State of European Economies

A new pecking order

There has been a change in Europe’s balance of economic power; but don’t expect it to last for long

AFP

FOR years leaders in continental Europe have been told by the Americans, the British and even this newspaper that their economies are sclerotic, overregulated and too state-dominated, and that to prosper in true Anglo-Saxon style they need a dose of free-market reform. But the global economic meltdown has given them the satisfying triple whammy of exposing the risks in deregulation, giving the state a more important role and (best of all) laying low les Anglo-Saxons.

At the April G20 summit in London, France’s Nicolas Sarkozy and Germany’s Angela Merkel stood shoulder-to-shoulder to insist pointedly that this recession was not of their making. Ms Merkel has never been a particular fan of Wall Street. But the rhetorical lead has been grabbed by Mr Sarkozy. The man who once wanted to make Paris more like London now declares laissez-faire a broken system. Jean-Baptiste Colbert once again reigns in Paris. Rather than challenge dirigisme, the British and Americans are busy following it: Gordon Brown is ushering in new financial rules and higher taxes, and Barack Obama is suggesting that America could copy some things from France, to the consternation of his more conservative countrymen. Indeed, a new European pecking order has emerged, with statist France on top, corporatist Germany in the middle and poor old liberal Britain floored.

A cockpit of competing capitalisms

It is easy to dismiss this as political opportunism. But behind it sits a big debate not only about the direction of the European Union, the world’s biggest economic unit, but also about what sort of economy works best in the modern world. Thirty years after Thatcherism began to work its cruel magic in Britain (see article), continental Europe still tends to favour a larger state, higher taxes, heavier regulation of product and labour markets and a more generous social safety-net than freer-market sorts like the Iron Lady would tolerate. So what is the evidence for the continental model being better?

The continental countries certainly have not escaped the recession: France may be doing a bit better than the world’s other big rich economies this year, but Germany, dragged down by its exporting industries, is doing significantly worse. Yet Mr Obama is right to admit that in some ways continental Europe has coped well. Tough job-protection laws have slowed the rise in unemployment. Generous welfare states have protected those who are always the first to suffer in a downturn from an immediate sharp drop in their incomes and acted as part of the “automatic stabilisers” that expand budget deficits when consumer spending shrinks. In Britain, and to an even greater extent in America, people have felt more exposed.

The downturn has also confirmed that the continental model has some strengths. France has a comparatively efficient public sector, thanks in part to years of investment in better roads, more high-speed trains, nuclear energy and even the restoration of old cathedrals (see article). Nor is it just a matter of pumping in ever more taxpayers’ cash. By any measure France’s health system delivers better value for money than America’s costlier one. Germany has not just looked after its public finances more prudently than others; its export-driven model has forced its companies to hold down costs, making them competitive not only in Europe but also globally. By design as well as luck, much of continental Europe avoided the debt-fuelled housing bubbles that popped spectacularly in Britain and America (though Spain did not, see article).

But will it last? The strengths that have made parts of continental Europe relatively resilient in recession could quickly emerge as weaknesses in a recovery. For there is a price to pay for more security and greater job protection: a slowness to adjust and innovate that means, in the long run, less growth. The rules against firing that stave off sharp rises in unemployment may mean that fewer jobs are created in new industries. Those generous welfare states that preserve people’s incomes tend to blunt incentives to take new work. That large state, which helps to sustain demand in hard times, becomes a drag on dynamic new firms when growth resumes. The latest forecasts are that the United States and Britain could rebound from recession faster than most of continental Europe.

Individual countries have specific failings of their own. Even if it did everything else right, Germany’s overreliance on exports at the expense of consumer spending has proved a grave weakness in a downturn (see article); its banks also look weak. The rate of youth unemployment in France is over 20% and it can be twice as high in the notorious banlieues where Muslim populations are concentrated. Italy and Spain have seen sharp rises in unit labour costs and their labour-productivity growth has stalled or gone into reverse. It may not be long before the fickle Mr Sarkozy is re-reading his Adam Smith.

Not what you aim for, but how you do it

If there is to be an argument about which model is best, then this newspaper stands firmly on the side of the liberal Anglo-Saxon model—not least because it leaves more power in the hands of individuals rather than the state. But the truth is that the governments on both sides of the intellectual divide could go a long way to making their models work better, without changing their underlying beliefs.

On the continental side, there is nothing especially socially cohesive about labour laws that favour insiders over outsiders, or rules that make the costs of starting a business excessive. Even Colbert might admit that Europe’s tax burdens are too onerous today, particularly since they are likely to have to rise in the future to meet the looming cost of the continent’s rapidly ageing populations.

