The G20 was created in extraordinary times. Its initial focus was on coordinating a global stimulus to ward off depression, equipping the IMF with sufficient resources to cope with potential requests, and beefing up global liquidity.

Data confirms that a stimulus was engineered not only in the advanced G20 group but also, and to a broadly similar extent, in the emerging group. Russia, India and China were among the countries where the 2008-09 effort was greatest. With hindsight, whether or not the IMF was right to call for a uniform response is a matter for discussion. Spain, especially, took part fully, but soon realised that it had overestimated its fiscal space. The IMF in this respect lacked caution. However it was probably wise to advocate an across-the-board stimulus, rather than a tailor-made one whose preparation would have taken precious time and opened the door to endless disputes.

The London summit also agreed on a $500 billion increase in IMF resources and on a special allocation of SDRs. The increase in IMF resources made a large increase in lending possible. Without the replenishment of resources at the time of the London summit, the commitment capacity of the Fund would have been severely constrained already in 2009.

Summing up, in this first period the G20 achieved fostered coordinated responses to the global crisis. For a group of rather heterogeneous countries with little tradition of dialogue and joint action, this must be considered a significant achievement.

The aftermath was more complicated because it involved addressing a conceptually debatable and politically delicate issue: the so-called global imbalances. The intellectual background to the policy agenda was the fear that the recovery would leave these imbalances largely untouched. The goal, to quote from the Pittsburgh declaration, was to develop “a forward-looking analysis of whether policies pursued by individual G20 countries are collectively consistent with more sustainable and balanced trajectories for the global economy” that would feed into the leader’s discussions and help decide on joint action. This was the purpose of the ‘Mutual Assessment Process’ (MAP).

This was a difficult endeavour. To start with, there had never been a consensus among economists on the risks involved in the persistence of global imbalances. Second, previous attempts at global discussions on imbalances had failed to deliver any meaningful result. Third, the G20 itself experienced difficulties with the topic, as indicated by the absence of an explicit reference to it in the Washington summit declaration of 2008.

As conducted for the Toronto and Seoul meetings, the MAP was a cumbersome exercise technically. At the Seoul meeting it was agreed to ‘enhance’ the MAP by outlining ‘concrete policy commitments’ for each of the members. This agreement opened the way to a more ambitious attempt at multilateral surveillance. A set of indicators and guidelines intended to help tackle global imbalances through policy adjustment in the key countries was adopted in April 2011. Recommendations were issued as part of the Cannes G20 Action Plan: there was agreement on differentiated budgetary consolidation strategies, including through letting automatic stabilisers work in Australia, Brazil, Canada, China, Germany, Korea and Indonesia.

The process however faces three difficulties. First, the model of international interdependence underlying the MAP may not capture the relevant channels of transmission of shocks. It puts emphasis on interdependence through flows and prices, while empirical research, notably the evaluations provided by the IMF in the context of its spillover reports, emphasises interdependence through cross-border holdings of financial assets. Interdependence through traditional channels can be dwarfed by that arising from gross holdings of financial assets and the bellweather role of US capital markets.

Second, the whole exercise is predicated on the assumption that global imbalances will remain a serious concern for the world economy. The pattern of imbalances, however, has changed significantly with the reduction of the Chinese surplus and the rise of those of oil-producing countries. Some observers do not see current-account imbalances as a problem but as a normal response to the asymmetry in the state of public finances between the advanced and the emerging countries. There is a difficult trade-off here: to keep focusing on the same issue helps narrowing down differences through the development of common concepts, indicators and guideposts. As indicated by the European experience, however, this process takes time. Keeping the focus on a particular set of issues involves the risk of focusing the policymakers’ attention on the wrong issues.

Third, it is not clear which of the participating countries is ready to trade a change in its own policy for a change in its partner’s policy. Would, for example, a Chinese exchange-rate adjustment facilitate a US budget agreement?

On the whole, this second period was clearly less successful than the first.

The third phase started in Cannes in November 2011. The summit was meant to be devoted to global discussions, not least about reforming the international monetary system, but it was largely hijacked by the euro crisis. In the months that followed, the international discussion was again largely dominated by the European crisis.

Decisions announced on the occasion of the 2012 IMF/World Bank spring meetings in Washington resulted in pledges to increase IMF resources by $430 billion. Although these resources are not earmarked for any particular country, they are widely regarded as motivated by the precarious state of the euro area and some countries within it.

On this occasion however the G20 as an institution failed to provide the ‘premier forum for international economic cooperation’ that it said it would be. First, two major members, the US and Canada, broke ranks with the consensus on increasing IMF resources. Second, disagreements on the policy prescription for Europe could not be resolved. In a context of serious concerns about the pace of the recovery, the communiqués from Mexico (February) and Washington DC (April) did not go beyond platitudes.

There are probably two reasons for this disappointing result. First, Europe is difficult because of its internal coordination process. Two-level coordination (ie coordination within the EU and between the EU and external partners) is inherently difficult. Second, the problem at stake is highly asymmetric. The rest of the world expect from Europe that it sorts out its problems and while it has shown willingness to extend a helping hand, this inevitably comes with strings attached: emerging countries want more say in exchange. This is not the easiest of all sorts of dialogue.

In conclusion, macroeconomic coordination has delivered less and less. To what extent is this decline in effectiveness due to the nature of the problems on the agenda and to what extent to the evolution of the dialogue and the participants’ commitment to the process? There is no easy answer to this question. Clearly, what was done in 2008-09 was by nature exceptional and the subsequent steps were bound to be of lower intensity. Also, the mere willingness to discuss global policy issues and their national ramifications is a non-negligible achievement. Issues, at least, are increasingly named.

Yet the outcome remains disappointing. One cannot but ask questions about the ability of the G20 to avoid the traps that, over time, greatly reduced the effectiveness of the G7/G8 summits. It is certainly too early to claim that the G20 has failed, but early enough to wonder whether it is on track towards lasting success.

We want to summarize their statements and compare them to what is being said in the German National Press and blogosphere, both of which appear much more skeptical about the possibility of a Greek exit.

The German minister of Finance, Wolfgang Schäuble, stated in an interview with the “Rheinische Post” on 11 May 2012 that Europe has the capacities to cope with a Greek Euro area exit. He said that Germany and its partners had learned a lot during the last two years and have put in place several protection mechanisms. Moreover, the risk of contagion to other countries has declined in the euro-zone and it has become as a whole more resilient. There is no other, easier way for Greece to remain in the euro-zone than implementing the reforms on which the member states agreed.
According to Spiegel online, he declared recently that Greece cannot have the one (stable government) without the other (meeting their obligations). Moreover, he  said on Sunday 13 May 2012, that Germany would be a strange government, if it was not prepared for all possible scenarios in order to cope with them.

Foreign Minister Guido Westerwelle declared according to an article on Spiegel online that whether Greece remains in the euro-zone or not, lies completely in the hands of the Greek. If Greece did not follow the started reforms, he would not see that the outstanding tranches for Greece will be paid off. ECB board member Jörg Asmussen, told the Handelsblatt that Greece must pursue the agreed reform programme if it wants to remain member of the euro-zone. The chief executive of the Federal Association of German Banks (BdB), Michael Kemmer, also believes that the euro-zone could cope with Greece’s exit and that the immediate impact would be limited. However, Kemmer believes that an exit would result in risks of contagion and would reduce the confidence in the existence of the common currency. Even German ex-Finance Minister Peer Steinbrück (SPD) considers a Greek exit inevitable and underlines the importance to be prepared for it.

On the contrary, the German press does not share exactly the same position.

The Frankfurter Allgemeine Zeitung  is aware of the negative impact a Greek Euro-zone exit would have on both the Greek as well as on the world economy and believes that there are currently still more reasons for Greece to remain in the Euro-Area rather than to exit.

In Die Welt, Martin Greive wrote on Sunday 13 May 2012 that while more and more bankers, politicians and economists speak of a possible Greek exit, one should not forget that this move will be highly expensive for Germany. This is particularly due to the fact that Germany would have to amortize the contributions already paid to Greece.

Daniela Schwarzer  looks  at the possible Greek exit from a Euro area perspective and concludes that the latter should do what it can to keep a defaulting Greece within the currency union rather than letting it exit. Apart from the negative impact this would have on Greece, an exit would have considerable negative effects on the European Union. First of all, the banking sector would be destabilized in the other member states. Euro deposits in a Greek bank would be worth a new drachma and the latter would see a strong devaluation. This would lead to a capital flight from other member states under pressure to countries such as Germany.
Secondly, from a political point of view one cannot promote a possible Greek exit: leaving the Euro area but not the European Union is, first of all, not compatible with EU law and would thus need a political solution. Then, the co-operation with Greece, as a EU but not a Euro zone member state would be challenging. Thus, there is no reason for a default to entail an automatic exit from the Euro area.

Thomas Fricke wrote on 11 May 2012 in the Financial Times Deutschland that one cannot make a comparison between Greece in 2012 and Germany in 2005, although there are some similarities such as the high unemployment rate and the hard, but needed reforms. However, there are still important differences: the unemployment rate is substantially higher in Greece and the political parties are more radical. What Greece needs are realistic targets to reduce the deficits in the medium term and no brachial experiments.  It is absurd to blame Greece now that they did not render possible, what in fact is impossible. Otherwise, this will lead to a panic euro-exit, which could drag Germany itself into the abyss.

However, “Acropolis Adieu! Why Greece must leave the euro” reads the front-page headline of the German magazine Der Spiegel on Monday 13 May 2012. It is time to realize that the rescue policy has failed, notably due to the disinterest of Greek politicians to implement reforms, and that Athens should now exit the currency union. Preparations are already made both at EU and at national level: the “Taskforce Griechenland” is working since one year in the German Ministry of Finance in order o prepare a possible Greek exit. Nevertheless, European solidarity is not bound to the Euro and the EU27 instead of the euro-zone members will contribute to support Greece also after an exit. This would be an advantage since it would include Great-Britain as contributor.

It will be interesting to follow the evolution of the public opinion, whether or not this stays in line with official declarations.

This is essentially the strategy that was pursued in Ireland in 2010 and that produced the results we know so well: cumulative banking sector losses in excess of 35% GDP and the resulting dramatic fiscal cuts. Arguably the banking system in Spain is different, total banks’ assets as a percentage of GDP is significantly smaller (330% in Spain vs. 979% for Ireland in 2010) and asset quality might be better. But the heart of the problem is the same: the euro area has a single market for financial services, a single monetary policy but national banking supervision, national guarantee of deposits and no European mechanism for banking sector resolution. The Spanish banking crisis is really a European banking crisis and in this sense cannot be solved alone by the Spanish government regardless of its merit and good intentions.

This solitary strategy has been tried and tested before and everywhere produced similar catastrophic results for taxpayers. There is no reason to believe that Spain could be different. In fact, solving together the Spanish banking crisis would not only be better for Spain because it would allow sharing the associated fiscal risks but it could also set Europe on a path towards a real pan European banking policy that would preserve taxpayers resources in the event of crises, improve financial stability and contribute to restart credit supply and economic growth. This is all within reach and should be an integral part of the “growth compact” that European Heads of State and Government will negotiate in June because the single biggest risk to growth in Europe today is that of prolonged financial distress.

The Kingdom of Spain should then formally request a financial assistance program specifically and only designed to address, recapitalize and restructure its banking system. Ideally, it should be accompanied by a precautionary program that would secure Spain’s access to financial markets and allow Spanish authorities to carry out their current fiscal adjustment without additional austerity measures. In practice, the ECB and the European Commision assisted by financial sector experts would propose a restructuring plan endorsed by the eurogroup that would be binding to Spanish authorities and the EFSF/ESM would provide the necessary capital.

For the banking system, this would necessarily involve further mergers, restructuring and possibly bankruptcy of some banks, which Spanish authorities alone, would have certainly found unpalatable. The European oversight and provision of capital would ensure that this restructuring process is taking place swiftly and in the best interest of the European financial system as whole outside of potential capture by regional, national, financial and political interests. More importantly, this process would create a precedent and the embryo of a real federal banking resolution framework along the line of the US FDIC, whose absence in Europe has been so costly to growth, employment and European taxpayers. Spain holds in its hands an historical opportunity to both solve its domestic banking crisis with its partners while planting the seed of a more stable European financial system, it should not waste this chance and risk more economic hardship for its people and for Europe at large.

A version of this column was also published in Spanish in La Razon

Une grande ambiguïté règne cependant, car des orientations très diverses se retrouvent sous le même étendard de la croissance. Dans ces conditions, François Hollande a le choix entre deux stratégies. La première est de se satisfaire peu ou prou des fruits qu’on va lui tendre et de déclarer victoire, pour pouvoir signer le traité budgétaire. Ces fruits, ce sont la création de project bonds associant implication publique et capitaux privés afin de rendre attractives des obligations trop risquées pour trouver aisément preneur sur le marché ; une recapitalisation de la Banque européenne d’investissement (BEI), actuellement menacée de perdre son AAA, pour lui permettre, au moins, de maintenir son volume de prêts ; un meilleur usage des fonds structurels européens, qui répondent trop souvent à une logique d’abonnement et mériteraient d’être mis au service du redressement économique ; ou encore des initiatives ciblées financées sur le budget communautaire.

Tout cela mérite attention. Mais il faut raison garder: l’Europe est déjà le continent le mieux doté en infrastructures ; elle sort à peine d’une bulle solaire induite par des subventions trop généreuses au regard de l’état de la technologie ; les fonds structurels ne pèsent macro-économiquement que dans quelques pays ; et, de toutes façons, quelques dizaines de milliards de nouveaux projets ne suffiront pas à redresser une économie dont le PIB est de 12.600 milliards d’euros.

L’autre stratégie est plus ambitieuse. Elle consiste pour le nouveau président à investir son capital politique dans une négociation de fond sur la solution aux problèmes systémiques et macroéconomiques qui menacent la prospérité et, à terme, la survie même de la zone euro.

Les problèmes systémiques tiennent à la fragilité d’une union monétaire incomplète en voie de désintégration financière sous l’effet de l’arrêt des flux de capitaux Nord-Sud et de la pression exercée sur les banques par les régulateurs nationaux. Une zone euro assise sur un marché des capitaux fragmenté perdrait beaucoup de sa raison d’être, c’est pourtant dans cette direction qu’elle continuera sans doute à se diriger si l’Europe n’engage pas la construction d’une union bancaire mettant en commun assurance des dépôts, supervision et mécanismes de résolution des crises bancaires, et ne réfléchit pas à des formes de mutualisation des dettes souveraines.  

Les problèmes macroéconomiques tiennent à la difficulté d’un rééquilibrage Nord-Sud après dix ans de dégradation de la compétitivité relative du Sud. Ce rééquilibrage passe inévitablement par des ajustements douloureux, dont l’austérité budgétaire est une composante, mais il ne peut se résumer à une série d’efforts sans contrepartie de la part des pays en difficulté. Il revêt aussi une dimension collective : demander au Sud de regagner la compétitivité par la déflation serait l’emprisonner dans le double carcan de la dette publique et de la dette privée, et donc augmenter considérablement les risques d’échec. La solution passe, plutôt, par un meilleur dosage des efforts budgétaires et une hausse des salaires au Nord. Avec 2% d’inflation moyenne dans la zone il faut, pour les années à venir, nettement moins de hausse des prix au Sud et nettement plus au Nord. Il importe donc de convaincre le Nord, qui commence d’ailleurs à en prendre conscience, d’accepter cet écart, et de s’engager à ne pas tenter de contenir sa propre inflation tant que la stabilité des prix restera assurée en moyenne dans la zone euro.       

Cette seconde stratégie est d’une toute autre ampleur que la première, elle comporte des risques, et elle est consommatrice de capital politique. Une union bancaire ou la mutualisation des dettes, avec ses inévitables contreparties budgétaires, impliqueraient un engagement européen politiquement coûteux au vu du premier tour. Et la France ne peut demander des efforts à l’Allemagne sans être prête à en faire elle-même, tant en matière de gestion des finances publiques que de réformes de compétitivité.

