OMFIFOMFIF Bulletin GlobalOfficial MonetaryInsight on and Official Monetary and Financial Institutions Financial Institutions Forum June 2012 SPECIAL ISSUE: TOWARDS THE EURO END-GAME Greek exit may be Europe’s chance After long denial, stark choice beckons Meghnad Desai, Chairman, Advisory Board

he Grexit may be upon us. It a linkage similar to the old exchange we first met in Frankfurt in March Tsounds like a weird creature from rate mechanism. The Spanish 2010. In this special edition, we bring Dr. Seuss, the fabled children’s story- bail-out on 9 June makes a Greek exit many proposals on Europe’s future, teller. It certainly brings a new phase in less worrisome. including David Owen’s suggestion economic and monetary union (EMU). for a restructured Europe (p.3), Greece faces a stark choice. Either stay The euro core is planning some kind of Fabrizio Saccomanni’s ideas on crisis in the euro and sign up to a generation fiscal union. Yet the strong showing by management (p.5), Edward Krubasik’s of austerity. Or exit, suffer immense the combined Left in the first round of and ’ /Paul van Seters’ pain instantly and then muddle along the French parliamentary elections on plea (respectively) for ‘smart’ (p.10) on its own. 10 June may make a Franco-German and ‘green’ growth’ (p.12) to improve compromise more difficult. the European economy, and Michael Greece may force a new equilibrium, Butler’s blueprint for a parallel euro with a bifurcation between weak and OMFIF has been anticipating a currency (p.13). strong euro economies connected by possible Greek EMU departure since (continued on page 6 ...) Emerging market central under-allocated to gold Central bank reserve managers accumulated 80 tonnes of gold in the first quarter this year, writesAshish Bhatia, World Gold Council. The gold purchases partly reflect lower attractiveness of sovereign bonds. They also appear to stem from a fundamental gold under-allocation by emerging market central banks, a finding borne out by recent work on gold’s relatively low volatility in emerging market currencies. SEE ARTICLE ON GOLD VOLATILITY AND EMERGING MARKET CENTRAL BANKS, P. 21-22 Contents New rule-book Why Europe must be restructured David Owen 3 Changing standards Fire brigades as well as firewalls Fabrizio Saccomanni 5 Michael Lafferty, Co-chairman Rediscovering family spirit Michael Kaimakliotis 7

Heightened political and economic risks Statistical forecasts 8 he rule-makers in the world of accounting standards-setting Flexibility on budget goals Stefan Bielmeier 9 Tare about to re-write one of the most sacred accounting principles, after intense and largely covert pressure from Smart growth and restructuring Edward G. Krubasik 10 central bankers via the Basel Committee and the Financial Clarion call of green growth Ruud Lubbers 12 Stability Board. Parallel currency is the way Michael Butler 13 , the former Dutch finance who is now BankNotes - The Fed Darrell Delamaide 14 chairman of the global rule-setting International Accounting Why Greek exit is not suicide Gabriel Stein 16 Standards Board (IASB) admitted this in a speech to European central bankers on 4 June. He also criticised regulators for not OMFIF Advisory Board 18 going far enough in deleveraging the global banking system Making up ground in gold Ashish Bhatia 21 and for contributing to flawed bank accounting practices. Athenian affliction inspires and repels Poetry Corner 23 ‘Basel III will undoubtedly be a great improvement, because The Keegan commentary William Keegan 24 it enhances the capital requirements both quantitatively and This document must not be copied OMFIF and is only to be made available qualitatively... Yet, under Basel III, a bank is still allowed to be Official Monetary and Financial Institutions Forum to OMFIF members, prospective leveraged 33 times,’ Hoogervorst pointed out. members and partner organisations (continued on page 6 ...)

www.omfif.org 1 OMFIF Official Monetary and Financial Institutions Forum Letter from the chairman

Official Monetary and Financial Institutions Forum Necessary, not sufficient One Lyric Square London W6 0NB United Kingdom Where it’s best to stay away t: +44 (0)20 3008 8415 f: +44 (0)20 3008 8426 David Marsh, Co-chairman Advisory Board

Meghnad Desai hen countries such as the UK, and Sweden opted not to join the euro, *Chairman, Advisory Board Wsome thought that governments in non-member countries would be permanently disadvantaged by being outside key meetings making landmark decisions on the John Nugée Frank Scheidig future of the continent. Certainly plenty of key meetings are going on, but London, Songzuo Xiang Copenhagen and Stockholm have been only too pleased not to be part of them. ** Deputy Chairmen, Advisory Board (See p.18-20 for full details) The lengthy euro area finance ministers telephone conference on 9 June that decided Management Board on a €100bn bail-out for troubled Spanish banks was a necessary but not sufficient David Marsh step towards healing Europe’s woes. A victory for economic and monetary union Co-chairman (EMU)? Certainly a milestone (as it has become trite to say) that could possibly usher [email protected] +44 (0)20 3008 5207 in the end-game. Hence the special attention paid to this subject in this OMFIF Bulletin.

Michael Lafferty Co-chairman All this takes place against the background of a world economy suffering growth [email protected] pangs. Yet countries which still have control over their own policies are taking steps +44 (0)20 3008 8415 to shift the economic trajectory. As Darrell Delamaide makes clear, the US Federal Evelyn Hunter-Jordan Reserve stands ready to relax policy further if employment flags during the summer. Managing Director [email protected] China has cut interest rates for the first time since 2008. Only the UK, the euro area’s +44 (0)20 3008 5283 most important trading partner, seems becalmed by inaction. OMFIF Secretariat What of Europe’s future? David Owen outlines his plan, elaborated in a new book Edward Longhurst-Pierce European Restructured?, for separating a remodelled European Community into two Annie Palacios Vikram Lopez groups of different levels of political and economic integration. Nikolai Blackie

[email protected] Edward Krubasik, a former board member of Siemens and past president of Orgalime, [email protected] the European engineering association, favours integrating industrialists’ methods for [email protected] [email protected] successful corporate turnarounds into measures for reorganising European economies. +44 (0)20 3008 5262 Michael Butler spells out again his plan (first put forward in 2011) for a dual currency Sanjay Ujoodia solution to EMU members' competitiveness problems. Fabrizio Saccomanni wants Chief Financial Officer innovative monetary measures including action to prevent undue rises in interest rates [email protected] +44 (0)20 3008 8421 for problem countries: an idea to which gives short shrift.

Darrell Delamaide Michael Kamaikliotis says Chancellor Merkel is the only person who can save Europe. US Editor [email protected] He describes the heavy responsibility borne in the EMU imbroglio by Germany – a +1 (0)202 248 1561 fundamental issue on which dramatic fault lines run through the continent. Meghnad Sales Desai and Gabriel Stein take a more relaxed view on all this – in monetary unions, Pooma Kimis 'stuff happens'. Stefan Bielmeier is also more relaxed, saying the firewalls erected to Christopher Goodwin stop the debt crisis spreading are now considered sufficient. One way of finding this [email protected] out is, of course, to have a fire. [email protected] +44 (0)20 3008 5262 The euro’s plight clearly has an effect on central banks’ asset management preferences. Thomas Heap Production Editor Ashish Bhatia looks at what appears to be a fundamental under-allocation to gold by [email protected] emerging market central banks. Beyond the immediate challenges, Ruud Lubbers and Paul van Seters point to the importance of ‘green growth’ in stimulating sustainable Strictly no photocopying is permitted. It is illegal to reproduce, store in a central retrieval system or transmit, recovery. Michael Lafferty reveals a significant change in international accounting electronically or otherwise, any of the content of this standards, moving from a system of ‘incurred loss’ provisioning for bad and doubtful publication without the prior consent of the publisher. All OMFIF members are entitled to PDFs of the current issue debts to one where provision is made for ‘expected’ losses. and to an archive of past issues via the member area of the OMFIF website: www.omfif.org Meghad Desai introduces a new OMFIF speciality – poetry. In his postscript, William While every care is taken to provide accurate information, Keegan warns David Cameron about his credibility problem in intruding on the family the publisher cannot accept liability for any errors or omissions. No responsibility will be accepted for any loss affair of the euro mess. It is a long-drawn out affair in which we all seem to be caught occurred by any individual due to acting or not acting as up – whether or not we attend the meetings.y a result of any content in this publication. On any specific matter reference should be made to an appropriate adviser.

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2 www.omfif.org OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions Forum TNheews future of EMU Financial Institutions Forum Why Europe must be restructured EMU can survive only with closer union David Owen, Advisory Board

he euro crisis is driving the to a point when it can no longer be Those countries Tambivalent about the two basic models for Europe. One is the present one: a union of within the euro self-governing nations with a separation of powers between the supranational and the intergovernmental. The other is the model we may have in the future: a fiscal union within which wish to the euro area. integrate further

Angela Merkel, the German chancellor, has chosen her model, greater integration, but she should do so. Those has repeatedly said she wants the UK to stay in the Single Market. In the UK, but also in countries which do some other countries, there are growing public demands for a principled and consistent not ever envisage position to resist any further merging of the two models. The people in these countries want to remain self-governing, in that they are determined to retain their own currency and becoming part of remain in control of foreign, defence and fiscal policies. the single currency

Yet these same countries see the argument for greater integration within the euro area to should remain in a help resolve its problems. These issues can be resolved in the following fashion. Those restructured single countries within the euro which wish to integrate further should do so. Those countries market. which do not ever envisage becoming part of the single currency should remain in a restructured single market.

