<![CDATA[Bruegel - Latest Updates]]> http://www.bruegel.org Thu, 31 Jul 2014 16:46:36 +0100 http://www.bruegel.org/fileadmin/images/bruegel-logo.png <![CDATA[Bruegel - Latest Updates]]> http://www.bruegel.org Zend_Feed http://blogs.law.harvard.edu/tech/rss <![CDATA[Fact of the week: Russia sanctioned from all sides]]> http://www.bruegel.org/nc/blog/detail/article/1408-fact-of-the-week-russia-sanctioned-from-all-sides/ blog1408

Yesterday, the EU introduced new sanctions targeted at specific sectors of the Russian economy. This came one day after an international arbitration court in The Hague had decided for an unprecedented ruling related to Yukos, an oil company with a very controversial fate.

On Monday a Tribunal of the Permanent Court of Arbitration in The Hague ruled unanimously that Russia shall pay 50 billion USD to shareholders of Yukos, which back in 2003 used to be Russia’s biggest oil company. It “used” to be, because Yukos actually does not exist anymore. It was seized by the Russian state ten years ago, after the imprisonment of its principal and controversial shareholder, Mikhail Khodorkovsky.

At the time of his imprisonment, Khodorkovsky happened to be  Russia’s richest man, with a fortune estimated by Forbes to be around $15 billion in 2004, and quite outspoken. In October 2003, he was allegedly seized by “masked agents” aboard his corporate jet during a refueling stop in Siberia and convicted of theft, tax evasion and money-laundering in 2005. After serving 10 years in jail and he was pardoned by Putin in 2013.

Source: The Economist

After Khodorkovsky’s arrest, Yukos was broken up and nationalized, and most of its assets were transferred to Rosneft, the state-owned energy group which is by the way already on the US blacklist and now may be hit by EU sanctions too. The chart above effectively summarizes the share price development in these two years.

More precisely, the FT reports that YNG - Yukos largest oil producing unit - was acquired by a company called Baikal Finance Group, which was established two weeks before the auction and whose registered address seems to have been that of a bar in a town north of Moscow. YNG was allegedly worth ⅔ of Yukos total value (around 40 USD billion), but its core assets were sold to Baikal at 9.35 USD billion. Baikal had a capital of $359 only, but it managed to make the cash deposit of $1.77bn required to register for the auction. Rosneft then acquired the company following the auction.

Anders Aslund’s explains in detail the origins and bases of the case. The arbitration is in fact based on the Energy Charter Treaty, concluded by about 50 European countries in 1994 and entered into force in 1998, which contains strong guarantees against confiscation. Russia happened to have signed but never ratified it. The signature however provided sufficient justification for this case. In 2009, Russia withdrew from the Energy Charter Treaty just after its jurisdiction for this case was accepted by The Hague court. As a consequence, no new case can be raised against Russia on the basis of the treaty, but this one could continue. The defendant was the Russian Federation whereas the main claimant was GML Ltd., which owned 60 percent of Yukos and was formed by Mikhail Khodorkovsky and partners in 1997. The primary beneficiary of trusts that own 70% of GML is Leonid Nevzlin, partner of Khodorkovsky, to whom Khodorkovsky gave up his dominant share in 2005. The original claim was $103.5 billion.

The FT has an interesting collection of quotations from the Yukos judgement, which questions the means and motives of the Yukos affaire.

The arbitrators explicitly states that “The decision to seize and sell Yuganskneftegaz, which accounted for approximately 12% of Russia’s oil output and whose value on any estimation dramatically exceeded that of the alleged tax debt, can only be reconciled with a desire to destroy the Company and appropriate its core assets”.  And again that “the desire of the State to acquire Yukos’ most valuable asset and bankrupt Yukos. In short, it was in effect a devious and calculated expropriation by Respondent of YNG”.

Concerning the company that took over YNG, the judgement points out that “one of the most opaque facets of the YNG auction is the identity of Baikal, the sole and successful bidder at the auction which was acquired by State-owned Rosneft three days after its successful bid. [...] It was obviously a vehicle created solely for the purpose of bidding for YNG at the auction.”

The most important link, however, is the one between Baikal and Rosneft. The judgement states that “Rosneft’s purchase of the YNG shares from Baikal was an action in the State’s interest, the inference being that the State, then 100 percent shareholder of Rosneft, the most senior officers of which were members of President Putin’s entourage, directed that purchase in the interest of the State. It follows that that act, as well as the auction of YNG shares that underlay it, is attributable to the Russian State. ”. FT Alphaville has a must-read account of how it has actually been the loose lip of Putin himself to lead the arbitrators to the conclusion that Rosneft was acting on behalf of the State.

Long story short, Yukos former shareholders were awarded 50 bn USD in damages to be paid by the Russian Federation. The award is largest than any prior international arbitration award (20 times the previous record, to be precise) and large for Russia, as it accounts to almost 2.5% of GDP, 11 per cent of Russia’s foreign exchange reserves and 10 per cent of the national budget. (see figure below for a detail account of how the 50 bn are derived).

Source: FT

In what looks like a masterpiece in perfect timing, this comes one day before the EU also agreed a package of additional restrictive measures against Russia on the reason of its role in Crimea and Ukraine.

According to the statement sanctions will be “targeting sectoral cooperation and exchanges with the Russian Federation. These decisions will limit access to EU capital markets for Russian State-owned financial institutions, impose an embargo on trade in arms, establish an export ban for dual use goods for military end users, and curtail Russian access to sensitive technologies particularly in the field of the oil sector”.

The phase-three sanctions details published by the Council states that:

  • EU nationals and companies may no more buy or sell new bonds, equity or similar financial instruments with a maturity exceeding 90 days, issued by major state-owned Russian banks, development banks, their subsidiaries and those acting on their behalf. Services related to the issuing of such financial instruments, e.g. brokering, are also prohibited.
  • An embargo on the import and export of arms and related material from/to Russia was agreed. It covers all items on the EU common military list. The measures will apply to new contracts and not existing deals. This point that has been quite controversial, due to France’s decision to honour an existing contract to sell Mistral-class helicopter assault ships to the Russian navy.
  • A prohibition on exports of dual use goods and technology for military use in Russia or to Russian military end-users. All items in the EU list of dual use goods are included.
  • Exports of certain energy-related equipment and technology to Russia will be subject to prior authorisation by competent authorities of Member States. Export licenses will be denied if products are destined for deep water oil exploration and production, arctic oil exploration or production and shale oil projects in Russia.

These restrictions will now be formally adopted by the Council through a written procedure and they will apply from the day following their publication in the EU Official Journal, which is scheduled for late on 31 July.

The sky is getting greyer over Moscow and the number of issues that could keep policymakers awake at night is growing, on both fronts. The Yukos ruling hit Russian stocks, and the dollar-denominated RTS index of Russian shares closed down 3 percent according to Reuters. Rosneft shares were down 2.6 percent and Rosneft Dollar Bonds Slump to 12-Week Low (see below).

Source: Bloomberg

The FT reports one person close to Mr Putin saying the Yukos ruling was insignificant in light of the bigger geopolitical stand-off over Ukraine. “There is a war coming in Europe,” he said. “Do you really think this matters?”. Hopefully, at least the first part of the statement will not prove right.

Wed, 30 Jul 2014 06:17:56 +0100
<![CDATA[Blogs review: The economics of big cities]]> http://www.bruegel.org/nc/blog/detail/article/1407-blogs-review-the-economics-of-big-cities/ blog1407

What’s at stake: An intriguing paradox of our age is that the global economy is becoming increasingly local, with super-productive cities driving innovation and growth nationwide. This has generated a discussion as to whether local land use policies, which restrict the housing supply in high productive metro-areas, should be constrained by central governments to limit their negative externalities on overall growth.

Local economies in the age of globalization

Enrico Moretti writes that the growing divergence between cities with a well-educated labor force and innovative employers and the rest of world points to one of the most intriguing paradoxes of our age: our global economy is becoming increasingly local. At the same time that goods and information travel at faster and faster speeds to all corners of the globe, we are witnessing an inverse gravitational pull toward certain key urban centers. We live in a world where economic success depends more than ever on location. Despite all the hype about exploding connectivity and the death of distance, economic research shows that cities are not just a collection of individuals but are complex, interrelated environments that foster the generation of new ideas and new ways of doing business.

Enrico Moretti writes that, historically, there have always been prosperous communities and struggling communities. But the difference was small until the 1980’s. The sheer size of the geographical differences within a country is now staggering, often exceeding the differences between countries. The mounting economic divide between American communities – arguably one of the most important developments in the history of the United States of the past half a century – is not an accident, but reflects a structural change in the American economy. Sixty years ago, the best predictor of a community’s economic success was physical capital. With the shift from traditional manufacturing to innovation and knowledge, the best predictor of a community’s economic success is human capital. 

Ejaz Ghani, William Kerr and Ishani Tewari explain that the debate on whether cities grow through specialization or diversification dates back to Alfred Marshall and Jane Jacobs. Marshall (1890) established the field of agglomeration and the study of clusters by noting the many ways in which similar firms from the same industry can benefit from locating together. Jacobs (1969), on the other hand, pushed back against these perspectives – she emphasized how knowledge flows across industries, and that industrial variety and diversity are conducive to growth. 

Big cities in the crisis

Richard Florida writes that in the years since the economic crisis, powerhouse metros like San Francisco, New York, and Washington, D.C., have continued to grow in importance. In 2012, the top ten largest metropolitan economies produced more than a third of the country's total economic output.

Josh Lehner writes that the largest metros (the 51 largest have a population of 1 million or more) have seen the strongest gains in recovery. The second set of metros have seen some acceleration and the nonmetro (rural) counties have seen deceleration over the past year. It is also interesting to note that only the largest cities have seen growth rates return to pre-recession levels, while the others lag. This is at least partly due to the nature of the Great Recession in which housing and government have been large weights on the recovery. These jobs also play a disproportionately large role in many medium, smaller and rural economies than in big cities.

Source: Oregon Office of Economic Analysis

Dealing with the nationwide externalities of local regulations on land use

Wonkblog reports that for Enrico Moretti we should care about how San Francisco and big cities like it restrict new housing because the economic repercussions of such local decisions stretch nationwide. These super-productive cities have been among the least likely to add new housing since 1990. By preventing more workers who would like to live in the city from moving in, big cities are holding back the U.S. economy from being as productive as it could be. Yet, despite these negative national externalities, land-use policy has always been a local issue.

Chang-Tai Hsieh and Enrico Moretti write that one possible way to minimize this negative externality would be for the federal government to constraint U.S. municipalities’ ability to set land use regulations. Currently, municipalities set land use regulations in almost complete autonomy, since the effect of such regulations have long been perceived as predominately localized. But if such policies have meaningful nationwide effects, then the adoption of federal standard intended to limit negative externalities may be in the aggregate interest.

Chang-Tai Hsieh and Enrico Moretti write that a possible solution is the development of forms of public transportation that link local labor markets characterized by high productivity and high nominal wages to local labor markets characterized by low nominal wages. Enrico Moretti writes that California high-speed rail has always been thought of as a fast way to move people from Los Angeles to San Francisco, as competing with the plane. But it might be that actually its most meaningful economic impact would be as a way to allow people in Central Valley low-wage cities to commute to the Bay Area

Inequality and big cities

Kristian Behrens and Frédéric Robert-Nicoud write that inequality is especially strong in large cities. Large cities are more unequal than the nations that host them. For example, income inequality in the New York Metro Area (MSA) is considerably higher than the US average and similar to that of Rwanda or Costa Rica. Large cities are also more unequal than smaller towns. While larger cities increase the income of everyone, the top 5% benefit substantially more than the bottom quintile.

Tue, 29 Jul 2014 08:25:32 +0100
<![CDATA[Chart of the Week: The Big Mac (index) and euro area adjustment]]> http://www.bruegel.org/nc/blog/detail/article/1406-chart-of-the-week-the-big-mac-index-and-euro-area-adjustment/ blog1406

Following up on previous comments on the Big Mac index and euro area adjustment, the latest data-update suggests a slow-down in the price adjustment between euro area countries taking place since the beginning of the crisis.

Source: The Economist. Note: the price for Portugal in July 2012 are considered an outlier, interpolation has been used to correct for this.

The chart above shows that there was nearly no change in big mac prices over the last year (blue bar, July 2013 to July 2014), except for Greece. While one could still observe major downward price adjustments of big mac burgers in Greece and Ireland in the period from 2011 to 2012, and to a lesser extent from 2012 to 2013, the price adjustment has stopped in Ireland and even reversed in Greece over 2013-2014. In Portugal, Spain and Italy, no downward pressure of prices could be observed, as big mac prices increased somewhat throughout the period.

A similar picture emerges when looking at inflation developments (see below). Inflation in the euro area has been falling since late 2011, and has been below one percent since October 2013. Core-inflation, a measure that excludes volatile energy and unprocessed food price developments, has followed suit. In particular, since the beginning of 2011, the core-inflation rates of Ireland and Portugal have dipped into negative territory at some point. More interestingly, Greece and to a lesser extent Cyprus have both experienced extended periods of deflation, and in the last months also Spain’s’ core inflation dropped to -0.1 % yoy. However, Greece recently experienced somewhat less deflation (-1.4 % yoy in June 2014) than some months ago and also Cypriot and Irish core inflation rates are on an upward trend. This suggests that price adjustment has slowed down in these countries.  

Source: Eurostat

Mon, 28 Jul 2014 14:03:21 +0100
<![CDATA[India torpedoes the Bali Trade Facilitation deal]]> http://www.bruegel.org/nc/blog/detail/article/1405-india-torpedoes-the-bali-trade-facilitation-deal/ blog1405

Citing concerns over food security, after a Cabinet meeting headed by the Prime Minister Narendra Modi last week, India reportedly decided against signing onto the trade facilitation protocol that was agreed upon at the WTO’s the Ninth Ministerial Conference at Bali last December as a key deliverable under the Bali package2. While this is not yet an official position on the issue, concerns are rife that India may actually make good on the threat, if only as calculated brinkmanship to get its way at the WTO on its food security and public stockholding concerns.

Other than South Africa and a few members from the G33 group, India stands alone in this most recent negotiating spat. Several countries even issued statements saying that a failure to agree on the protocol would be a massive blow to the WTO’s credibility3. Member’s adopting/signing onto the TFA protocol on July 31 is a key first step before the deal can be ratified for implementation by July 31, 2015.

The Bali package is an early harvest of the 13 year old multilateral trade negotiations under the Doha Development Round (DDR), which has been faltering since its inception given the wide divergence in expectations of the key negotiating partners from the trade agreement. The Bali package included 10 agreements. They comprise a binding agreement on trade facilitation4 and four descriptive items in agriculture such as general services, public stockholding for food security purposes, understanding the tariff rate quota administration provisions of agriculture products, and export competition. In the development dossier, the Bali package offered non-binding best endeavour outcomes on preferential rules of origin for least developed countries, organisation for the waiver concerning preferential treatment to services, duty-free and quota-free market access, and a monitoring mechanism on special and differential treatment.

As this author had noted in an earlier post, “the net immediate gains from the Bali agreement therefore boils down to the symbolism of resurgent multilateralism and the WTO”, given that other than in trade facilitation and food security, “in several other areas the ministerial declaration only consists of statements of intent and conditional implementation promises”. However, while commentators have noted the various asymmetries marking WTO's Bali package and the hypocritical stance of the developed countries at the WTO, and in particular the USA in the agriculture negotiations, the adoption of the mini-agreement in December 2013 did indicate a support for multilateral trade negotiations at a time when the world’s leading economies have decidedly turned pro-regional and increasingly nationalistic in their approach to trade liberalisation negotiations.

Is there any method in India’s madness?

As regards its design, under the paragraph 47 of the Doha Declaration of 20015, the early harvest Bali package is part of DDR’s single undertaking, although it can be implemented in a manner decided during the negotiations. And the Bali package envisaged agenda-wise sequential timelines for delivery6 of the different parts of the package, without hinting that progress in the different protocols need to be simultaneous or at similar speed, with the TFA adoption being the first deliverable scheduled for July 31, 2014 in order to facilitate implementation within the next 12 months.

The next key deliverable on the timeline was finalisation of the post-Bali DDA work programme before December 2014, while the permanent solution on public stockholding for food security purposes under the Agriculture Committee negotiations were slated for conclusion with a 2017 deadline, the latter’s extended timeline also reflecting the fact that food security issues still have to be negotiated, most likely as a part of the overall agriculture agreement. The only assurance on the subject was that the Peace Clause7 expiry was tied to the timeline of a “permanent solution” on the dispute over the legitimate uses of food reserves for food security, a definite negotiation gain that India scored at Bali.

Thus it can be argued that the above differential implementation timelines have determined prioritisation of certain sections of the Bali package in the Geneva based negotiations in 2014, although it has drawn criticism from the LDC group that expressed unhappiness stating that “everything else is being held hostage pending the conclusion of discussions on the TFA”. Critics have however argued that the concept of the single undertaking was undermined because trade facilitation had a quick implementation deadline while the other two parts of the Bali package, food security and policies to support least developed countries, had only vague commitments and distant deadlines. The fear is that by advancing agreement on only some parts of that broader development agenda, and by fast-tracking an issue of most interest to developed countries – trade facilitation8the logic of the single undertaking would dissolve and they would see no movement on the issues that matter to them most, agriculture and food security.

As discussed above, in light of the fact that India is likely to push for an extension of the July 31 first implementation deadline or suggest that the trade facilitation agreement be made “provisional” subject to progress on other Bali issues, countries now fear a derailment of the tentative gains in the multilateral track negotiations at the WTO. Concerned WTO members, in particular industrialised countries and other major developing country trading nations, have warned that failing to seal the trade facilitation protocol would unravel the whole package of trade agreements agreed upon in Bali, effectively destroying the chance of further global trade reform, something that India has long demanded. New Delhi’s stance that progress in food security negotiations would determine its adoption of the TFA protocol is thus treading on dangerous waters.

But it may be interesting to understand whether India’s threat to withhold its support for trade facilitation can effectively scuttle the Bali deal in the WTO’s consensus-based process. In fact there is a legitimate view emerging that perhaps too much is being made out of the TFA protocol outcome. All the protocol does is open the Marrakesh Agreement establishing the WTO to allow another agreement, in this case the TFA, to be added to the existing WTO Agreements. The protocol is therefore a mere legal instrument which allows this change to happen. Governments must still ratify the TFA following WTO’s procedural requirements, and only when two-thirds of the Members do so does it enter into force, but only for those countries which ratify. In fact it is theoretically possible that India could actually never ratify and thus never have to comply with the TFA requirements.

Unfortunately that move will be counterproductive for Indian businesses and their external competitiveness, even when Indian exports are largely in a narrow band of product categories that are either commodities or niche (traditional and manufactured) products and services, and are unrelated to any major global production networks’ trade chain. And this is the reason why Indian industry has been vocal in its disapproval over the current supposedly pro-business government’s willingness to put in jeopardy an agreement that would enhance national export competitiveness merely to “ensure that Indian minimum support prices (MSPs) for food products continue to be high”. Others have argued that if India's refusal to back the protocol derails the Bali deal, it could lose the four-year reprieve and face sanctions on its current foodgrain stockpile9 which critics say could be dumped into global markets, although in practice India does not have a history of dumping grain that it acquires for purposes of food security for the economically vulnerable, and its exports are usually at market prices.

Strategy or Lack of Vision?

Multilateral negotiations at the WTO are an extremely complicated exercise, requiring the fine balancing of a multitude of sectors and interests. Countries have to play off their internal lobbies' demand against the gains from trade, which are generally spread out over all their citizens; and unanimity is required, making progress subject to vetoes from countries with no stake in the future. It is doubly tragic, therefore, if such hard-won outcomes get torpedoed by one of the countries with most to gain from a strong multilateral trading system; India’s current economic development and trade patterns indicate that unilateralism and multilateralism are its welfare-optimising options, and ought to be preferred over the much-hyped gains from regionalism.

The new Prime Minister has often emphasised that all his policy actions will have only one single criterion of whether or not they serve India’s national interests. Mr. Modi has vowed to spur economic growth through sweeping changes to policies and seems committed to boosting India’s competitiveness by improving its business climate. In that light, the present government’s fixation with focusing primarily on alleviating domestic infrastructure and policy constraints for growth is laudable if India hopes to catch up with its neighbouring Asian powerhouse; China’s GNI per capita (PPP, in current international $) in 2013 stood at $11,850 – more than double of India’s $5,35010. And his government’s apathy to global governance issues and proactive multilateral engagement is then a corollary if one believes that good bureaucratic and diplomatic resources are limited and become ineffective when spread out thin.

That said, the strategists in the present Indian government would do well to consider in totality the related geo-economic developments before determining the country’s future stance towards regional/ global engagement. Unfortunately, not unlike the other economic powerhouses, the new Indian government’s current stance on the TFA (and multilateral trade negotiations in general) seems to reinforce the concern that a grand vision on future trade policy and a longer-term governance strategy is sorely lacking; the current thinking seems to be largely dominated by short-termism and protectionist-nationalist mindsets. As the panellists argued in a recent Bruegel workshop on the subject, this lack of strategic thinking may have grave consequences for the future of the global trade governance system, which if evolves in favour of fractured regional trade governance regimes will harm most the weaker developing countries, including emerging markets like India with limited integration into the global production and supply networks, and a large population of poor low-skilled workforce.

India has a history of resorting to aggressive brinkmanship to get its way at the GATT/WTO, but as an oft-used strategy it may have lost its edge already. It is clear that there is very limited support for its latest stance on the TFA protocol. On the other hand, doing nothing is an acceptable strategy only when it is backed by a long-term strategic thinking and foresight. Inertia and political opportunism are also often confused with continuity in policy making. Thus, one only hopes that there is more to India’s recalcitrant stance in the WTO this time around, beyond its use as a mere negotiating tactic. For it is becoming painfully apparent that in the current geo-political and economic context, doing nothing/ maintaining status quo in the multilateral forums is likely to extract a very stiff price in the future from everyone, and in particular a country like India.


[1] Marie Curie Fellow at Bruegel (Project MULTITRADE, No. 328351). This blog reflects only the author’s views and the European Union is not liable for any use that may be made of the information contained therein.

[2] However, media reports on the following day seemed to suggest that a change of stance is possible, and India might finally relent on the trade facilitation agreement (TFA), provided it gets an “assurance” from the WTO’s  member-countries, especially the developed nations, that issues concerning food security would be addressed along with TFA.

[3] The European Union has warned: "Without adoption of the Trade Facilitation Protocol by July 31 a great opportunity to mobilise trade as an instrument for growth and development would be lost, and the credibility of the WTO, which has during the financial crisis proven its value as a firewall against protectionism, would be further damaged." Japan also said it strongly urged "those members who take a contradictory stance" to try to achieve the common objective. A statement made by Thailand, Malaysia, Vietnam, Pakistan and other developing countries said: “A decision to step away (from TFA) will be in no one’s interest. It will undermine the ability of WTO to deliver for the future.”

[4] The TFA is often described as a "good governance agreement" for customs procedures that industrialised countries want the developing and the poorest countries to implement on a binding basis, failing which the latter can be hauled up at the WTO’s dispute settlement body.

[5] Paragraph 47 states:  With the exception of the improvements and clarifications of the Dispute Settlement Understanding, the conduct, conclusion and entry into force of the outcome of the negotiations shall be treated as parts of a single undertaking. However, agreements reached at an early stage may be implemented on a provisional or a definitive basis. Early agreements shall be taken into account in assessing the overall balance of the negotiations.

[6] And several countries have already said that renegotiation of existing timelines is not an option.

[7] We acknowledge here the inherent injustice of the Bali Peace Clause being offered to India and the G‐33 countries for just four years, and also that it excludes the subsidies measures and expires even if there has been no resolution of the other outstanding Doha issues. This is in sharp contrast to the nine-year long Peace Clause that the US and the EU negotiated in 1994 to protect themselves from WTO lawsuits over their hugely distorting subsidies and countervailing measures.

[8] This unfortunately has indeed been recommended by some American trade policy experts.

[9] India’s vast grain stockpiling and a US$22 billion annual food subsidy programme implemented by the previous government are (price) subsidies in breach of the WTO’s current specified limits.

[10] The corresponding figures in GDP per capita (current US$ ) are China: 6,807, India: 1,499, indicating a more than 4-fold gap.  

Mon, 28 Jul 2014 10:01:03 +0100
<![CDATA[Is the BRICS rise over?]]> http://www.bruegel.org/nc/blog/detail/article/1404-is-the-brics-rise-over/ blog1404

On one level, this seems like a rather odd time to be asking such a question, especially when the BRICS political leaders have just agreed to set up a joint development bank to be headquartered in Shanghai. So the BRICS name is certainly here to stay, and in terms of global governance, their influence is likely to rise as a group because of this development.  

Previously, the BRICS political leaders meetings had failed to agree anything specific and even once the creation of such a bank was first mooted, for the past two years, they appeared to have difficulties in agreeing where it might be located and how it should be capitalised. At this Fontaleza meeting in Brazil, they have confounded sceptics by agreeing not only both these key things, but also to have the first head of the Bank to be an Indian. What the Bank will prioritise in terms of lending and projects, we will have to wait and see, but one can think of many good ideas including shared road and rail infrastructure challenges, especially those with some common borders, projects for energy efficiency, alternative energies, clean and safe water, and of great importance to themselves, to focus on the growing resistance to antibiotics, a challenge that if a solution cannot be found will be very harmful for their futures.

But if the BRICS leaders hadn’t made this breakthrough, I am sure the siren rising about the end of the BRIC economic phenomena would be even louder and it is important to try and objectively deal with this, separately from this announcement, important as that is.

So, let’s deal with the case as to why the BRIC story might be past its prime. Some observers believed that the whole notion of a grouping of Brazil, Russia, India and China never made any sound sense because beyond having a lot of people, they didn’t share anything else in common. In particular, two are democracies, and two are not, obviously, China and Russia.  Similarly, two are major commodity producers, Brazil and Russia, the other two, not. And their levels of wealth are quite different, with Brazil and Russia well above $10,000, China around $ 7-8 k, and India less than $ 2k per head.  And the sceptic would follow all of this by saying, the only reason why Brazil and Russia grew so well in the past decade was simply due to a persistent boom in commodity prices, and once that finished, as appears to be the case now, then their economies would lose their shine, as indeed appears to be the case.  Throw in that China would inevitably be caught by its own significant challenges at some point, which the doubters would say, is now, then all is left is India, and if it weren’t for the election of Modi recently, there has not been a lot to justify structural optimism about that country recently.

It is factually the case that all four BRIC countries have seen their GDP growth rates slow sharply in this decade. From 2011-13, China has grown by 8.2pct compared to 10.5 pct the last decade, India has slowed to 4.6pct , down from 7.6, Brazil has grown by 2pct, down from 3.6, and Russia , some 3pct, compared to 4.6pct.  So all four have grown less, and in all cases, there are plenty of issues to worry about.

But, let’s now start to get serious. Because of China’s huge importance, the weighted average performance of the BRIC growth rate since 2011 is 6.5pct. Now this is down from 7.9pct the last decade, but higher than the previous two decades. China today is one and a half times the size of the other three put together, so its influence on their combined growth rate is more important. Related to this, the BRIC countries combined GDP is nearly as large as the US, and by end 2015, it will be the same size in current US$. (In PPP terms, it is already substantially larger than the US). So even with slower growth, the BRIC country’s economic influence is on the rise. In US$ terms, they are contributing decade to date more than 3 times to the world economy that of the US, and obviously in PPP terms, even more.

So, the idea that the importance of the BRICs is over is really not a credible objective economic issue. ( note I don’t make any inclusion of South Africa as that economy is so small, it is not justified to be regarded in the same economic sphere. It is actually not even the largest economy in sub-Sahara Africa anymore, Nigeria is today. And there at least 8 other so called emerging economies are much bigger than South Africa, some of them at least 3 times)

What is undoubtedly true is that the RATE of BRIC growth has slowed, but while this might be a surprise to the casual observer, it certainly isn’t to most who follow them closely. In fact, the 6.5pct decade to date is just 0.1pt less than I had assumed in 2010 that they would grow by 6.6pct. China, crucially is actually growing by more than I assumed, so far by 8.2pct, actually more than the 7.5pct I assumed. This is compensating for the weaker growth in the other three, which indeed has disappointed my expectations, especially Brazil and Russia, and to some degree India. So it might be truer that the BRIC story decade to date has been purely supported by China, and without that, then the disappointment might be much more justified. And it would follow that if China is about to slow a lot further, which many sceptics think, then the BRIC economic story would become marginally less.

The problem with this line of thinking is that while there are considerable challenges for China, in many cases, there is evidence that the policymakers are rising to those challenges and trying to deal with them, which I might point out is quite different from many other countries that often ignore them until they cause massive crises. For example, how many readers can recall any country deliberately trying to stop house prices rising as China has- possibly-successfully-done? A couple of years ago, people worried about housing bubbles in Beijing and Shanghai, they don’t talk about that anymore. Why? Because the problem has eased due to policy. Today the sceptics fear bubbles in so-called second and third tier cities, but I think there is a reasonable chance that the policymakers will deal with them especially with so many migrants still to migrate and, now, to receive proper full blown urban citizen rights including house ownership. And more importantly still, is the data itself. After months of clear slowing, much of it, including the recent PMI’s and June’s raft of economic data has all improved further, and from what I can see, 7.5pct looks to be in the bag for 2014, if not a bit stronger.

