<![CDATA[Bruegel - Latest Updates]]> http://www.bruegel.org Tue, 22 Jul 2014 12:30:04 +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[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
<![CDATA[Fact of the week: Not one European city in the top 10 for tech talent]]> http://www.bruegel.org/nc/blog/detail/article/1383-fact-of-the-week-not-one-european-city-in-the-top-10-for-tech-talent/ blog1383

Two recent LinkedIn analyses show some interesting facts about work-related migration in the 21st century and how this reshapes the world’s economic environment. The data shows that European countries tend to be net losers from migration of skilled workers and that they lag behind the US and especially India in the ranking of cities able to attract tech talents.

There are some long-lived and recurrent questions in economics. For example, where, how and why do workers migrate? which countries are successful in attracting skilled talents? who is gaining and who is losing from the brain train around the world?

In the age of big data, these questions can find interesting answers from the social networks. In particular, from a business-focused one such as LinkedIn, which has access to career data for more than 300 million professionals. It goes without saying that the analysis is seen “through the lens of LinkedIn data”. This means that the sample is limited to people having a LinkedIn profile - which could imply some degree of self-selection. But insights are very interesting.

Figure 1

A first analysis looks at job-related migration between November 2012 and November 2013, trying to understand which countries gained and lost from this migration, as well as what the characteristics of the LinkedIn members that decided to relocate their careers are. LinkedIn’s Lindsay Ahearne determined the geographic movements of the members in the sample by looking at every new position that was added to their LinkedIn profiles between November 2012 and November 2013, limited to those  that included a regionally specific location different from the one of the previously held position. Individuals were also grouped according to their different skills (to identify the skill categories that could be found uniquely among movers), industries and business functions (to determine those that are most likely to move).

This work yields an insightful ranking of countries, ordered in terms of the net inflows of workers registered over the period between November 2012 and November 2013 (figure 1).

As a percentage of the total country workforce, the United Arab Emirates is the country that experienced the biggest inflow (75% of which is found to come from outside the Middle East). Somewhat unsurprisingly, LinkedIn profiles reveal that these immigrants were mostly architects and engineers. Top gainers from relocation include two Gulf countries (UAE and Saudi Arabia); two European countries (Switzerland and Germany); Nigeria and South Africa; India and Singapore.

The effect of the European crisis is strikingly evident. Among EU countries, Germany had a net gain of 0.4% of total labour force, with more than 60% of inflows coming from another European country. Ireland, Italy, France and especially Spain registered negative balances, of -0.1%, -0.1%, -0.2% and -0.3% respectively. Concerning Spain, LinkedIn data show that 60% of emigrants remained within Europe while 20% moved as far as to Spanish-speaking countries in Latin America.

In terms of skills uniquely identified in movers, Math, Science, Technology and Engineering seem to play a particularly important role. In terms of industries, movers are found to work mostly in media and entertainment; professional services; oil and energy; government, education and non-profit but most importantly, technology-software.

Which lead us to a different but related LinkedIn analysis, looking at what are the 21st century’s technology “hotspots”, which are successful in attracting migrants with tech skills. Sohan Murthy looked at cities that saw at least 10,000 new residents between November 2012 and November 2013, and computed the percentage of new residents with technology skills.

Figure 2

The results (figure 2) are quite striking. Five out of ten cities attracting people with tech skills (especially IT infrastructure and system managements; Java development and web programming) are located in India, including the first four of the list. San Francisco only comes fifth, followed by two other US cities and two Australian.

No European city at all makes it to the list. For the 52 cities looked at in the study, the median percentage of new residents with tech skills was 16%, or just under 1 in 6; in many of the Indian cities, its more than double that figure. European cities are the real laggards: the percentage of new residents with tech skills was 18% in Berlin, 15% in Paris, 13% in Madrid and 11% in Paris.

The trend obviously mirror the Indian ongoing technology boom, in a still rather “virgin” environment. Kunal Bahl - founder of Snapdeal, a wannabe Indian Amazon - told USA Today in 2011 that India offers huge opportunity “because there are no mature companies, like Google and Microsoft, over there. The feeling is like in the U.S. in 1999."

But there may be more to that.. Research by Vivek Wadhwa (Stanford) revealed that half of Silicon Valley start-ups were launched by immigrants, many of them educated in US top universities. But he also noticed that "for the first time, immigrants have better opportunities outside the U.S." because, among other things, of rather strict immigration laws and California's steep cost of living. Bahl himself, who studied in the US and spent some time working at Microsoft, reportedly wanted to initiate his company in the US but eventually went back to India because of visa problems.

