dynamic. The challenge has been to convert a “quasi-static” IS-LM model into something closer to the temporary-equilibrium method that Hicks introduced, but did not fully execute in Value and Capital. What are the alternatives? One — which took over much of macro — is to do intertemporal equilibrium all the way, with consumers making lifetime consumption plans, prices set with the future rationally expected, and so on. That’s DSGE — and I think Glasner and I agree that this hasn’t worked out too well. In fact, economists who never learned temporary-equiibrium-style modeling have had a strong tendency to reinvent pre-Keynesian fallacies (cough-Say’s Law-cough), because they don’t know how to think out of the forever-equilibrium straitjacket. Yes, I agree! Rational expectations, full-equilibrium models have turned out to be a regression, not an advance. But the way I would make the point is that the temporary- equilibrium method provides a sort of a middle way to do intertemporal dynamics without presuming that consumption plans and investment plans are always optimal. What about disequilibrium dynamics all the way? Basically, I have never seen anyone pull this off. Like the forever-equilibrium types, constant-disequilibrium theorists have a remarkable tendency to make elementary conceptual mistakes. Again, I agree. We can’t work without some sort of equilibrium conditions, but temporary equilibrium provides a way to keep the discipline of equilibrium without assuming (nearly) full optimality. Still, Glasner says that temporary equilibrium must involve disappointed expectations, and fails to take account of the dynamics that must result as expectations are revised.

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Perhaps I was unclear, but I thought I was saying just the opposite. It’s the “quasi- static” IS-LM model, not temporary equilibrium, that fails to take account of the dynamics produced by revised expectations. I guess I’d say two things. First, I’m not sure that this is always true. Hicks did indeed assume static expectations — the future will be like the present; but in Keynes’s vision of an economy stuck in sustained depression, such static expectations will be more or less right. Again, I agree. There may be self-fulfilling expectations of a low-income, low- employment equilibrium. But I don’t think that that is the only explanation for such a situation, and certainly not for the downturn that can lead to such an equilibrium. Second, those of us who use temporary equilibrium often do think in terms of dynamics as expectations adjust. In fact, you could say that the textbook story of how the short- run aggregate supply curve adjusts over time, eventually restoring full employment, is just that kind of thing. It’s not a great story, but it is the kind of dynamics Glasner wants — and it’s Econ 101 stuff. Again, I agree. It’s not a great story, but, like it or not, the story is not a Keynesian story. So where does this leave us? I’m not sure, but my impression is that Krugman, in his admiration for the IS-LM model, is trying too hard to identify IS-LM with the temporary-equilibrium approach, which I think represented a major conceptual advance over both the Keynesian model and the IS-LM representation of the Keynesian model. Temporary equilibrium and IS-LM are not necessarily inconsistent, but I mainly wanted to point out that the two aren’t the same, and shouldn’t be conflated. http://uneasymoney.com/2014/09/23/temporary-equilibrium-one-more-time/ Krugman on Minsky, IS-LM and Temporary Equilibrium Published September 21, 2014 expectations , IS-LM , J. R. Hicks , Keynes , Paul Krugman , temporary equilibrium10 Comments Tags: Brad Delong, Hicks, Hyman Minsky, IS-LM, Keynes, Krugman, Lars Syll, Roger Farmer

Catching up on my blog reading, I found this one from Paul Krugman from almost two weeks ago defending the IS-LM model against Hyman Minsky’s criticism (channeled by his student Lars Syll) that IS-LM misrepresented the message of Keynes’s General Theory. That is an old debate, and it’s a debate that will never be resolved because IS- LM is a nice way of incorporating monetary effects into the pure income-expenditure model that was the basis of Keynes’s multiplier analysis and his policy prescriptions. On the other hand, the model leaves out much of what most interesting and insightful in the General Theory – precisely the stuff that could not easily be distilled into a simple analytic model. Here’s Krugman: 238