I do believe each of Brazil and Russia have got some challenges to face, that they are not yet confronting, which at the core is to reduce their dependency to the commodity cycle, and while there are many differences between them, they do both need to become more competitive and entrepreneurial outside of commodities and to boost private sector investment. Which leaves India, about who I have to say, following the really powerful election victory of Modi, I think there are clear reasons to expect big policy improvements, and I now don’t entirely rule out that this country could still match my 7.5pct expectation for the decade. It will be really difficult, but what is quite likely is that they may grow more than 7.5pct in the second half of the decade, and possibly faster than China.

So the BRIC economic story over? I think not, even without their historically important decision to create a shared development bank, the consequences of which we are set to learn about.

Sat, 26 Jul 2014 08:55:03 +0100
<![CDATA[What do legal cartels tell us about illegal ones?]]> http://www.bruegel.org/nc/events/event-detail/event/453-what-do-legal-cartels-tell-us-about-illegal-ones/ even453

Economists and policy analysts know very little about the conditions under which cartels are formed in different legal environments, how they behave against outsiders, how they behave against deviating insiders, and how they react to changes in the economic environment. This event will provide a space to discuss these aspects, based on two projects funded by SEEK.

One of the projects studies cartel organization – a topic on which there is little information to date – through the lens of legal cartels. While such cartels did not have to fear detection and prosecution, they faced the same internal organizational challenges as illegal cartels. The focus is on comparing empirically, in specific sectors, the organizational forms of legal cartels in countries with different legal regimes. The project has collected data on Austrian, Finnish, Norwegian, Swedish and American legal cartels.

The other project has developed new theoretical insight into the anatomy of hard-core cartels and combined it with a rich data set on the recent German cement cartel. The results of this project will be presented to the audience attending the event. The private data set comprises about 340.000 market transactions from 36 customers of German cement producers and encompasses most of the period during which the cartel was functioning, as well as a period after the collapse of the cartel.

This event is jointly organised by SEEK.


11.30 -11.45: Welcome speech by Reinhilde Veugelers, Bruegel

11.45 – 12.15: Legal Cartels in Europe – A Historical Episode?

  • David Genesove, The Hebrew University of Jerusalem, Israel

12.15 – 12.45: Legal Cartels in Europe – A Cross National Comparison

  • Otto Toivanen, KUL Leuven Belgium
  • Konrad Stahl, University of Mannheim, Germany

12.45 – 13.00: Coffee Break

13.00 – 13.30: Cartels in Cement Production and Distribution

  • Joe Harrington, Wharton School of Business, University of Pennsylvania, Philadelphia, USA

13.30 – 14.00:Discussion

  • Massimo Motta, Chief Economist at DG COMP, European Commission, and University Pompeu Fabra
  • Christian Ewald (TBC)

14..00 – 14.30: Lunch

Fri, 25 Jul 2014 15:50:56 +0100
<![CDATA[Fact of the week: Lithuania changes the ECB’s voting system]]> http://www.bruegel.org/nc/blog/detail/article/1403-fact-of-the-week-lithuania-changes-the-ecbs-voting-system/ blog1403

Lithuania will become the 19th member of the Euro area on the 1st of January, following Wednesday’s Council endorsement. The most important part of the story - however - is not that someone is still brave enough to join the Euro area, but that Lithuania's accession will trigger a change in the voting system of the ECB.

Lithuania’s accession to the euro area will be effective on the 1st of January 2015. This will bring the number of eurozone members to 19 and the Governing Council’s members to 25 (6 members of the executive board and 19 National Central Bank governors). Enough to trigger a change in the ECB’s Governing Council’s voting system, which will start rotating.

Actually, the statutes of the European System of Central Banks and of the ECB already envisaged the switch to a rotating system when the number of euro area countries exceeded 15 (which has been the case since quite some time). However, in December 2008, the Governing Council decided to defer the decision until the number of governors exceeded 18. This was an exception possible under the letter of the Treaty, but no other escape clause is offered and the rotation is therefore unavoidable.

The idea behind the rotation is to ensure the effectiveness of the ECB’s decision making even with an increased number of participants. The Federal Open Market Committee (FOMC) of the US Federal Reserve uses a similar system, with 12 voting members, 7 of whom are members of the Board of Governors and hold permanent voting rights. Differently from the ECB’s case, in the US specific regional governors enjoy special treatment. The President of the New York Fed has a permanent voting right, the Presidents of the Federal Reserve Banks of Chicago and Cleveland vote every other year and the Presidents of the other nine Federal Reserve Districts vote every third year.

At present, the ECB governing council works under the principle of “one man, one vote” and decisions are taken with simple majority. Under the new regime, voting rights will invariably rotate every month. Only 15 (out of 19) governors will be given the right to vote every month, based on a rotating selection. 6 votes will come from the members of the ECB’s Executive Board, which will retain the voting right permanently, bringing the total number of votes to 21 (3 less than at present).

On top of that, votes will not be completely independent on the size of the countries anymore. The member of the Governing Council will in fact be assigned to groups, depending on the respective weight of their countries in the euro area economy (GDP at market prices, weighted for ⅚) and financial sector (MFIs’ aggregated balance sheet, weighted ⅙). The aggregate reference measure will be adjusted either every five years or when the number of EMU member states changes. Based on this ranking and as long as the number of governors does not exceed 21, the groups will be as follows (figure 1):

  • Group 1: will comprise the governors of the NCBs of the 5 countries with the largest weight in the euro area. At present, members would be Germany, France, Italy, Spain and the Netherlands. This countries will  share 4 votes, so each country will miss one vote every five.
  • Group 2: includes the rest of the world, i.e. the governors of the NCBs of the remaining countries. These are 14 countries and will share 11 votes.

Figure 1

Source: Deutsche Bundesbank

This system will hold until the number of euro area member countries reaches 22. At that point, rotation will become more complex and it will be structured around three groups, based on the size of the economies. The first group will still be composed by the 5 governors of the national central banks of the main euro area economies, still with 4 votes. The second group will half of the total number of governors, with 8 voting rights and the third group is made up of the residual countries which will share 3 voting rights (Figure 2).

Figure 2

Source: Deutsche Bundesbank

All governors will nevertheless take part to the discussions. The decision making process will still follow the “one man one vote” principle, but this time majority will be computed only among those voters who have the right to vote at a given meeting. And the frequency at which countries will be given the right to vote will depend on the group they are in, which in turn depends on their relative size.

Tables I and II - from ECB’s monthly bulletin of July 2009 - clarifies the point. Countries in Group 1 (the biggest countries) will always retain 80% voting frequency, no matter how many countries were to eventually join the monetary union. Countries in Group 2 will see their voting frequency decrease potentially down to 57%, as long as new members join. Countries in Group 3 (if ever the number of euro area members were to surpass 22) will be allowed to vote at most 50% of the time, less than 40% in the “worst” case scenario. In other words, this means that the biggest 5 can consider themselves in a rather secure position, whereas small countries are likely to see their influence decrease over time, if bigger members were to join.

To avoid excessively long periods of suspension of the voting rights, the rotation will be monthly. In the first group, one governor will join/leave at each rotation. For the second and third groups, things are more complicated. The number of governors gaining voting rights at the start of each month will be equal to the difference between the number of governors allocated to the group and the number of voting rights assigned to it, minus two.  (e.g. with 19 governors as in 2015, 14-11-2 = 1). This means that not all of the governors without a vote in a given month will regain their voting rights in the subsequent rotation period. With this system, the length of suspension of the voting rights will be one month in the first group and three months in the second group in 2015 (assuming less than 22 governors).

What will be the effects of this change? First, the power of the Executive Board will potentially rise, since it will have 29% of the votes at each session and in a permanent way. Second, in terms of voting rights balance, not much changes. The 5 biggest countries will have under this system 19% of the voting power against 20% in the non-rotating system. The small countries will instead have 52% of the votes against 56% at present. Third, the influence of biggest countries will be maintained - the period of rotation is one month, so no one will be excluded for a long period of time -  and most importantly it will be secured in the long term, as they the voting frequency within the group of five will always be 80%. Moreover, since all governors (also those who cannot vote in a given section) are present to the discussions and since this voting is by definition a sort of repeated game, it seems unlikely that decisions will be taken “behind the back” of any big country.

Last but not least, after explaining how it works, there is another “small” issue to point out. This system of rotation is built with a monthly frequency, with rotation occurring at the beginning of the month. The ECB in its Monthly bulletin of July 2009 clarifies that “as a rule, two physical Governing Council meetings take place every month. The first is dedicated exclusively to monetary policy decisions, and the second generally deals with all other issues to be decided by the Governing Council. The one month rotation period allows governors to exercise their voting rights in both types of meeting.” But ECB President Draghi recently communicated that from January 2015 onwards the Governing Council will make monetary policy decisions once every six weeks rather than once every month. Which means that the length of each “voting-right cycle” would be not match (will be shorter) than the “monetary policy decision cycle”.

Unless the ECB wishes to change the rotating voting system again, of course.

Fri, 25 Jul 2014 06:32:23 +0100
<![CDATA[Asset-backed securities: The key to unlocking Europe's credit markets?]]> http://www.bruegel.org/publications/publication-detail/publication/842-asset-backed-securities-the-key-to-unlocking-europes-credit-markets/ publ842

The European market for asset-backed securities (ABS) has all but closed for business since the start of the economic and financial crisis. ABS (see Box 1) were in fact the first financial assets hit at the onset of the crisis in 2008. The subprime mortgage meltdown caused a deterioration in the quality of collateral in the ABS market in the United States, which in turn dried up overall liquidity because ABS AAA notes were popular collateral for inter-bank lending. The lack of demand for these products, together with the Great Recession in 2009, had a considerable negative impact on the European ABS market.

The post-crisis regulatory environment has further undermined the market. The practice of slicing and dicing of loans into ABS packages was blamed for starting and spreading the crisis through the global financial system. Regulation in the post-crisis context has thus been relatively unfavourable to these types of instruments, with heightened capital requirements now necessary for the issuance of new ABS products.

And yet policymakers have recently underlined the need to revitalise the ABS market as a tool to improve credit market conditions in the euro area and to enhance transmission of monetary policy. In particular, the European Central Bank and the Bank of England have jointly emphasised that:

“a market for prudently designed ABS has the potential to improve the efficiency of resource allocation in the economy and to allow for better risk sharing... by transforming relatively illiquid assets into more liquid securities. These can then be sold to investors thereby allowing originators to obtain funding and, potentially, transfer part of the underlying risk, while investors in such securities can diversify their portfolios... . This can lead to lower costs of capital, higher economic growth and a broader distribution of risk” (ECB and Bank of England, 2014a).

In addition, consideration has started to be given to the extent to which ABS products could become the target of explicit monetary policy operations, a line of action proposed by Claeys et al (2014). The ECB has officially announced the start of preparatory work related to possible outright purchases of selected ABS1.

In this paper we discuss how a revamped market for corporate loans securitised via ABS products, and how use of ABS as a monetary policy instrument, can indeed play a role in revitalising Europe’s credit market.

However, before using this instrument a number of issues should be addressed:

First, the European ABS market has significantly contracted since the crisis. Hence it needs to be revamped through appropriate regulation if securitisation is to play a role in improving the efficiency of resource allocation in the economy.

Second, even assuming that this market can expand again, the European ABS market is heterogeneous: lending criteria are different in different countries and banking institutions and the rating methodologies to assess the quality of the borrowers have to take these differences into account. One further element of differentiation is default law, which is specific to national jurisdictions in the euro area. Therefore, the pool of loans will not only be different in terms of the macro risks related to each country of origination (which is a ‘positive’ idiosyncratic risk, because it enables a portfolio manager to differentiate), but also in terms of the normative side, in case of default. The latter introduces uncertainties and inefficiencies in the ABS market that could create arbitrage opportunities.

It is also unclear to what extent a direct purchase of these securities by the ECB might have an impact on the credit market. This will depend on, for example, the type of securities targeted in terms of the underlying assets that would be considered as eligible for inclusion (such as loans to small and medium-sized companies, car loans, leases, residential and commercial mortgages). The timing of a possible move by the ECB is also an issue; immediate action would take place in the context of relatively limited market volumes, while if the ECB waits, it might have access to a larger market, provided steps are taken in the next few months to revamp the market.

We start by discussing the first of these issues – the size of the EU ABS market. We estimate how much this market could be worth if some specific measures are implemented. We then discuss the different options available to the ECB should they decide to intervene in the EU ABS market. We include a preliminary list of regulatory steps that could be taken to homogenise asset-backed securities in the euro area. We conclude with our recommended course of action.

The European ABS market: evolution and current size

The ABS market peaked in Europe before the crisis, with a total of $1.2 trillion in new ABS issuance in 2008. By 2013, total new issuance was only $239 billion (Figure 1). Demand for these assets plummeted after 2008 because of the deterioration in the rating of the collateral behind the various types of ABS, leading to a major market price correction of ABS products.

Figure 1: New issuance in the EU ABS market, 1999-2013 (2014Q2)

Source: SIFMA (July 2014).

Moreover, the freeze in European inter-bank lending reduced demand for these assets as collateral for repurchase (repo) agreements (in other words, agreement to sell an asset and buy it back at a later date). In particular, after the start of the financial crisis in 2007-08, the ECB progressively tightened the rating and structural requirements for ABS it would accept as repo collateral, with the result that using ABS as repo collateral became expensive, in particular compared to covered bonds. Hence, after 2008, the amount of eligible ABS declined by 38 percent while covered bonds increased by 14 percent, until in mid-2012 covered bonds overtook ABS as delivered repo collateral for the first time since 2007.

A final blow to the ABS market during the crisis came from the insurance sector. Insurance funds, traditionally large buyers of ABS products, were also negatively impacted by the introduction of more restrictive regulation in response to the crisis, and consequently limited their ABS purchases.

Country-by-country, the smallest players in the market (eg Belgium and Ireland) saw a decrease in new issuance of more than 95 percent from the peak, while, among the main issuers, new issuance in Italy, the Netherlands and Spain dropped by about 73 percent. In Germany, the decline was 80 percent. It is interesting to look at the United Kingdom: here, new issuance represented almost a third of total European issuance on average until 2008, but after the peak, UK flows dropped by 90 percent, with new issuance in 2013 representing less than 20 percent of the European total. Considering this change in the UK’s role in the structured product market, new issuance in the euro area rose to 73 percent of total European new issuance in 2013, from 63 percent in 2008. However, in volume terms, euro-area issuance was slashed from $766 billion to $175 billion.

Interestingly, the collateral behind the ABS products also varied during the crisis, with the collapse in the issuance of Real Mortgage Backed Securities (RMBS) and European Collateralised Debt Obligations (CDOs), with issuance of both dropping by 90 percent between 2008 and 2013 (Figure 2). The composition of overall issuance thus changed, with a (relative) increase in ABS with consumer credit as collateral, and a marginal increase in ABS backed by loans to small and medium-sized enterprises.

Figure 2: Breakdown of ABS issuance per type of collateral, various years

Source: SIFMA (July 2014).

Another indication of the reduction in the liquidity of this product is the amount of new issuance placed on the market relative to ABS retained by originators, such as banks that package securitised products (Figure 3). Before the crisis, almost 70 percent of new issuance was placed on the market, and the remainder retained by originators. After 2008, the share of new issuance placed on the market dropped to below 10 percent, signalling virtual market refusal of these securities. More recent figures point to a market placement rate of about 40 percent, though at much lower overall volumes.

Figure 3: Retention rate of ABS products, various years and type of collateral

Source: SIFMA (July 2014).

However, originator retention rates vary by type of instrument. Despite the dramatic reduction in issuance of CDO and Commercial Mortgage Backed Securities (CMBS), currently around 90 percent of their new issuance is placed on the market, probably because of demand from specialised investors, who could no longer find these securities on the market. By contrast, there is weaker market demand for RMBS, generic ABS (car loans, leases, etc) and SME ABS. In particular, almost all new SME ABS are retained on banks’ balance sheets, with only 10 percent placed on the market.

What is the potential for an increase in the size of the ABS market?

The outstanding amount of European securitisation, at the end of 2013, was approximately €1 trillion, of which roughly half was placed on the market (Table 1 on the next page). For comparison, at its peak in 2008, the overall outstanding amount of the ABS market reached more than €2.2 trillion. About 60 percent of the market (€637 billion) is made up of mortgage-backed securities (residential and commercial), followed by standard ABS (car loans, leases, etc) with a volume of €150 billion, and SME ABS for €102 billion. CDOs stood at €113 billion.

Table 1: Total outstanding amount of EU securitised products

Source: SIFMA data Q1-2014.

The quality of these securities varies in terms of collateral type, with about 77 percent of the amount outstanding rated above BBB, and therefore eligible for collateral transactions with the ECB3 (Figure 4). The highest presence of high-rated securities is in France and Germany, while Italian and Spanish ABS are more concentrated in the ‘single A’ category, in line with the evolution of the sovereign ratings in these countries. In terms of collateral type, SME ABS are the lowest quality, probably due to the heterogeneity of the collateral and the deterioration of companies’ balance sheets during the crisis. Moreover, in the case of SMEs the quality of financial information reported in balance sheets is in general less regular and accurate, an issue that also impacts negatively on the rating, because it implies a more negative assessment of the probability that loans will be repaid. From 30 to 40 percent of SME ABS are currently estimated to be sub-investment grade or not rated. Italy and Spain are also the countries with the main outstanding volumes of SME ABS.

Figure 4: Rating of ABS products per type of collateral and country, 2013

Source: SIFMA

Given these figures, what potential for growth does the ABS market have overall, on the basis that potential ECB purchases could create sufficient demand to revitalise the market?

Looking at the markets for collateral, data from monetary financial institutions shows (Figure 5) that the outstanding amount of mortgages for house purchases (thus secured lending) stabilised at about €3.8 trillion in 2013 in the euro area, while the outstanding amount of bank loans to non-financial corporations (NFC) in the euro area reached about €4.2 trillion. Figure 5 also compares the trend in the mortgage market to that in the RMBS market (left panel), and NFC loans to SME ABS (right panel).

In both cases, there has been an evident fall in volumes of both types of securitised product, with SME ABS performing relatively worse. The reason is the contraction of credit demand coupled with bank deleveraging, leading to a contraction of NFC loans, compared to relative stability in the volume of mortgage loans outstanding. Hence, collateral for SME ABS operations has been squeezed relatively more compared to RMBS. Moreover, one has to consider the negative regulatory impact on capital requirements associated with the issuance of this type of product.

The question is, then, how much of these outstanding volumes of loans to NFCs or mortgage loans worth €8 trillion could be translated into new issuance of RMBS and SME ABS. In line with Batchvarov (2014), we make estimates on the basis of mortgage loans to households and loans to non-financial corporations, for the countries that represent 80 percent of the total portfolio of outstanding loans in the euro area (Germany, France, Italy, Spain, Ireland and Portugal). The share of SME loans in total NFC loans, as estimated by the OECD (2013), varies between these countries. Applying these shares to the euro area, the implied euro-area SME ABS share is approximately 25 percent of total outstanding NFC loans.

On the basis of the conservative assumption that only 50 percent of the €8 trillion of existing loans is ultimately eligible for securitisation (eg for reasons of maturity or loan characteristics), we then introduce a different haircut so that the securitised products attain an investment grade rating (to be eligible as a collateral for the ECB). Unlike the standard assumption of a homogeneous 10 percent haircut for subordination for all categories of assets (Batchvarov, 2014), we apply a more prudential and differentiated haircut for the three main categories of assets selected, as retrieved from updated statistics for these securities (SIFMA): 35 percent for SMEs loans, 30 percent for ABS backed by loans to large corporations, and 15 percent for mortgages.

Based on this, we estimate a maximum amount of securitisation of roughly €3 trillion (compared to €4 trillion estimated by Batchvarov, 2014), broken down as shown by Figure 6 on the next page. It should be noted that SME ABS would represent the smallest fraction (about 10 percent) of this market.

Figure 6: Estimates of potential ABS market for the euro area (€ billions)

Source: Bruegel.

Table 2 on the next page shows that the estimated breakdown of the potential overall ABS market by country will vary according to the size and composition of each country’s underlying market for collateral5: Germany, France and Italy would each represent almost 20 percent of the total NFC-loan ABS, while in terms of SME ABS, Spain would count for a fifth of the whole amount, with Germany and France accounting for about 17 percent each. The role of Germany is also significant in the RMBS market, representing about 26 percent of the outstanding amount, followed by France, Spain and Italy.

Table 2: Potential availability of ABS per country (%), est.

Source: Bruegel estimates based on MFI data (March 2014) and OECD

The revival of the ABS market: the options

Our estimates show that the euro-area securitisation market has the potential to build significant volume and to be sufficiently liquid for use in possible non-conventional monetary operations. However, a number of trade-offs must be considered relating to the timing of ABS market measures, and the underlying size of the market at that moment: the earlier that measures are taken, the more restricted will be the type of ABS product that can be targeted for direct purchase (eg SME ABS only), reducing the impact of potential ECB operations on credit markets.

These trade-offs arise because the current securitised products on the market differ in terms of underlying characteristics, ie collateral type and thus rating, borrowers’ quality and geographic distribution, loans’ residual maturity, frequency of repayment, cost of credit, type and amount of interest (fixed or variable), prepayment rates and possible credit enhancements built into the structure6. Because of these heterogeneous characteristics, only a fraction of existing ABS products are ‘ready to use’, if ever, by the ECB. Moreover, within the existing range of products, there are different implications of the ECB targeting for direct purchase only SME ABS rather than RMBS. Undertaking specific regulatory steps aimed at standardising the characteristics of securitised products in different countries might allow the full activation of the estimated €3 trillion in potential ABS market volume, but reaching such a figure would require time for implementation.

In the following sections we detail the ECB’s options.

Option 1: Act small and fast

Option 1 would involve the direct purchase of very simple (‘plain vanilla’) existing ABS products with corporate credit exposure7. By pursuing this option, the ECB could act immediately, but would have a limited direct impact on credit markets. Existing ABS products limited to SMEs loans amount to €102 billion (Table 1). If the lease component of generic ABS is included, one could add a further €15 billion8. With respect to these figures, the volume of securitised products available for immediate use with a rating above investment grade is 60 percent of SMEs ABS and 50 percent of the lease components. As a result, with these constraints, the maximum theoretical size of the ABS market for immediate ECB intervention is about €68 billion. This is probably not enough to generate a direct impact on credit conditions in the euro area.

This does not imply, however, that there is no role for an ABS market backed only by corporate credit exposure, even in its current form. In the wake of the crisis, origination of ABS products has been subject to the introduction of stricter regulations on capital requirements for insurance companies, and on risk-weighted assets for banks (see Annex 1 for a summary of ABS capital requirements/risk weights)9. Within the current set of rules, therefore, any type of non-conventional monetary policy under which ABS assets are purchased will ultimately free up capital in banks’ balance sheets. This is particularly true for SME ABS, since their average rating is low and therefore the capital absorption for senior tranches below AAA is huge and greater than capital absorbed by the loans themselves. Consequently, ECB intervention in the ABS market, even if potentially limited in size, could magnify the effects on credit origination of the ECB's targeted longer-term refinancing operation (TLTRO), announced in June 2014, although the exact additional magnitude of these effects is hard to predict.

Option 1 could thus be a way of solving the trade-off for the ECB: intervening immediately in the relatively small (at its current volume) ‘plain vanilla’ ABS market, but limiting the scope of the operation to an ‘indirect’ vehicle through which the effects of the TLTRO could be magnified.

Option 2: Act large and slow

Option 2 essentially implies reviving, deepening and integrating the euro-area ABS market so it can be used as a new tool for non-conventional monetary policy. The ECB and the Bank of England (2014b) point at improving the regulatory environment for ABS products to better differentiate the necessary prudential requirements for relatively simple, robust and transparent ABS products (eg consumer finance ABS, RMBS and SME ABS) from more complex and potentially illiquid instruments. By revamping this market, these instruments could be used effectively as a ‘direct’ vehicle through which non-conventional monetary operations could be run. Clearly, the trade-off here is that developing the latter would require a number of changes to underlying regulation, and would thus take time.

To achieve a high-quality, simple and transparent European ABS product, two areas of regulatory change should be developed: one on collateral rules, for the corporate loan market in particular; the other on ABS product characteristics, ie the format to be applied to various types of ABS10.

Collateral rules

Regarding the rules on collateral, two issues should be addressed:

1 More selective regulation on capital requirements

ABS are a tool that could provide more flexibility to financial institutions to achieve better capital ratios throughout the system, and to reduce leverage ratios, since securitisation, when sold by originators, would enable reductions in risk weighting. Changes in ABS risk weighting could lead to high-quality, simple and prudently-structured securitisation products receiving more consistent regulatory treatment across financial legislation11. In particular, regulators could work to reduce the discrepancy between regulatory treatment of ABS and collateral12.

During 2013, progress was made on financial regulation, but further steps are necessary as part of the implementation of the Capital Requirements Directive IV to clarify whether and to what extent ‘European’ ABS would count as regulatory liquidity, the future risk weights they will have for securitisation in the banking and trading books and the extent to which their rating would be correlated with the sovereign credit rating of the originating country13.

As far as insurance regulation is concerned, in relation to the Solvency II directive (which is to enter into force in 2016), the European Insurance and Occupational Pension Authority (EIOPA) is also examining regulatory capital requirements for insurers’ ABS investments, in order to reduce capital requirements for insurance companies.

2 More transparent and available information on collateral

In order to stimulate further the market for ABS, especially for SME loans, common guidelines on a minimum level of information to be reported in SME balance sheets should be agreed, in line with the ECB eligibility requirement that loan-level data should be publicly available. Balance sheets thus produced should be made available to originators, in order to increase transparency and comparability of collateral. At the same time, rules on standardised rating methodologies for securitised products should be enforced within the Single Supervisory Mechanism.

The homogenisation of company reporting, to also encompass non-listed companies, will enable analysis of the performance of individual companies in European countries, and will facilitate access to credit at the same cost for companies within the same sector in different countries. In addition, steps towards the coordination of default laws in different countries should also be undertaken, to reduce uncertainty for bondholders in case of defaults.

ABS product characteristics

Two issues also need to be addressed in terms of the format of securities:

1 Common guidelines on ABS structure

The risks of ABS are embedded not only in the type of underlying collateral that is securitised, but also in the way collateral is sliced and packaged (see Box 1 for an overview of the basic elements constituting an ABS product).

A common structure for each type of collateral would ease the origination process and imply that the spread between different bonds in each rating category would depend only on differences between collateral characteristics (such as geographical distribution, maturity or the legal framework applying to default). Common structure could tremendously boost market liquidity. Also, the cost of creating the instruments should decrease, as pan-European banks will be able to leverage the size of their loan pool across European markets. With a common structure, the rating framework should become more homogeneous as well, cutting the cost of providing ratings and making the European ABS market much more similar to the US market. Ratings will become more closely related to collateral characteristics and less to the sovereign rating of the originator, and monitoring by rating agencies during the life of the product will focus more on collateral evolution. A straightforward way of achieving this result would be to build on the idea, already hinted at by the ECB, that only an ABS format with a ‘plain vanilla’ structure would be eligible for purchase by the ECB.

2 Common guidelines on the setup of SPVs within national borders

Another key factor in the underlying heterogeneity of the securitisation process is also related to the different role that the ‘Special Purpose Vehicle’ (SPV) might acquire (see Box 1). The SPV is a unique entity the role of which is the acquisition of an identified pool of assets. The SPV is the holder of the collateral within the securitisation. The owner of the SPV, whether it is the originator or a pool of originators, bears the risk of the SPV. A possible guideline is that an originator could establish only one SPV for all the transactions of the same type to be issued, instead of one SPV for each transaction. In the case of a single SPV for all transactions, since the vehicle is immediately available, transaction costs will diminish and the process of securitisation will speed up.

In cases in which a group of originators considers creating a common SPV for the ABS market (whether or not specialised by type of collateral) the risk will be borne by the owners of the SPV. A Banque de France initiative to re-start the securitised SME loan market has worked along these lines.

The creation of a joint SPV within national borders allows for sharing of set-up and operating costs. Standardised legal documentation used by the originators will also reduce costs and operational frictions, and make the SPV a very efficient credit claims mobilisation tool. Whether such a set-up is legally compatible with each country's legal framework, and whether such a choice could be more efficient from the market point of view, are however open questions. The answer in part would depend on the risk weighting assigned to the shareholders of the SPV.

Another reason for the creation of a joint SPV is that, once a common ABS structure with the same collateral type is defined ex ante, there will be less flexibility or creativity in the structuring phase, so that certain type of collateral, if available in volumes that are insufficient to respond to the structuring requirements (such as over- collateralisation criteria), could not be used. While in the past the lack of assets to create credit enhancement in the form of over-collateralisation was compensated for by other forms of internal or external credit enhancement, the absence of this choice in the new system could place a limit on the participation of small and medium players in the ABS market, because of lack of collateral. The problem could however be circumvented through the creation of an SPV at national level, or jointly created by small originators. This would stimulate more consolidation of the banking sector within countries.

In summary for option 2, we can conclude that, under the Single Supervisory Mechanism headed by the ECB, there is ample room to refine all the existing regulation, as we have discussed, in order to create a large pan-European market for simple, robust and transparent ABS products. However, it is also clear that, because of the time it will take to implement the necessary regulatory changes, these developments might only be relevant for the next business cycle, unless this process is accelerated.