And this is also why the tech industry - at the (by now almost) desperate search for engineers - is supporting the introduction of specific “start-up visa” for high-skilled workers in the US. The insights provided by this data is particularly important in the context of the recent discussions on the US immigration reform, but it is not without implications for Europe, which is at the bottom of the ranking as far as attracting tech talent is concerned.

From that position, the US looks far ahead, but the new really hot tech hotspot are not even in sight.

Details about the sampling methodology used is provided in the two LinkedIn analyses here and here.

Wed, 09 Jul 2014 14:36:18 +0100
<![CDATA[Juncker's first move]]> http://www.bruegel.org/nc/blog/detail/article/1382-junckers-first-move/ blog1382

When European Commission president-designate Jean-Claude Juncker takes over the office later this year, his task will be to prove that the European Union and its institutions are relevant for dealing with globalisation and global demographic, technological and environmental change. In our recent Bruegel policy brief, The great transformation: memo to the incoming EU Presidents, we discuss the central challenges that he as well as the Presidents of the European Council and the Parliament face. We argue that the three Presidents jointly have to work on developing a proper growth strategy and driving a reflection process on treaty change. The reform of the institutions is of central importance to deal with the challenges – and is a primary obligation of the new European Commission president and the topic of this blog post.   

One early move that Juncker should make is to do away with the current European Commission college structure of one portfolio for each of the 28 member states. This would demonstrate that he is prepared to make changes, and would be a signal to those that are disenchanted with the EU that he recognises their basic concerns, primarily the need for growth and jobs.

An effective Commission would have only a dozen policy areas in which it would take action. While the number of commissioners cannot easily be reduced, it should be acknowledged that not every commissioner can have a full portfolio without leading to inconsistency of policy and excessive activism. A solution would be for every commissioner to have the full rights of a commissioner with a full vote in the college. However, not every commissioner would be responsible for a distinct portfolio. An alternative constellation would consist of several clusters of competences for which several commissioners would be jointly responsible.

A first step should be the appointment of a senior vice president without portfolio responsible for the European growth strategy. The senior vice president would oversee all the relevant Commission activities to ensure that policies are implemented to their maximum effectiveness to promote growth. There would be a particular focus on single market and industry, the digital agenda, science and research, education and skills, and regional policy. The senior vice president would have a small staff, consisting essentially of the part of the General Secretariat currently in charge of the Europe2020 strategy.

Meanwhile, the enterprise and single market portfolios should be merged into a single market and industry portfolio to emphasise that European industrial policy should be about framework conditions and deepening the single market while reducing national regulatory fragmentation. Industrial policy based on subsidies and support for national champions is not the right approach for more growth and jobs in Europe.

The rigorous enforcement of competition rules is central for economic performance. Attempts to make competition policy subject to narrow industrial policy interests are unwarranted, as are claims that it prevents the emergence of European champions. Many sectors remain dominated by national operators in the different national markets, and substantial regulatory barriers still prevent companies, in particular in the services sector, offering their products in other EU countries. The single market agenda is therefore more relevant than ever. However, acknowledging the inherently complex nature of competition policy, a high-level committee of five independent experts should be appointed to review once a year the actions of the European Commission, and give independent advice on the direction of competition policy. Their reports should be public but should not be binding.

The economic and financial affairs commissioner must play a central role in the growth strategy, including by shaping the EU-wide fiscal stance, but she will have to operate independently of the many requests from within the Commission and focus on her mandate and the need to keep fiscal policy credible. In many countries, debt levels are already very high and fiscal consolidation is therefore important.

These moves will help to create a better foundation for a coherent strategy to address Europe's big challenges. These are threefold: boosting feeble economic growth in the face of emerging-economy competition, streamlining the EU's institutional set-up and proving that it is capable of dealing with pressing external matters, and, ultimately, facing up to the need for treaty change in order to clarify the relationship between the euro area and the EU, and move beyond the factional politics of ‘More Europe’ versus ‘Less Europe’ to ‘Better Europe,’ with the right competences allocated to European level while others remain at, or are even repatriated to, national level.

The appointment of Jean-Claude Juncker has been a difficult process, and the signals he sends early in his mandate will be important to heal rifts and set the tone. Changes to improve the functioning of the top-heavy Commission college, and to focus it on the right priorities, will be central.

