Persistent optimism reflects a serious misdiagnosis of the global economy’s troubles. Most notably, economic projections have vastly underestimated the severity of the eurozone crisis, as well as its impact on the rest of the world. And recovery prospects continue to depend on the emerging economies, even as they experience a sharp slowdown. The WEO’s prediction of a strengthening recovery this year continues the misdiagnosis.

European Central Bank President Mario Draghi’s announcement last summer that the ECB would do “whatever it takes” to preserve the euro reassured financial markets. But, as pressure from financial markets has eased, so has European leaders’ incentive to address problems with the eurozone’s underlying economic and political dynamics. Easy ECB liquidity is now sustaining a vast swath of Europe’s banking system.

The eurozone is operating under the pretense that public and private debts will, at some point, be repaid, although, in many countries, the distress now is greater than it was at the start of the crisis almost five years ago. As a result, banks, borrowers, and governments are dragging each other into a vicious downward spiral. Politicians have exacerbated the situation by doubling down on fiscal austerity, which has undermined GDP growth while failing to shrink government debt/GDP ratios. And no decisive policy action aimed at healing private balance sheets appears imminent.

Moreover, Europe’s problems are no longer its own. Europe’s extensive regional and global trade networks mean that its internal problems are impeding world trade and, in turn, global economic growth. In 2012, world trade expanded by only 2.5%, while global GDP grew at a disappointing 3.2% rate.

Periods in which trade grows at a slower pace than output are rare, and reflect severe strain on the global economy’s health. While the trauma is no longer acute, as it was in 2009, wounds remain – and they are breeding new pathologies. Unfortunately, the damage is occurring quietly, enabling political interests to overshadow any sense of urgency about the need to redress the global economy’s intensifying problems.

Against this bleak background, it is easy to celebrate the success of emerging markets. After all, emerging and developing economies are growing much faster than the advanced countries. But even the world’s most dynamic emerging markets – including China, Brazil, and India – are experiencing a sharp deceleration that cannot be ignored.

Consider India, where growth is now running at an annualized rate of 4.5%, down from 7.7% annual growth in 2011. To be sure, the IMF projects that India’s economy will rebound later in 2013, but the basis for this optimism is unclear, given that all indicators so far suggest another dismal year.

The emerging economies’ supposed resilience, which has buoyed economic forecasts in recent years, needs to be reassessed. Like the advanced economies, emerging economies experienced a boom in 2000-2007. But, unlike the advanced economies, they maintained high GDP growth rates and relative stability even at the height of the crisis. This was viewed as powerful evidence of their new economic might. In fact, it was largely a result of massive fiscal stimulus and credit expansion.

Indeed, as the effects of stimulus programs wear off, new weaknesses are emerging, such as persistent inflation in India and credit misallocation in China. Given this, the notion that emerging economies will recapture the growth levels of the bubble years seems farfetched.

Economic forecasts rest on the assumption that economies ultimately heal themselves. But economies’ powerful self-healing capabilities work slowly. More problematic, a misdiagnosis can lead to treatments that impair the healing process. Overly optimistic economic projections based on mistaken assessments of the global economy’s ailments thus threaten recovery prospects – with potentially far-reaching consequences.

In Europe, the banks’ wounds must be closed – weak banks must be shut down or merged with stronger banks – before recovery can begin. This will require an extensive swap of private debts for equity. For the global economy, the malaise reflected in anemic trade growth calls for coordinated fiscal stimulus by the world’s major economies. Otherwise, the risk of another global recession will continue to rise.

This column was first published at Project Syndicate

Das 2005 eingeführte Europäische Emissionshandelssystem ETS ist die tragende Säule der europäischen Klimaschutz-Strategie - und es ist das größte Emissionshandelssystem der Welt. Doch es ist ins Gerede gekommen. Denn nach den Höchstständen im Mai 2008 ist der Preis für Emissionszertifikate eingebrochen. Industrie, Zivilgesellschaft und Politiker begannen, über eine „Reparatur“ des ETS nachzudenken.

Die für das ETS zuständige EU-Kommission schlug schließlich das so genannte „Backloading“ vor: Sie will die Herausgabe neuer CO2-Rechte um vier bis sieben Jahre verschieben. Dadurch soll  das Marktangebot verknappt und der Preis für Verschmutzungsrechte erhöht werden. Doch die Reform scheiterte vorläufig im Europaparlament. Seither sind die Preise für ETS-Zertifikate weiter gesunken.

Das Scheitern des „Backloading“-Vorschlages  sei kein Drama, meint Bruegel-Forscher Georg Zachmann. Trotz der aktuellen Probleme bleibe das ETS ein effektives und effizientes Instrument, um Treibhausgas-Emissionen zu beschränken. Obwohl die Preise nicht stabil waren, ist das System gewachsen. Es deckt heute mehr Industriesektoren und Treibhausgase ab denn je, und es ist robuster und weniger verzerrend geworden.

Um das ETS zu stabilisieren, sollte nicht kurzfristig in die Vergabe von Verschmutzungsrechten eingegriffen werden, sondern die langfristige Glaubwürdigkeit des Systems erhöht werden. Um diese Ziele zu erreichen, sollte die Europäische Investitionsbank Versicherungen verkaufen, die den betroffenen Firmen einen bestimmten ETS-Preis in der Zukunft garantieren. Dies würde das Risiko für klimafreundliche Investitionen senken und das ETS stabilisieren, bis Entscheidungen über die langfristigen Klimaziele der EU getroffen werden.

Wie das in der Praxis aussehen könnte, erläutert Georg Zachmann in fünf Fragen und Antworten:

Warum ist das „Backloading“ keine Lösung für die aktuellen Probleme?

Ich sehe das "Backloading" als ein Placebo. Wobei die Frage ist, ob das Placebo einen messbaren medizinischen Erfolg hat oder nicht. Man nimmt Emissionsrechte, die man eigentlich jetzt versteigern will, und verschiebt  die Auktion um fünf Jahre. Das dürfte keinen ökonomischen Effekt auf das gesamte System haben. Solange man die Möglichkeit hat, die zurückgehaltenen Emissionsrechte in Zukunft doch noch zu kaufen, sollte sich der Preis dadurch nicht massiv beeinflussen lassen.

Ist das ETS ohne die Reform zum Scheitern verurteilt?

Bis zum Krisenausbruch 2008 hat sich das ETS relativ gut bewährt. Das ETS war in der  Lage, zusätzliche Emissionsreduktionen anzustoßen. Das ETS war in der Lage, die Industrieproduktion zu modernisieren. Das ETS hat in unterschiedlichen Sektoren unterschiedlich stark gewirkt. Insgesamt war die Performance ziemlich gut. Jetzt ist der Preis eingebrochen und wir stehen vor der Frage, was zu tun ist. Strukturelle Maßnahmen sind wahrscheinlich nötig, um die Glaubwürdigkeit zu erhöhen. Aber das ETS als solches kann man nicht als klinisch tot bezeichnen, weil es juristisch gesehen ein in Stein gemeißeltes System ist - quasi mit Verfassungsrang. Nur auf Vorschlag der EU Kommission und mit qualifizierter Mehrheit der Mitgliedstaaten kann es abgeschafft werden. 

Drohen nun nationale Alleingänge?

Wir haben jetzt zugegebenermaßen die Situation, dass mit Großbritannien ein großer Mitgliedstaat auf dem Weg ist, seinen eigenen CO2-Preis zu etablieren, der über dem europäischen CO2-Preis liegen soll. Alle Ökonomen weisen darauf hin, dass das - gelinde gesagt - Unfug ist. Denn das wird nur dazu führen, dass mehr Emissionen in anderen Teilen Europas produziert werden. Die europäischen Zertifikate, die in Großbritannien durch das strengere nationale Ziel übrig bleiben, werden nicht verfallen, sondern in den Rest Europas exportiert, wo sie zu zusätzlichem CO2-Ausstoß genutzt werden. Den Mitgliedstaaten müsste sich eigentlich erschließen, dass sie damit eine Politik betreiben, die gegen ihre eigenen nationalen Interessen gerichtet ist.

Wie sieht das Bruegel-Modell aus?

Wir schlagen ein Art Versicherungsmodell vor. Firmen sollen bei der Europäischen Investitionsbank (EIB) Versicherungen kaufen können, mit denen ihnen ein bestimmter Preis für Emissionsrechte in der Zukunft garantiert würde. Ein solcher Vertrag würde beispielsweise verbriefen, dass das versicherte Unternehmen im Jahr 2030 das Recht hat, eine bestimmte Menge überschüssiger Verschmutzungsrechte zu mindestens 40 Euro zu verkaufen. Damit sichern sich Investoren gegen niedrigere Preise ab. Am Anfang macht der Staat oder die EIB beim Verkauf der Versicherung mit der Optionsprämie erst Mal einen Gewinn.

Wie würden die Zertifikate-Preise festgelegt?

Das Versicherungsmodell würde keinen fixen Zertifikate-Preis festlegen - die Ausübungspreise könnten beispielsweise gestaffelt werden. Selbstverständlich würden Investoren für das Recht, ein Zertifikat zu einem Preis von 40 Euro zu verkaufen, heute mehr bezahlen, als für das Recht, zu einem Preis von 10 Euro zu verkaufen. Die Marktakteure legen ihren langfristigen Investitionen Annahmen über den künftigen CO2-Preis zugrunde. Es ist nur fair, dass jetzt Geld auf den Tisch gelegt wird, um die Investoren abzusichern, die heute in CO2-Reduktionen investieren.

Die Statistikbehörde Eurostat hat Mitte Mai eine vorläufige Schätzung für das Wirtschaftswachstum im ersten Quartal 2013 vorgelegt: Die Wirtschaftsleistung der Eurozone schrumpfte im Vergleich zum letzten Quartal um 0,2 Prozent und um ein Prozent gegenüber dem Vorjahresquartal. Sogar das deutsche BIP fiel um 0,3 Prozent gegenüber dem Vorjahr. Die europäische Entwicklung steht in scharfem Kontrast zu den USA, die im ersten Quartal ein Wachstum von 1,8 Prozent meldeten. Dort steigt die Produktivität, die Investitionen kommen zurück, die Kreditvergabe zieht an, und der private Konsum wächst - nach einem großen Deleveraging des Immobiliensektors.

Die europäische Antwort auf das Wachstumsproblem besteht in Strukturreformen zur Erhöhung des langfristigen Wachstumspotentials und in einer fiskalischen Konsolidierung, die das Ziel verfolgt, das Vertrauen und die fiskalische Nachhaltigkeit wiederherzustellen. Weitere Kernziele sind - jedenfalls auf dem Papier - die Reform des Finanzsystems und einige weitgehend symbolische Initiativen, um die Nachfrageschwäche anzugehen. Dazu gehören die schnellere Bereitstellung von Strukturfonds, mehr Investitionen der EIB und die Ausgabe von Projektbonds. Doch sogar EU-Kommissionschef Barroso hat vor zwei Monaten eingeräumt, dass die Umsetzung des im letzten Jahr verabschiedeten Wachstumspakts „zu zaghaft und zu langsam“ vorankommt. In Wahrheit war die europäische Antwort auf die aktuellen Wachstumsprobleme extrem schwach.

Europa leidet unter einer gut dokumentierten Wachstumsschwäche (siehe unseren letzten policy brief). Doch nun kommt noch das Risiko hinzu, dass kurzfristige Konjunkturprobleme das langfristige Wachstumspotential weiter schädigen - und zwar aus sechs Gründen:

Erstens: Eine anhaltend hohe Arbeitslosigkeit entwertet berufliche Fähigkeiten und entmutigt die Betroffenen, am Arbeitsmarkt teilzunehmen. Dadurch wird das langfristige Wachstumspotential geschwächt. Die Jugendarbeitslosigkeit, die in einer ganzen Reihe von Ländern ein Rekordhoch erreicht hat, ist besonders alarmierend. Denn eine lange Zeit ohne Beschäftigung nach dem Schulabschluss kann die gesamte Karriere zerstören. Die EU-Politiker haben zwar versprochen, energisch gegen die Arbeitslosigkeit vorzugehen. Doch bisher ist noch kein Ergebnis zu sehen.

Zweitens: Unternehmensinterne Forschung und Entwicklung (R&D) ist ein prozyklisches Geschäft. Die Firmen geben dafür bei einem Abschwung deutlich weniger aus - vor allem dann, wenn sich keine Erholung abzeichnet. Eine lange Zurückhaltung bei R&D verringert jedoch die Effizienz von Unternehmen. Seit 2007 sinkt die totale Faktorproduktivität in fast ganz Europa. Durch die geringere Effizienz kann das Wachstum geringer ausfallen, wenn die Nachfrage wieder anzieht.

Drittens: Schwaches Wachstum und schwache Bankbilanzen verstärken sich wechselseitig, mit einem negativen Impact für das langfristige Wachstum. Eine schwache Wirtschaft führt zu Verlusten im Bankgeschäft, die wiederum die Bankbilanz verschlechtern. Banken mit einer schlechten Bilanz neigen dazu, zweifelhafte Darlehen ihrer Bestands-Kunden zu verlängern, anstatt weitere Verluste hinzunehmen (man nennt diesen Prozess „Zombifikation“). Gleichzeitig geben sie jungen und innovativen Firmen keine Kredite. Dadurch werden Notleidende Firmen, die wenig Wachstum generieren, am Leben erhalten, während neue und produktivere Firmen nicht wachsen können. Ähnliche Entwicklungen haben sich in den 90er Jahren in Japan abgespielt; sie führten zu einer verlorenen Dekade. Europa hat sich zwar bereit erklärt, seine Banken zu stützen. Doch die Politik war weitaus zögerlicher als in den USA, wo die Restrukturierung der Banken schon 2009 weitgehend abgeschlossen wurde.

Viertens: Vor der Krise hat sich die private Verschuldung der Haushalte und Unternehmen deutlich erhöht. In einigen EU-Länder erreichte sie zu hohe Marken. Doch das Deleveraging der privaten Schulden ging viel langsamer voran als in den USA. Die Geschichte lehrt uns, dass die Entschuldung sich in die Länge ziehen und das Wachstum hemmen kann. Die aktuelle wirtschaftliche Stagnation macht es schwerer für den Privatsektor, die Schuldenlast zu verringern. Dies kann das Deleveraging verlängern und das Wachstum mittelfristig unterminieren.

Fünftens: Die Stagnation schmälert die Attraktivität Europas für Investitionen. Wenn Investitionen in andere Regionen abwandern, schwächt dies das langfristige Wachstumspotential in Europa.

Sechstens: Eine anhaltende Periode schwachen Wachstums und hoher Arbeitslosigkeit unterminiert das Vertrauen der EU-Bürger in die EU-Institutionen, die richtigen Lösungen zu finden. Damit schwächt es auch die Akzeptanz von lebenswichtigen, aber schmerzhaften Strukturreformen, die ebenfalls von der EU vorangetrieben werden. Ein Zurückweichen bei Strukturreformen wurde das langfristige Wachstumspotential schwächen.

Angesichts vieler enttäuschender Konjunkturdaten braucht Europa eine umfassende Initiative für mehr Wachstum. Andernfalls könnte Europa genau wie Japan eine verlorene Dekade drohen. Die höchste Priorität hat jetzt die Sanierung des Bankensektors, sie muss noch 2013 in Angriff genommen werden. Wir brauchen Maßnahmen, die die Kreditvergabe erleichtern, auch an kleine und mittlere Unternehmen. Zweitens sollte man über verschiedene Maßnahmen zugunsten von Investitionen und Innovationen nachdenken. Die EIB braucht viel mehr frisches Kapital als die 10 Mrd. Euro, die im letzten Jahr freigegeben wurden. Zudem müssen die internen Strukturen der EIB verbessert werden, um schnellere Investitionen zu erlauben. Drittens muss das Problem der schwachen privaten Nachfrage angegangen werden. Dazu sollte die Fiskalpolitik der wirtschaftlichen Lage angepasst werden. Während die Konsolidierung in den hochverschuldeten Ländern Südeuropas weitergehen muss, gibt es gute Argumente für eine Neuausrichtung der Fiskalpolitik in Nordeuropa. Viertens müssen die großen Ungleichgewichte im Euroraum ausgeglichen werden. Dies kann nicht bei schwacher Inflation erreicht werden. Die EZB sollte daher sicherstellen, dass die Inflationsrate nicht unter den Zielwert von zwei Prozent fällt. Zudem sollten die Länder Nordeuropas alles vermeiden, was einen Anstieg der Inflation über die Zwei-Prozent-Marke verhindert. 

Sie sind neu bei Bruegel - könnten Sie sich kurz vorstellen?