In such a process, there is a danger of long and tortured arguments, including challenges to the legal interpretation of the treaties and allegations of bad faith. This can be avoided if all EU countries are involved as equals. All should remain full members of a single market based on the existing acquis communautaire, but it should become a larger, separate organisation. It should continue to operate under qualified majority voting based on a revitalised single market and customs union, and would hopefully include Turkey as a full participating member as well as other members of the European Economic Area (EEA).

Such a grouping of 32 states or more with Turkey could be called the European Community, funded and controlled by all its member states. It would have common international environmental policies and could use the old political cooperation mechanism for coordinating foreign and security policies, as well as most constituents' NATO membership. It would have its own secretary general. Whoever is the EU external trade commissioner might be at least initially the single negotiator world-wide on behalf of the group.

The is greatly involved with single market legislation now that most of it is adopted under ordinary legislative procedure, that is by co-decision between the Council of Ministers and the Parliament. So the EU will inevitably be the lead element in devising the legislation for the wider single market, but not the ultimate authority.

As part of this restructuring, a more integrated euro area will progressively emerge. This will have economic, fiscal and monetary policies, together with the Lisbon Treaty arrangements for foreign and security policy, that will develop in ways that involve, to all intents and purposes, though not in name, a single government.

This will probably be acceptable for most but not all of the existing euro countries and potentially for many other countries which intend to join the euro. Such a grouping would continue to be called the European Union. As indicated in the box on p.4, the list excludes some countries that are currently members such as Greece.

A step in this direction was taken in 2012 when, to make the euro area work more effectively, 25 countries, comprising all those in the euro and others aspiring to join, created new financial and economic disciplines with a fiscal compact treaty outside the EU treaties. This is now in the process of being ratified in some countries and is being negotiated in others. It represents a limited move towards a single economic government.

June 2012 3 OMFIF Official Monetary and Financial Institutions Forum

The UK and the Czech Republic did not sign. Some of the countries, particularly Germany, There will be want further economic integration. Some have likened this new situation in Europe to the point in the creation of the US when the 1787 Constitution was adopted. Since the German resistance to the people will provide the money for any fiscal union, they will have to agree it first through a German design of federal election as there is no place in their constitution for referendums. a fiscal union from There will be resistance to the German design of a fiscal union from under President President François François Hollande. But he is likely to choose, as did his role model, François Mitterrand, Hollande. But he is to continue the Franco-German route. Mitterrand only narrowly won the referendum to do this in 1992. With a reinvigorated political right, following the defeat of President Sarkozy, likely to choose, as Hollande might have difficulty in winning another referendum in France. But even if he did did his role model, lose, Germany would not let the euro fall and return to the D-Mark. It will assemble a small François Mitterrand, group to keep the euro intact and expect, at some later date, that the number of countries within the euro area will increase. to continue the Franco-German Other countries, such as Greece, Portugal, Ireland, and , at present inside the euro area but with mounting economic difficulties, may find public criticism of austerity route. too strong to withstand. Public opinion may demand measures aimed at economic growth and in the process become resigned to leaving the euro area. It is not clear whether, if they leave, these countries will be able to stay in the EU, hoping to rejoin the euro area; if they are not welcome, they would be fully entitled to be members of the single market and European Community.

In the UK, by the general election of 2015, unless the Conservative party and Labour change the situation over Europe, the UK Independence Party (UKIP) may grow in strength as it develops a wider agenda to include public anger against crime, immigration and feelings that the British are being pushed around by euro integration.

At the very least, UKIP will be the lever for forcing a Conservative government to concede a referendum on Europe, as James Goldsmith’s Referendum Party did in 1997. Labour will be forced to concede as well. A UK referendum on the future of Europe is inevitable between 2013 and 2106. But a referendum will be lost in the UK and perhaps in some other countries if the only option is ever greater integration within the EU. It will only be won if the present Europe is restructured .

In all logic, saving the euro area, whether it continues with the existing number of countries or fewer, demands the restructuring of Europe as a whole. The degree of integration needed within the euro area must become predominantly an issue for those countries which intend to be part of it. The UK and some other European countries outside the euro must assert their rights. A country like Turkey cannot be left on the sidelines of any European restructuring. y Owen plan for restructured Europe

David Owen’s plan for a remodelled Europe aims to move from ‘Existing Europe’, made up of NATO, the EEA, the EEC/EU and the euro area, to ‘Restructured Europe’, made up of NATO, the Single Market/European Community (including Turkey) and the EU/ euro area.

According to Owen, the latter will consist of , , Bulgaria, Croatia, Cyprus, Estonia, Finland, France, Germany, Hungary, Latvia, Lithuania, , Malta, , Slovakia and Slovenia. He says the Czech Republic, Denmark, , Sweden and the UK may need a referendum on whether to stay in the EU/euro area.

Bulgaria, Hungary and Romania may not wish to stay under the new EU/euro area financial disciplines, while Greece, Ireland, Italy, Portugal and Spain may not comply economically with EU/euro area requirements.

This article is based on extracts from Lord Owen’s book “Europe Restructured? The Eurozone and Its Aftermath” published by Methuen. It can be acquired via www.amazon,co.uk £7.99.

4 www.omfif.org OMFIF Official Monetary and NewsWorld economy Financial Institutions Forum

Fire brigades as well as firewalls Stabilising the international financial system Fabrizio Saccomanni, Director General, Banca d’Italia fter the collapse of Lehman Brothers in September 2008, the Group of 20 made Investors should be Aimportant promises. They included ‘policies, regulations and reforms to meet the needs of the 21st century global economy’ and setting of conditions to allow ‘growth made aware of the without cycles of boom and bust and markets that foster responsibility not recklessness.’ risks involved in bond market yields This raised expectations that a new international monetary and financial was in the making, a kind of ‘New Bretton Woods’ that would be a stability-oriented anchor for that are negative macroeconomic policies, an internationally-agreed system of financial regulation and an in real terms for open, multilateral system for trade. protracted periods, Achievements have been disappointing. On trade, the Doha round is dead and we are where there is suffering creeping low-intensity protectionism. With regard to global financial regulation, evidence of possible the Financial Stability Board agenda and Basel III have been approved but doubts persist about implementation, and there is a risk of ‘ring fencing’. And in the search for a policy financial bubbles. anchor, there has been some progress on IMF surveillance and analysis of policy interactions and spill-overs. But the process is still based on ‘peer review’ without rules or sanctions and with only a limited role for the IMF. Partly as a result, global imbalances persist.

IMF resources have been tripled to $500bn and quotas (marginally) rebalanced. A new $250bn allocation of Special Drawing Rights was approved in 2009. The same year Governor Zhou of People’s Bank of China advocated creation of ‘an international reserve currency that is disconnected from individual nations and is able to remain stable’ as a ‘super-sovereign reserve currency managed by a global institution’ – but there was no follow-up to the proposal. In the meantime, the G20 reached agreement in April 2012 on a further $430bn increase in IMF resources.

The world financial system still faces crucial challenges. The legacy of the period of financial euphoria is excessive indebtedness of governments, households, enterprises and intermediaries. A gigantic, orderly process of deleveraging is required and this will take several years. Debt reduction policies adopted by indebted governments have failed to restore market confidence. Firewalls established by the EU and the IMF have not put out the fires of financial instability. Monetary policies are still highly expansionary to compensate for the malfunctioning of large segments of monetary and interbank markets

Financial markets play a crucial role in setting the direction and the speed of deleveraging. Having operated in the past as if all marketable liabilities were risk-free, market players are involved in a frantic ‘flight to quality’. Market dynamics are a major factor in the determination of yields on government debt and on interest rate spreads. Investment strategies of global market players are often based on over-simplified worst-case scenarios, for example in the forecasts of an inevitable euro area collapse. Firewalls established by EU/IMF are mostly designed to fund adjustment programmes linked to macroeconomic policy conditionality – with no direct impact on market dynamics

We need an innovative approach. The G20 and IMF should focus on correcting global imbalances. Crisis management institutions (‘fire brigades’) should monitor financial market dynamics to identify tensions not justified by economic fundamentals. National central banks and financial supervisors should coordinate strategies to ensure monetary and financial stability, developing appropriate macroprudential approaches and instruments.