Lars Syll approvingly quotes Hyman Minsky denouncing IS-LM analysis as an “obfuscation” of Keynes; Brad DeLong disagrees. As you might guess, so do I. There are really two questions here. The less important is whether something like IS- LM — a static, equilibrium analysis of output and employment that takes expectations and financial conditions as given — does violence to the spirit of Keynes. Why isn’t this all that important? Because Keynes was a smart guy, not a prophet. The General Theory is interesting and inspiring, but not holy writ. It’s also a protean work that contains a lot of different ideas, not necessarily consistent with each other. Still, when I read Minsky putting into Keynes’s mouth the claim that Only a theory that was explicitly cyclical and overtly financial was capable of being useful I have to wonder whether he really read the book! As I read the General Theory — and I’ve read it carefully — one of Keynes’s central insights was precisely that you wanted to step back from thinking about the business cycle. Previous thinkers had focused all their energy on trying to explain booms and busts; Keynes argued that the real thing that needed explanation was the way the economy seemed to spend prolonged periods in a state of underemployment: [I]t is an outstanding characteristic of the economic system in which we live that, whilst it is subject to severe fluctuations in respect of output and employment, it is not violently unstable. Indeed it seems capable of remaining in a chronic condition of subnormal activity for a considerable period without any marked tendency either towards recovery or towards complete collapse. So Keynes started with a, yes, equilibrium model of a depressed economy. He then went on to offer thoughts about how changes in animal spirits could alter this equilibrium; but he waited until Chapter 22 (!) to sketch out a story about the business cycle, and made it clear that this was not the centerpiece of his theory. Yes, I know that he later wrote an article claiming that it was all about the instability of expectations, but the book is what changed economics, and that’s not what it says. This all seems pretty sensible to me. Nevertheless, there is so much in the General Theory — both good and bad – that isn’t reflected in IS-LM, that to reduce the General Theory to IS-LM is a kind of misrepresentation. And to be fair, Hicks himself acknowledged that IS-LM was merely a way of representing one critical difference in the assumptions underlying the Keynesian and the “Classical” analyses of macroeconomic equilibrium. But I would take issue with the following assertion by Krugman. The point is that Keynes very much made use of the method of temporary equilibrium — interpreting the state of the economy in the short run as if it were a static equilibrium with a lot of stuff taken provisionally as given — as a way to clarify thought. And the larger point is that he was right to do this. When people like me use something like IS-LM, we’re not imagining that the IS curve is fixed in position for ever after. It’s a ceteris paribus thing, just like supply and demand. Assuming short-run equilibrium in some things — in this case interest rates and output — doesn’t mean that you’ve forgotten that things change, it’s just a way to 239

clarify your thought. And the truth is that people who try to think in terms of everything being dynamic all at once almost always end up either confused or engaging in a lot of implicit theorizing they don’t even realize they’re doing. When I think of a temporary equilibrium, the most important – indeed the defining — characteristic of that temporary equilibrium is that expectations of at least some agents have been disappointed. The disappointment of expectations is likely to, but does not strictly require, a revision of disappointed expectations and of the plans conditioned on those expectations. The revision of expectations and plans as a result of expectations being disappointed is what gives rise to a dynamic adjustment process. But that is precisely what is excluded from – or at least not explicitly taken into account by – the IS-LM model. There is nothing in the IS-LM model that provides any direct insight into the process by which expectations are revised as a result of being disappointed. That Keynes could so easily think in terms of a depressed economy being in equilibrium suggests to me that he was missing what I regard as the key insight of the temporary- equilibrium method. Of course, there are those who argue, perhaps most notably Roger Farmer, that economies have multiple equilibria, each with different levels of output and employment corresponding to different expectational parameters. That seems to me a more Keynesian approach, an approach recognizing that expectations can be self- fulfilling, than the temporary-equilibrium approach in which the focus is on mistaken and conflicting expectations, not their self-fulfillment. Now to be fair, I have to admit that Hicks, himself, who introduced the temporary- equilibrium approach in Value and Capital (1939) later (1965) suggested in Capital and Growth (p. 65) that both the Keynes in the General Theory and the temporary- equilibrium approach of Value and Capital were “quasi-static.” The analysis of the General Theory “is not the analysis of a process; no means has been provided by which we can pass from one Keynesian period to the next. . . . The Temporary Equilibrium model of Value and Capital, also, is quasi-static in just the same sense. The reason why I was contented with such a model was because I had my eyes fixed on Keynes. Despite Hicks’s identification of the temporary-equilibrium method with Keynes’s method in the General Theory, I think that Hicks was overly modest in assessing his own contribution in Value and Capital, failing to appreciate the full significance of the method he had introduced. Which, I suppose, just goes to show that you can’t assume that the person who invents a concept or an idea is necessarily the one who has the best, or most comprehensive, understanding of what the concept means of what its significance is. http://uneasymoney.com/2014/09/21/krugman-on-minsky-is-lm-and-temporary- equilibrium/