Gern. Ich komme aus Italien und habe am European University Institute of Fiesole in Florenz studiert, wo ich einen Ph.D in Industrial Organization erworben habe. Von 2007 bis 2012 gehörte ich dem Chief Economist Team der Generaldirektion Wettbewerb in der EU-Kommission Brüssel an. Ich habe  an der ökonomischen Analyse wichtiger Wettbewerbsverfahren mitgewirkt. Außerdem habe ich zur wirtschaftspolitischen Expertise der Generaldirektion beigetragen und neue wirtschaftspolitische Instrumente mit entwickelt.

Warum sind Sie zu Bruegel gekommen?

Nun, die Arbeit bei Bruegel ist nicht allzu verschieden von dem, was ich in der Kommission zu tun hatte. Mir geht es weiter darum, die europäische Wirtschaftspolitik zu verbessern. Bei Bruegel werde ich versuchen, eine andere Warte einzunehmen und das „broader picture“ zu betrachten. Zu diesem Zweck will ich das Feld der Wettbewerbspolitik in drei Dimensionen erschließen: Durch Forschung, Monitoring und den Aufbau eines neuen „Policy labs“. Bei der Forschung geht es um die Frage, wie Industrienormen und Kartellstrafen auf der Makroebene wirken: Hilft ein funktionierender Wettbewerb in nationalen Märkten den europäischen Firmen auch auf internationaler Ebene? Beim Monitoring konzentriere ich mich auf die EU-Kommission. Die Wettbewerbsverfahren und -entscheidungen werde ich mit Kommentaren und Blogposts begleiten. Schließlich baue ich noch das Policy Lab auf - als unabhängige Plattform für Fachdiskussionen.

Welche Bedeutung hat die EU-Kartellpolitik?

Es geht um das Wohl der Konsumenten. Die EU möchte sicherstellen, dass die Unternehmen in einen fairen Wettbewerb eintreten. Die Kartell- oder Antitrustpolitik zielt zum Beispiel darauf ab, Preisabsprachen zwischen Unternehmen zu verhindern - oder zu vermeiden, dass eine Firma ihre marktbeherrschende Stellung ausnutzt, um einen Rivalen vom Markt zu drängen. Daneben haben wir noch die Fusionskontrolle. Die EU kann Unternehmenszusammenschlüsse verbieten oder Bedingungen stellen, wenn eine Fusion den Wettbewerb in einem Markt derart einschränkt, dass die Konsumenten am Ende höhere Preise zahlen müssten.

Ist diese Politik erfolgreich?

Ja, durchaus, die EU-Kommission hat großen Erfolg. Natürlich weiß ich, dass die Kommission derzeit nicht in sehr hohem Kurs steht. Doch im Bereich der Wettbewerbspolitik leistet sie eine sehr schwierige und wertvolle Arbeit.

Könnten Sie uns einige Beispiele nennen? Wie sieht es mit den laufenden Verfahren gegen Microsoft und Google aus?

Gern. Nehmen wir die letzte Entscheidung zu Microsoft. Dies ist ein einfacher Fall, denn die EU-Kommission bezieht sich dabei auf eine Einigung mit Microsoft aus dem Jahr 2010. Microsoft hat die damaligen Auflagen nicht eingehalten und wurde deshalb jetzt - als erstes Unternehmen überhaupt - mit einer Sanktion wegen Nichteinhaltung von Auflagen bestraft. Das ist eine fundamentale Entscheidung, die eine völlig neue Lage schafft. Sie bedeutet, dass Microsoft und jede andere Firma, gegen die die Kommission ermittelt, die Auflagen der Behörde einhalten müssen - ganz so, als handele es sich um eine abschließende Entscheidung. Kommissar Almunia hat damit ein starkes Signal an alle Unternehmen gesendet, die sich in Gesprächen mit der EU befinden. Es richtet sich ganz offenbar auch an Google, das gerade versucht, eine Einigung mit der Kommission herbeizuführen. Nach der Microsoft-Entscheidung ist nun klar, dass Google empfindliche Strafen riskiert, wenn es die Absprachen nicht einhält, die es mit Brüssel eingeht.

Welche Bedeutung haben Geldstrafen?

Die Strafen sind sehr wichtig, denn sie signalisieren, dass eine Verletzung der EU-Regeln mit Kosten verbunden ist. Die große Frage ist jedoch, wie hoch die Strafen sein müssen, um zu wirken. Wenn man davon ausgeht, dass die Wahrscheinlichkeit, ein Kartell aufzudecken, höchstens bei 15 Prozent liegt, dann müssen die Strafen wesentlich höher sein als der Profit, der sich aus einem Kartell schlagen lässt. Es könnte jedoch schwierig sein, hohe Strafen durchzusetzen. Schon jetzt wird die Klage laut, die Strafen seien viel zu hoch. Wenn man jedoch genauer hinschaut, dann sind sie nicht so hoch, wie sie eigentlich sein müssten. Wie lässt sich dieses Problem lösen? Eine Möglichkeit wäre, die Entscheidungsträger in den Firmen haftbar zu machen. Hier stoßen wir jedoch auch ein weiteres Problem: strafrechtliche Sanktionen sind ausgeschlossen, da sie nicht in die EU-Zuständigkeit fallen.

Wo müssen Unternehmen höhere Strafen zahlen, in der EU oder in den USA?  

In der Regel sind die Strafen in der EU viel höher als in den USA. Dabei muss man jedoch bedenken, dass die Amerikaner strafrechtliche Sanktionen haben. Deshalb ist es schwer, beide Systemen miteinander zu vergleichen.

Ihre ersten Veröffentlichungen bei Bruegel drehen sich um das Thema Normung. Warum ist die Festlegung von Normen und Industriestandards so wichtig für die Wettbewerbspolitik?

Normen erlauben es der Industrie, ihre Produktion auf eine bestimmte Technologie auszurichten. Wenn Sie eine Norm setzen können, so bedeutet dies in der Regel, dass sie große wirtschaftliche Vorteile erwarten dürfen. Andererseits wird der Wettbewerb eingeschränkt, sobald einmal eine Norm festgelegt wurde. Dies kann ein Problem sein; der Normgeber könnte versuchen, die Gewährung von Lizenzen zu Erpressungsversuchen nutzen. Um dieses Problem zu lösen, versucht die EU faire, vernünftige und nichtdiskriminierende Regeln durchzusetzen - mit der so genannten FRAND-Prozedur. Doch wie kann man Fairness durchsetzen? Das war die Frage in den Samsung und Google-Motorola-Fällen. Eine Entscheidung der EU-Kommission steht noch aus. Sie wird für die Normierung überaus wichtig.

Wann rechnen Sie mit einer Entscheidung?

Bisher gibt es noch keinen Zeitplan. Sicher ist nur eins: Angesichts der Fülle von aktuellen und potentiellen Fällen, die mit dem Missbrauch von Normen und Patenten zu tun haben, können die Wettbewerbsbehörden unmöglich alle bearbeiten. Deshalb stellt sich die Frage, ob Wettbewerbsverfahren die richtige Antwort sind und - wenn ja - welche Fälle es wert sind, dass sich die Behörden damit befassen. Anders gesagt: die EU muss herausfinden, in welchen Fällen der größte Schaden für die Verbraucher entstehen könnte.

Noch einmal nachgefragt: Zeigt die Wettbewerbspolitik Wirkung? Wenn man sich die wachsende Konzentration auf dem Automarkt oder die Kartelle bei den Energieversorgern anschaut, könnte man ins Grübeln kommen...

Konzentration an sich ist nicht unbedingt ein Problem. Ein Unternehmen kann  Marktmacht schlicht dadurch gewinnen, dass es effizienter arbeitet als seine Wettbewerber. Dies ist sogar wettbewerbsfördernd. Im Automarkt könnte dies derzeit der Fall sein - deutsche Hersteller könnten Marktanteile einfach deshalb gewinnen, weil sie effizienter arbeiten. Dies vorausgeschickt, hat die EU-Kommission durchaus das Recht, Konzentrationsprozesse zu beobachten. Aber sie kann keine Sanktionen verhängen, das ist nicht vorgesehen. Wenn es in diesem Bereich ein Problem gibt, dann müssen die Mitgliedsstaaten die europäischen Behörden einschalten. Wenn die belgische Regierung der Meinung ist, dass es nicht fair sei, wenn die Autohersteller ihre Fabriken in Belgien schließen, dann müsste die Regierung erst einmal herausfinden, wo das Problem liegt. Letztlich ist dies wohl eher ein Thema für den Binnenmarkt, aber nicht für die Wettbewerbspolitik - es sei denn, eine Firma würde sich wettbewerbswidrig verhalten. Wenn es um einzelne Branchen geht, kann die EU-Kommission eine sektorale Untersuchung einleiten. Wenn sie Wettbewerbsprobleme sieht, kann sie Vorschläge zu ihrer Behebung machen - zum Beispiel, indem der Einstieg neuer Wettbewerber erleichtert wird. Das ist aber auch alles.

Die Fragen stellte Eric Bonse

nie war die Aufgabe von Bruegel klarer und seine Stimme lauter als im vergangenen Jahr. In den zehn Jahren, die seit der Gründungserklärung von Präsident Chirac und Kanzler Schröder aus Anlass des 40. Jahrestags des Elysée-Vertrags vergangen sind, hat sich Bruegel glänzend entwickelt. Der Thinktank ist zu einer Organisation herangereift, die ihre Mission erfüllt und die Entscheider in der Politik mit jener leidenschaftslosen und innovativen Expertise versorgt, die sie brauchen, um die fragile Lage in Europa und wichtige globale Probleme zu meistern.

Die führenden Industrienationen müssen mit der schlimmsten Finanzkrise seit dem 2. Weltkrieg fertig werden. Europa muss seine Gouvernance in der Wirtschafts- und Fiskalpolitik deutlich verbessern. In dieser Lage hat es Bruegel verstanden, den Weg zu dauerhaften Reformen und erfolgreichen Integrationsschritten zu zeigen. Seine führende Rolle bei der Entwicklung der Bankenunion illustriert sehr gut, was wir anstreben. Mit Workshops, Veröffentlichungen und Presseartikeln hat Bruegel die politischen Optionen und die Konsequenzen dieser Optionen aufgezeigt - und zwar sowohl die beabsichtigten wie die nicht beabsichtigten.

Ich freue mich besonders, dass die harte, innovative Arbeit 2012 auf fruchtbaren Boden fiel. Bruegel erfuhr mehr denn je Anerkennung innerhalb und außerhalb Europas. Zum einen aus der Politik: Die Bruegel-Forscher wurden regelmäßig gebeten, ihre Expertise nationalen, europäischen und amerikanischen Parlamenten zur Verfügung zu stellen. Sie wurden auch zweimal zum Ecofin, dem Rat der EU-Finanzminister, eingeladen. Zum anderen kam die Anerkennung auch aus dem akademischen Umfeld. Bruegel wurde als bester Thinktank in Westeuropa gerankt, als zweitbester weltweit (außerhalb der USA), und sogar als erster Thinktank in Internationaler Wirtschaftspolitik. Dies geht aus dem Global Go To Think Tanks Report 2012 hervor, der jedes Jahr von der Universität von Pennsylvania veröffentlicht wird. Erfreulich war auch, dass das Prospect Magazine Bruegel zum Europäischen und Globalen Thinktank des Jahres kürte.

Es ist eine Ehre und ein Privileg für mich, so einer dynamischen Organisation vorzustehen und seinem respektierten Gründungspräsidenten Mario Monti sowie meinem früheren Kollegen Leszek Balcerowicz nachzufolgen. Ich freue mich darauf, Bruegel durch künftige Erfolge und Herausforderungen zu führen. Dazu zählt auch der erste große institutionelle Wechsel mit dem Abschied des Gründungsdirektors Jean Pisani-Ferry.

Jeans unermüdlicher Enthusiasmus und sein unvergleichliches Talent haben das Bruegel-Abenteuer überhaupt erst möglich gemacht. Sein Bekenntnis zu Unabhängigkeit und Transparenz hat dazu beigetragen, die höchsten Standards für Bruegel zu setzen und den Thinktank zu einem Partner und Herausforderer der Politik zu machen. Sein Beitrag zur Wirtschaftspolitik, den er sowohl durch Forschung als auch durch Überzeugungsarbeit leistete, wird von unschätzbarem Wert bleiben.

The broken mechanism

The Economist writes that when the ECB lowered its rate by half a percentage point in 2003, firms’ borrowing rates fell by the same amount. When it tightened policy between 2005 and 2007, the pattern was the same. As the ECB rate went from 2% to 4%, firms’ borrowing rates rose from 4% to 6%. This predictable wedge between policy and market interest rates meant the ECB knew how its decisions would feed through to the interest rates that influence output and inflation. In 2008, as the euro zone started to contract, the ECB slashed its main rate from 4.25% to 1%. But firms’ borrowing rates fell by less than normal.

Brad Plummer writes that ECB interest-rate cuts have had little effect over the past five years on two of the countries that really need economic stimulus — Greece and Portugal — in part because their banking systems are in tatters. This “transmission mechanism” isn’t quite as broken for Spain and Italy, but even those two struggling countries get less of an economic boost from rate cuts than their neighbors up north.

Place du Luxembourg writes that the decline in M3 and EONIA volumes hide a wide divergence between the core and the periphery, caused by core banks considerably decreasing their exposure to the periphery. It meant that peripheral banks were largely unable to fund in the interbank market from their core competitors, who preferred to stash their cash at the ECB. Gregory Connor writes that the bank lending market dislocation in the Eurozone is arguably more severe than the CMO, CMO-CDS, CP market dislocation which sparked the 2007-8 credit-liquidity crisis.

Michael McMahon writes that this broken transmission mechanism is of particular concern given the importance of SMEs to the euro area economy (especially for jobs—SMEs account for about 75% of total euro area employment) and given the reliance of SMEs on bank lending for both investment but also, perhaps more pertinently, for working capital purposes. The ECB already has schemes, such as long-term refinancing operations (LTRO) that offer lower funding to banks. In fact, the ECB already allows banks to finance SME loans via the normal ECB operations at the refinancing rate. The problem is that there are large haircuts applied to the collateral; even if it is an Asset-Backed Security of SME loans, the haircut is 16%.

A negative interest rate on deposit

Place du Luxembourg writes that traditionally speaking the MRO is the interbanking target of the ECB, which means that a rate cut of the MRO is meant to make funds cheaper as measured by EONIA, but also EURIBOR, EUREPO and EURO-SWAP. However, since 2009 and the change from a variable rate/pro rata allotment to a fixed rate/full allotment of MRO funds at auction, the Deposit Facility has been the benchmark of the interbank market. As a result, cutting the MRO serves no purpose.

Source: Place du Luxembourg

Megan Greene writes that in its efforts to get banks lending again, the ECB is looking at excess reserves – some 120 billion euros the banks have been holding on deposit at the central bank for safekeeping. If the ECB were to introduce a negative interest rate on deposits, effectively charging a fee, the banks might choose to lend the money out rather than watch it lose value. This logic is far from ironclad. Instead of lending the money to businesses and individuals, the banks could simply park it elsewhere – for example, in the sovereign bonds of Germany and other countries perceived to be financially healthy. This might benefit Germany by further pushing down its borrowing costs, but would do little to unblock credit to businesses. Banks might even try to cover their losses on the ECB deposits by charging higher interest rates on business loans, precisely the opposite of the desired outcome.

Scott Sumner writes that Greene is right that the initial effect of negative IOR would be for banks to buy government bonds.  This means that banks would essentially be doing “QE.”  Why is that better than the ECB doing QE?  It’s not clear it is, although some people worry about the bloated balance sheets of the major central banks, and negative IOR would greatly reduce that “problem.”

Megan Greene argues that there are better ways for the ECB to encourage banks to lend. Banks might make more business loans, for example, if the ECB made it easier to use those loans as collateral for cheap central-bank credit. The ECB could do so by loosening requirements for the amount and type of business loans that it accepts in exchange for liquidity, and by lending more against a given value of loans. The central bank could go a step further and agree to purchase business loans in the secondary markets. Banks would be more willing to accept the risk of lending to small and medium-sized enterprises if they knew they could turn around and sell those loans to the ECB. For now, the ECB is unwilling to accept this degree of risk on its own balance sheet. That could change as the recession in the euro area deepens further.

The UK's Funding for Lending Scheme (FLS)

The Economist writes that Britain’s experience provides ideas the ECB can use. The Bank of England’s policy rate has been 0.5% since 2009, yet SME borrowing costs have been high and business lending has contracted. Since studies showed that tight loan supply was partly to blame, a new tool, the Funding for Lending scheme (FLS), was created in 2012. Banks first swap their assets, including bundles of SME loans, with the central bank. In return they get ultra-safe treasury bills. Banks can then offer this good collateral as security when they borrow. Because the bank’s creditor gets the safe assets if the bank defaults, this form of funding is cheap.