For the liberals, even if the cycle swings back in their direction, the financial crisis and the recession have shown up defects in the way they too implemented their model. Getting regulation right matters as much as freeing up markets; an efficient public sector may count as much as an efficient private one; public investment in transport, schools and health care, done well, can pay dividends. The pecking order may change, but pragmatism and efficiency will always count.

(May 7th 2009
From The Economist print edition)

Latin America's economies That fragile thing: a good reputation

A reformed region cannot escape recession but it can mitigate its impact

FOR much of the past two centuries Latin America has been a byword for the profligate squandering of economic promise and for financial crisis. So ingrained is this reputation that when Chile’s president recently met Britain’s prime minister and boasted of her government’s foresight in saving some of its windfall revenues during the boom years, George Osborne, the shadow chancellor of the exchequer, sneered: “Gordon Brown is getting lessons from the Latin Americans about sound public finances. You couldn’t make it up.”

Happily, Mr Osborne’s view of Latin America is outdated, or at least it now applies in only a few places. Over the past decade, most of the bigger countries in the region have greatly improved their economic policies and the government institutions that implement them. That is the main reason why Latin America was until recently a spectator in the world financial crisis. Its banks are generally conservative and well-regulated. Many countries eschewed their past habit of abusing a boom to borrow. Public finances were mostly in balance, public debt fell and the region ran a current-account surplus. Indeed Chile is one of the world’s best-managed economies by almost any yardstick, but Mexico, Brazil, Colombia, Peru and Uruguay are not all that far behind.

Sadly none of this has shielded the region from the world recession (see article). Most forecasters predict that Latin America’s output will contract this year and recover only modestly next year, so income per head will shrink. Some countries are doing worse than others. Even before the flu outbreak, Mexico had been especially hard hit, because its economy is so closely tied to that of the United States. Brazil is better placed. Argentina, Venezuela and Ecuador have spurned the prudence of their neighbours and antagonised investors. Only the uncertain prospect of Chinese aid stands between these three countries and possible financial crisis next year.

Yet overall, in contrast to its past recessions, Latin America is doing no worse than the world as a whole. In other words, it is not adding to its troubles with internal weaknesses. What’s more, its governments have been able to cushion the blow with counter-cyclical policies of the kind that the rich world has taken for granted since Keynes but which Latin America’s habitual profligacy and lack of credibility denied it in the past. So instead of having to cut spending as tax revenues fall, this time many governments have been able to increase it. Their central banks have earned sufficient credentials as inflation fighters, and many have enough reserves, to cut interest rates without prompting a dangerous weakening of the currency.

Know your limits

Still, there are limits to what governments can do to mitigate the pain. While there’s scope, by and large, for easing monetary policy, fiscal policy is more constrained. The IMF, the World Bank and the Inter-American Development Bank will plug much of the gap this year, but next year looks harder. Tax revenues will have fallen further and Latin American governments’ dodgy past records may hamper their ability to raise money in debt markets that will be heavily oversubscribed.

The priority for those governments should be to maintain their hard-won reputation for financial stability. That will mean keeping a tight rein on budgets. Some of the social gains of recent years will inevitably be lost. But governments can help the poor by focusing spending on, for instance, preventing child malnutrition, discouraging pupils from dropping out of school and beefing up health services.

There is another, harder lesson. Latin America’s recent growth owed much to the outside world, cheap money and high commodity prices. With the world economy facing (at best) several sluggish years, the region will have to look closer to home for growth, by raising its productivity. That needs a huge effort not just to improve education, but also to implement long-postponed reforms of, for instance, labour markets. Such things are never easy in Latin America, where democratic politicians face voters who have to bear the world’s widest inequalities of income. But if the region is to consolidate its still novel reputation for prudent progress and good management, they will have to be done.

(From The Economist print edition)

News from the Business Schools, April 2009

A selection of news from around the business campuses

Case for the prosecution

In a magnificent example of circular thinking, Harvard Business School professors are writing a case study examining whether teaching at the school—which, famously, is exclusively via the case-study method—is adequately preparing its alumni to manage risk.

The school, whose alumni include Stan O’Neal and Andrew Hornby, the men who were at the helm of failed banks Merrill Lynch and HBOS, is looking particularly exposed to the gathering criticism over business schools’ role in the current economic turmoil. However, many professors remain perplexed at the flak coming their way, arguing that, by its very nature, the case-study method imbues students with a sense of long-term risk. Most case studies taught in business school classrooms tend to be several years old. While this is often to the chagrin of students—who continuously complain about material being out of date—it does, in theory, discourage short-termism as MBAs get to learn the real-world outcomes to the corporate dilemmas on which they have been deliberating. The case, it appears, remains unproven.