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mainly macro Comment on macroeconomic issues Monday, 22 September 2014 Misleading a country Simon Wren-Lewis

When this happens (taken from a post by Jérémie Cohen-Setton), something has gone very wrong. The Euro was meant to increase growth, not create stagnation. So what, or who, is to blame? Many outside the Eurozone, and a growing minority within it, will say the Euro itself. But that is not a very helpful response. Given the level of commitment to the Euro, it is the onlycorrect response if there is no version of this currency union that can be made to work better. Others will say that the only way forward is further political integration through a fiscal union. That seems like the political equivalent of going from the frying pan into the fire. The story of the Euro is as much a political failure as an economic failure. But I also suspect support among many economists for fiscal union is built upon a questionable premise. The premise is that the current difficulties arise because it is inevitable that Germany will put its national interest above the interests of the Eurozone as a whole. This argument goes as follows. As a result of undercutting other union members, Germany has become too competitive within the Eurozone. This will be reversed. The ECB has an inflation target of almost 2%. Therefore in normal circumstances we would see inflation above 2% in Germany for some period. This is unfortunate for Germany, but those are the macroeconomic rules of the game in a monetary union. However we are not in normal circumstances, because the interest rate set by the ECB cannot fall any further. As a result, Eurozone inflation is well below 2%. There is an obvious solution to this problem: replace monetary stimulus with fiscal stimulus. However, this is not in Germany’s interests: as a result of becoming too competitive, their economy is relatively healthy, and they do not want above 2% inflation. Therefore we need a fiscal union to impose fiscal stimulus on Germany. (There is a variant of this

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argument where we focus on the failure of monetary policy and German pressure on the ECB.) It is natural for economists to reason this way, because we are used to thinking about rational self-interested individuals. But suppose the problem with German public opinion is not that it is being narrowly self-interested, but that it has been encouraged to think about this in the wrong way. There are two aspects to this. First, although Keynesian economics is taught in all universities, in appears taboo in much German public discussion. Under this anti-Keynesian view the chart above has nothing to do with fiscal contraction, so it must be all about the lack of ‘structural reform’ outside Germany. Second, German politicians are in denial about the implications of low German inflation before the crisis. Logically the only way Germany can avoid above 2% inflation is if the Eurozone as a whole goes through a prolonged depression, but as is painfully obvious from the comments on some of my recent posts, the German public is not told about this. The two deceptions help reinforce each other. Germany says it is doing OK without the need for fiscal stimulus, so why do other countries need it? Of course Germany is doing fine because its period of relatively low inflation allowed it to uncut its Eurozone competitors. Never underestimate the power of bad ideas, particularly if they have ideological roots. Here we have the two mistakes that led to the Great Depression being repeated. We look back at the 1930s and think if only they had known about Keynesian economics a depression could have been avoided. However the depression was as much about countries attempting to stick with the gold standard, and the problems with that were obvious at the time. Today we do know about Keynesian economics, but both mistakes continue. It is possible to believe that balanced-budget fundamentalism is somehow hard wired into the German psyche, and I have personally experienced moments like that described in this comment to my earlier post that seem to confirm this. So I do not want to discount such explanations entirely, but I do wonder if a powerful motive behind this is just the same anti-state neoliberalism that you see elsewhere. Those on the right appear to have a greater distrust of economists and their theories. This may be true of popular attitudes (HT Tyler Cowen), but it is also the case of those running the country. According to Der Spiegel, the three permanent secretaries running the German finance ministry have studied law rather than economics. Among the nine department heads seven are lawyers and just two are economists. While the balance between lawyers and economists has always favoured lawyers, it has apparently become worse under Schäuble (whose doctorate is also in law). As a result of all this, it is not at all clear to me that the current problems of the Eurozone are all down to German self-interest. The case for additional infrastructure spending in Germany looks strong, as arguedby Marcel Fratzscher, head of the German Institute for Economic Research (DIW). It would therefore seem more than possible to get Germany to take part in a Eurozone wide programme of additional public investment, which can be justified on a microeconomic/supply side basis as well as on macroeconomic/demand side grounds. All that stands in the way is the power of bad ideas, and its embodiment in the Eurozone’s fiscal rules. http://mainlymacro.blogspot.com.es/2014/09/misleading-country.html 242

ft.com comment Columnists September 5, 2014 8:16 am An astute move but not the Big One