Michael McMahon writes that under the FLS all banks can get funding worth five per cent of their existing stock of loans at a funding cost of 25bps. Regardless of what the bank does with net new lending (lending net of repayments), the bank can get access to this five per cent; however, for every £1 of new net lending, they can access £1 more of FLS funding at 25bps. If they cut net new lending, they can still access the five per cent stock of funding, but the price on all the funding gradually rises up to a maximum of 150bps; this prevents deleveraging banks from taking the funding and using it to not expand lending. While the scheme in its first incarnation was successful at lowering banks funding costs, the concern was that banks were only expanding lending to safe borrowers (large corporates or high LTV mortgage borrowers). Therefore the UK authorities recently extended the original FLS and altered the incentive such that SME lending is worth ten times that of other types of new lending in terms of eligibility for new FLS funding; £1 of new net lending to SMEs would allow banks access to £10 of extra funding at 25bps.

Source: Bank of England

Implementation issues for a new program targeted to SMEs

Gavyn Davies writes that to make a difference, the new ECB program for SMEs needs to involve not just a liquidity provision, but a genuine risk transfer from banks or the EIB (which would package the loans) to the ECB itself. It also needs to be done in tens of billions of euros, which might take a while. The logistics of getting this done are not straightforward.

Michael McMahon lists a number of challenges for the ECB if it were to design a similar scheme:

• Will the ECB operate the scheme through any existing schemes, for example adjusting the haircut applied to SME loans in refinancing operations, or will it design a specific scheme to meet the challenge?

• How can the design of the scheme in order to ensure that SMEs facing the greatest credit restrictions see the greatest expansion of credit? Perhaps the scheme will involve some form of dependence on the state of the national macroeconomy? Or the relative contraction of SME lending compared to some previous norm? Perhaps it is possible to link available funding to those economies in which equivalently measured SME loan applications are turned down more frequently?

• Can the ECB, the national central banks and the supervisory authorities get access to sufficiently detailed data to proceed with such an approach? Can policy incentivize cross-border SME lending in weaker economies by banks in stronger economies?

In a recent email, Nivethan Tharmendiran wrote that a SME facility could take several forms.

• A supra national backed Bank Collaterized Loan Obligation (CLO)'s using SME pools or less likely supra-national issued CLOs both of which would be ECB eligible.

• A more broad-stroked approach could see an LTRO that uses SME collateral - UK FLS style.

Europe’s response to the growth problem consists of structural reforms to boost the long-term growth potential and fiscal consolidation to restore trust and fiscal sustainability. Also, key targets, at least in words, are the restoration of a healthy financial system and some largely symbolic initiatives to address demand shortage problems, such as the faster use of structural funds, more investments by European Investment Bank, and the issuance of project bonds. But even President Barosso acknowledged two months ago that the implementation of last year’s Compact for Growth and Jobs “is too low and too slow”. In fact, Europe’s response to the short-term growth problem has been extremely weak.

Europe has a well-known long-term growth problem (see our recent policy brief), but there is a major risk that short-term troubles will damage further the long-term growth potential, for six main reasons.

First, persistently high unemployment is eroding skills, discouraging labour market participation, thereby undermining the long-term growth potential. Youth unemployment, which is at record high in a number of countries, is especially alarming as a long period of unemployment after graduation, when a worker should acquire the first working skills, can undermine the whole career of a worker. EU leaders promised to act decisively against unemployment, yet no result is seen so far.

Second, business research and development (R&D) activities are rather pro-cyclical, ie firms spend much less on these activities in an economic downturn, especially when the timing of recovery is seen remote. But a long period of withheld R&D reduces the efficiency of companies. Since 2007, total factor productivity is sinking in most of Europe. At a lower efficiency, the growth of supply can be slower when demand returns.

Third, weak economic growth and weak bank balance sheet are mutually reinforcing each other, with negative implications for long-term growth. A weak economy leads to bank losses, thereby deteriorating bank balance sheets. Banks with weak balance sheet tend to roll-over the dubious loans of their existing clients, instead of realising further losses (a process frequently called “zombificaion”), and do not grant credit to young and innovative firms. Thereby, struggling firms that do not generate much growth are kept alive, but new and more productive firms are unable to grow. Similar developments characterised Japan in the 1990ies that has led to a lost decade. Europe committed to shore-up banks, but policies so far was clearly inferior to the US, where bank restructuring was largely completed by 2009.

Fourth, before the crisis, household and corporate debt increased substantially and reached too-high levels in a number of EU countries. But private debt deleveraging has been much slower in Europe than in the US since the crisis. History shows that deleveraging episodes can be protracted and can act as a drag on growth. Economic stagnation in the short run makes it more difficult for the private sector to deleverage and thereby can protract the period of deleveraging and undermine growth in the medium term.

Fifth, stagnation in Europe undermines the attractiveness of Europe for investment. When investment moves to other locations instead of Europe, the long-run growth potential of Europe is weakened.

And sixth, a protracted period of weak growth and high unemployment are undermining the EU citizens’ trust in the ability of EU institutions to provide useful policy advice. Thereby, it weakens domestic commitments to vitally important but painful structural reforms, which are also fostered by EU institutions. Backtracking on structural reforms would weaken the long-term growth potential.

After the so many disappointing growth and unemployment figures, a comprehensive effort is needed to revive growth in Europe. Otherwise, Europe may follow a Japanese-style lost decade. The top priority is to fix banks now, ie in 2013. Measures supporting lending, including lending to small and medium sized enterprises, are needed. Secondly, various measures for investment and innovation should be sought. The EIB needs much more additional capital than the €10 billion agreed last year and the internal procedures of the EIB should be revived to allow for much faster investments. Thirdly, the problem of private demand shortage should be addressed and fiscal strategies should be adapted to the economic situation. While in the highly-indebted southern European countries a gradual fiscal consolidation has to continue, there is a case for a new direction for fiscal policy in northern European countries. Fourth, the major imbalances inside the euro area have to be reversed, which cannot be achieved at a low inflation: the ECB should ensure that inflation does not fall below the two percent target, and countries in northern Europe should refrain from domestic policy actions that would prevent inflation from rising above two percent.

German wage growth rates have been increasing over the previous 8 years, except for a sharp decrease to 0.4 percent in 2010 when Germany had one of the lowest rates in Europe (see Figure 2). When looking at the net wage increase and taking inflation into account the picture becomes even more pronounced. In 2012 Germany had an inflation rate of 2.1 percent, resulting in a net rise in wages of 0.4 percent compared to 2011; meanwhile the Eurozone experienced 2.5 percent inflation, France 2.2 percent and Italy 3.3 percent causing a decrease in net wages of 0.8 percent in the Eurozone, 0.1 percent in France and even 2.2 percent in Italy[1].

In our blog post from December we further looked at the annualized wage growth rate coming from collective bargaining agreements in Germany’s main industries in 2012. However, many of the collective agreements had been reached in 2011 already. In 2013 many of the agreements have already ended or will end in the near future making it an interesting study to compare the newly negotiated wage increases and have a look at the wage development of this year. With expectations of a small increase in economic growth, German unions started the year with demands of wage increases of around 6 percent, several rounds later most of the main sectors have concluded the bargaining process resulting in an increase in the annualized growth rate for 2013 compared to the previous year. Overall, the average increased from 2.63 percent in 2012 to 2.84 percent in 2013.

The sector with the slowest wage growth remains the printing industry while the construction sector concluded negotiations with the highest annual increase in wages, especially in East-Germany. However, important sectors such as insurance and wholesale and external trade have not been able to conclude the bargaining process yet. Moreover, in retail the collective bargaining process seems to have reached a deadlock after employers all over the nation withdrew from the current contracts at the beginning of the year due to the need for a major update as job descriptions and titles have changed tremendously while the contract definitions remained the same. Even more importantly, the metal and electronics industry, one of Germany’s largest sectors, represented by one of the most powerful unions in the country (IG Metall) is also still in the middle of negotiations, but with employers offering 2.3 percent in the second round it appears likely this sector will experience an increased wage growth of above 2.5 percent as well (see Table 1 below).

Again, looking at real wages in Germany shows that with the latest inflation data lying at 1.8 percent in March 2013 and an AMECO forecast of 2 percent for 2013, most real wages in Germany will also increase this year.

This review confirms the conclusion made in December 2012; the adjustment process is continuing in the euro area. At the same time, the size of the differential between Germany and the euro area is still of a size that relative adjustment of wages may take 5 years.

[1] Source: Eurostat

[2] Faz.de (08.04.2013)

[3] Handelsblatt.de (06.05.2013)

[4] Ver.di (May 2013)

[5] Ver.di (May 2013)

[6] Deutsches Statistisches Bundesamt (2012)

The Commission lowered their real GDP forecast for the EU from 0.1% to -0.1% in 2013. For the euro area they expect -0.4% growth in 2013 (previously -0.3%). Growth is anticipated to “to turn positive gradually in the second half of the year before gaining some traction in 2014” (European Commission 2013). As a result, real GDP is expected to grow by 1.4% in 2014 (previously 1.6%) in the EU and by 1.2% (previously 1.4%) in the euro area.

The figure below shows the new forecasts by the EC. The Commission expects nine European economies (Cyprus, Czech Republic, France, Greece, Italy, Netherlands, Portugal, Slovenia and Spain) to be in recession in 2013. Seven of them are projected to return to growth next year.

Figure 1: Real GDP forecasts

Source: AMECO database.

While the latest batch of EC forecasts overall is slightly more cautious, the by far largest changes were made to the Cypriot outlook. Real GDP is expected to collapse by -8.7% in 2013 and by -3.9% in 2014. The following figure illustrates the massive revisions that were made to the winter real GDP projections for Cyprus as released in February.

Figure 2: Real GDP forecast for Cyprus

Source: AMECO database.

Overall the economy is expected to shrink by around 14% in 2012-2014. The Commission expects this as a result of the fast restructuring of the banking sector, fiscal consolidation and generally high economic uncertainty (European Commission 2013). Additionally, the report stresses the negative impact on growth of the temporary imposition of capital controls and the expected decline in private consumption and investment due to the bail-in of uninsured depositors; measures that obviously were not taken into account in the winter forecast. It does not come as a surprise that the unemployment rate is expected to push to unprecedented levels in turn.

The economic projections for Cyprus look similarly painful as the Greek recession in 2011 (real GDP -7.1%). However, bear in mind that for Greece 2011 was only one of several years with negative growth and the Greek economy did not have to cope with the side effects of capital controls and a bail-in of uninsured depositors. These factors make an even faster contraction in the case of Cyprus very likely. One thing is for sure however, they add to the high degree of uncertainty that these forecasts come with. It does not surprise that the Commission sees significant downside risks to their projections due to the implementation of the agreed macroeconomic adjustment programme. In their latest World Economic Outlook (see the report here), the IMF decided to simply exclude any projections for Cyprus due to the high degree of uncertainty that the on-going crisis comes with. The forecasts of the EC for the Cypriot economy have to be handled very carefully. Substantial downside risks exist. Neither of the institutions gives any indication on when the Cypriot economy will return to growth.

References

European Commission (2013), ‘European Economic Forecast Spring 2013’, European Economy, 2/2013.

International Monetary Fund (2013), ‘Hopes, Realities, and Risks’, World Economic Outlook, April 2013. 

On 18 April, Bruegel hosted a Competition Policy Lab. Competition Policy Labs offer an independent ‘hands-on’ platform for practitioners and academics to meet and discuss hot topics on the competition policy agenda. This time we had Anna Vernet and Luc Peeperkorn for the Commission, and Jacques Crémer from the Toulouse School of Economics.

The Commission's main proposed changes

Article 101 of the Treaty on the Functioning of the European Union (TFEU) prohibits anticompetitive agreements. Companies are required to self-assess if the agreements they enter into infringe Art. 101 TFEU. The criteria laid down by the Commission in the Technology Transfer Block Exemption Regulation (TTBER) and the Guidelines are meant to help companies in performing this task, particularly by indicating the boundaries of so-called ‘safe harbours’ ie conditions that, if respected, would normally guarantee conformity with Art. 101 TFEU.

The underlying philosophy of the Commission’s approach is that technology transfer agreements are generally good for society, because they foster innovation and normally bring about short and long-term benefits for consumers. Nonetheless, these agreements may entail anti-competitive effects: for example, exclusive agreements may restrict competition; or grant-back clauses – under which the licensee has to disclose and transfer all improvements to the licensor – may reduce the incentive for innovation by reducing the expected reward for risky investments. Under certain conditions, agreements between competitors can also foster collusion or generally determine an increase in the price paid by end consumers.

During the workshop, Anna Vernet and Luc Peeperkorn explained the main proposed changes to the framework. In particular:

• Market share thresholds in TTBER. To benefit from the safe harbour, the undertakings’ market share cannot exceed 20 percent when they are competitors and 30 percent in each market in which they are non-competitors. It is now proposed that the 20 percent threshold shall also apply when the licensee owns a technology that it only uses for in-house production, and which is substitutable for the licensed technology.
• Hardcore restrictions in TTBER. A provision on passive sales is proposed to be removed from the hardcore restrictions’ list, ie those provisions for which exemptions can never be automatically granted. The Commission acknowledges that this restriction is sometimes necessary and plans to align TTBER with its general approach to vertical agreements by giving this message in the Guidelines.
• Settlements in the Guidelines. It is proposed to be clarified that certain specific type of settlements may breach Article 101, in particular when a licensee accepts more restrictive terms than what it would have accepted solely on the basis of the value of a licensor’s technology. This practice is often referred to as ‘pay-for-delay’ or ‘reverse payment patent settlement’.
• Patent pools in the Guidelines. The version of the Guidelines in public consultation provides a safe harbour that covers both the creation of a patent pool and its subsequent licensing out.
• Grant-backs and termination clauses. The proposed TTBER does not anymore distinguish between different types of exclusive grant-backs. Moreover, clauses that allow termination of the agreement if the licensee challenges the validity of a technology cannot anymore benefit from the safe harbour of the TTBER.

The discussion

Professor Jacques Crémer commented mostly on market shares and patent pools.

His first concern was that the TTBER and the Guidelines could alter the relative cost of licensing in favour of small undertakings because of the market share thresholds: an agreement with a small company ensures legal certainty whereas an agreement with a big company could breach Article 101. Prof. Crémer pointed out that it might be more efficient to grant licenses to bigger companies, or even to all companies on the market, through a broad non-discriminatory license, because this would make the innovation available to a wider audience. In his view, the Commission should promote broad licensing at least in the Guidelines, and should provide clear explanations about why exceeding the market share thresholds is potentially anticompetitive.

In their answer to Prof. Crémer, Ms Vernet and Mr Peeperkorn suggested that any regulation would entail a form of distortion of the incentive to comply with it. Regulation is however needed for at least two reasons: first, companies whose agreements are covered by the safe harbour enjoy legal certainty because they can be reasonably sure that the Commission will not contest their agreements; second, it is good to have harmonisation of competition enforcement by national courts,  national competition authorities and the Commission and this is partly achieved by having a block exemption regulation and guidelines. A different question is: given that we have a block exemption regulation, are current market share thresholds low? According to Mr Peeperkorn, if anything, the 20 and 30 percent thresholds are high, in particular when taking into account possible cumulative effect scenarios: even agreements falling below the current thresholds can raise anticompetitive issues such as potential market foreclosure (ie a limit to competition achieved through privileged access to an input) or incentives to collude. Mr Peeperkorn also stressed that no rule in the current regulation prevents broad non-discriminatory licensing; in principle non-exclusive agreements without further restrictions are likely to be pro-competitive.

On patent pools, Prof. Crémer said that two conditions in the proposed guidelines are particularly relevant: that (a) sufficient safeguards are adopted to ensure that only essential technologies are pooled and (b) each IPR holder can still license out outside the pool. Prof. Crémer commented that independent licensing is crucial and could be enough to guarantee that every technology-transfer agreement created voluntarily is beneficial, meaning that the condition on essentiality is potentially negative because it discourages beneficial pools. This argument was first introduced by Lerner and Tirole (2004): the economic logic is based on the double marginalisation effect for which the profit maximising price of a pool of complementary patents is lower than the sum of the profit-maximising prices of the patents taken singularly. For this reason a patent pool of complementary patents would be pro-competitive and socially desirable. However, whereas essentiality is a technical condition, substitutability is an economic one: patents can be complements at low prices and substitutes at high prices. According to Lerner and Tirole, the independent licensing clause solves the issue: only socially-desirable pools become strongly stable once you include this provision. Hence, there is no need to have a condition on the essentiality of patents.

Ms Vernet and Mr Peeperkorn explained that economic theory clearly suggests that patent pools are more likely to have anti-competitive effects if substitutable technologies are included in the pool. To be provocative, one could say that Lerner and Tirole could justify a cartel agreement in which the undertakings can still sell independently from the pool.

The Regibeau and Rockett study (2011) describes the literature and finds contradictory views: while they recognise the generality of the Lerner-Tirole result, they also find several special cases in which it is not possible to determine if a patent pool is beneficial. For example, the case of patent pools offering different menus of patents to outsiders and the case of incomplete pools, ie pools not gathering all relevant patents in the field, cannot be assessed on the basis of Lerner and Tirole. These points ultimately suggest that the Commission should not exclude the ‘essentiality condition’ from the Guidelines, and it should also assess on a per-case basis pools involving non-essential patents.