Investors should be made aware of the risks involved in bond market yields that are negative in real terms for protracted periods, where there is evidence of possible financial bubbles. Activation of financial support should allow the targeting specific market variables (i.e. bond spreads) or banking sector requirements (i.e. strengthening of the capital base). y This article is based on a speech to OMFIF in London on 21 May

June 2012 5 OMFIF Official Monetary and Financial Institutions Forum News

Greek exit may be Europe's chance (... continued from page 1) Initially, no one from the euro area took this?), then a pro-euro government may to frustrate French attempts to collect much notice of concerns about Greece. be formed. If so, it will try and fail to reparations by occupying the Ruhr. The Realisation about the Greek problem renegotiate and then may have to resign Greeks cannot sabotage the euro in has lagged three to six months behind and call, yet again, for new elections. the same way, but they can dent it by what writers in the OMFIF Bulletin have If it quietly accepts the existing terms of exiting. been saying. the agreements, it will have a hard time governing. There is no way Greece can Germany avoided paying reparations Whether it was the need for IMF to pay even the reduced debt burden and after 1923. But they carried on come to the rescue, or for debt write- avoid extreme hardship. complaining about the episode and downs advocated in September 2010 at the same time stoked up fear of by myself (at the annual meetings If the left-wing party Syriza gets to hyperinflation that they had engineered of the IMF and World Bank) and my the top then we may see a faster themselves . colleague Niels Thygesen (OMFIF unwinding. It may come about by Bulletin, September 2010, p. 8-9), the Syriza nationalising banks and Attention has been focused on deposits story is the same. What OMFIF said bringing in capital controls; both of in Greek banks. Withdrawals may would happen did happen, but with a these are anathema to the European accelerate, likely to spark a need for delay and after initial denials. Union. Then the Grexit follows. still greater help from the European Central Bank. Greece will need further Last year (OMFIF Bulletin, June 2011, How did Greece implement the aquis payments from creditors to pay salaries. p.3) I proposed a referendum in communautaire and still manage The Government cannot borrow from Greece on euro membership, along the to preserve its dysfunctional fiscal the banks. And the ECB may refuse lines of a similar plebiscite in Iceland. culture? Greece’s record of getting into Emergency Liquidity Assistance. George Papandreou, then Greek prime unsustainable debt is known, as the minister, proposed such a referendum seminal work by Carmen Reinhart and There is much discussion about euro- in early November last year .He Kenneth Rogoff has shown. If so, why denominated contracts and debts. But was humiliated when was it admitted to EMU? that is a worry about money as a store and forced him to of wealth. For most Greeks what matters withdraw that suggestion. Now we The decision was political. The euro was is money as a means of payment. hear that Merkel would like Greece’s created to give the D-Mark cover to hide Greece can issue a parallel currency second election on 17 June to embody the strength of the German economy. which it prints to pay its employees. a euro referendum. knew this when he insisted The employees can spend it in shops on Italy being admitted. If the decision which can pay their suppliers, at least The Greek polling outcome will be is political then the punishment cannot domestic ones. The euro may float indecisive. If one of the older parties be purely economic. But it is. This is alongside. One can envisage gradual (New Democracy most likely) comes to the 21st century equivalent of the post- establishment of another currency the top and gets the bonus of 50 extra 1918 reparations stand-off. In 1923 whose relation to the euro will stabilise seats (how did any constitution allow the Germans sabotaged their currency in six months to a year. y New rule-book (... continued from page 1)

Hoogervorst went on: ‘I truly wonder out fluctuations in the economic cycle to give the impression that they have if a bank with leverage of even just by levelling out the reported results of more capital in a bad year than their 20 times can accommodate a crisis banks and indeed all companies. accounts show at present. of Spanish or Irish proportions. In addition, the system of risk weighting Critics say the central bankers The introduction of so-called dynamic of assets is still fraught with risk. ’ themselves are substantially to blame bad debt accounting in Spain was for the muddle that goes on in much initially lauded by many central bankers He spelled out the proposed of bank accounting at present. but is now seriously discredited. accounting standards. The result is that Although financial reporting rules are Hoogervorst is himself a critic: ‘I know lower profits will be reported in good not normally their responsibility, bank that many prudential regulators hope years, while losses may be understated supervisors around the world routinely that an expected loss model can serve in bad years. Central bankers believe interfere in banking accounting matters to dampen the cycle of credit booms that accounting, which is supposed to and tend to condone stretching the and busts. They have often pointed be about transparency and presenting rules, especially when times are tough at the dynamic provisioning model an unbiased, true and fair view to all that Spanish banks were using before users of financial statements, should Critics add that the real problem is the the crisis broke out. While dynamic become an instrument of economic shortage of bank capital and warn provisioning contained some elements policy. They believe that economic that there are serious dangers in banks of an expected loss model, it clearly stability should be the primary goal of manipulating their balance sheets was not able to adequately counter the financial reporting and want to smooth and profit and loss accounts so as cycle.’y

6 www.omfif.org OMFIF OMFIF Official Monetary and Official Monetary and Financial Institutions Forum Germany?????????? & the euro Financial Institutions Forum Rediscovering family spirit Only Merkel can save the day for Europe Michael Kaimakliotis, Quantum Global Wealth Management catastrophic end to the euro crisis would do great damage to the entire European Merkel must speak AUnion. Only Germany can save the day. Only Chancellor Merkel can persuade Germany to do so. But her window of opportunity is closing quickly. She is fast losing transparently about popularity. This is not the time for Germany to be thrown into disarray. What can be done? the failures of Greek politicians in the Merkel must make the case to the German people that both Greece and the euro must be saved. Like the sisters Elinor and Marianne in Jane Austen’s Sense and Sensibility, the context of failures emotional Greeks and the rational Germans can converge on a common set of norms. This by German, French, takes time. It could not be expected that Marianne would mature overnight, nor that the Greeks would pay their taxes tomorrow. But the Greeks and the Germans are a family now Spanish and others. whether they like it or not. When the Greeks lied to get into the Merkel must speak transparently about the failures of Greek politicians in the context of failures by German, French, Spanish and others. When the Greeks lied to get into the euro, the Germans euro, the Germans and French were complicit. The result was a decade of prosperity that and French were accrued to the Greek elite and now a decade of depression to be paid for by the poor and middle classes. complicit.

The French had no intention of implementing the criteria. The Germans also had no intention of implementing Maastricht while enduring the aftermath of reunification. Both countries knew the Greeks didn’t really belong in the monetary union. But who were they to push for greater analysis of the Greek numbers when they were also flouting the treaties?

Hysteria and hysteresis beckon as the Spanish, too, break their promises

Are the Spanish much better? For years we’ve been listening to officials say they were making great progress on reducing their fiscal deficits, that there were adequate provisions, that necessary recapitalisations could be financed, and that the only problem was property loans. But the deficits have been much higher than we were told, the Spanish broke their promise to reduce their deficit to 4.3% in 2012, the Fund for Orderly Bank Restructuring (which has almost no remaining funds) was insufficient and the banks face large losses, too, on mortgage and corporate loans.

Everyone in this family is somewhat dysfunctional. But someone has to make the case that they share some common values and most importantly that they should and do care for one another. Policymakers must clearly indicate where they want to go. They must recognise that different paths will have different costs and benefits.

If we did a discounted dividend model of the national income of the euro area countries, we would find a much higher value on the paths that maintain the current membership of the euro area, involving mutualisation of outstanding debts.

The main reason is hysteresis. This means that economic shocks have a persistent impact. This is in contrast to most economic models whereby shocks eventually wash away and the economy returns to the predestined long run equilibrium.

Europe faces permanent losses to prosperity by creating an entire lost generation in some regions. These are youths who will never have a job and therefore have no means of creating wealth and developing their human capital after they leave school.

To overcome hysteria in Germany about the costs of solidarity, Merkel must explain that everyone has the responsibility to ensure that this failure is not the final result of creating ‘Europe’. Yes, sacrifices will be necessary in Germany. But it will be worth it. y

June 2012 7 OMFIF Official Monetary and Financial Institutions Forum Statistical forecasts Heightened political and economic risks French worries about Spanish banks and Chinese slowdown DZ Bank Economic Forecast Table ecent weeks have brought growing uncertainty with Rboth the financial markets and the corporate sector GDP growth beginning to doubt Europe’s ability to resolve its debt crisis. 2 011 2012 2013 The Greek election result and the resulting power vacuum US 1.7 2.0 2.0 were probably the main contributory causes.

