Kemal Dervis – Economy Watch

Will August Be A Decisive Turning Point For The Eurozone Crisis?: Kemal Dervis

Kemal Dervis — Mon, 06 Aug 2012 09:14:14 +0000

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August has been a dangerous month in European history, but this year it could be the turning point for the eurozone – and perhaps for the world economy. That depends on whether – and how – the European Central Bank makes good on official pledges to do “whatever it takes” to preserve the euro.

WASHINGTON, DC – August has been a dangerous month in European history, but this year it could be the turning point for the eurozone – and perhaps for the world economy. On July 26, Mario Draghi, President of the European Central Bank, declared that his institution would do “whatever it takes” to preserve the euro, and added: “Believe me, it will be enough.”

Draghi’s strong – indeed, unprecedented – statement was widely interpreted as signalling that the ECB would soon revive its bond-purchase program, focusing on Spanish debt in particular. Stock markets around the world soared. Jens Weidemann of the Bundesbank immediately expressed reservations, but the next day German Chancellor Angela Merkel and French President François Hollande issued a joint statement expressing their determination “to do everything in order to protect the eurozone.”

I recently argued that the ECB, working with the nascent European Stability Mechanism (ESM), was the only institution that could save the eurozone. It could do so by buying Italian and Spanish bonds in the secondary market with the pre-announced intention of keeping their sovereign interest rates below a certain threshold for a certain time.

It is likely that Draghi’s statement will indeed be followed by ECB purchases of Spanish (and Italian) sovereign bonds. A man like Draghi would not have issued such a statement without believing that he could follow through on it. But, if this is to become a decisive turning point in the eurozone crisis, three things must happen.

First, the ECB’s renewed bond purchases must express the clear intention of reducing sovereign interest rates to sustainable levels, which are at least 200 basis points below their July averages. A high-level German diplomat reportedly dismissed Spain’s 6.5-7 percent interest rates recently, on the grounds that Spain borrowed at nearly the same rates in the 1990’s. But that statement, amazingly, ignored Spain’s higher pre-euro inflation – thus confusing real and nominal rates – and more rapid GDP growth.

For countries that are following agreed reform programs, the ECB should commit itself to bringing down interest rates to levels compatible with projected inflation and growth rates, and announce how long (say, nine months) this will continue. A sporadic program without such announced objectives is unlikely to work, and could even be counterproductive, as private investors might well demand even higher returns because the growing ECB share of the debt would be considered senior, augmenting their risk.

[quote]That would not happen if the ECB announced – and demonstrated – its determination to bring down interest rates, whatever it takes, for a significant period of time. Doing so would allow the eurozone to establish the institutional and legal means to achieve greater cooperation and integration, as agreed at the European Council’s meeting in June. [/quote]

The second thing that must happen is that eurozone leaders and parliaments, with the cooperation of the courts, must be seen to push ahead with institutional reforms to establish not only the ESM, but also a banking union and partial debt mutualization. But, while greater merging of economic sovereignty is the only long-term solution to the eurozone’s woes, such reforms cannot happen very quickly, which is why the ECB’s role is so crucial. The eurozone can no longer sustain continued uncertainty and high real interest rates in the peripheral countries, so the ECB must provide a solid and credible bridge to the future.

Finally, the adjustment programs themselves must be carefully re-calibrated. It should be clear by now that excessive, front-loaded austerity measures tend to be self-defeating, because they trigger a downward spiral of output, employment, and tax revenues. Indeed, the International Monetary Fund’s most recent report on the eurozone says as much (if cautiously).

The pace of deficit reduction must be slowed, particularly in Spain, because output is determined in the short run by demand, and private demand cannot replace public demand until a degree of faith in the future is restored. This move toward support of effective demand must be combined with the kind of structural reforms that will allow more rapid, supply-side growth in the longer term.

If these three steps – an ECB bond-buying program to hold down sovereign interest rates, concrete progress on establishing a real economic union, and realistic revision of current adjustment programs – could be achieved as a package, the resources that the ECB would need to use for its bond purchases would drop, because credibility would be restored. Even if there is further bad news for Europe – from Greece, for example, or from a sharper-than-expected slowdown in China – the eurozone could begin to move out of crisis mode this month.

[quote]But that is possible only if, this time, the “big bazooka” really is put in place. Otherwise, the eurozone’s position – financially, politically, and socially – will soon become un-defendable.[/quote]

By Kemal Dervis

Copyright: Project-Syndicate, 2012

Kemal DerviÅŸ, a former minister of economics in Turkey, administrator of the United Nations Development Program (UNDP), and vice president of the World Bank, is currently Vice President and Director of the Global Economy and Development Program at the Brookings Institution.