Figure 1: Nominal GDP.
Source: AMECO database.

While both economies contracted similarly in the midst of the financial crisis, the U.S. experienced a much stronger recovery in the years thereafter. In particular since 2012, the two economies have developed with a completely different speed. To put it in numbers: The U.S. experienced an average growth rate of 2.4% in 2008-2013 while nominal GDP in the euro area on average expanded by 1.1% only. Taking only 2010-2013 into consideration, the difference in the average growth rate is even more astonishing (or shocking from a European perspective): Average U.S. growth was 3.8% compared to 1.9% in the euro area. The U.S. recovery, although having not yet yielded the wished for employment effects, seems to be decoupled from the troubles and hence years of weak growth the euro area has been facing so far.

The large nominal GDP growth differential between the two economies compares to an almost synchronous increase in consumer prices (CPI): Average consumer price inflation in the euro area and in the U.S. was almost precisely 2% in 2008-2013.

Figure 2: Consumer price indices.
Source: AMECO database.

What does this mean for the real GDP differential?

Very little, in fact. The equal increase in CPI does not imply that the growth differential in real GDP is of the same magnitude as in nominal GDP. Real GDP is calculated based on the GDP deflator as a price index, which reflects price changes of produced rather than consumed goods and services.

The GDP deflator and the CPI thus do not necessarily measure the same price changes. U.S. producer prices (measured with the GDP deflator) increased on average by 1.6% in 2008-2013 while they increased by only 1.3% in the euro area. Of the 9% difference in nominal GDP performance in 2008-2013, 3 percentage points can thus be explained by the difference in price deflators, which are unrelated to consumer price developments. A real GDP growth differential of still impressive 6 percentage points makes up for the remaining difference in 2008-2013. More work on explaining the difference between CPI and the GDP deflator seems warranted.

Figure 3: Real GDP.
Source: AMECO database. 

In almost every case where capital account restrictions were imposed, a parallel or black exchange rate market arose[1]. Current cases of black exchange markets include Argentina where exchange controls were put in place in 2011 in the same fashion than the Venezuelan exchange rate controls which are in place since 2003. Both governments defend overvalued[2] exchange rates by restricting the amounts and conditions in which their residents can purchase foreign currency. But these are not isolated cases, especially in the developing world, other recent and current cases of parallel and multiple exchange rates according to Ilzetzki, Reinhart and Rogoff (2011) include Egypt, Gambia, Guyana, Haiti, Libya, Myanmar, Nepal, Nicaragua, Nigeria, Peru, Russian Federation, Suriname, Swaziland, Syria, Turkmenistan, Vietnam and Zambia.

Advanced economies are not immune to the surge of black markets either: Iceland has controls over capital outflows since 2008 and despite the lack of data, there is some evidence of the existence of a black market.[3]

As an illustrative example: how does the black market work in Venezuela?

The Venezuelan financial system is completely isolated from the rest of the world by an exchange control system that renders it technically impossible to make any kind of payment between a bank account abroad and one inside the country, or to use local credit cards abroad or online without requesting permission to the commission of administration of foreign currency (CADIVI). Until May 2010 Venezuelan bolivars could be freely and legally exchanged with foreign currency in brokerage houses through the use of a few financial instruments that could be traded in the local market in local currency and on foreign market in foreign currency. But thereafter this parallel market also known as swap dollar (dólar permuta) was declared illegal and it was immediately replaced by an illegal black market.

In the current black market, two parties agree on an exchange rate (there is no trustable reference of the price anymore since it also became illegal to be disclosed in any media) and based on trust that one of them will transfer funds in local currency from her Venezuelan account to the other party’s Venezuelan account while the other would do the same from her foreign account to the other person’s foreign account in foreign currency at the agreed exchange rate; in this sense the transaction does not go through the balance of payments, is just a local transfer of funds with a counterpart in some external market. Of course as the system is based on trust and there is no legal basis on these verbal contracts scams are at the order of the day.

In the following graph the blue shaded bars show the estimated share of total Venezuelan imports that were paid through the parallel market; despite its illegal character (since May 2010: vertical line) the black market keeps financing a non-marginal share of total imports. The spread between the official and parallel exchange rates gives an idea of the potential profits that can be obtained by illegally diverting funds from one market to the other.

Venezuelan bolivar exchange rates

Sources: Central Bank of Venezuela (BCV) and Ecoanalítica

How would a black market work in Cyprus and why don’t we see it operational so far?

Usually, exchange controls imply restrictions on the purchase/sale of foreign currencies by residents and/or on the purchase/sale of local currency by nonresidents. In the case of Cyprus the local and the foreign currency could be the same one: “euro”, but because funds held in Cyprus cannot be freely transferred abroad, Cypriot euros can be considered a different and less valued currency than the rest of the euros.

One big difference between the Cypriot and other exchange and capital controls is that the Cypriot government also imposed restrictions on transactions within the Republic of Cyprus unless they are made within the same credit institution.

These additional restrictions are currently set at €10,000/€50,000 per natural/legal person per month per credit institution, plus the prohibition of opening new accounts to customers unless they are already customers of that particular credit institution[4] make the development of a black market much more difficult, though not impossible. Only two parties with bank accounts in the same institution inside Cyprus and bank accounts abroad could perform a swap of local and foreign funds for an amount superior to the before mentioned monthly limit.

Another black market that could be developed is the swap of frozen Cypriot deposits by liquid funds abroad; there is some evidence of something like this going on already but there are legal limitations to be solved in order to enforce the contracts of this kind of swaps once the Cypriot deposits are unfrozen.

Since the 25^th of April, when the tenth decree for temporary restrictive measures on transactions was published, cashless payments or transfers within Cyprus for the purchase of goods and services are allowed without the approval of the Committee, by presenting the relevant supporting documents, before this was only possible for an amount smaller than €300,000. Relaxing the restrictions on transactions is a positive sign, also with a view to prevent potentially emerging corruption.[5]

In more than 10 years of exchange controls in Venezuela finaglers have found every flaw in a system that is continuously amended as the government notices the weak points only to become aware that capital outflows keep increasing year by year.

Capital outflows from  Venezuela

Note: the blue shadow indicates the start of the exchange control

Sources: BCV and Ecoanalítica’s calculations

Conclusion

Wherever the government builds fences the market will try to create stairs to climb them. Several studies (Rogoff 2002, Forbes 2007, Ewards 1999, Danielson 2013) have shown that controls on capital outflows are not only ineffective but they also generate incentives to corruption as they create arbitrage opportunities that some economic agents are willing to take as long as the profitability justifies the risks taken. The Cypriot government should continue to ease the restrictions on transactions as it has been doing so far and end with the capital controls sooner than later, before it creates further distortions and perverse incentives.

References

Chinn, M. and Ito, H., (2007), “A new measure of financial openness”. Journal of Development Economics, 2006.

Danielsson, J. (2013) “The capital controls in Cyprus and the Icelandic experience”. VoxEU.org, 28, March, 2013.

Edwards, S., (1999), “How effective are capital controls”. National Bureau of Economic Research, working paper 7413, November, 1999.

Forbes, K. (2007), “The microeconomic evidence on capital controls: no free lunch”, in Edwards, S., (2007), Capital controls and capital flows in emerging economies: policies, practices and consequences, (p. 171 – 202). National Bureau of Economic Research.

Ilzetzki, E., Reinhart, C. and Rogoff, K., (2011), “The country chronologies and background material to exchange rate arrangements in the 21^st century: will the anchor currency hold?”. Quarterly Journal of Economics 119(1):1-48, February 2004.

Rogoff (2002), K., “Straight Talk -- Rethinking capital controls: When should we keep an open mind?” Finance Development: a quarterly magazine of the IMF. December 2002, Volume 39, Number 4.

[1] We look at the exchange rate arrangements database built by Ilzetzki, Reinhart and Rogoff (2011) and matched it with the capital account openness index created by Chinn and Ito (2007)

[2] According to the last update of the economist big mac index, the Venezuelan currency was the most overvalued in the world as of January 2013, and even though it was devaluated by 46% in February it is still highly overvalued

[3] Jon Danielsson and Ragnar Arnason published interesting articles at VOX criticizing capital controls in Iceland: Capital controls are exactly wrong for Iceland and The capital controls in Cyprus and the Icelandic experience

[4] http://www.centralbank.gov.cy/media//pdf/TenthDecree_EN_25042013.pdf

[5] In particular, the CBC is aware that this kind of transactions is prone to be used to circumvent the restrictive measures and in their sixth decree states: “It should also be clarified that the relaxation of restrictions on cashless payments and money transfers for amounts up to €300.000 was made in order to facilitate transactions within the Republic of Cyprus and not to transfer funds from one institution to another. Hence, the provision of paragraph 3 (i) of the Decree is pertinent here, which states that it is prohibited for any credit institution to make payments or transfers which aim to circumvent the restrictive measures.” But the penalty for evading the restrictions is not clear. 

Monetary policy first and foremost needs to look at the euro area aggregate. Inflation as well as core inflation in the euro area in April is at 1.2% and the 2-year-ahead market based inflation forecasts are below 1.5%. The output gap of the euro area for 2013 as of the February forecast of the European Commission stands at almost 3% suggesting significant slack in the euro area economy. The area wide economic indicators therefore clearly signal that the euro area is in a recession and that inflation is well below the envisaged 2%. For the area as a whole, more expansionary macroeconomic policies thus seem warranted.

Turning next to the individual countries of the euro area, the weak economy in the South of Europe is particularly worrisome. Yet, even the strongest countries of the euro area including Germany currently record a negative output gap. Inflation in Germany is below 2% at 1.8% in March and therefore almost at March euro area average of 1.7. So in absolute levels, Germany also appears to enter a recession and the low inflation rate would warrant a further stimulus to the German economy.

The snapshot of the current situation in Germany underestimates the need of Germany to be the growth locomotive of Europe. In the first 9 years of monetary union, euro area economic growth was driven by strong but unsustainable growth in the South. It is now for Germany to grow above average to help correct imbalances. German inflation rate had been significantly below euro area average while in several countries in the South of Europe it had been significantly above the average. This relative price divergence may require a correction of prices amounting to 10-20% depending on the countries considered. An arithmetic consequence of this past divergence is that going forward German inflation rates will have to be above the euro area average. For this to happen, the German economy should be in a strong boom.

Would a further rate cut by the ECB help to increase growth and investment in Germany? German banks can currently borrow at a rate that is significantly below the ECB repo rate. A cut in the main rate is therefore unlikely to ease funding conditions for German banks. The German ECB Board member Jörg Asmussen has therefore warned not to overestimate the effects of a rate cut. Instead, an increase in public investment would be warranted as a way to trigger growth. With German government bond rates at close to zero, any public investment project with a return higher than zero would be beneficial to the German economy.

An ECB rate cut would help banks in the South by lowering their funding conditions. Yet, a cut is unlikely to make a significant contribution to overcoming the deep recession in the South of Europe. The weak balance sheets of banks and the risk of zombification prevent proper transmission of monetary policy signals to the real economy. Funding conditions for corporations remain highly restrictive even when they have profitable business projects. In addition to a rate cut, the ECB should therefore step up its non-standard measures to promote credit growth, in particular in the South of Europe. This could include loosening collateral standards for corporate credits.

Overall, a rate cut is an important signal to guide market expectations but it is unlikely to make a big contribution to overcoming the recession. Instead, more aggressive measures to repair monetary policy transmission in the South of Europe and public investment in the core of the eurozone are warranted.

The figure below reveals that total deposits in Cypriot banks decreased from 67.5bn at the end of February to 63.7bn in March, a fall of 5.6 %. This is the biggest absolute and relative monthly decline in deposits in the sample, which starts in December 2005. The previous record (in relative terms) was a decline of 3 % in May 2008.

It is interesting to look at how the decline was distributed among depositors of different nationality and across sectors. Firstly, deposits of domestic residents decreased 3.1 %, those of other euro area residents 12.8 % and those from the rest of the world 9.3 %. Foreigners therefore seemed more eager or more able to withdraw deposits from Cypriot banks.

Differentiating by type of institutions, the decline was most pronounced for ‘other financial intermediaries’ (-11.5 %), followed by non-financial corporations (-7 %), households (-4 %), general government (-1.6 %) and insurance corporations and pension funds (-0.1 %). There was a distinction in sectoral developments, however, depending on the residence of depositors. For instance, whereas deposits by foreign households decreased 10.4 %, the decline was only 2.2 % for Cypriot households. A surprising piece of data is that deposits by foreign governments almost doubled (although from a very low basis) – they increased from 6.3bn in February to 11.8bn in March. Almost all (4.4bn) of this increase was by governments outside the euro area.

The data therefore affirms a significant – though not massive – reduction in deposits since the Cypriot rescue. It also reveals differences in the ability or desire of different agents to decrease their exposure to the Cypriot banking system. The data incorporates, however, only the first two weeks since the original rescue package.  Subsequent data will tell to what degree capital controls have prevented a further reduction in the depositor base.

Making monetary policy more flexible

Markus Brunnermeier writes that the ECB could optimize its currency area by using “regional tools” that affect the regional credit and term spreads. Unconventional monetary policy allows central banks to influence term and credit spreads directly by buying or selling long-term risky assets. But the ECB could also use its haircut policy to lean against regional imbalances. Using haircuts to lean against regional imbalances is in sharp contrast to the ECB’s current policy. Currently, the ECB uses collateral and haircut policy purely as a risk management tool, i.e., to minimize potential losses from lending against certain assets. Furthermore, there is a tendency to treat all member countries the same and avoid any differentiation. This makes all spreads more uniform across the membership countries – the opposite effect of what a targeted active policy that leans against regional imbalances would prescribe.

Harold James also argues that different interest rates in different countries might open the door to a more stable eurozone, but notes that different policy rates might even be possible. When the EC Committee of Central Bank Governors began to draft the ECB statute, it took the indivisibility and centralization of monetary policy as given. But it was not really justified either historically or in terms of economic fundamentals. The history of the gold standard, and of other large common-currency areas show that despite the theoretical possibility of capital being sent over vast distances to other parts of the world, much capital remained local, making the differentiation of interest rates possible. In the early history of the Federal Reserve System, individual Reserve Banks set their own discount rates. In smooth or normal times, the rates tended to converge. But in times of shocks, they could move apart. The Eurozone is now moving to a modern equivalent as bank collateral requirements are being differentiated in different areas. This represents a remarkable incipient innovation.

Source: Harold James

A common currency does not mean a single currency

Harold James notes that was one of the possibilities that was raised in the discussions on monetary union in the early 1990s was that there might be a common currency but not necessarily a single currency. Keeping the Euro for all members of the Eurozone but also allowing some of them (in principle all of them) to issue national currencies would be the modern equivalent to the band widening of 1993. The countries that do that would find that their new currencies immediately trading at what would probably be a heavy discount. California recently adopted a similar approach, issuing IOUs when faced by the impossibility of access to funding. Such a course would not require the redenomination of bank assets or liabilities, and hence would not be subject to the multiple legal challenges that a more radical alternative would encounter.

Harold James writes that such a state of affairs is not just a theoretical construct in fringe debates in the early 1990s, but a real historical alternative. There is in fact a rather surprising parallel for such a stable coexistence of two currencies over a surprisingly long period of time. Before the victory of the gold standard in the 1870s, Europe operated with a bimetallic standard for centuries, not only gold but also silver. One trick that made this regime so successful was that the coins were used for different purposes. High value gold coins were used as a reference for large value transactions and for international business. Low value silver coins were used for small day to day transactions, for the payment of modest wages and rents. A depreciation of silver relative to gold in this system would bring down real wages and improve competitiveness. In the modern setting, the equivalent of the adjustment mechanism in the early modern world of bimetallism would be a fall in Greek (or other crisis country) wage costs as the wages were paid in the national currency, as long as it was traded at a discount. These would be the equivalent of silver currencies. Meanwhile, the Euro would be the equivalent of the gold standard. It would be kept stable by the institutions which already exist today, the ECB and the ECSB of those national central banks who have no new alternative.

Hugh Rockoff argues that the case of the West in the 19^th century suggests that dividing the Eurozone in two currency zones is possible. From the outbreak of the war until 1879 the West remained on the gold standard while the East was on the greenback standard. National banks in the West issued “goldbacks” redeemable in gold. The exchange rate between greenbacks and goldbacks fluctuated. A curiosum, but perhaps one that suggests that dividing the Eurozone in two currency zones is possible.