Japan -0.7 2.3 1.5 However, constant reports of deterioration in the Spanish China 9.2 8.2 8.8 banking sector have made things worse. The Spanish Euro area 1.5 -0.1 0.6 government’s application on 9 June for official European help to meet the banks’ capital requirements showed Madrid Germany 3.0 1.4 1.5 was bowing to the inevitable. Spain’s 10-year government France 1.7 0.5 0.8 bond spreads have widened by well over 100 basis points Italy 0.5 -1.8 -0.2 in the last month alone. Spain 0.7 -1.3 -1.2 This heightened uncertainty is also showing in the surveys UK 0.7 0.5 0.5 of euro area economic confidence. Companies expressed greater pessimism again in May, and the aggregate Addendum economic climate indicator has fallen to its lowest level since October 2009. Asia excl. 7. 3 6.8 7. 5 World 3.6 3.3 3.6 Sentiment deteriorated further in the last month, especially in Italy but also significantly in Belgium and the Netherlands. The business climate has worsened considerably in Germany Consumer prices (% y/y) in the last month, with the May IFO business climate index US 3.1 2.4 2.6 – a key measure of corporate confidence – showing its first Japan -0.3 0.2 0.2 significant fall in six months. We remain confident, however, China 5.4 3.0 3.4 that the German economy will clearly outperform most of the other euro members this year and record growth of Euro area 2.7 2.4 2.4 somewhat more than 1%. Germany 2.5 2.2 2.4 France 2.3 2.4 2.4 Greece’s second-round election on 17 June will decide whether this crisis-stricken country is headed for a rapid Italy 2.9 2.9 2.4 exit from the common currency or will instead find its way Spain 3.1 1.8 2.2 to a majority government committed to stability. There is UK 4.5 2.9 2.4 presumably a far-from-minor probability that the euro will no longer be Greece’s official currency at the end of this year. Now that the firewalls have been put in place, the Current account balance (% of GDP) departure of Greece is no longer a taboo subject for the US -3.1 -3.2 -3.1 rest of Europe. If this scenario were to materialise however, Japan 2.1 2.4 2.8 a period of financial market stress would inevitably ensue. China 4.1 3.2 3.4 The US economy lost a lot of upwards momentum. State-sector Euro area 0.0 -0.1 0.0 cutbacks are exerting a contractive influence at present and Germany 5.1 4.7 4.3 are reducing jobs growth. Later this year we should expect still more restriction. A concentrated ‘restrictive shock’ would France -2.2 -2.2 -2.0 harbours fresh recession risks which nobody in Washington Italy -3.2 -2.6 -2.2 wants. So we expect at least temporary extensions of Bush- Spain -3.5 -3.0 -2.8 era lower tax rates. UK -2.5 -3.0 -2.0 Some of economic data from China have been greatly disappointing. Beijing holds out the prospect of further fiscal measures to alleviate the growth slowdown, but we do not Produced in association with DZ Bank group, expect a major stimulus programme, only a cushioning of a partner and supporter of OMFIF the downturn. On the other hand, the Chinese authorities have also shown they are ready to relax monetary policy if appropriate. y

8 www.omfif.org OMFIF Official Monetary and TNheews future of EMU Financial Institutions Forum

Flexibility on budget goals Greek chaos may encourage others to stay Stefan Bielmeier, Advisory Board he only conceivable path for economic and monetary union (EMU) to survive intact would The firewalls erected Tbe to extend the timetable for government’s budget objectives – without questioning their binding nature. This would acknowledge that the original targets were too ambitious, to stop the debt as they dramatically underestimated the effects of recession. crisis spreading are now considered In the crisis countries this could lessen immediate pressures. Markets might even respond positively if they get the message that orderly debt service becomes more likely. sufficient, meaning a Greek exit appears We have reached this point at a time when the European Central Bank has managed to stabilise but not normalise financial markets. It may soon have to consider cutting back its manageable. massive support. Mario Draghi, the ECB president, has made repeatedly clear that it is not the ECB’s task to do the job of governments.

Austerity has sharpened the recession more than expected. The schedules for budget consolidation now seem even less realistic than before. In view of the French and Greek elections, European politicians increasingly believe that austerity has to be scaled back. On the other hand, the firewalls erected to stop the debt crisis spreading are now considered sufficient, meaning a Greek exit appears manageable and is no longer a taboo.

If the 17 June Greek election turned out favourably, Europeans leaders could hardly refuse giving a helping hand. But for lasting relief this must be combined with a commitment to the fiscal pact and to structural reforms and an agreement on the basic rules for Eurobonds.

In case of a negative Greek election result, the public and parliaments in creditor countries would demand a halt to payments. Greece would become insolvent and have to leave the euro. This would be manageable for other countries, but a disaster for Greece itself. So the question of common assistance would arise anew. It is not clear whether this path would be cheaper for creditors.

A Greek exit would not necessarily make further exits more probable. The ensuing chaos may serve as a lesson to others to preserve what is left.

A big test will come with the parliamentary elections in Italy next year (or sooner). If Italy as a founding member of the EU and the third largest EMU member state were to replace Mario Monti with a government inimical to reforms, public support for any form of further muddling through would collapse. Then there would also be no keeping Spain in. A ‘northern euro’ grouped around France and Germany would be the least undesirable path.

If not an Italian election, there are many other stumbling blocks. There is a strong combined probability of events that could bring down the euro en route to solving the problems. Our most likely scenario remains, however, that the euro survives, with or without Greece.

Irrespective of whether and in what composition the euro remains, the task for coming years is to regain competitiveness, implement structural reforms, and lay down a long-term path of fiscal consolidation. The divergence of growth rates within Europe will remain large. Germany will have no choice but to tolerate above-average inflation and higher wage increases for a while, thus strengthening domestic demand and weakening exports.

The path is already set in the direction of a transfer union or fiscal union. Monetary union without fiscal union might theoretically have worked if all members had stuck to the stability rules. But it doesn’t function under less idealistic conditions. Now, rules for the fiscal union need to be written which cover as many elements of the ideal ‘stability union’ as possible. That also includes Eurobonds, albeit with clear rules on their scope and uses. y

June 2012 9 OMFIF Official Monetary and Financial Institutions Forum The future of EMU

Smart growth and restructuring Europe needs to learn from industry turnarounds Edward Krubasik, former president, Orgalime, European Engineering Association e need a revival of the European spirit to make the European Union and economic and Restructuring is a Wmonetary union (EMU) attractive again. This requires overcoming EMU’s problems with a new doctrine of ‘smart growth’, involving fresh emphasis on enhancing competition, prerequisite for productivity, investment and new technologies. growth in over- indebted nations, Such a strategy demands that we regain financial markets’ trust in countries’ policies. Differentiated interest rates are needed as a potent force of discipline. However, austerity just as for over- and restructuring alone are not enough. As with turnarounds in industry, we need to combine indebted enterprises. restructuring and growth in an intelligent way. For companies, this presupposes mobilising management and unions for necessary restructuring and shifting the business portfolio. But, without growth, For a country, this means switching away from growth led by consumption towards growth fiscal and structural generated by investment. renewal is much Restructuring is a prerequisite for growth in over-indebted nations, just as for over-indebted most difficult. enterprises. But, without growth, fiscal and structural renewal is much most difficult.

Financial markets do not allow governments simply to postpone the pain of solving debt problems. High interest rates force governments to get deficit spending and debt levels under control. Placating financial markets through mutualised Eurobonds to finance national deficits or unlimited bond purchases by the European Central Bank would only cover up, not heal, euro members’ problems.

The euro area needs to fix some basic design flaws and overcome decades-old growth problems. Some effective measures have been taken already, through short-term ECB liquidity support and recapitalisation rules for euro area banks. A credible firewall is being built around euro economies. Yet far more needs to be done.

In the first decade of EMU, the euro area displayed diverging competitiveness, leading to trade and balance of payments disequilibria and fiscal (and economic) divergence instead of convergence. The new European treaty on stronger financial and economic integration agreed in March by 25 of the 27 EU member states will help produce much better economic balance. To avoid the divergence of the past 10 years, we need harmonisation of EU economic, labour and social policies.

An Economic and Finance Commissioner is needed to enforce financial discipline and true economic convergence and competitiveness. For countries with exceptional problems, financial stabilisation via the creditors has become a standard method for handling transition. In the longer term, Eurobonds may be possible to finance infrastructure and growth policies, but only after fiscal and economic integration has been achieved.

If politicians follow industrial turnaround lessons, a tough restructuring programme is just the beginning. Demanding goals are needed. Not just measures to stop losses, but programmes to cut costs by 20-40%, may be required for failing businesses, just as they are for uncompetitive national economies. In both cases, reducing debt to sustainable levels requires an organised process of asset liquidation and asset management.

Such programmes to reduce national debt and interest burdens are now being effected in Greece, Portugal, Italy and Belgium. As in any industrial turnaround, the first task for over-indebted nations is radical asset management through sales of nationalised assets to reduce government debt. This is followed by stringent collection of outstanding tax revenues, renegotiation of payables and finally even debt restructuring.

In healthier countries, deleveraging the private sector and stimulating growth may help the rest of the euro area and will also end up deleveraging the national balance sheet.

10 www.omfif.org OMFIF Official Monetary and News Financial Institutions Forum

Governments under great market pressure need to cut short-term deficits by reducing Why not start a expenditures and broadening tax income. In the most extreme cases, some countries should be allowed to take a sabbatical from the euro. To achieve a necessary 30-40% cost massive internal reduction within the euro may be too difficult for countries in the greatest distress and too FDI initiative in expensive for the rest of the euro area. It may be cheaper to permit currency devaluation the European and restart growth from a more competitive cost base. Union to enhance Yet much more is needed. Southern Europe must build sound administrations. Lack of participation in the administrative skills and discipline has led to entrepreneurial and investment hold-ups, tax evasion and corruption. Targeting support for reconstructing administrations with the common market and help of northern experts may be needed to make restructuring work. Supporting ailing so mobilise growth? countries with government staff from best-practice administrations elsewhere in Europe could become a new way of showing solidarity in the euro area.