By Wolfgang Münchau ECB’s plan to buy private-sector assets is not nearly enough to lift it out of its misery, writes Wolfgang Münchau

©EPA T his is not quite the Big One – more like an amuse-bouche or an aperitivo. But Thursday’s action by the European Central Bank – a rate cut and a decision in principle to go ahead with private-sector asset purchases – constitute the penultimate step before the Big Bazooka: a multi-trillion heavy programme to buy government bonds. The ECB will, for now, only buy private sector assets, of which the eurozone has some, but not many – and not nearly enough to lift it out of its misery. I still expect proper quantitative easing to happen before the end of the year. The trouble is only that once the conditions for such a programme materialise – a further weakening in inflation rates – we may get uncomfortably close to a situation in which even QE would no longer work. More ON THIS STORY// ECB Draghi’s eurozone deal/ Gavyn Davies Draghi’s incursion into fiscal policy/ Stephanie Flanders Draghi’s moment/ Eurozone slips a step closer to deflation/ Eurozone inflation hits five-year low ON THIS TOPIC// ECB defends bond plan at top EU court/ Draghi vows to fight eurozone deflation/ Eurozone inflation gauge hits record low/ The Short View Inflation outlook brings ECB QE into view WOLFGANG MÜNCHAU// Germany’s weak point/ Europe’s recovery dream/ Germany’s eurosceptics/ Italian debt

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I will, however, not dismiss Thursday’s decision in the way I dismissed the ECB governing council’s resolutions in June, which focused more on liquidity than on inflation. What impressed me was not so much the rate cut, but that Mario Draghi, ECB president, allowed the decision to be taken on a majority vote. Quite a few central bankers were opposed. That tells us that those wishing to move ahead are more determined than they were previously, and that they are willing to push the opponents into a minority role. That’s genuinely new. The rate cut itself is largely symbolic. Mr Draghi was right in June when he said the ECB had reached the lower bound for all practical purposes. We are still there today. The rate cut should be seen as a statement that the ECB is more alarmed today than it seemed to be in June. The information it conveys trumps the direct economic effects. The ABS programme is the more significant decision of the two. It is best to think of it as quantitative easing on a small scale. The assets including covered bonds – bonds issued by banks with a collateral guarantee – and asset-backed securities. The latter are securities issued by banks against loans they have given, for example, to individuals and companies. A purchase guarantee for those bonds should make it easier for banks to lend because they can pass on the risk to the ECB – and ultimately the eurozone taxpayers if the borrowers default on their loans. The ECB will only buy so-called vanilla-ABS, simple securities with no funny structures. But the market is unfortunately quite small. The ballpark for this programme is going a few hundred billion euro maximum – not much in view of the eurozone’s annual economic output of almost €10tn.To lift such a large economy out of its coma requires a different order of magnitude. But the ECB has at least made a start. Mr Draghi has initiated his policy U-turn in his speech in Jackson Hole where he acknowledged that inflation expectations might become unhinged, and that the eurozone suffers from a shortage of aggregate demand. Commentators like myself say these things three times a day, but it is not often that one hears those words from a conservative European central banker. The big question is whether and over which period this policy can work, and whether the eurozone’s political leaders can deliver an accompanying fiscal expansion through a tax cut or an investment stimulus. For this to work, both fiscal and monetary policies need to expand. The ECB and Mr Draghi deserve credit for making a start. But we should also be aware that are still a long way from the halfway mark. http://www.ft.com/intl/cms/s/0/63384466-344f-11e4-b81c- 00144feabdc0.html#axzz3G1L0w6ka