A monetary union without a fiscal/political union

Simon Wren-Lewis writes that the view that the Eurozone will have to move to fiscal union, which implies some form of political union, seems to be a very common view at the moment. Those working in the political unions that are the US or the UK, know combined monetary and fiscal unions can work. From this perspective, the monetary only union of the Eurozone was a largely untried experiment, and it appears to be failing. Within the Eurozone itself, there has always been a powerful lobby for further integration. It is therefore not surprising that actors like the Commission see further integration as the longer-term solution to the Eurozone’s problems.

Harold James writes that the idea that Europeans simply need a country because they happen to have a currency reflects a misunderstanding about the reasons politicians embarked on the economic and monetary union of Europe.

Simon Wren-Lewis writes that we should be very cautious about making generalizations from a single observation. The Eurozone has not been a fair test of monetary union without fiscal union since poor policies were also put in place at the same time. 1) No attempt was made to use fiscal policy to offset overheating in periphery countries. 2) Instead of recognizing the need for default early on, the union made a futile attempt to avoid it by replacing private debt with intergovernmental lending. 3) The fiscal position of Eurozone economies became critical because the ECB refused to act as a lender of last resort. 4) The current double dip recession in the Eurozone is largely about a collective failure of fiscal and monetary policy.

Benjamin Cohen writes that history suggests that political union is not necessary for the longevity of the euro area. In the modern era (19^th century onward), there are at least seven notable examples – other than EMU – of formal monetary unions without political union: The Latin Monetary Union, the Scandinavian Monetary Union, the Belgium-Luxembourg Economic Union, the CFA Franc Zone, the East African Community, the East Caribbean Currency, and the West African Monetary Area. Two of the seven (CFA, ECCA) remain in existence to the present day; a third (BLEU) existed for 3/4 century until incorporated into the larger EMU; and two other (LMU, SMU) managed to survive for more than a half century until brought to an end by World War I.

Randall Henning writes that a couple of observations emerge from the history of the US fiscal rulemaking that seem especially relevant to the EU now.

1.      Even though the debt brakes of the fiscal compact are introduced into national constitutions and framework laws, the process has been initiated by the center and in some cases under duress. In the United States, rules were adopted autonomously by the states. This has implications for domestic political “ownership”.

2.      Community institutions play a leading role in enforcing the rules, whereas the U.S. federal government has no such role. In fact, the U.S. federal government in fact cannot legislate fiscal rules for the states; this would be an unconstitutional infringement on “state sovereignty.” The U.S. model of fiscal rectitude for the states rests on multiple layers of rules combined with the no bailout norm.

Germany: the missing hegemon

Benjamin Cohen writes that experience suggests that in the absence of political union, a local hegemony or solidarity are necessary to keep a monetary union functioning reasonably well; where both conditions are present, they are sufficient. The importance of a local hegemon was well demonstrated by BLEU (Belgium, twenty times the size of Luxembourg, called the shots). The importance of solidarity is evident in the longevity of SMU, BLEU, ECCA. All three involved groups of partners with a strong sense of common identity, grounded in a shared cultural and political background and institutionalized in a broad network of related economic and political agreements.

Brad DeLong writes that the Kindlebergian perspective would lead one to think that the problem of Europe today is that Germany does not want to assume the burden, or assume the role, or is not wanted by the rest of Europe to assume the explicit role on terms that Germany wishes to exercise it. Brad DeLong and Barry Eichengreen write the German Federal government has room for countercyclical fiscal policy. It could encourage the European Central Bank to make more active use of monetary policy. It could fund a Marshall Plan for Greece and signal a willingness to assume joint responsibility, along with its EU partners, for some fraction of their collective debt. But Germany still thinks of itself as the steward in a small open economy.

Entre consolidation budgétaire et panne de croissance, y a-t-il lien de cause à effet ? Sans que l’un soit la seule raison de l’autre, on ne peut le nier. D’autant que deux erreurs ont été commises. L’UE, d’abord, a voulu croire que son premier problème était budgétaire, oubliant au passage que le mauvais état de ses systèmes bancaires et l’excès de dette privée dont souffrent plusieurs pays. Ces handicaps ont empêché la demande privée de prendre le relais de la demande publique. Avec des taux d’intérêt de la BCE bloqués au voisinage de zéro, les conséquences économiques des politiques de rigueur soient particulièrement marquées. 

La deuxième erreur a été de vouloir répondre à la hausse des taux sur les marchés obligataires en fixant des objectifs budgétaires nominaux (ramener le déficit à X% du PIB à la date T) plutôt que structurels (réduire les dépenses ou augmenter les recettes de Y points de PIB par an). L’Europe s’est ainsi mise à la merci d’une logique d’amplification des cycles qui contraint à d’autant plus d’efforts que la situation est mauvaise. La Commission s’efforce d’y échapper en accordant des délais aux pays qui étaient à la peine, mais trop tard et comme à contrecœur. 

Les Etats-Unis, quant à eux, ont réparé leur système bancaire dès 2009 et ont donné aux ménages le temps de se désendetter (y compris par des faillites personnelles). La Fed a vigoureusement soutenu la demande. Et, jusqu’à la fin 2012, l’ajustement budgétaire a été graduel. Le choc est venu en 2013, avec les coupes automatiques de dépenses, mais entre-temps l’économie privée avait gagné en vigueur. Cette stratégie a donné de meilleurs résultats.

Qu’en déduire pour l’avenir ? Sauf à envisager une répudiation de la dette ou la sortie de l’euro, l’une et l’autre bien plus coûteuses, certainement pas qu’il faut jeter le sérieux budgétaire à la rivière. La question n’est pas de savoir s’il faut réduire les ratios de dette publique, mais quand et comment. Avec ou sans Reinhart et Rogoff, il demeure qu’il est dangereux de laisser la dette publique avoisiner 100% du PIB. Or huit pays de la zone euro seront dans cette zone fin 2013.

La bonne stratégie consiste à conduire la consolidation budgétaire graduellement mais avec persistance, en veillant à la qualité des mesures tout autant qu’à leur quantité. Les gouvernements craignent cependant qu’en procédant ainsi, ils suscitent la méfiance des marchés et que leurs coûts d’emprunt s’en ressentent. Parce qu’ils n’ont pas confiance en leurs partenaires, beaucoup en Europe du Nord continuent aussi à faire des objectifs nominaux l’alpha et l’oméga de la stratégie budgétaire. Dans les deux cas le problème est le même : retarder une partie de l’ajustement pour préserver la croissance, n’est-ce pas en fait le repousser aux calendes grecques. N’est-ce pas s’avouer incapable d’affronter les choix qu’exige une maîtrise durable des finances publiques ?

La solution consiste à crédibiliser l’engagement de réduction du déficit Pour cela il faut fonder ses calculs sur des prévisions prudentes ; décider dès aujourd’hui des mesures qui s’appliqueront demain, ou du moins avancer suffisamment dans leur préparation éclairer l’horizon ; identifier les gisements d’efficacité dans la sphère publique ; programmer la fin des politiques dont le rapport coût-bénéfice est trop élevé ; mettre en place les mesures propres à équilibrer les régimes de retraite sur plusieurs décennies ; fixer pour l’assurance-maladie et le chômage des règles d’équilibre sur le cycle ; donner, enfin, les grandes lignes des réformes fiscales qui apporteront de la ressource sans décourager l’activité. Rien de tout cela n’empêchera, évidemment, un parlement de voter demain en sens contraire ; mais cela le rendra moins probable.

Au niveau européen, les programmes de stabilité que les gouvernements adressent chaque année à Bruxelles devraient servir de support à un dialogue sur ces mesures à venir et à certifier les engagements nationaux. Au lieu de limiter les marges de manœuvre immédiates, ils devraient servir à les élargir en rassurant sur le fait que la consolidation budgétaire aura bien lieu.

La logique est imparable : plus on se lie les mains pour demain, plus on gagne des marges de liberté pour aujourd’hui. C’est cela qu’il faut faire.

This article was first published in le Monde.

The longer, but still broad-brush, answer starts from noting that two important documents have been issued in the last few days: the In-depth reviews following the so called AMR (Alert Mechanism Report) from the European Commission and the World Economic Outlook from the IMF. It is useful to look at these two documents from a specific perspective, namely to find elements to answer the question whether the balance between good and bad news about the euro area is positive or negative. Equivalently, one can use the information and the assessments they provide to conclude how the healing process from the euro area crisis is progressing. An assessment in the same vein, concentrating on the growth problem in the euro-area, is offered by the recent Bruegel Policy Brief by Zsolt Darvas, Jean Pisani-Ferry and Guntram B. Wolff.

Let´s follow the scorpion approach - in cauda venenum - and begin with the good news.

The first piece of good news is the fact itself that the EU Commission has produced a thorough AMR, which is an element of the MIP (Macroeconomic Imbalances Procedure), which is in turn part of the so called 'Six-Pack' governance package. The sequence of acronyms is terrible, but those willing to go beyond it and recall the famous sentence of Monnet: “J’ai toujours pensé que l’Europe se ferait dans les crises, et qu’elle serait la somme des solutions qu’on apporterait à ces crises.” (I always thought that Europe will be built on the occasion of crises, and that it will result from the accumulation of solutions implemented to deal with these crises.) can understand why this is good news. The euro area has exploited the opportunity of the crisis to improve its macroeconomic governance and the AMR-MIP-Six Pack sequence is part of this progress. The remark from the IMF WEO (page xiii) that “institutional progress has been made over the past year, in particular on creating a road map for a banking union” as well as the achievement of the European Stability Mechanism and the decision on the Outright Monetary Transaction programs go in the same direction.

The second piece of good news is that both the WEO and the AMR show that flows are continuing to adjust in the euro area, even if there are “differences in nature and pace across the Member States” and this could generate spill-overs across countries. The adjustment is evident in current account developments, in fiscal deficits, in the changes in external competitiveness, in Unit Labour Costs, in the correction of house prices, in the reduction of private debt. Of course, the question is whether the improvements in the flows are temporary, basically forced by the brunt of the recession, in particular in Southern Europe, or are more structural. In this respect, both the WEO and the AMR forecast that the improvement will continue at least over the immediate future.

The third piece of good news, reported by the WEO (page xv), is that “over the past six months, advanced economy policymakers have successfully defused two of the biggest short-term threats to the global recovery: the threat of a euro area breakup and a sharp fiscal contraction in the United States caused by a plunge off the fiscal cliff. In response, financial markets have rallied on a broad front.” Somewhat in the same line, goes the assessment of April 2013 Global Financial Stability Report of IMF that “near-term financial stability risks have eased.” The lower spreads on the sovereign bonds of the peripheral countries, the easing of tension in the funding of Southern European banks shown by the reducing Target balances, the incipient market access for Portugal and Ireland confirm that the financial situation has improved. (See Chart 1 below)

Chart 1 – Financial Condition Index, standard deviations from average, positive = tightening

Now come the bad news

The first bad news is that, while flows are adjusting, stocks are still unbalanced. The net international investment positions as a share of GDP have stayed at high negative levels in many current account deficit countries, the long-run price competitiveness losses have not been fully corrected in most Member States, public and private debt (households and corporations) remains in a number of cases too high.

The second bad news is that Europe is lagging behind in the recovery and the IMF had to move from a two speed to a three speed paradigm to describe the current global developments, where Europe is trailing behind emerging economies and the United States, with rates of growth negative this year and anaemic the next one. This is aggravated by the latitudinal macro divide between a South in recession and a North just managing to stay in the positive domain and by the fact that, because of the still fragmented financial conditions impairing the monetary policy transmission mechanism, monetary policy is tighter in the South of Europe than in the North.

Going forward, a potentially third bad news is that the euro area may be trapped in a no-win situation: if financial tensions aggravate, there will necessarily be negative consequences for the real economy, mostly in the South. If the financial tensions further come down, the euro exchange rate may be pushed up from the «modestly stronger relative to medium-term fundamentals» (WEO, page 12) level by the “endogenous tightening mechanism” that is at work in the euro area. This is triggered when commercial banks reduce the liquidity they draw from the ECB and, as a consequence, the money market rate moves away from close to zero up to the 0.75 per cent level of the ECB official rate. This “endogenous tightening”, which would be equivalent to 3 steps of quarter-point explicit monetary policy tightening, could result in exchange appreciation, which would be particularly unwelcome at a time when other central banks in the advanced world are either continuing or even enhancing their expansionary policies.

The fourth bad news is that there seems to be always a new candidate from the rank of euro area countries ready to take the role of crisis bearer: Cyprus has just done it and there is a fear Slovenia may be the next one.

The fifth bad news is that “relative to U.S. banks, euro area banks have made less progress in rationalizing their balance sheets, cutting administrative costs, and rebuilding profitability and capital”, in the words of WEO (page 21).

The worst bad news is the sixth one and takes the overall name of risk of complacency, of which there are three variants: first, adjustment fatigue, in stressed jurisdictions; second, support fatigue in core jurisdictions; third, relenting on institutional innovation, in particular on essential progress for a banking union. Indeed, the WEO quotation above that “institutional progress has been made over the past year, in particular on creating a road map for a banking union” was deliberately incomplete, missing the crucial qualification: “Yet this is not enough”.

And the net is…

Just counting the three good and the six bad news, one would clearly indicate that the net is negative. But there are attenuating factors about some of the six bad news that can tilt the balance in the opposite direction.

The story about the flows and the stocks can be summarized by saying that correction is on-going but not complete and that a continuation of the current trends can achieve the necessary macroeconomic adjustment.

The considerations about growth need to be a bit longer. The first factor attenuating the negative growth situation is that, as shown in the WEO, much of the needed fiscal correction has already been done, especially in Southern Europe, and front loading is painful when you are doing it but helps when you have done it. The second attenuating factor is that the ECB still has room to lower its policy rate and is apparently considering this possibility. In addition, the President fed expectations that the ingenuity of the ECB will devise new ways to repair the broken transmission mechanism, especially when it comes to medium and small enterprises in the South. Finally, structural measures could improve growth prospects.

The ability of the ECB to further expand monetary policy, if necessary, should also protect against the third potential bad news mentioned above.

As regards the fourth bad news, the attenuating factor is that the record of the euro area policy makers in dealing with stressed jurisdictions is, by now, fairly solid on substance even if appalling in style and communication. The progress achieved on the older cases, Greece, Ireland and Portugal, as well as the solution, at least on the fiscal front, finally decided for Cyprus are a good omens about the ability of the euro area to deal with crisis situations.

Unfortunately, it is not easy to identify attenuating factors for bad news five and six. What can be said here is that the record so far is that remedial action has been proportional to market pressure. One would of course had hoped the proportionality parameter to be larger, with a given degree of market pressure delivering more in terms of action by banks as well as policy makers. The hope is, however, that the parameter is high enough to progressively build sufficient measures. In a way, the Monnet sentence reported above describes a dynamic process: crises generate actions that deal with them and cumulatively build the European Union. History shows that Monnet´s prediction turned true. If the historical trend will not be broken, we have found an attenuating factor also for bad news five and six. Thus, one can indeed confirm the short answer: yes, the net of good and bad news coming from Brussels and Washington is somewhat positive for the euro area.

The 90% threshold, the austerity narrative, and the twitter backlash

Paul Krugman writes that the intellectual edifice of austerity economics rests largely on two academic papers that have now been debunked. One was Alesina/Ardagna (see our previous review here) on expansionary fiscal contractions. The other paper, which has had immense influence, was Reinhart/Rogoff on the negative effects of debt on growth. Very quickly, everyone “knew” that terrible things happen when debt passes 90 percent of GDP.

Mike Konczal writes that from the beginning there have been complaints that RR weren't releasing the data for their results (e.g. Dean Baker). Konczal knew of several people trying to replicate the results who were bumping into walls left and right - it couldn't be done. After trying to replicate the RR results and failing, Thomas Herndon, Michael Ash, Robert Pollin (HAP) reached out to RR and they were willing to share their data spreadsheet. This allowed Herndon et al. to see how RR's data was constructed.

Peter Coy (HT Tim Duy) notes that the Twitterverse exploded with chatter about the new research paper claiming to find holes in a landmark academic paper that’s been cited to justify extreme austerity measures. By mid-afternoon the authors had emailed reporters a quick reply defending their work.

Data issues in “Growth in a time of debt”

Mike Konczal writes that HAP find that three main issues stand out. First, RR selectively exclude years of high debt and average growth. Second, they use a debatable method to weight the countries. Third, there also appears to be a coding error that excludes high-debt and average-growth countries. All three bias their results, and without them you don't get their controversial result about low growth for countries with a debt to GDP ratio higher than 90%.

Ritwik Priya writes that removing the asymmetric weights and including all episodes is really where the meat and juice of the debate lies. The excel error only changes the results from -0.1 to 0.1 (see Ritchie King for a picture of the now infamous excel spreadsheet and some tips on how to use excel properly!), while this changes the result further from 0.1% to 2.2%. 2% vs 3% simply lacks the jaw-drop value of less than 0% vs. 3%, and is actually not even statistically significant.