Changing course

Dartmouth College’s Tuck School of Business is launching what it believes is the world’s first MBA elective focusing on climate change. The course, “Business and Climate Change”, is the brainchild of Anant Sundaram, a professor at Tuck and the pioneer of a model which gauges firms’ vulnerability to fossil-fuel prices. Professor Sundaram says that rather than acting as a constraint on companies, a warming planet could be a huge business opportunity: “The implications are enormous. Massive wealth will be created by companies that get in front of this issue and lost by those that do not.”

The trend towards greener MBAs has been evident for much of the last decade. What is new is the driving force behind the change: schools are becoming greener not just because it is seen as socially important, but also because it is seen as a potential competitive advantage for companies. Babson College’s Olin Graduate School of Business, for example, has introduced a “Sustainable Entrepreneurship by Nature” course. Meanwhile, New York’s Stern Business School recently announced it had officially “gone green” after it unveiled a plan to make its campus more environmentally friendly. It is also launching a “Leading Sustainable Enterprises”

Oil exploration

Coming at the issue from another angle, Warwick Business School is launching a Global Energy MBA in May. Aimed at those already working within the energy industry, the programme will tackle the dual challenges of how to meet demand for oil and gas and how to bring on alternative, renewable sources of energy to help combat climate change.

According to the programme’s academic director, David Elmes, the MBA will also help students get to grips with a recent shift in responsibility between countries and companies. “Companies who would have accessed funds from banks or markets are now pinning their hopes on government stimulus packages,” he says. “The risk is that the momentum to sustain today’s energy sources and develop alternatives is stalling.” The MBA is delivered over three years, combining week-long seminars and self-study.

Opening for business

Pakistan is to get a new private business school. The Karachi School for Business and Leadership (KSBL) is being set up by the Karachi Education Initiative in partnership with the University of Cambridge’s Judge Business School. It plans to offer executive development programmes from next year, with an MBA following in 2011 and an executive MBA the year after that. It is also being charged with teaching students what it takes to run a for-profit business school in Pakistan.

Pakistan has a dearth of world-class business schools. The most prestigious is probably the Institute of Business Administration in Karachi, which was set up in 1955 by the University of Pennsylvania’s Wharton School of Business. Nonetheless, it, in common with other Pakistani schools, regularly gets overlooked in the important international rankings. Many students head out of the country to pursue their business education, something that KSBL hopes to address.

Joint Finnish

Finland’s premier business school, the Helsinki School of Economics (HSE), is merging with the University of Art and Design Helsinki and the Helsinki University of Technology. The new institution, to be named Aalto University, after Alvar Aalto, an architect and one of Finland’s iconic figures, will open its doors to students in 2010 and will continue to offer many of the business programmes currently run by HSE—including an MBA and Executive MBA. The university says that the combination of three such prestigious institutions opens up new possibilities for multi-disciplinary education and research. Critics have voiced concern, however, that competition in the Finnish market will be stifled, such will be Aalto’s dominance.

Class in Gulf

Grenoble Graduate School of Business is to offer some of its business programmes in Saudi Arabia. The French school will link up with the College of Business Administration (CBA) in Jeddah to run its Master in International Business and Doctorate in Business Administration. The programmes will be taught solely in English by Grenoble faculty on the CBA campus. The school said it also hoped to offer Saudi versions of its MSc in Innovation and Technology Management, MSc in Construction Management and executive education training in the future.

Grenoble isn’t the only school looking to expand in the region. Britain’s Manchester Business School has announced that it will be launching an MBA in Dubai. The programme, lasting 30-36 months, is to be taught through a mixture of self-study, residential workshops in the Emirates and virtual learning. Meanwhile, Canada’s Queen’s School of Business will be rolling out its three-day operational leadership programme in Oman, adding to programmes it already runs in the UAE.

Latin lessons

The University of Miami School of Business Administration is hoping to further expand into Latin America after it announced plans to offer its Executive MBA programme in Puerto Rico. The proposed programme, which is awaiting approval from the Puerto Rican government, would be taught at the headquarters of El Nuevo Día, a local newspaper and partner of the school.

Unsurprisingly, given its location, the Miami school already has strong links to the region. Its Master of Science in Professional Management and Executive MBA programme, which run on its Florida campus, are taught entirely in Spanish and target executives working in Latin America. It has also established several partnerships with Latin American business schools, including Universidad de San Andres in Argentina, the University of São Paulo in Brazil, and CENTRUM Católica in Peru.