Option 3: Act bold

If direct outright purchases in the ABS market are really meant to significantly enhance the functioning of the monetary policy transmission mechanism within the next few months (ie working immediately, and not just as potential amplifiers of the TLTRO), there is a third alternative to the fast/small versus slow/large options we have analysed. A further option, already suggested by Claeys et al (2014), is the direct purchase of RMBS.

An RMBS purchase programme would have a much greater impact on the economy, given the size of the market already at current volumes, ie €601 billion (Table 1), which becomes some €500 billion of targetable products once the minimum rating eligibility criteria are applied15 .

On top of the size of the market, the argument for RMBS purchases also stems from the potential limited impact that the purchase of SME ABS (option 1) might have in terms of the ECB objective of combating the risk of deflation within the cycle. Even assuming that new loans stimulated by the TLTRO and SME ABS purchases ultimately foster the transfer of central bank liquidity directly to the productive sector of the economy, thus restarting credit markets in the euro-area periphery, part of this additional liquidity might have a muted effect on demand. This could happen because companies face a restructuring phase to increase productivity. Therefore, the additional liquidity companies will receive might be used partly for capital expenditure, helped by low rates, and partly for consolidation within sectors, both within or between countries, with a muted effect on employment.

In other words, intervention aimed at increasing the flow of credit to the economy (TLTRO and direct purchase of SME ABS) might have positive effects on demand, and thus consumer prices, only later in the cycle, ie they might not be immediately successful in countering deflation.

Nevertheless, considering that in Europe a relatively low share of households’ wealth is invested in the stock exchange, but a relatively high share is invested in the housing sector, intervening with outright purchases in an ABS market in which RMBS are also considered might have a larger, more immediate effect in revitalising the demand side of the economy, and therefore putting a floor on the trend of declining inflation within the euro area. In this sense, RMBS purchases would not only act as a mechanism to unlock credit markets in the euro area, but would rather be closer to a form of quantitative easing.

In fact, the improvement in banks’ balance sheets would be marginal (given the lower capital absorption of these instruments), while clearly a careful assessment should be made of the need to minimise the impact of RMBS purchases on house prices (and the ensuing wealth effects for households) in the euro area, in order to avoid new bubbles, or to stop the correction of existing ones. While the monitoring exercise now routinely carried out as part of the Excessive Imbalance Procedure can be deployed to avoid such a risk, the fiscal implications of these actions should nevertheless be carefully assessed.


Our evidence shows how direct ECB intervention could turn ABS products into one of the mechanisms that could unlock credit markets in the euro area.

A number of trade-offs arise in terms of the speed and efficacy of the actions that the ECB could take. Acting immediately on existing ABS products (SMEs and corporate-backed eligible ABS) is likely to produce little direct effect, given the small relative size of the targetable market, estimated at some €68 billion. However, an indirect and not necessarily insignificant effect can arise through this action, through the freeing up of capital on banks’ balance sheets, and thus the possibility to exploit on a larger scale (as more loans can be granted with the same amount of capital) the opportunities available through the new TLTRO programme.

Working on the improvement of the regulatory environment for ABS products might revamp a market that can be conservatively estimated at some €3 trillion for the euro area (€1.6 trillion in RMBS and €1.4 trillion in corporate-backed ABS, of which about €300 billion in SMEs ABS), but these actions require time for implementation.

Finally, resorting to the purchase of existing RMBS can achieve the target of an intervention that is both immediate and sizeable in terms of targetable instruments (we estimate a volume of about €500 billion). The characteristics of euro-area credit markets especially favour this option if, notwithstanding a revamped flow of credit to the economy, deflation risks remain critical over the next few months. However this option is closer to a form of quantitative easing and has implications for fiscal policy, and thus should be considered with care.

On the basis of the above, we recommend parallel actions to be taken by the European institutions at the same time. In particular:

  • From a regulatory point of view, the resolution of the ongoing uncertainty about the selective treatment of ABS products in terms of capital requirements in the context of the implementation of the Basel III agreements for banks and insurance companies, should take priority over other pending issues;The European Commission and the ECB should start work on a common set of guidelines on data availability and reporting for collateral (loans), and on the definition of a simple and transparent ‘European’ ABS format (structure/set-up of the SPV);
  • In the near future, the ECB should start a programme of direct purchases of SME ABS (our option 1), while monitoring the indirect effects this might have on the TLTRO. If deflationary risks persist, notwithstanding positive developments in the credit market, the ECB should also consider purchases of RMBS.

Asset-backed securities: The key to unlocking Europe's credit markets? (English)
Thu, 24 Jul 2014 13:15:48 +0100
<![CDATA[China gingerly taking the capital account liberalisation path]]> http://www.bruegel.org/nc/blog/detail/article/1402-china-gingerly-taking-the-capital-account-liberalisation-path/ blog1402

Since China is the number one trading nation, the second largest economy and a large net creditor, the world has a huge stake in how China manages its tricky transition from a state of binding capital controls to one of closer integration with the global financial market and system.

A natural starting point is, of course, where China currently stands in its financial integration with the rest of the world. How open financially is China when we compare it to its own recent past or its major emerging market peers like India?

To answer this question, Robert N. McCauley and I conducted a study by analysing eight measures of capital account openness (four price-based measures and four non-price ones). Our four price-based measures were based on the ‘law of one price’: the same financial asset should trade at about the same price in the onshore and offshore markets. The study covered the forward market, money market, bond market and stock market.

The non-price indicators involved macroeconomic openness, cross-border financial flows and positions, banking market integration and currency internationalisation.

The study shows that China has been financially less open than India on average over the past decade, contradicting the conventional wisdom and other, more widely known measures of financial openness. This may have a lot to do with a mix of the need to fund current account deficits in India; the greater rigour with which the capital controls are enforced in China; the long-standing multinational operations of Indian private firms that can arbitrage onshore and offshore markets; and a larger footprint of global banks in the Indian domestic banking market.

Both economies over the years have been advancing in their financial integration with the world, though in the wake of the global financial crisis China has beencatching up with India. This in part could relate to the fact that emerging markets running current account deficits, like India, face a more binding external financing constraint, especially in a world of highly pro-cyclical and volatile capital flows. The policy-supported renminbi internationalisation in recent years has also punched holesin the Chinese wall of capital controls.

But both China and India still have quite some way to go in opening their financial markets to the outside world, suggesting that the task of capital opening is a real challenge. Controls of their capital accounts may be leaky but still bind substantially. This is true not only by comparison with advanced economies but also when measured against a benchmark of major emerging market economies.

The evidence indicates strong inward pressure on bond and bank flows in China upon full capital account opening, at least in the short term. This is because Chinese fixed income instruments have been cheaper onshore than offshore. This finding contrasts with consensus forecasts which have predicted that, over the medium term, China is likely to experience net private capital outflows under the channels of direct and portfolio investment. Also, our reading of net inflow pressure in the short term and the consensus reading of net outflow pressure over the medium term could imply that two-way capital flows can be highly volatile during the liberalisation process.

This implies three important things for Chinese policymakers.

Care needs to be taken when drawing lessons and insights from some of the freely available popular measures of financial openness. These do not reliably signal progress in capital account opening.

There must be careful monitoring of the risks that lie along the path of capital account liberalisation. Stronger and more transparent reporting and statistical systems should be put in place so that broad market positions and cross-border flows can be tracked in a timely and systematic fashion. In particular, bank flows need to be monitored closely and any seeming inconsistencies between national data and partner data like those compiled by the Bank for International Settlements need to be explained.

Finally, policymakers need to proactively manage the risks that come with liberalisation. A sustained increase in exchange rate variability ahead of substantial capital opening could serve to render the renminbi a less attractive carry-trade target. The widening of the permitted daily trading band of the renminbi — from plus or minus one per cent to plus or minus two per cent in March 2014 — might help ease short-term inflow pressure and facilitate the transition to medium-term net outflows upon full capital opening.

Thu, 24 Jul 2014 10:25:10 +0100
<![CDATA[The world is ready for a global economic governance reform, are world leaders?]]> http://www.bruegel.org/nc/blog/detail/article/1401-the-world-is-ready-for-a-global-economic-governance-reform-are-world-leaders/ blog1401

Bottom line: A survey of G20 practitioners reveals how, notwithstanding the post-crisis loss of momentum, the G20 is still considered a useful forum of discussions. While changes to its composition and workings would be accepted (to varying degree), major revisions in global economic governance are ruled out, bar in case of another major crisis. Our claim is that, at a time of major rebalancing in world economic weight, intransigence by the detainers of power in (what now looks like) an old global governance framework will imply a fade in relevance of the Bretton Woods institutions and G-fora, and their replacement by new avenues of coordination and discussion.

The 2008 financial crisis has markedly changed the landscape of global economic governance. Fora like the G20, which had existed since the Asian financial crisis with a limited discussion role, suddenly were elevated to ‘global economic steering committee’. Since then, however, it seems as though the G20 has somewhat lost direction and momentum. As the most acute phase of the global economic crisis has passed, heads of state and government have had less need to act in unison and rather returned to focus on their national agendas. To some extent, it naturally follows that the focus both on and of the G20 has become less. However, we need effective global governance permanently, not just in crisis. And this is true for the G20, as it is for the G7/8[1] and the IMF.

In a recent paper, we argued that, given the fast-paced changes in global wealth creation and trade patterns, global governance will have to adapt much more significantly and quickly or else risk becoming insignificant. On top of calling for a far-reaching IMF quota reform (going beyond the pending 2010 revision), we argued that it would make sense for euro area countries to have a united global representation. This could happen in a ‘revised’ G7/8, hence opening up space for China and other emerging economies. If there were a more representative G7/8, it would immediately follow that the G20, close to its current membership group, could survive, although it would not be required to have such a demanding role that it is does currently. As such, a smaller, equally representative G7/8 could be more effective than the representative but cumbersome G20.

Against this background, we decided to test many of these claims with G20 practitioners, former Sherpas, and senior government officials involved with the preparation of the G20. To this purpose, we constructed and administered a survey, with the aim of sensing the degree of acceptance of the need and feasibility of a reform of global economic governance.

The survey was administered via e-mail or phone between the 7 May 2014 and 20 June 2014 to the Sherpas of the countries that belong to the G20 Permanent Members grouping, and to the Invited Members, for which contact details were found (see Table 1). This was complemented by a group of 9 high-level global governance experts and former G20 practitioners. Of the 34 people contacted, 23 agreed to participate in the survey. In the end, 15 questionnaires were returned completed.

Table 1. List of G20 participants

Permanent Members

Invited Members[2]

















Saudi Arabia

South Africa

South Korea


United Kingdom




World Bank











Source: en.g20russia.ru

The survey was conducted under full anonymity, as its purpose was not to detail specific governments’ positions, but rather to build on the expertise of insiders and former practitioners in analysing the problems the current global economic governance framework faces, and verify the conditions for and likelihood of reform.

All in all, while participation was not complete, the response rate was acceptable, bearing in mind that most Sherpas are deputy foreign/finance ministers, top-ranking government officials, ambassadors, heads of cabinet, individuals that tend to be rather short of time. As detailed by Figures 1 and 2 (below), a diverse range of participants replied, both based on post-holdings and geographical origin. As such, we believe our survey to be broadly balanced in composition and to give a fair analysis of the different streams of thought within the G20.

Figure 1 and 2. Respondents’ current post (lhs) and geographical origin of employing institution (rhs)

Note: Geographical origin allowed for multiple answer.    
Source: Bruegel.

Survey Results

The first question we posed in our global governance survey was whether with 19 countries, a two-headed EU, permanent guests, countries invited on behalf of regional groupings, and international organisations, the G20 is too large a group to decide on macroeconomic and monetary issues, for which only few countries are relevant. A large majority of G20 practitioners proved to disagree with this statement. Some of the survey participants who disagreed backed their take by stating:

“I see no evidence the size has made discussions too unwieldy. However, I think it could be better to limit the membership to G20 members instead of also having the IOs and invited countries present.”

Others agreed completely:

“The group is too large and not truly reflective of what would be needed from a representation point of view to 1/ debate and find consensus around set of actions and/or 2/ decide on a set of actions. There are several difficulties with membership: too many Europeans, Argentina not relevant, Saudi Arabia a one-issue member; Africa under-represented.”

Finally, a central banker noted that:

“[the G20 is indeed too large a group] especially for monetary issues. It is possibly the right grouping for regulatory issues. Only group beyond G7 that is good (for monetary matters) is that of the G10 central bankers[4], which meets (informally) in Basel, and this is good, and very open.  For example, in such setting the Fed communicated to everyone (including the Indians…) in advance its intention to start tapering QE.”

We then asked survey participants whether they thought the G20 to be an effective forum of deliberation on global economic issues in non-crisis times. Here the picture was a bit more mixed but still with two thirds of participants positioning themselves in the ‘Yes’ camp.

Notably, a survey participant stated:

 “The definition of effectiveness should be adapted to the current global economic context. It is usually during a crisis period that countries are more incentivised to act in the interest of the “common good” and move faster towards policy coordination. Therefore, the impact and magnitude of the measures taken by G20 are unlikely to be the same in a crisis and non-crisis period. Similarly, the issues that the G20 is best positioned to take on will also depend on the global economic context. In a non-crisis period, focus should be placed on medium-term agenda that can increase the trajectory of global growth on a sustainable basis, such as enhancing trade, investment and infrastructure financing. The effectiveness of a forum is not necessarily determined by the number of participants alone, but also contingent on other factors, such as how well each participant can contribute to the conversation and the ability of the Chair to steer discussions. An effective G20 in a non-crisis period would be able to coordinate meaningful solutions to medium-term issues through robust debates and exploration of constructive ideas.”

On top of this, it was also noted that:

“The time of diplomacy is different from that of financial markets. There is less urgency now. Macroeconomic coordination is complex and unchartered water, but things are moving.”

However, a former G20 Sherpa noted how:

“[the G20] is the best forum for deliberating on global economic issues, provided the membership is adjusted; but it lacks effectiveness: it should have a greater focus on intimate discussions among leaders with less officials around. In many delegations there is a dis-function between Sherpas and finance Sherpas. Also, the agenda has grown too wide.”

This statement connects us nicely to the next question posed, namely regarding the main element potentially hampering the effectiveness of the G20. Results are displayed in Figure 3, below. Respondents seemed to widely agree on the fact that the G20’s agenda is currently too wide. Furthermore, the heterogeneity of interests and preferences of countries involved seemed also to contribute significantly in hampering the G20’s effectiveness. Interestingly, among the “other” reasons, the fact that Sherpas are not sufficiently empowered to act was mentioned.

Figure 3. Which of the following is the main element hampering the effectiveness of the G20?

Note: * In theory, “achieving strong, sustainable and balanced growth for the global economy” – which is admittedly very broad.
Source: Bruegel

Following up on this, we asked survey participants directly whether the G20’s agenda should be narrowed down and, if so, along what lines. Whereas there was almost unanimity (14/15) on the need to restrict the focus of the G20, survey participants had very different views regarding the topics on which the forum should concentrate.

Figure 4. On which topics should the G20 focus?

Note: Multiple answers allowed.
Source: Bruegel

Interesting thoughts were shared under the ‘other’ category (see Table 2, below). Some survey participants highlighted how a narrow agenda should be set every year, whereas others focused on the operations of the working groups.

Table 2. Other elements on which the G20 should focus


Specifications of 'other'


The issue is not to limit the agenda permanently, but focus on a few issues at a time and discontinue working groups when they have finished a specific task instead of giving them new mandates, which may be less relevant.


Essentially it should be about economic governance, climate being an integral part of it.


Supporting global growth.




Trade, Investment, Infrastructure.


Select very small number of specific subjects on a yearly basis.



Source: Bruegel

As various degrees of dysfunctionality were identified, we then turned to questions regarding ways of tackling it. Commentators in the past have claimed that tweaks in the governance of the G20 (including the establishment of a permanent secretariat, better streamlining of internal processes, etc.) could improve its effectiveness, as its weaknesses are not structural in nature. 60% of our survey respondents disagreed with this claim. One survey participant mentioned that a secretariat would just add to the bureaucracy of the forum, and there is no need for it. S/he then added that:

“[within the G20 setting] Nobody listens to the IMF itself, so it is not clear why they would listen to the secretariat.”

The G20 being merely a forum of discussion with no coercive powers, we turned to test the idea that peer-pressure is significantly felt and is effective at nudging country leaders into policy action. Almost the totality (14/15) of survey participants agreed with the proposition that peer-pressure within the G20 can push a sovereign government to take actions based on previously agreed commitments. In the discussion that ensued, survey participants expressed a somewhat milder (positive) judgement:

“Taking policy actions based on previously agreed commitments will be essential to the credibility of the G20, and G20 members need to recognise this as a group. The Accountability Assessment exercise and the peer review process in the Framework Working Group are good steps, but as sovereign states, countries retain the right to take actions aligned with their national interests. It remains uncertain whether peer pressure amongst G20 members would be sufficient to affect agreed policy changes across the board, such as the standstill on protectionist measures. Having said that, the G20 has achieved success in certain areas, such as financial regulation.”

In this respect, we note that several respondents highlighted financial regulation as a field in which peer pressure has had a significant impact within a G20 context.

Finally, two survey participants detailed the requirements for peer-pressure to succeed:

“yes, if done intelligently and in a focused manner, i.e. around a limited set of issues; collective behaviour in resisting temptation to go protectionist was a clear example of this; many countries sued the G20 commitment to resists political pressures at home.”

“This is how the OECD is functioning (peer review/peer pressure in the context of its Committees) and this is working pretty well with concrete outcomes, e.g. the convergence of policies towards the best practices. But peer-pressure, to be effective and yield concrete results, requires initial and specific commitments by members of the Group – that are specific and assessable, that can be monitored and to which countries can be held accountable. To make such commitments, countries need to make compromise and look beyond their immediate short term interest. This requires trust among members, a zone of comfort and a degree of like-mindedness, which G20 members may not have reached as yet.”

Along the same lines, we then asked survey participants whether, more in general, some national-level policies in the past had been taken as a consequence of agreements within the G20, and would not have taken place without this forum. Again, the quasi-totality of survey participants (14/15) was positive in its assessment of the G20’s capacity to nudge countries into action. G20 practitioners clarified how:

“G20 commitments have a real domestic impact in member countries. […] it is worth noting that countries have decided to join international instruments as a result of their G20 membership. For instance, Saudi Arabia decided to ratify the United Nations Convention against Corruption (UNCAC) largely as a result of its engagement with the G20 Anti-corruption Working Group.”

Some enthusiastic detailed the dossiers on which G20 peer-pressure had been successful:

“Yes, definitely, the international tax transparency agenda (fight against tax heavens and bank secrecy) and the fantastic results achieved in this domain by the G20 are the best illustration of this. The AMIS – to reduce food price volatility and improve food security - is also a good example.”

Even the sceptical voices, accepted a role to be played by G20 peer-pressure and commitments:

“It seems more plausible that domestic interests remain the key reasons for the adoption of national-level policies. Such interests might include relations with key international counterparts, therefore concluding that these policies were a consequence of agreements within the G20 might not be entirely accurate. Having said that, it is indeed to the G20’s credit that certain issues are placed in the limelight, so that countries would accelerate the progress or implementation of such policies. In the case of financial regulation, the G20 empowered an international body – the Financial Stability Board – to coordinate international policy development, and monitor implementation of G20 commitments.”

Finally, a central banker noted that peer pressure is much more effective when pursuing stimulus packages than for policies of economic restraint.

At this point, we turned to test the palatability and feasibility of the idea presented in O’Neill and Terzi (2014) of having a ‘revised’ G7/8 (where euro area countries would have a unique representation, opening up space for China and another emerging economy) as an alternative prime forum on global economic issues. In fact, a large majority (73%) of G20 Sherpas and (former) practitioners expressed their scepticism towards this solution. In the discussion that ensued, however, many respondents moderated their dissent:

“There is a need to have a more rational representation of the EU in the G20 and there is a need to have a smaller number of members but it will have to be bigger than the G8 and smaller than the G20.”

Another (dissenting) respondent proved to be in favour of an even smaller prime forum:

“Would use space to reduce the number of seats, not to add new members. Could also use international and regional bodies more effectively to represent those not at the table.”

Others made a more wholehearted plead in favour of the G20 in its current setting:

“The “steering committee” of the world economy needs the perspective of countries that are not necessarily systemic (such as South Africa that somehow gives an African perspective on world economic affairs). A forum of global economic governance needs to balance between: legitimacy – ensuring that all major economies work together on an equal footing in international organisations and effectiveness – the ability to cover the right issues, forge a strong common consensus and effectively co-ordinate across different fora. This is important for its credibility and influence at the global level. Also, the present G20 format provides an opportunity for a genuine joint learning process between advanced and emerging economies and a full-fledged two-way exchange of experiences among them.”

Finally, some of the dissenting voices based their position more on the feasibility of the option, rather than on the palatability:

“We should take note that euro area countries do not necessarily have united position on all the issues being discussed in the G20.  However, at the same time, it might be worthwhile to consider reducing the number of euro area countries and freeing up space for non-euro area countries in Asia and Africa.”

When asked specifically about the feasibility of creating such a ‘revised G7/8’, 100% of the respondents were negative. In the discussion, some explained that further euro area integration is needed before such a step can be taken.

We then asked (only) non-euro area country representatives whether they would prefer to liaise with a united euro area in global fora. Interestingly, some survey respondents chose not to answer this question. Of those who did, 63% (7/11) expressed a positive answer. Interesting comments ensued:

“When EU members agree, having a large representation around the table plus President of the Commission and Council just means repeating the same arguments over and over again, to the frustration of non-EU players; coherence among EU is to be shaped in Brussels and not at the G8 or G20; when it has not been shaped in Brussels, then the multiple EU representation at the G20 simply show the degree of the disagreement.”

Along the same lines, a BRIC representative explained that:

“Yes [it would be better to liaise with a unique euro area representative], also in the G20. Too many Europeans saying the same thing creates the idea of a false majority in the room.”

However, a G20 Sherpa representing an international organisation highlighted that:

“That would make sense indeed but provided it reflects a genuine unity of view. Otherwise the common representation will lack credibility in the G20 – which would be counterproductive for euro area countries and the G20 itself.”

Finally, a G20 Sherpa clarified that, although the composition of the G20 is dubious (only one African country, only three Latin American, and too many Europeans), the forum has decided to focus on policy coordination, and leave aside discussions regarding membership and/or enlargement.

When asking (only) G7/8 members whether our ‘revised G7/8’ seems sensible as an alternative scenario to the current Group of Seven, which increasingly represents a small club of advanced democracies, three out of five respondents disagreed. Defenders of the current G7/8 highlighted the importance of having a small club of likeminded countries:

“A ‘small club of advanced democracies’ can effectively project authority, unity and vision: very valuable goods. This, without pretence of global governance, which needs close-to-universal representation, and is already the goal of other fora.”

This chimes well with another respondent, who made the point that:

“The current G7/8 framework has its own significance and effectiveness as a small club of advanced economies, where the G7/8 Leaders can have frank discussions on important issues that the international community is facing.  It should not be replaced by any alternative framework.”

Moving beyond the G7/8 and the G20, we asked global governance practitioners and experts whether in their opinion the pending 2010 IMF quota reform had gone far enough in rebalancing power between declining and emerging economies. A wide majority of respondents (13/15) agreed that the 2010 IMF reform was now already somewhat outdated. We hence posed the question of whether the implementation of our proposed ‘revised G7/8’ would pave the way for a speedier reform of the IMF. A wide majority of respondents (73%) disagreed, mostly citing the fact that the current reform is being held back by the U.S. Congress and its internal political quarrels, rather than by the G20. However, it was also highlighted how:

“You need the G20, and especially the BRICS, to make the reform advance. G7 would not be really interested in moving it.”

After having underlined the role of the US Congress, one survey participant explained how:

“[...] The IMF has a regular schedule for reviews of quotas and the composition of the Executive Board. The schedule was even accelerated by the G20 in 2010, with a view to bring about a shift in voting share towards emerging markets sooner. It is useful to note that there is a practical limitation to how quickly quota shares of Emerging and Developing countries can be increased. A country can increase its quota share only via its own contributions to the IMF. Countries whose quota shares need to decline cannot be forced to withdraw their contributions. This imposes a mathematical constraint on how much a country’s quota share can rise, particularly when the quota shares of several countries increase at the same time. However, G20 provides additional impetus for reform. 2010 reforms were “historic” in no small part due to the ambition and political commitment from G20.”

To conclude our survey, we asked G20 practitioners and experts under what conditions a far-reaching reform of global economic governance is to be expected, given the current framework (which has at its centre the IMF, WTO, and World Bank) effectively rose from the ashes of World War II and has remained broadly unaltered ever since. Somewhat unsurprisingly, and in many ways, worryingly, the most common response was ‘another crisis’. Strong political will (especially among developed country leaders) was also a recurrent theme. However, other respondents made other valuable points. A current Sherpa offers a dual framework to think about changes in the current global governance framework:

“The current structure of economic governance has never been truly global. It reflects the balance of economic strength that prevailed after the war and in the decades that followed. This balance has shifted more quickly in the last two decades, and the old structure has become increasingly irrelevant. Naturally, those who stand to lose out have resisted allowing the structure to evolve with economic realities. There are two ways a new structure can emerge: by a gradual adjustment from the current state to the one envisioned; or a sudden adjustment in which the old structure is dismantled and a new one constructed in its place. A gradual adjustment is less disruptive. But the longer imbalances persist, the more likely it is that the system becomes unstable and economic multilateralism ultimately disintegrates. In addition, it is important to have an inclusive, open, transparent and merit-based process in selecting the senior leadership of international organisations such as the IMF and World Bank.”

And indeed, some of the survey participants believe that a step-by-step approach will lead to a substantial change in the current framework.

“Time [is needed]. Emerging countries continue to grow at faster rate than advanced one. At some point thing will be reflected in a deeper reform of the current architecture or the creation of a new one, perhaps with new financial institutions outside the control of currently advanced economies.”


All in all, our survey did not really support our policy recommendation for immediate pro-active reform of global governance. Perhaps this is not surprising in view of the fact that most of the participants are actively involved in some aspect of the current governance framework, and institutions tend to self-perpetrate. Nonetheless it was interesting for us to see the general response to far-reaching reform proposals, which go beyond a fine-tuning or streamlining of the internal workings of the current global governance framework.

As it relates to the G20, virtually all respondents answered that the G20 is a useful forum, with many indicating that it plays a positive role. In this sense, the G20 is clearly seen as legitimate by those who participate. A number of participants made it clear however that the G20 agenda is often too diverse and it would benefit from having a more defined focus. Just as interesting, there was not much support for the idea of a devoted secretariat in helping create a regular focus. As could be garnered from the last answer about what would be necessary for further accelerated reform of global governance (answer was overwhelmingly, another crisis), it seems as though G20 participants believe that a crisis forces policymakers to focus on the immediate solutions, and outside of crisis, they will not have the same need or incentives.

When it comes to faster reform of the IMF, as we prescribed in O’Neill and Terzi (2014), very few survey participants believed that the structure of the G20 or G7 was a hindrance, and in fact, it was primarily the inability or lack of desire by the US Congress to ratify already agreed G20 proposals that were holding back any initiatives at faster reform. In this respect, a certain degree of vexation could be sensed among G20 Sherpas and practitioners.

Finally, one of our previous key recommendations that we explored was, that inside the G20, a reshaped G7 should be found in which all euro area members were represented by just one, allowing space for China and other key emerging economies. We did find some sympathy for this idea from non-G7 countries and non-euro area members, perhaps not surprisingly. However, we did not get any voluntary support for such a shift from either euro member countries or other G7 countries, with those that responded actually suggesting that it was impractical to expect such a shift, not least because the euro area member countries still often have different views, and according to some, it is very beneficial still to have an effective group of like-minded advanced country democracies.  One respondent pointed out that when it came to monetary policy, as opposed to fiscal and other policy matters, the central bankers gatherings in Basle are quite effective for discussion and, when necessary, advance warning and co-ordination. The fact that this took place with less fanfare was also advantageous.

It seems as though any revamp of the G7/8 is not set to voluntarily happen from within for the foreseeable future. We believe that, at a time of major rebalancing in world economic weight, intransigence by the detainers of power in (what now looks like) an old global governance framework will imply a fade in relevance of the Bretton Woods institutions and G-fora, and their replacement by new avenues of coordination and discussion. In this respect, the recent agreement to establish a BRICS Development Bank is highly symbolic. The world is fast changing and ready for more representative, more effective global economic governance. G7/8 leaders can drive this change, or merely face its consequences.

[1] Throughout the post, we will refer to the G7 or G8 interchangeably, as in this instance we do not wish to enter the discussions surrounding Russia’s role in the Group of Eight following the Ukrainian crisis.

[2] Invited members vary from summit to summit. These correspond to the invitees of the last Summit (Saint Petersburg – September 2013).

[3] Spain is a permanent guest.

[4] The composition of this informal group was not formalised but seemed to include G7 members, China, India, and Mexico. 



Thu, 24 Jul 2014 09:02:20 +0100
<![CDATA[Juncker’s new start for Europe]]> http://www.bruegel.org/nc/blog/detail/article/1400-junckers-new-start-for-europe/ blog1400

Last week, President Elect Jean-Claude Juncker published his agenda for Europe. To inform the policy debate, we would like to highlight and summarize some of the key research Bruegel scholars have done over the last years covering the issues raised.