Pour un dirigeant politique normalement constitué la tentation doit être forte d’adopter la première stratégie, et de déclarer victoire à peu de frais avant de passer à autre chose. Dès avant la brutale aggravation de la crise politique grecque, cette réponse n’était déjà qu’un faux-semblant. La choisir au moment où menace la rechute serait accepter le danger d’un éclatement de la zone euro d’ici la fin du quinquennat.

Désolé M. Hollande, ce n’est pas le moment d’être normal.

A version of this column was also published in Le Monde

In Germany, the elections in North Rhine-Westphalia (German’s most populous state and not Schleswig-Holstein as I mistakenly wrote last week, apologies for this…) brought a victory for the SPD and the Greens. The CDU collapsed to its post war low while the FDP surprisingly held up (around 8%) which, at the Federal level, should help keep the coalition together until the 2013 election. The pirates did a fairly strong showing at 7.5% and will enter the parliament in NRW but are lower than their recent national polls. These domestic political considerations will be important in future European negotiations and are likely to tilt Merkel towards a softer stance. In addition, with respect to domestic German developments, it is important to monitor domestic wages dynamics and the resumption of wage bargaining with IG Metall due to restart on May 15^th. In this context, the speech by the Bundesbank chief economist Jens Ulbrich in the Bundestag on May 9^th is particularly interesting and somewhat encouraging. It shows acceptance for a future with higher inflation in Germany: “adjustment processes will lead to an improvement of the competitiveness of peripheral countries vis-à-vis German. In this scenario, Germany should be expected to show inflation rates above the EMU average in the future, although monetary policy will have to ensure that inflation overall in the euro area is consistent with the objective of price stability”.

Meanwhile, in France, Hollande is preparing to take office on Tuesday (he will fly to Berlin on that very day) and announce his government on Wednesday. Attention has already turned to the May 23^rd informal dinner of the European Council where the outline of the “Growth Compact“ ought to be negotiated. From what I understand, this outline is broadly consistent with what I wrote last week but there are important elements missing in particular with respect to Spain and Greece.

1.    Spain and the way to a banking union

2.    syriza needs a sensible European response

3.    The path to Eurobonds

Spain and the way to a banking union

I published a short OpEd for La Razon this weekend where I basically argue that the new financial sector plan presented by the Spanish authorities (see their presentation attached) see their presentation attached  is unsatisfactory. My main argument is that we are passed the point where Spain can solve its banking sector challenge on its own. The program is well designed and its cost could possibly be met. But confidence has slipped too low to give this plan a chance and the probability that its implementation will press the Spanish government’s borrowing cost to a level that challenges its very own debt sustainability.

As a result, Spain should rapidly request a European plan to restructure and recapitalize its banking system. Beyond Spain, this plan would set a precedent to design the contours of a banking resolution framework that could be institutionalized and applied across Europe following the Spanish experience.

In the short term, financial means are not the main challenge. The EFSF and the ESM can actually be used to this effect. Hence, even though it would be preferable if the EFSF/ESM could take equity stakes directly in the banks, with some financial engineering, the EFSF/ESM loans to the Spanish government could, be structured like quasi-equity stakes in the banking system.

What is key is the acceptance that the lenders will participate in the upside if the restructuring works as planned and more importantly and politically challenging that the lender will make losses over and above a certain threshold to ensure that the Spanish government doesn’t become insolvent if the banking sector restructuring ends up costing more than initially assumed. But this agreement doesn’t need to be absolutely explicit so long as it is understood as such by the different stakeholders and by financial markets. (Today, financial markets understand that there will be an official sector involvement in Greece at some stage even though this is still forcefully objected my most European policymakers)

Beyond the financial aspects, the main challenge really is to design a banking sector resolution/restructuring effort with the various stakeholders ensuring both effectiveness and accountability. The reality is that there should be a dedicated institution for this (a European FDIC lodged by the ESM for instance) but the other reality is that there is no time to create this new institution and Europeans have to work with bits and pieces of existing institutions and within the broad operational framework of an EFSF/ESM program.

The program should be designed and targeted specifically at the banking system and have no conditionality related to fiscal policy other than the current plan presented by the Spanish authorities (which will have to renegotiated). In this program:

·         The ECB and the EBA would spearhead and take the technical responsibility for a deep analysis of Spanish banks’ balance sheets possibly by enlisting the expertise of private sector specialists.

·         On the basis of this analysis, they should propose, along with the Commission a restructuring Memorandum of Understanding that would involve concrete steps to be implemented by Spanish authorities.

·         The eurogroup would approve this MoU and be politically accountable for it while the ECB/EBA and Commission would be in charge of its ongoing monitoring. Performance criteria with specific deliverables should be designed to ensure ongoing involvement of the Spanish authorities.

·         In addition, once the banking sector program is agreed and for the entire period of the program (which could well last several years), the IMF and the EFSF/ESM should extend a distinct precautionary program to Spain. This would come with no additional fiscal consolidation strings attached but could be suspended at any time if Spain doesn’t meet the performance criteria of the restructuring MoU.

With the framework aforementioned, financing and burden sharing would be made available, credibility and technical assistance would be provided and policy conditionality would finally be placed on the restructuring of the financial system and not on fiscal policy. We would start dealing with the disease and not only with its symptoms.

In addition, if Spain had the courage to engage in this direction, it would force Europe as a whole in the much needed direction of a real banking union that includes, a real federal supervision, a real supranational guarantee of deposits and a credible resolution framework.

European HoSG need to understand that the single biggest risk to the European growth outlook today is the instability of the banking sector. Dealing credibly with Spain at the European level could be the single most important item of a meaningful “growth compact”.

Greece needs a sensible European response

I have written last week that the rise of syriza confirmed the collapse of the previous political order. Although certainly worrying in the short term, this is possibly good news for the medium to long term. We are witnessing an accelerated recomposition of the Greek political system. And despite the commotion that it is creating, anti-European parties are getting far less votes than in a country like France!! This is quite remarkable.

The current dynamic is very fluid but if there is a coalition unity government without syriza, it will be able to achieve little and will ensure syriza a large victory at the next election (the first polls after the election were making syriza the first political force in the country rising from 17% to 23%). Pressure on syriza to join a national unity government is extremely high but it might well choose to precipitate elections so as to form a government over which it would have true control.

In this context, the current deadlock where on one hand syriza claimed it wanted no program whatsoever and on the other German representatives claim that they wanted the program, all the program and nothing but the program needs to be resolved.

Despite its initial confrontational stance, syriza has made a notable U-turn this week and is rapidly morphing into a potential government party. It now insists it wants to renegotiate the current program and doesn’t seek its annulment. Europeans need to respond to this U-turn by acknowledging that indeed, the current program is not tenable, it is not yielding the expected results and it therefore can and should be renegotiated through an open discussion.

But the reality is that only Germany can say this publicly. Hollande might be closer intellectually to this thinking but he cannot come out publicly on the matter without giving the impression that he is ransacking three years of European negotiations and opening a real rift with Germany.

European capitals need to stop demonizing syriza and start engaging with what is now clearly the largest political force in Greece. This discussion will rapidly raise important questions for all: how far can syriza go in delivering structural adjustment, administrative changes? How much losses Europeans are ready to take on the 240bn committed (146bn disbursed) to Greece? Are they ready to put more money into it now, either by increasing their commitments or by frontloading existing commitments?

These questions need an urgent answer and require all stakeholders to return to the negotiation table. The time for posturing is over.

The path to Eurobonds

I was invited to the European Parliament to give a short presentation a short presentation  on Eurobonds last week. I didn’t realize how far the parliamentary debates had gone on this matter. Parliamentarians rightly want to push the European Commission to draft a roadmap for eurobonds.

This is encouraging but in the precipitation, the parliament risks engaging on a path that fails to build on the strength and weaknesses of the various Eurobond proposals and give undue preference to the German Debt Redemption Fund. Indeed, the increasingly accepted view seems to be that the European Redemption Fund should be favoured in the short term while our analysis suggests that it is not the option that maximizes financial benefits and minimizes political costs.

Indeed, our assessment so far is that the European Redemption Fund was largely designed to meet real or perceived German political and legal constraints but it has important economic and financial flaws: (i) it forces to decide and know today which countries are solvent which ones are not, (ii) it isn’t designed to respond to future macroeconomic shocks and (iii) it forces an adjustment path on some countries (in particular Italy) that has never been observed in the developed world recent history (4% of GDP of primary surplus for the next 20 years).

Europeans need to engage a deep analysis of the many different Eurobonds proposal, assess their respective strength and weaknesses and design a possible path towards a solid form of common debt issuance in the euro area.

Our recent work suggest that one possible path that allows to maximize financial stability benefits and reduce political costs would be to start by focusing on short term debt through the common issuance of eurobills. This would have limited political cost since the process offers an effective veto power to creditor country every time the bills need to be rolled. This would be an important precedent and would show that Europe is making concrete steps in the direction of a more integrated fiscal union.

Happy to have your thoughts as usual,

Best Regards,

Shahin Vallée

The importance of CRD4

Karel Lannoo of the Center for European Policy Studies points that the EU is the only jurisdiction codifying Basel 3 in EU law for application and implementation in the national law of 30 states, whose banking system represent one-half of the world’s banking assets. Other jurisdictions leave this responsibility to the discretion of national supervisory authorities. The Commission’s proposal is hugely complex, composed of a Regulation consisting of 488 articles and 4 annexes and a Directive consisting of 154 articles and 1 annex – in total good for about 220,154 words!

Benoît Cœuré, member of the executive board of the ECB, said in a recent speech that the ECB regards the single rulebook as a major step in the establishment of a true financial union. We consider the introduction of a single rulebook in the EU as an important step towards establishing a single market for financial services and enhancing financial integration in Europe. One of the benefits of this rulebook would be a commonly agreed definition of regulatory capital. The consistent application of such a definition would make it easier to compare eligible capital instruments from bank to bank within the EU, thereby strengthening the confidence of market participants in the loss-absorbing capacity of banks’ capital and, more generally, in the resilience of the EU’s financial sector.

What is CRD4 building on?

CRD4 is composed of two legislative instruments: a directive and a regulation. The directive needs to be transposed by member states into national law, while the regulation is applicable directly. Its key elements include:

1.       Capital rules

a.       More and better capital

b.      Higher risk weights

c.       A conservation buffer

d.      A countercyclical buffer

2.       Liquidity rules

a.       Short term stress liquidity ratio applicable in 2015

b.      Longer term Net Stable Funding Ratio applicable in 2018

3.       Leverage

a.       Leverage ration backstop (with a view to binding measure by 2018)

The main issues

In his Sunday Wrap-Up email, Erik Nielsen argues that there are three key issues:

·         First, while appropriate for the longer term, the very idea agreed some 18 months ago by the Basel Committee on Banking Supervision to raise bank capital requirements, reduce leverage etc is inherently pro-cyclical in the current environment, and comes on top of an aggressive fiscal tightening implemented in many countries while the US has not even started considering how they’ll implement Basel III. 

·         The second issue relates to the definition of capital when turning the Basel III agreement into legislation.  Possibly under pressure from Berlin and Paris, the European Commission has defined capital in a way that seems to benefit German banks with respect to “silent capital” and French banks with respect to insurance subsidiaries. 

·         The third issue relates to whether individual member states should be allowed to impose stricter rules, e.g. higher capital requirements, on their banks without prior approval from Brussels. Basel III suggests that countries should be encouraged to do so, and the UK is adamant that it wants to exercise this option; i.e. put stricter requirements on UK banks than required by Basel.  But the European Commission sees the EU as one entity because of the single market, and argues therefore that individual national rules would distort competition.

The maximum harmonization approach

Martin Wolf makes the case against maximum harmonization in EU banking. The UK wants to preserve its discretion in raising capital requirements, on the grounds that the consequences of failing to do so would fall on its own economy and taxpayers: responsibility should align with consequences. The proposal, in contrast, seeks to limit such freedom. The idea that member states should be prevented from making their banking systems “too safe” goes under the rubric of “maximum harmonisation”. It is a weird notion. Why, in sum, should anybody complain about a “race to the top” in banking? One argument is that if a country were to insist on higher capital, lending by its banks might shrink within other member countries. Wolf argues that, while negative spillovers from higher standards are conceivable, it cannot be legitimate for the European regulators, who are not fiscally accountable, to force member states to bear risks that its nationally accountable regulators view as excessive. This would not be a problem if banks could be resolved without adverse economic, financial and fiscal consequences. But that is not the case.

Benoît Cœuré points out what the ECB proposed in its Opinion on this issue. The ECB proposes the possibility for national authorities, within the framework of a single EU rulebook, to adopt – with specific safeguards – stricter requirements in their respective Member States for macro-prudential reasons. This is necessary because Member States need to address country-specific financial stability concerns stemming from different structural features of their domestic financial systems. It is key that the possibility for Member States to apply these stricter requirements should be framed within the single EU rulebook framework. To this end, specific safeguards should be put in place. First, definitions should remain intact; only quantitative ratios and limits can be tightened. Second, the European Systemic Risk Board could play a coordinating role in assessing financial stability concerns and possible unintended consequences and spillovers to other Member States. Furthermore, the European Banking Agency (EBA) and the ESRB should publish regular updates on their websites of measures adopted by Member States and the underlying reasons for stricter requirements. Third, where financial stability concerns that triggered the application of more stringent measures cease to exist, the quantitative ratios and limits should return to a harmonized level set by the regulation.

Erik Nielsen writes in a recent research paper that the Commission is absolutely right on this one. The EU desperately needs one single bank supervisor and one single “underwriter” of the banking system, i.e. a common deposit guarantee and a common resolution mechanism. It is now glaringly clear that one cannot have a functioning monetary union without a “banking union”.  His personal view is that if any of the ten EU members who are not eurozone members try to block such further integration, then the eurozone will need to create arrangements for themselves and leave non-EMU-EU members behind on a slower track. 

The limits of CRD4: the reliance on banks’ risk management models

Jacopo Carmassi and Stefano Micossi argue that CDR4 fails to delink the calculation of capital requirements from banks’ own risk management models. In the Basel III Accord capital requirements are still calculated with reference to risk-weighted assets and even broader national discretion. In their evaluation of banks’ internal models, the UK’s Financial Services Authority shows that internal models produce widely divergent risk assessments of identical portfolios, making them unusable for any objective evaluation of risk exposures. The models used by banks in the calculation of risk-weighted assets suffer from fundamental technical flaws that have been exposed by a blooming literature but are ignored by Basel regulators. Among other things:

·         The models are estimated from non-stationary time series and thus have weak predictive value for large changes in the state variables;

·         They are almost by assumption unable to account for systemic risks, when expectations converge and correlations between portfolio performances rise dramatically; and,

·         They actually create incentives for banks to concentrate their exposures in the tail of risk distributions in order to economize capital, thus raising the probability and the impact of rare catastrophic events actually happening.

Of demand and supply of safe collateral

Manmohan Singh points to the problem that recent regulatory efforts will require significant collateral on many fronts – Basel’s liquidity ratios, EU Solvency II and CRD IV, and moving OTC derivatives to CCPs. Unless there is a rebound in the pledgeable collateral market, the likely asymmetry in the demand and supply in this market may entail some difficult choices for the markets and the regulators. Markets may create cottage industries for upgrade collateral to meet regulatory needs, which may not all be transparent. Also regulators may, due to collateral constraints, see some facets of financial industry shrink. Alternately, it is also possible that regulatory efforts may have to prioritize proposals to bridge the collateral shortfall.

Colm McCarthy notes that, according to calculations from Karl Whelan, the 0.5% deficit/GDP rule envisaged in the ‘fiscal compact’ eventually yields a debt ratio at only 17% of GDP. This happens whether you start from zero or from Greece. The liquidity part does not (yet) specify a quantitative ratio of liquid to total assets but could turn out to require 20% or 25%. If balance sheets end up at something sensible like 150% of GDP (UK currently 400%), this implies say 35% of GDP needs to be available as high-quality liquidity. Aside from central bank money, this means short (< 5 yr) sovereign bonds. It can’t all be central bank money (or if it can, explain how monetary policy would work). If the debt ratio drops much below 50%, sovereign debt duration has to drop dangerously. There are reasons for not having too many sovereign bonds about. There are also reasons for not having too few.