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Is The Great State Debate Outdated? : Kemal Dervis

Kemal Dervis — Mon, 30 Jul 2012 09:34:15 +0000

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Throughout history, economists and policy makers have often clashed over the role of the government in the economy. Even today, this debate continues; but despite the realities of twenty-first-century technology and globalisation, it is still conducted largely as if governance and public policy were almost exclusively the domain of the nation-state.

WASHINGTON, DC – The financial crisis of 2008 has spurred a global debate on how much government regulation of markets – and what kind – is appropriate. In the United States, it is a key theme in the upcoming presidential election, and it is shaping politics in Europe and emerging markets as well.

For starters, China’s impressive growth performance over the last three decades has given the world an economically successful example of what many call “state capitalism.” Brazil’s development policies have also accorded a strong role to the state.

Questions concerning the state’s size and the sustainable role of government are central to the debate over the eurozone’s fate as well. Many critics of Europe, particularly in the US, link the euro crisis to the outsize role of government there, though the Scandinavian countries are doing well, despite high public spending. In France, the new centre-left government faces the challenge of delivering on its promise of strengthening social solidarity while substantially reducing the budget deficit.

Alongside the mostly economic arguments about the role of government, many countries are experiencing widespread disillusionment with politics and a growing distance between citizens and government (particularly national government). In many countries, participation rates in national elections are falling, and new parties and movements, such as the Pirate Party in Germany and the Five Star Movement in Italy, reflect strong discontent with existing governance.

In the US, the approval rating of Congress is at a record-low of 14 percent. Many there, such as my colleague Bruce Katz at the Brookings Institution, believe that the only solution is to bring a larger share of governance and policy initiation to the state and municipal level, in close partnership with the private sector and civil society.

But that approach, too, might have a downside. Consider Spain, where too much fiscal decentralization to regional governments contributed significantly to weakening otherwise strong public finances.

[quote]A crucial problem for this global debate is that, despite the realities of twenty-first-century technology and globalization, it is still conducted largely as if governance and public policy were almost exclusively the domain of the nation-state. To adapt the debate to the real challenges that we face, we should focus on four levels of governance and identify the most appropriate allocation of public-policy functions to them.[/quote]

First, many policies – including support for local infrastructure, land zoning, facilitation of industrial production and training, traffic ordinances, and environmental regulations – can largely be determined at the local or metropolitan level and reflect the wishes of a local electorate.

Of course, defence and foreign policy will continue to be conducted primarily at the second level – the nation-state. Most nation-states maintain national currencies, and must therefore pursue fiscal and economic policies that support a monetary union. As the eurozone crisis has starkly reminded us, decentralization cannot extend too far into the budgetary sphere, lest it threaten the common currency’s survival.

The US system is manageable, because the American states are largely constrained to running balanced budgets, while the federal government accounts for most fiscal policy. Moreover, banking regulation and deposit insurance are centralized in the US, as they must be in a monetary union. The eurozone has finally recognized this.

So, governance at the nation-state level remains hugely important and is intimately linked to monetary sovereignty. The key problem in Europe today is whether eurozone members will advance towards something resembling a federal nation-state. Unless they do, it is difficult to see how the common currency can survive.

There is also a third, regional or continental, level of governance, which is most advanced in the European Union (and is being tested in Latin America, Africa, and Asia) and can be very useful. Customs unions, free-trade areas, or a single market, as in Europe, allow greater mobility of goods and services, which can lead to benefits from economies of scale that remaining trade impediments at the global level do not permit. Europe’s borderless Schengen Area is another example of regional supra-national governance. There are also aspects of infrastructure that can best be addressed at the continental level.

Finally, there is the global level. The spread of infectious disease, global trade and finance, climate change, nuclear non-proliferation, counterterrorism, and cyber security are just some of the issues that require broad international cooperation and global governance.

In today’s interdependent world, the debate about the role of public policy, the size and functions of government, and the legitimacy of public decision-making should be conducted with the four levels of governance much more clearly in focus. The levels often will overlap (infrastructure and clean energy issues, for example), but democracy could be greatly strengthened if the issues were linked to the levels at which decisions can best be taken.

[quote]As Pascal Lamy, the director of the World Trade Organization, has said, it is not only the “local” that has to be brought to the “global”; the inherently “local” political sphere has to internalize the global or regional context. That is a huge challenge for political leadership and communication, but, if it is not met, democracy and globalization will be difficult to reconcile. How to conduct democratic debate with reference to these local, national, continental, and global levels, and to structure a political space that better reflects economic and social space, will be the great challenge of the decades ahead.[/quote]

By Kemal Dervis

Copyright: Project-Syndicate, 2012

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Small Economies, Big Trouble: Kemal Derviş

Kemal Dervis — Thu, 28 Jul 2011 08:06:02 +0000

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28 July 2011.