Wed, 09 Jul 2014 09:14:09 +0100
<![CDATA[The (not so) Unconventional Monetary Policy of the European Central Bank since 2008]]> http://www.bruegel.org/publications/publication-detail/publication/837-the-not-so-unconventional-monetary-policy-of-the-european-central-bank-since-2008/ publ837

This paper is one in a series of nine documents prepared by Policy Department A for the Monetary Dialogue discussions in the Economic and Monetary Affairs Committee (ECON) of the European Parliament.


The global financial and economic crisis forced major central banks to act swiftly and to innovate to avoid a free fall of their economies. This paper reviews in depth the measures adopted by the European Central Bank, and compares them with the ones adopted by the Federal Reserve and the Bank of England since 2008. The ECB has been very active since the beginning of the crisis and its actions helped the financial sector to avoid a complete meltdown. However, the ECB adopted measures that were mainly directed at ensuring the provision of liquidity and repairing the bank-lending channel, through changes to its usual framework for the implementation of monetary policy. By contrast, the Fed and the Bank of England quickly pursued unconventional monetary policies by implementing quantitative easing programmes that appeared to have a positive impact on financial variables and also on the real economy. Today, the ECB is confronted by inflation well below 2% and has reacted by implementing a broad package of fairly conventional measures. This analytical note pleads for the ECB to implement a large-scale asset-purchase programme and makes recommendations about the design of such a programme.


  • The global financial and economic crisis that started in 2008 forced major central banks around the globe to act swiftly and to innovate in order to avoid a complete meltdown of the financial sector, and to limit the consequences for the real economy.
  • The ECB’s policy response to the crisis was mainly oriented towards ensuring the provision of liquidity and repairing the bank-lending channel. In order to do that, the ECB mainly modified its existing monetary policy tools. It increased the average maturity of its refinancing operations from months to years. It eased the collateral requirements to access those refinancing operations, and liquidity was allocated at a fixed rate and full-allotment basis. Retrospectively, those measures appear to have been a very appropriate and effective way to deal with the liquidity crisis of 2008-2012.
  • The ECB also introduced more unconventional measures with the Securities Market Programme and the Covered Bonds Purchase Programme, which it used to buy particular assets – government bonds from troubled countries and covered bank bonds – in order to repair the monetary transmission channel in the euro area. However, the scope and impact of those measures was limited and short-lived. The ECB also announced the Outright Monetary Transactions programme, in order to purchase unlimited amounts of government bonds of member states subject to a European Stability Mechanism (ESM) programme. This measure has not been used, but its announcement had a significant impact on government bond yields of the EMU member states because it demonstrated the determination of the ECB to maintain the integrity of the euro area.
  • The Federal Reserve (Fed) and the Bank of England chose a more radical and unconventional path in terms of monetary policy when they decided very quickly to implement large-scale asset-purchases programmes as their main response to the crisis. The sizes of these programmes were very significant (grossly equivalent to 20-25% of GDP) and, although it is very difficult to estimate their impact, there is a broad consensus in the literature that those measures had a positive impact on financial variables and also on GDP and inflation in the US and the UK.
  • The liquidity crises that have plagued the euro area in the last few years seem to be behind us. The ECB’s main problem now is the continuous decline of inflation in the euro area to a level well below its definition of price stability of close but below 2%. In order to counteract this fall and to bring inflation back to 2% in the medium term, the ECB announced a broad package of measures at its June 2014 Governing Council meeting. However, although we welcome the fact that the ECB finally recognised that inflation will be too low for a too-long period and decided to act, we believe that the measures it proposes arrive too late, are too limited, and might be too “conventional” to solve the current problem. That is why we urge the ECB to implement a large-scale asset-purchase programme as soon as possible. To do that, we propose monthly purchases of €35bn of ESM/EFSF/EIB bonds, corporate bonds and asset-backed securities (ABS) in order to anchor inflation expectations and bring euro-area inflation back to 2% in the medium-term.


Since 2008, the central banks of the main advanced economies have been very active in order to avoid the complete meltdown of their financial sectors and limit the adverse consequences for the real economy. However, central banks around the globe chose different paths to take action. The main aim of this paper is to compare these different paths since the beginning of the crisis and to assess the impact of those policies. Another goal of this paper is to determine what kind of unconventional policies the ECB should adopt today in order to fulfil its price stability mandate for the euro area.