Korea’s accounting standards, and the quality of financial information, have improved since the adoption of IFRS in 2011, but comparability between financial statements has declined.

• IFRS was first adopted for listed companies in EU member countries in 2005. Since then, it has expanded rapidly across the globe, leading Korea to also adopt the standards for its listed corporate bodies and most financial companies.
• IFRS regards consolidated financial statements as the main financial statements, and greatly expands disclosure requirements. Therefore, transparency in accounting standards and the quality of overall financial information have been upgraded. However, it is commonly recognised that the comparability of financial statements has declined because unlike the previous Korean GAAP (K-GAAP) standards, IFRS follows ‘principle-based standards’.

The introduction of IFRS benefited Korean banks by reducing the requirement to make an allowance for bad debts, but it has become more difficult for Korean banks to dispose of non-performing loans (NPL) through securitisation. And the adoption of IFRS has increased the exposure of Korean banks’ profits to the fluctuation of foreign exchange rates.

• Under IFRS, bad debts remain on the books even if the bank sells the debt to a third party through securitisation – where the bank is connected to the liquidised asset through subordinated debt or payment guarantee [1].
• Direct investment in a foreign subsidiary is classified as a non-monetary asset where there is no profit and loss with the fluctuation of the exchange rate. On the other hand, the investment source is financed with monetary liabilities, which are subject to foreign exchange risk if there is no hedging [2].
• Impairment of marketable securities directly affects net profit under IFRS, thus requiring enforcement of risk management on those securities.

In order to effectively utilise financial information for loan evaluation, Korean banks need to reshape their credit-rating models and re-educate loan officers.

• Annual IFRS financial statements are being disclosed for the first time in the first half of 2012. So, use of financial information based on the previous K-GAAP standard will no longer be comparable.
• Also, a wide range of footnotes needs to be effectively utilised in the process of credit-rating evaluation.

Korean banks will have to enhance their loan-information infrastructure in order to prudently adapt to further changes in the accounting standard for loan losses.

• Unlike the previous incurred-loss model, the expected-loss model of ‘IFRS 9 Financial Instruments’, which may be adopted in 2015, distributes credit loss provisions until maturity. So, a database of loan loss information needs to be developed in order to reflect long-term loss as a whole. 

Empirical studies [3] of 90 EU banks showed that the cost of equity capital rose after the mandatory adoption of IFRS in 2005. But, countries with efficient legal enforcement [4], such as Belgium, Denmark, Germany and the United Kingdom did not see an increase in their capital costs.

• This indicates that prevention of false reports through legal enforcement rather than increased disclosure requirements is more effective in alleviating information asymmetry.

In an effort to embed IFRS in the banking sector, the authorities should provide more transparent disclosure guidelines, and enhance enforcement to prevent false disclosure.

• Since the intent of IFRS is to allow a certain degree of discretion to individual firms, it would be better to provide examples of bad adoption, rather than to specify rules on how to handle each footnote.

1. For this reason, during 2010-11, domestic banks did not use the method of securitisation when disposing of insolvent obligations. This led to an energising of the NPL market in Korea.
   
   
2. Monetary assets include cash, loans, deposits, corporate bonds, etc, while non-monetary assets include stock investments, inventories, etc. If foreign assets or debts fall into monetary items, then they are evaluated using the exchange rate at the end of the fiscal year, but if they fall into non-monetary items, they are evaluated mostly using historical prices. In particular, as Korean banks expand their investments in Southeast Asia, their cross-currency exchange risk is increasing.
   
   
3. Hwang, L., J. H. Suh and S. Yim (2011) ‘The Impact of Mandatory IFRS Adoption on the Cost of Equity Capital: An Empirical Analysis of European Banks’, KIF Working Paper, December.
   
   
4. For more information, see La Porta, R., F. López-de-Silanes, A. Shleifer, R. Vishny (1998) ‘Law and Finance’, Journal of Political Economy 106, 1113-1155.

In Greece, it appears highly unlikely that elections will change the current policies. De facto, even if there was to be a new election due to the inability to form a government and at the next elections the anti-austerity Syriza party would come to dominate the political scene, there is still little it could change. The Greek adjustment path is largely set by the Troika, i.e. the European Commission, the IMF and the ECB. The Troika will not be willing to renegotiate the agreement. If they were, they would give an election recommendation to all other countries under financial assistance programmes and conditionality would lose its meaning. The Greek election shows the impotence of democracy in a state that has lost sovereignty.  

Also in France, the new president will have limited room to completely reverse fiscal policy. Francois Hollande cannot and will not enter on a large scale public spending programme. International investors are typically fiscal conservatives and will immediately react and demand a risk premium. Looking at the French economy, it is also clear that France needs ambitious reforms to become more competitive and more innovative. Already now, it has one of the largest government sectors and its fiscal performance is poor. In fact, France did not balance its budget since 1974. Instead of spending, Hollande will have to do the kind of courageous reforms that the former German chancellor Gerhard Schröder did. This is hardly in line with his election promises. But only a stronger and more vibrant French economy will increase France’s negotiating power in Europe.

But Hollande’s victory will make a big difference on the European scene nevertheless. The German chancellor Angela Merkel will be more alone in her demands. Voters across Europe clearly say that something needs to be done to improve their lives. Merkel cannot ignore these voices and more and more heads of state and government will tell her that something needs to change. Moreover domestically, her aim is to reduce income inequality and make sure that at the next federal election, the left cannot start a social campaign against her. One of Merkel’s closest domestic allies, the labour minister Ursula von der Leyen has therefore already demanded a minimum wage in Germany.

The European signal is clear: European voters ask for more demand and more demand will also be helpful for German domestic politics. The obvious solution to this constellation is to create more demand in Germany. The probably best way to produce demand in Germany is by increasing wages significantly. This is a much more effective mechanism than a short-run fiscal stimulus programme as higher wages will permanently increase income. It is also an effective way of adjusting imbalances in the euro area as German inflation will increase beyond the euro area average allowing other countries’ inflation rates to fall below the average. It is also likely that demand spillovers to other European countries will be stronger for German household income than German public sector spending. In fact, it is well known that public spending is typically targeted on domestically produced goods and has relatively little spill-over effects across borders.

The German finance minister, Wolfgang Schäuble understands the basic symmetry argument and the French elections make this argument even more important politically. He has therefore said clearly to the German wage negotiating parties that higher wage growth is absolutely warranted. The ongoing wage negotiations against the background of record low unemployment provide some evidence that wages in some key sectors of Germany may grow by 4% or more. This would imply some extra inflation in Germany beyond the two percent euro area average. In that sense, the election in France may make a big difference for Europe. It is not so much that France will be able to reverse its own policy course. But France will send the right message to Germany and Germany may change course.

A rebalancing of the euro area requires a shift of demand from Southern Europe to Germany. To date, demand in Southern Europe has dropped significantly with the strong deleveraging process ongoing in the household and corporate sector. This is a necessary and unavoidable process resulting from the overly high debt levels in the corporate, household and/or government sectors. Large fiscal deficits in some countries have been used to dampen the effect of the deleveraging on overall demand. However, large deficits will prove unsustainable and will have to be reduced eventually. The current debate about austerity versus growth is largely about the question of the best speed of fiscal consolidation in the South.

At the same time, to avoid a recession in the eurozone, more demand will need to be produced in countries of the North. The currently weak growth of the eurozone as a whole shows that insufficient demand in Germany has been created. The best way to create more demand will be by increasing German wages on the back of a strong boom in Germany. Ultimately the rebalancing will have to come from a change in relative wages with wages growing below the average in the South and above the average in Germany.  This is the real challenge Europe faces and the elections may make this happen by forcing German politics to change course on wages. Resisting wage growth and a credit boom in Germany would be a mistake. The German political system has started to understand that resisting symmetric adjustment will prove costly for Germany.

From an Italian perspective, it can be regarded as a skillful initiative to get the major political groupings to accept that there is common ground on Europe so as to maintain a continuous and credible foreign policy. But it is also relevant from a European perspective: the UK, France, the Netherlands and Poland are all countries where Europe is not consensual. The same question continues to come up there and elsewhere: is there a reasonable common ground on Europe? Can there be, should there be a Brussels consensus” (to use a variant of John Williamson’s “Washington consensus”)? An attempt will be made here to examine the problem from this angle.

Constitutional vs. partisan politics

The document in fact attempts to draw a border between constitutional politics – on which consensus is expected – and partisan politics – on which reasonable people may disagree. This is not an easy task, as illustrated last year in the debate during the referenda on the draft constitution. People in France actually disagreed on the basics: a unifying theme of the “no” camp –
to which the “yes” camp was not really able to respond convincingly –was that the referendum was about constitutionalising matters which belong to the realm of partisan politics. While participants in the Convention on the Future of Europe thought they had reached a reasonable consensus, the victory of the no in fact indicated that there was disagreement on the very principle of claiming that some choices were beyond dispute.

In France as elsewhere in Europe, there is evident dissatisfaction about the state of the European Union. There can be various interpretations of it, but polls strongly suggest that this dissatisfaction stems mostly from the state of the economy. People rightly regard European integration as an endeavour that is meant to deliver prosperity, a major European public
good. However, they do not see the prosperity and hence are dissatisfied.

The question is therefore not whether people are satisfied or not. It is whether they are dissatisfied with European integration in general or with the specific policies adopted, which are partly the responsibility of the EU and partly the responsibility of member states. And therefore, whether it is possible for them to express dissatisfaction with the way the EU is run without questioning the EU itself. The greater the scope for disagreement on how the EU is run, the more consensus there can be on the essentials of European integration.

Drawing the border between constitutional and partisan politics is thus important not only because it highlights what you agree on, but also because it establishes what you can disagree on. Bertold Brecht once told the Communist Party of the former German Democratic Republic that it should draw up a list of questions to which there is no answer because the party was
always pretending to have an answer to everything. In the same manner, what I suggest is to draw up a list of the issues on which there can be disagreement among dedicated Europeans.

European partisan politics?

Is there, however, something like partisan European politics? The widespread perception is that it hardly exists because at the end of the day, divisions are along national rather than partisan lines.

But recent research by Simon Hix, Abdul Noury and Gérard Roland sheds a different light on the issue.1 They have studied all votes in the European Parliament over the last 25 years and found that there is increasing partisanship within the institution, that is, that the members of the European Parliament vote less and less along national lines and more and more along partisan lines.

This is not to say that national views do not matter. But the trend is unmistakeable: there is increasingly a European debate in which there are disagreements between the right and the left on a certain set of European issues.

This is good news because it is an indication that you can be in favour of the EU system and at the same time disagree on specific policies, as in any country where you can accept the constitution but disagree on policies. The problem is that citizens hardly perceive this trend. Links between MEPs and the electorate are weak. Electoral campaigns for the EP are fought along different lines in different countries and issues that are divisive within the EP are not perceived at the national level.

The matter also has to be taken one step further to see what room there is for partisan politics on the main European economic policies. A simple way to investigate this is to use the intellectual structure of the report written almost 20 years ago by Tommaso Padoa-Schioppa called “Efficiency, stability and equity”.2 It breaks economic policy down into three basic elements, the three pillars of the economic policy debate: allocation policies, which have to do with efficiency; macroeconomic policies, which have to do with stabilisation, and redistribution policies, which have to do with equity.

Political parties within EU countries have different views on what is desirable as regards efficiency, stability and equity. Do those disagreements have a European dimension? Do they trigger a European debate?

Efficiency

On efficiency, my short answer is: increasingly. There are different views in the European Parliament on the extent of public regulation, harmonisation vs. competition on regulatory or tax matters, corporate governance, the role of industrial policy, etc. This has been illustrated in a number of recent 1 S. Hix, A. Noury and G. Roland, Democratic Politics in the European Parliament (place of publication: name of publisher, forthcoming). See also S. Hix, "A Supranational Party System and
the Legitimacy of the European Union", The International Spectator, vol. 37, no. 4, 2002, pp. 49- 60. T. Padoa Schioppa, Efficiency, Stability and Equity, Report to the President of the European Commission (Oxford: Oxford University Press, 1987). debates, not only over the services directive, but also over the Reach
directive and the takeover directive.

In all these issues there are different views that distinguish the right from the left. This dimension of the left-wing debate was overshadowed in the 1980s and the 1990s by the dispute between integrationists and partisans of national sovereignty. Throughout the history of the EU, and especially since the launch of the Single Market, integration has been closely associated with liberalisation. Opposition to liberalisation thus went along with opposition to integration.

But those times are over. Except in specific sectors like utilities, the de facto alliance around the Single Market between Jacques Delors the integrationist and Margaret Thatcher the liberaliser has dissolved. As integration has matured, there is increasingly a debate on the structure and regulation of European markets. There is thus room for disagreement between left and right. From this perspective, the controversy on economic “patriotism” or “nationalism” that emerged in early 2006 is very dangerous.

The risk is that it will once again overshadow the discussion on how the EU should be run and lead back to paleolithic discussions on the exclusive role
of the nation state in the protection of national economic interests.

Stability

On stability, the answer is: potentially. Within a framework where there is agreement on the need to preserve price stability and fiscal sustainability, there is also scope for disagreement on the degree of activism of both monetary and fiscal policy. To take just one example: the British monetary framework is different from that of the euro zone, yet it is also compatible with price stability and fiscal sustainability. So you can have different frameworks that meet certain requirements and at same time endorse
different views on macroeconomic policy.

The problem here, however, is that there is still too little debate on these issues, in part because monetary issues are beyond the reach of politics and
in the hands of the European Central Bank, which prefers to avoid being challenged on its priorities and strategy, and also because fiscal policy is very much restricted to the national framework. So potentially there is scope for debate, but it has not yet been realised at the EU level.

Making room for a macroeconomic debate should be a priority for the EU. The discussion on the reform of the Stability and Growth Pact was a first example of what can be discussed and must be regarded as a positive development. More should follow and whatever one’s view on the issues at hand, discussion should be welcomed.

Equity

Finally, on equity, the short answer is: to a very limited extent. The difficulty is one of competence, so it is a serious one. The European Union has responsibility for redistribution between countries or regions, but none for redistribution among persons. Thus the debate on the equity dimensions of reform, which is a major topic for controversy in some European countries, does not take place to the same extent in Europe. The result is that the people who care the most about equity – and about alleviating the pains of those adversely affected by economic liberalisation and globalisation – do not find an answer at the EU level. This is a potentially dangerous threat to the legitimacy of the EU because people do care about equity. An EU that has nothing to say about it could easily turn into a scapegoat.

In this respect, the proposals put forward by Commission President Barroso for a globalisation fund are useful. The very fact that they have been put forward is an indication that he is aware of the issue and in search of political responses. There are, obviously, many technical problems involved in the operation of such a fund, but it is nevertheless a clear attempt to introduce the interpersonal equity dimension in the European Union toolkit.

In fact the debate this proposal has triggered already encompasses familiar themes in the left-right debate, such as the trade-off between assistance and moral hazard.

Conclusion

It is important to know what you can agree on, but equally important to know what you can disagree on. The upshot of the analysis made here is that there is some, but still not enough scope for political disagreement among those who favour European integration. This is unsafe for Europe and one of the best ways to develop ownership in the EU among citizens is to engage in sound debates on the way it is run.

How did the German press and blogosphere react to the results of the French election?

Hollande – a possible danger?

Günther Nonnemacher states in the Frankfurter Allgemeine Zeitung (FAZ) that two reasons led to his victory.  First, it was not enthusiasm, but his insistence: when he announced his candidacy in 2011, hardly anyone believed that he would win the primaries of the French Socialist Party (PS). Secondly, Hollande benefited greatly from the widespread aversion against Sarkozy as the “president of the rich” and his hyperactive style of government. However, Hollande will not have a test phase now; he will have to prove himself soon during the G8 and Nato meetings has and he will have to handle the Euro crisis.

Thomas Hanke writes,  that unlike Sarkozy, François Hollande will not surprise Merkel. The former for example, attacked Merkel in the very beginning of his mandate by suggesting building a Mediterranean Union. Hollande is much more predictable, but he still has to learn that he only can get stronger when he fosters France’s economic health. France should also pay more attention to its crucial role as a link between the north and the south in Europe.  Hanke also explains that the French campaign is over and Hollande has to face reality now. He has to gain the confidence of both his European partners as well as that of financial markets.