Juncker has excluded some topics, but we will focus on his announced agenda. In the upcoming Memos to the New EU leadership to be launched on September 4, our scholars will highlight the many challenges for the new leadership and propose new solutions, covering also areas omitted by Juncker.

Please note that this is meant as a helpful collection of past contributions linked to the relevant topics rather than an assessment of Juncker’s proposals. For a policy oriented analysis of the agenda ahead of Juncker’s announcements we refer to the #EU2DO Memo to the incoming EU Presidents, where Andre Sapir and Guntram Wolff highlight a number of important priorities for the new leadership.

1. A New Boost for Jobs, Growth and Investment

A boost for jobs, growth and investment is a recurrent topic in policy discussions which Bruegel scholars have published a sizable amount of suggestions on. Zsolt Darvas, Jean Pisani-Ferry and Guntram Wolff warned against “Europe’s growth problem” in April 2013, pointing out that weak growth was putting private and public deleveraging at risk, while persistently high unemployment was eroding skills. As a result, the EU also faces major social problems as Darvas and Wolff argued. More than six million jobs were lost from 2008-13 and poverty has increased against social security systems whose efficiency varies widely. High private debt, high unemployment, poverty and more limited access to education undermine long-term growth and social and political stability. All this is happening in the context of great transformation of the global economy, in which  emerging and developing market economies continue to forge ahead in the last decade and the EU risks being left behind.

In such context, the role of public investment is key to revert the path of declining growth. Francesca Barbiero and Zsolt Darvas showed how the long-term decline in gross public investment in European Union countries mirrors the trend in other advanced economies, but recent developments have been different. Public investment has in fact  increased elsewhere, but in the EU it has declined and even collapsed in the most vulnerable countries, exaggerating the output fall. However, the provisions in the EU fiscal framework to support public investment are very weak. In the short term, the authors argue that the exclusion of national co-funding of EU-supported investments from the fiscal indicators considered in the Stability and Growth Pact would be sensible. In the medium term, instead, the EU fiscal framework should be extended with an asymmetric ‘golden rule’ to further protect public investment in bad times, while limiting adverse incentives in good times.

Reinhilde Veuglers looked at how the crisis is affecting public Research & Development budgets across the EU, finding that the gap between EU countries in public R&I expenditure has widened. Even though the EU budget serves as mechanism to somewhat ease the growing public R&I divide in Europe - EU funds are relatively more significant for innovation-lagging countries with low national R&I budgets - it is crucial to assess whether the effectiveness of these R&I programmes.

Guntram Wolff suggests that the “EU must avoid another useless fight over its fiscal rules and instead use political capital to foster growth”. A deal should take into account the fact that there is no fiscal space to engage in a new stimulus as a growth instrument, in those countries where it would be needed the most. Countries that do have fiscal space, such as Germany, the Netherlands, Denmark, Sweden, Poland and Finland are those where a public investment spending stimulus, financed with deficits, should start. The third and most important element is recognizing that Europe underinvest in European public goods. Investment at the EU level could e.g. target projects such as  trans-European infrastructure, the European energy network, a European telecom networks and, on the social side,  a European mobility scheme for young workers.

2. A Connected Digital Single Market

President Juncker’s ambition for the potential impact of a connected digital single market in Europe is important. Mario Mariniello wrote last fall “If Europe had a genuine single digital market, every citizen and company could subscribe to any telecom operator active on the Continent. Pan-European operators could compete across different countries. New technologies would be profitable and rapidly deployed. High-speed access to the Internet would be available to all.”

However, we are a far cry from a connected digital single market today, as Jeremy Bowles illustrated through market fragmentation in telecoms. While it’s hard to draw any strong conclusions, it’s not unreasonable that this goes part of the way to explain the notable absence of any European cities on LinkedIn’s top ten for tech talent.

Unfortunately, the long-awaited telecom package unveiled by Digital Agenda Commissioner Neelie Kroes will not get Europe there—or at least not as quickly as some hoped, Mario Mariniello argued, so Juncker will have to make good on his promise to take ambitious legislative steps. He also faces a challenge from DG Competition, as the recent conditional clearance of the Telefonica/E-Plus merger in Germany poured cold water on Europe’s digital dream.

3. A Resilient Energy Union with a Forward-Looking Climate Change Policy

Last year, Bruegel’s expert on energy and climate, Georg Zachmann, wrote that the most straightforward European single energy market design would entail a European system operator regulated by a single European regulator. To reap the significant benefits from an integrated European electricity market, he proposed the following Blueprint, for the new Commissioner for Energy to consider.

  • Add a European system-management layer to complement national operation centre
  • Upgrade the role of the European ten year network development plan (TYNDP)
  • Share the cost of network investments in Europe

As the crisis in Ukraine unfolded this March, Zachmann also provided what he calls a ‘rough overview’ of alternatives to Russia for Europe’s gas imports. This may serve as inspiration for the new President in consolidating Europe’s negotiating power vis-a-vis third countries.

The EU has been leading the way on fighting climate change globally for a while and we welcome Juncker’s affirmed commitment to the 2 degree objective. Low-carbon energy technologies are pivotal for decarbonising our economies up to 2050 while ensuring secure and affordable energy, but when and how to support renewables? Together with Michele Peruzzi and Amma Serwaah, Zachmann let the data speak on this question, and also recommended to increase public investment to reduce the cost advantage of fossil fuels.

In a different paper from early 2013, Zachmann also argued that the Emissions Trading System (ETS) must be stabilised by reinforcing the credibility of the system so that the use of existing low-carbon alternatives (for example burning gas instead of coal) is incentivised and investment in low-carbon assets is ensured.

4. A Deeper and Fairer Internal Market with a Strengthened Industrial Base

Manufacturing Europe's future means getting the policies right for firms to grow and prosper. It is not about picking one sector over another, but primarily about setting the right framework conditions for growth, innovation and jobs. André Sapir and Reinhilde Veugelers write that the ‘Europe needs industry' credo should be replaced by ‘Europe needs innovative firms that operate in activities with a high value-added and participate in European and global value chains'. The goal of European policymakers should be to make Europe an attractive place for innovative firms, regardless of their sectoral activity.

No industry no future? asked Guntram Wolff in June. He argues that the quantitative goal set by Juncker, and previously by the EU, to increase industry’s weight in the EU’s GDP to 20% by 2020 needs to be dropped in favour of an approach based on competition, an integrated single market and public policies focused on real market failures.

It will be essential to ensure the fairness of the internal market proclaimed by Juncker. In the past few months Mario Mariniello has looked at the EU antitrust dilemma and estimated the antitrust risk in EU manufacturing by sector. He has also highlighted that until Europe has accomplished a uniform regulatory framework fostering cross-border competition, the cost of the Commission’s mistakes will be always be borne by national consumers.

As policymakers refocus on growth, the ability to take a firm-level view is key to disentangling the various factors at the root of competitiveness, and thus to designing appropriate policies. This was very well analysed by Carlo Altomonte, Filippo di Mauro, Giorgio Barba Navaretti and Gianmarco Ottaviano in Assessing competitiveness: how firm-level data can help.

Juncker also called for a Capital Union. This is an important topic on which many Bruegel scholars have written. What kind of banking union? was an important part of Bruegel’s research on capital union. Here is a non-exhaustive list to explore.

Pagliari, Vallée and Monnet argue that the relationship between governments and financial systems in Europe cannot be reduced to polar notions of “capture” and “repression” the current reconfiguration of Europe’s national financial systems is influenced by history but is not a return to past interventionist policies. Sapir and Wolff argued about the need to deepen capital markets alongside banking markets in a contribution to the informal ECOFIN. Nicloas Véron looks at financial reform after the crisis and at bank versus non-bank credit in EU, China and US.

5. A Deeper and Fairer Economic and Monetary Union

Already in 2012, Guntram Wolff highlighted that in a monetary union, national fiscal deficits are of limited help to counteract deep recessions; union-wide support is needed. A common euro-area budget (1) should provide a temporary but significant transfer of resources in case of large regional shocks, (2) would be an instrument to counteract severe recessions in the area as a whole, and (3) would ensure financial stability. Such a common resource would need to be well-designed to be distributionally neutral, avoid free-riding behaviour and foster structural change while be of sufficient size to have an impact.

Revising the mechanisms of accountability and democratic control of the Troika should also take into consideration an in-depth assessment of successes and so far. Carlos De Sousa, André Sapir, Alessio Terzi and Guntram Wolff on 19th February 2014 highlighted how the programmes in Ireland, Portugal, Greece and Cyprus were based on far too optimistic assumptions about adjustment and recovery in Greece and Portugal. In all four countries, unemployment increased much more significantly than expected. Although fiscal targets were broadly respected, debt-to-GDP ratios ballooned in excess of expectations due to sharp GDP contraction.

Changes to the IMF forecast for euro-area GDP between 2010 and 2014

Concerning the importance highlighted by Juncker on social impact assessment of reform programmes, Zsolt Darvas and Guntram Wolff Fiscal reminded in their piece on the implications of social problems for economic growth that fiscal consolidation has generally attempted to spare social protection from spending cuts, but the distribution of adjustment costs between the young and old has been uneven; a growing generational divide is evident, disadvantaging the young.

6. A Reasonable and Balanced Free Trade Agreement with the U.S.

The proposal of Juncker on the EU-USA Free Trade Agreement is not a novelty but rather the continuation of a vivid discussion recently summarized by David C. Saha and contributed to by Mario Antonielli in looking at how TTIP fits in the evolving global trade landscape. In a video interview, André Sapir considered the issue and asked the crucial question, should the TTIP generate hope or is it a hype? He warns that “there is more chance that, if it has any real effect other than a signature ceremony in Brussels and in Washington, TTIP will mark the beginning of the end of the multilateral trading system as it exists today.”

Looking at the prospects for regulatory convergence under TTIP, Suparna Karmakar highlighted the requirement of the unilateral and unconditional recognition by the TTIP partners of each other’s standards, procedures and conformity assessment tests.

7. An Area of Justice and Fundamental Rights Based on Mutual Trust

The data protection of EU citizens has been in focus ever since the surge in espionage scandals that began with the leaks from Edward Snowden, and we welcome Juncker’s desire to move forwards on this issue. In a blog from last winter, Carlos De Sousa and Reinhilde Veugelers put attention on the economic perspective surrounding this matter, arguing the issue comprises of three main aspects.

  • The discussion of a revision of the US-EU Safe Harbour Arrangement, whereby US firms can operate in Europe under US privacy rules as long as they comply with the seven principles of the EU Data Protection Directive, thus allowing US intelligence (NSA) to survey EU citizens’, as is very well explained in this FT article.
  • The revision of the current EU Data Protection Directive (95/46/EC DPD), which has been in force for almost two decades now and is scheduled to be updated in spring 2014, so as to reflect the changes in technology, markets and preferences/attitudes of consumers.
  • And last but not least, the EU also needs to work towards a single digital market that provides the right conditions for global IT companies to do business in Europe while carrying an adequate tax burden, and at the same time creating conditions for European IT companies to develop and be competitive in the global digital market.

8. Towards a New Policy on Migration

Juncker set the goal to move away from unilateral migration policies towards Europe-wide negotiated win-win solutions aiming at “reducing the costs of, and enhancing the welfare gains from, migration and remittances”. Rainer Münz highlighted this, as well as other crucial aspects of the complex issue, in the his policy brief on Europe’s migration challenge. If Münz is right in his predictions, Europe will face a severe shortage of labour in the future.

Projected change in working-age population 2010-2050

We have been monitoring the international and the European debate on migration in several blogs reviews, specifically addressing the debate on freedom of movement in Europe after the Swiss referendum and the economics and politics of migration in the economic crisis.

9. A Stronger Global Actor

In his working paper from February, Jim O’Neill suggests that China will take over as the number one trading partner for many central European countries over the next few years. This relates to the point on the free trade agreement with the United States, and beyond the economics this has implications for Europe position on the global scale.

The need for a stronger Europe in the World is one of the key axes of the recent Memo to the new Presidents by André Sapir and Guntram Wolff. The EU needs to adapt its economy and even societies to the Great Transformation resulting from the combined forces of globalisation, demographic, technological and environmental change. According to the memo, Juncker will also have to rethink the EU’s neighbourhood strategy and strengthen the EU’s place in the world.

10. A Union of Democratic Change

Juncker stressed the need for a political dialogue and political solutions, against the backdrop of the political signals expressed by citizens at the European Elections in May. Bruegel also highlighted this several times over the past months.

In a seminal piece from last fall, the German Glienicker Group laid out its vision towards a Euro Union, writing that Europe needs this because it “has structural problems that require structural solutions. Even though this is not a popular view at the moment, we are convinced that the monetary union needs deeper integration. More particularly, it needs a sufficiently powerful European economic government.”

The French Eiffel Group wrote in response to Glienicker Group, that the strategic choice for Europe should be “[to build] a political and democratic Community based on the euro, while remembering that monetary union was conceived as the bedrock of a much greater project, which intended to unite men and not as an end in itself”.

However, also a more critical voice was raised by Ashoka Mody arguing the need for A Schuman compact for the euro area based on the idea that since the very inception of the EU, Europe’s leaders have been unwilling to cross a threshold that compromised core national sovereignty. Silvia Merler provided an interesting insight on the question of the appetite and scope for further political integration by looking at data from the European Commission’s Eurobarometer.

While it is interesting to reflect on the wider debate and gauge the willingness to move towards a more genuine political dialogue, André Sapir and Guntram Wolff underlines that Juncker's first move should be towards a rationalisation of the structure of the College of Commissioners. An effective Commission would have only a dozen policy areas in which it would take action.

Wed, 23 Jul 2014 07:11:57 +0100
<![CDATA[Abenomics – stock-taking and lessons for the EU]]> http://www.bruegel.org/nc/events/event-detail/event/452-abenomics-stock-taking-and-lessons-for-the-eu/ even452

Japan’s economy has experienced long-term stagnation for over 20 years. Since Autumn 2012, drastic economic policies known as ‘Abenomics’ have been enforced to break this pattern. Meanwhile inflation in the EU is an alarming indicator of a possible deflationary phase that could cripple economic activity. These phenomena are similar to those experienced in Japan in the 1990s. This conference offers the possibility to deepen our economic understanding of two major economies facing similar problems and opportunities.

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This event is jointly organised with the Graduate School of Economics, Kobe University Conference.


Tue, 22 Jul 2014 14:02:54 +0100
<![CDATA[Chart of the Week: 54% of EU jobs at risk of computerisation]]> http://www.bruegel.org/nc/blog/detail/article/1399-chart-of-the-week-54-percent-of-eu-jobs-at-risk-of-computerisation/ blog1399

Based on a European application of Frey & Osborne (2013)’s data on the probability of job automation across occupations, the proportion of the EU work force predicted to be impacted significantly by advances in technology over the coming decades ranges from the mid-40% range (similar to the US) up to well over 60%.

Tue, 22 Jul 2014 07:03:47 +0100
<![CDATA[Blogs review: The Taylor Rule legislation debate]]> http://www.bruegel.org/nc/blog/detail/article/1398-blogs-review-the-taylor-rule-legislation-debate/ blog1398

What’s at stake: A draft legislation was introduced on July 7 by two Republican members of the House, which would require the Fed to adopt a policy rule. The “Federal Reserve Accountability and Transparency Act of 2014″ (FRAT, HR 5018) was not well received by Federal Reserve’s chairwoman, Janet L. Yellen, who said on Wednesday that it would be a “grave mistake” for Congress to adopt such legislation.

Alan Blinder writes that while the House can't manage to engage on important issues like tax reform, immigration reform and the minimum wage, it's more than willing to propose radical "reform" of one of the few national policies that is working well. As the title of Section 2 puts it, FRAT would impose "Requirements for Policy Rules of the Federal Open Market Committee." In the debate over such rules, two have attracted the most attention. More than 50 years ago, Milton Friedman famously urged the Fed to keep the money supply growing at a constant rate—say, 4% or 5% per year—rather than varying money growth to influence inflation or unemployment. About two decades ago, Stanford economist John Taylor began plumping for a different sort of rule, one which forces monetary policy to respond to changes in the economy—but mechanically, in ways that can be programmed into a computer. 

Nick Rowe writes that we need to distinguish between "instrument rules" and "target rules". The Bank of Canada, for example, sets a nominal interest rate instrument to target 2% inflation. The Bank of Canada follows a very simple target rule: "set (future) inflation at 2%". But it does not follow any instrument rule like the Taylor Rule. Instead it uses its discretion.

Illustration source: Jayachandran/Mint

John Taylor writes in his Testimony to Congress that there is precedent for the type of Congressional oversight in the proposed legislation. Previous legislative language, which appeared in the Federal Reserve Act until it was removed in 2000, required reporting of the ranges of the monetary aggregates. The legislation did not specify exactly what the numerical settings of these ranges should be, but the greater focus on the money and credit ranges were helpful in the disinflation efforts of the 1980s. When the requirements for reporting ranges for the monetary aggregates were removed from the law in 2000, nothing was put in its place.

Tony Yates writes that we should remember that John Taylor sees the performance of the US post-crisis as resulting from the deleterious effects of uncertainty about policy that come with a departure from rules-based policy (for the king of evidence used to make this case, see this post). Nick Rowe writes that it is hardly surprising that structural breaks in an estimated central bank's reaction function should be associated with worse economic outcomes. Suppose a central bank is targeting 2% inflation. Then a big shock hits, that causes a permanent fall in the (unobserved) natural rate of interest. That shock may itself cause worse economic performance. Plus, if the central bank is not immediately aware of that shock, or its magnitude, and fails to adjust its reaction function quickly enough, that will also cause worse economic performance. An econometrician who estimated the central bank's reaction function would notice a structural break in that reaction function, and that structural break being associated with worse economic performance.

The two rules in FRAT

Alex Nikolsko-Rzhevskyy, David Papell and Ruxandra Prodan write that FRAT actually specifies two rules. The “Directive Policy Rule” would be chosen by the Fed, and would describe how the Fed’s policy instrument, such as the federal funds rate, would respond to a change in the intermediate policy inputs. In addition, the report must include a statement as to whether the Directive Policy Rule substantially conforms to the “Reference Policy Rule,” with an explanation or justification if it does not. The Reference Policy Rule is specified as the sum of (a) the rate of inflation over the previous four quarters, (b) one-half of the percentage deviation of real GDP from an estimate of potential GDP, (c) one-half of the difference between the rate of inflation over the previous four quarters and two, and (d) two. This is the Taylor rule, and is obviously not chosen by the Fed.

Alan Blinder writes that while hundreds of "Taylor rules" have been considered over the years, FRAT would inscribe Mr. Taylor's original 1993 version into law as the "Reference Policy Rule." The law would require the Fed to pick a rule, and if their choice differed substantially from the Reference Policy Rule, it would have to explain why. All this would be subject to audit by the Government Accountability Office (GAO), with prompt reporting to Congress. John Taylor writes that to provide some flexibility the legislation allows for the Fed to change the rule or deviate from it if the Fed thought it was necessary.

Gavyn Davies writes that in 2012 Janet Yellen argued that Taylor’s original 1993 Rule was no longer her preferred interpretation of the Rule. She suggested a “balanced approach” alternative, in which the importance given to the unemployment/GDP objective was increased, relative to the importance given to inflation. She also suggested an optimal control approach, under which interest rates would stay even lower than under the balanced approach, because policy needed to compensate for a prolonged period in which the stance had been too tight as a result of the zero lower bound on rates.

Policy rules in extraordinary times

Alan Blinder writes that the deeper problem is that the Fed has not used the fed-funds rate as its principal monetary policy instrument since it hit (almost) zero in December 2008. Instead, its two main policy instruments have been "quantitative easing," which is now ending, and "forward guidance," which means guiding markets by using words to describe future policy intentions. Gavyn Davies writes that the Rule does not say how and when to reduce the size of the Fed’s balance sheet, and how that decision should relate to the appropriate level of short rates. The Rule is also largely silent on another of the Fed’s main headaches right now, which is whether to treat the official unemployment rate as a good indicator of the amount of slack in the labor market.

Simon Wren-Lewis writes that the current natural real rate of interest is likely to be a lot lower than the constant in any Taylor rule. At low levels of inflation, inflation also appears to be less responsive to excess demand. On its own this means that the coefficients on excess inflation in a horse for all courses Taylor rule will be too low when inflation is below 2%.

John Cochrane writes that what is most interesting about a rule is what it leaves out. Notably absent here is "macroprudential" policy, "financial stability" goals, i.e. raising rates to prick perceived asset price "bubbles" and so forth. Of course, the Fed could always add it as a "temporary" need to deviate from the rule. Still, many people might think that should be part of the rule not part of the exception. It also leaves out housing, exchange rates, and all the other things that central banks like to pay attention to.

Mon, 21 Jul 2014 09:52:39 +0100
<![CDATA[Towards a European unemployment insurance?]]> http://www.bruegel.org/nc/blog/detail/article/1397-towards-a-european-unemployment-insurance/ blog1397

The Italian Presidency of the EU has asked Bruegel to give a presentation to European Labour and Social Ministers at the informal EPSCO meeting in Milan on July 18. The aim of our presentation was to clearly lay out the major issues and to discuss the pros and cons of a European Unemployment Insurance (EUI). A number of important technical papers have already been done on the topic, for example by the French treasury. Taking one step back, we gave the following key messages.

  • Prior political consent to fiscal risk sharing needed
  • Ambitious project with implications for
    • labour market institutions, activation policies etc.
    • moral hazard (e.g. early retirement policies, health insurance(?), etc.)
    • and public finances
  • While more European stabilization mechanisms desirable, other mechanisms may be quicker
    • EUI not easy to build therefore rather for next crisis
    • Investment fund and better use of EU budget may be more practicable
  • Could be a powerful signal of a further „federalisation“ of Europe and solidarity if political consensus
  • Could be a strong mechanism to fundamentally reform labour markets. 

The detailed powerpoint is available to download here.

Fri, 18 Jul 2014 11:42:32 +0100
<![CDATA[Fact of the week: Norway is the safest place on Earth]]> http://www.bruegel.org/nc/blog/detail/article/1396-fact-of-the-week-norway-is-the-safest-place-on-earth/ blog1396

Standard and Poor’s published its Global Sovereign Debt report for the second quarter of 2014 recently . The report ranks countries according to the riskiness of their debt, depicting a North-South divide in creditworthiness, with Norway being the least and Argentina being the most risky.

Standard and Poor’s Global Sovereign Debt report for the second quarter of 2014 rates  Norway as the least risky sovereign and Argentina as the most risky one. Norway is followed by Sweden and the US, whereas the UK climbs up to to fourth place, which used to belong to Germany.

The four “eurozone core”’s members (Germany, Austria, Finland and the Netherlands) make up almost half of the top ten, whereas only two “eurozone periphery”’s countries are still among the worst ten. Greece and Cyprus are classified as the 5th and 6th most risky sovereigns, down 2 places and up 1 place respectively. The top three in terms of riskiness remain Argentina, Venezuela and Ukraine.

The issue with the S&P report is that all the rankings seem to be relying heavily on the implied risk profile inferred from Credit Default Swap (CDS) movement, more specifically five year mid PAR spreads. CDS are normally used as a proxy of the cost of ensuring against the default of a certain country. In that respect they should give an indirect indication of sovereign risk. However, the reliability of CDS as indicators of sovereign risk has been often questioned, importantly also by the IMF, because of the relatively low liquidity in part of the market. Moreover, where CDS data for the sovereign is not available S&P report uses a majority state owned national bank as proxy to derive CDS and consequently the CPD of the country. This is the case for India, for which data for the “State Bank of India” is used, and for Tunisia, for which the “Banque Centrale de Tunisie” is used. Figure 2 below (from BBVA research) shows the time series evolution of sovereign CDS spread across countries in the world suggesting that, apart from the case of Norway on the one hand and Greece and Argentina on the other, the CDS does not always yield an uncontroversial ranking.

Source: BBVA research

It is interesting to look complementary at another Sovereign risk indicator that has been recently updated, i.e. the BlackRock’s Sovereign Risk Index (see here for the methodology). This index is an aggregate of many indicators largely grouped in the following categories.

  • Fiscal Space (40% weight), trying to assess if the fiscal dynamics of a particular country are on a sustainable path.External Finance Position (20% weight), trying to measure how leveraged a country might be to macroeconomic trade and policy shocks outside of its control.
  • Financial Sector Health (10% weight), assessing the degree to which the financial sector of a country poses a threat to its creditworthiness, were the sector were to be nationalized, and estimates the likelihood that the financial sector may require nationalization.
  • Willingness to Pay (30% weight), grouping political and institutional factors that could affect a country’s ability and willingness to pay off real debt.

This index has the advantage to also tell what are the roots of sovereign risk, which is the most interesting part, taking account of countries’ specificities (you can build your own rankings here).

Norway is again top of the list, thanks to extremely low absolute levels of debt, an institutional context that is perceived to be strong and very limited risks from external and financial shocks. Germany, Netherlands and Finland still make it in the top 10, whereas Portugal, Ireland Italy and Greece make it to the top wors. Greece is actually the bottom of the list, although this ranking was done in june so admittedly Argentina might have taken over in July.

Fiscal space rating

Financial sector risk

What is interesting is looking at the relative positions on the different subcategories, which can vary even considerably with respect to the overall score. As an example, lets compare the relative rankings in terms of fiscal space and financial sector risk - which can interact in unpleasant way during crises. Norway is a clear outlier in terms of fiscal space ranking (figure 1) whereas it performs less well in terms of financial sector health. The same is true for Germany and Finland, which rank high on fiscal space and significantly lower in terms of financial sector health. Netherlands is strikingly, 14th in terms of fiscal space and in the worst top ten in terms of financial sector heath. China too ranks high in fiscal space and low in financial risk as well.

The relative ranking is extremely interesting, as it clearly visualises that fiscal sustainability (and sovereign risk with it) is far from exact science and there’s nothing more relative in this world as the definition of a  “safe debt”.

Fri, 18 Jul 2014 08:23:07 +0100
<![CDATA[The computerisation of European jobs]]> http://www.bruegel.org/nc/blog/detail/article/1394-the-computerisation-of-european-jobs/ blog1394

Who will win and who will lose from the impact of new technology onto old areas of employment? This is a centuries-old question but new literature, which we apply here to the European case, provides some interesting implications.

The key takeaway is this: even though the European policy impetus remains to bolster residually weak employment statistics, there is an important second order concern to consider: technology is likely to dramatically reshape labour markets in the long run and to cause reallocations in the types of skills that the workers of tomorrow will need. To mitigate the risks of this reallocation it is important for our educational system to adapt.

Debates on the macroeconomic implications of new technology divide loosely between the minimalists (who believe little will change) and the maximalists (who believe that everything will).

In the former camp, recent work by Robert Gordon has outlined the hypothesis that we are entering a new era of low economic growth where new technological developments will have less impact than past ones. Against him are the maximalists, like Andrew McAfee and Erik Brynjolfsson, who predict dramatic economic shifts to result from the coming of the ‘Second Machine Age’. They expect a spiralling race between technology and education in the battle for employment which will dramatically reshape the kind of skills required by workers. According to this view, the automation of jobs threatens not just routine tasks with rule-based activities but also, increasingly, jobs defined by pattern recognition and non-routine cognitive tasks.

It is this second camp - those who predict dramatic shifts in employment driven by technological progress - that a recent working paper by Carl Frey and Michael Osborne of Oxford University speaks to, and which has attracted a significant amount of attention. In it, they combine elements from the labour economics literature with techniques from machine learning to estimate how ‘computerisable’ different jobs are. The gist of their approach is to modify the theoretical model of Autor et al. (2003) by identifying three engineering bottlenecks that prevent the automation of given jobs – these are creative intelligence, social intelligence and perception and manipulation tasks. They then classify 702 occupations according to the degree to which these bottlenecks persist. These are bottlenecks which technological advances – including machine learning (ML), developments in artificial intelligence (AI) and mobile robotics (MR) – will find it hard to overcome.

Using these classifications, they estimate the probability (or risk) of computerisation – this means that the job is “potentially automatable over some unspecified number of years, perhaps a decade or two”. Their focus is on “estimating the share of employment that can potentially be substituted by computer capital, from a technological capabilities point of view, over some unspecified number of years.” If a job presents the above engineering bottlenecks strongly then technological advances will have little chance of replacing a human with a computer, whereas if the job involves little creative intelligence, social intelligence or perceptual tasks then there is a much higher probability of ML, AI and MR leading to its computerisation. These risks range from telemarketers (99% risk of computerisation) to recreational therapists (0.28% risk of computerisation).

Predictions are fickle and so their results should only be interpreted in a broad, heuristic way (as they also say), but the findings are provocative. Their headline result is that 47% of US jobs are vulnerable to such computerisation (based on jobs currently existing), and their key graph is shown below, where they estimate the probability of computerisation across their 702 jobs mapped onto American sectoral employment data.

How do these risks distribute across different profiles of people? That is, do we witness a threat to high-skilled manufacturing labour as in the 19th century, a ‘hollowing out’ of routine middle-income jobs observed in large parts of the 20th as jobs spread to low-skill service industries, or something else? The authors expect that new advances in technology will primarily damage the low-skill, low-wage end of the labour market as tasks previously hard to computerise in the service sector become vulnerable to technological advance.