In the first section of the paper, we will see that the ECB has mainly preferred to adapt its usual monetary policy framework to ensure the provision of liquidity to the banking sector and to repair the bank-lending channel to try to revive credit in the euro area, rather than to implement a more radical monetary policy. In the meantime, the Fed and the Bank of England embarked quickly on unconventional monetary policies by implementing quantitative easing programmes that seemed to have a positive impact on financial variables but also on the real economy through various channels.

The second section of this briefing paper essentially summarizes and updates the analysis and recommendations of Claeys et al (2014a and 2014b). It describes the main challenge faced by the ECB today, i.e. the current downward trend in inflation. During its June 2014 Governing Council, the ECB decided to react to this dangerous situation by implementing a broad package of measures. We will try to assess if these measures are enough to bring inflation back to 2% in the medium term, and we will see what kind of unconventional monetary policy could be implemented to achieve price stability in the medium term in the euro area.

1. Unconventional measures implemented by the ECB, the Fed and the Bank of England since 2008

1.1. ECB 2008-2013: saving the banking system, solving the liquidity crises

The ECB’s policy response to the crisis was mainly oriented towards ensuring the provision of the liquidity needed by the banking sector at a point at which the interbank market and other sources of short-term funding were almost frozen.

1.1.1 Modifications to the ECB’s refinancing operations

Together with the lowering of the policy rate from 4.25% to 1% between October 2008 and May 2009 (and later down to 0.15% from December 2011 to June 2014), the ECB introduced a number of measures to provide “enhanced credit support” to the economy.

Liquidity started to be allocated, through main refinancing operations (MRO) and long-term refinancing operations (LTRO), at a fixed rate and full-allotment basis, meaning de facto that banks had unlimited access to central bank liquidity, on the basis of the provision of adequate collateral.

Collateral requirements were in turn eased a number of times, and on top of that, the maturity of LTROs – originally of 3 months only – was lengthened, introducing operations with maturity of, first, 6 months, then 1 year and eventually by conducting two massive very long-term refinancing operations (VLTROs) with a maturity of 3 years (in December 2011 and February 2012). The cumulative take-up of these two operations exceeded €1 trillion (although part of it substituted the borrowing through other maturities). As a consequence, the maturity of the ECB’s balance sheet has lengthened. Figure 1 shows that about 80% of all the liquidity provided to the banks – which constitutes the biggest component on the asset side of the Eurosystem’s consolidated balance sheet – has now a maturity of 3 years.

Not surprisingly, the use of the LTRO facility has been skewed towards certain countries, with banks in Spain, Italy, Greece, Ireland and Portugal accounting for 70 to 80% of the total borrowing since 2010. Symmetrically, banks from the North – which had benefited from inflows of capital in search of safety – reduced their reliance on the ECB operations to minimum levels. The VLTROs was constructed as a euro area-wide policy – i.e. open and directed to all banks in the euro area, but banks from the South of the euro area ended up using it more than the others because they were the most affected by the liquidity crisis taking place at the time in the European banking sector.

Figure 1: Eurosystem refinancing operations

Source: ECB

Since January 2013, the ECB has allowed banks to repay the funds borrowed under the three-year LTRO, earlier than on maturity date. Banks have been using this opportunity quite sensibly, especially in Spain, where the reliance on the Eurosystem facility was previously the largest. As a consequence of frontloaded reimbursements, the amount of liquidity in the euro area has started to fall rapidly. Figure 2 shows that the excess liquidity in the euro area[1] has dropped significantly since the beginning of 2013 and is now almost completely re-absorbed.

Figure 2: Excess liquidity – euro area, in €bn

Source: ECB

The empirical literature analysing LTROs suggest that those operations were very useful in improving monetary conditions at the height of the crisis[2]. While LTROs were a very appropriate and effective measure to deal with the liquidity crisis of 2011-12, these operations did little to trigger additional lending to the private sector (even though they might have helped to prevent the collapse of existing lending). To a great extent, banks either deposited the cheap central bank funding at the ECB for rainy days, or purchased higher yielding government bonds. Thereby, the LTROs in effect supported liquidity, ensured stable long-term (three-year) financing of banks, subsidised the banking system and helped to restore its profitability, and temporarily supported distressed government bond markets. Considering the alternative of a potentially escalating financial crisis, these developments were beneficial.