Gabor Steingart of Handelsblatt, states that if Hollande goes on to accomplish the promises he made during the campaign (e.g. expansive social policies, fight against a debt brake, further politicizing of the ECB), France will become Germany’s rival.

In an interview to Die Welt Hans-Werner Sinn, President of the Munich-based Ifo Institute sees the result of the French elections very critically: Hollande fooled people with the slogan ‘growth instead of savings’.

Hollande – hope for better co-operation?

Stefan Ulrich writes in the Süddeutsche Zeitung that France now indeed has to face the truth, but Hollande, according to Ulrich, may be capable of finding the right way to do so. Also for Merkel he may turn out to be the better partner. Egalité is for France, what the social market economy is for Germany. Germany has already under Schröder begun to carry out necessary reforms in order to preserve this value. France must now do the same thing: it will be inter alia necessary to say goodbye to the 35-hour week and to early retirement schemes. Moreover, trade unions and employers will have to learn to see each other as partners and not as enemies. Until now, Hollande has been silent about all this; it is now time to explain that the French are willing to go with the other European people.

In the Blog of the Zeit Herdentrieb Dieter Wermuth writes on 7 May 2012 about the financial markets’ reaction to the outcome of the French elections. The economic programme of M. Hollande could have caused fear among financial markets’ participants, but it did not: there is no trace of panic. The slight fall of the euro is probably rather due to the Greek elections results. The French government bond market is even better than the German one– a surprising result. Market participants apparently trust Hollande to be sufficiently pragmatic and capable of compromises.

Dirk Elsner analyzes on Blicklog the probable impact of the recent elections on the European ‘tectonics’. The impact depends mainly on whether Hollande will really implement his announced ‘industrial policy socialism’. However, in most cases, elected politicians tend to opt for the realpolitik-approach, which follows more or less (political) economic calculations. The German austerity is internationally controversial and attacked by many economists. Thus, this ‘religious war’ around austerity will be at the heart of future conflicts. What is clear now is that the French-German relations are currently tense.

1. Un test sévère Les bilans de l’euro publiés au cours de l’année 2008 ont généralement soulignés ses succès : la stabilité des prix, une croissance certes peu vigoureuse mais au moins régulière, la baisse continue du chômage. Ces analyses ont cependant omis de souligner combien la monnaie européenne avait bénéficié de circonstances internationales exceptionnelles : jusqu’à l’automne 2008, les années 2000 avaient été marquées par ce que les économistes ont appelé la « grande modération » : croissance stable, convergence générale vers la désinflation, faible volatilité macroéconomique. Il est heureux que l’apprentissage de l’euro ait pu se faire dans un tel contexte. Mais on n’aurait pas dû oublier à quel point celui-ci était anormalement favorable.

Or la qualité d’un système de gouvernance ne se juge pas seulement par temps calme. Elle se mesure aussi, peut-être même surtout, à l’épreuve des tempêtes. Qui plus est, les propriétés qu’on attend d’un tel système ne sont pas les mêmes dans les deux types de situations : autant précision des règles, prévisibilité des décisions et recours aux incitations plutôt qu’à la contrainte sont en temps normal souhaitables, autant capacité à rompre avec les habitudes, aptitude à s’adapter aux circonstances et fermeté du commandement sont nécessaires en période de crise. Le passage d’un contexte anormalement favorable à une crise d’une rare violence a ainsi brutalement mis à l’épreuve la robustesse de l’euro.

La crise a, en outre, souligné les divergences entre participants à la monnaie unique. Comme l’a dit Warren Buffet, « c’est seulement quand la marée se retire qu’on découvre qui nageait tout nu ». La métaphore s’applique bien aux pays de la zone euro : les derniers mois ont en particulier révélé la fragilité des performances de l’Irlande, dont le PIB devrait se contracter de 5% en 2009 alors que la croissance était encore de 6% en 2007 (parallèlement son budget devrait passer de l’équilibre à un déficit de 11% du PIB), et la dégradation espagnole est à peine moins spectaculaire. A l’euphorie succède la souffrance, avant peut-être la rancoeur. Pour ces deux raisons, le test a été sévère. Comment a-t-il été passé ?

2. La gouvernance en temps de crise C’est par une surprise bienvenue qu’a commencé l’apprentissage des temps difficile : dès les débuts de la crise de liquidité sur le marché interbancaire, en août 2007, la Banque centrale européenne a  agi avec célérité et imagination. Une institution qui s’était jusque là attaché à montrer qu’elle pouvait être encore plus conservatrice et ennuyeuse que les autres banques centrales s’est soudain révélée capable d’innover et de prendre des risques. Cela ne s’applique certes pas à toute la gamme de ses instruments – elle hésitait, au début 2009, à ramener les taux d’intérêt au voisinage de zéro et à se déclarer prête à mettre en oeuvre, le cas échéant, une stratégie non-conventionnelle d’achat de titres – mais l’autorité dont elle a fait preuve dans la crise lui a donné une légitimité que sa seule performance dans le contrôle de l’inflation n’avait pas suffi à pleinement assurer.

On ne peut malheureusement pas en dire autant des institutions de coordination. La Commission européenne, à qui il incombait de montrer le cap dans une situation propice au chacun pour soi, s’est montrée hésitante lors de l’explosion de la crise bancaire en octobre 2008 et n’a réussi en décembre qu’à donner un semblant de cohérence aux plans nationaux de relance. Il faut dire à sa décharge que l’Eurogroupe, qui avait été créé pour coordonner l’action des gouvernements de la zone euro, ne lui a pas facilité la tâche en faisant montre d’un remarquable manque d’initiative.

Sur le plan financier, les désaccords franco-allemands sur l’opportunité d’un programme coordonné de recapitalisation des banques ont dans un premier temps bloqué toute initiative significative jusqu’à ce qu’au bord du gouffre, le sommet de l’Eurogroupe réuni à Paris le dimanche 11 octobre débouche sur un plan d’action du Royaume-Uni des pays de la zone euro. Cependant des divergences d’orientation se sont rapidement fait jour dans la mise en oeuvre de ce plan. Le redécoupage de la banque belgo-néerlandaise Fortis a illustré les limites de l’action commune.

Sur le plan budgétaire, la Commission a pris en novembre l’initiative d’une proposition qui a ensuite servi de cadre aux plans nationaux de relance, mais la réalité est une grande disparité d’ampleur (d’un paquet à hauteur de 1,4% du PIB à l’absence d’action significative en Italie) et d’orientation (d’un programme de demande au Royaume-Uni à un programme d’offre en France. Quant au montant de l’effort budgétaire effectivement engagé, il reste modeste (0,85% du PIB en Europe en 2009, contre sans doute 1,8% aux Etats-Unis – pour un programme voté en février seulement – et 7% en Chine).

Au total, si le pire a été évité, le système institutionnel de coordination n’a pas bien passé l’épreuve de la crise.

3. La zone euro face aux divergences

Si la crise est commune, ses manifestations diffèrent sensiblement d’un pays à l’autre, non seulement dans leur ampleur mais aussi dans leur nature. L’Allemagne connaît une crise bancaire mais ignore la crise immobilière, tandis que l’Espagne est dans la situation opposée, que l’Irlande cumule les deux chocs et que la Grèce souffre quant à elle de son déficit extérieur et de la méfiance des marchés à l’égard de ses finances publiques. Cette divergence n’est pas un problème nouveau, même si elle s’est évidemment beaucoup amplifiée. La question avait été identifiée lorsqu’il était apparu que la participation à la monnaie unique s’accompagnait d’une déconnexion persistance des marchés des biens et surtout de certains actifs comme l’immobilier. Mais elle était restée à l’état de question.

Ces divergences sont de manière croissante le support de spéculations sur la capacité des Etats à servir leur dette ou, éventuellement, sur leur capacité à demeurer dans l’euro. Les écarts de taux d’intérêt sur les dettes publiques, qui étaient restés très faibles pendant les dix premières années, se sont brusquement tendus à la fin 2008. Cela ne veut pas nécessairement dire que la zone euro court un risque de défaillance d’un Etat souverain, ni qu’elle va se fragmenter. Le coût d’une sortie serait exorbitant, car tous les contrats, notamment ceux relatifs à la dette publique, sont libellés en euros, ce qui implique qu’au lieu d’alléger les dettes, la réintroduction d’une monnaie nationale les alourdirait. En revanche des crises de financement sur le marché obligataire sont possibles. Or on découvre à cette occasion que la zone euro ne dispose ni d’instrument financier ni de procédures pour traiter une telle crise en son sein. Par confiance dans les mécanismes préventifs, par volonté aussi de ne pas suggérer une possible coresponsabilité sur les dettes publiques, ce type de risque a été volontairement ignoré.

Enfin la zone euro est aujourd’hui confrontée à une crise violente dans son voisinage immédiat. Qu’ils fassent ou pas partie de l’Union, les pays d’Europe centrale et orientale subissent aujourd’hui des retraits de capitaux qui déstabilisent leurs économies et mettent en question un modèle de croissance fondé sur le financement des investissements par appel à l’épargne étrangère. Les dernières prévisions du FMI illustrent bien la violence du choc, avec une chute de croissance attendue en 2008-2009 sensiblement plus violente que pour les Etats-Unis, et les taux de change sont (sauf dans les pays rattachés à l’euro) en chute. Si beaucoup est dû aux politiques économiques de ces pays – en Hongrie notamment – la zone euro ne peut s’en désintéresser : outre qu’il s’agit de voisins immédiats et d’importants partenaires commerciaux, une partie de leur difficultés vient des effets de bord de décisions prises par les participants à la monnaie unique. Notamment, la liquidité en euro a fait défaut alors que les systèmes financiers sont largement euroisées, et les banques ouest-européennes, très actives dans la région, sont incitées à privilégier le crédit dans leur pays d’origine. Il y a aujourd’hui un risque réel de nouvelle coupure, politique et économique, entre les deux parties de l’Europe.

4. Les réformes nécessaires

Les difficultés et les faiblesses révélées par la crise appellent aujourd’hui des réformes de la gouvernance européenne. Toutes ne sont évidemment pas urgentes, et la priorité doit continuer d’être donnée à la gestion de la crise. Mais un accord sur le diagnostic et les principaux chantiers serait de nature à rassurer sur la capacité de la zone euro à apprendre et à tirer les leçons de l’expérience.

Un premier chantier touche à ce qui est usuellement appelé surveillance : le suivi des politiques et des performances des pays et la définition, en concertation, de réponses adaptées. Le système de surveillance européen avait pour caractéristique d’être centré sur la performance budgétaire. Malgré des succès indéniables, il souffre à la fois de n’avoir pas empêché les dérives budgétaires – la Grèce par exemple, au terme de plusieurs années de croissance rapide, affichait encore un déficit supérieur à 3% du PIB – et d’avoir presque totalement ignoré d’autres sources d’instabilité comme les bulles du crédit immobilier en Espagne et en Irlande. Il faut donc à la fois élargir le champ de la surveillance et accroître son effectivité, ce qui suppose certainement de la centrer sur les déséquilibres graves au lieu d’en faire une routine consommatrice d’énergie bureaucratique.

Le deuxième chantier est celui de la gestion des crises. Il ne suffit plus d’une gouvernance préventive pour les temps calmes, la zone euro a besoin d’une capacité propre de gestion des crises. Cela concerne les crises affectant la zone dans son ensemble, pour lesquelles il serait souhaitable de prévoir des procédures spécifiques de coordination, et les crises affectant certains pays, pour lesquelles le choix est entre se résoudre à sous-traiter cette fonction au FMI – ce qui serait sans doute perçu comme un échec politique – et constituer au sein de l’Union une capacité crédible d’intervention. Si cette seconde voie et choisie, le plus difficile sera pour l’Union d’acquérir la crédibilité nécessaire.

Le troisième chantier a trait aux responsabilités régionales de la zone euro. Malgré les ambitions affichées, la monnaie européenne n’est pas aujourd’hui une monnaie mondiale, en revanche c’est déjà très clairement une monnaie régionale. Cela crée des responsabilités. La zone euro a par ailleurs intérêt à la stabilité économique dans son voisinage. Elle prête déjà aux pays en crise, en appui aux programmes FMI. Elle devrait aller plus loin, en veillant aux effets de ses propres décisions sur ses voisins, en organisant des coopérations entre banques centrales pour éviter des pénuries de liquidités, en reconsidérant les critères d’entrée dans la zone euro, et de manière générale en manifestant son engagement politique aux côtés des pays de son pourtour.

A version of this article was also published in Constructif

Much remains to be done to enable Asians to feel a genuine sense of ownership, however. Membership may have been broadened, but these institutions, which were generally created by Westerners for Westerners, remain predominantly run by Westerners [1]. In a recent count of the 25 top full-time and part-time positions at the 11 main global financial authorities [2], 20 were held by Westerners, and only three by Asians, including two deputy positions (Véron, 2012). Meanwhile, Asia now represents 25 to 35 percent of the world’s economy and financial system (depending on the indicator chosen), a share almost certain to increase in the near future. Asians correctly perceive a mismatch between their role in the global economy and their voice in global institutions (Cho, 2011).

An important but underestimated contributor to this mismatch is the fact that all global financial authorities are located in the West, and almost all in Europe (the two exceptions are the International Monetary Fund and World Bank, both in Washington). This is obviously a historical legacy. The first such institution, the Bank for International Developments (BIS), was established in Basel primarily to solve a European problem, the payment of first world war reparations by Germany, which involved mostly European stakeholders. Once created, institutions generally do not move, and some of them spin off new ones in the same place. The BIS now hosts five other global financial authorities, including the FSB. But the issue of location is not merely symbolic. Anyone who has ever had to plan a round trip from Beijing (or for that matter, Brasilia) to Basel knows that being physically close to global institutions, as are all Europeans, offers a practical advantage in international financial regulatory discussions.

For each institution, there is a perfectly good case to keep it where it is. Beyond the cost of moving, the need for authorities to work together provides a justification for keeping them close to each other. In addition, Europe’s time zones make it easier to maintain liaison with both Asia and the US. But according to this logic, no global financial authority will ever be located in Asia, and it will be increasingly difficult for Asians to resist the impression that they don’t have an equal stake in the global system.

The G20 leaders should break this cycle. Fortunately, an almost ideal opportunity is at hand. Negotiations are ongoing under the Mexican presidency of the G20 to reform and strengthen the governance of the FSB, loosening its ties with the BIS both in terms of financing and of operational arrangements. The discussions are expected to produce an agreement at the mid-June summit of the G20 in Los Cabos. Much of the discussion concentrates on the future representation in the FSB’s structures of different policy sub-communities (central bankers, finance ministry officials, supervisors). But relocation of its permanent secretariat should also be on the agenda. Unlike the IMF, OECD or BIS, the FSB secretariat has only a small staff of about 20 professionals, most of whom are internationally mobile. And because its global role is increasingly important, a transfer to Asia would be more than a token gesture.

Where in Asia? Some obvious criteria need to be fulfilled: air travel accessibility; political stability; the rule of law; and amenities that make it possible to attract highly qualified international staff. Among Asian cities, Hong Kong, Seoul, Singapore, and Tokyo meet these criteria to a sufficient degree. Switzerland can be expected to resist losing the FSB, but it would gain from strengthening the global financial policymaking order. So would all Western players.

Relocating the FSB to Asia, of course, should not be a substitute for other initiatives to fulfil the G20 promise to deliver an effective global financial policy framework that will achieve the goals of stability, growth and inclusiveness. Nor should it substitute for financial reform in Asia, where the allocation of capital remains inefficient. But tackling the mismatch, in which Asians are inadequately empowered even as their economic and financial position is increasingly central, has to start somewhere. Moving the FSB secretariat eastwards would be a reasonable place to begin.