Tough action is needed, too, to create the right incentives. Getting trade back into balance and helping the more difficult EU restructuring cases can be achieved only if sick countries are no longer allowed to continue financing their imports with debt. Creating growth in neighbouring countries will help their own initiatives. Generating dynamism in central and northern Europe will help the ailing southern half.

While they must stick to deficit reduction targets, healthy and competitive countries like Germany, Scandinavia, Austria and the Netherlands must stimulate internal demand and investment and thus increase imports.

Right regulations are needed for competition to drive investment

Transferring best practice in economic restructuring programmes is recommended. Programmes such as that brought in recently by Mario Monti, the Italian prime minister, or (further in the past) the successful restructuring of Sweden, Finland, Poland and Czechoslovakia (after 1990) can all act as inspirations.

Microeconomic initiatives are needed too. We need the right regulations for competition to drive investment; liberalised labour market rules; and methods to boost entrepreneurial behaviour through more venture capital and better education.

I call for a 10 year EU growth and investment programme that can double the continent’s growth potential. Lack of EU investment is not due to lack of funds. Trillions of euros are looking for investment opportunities around the globe every year. We can put some of this money to good use.

The most striking opportunities for the EU to generate jobs and construct a better future are through infrastructure projects. Building such infrastructure will require more national and international EU investment projects such as the high-speed rail link from Stockholm to Naples, Amsterdam to Bucharest or Lisbon to St. Petersburg.

These EU projects should include networks for shifting energy from low-cost to high-cost countries, investments in energy efficiency and clean technology, and economically viable alternative energy projects. This will need a new framework for accelerated planning and execution of EU infrastructure investment.

Green investments are a propitious way forward. Energy savings and alternative energy technologies provide a worthwhile field for profitable investment. So does investment in service industries: a neglected growth and productivity opportunity for Europe

Fostering large-scale application of existing recent technologies, as well as attracting more foreign direct investment (FDI) towards the EU, are both good routes to follow. Why not start a massive EU internal FDI initiative to enhance participation in the common market and so mobilise growth? Almost all these proposals for private investment initiatives can generate growth without adding to government debt. These are the ‘smart growth’ instruments we should employ if we wish to protect Europe from distress and give it a brighter future. y

June 2012 11 OMFIF Official Monetary and Financial Institutions Forum NewsWorld economy

Clarion call of green growth Dual strategy to get economies moving Ruud Lubbers and Paul van Seters, Advisory Board une sees two meetings in Latin America of enormous importance for the world’s well- Europe is witnessing Jbeing. On June 18-19, the Group of 20 convenes in Los Cabos, Mexico. And on June 20-22 Rio de Janeiro plays host to Rio+20, the Sustainability Conference of the United much debate about Nations. The G20 and Rio+20 agendas are different, but they share a common focus. generating both In Mexico and Brazil, the global necessity of green growth has highest priority. Europe stability and growth, is witnessing much debate about generating both stability and growth, and about the interdependence of these two. Green growth adds a crucial dimension. and about the interdependence of Since autumn 2008, Europe has been suffering from the related problems of the credit crisis and the euro crisis. In the fight against this two-headed monster, the main goals over these two. Green the past few years have been strengthening banks’ equity by building up financial buffers, growth adds a and cutting countries’ budget deficits to a maximum of 3% of GDP. Yet increasingly we crucial dimension. hear the call for more growth to overcome the malaise. It is high time these calls were heeded.

Stability and growth, by themselves, are not what the world in the 21st century most urgently needs. What is required is green growth: growth aimed at the transition toward a sustainable economy. Last year the Organisation for Economic Cooperation and Development issued three extensive reports advocating green growth. In Kyoto in 1997 all countries accepted the principle of ‘common but differentiated responsibilities.’ In that spirit, many countries are launching new green growth programmes.

World-wide we see an increasing diversity of emission trade systems (ETS). The EU was

here first, but we need urgently to speed up the efforts to boost the price of CO2 , especially through generous so-called set-aside schemes. The damage for energy-intensive firms will be more than balanced by investments in new technologies directed at a more energy- efficient economy. Much is already available, ready for take-off. But first we need to raise

the price of CO2 and invest the money produced in this way into green growth.

At the same time we have to persevere with the euro. Euro member countries are now all committed to huge deficit-cutting measures. In July the ESM, the permanent rescue fund, will officially start. Like the EFSF, the temporary rescue fund, this permanent fund will support countries that are no longer able to meet their financial obligations. But it will provide this support only under strict conditions and close supervision by the European Central Bank, the and the IMF.

When after some time the ESM has gained sufficient experience, then the time will come to start thinking about introduction of Eurobonds, on the basis of the same strict conditions and close supervision. The EU must follow a twofold strategy: strictly conditional support, including through Eurobonds, plus investment in green growth through investment-

generating higher CO2 prices.

This clarion call of green growth will be heard loudly and clearly at the G20 and Rio+20 gatherings. It is unlikely that participants in Los Cabos or Rio de Janeiro will agree on a concrete Green Growth Deal. Differences of interest and opinion are still too large. Think about the question of which countries have most caused the rise of the Earth’s temperature and are thus responsible for climate change. But the G20 and Rio+20 significance is not determined by individual countries.

Especially in Rio de Janeiro, representatives of the private sector and civil society will be present in large numbers. Over the past 20 years, the impetus for and green growth has shifted from the public sector to the private sector and civil society, now wielding much more influence on public bodies. These sources can give tremendous impetus for positive outcomes. y

12 www.omfif.org OMFIF Official Monetary and TNheews future of EMU Financial Institutions Forum

Parallel currency is the way Keep euro, regain strength, stabilise Europe Michael Butler, former UK Permanent Representative, European Community he fiscal compact treaty has not tackled the major flaw in the present position of Uncompetitive Teconomic and monetary union (EMU), namely the loss of competitiveness of all the Mediterranean countries (even France) relative to Germany in the years since the national countries would currencies were abolished. recreate national currencies alongside Telling them to deal with this problem by screwing their economies down so that costs can be reduced will not work, especially since the Germans show no signs of being the euro. Initial ready to engage in a bout of inflation to share the burden. Chancellor Angela Merkel parities would be probably believes that she has been acting in Europe’s best interests. But she has been pushing countries which have lost up to 30% of competitiveness versus Germany since fixed by the ECB and 2000 towards years of depressed economic performance. These countries need a measure the authorities of the of exchange rate flexibility. Without it they will inevitably have to ask for more bail-outs country concerned. before long - a serious burden on taxpayers and the entire euro area.

More than a year ago I put forward a proposal to address this need. (See OMFIF Bulletin, January 2011, p.1.) It was probably premature. But it might get a better hearing now that the causes of the crisis are better understood. The proposal was based upon the ‘hard Ecu plan’ originated by the City European Committee and adopted by the British government in early June 1990.

There is an important difference between the 1990s and now. Then we would have been creating a new common currency. Now there is a single currency, and we would be recreating new national currencies.

Uncompetitive countries would recreate national currencies alongside the euro (initially in the form of bank accounts, not notes and coins). Initial parities against the euro would be fixed by the European Central Bank and the authorities of the country concerned. Thereafter the new currencies would be allowed to float against the euro. The ECB, in consultation with euro area central banks, would manage the euro against the new national currencies, which would be certain to depreciate.

Companies would be free to price wages and, where appropriate, other inputs as well as exports in national currencies. This would no doubt lead in time to devaluations. The euro would remain legal tender in the devaluing countries. Euro debts (with the exception mentioned below) would be honoured in euros. This would provide a strong disincentive to loose policies. Initially notes and coins would not be issued, but that option would be open to the countries issuing national currencies. Banks would be required to open bank accounts in national currencies for creditworthy customers from the outset. Companies would be free to price internally in national currencies or euros.

The plan would certainly not be pain-free and some of the countries issuing national currencies could still default on some of their debt. But all of them would have a strong incentive to make it work. Contracts in euros would be honoured in euros – with one exception, namely that contracts between entities within a country recreating its currency would be redenominated in national currency at the agreed parity on day one.

One advantage would be that pressure would gradually be removed from the balance of payments of the debtor countries. The euro would be preserved and would no doubt continue to be used by tourists. Those countries with national currencies would be free to make the heroic efforts needed to get to a situation where they would no longer need to use them. If there were countries that wished to leave the euro, they could drop it without drama. The richer countries would have to pay less in bail-outs. Less centrally imposed austerity would be needed. The Single Market need not be affected by this. And the EU would be much strengthened if growth could be restored. y

May 2012 13 OMFIF Official Monetary and Financial Institutions Forum BankNotes - The Fed Further stimulus in the air Europe, US fiscal policy seen as ‘headwinds’ Darrell Delamaide, Board of Contributing Editors

he watchword for the Federal Reserve is keeping options open. Fed officials, speaking in May ahead of the disastrous Tjobs report for the month on 1 June, were clearly wary about bad economic news. The deterioration in unemployment, with the headline rate moving up a tick to 8.2%, has increased speculation that the Federal Open Market Committee will consider a further round of asset purchases, or QE3, perhaps as early as the meeting in June.