1.1.2 The Securities Market Programme (SMP), Outright Monetary Transactions (OMT) and the Covered Bonds Purchase Programme (CBPP)

Under the SMP, initiated in May 2010, the ECB bought around €220 billion of Greek, Irish, Portuguese, Italian and Spanish government bonds. At the time, the ECB announced that the bonds would be held to maturity and that the purchases are entirely sterilised. The intervention was justified in light of the severe tensions in certain market segments that were hampering the transmission of the ECB’s monetary policy. At present there are €175.5bn of SMP bonds left, the maturities of which are not publicly disclosed by the ECB. The empirical literature[3] has tried to assess the impact of SMP and concludes that it had a positive but short-lived effect on market functioning by reducing liquidity premia and reducing the level as well as the volatility of European government bond yields.

However, the programme was stopped in September 2012, when the ECB introduced the new Outright Monetary Transactions (OMT), the announcement of which had a remarkable effect on European bond yields even without the programme having ever been used. The programme allows the ECB to purchase essentially unlimited amounts of government bonds of member states that are already subject to a European Stability Mechanism (ESM) programme, as long as the member states in question respect the conditions of the ESM programme. The ECB contends that this policy could be necessary on monetary policy grounds, namely to safeguard “an appropriate monetary policy transmission and the singleness of the monetary policy”[4].

The ECB also introduced in 2009 a Covered Bonds Purchase Programme (CBPP), which was not sterilised and aimed at reviving the covered bond market, which plays an important role for the financing of banks. The ECB initially bought covered securities such as Pfandbriefe worth an aggregate volume of €60 billion within a one-year period. In November 2011, the ECB launched a second CBPP with a total volume of €40 billion, but it decided to interrupt it in October 2012, after covered bonds totalling €16.4 billion had been purchased.

1.1.3 Introduction of a Forward Guidance strategy

In July 2013, the ECB formally introduced forward guidance as a new monetary policy tool when President Draghi announced during the introductory statement of the press conference that “the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time”[5].

Initially, the main idea behind forward guidance, introduced by Krugman (1998) when analysing the deflation and liquidity trap problem of Japan in the 1990s, was that central banks could gain traction on the economy at the zero lower bound if they manage to convince the public that they will pursue a more inflationary policy than previously expected after the economy recovers, what Krugman calls a “credible promise to be irresponsible”. This policy should indeed result in low short-term rates for an extended period of time and an increase in inflation expectations, which should both have a negative effect on real long-term rates today and should therefore boost investment and consumption.

However, the main problem of forward guidance is time-inconsistency. Central bankers do not want to commit themselves to future policy decisions and they will always have an incentive to raise rates when inflation returns to preserve their credibility to fulfil their price stability mandate. But if forward guidance is not time consistent, it is not credible and agents anticipate that rates will be raised earlier and it will therefore not be effective. To be credible it is possible that forward guidance needs a commitment or a time-consistency device to work better, a role that a massive asset purchase programme could play, given the potential delays resulting from a gradual and ordered exit strategy (as demonstrated by the current slow US QE tapering process).

Contrarily to what was advocated in the theoretical academic literature, the ECB clarified[6] quickly its forward guidance strategy by saying that it did not promise either “irresponsibility” or a suspension – even temporarily – of its usual strategy. The ECB considers only forward guidance as a new way to communicate its strategy in order to better anchor expectations about the future path of interest rates, and not at all as a commitment to keep rates lower longer than necessary in order to have a more significant immediate impact of monetary policy. This may have therefore reduced the effectiveness of the measure.

1.2. Unconventional measures adopted by the FED and the BoE: the quantitative easing experience

In response to the global financial and economic crisis, the Federal Reserve (Fed) and the Bank of England engaged in large-scale asset purchase programmes, or quantitative easing (QE)[7]. From the beginning of 2009 to March 2014, the Federal Reserve purchased $1.9 trillion (11.9 percent of US GDP) of US long-term Treasury bonds and $1.6 trillion (9.6 percent of US GDP) of mortgage-backed securities. Between January 2009 and November 2012, the Bank of England purchased £375 billion (24 percent of GDP) of mostly medium- and long-term government bonds. In addition to such asset purchases, these central banks also implemented programmes to support liquidity in various markets. All those measures resulted in a significant expansion of the central banks’ balance sheets (see Figure 3). Unlike the two other major central banks, the ECB has made few asset purchases so far but reacted to the crisis by providing liquidity to the banking system as we have seen before.