References

Cho Yoon Je (2011), “What do Asian Countries Want the Seat at the High Table for? G20 as a New Global Economic Governance Forum and the Role of Asia,” ADB Working Paper Series on Regional Economic Integration No. 73, Asian Development Bank

Véron, Nicolas (2012), “Asia’s Changing Position in Global Financial Regulation”, Asian Development Bank / Korea Capital Markets Institute / Peterson Institute for International Economics, forthcoming

[1] Defining the “West” according to common practice, as the US and Canada, Europe up to the current Eastern boundary of the EU, Israel, Australia and New Zealand.

[2] These are the FSB itself and its ten members which have a global scope, namely the Bank for International Settlements, Basel Committee on Banking Supervision, Committee on the Global Financial System, Committee on Payment and Settlement Systems, International Association of Insurance Supervisors, International Accounting Standards Board, International Monetary Fund, International Organization of Securities Commissions, Organization for Economic Co-operation and Development, and World Bank.

First, austerity may be a price worth paying for those who pay least. Despite being the most vocal advocates of austerity, Germany, the Netherlands, Finland, or Austria have had a gradual approach to austerity at home. Instead, countries like Spain, Portugal, Greece or Italy bear the brunt of the burden. This begs the question why the latter countries agreed to austerity in the first place. One answer may be that austerity was pushed through when southern European countries were in need of support and they had little bargaining power. If we believe that austerity has substantial negative effects on growth in problem countries, the question then becomes: why is austerity not renegotiated? Here a possible answer may be as follows. Countries have received support in return for implementing severe austerity. Reducing austerity would at this point increase growth. These benefits, however, materialize mainly locally. Spain may reduce unemployment and increase growth, but how does this benefit Germany? How can problem countries somehow let northern countries share in the benefits of reduced austerity? If eurozone countries are incapable of solving this problem, they will be unable to bargain their way out of a sub-optimal equilibrium. If this view is correct, economists should try to find ways for problem countries to share the benefits of reduced austerity with other countries. In a transfer union like the US lower unemployment reduces transfer payments from rich to poor states, but other (politically feasible) mechanisms may also be possible.

Second, the cost of austerity may simply be the shadow price of moral hazard. In this view, the choice is not between austerity now and austerity later while postponing structural reforms and budget cuts. In fact, economic theory dictates that austerity should come with an ex post inefficient amount of pain, because that is actually the best way to promote ex ante discipline. If this view is correct, politicians know they introduce inefficiency by requiring austerity for eurozone countries. But the alternative in their view is not tailor-made policy, it is complacency before reforms and budget cuts. The cost of austerity then simply reflects the value politicians attach to reducing moral hazard. Economists like Paul Krugman, who point out the cost of austerity again and again and again, implicitly assume they outweigh the benefits of improved ex ante discipline. In doing so, they fail to recognize where their difference of opinion with policymakers lies. It is not in the cost of austerity, but in the benefit of reducing moral hazard. If this point of view is correct, economists should put more effort in quantifying these benefits in order to assess whether politicians’ perceptions are correct.

It has been a busy election weekend in Germany, Greece and France. Each election is an idiosyncratic response to the current European crisis and will somehow set the stage of European politics for the months to come.

In Germany, the results in Schleswig-Holstein suggests a further erosion of the FDP (although smaller than forecasted), an additional weakening of the CDU (worst score since 1950). The CDU can try to form a coalition. But in fact, the SPD, the Greens and the Pirates along a couple of smaller parties (that of the Danish minority) could form a majority. This ought to have national relevance too and contribute to tilt further the CDU closer to the SPD in anticipation of a possible coalition in 2013. It is also striking to see the rise of a small party like the pirates, which could become a force to reckon with in a future grand coalition in 2013.

In Greece, this election marks the beginning of the end of the historical Greek parties (and more specifically of PASOK at this election). This looks worrying from the distance but is an unavoidable consequence of the crisis. The challenge for the Greek polity and for Europe as a whole is for the Greek democracy to achieve an unprecedented and rapid change of its political class/system while sticking to its European compass. Syriza, the new party to the left of PASOK, which is making a very strong showing, is against the current adjustment program but in favour of the euro. One has to expect some difficult negotiations with the troika but they have no reason to be disruptive to financial markets unless the threat of forced euro exit is raised. Financial markets are often schizophrenic but they cannot both call for a complete overhaul of the Greek political apparatus, whom they consider responsible for the current debacle and yet be disgruntled when it comes.

In France, Hollande’s victory is the most expected political outcome of the weekend. He has started to have conversations with European HoSG and informal exchanges about the ongoing European negotiations will start immediately. He will officially take office around May 15^th but the exact date can be negotiated between Sarkozy and Hollande this week. Hollande confirmed that he would meet Angela Merkel immediately after taking office but also repeated that he would give a new direction to Europe.

Meanwhile I will focus on:

1.    The shape and form of the “growth compact”

2.    CRD IV: Of capital and liquidity

The shape and form of the growth compact

This is going to be the first and biggest challenge for Hollande’s new presidency but luckily, the terrain has become easier in the last few weeks. Hollande was a lone voice calling for a growth agenda a weeks ago and there is now a broader intellectual and political consensus around this idea.

Yet there are important misunderstanding and disagreements between member states on the exact contours of this new “growth compact”. Both Italy and Germany seem to have hammered out the outline of an agreement negotiated bilaterally to a large degree.

This agreement would revolve around:

• A directive for further liberalization of the internal market principally directive at services (essentially a revamped and enhanced Bolkenstein Directive). This directive would primarily aim at improving the situation in the labour market with 3 objectives which were mentioned by President Draghi during the Press conference this week (i) flexibility of the labour market, (ii) mobility with possibly more resources being allocated to encourage mobility within member states and within the EU and (iii) equity to earmark as much resources as possible to address youth unemployment which is viewed as the biggest risk to social cohesion and to potential growth.
• Recapitalization of the European Investment Bank so as to increase its scope and the size of its possible interventions
• Redesign of cohesion policy so that it benefits more the countries that need it the most and so that these funds can be disbursed more rapidly in the existing envelopes.
• Project Bonds, launch of (small) jointly issued bonds to finance dedicated infrastructure projects (likely to be targeted to the energy sector)

This is already probably more than Hollande could have expected just a few weeks ago. But the first part on the single market might come at some political cost for him. In return, he could probably secure a few more commitments that would be key for the medium term and that would help him to frame a long term vision towards a real completion of the monetary union.

This includes:

• Concrete steps towards a banking union. This ought to be a long and tensed negotiation (especially between the UK and the euro area) but it can be kickstarted fairly easily by dealing with Spain and arrange rapidly a program to recapitalize its banking system. The ECB seems more ready to play a role in this transitory phase where a real resolution framework remains lacking. My neo-functionalist mind firmly believes that once Europeans will have contributed money to recapitalize the Spanish banking system, they will organize the right framework and institutions to set up a proper banking union.
• A timetable towards a real fiscal union, that would aim to use some form of joint and several borrowing (eurobills, project bonds) as a first step towards a real European Treasury and a unified bond market.

These two last points are challenging in the current context but they would help to respond to Draghi’s call for a 10 years European agenda. Indeed, the best way to reduce the short term uncertainty that is freezing financial markets and creating so much collateral damage is to look beyond short term challenges and set out a vision for the euro area that financial markets can see through.

CRD IV: Of capital and liquidity

After these high-level considerations, at a more technical level, the last ECOFIN has been the occasion of a fierce negotiation on CRD4 (the adaptation in EU legislation of the Basel Committee rules known as Basel III). Unsurprisingly, this has exposed important divides in Europe, in particular between the continental Europe and the UK such that no agreement was reached.

What is striking though is the extent to which the debate is crystallizing on the capital adequacy ratio and in particular on the ability for each jurisdiction to define what constitutes capital and retain some flexibility to raise the required level of capital. But both the LCR (Liquidity Coverage Ratio) and the NSFR (Net Stable Funding Ratio) are being somewhat ignored in this debate while they could be extraordinarily important in the short term.

In fact, the EBA calculated in its most recent monitoring exercise that the European Banking sector would have a shortfall of more than 1.3 trillion euros of safe and liquid assets. This is particularly worrying because it could be well be that alike that the recapitalization exercise that was wrongly designed last summer and which set in motion a real credit crunch, the implementation of the largely ignored Liquidity Coverage Ratio could force European banks towards a real run to safe and liquid assets resulting in a net contraction of credit towards the real economy.

The ECOFIN and the parliament will be discussing the CRD4 directive again. They ought to look beyond the debate on capital and its definition and look closely at the implications for credit growth of measures affecting the Liquidity Coverage Ratio and Net Stable Funding Ratio. These two forgotten debates, might alone contribute to set in motion another wave of credit contraction in the euro area if the directive is passed as it is now.

Happy to have your thoughts as usual,

Best Regards,

Shahin Vallee

The productivity - median compensation wedge

Lawrence Mishel has a recent paper on this issue for the Economic Policy Institute. During the 1973 to 2011 period, labor productivity rose 80.4 percent but real median hourly wage increased 4.0 percent, and the real median hourly compensation (including all wages and benefits) increased just 10.7 percent. If the real median hourly compensation had grown at the same rate as labor productivity over the period, it would have been $32.61 in 2011 (2011 dollars), considerably more than the actual $20.01 (2011 dollars). Consequently, the conventional notion that increased productivity is the mechanism by which living standards increases are produced must be revised to this: productivity growth establishes the potential for living standards improvements and economic policy must work to reconnect pay and productivity.

Paul Krugman writes that it’s two-thirds the inequality, stupid. One third of the difference is due to a technical issue involving price indexes. The rest, however, reflects a shift of income from labor to capital and, within that, a shift of labor income to the top and away from the middle. What this says is that widening inequality makes a huge difference. Income stagnation does not reflect overall economic stagnation; the incomes of typical workers would be 30 or 40 percent higher than they are if income inequality hadn’t soared.

The price mark-up puzzle

The 2012 Economic Report of the President dug up another related but somewhat different puzzle for the US in the 2000s (note that the wedge between productivity and median compensation has been growing for the last 30 years not just the last 10). According to the report, “most of the inflation in nonfarm business prices during the past four years has been due to a rise in the price markup over unit labor costs rather than to rising unit labor costs.”

Nominal hourly compensation has risen at a roughly 2.3 percent annual rate during the four years since the business-cycle peak in December 2007, but this growth has been mostly offset by growth of labor productivity at an annual rate of about 1.7 percent during the same period, leaving unit labor costs essentially unchanged. Historically, prices of nonfarm business output have risen in a roughly parallel fashion to unit labor costs, so the markup of prices relative to unit labor costs has been flat. As can be seen in Figure 2-11, this long-term property of the U.S. economy appears to have broken down over the past decade or arguably even as early as the mid 1990s. The markup has now risen to its highest level in post–World War II history, with much of that increase taking place over the past four years.

If you want to reproduce the diagram from the Council of Economic Advisors’ ERP, Menzie Chinn has a useful do it yourself guide.

Shifts in price mark-ups and labor shares

The Economic Report of the President concludes that “because the markup of prices over unit labor costs is the inverse of the labor share of output, saying that an increase in the price markup is the highest in postwar history is equivalent to saying that the labor share of output has fallen to its lowest level.” In turn, the labor share can decline due to either lower compensation per hour worked, or due to less labor required to produce a given level of output. The latter is mostly driven by technological changes in the production structure of advanced economies, and is thus not necessarily a negative development from a welfare standpoint.

The markup puzzle is indeed picking up some of the declining labor share, but not only. In particular, notice that ULC=nominal hourly compensation/hourly productivity (see the OECD for more on these definitions) and that nominal compensation has been growing faster than productivity in the US over the past 2 decades at least. This implies ULC has been growing (with the exception of the last 4 years since the start of the Great Recession), not declining, and hence the rise of the markup ratio from the early 2000s to 2007 cannot be explained by a decline in the denominator of the mark-up-ULC ratio. Rather, it must be that the profit share (as defined below) is growing faster than labor costs (note the ratio can be expressed either as price of output/ULC or equivalently as total profits/total labor compensation).

Given this, there are several possible factors other than a declining labor share that may have driven the markup/unit labor cost ratio over the past decade especially:

The ratio could be partially driven by compensation inequality at the firm level between managerial and non-managerial compensation, since stock options are not fully included in the BLS measure of labor compensation. In particular, they happen to be included only once exercised. Non-exercised stock options (a rising item in executive compensation) could have thus played a role. This relates to the idea of a shift in bargaining power in the labor market. Michel Dumont, Glenn Rayp, and Peter Willemé as well as Lourdes Moreno and Diego Rodríguez Moreno have, for example, recent papers differentiating the rise of bargaining power by high-skilled workers due to the preeminence of R&D versus a decline in bargaining power by low-skilled workers driven by increasing global market competition.

The ratio could also be driven by what Jesus Felipe and Utsav Kumar call "unit capital costs", the ratio of nominal profit rate to capital productivity. The markup over labor compensation ratio is intrinsically misleading because the numerator does not equal firm operating profits. In fact, it includes gross value added before taxes and financing costs. Rising debt or equity costs, as well as increases in the tax burden, could therefore also play a role. Harris Della and Ana Fernandes discuss theoretical channels through which increased financial sector concentration could drive up markup indexes in non-financial product markets by tightening financing constraints in financially dependent sectors.

Figure 1: Financial disintegration and the mediating role fo the ECB

Source: National Central Banks; ECB. South = Greece, Ireland, Portugal, Spain, Italy; North = Germany, Luxembourg, Finland, Belgium.

Figure 1 shows that countries in the South of the Euro Area have been taking up an increasing share of Eurosystem liquidity since the start of the crisis, while the share of North has been declining. During 2011, Greece, Ireland, Portugal, Italy and Spain accounted for about 70% of the entire Eurosystem liquidity, which has been key in replacing outflows of private capital and sheltering countries from the consequences of a sudden stop in capital flows (see our recent Policy Contribution on this question).

But our reconstruction on a country by country of the use of the LTRO in figure 2 illustrates interesting divergence even within the aforementioned groups of countries. This data is not straightforward to gather. The ECB only publishes the aggregate volume of Marginal and Longer Term refinancing Operations (MRO and LTRO), without any country breakdown. To reconstruct each country’s share, we merged data provided by National Central Banks but the aggregation sometimes may require some assumption due to the different periodicity of data publication or level of details. For example, we had to keep the shares of Greece and Italy in March fixed at the same level as they were in February, because the latest data have not been released yet. Data for France only cover the period of 2011, because a monthly breakdown is not available for previous years.

Figure 2: Country breakdown of ECB liquidity provision

Source: National Central Banks, ECB. Note: the Bank of Greece has not published the disaggregation of Central Banks’ lending into MRO and LTRO since December. Data for January and February are therefore proxied with the general series “Claims on Domestic MFIs” on the Bank of Greece’s balance sheet assets. Over the past, the series however is very consistent with the numbers that we would obtain by summing LTRO and MRO figures.

The first item matters not only for the EU but also from a global perspective. The current EU debate is mostly about the definition of capital, and especially the exception for so-called “silent participation” in some German banks and the capital treatment of insurance subsidiaries, which affect some large French banks among others; on both items, the CRD4/CRR draft is seen by many observers as not compliant with Basel III.

I would argue it is part of a broader question. The EU was a strong promoter of internationally consistent financial standards before the crisis. One main reason is that this helped EU institutions fulfill their own agenda of single market harmonization. The EU promotion and adoption of Basel II (the original Capital Requirements Directive), but also its 2002-05 adoption of International Financial Reporting Standards (IFRS) are quintessential examples of this: there was a de facto alignment of interests between EU institutions and global standard-setters, and EU institutions tended to view harmonization as an overriding good that would supersede most misgivings they may have about a particular standard’s content. There were exceptions of course (e.g. the “carving out” by the European Commission of some parts of the IAS 39 accounting standard on financial instruments when it was endorsed into EU legislation in late 2004) but the general picture was very consistent. This made the EU an outlier in the global context, as a consistent champion of global standards even when it did not determine their content (Elliot Posner and I analyzed this dynamic in a 2010 paper).