HAP writes that RR adopts a non-standard weighting methodology for measuring average real GDP growth within their public debt/GDP categories. After assigning each country-year to one of four public debt/GDP groups, RR calculates the average real GDP growth for each country within the group, that is, a single average value for the country for all the years it appeared in the category. The country averages within each group were then averaged, equally weighted by country, to calculate the average real GDP growth rate within each public debt/GDP grouping. The problem is that equal weighting by country gives a one-year episode as much weight as nearly two decades in the above 90 percent public debt/GDP range.

Reinhart and Rogoff argue that their weighting procedure is hardly unconventional. We do not want to excessively weight Greece, for example, which has debt over 90% for 19 years in the 1946-2009 sample. The post-war Advanced Economy experience would quickly reduce to the experiences of Greece and Japan. Our approach has been followed in many other settings where one does not want to overly weight a small number of countries that may have their own peculiarities.

Josh Barro writes that because there were only seven countries in the data set that RR used to calculate average GDP growth under high debt conditions, and because they weighted each country’s average growth equally, getting New Zealand wrong by more than 10 percentage points was a very big deal, shaving 1.5 percentage points off their estimate of average growth. Ritwik Priya writes that it’s true that any data analysis exercise will have to make these choices about weighting. But for precisely this reason data analysis exercises offer, or should offer, at the very least, footnotes or explanatory pieces detailing these choices and a short note on why they were preferred to other choices.

Reinhart and Rogoff writes that the charge of selective omissions is the one they object to in the strongest terms. The “gaps” are explained by the fact there were still gaps in our public data debt set at the time of this paper, a data set no one else had ever been able to construct before and which we now have filled in much more completely.

The conceptual issues in “Growth in a time of debt”

Coppola writes that the Rortybomb blog delivered the killer punch to RR. Econometric analysis by Arindrajit Dube demonstrated that even with good data, the economic analysis was flawed and the conclusions unjustifiable. High public debt cannot reliably be shown to cause low growth. But low growth can reasonably reliably be shown to cause high public debt. Ritwik Priya writes that it is worth pointing out that the main reason RR come up with the 90% figure is because their intervals are of 30% i.e. they split the data into buckets of 0-30%, 30-60% and so on. This is purely a modeling choice artifact, and the actual tipping point, assuming any exists, may be 80% or 110% or 93.7%.

Arindrajit Dube notes that there is a visible negative relationship between growth and debt-to-GDP, but as HAP point out, the strength of the relationship is actually much stronger at low ratios of debt-to-GDP.  This makes us worry about the causal mechanism. After all, while nonlinearity may be expected at high ratios due to a tipping point, the stronger negative relationship at low ratios is difficult to rationalize using a tipping point dynamic.

Arindrajit Dube writes that while it is difficult to ascertain causality from plots like this, we can leverage the time pattern of changes to gain some insight. Here is a simple question: does a high debt-to-GDP ratio better predict future growth rates, or past ones? As is evident from the diagram below, current period debt-to-GDP is a pretty poor predictor of future GDP growth at debt-to-GDP ratios of 30 or greater—the range where one might expect to find a tipping point dynamic.  But it does a great job predicting past growth. This pattern is a telltale sign of reverse causality.

The do-file for reproducing Arindrajit Dube’s analysis is here.

Data issues in “This Time is Different”

A number of authors like Cardiff Garcia and Joseph Cotterill, Adam Posen, Ryan Avent (on Twitter) think that the criticism of this finding should be kept separate from judgments about their earlier book, “This Time is Different”, which remains a highly valuable contribution to the study of finance crises. Paul Krugman writes the book had a sound empirical strategy: it focused only on extreme events, then described what happened around those events. Because of the severity of the shock, it was reasonable to infer that whatever happened around crises was in fact crisis-related, so problems of causation were sidestepped.

But several authors have noted that there were also signs of sloppiness in the construction of the dataset for “This Time if Different”.

Andrew Jalil reveals the major inconsistencies in the banking panics series of “This Time is Different” based on his reading of contemporary news reports surrounding each of the banking panics episodes identified by RR. Jalil notes that the book actually provides two, sometimes contradicting, versions of the banking crisis series (Table A.3.1 and Table A.4.1). One version, for example, identifies December 1861 and April 1864 as banking crises, whereas the other does not contain. [April 1864 should not be classified as a banking panic since what happened was just a serious disturbance on stock markets that was unrelated to the states of banks and did not turn into a banking panic]. The RR series also happens to classify certain foreign crises as domestic ones.  The banking panic that took place in England in 1825 is, for example, wrongly classified as one that affected the US.

David Lopez-Salido and Edward Nelson write that the account of postwar U.S. financial crises by RR is also questionable on several counts. They treat the 1970s as free of financial crises in the United States, even though the mid-1970s witnessed banking stresses that saw banks’ equity capital ratio plunge to a postwar low. RR do not treat 1982 and 1983 as years of financial crisis, despite the pressure in those years on U.S. commercial banks brought by the LDC debt position. And the savings and loan crisis is referred to by R&R as the S&L crisis of 1984, even though S&L failures actually were lower in 1984 than in any other year in 1981-1989.

Growth forecasts at different dates (2007=100) (click to enlarge)

Source: calculations based on different editions of the IMF World Economic Outlook. Note: the first vertical dashed line in each panel indicates 2007, the second 2012.

The next figure shows data for each EU country, including the soon-to-be member Croatia. There were only six countries that did not face downward revision from October 2012 to April 2013: Belgium, Estonia, Germany, Ireland, Latvia and Lithuania. The other 22 countries faced smaller or larger downward revisions from the October 2012 outlooks, which, by the way, were not really bright for most.

It is high time to address Europe’s growth problem.

Growth forecasts at different dates (2007=100) (click to enlarge)

Source: calculations based on different editions of the IMF World Economic Outlook. Note: EU15: EU members before 2004; EU11: EU members joined in 2004=2007 except Cyprus (the current WEO does not include forecasts for Cyprus). The first vertical dashed line in each panel indicates 2007, the second 2012.

Monday’s official announcement that growth slowed to 7.7 per cent in the first quarter of the year is a sign that the era of double-digit expansion is over. The potential for infrastructure investment has contracted, returns on assets have fallen, export growth is slowing and overcapacity has soared. The old engine of growth is spluttering.

Furthermore, China has suffered from the global slowdown that followed the US financial crisis and the debt crisis in Europe. It is now a factory that is too big for the world market. Since 2009, the contribution of net exports to growth in gross domestic product has turned from significantly positive to negative – a telling development.

In other words, China is staring at the “middle-income trap”: the tendency for countries to stop growing quickly once they reach a certain level of annual income. Although optimists suggest China has a way to go before it falls into the trap, this is not convincing. A new source of growth is needed.

What could this be? The answer is the service sector.

China has a peculiar industry structure. The proportion of the country’s potential economic capacity that is in use has declined from about 80 per cent before 2008 to about 60 per cent in 2012, according to the International Monetary Fund. Despite this, the service sector lacks investment, and is therefore short of both capital and labour. Finance, education and healthcare suffer from monopolies and regulations, which lead to supply constraints and high prices. These constraints also contribute to several important structural problems.

First, most factories are short of workers, even migrant workers, and wages have increased more than 10 per cent per annum for many years. At the same time, it is difficult for university graduates to find work, and their salaries have not risen so quickly.

To understand why, look at the inhibited services industry. Employment here represents only 34 per cent of the total workforce, compared with 60 per cent in Malaysia and 81 per cent in the US. Based on where China is on the typical development path, one would expect the service sector to account for about half of today’s jobs. The deficit is particularly apparent in healthcare, finance and education.

Second, consumption as a share of GDP fell from more than 60 per cent to less than 50 per cent between 2000 and 2010. The shortage in the supply of services inhibits consumption. Again, medical treatment, education and financial services are difficult to obtain and expensive – a hot topic of conversation for many Chinese.

Third, the distortion in services has consequences for trade. Manufacturing is highly tradable and capital-intensive. Services are less so. Therefore the former’s dominance contributes to international imbalances and the domestic imbalance between capital and labour. It may also lead to greater inequality, as these high returns to capital lead inevitably to the gains accruing to the few with investments.

In the short term, the high levels of fixed-asset investment (that is, investment in long-term physical assets such as property) could be redirected towards investment in services. This would relieve the shock of currently falling investment levels. Indeed, given the supply constraints, returns on investment could even be higher in services than they have been in industry.

In the long run, the development of services could finally produce enough supply to match the demand of domestic consumers. Structural unemployment among graduates would decrease; their wages would increase; national income distribution could be made fairer; and consumption in innovative services could be fuelled. Reliance on investment and foreign demand could also become less important.

The distortions I describe have not emerged just as concern about China’s growth statistics intensifies – they have been in place for at least a decade, and it will not be possible to remove them overnight. But they are the new government’s big economic challenge. China’s ability to leap over the middle-income trap depends on reform of the services sector.

This article was originally published by the Financial Times.

Why is this so?

Structural weaknesses are part of the explanation. But Europe also made two mistakes in responding to the crisis. First, it failed to recognise the true extent of its banking problem. It believed – or pretended to believe – that the guarantees and recapitalisations of 2008-2009 had addressed the issue whereas weaknesses were in fact much more widespread. Second, it failed to appreciate that excessive private-sector debt was not just an American problem. In Europe too many households and companies needed to deleverage.

The European mantra – structural reform and fiscal consolidation – was and remains correct. But a still-dysfunctional financial system and an overleveraged private sector made the eurozone unable to reallocate resources, engender productivity and sustain demand. Add relative price rigidity in the euro area and the picture is complete: the medicine may be the right one, but the patient is not yet fit to really benefit from it.

How does Europe get out of this predicament?

Comprehensive action is needed to break the mutually reinforcing links between limited productivity, slow deleveraging, weak banking sectors and distorted relative prices.

The first priority is financial repair. Banks with weak balance sheets lend on too expensive terms or lend to insolvent borrowers to keep them afloat and do not grant credit to new firms. This prevents profitable investment and the growth of new, more efficient firms. A comprehensive bank balance sheet assessment is needed. For those that would take part in this assessment, the introduction of the Single Supervisory Mechanism, the first element of the European banking union, offers a opportunity. The ECB should not and will not accept undercapitalised – let alone insolvent – banks to fall under the common supervision. National authorities therefore have to initiate a recapitalisation of undercapitalised banks and a resolution of the insolvent ones. The moment is now. When public money is needed, the European Commission should exclude it when making decision on excessive deficits.

Even before the repair is completed, action is needed because the monetary policy transmission mechanism in the eurozone is impaired in some countries, further limiting credit supply. Significant haircuts on collateral in the repo operations that underpin the provision of central bank liquidity limit the willingness to provide credit to small firms. This limitation has a particular importance in the current low-growth environment and needs temporary but forceful action. The ECB alone cannot solve the problem because it has a fiscal dimension. The EU should explore temporary collateral enhancement schemes, for example, in liaison with the European Investment Bank.

The second priority is to balance private and public deleveraging. This requires an appropriate speed of fiscal adjustment, one that is adapted to the context of stagnating economies. Where consolidation is needed – that is, in most countries – there is a case for spreading it out over a longer period, provided governments can credibly commit to future action. One way is to legislate now for the years to come, for example on far-reaching pension reforms. Another is to use the EU fiscal framework as a credible commitment device. More needs to be done to prevent fiscal retrenchment in the south of Europe from further dampening economic activity and increasing social hardship, ultimately undermining economic and political stability. Up-front payments from existing EU convergence funds and increased EU-supported investments would be a good way to help address demand weaknesses.

The third set of measures should aim at addressing the differences of competitiveness acorss eurozone countries; a problem that was in place before the crisis. Structural reforms are of central importance to increasing long-term productivity and need to be continued vigorously. The EU should provide incentives to addressing weaknesses in product, labour and capital markets as well in skills. It should explore new approaches, including, contractual budgetary support in specific policy areas. Nevertheless, within the eurozone, wage rebalancing should involve northern Europe as well as southern Europe. Consistent with the ECB mandate, average inflation in the eurozone should be close to the 2 per cent target yet inflation expectations have fallen to well below that. Northern Europe should refrain from domestic policy action that would prevent domestic inflation from rising above 2 per cent, as long as eurozone price stability remains ensured.

The solution to Europe’s economic problem is neither stubborn persistence nor a U-turn. It is not to add a new policy procedure to the many existing ones. It is to recognise the true nature of the challenge it is facing and to adopt a more comprehensive approach.

This comment is based on the Bruegel paper ‘Europe’s growth problem (and what to do about it)‘.

This observation is unsurprising. What started as a financial crisis in 2008 has had significant impacts on the real economy.  Industry produces less to meet lower demand, and therefore emits less carbon. This story is illustrated by Eurostat’s industrial confidence indicator superimposed on the graph of sectoral emissions.

It is interesting, however, to probe the data a bit further. In addition to verified emissions, CITL provides data on allocated emissions allowances. The difference between verified emissions and allocated emission allowances can be thought of as an allowance surplus.  It is basically the difference between the amount of carbon a firm was allowed to pollute and the amount of carbon the firm actually polluted. This difference can be traded at the carbon market.

Figure 2 demonstrates an interesting trend in the change in surpluses over the crisis period. Countries that have weathered the crisis relatively well show a decline in the surplus, whereas countries that have struggled demonstrate an increase in the allowance surplus. In particular the surplus in Germany is about 60 million tonnes lower while that in Spain and Italy is about 30-40 million tonnes higher. This indicates a sort of intra-European transfer mechanism. While not an explicit goal of the ETS, this points to a possible countercyclical function of the EU-wide trading mechanism.

As the treasuries in all EU countries are allowed to sell a fixed quota of allowances while industry only uses allowances if it is producing , a tight ETS could be an effective European countercyclical fiscal policy. However, at the current emission allowance price of about €5 per tonne this countercyclical potential is not reaped. The transfer only amounts to about €300 million from Germany to Italy and Spain. At a carbon price of €20 observed before the crisis, this transfer would already amount to more than one billion Euro.  The recent Policy Brief proposes one mechanism to get a more sensible ETS price. This could bolster an additional tool in the countercyclical arsenal, at a time when Europe most needs them.

The recent popularity of Bitcoins

James Surowiecki writes when the virtual currency bitcoin was released, in January 2009, it appeared to be an interesting way for people to trade among themselves in a secure, low-cost, and private fashion. The Bitcoin network uses a decentralized peer-to-peer system to verify transactions, which meant that people could exchange goods and services electronically, and anonymously, without having to rely on third parties like banks. Its medium of exchange, the bitcoin, was an invented currency that people could earn—or, in Bitcoin’s jargon, “mine”—by lending their computers’ resources to service the needs of the Bitcoin network. Once in existence, bitcoins could also be bought and sold for dollars or other currencies on online exchanges.

Maria Bustillos writes that a number of businesses have recently begun accepting bitcoins in payment for their services. At bitcoinstore.com, you can buy electronics—including cameras, musical instruments, blood-pressure monitors, and computers—using just bitcoins. There are bitcoin-only casinos, like SatoshiBet, and a bitcoin-based Intrade-style prediction market called Bets of Bitcoin.

Yves Smith writes at Naked Capitalism that Bitcoins have been making headlines on mainstream news sites, on blogs and even on precious metal forums recently and with good reason given the vertical rise in price per Bitcoin.

Source: Bitcoin Charts

Felix Salmon writes that Bitcoin has become suddenly popular in Cyprus for obvious reasons: no government can confiscate your bitcoins, or prevent you from transporting them out of the country. Yves Smith notes that much of this speculation about the impact of Cyprus on the popularity of Bitcoins, however, boils down to an increase in app downloads in a single country where iPhones do not have a large market share. Alec Liu thinks that Bitcoin is rallying because of government-backed legitimacy thanks to the recent guidance from the anti-money laundering arm of the U.S. Treasury, FinCEN (see here). A number of authors think that it’s simply a bubble.

The rationale for an alternative currency

Satoshi Nakamoto – the pseudonymous person or group of people who designed and created the original Bitcoin software – writes that the root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency. Banks must be trusted to hold our money and transfer it electronically. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts… With e-currency based on cryptographic proof, without the need to trust a third party middleman, money can be secure and transactions effortless.

Satoshi Nakamoto writes that the commerce on the Internet that relies on financial institutions works well for most transactions, but suffers from the inherent weaknesses of the trust based model. First, the cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions. Second, with the possibility of reversal of transactions, merchants must be wary of their customers, hassling them for more information than they would otherwise need.

Satoshi Nakamoto writes that the idea of a purely peer-to-peer version of electronic cash is to allow online payments to be sent directly from one party to another without going through a financial institution. Digital signatures provide part of the solution, but the main benefits are lost if a trusted third party is still required to prevent double-spending. To deal with the problem of double-spending, Nakamoto proposed a solution that uses a peer-to-peer network. The network timestamps transactions by hashing them into an ongoing chain of hash-based proof-of-work, forming a record that cannot be changed without redoing the proof-of-work.