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Der Spiegel 24/2014

Jul/06/2014 Gobierno Regla de los abogados Desde Reiermann, Christian El Ministerio de Hacienda tiene mucho poder económico. Pero el jefe de departamento de Schäuble ocupó posiciones de preferencia con los estudiosos del derecho. ¿Por qué? Por Wolfgang Schäuble se conoce que considera la jurisprudencia de una de las disciplinas académicas más distinguidas y se entregó por uno de sus representantes más dignos. Gern destaca el Ministro de Hacienda con el conocimiento Cláusula, comenta sobre la necesidad de una reforma en la UE a menudo en los bancos de conferencias sobre Derecho Constitucional Europeo de. Los visitantes de los mercados emergentes pueden estar seguros de que se les enseñe en Inglés Badischer sobre los méritos del "estado de derecho". Este estado de derecho ha Schäuble ahora ayudado en su ministerio de una forma particular: es la regla del jurista. Aunque el Ministerio de Finanzas, con su potencia de diseño sobre los impuestos, el presupuesto y el euro de rescate es el centro de control de la política económica no sólo en Alemania, sino que ahora también en Europa, que se guía principalmente por los abogados. Los economistas se han convertido en el nivel ejecutivo del departamento a una especie rara. En su entorno de trabajo más cercano de un abogado calificado PhD Schäuble contar con egresados de su propia disciplina. Los tres secretarios permanentes han estudiado derecho. Entre los nueve jefes de departamento son siete abogados y dos economistas. El desequilibrio continúa en todos los niveles del Ministerio. De los 23 jefes de departamento son sub-14 abogados, el resto son economistas. Actualmente trabaja 333 abogados de Schäuble, pero sólo 214 economistas. Los miembros de ambos grupos académicos que trabajan tradicionalmente han compartido. Los abogados escriben textos legales, como en el departamento de impuestos, los economistas observan el estado de la economía y analizar el impacto de las acciones de política sobre la economía y el presupuesto. Bajo los predecesores de Schäuble - si Peer Steinbrück, Hans Eichel, Oskar Lafontaine o Theo Waigel - había al menos un economista en el grupo de secretarios de Estado, su cuota entre los jefes de departamento se redujo de mayor. Desde entonces, sin embargo, el balance ha evolucionado negativamente. ¿Cuánto dan los abogados del Berlin Wilhelmstrasse el tono, que se manifiesta durante la crisis del euro. Con frecuencia, el Tesoro en Bruselas y Atenas no prestó atención a la economía, pero con argumentos jurídicos. Union Bank, gobierno económico, Euro Bonds: Siempre hizo Schäuble se refiere principalmente a las reclamaciones. Antes de 245

las reformas podrían ser iniciados, fueron los primeros en cambiar los tratados europeos fue su argumento estándar. En el extranjero, la prioridad de la lealtad Cláusula vinieron antes pragmatismo con poca comprensión. "Si bien la crisis del euro mezquindad legalista impidió política sensata," los británicos blasfemado Economista recientemente acerca de la gestión de crisis de Berlín. De su desdén por los economistas Schäuble no oculta. Sus declaraciones son demasiado vagas para él. Él siempre se encuentra en frente del problema ", que es a menudo diferente, si las recomendaciones no contradictorias seguir", se quejó una vez. En sus palabras, se perdió el rigor lógico, que se utiliza en la jurisprudencia. La acción de Winston Churchill no le es ajeno. Si le pidiera a dos economistas, el primer ministro británico, una vez que se había quejado, se obtuvo una respuesta diferente de cada uno, a menos que John Maynard Keynes, el entonces decano del gremio, estaba entre ellos. Entonces él consiguió tres. La preferencia de Schäuble para abogados ha exacerbado las graves peleas en la casa. Varios talentos dejan el ministerio no sólo porque no provienen de razones político- partidistas para entrenar en la Cámara dominada por el CDU. En los últimos meses, especialmente economistas fueron. Algunos encontraron refugio en las fracciones del Bundestag, otros al Senado. Un Subdirector cambió recientemente como economista jefe adjunto de la OCDE en París. En una posición Schäuble clave, sin embargo, ha roto sus patrones de reclutamiento. Su nuevo portavoz Martin Jäger es ni un abogado ni un economista, que ha estudiado la etnología y la política. Él es los oradores mejor pagados de todos los ministerios federales. Como jefe de departamento, él consigue el rango de Director Ministerial y voluntad de B 9 Grado salarial (salario base: € 10.515 por mes). Generalmente ocupar el puesto de jefe de la portavoz del Ministerio de unidad, la mayor parte del gerente sub- departamento. El mayor desafío para la gestión de la propiedad de Schäuble en la actualidad es el nuevo Jefe de Departamento para la construcción de una base adecuada con el número necesario de unidades, por lo que el alto salario está justificada. Pero esta es una cuestión administrativa, no una económica. http://www.spiegel.de/spiegel/print/d-127396635.html