The crisis has changed that. Now, EU institutions seem to care more about the content of the standards than about global harmonization or convergence per se. This is not necessarily a conscious change: in both the Commission and Parliament, most people still see the EU as an internationalist player. But in practice the EU now looks much more like the US, in favor of global standards when it “likes” them and not in favor when it “dislikes” them. However things are made more complicated in the EU by the fact that there is much less of a consistent infrastructure for policy elaboration to determine whether a standard is “liked” or “disliked”, often resulting in high vulnerability to special-interest pleading. From a global perspective, it is destabilizing for global standard-setters as they have lost the EU as a consistent global champion compared with the previous era. Many EU officials still underestimate the extent to which CRD4/CRR deviations from Basel III undermine the global authority of the Basel Committee. Many other jurisdictions are carefully watching the direction in which this EU legislative debate goes. If the EU adopts final legislation that is not compliant with Basel III in terms of the definition of capital, it will be seen by at least some others as a license to introduce their own deviations that suit their own special interests.

Obviously the US does not help by delaying their own proposals for Basel III implementation. In November 2011, Federal Reserve Board Governor Daniel Tarullo publicly announced there would be a public regulatory proposal before the end of March 2012. We are in early May now, and still waiting. This is a regrettable failure of US leadership. If the US published a proposal that is Basel III-compliant, it would create a strong incentive for the EU to comply as well. The same is true in the IFRS space, where the US Securities and Exchange Commission keeps delaying its stance on IFRS adoption, thus undermining the global credibility of IFRS. Almost everybody accepts that the US is not going to adopt all IFRS in the short term or even set a firm date for complete adoption given domestic political constraints. But the SEC’s “condorsement” concept allows for a lot of flexibility in terms of gradual adoption. That the SEC remains so far unable to commit itself to even a minimalist form of IFRS condorsement is disheartening from the standpoint of global financial reform.

The second big issue in the CRD4/CRR debate is arguably more of an intra-EU matter. The European Commission argues in favor of a “maximum harmonization” approach that prevents individual member states from raising their Pillar I capital requirements from the commonly agreed minimum, on the basis that this would introduce competitive distortions inside the EU single market. But this argument seems to ignore that the main distortion by far in the EU market for banking services is the fact that most of the bank supervision /resolution policy framework remains national, which pegs banks’ financial situation to the situation of their home-country sovereign, with disastrous effects these days particularly in the Eurozone. The Commission’s DG MARKT has failed to properly address this distortion: a legislative proposal on bank crisis management and resolution, which is not even published in draft form at this point, should have come much more forcefully and earlier, arguably as early as mid-2009 to preempt diverging legislative moves on national resolution frameworks which have been adopted by many member states in the meantime.

Given this failure, the Commission’s argument that higher capital requirements in countries such as Sweden or the UK would harm the single market rings somewhat hollow, especially as the Basel Committee has been explicit on the fact that its standards were a mere minimum and that individual jurisdictions were encouraged to go beyond, as Switzerland in particular has already decided to do. In its comment letter on the CRD4/CRR proposals in March, the European Systemic Risk Board has come up with a balanced proposal to combine freedom to decide on macro-prudential measures in individual member states, including by raising Pillar I capital requirements, with the need for EU-level coordination. These proposals make a lot of sense and should be endorsed in the final legislation.

I have been away from civilization and I haven’t touched a Bloomberg terminal, a twitter account and a telephone for the past few days, but after a quick catch up. I feel that at least two topics are progressing in European circles.

The first one is that of a banking union, which I have alluded to in the last couple of weeks and which despite violent push back by German official will undoubtedly move forward.  I’m willing to take a bet that this is another instance of German resistance before ultimately caving in.

The second is that of a "growth compact" for Europe, which Mario Draghi (before the European Parliament), Angela Merkel and Herman Von Rompuy have referred to. As I understand it, the Commission seems to preparing some elements of a strategy likely to be discussed at the European Council of June 28/29^th , which will be decisive in this respect.

Meanwhile, I will focus on:

1. The fudgy IMF resources increase
2. Some highlights from the monetary policy dialogue

The fudgy IMF resources increase

The IMF’s increase in its resources appears to be fudgier than it seems and there are several sources of uncertainty.

The first and most striking one is the difficult way to track precisely who the contributors to this 430bn USD in resources really are. Indeed, the press statement by the Managing Director included a nice table from which I can only identify 363bn USD. The balance being provided by the BRIC countries with no specific amount for each and by Thailand, Indonesia and Malaysia who will contribute but need to go through “necessary domestic consultations”.

In reality, BRIC countries have held back their contribution so long as the 2010 quota reform hasn’t been ratified by the necessary quorum to make it effective. Only about 53.7% of the membership has ratified it so far while the amendment will have to be accepted by three-fifths of the IMF’s 187 member countries, having at least 85 percent of total voting power (the key laggards include Germany, the United States…)

At this pace, it is unclear that the BRIC countries will have enough assurances that this will happen before the Los Cabos G20 meeting in June or even before the annual meetings in Tokyo in October. In reality, the key swing voter in this process remains the US and it is very unlikely that the Obama administration will put this through Congress before a new House of Representatives comes in after the November 2012 elections.

So while the US didn’t contribute to this increase in resources (because it is already making FX swap lines available via the Fed says the US Treasury as a tepid excuse…), it is also de facto slowing the implementation of the 2010 quota increase, which BRIC countries see as an essential gesture of goodwill. This means that until this issue is resolved or until BRIC countries are given enough assurances that it will be, the real increase in resources of the fund is below 350bn (the UK also said it would make its pledge conditional on the 2010 reform being implemented).

The second area of uncertainty is the extent to which this increase in resources if permanent or temporary. In fact, these commitments have been made under the New Arrangement to Borrow (NAB) part of which has been temporarily expanded and will be rolled in to the permanent quota increase decided in 2010. The new increase is meant to “in addition of 2010 quota increase resource”s which will then be 736bn USD while today’s quota is 368bn USD.

All in all, it is very likely that the excess in NAB resources will not be prolonged after the quotas are increased in accordance to the 2010 reform and this will reduce the NAB by some 142bn USD. In this case, the commitment taken at the Spring meeting would add 290bn USD to the new quota post 2010 reform, and not 430bn.

All in all, somewhat ironically the IMF is using the same smokes and mirrors than the Europeans were with their firewall. More fundamentally, this highlights the important challenges lying ahead of the MD to make the IMF more effective while strengthening its governance and legitimacy.

Some highlights from the monetary policy dialogue

There was a flurry of ECB speeches this week, mostly revolving around the financial sector. I still haven’t figured out whether the ECB is simply calling on governments to move forward on the banking union front or whether it is ready to play some role in the interim.

Draghi reiterated the need for “strengthening banking resolution at European level” followed by echoing calls made by the ECB VP Constancio during the presentation of the 2011 Annual report before the ECOFIN but he also importantly

But the real focus of the monetary policy dialogue revolved around external imbalances for which a number of experts’ contributions were made (the best one being my Stefan Collignon IMHO). The papers have different focuses but they seem to converge on a few important points:

o   Current account and NIIP are very poor proxies for competitiveness and should therefore not be at the heart of the Macroeconomic imbalance procedure.

o   Competitiveness is largely endogeneous and cannot be limited to wage policy

o   Monetary policy plays an important role in sustaining imbalances and fostering divergence in competitiveness even though the ECB claims this can only be fixed by National Governments.

o   The ESRB is potentially an important vehicle to avoid the creation of imbalances but still hasn’t found the way to puts its theoretical useful into practical policy action. This is the biggest challenge lying ahead for the ECB.

Happy to have your thoughts as usual,

Best Regards,

Shahin Vallée

These are the first skirmishes in what is bound to be a debate of great significance for Europe. It revolves around two major issues, austerity and integration.

Start with austerity. The question here is not whether deficits should be reduced. They have to in view of the dire situation of European public finances, and also because the countries whose competitiveness deteriorated during the first decade of monetary union must tighten to deliver the necessary wage/price adjustment. It is indeed telling that because they have benefitted from wholesale central bank liquidity provision, euro countries that found themselves in serious external imbalance at the onset of the crisis have reduced their current account deficit much less than non-euro countries in a similar situation. Germany, the arch-advocate of austerity, is right on this point.

The problem however is that austerity has perverse effects too. Private and public deleveraging can hardly take place at the same time, unless trade partners generate enough demand for exports. Recession and price deflation reduce tax receipts and worsen the dynamics of public debt, threatening the return to sustainability. Also headline deficit targets lead governments to respond to recessions by introducing austerity packages one after another, generally without much regard for the adverse supply-side effects of hasty consolidation measures. So there is a need for approaching austerity and rebalancing strategically. The EU in this respect has made three mistakes.

First, finance ministers in October last year tried to reassure markets by demonstrating toughness and endorsing headline instead of cyclically-adjusted deficit targets. This may be justified for a country at the verge of losing access to capital markets but certainly not for a country with relatively low debt and a moderate deficit, as the Netherlands. Ministers should change course and revert to their original 2009 commitment, which was to plan consolidation efforts and stick to them through fluctuations and shocks.  

Second, the euro area still shies away from a comprehensive approach to its internal rebalancing. Price competitiveness is not an absolute but a relative concept, yet the policy discussion still pretends to ignore this basic fact. This is paradoxical, because the European Central Bank’s policy framework provides clear guidance: the ECB is committed to 2 per cent inflation in the euro area as a whole, which implies that lower wage and price increases in Southern Europe arithmetically mean higher wage and price increases in Northern Europe. It is time to say loud and clear (a) that the ECB will fight hard to keep average inflation on target, and (b) that Northern Europe – and especially Germany – will not attempt to counter higher domestic inflation as long as price stability is maintained on average in the euro area. This would significantly help map out a sensible rebalancing strategy. 

The third mistake is of omission: as ECB president Mario Draghi recently said, Europe has a fiscal compact but it does not have a growth compact yet. For sure, there are no quick fixes in this field: initiatives on infrastructure investment may grab headlines but they certainly do not measure up to the challenge. Nevertheless, a serious discussion should start on how to use the EU budget for performance instead of redistribution only, how to foster pro-growth reforms at national level and how to help elicit investment in the tradable sector of the periphery. A well thought-out growth compact would help overcome immediate hurdles. We should not forget that students of the post-war Marshall plan have found that it is not the sheer size of the money pot that made it so successful, rather that it helped overcome zero-sum games and self-fulfilling pessimism. This is a lesson worth keeping in mind.

Austerity however is not the only dimension of the debate. Integration is the other one. The matter here is that developments over the last two years have exposed the weaknesses of a ‘bare-bones’ monetary union that relies on a single monetary policy and fiscal discipline only. Recent reforms have drawn lessons from the Greek crisis and have equipped the euro area with crisis management capabilities and this is a very welcome addition to the policy architecture. Yet more is needed to restore confidence, ensure financial stability and ward off financial fragmentation.

A key characteristic of the European crisis has been the very strong correlation between banking stress and sovereign stress. Time and again, bank woes have affected sovereigns and concerns over sovereign solvency have affected banks. This major potential threat to financial stability has been temporarily alleviated, but not solved, by the central bank’s large-scale provision of liquidity. Concerns about Spain have shown that the problem was still there. Systemic reforms to address it all involve a significant step towards integration: either the joint issuance of government bonds that play the role of safe asset in the banks’ portfolios; or a ‘banking union’ consisting in a common regime for deposit insurance, supervision and crisis resolution; or both. Either one involves significant risk-sharing among euro-area members and involve some degree of fiscal mutualisation. The question then is whether there is enough trust and political acceptance for integration to start discussing such reforms.

This is where politics strikes back. In France, in the Netherlands but also elsewhere, a significant proportion of the citizens see Europe as a threat to their way of life. Telling them that the euro is an unfinished construct that requires even more commitment that what they already feel excessive is a hard call for politicians. The question for the coming months is whether the European leaders will have enough political capital to embark on further reforms and make the case for them in front of angry citizens, or whether they will limit themselves to agreeing on mere platitudes, and hope for the best.

A version of this column was also published in Century Weekly

Figure 1

The ECB’s language is ambiguous. On the one hand its explicit separation principle states that whereas quantitative easing à la Fed is a substitute for conventional easing once the policy rate has reached the zero bound, the ECB’s non-conventional operations only aim at ensuring a proper transmission of monetary policy and could conceptually be undertaken at any level of interest rate (Fahr et al., 2011). On the other hand the ECB emphasises that it is doing much to prop up the economy. 

To find out what central banks have actually done, we have decomposed the asset side of their balance sheets into five categories:

1. Lending to financial institutions, mainly through repos;
2. Government securities held within the framework of asset purchase programmes;
3. Non-government securities held within the framework of asset purchase programmes;
4. Foreign exchange swaps with other central banks (for the Fed)/foreign currency lending to domestic institutions (for the Bank of England and the ECB)
5. Other assets.

Figures 2 to 4 give the results. It is apparent that in both the US and the UK, the surge of repo lending to financial institutions was short-lived. It took place in response to the disruption of the interbank market following the Lehman shock and was unwound during 2009. The BoE undertook a special off-balance sheet liquidity scheme, which took more than 2 years to be unwound until basically the end of 2011[2]. By the beginning of 2010 the surge of repo lending had either disappeared entirely (Fed) or been reduced to traditional proportions (Bank of England), and did not resume afterward. In the case of the ECB, however, there were repeated spikes of repo lending, with a resumption on a massive scale in December 2011.

Figures 2 – FED Balance Sheet (% of 2007 GDP)

Figure 3 – Bank of England Balance Sheet (% of 2007 GDP)

Figure 6 – European Central Bank Balance Sheet (% of 2007 GDP)

      In the US and the UK, government bonds purchased within the framework of credit easing or quantitative easing programmes largely substituted repo operations from 2009 onwards. At the end of February 2012, these assets accounted for 103 per cent of the increase in the overall size of the Fed balance sheet since February 2007, and 116 per cent in the UK. In the euro area, however, the bulk of the increase took the form of repos operations. These accounted for 64 percent of the increase in the size of the balance sheet between February 2007 and February 2012, against 20 percent for government bonds purchased within the framework of the Securities Market Programme and the Covered Bonds Programme.

     
So the three central banks have increased their balance sheets by roughly comparable amounts, but the composition of the increase is entirely different. The question is whether this difference is indicative of different goals pursued, on the one hand, by the Fed and the BoE, and on the other hand by the ECB; or of alternative ways of reaching the same goal (in the case of the ECB, of promoting bank credit to the non-financial sector and/or purchases of government bonds).

     
In fact a series of facts suggest that the outcome of ECB policy does not compare to those of BoE and Fed initiatives:

     
At end-March 2012 €700bn had been parked by commercial banks at the ECB deposit facility, indicating that it was largely substituting the interbank market;

     
Reliance on Eurosystem refinancing is highly asymmetric across countries. Banks in Southern Europe recently accounted for 70 per cent of medium- and long-term refinancing operations against 20 per cent before the crisis (Figure 5). The Eurosystem is therefore stepping into a dysfunctional interbank market rather than propping up total bank credit;

Bank loans are growing in Northern Europe, but contracting in Southern Europe whereas the opposite applies for bank holdings of government securities;

The impact of the LTRO on the yield curve has been significant for distressed issuers, but much less so for AAA issuers.

The ECB has, with the recent LTROs, managed a massive expansion of its balance sheet. This has been called the euro-area equivalent of quantitative easing, as done by the Fed and the Bank of England. Large portions of this liquidity, however, are parked in overnight deposits at the ECB, reducing its effectiveness for the overall monetary policy stance.

The main obstacle for the ECB is not the fact that the Treaty on which it is based places tight limits on the purchase of government bonds, compared to those existing in the UK and the US. Rather, the absence of a banking and fiscal union and the strong heterogeneity within the euro area reduces the effectiveness of the instruments the ECB has.

The disconnect between academic research and the beliefs of policymakers

Christina Romer has a new essay about what we have learned about fiscal policy over the last few years where she draws two lessons main lessons: that fiscal policy matters in the short run, and that large, persistent deficits are ultimately very costly. These lessons are certainly not novel. To a large degree, the experience of the past few years has just solidified or amplified what we already knew (or should have known). But, the implications that flow from these lessons are at odds with much of what we see going on with policy.