Although such predictions are no doubt fragile, the results are certainly suggestive. So what do these findings imply for Europe? Which countries are vulnerable? To answer this, we take their data and apply it to the EU.

At the end of their paper (p57-72) the authors provide a table of all the jobs they classify, that job’s probability of computerisation and the Standard Occupational Classification (SOC) code associated with the job. The computerisation risks we use are exactly the same as in their paper but we need to translate them to a different classification system to say anything about European employment. Since the SOC system is not generally used in Europe, for each of these jobs we translated the relevant SOC code into an International Standard Classification of Occupations (ISCO) code,  which is the system used by the ILO. (see appendix)  This enables us to apply the risks of computerisation Frey & Osborne generate to data on European employment.

Having obtained these risks of computerisation per ISCO job, we combine these with European employment data broken up according to ISCO-defined sectors. This was done using the ILO data which is based on the 2012 EU Labour Force Survey. From this, we generate an overall index of computerisation risk equivalent to the proportion of total employment likely to be challenged significantly by technological advances in the next decade or two across the entirety of EU-28.

It is worth mentioning a significant limitation of the original paper which the authors acknowledge – as individual tasks are made obsolete by technology, this frees up time for workers to perform other tasks and particular job definitions will shift accordingly. It is hard to predict how the jobs of 2014 will look in a decade or two and consequently it should be remembered that the estimates consider how many jobs as currently defined could be replaced by computers over this horizon.

Thu, 17 Jul 2014 15:52:00 +0100
<![CDATA[Tax harmonization in Europe: Moving forward]]> http://www.bruegel.org/publications/publication-detail/publication/841-tax-harmonization-in-europe-moving-forward/ publ841

The debate on tax competition opposes those who praise its positive effect on government efficiency, and those who accuse it of distorting public choices, inducing inequality but also undermining the functioning of markets. These two polar versions coexist in the European Union. Since decisions on taxation require unanimity, it is not surprising that tax cooperation remains difficult. Still, the argument that tax distortions undermine the single market has justified some harmonization in the area of indirect taxation (Value Added Tax, excise duties); much less harmonization, however, has happened on the direct taxation of capital and labor.

The sovereign debt crisis that started in 2009 has given an impetus to the debate on tax harmonization, for three reasons:

  • Governments have been obliged to rapidly raise taxes while facing international tax competition and domestic discontent concerning the distribution of the burden;
  • Emergency assistance to crisis countries has sometimes been considered illegitimate given the low levels of taxation in some countries for companies or wealthy individuals;
  • The need for a “fiscal capacity” has emerged as a complement to the monetary union and to the banking union.

It should be noted at this stage that although they are often considered as synonymous, the words “coordination”, “cooperation”, “convergence” and “harmonization” cover somewhat different concepts. Tax harmonization (e.g. the minimum standard VAT rate, or common rules embodied in different directives on the corporate taxation), is a form of coordination. The Common Consolidated Corporate Tax Base project (CCCTB) envisages a harmonization of CIT bases, but also some cooperation through the consolidation and apportionment of tax bases.3 As for convergence, it is a broader concept that is compatible with both tax coordination and tax competition. In the following, we concentrate on tax harmonization and cooperation.

Tax harmonization in Europe: Moving forward (English)
Thu, 17 Jul 2014 10:06:11 +0100
<![CDATA[Annual Meeting - Europe: the way ahead]]> http://www.bruegel.org/nc/events/event-detail/event/451-annual-meeting-europe-the-way-ahead/ even451

Europe, the way ahead will be on the focus of this year’s Bruegel annual meeting. In the fall and after the European election, a new leadership will come into office. It will be time to reflect on the next steps Europe should take to overcome its weak growth performance; to re-invent its institutions and the collaboration process among them; to address the remaining banking problems; and also to revive the debate on the constitution and legitimacy of Europe.

At the annual meeting, we would like to have an open and frank debate. High-level representatives of Bruegel's state;corporate and institutional members will gather;on 4-5 September in Brussels;to discuss the economic issues that will shape Europe under the new leadership and in the context of new global challenges.

September 4 (on the record)

  • 19.00 - Welcome drinks
  • 19:30 - Bruegel annual dinner
    • Chair: Jean-Claude Trichet, Bruegel chairman
    • Dinner keynote: Finance Minister Mateusz Szczurek, Poland

September 5 (day under Chatham house rules)

  • 8.30-8.40 - Welcome speech by Guntram Wolff
  • 8.40-10.30 - First panel: “How to address the global and European growth challenges?”
    • Chair: Rachel Lomax, Bruegel board member
    • Panel:
      • Steffen Kampeter, Deputy Finance Minister, Germany
      • Huw Pill, Chief Economist, Goldman Sachs
      • Agnès Benassy-Quéré, Executive president CAE and Professor, France
      • Hubert Penot, EMEA CIO, Metlife
  • 10.30-11.00 - Coffee break
  • 11.00-13.00 - Second panel: “Europe's banking landscape: next steps”
    • Chair: (tbd)
    • Panel:
      • Filippo Altissimo, Tudor
      • Stephan Leithner, Chief Executive Officer Europe (except Germany and UK), Human Resources, Legal & Compliance, Government & Regulatory Affairs, Deutsche Bank
      • Danièle Nouy, Chair of the Supervisory Board of the single supervisory mechanism, ECB
      • Marco Pagano, Professor, University of Naples Federico II
  • 13.00-14.00 - Lunch
  • 14.00-14.30 - Keynote Sergei Guriev, Professor Science Po: “Europe and its neighbourhood: back to stability?”
  • 14.30-16.30 - Third panel: “Further institutional challenges for the EU and the euro area”
    • Chair: Jean Pisani-Ferry, Commissioner for Strategy and Policy, France
    • Panel:
      • Lord Roger Liddle, House of Lords, UK
      • Daniela Schwarzer, Glienicker Gruppe
      • József Szájer, Member of European Parliament

Thu, 17 Jul 2014 09:25:22 +0100
<![CDATA[Can Brazil get over the World Cup?]]> http://www.bruegel.org/nc/blog/detail/article/1393-can-brazil-get-over-the-world-cup/ blog1393

This article was first published in BloombergView.

Brazilians had mixed feelings about the World Cup even before their team's humiliation in the semi-final match against Germany. Now they're left to dwell on what's been spent on the competition and what they got out of it -- a pretty dismal return on investment.

While Brazil is chewing that over, the country will be hosting the sixth summit of the BRICS nations this week. Maybe greeting delegations from Russia, India, China and South Africa to discuss the future of the world's major emerging economies will be a welcome distraction. There's real work to be done at this gathering, so it might let Brazil's government look a bit more purposeful than it has lately. Then again, it might rub salt in the wounds.

Let's talk about the soccer atrocity first. You'd struggle to exaggerate the disappointment Brazilians feel right now. I saw the fans' delight on Copacabana after their team beat Colombia, and heard their joyful chanting at matches where Brazil wasn't even playing. Other things might let them down, but they could take pride in their football. Then I saw that pride collapse after the game against Germany. It was heart-breaking.

Brazil has a bit of growing up to do when it comes to soccer. It no longer has players of the caliber of its wonder years from the 1960s to the early 1980s. For years, its national teams have been successful, but not as dominant as they once were. In that sense, the expectations had gotten out of hand and the country was riding for a fall. A bit more realism and the sense that football's just a game wouldn't go amiss. Perhaps that kind of maturity is what we're seeing in Brazil right now, despite the dismay. Life goes on. That, at least, is what I keep telling myself as a fan of Manchester United.

It's worth remembering that Brazil isn't the first country -- and it won't be the last -- to spend money on a big sporting event that would have been better spent on other things. The same was true for South Africa for the 2010 World Cup, and probably for both Japan and South Korea for the 2002 World Cup. (In 2006, Germany already had most of what it needed to host the competition.)

Or think of the Olympics, where wasted spending on a vast scale is almost mandatory. Rio hosts the Olympics in 2016, so its planners might have learned a thing or two lately.

Although it's right for Brazilians to protest about the excessive cost -- and a welcome expression of democratic expectations, by the way -- the country shouldn't beat itself up too much over its outlays for the World Cup. Much less should it be criticized by foreigners who've made the same mistake.

Meanwhile Brazil's economy isn't exactly thriving. The past few years have been a letdown. My earlier prediction of 5 percent growth over the course of this decade is almost certainly going to be proved wrong. The end of the commodity-driven boom years hasn't been easy.

Again, though, one needs to keep a sense of perspective. Brazil only appeared to have grown so strongly in the previous decade because of the soaring value of its currency and rising commodity prices. These translated into a very fast increases in dollar-denominated output and spending. Real gross domestic product growth was less than 4 percent a year over the decade. Moreover, as disappointing as this decade's growth of roughly 2 percent a year has been, outright Brazilian-style crises are a distant memory.

Analysts who write about the country's high and rising inflation -- currently running about 6 percent -- forget that prices sometimes rose 6 percent each month in the 1970s and 1980s. The currency lost value so rapidly it had to be repeatedly scrapped and replaced. Those days are over.

Certainly the government has to get out of the way, and stop “doing a China” by trying to direct so much of the economy itself. (Even China is no longer doing a China.) Brazil needs to be more competitive and more inventive; it needs its private enterprises to invest more in creating wealth and boosting productivity.

In this, the BRICS summit could play a small yet useful role. Brazil could push to shape the much-discussed BRICS Development Bank in the right way. Where will it be based? How exactly will it be capitalized? What big projects might it help to advance? Maybe some funding for the Rio Olympics?

As the inventor of the acronym, I have a stake in the BRICS. I want to see them succeed, and I'm sure they can. For all sorts of reasons, now would be a great time for the B in the BRICS to make some decisions and silence the doubters.

Thu, 17 Jul 2014 06:47:18 +0100
<![CDATA[Why Juncker’s industrial goals are unlikely to be achieved]]> http://www.bruegel.org/nc/blog/detail/article/1392-why-junckers-industrial-goals-are-unlikely-to-be-achieved/ blog1392

'Industrial policy is back!’ This is the message given by the President Elect of the European Commission, Jean-Claude Juncker, at his confirmation by the European Parliament yesterday. In his speech, Juncker said

“It would be naïve to believe that growth in Europe could be built on the basis of services alone. We need to bring back industry’s weight in the EU’s GDP back to 20% by 2020, from less than 16% today.”

Historical evidence suggests that this goal is unlikely to be achieved. Manufacturing’s share of GDP has decreased around the world over the last 30 years. Paradoxically, this relative decline has been a reflection of manufacturing’s strength. Higher productivity growth in manufacturing than in the economy overall resulted in relative decline. A strategy to reverse this trend and move to an industrial share of above 20 percent might therefore risk undermining the original strength of industry – higher productivity growth.

In our blueprint on manufacturing Europe’s future, we take a different approach. It starts by looking in depth into the manufacturing sector and how it is developing. It emphasises the extent to which European industry has become integrated with other parts of the economy, in particular with the increasingly specialised services sector, and how both sectors depend on each other. It convincingly argues that industrial activity is increasingly spread through global value chains. As a result, employment in the sector has increasingly become highly skilled, while those parts of production for which high skill levels are not needed have been shifted to regions with lower labour costs.

But this splitting up of production is not driving the apparent manufacturing decline. Participation in global value chains within Europe is strongly EU-oriented with a central position for the EU15 and in particular Germany in EU manufacturing. This internationalisation of production has resulted in deeper integration of EU manufacturing, with member states specialising in sectors according to their comparative advantage. It has therefore helped to raise productivity and growth. As a result, the foreign content of countries’ exports has increased. Germany, in particular, has been able to benefit from the greater possibilities to outsource parts of production to central and eastern Europe and to emerging markets, and is in fact one of the countries with the smallest manufacturing share declines in the last 15 years. The Blueprint also highlights the importance of energy for the structure and specialisation of manufacturing.

Capital-intensive manufacturing faces both urgent challenges and medium-term challenges. In the short-term, one of the most pressing problems is the fragmentation of financial markets in Europe,which undermines access to finance. This affects small to medium-sized firms in particular because they are the most dependent on bank credit. In some southern European countries, even the financing of working capital is endangered. It should therefore be a high priority for policymakers to fix Europe’s banking problems and create better functioning capital markets, including for venture capital.

A second important conclusion is that, given the strong links between innovation,internationalisation and firm productivity, it is important to erase the dividing lines between industrial policy, single market policy, ICT policy and service sector policy. A highly integrated economic system needs a coherent set of policies that aim at improving business conditions everywhere. Attempts to promote one sector at the expense of another one are likely to result in significant inefficiencies and weaker overall growth. Governments are notoriously bad at picking winners. Instead, Europe needs policies that are conducive to a better business climate, less-burdensome regulations and the right framework conditions.

Third, public policies need to change to foster competition, allow economic restructuring and focus on market failures. In a recent paper for the French Conseil d’Analyse Economique, we argued that the discourse on industrial policy needs to be adapted to favour restructuring and economic dynamism while focusing on public policies on areas where markets fail For example, the education system and R&D policies are of central importance for the economy and needs to be adapted to the needs of modern economies. The single market is important for both manufacturing and services and progress is needed to unleash its potential for growth. Reducing trade barriers is particularly important for industrial firms that increasingly rely in global value chains. Distortions in energy prices are also detrimental to industrial activity and should be avoided.

Manufacturing Europe’s future’ therefore means getting the policies right for firms to grow and prosper. It is not about picking one sector over another, but primarily about setting the right framework conditions for growth, innovation and jobs.

Wed, 16 Jul 2014 14:54:44 +0100
<![CDATA[The OMT programme was justified but the fiscal union question remains]]> http://www.bruegel.org/nc/blog/detail/article/1391-the-omt-programme-was-justified-but-the-fiscal-union-question-remains/ blog1391

Ashoka Mody has written an important paper on the German court’s ruling on the Outright Monetary Transactions (OMT) programme, the issues related to this that the European Union Court of Justice (ECJ) will have to deal with and what all of this means for the further construction of Europe.

I concur with the overall conclusion that the monetary union, even with the OMT programme, is incomplete and the issue of fiscal union remains unresolved. To permanently stabilise monetary union, the EU will need to agree on a small fiscal union. I am, however, less convinced by the criticism of the OMT programme as such (see also my previous piece providing evidence in favour of OMT).

Let me organise my comments into seven main points.

  1. To start with, I would like to emphasise that the OMT programme has been extraordinarily successful. Ahead of the European Central Bank's summer 2012 announcement, financial markets were speculating against a number of EU governments. As Paul de Grauwe (2011) and Guillermo Calvo (1988) have convincingly shown, multiple equilibria in bond markets are possible. In the language of economists, markets were converging on a bad equilibrium, in which rising interest rates would render debt unsustainable. The only party that can move markets from the bad to the good equilibrium is the central bank. The ECB therefore rightly acted to move markets to the right equilibrium. The announcement of possible ECB intervention was sufficient to guide markets to the good equilibrium. The fact that the ECB did not have to buy a single bond to achieve this suggests that the problem was one of multiple equilibria.
  2. The OMT announcement was in line with the ECB's mandate. The ECB’s task is, among others, to define and implement monetary policy and to promote the smooth operation of the payment system. In July 2012, monetary policy was arguably not properly implemented in a number of EU member states. The ECB's interest rate signals did not get transmitted to the creditors and monetary conditions therefore became extremely tight in the countries under attack. The bad equilibrium in the sovereign bond market prevented the banking system from operating properly. The interbank market had broken down and only a very substantial increase in ECB liquidity prevented a liquidity run in the banking system. Target2 balances built up and ECB liquidity became heavily tilted towards the periphery banks. Banks stopped extending credit and therefore monetary policy decisions were not transmitted to the real economy. Even the payment system was starting to be seriously questioned. The ECB therefore had to act to fulfil its mandate according to Article 127. The fact that policy action would be local is totally in line with monetary policy objective of achieving a homogenous price stability goal across the union. The monetary policy mechanism therefore had to be repaired where it was broken.  Announcing the OMT programme was successful in re-ordering market participants around the good equilibrium.
  3. The OMT discussion should not ignore the counterfactual. Not announcing a potential OMT programme could have much more significant fiscal consequences. In fact, the ECB is involved in a large number of standard monetary policy operations which all imply loss sharing across the ECB’s shareholders if there were losses. The aim of the OMT programme announcement was to stabilize markets in which monetary policy did not operate properly anymore. In doing so, the actual risk for the shareholders of the ECB decreased significantly.

A trickier question is under which circumstances implementation of an OMT programme and purchases of government bonds of countries under a European Stability Mechanism (ESM) programme would be legal, and under which conditions it would violate the no-bail-out (Article 125) and no-monetary financing rule (Article 123) of the Maastricht treaty. The core of the argument made by the German court and by Ashoka Mody is that government bond purchases in the context of an ESM programme are a fiscal operation and not a monetary operation, and should therefore be a political decision. If they were fiscal operations, they would violate Articles 123 and 125 and would certainly be against the spirit of the Maastricht treaty that aimed to establish a monetary union without a fiscal union. The authors argue that liquidity and solvency cannot be properly distinguished and therefore ECB intervention would necessarily become a fiscal operation in the context of an ESM programme. They also argue that the acceptance of pari passu by the ECB would contradict the ECB’s liquidity mandate and would therefore be an explicit acceptance of losses, making the operation a fiscal operation. I would counter this reasoning with a number of arguments:

  1. Article 13 (1b) of the ESM treaty requires that prior to an ESM programme, the European Commission in liaison with the ECB has to assess if public debt is sustainable. Wherever appropriate and possible, this assessment will be conducted together with the International Monetary Fund. So in principle, the ESM programme is only approved when debt is assessed to be sustainable. More importantly, the ESM programme is only granted if there is a unanimous agreement by all ESM members to do so. This means that there is not only a technical debt sustainability assessment but also a unanimous political agreement that debt is sustainable and that the recipient of the assistance will be able to honour its commitment. This political agreement between member states is very important for a number of reasons:
    1. First, the sustainability of debt under normal interest rate conditions, and therefore the solvency of a country, is primarily a political issue. The servicing of even very high debt levels when interest rates are low is a political decision because it implies cutting back on other spending. A political commitment to the partners is therefore a strong signal that, in fact, the problem the country is undergoing is one of liquidity and not of fundamental solvency.
    2. Unanimity also implies that all creditors agree that they believe in the country’s intention to honour its obligation. They therefore declare that they trust the country’s ability to service its debt.
    3. As a result, I would argue that the distinction between solvency and liquidity problems, which Mody argue cannot be made, is, in fact, made by a very strong political commitment on all sides.
    4. It is true, however, that ex post, this political commitment may disappear, for example after an election. Ex post, a country might decide to default on its obligation. The relevant question to assess the legality of the OMT programme is therefore whether the possibility of an ex-post default by a country makes an ECB action incompatible with the treaty. I would argue that this cannot possibly be the case. In fact, any ECB operation is carried out under the ex-ante supposition that the liquidity granted will be paid back. This is, for example, the case in standard main refinancing operations (MRO), and in asset-purchase programmes. The ex-ante guarantee, on which the ECB relies in the MRO, is a supervisory assessment of the solvency of the bank and, in the case of an asset purchase, it is based on ratings. In the case of an ESM programme, it would be based on the political and technical assessment of solvency. A strong ex-ante presumption that debt is sustainable should therefore be sufficient to justify ECB purchases.
  2. Mody argues that OMT pulls the ECB inevitably into making political choices. While I agree that the ECB currently is in a very uncomfortable position, in which the missing fiscal union increases the need for the ECB to be political, I would argue that the ESM programme is actually the best way of protecting the ECB from national politics. In fact, buying government bonds without an ESM programme, as some have advocated in the context of the quantitative easing debate, appears to me a much more delicate issue because the ECB would intervene in the pricing process of sovereign bonds without a prior political agreement on the fact that markets are mispricing sovereign debt. It would, in fact, mean that the ECB itself is making this judgement and therefore buys bonds, a much more political action.
  3. The trickiest issue is perhaps the pari-passu clause announced by the ECB. In fact, to be effective, the ECB had to announce pari passu. Pari passu, incidentally, is the standard format for monetary policy measures (in MRO and QE, the ECB also has pari-passu status). But announcing pari passu means that the ECB would have to accept losses in a case of sovereign default. I think I have convincingly argued that accepting losses ex post is unproblematic from the point of view of the EU treaty if ex ante one can be reasonably sure that they will not be suffered. It is, however, problematic that the ESM has the status of a senior creditor while the ECB is pari passu. This ordering of creditors appears to be inconsistent with the Pringle judgement of the ECJ (in the reading of Mody) which protects the ECB ahead of the ESM.
  4. A logical solution to the pari-passu problem in case the ECJ follows the reading of Mody of the Pringle judgement in its OMT judgment would be to make the ESM the junior creditor or at least pari-passu. In doing so, a number of important aims would be achieved. First, one would have a political agreement by fiscal authorities on burden sharing if a country defaults. This would be in line with Mody’s call for a political agreement on burden sharing. Second, one would grant a strong political incentive to only start an ESM programme if the likelihood of insolvency is very low. Third, it would be a clear step towards a fiscal union (even though other justifications for a fiscal union exist) in which, if member states decide that they assess a possible default of a country to be too costly, they can grant assistance, but only by taking on a substantial risk for their own taxpayers.

Arguably, while I believe the German court has stepped beyond its remit by taking this case and ruling on it, as has been convincingly argued by the outvoted German court judge Lübbe-Wolff and also by Professor Franz Mayer, the German court does Europe a favour on this point by forcing Europe to better define the boundaries of fiscal and monetary policy.

Wed, 16 Jul 2014 06:58:00 +0100
<![CDATA[China's Ambassador to the EU on the role of emerging markets in WTO]]> http://www.bruegel.org/nc/blog/detail/article/1390-chinas-ambassador-to-the-eu-on-the-role-of-emerging-markets-in-wto/ blog1390

Remarks delivered by Her Excellency the Ambassador of the People's Republic of China to the European Union, Yang Yanyi, at our workshop 'The future of trade multilateralism - Governance of 21st century trade and the role of the WTO' on the 14th of July 2014.

Distinguished guests,

Ladies and gentlemen,

Good afternoon. It's my pleasure to be at Bruegel, a prestigious European think tank that is renowned for carving a unique discussion space for improving the quality of economic policy.

I wish to commend Bruegel for putting under the spotlight the future of trade and multilateralism--governance of 21st century trade and the WTO. Indeed, against the backdrop of rising multi-polarity and mega-regional trade agreements, how shall global trade be better managed and what will be the future of trade multilateralism are serious questions that need to be answered.

That said, the topics under today's discussion are heavy and have no simple solutions. The academic world so well represented in this audience may offer a fundamental contribution. As a laywoman, I will only venture on some short and humble points.

On opportunities and challenges

As mentioned by many speakers and observers, the Bali Ministerial of last December was a resounding success. Constructive engagement by all the Members enabled a very successful and inclusive outcome, particularly in three key areas-agriculture, trade facilitation and development.

Once implemented, the Bali Package will provide a shot in the arm to the global economy, delivering growth and jobs.

Among others, by streamlining customs procedures, the Trade Facilitation Agreement could lead to an expansion in developing country exports of up to 9.9% and the creation of up to 18 million jobs in developing economies. It could also reduce advanced economies' cost for doing business internationally by 10%.

The Bali Ministerial breathed new life into multilateralism and restored the credibility of the WTO. It demonstrated for the first time since its creation in 1995 that the WTO is capable of making multilateral decisions and delivering results.

The Bali Ministerial has also set in motion a process whereby members will decide by the end of this year on a clear road map for concluding the Doha Development Agenda.

It is encouraging to learn that in Geneva, there is a tangible feeling of momentum. Positive message has been delivered to the Director-General Roberto Azevedo during his travels to numerous countries in recent months. Members have expressed their willingness to build on the momentum created in Bali and ensure that the WTO will deliver even more in the future.

Having said the above, there is no denying that there are challenges.

The world is far from tranquil and development continues to be uneven, with the North staying strong and rich while the South remaining weak and under-developed.

International trade is still feeling the aftershocks of the global financial crisis. The path of global economic recovery is tortuous and growth remains lackluster.

Global challenges such as food security, energy security and sustainable development remain pronounced.

Developing countries are still faced with a harsh international trade and development environment. While some have been successful in participating in global value chains, a significant number of low-income countries, particularly the least-developed, are still absent.

The continuing stalemate of the complex negotiations of the Doha Round has led to frustration and cynicism of the multilateral trading system. There has been declining interest in multilateral trade system and shifting of priorities to regional and plurilateral trade agreements, including TTP and TTIP.

And in this connection, there is a growing concern that the increase in regional and plurilateral trade deals could come to be seen as a substitute for, rather than a complement to, multilateral liberalization and non-discriminatory set of rules to govern international trade.  

Protectionism has been on the rise and the use of anti-dumping and countervailing duties is soaring, threatening the gains from liberalization.

The wider and more diverse membership of the WTO has made coordination and decision-making more complicated. 

On the overall approach towards governance of trade

First, it is more important than ever that we commit ourselves to supporting development through trade. As one of the key enablers of inclusive and sustainable development, trade has played a central role in helping business in the poorest economies connect to open global markets and lifting millions of people out of poverty. To ensure shared growth and prosperity, trade should continue to play a greater role in the future.

Second, multilateral trading system under the WTO should remain at the heart of global trade discourse and norm-setting exercise. The continuing integration of our economies and the deepening and broadening of the global value chains have shown and will continue to show that only the multilateral trading system is in a position to ensure a more level playing field and fair and equitable order in global trade.

Third, WTO Members should prepare with a sense of urgency a clearly defined work program by the end of this year to secure an appropriate and balanced conclusion to the DDA, and, in particular, address outstanding market access barriers and trade-distorting practices in agriculture, industrial goods and services.

Fourth, at these demanding times, all the WTO Members must be disciplined in abiding by the principle of locking-in what have already agreed on and not re-open the existing package and jeopardize the delicately balanced compromises achieved. And all members, mainly the developed members should display required political predisposition, good faith, pragmatism and necessary flexibility to facilitate progress.

Fifth, to make the global trading system fully responsive to the needs and aspirations of majority of the people around the world, in particular the LDCs, the principle of special and differential treatment in favor of developing countries should be reaffirmed and upheld. The formula for full integration into global trade flows has to be country-specific. One-size-fits-all approach is ill-suited and not advisable. We need an approach that respects the political and economic limitations of each member; finds meaningful outcomes of interest to all; and keeps us moving in the right direction.

Sixth, functioning of the multilateral trading system should remain current and relevant. Negotiations should be open, inclusive and transparent. Due considerations should be given to differences between parties. No party or parties should try to impose their own will. Multilateral agenda should be discussed within the multilateral framework and consensus should be reached with all members joining the discussion.

Seventh, coexisting with each other, different tracks--bilateral, regional, plurilateral and multilaterals should not be mutually exclusive; rather they should complement and reinforce each other. While regional initiatives are necessary building blocks to build the edifice of global trade rules and trade liberalization, they are not sufficient on their own. Many of the big issues can only be tackled at the global level, and therefore many of the big gains can only be delivered at this level. Any attempt to set some bilateral or regional trade standards as reference for future multilateral negotiations should be guarded against.

Last but not least, protectionism should be guarded against by all means. We must detect trade-restrictive measures in their early stages; wherever they show up, we must discourage their adoption and encourage their dismantling.

On the role of emerging markets

I would like to take the sub-agenda item before us as recognition of and complement to the increasingly important role played by the developing world in promotion of growth and development.

Management of 21st century global trade is a joint endeavor and shared responsibility. The building of a fair and equitable international order hinges on commitment by developing and developed countries alike.

Talking about the role of emerging markets, I would like to briefly touch upon what China is doing and continue to do.

The past three decades and more tell us that only an open and inclusive country can be strong and prosperous.

For this reason, the new leadership of China is fully committed to comprehensively deepening reform and pressing ahead proactively with the opening-up.

The key of the reform is to streamline administration and delegate government power to further energize the market and generate greater creativity from the society. Among others, reform of business registration system has been followed by a surge of over 40% in the number of newly registered businesses; and advancement of structural reform and easing of market access has given more play to the role of private capital.

In the meantime, the new round of opening-up has led to easing market access for foreign investment and further opening of the sevices sector and hinterland and border areas.

With a view to providing a level playing field for Chinese and foreign investors and business alike, we are exploring, through the China (Shanghai) Pilot Free Trade Zone, a management model featuring pre-establishment national treatment plus a negative list approach. 

    As an active participant, staunch supporter and important contributor of an open, rule-based multilateral trading system, China has unswervingly supported the WTO and assumed its due responsibilities as a major developing trading nation.

China has fulfilled in a timely manner its notification obligations under the WTO's financial crisis monitoring mechanism, and honored its commitment to implement the Agreement on Trade Facilitation according to the timetable set up by the Bali Ministerial.

As the host to this year's APEC meetings, China contributed to the adoption at the Minister Responsible for Trade Meeting, a Standalone Statement on Supporting the Multilateral Trading System.

China has, since 2008, contributed to the Aid for Trade Fund under the multilateral framework of the WTO. China also established China's LDCs and Accessions Program, and donated US$1.2 million in total to this Program.  

China has been the largest export market for the LDCs for five consecutive years, providing since July 2010 duty-free treatment to exports from the LDCs, and importing over US$2.2 billion of goods from 26 beneficiary countries, and offered a tariff exemption of RMB1.34 billion yuan.