Figure 3: Size of balance sheets of various central banks, in % of GDP

Source: FRED, IMF.

1.2.1 Unconventional monetary policy in the US

In the US, quantitative easing (QE) began immediately in November 2008 and is on-going. In total, it has expanded its balance sheet from $860 billion at the beginning of 2007 to $4.2 trillion today. The Fed announced in December 2013 a ‘tapering’ of its programme, and has reduced gradually its monthly purchases from $85 billion to $35 billion.

On top of its QE policy the Fed also introduced some short-term liquidity measures, such as the Commercial Paper Funding Facility, which purchased 3-month unsecured and asset-backed commercial paper with top tier credit rating, to support the commercial paper market and reduce the rollover risk. Another programme, initiated in November 2008, was the TALF (Term Asset Backed Securities). This was aimed at addressing the funding liquidity problem in the securitisation markets for consumer and business ABS (Asset-Backed Securities) and CMBS (Collateralised Mortgage-Backed Securities). Under this programme, the Federal Reserve extended term loans collateralised by securities to buyers of certain high-quality ABS and CMBS, with the intent of reopening the new-issue ABS market. The programme provided both liquidity and capital to the consumer and small business loan asset-backed securities markets: the Fed lent money against asset-backed securities while the Treasury Department provided $100 billion in credit protection from its Troubled Asset Relief Program (TARP) to the TALF (as a cushion against losses on the ABS collateral). On top of this asset-buying programmes, the Fed also introduced a number of facilities aimed at helping the banks to meet their liquidity needs, such as the Term-Auction Facility (TAF) that was intended to provide liquidity with a maturity of one month against the same kind of collateral that could be used to borrow overnight at the Fed’s discount window, but without the ‘stigma effect’ that was associated with the use of the discount window.

Figure 4: Size of asset side of the Fed’s balance sheet, in % of GDP

Source: FED

As noted in Joyce et al (2012), there is a broad consensus in studies estimating the impact of QE on financial markets that it has been successful in reducing government bonds rates. More precisely, Gagnon et al (2011) shows that the Fed’s QE1 between December 2008 and March 2010 had significant and long-lasting effects on longer-term interest rates on a variety of securities, including Treasuries', agency mortgage-backed securities and corporate bonds. Estimations suggest a fall in 10-year term premium by somewhere between 30 and 100 basis points overall[8] and substantial effects on international long-term rates and the spot value of the dollar. Concerning the MBS purchase programme, Hancock and Passmore (2011) focus specifically on whether it has lowered mortgage rates, and conclude that the programme’s announcement reduced mortgage rates by about 85 basis points in the month following the announcement, and that it contributed an additional 50 basis points towards lowering risk premiums once the programme had started.

As far as liquidity measures are concerned, Ashcraft et al (2009) assess the effectiveness of the TALF by observing volumes and patterns of ABS and CMBS issuance as well as liquidity conditions in these markets. Overall, they find that improvement in market conditions and liquidity in the term ABS and CMBS markets in 2009 was dramatic, particularly in view of the lower-than-expected volume of lending through TALF. A total of $71.1 billion in TALF loans was requested and the volume of outstanding loans peaked in March 2010 at $48.2 billion, although the programme was authorised to reach $200 billion and at one point up to $1 trillion in loan volume was envisioned. Through the TALF programme, the Federal Reserve seems to have been able to prevent the shutdown of lending to consumers and small businesses, while limiting the public sector’s risk.

Estimating the macro impact of QE poses a number of difficult challenges given other potential factors that could also have influenced the economic developments of the period in which QE has been implemented. Therefore, the various results found in the literature have a higher variance. That’s why we would recommend focusing on the sign of the effect more than on its size. According to Chung et al (2012), the combination of QE1 and QE2 raised the level of real GDP relative to baseline by 3%, and inflation is 1% higher than if the Federal Reserve had not carried out the programme. They calculate that this would be equivalent to a cut in the federal funds rate of around 300 basis points from early 2009 to 2012. In contrast, Chen et al (2012) find that QE2 policy increased GDP growth by 0.4% on impact and has a minimal impact on inflation (equivalent to an effect of a 50-basis point cut in the federal funds rate). These findings show that QE has been effective (even though the effect can appear to be quite small in comparison to size of the asset purchases in terms of GDP). In terms of choice of the asset to buy, some papers such as Woodford (2012) and Krishnamurthy and Vissing-Jorgensen (2013) suggest that QE is much more effective when it takes the form of credit easing, i.e. when private assets are bought.