Jacob Funk Kirkegaard argues that like it or not, fiscal austerity has to precede fiscal solidarity. Just because top euro area policymakers succumbed to promises of what my colleague John Williamson, in another context, once dubbed an “immaculate transfer” does not mean they are all imbeciles or members of the hardcore cult of austerity presided over by retired Bundesbankers. The reality is more nuanced. Fiscal consolidation today should be viewed as a political down payment by countries seeking guarantees from German taxpayers. It would be wonderful and much easier if a cooperative solution were available free of moral hazard. But few are so blessed in the real world. That is why the fiscal austerity and debt and deficit rules under way are important. The new EU fiscal surveillance packages in the so-called Six-Pack (consisting of five new regulations and one directive), the Two-Pack (the two new regulations under discussion), the Fiscal Compact Treaty, and the austerity in Spain and elsewhere might appear to be doing senseless damage to short-term macro-economic growth. But these steps make sense as laying out a path to new and necessary institutions to sustain the euro area.

Simon Wren Lewis notes that the degree of austerity imposed is, however, radical as the recent agreements are imposing tougher measures than the US or the UK, while it budgetary position of the euro area as a whole is more favourable.

The pace of consolidation, signaling, and the source of risk premia

As a benchmark, if financial markets are rational it should not matter when we generate income, only that it will eventually materialize. If fiscal multipliers are large, this results in recommendations to bias policy towards longer-term reforms while reducing short-term spending cuts. Pontus Rendahl makes this point on Voxeu.  He argues that the fiscal multiplier can easily exceed one irrespective of the mode of financing when the economy is in a liquidity trap, there is high unemployment, and when unemployment is persistent.

However, one argument in favor of quick reduction of deficits might still be that quick spending cuts act as a signaling device. Simon Wren-Lewis argues that one reason why government might default is a political inability to cut spending or raise taxes enough to get the primary budget balance into surplus. Governments can demonstrate that they do have that ability by cutting the deficit rapidly now. Since governments are prone to short-termism, the incentives to default can also peak during short periods of high-indebtedness. Fast reduction of high risk-premia can then be necessary to reduce the probability of default.

An important factor when considering the optimal pace of consolidation is the source of risk premium on government debt. If the dominant factor in driving market perceptions of sovereign risk is short-term fiscal policy, reducing debt in the short term is more effective than reducing it in the longer term. But if the perception of sovereign risk is driven by the existence of multiple equilibriums in debt markets – as argued by Paul de Grauwe or Jonathan Portes – the obvious and direct way to deal with this issue is to provide explicit or implicit guarantees – either through the introduction of Eurobonds or aggressive intervention by the ECB (for more on these issues see our reviews on the ECB as a lender of last resort to sovereigns and eurobonds).

Chasing the wrong target and hysteresis

Wolfgang Münchau argues that there is a fundamental misunderstanding, in Brussels and Madrid, about the nature of the market panic about Spain. The markets are not panicking because Spain may miss the deficit target, but because Spain is trying to hit it. To hit these targets with a declining economy is not only bad economics, but physically impossible. He says a more credible strategy would be for Spain to focus on the banks first, forcing them to take losses, and consolidating them. That can only be done through the ESM, a task for which the Spanish government and the private sector are too weak. Eventually, such a programme could give rise to a bank resolution/supervision scheme. While the private sector deleveraging occurs, it would be unwise to engage in a simultaneous exercise of public sector retrenchment, which can wait a few years.

In a much debated paper presented at the Brookings Panel on Economic Activity, Brad DeLong and Lawrence Summers argue that under the very specific circumstances that characterize advanced economies today – MP @ the ZLB and high level of slack in the economy – temporary fiscal stimulus leads to an eventual reduction in the debt to GDP ratio for plausible levels of hysteresis. As today’s output level has long-lasting effects on future output, increasing deficits in times where the multipliers is big – Pascal Michaillat, Yuriy Gorodnichenko and Alan Auerbach for models and empirical evidence on how the multipliers evolve over the cycle, as well as our recent review of micro based studies – increasing in spending can be self-financing. The mirror image of self-financing deficits in the current environment is self-defeating fiscal consolidations.

Brad DeLong reacts to the latest attempt of Paul Krugman to estimate the impact of consolidation on the debt to GDP ratio. Paul Krugman argues that €1.00 of spending cuts in Europe produces only €0.40 of debt reduction relative to baseline and produces a €1.25 fall in production in the short run. Assuming a long-term real interest rate on secure government debt of 4%/year, that means that austerity now improves the government's long-run fiscal condition only if the η – the hysteresis shadow cast on future European output by the current downturn – for Europe right now is less than 0.014. If even 3 out of 200 workers laid off for a year during this depression never return to work and 3 out of every 200 machines not installed in factories are never installed, then austerity is a bad bet on pure fiscal-stability grounds alone.

Daniel Gros argues instead that even assuming that the impact of a permanent cut in public expenditure on demand and output is also permanent, the GDP reduction remains a one-off phenomenon, whereas the lower deficit continues to have a positive impact on the debt level year after year.

How to cope with external effects of fiscal policy?

To discuss the role of external effects, an interesting discussion has emerged on the policies an ideal European government would implement, to contrast this with the actual policies that individual countries are implementing, or with the policies that the six-pack is requiring.  Simon Wren-Lewis argues that Europe needs a large stimulus relative to existing plans and a significant inflation differential between Germany and non-Germany. An ideal European government would raise inflation in Germany above the optimal level from the German national point of view.

Kantoos disagrees. An ideal European government would do three things that do not include fiscal stimulus in Germany. First, it would institute a monetary policy regime that does not narrow-mindedly focus on headline inflation but that does stabilize the nominal economy in Europe, ideally with a nominal GDP level target, targeting the forecast of course. Second, it would use all available tools (from macro-prudential regulation to monetary policy to fiscal rules) to manage the macroeconomy better and prevent regional booms and unsustainable sovereign debt. Third, it would conduct regional fiscal stabilization policy to support those regions that are in contraction despite the tools mentioned before, while at the same time forcing the countries to conduct the necessary reforms.

Is restructuring of household debt an alterbative?

Robert Skidelsky argues that in the Eurozone, both lenders and borrowers would be better off from a comprehensive debt cancelation. So would citizens whose livelihoods are being destroyed by governments’ desperate attempts to de-leverage. Rather than waiting to get rid of debt through bankruptcies, governments should “mandate debt forgiveness.”

In a very interesting interview with Mike Konczal on balance sheet recessions, Amir Sufi argues that we should at least try debt forgiveness. We are about four years into this mess, and we still don’t have any sense what the elasticity of consumption would be with respect to principal forgiveness. The reason we don’t have that estimate is that there’s been no principal forgiveness government programs. Of all that has been allocated, there’s been virtually nothing allocated to principal reduction to see if it works. I’m not willing to come out and say principal forgiveness will solve all of our problems. But at the very least, shouldn’t we have some basic idea of how responsive spending of highly indebted households would be to principal forgiveness? We’ve tried a ridiculous number of things in terms of government policy during this downturn: fiscal stimulus, homebuyer tax rebates, cash for clunkers, etc. Can’t we at least give principal forgiveness a chance, even if it is on a very small scale?

For more on all of these issues, the required reading is, as usual, the IMF Fiscal Monitor.

*Bruegel Economic Blogs Review is an information service that surveys external blogs. It does not survey Bruegel’s own publications, nor does it include comments by Bruegel authors.

The ‘new Dutch disease’ is of very different nature and will likely be less harmful for the Netherlands, at least in economic terms. Recently, there was no agreement in the Dutch parliament whether fiscal consolidation should be speeded up to meet the 3 percent of GDP deficit target by 2013, as envisioned by the excessive deficit procedure (EDP), at a time when the economy is expected to shrink. As a consequence, Prime Minister Mark Rutte offered his resignation on 23 April 2012. In the Netherlands, where the quality of fiscal institutions is excellent (see Table 8 on page 162 here) and the gross public debt is below 70 percent of GDP, the economic rationale would definitely not call for faster fiscal consolidation. See my arguments from mid-2010 or the recent Fiscal Monitor of the IMF, which also presents evidence that the negative impact of fiscal consolidation on output is stronger in an economic downturn.

The IMF forecasts a 4.9 percent budget deficit for the Netherlands in 2013: if that would be the outturn instead of 3.0 percent EDP target, public debt sustainability would not at all be in danger, but the Dutch economy, as well as trading partner countries, would benefit from a smoother adjustment. Market yields on Dutch treasury bills and bonds have not much changed and the Netherlands can still borrow at super-low interest rates (eg 0.05 percent at the 3-month horizon, 0.7 percent at the 3-year horizon and 2.3 percent at the 10-year horizon), reflecting the strong underlying fiscal position.

But the new Dutch disease is more significant from the perspective of the eurozone’s new fiscal architecture, which lays a very strong emphasis on meeting nominal targets (even if the new fiscal compact considers the so called structural balance, which is the nominal balance adjusted by the impact of the economic cycle and one-time items). If the Netherlands will be given leeway, other countries would likely, and rightly, demand the same. This would undermine the remaining credibility of the reinforced fiscal architecture. A fine for the Netherlands would do the same, by signalling that a low-debt/strong-institution country is punished when economics would call for a higher budget deficit. Probably the outturn will be a compromise, as always in Europe, whereby additional efforts will be requested, but the target date would be extended from 2013 by one or two years.

Yet there would be a first best solution, which is, unfortunately, just a dream now. In the US, where states have to consolidate in an economic downturn due to balanced budget rules, most automatic stabilisers are run by the federal government, which also stimulates economic activity with discretionary measures in distressed states. Lack of such European functions is a major root of the euro crisis and unfortunately there are no discussions about them. We can just hope that the new Dutch disease will bring such discussions to the table.

Even though the Hungarian government continuously communicated its commitment to fulfilling the expectations for the start of such negotiations, the progress has been painfully slow since the first indication of financial assistance request in November 2011. Several observes concluded that Hungary may wish to play a Turkish strategy: Turkey started negotiations for financial assistance with the IMF in the height of the crisis, which boosted confidence, but as time passed and the situation improved, the negotiations were not concluded. But Hungary is no Turkey: public debt is about 80% of GDP in Hungary and 40% in Turkey, and Turkey has a great growth potential, as reflected by the 9.0 and 8.5 percent annual real growth rate in 2010 and 2011, respectively, in contrast to the 1.3 and 1.7 percent growth of Hungary during the same years. And there are several other important differences as well, such as net external debt, which is in Turkey only about one-third of the Hungarian figure as a percent of GDP.

What has changed the Commission’s view? One possible explanation is that budget anxieties of Spain and the Netherlands (eg the IMF forecasts 5.7 and 4.9 percent of GDP deficit in 2013, respectively for the two countries, way above the 3.0 percent target) underlined that the Commission cannot be equally tough for all EU countries and therefore it became more lenient. (Indeed, there are strong reasons not to enforce the 3.0 percent deficit target by 2013 for both Spain and the Netherlands.) But I continue to think that the Hungarian government has a very strong incentive to comply: market pressure earlier this year and the continued very high borrowing cost made it clear that without an agreement, Hungary is running a serious risk of insolvency. Borrowing at 9 percent per year in a country with weak growth outlook, high external debt, still high share of foreign currency loans and sinking trust is not just very expensive, but not really sustainable. Regaining market confidence without the support of the Commission and IMF is not a real option.

The negotiations will likely be tough, but will be helped by the new fiscal adjustment plan announced earlier this week, which was generally well received. The willingness to agree form the side of the Hungarian government is also helped by the result of some recent opinion polls, which suggested that the majority of voters, including voters of the current governing party, would favour such an agreement. An eventual conclusion of the negotiations would help to restore trust, thereby further lowering borrowing costs from the market, because the current 8 percent rate is still too high. But the country should also make use of the very low interest rate of official lending, even though current communication of the Hungarian government suggests that the programme is seen as precautionary. While maintaining market access certainly makes sense, not exploiting the borrowing opportunity at about 3 percent per year, when the market rate will likely be still much higher, would be unnecessarily costly. A fifty-fifty reliance on market and official funding would be a good benchmark. And we should never forget: Hungary is no Turkey

As part of this larger deal, the legislative package on the new EU cohesion policy defines the principles behind the allocation and management of Structural and Cohesion Funds over the next seven years.

So far the debate on the future EU cohesion policy has not been as visible as others. And yet, Structural and Cohesion funds have played an important role in the European crisis and must be put to use to address current challenges from youth unemployment to the credit constraints facing Small and Medium Enterprises (SME) and rising national and regional disparities (see).

The legislative package on EU cohesion policy that the European Commission proposed on 6 October 2011 and now under the scrutiny of the General Affairs Council builds on a number of new principles:

• Thematic concentration
• Ex ante (regulatory) conditions for the allocation of funds
• Macroeconomic conditionality
• Performance-oriented EU cohesion policy
• Greater flexibility in the design of funded programmes

In a nutshell, the principles above imply that EU countries need to focus on a limited number of priorities; that the allocation of EU funds is subject to the existence of a number of conditions pertaining to the regulatory framework (for example, the appropriate transposition of EU laws on public procurement) but also the macroeconomic environment (namely, absence of excessive deficits and/or excessive macroeconomic imbalances); and finally that there will be a greater focus on performance including rewards for those that meet the agreed targets and the revision of programmes half-way through if they appear not to be effective.

The renewal of governance and the integrated approach are very much appropriate considering that the impact of EU funds on economic growth and cohesion is mostly a function of the way in which the funds are actually delivered. But there is still a gap to fill between the national and the European level.

The thematic-concentration approach forces recipient countries to pick a number of priorities from a list of eleven objectives. The priorities need to fit into a so-called Common Strategic Framework to makes sure they are consistent with each other and their interaction delivers the strongest possible impact. It sounds like common sense. However, because in an integrated market transnational spill-overs are as important as national ones, concentration makes full sense only if there is coordination at the European level (and not only at the national level), so that neighbouring regions maximise gains from, for example, international production value chains or investment in projects that produce important externalities (eg energy).

One such form of EU coordination could well take the form of a European industrial policy. Philippe Aghion has already advocated a rethinking of industrial policy in Europe. The argument is that targeted state intervention to support the most competitive sectors, possibly also using EU funds, can have important growth-enhancing effects (see the policy brief Rethinking industrial policy)

The European Commission has here a great role to play. It can take advantage of the new European Semester process. The Semester is an exercise in economic policy coordination for which EU member states submit their fiscal and structural reform plans early on in the year and at the same time to show that the framing of fiscal policy is consistent with other structural interventions including the use of EU funds to support long-term investment. That way internal consistency across policy areas is guaranteed. It is important that the same consistency exists across national reform plans. A European industrial policy strategy is what would contribute to enhanced coordination across countries.

1. The last decade

We look specifically at regional disparities in employment given the importance of labour markets and the fact that they have been strongly affected in the crisis. Chart 1 juxtaposes starting dispersion in regional employment in each country as of 2001 (vertical axis) and the change in the dispersion of regional employment from 2001 to 2010 (horizontal axis). Negative values on the horizontal axis point to less dispersion in regional employment, whilst positive values suggest rising disparities. A majority of EU member states managed to foster cohesion to some extent and probably for very diverse reasons considering that the two top performers, Poland and Finland, are very different from each other along numerous dimensions. But there are also countries where the cohesion record has actually deteriorated from 2001 to 2010. These include Bulgaria, Belgium, Austria, Italy and Portugal.

Furthermore, the poor correlation between the two variables is indicative of the fact that there has not been a proper convergence process meaning that internally diversified EU countries have not caught up over the last decade to become more homogeneous.

Chart 1: Regional disparities in employment (age group 15-64)

Source: author’s own elaboration based on Eurostat data.

2. The impact of the crisis on cohesion

One related question is the extent to which the recent crisis has contributed to regional disparities. Chart 2 is a scatter plot looking at the change in employment dispersion in the midst of the crisis from 2008 to 2010 (vertical axis) and in the pre-crisis period from 2001 to 2007 (horizontal axis). The general trend is towards an intensification of regional disparities during the crisis, which is both expected and worrying. But, as above, a closer look reveals quite a diversified picture. A few countries have indeed seen a dramatic deterioration in internal cohesion during the crisis compared with the previous period. These are Spain, which is top of the list, followed at some distance by Romania, the Czech Republic, Italy and Portugal. At the other extreme, however, Hungary and Austria have even improved internal cohesion during the crisis compared with the previous period. Others have generally posted a good record but the crisis has clearly interrupted the trend towards greater convergence, as evident on the example of Poland.  