Jerome Powell (voter) and Jeremy Stein (voter) were sworn in as governors at the end of May, bringing the Federal Reserve Board of Governors to its full strength of seven for the first time since 2006. President Barack Obama helped speed these two nominations along by pairing the Republican-affiliated Powell, a private equity manager and Treasury official under the first President Bush, with Democratic-affiliated Stein, a Harvard economics professor.

Jerome Powell Jeremy Stein Most Fed watchers presume that the two new Board members, who are not monetary policy experts, will follow Chairman Ben Bernanke’s (voter) lead on the FOMC. Both Bernanke and his deputy Janet Yellen, speaking in early June, stressed that the Fed stood ready to act if further weakening of employment and economic data made this appropriate.

New York’s Dudley warns about European crisis, US ‘fiscal cliff’

William Dudley (voter), head of the New York Fed and vice chairman of the FOMC, is considered a reliable surrogate for Bernanke’s views. Speaking to reporters at the end of May, he reiterated his belief that no further accommodative action from the Fed is necessary right now. ‘As long as the US economy continues to grow sufficiently fast to cut into the nation’s unused economic resources at a meaningful pace….I think the benefits from further action are unlikely to exceed the costs.'

He acknowledged, however, that the US economy faces ‘headwinds,’ not only from the crisis in Europe, William Dudley but also from the so-called ‘fiscal cliff’ faced by the US at the end of the year, when tax cuts are scheduled to expire and spending cuts to kick in unless Congress takes action.

Cleveland’s Pianalto says monetary easing helps ‘cyclical’ employment problem

Cleveland Fed chief Sandra Pianalto (voter), considered dovish-leaning, put the emphasis on maintaining the Fed’s accommodative stance.

‘My current assessment is that the real economy continues to show considerable cyclical weakness,’ she said in a speech to the National Association of Business Economists in Cleveland. ‘This assessment, along with my outlook for moderate growth and subdued inflation, calls for today's highly accommodative monetary policy.' The fact that there are three job-seekers for every job opening now indicates to her that Sandra Pianalto the current high level of unemployment is more cyclical than structural. But, she adds, ‘persistent cyclical unemployment runs the risk of translating into structural unemployment through the loss of skills.’

Boston Fed chief sees further easing as necessary

Boston Fed chief Eric Rosengren (non-voter), an outright dove, predictably goes a step further and says further monetary stimulus is necessary because the slow growth in employment is due to lack of demand and not structural considerations like lack of job skills.

He cited similar patterns in job loss across regions and industries as evidence that it was cyclical rather than structural.‘Moreover, during the recovery the pattern has been similar across industries – with a modest pickup in employment across industries but no industry standing out as having comparably rapid

Eric Rosengren growth,’ Rosengren said in a speech at Worcester, Massachusetts. ‘Again this seems more reflective of inadequate demand rather than structural impediments to growth, such as major industries being unable to find sufficient workers.’

14 www.omfif.org OMFIF Official Monetary and Financial Institutions Forum

Further stimulus in the air Williams says Fed ready to step up stimulus Another FOMC dove, Federal Reserve Bank of San Francisco President John Williams (voter) said the central bank should be ready to step up stimulus in case economic growth slows and threatens to delay 'QE3 will work improvement in the job market. under the right circumstances. But The Fed must ‘stand ready to do even more if needed to best achieve our statutory goals of maximum employment and price stability,’ I don't believe such Williams said in the text of remarks prepared for a speech in Bellevue, John Williams circumstances prevail Washington, on 6 June. at this time' If growth were to worsen or the inflation outlook fall below the Fed’s goal of 2 percent, ‘additional monetary accommodation would be warranted.’

Lockhart says US outlook ‘tiled’ to downside

Dennis Lockhart (voter), the Atlanta Fed chief who generally is considered more middle of the road, did not join Rosengren’s call for immediate action, but said further quantitative easing by the US central bank couldn’t be ruled out.

While Lockhart expects modest growth in the US over the next few years, he warned of ‘larger-than-normal risks,’ chiefly the potential for ‘broad

Dennis Lockhart spillover’ from the European crisis.

‘For this reason in particular, I currently judge the risks to the US outlook as tilted modestly to the downside,’ he said in Tokyo. He noted that many people are ruling out a third round of Fed asset purchases, or quantitative easing (QE3). ‘I do not think this option can be taken off the table... QE3 will work under the right circumstances. But I don't believe such circumstances prevail at this time.'

Dimon target of resignation call by Kansas City’s George

While some politicians were quick to call for the resignation of JP Morgan Chase CEO Jamie Dimon from the board of the New York Fed after his bank revealed it lost billions of dollars in a single trading strategy gone awry, it was left to the newest of the Fed regional presidents, Kansas City’s Esther George (non-voter), to weigh in on the question.

In what were widely seen as pointed remarks directed at Dimon, George Ester George said that standards for bankers to serve on the boards are very high. ‘When an individual no longer meets these standards,’ she said in a statement in late May, ‘the director resigns voluntarily to allow someone who does meet the criteria to serve.’

Each of the nine-member boards at the 12 regional banks includes three bankers from the district to provide their input into the Fed’s monitoring of the local economies. They play no role in regulating other financial institutions, George noted.

‘Directors have a special obligation for maintaining the integrity, dignity and reputation of the Federal Reserve System,’ George said. Among the

Jamie Dimon criteria specified in the Fed’s governing statue is that directors should avoid any action ‘affecting adversely the confidence of the public in the integrity’ of the Fed.

George, who took office in October, concluded her statement with a remark designed to cut down the biggest of egos: ‘No individual is more important than the institution and the public’s trust.’ y

June 2012 15 OMFIF Official Monetary and Financial Institutions Forum The future of EMU

Why Greek exit is not suicide Lessons of history for monetary union Gabriel Stein, Lombard Street Research s ‘Grexit’ – Greece leaving EMU – suicidal? Or is it rather staying in and submitting to For a monetary Iausterity that will kill off the country? Both views have been heard in the Greek political debate (as well as outside Greece). While both views could in theory be right, it is unlikely union between that either is. (roughly speaking) equal-sized History makes two things clear. First, monetary unions frequently break up. Second, when they do, the consequences are seldom catastrophic. Wolfgang Schäuble, the German economies to survive finance minister, becoming increasingly ready to accept the idea of Greek departure, and prosper, a fiscal told the German newspaper Handelsblatt on 6 June that Greece had to decide its own destiny, adding sardonically: ‘The great scenarios of the end of the world have never been union is a necessary, realised.’ Since the Second World War, more than 70 monetary unions have come to an but not sufficient end around the globe. And, as Schäuble noted, we managed to live through them all. condition. The lesson of history is that a monetary union that is not a fiscal union can work between a large country and a small one. That is because the large country sets monetary policy to suit itself, regardless of the situation of the small country. However, for a monetary union between (roughly speaking) equal-sized economies to survive and prosper, a fiscal union is a necessary, but not sufficient condition.

There is not a single case of a monetary union between equal-sized economies surviving without becoming a fiscal – and that means political – union. But there are plenty of cases of political unions breaking up, in whole or in part, with the new entities intending to retain the same currency and quickly failing to do so.

A fiscal union is needed is because there is always a risk in a monetary union that one country will allocate to itself resources at the expense of the other members by running a fiscal deficit. In the absence of a fiscal union, which regulates such issues, the union will have to be policed by the strongest country. This was partly the undoing of the Latin Monetary Union (LMU).

True, the LMU lasted from 1865 to 1927 (although it de facto broke down with the outbreak of the First World War). While the LMU initially had only four members (France, Belgium, Switzerland and Sardinia), the intention was to expand it. In 1867, a conference was held in Paris (coinciding with a move to the gold standard) with a view to adding more countries.

However, it quickly turned out that the countries that wanted to join the LMU – Greece, the Papal States and Romania – were also the countries that existing members least wanted. By contrast, countries that were welcome – such as the UK, which would have brought in Portugal, the Netherlands and perhaps some northern German states, or the US – were unwilling to make the necessary minimal adjustments to the gold content of their respective currencies.

This is a clear parallel with EMU, where the UK, Sweden and Denmark – none of which is willing to join – would most likely be made far more welcome than some of the Balkan states. It also highlights another parallel between the LMU and EMU, namely the heterogeneous nature of the member countries.

This meant that the LMU ended up saddled with countries with weak public finances, which would – and did – destabilise the union’s finances by issuing excessive divisionary coinage and allocate to themselves seigniorage profits at the expense of the other countries. That strengthened the opposition to expanding the union and brought the whole concept of monetary union into disrepute.