On paper at least, few would consider Greece to be a systemically significant economy. Yet today, the country is at the centre of a crisis that threatens to engulf the entire European Union. But the case of Greece is not unique. In 1997, another relatively small economy, Thailand, was at the epicentre of the Asian Financial Crisis. How can small economies cause such big problems? By Kemal Derviş.

28 July 2011.

WASHINGTON, DC – Greece’s GDP, at about $300 billion, represents approximately 0.5% of world output. Its $470 billion public debt is very large relative to the Greek economy’s size, but less than 1% of global debt – and less than half is held by private banks (mainly Greek). Barclays Capital estimates that only a few globally significant foreign banks hold close to 10% of their Tier 1 capital in Greek government bonds, with the majority holding much less.

So, at least on paper, Greece should not be a systemically important economy. Yet there are several reasons why the Greek crisis is having substantial spillover effects. Moreover, Greece is not alone in this respect.

First, in the Greek case, there is the fear of contagion to other distressed European economies, such as Portugal and Ireland, or even Spain and Italy. There are also substantial investments by American money-market funds in instruments issued by some of the exposed banks.

Then there are various derivatives, such as credit-default swaps, through which banks holding Greek debt have insured themselves against non-payment. If CDSs are concentrated in particular financial institutions, these institutions could be at risk – more so than the primary purchasers of Greek debt themselves. But no one knows who is holding how much of these derivatives, or whether they reduce or magnify the risk, because CDSs are not transparently traded on open exchanges.

Finally, Greece’s difficulties imply problems for managing the euro, as well as possible disorderly behaviour in foreign-exchange markets, which threaten to augment uncertainty and negatively influence the already-weakening global recovery. Clearly, the world economy has a large stake in Greece’s recovery.

In the same vein, consider a completely different case, that of Yemen. Greece and Yemen have no relevant similarities, except the contrast between their size and possible spillover effects. Yemen’s GDP is only 10% the size of Greece’s, representing 0.05% of global output, and its economy is not significantly linked to the international financial system.

But Yemen’s population is close to that of Saudi Arabia, and its border is very hard to control. Chaos in Yemen, coupled with the growing strength of extremists, could seriously destabilize Saudi Arabia and threaten oil production. In that case, the price of oil could shoot up to $150 a barrel or more, dealing a heavy blow to the global economy.

One can find other examples of this kind. Recall that the 1997 Asian crisis started in Thailand – again, not a large economy. The strong trade, financial, and natural-resource-related interconnections that have developed in the world economy turn many otherwise small countries, or problems, into global systemic risks.

[break]

Implications of Global Interdependence

The implications for global economic governance need to be understood and addressed. At the Seoul G-20 summit in November 2010, the assembled leaders encouraged the International Monetary Fund to work with the Financial Stability Forum to develop an early-warning system for global financial risks, and to analyze spillover effects on “large economies” (China, the United States, the United Kingdom, Japan, and the eurozone).

The spillover reports are currently being discussed by the IMF’s board. A synthetic report by the Fund’s Managing Director is to be presented to the International Monetary and Financial Committee when officials from the IMF’s member states meet in September.

This step, if pursued seriously, would enable a deeper analysis of interdependence in the world economy. It could also increase the IMF’s legitimacy as an institution that is global not only in its membership, but also in its treatment of different types of members. So long as the IMF’s macroeconomic surveillance was in fact applied only to developing countries, with the G-7 and other rich countries evading a serious monitoring process, the Fund could not be perceived as fair and impartial.

As these examples indicate, however, systemic importance is not just a question of size. What matters is the interconnections that link a particular country, institution, or group of institutions (for example, Lehman Brothers and AIG) to the wider world economy.

Surveillance of systemic risk must proactively test and analyze these interconnections, and try to imagine the “hard to imagine.” After all, as we now know only too well, systemic risk can emerge in unexpected places.

Interdependence has become much more complex than it was even a decade ago. The IMF needs to be empowered to analyze the macroeconomic and macro-financial risks that have emerged, establish an early-warning system, and propose possible preemptive policy measures. The Fund’s almost universal membership and its staff’s technical expertise should enable it to carry out effective multilateral surveillance, provided that it accelerates its own governance reforms, so that surveillance is perceived as being in everyone’s interest.

By Kemal Derviş

Kemal Derviş served as Turkey’s Minister of State for Economic Affairs before being appointed as the head of the United Nations Development Program (UNDP) from 2005-2009. Currently, he is the Vice President and Director of the Global Economy and Development Program at the Brookings Institution. Among his honours include being conferred the Order of the Rising Sun, Grand Cordon, by the Japanese government in 2009 for his contributions in mainstreaming Japan’s development assistance policy.

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