Satoshi Nakamoto points that no mechanism existed, prior Bitcoins, to make payments over a communications channel without a trusted party. The idea of Bitcoin is to define an electronic coin as a chain of digital signatures. Each owner transfers the coin to the next by digitally signing a hash of the previous transaction and the public key of the next owner and adding these to the end of the coin. For the system to work, we need a way for the payee to know that the previous owners did not sign any earlier transactions. The only way to confirm the absence of a transaction is to be aware of all transactions. To accomplish this without a trusted party, transactions must be publicly announced, and we need a system for participants to agree on a single history of the order in which they were received.

The details of the Bitcoin network (very wonkish)

Felix Salmon writes that for the time being, Bitcoin is in many ways the best and cleanest payments mechanism the world has ever seen. So if we’re ever going to create something better (see next section on the economics of the system), we’re going to have to learn from what Bitcoin does right – as well as what it does wrong.

Nemo has the best understandable description of the technical aspects of the Bitcoin network in a series of posts on his blog Self-evident. He starts by noting that Bitcoin relies on extremely elementary cryptography.

Nemo writes that a central ingredient in the system is the use of one-way functions. A one-way function is a function that is easy to compute but hard to invert. The formal definition of “hard” is a little tricky, but the basic idea is that you either have to get very lucky or you have to take a very long time to invert them. Indeed, good one-way functions usually have the property that your best strategy for inverting them is to keep guessing values of x until you stumble across one with f(x) = y. Indeed, Bitcoin “miners” are currently doing precisely this fifty trillion times per second.

The key ingredient is actually a trapdoor one-way function, which is a function that is easy to compute but hard to invert… for everybody except the person who created it. The idea is that you create your own personal function g(x) that has a secret (called a private key), such that inverting g is easy if and only if you know the secret. You share the function — but not the secret — with the whole world. So now the whole world can compute the function, but only you can invert it. Every Bitcoin “address” represents a unique trapdoor one-way function.

Nemo gives a simple example illustrating how these functions can be used. Suppose you and I want to bet on a coin toss over the phone. Is it possible for two untrustworthy people, like you and me, to play this game fairly? By the power of the one-way function, it is! Here is how. First, we agree on a one-way function f. Then I flip a coin. If the coin lands “tails”, I pick a big even number. If it lands “heads”, I pick a big odd number. Call that number x. Then I compute y=f(x) and tell you y. Then you guess “heads” or “tails”. Then, finally, I reveal x. Since you cannot invert f(x), you have no idea whether x is even or odd at the time you make your guess. And since I cannot invert f either, you can check the x I revealed simply by confirming that f(x)=y. Thus we have flipped a coin over the phone fairly, even if both of us would rather cheat.

Izabella Kaminska writes on her personal blog that miners effectively make money from seigniorage in its very basic form.

Nemo explains how mining works. Miners are clients that attempt to create new valid blocks. A block is a record of some or all of the most recent Bitcoin transactions that have not yet been recorded in any prior blocks. They do this by putting some transactions in a candidate block, picking a nonsense word called a nonce, computing the hash of the resulting block, and repeating with different nonces until they find a block whose hash does not exceed a certain threshold called a target. The current target for the block chain is defined by a calculation, so any two clients looking at the block chain will calculate the same target. This calculation aims to adjust the target such that one block will be mined every ten minutes, no matter how much total computing power is devoted to mining. Then they broadcast that block to the network, thus appending it to the block chain that every client sees. The Bitcoin software's Prime Directive is: When faced with conflicting versions of the block chain, the one with the greatest total sum of work is the Truth.

Paul Bohm writes that to rig the vote an attacker would need to control more computational power than the honest nodes. To ensure it's more expensive for an attacker to purchase the computational power needed to attack the system, Bitcoin adds an incentive scheme. Users who contribute computational power get rewarded for their work. This computational process ("mining") is not wasteful at all, but an incredibly efficient way to make attacks economically unprofitable.

Nemo explains the structure of the financial incentive for miners: They can embed one coinbase transaction in each block they mine. The coinbase transaction includes new bitcoins (hence the term “mining”) and also any transaction fees associated with the transactions in the block.

The economics of Bitcoins

James Surowiecki writes that the problem with Bitcoins is that instead of being used as a currency, bitcoins are today mostly seen as (and traded as) an investment. The problem with having the Bitcoin economy dominated by speculators is that it gives people an incentive to hoard their bitcoins rather than spend them, which is the opposite of what you need people to do in order to make a currency successful. Zachary Seward reports that when researchers examined the bitcoin universe last year, they found that between 55% and 73% of bitcoins, depending on how you count, were being held in dormant accounts.

Paul Krugman writes that Bitcoin has created its own private gold standard world, in which the money supply is fixed rather than subject to increase via the printing press. Bitcoin, rather than fixing the value of the virtual currency in terms of those green pieces of paper, fixes the total quantity of cybercurrency instead, and lets its dollar value float. What that means is that if you measure prices in Bitcoins, they have plunged; the Bitcoin economy has in effect experienced massive deflation. The actual value of transactions in Bitcoins has fallen rather than rising. In effect, real gross Bitcoin product has fallen sharply.

We documented early signs of improved market sentiment towards struggling euro members in this post at the end of January. Since then, however, European economic data has been mostly disappointing. Additionally, the Italian election’s unclear outcome has increased uncertainty about the policy direction. Therefore, in this post we look if recent turbulence has put a halt on the normalization of euro area capital flows.

A first indicator are the TARGET2 balances that measure the liabilities of national central banks towards the eurosystem (see here for a clarification of TARGET2). These started to decline after Draghi’s famous speech in June 2012.

The convergence towards balance has broadly continued with net liabilities in February 2013 down by 15–29 % in Portugal, Greece, Spain and Ireland compared to June 2012 levels. Interestingly. Italy released data yesterday for March 2013, which is the first full month since its inconclusive elections. Previously, Italy’s TARGET2 liabilities had declined from 274 bn in June 2012 to 228 bn in January 2013, a reduction of 17 %. They then increased again in February to 256 bn. The March data, however, revealed a decrease in net liabilities back to 243 bn. The surprising election result did not therefore seem to increase the reliance of Italian banks on central bank funding. The effects on government bond yields have also been limited. Although the 10-year yield shot up from 4.4 % to 4.9 % immediately after the results were released, it has since decreased back to the pre-election level.

We have also been tracking private capital flows since the piece by Merler and Pisani-Ferry (2012) on sudden stops. This data extends now until 2012Q4 for Ireland and January 2013 for Italy, Spain, Greece and Portugal. Private inflows have rebounded in Italy, Spain and Portugal, where cumulated inflows are now higher than in June 2012. Nevertheless, Greece and Ireland have continued to experience private capital outflows since last June although these seem to have stabilized in recent months.

Our final metric, the share of foreign holdings of southern European sovereign bonds, has been updated only for Ireland and Italy since our last post. In Ireland, the share of non-residents had dropped slightly from 72.6 % in September 2012 to 71.7 % in January 2013.[1] In Italy, foreign holdings dipped from 40.6 % in September 2012 to 39.7 % and then rose slightly to reach 40.3% at the end of the year.

All in all, the data suggests that recent bad economic news have not so far resulted in resurgent capital outflows from southern Europe. Nevertheless, the wider release of early 2013 data could yet overturn this conclusion if sentiment has recently deteriorated, for instance after the clumsy Cyprus rescue. Additionally, future challenges await – especially so in Italy, where the formation of a solid government is still dependent on overcoming many institutional and electoral hurdles. Finally, if analyzed from the opposite direction, the pace of normalization is clearly not fast enough to bring along a speedy recovery.

[1] In February, the share dropped to 55.4 % but this was because the Irish central bank acquired 25 bn in new bonds as part of the promissory note deal. Without it, the non-resident share would have stayed at around 71 %.

 Diamond and Dybvig (1983) showed that deposit-taking banks are vulnerable to a bad equilibrium where all depositors rush to withdraw their money simultaneously without the bank being able to repay them. This is because of the mismatch between liquid liabilities and illiquid assets, which renders it impossible for banks to reimburse all deposits instantaneously. Crucially, bank runs can be triggered not only as a result of negative new information about the solvency of a bank, but also as a self-fulfilling prophecy.[2]

To prevent the economically destructive recalling of loans once a stampede starts, banks subject to a run need to find an alternative source of liquidity. If there is little doubt about the solvency of the institution, interbank markets are able to provide this. The fall of Lehman Brothers showed though that these markets can seize up in situations of high uncertainty. Therefore more secure institutional arrangements are needed.

These are primarily the suspension of convertibility (up to a limit) and/or deposit guarantees. Both aim to ensure depositors that they will be able to withdraw their money when they need it instead of feeling forced to do it immediately. Capital controls can be considered a weaker, although often longer lasting, form of suspension of convertibility. Instead of limiting access to cash, they only confine it in a given geographical area.

However, bothsuspension of convertibility and deposit guarantees also have their weaknesses. Limits to convertibility can prevent not only panic-induced withdrawals but also restrict access to cash for households that genuinely need it. Ennis and Keister (2009) argue that such limits are therefore time inconsistent. Because governments are unwilling or find it hard to implement them, suspension of convertibility is not necessarily enough to prevent bank runs. A deposit guarantee system is more robust. Ultimately though, it is only as good as the creditworthiness of its guarantor.

An alternative way to respond to banking panics is for the central bank to perform its lender-of-last-sort (LOLR) function (Bagehot 1873). Nevertheless, it is primarily a complement and not a substitute to a deposit insurance system. The former primarily deals with illiquidity whereas the latter ensures depositors that they will be repaid even if a bank goes bankrupt. Deposit insurance aims to prevent a liquidity crunch by depositors whereas the LOLR is meant to ensure the provision of liquidity as a response to a dearth of general liquidity, not only deposits.

LOLR is less certain to prevent a bank run than a deposit guarantee because the central bank is only allowed to lend against eligible collateral and because it requires discretionary action, which renders it less certain than pre-specified rules (Cecchetti 2007). If depositors fear that banks are insolvent they have a reason to doubt that central banks will save them. This comes with Goodhart’ (1999) qualifier that it is difficult for central banks to ensure the solvency of the counterparty when acting as a LOLR. If a bank cannot obtain financing from the market, it most often means that its solvency is in doubt.

Repullo (2000) studies if it is better to allocate the responsibility for LOLR to the deposit insurance agency or the central bank. The division matters because of agency considerationsif the two institutions are primarily interested in their individual instead of social benefit. Repullo shows that if liquidity shocks are sufficiently small, it is optimal to entrust the central bank with LOLR responsibilities. Conversely, in the case of large shocks the deposit insurance system is the better guardian of the LOLR facility. The deposit insurance is always too stingy relative to social optimum to provide liquidity whereas the central bank is too lenient in the case of small shocks and even stingier than deposit insurance in case of large shocks.

The result stems from the fact that for small shocks the central bank prefers to avoid the certain cost of liquidation in favor of a positive probability of a loss on its loan. As the expected loss for the central bank increases with the size of the loan though, it becomes less and less willing to provide liquidity in the case of a large shock even if this would be socially optimal. The deposit insurance corporation on the other hand does not face increasing losses as a function of the size of the shock, because its maximum liabilities are capped by the total amount of deposits. However, this result depends on the assumption that banks only finance themselves with deposits that are fully insured. If this is not the case, the interests of the two agencies become more similar in case of a large liquidity shock. This leads to an expanded range of shocks for which the central bank should be the LOLR.[3]

Another relevant issue is the distinction between essentially random self-fulfilling runs and those based on revealed information about banks’ (in)solvency because they imply distinct optimal policy responses. If a run is random, there should be no costs to government from deposit guarantees and liquidity provision. Indeed, deposit insuranceshould prevent the run in the first place and inhibit any damage to the real economy. But if governments guarantee the liabilities of banks that are in fact insolvent, the fiscal costs of accommodating policies tend to be high (Honohan and Klingebiel 2003). Furthermore, Claessens et al. (2005) argue that government support during these ‘real’ banking crises does not even accelerate the subsequent recovery (even the contrary). The optimal policy in these cases is to restructure the banking system. To allow this to be done in the most efficient manner, governments should ensure the existence of a proper institutional resolution framework.

References

Allen, Franklin & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.

Bagehot, Walter 1873, “Lombard Street: A Description of the Money Market”, revised edition with a foreword by Peter Bernstein. New York: Wiley (1999). 

Cecchetti, Stephen, 2007, “Subprime Series, part 2: Deposit insurance and the lender of last resort”. VoxEU column. http://www.voxeu.com/article/subprime-series-part-2-deposit-insurance-and-lender-last-resort

Claessens, Stijn & Daniela Klingebiel & Luc Laeven, 2005, “Crisis Resolution, Policies, and Institutions: Empirical Evidence” in eds. Honohan, Patrick & Luc Laeven, 2005, “Systemic Financial Crises: Containment and Resolution”.

Darvas, Zsolt & Wolff, Guntram, 2013, “It is not yet too late to drop the idea of capital controls in Cyprus, Bruegel blog 27.3.2013. www.bruegel.org/nc/blog/detail/article/1061-it-is-not-yet-too-late-to-drop-the-idea-of-capital-controls-in-cyprus/

Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.

Huberto M. Ennis & Todd Keister, 2009. "Bank Runs and Institutions: The Perils of Intervention," American Economic Review, American Economic Association, vol. 99(4), pages 1588-1607, September.

Goodhart, Charles A E, 1999. "Myths about the Lender of Last Resort," International Finance, Wiley Blackwell, vol. 2(3), pages 339-60, November.

Gorton, Gary, 1988. "Banking Panics and Business Cycles," Oxford Economic Papers, Oxford University Press, vol. 40(4), pages 751-81, December.

Honohan, Patrick & Klingebiel, Daniela, 2003. "The fiscal cost implications of an accommodating approach to banking crises," Journal of Banking & Finance, Elsevier, vol. 27(8), pages 1539-1560, August.

Kahn, Charles M. & Santos, Joao A.C., 2005. "Allocating bank regulatory powers: Lender of last resort, deposit insurance and supervision,"European Economic Review, Elsevier, vol. 49(8), pages 2107-2136, November.

Repullo, Rafael, 2000. "Who Should Act as Lender of Last Resort? An Incomplete Contracts Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 580-605, August.

Saunders, Anthony & Wilson, Berry, 1996. "Contagious Bank Runs: Evidence from the 1929-1933 Period," Journal of Financial Intermediation, Elsevier, vol. 5(4), pages 409-423, October.

Wolff, Guntram, 2013, “Capital controls will put euro at risk”, Bruegel blog 26.3.2013, www.bruegel.org/nc/blog/detail/article/1060-capital-controls-will-put-the-euro-at-risk/

[1] www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ecofin/136487.pdf

[2] For a model of an information-based bank run, see e.g. Allen and Gale (1998). Gorton (1988) and Saunders and Wilson (1996) have shown that most bank runs are indeed based on revealed information about banks’ increased insolvency risk.

[3] Kahn and Santos (2005) develop Repullo’s model further for example by studying the incentives for information sharing between different regulators.

During the subsequent few days policymakers all busily disclaimed all responsibility for the decision -- a typical European nonsense. Then the Cypriot parliament turned around and rejected the deal, after which the country sought help from Russia – without success. Cyprus ended up reaching a new agreement with the Eurogroup and the troika on 25 March, to avoid a disorderly exit from the euro area.

The new deal is quite sensible in a number of aspects: it fully protects all insured deposits up the €100,000 threshold of the deposit guarantee scheme. Bank shareholders and big creditors take the first hit, while deposits over the €100,000 threshold of the troubled banks will also have to bear the burden of bank losses and contribute to bank recapitalisation as much as needed.

Yet the involvement of uninsured depositors sparked a major controversy: will this be the new 'template' for dealing with banking crises in the euro area in the future? The answer is clearly no, even though the communication fiasco that resulted from the public disagreement did not help matters.

The Cyprus case is special. The capital shortfall is estimated at about a half of Cypriot GDP: I cannot imagine a banking loss of this magnitude in any other country. And someone had to bear these Cypriot losses. The government did not have the fiscal means to absorb them; Russia did not step in with a huge grant; and euro area partners did not want to burden their taxpayers further. The only remaining solution was to involve bank shareholders and lenders, including uninsured depositors.

It is likely that there will be more ‘bail-ins’ in Europe in the future - that is, involving owners and certain investors in the cleanup of banking losses. But these will be along the harmonised principles of the soon-to-be-adopted Bank Recovery and Resolution Directive (BRRD). This in fact aims to protect deposits.

Even if Cypriot banking mess is a unique case, it has made one broader lesson abundantly clear: the euro area needs to adopt a fully-fledged banking union. Under this, bank supervision, resolution, and deposit guarantees would be centralised in euro-area countries, as well as those non-euro countries of the EU that decide to opt-in.