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ft.com Comment The A-List

Stephen King September 11, 2014 To survive, the eurozone must embrace an “all for one, one for all” mindset Can monetary policy alone really solve the eurozone’s deep-rooted problems? Certainly, Mario Draghi appears to have the magic touch, whether he’s promising to do whatever it takes or, last week, planning to buy large amounts of paper in a bid to avoid the onset of deflation. Unfortunately, monetary policy – conventional or otherwise – has its limits. Even if Mr Draghi manages to alleviate the deflationary threat, the eurozone will still be faced with severe fault lines. It’s difficult to believe now but, in the 1980s and 1990s, Italy experienced a bigger increase in living standards than either Germany or France. Since 1999 – following the euro’s creation – there has been a dramatic role reversal. German per capita incomes have risen around 20 per cent while, shockingly, Italian incomes have actually fallen. In 1999, Italian living standards were roughly 90 per cent of those in Germany. In fifteen years’ time, should current trends continue, that number might be down to just 60 per cent. Put another way, the eurozone’s problems are not just about deflation, or occasional upheavals in sovereign bond markets. They are, more than anything, about the growing gulf in living standards between the different nations within the single currency area. Optimists – and those of a Teutonic disposition – will doubtless argue that Italy should attempt to emulate Spain, a nation that saw a massive loss of competitiveness ahead of the financial crisis but, through a combination of painful fiscal austerity and labour market reform, has finally turned the corner: the Italian economy may still be contracting but Spain is apparently enjoying a new lease of life. The problem, however, is that Spain’s gains and Italy’s losses are intimately entwined. Falling Spanish labour costs have allowed the Spanish economy to deliver an “internal devaluation” associated with the onset of deflation. By definition, however, Spain’s internal devaluation has to be someone else’s internal revaluation: within the eurozone, Italy and France have lost out. Had Italy and France followed the Spanish approach, Spain would have enjoyed less of an internal devaluation and the eurozone as a whole would now be staring even further into a deflationary abyss. This reflects a fundamental design flaw. Thanks to the global financial crisis and the eurozone ructions that followed shortly thereafter, we now know that, in the eurozone, what should be regarded as a system-wide problem requiring

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collective action is routinely misdiagnosed as no more than a series of individual misdemeanours. Admitting there’s a system-wide problem is, of course, half the battle. The challenge lies in getting both creditor and debtor nations to agree that they are simply two sides of the same coin. Germany tends to blame what it often sees as the more profligate nations in southern Europe for running excessively large balance of payments current account deficits when those deficits are no more than the mirror image of Germany’s excessively large current account surplus and, thus, its savings “glut”. This “blame game” makes collective action in the face of widespread economic trauma less likely. Successful monetary unions – the US and the UK are two such examples – thrive on a collective action principle (something for Scottish voters to ponder), largely by having institutional arrangements that prevent the “strong” from being able to impose all the costs of adjustment on the “weak”. This happens either through fiscal union or, in the case of US states and municipalities, via occasional default and debt restructuring. The eurozone has yet to embrace either approach. In 2012, Mr Draghi more or less accepted the argument, stating that “if we want to have a fiscal union, we have to accept a delegation of fiscal sovereignty from the national governments to some form of central body”. Since then, partly because of ongoing monetary support, little real progress has been made. For the future of the euro, this is unfortunate. The risk now is a widening income gap that could, eventually, threaten a political crisis in one or more of the single currency’s members. It’s time to establish the principle of “All for one, one for all”: far better, after all, to welcome the Three Musketeers than the Four Horsemen of the Apocalypse. Stephen King is HSBC’s Chief Global Economist and author of ‘When the Money Runs Out’ http://blogs.ft.com/the-a-list/2014/09/11/to-survive-the-eurozone-must-embrace-an-all- for-one-one-for-all-mindset/