16 www.omfif.org OMFIF Official Monetary and News Financial Institutions Forum

The conditions for joining were made harder and so onerous that only a weak and No one thinks desperate country would be prepared to accept them. This is reminiscent of the criteria leaving EMU is set by the Maastricht treaty and Stability and Growth Pact and especially of the recent repeated terms imposed on countries needing rescue packages from their EMU partners. easy, smooth or The only country that formally joined the LMU after the founder members was therefore painless. It will Greece; and Greece was only allowed to join on condition that its coinage was carried out in France under French control and with limits on its notes issuance. be difficult, rough and painful. But it The LMU could flourish only as long as France was willing to police it. After its defeat is not impossible, by Prussia in 1870-71, France had neither the will nor the strength to continue to do so, and although a number of countries unilaterally aligned their currencies to the LMU, the nor necessarily union never regained its vitality. The LMU could have limped on after the First World War, disastrous. but the fundamental misalignments between the participating nations had widened so much that this was no longer possible without significant realignments. That was also the situation for the LMU’s northern contemporary, the Scandinavian Monetary Union.

The history of other monetary unions confirms that, without a fiscal union, a monetary union will not last. Perhaps the best example is the Czech-Slovak monetary union. After the break-up of Czechoslovakia on 1 January 1993, the Czech and Slovak Republics intended to maintain the same currency. Six weeks later, they already had separate currencies.

All this shows that monetary unions can dissolve – and it is not the end of the world. Nor does their dissolution have to lead to war and breakdown. Admittedly, there has been no dissolution of a monetary union with EMU’s advanced and integrated financial system. But that does not make it impossible – just complicated. The same goes for legal aspects.

Greece’s partners, confronted with a country that – in the words of the OECD – is structurally incapable of reform and therefore needs huge transfers for the foreseeable future – will not let the absence of treaty provisions stop them from trying to arrange such an exit if they perceive that to be in their national interests. The threats by the Bundesbank to cut off the Bank of Greece’s emergency liquidity assistance support this view. No one thinks leaving EMU is easy, smooth or painless. It will be difficult, rough and painful – for everyone concerned. But it is not impossible, nor necessarily disastrous. y

Net Net Balance Balance with with the Eurosystem the / Eurosystem Target - €bn / Target [bn €] 650

550 Finland France Germany Greece Ireland Italy 450 Netherlands Portugal Spain Luxembourg 350

250

150

50

-­‐50

-­‐150

-­‐250

-­‐350 Jul-­‐07 Jul-­‐07 Jul-­‐08 Jul-­‐09 Jul-­‐11 Jul-­‐10 Jul-­‐10 Jan-­‐07 Jan-­‐07 Jan-­‐09 Jan-­‐10 Jan-­‐11 Jan-­‐12 Jan-­‐08 Jan-­‐08 Sep-­‐07 Sep-­‐08 Sep-­‐09 Sep-­‐10 Sep-­‐11 Nov-­‐07 Nov-­‐08 Nov-­‐10 Nov-­‐11 Nov-­‐09 Mar-­‐08 Mar-­‐09 Mar-­‐10 Mar-­‐11 Mar-­‐07 Mar-­‐12 May-­‐08 May-­‐09 May-­‐10 May-­‐11 May-­‐07 Source: Institute of Empirical Economic Research - Universität Osnabrück June 2012 17 OMFIF Official Monetary and Financial Institutions Forum NewsOMFIF Advisory Board CHAIRMEN Meghnad Desai John Nugée Frank Scheidig Songzuo Xiang Chairman Deputy Chairman Deputy Chairman Deputy Chairman

Frits Bolkestein Neil Courtis Natalie Dempster Willem van Hasselt Vladimir Dlouhy y

Paul Judge John Kornblum Norman Lamont Thomas Laryea Ruud Lubbers Luiz Eduardo Melin polic public

Phil Middleton Isabel Miranda John Nugée** David Owen Martin Raven

Janusz Reiter Shumpei Takemori Christopher Tugendhat Linda Yueh

Katinka Barysch Paul Boyle Albert Bressand Stephane Deo Pawel Kowalewski Gerard Lyons ecomomics & & research

Mariela Mendez Vilem Semerak Paola Subacchi Peter Walton John West Songzuo Xiang**

18 www.omfif.org OMFIF Official Monetary and Financial Institutions Forum

Nick Butler Jon Davis Meghnad Desai* Steve Hanke John Hughes Ashley Eva Millar education

Rakesh Mohan Danny Quah Abdul Rahman Paul van Seters Niels Thygesen Makoto Utsumi y Paul Betts Nick Bray Peter Bruce Darrell Delamaide Jonathan Fenby Stewart Fleming ommentar & C &

Haihong Gao Trevor Greetham Harold James Roel Janssen William Keegan Joel Kibazo E ditorial

Peter Norman Ila Patnaik John Plender Robin Poynder Michael Stürmer David White

arkets Hon Cheung John Cummins Frederick Hopson Matthew Hurn Mumtaz Khan George Milling-Stanley M apital C

Paul Newton Saker Nusseibeh Bruce Packard Marina Shargorodska Hendrik du Toit Jack Wigglesworth

June 2012 19 OMFIF Official Monetary and Financial Institutions Forum

Notes on contributors

Prof. Lord Desai is Emeritus Professor at the London School of Economics. The book he refers to is This Time Is Different: Eight Centuries of Financial Folly by Carmen M. Reinhart and Kenneth Rogoff (Princeton University Press, 2010). See Reinhart and Rogoff’s index on Greece, p.453.

Ashish Bhatia is Manager for Government Affairs at the World Gold Council

Stefan Bielmeier is Head of Research at DZ Bank, and a member of the OMFIF Advisory Board.

Sir Michael Butler was UK Permanent Representative to the European Community 1979-85, and Chairman of the City’s European Committee which produced the ‘hard Ecu’ plan, adopted by the British government in June 1990. He writes in a personal capacity.

Michael Kamaikliotis is Head of Investment at Quantum Global Investment Management.

William Keegan is Senior Economics Commentator at The Observer.

Prof. Edward G. Krubasik is former President of the European Engineering Association Orgalime and a former Management Board Member of Siemens. A longer version of Prof. Krubasik’s article will be published in the Q2 CESifo brochure in July.

Ruud Lubbers is a former Prime Minister of the Netherlands.

Paul van Seters is Professor of Globalisation and Sustainable Development, TiasNimbas Business School at University.

Lord Owen was Foreign Secretary 1977-79 and was EU peace negotiator in the former Yugoslavia 1992-95. His latest book, Europe Restructured? The Eurozone crisis and its aftermath (Methuen, 2012), and is available for purchase via the following link: amzn.to/Lqrxo3.

Gabriel Stein is a Director of Lombard Street Research. He becomes Chief Executive of OMFIF on 1 July.

OMFIF ADVISORY BOARD (cont.)

John Adams Mario Blejer Consuelo Brooke YY Chin Aslihan Gedik Dick Harryvan BANKING

Carl Holsters Akinari Horii David Kihangire Philippe Lagayette Andrew Large Oscar Lewisohn

Frank Scheidig** Jens Thomsen Ernst Welteke Derek Wong Sushil Wadhwani

20 www.omfif.org OMFIF Official Monetary and Central bank reserves Financial Institutions Forum

Making up ground in gold Lower volatility supports higher allocations Ashish Bhatia, World Gold Council old is relatively under-owned by emerging market central banks. While advanced 'Past analyses show Geconomies hold on average 22% of their reserves in gold, emerging market central banks hold on average less than 4%. Given the vast divide, many emerging market that gold allocations reserve managers have been eager to accumulate more gold. In the process of building between 4-7% are their reserves, central banks are no longer questioning whether to accumulate, but rather optimal for a typical how much more is needed to be optimal. emerging market This is one of the reasons behind increases of 80 tonnes of gold in central bank reserves central bank.' in the first quarter of this year, following 440 tonnes of collective purchases in 2011. Part of this drive reflects lower attractiveness of other reserve assets like sovereign bonds, undermined by the sovereign debt crises. Gold’s lack of credit risk, market depth and almost universal acceptability for the world’s central banks make it an attractive alternative. Past analyses show that gold allocations between 4-7% are optimal for a ‘typical’ emerging market central bank. But this is often considered only from a dollar perspective. Looked at from a local currency viewpoint, the picture looks still more skewed.

It is worthwhile carrying out an assessment in local currency terms for some of the largest reserve holders with relatively flexible currencies like Brazil, Mexico, Korea, India, Philippines, Singapore, Indonesia, Poland and Thailand. The key is to examine the performance of a ‘typical’ central bank when the reserve portfolio is denominated in each of the nine emerging market currencies.

Our investigation centres on 13 years of historical returns (1998-2011), volatilities, and correlation data on the primary reserve assets of US, European, and Japanese sovereign bonds and gold. To carry out this test, we used a very conservative return estimate of only 4% for gold, when gold actually returned 13.5% during the period of analysis. We then ran 1000 simulations using an optimisation technique of resampling.