China has refrained from taking trade protectionist measures, remained vigilant against all forms of trade protectionism, and remained committed to exercising maximum trestraint in applying measures that may be considered WTO compatible but still have a significant protectionist effect.

While supporting the multilateral trading system with the WTO as its core, China has participated in some bilateral and regional agreements, including the recently entering-into-force of China-Iceland and China-Switzerland free trade agreements. China is seriously engaged in negotiation of a bilateral investment treaty with the US and a comprehensive inestment agreement with the EU.

China has also come up with the strategic initiatives of "Silk Road Economic Belt" and "Maritime Silk Road" to promote shared prosperity among different regions.   

As a champion of the multilateral trading system, China will, as always, join hands with other WTO members build on the momentum created inBali and secure an appropriate and balanced conclusion to the DDA.

China's reform and opening-up not only augurs well for its 1.3 billion people but also the rest of the world. As the largest trading partner for more than 120 countries and regions, China imported over the past years US$ 2 tillion goods and created immense job and business opportunities. In the coming five years, China will import more than US$10 trillion worth of goods and invest over US$500 billion overseas. Outbound visits by Chinese tourists will exceed 500 million.

Having said the above, I wish to underline here that despite being the biggest merchandise trader and the second largest economy, Chinaremains a developing country.

China's per capita GDP is below US$7000, ranking 84th in the world and 101 out of 187 in UNDP's human development index. Today, some 128 million Chinese people still live under the porverty line. "Made in China" products remain at the lower end of global value chain. There is a long way to go before China realizes modernization. China therefore can only assume responsibilities in international trade and economic affairs commensurate with its level of development.

In conclusion, I wish to once again thank Bruegel for bringing us here to reflect upon the future of the multilateral trading system.

I am sure deliberations will contribute to generate fresh dynamism of the WTO and channel our energy towards a common good, the promotion of constructive cooperation. This we owe to our common belief in trade as a vehicle for green growth and poverty reduction and that keeping multilateralism alive serves our long-term interest.

Thank you for your attention.

Tue, 15 Jul 2014 13:39:53 +0100
<![CDATA[Did the German court do Europe a favour?]]> http://www.bruegel.org/publications/publication-detail/publication/840-did-the-german-court-do-europe-a-favour/ publ840

Contributions from, and collaboration with, Will Levine of Union Square Group Capital have greatly enriched this paper. For generous comments, the author is grateful to Kevin Cardiff, Paul de Grauwe, Aerdt Houben, Dan Kelemen, Rosa Lastra, Karl Whelan, Jeromin Zettelmeyer, and especially to Peter Lindseth and Guntram Wolff.

The European Central Bank’s Outright Monetary Transactions (OMT) programme was a politically-pragmatic tool to diffuse the euro-area crisis. But it did not deal with the fundamental incompleteness of the European monetary union. As such, it blurred the boundary between monetary and fiscal policy. The fuzziness of this boundary helped in the short-term but pushed political and economic risks to the future. Unless a credible commitment to enforcing losses on private creditors is instituted, these conundrums will persist. The German Federal Constitutional Court has helped by insisting that such a dialogue be conducted in order to achieve a more durable political and economic solution. A study of the European Union Court of Justice’s Pringle decision (Thomas Pringle v Government of Ireland, Ireland and The Attorney General, Case C-370/12, ECJ, 27 November 2012) suggests that the ECJ will also not rubber-stamp the OMT – and, if it does, the legal victory will not resolve the fundamental dilemmas.

Working paper 2014/09

As the risk premia on Spanish and Italian bonds soared in the summer of 2012, Mario Draghi, the President of the European Central Bank, promised on 26 July to do “whatever it takes” to restore confidence in the euro area (Draghi, 2012a). In successive announcements in August and September, the Outright Monetary Transactions (OMT) programme was rolled out. Governments benefiting from the programme would be required to step up their fiscal discipline; in return, the ECB would buy their bonds in unlimited quantities to place a ceiling on their interest rates. Markets calmed down, the risks spreads began a steady fall, the lingering crisis abated and a nascent recovery began. Draghi (2013) himself later described the programme as “probably the most successful monetary policy measure undertaken in recent time”.

On 14 January 2014, Germany’s Federal Constitutional Court (the German Court) made news. It determined that OMT is prima facie incompatible with the Treaty on the Functioning of the European Union (TFEU), the legal basis for the European Union[1]. However, before delivering its final judgment, the German Court chose – for the first time – to seek the opinion of the European Court of Justice (the ECJ). The eventual resolution of the questions raised will have wide-ranging implications for the economics and politics of the euro, and for European integration.

ECB action via the OMT was needed because the fiscal options to deal with the crisis had been narrowed down to austerity, which was not paying dividends. European policymakers had determined that they would not – other than in exceptional circumstances – allow euro-area sovereigns to default on their debt to private creditors, although the option of such default was implied in the Treaty’s so-called 'no bailout' clauses (Articles 123 and 125). There was, moreover, no political will to compromise national interests in a fiscal union with a sizeable pool of budgetary resources. That placed the entire burden on austerity. While budget trimming would eventually reduce public debt-to-GDP ratios to acceptable levels, markets were losing confidence.

The OMT was politically attractive. The German Chancellor, Angela Merkel, lent it her support even though the Bundesbank President, Jens Weidmann, steadfastly opposed it. For Merkel, who had bought into the ECB’s opposition to imposing losses on private creditors, the OMT was the only way to distance her actions in support of Europe from a sceptical German public.

The heart of the German Court’s case is that the OMT could spread the losses across governments in the euro area. It thus creates a de-facto fiscal union, which is contrary to the political contract. The TFEU authorises a common currency shared among European Union’s member states but consciously leaves fiscal sovereignty and responsibility at the national level since the member states have remained unwilling to pay for the mistakes of other member states. The TFEU achieves economic consistency by permitting – arguably encouraging – that the burden of these mistakes be shared by the sovereign’s private creditors. But this outlet was closed by a policy decision.

To the supporters of the OMT, the activist German Court is endangering a fragile economic and financial calm, while overstating the limits set by the political contract.

The ECB’s position is that the OMT was required mainly to correct distortions in financial markets, which were pricing in unwarranted fears of euro-area exits by stressed countries[2]. Since this market fear blunted the ECB’s ability to conduct monetary policy, the OMT was designed to remove the threat of exit and, thereby, improve liquidity to countries under stress. Along with greater fiscal discipline on the part of the distressed sovereign, the OMT would achieve stability without imposing costs on other sovereigns.

The German Court’s decision has forced a crucially-important discussion on the state of monetary and fiscal integration in the euro area. Put simply, does the survival of the euro require that the political contract be rewritten? In other words, do member states need to – and are they willing to – transparently subordinate their national fiscal interests to help distressed member states? Or, can creative flexibility within the existing framework allow reliance on OMT-like measures that skirt the limits of the TFEU?

The ECJ might seek to appease many parties – as is common in European decisions – and matters might remain confused. However, a clear eventual judgment by the ECJ would have far reaching consequences for the legal and economic basis of the euro area.

Also at stake is the relationship between national constitutional courts and the ECJ. The German Court has often been caricatured as biased against the monetary union and prone to nationalistic decisions. Some have read the latest decision in that light as politically confrontational (Pistor, 2014). However, this reputation and interpretation are ill-deserved. In October 1993, as much of Europe held its breath, the German Court determined that the Bundestag, the German parliament, had the authority to determine Germany’s participation in the monetary union as conceived in the Maastricht Treaty. Later when prominent German economists tried to again the stir the Court in a final bid to stop the euro, the judges summarily dismissed their case (Norman, 1998).

In this latest instance, by forcing the discussion, the German Court has done Europe a favour. The Court’s uneasiness arises from the culture of quick fixes since the crisis started. An opening has been created for a more durable political and economic solution, necessary for the euro to survive. The issues raised by the German Court should not be viewed as reflecting a Germany-versus-Europe divide. Rather, they raise questions central to the design of the euro area. Specifically, does the TFEU permit a fiscal union? More controversially, can such a fiscal union be implicitly located in the ECB without the political willingness to transparently achieve that elusive goal?

On process, the German Court’s deference to the ECJ’s opinion could be read as an effort to proactively build a cooperative relationship. The legal scholar and former judge of the German Court, Dieter Grimm, proposed some years ago that when national constitutional courts are concerned that European policies are creating national obligations greater than intended in the Treaty, it is best to ask the ECJ’s opinion rather than act unilaterally (Grimm, 1997). This approach makes particular sense since the OMT has not been reviewed or authorised by the Bundestag.

The rest of this paper makes the following arguments. The euro is the common currency of an incomplete monetary union and the OMT was needed to plug the holes that became apparent at the height of the crisis. The German Court is concerned that the OMT blurred the boundary between monetary and fiscal policy defined in the TFEU. The ECJ, based on its so-called 'Pringle decision', will be sympathetic to the philosophy and details spelled out in the German Court’s decision. The German Court’s position is supported not only by the TFEU but also by a traditional view on the role and limits of central banks as lenders-of-last resort. I conclude by speculating on the prospects and possibilities that lie ahead.

The OMT in an incomplete monetary union

On 1 January 1999, the euro became the common currency of an incomplete monetary union. The monetary union remains incomplete because the member countries – having given up independent monetary policy – lack reliable alternative mechanisms for adjustment when under economic stress. Although there are no legal barriers to the movement of people, labour mobility across the countries of the euro area is limited. Since economic adjustment through a moderation in wages is also unreliable, Peter Kenen had proposed in 1969 that a fiscal union is needed to pool budgetary resources for providing relief to countries in distress. An additional problem is that as the central bank of the common currency, the ECB is not clearly authorised to act as a lender-of-last resort to sovereigns (Sims, 2012); such support is needed when access to market financing is temporarily lost and the sovereign needs to be tided over till confidence is restored.

Despite the fall in the sovereign risk premia prompted by the OMT announcements, the President of the German Bundesbank, Jens Weidmann – also a member of the ECB’s Governing Council – openly criticised the programme. On 2 August 2012, when Draghi spoke of possibly unlimited purchases of sovereign bonds under the OMT, he also reported that Weidmann was opposed to the initiative (Draghi, 2012b). The Bundesbank publicly expressed concerns (Steen, 2012). First, by 'printing' reserves to finance the bond purchases, the ECB would ease the pressure on governments to maintain fiscal discipline. Second, ECB actions might ultimately impose costs on German and other taxpayers if the bonds purchased were not repaid in full.

In contrast to Weidmann, the German Chancellor, Angela Merkel, lent the programme her implicit support. On 7 September, a day after the operational details of the OMT were unveiled, she helpfully noted that the ECB was an independent organisation and the risks to the OMT would be limited since the countries whose bonds were purchased would need to maintain strict fiscal discipline (Wearden, 2012). Merkel was echoing Draghi’s themes of enforcing country responsibility[3].

Despite the German Chancellor’s continued support of the OMT, in December 2012, the Bundesbank submitted an extensive critique of the OMT to the German Court[4]. That critique significantly influenced the Court’s views.

The future of the OMT is so important because even as it eased market fears, it exposed key fault lines in the architecture of the euro. In creating a temporary fix for the incompleteness of the euro-area monetary union, the OMT blurred the line between monetary and fiscal policy. As the Bundesbank correctly stated in its submission to the German Court, the European monetary union was created as “… a community of countries which have assigned responsibility for monetary policy over to the supranational level, but which continue to decide on fiscal and economic policy primarily at a national level, and which deliberately did not enter into a liability or transfer union”[5]. This structure was embodied especially in Articles 123 and 125 of the TFEU.

The legal and economic question of interest is whether the OMT tried to bypass the intent of the Treaty by creating a de-facto fiscal union (a liability or transfer union in Bundesbank terminology). If so, without their explicit authorisation, countries had become fiscally responsible for the mistakes of other member countries.

The boundaries of monetary and fiscal policy in the euro area

The TFEU requires that the ECB must not 'print' money to finance the government. This is the so-called 'monetary financing' concern. In particular, the ECB must not finance a specific government and, in the process, impose an eventual financial obligation on the taxpayers of another government. The Treaty’s intent is to prohibit one member state from 'bailing out' another member state and, thereby, enforce national responsibility of fiscal affairs.

The German Court’s position is straightforward. The ECB’s mandate is to conduct monetary policy for the common currency area. However, the OMT would operate by selectively lowering interest rates for particular countries. The OMT’s focus on support for a particular country is not incidental – it is integral to the OMT. ECB financial capacity is intended to leverage lending to the distressed member state by the European Stability Mechanism (the ESM) under condition of prudent fiscal behaviour. For this reason, the German Court’s position is that OMT is not an instrument of monetary policy. Instead, it pursues economic policy in the interest of a particular member state and, hence, “manifestly violates” the distribution of authority between the central bank and member states. As such, it goes beyond the authority accorded to the ECB under Articles 119 and 127 of the TFEU. In addition, the OMT circumvents Article 123 of the TFEU, which prohibits the monetary financing and bailout of governments by the ECB.

A widely-held presumption is that the ECJ, since it leans towards 'more Europe', will rule in favour of the OMT, possibly with some inconsequential restrictions to appease the German Court. However, there may be rather more common ground between the German Court and the ECJ than is generally presumed. The ECJ’s Pringle decision (ECJ, 2012) – which confirmed the legal standing of the European Stability Mechanism (the ESM) – suggests that the ECJ will be predisposed to support the German Court’s interpretation of the OMT. The ECJ’s room for manoeuvre will be limited by the positions it has taken on Articles 123 and 125 of the TFEU, which enshrine the fiscal sovereignty of the member state.

The ESM was an intergovernmental agreement – and did not involve the ECB. As such, the issue at hand was Article 125, the 'no-bailout' clause that prohibits a member state from taking on the financial obligations of another member state. In July 2012, Irish parliamentarian, Thomas Pringle, claimed before the Irish Supreme Court that the ESM violated this provision. The Supreme Court referred the matter to the ECJ. In November 2012, the ECJ determined that the ESM did not violate Article 125. In doing so, the ECJ allowed rather more scope for bailout than had been generally presumed, but arguably that was appropriate in a critical phase of the crisis. The German Court similarly acted in sympathy with the policy objectives of the ESM. That makes the German Court’s concerns on the OMT particularly significant.

By finding space between Articles 122 and 123 of the Treaty (paragraphs 131 and 132 of the judgment), the ECJ arrived at a creative interpretation of Article 125 to validate the ESM (Craig, 2013). But that very creativity implied clear restraints on the ECB. In essence, the ECJ found latitude in the Treaty for governments – responsible to their own taxpayers – to assist other governments. But the ECB, as the independent central bank, has no such leeway. Moreover, the German Court’s argument implies that the OMT’s reach transcends even the latitude within which the ESM operates.

Article 122 allows for the possibility that the European Union or a member state may provide financial support to another member state facing exceptional circumstances beyond its control. In May 2010, the European Financial Stability Mechanism (the EFSM) was established on the basis of Article 122. However, because 'exceptional' circumstances could not be invoked readily for a permanent body such as the ESM, and because it was not straightforward to claim that problems on account of excessive sovereign debt were beyond the member’s control, Article 122 was not used directly to establish the ESM (de Witte, 2013). Instead, the ECJ used it mainly to note that Article 125 could not have prohibited financial assistance of any sort because then Article 122 would have been inconsistent with the Treaty (paragraph 131).

To define the space for the ESM, the ECJ also highlighted that Article 123 of the TFEU creates a stricter prohibition on the ECB, denying it any form of lending (“overdraft or any other type of credit facility”) in favour of member states. Specifically, the ECJ found that the ESM could do what the ECB could not. Thus the ECJ allowed for latitude in governmental action authorised by national parliaments. But it insisted that the ECB is still bound by the limits set in the TFEU.

Thus, although not called on to comment on Article 123, the ECJ did so to highlight the difference between the ECB and the ESM. Importantly then for the OMT, just as the ECJ opened the door for the ESM, it went out of its way to warn that, under Article 123, the ECB is barred from similar action. Presumably, when financial assistance to a specific member state becomes necessary, it must be a political decision since it implies a fiscal action.

The ECJ’s reasoning in the Pringle decision is consistent with the German Court’s concern that the OMT blurs the distinction between common monetary and national fiscal policy.

Moreover, the ECJ identified limits on the ESM, which place further question marks on the scope for OMT. Article 125 allows for “financial assistance” but prohibits the Union or a member state from taking on the commitments of another member state.“Financial assistance” can take the form of a loan (“credit line”) to a distressed member state provided it is repaid over time with “an appropriate margin” (paragraph 139). The fine distinction, presumably, is that financial assistance is to be repaid, but if commitments are assumed, the distressed member state is relieved of the burden of honouring its obligations. Thus, even if the OMT were to jump the hurdle set by Article 123, it would need to be deemed “financial assistance” rather than the assumption of a government’s obligations and, hence, a 'bailout'. Importantly, the definition of 'no bailout' requires that the member state being assisted pays an “appropriate margin”.

Supporters of the OMT contend that it is a monetary policy tool. It would be triggered under extraordinary circumstances when the market’s risk assessments are distorted by an unwarranted 'fear' that a member state might leave the euro. Assistance under the OMT would be provided by helping the distressed member state regain market access at interest rates that are more in line with its economic fundamentals. This task is rightfully undertaken by the ECB because returning markets to normal functioning is essential for the conduct of euro-area monetary policy.

While the Bundesbank took the strong position that the ECB should not be in the business of guaranteeing that a member state remains in the euro area, the basic contention of the German Court – a contention that finds support in the ECJ’s Pringle decision – is that a fiscal union cannot be created by the backdoor. That is a political decision and must occur through a change of the Treaty and not through its creative reinterpretation. Specifically, the German Court asked:

  • Whether the “fear factor” alleged to cause an “undue” rise in sovereign spreads could be differentiated from a real threat of insolvency;
  • Whether the OMT's offer to buy “unlimited” amounts of sovereign debt implied assuming the debt repayment obligations of the distressed government; and, moreover, whether the ECB’s commitment to be pari passu with private lenders – ie in the event of a default, being repaid on the same terms as private lenders – created additional risk that the ECB, and, by extension, to other sovereigns would incur losses.

The next two sections elaborate on these concerns expressed by the German Court and argue that the ECJ will likely concur with them.

The fear factor and monetary transmission

The German Court sums up the ECB’s position on the OMT in this way:

“[The ECB’s] monetary policy is no longer appropriately implemented in the Member States of the euro currency area because the so-called monetary policy transmission mechanism is disrupted. In particular, the link between the key interest rate and the bank interest rates is impaired. Unfounded fears of investors with regard to the reversibility of the euro have resulted in unjustified interest spreads. The Outright Monetary Transactions were intended to neutralise these spreads.

But the German Court was unconvinced by this argument. Citing the Bundesbank and other experts, the German Court’s assessment reads: “…such interest rate spreads only reflect the scepticism of market participants that individual Member States will show sufficient budgetary discipline to stay permanently solvent. …one cannot in practice divide interest rate spreads into a rational and an irrational part…”

The key empirical and analytical question, therefore, is whether the spreads can be decomposed into components representing 'fear of disruption' and 'country credit risk'. The ECB’s evidence on this has been less than persuasive. For example, in a September 2012 speech justifying the OMT, President Draghi chose a persistent outlier to make his point (Draghi, 2012c).He referred to rates on Spanish mortgages in the 5-10 year maturity range as having a larger risk premium than comparable German mortgages. However, an examination of that evidence shows that “both longer and shorter maturities had much lower rate differences than did his chosen category[6]. Strikingly, the chosen maturity category has de minimis volume in Spain”. This example is all the more curious because the OMT intends to target sovereign debt at maturities of 1-3 years; the link from there to mortgages of 5-10 years is a tenuous one.

The scholarly evidence for market sentiments as drivers of risk premia is also unpersuasive. It is commonly stated that markets were unduly optimistic before the crisis and became excessively pessimistic towards the end of 2010 (for example, de Grauwe and Ji, 2012). But the roller-coaster movements in euro-area sovereign spreads are better explained by incoherent policy. Before the crisis, markets did not believe the threat that losses would be imposed on private creditors – and, hence, the Irish paid lower risk spreads than the Germans in 2007. After the crisis started, the countries receiving official assistance came under particularly severe market pressure because privately-held debt was now subordinated to the senior, official debt. The rise in spreads between late 2010 and mid-2011 is almost entirely explained by the subordination of private debt (Steinkamp and Westerman, 2013, and Mody, 2014). The fall in spreads, thereafter, is explained by the policy steps to subordinate official to private debt. In July 2011, the terms of official lending to the assisted countries were eased, sending a signal that official creditors will bear the initial burden of further sovereign distress. When that proved insufficient for Italy and Spain, the OMT was needed in the second half of 2012 to spread the Europhoria (Mody, 2014).

The German Court goes on to argue that an ill-conceived attempt to make a distinction between a country’s real solvency risk and the market’s ill-founded fear and to act on that basis to lower the risk premia runs the risk of violating the core intent of the TFEU – and, in doing so, it invokes the ECJ’s Pringle decision:

“… the existence of such [risk] spreads is entirely intended. As the Court of Justice of the European Union has pointed out in its Pringle decision, they are an expression of the independence of national budgets, which relies on market incentives and cannot be lowered by bond purchases by central banks without suspending this independence”.

In his submission to the German Court, former ECB Executive Board member, Jorg Asmussen, conceded that the OMT was not just trying to dampen the 'fear factor' (Asmussen, 2013). The two-fold objective of the OMT programme, he said, is “protecting the market mechanism so as to urge the Member States to make the necessary reforms”. But if this is so – and since the OMT is to act in concert with ESM lending – the German Court and the ECJ are not so far apart. The German Court is concerned that rather than conducting 'monetary' policy, the ECB is also engaging in 'economic' policy – urging member states to undertake reforms, in Asmussen’s terms.

There is, moreover, an operational problem. Even assuming that a 'fear' factor exists, its size and significance will depend on the country’s creditworthiness. Hence, in each instance, the ECB will be required to make a judgment. No simple rule, such as a transparent threshold, is possible. The ECB will, therefore, be necessarily drawn into making country-specific judgments and decisions.

That, of course, is the antithesis of what the central bank should be doing. Especially because the OMT cannot be triggered unless a country asks for ESM support, governments and their creditors could pursue an unsustainable strategy until it is too late. At that point, the ECB will inevitably be sucked into political judgments.

No bailout

The ECB contends that by only purchasing bonds on the secondary market, it is neither extending credit nor is it influencing the market pricing mechanism, and, it is, therefore, not assuming a sovereign commitment. But the German Court is only stating the obvious when it notes that even if the ECB allows some time distance from the sovereign’s primary bond issue, the OMT “encourage[s] third parties to purchase the government bonds at issue on the primary market by providing the prospect of assuming the risk associated with the acquisition”. In other words, the German Court is saying that the OMT is either providing credit or a free 'put option' to investors. That interpretation leads to a violation of Article 123. It is hard to see how the ECJ could conclude otherwise.

In his submission, Asmussen acknowledged the limits set by Article 123:

“Article 123 of the Treaty prohibits monetary financing. In particular, we are not allowed to buy any government bonds directly, i.e. on the primary market. Government bonds can only be purchased if they are already on the market and traded freely”.

But he did not clarify how the limits set by Article 123 would be honoured. The OMT was also sold as an 'unlimited' programme – the 'whatever it takes' bazooka. Along with being pari passu with creditors (discussed below), the promise of unlimited purchases helped calm markets. Once again, Asmussen reflected this tension in his submission.

“No ex ante quantitative limits are set on the size of Outright Monetary Transactions. ...we announced that our OMT interventions would be ex ante ‘unlimited.’ We have no doubt that this strong signal was required in order to convince market participants of our seriousness and decisiveness in pursuing the objective of price stability. At the same time, however, the design of OMTs makes it clear to everyone that the programme is effectively limited, for one by the restriction to the shorter part of the yield curve and the resulting limited pool of bonds which may actually be purchased”.

Perhaps, unlimited purchases at the short-end are sufficient to eliminate the so-called 'redenomination' risk – the risk that the euro could break up. The German Court is concerned:

“The ‘factual’ limitation of the volume of bond purchases by the amount of the government bonds issued already in the currently scheduled maturity spectrum of one to three years – highlighted by the European Central Bank in the proceedings before the Federal Constitutional Court – is not likely to sufficiently ensure an adequate quantitative limitation. By changing their refinancing policies, the Member States that benefit can increase the volume of government bonds that are currently covered by the OMT Decision; it is unclear what would follow from the European Central Bank’s intention to observe the emission behaviour of individual Member States”.

To this, the ECB response has been that the conditionality that accompanies the ESM programme could require that countries continue to issue longer maturity bonds. In addition, it will monitor countries subject to the OMT to ensure that they don’t begin issuing all of their new debt in the OMT-eligible 1-3 year maturity bucket (Cotterill, 2012).

Thus, at least implicitly, the ECB recognises that 'unlimited purchases' violate Article 123 but limited purchases dilute the value of the programme. Moreover, once again, the intent of monitoring a country’s debt issuance strategy exposes the ECB to political terrain.

But, perhaps, the most important German Court concern is the risk of default on the ECB’s holdings acquired under OMT. This could be rephrased in the ECJ’s Pringle terminology to ask whether the ECB is being compensated with an appropriate margin.

Recall that in its expansive interpretation of Article 125, the ECJ, while determining that loans made by the ESM are consistent with the TFEU, required that the loan pay an adequate return to the lender. The ECJ was clear that the ESM Treaty “in no way implies that the ESM will assume the debts of the recipient Member State” (paragraph 139). The ECJ notion of return to the lender was a narrow one: it did not include the benefits achieved by providing systemic financial stability and resilience. Indeed, it reaffirmed the conventional TFEU interpretation that the goal of financial stability is to be achieved by the member states maintaining the needed fiscal discipline for honouring their debts. For this reason, if a particular OMT transaction were to face losses, it could not be legitimised on the basis of financial stability or a similarly broad dividend to the Union.

By accepting losses on account of a particular sovereign, the ECB would be imposing a fiscal burden on the other member states – without the necessary political authorisation. In a country with a single fiscal authority, the central bank has recourse to fiscal support in the event of a loss. With multiple fiscal authorities, the authors of the TFEU were rightly concerned that such recourse would create incentives for fiscal indiscipline.

In a recent, much-read, position, Paul De Grauwe (2014) claimed that a central bank cannot incur losses. Were a sovereign to default on its obligations to the ECB, the member states would recapitalise the ECB by lending it money. Over time, the ECB would pay interest to the member states for that loaned money. This process, De Grauwe asserts, is costless to all parties[7].

But, of course, the interest that the ECB pays to the member states would come from its profits. Thus, those profits would have been used, in effect, to pay for the losses incurred by the ECB. In so doing, the ECB would have acted to favour a particular sovereign, and thereby would have created a fiscal transfer mechanism. That transfer would be particularly costly if the assisted member state eventually left the euro area[8].

This matter is aggravated by the pari passu feature of the OMT. The ECB’s holdings of Greek debt acquired earlier under its Securities Markets Programme (SMP), starting May 2010, were effectively granted senior status to private creditors. When Greek debt was restructured in March 2012, the ECB exchanged its holdings for bonds that were not subject to the losses imposed on private creditors (Black, 2012). Thus, the ECB remained whole.

However, since ECB seniority under SMP increased the losses borne by bondholders whose securities were not purchased by the ECB, the SMP was not popular in the market. For this reason, to further reassure market investors, the seniority claim was apparently relinquished under the OMT. In the OMT press release, the ECB said

“The Eurosystem intends to clarify in the legal act concerning Outright Monetary Transactions that it accepts the same (pari passu) treatment as private or other creditors with respect to bonds issued by euro area countries and purchased by the Eurosystem through Outright Monetary Transactions, in accordance with the terms of such bonds”.

Note, therefore, in highlighting its pari passu status, the ECB recognised that it was moving beyond the central banking domain of managing liquidity disruptions into space were insolvency to become a real market concern.

The German Court has concluded that such equal treatment in creditor status probably renders the OMT unconstitutional. Their interpretation of Article 123 of the TFEU is that “the possibility of a debt cut must be excluded”. Thus, the court is concerned not with the seniority issue per se but by the possibility that the ECB will not be repaid in full, in which case, the ECB would have acted to bailout the sovereign creditor in contravention to Articles 123 and 125.

It is possible that the ECJ may invoke a broader community goal in validating the OMT. But that would be a departure both from how the OMT has been sold and how the TFEU has so far been interpreted. It would imply an interpretation that the TFEU permits a fiscal union.

The economic analysis of the lender of last resort

The ECJ will also need to contend with well-established central banking practices, which are implicit in the German Court’s reasoning. A central bank must address systemic liquidity risk arising from short-term financial disruption; it should not address solvency problems that are at the heart of the OMT’s design.

The legal analysis, therefore, parallels an economic logic. At its centre is the distinction between liquidity and solvency. Temporary market disruption leads to short-term funding requirements that are met through liquidity provision by the central bank acting in its capacity as a lender of last resort. The risk of sovereign insolvency, however, is a fiscal problem. This is never an easy distinction to make in practice, requiring a presumption one way or another.

Is the OMT intended to solve a solvency or liquidity problem? The way it is designed, the solvency concern looms large and, at best, the solvency and liquidity threats are rolled into one. The OMT is to be triggered precisely when a member state faces a real threat of insolvency; the market merely amplifies that threat into a broader financial panic. A central bank’s liquidity operation in such a situation places it in an untenable position.