Groups of countries that have gone through a similar transformation are never a consistent category (euro area countries, Central and Eastern European countries or Southern European countries, etc.). This should be taken as an indication of the fact that there is probably not one single determinant of socio-economic cohesion and that many intervening factors contribute to the final result (eg. the asymmetric consequences from the crisis, the availability of EU funds, internal fiscal transfers, sheer luck or lack of, etc).

Chart 2: Regional disparities in employment (age group 15-64) before and after the crisis

Source: author’s own elaboration based on Eurostat data.

The IMF can provide typical financial assistance to one of its member states. Should a further country of the euro area get into financial difficulties, IMF resources could thus be used together with the EFSF/ESM to provide assistance to the country concerned. The logic of this assistance is that the vulnerable member states of the euro area are individually in difficulties and need country-by-country financial assistance. These assistance programmes would come with the typical conditionality that aims at improving national policies so that public finances return to a viable track, economic growth and adjustment is fostered and financial stability in the banking system is re-established.

This standard approach to financial assistance was recently undertaken in Greece, Ireland and Portugal and it may be justified in other countries of the euro area. The 430 bn US$ are a welcome increase that will allow one of the large euro-area countries to benefit from such a financial assistance programme. However, this approach will be inadequate if the crisis goes beyond country-specific problems. In fact, it becomes increasingly clear that we are witnessing a crisis of the euro area as a whole. It is not only individual countries; it is the design of the euro area that needs fixing as it is deeply flawed. How then can the Fund adjust its policies to the complex euro area reality?

An immediate solution would be that the Fund provides financial assistance to the euro area as a whole and imposes conditionality on the euro area as a whole. However, the current statutes of the Fund prevent it from providing assistance to a monetary union or other regional arrangements. In fact, the Fund can provide assistance only to its members and the euro area is not a member of the Fund. This is of course because euro area member states have so far failed to agree on integrating their external representation. And this failure reflects the unwillingness of euro-area members to form a true union with integrated fiscal and financial policies. This is the fundamental design flaw of the euro.

For countries outside the euro area that have committed a large amount of resources to the Fund, the design flaw of the euro area poses a dilemma. They can only provide assistance to individual countries while they would rather like to contribute to the solution of the problems of monetary union as a whole. A radical solution that these member states could therefore demand from the IMF is to only lend resources to the euro area and not to its members.  This would require the euro area to unify its representation, form a political union and become a member of the IMF. The problem with this approach is that it would effectively prevent the Fund from lending while the house is on fire until long and difficult institutional adjustments and potentially a new Treaty are established. And indeed, Fund resources may be needed earlier to stabilize the euro area and prevent a major catastrophy for the world economy.

Instead, it appears sensible that the Fund adopts a more flexible approach. It should engage in further lending activities to euro-area member states when necessary. The conditionality should be focused on the problems of the member state. At the same time, the IMF should increase its pressure on euro area authorities to address the institutional design flaws. The IMF is currently stepping up its work on the euro-area financial system with a new Financial Sector Assessment Program report. This report should be used to be clear and specific on the elements needed to stabilise the euro-area financial system.

The larger the IMF’s involvement in countries of the euro area, the more it should demand from the Eurogroup collectively and Fund’s member states located in the euro area individually to address these design flaws. This is particularly warranted if it becomes clear that a member state turns to the IMF because of a euro area institutional flaw. In that case, conditionality should be extended to institutional reform. While the constitution of the euro area ultimately needs to rest on the will of the people of the euro area, the IMF’s role goes far beyond individual country assistance programmes. 430bn US$ should be spent to promote change in Europe.

More broadly twelve other heads of state and governments in Europe signed a letter to the European Council at the end of March arguing that Europe was wrong headed and lacked a growth strategy. This should resonate well in France where the presidential frontrunner, François Hollande, has argued repeatedly that he would renegotiate the fiscal compact and seek to strengthen the pro-growth dimension of the current European strategy.

However, Europeans differ fundamentally over what makes an effective growth strategy. Some support deregulation, free trade and liberalization to promote structural growth, others continue to believe that fiscal rigor leads to private sector investments and consumer confidence. Still others argue for public sector investments that support demand and innovation. The final growth strategy is likely to be a compromise of these three visions, but getting to that compromise means accepting that the current strategy is incapable of delivering the goods.

But the biggest risk to the European economic outlook is that of renewed financial distress. Indeed, Europe still has a very fragile banking system and doesn’t have a coherent and effective financial sector policy that would stabilize its financial markets, allowing its banks to lend again and give a new growth strategy a real chance.

Over the next few months, Europe needs to do two things. First, tweak the existing rescue instruments to help recapitalize and restructure the Spanish banking system. This will be the embryo of a real banking union jointly backed by member states and a supranational guarantee of deposits similar to the F.D.I.C. in the United States. Second, European member states need to create the equivalent of the federal government debt market to supply safe assets to its banking system and strengthen its surveillance mechanism. There are a few proposals on the table to do that, but the more modest one that would lead euro area governments to issue eurobills currently strikes the best balance between economic effectiveness and political feasibility.

Once these steps are completed, Europe will be in a much stronger position to devise and implement a concerted and multifaceted growth strategy. Before then, all efforts will be wasted because an impaired financial system will yield limited results and continue to tear Europe apart, pulling a growing number of its countries into a spiraling debt deflation.

Dear All,

It has been an eventful last few days for the Spring Meetings of the IMF and the occasion of a series of speeches, conferences and corridor discussions which I have only followed from the distance and via proxies.

Despite, the disappointment on the European firewall (or the lack thereof), the IMF unleashed some 430bn dollars of additional resources but the focus has turned on the necessity to tackle convincingly the banking sector (and therefore Spain).

I will only focus on:

European banking resolution: What we have and what we need?

After fiscal consolidation, the consensus seems to be that financial stability is the biggest downside risk to the economy and that the credit multiplier is key to the recovery and that this will only come through a stable banking system. In this context, policy efforts should intensify to quell the European banking crisis.

I have already discussed this to some degree last week where I was complaining that the ECB was wrongly channeling its pressure on governments towards fiscal consolidation and not towards banking sector restructuring. I’m happy to being proven wrong this week by at least three ECB speeches, one by Benoit Coeure on risk sharing where he repeated his call for banking sector resolution and restructuring authority, one by Constancio at the Banque de France’s Stability Review presentation in DC, one by Jorg Asmussen who also essentially called for a European FDIC.

These three speeches are very encouraging and contrast with the previous discretion of the ECB on these matters. The fact that they are also apparently coordinated means that they are more than personal reflections (Benoit Coeure had already mentioned these ideas before) but are now more broadly shared and advocated by the Executive Board.

What is somewhat disappointing still is that these speeches outline what looks like a long-term objective but do not translate into actionable policy responses in the short term. In particular, it is not very clear how one reconciles those lofty ideas about decentralized risk sharing in the euro area with the urgency of the Spanish situation.

Here I think one needs to appreciate that we do not really need new institutions in the short-term and that the embryonic structure of the future banking resolution and restructuring mechanism is the EFSF (and ESM to be). The EFSF does not have the real political mandate and technical ability but it can create the former and buy the latter.

Indeed, the EFSF was given last summer the ability to be used for the purpose of banking sector recapitalization. It can therefore totally act as the agent for a profound restructuring of the banking sector any given program country. In its current setting, it would have to lend onto the governments but could structure the loan such that its terms mimic an indirect equity participation in the banking sector. More importantly, beyond the financial aspects, the “Troika” would have to design a banking restructuring plan to which national authorities would have to adhere.

This is where the challenge starts because nobody in the “troika” has this sort of expertise. The first type of expertise needed is a detailed analysis/valuation of each and every asset in all banks’ balance sheets. This is tedious work but Blackrock and other firms seem to have developed (in Greece and elsewhere) the technology to do this fairly effectively and this expertise can therefore be subcontracted.

But once this is done, important political decisions need to be taken about the banks that will be let go, the ways to recapitalize them and the amount of public resources that should be dedicated to this effort. These decisions are likely to be inadequate, if they are taken by national authorities alone, and they are likely to ignore important national idiosyncrasies if they are completely imposed by the troika.

This trade-off can only be resolved by a body with more executive authority and legitimacy than the EFSF currently enjoys (the ESM will have more authority in this respect, especially if it is chaired by the chairman of the eurogroup). The question is whether the ECB could be this agent until a new body/institution is created?

Finally, the ECB remains extremely silent on deposit guarantee schemes (ironically forgetting that this is the primary function of the FDIC to which all of these speeches make direct or indirect reference!). Even though, the ECB has understandable difficulties in talking openly about deposit guarantees (risks of self-fulfilling runs), organizing a supranational backstop of deposits is an important preemptive tool and would go along the lines of clarifying fiscal and monetary responsibilities in the risk sharing.

In fact, it might be a necessary precondition because in a number of instances, if bank creditors are to make a loss in the restructuring, they might spark runs across all categories of creditors in the capital structure. For instance, depositors in Spain who have invested in hybrid quasi-equity structures in Cajas where they keep their deposits will be more likely to move their deposits abroad if they are to make a loss on their equity investment. These cross-correlations can be addressed only with an effective and credible deposit guarantee scheme.

All in all, we are slowly moving in the right direction (Banking union) but:

• We need to start thinking more seriously about supranational guarantee schemes. An EFSF backstop of national schemes could do but ideally a real supranational backstop of all deposits along equal terms would be better. Having this in place, would greatly simplify restructuring/resolution. One should think of it as anaesthesia before surgery.

• We do not need a new FDIC type of institution now but need a transitory one. The EFSF and the ECB could be temporary fixes to on one hand finance and take responsibility for and on the other hand outline and implement a restructuring/resolution plan.
  
  
• We need to think about better institutions for the future but cannot afford to wait to have these institutions before we act in Spain.

Finally, I can’t conclude without a couple of words on the French election where political analysts seem to consider that Hollande’s victory is now within reach. I’m a bit more doubtful and think that the polls are showing an excessive advance for Hollande in the second round and that Sarkozy will be a much tougher opponent. But regardless of the final result, I think the most important outcome of this first round is the very strong showing of the far right (around 19%). The Front National is likely to take a place in the French political landscape that it never had since WWII. This is a bad moment for Europe and is likely to be echoed across the continent. Watch how the early elections in the Netherlands are going to unfold for more on this…

Happy to have your thoughts as usual,

Best Regards,

Standard Cost-Benefit Analysis

The 2006 Stern Review on the Economics of Climate Change broke down the social discount rate into three components: the pure time discount rate (d), the elasticity of the social marginal utility of consumption with respect to consumption (h), and the growth rate of technology (g): SDR = d + hg. In terms of numeric values, Stern sets d=0.001, implying a 0.1% chance of human extinction each year. Stern thus basically treats current and future generations equally; the only difference between the two arises from a small possibility of extinction. Stern then sets h=1, which implies that the elasticity of marginal consumption between better-off and worse-off individuals is equal to the ratio of their wealth. A high value of h means that transfers of wealth from rich to poor are endorsed, while a low h implies little concern about distributional equality. Stern then goes on to make a positive assumption about the growth rate of technology and sets g=1.3%. This leads to an SDR of 1.4%. With this value, urgent action against climate change is warranted. The practical policy implication Stern calls for is an investment of 1% of global GDP in the fight against CO₂ emissions, which would stabilize global stocks of GHG below the 550ppm threshold.

Martin Weitzman – of Harvard University – argues in the Journal of Economic Literature that the conclusions of the report rely on parameter values that are imposed a priori rather than chosen in a democratic manner. The author argues that it is possible to come up with more reasonable numbers based on observed behavior in the marketplace. One option would be an SDR of 6%, obtained by setting d=2%, h=2, and g=2%. He further suggests that the general uncertainty surrounding the topic warrants a higher SDR. This need not be 6, as in the previous example and could also lie in the 2-4 range. This would create a middle-ground between Stern’s recommendations and more skeptical views according to which climate change action should be delayed.

William Nordhaus argues that the findings of Stern – that “if we don’t act, the overall costs and risks of climate change will be equivalent to losing at least 5% of global GDP each year, now and forever. If a wider range of risks and impacts is taken into account, the estimates of damage could rise to 20% of GDP or more” – differ markedly from economic models that calculate least-cost emissions paths to stabilize concentrations or paths that balance the costs and benefits of emissions reductions. Mainstream economic models definitely find it economically beneficial to take steps today to slow global warming, but efficient policies generally involve modest rates of emissions reductions in the near term, followed by sharp reductions in the medium and long term. Nordhaus suggests taking an h=3 and keeping d close to 0. This, he argues, would lead to real returns and savings rates closer to values observed in the economy. Stern’s findings rely on a low discount rate and low inequality aversion, which results in savings rates and real returns which are very different from actual economic values. In a recent article for the NYT Review of Books, Nordhaus argues in favor of immediate moderate action, via cap-and-trade or carbon taxes.

Partha Dasgupta – of Cambridge University – is suspicious as to whether Stern’s theory remains defensible in the face of small changes in parameter values. If a g=0 were to come about (while keeping d and h fixed at the values chosen by Stern), Dasgupta argues that current generations ought to save 97.5% of current production for future generations. He thus accuses Stern’s theory of exhibiting normative bias. Brad DeLong responds to Dasgupta’s assessment. DeLong considers the arithmetic underlying Dasgupta’s conclusion and finds that a savings rate of 22.5%, not of 97.5 %, is in fact required. This renders Stern’s prescription more reasonable. DeLong also advocates a d=0, which implies that current and future generations carry equal weight in climate change mitigation. DeLong goes on to express his agreement with Dasgupta with regards to the importance of the h parameter. He suggests that different h_s, in the range of 1 to 5, should be considered and that this should have also been the approach of the Stern Review.

Richard Tol does a meta-analysis of the social cost of carbon. The author finds that there is a downward trend in the estimates of the social cost of carbon and that the Stern Review is an outlier. Its impact estimates are pessimistic even when compared to other studies in the gray literature and other estimates that use low discount rates. The uncertainty about the social cost of carbon is so large that the tails of the distribution may dominate the conclusions.

Fat tails and the economics of climate change

In a recent article, Martin Weitzmann argues that the most striking feature of the economics of climate change is that its extreme downside is nonnegligible and that the way in which this deep uncertainty is conceptualized and formalized influences the outcomes of any reasonable cost-benefit analysis (CBA) of climate change. The author does not argue that the standard model is wrong or even implausible, but rather that it may not be robust with respect to the modeling of catastrophic outcomes.

He suggests that the unprecedented scale and speed of GHG increases brings policy makers into uncharted territory, rendering climate predictions very difficult. Current CBA models assume that the climate will respond in a certain way to increased GHG emissions and that this response will follow a distribution with thin tails. This implies very little concern for potentially extreme outcomes. Weitzman points out that modeling tail probabilities one way or the other can have huge consequences. He contrasts a Pareto distribution with a normal distribution, assuming that the latter is usually at the heart of CBA models. Carrying out simulations using the two leads to extremely different estimates, particularly regarding the reactiveness of high-temperature probabilities to the level of GHGs.  He concludes that the focus should be shifted away from central tendencies and towards extreme tails.

William Nordhaus provides an assessment of Weitzman’s initial views on this topic. He particularly focuses on Weitzman’s point that under certain strict assumptions about the structure of uncertainty and preferences, “society has an indefinitely large expected loss from high-consequence, low-probability events” (the ‘dismal theory’). Nordhaus stresses that the theory is only applicable under very limited conditions involving strong risk aversion, a fat tail for the uncertain variables and an inability on society’s part to act in time against climate change. He finds nonetheless that tail events deserve attention and careful analysis and acknowledges Weitzman’s merit in drawing attention to the existence of deep uncertainties. He goes on to suggest that it is unclear when cost-benefit analysis should or should not be employed. He concludes that this decision will rest largely on the “the uncertainty surrounding specific issues and phenomena, as well as attitudes toward risk.”