Losses from Meltdown to reach 4 Thrillion USD

The International Monetary Fund (IMF) has warned that potential losses from the credit crunch could reach $4 trillion (£2.75tn) and damage the financial system for years to come.

It says that even if urgent action is taken to clean up the banking system, the process will be "slow and painful", delaying economic recovery.

It says that banks may need $1.7 trillion in additional capital.

But it warns that political support for further bank bail-outs is waning.

WHY $4TN LOSS MATTERS The banks' huge losses have made them reluctant to lend The lack of lending has pushed the world economy into a deep recession Government budgets are strained by the cost of the bail-outs, hitting taxpayers

One year ago, the IMF estimated that total losses from the credit crunch would be $1 trillion, which has been exceeded, showing how rapidly the financial meltdown has escalated.

The IMF now says that banks are likely to lose $2.7 trillion, but other financial institutions such as insurance companies and pension funds are also now coming under strain.

And it says that emerging market economies, which will need $1.8 trillion in refinancing next year, will be hard-hit by the collapse of cross-border lending, and it predicts that there will be no net private lending at all to developing countries this year.

The report comes as the IMF and World Bank are beginning their spring meeting in Washington, after receiving a promise of $750bn in fresh funds agreed at the G20 summit.

Policy response

The IMF's latest Global Stability Report says that the banking system has not yet been stabilised, despite the billions of dollars spent by governments.

Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested IMF

But it warns that they may be "a real risk that governments will be reluctant to allocate enough resources to solve the problem" because the public has become "disillusioned by what it perceives as abuse of taxpayer funds".

This is the situation especially in the US, where Congress appears reluctant to allocate additional bail-out funds above the $700bn approved last autumn despite the inclusion of another $750bn in President Obama's latest budget proposal.

The US Treasury has instead proposed a private-public partnership to buy up troubled assets underwritten by loans from the Federal Reserve.

But the IMF comments that "uncertainty about political reactions may undermine the likelihood that the the private sector will constructively engage in finding orderly solution to financial stress."

Deeper recession

The IMF says that restoring the banking system so that it functions normally is likely to take several years, and this will make the recession longer and deeper than usual.

COST OF REBUILDING BANKS US banks: $275bn Eurozone banks: $725bn UK banks: $250bn Other European banks: $225bn Source: IMF, based on 6% capital/assets ratio

But it warns that if policies are unclear or not implemented forcefully and promptly, "the recovery process is even more delayed and the costs, in terms of taxpayer money and economic activity, are even greater."

It says that the worldwide recession has deepened the financial crisis.

"Systemic risks remain high and the adverse feedback loop between the financial system and the real economy has yet to be arrested, despite the wide range of policy actions and some limited improvement in market functioning.

"Further effective government action - particularly geared toward cleansing balance sheets and strengthening institutions - will be required to stabilise the global financial system and to provide the foundation for a sustainable economic recovery."

On Wednesday, the IMF will present its world economic forecast.

It is expected to be the gloomiest for 60 years, with the world falling into a global recession, and an even sharper decline in output in the rich countries.

US economy 'deteriorates further'

The Fed called the prospects for near-term economic improvement "poor"

US economic conditions got worse in January and February, the Federal Reserve has said in its influential Beige Book.

The report, which is used to help determine US interest rates, also said that improvement was not expected before late 2009 or early 2010.

"The deterioration was broad-based, with only a few sectors... appearing to be exceptions," it said.

The bank said housing markets remained "in the doldrums" in most US regions.

The report, based on information collected before 23 February, will be used at the forthcoming meeting of Federal Reserve policymakers in two weeks.

'Steep declines'

"Consumer spending remained sluggish on net, although many districts noted some improvement in January and February compared with a dismal holiday spending season," the Beige Book said.

In manufacturing, reports from most areas "suggested steep declines in activity in some sectors and pronounced declines overall".

"Reports from banks and other financial institutions indicated further drops in business loan demand, a slight deterioration in credit quality for businesses and households, and continued tight credit availability," the Federal Reserve said.

It was reported last week that the US economy had shrunk at an annual rate of 6.2% in the last three months of 2008 official figures show, a far sharper fall than previously reported.

On Tuesday Federal Reserve chairman Ben Bernanke warned of stagnation if the US authorities do not move "aggressively" to stimulate the economy.

He told the Senate Budget Committee that stabilising financial markets would be crucial for economic recovery.

