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Optimism gives way to economic realism

Optimism gives way to economic realism

False feelings of security prolong crisis
Chinese exercise pragmatism


by David Marsh

Tue 12 Feb 2013

What do Mark Carney, Angela Merkel, David Cameron, Athanasios Orphanides and Jin Zhongxia have in common? Answer: they have all contributed to a collective outbreak of global financial and economic realism. We had better watch out. It may prove contagious. The agreement reached by European leaders in Brussels on Friday – under UK prime minister Cameron's spur – to the first-ever cut to the European Union budget, is just one example of the growing trend.

Cameron promptly claimed victory. He may have a point. In his accord on budgetary austerity, he was given solid backing by German chancellor Merkel, visibly discomfiting French president François Hollande. This increases Cameron's hopes that, in forthcoming wider negotiations on a new power mechanism for the European Union, Berlin may be a useful ally.

But longer term, it’s probably not good news for the euro. The spending deal, which still has to be ratified by the European parliament, limits the EU budget to 1% of GDP, well below the 3% proposed by the European Commission in the 1990s to make economic and monetary union (EMU) work.

Another place where we’ve seen an outbreak of realism is in Beijing. In March 2009, Zhou Xiaochuan, governor of the People's Bank of China, caused a considerable stir by calling for the replacement of the dollar as the dominant world currency. Instead, he urged 'an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run'. Four years later, Chinese talk of dethroning the dollar is no longer in vogue.

In an article due to appear in the OMFIF Monthly Bulletin for February, Dr. Jin Zhongxia, head of the research institute of the People's Bank of China, said the dollar will remain the world's dominant reserve currency and may even strengthen over time as the US balance of payments improves.

Making his comments in a personal capacity, Dr. Jin said: 'For the foreseeable future, we can speak of the global currency system as a framework of "1+4". The dollar will continue to be the super reserve currency, supplemented by four smaller reserve currencies: the euro and the British pound in Europe, and the Japanese yen and the Chinese renminbi in Asia.'

In Europe, central bankers are fretting that the revival in financial markets has become dislocated from the still-dire economic reality. Another area where we may see some upheavals. European central bankers have been saying, off-the-record, for some time that they could foresee dire outcomes if politicians continue to hide behind the European Central Bank's much-hyped but untested promise 'to do what it takes' to support the euro.

Now one former member of the 23-member ECB Governing Council has said this out loud. Orphanides, former governor of the Central Bank of Cyprus, who stepped down in May last year, is a fervent euro supporter who took the island state into the single currency in 2008. But last week in Frankfurt he told a university audience that 'the sovereign crisis is tearing the system [EMU] apart', and added: 'States with the worst macroeconomic conditions are the ones with the highest interest rates … EMU has amplified heterogeneity rather than mitigating it.'

Although a supporter of the ECB’s attempts to stabilise markets through unconventional monetary measures, Orphanides said the ECB’s bailout actions provided a built-in reason for governments to slow their own structural reforms. This is an 'impossible dilemma' for the ECB, he added. Far from saving the euro, the ECB – by giving governments a false feeling of security that all may be well – could be storing up considerable trouble for the future.

A man who anticipates such obstacles in the future is Carney, governor of the Bank of Canada. On 1 July he will take over from Mervyn King as governor of the Bank of England. Last week, speaking to the Treasury select committee in the British parliament, he played down any idea that monetary policy could provide a panacea for the UK's economic ills and appeared to water down his previous advocacy of nominal GDP instead of inflation as a target for the Bank's monetary policy.

He did say, however, that he wanted a 'debate' on the issue. All that and more, will be in store for Carney as he takes over at a particularly trying time for the UK economy and for the Conservative-led government.

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