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ft.com Comment The A-List

Lorenzo Bini Smaghi September 2, 2014 Europe • Global Economy Why the opponents of QE have failed to make their case The European Central Bank is the only major central bank in the advanced world that has not implemented quantitative easing – yet. A lot of arguments have been argued in defence of not following the Federal Resere, the Bank of England and Bank of Japan along the path of QE. But their validity is fast diminishing. Here is why QE’s detractors are wrong – possibly dangerously so. The first argument advanced against QE is that eurozone monetary policy operates mainly through the banking system. The ECB injects liquidity by directly refinancing banks, against collateral. Since the outbreak of the crisis six years ago the maturity of these operations has been gradually extended and the amounts have become unlimited . However, demand for central bank liquidity has fallen recently, in line with the slowdown of the economy and banks’ concern about their capital requirements. As a result, the ECB’s balance sheet has shrunk . QE would allow the ECB to circumvent the bottleneck in the banking system and directly influence interest rates, regardless of maturity. The second reason given that QE is not needed is that inflation expectations are well anchored and the current reduction in inflation is temporary and largely due to relative price changes. This argument is not any more valid, as inflation expectations have recently fallen below the 2 per cent mark over the short term and medium term horizon. The recent data also show that the objective of price stability is not being achieved even for core inflation. Reason number three: QE would inflate the ECB’s balance sheet and create the basis for future inflation. Really? Economic literature has clearly shown that there is no direct relationship between the size of the central bank balance sheet and inflation. What matters is eventually the quantity of private money in circulation, which has been quite subdued over the recent years. The fears of inflation have proved wrong and the main concern today is rather on the opposite side. Number four: QE may distort asset prices and generate bubbles that may burst – with negative effects on the real economy. It is interesting that this argument is pushed by those who also oppose giving the ECB a dual mandate, adding financial stability to the primary objective of price stability. While it is very difficult to identify bubbles, monetary policy cannot achieve two separate goals with only one instrument. It thus has 249

to focus on price stability and do whatever it takes to achieve it. Avoiding bubbles is a task which should be primarily achieved through prudential regulation. The ECB has now been given extensive powers in this field. The fifth reason is that by purchasing government bonds, QE would violate the statutory prohibition of monetary financing. However, there is an ample legal and economic literature explaining that asset purchases in the secondary markets are a textbook instrument of monetary policy. All other central banks in the world have used and still use such an instrument. It’s not clear why the ECB should be the only exception. The sixth reason offered up is that the implementation of QE in the eurozone would require purchasing a basket of national government bonds, which could distort relative prices. This argument misses the key point that the main goal of an asset purchase program is to modify the portfolio composition of financial institutions, increasing their liquidity and thus inducing them to invest in new assets or extend new loans. The assessment of the relative risk-return characteristic of these assets remains in the hands of market participants. Argument number seven: QE would lower even further the very low interest rates, thus redistributing income away from net savers, which are mainly in Northern Europe. This is wrong factually and analytically. While nominal interest rates have fallen over the last two years, also in Germany, inflation has fallen even more so that real rates have in fact risen. For instance, in 2012 the yield on German government Bunds was on average lower than inflation (1.5 per cent against 2.1 per cent), it is currently higher (1 per cent against 0.8 per cent). Furthermore, nominal yields are low because inflation is low, and not vice versa. If inflation was higher rates would be higher, which suggests that the longer inflation remains low, the longer rates will have to be very low, as the Japanese experience showed. The eight argument is that QE is ineffective in raising inflation, especially in the absence of structural reforms. This contradicts the long held view – cherished in particular in Germany – that inflation is ultimately a monetary phenomenon. Without structural reforms monetary policy alone cannot stimulate growth, but there are no reasons why it should not be able to achieve price stability, which is a necessary (not sufficient) condition for growth and job creation. Finally, it is often stated that low interest rates reduce politicians’ incentive to reform. This may be true, but it is not the task of the central bank to create incentives or disincentives for politicians. The central bank is independent because it aims at one key objective, price stability, and is accountable for it. If it starts giving itself political objectives, it risks losing its independence. As time passes, and the risk of deflation or low flation increases, the arguments which have been raised against QE appear to be weaker and weaker – and ultimately wrong. http://blogs.ft.com/the-a-list/2014/09/02/why-the-opponents-of-qe-have-failed-to-make- their-case/