Economics focus Banks need more capital

Alan Greenspan says banks will need much thicker capital cushions than they had before the bust

Greenspan AssociatesAlan Greenspan was the chairman of the Federal Reserve Board from 1987 to 2006. He is now president of Greenspan Associates

GLOBAL financial intermediation is broken. That intricate and interdependent system directing the world’s saving into productive capital investment was severely weakened in August 2007. The disclosure that highly leveraged financial institutions were holding toxic securitised American subprime mortgages shocked market participants. For a year, banks struggled to respond to investor demands for larger capital cushions. But the effort fell short and in the wake of the Lehman Brothers default on September 15th 2008, the system cracked. Banks, fearful of their own solvency, all but stopped lending. Issuance of corporate bonds, commercial paper and a wide variety of other financial products largely ceased. Credit-financed economic activity was brought to a virtual standstill. The world faced a major financial crisis.

For decades, holders of the liabilities of banks in the United States had felt secure with the protection of a modest equity-capital cushion, allowing banks to lend freely. As recently as the summer of 2006, with average book capital at 10%, a federal agency noted that “more than 99% of all insured institutions met or exceeded the requirements of the highest regulatory capital standards.”

Today, fearful investors clearly require a far larger capital cushion to lend, unsecured, to any financial intermediary. When bank book capital finally adjusts to current market imperatives, it may well reach its highest levels in 75 years, at least temporarily (see chart). It is not a stretch to infer that these heightened levels will be the basis of a new regulatory system.

The three-month LIBOR/Overnight Index Swap (OIS) spread, a measure of market perceptions of potential bank insolvency and thus of extra capital needs, rose from a long-standing ten basis points in the summer of 2007 to 90 points by that autumn. Though elevated, the LIBOR/OIS spread appeared range-bound for about a year up to mid-September 2008. The Lehman default, however, drove LIBOR/OIS up markedly. It reached a riveting 364 basis points on October 10th.

The passage by Congress of the $700 billion Troubled Assets Relief Programme (TARP) on October 3rd eased, but did not erase, the post-Lehman surge in LIBOR/OIS. The spread apparently stalled in mid-November and remains worryingly high.

How much extra capital, both private and sovereign, will investors require of banks and other intermediaries to conclude that they are not at significant risk in holding financial institutions’ deposits or debt, a precondition to solving the crisis?

The insertion, last month, of $250 billion of equity into American banks through TARP (a two-percentage-point addition to capital-asset ratios) halved the post-Lehman surge of the LIBOR/OIS spread. Assuming modest further write-offs, simple linear extrapolation would suggest that another $250 billion would bring the spread back to near its pre-crisis norm. This arithmetic would imply that investors now require 14% capital rather than the 10% of mid-2006. Such linear calculations, of course, can only be very rough approximations. But recent data do suggest that, while helpful, the Treasury’s $250 billion goes only partway towards the levels required to support renewed lending.

Government credit has in effect acted as counterparty to a large segment of the financial intermediary system. But for reasons that go beyond the scope of this note, I strongly believe that the use of government credit must be temporary. What, then, will be the source of the new private capital that allows sovereign lending to be withdrawn? Eventually, the most credible source is a partial restoration of the $30 trillion of global stockmarket value wiped out this year, which would enable banks to raise the needed equity. Markets are being suppressed by a degree of fear not experienced since the early 20th century (1907 and 1932 come to mind). Human nature being what it is, we can count on a market reversal, hopefully, within six months to a year.

Though capital gains cannot finance physical investment, they can replenish balance-sheets. This can best be seen in the context of the consolidated balance-sheet of the world economy. All debt and derivative claims are offset in global accounting consolidation, but capital is not. This leaves the market value of the world’s real physical and intellectual assets reflected as capital. Obviously, higher global stock prices will enlarge the pool of equity that can facilitate the recapitalisation of financial institutions. Lower stock prices can impede the process. A higher level of equity, of course, makes it easier to issue debt.

Another critical price for the return of global financial stability is that of American homes. Those prices are likely to stabilise next year and with them the levels of home equity—the ultimate collateral for global holdings of American mortgage-backed securities, some toxic. Home-price stabilisation will help clarify the market value of financial institutions’ assets and therefore more closely equate the size of their book capital with the realities of market pricing. That should help stabilise their stock prices. The eventual partial recovery of global equities, as fear inevitably dissipates, should do the rest. Temporary public capital injections into banks would facilitate this process and arguably provide far more benefit per dollar than conventional fiscal stimulus.

Even before the market linkages among banks, other financial institutions and non-financial businesses are fully re-established, we will need to start unwinding the massive sovereign credit and guarantees put in place during the crisis, now estimated at $7 trillion. The economics of such a course are fairly clear. The politics of draining off that much credit support in a timely way is quite another matter.

Trade, exchange rates, budget balances and interest rates as of August 28

Trade, exchange rates, budget balances and interest rates

Aug 28th 2008
From The Economist print edition