In all of the nine emerging market currencies examined, the optimal allocation to gold was considerably higher than in the equivalent dollar-based study (see Chart 1). Furthermore, the mid-range of optimal allocations to gold increased to 8% to 10% (from 4%-7% in dollar terms). This means central banks that might have been targeting a 4%-7% allocation would leave themselves largely underallocated to gold from a risk-return efficiency perspective. For example, in Mexican pesos we found optimal allocations rose to 6-8%, while in Brazilian real the allocation went to 19%.

Two factors account for this difference. First, shifting the analysis from a dollar-based study to an analysis based on local currencies, broadly shifted allocations away from the dollar and toward other reserve assets. Any dollar-orientated analysis naturally favours US assets as this would not incorporate any foreign exchange risk. As gold is negatively correlated to the dollar, its volatility was much less affected than other reserve assets when translated into other currencies.

This second result points to an important quality of gold. Specifically, the volatility of gold is the most stable of all reserve assets when translated into the nine different currencies. In translating gold’s volatility from dollars to the nine currencies, gold’s volatility on average increased by only 1.7 percentage points. Meanwhile, when translating US, German, UK, and Japanese government bonds into these nine currencies, their respective volatilities increased by more than 7 percentage points and went as high as 12 percentage points higher for Japanese bonds (see Chart 2). Thus, regardless of numeraire, gold’s volatility remained relatively stable. Looking at US Treasury bonds helps to illustrate this point further. Between 1998 and 2011, US Treasuries exhibited annualised volatility of only 4.8%. However, when US Treasuries are converted into a local emerging market currency and examined through that lens, Treasuries no longer seem as stable.

June 2012 21 OMFIF Official Monetary and Financial Institutions Forum

For example, in Mexican peso terms during the same period, an investment in US Treasuries Only a relatively had a volatility of 10.8% and as high as 20% in Brazilian real terms. small number of Currently, only a relatively small number of central banks make investments decisions based central banks make on a local currency perspective. However, as central bank reserve managers increasingly investments decisions question the ability of the dollar and euro to maintain their roles as the primary reserve assets in an evolving international monetary system, many are increasingly paying attention based on a local to calculations in local currencies. currency perspective. As more central banks consider a local numeraire, gold’s stable volatility across different currencies is a key factor. This is another quality to consider alongside gold’s liquidity, low correlation with other assets and lack of credit risk. Gold’s stable volatility in a range of currencies, compared with unstable volatilities of other reserve assets (dollar, euro, yen, and sterling government bonds), supports the principle of higher optimal allocations to gold for many emerging market central banks. y

Chart 1: Optimal gold allocation range by currency

Source: RBS Reserve Management Trends 2012, "Optimal gold allocations for emerging-market central banks"

Chart 2: - Range of impact on volatility from translating assets into EM currencies

Source: RBS Reserve Management Trends 2012, "Optimal gold allocations for emerging-market central banks"

22 www.omfif.org OMFIF Official Monetary and Poetry corner Financial Institutions Forum

An occasional foray into monetary problems inscribed in verse Athenian affliction inspires and repels Grass and Desai portrayals sum up the adventure and adversity facing Greece and its neighbours at Europe’s hour of need

ünter Grass, the German Nobel literature laureate, has written a poem about Greece and its predicament, published Gin German newspapers on 25 May. Prof. Lord Desai, chairman of the OMFIF advisory board, has done the same (with apologies to Dr. Seuss). We publish the verses here, in the hope that they may be a useful contribution to the EMU debate. Europe’s shame A Europoem or Angela's Lament By Günter Grass By Meghnad Desai

Locked in chaos, victim of an unjust market . (with apologies to Dr. Seuss) Country that was your cradle. Now far-off land. It came upon us I don’t know I swear We searched for Greece in ur souls, and found it there. When it did or from where We find it anew, rusting, sold as scrap. It was hardly a speck But it’s made us a wreck For this country, we once gave eternal thanks. O have you seen the Grexit? Now a debtor, arrayed naked on the pillory, suffering before us. There were ten of us hardies But along came the tardies Condemned to poverty. Doomed land, We tied them down with Treaties wealth went abroad to beautify museums Bought their bonds like sweeties with the loot you kept. O have you seen the Grexit?

Uniformed men with arms who violated Happy did we travel the country and its sceptr’d isles. They were never any trouble They carried poetry in their knapsacks. We admired them a lot Till it all went to pot You once saw the colonels as partners and allies. O have you seen the Grexit? Now they are fallen, abjured, forsaken. How did they join our club? Land that lost its rights. Why did we not them snub? Its belt tightened, tightened again Were we perhaps too kind by the powerful and secure. Couldn't leave the lot behind ? O have you seen the Grexit ? Antigone defies you, wearing black. The people whose guest you once were stoop, Their budgets are bloated in mourning shrouds. With debts overloaded Their banks are worse All that shines with gold lustre in your vaults, Get ready the hearse! hoarded now, beyond borders, O have you seen the Grexit ? by successors to Croesus. They neither work nor pay their due Drink up, drink up! cry the Commissioners, charmlessly. They spend and spend without a clue Socrates, enraged, passes you the cup, full to the brim. Why can’t they be like us Save and suffer without fuss? You wished to steal the gods’ Olympus. O have you seen the Grexit? They curse you now in chorus, and you will not prosper. And now it’s come to this O Europe! You were invented by Greek minds. They’ll go bust with bliss Without its spirit, you will grow rotten. They’ve queered our pitch And left us in the ditch O HAVE YOU SEEN THE GREXIT?

June 2012 23 OMFIF Official Monetary and Financial Institutions Forum The Keegan commentary

A regular round-up on international monetary affairs Beware of family rows Why Cameron advice to Draghi is not wanted

William Keegan, Chairman, Board of Contributing Editors avid Cameron is a happily married the ECB should extend its operations. from eurosceptical colleagues whom Dman who has been attacked by The fact that his advice – on the he once referred to as ‘the bastards’. dissident colleagues and sections of issue of Eurobonds and more direct the media recently for spending too ‘monetary activism’ to stimulate growth After Major’s resignation in 1997 much time with his family. – has become, so to speak, common the Conservatives had a series of currency in the debate within the euro eurosceptical leaders who did not Wanting to spend more time with one’s area is neither here nor there. It was have staying power. Despite the UK’s family has become code over the years not relished from the prime minister of non-membership of, and distaste for, for British ministers who announce a nation that pointedly declined to sign the euro, the persistent attacks from the their resignations, whether these are up to the single currency. Conservative right wing on all things voluntary or not. European did not go down well with Apart from anything else, when urging the electorate. In Cameron’s case there may be the ECB to behave more like the Bank opponents within his own Conservative of England in the matter of so-called We therefore find ourselves with party out to get him, but there is no ‘quantitative easing’ Cameron has a a prime minister whose right wing question of his wanting to resign. Prime slight credibility problem. It is a matter would like to unseat him because he minister or no, he just seeks what is of some debate within the UK just how is not eurosceptical enough and whose known in the jargon as the right ‘work/ efficacious QE is when it comes to European counterparts do not take life balance’, and your correspondent reaching the parts of the economy that kindly to his would-be helpful advice. is completely with him in this respect, other growth stimuli cannot reach. if not entirely supportive of his austerity It was Chancellor George Osborne, I policies. The situation is rich with the kind of think, who first surprised us all by urging ironies that we Anglo-Saxons and members of the euro area to follow ‘the However, as a family man David Anglo-Irish appreciate. Cameron hails remorseless logic’ of monetary union, Cameron ought to have observed over from a eurosceptical background but by moving closer towards fiscal union, the years that when there are problems has been trying to pursue a moderately and Cameron himself frequently makes within families, helpful advice from pro-EU line, having witnessed what this point. Now, Draghi and German outside is not necessarily well received. euroscepticism did to so many of politicians may agree entirely with We are all aware of those warring his predecessors as leaders of the Cameron on this point, but, frankly, they couples who unite in the face of outside Conservative Party. do not consider him part of the family. interference. And they know that joining a political At one stage in the 1980s the balance union is the last thing Cameron would Such has been Cameron’s experience of power within the Conservative want to do. recently with his admonitions towards party was so pro-European that Mrs members of the euro area. In particular, Thatcher’s blatant euroscepticism What with his difficult relationship he incurred the wrath of Mario Draghi, was one of the factors that led to her with Europe, and his problems with his president of the European Central being ousted as prime minister. But her own right wing on Europe, no wonder Bank, when he dared to offer what he successor ’s life was made Cameron likes to spend as much time regarded as helpful advice about how difficult by constant guerrilla tactics as possible with his real family. y Looking ahead – 2012 diary dates

Word Banking & Finance Summit 2012 Lecture with Prasarn Trairatvorakul Managing Economic Transformation Governor, Bank of Thailand, 26-27 June, Drapers’ Hall, London 12 September, London

Lecture with James Bullard Lecture with Carlos Costa President, Federal Reserve Bank of St. Louis, Governor, Banco de Portugal, 10 July, London 26 September, London

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