The strong preference of private creditors that they receive same treatment as the ECB in the event of a default, and discussion of the financial options in that event, reflect the concern that the OMT is designed for conditions in which a default risk is non-trivial. The German Court’s reservations on these matters mirror those voiced by central banking experts (Capie, 2002).

The situation is clearly aggravated in the euro area since, were there to be insolvency, the losses would be distributed among member states whose governments and taxpayers were not party to the decisions made. A central bank’s role as a lender of last resort also requires that it not undertake operations primarily to assist specific entities in distress (Capie, 2002), because that creates the so-called 'moral hazard' risk that lenders will lend with reckless abandon in the knowledge that they will be protected. Thus, Sims (2012, p. 221) notes:

“… with the expanded balance sheets of the central banks, returns on their assets will no longer necessarily move in parallel to the rate on reserve deposits. In the case of the ECB, sovereign debt assets could default. For both these reasons, future monetary tightening could require the central bank to ask for a capital injection from the treasury. For the ECB, there is no one treasury to respond. There is a formal “capital key,” a set of proportions according to which countries of the euro zone are required to share in providing capital to the ECB when needed. But if this were required, Germany would bear a large part of the burden, and it would be clear that German financial resources were being used to compensate for ECB losses on other countries’ sovereign debts”.

Once again, the German Court’s concerns with 'selectivity' have echoes in the central banking literature. A thought experiment helps clarify the salience of the selectivity issue in an incomplete monetary union. Should the ECB tailor its policy rates to a particular member state? During the boom years, should interest rates have been raised to dampen the real estate booms in Ireland and Spain? The argument can be made that the failure to do so had systemic consequences. Or consider Italy today. The OMT is a promise to place a floor on the price of Italian bonds. If that falls within the authority of the ECB, then should the ECB have pursued more aggressive reduction of its policy interest rate early on to pre-empt deflationary conditions in the weakest economies; and should it not have long since being pursuing unconventional methods to prevent Italian deflation? Deflation can be at least as serious a risk to debt dynamics as excessively high interest rates. Fiscal austerity in a deflationary condition can be debilitating.

Because the member states chose to move ahead with a monetary union without a fiscal union to backstop such eventualities, the TFEU is based on the promise of fiscal discipline by each member state to prevent such risks from arising in the first place. Where the presumed discipline proves insufficient, the TFEU’s intention – expressed in Article 125 – is that the country would not repay its private creditors. The effort today is to square a circle: sovereigns must repay private creditors (barring exceptional circumstances) but without the pooled resources of a fiscal union. The OMT steps into that breach.

Prospects and possibilities

The German Court has challenged the OMT on the basis of its congruence with European law. In the end, the German Court may, indeed, restrain Germany from cooperating with the OMT because it implies obligations that are not permitted by the German constitution. But for now, the task is very much on how to interpret the TFEU.

The ECJ may be less fussy than the German Court in determining the circumstances under which the OMT could be triggered. The ECB may then be able to use that flexibility and not hang its OMT trigger on the fuzzy 'fear factor'. But a general state of financial instability, which creates a legitimate role for a central bank, does not imply support for a particular member state. That the ECB, nevertheless, has chosen to link the OMT to conditional lending by the ESM suggests that the ECB is aware that the OMT is not a proper lender-of-last resort function. It bridges into lending to sovereigns facing solvency risk.

If so, the ECJ is very clear. It has interpreted Article 123 as strictly prohibiting any lending to a sovereign by the ECB. There appear no exceptions to fall back on for breathing new life into Article 123. This is all the more so since the economic conditions under which the OMT is to be operational are more dire than those stipulated for the ESM and, as such, might not even meet the standards of Article 125. The ESM was given the green light by the ECJ on the basis that the support would be through a loan that would be paid back with an appropriate return. In the case of the OMT, the support is to be provided when the ESM has proved insufficient and the conditions expressly raise the prospect of a loss to be borne by the ECB’s balance sheet and its shareholders. It, therefore, directly violates the 'no-bailout' intent of Article 125. Moreover, it does so by lowering the interest rate paid by the sovereign and, hence, raises the concern that market discipline is being diluted.

The problem is a simple one. The authors of the TFEU wrote a document that was consistent with the vision of the euro as an incomplete monetary union. That construct was intended to work on the basis of fiscal discipline by countries accompanied by default on debt held by private creditors where the discipline proved insufficient. The threat of the default was intended to focus the minds of both the lenders and the borrowers. Decision makers today have concluded that default is too costly but the alternative of completing the monetary union through a fiscal union is not politically feasible.

The fact that the OMT was successful in dampening market concerns is testament to the need for a fiscal union. It also is an indication of the size of such centralised fiscal resources that would be a credible bulwark against market speculation.

A democratically-validated, political path to a fiscal union has proven to be a receding target. This should not have been a surprise to those who have observed the evolution of the euro. The OMT, in effect, offers an apparently elegant technocratic solution to the euro-area’s fiscal union conundrum.

In highlighting the tensions between the TFEU and the OMT, the German Court is basically concerned that the OMT is a fiscal union by the backdoor. The ECJ could validate the current design of the OMT – locating the fiscal union in the central bank – in which case, the nature of the euro area will be fundamentally altered and the ECB will become a more political institution. Alternatively, if the ECJ were to determine that the German Court’s concerns need to be addressed by changes to the OMT – by imposing serious limits on purchases of sovereign bonds and requiring the ECB to claim seniority to private creditors – the OMT will be rendered ineffective.

There is a third option. And that would be to agree that the OMT is needed as temporary support because an incomplete monetary union creates intolerable risks. The ECJ would ask the political actors to meet their responsibility by providing a transparent and legitimate mandate for a permanent OMT. They would do so by jointly guaranteeing the ECB against losses incurred if a particular transaction ends in a default. That guarantee may never be needed. But it would focus the minds and clarify who bears the cost. Then Europe would have taken a real step forward.


Asmussen, Jörg (2013) 'Introductory Statement by the ECB in the Proceedings before the Federal Constitutional Court', 11 June

Black, Jeff (2012) 'ECB Is Said to Swap Greek Bonds for New Debt to Avoid Any Enforced Losses', 17 February

Capie, Forrest (2002) 'Can there be an International Lender-of-Last-Resort?' International Finance 1(2): 311–325

Cotterill, Joseph (2012) 'The OMT and "limits"', Financial Times Alphaville, 18 September

Craig, Paul (2013) 'Pringle: Legal Reasoning, Text, Purpose and Teleology', Maastricht Journal of European and Comparative Law 20 (1): 3-11

De Grauwe, Paul (2014) 'Why the European Court of Justice should reject the German Constitutional Court’s ruling on Outright Monetary Transactions'

De Grauwe, Paul and Yuemei Ji (2012) 'Mispricing of Sovereign Risk and Multiple Equilibria in the Eurozone', Journal of Common Market Studies 50(6): 866–880

De Witte, Bruno (2013) 'Using International Law in the Euro Crisis', Centre for European Studies, University of Oslo, Working Paper 4

Draghi, Mario (2012a) 'Verbatim of the Remarks made by Mario Draghi', Global Investment Conference in London, 26 July

Draghi, Mario (2012b) 'Introductory statement to the press conference (with Q&A)', Frankfurt am Main, 2 August

Draghi, Mario (2012c) 'Building the Bridge to a Stable European Economy', The Federation of German Industries, Berlin, 25 September

Draghi, Mario (2013) 'Questions and Answers at Press Conference', 6 June, Frankfurt am Main

European Central Bank (2012) 'The OMT Press Release'

European Court of Justice (2012) 'Judgment of the Court (Full Court): Thomas Pringle v Government of Ireland and The Attorney General', 27 November

Federal Constitutional Court (2014) 'Principal Proceedings ESM/ECB: Pronouncement of the Judgment and Referral for a Preliminary Ruling to the Court of Justice of the European Union', judgment; press release

Grimm, Dieter (1997) 'The European Court of Justice and National Courts: the German Constitutional Perspective after the Maastricht Decision', Columbia Journal of European Law 3: 229-242

Kenen, Peter (1969) 'The Theory of Optimum Currency Areas: An Eclectic View', in Robert Mundell and Alexander Swoboda (eds) Monetary Problems of the International Economy, Chicago: University of Chicago Press

Mody, Ashoka (2014) 'Europhoria, Once Again'

Norman, Peter (1998) 'German Court Rejects Emu Challenge', Financial Times, 3 April

Pistor, Katharina (2014) 'German Court decision: Legal authority and deep power implications'

Steen, Michael (2012) 'Weidmann isolated as ECB Plan Approved', Financial Times, 6 September

Steinkamp, Sven and Frank Westermann (2014) 'The Role of Creditor Seniority in Europe’s Sovereign Debt Crisis', forthcoming in Economic Policy, 29(79): July

Wearden, Graham (2012) 'Eurozone crisis live: Merkel backs ECB rescue plan as markets remain cheerful – as it happened', The Guardian, 12 September


[1] The Lisbon Treaty, signed on 13 December 2007, consolidated the texts of the European Union Treaties, the Treaty of the European Union and the Treaty on the Functioning of the European Union.

[2] Euro exits fears were, in no small measure, sparked by threats emanating from ECB and other euro-area officials. See 'European Officials as Source of Convertibility Risk'.

[3] In August and September 2012, Draghi repeatedly insisted on national fiscal discipline.

[4] The English translation of the Bundesbank submission to the German Court.

[5] The English translation.

[6] 'Convertibility Risk – Cherry Picking* Interest Rate Spreads', 2012.

[7] The process of calling capital from the member countries is, moreover, far from straightforward. For instance, a vote on loss-sharing is required, not to mention the obstacles to sharing losses in the event of an exit from the euro. See 'Loss Sharing in the Eurosystem – excluding Target2 Losses'.

[8] These same problems arise also in the context of ECB exposure to banks that are insolvent, and for the same reason – insufficient clarity on the policy and willingness to institute losses on private creditors. This may change, but the extent to which it will remains unclear.

Did the German court do Europe a favour? (English)
Tue, 15 Jul 2014 11:26:49 +0100
<![CDATA[Chart of the week: Real interest divergence weighs on growth]]> http://www.bruegel.org/nc/blog/detail/article/1387-chart-of-the-week-real-interest-divergence-weighs-on-growth/ blog1387

The real interest rate divergence in the Euro Area has recently generated new attention. Real interest rates fell quite substantially in the crisis up to the end of 2011, but have been rising since then (see graph). However, there have been substantial differences across countries, which can be explained by differences in nominal interest rates as well as by diverging inflation rates.

Sources: ECB Statistical Warehouse and Eurostat.

Note: Real long term interest rates calculated by subtracting HICP rates (all items) from 10-year maturity sovereign bonds.

Economic theory would suggest that persistent divergences in such real rates should have had an effect on economic growth performance, and the chart below suggests that indeed is the case. The four countries with the highest real interest rates (Spain, Italy, Ireland, Portugal) evidently had the lowest real GDP growth over the crisis years. Such a simple correlation obviously should not be interpreted as proof of causality, and other factors certainly have played an important role in explaining the lacklustre performance of the four economies. Yet, the fact that real interest rates have also moved into negative territory in Germany and the UK may  suggest that lower interest rates facilitate greater opportunities for growth.

Sources: Datastream and Eurostat

Note: Average monthly real interest rate calculated with same HICP data as above subtracted by 2-year treasury bond yield data. Both indicators measured a percentages.

Special thanks to Pia Hüttl for their contributions.

Tue, 15 Jul 2014 06:45:33 +0100
<![CDATA[Three questions on the Banco Espírito Santo case for banking union]]> http://www.bruegel.org/nc/blog/detail/article/1386-three-questions-on-the-banco-espirito-santo-case-for-banking-union/ blog1386

As shares were suspended in Portugal's third largest bank, Banco Espírito Santo last week, sovereign spreads in the euro area increased and bank stocks were weakened.

Together with Zsolt Darvas and André Sapir I published a policy contribution in February, looking at how to manage exits from financial assistance for Ireland, Portugal and Greece. In our recommendations for Portugal, we argued that the country should not have made a clean exit when its programme ended in May 2014, because compared to Ireland it faced higher interest rates, had poorer growth prospects and had probably less ability to generate a consistently high primary surplus. A precautionary arrangement would have been advisable for a number of reasons but most importantly as a measure to stabilize market expectations and prevent market over-reactions.

The key questions now are three-fold:

  1. Is the BES case an isolated case in which problems had grown too big to be hidden any more? It may also foreshadow a changing supervisory regime, with the ECB gradually taking over, which changes supervisory incentives and increases the pressure on banks and supervisors to act. If the latter, will we be seeing more such instances happening in the next months? 
  2. How and how much will the BES case affect economic growth of Portugal? Hopes are it will be an instance of de-zombification, which improves growth prospects, but negative market reactions and spreading contagion could undermine growth instead, at least in the short run.
  3. Will the relatively tough bail-in rules be implemented? If yes, will the system prove robust enough to withstand the shock or will financial nervousness increase? If no, will the Portuguese government eventually have to step in with state aid and how much will this undermine debt sustainability increasing market nervousness instead?

Overall, the current case is not only very interesting on its own right but even more so in its broader implications for Europe's emerging banking union. Answers to the questions above will be crucial for Europe's banking union.

Mon, 14 Jul 2014 14:45:45 +0100
<![CDATA[The future of asset-backed securities in the euro area]]> http://www.bruegel.org/videos/detail/video/139-the-future-of-asset-backed-securities-in-the-euro-area/ vide139

In his new Policy Contribution Carlo Altomonte tackles the future and impact of asset-backed securities.

Mon, 14 Jul 2014 11:25:37 +0100
<![CDATA[Blogs review: U.S. inflation and growth]]> http://www.bruegel.org/nc/blog/detail/article/1385-blogs-review-us-inflation-and-growth/ blog1385

What’s at stake: Most discussions over the past few weeks on the blogosphere have centered around whether the U.S. economy is, eventually, gaining enough pace to generate an uptick in inflation. While Q1 GDP was drastically revised down, other indicators suggest that the economy is indeed heating up.

Is inflation about to pick up?

Real Time Economics writes that minutes from the Federal Reserve’s June meeting suggest there is a growing gap between officials who believe U.S. inflation could remain too low for the Fed’s comfort and those who believe a spike in consumer prices could be closer than forecasters think. Some policy makers “expressed concern about the persistence of below-trend inflation,” the minutes said. Indeed, a couple even suggested the central bank might have to let unemployment fall below its long-term normal rate in order to ensure inflation moves back toward the 2% target. That sentiment was far from unanimous, however. “Some others expected a faster pickup in inflation or saw upside risks to inflation expectations because they anticipated a more rapid decline in economic slack.”

Joe Weisenthal writes that it's becoming conventional wisdom that the economy is heating up for real this time. After numerous false starts and disappointments since the financial crisis, it appears we've kicked into a higher gear. Deutsche Bank economist Torsten Slok make for a good overview of the case that inflation is coming. First, capacity utilization is high. Meanwhile, surveys show that businesses are finding it harder and harder to fill job openings. Third because companies are having a harder time finding employees, they're indicating that salary increases are coming.

Calculated Risk writes that for most of the '90s there was a huge "gap" between capacity utilization and CPI. There were periods when capacity utilization was higher than now - and inflation lower.  As an example, capacity utilization was close to 83% in 1998, and YoY inflation averaged 1.5%.  So I don't think the first graph presented by Deutsche Bank is convincing that inflation is "right around the corner". Also note that the last two other pieces of information are from a small survey and also not convincing.

Source: CR

Ryan Avent writes that there are two ways one can reconcile the view that inflation is going to remain low with what appears to be happening in labor markets. One possibility is that both markets and the Fed have it wrong (or that markets have it wrong because the Fed has it wrong). It could be the case that there is more inflationary pressure in the economy than markets anticipate, and that either the Fed will have to act faster to check that pressure or will reveal that it is in fact happy to accept a rate of inflation a bit faster than anything America experienced over the past two decades. The other possibility is that tightening labor markets simply aren't going to exert much inflationary pressure on the economy. In the 2000s, nominal wage growth reached 4.5% amid rising commodity prices, yet core inflation never reached 2.5%. In the 1990s wage growth reached 5%, yet core inflation declined steadily. It may simply be the case that we aren't appreciating just how many margins there are along which labor markets have room to adjust. 

Tim Duy writes that the Fed has consistently predicted higher inflation, and consistently been surprised that that inflation has not yet arrived despite rapidly falling unemployment rates. If you are betting on inflation over the medium-term, you are essentially betting that the Fed will not do what it has done since Federal Reserve Chair Paul Volker - tighten policy in the face of credible inflationary pressures. Over the last twenty years (mean core-PCE inflation:  1.7%; mean core-CPI inflation: 2.2%.), core measures of inflation have more often than not been at or below the upper range of the Fed's error band, especially for core-PCE inflation. And this included periods in which the US economy was at times substantially outperforming the current environment no less.  

What to make of the downward GDP revision in Q1

Stephen Cecchetti and Kermit Schoenholtz write that growth from the fourth quarter of 2013 to the first quarter of 2014, originally thought to have been about +0.1% in April, was revised last week to –2.9%. News reports varied between shock and concern. Was the anemic recovery over?  Or, was it just that this winter was especially harsh? Kevin Drum writes that there are two way to look at this. The glass-half-full view is: Whew! That huge GDP drop in Q1 really was a bit of a blip, not an omen of a coming recession. The economy isn't setting records or anything, but it's back on track. The glass-half-empty view is: Yikes! If the dismal Q1 number had really been a blip, perhaps caused by bad weather, we'd expect to see makeup growth in Q2. It's just horrible news if it turns out that during a "recovery" we can experience a massive drop in GDP and then do nothing to make up for it over the next quarter. 

Gavyn Davies writes that if confirmed in future releases, this would be the weakest quarter for US real GDP outside a recession since the Second World War. The markets largely ignored this piece of news because investors still seem convinced that the first quarter was hit by a series of temporary shocks to GDP. The extreme weather was clearly the main such shock (a point confirmed with micro data by Atif Mian and Amir Sufi), but there was also an outsized downward revision to the official estimate of consumers’ expenditure on health services. Another reason why the markets are ignoring any recession risk in the US is that the GDP data are at odds with many other sources of information on the underlying growth rate in the American economy, including the improving employment data, buoyant business surveys, and robust manufacturing and durable goods reports.

Stephen Cecchetti and Kermit Schoenholtz point to two factors that deserve deserve special attention: (1) the statistical noise created by seasonality; and (2) the propensity to revise GDP many years after the period being measured.

Seasonality in GDP is enormous. The chart below shows that the seasonal adjustments swamp the small changes in the adjusted growth rates. If you looked only at unadjusted data, you could say that the U.S. economy goes through a depression in the first quarter of every year, as the level of output plunges on average by 18 percent! When the seasonal factor is large and variable, as it is in the first quarter of every year in the United States, it is heroic to draw inferences from a percentage point here or there.

Source: Stephen Cecchetti and Kermit Schoenholtz

Stephen Cecchetti and Kermit Schoenholtz write that revisions can also be quite big. Prior to last week’s release of revised first-quarter data, the biggest revision on record was only 2.5 percentage points. So, a 3-percentage point revision only three months after the quarter ended is enormous. Nevertheless, further large revisions may still lie ahead! Statistically, the revisions to economic growth for quarter t between the t+3-month estimate (which we just received last week for the first quarter) to the t+10-year estimate (which will not be available for nearly a decade) have ranged from minus 6 percentage points to plus 7 percentage points over the past 40 years, with a standard deviation of about 2 percentage points.

Mon, 14 Jul 2014 06:54:42 +0100
<![CDATA[Chart of the week: The great transformation]]> http://www.bruegel.org/nc/blog/detail/article/1384-chart-of-the-week-the-great-transformation/ blog1384

One of the main challenges for the incoming EU leadership will be to deal with the great transformation of the global economy. How should the EU master globalisation as well as demographic, technological and environmental change? In this week's chart of the week, we document two striking features of the changing global economy: Emerging and developing market economies continued to forge ahead in the last decade, having been relatively immune to the financial crisis. Two key facts stand out: In 2013, emerging and developing countries together accounted – for the first time since at least 1850 – for more than 50 % of global GDP; meanwhile, their average public debt-to-GDP ratio dropped below 40 percent, while it nearly reached 110 percent in the advanced economies. This leaves the emerging markets in way better shape than the advanced economies to face the challenges in the future.

In the recent policy brief 'The great transformation' we discuss how the new EU leadership should deal with this challenge.

Thu, 10 Jul 2014 12:54:10 +0100
<![CDATA[Europe between financial repression and regulatory capture]]> http://www.bruegel.org/publications/publication-detail/publication/838-europe-between-financial-repression-and-regulatory-capture/ publ838


The financial crisis modified drastically and rapidly the European financial system’s political economy, with the emergence of two competing narratives. First, government agencies are frequently described as being at the mercy of the financial sector, routinely hijacking political, regulatory and supervisory processes, a trend often referred to as “capture”. But alternatively, governments are portrayed as subverting markets and abusing the financial system to their benefit, mainly to secure better financing conditions and allocate credit to the economy on preferential terms, referred to as “financial repression”.

We take a critical look at this debate in the European context. First, we argue that the relationship between governments and financial systems in Europe cannot be reduced to polar notions of “capture” and “repression”, but that channels of pressure and influence bet-ween governments and their financial systems have frequently run both ways and fed from each other. Second, we put these issues into an historical perspective and show that the current reconfiguration of Europe’s national financial systems is influenced by history but is not a return to past interventionist policies. We conclude by analysing the impact of the reform of the European financial architecture and the design of a European banking union on the configuration of national financial ecosystems.

1. Introduction

In the long shadow of the euro-area crisis, the relationship between governments and their banks has been brought to the the centre of the policy debate in Europe by the implementation of regulatory reforms, the risks associated with financial fragmentation, and the fight to sustain the flow of credit to governments and corporates. The attempt to interpret the patterns of pressure and influence running between governments and their financial system has led commentators to rediscover and give new life to concepts originating from academic debates of the 1970s such as “regulatory capture” and “financial repression”. Government agencies have been frequently described as being at the mercy of the financial sector, often allowing financial interests to hijack political, regulatory and supervisory processes in order to favouring their own private interests over the public good 1. An opposite view has instead pointed the finger at governments, which have often been portrayed as subverting markets and abusing the financial system to their benefit, either in order to secure better financing conditions to overcome their own financial difficulties, or with the objective of directing credit to certain sectors of the economy, “repressing” the free functioning of financial markets and potentially the private interests of some of its participants 2.

But a closer look at the experience of European countries suggests that both the notion of “capture” and “repression” are too narrow to describe the complex relationship between financial stakeholders and their national governments. Instead, the history of European financial systems reveals how governments, central banks, public sector banks and financial institutions have historically been part of deeply interconnected European financial ecosystems bound both by political and financial relations. Patterns of pressures and influence within these financial ecosystems have always run in both directions and have been mutually reinforcing.

As Andrew Shonfield argued in 1965 in one of the first detailed analyses of the role of governments and of the “balance of public and private power” in western capitalism after WWII, these different financial ecosystems in Europe varied across countries because of different histories and institutions that framed such relationships 3. These national differences have frequently been presented as declining with time and in response to deeper financial integration. The breakdown of the Bretton Woods system in the early 1970s, the removal of restrictions to the circulation of capital within Europe following the 1986 Single European Act, the creation of the single currency, and the process initiated in 2001 by the European Commission with the Lamfalussy Report to extend the single market to financial services have fostered a greater integration of banking and financial activities across national borders that have profoundly altered existing national ecosystems 4. The response to the euro-area crisis seems to have further encouraged this trend, and new institutional mechanisms, in particular the creation of a European banking union, typically aims at Europeanising further banking supervision and resolution thereby potentially reducing further the weight of national historical and institutional idiosyncrasies.

However, claims suggesting the end of national financial ecosystems in Europe are at best premature. This paper discusses how national financial ecosystems in Europe continue in fact to exercise a significant influence over financial policy-making and how the transition towards a more integrated financial framework (ie banking union) influences these relations. Our conjecture is that the rapid reversal of financial integration and a re-domestication of financial flows and financial risks triggered by the crisis 5 have built on practices, ties and institutions that have deep historical roots. Meanwhile, the European policy response, which intended to repair financial fragmentation and recreate a more integrated financial sector has attempted to Europeanise the regulation, supervision, resolution of the financial sector thereby trying to break historical ties within national financial ecosystems. It is therefore important to take a critical look at these opposite movements and they way they affect not only the efficacy of capital allocation and credit intermediation at the national level, but also the policy-making process at the European level.

2. Banks and governments: Competing narratives across the Atlantic

Attitudes towards the relationship between governments and national financial institutions have historically varied significantly across the United States and Europe. Suspicions over the involvement of politically powerful banks in the political system have been an integral part of the US political debate. These can be traced as far back as the controversy between Alexander Hamilton and Thomas Jefferson about the establishment of the First Bank of the United States in 1791 6. More recently, many commentators seeking to explain the regulatory failures at the origin of the financial crisis have repeatedly pointed the finger towards the political clout of financial lobbies. The Report by the Financial Crisis Inquiry Commission established by the US Congress to investigate the roots of the crisis found that: “the financial industry itself played a key role in weakening regulatory constraints on institutions, markets, and products”. The Commission explained this influence by making reference to the $2.7 billion in federal lobbying expenses and $1 billion in campaign contributions spent by the financial sector between 1999 and 2008 7. Others have highlighted how the role of the preferential access allowed by the “revolving doors” between Wall Street and US regulatory agencies 8.

The perception of financial industry groups capable to often act as rule-makers has brought a number of commentators to analyse the relationship between US financial firms and the political system through the lenses of “regulatory capture”. The origins of the term are usually attributed to the work of George Stigler in the early 1970s but this concept has been brought to the fore by Simon Johnson, former IMF chief economist, and other commentators during the recent financial crisis 9.

This description of the financial industry as systematically “capturing” the design and implementation financial regulatory reforms has however resonated more broadly in the US than across the Atlantic. This is in part the result of the fact that the focus of most US-centric analyses on financial resources, campaign contributions and revolving doors as means through which the financial industry is capable to routinely “buy” regulatory policies does not sit comfortably with the experience of most European countries, where political party financing and electoral rules limit the importance of financial resources in buying political support, while bureaucrats in financial regulatory agencies and central banks are more likely to spend most of their career in the public sector.

Campaign contributions and revolving doors are not the only channels through which the interest groups are capable to capture the policy-making process. On the contrary, while theories of regulatory capture developed from the US experience have focused on the resources that different financial groups are capable of deploying in the lobbying of the US Congress or federal regulatory authorities, the European experience is illustrative of the wider and often less visible channels through financial which banks often influence the design of financial policies. A number of structural characteristics of different financial ecosystems in Europe have bolstered the influence of European banks over the design of financial policies. These include for instance the formal and informal links between the political system and the banking system. For instance, German public saving banks (Sparkassen and Landesbanken) that held some 33 percent of the assets of the German Banking sector in 2009 remain owned and controlled by regional governments 10, which naturally create a peculiar relationship. In Italy, state-owned banks have been privatised over the last few decades, but many of these institutions remain still today under the influence or control of foundations (“fondazioni bancarie”) that maintain close ties with the political system and in some cases are directly appointed by political parties 11. In Spain, small and medium size Cajas remained partly owned by the public and largely under the influence and control of regional officials and religious leaders, thus weakening the hand of the central government in supervising and regulating them and favouring undue forbearance by the central authorities. These formal ties are frequently reinforced by informal ties, such as the social networks embedded in the French Grandes écoles where future civil servants, politicians and bankers are trained together and come to form networks of influence organises around the Grands Corps 12. These formal and informal ties between the political system and the banking system make banks particularly receptive to political guidance at the local, state and federal level but also allow these institutions to exercise a significant influence over the regulatory process through their political connections.

Another characteristics of the European financial systems that is often ignored by US-centric analysis of regulatory capture is the greater reliance of European countries on bank credit for financing the real economy as well as sovereign debt. This structural feature of European financial systems, gives to banks rather than other financial intermediaries a particular importance and creates channels through which national financial institutions are likely to gain leverage over policy makers. As Cornelia Woll argues, “decision-makers will act in favour of the industry because they need finance for funding the so-called real economy, for funding the government and as a motor for growth” 13. These kinds of relations also explain why even without strong pressures by the financial industry, governments feel compelled to consider that the interest of the financial sector are aligned with those of the economy and the country as a whole. For example, Sir Howard Davies, the first Chair of the UK Financial Services Authority explained how during the pre crisis period “on the whole, banks [in the UK] did not have to lobby politicians, largely because politicians argued the case for them without obvious inducement” 14.

Indeed, some of the same dynamics have been fully in display during the response to the global financial crisis when concerns about the potential impact of regulation on banks balance sheets and possible consequences on the extension of credit to the economy have brought politicians in a number of European countries to support the demands from their financial industry to water down these regulatory measures. The greater success of European banking lobbies in having their demands met during the implementation of Basel III at the European level has clearly been influenced by the link with the real economy that the financial industry was able to establish 15. Indeed, financial industry lobbies seem to have achieved concessions conditional on their capacity to highlight the impact of different pieces of regulation over their capacity to provide credit to the broader economy 16. At the same time, the watering down of key regulatory requirements has been accompanied by repeated calls from European politicians towards banks which were asked to commit to increase credit to the domestic economy.