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World Affairs

J. Bradford DeLong J. Bradford DeLong is Professor of Economics at the University of California at Berkeley and a research associate at the National Bureau of Economic Research. He was Deputy Assistant US Treasury Secretary during the Clinton Administration, where he was heavily involved in budget and trade negotiations. His role in designing the bailout of Mexico during the 1994 peso crisis placed him at the forefront of Latin America’s transformation into a region of open economies, and cemented his stature as a leading voice in economic-policy debates. JUN 29, 2007 The Great Moderation It has been 20 years since Alan Greenspan became chairman of America’s Federal Reserve Bank. The years since then have seen the fastest global average income growth rate of any generation, as well as remarkably few outbreaks of mass unemployment- causing deflation or wealth-destroying inflation. Only Japan’s lost decade-and-a-half and the hardships of the transition from communism count as true macroeconomic catastrophes of a magnitude that was depressingly common in earlier decades. This “great moderation” was not anticipated when Alan Greenspan took office. America’s fiscal policy was then thoroughly deranged – much more so than it is now. India appeared mired in stagnation. China was growing, but median living standards were not clearly in excess of those of China’s so-called “golden years” of the early 1950’s, after land redistribution and before forced collectivization turned the peasantry into serfs. European unemployment had just taken another large upward leap, and the “socialist” countries were so incompatible with rational economic development that their political systems would collapse within two years. Latin America was stuck in its own lost decade after the debt crisis at the start of the 1980’s. Of course, the years since 1987 have not been without big macroeconomic shocks. America’s stock market plummeted for technical reasons in the fall of that year. Saddam Hussein’s invasion of Kuwait in 1991 shocked the world oil market. Europe's fixed exchange rate mechanism collapsed in 1992. The rest of the decade was punctuated by the Mexican peso crisis of 1994, the East Asian crisis of 1997-98, and troubles in Brazil, Argentina, Turkey, and elsewhere, and the new millennium began with the collapse of the dot-com bubble in 2000 and the economic fallout from the September 11, 2001, terrorist attacks.

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Moreover, today’s global imbalances and misaligned real exchange rates threaten to bring on not just mild recession, but significant and prolonged depression. Yet, so far, none of these events – aside from Japan starting in the early 1990’s and the failures of transition in the lands east of Poland – has caused a prolonged crisis. Economists have proposed three explanations for why macroeconomic catastrophes have not caused more human suffering and deranged long-run economic growth over the past generation. First, some economists argue that we have simply been lucky, because there has been no structural change that has made the world economy more resilient. According to this view, we have simply rolled the dice and won five times in a row. We should be happy and grateful, but we should not expect it to continue. Second, central bankers have finally learned how to do their jobs. Before 1985, according to this theory, central bankers switched their objectives from year to year. One year, they might seek to control inflation, but the previous year they sought to reduce unemployment, and next year they might try to lower the government’s debt refinancing costs, and the year after that they might worry about keeping the exchange rate at whatever value their political masters prefer. The lack of far-sighted decision-making on the part of central bankers meant that economic policy lurched from stop to go to accelerate to slow down. When added to the normal shocks that afflict the world economy, this source of destabilizing volatility created the unstable world before 1987 that led many to wonder why somebody like Alan Greenspan – who had previously only spent a couple of years in government – would want the job. The final explanation is that financial markets have calmed down. Today, the smart money in financial markets takes a long-term view that asset prices are for the most part rational expectations of discounted future fundamental values. Before 1985, by contrast, financial markets were overwhelmingly dominated by the herd behavior of short-term traders, people who sought not to identify fundamentals, but to predict what average opinion would expect average opinion to be, and to predict it before average opinion did. Thus, central bankers were stuck trying to control a world economy shocked by random changes in the animal spirits of investors and traders. When I examine these issues, I see no evidence in favor of the first theory. Our luck has not been good since 1985. On the contrary, I think our luck – measured by the magnitude of the private sector and other shocks that have hit the global economy – has, in fact, been relatively bad. Nor do I see any evidence at all in favor of the third explanation. It would be nice if our financial markets were more rational than those of previous generations. But I don’t see any institutional changes that have made them so. So my guess is that we would be well-advised to put our money on the theory that our central bankers today are more skilled, more far-sighted, and less prone to either short- sightedly jerking themselves around or being jerked around by political masters who unpredictably change the objectives they are supposed to pursue year after year. Long may this state of affairs continue. https://www.project-syndicate.org/commentary/the-great-moderation

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