As things stand, we are only part of the way there. The agreement on centralised supervision has been reached, and banks in the participating countries will be supervised by the ECB, most likely from the middle of next year. In itself this will be a major plus, because the ECB will presumably do everything to avoid flops like the Cyprus disaster, or the sudden crumpling of Dexia in Belgium and the Dutch financial conglomerate SNS Reaal.

But it won’t be enough. Trust in deposit insurance has been shaken by chain of events in Cyprus. This may indeed be a special case, but not all small depositors throughout the euro area will understand this. The grave mistake of introducing payments and capital controls in Cyprus to stop money flowing abroad will make matters worse.

To rebuild that shattered trust, euro area-wide deposit insurance will be needed. On top of this, a euro-area resolution authority equipped with a well-defined toolbox along the lines of the BRRD is needed in cases of bank failures. And there has to be a burden sharing agreement on eventual banking losses, otherwise, a half-baked banking union will not separate banking and sovereign risks from each other, which would have detrimental effects of the economy.

The Cyprus crisis may be contained for now, but it is not over. The payment controls will deepen the already bleak economic outlook, because even the few relatively healthy banks will not be able provide adequate financial services to the economy. The deep economic contraction ahead in Cyprus will make it very difficult to implement the fiscal and structural adjustment programme, and therefore we cannot be assured that Cyprus is saved.

Cyprus’s situation is so desperate that it has no choice but to forge ahead with fiscal consolidation and structural reforms. This is not the case in most of the euro area, where fiscal accounts are much stronger. Boosting private investment in core euro area countries with tax breaks, or even increasing public investment financed from government borrowing at the close to zero rates, would revive the economy of the euro area core -- with positive spill-overs to southern Europe.

The time has also come to engineer a massive investment programme for southern Europe, like a kind of new Marshall-plan. After all, every euro-member is responsible for the defunct architecture of the euro that allowed the build-up of vulnerabilities that are now causing suffering to millions of people.

This column was published in The Times: http://www.thetimes.co.uk/tto/business/columnists/article3728435.ece

Towards a gradual exit

Real Time Economics writes that twice before the size of the Fed’s holdings have reached a share of the nation’s GDP comparable to where the central bank appears to be heading.

Ylan Mui writes at the Wonkblog that consensus is growing, inside the Federal Reserve, over the need to dial back the central bank’s $85-billion-dollar-a-month bond-buying program — but for very different reasons. It boils down to two sides: Hawks, who want to curtail quantitative easing programs because of the risks they create (see page 39 of the Monetary Policy Report for more on this). And doves, who see evidence that they’re working well enough at stimulating growth that they might soon no longer be needed.

Gavyn Davies notes that the markets are increasingly focused on whether the exit can be handled successfully (Sober Look writes that the exit strategy will drive the fixed income markets for years to come). In 1994, Alan Greenspan and colleagues believed that monetary policy had been behind the curve in previous economic cycles, and they saw virtue in acting in an unexpected way to maximize the effect of the policy change. But the consequences for a complacent financial system were extremely severe. When Greenspan had his next opportunity to tighten policy from 2004 onwards, he reassured the market that this would happen at a “measured pace”, but it is now believed to have taken place in an excessively gradual manner.

Timing and composition

Tim Duy writes that policymakers anticipate a gradual end to the program, and they want to communicate their intentions well ahead of the actual timing of the policy change. So expect them to continue to walk a fine line between acknowledging the exit strategy while making clear the exit is not imminent.

In a recent paper, several economists at the Federal Reserve Board provide a framework for projecting Federal Reserve assets and liabilities and income through time. The authors base their projections on the general principles for the exit strategy that the FOMC outlined in the minutes of the June 2011 FOMC meeting. The Committee stated that it intended to take the following steps in the following order:

1.      Cease reinvesting some or all payments of principal on the securities holdings in the System Open Market Account portfolio—that is, its holdings of securities;

2.      Modify forward guidance on the path of the federal funds rate and initiate temporary reserve‐draining operations aimed at supporting the implementation of an increase in the federal funds rate when appropriate;

3.      Raise the target federal funds rate;

4.      Sell agency securities over a period of three to five years; and

5.      Once sales begin, normalize the size of the balance sheet over two to three years.

The politics of exiting

Gavyn Davies writes that the politics of paying less money to the Treasury and more to the banks will be very difficult.

James Hamilton illustrates that if the Fed is buying assets when long-term rates are low, and selling them when rates have risen, the Fed will make a capital loss on its purchases (the red region on the graph below). The Fed will also have to be paying more in interest on reserves as rates rise (the blue region below). According to the baseline calculations of the authors, during 2017-2019 these expenditures for the Fed will be greater than income coming in from interest on retained assets (the green region in the graph above).

Source: Hamilton and al. (2013)

James Hamilton, however, notes that – under their baseline scenario – the Fed's profits in its good years exceed its losses in its bad years. For this reason, Brad DeLong disagrees with Gavyn Davies and thinks that the politics will not be difficult.

John Cochrane notes another difficulty: monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest, something that will be hard to swallow for Congress.

The How: IOER, Reverse repos, Term deposits…

The Monetary Policy Report of the Federal Reserve explains that it will be able to put upward pressure on short-term interest rates at the appropriate time by raising the interest rate it pays on reserves, using draining tools like reverse repurchase agreements or term deposits with depository institutions, or selling securities from the Federal Reserve’s portfolio.

Mark Sniderman – Executive Vice President of the Cleveland Fed – writes that the Federal Reserve can use the power granted by congress to pay interest on reserves to immobilize some portion of the excess reserves until it can remove them from the balance sheet through other means. By increasing the interest rate paid on reserves, the Federal Reserve can also raise the federal funds rate while holding the same level of reserve supply as before. That’s because the interest rate on excess reserves puts a de facto floor under the demand for reserves in the banking system—banks won’t want to trade with one another at the federal funds rate, even as it rises, if they can get a better rate by keeping excess reserves on deposit at the Federal Reserve.

Source: Cleveland Fed

As the economy recovers, the Federal Reserve may want to continue increasing the federal funds rate. To do so, the Federal Reserve could first raise the interest paid on excess reserves. Then, to manage the supply of bank reserves, any or all of three other tools could be put to use:

1.      Term deposits – banks put money on deposit for a specified term, such as three months.

2.      Reverse repos – the Federal Reserve lends out securities from its portfolio and banks use reserves on deposit as payment, keeping those reserves out of the marketplace.

3.      Redemption of maturing MBS or their outright sale.

Sober Look writes that back in 2009 the Fed set up tri-party repo arrangements with a number of dealers. Eventually that will allow the central bank to lend out the securities instead of selling them. As dealers borrow the securities over a period of a week for example, they post cash as collateral to the Fed (dealers pay the coupon on the securities they borrow and receive the market repo rate on their cash “collateral”). That cash going into the repo account is taken out of “circulation”, thus draining the reserves. If the Fed rolls these repo positions over time, the reserves will stay “drained” but the securities will still be owned by the Fed - until they pay down or mature.

Jeremy Siegel writes that by increasing required reserves, the Fed’s strategy to regain control over the level of deposits can be made easier. The Fed has not altered reserve requirements in more than 20 years and has not raised any reserve ratio on any deposit in almost four decades. The Fed’s Flow of Funds Account indicates that total deposits in financial institutions were $10.6tn at the end of 2012. This implies that a 15 per cent reserve requirement on deposits would absorb almost all the excess reserves now in the banks.

Cyprus has been the latest battleground between the two camps. On March 25, after the decision had been taken to resolve the country’s second-largest bank, and to impose large losses on uninsured depositors in the process, Eurogroup President Jeroen Dijsselbloem, the Dutch finance minister, declared that a healthy financial sector requires that “where you take on the risks, you must deal with them.” The aim, he added, should be to create an environment in which Europe’s finance ministers “never need to consider a direct recapitalization” of a bank by the European Stability Mechanism. He was apparently reading from a textbook on moral hazard.

Immediately after this declaration, however, prices of European bank stocks plunged, and Dijsselbloem was accused by many (including some of his colleagues) of having poured oil on a burning fire. Within hours, he issued a statement indicating that “Cyprus is a specific case with exceptional challenges,” and that “no templates are used” in the approach to the European crisis.

This is not convincing. Markets learn from a current crisis which principles will be applied in the next one. And letting them learn is precisely what the fight against moral hazard is about.

European policymakers have been agonizing over the same dilemma throughout the Cypriot crisis. The burden of bailing out the country’s ailing financial institutions was too heavy for an already-indebted Cypriot state, and the International Monetary Fund was adamant that it would not pretend otherwise. So, in mid-March, Cyprus was heading for a precipitous retrenchment of its banking system, resulting in the loss of a very large part of the country’s financial wealth. For the IMF and Germany, which pushed for such an outcome, the rationale was the need to prevent moral hazard.

Cypriot President Nicos Anastasiades, reportedly with some support from European institutions, desperately tried to avoid this fate – in the name of financial stability. The solution found during the night of March 15 – a one-tie tax on deposits – was defensible from the Cypriot viewpoint. Preserving domestic financial stability required limiting taxation of large deposits, because a substantial proportion belonged to foreign account-holders. Avoiding a massive withdrawal of foreign capital therefore implied taxing all deposits below the €100,000 ($130,000) threshold. Absent a foreign bailout, no other solution was on offer.

But this solution was detrimental to financial stability in the rest of Europe, because it signaled that the €100,000 threshold below which deposits are guaranteed was not sacrosanct. Legally, of course, this guarantee is only worth the solvency of the guarantor – in this case the near-bankrupt Cypriot state. But its abrogation would nonetheless be symbolically powerful, sparking anxiety throughout Europe.

The obvious way out of this dilemma would have been for Cyprus’s eurozone partners to assume the cost of the tax on deposits below €100,000. Doing so would have cost them an estimated €1.3 billion, or roughly 0.01% of their GDP – a ridiculously low price to pay for financial stability. It would not have created much moral hazard: large depositors would have been taxed, and the Cypriot government would still have suffered the strictures of an IMF/eurozone program – bitter enough medicine.

But, at a time when northern European citizens are full of resentment against banks and seething with anger over transfers to the south, German Chancellor Angela Merkel and her peers did not want to ask their taxpayers to pay for a partner country’s mistakes.

That agreement was not politically viable, and was overwhelmingly rejected by the Cypriot parliament. So, ten days after their agreement on an ill-fated solution, the Eurogroup ministers changed course and adopted the approach that they had tried to avoid. Banks are being precipitously resolved.

The consequences are already visible: to avoid a complete meltdown, Cyprus has been forced to introduce capital controls – which everyone had thought were illegal and unthinkable within the eurozone. As a result, investors and depositors have learned that the erection of financial barriers within the currency area is indeed a genuine risk. And the Cypriots are so angry at Europe that a deliberate exit from the eurozone has become a distinct possibility.

Ultimately, the true contest is less between moral hazard and financial stability than it is between financially sensible and politically acceptable solutions. In Europe, as elsewhere, financial policy used to be the remit of specialists – central bankers, regulators, and supervisors. Not anymore: the experts have lost their legitimacy.

Nowadays, angry citizens are in charge. Financial policy is driven by politics. But politics in Europe is national, and what one national parliament regards as the only possible solution another national parliament regards as entirely unacceptable. Europe has not yet found a response to this problem, and it is not on the way to finding one.

This danger was made clear when Jeroen Dijsselbloem, the Dutch president of the eurogroup of finance ministers, rocked financial markets on Monday by hinting at a new doctrine that would put the full burden of future bank restructuring on creditors and depositors rather than taxpayers. In his words, “where you take on the risks you must deal with them, and if you can’t deal with them then you shouldn’t have taken them on”. This hardline stance echoes the memorable advice of Andrew Mellon, US Treasury secretary in the early 1930s, as reported by then President Herbert Hoover: “Liquidate labour, liquidate stocks, liquidate farmers, liquidate real estate… It will purge the rottenness out of the system… People will work harder, live a more moral life.”

In July 2007, the opposite position was enunciated by Jochen Sanio, then Germany’s top financial supervisor. As IKB, a medium-sized German bank, revealed massive subprime-related losses, he argued that not bailing it out would trigger “the worst financial crisis since 1931” – an intentionally frightening reference. EU countries have since then implemented the “Sanio doctrine” by scrupulously reimbursing all creditors, including junior ones, of almost all failed banks with few and rather small exceptions in Denmark, Ireland and the UK. That this consistent dismissal of moral hazard originated in a German decision is ironic in light of later events.

Then change has come, gradually. In Deauville in October 2010, Angela Merkel, German chancellor, and President Nicolas Sarkozy of France announced that holders of euro area sovereign debt could face losses, but soon afterwards Ireland was still forbidden from “burning” senior bank bondholders. However, policy makers slowly realised that guaranteeing all bank liabilities reinforced a damaging “doom loop” between banks and sovereigns. In July last year, Mario Draghi, president of the European Central Bank, noted that “the question of burden sharing with senior bond holders is evolving at the European level”. Spain’s bank restructurings later that year imposed losses on many subordinated creditors. Earlier this year Ireland negotiated a deal that involved a loss for some senior bank bondholders. A largely silent revolution was instilling more market discipline into the financing of Europe’s banks.

This gradual shift was welcome. But in Cyprus it accelerated out of control, all the way to full “Mellon doctrine”. The island’s two biggest banks are now being liquidated, even though the process is administrative rather than judicial, with no government financial assistance. In an echo of Deauville, European leaders signalled on March 16 that deposits were no longer safe, after which the German finance minister Wolfgang Schäuble confirmed that deposit guarantees were “only as good as a state’s solvency”. This move annihilated trust in Cypriot banks and made the imposition of capital controls inevitable.

Just as the Sanio doctrine was made unsustainable by moral hazard and fiscal constraints, the Mellon doctrine is made unsustainable by the reality of systemic risk – today as in the 1930s. In fairness to Mr Dijsselbloem, he acknowledged that governments may not impose full financial discipline “in times of crisis”, but then implied that we are in no such times right now: a heroic claim. Governments have a responsibility to protect their citizens from catastrophic meltdowns. This is why a chastened US government had to bail out AIG, the insurance group, a day after letting Lehman Brothers go bankrupt.

As the US learnt the hard way, predictability is essential in such matters but also difficult to attain. Europe must now chart a path between untenable Sanio and unrealistic Mellon.

The trade-off is not only between moral hazard and systemic fragility, but also between national fiscal responsibility and European integration. The eurogroup’s new insistence that “all insured depositors in all banks will be fully protected” may or may not be seen as a form of “deposit reinsurance”, meaning that a deposit guarantee can indeed be stronger than a member state’s own solvency. But this declaration will have little impact on depositors’ behaviour unless a European backing of national deposit guarantee systems is made explicit.

Similarly, the insistence on orderly bank restructurings in an integrated market calls for a centralised process, which should be in place before the ECB conducts a comprehensive balance sheet assessment of all 150-odd banks transferred under its direct supervisory authority, a deadline now planned around mid-2014. The clock is ticking.

This article was first published in The Financial Times.

Let’s start with Cyprus. The table below shows the return on assets and equity of the seven largest Cypriot banks in 2011 (and 2010 for one of the banks; more recent data is not available).

Source: The Banker Database

Laiki Bank lost more than $5bn in 2011, which is 12.2 percent of its assets and 162 percent of its equity. This loss is indeed dramatic. Bank of Cyprus lost $1.7bn, which is 3.6% of its assets and 19 percent of its equity in 2011, which are also large figures. However, the returns of the other banks were not that bad, at least in 2011.

What about other countries? The figure below indicates that compared to Cyprus, Luxembourg has a much larger banking sector relative to GDP, the relative size of banks in Malta and Ireland is similar, and not much smaller in the UK and Denmark. Ireland already has a financial assistance programme, including a programme for restructuring the banking system, so let’s look at the other four countries with large banking sectors relative to GDP.

The Figure below shows return on assets of banks. Cyprus is clearly an outlier. Banks in Malta and Luxembourg were rather profitable during the past four years, while Danish and UK banks had close to zero return.

Source: IMF eLIBRARY Data, http://elibrary-data.imf.org/DataExplorer.aspx

Cypriot banks recorded profits in 2009 and 2010 and their profitability started to deteriorate in 2011. A main reason for Cypriot banks getting into trouble was their exposure to Greece. But the share of non-performing loans also started to skyrocket in Cyprus (see the chart below), suggesting that there are major problems with domestic loans as well. While this share has also increased somewhat in Malta, it is not comparable to the Cypriot problem, and as we pointed out using the previous chart, banks in Malta remained very profitable (how do they do this?). The share of non-performing loans is quite low in Demark and the UK, and almost zero in Luxembourg.

Source: IMF eLIBRARY Data, http://elibrary-data.imf.org/DataExplorer.aspx  

Overall, banks in other EU countries with large balance sheet relative to GDP continue to have profits, or close to zero returns, and the current shares of non-performing loans do not suggests that their profitability will deteriorate in the near term. While there is no reason to be complacent, as Cypriot banks were also profitable in 2009 and 2010, but Cyprus is clearly different.