Overall, the experience of recent banking regulatory reforms in Europe are indicative not only of the fact that the significant political influence of banks is not uniquely a US phenomena. On the contrary, the influence of European banks over the design of financial policies frequently arises from a number of structural characteristics of the different financial ecosystems in which they find themselves operating. But shifting the focus from the direct lobbying of financial institutions towards the characteristics of different financial ecosystems in Europe also reveals a further corrective to notion of ‘capture’ that has frequently been used to interpret the relationship between banks and government agencies. While many US-centric have focused on the influence of financial actors and other interest groups over the state, channels of pressure and influence between European governments and their banking system within distinct European financial ecosystems have frequently been presented as running both ways and feeding from each other. These reciprocal channels of influence between European governments and their banking systems will be explored in the next section by looking at modern European history.

3. Historical perspectives on financial ecosystems

Examples of this symbiotic relationship between European governments and their financial system abound throughout modern European history. European governments have indeed frequently used banks to expand and broaden their reach over the economy either domestically or internationally. The creation of Deutsche Bank in 1870 in the context of the formation of the German Empire and the need to challenge the leadership of British banks in the global markets, as well as the creation of public credit institutions in Italy and France to support national financial development or postwar reconstructions are only some of the many examples throughout modern European history of the way through which financial nationalism and The promotion of “national banking champions” was also often intended to allow competition with European neighbours and the projection of power internationally to accompany the internationalisation of domestic firms 17.

The involvement of the State in financial developments in the nineteenth century went beyond the promotion of international champions. During this period, financial liberalisation went hand in hand with the promotion of national credit and state intervention. Governments were indeed keen on rescuing banks in order to save bankers interests as well as the financing of the economy, and personal connections between politicians and bankers were crucial to this process 18. Central banks − which were still at the time institutions with private shareholders granted with a monopoly on the right to issue − were perfect examples of these connections between governments and financial capitalism that developed throughout the nineteenth century. European governments or monarchs also exerted controls on some large credit institutions that were crucial for the financing needs and debt repayments of local authorities, as the Caisse des Dépôts and Crédit Foncier in France and the Cassa Depositi e Prestiti in Italy.

For a long period, the collusion between State and banks went hand in hand with significant government interference in the activities of financial firms in order to channel and allocate credit in a non-competitive way. But the controls of the State over financial systems strongly increased after the Great Crash throughout the 1930s in democratic and dictatorships alike, and were reinforced after the second world war with bank nationalisations and the increasing role given to public credit institutions.

Also in the years following the end of the second world war, western European governments continued to strategically directs their domestic banking system towards the achievement of specific public policy objectives. The term “financial repression” − coined in the early 1970s to describe developing economies in Asia and Latin America 19 − has been used retrospectively to indicate a wide range of targeted prudential controls and requirements such as capital controls, reserve requirements, capital requirements, and various taxes and levies to favour – directly or indirectly – the holding of government debt. In addition, over the same period, interventionist credit policies were developed to influence the allocation of credit through price or quantity rules so as to offer a competitive advantage to certain economic sectors. A key feature of these interactions during this period was to force financial institutions to extend credit that would otherwise have to be funded by government deficits expenditures 20. This alternative financing of state intervention contained public debt while introducing political pressures and "distortions" of competition in the financial sector. Banks were sometimes requested to hold a certain amount of government bonds and of claims on certain sectors as a percentage of their total asset. The same outcomes could also be pursued indirectly by central banks in their design of monetary policy operations (reserve requirements, credit ceilings, liquidity ratios) and through collateral policy facilitating banks access to the discount window for certain categories of claims. The intervention of governments in the working of their respective domestic markets also frequently occurred through the development of public credit institutions as substitutes to banks and through the direct investment of Western European governments in some specific sectors (housing, agriculture, industry etc) and support industrial policies or resort to the development of state-owned credit institutions or public banks as substitutes to banks.

All in all, these policies were used – at different degrees across countries– to control risk in the banking sector, to support industrial policy, facilitate government-financing needs and control inflationary risks 21.

These tools also shared a strong national bias; most savings, investments, government financing came from domestic sources and financial regulation aimed to mitigate risks and influence the allocation of credit at the national level. As a consequence, the political economy of these systems relied on connections and coordination 22 at the national level between government agencies, public and private lending institutions and industries. Employees circulated easily and frequently between public administrations and nationalised firms or banks. In the name of the public interest, industries negotiated with governments in order to receive subsidies, to be given priority, and sometimes to be rescued 23.

It is only in the late 1970s and 1980s, that these symbiotic relations between Western European governments and their national banking systems approach were challenged by profound intellectual changes about the merits of financial liberalisation and independent central banking and that the negative effects of governments interventions (unproductive rents, crowding out, over-saving by state owned institutions) became more central to economic thinking and policymaking. As a result, the recourse to these interventions and instruments gradually but rapidly vanished. Countries – prominently France– experienced a radical liberalisation in the mid 1980s and all converged towards and open financial system with a mature money market in the early 1990s.

As a result of this new settlement, financial ecosystems were organically but deeply redesigned, and as a result, financial and political relationships were recomposed. The expansion and deepening of cross border capital flows supported further financial market openness, independence of central banks and disengagement from the public sector 24.

In sum, while distinct financial ecosystems characterised by symbiotic relationship and reciprocal patterns of influence between governments and their banking industry have exercised a significant influence in the past, these differences have frequently been presented as in decline at the turn of the century. The question remains whether the current crisis has interrupted this decline and reinvigorated past behaviours and historical relationships?

4. The European crisis and the recomposition of national ecosystems

The abrupt interruption in cross border capital movement has triggered a clear renationalisation of finance over the last three years and has profoundly modified relations between national financial systems and governments in Europe 25. The vast and ubiquitous use of government expenditures and guarantees to support the financial system 26 has been followed by widespread calls for tighter regulation and supervision of the financial sector as a whole and of the banking sector in particular. In addition, in many instances, the crisis has unsettled governments' access to financial markets and increased their borrowing cost. The economic downturn has in turn woken up a certain desire and a need to address credit shortages and intervene more forcefully in the financial system to improve and augment the extension of credit and facilitate the recovery. However, if governments in Europe have not resorted completely and openly to the policies and instruments that had characterised the Bretton Woods era, a number of developments could indicate a redefinition of the relations between the public and the financial sector along the lines of pre-existing historical relations and behaviours.

The most common and clearly identified aspect of these changing landscapes is the extent to which holdings of public debt have been on balance re-nationalised. Debt sustainability concerns, uncertainty about the integrity of the European monetary union and the reluctance of the central bank to address risks of multiple equilibria in sovereign debt markets in the euro area 27 have all contributed to put sovereign debt markets under strain and forced governments to rely on national savings and national financial institutions to finance their expenditures. Despite these developments, the current re-domestication of government debt holding does not appear to be an unseen phenomenon, nor a direct return to the pre-EMU situation. Among countries of the euro area, only Spain has today a level of sovereign debt held by residents (including central banks and financial corporations) higher than before it joined the euro.

The huge exposure of government towards their banking system is therefore not a phenomenon that was born during the crisis but is a well-established feature of European economies since the 1980s. Nevertheless, what is true on average is not necessarily true on an individual basis. Ireland and Portugal for instance, have experienced a dramatic increase in this ratio from 2006 to 2011 while in Germany, Belgium and France, on the contrary, the financial crisis has not stopped a downward trend in the domestic holding of government debt. These trends are characterised by a strong path dependency, which supports the argument that historical trends are still important for the structure of bank holdings.

A second aspect of these changing landscapes is the evolution in the centrality of central banks in the European national financial ecosystems. This role had significantly been curtailed after the demise of Bretton Woodswith the creation of the Eurosystem, the centralisation of key central prerogatives within the ECB and the emergence of principle of central bank independence. However, during the current crisis, with growing financial fragmentation, impaired transmission mechanisms, the European Central Bank was forced to take a more active role to repair transmission channels and it contributed to increase the holding of government bonds held by central banks of the Eurosystem. This modification of its collateral framework also allowed National Central Banks to exert some discretion in the types of claims they could accept as collateral which may have increased the national bias in the refinancing of credit claims 28.

These dynamics have provoked a vivid reaction denouncing both financial repression and “fiscal dominance” 29 of central banks but these criticisms seem to ignore the fact that the most striking feature of European national central banks’ balance sheet expansion is not the result of greater accumulation of public debt but rather of an historically unprecedented increase in central bank credit to the private economy. Central bank balance sheet usually increased during wars and recessions mostly to ease government financing. After 1945, some central banks became more involved in directed credit and used their balance sheet to finance long-term investment and influence the allocation of credit through re-discount privileges and choices. However, even in the central banks that used these techniques extensively such as France, the ratio of central bank’s claim on the domestic banking sector never really exceeded 8-10 percent of GDP. In the euro area, it has now reached more than 30 percent of GDP. This contrasts starkly with the UK and the US where the Bank of England and the Fed assets purchase were largely government and quasi-government liabilities 30.

Arguably, a large part of these claims, are in reality claims on the financial sector caused by the extension of large amounts of liquidity to the banking sector. Indeed, never in history did central banks support an entire financial system to this extent. While the UK stands out here as having provided relatively little liquidity support to its banking sector beyond purchase of government bonds, the ECB, on the contrary, has accumulated claims to the banking sector by a record amount. In 2011, central bank claims on the banking sector in the euro area was 30 percent of GDP, ranging from 0.1 percent for the Bank of Finland to 68.7 percent for the Bank of Ireland. Interestingly, those central banks that have the least government debt, tend to have the most claims on the private sector thereby potentially revealing important differences in the structures of national ecosystems.

The intervention of central banks in the financial sector has further been increased by the acknowledgement that macro-prudential regulation is a necessary complement to modern central banking. The new macroprudential mandate acquired granted during the crisis to central banks is in part a return to the theory and practice of central banking 30 years ago in Europe (even though the term “macroprudential” was coined recently) when central bankers thought their role extended well beyond the narrow remit of monetary policy.

A third significant evolution in the relationship between governments and the financial system that has in part turned the clock back can be found in the return of “public credit institutions” (also known as “development banks”). These state-owned lenders in France, Germany, Italy and Spain, respectively the Caisse des dépôts et consignations (CDC), the Kreditanstalt für Wiederaufbau (KfW), the Cassa depositi e prestiti (CDP) and the Instituto de Crédito Oficial (ICO) have considerably increased their scope as of recently. The CDC and CDP are old state owned institutions (created respectively in 1816 and 1863) that played an important historical role in the economic development of France and Italy. The KfW was created in 1948 to support the reconstruction of the German economy while the Spanish ICO is more recent (1971). Their role in the economy has increased greatly and rapidly during the financial crisis.While total assets of the credit institutions of the Euro Area increased by only 4 percent from 2008 to 2012, assets of public credit institutions increased by at least 30 percent and even 128 percent for the ICO. These institutions have also, together with the European Investment Bank, which has also expanded its lending activities quite substantially by 56 percent over the same period (2008-2012), collectively created the “long-term investors” club to promote their role in the economy as a provider of long term financing 31.

The detailed balance sheets of these institutions show that they have performed various functions over time with different emphasis in each country. The Cassa de Depositi e Prestiti for example has expanded its credits to the public sector tremendously, extending some €85bn worth of loans to public (mainly local) entities and purchasing some €90bn in Italian government bonds and bills. In France, the CDC has repositioned its portfolios away from European peripheral countries’ debt into French sovereign debt where the exposure almost doubled. The CNP insurances company, which is the 6th European insurance company in assets size and which is owned by the CDC, has also accomplished a similar portfolio rebalancing towards domestic debt.

Meanwhile, in Germany, KfW played a quite different role by first being largely used to provide capital, loans and guarantees to the financial sector 32 during the first wave of the crisis in particular in the case of IKB. It also expanded its financing to local SME and infrastructure in Germany and abroad. Indeed, the KfW played an important role in German financial aid to other European countries as in Greece with some €22bn of outstanding credits at the end of 2011, Italy with some €1.7bn, Ireland with €1.4bn, Spain with €3.2bn. These institutions are therefore not only important to understand the political economy of national eco-systems but also of new financial relationships between European nations during the crisis. Indeed, in Spain for instance, KfW lends to Spanish SMEs through the ICO. It is also interesting to observe that the countries that did not have an important “development bank” (such as Portugal and Greece) are now in the process of creating one 33.

In essence, the existence of these institutions has allowed reactivating practices and mechanisms of intrusion in the intermediation system that were an essential part of the financial ecosystem over the last century. Their role is probably even reinforced in European countries today by the fact that national central banks and governments cannot provide direct public support or target specific sectors via subsidised loans as they used to do in the immediate post war period. In many countries (but not in all) national credit institutions never really disappeared, they just blended in. The CDC’s total assets for instance represent 15 percent of GDP in 2012 when it was equal to 17 percent of GDP in 1970. Governments for the most part therefore never really disbanded the institutions they had built of the last century and they proved relatively easy to awaken and mobilise as the crisis hit.

Contrary to Carmen Reinhart’s argument, it is misleading to these developments as a mere “return of financial repression” 34. The intervention of European states in their financial system have not intended to become substitute for fiscal or industrial policy and thus differ drastically from historical quantitative tools used by central banks thirty years ago. Nonetheless, it is clear that the greater re-nationalisation in the holding of public debt by domestic financial institution, the unprecedented increase in central bank credit to the private economy, and the return of public credit institutions are three developments since the financial crisis that have reaffirmed the centrality of distinct European financial ecosystems after two decades in which these ties had been eroded by financial liberalisation and the process of European monetary integration.

5. European financial ecosystems and the move towards a banking union

The previous section has discussed how the changes in the patterns of financial intermediation and sovereign debt holding emerged in response to the crisis, but the implications of these trends extends well beyond economics and deep into the political arena and the debate concerning the reform in the European financial architecture.

The long and troubled history of the construction of an integrated market for financial services in Europe has often been described as a “battle of the systems” across different European countries, in particular between systems such as Britain where capital markets played a key role as the main source of financing and the continent where banks dominated the provision of credit 35. But on the continent itself, national practices and structures also differ greatly and are somewhat embedded in the domestic institutions and possibly in different varieties of capitalism 36.

The realisation of an integrated financial market encouraged first by the Banking Directive in 1977, the Single European act in 1986 and the Lamfalussy Report in 2001 had partially redesigned the fault lines in European financial policies. The traditional conflicts across different countries reflecting the preferences of their national champions was complemented by the emergence of coalitions of large pan-European groups with a strong interest in removing obstacles to the emergence of an integrated financial market for financial services in Europe, often pitted against firms with a more local or national outlook threatened by this trend.

The dynamics triggered by the financial crisis have reinforced the channels of pressure and influence between European governments and their banking systems. The greater nationalisation of financial intermediation as well as the wave of re-regulation revive strong national preferences and tensions in the design of financial policies. Debates surrounding the design and implementation of Basel III for example, have instead witnessed the re-emergence of traditional national cleavages, with different European regulatory authorities frequently running in support of their banking industry at the negotiating table. The violent realisation that the monetary union did imply lesser avenues for economic adjustment in response to shocks has certainly strengthened the reluctance of national governments to deprive themselves of policy levers to influence credit intermediation. On the other hand, the financial sector seems to have been able to use this dependency in order to extract concessions from national regulatory authorities that would serve its own interests. The influence of financial industry groups over the position of their respective governments has not been confined to countries with large financial sectors, but it has been pervasive also in countries where the financial industry occupies a smaller position in the economy 37.

The path towards a banking union – a single supervisory mechanism applying a single rulebook and eventually a single resolution mechanism – is therefore particularly important in this respect. If successful, it should precipitate a profound redefinition of national financial ecosystems in Europe and have broader consequences on the underlying structure of financial intermediation in Europe. This may not be completely compatible with sustaining national preferences as far as the organisation of the financial system is concerned. But it could also reduce the ability of member states to use their financial system to play a cushioning role in the event of economic downturns. This could imply a further reduction in the ability of member state to stabilise their economies and entail much more radical changes in the structures of national capitalisms. The tensions existing between these changes and the historical ties between different governments and their banking systems explain the opposition of domestic financial interests and some national governments have been source of resistance on the way for the establishment of a banking union. The resilience of history within national financial ecosystems and the symbiotic relationships remaining between western European governments and their national banking systems are a key factor shaping the path towards the Europeanisation in the regulation, supervision, resolution of the financial sector that the banking union entails. Will the union break national ties, create a new balance of public and private power at the European level or, on the contrary reinforce domestic specificities and relationships such that a dual system might emerge with two separate levels of activities and political economies (national and European)? There is a wide research agenda ahead as very little has been written up to now on the potential consequences of the banking union for the political economy of national financial ecosystems. The debate has not even fully started and insights from economics, history and political sciences are more than needed at this stage.

6. Conclusion

Despite their renewed popularity among economists and policymakers since 2008, neither the notions of “capture” nor “financial repression” appear sufficient to fully understand today’s European dynamic and complex patterns that characterise the relationship between governments and their financial industries at the national and increasingly at the European level.

These seem to be evolving profoundly in two directions. First an apparent rapid reduction of banks’ balance sheets that will probably increase the role of non-banks in the provision of credit and thereby certainly affect profoundly the ties between banks and government insofar as they influence the extension and allocation and credit to the economy. Second, and maybe more importantly, the ongoing process of Europeanisation of financial policy is likely to have profound ramifications for both financial ecosystems themselves and for the relationships that governments and financial institutions develop. In particular, it could be expected that relationships that were so far developed within the confines of national borders would be gradually transferred over the to the European level via the process of the banking union, thereby side-lining or at least minimising the importance of national governments.

However, developments in the last few years very much question this notion as it appears clearly that the financial crisis has actually awakened institutions, practices and relations that have strengthened the ties between governments and their respective financial ecosystems. Starting from the breadth and scope of financial support 38, to the reactivation of certain supervisory and even monetary practices, the ties between national governments and the banking system has been in many ways reactivated in a way that tends to blur the rigid categories of capture and repression. As a result, a more nuanced prism is needed, focusing on agency that national specificities will be able to develop within European contexts as well as on the non-trivial equilibria between public and private interests. The political science literature, which has highlighted the existence and persistence of “varieties of capitalism” in Europe and the resilience of national ecosystems, will be particularly helpful in this respect. This strand of work should also help us to introduce the perspective brought by the political economy literature in the debates about the European monetary union over and above the importance of the need for a banking union as a necessary stabilising feature of the single currency.


1 Baxter has defined capture as occurring “whenever a particular sector of the industry, subject to the regulatory regime, has acquired persistent influence disproportionate to the balance of interests envisaged when the regulatory system was established”. Lawrence G. Baxter (2011) 'Capture in Financial Regulation: Can We Redirect It Toward the Common Good?' Cornell Journal of Law & Public Policy 175-200. The origins of the concept: see George J. Stigler (1971) 'The Theory of Economic Regulation', The Bell Journal of Economics and Management Science, Vol. 2, No. 1. See also Dal Bó, Ernesto (2006) 'Regulatory Capture: A Review', Oxford Review of Economic Policy, 22(2), 203–225. For a recent discussion of the problem of capture in the context of the financial crisis see Carpenter, Daniel and David A. Moss (eds) (2013) Preventing Regulatory Capture: Special Interest Influence and How to Limit it, Cambridge University Press; Johnson, Simon (2009) 'The Quiet Coup', Atlantic Monthly, May; and Daron Acemoglu and Simon Johnson (2012) ‘Captured Europe’, Project Syndicate, May.

2 Reinhart, Carmen. M. (2012) 'The return of financial repression', Financial Stability Review, 16, 37-48; Kirkegaard, Jacob F. and Carmen M Reinhart (2012) 'Financial repression, then and now', VoxEU.org, May; Allianz Global Investors (2013) Financial Repression. It Is Happening Already.

3 Andrew Schonfield (1965) Modern capitalism: The changing balance of public and private power, Oxford University Press. A subsequent literature in political sciences has coined the term i>“varieties of capitalism” to study these differences and their institutional roots: Colin Crouch and Wolfgang Streeck (eds) (1997) The Political Economy of Modern Capitalism: Mapping Convergence and Diversity, London: Sage; Peter A. Hall, David Soskice (eds) (2001) Varieties of Capitalism. The Institutional Foundations of Comparative Advantage, Oxford University Press.

4 ;De Larosière Jacques (2009) Report on financial supervision to the European Commission; Mügge, Daniel (2006) 'Reordering the Marketplace: Competition Politics in European Finance', Journal of Common Market Studies, 44(5), 991– 1022.

5 For the literature on financial retrenchment globally see for example Lund, Susan et al (2013) Financial globalization: retreat or reset?McKinsey, available at Milesi-Ferretti, Gian Maria and Cedric Tille (2011) 'The Great Retrenchment: International Capital Flows during the Global Financial Crisis', Economic Policy vol. 26(4), pp. 285-342. Re-nationalisation of financial intermediation and financial policy has emerged as a response to the contradiction between international market integration and spatially limited political mandates, as highlighted in the political science literature: Pontusson, J. and Raess, D. (2012) 'How (and Why) Is This Time Different? The Politics of Economic Crisis in Western Europe and the United States', Annual Review of Political Science, 15, 13-33; Clift, B. and Woll, C. (2012) 'Economic patriotism: reinventing control over open markets', Journal of European Public Policy, 19(3), 307-323; Schmidt, V. A. and Thatcher, M. (eds) (2013) Resilient liberalism in Europe's political economy, Cambridge University Press.

6 Goldstein, Morris and Veron, Nicolas (2011) 'Too Big to Fail: The Transatlantic Debate', Working Paper No. 11-2, Peterson Institute for International Economics; Johnson, Simon and Kwak, James (2011) 13 bankers: the Wall Street takeover and the next financial meltdown, Vintage.

7 FCIC (2011) The Financial Crisis Inquiry Report. Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Washington, DC: The Financial Crisis Inquiry Commission. See also Johnson, Simon (2009) 'The Quiet Coup', Atlantic Monthly, May.

8 US GAO (2011) 'Securities and Exchange Commission. Existing Post-Employment Controls Could be Further Strengthened', Government Accountability Office, GAO-11-654 Report, Washington DC.

9 Stigler (1971). See footnote 1.

10 The Landesbanken are themselves partly owned by regional confederations of Sparkassen (saving banks) and respective federal states. See also Grossman Emiliano (2006) 'Europeanisation as an interactive process: German public banks meet EU competition policy', Journal of Common Market Studies, vol. 44, n°2, p. 325-347.

11 Giani, Leonardo (2008) ‘Ownership and Control of Italian Banks: A Short Inquiry into the Roots of the Current Context', Corporate Ownership & Control, Vol. 6, No. 1, pp. 87-98.

12 On the role of these networks for banking reforms, see Butzbach Olivier, Grossman Emiliano (2004) 'La réforme de la politique bancaire en France et en Italie : le rôle ambigu de l’instrumentation de l’action publique', in L’instrumentation de l’action publique (sous la dir. de Pierre Lascoumes et Patrick Le Galès), Presses de Sciences Po, Paris, pp. 301-330. More general references are Swartz, David (1985) 'French Interlocking Directorships: Financial and Industrial Groups', in Stokman, Ziegler and Scott (eds) Networks of Corporate Powers: A Comparative Analysis of Ten Countries; Kadushin, Charles (1995) 'Friendship Among the French Financial Elite', American Sociological Review, Vol 60, N_2, pp 202-221. For a quantitative approach highlighting the role of networks of former high ranking civil servants in shaping board composition of banks and other corporations, see Kramarz, Francis and Thesmar, David (2013) 'Social networks in the boardroom', Journal of the European Economic Association, 11:780–807.

13 Woll, Cornelia (2013) 'The power of banks', Speri, University of Sheffield, July.

14 Davies, Howard (2010) 'Comments on Ross Levine’s paper “The governance of financial regulation: reform lessons from the recent crisis”', Bank for International Settlements; see also The Warwick Commission on International Financial Reform (2009) In Praise of Unlevel Playing Fields, University of Warwick.

15 Howarth, David and Quaglia, Lucia (2013) 'Banking on Stability: The Political Economy of New Capital Requirements in the European Union', Journal of European Integration (May), 37–41.

16 Pagliari, Stefano and Young, Kevin L. (2014) 'Leveraged interests: Financial industry power and the role of private sector coalitions', Review of International Political Economy, 21(3), 575–610.

17 Morris and Veron (2011), see footnote 6. Gerschenkron, A. (1962) Economic backwardness in historical perspective. Economic backwardness in historical perspective, Harvard University Press.

18 Hautcoeur, Pierre Cyrille, Riva Angelo, and White Eugene N. (2013) 'Can Moral Hazard Be Avoided? The Banque de France and the Crisis of 1889', paper presented at the 82nd Meeting of the Carnegie-Rochester-NYU Conference on Public Policy; Caroline Fohlin (2012) Mobilizing Money: How the World’s Richest Nations Financed Industrial Growth, New York: Cambridge University Press.

19 McKinnon, Ronald (1973) Money and capital in economic development, Brookings Institution Press.

20 Hodgman Battilossi, Stefano (2005) 'The Second Reversal: The ebb and flow of financial repression in Western Europe, 1960-91', Open Access publications from Universidad Carlos III de Madrid; Monnet, Eric (2014) 'The diversity in national monetary and credit policies in Western Europe under Bretton Woods', in Central banks and the nation states, O.Feiertag and M.Margairaz (eds), Paris, Sciences Po, forthcoming; Monnet, Eric (2013) 'Financing a planned economy, institutions and credit allocation in the French golden age of growth (1954-1974)', BEHL Working Paper n°2, University of Berkeley; Hodgman, Donald (1973) 'Credit controls in Western Europe: An evaluative review', Credit Allocation Techniques and Monetary Policy, The Federal Reserve Bank of Boston.21 Monnet Eric (2012) 'Monetary policy without interest rates. Evidence from France’s Golden Age (1948-1973) using a narrative approach', Working Papers 0032, European Historical Economics Society (EHES).

22 Eichengreen, Barry (2008) The European economy since 1945: coordinated capitalism and beyond, Princeton University Press.

23 Pontusson & Raess (2012) 'How (and Why) Is This Time Different? The Politics of Economic Crisis in Western Europe and the United States', Annual Review of Political Science, vol. 15, pp. 13-33; Zysman, John (1983) Governments, markets, and growth: financial systems and the politics of industrial change, Cornell University Press. The academic literature that builds on the “varieties of capitalism” has studied extensively how these national characteristics and “institutional complementarities” were shaped and reinforced by the role of the state, then shaping these various forms of “capitalism”. Schonfield, A. (1965) Modern Capitalism: The Changing Balance of Public and Private Power, Oxford University Press. Peter Katzenstein (1985) Small States in World Markets, Ithaca, Cornell University Press; Peter Hall, David Soskice (eds) (2001) Varieties of Capitalism, Oxford University Press.

24 Mügge, Daniel (2006) 'Reordering the Marketplace: Competition Politics in European Finance', Journal of Common Market Studies, 44(5), 991–1022.

25 Carmen Reinhart (2012) 'The return of financial repression', CEPR, DP8947; Sapir, André, and Wolff, Guntram (2013) 'The neglected side of banking union: reshaping Europe’s financial system', Policy Contribution, Bruegel; Goodhart, Charles (2013) 'Lessons for monetary policy from the Euro-area crisis', Journal of Macroeconomics.

26 Stolz, S. M., and Wedow, M. (2010) 'Extraordinary measures in extraordinary times: Public measures in support of the financial sector in the EU and the United States', Occasional Paper 117, European Central Bank.

27 De Grauwe, Paul (2011) 'The European Central Bank: Lender of last resort in the government bond markets?' CESifo working paper: Monetary Policy and International Finance (No. 3569). De Grauwe, Paul, and Ji, Yuemei (2012) 'Mispricing of sovereign risk and multiple equilibria in the Eurozone', Centre for European Policy Working Paper 361.

28 Merler, Silvia, and Pisani-Ferry, Jean (2011) 'Hazardous tango: sovereign-bank interdependence and financial stability in the euro area', Financial Stability Review, (16), 201-210.

29 In a 25 November 2013 speech, J. Weidmann said that Monetary policy runs the risk of becoming subject to financial and fiscal dominance”.

30 For example, speech by David Miles from the BoE: 'Government debt and unconventional monetary policy', at the 28th NABE Economic Policy Conference, Virginia, 26 March 2012.

31 The long-term investors club: See also green paper by the European Commission on long-term finance.

32 Between the end of 2007 and February 2008, IKB had to go through several rounds of financial support in which banks and the KfW agreed to two more bailout packages, which ended up increasing KfW’s participation in IKB from 38 percent to 90.8 percent. For more details see Cornelia Woll (2014) The Power of Collective Inaction: Bank Bailouts in Comparison, Ithaca, Cornell University Press.

33 'Germany to help Spain with cheap loans', EUObserver, 28 May 2013, euobserver.com/economic/120278.

34 Reinhart, C. M. (2012) 'The return of financial repression', Financial Stability Review, 16, 37-48.

35 Story, Jonathan, and Walter, Ingo (1997) Political Economy of Financial Integration in Europe: The Battle of the Systems, MIT Press.

36 Hall, Peter and Soskice, David (2001) Varieties Of Capitalism: The Institutional Foundations of Comparative Advantage, Oxford University Press.

37 Howarth, David, and Quaglia, Lucia (2013) 'Banking on Stability:  The Political Economy of New Capital Requirements in the European Union', Journal of European Integration (May), 37–41; Bruegel blogpost by Nicolas Veron.

38 Woll (2014). See footnote 32.

Europe between financial repression and regulatory capture (English)
Thu, 10 Jul 2014 07:40:58 +0100