1.2.2 Unconventional monetary policy in the UK

The Bank of England began its quantitative easing programme in January 2009 and purchased £200 billion worth of mostly medium- and long-term government bonds from the non-bank private sector by January 2010. It made further purchases in 2011 and 2012, which took the total amount to £375 billion.

Figure 5: Size of asset side of the BoE’s balance sheet, in % of GDP

Source: BoE

There is also a broad consensus in the empirical literature that the Bank of England’s quantitative easing had significant effects on gilt yields but also on corporate bond rates and on the sterling exchange rate[9]. As in the US, conclusions on the impact on GDP and inflation in the UK differ in magnitude, but all research papers report positive impacts. For instance, in a recent paper Weale and Wieladek (2014) estimated that asset purchases equivalent to one percent of GDP led, respectively in the US and the UK, to a 0.36 and 0.18 percentage-point increase in real GDP and to a 0.38 and 0.3 percentage-point increase in CPI after five to eight quarters.

2. 2014: Addressing weak inflation in the euro area

2.1 What is the current problem to solve in the euro area?

The ECB’s current situation is very different from the one it faced in the immediate aftermath of the financial crisis. The liquidity crises in the banking sector and in the periphery’s sovereign markets seem to be fading as speculation about the break-up of the euro area has clearly receded. The interbank market has been revived and European sovereign yields are now at very low levels, including for periphery countries, since uncertainty about the integrity of the euro area was dissipated by President Draghi’s commitment to do “whatever it takes” to preserve it, when he announced the OMT programme in September 2012. On top of that, the structural weaknesses of the European banking sector are gradually being mended thanks to the ECB’s Comprehensive Assessment currently taking place.

The main problem for the ECB at the moment is that 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 food price developments, has developed similarly. Five of the 18 euro-area member countries (Cyprus, Greece, Portugal, Slovakia and Spain) have experienced negative rate of inflation in the last few months. Even in the countries that are not in a recession, such as Belgium, France and Germany, inflation rates are well below the euro-area target of close to but below two percent. More worryingly, the ECB’s forecast suggests that inflation will not return to close to two percent in the medium term.

In the current European circumstances, low overall euro-area inflation implies that in some euro-area member states inflation has to be very low or even negative in order to regain competitiveness relative to the core. The lower the overall inflation rate, the more periphery inflation rates will have to fall in order to achieve the same competitiveness gains. Given that wages are often sticky and rarely decline, significant unemployment increases can result from the adjustment process. In addition, lower-than-anticipated inflation undermines the sustainability of public and private debt if the debt contracts are long-term nominal contracts. For governments, falling inflation rates often mean that nominal tax revenues fall, which makes the servicing or repayment of debt more difficult.

More worryingly for the ECB, inflation expectations have been falling since at least mid-2012. Figure 6 presents expectations from two sources (an ECB survey and a market-based indicator) and for two maturities. The two-year-ahead expectations are significantly below two percent and even below one percent according to the market-based indicator. In the period relevant for the ECB, inflation expectations have thus become de-anchored from 2 percent. Lack of ECB action when the ECB’s own medium-term inflation forecasts fell below the two percent threshold was a signal to markets that probably resulted in the downward revision of longer-term inflation expectations. The ECB is now less effective in anchoring longer-term expectations to, or close to, the 2 percent level.

Figure 6: Inflation expectations: ECB’s survey of professional forecasters (SPF) and market-based inflationary expectations in the euro area, 2002Q1-2014Q2

Source: ECB’s Survey of Professional Forecasters and Datastream. Note: In the ECB’s survey the horizon of “Long term” is not specified. Market-based expectations refer to overnight inflation swaps (OIS), which can be used as a market based proxy for future inflation expectations. The 2014Q2 values of market-based expectations are the average during 1-23 April 2014, while the latest available values for the SPF are end of March 2014.

There are two other reasons that suggest that the ECB should have adopted additional monetary stimulus since the beginning of 2014. First, at a low level of inflation, the costs of deviation from the ECB’s forecast inflation are highly asymmetric. If inflation is higher than forecast, it would mean that inflation would be closer to the two percent threshold – a benign development. But if inflation is lower than forecast, then countries in the euro-area periphery would have to maintain even lower inflation or higher deflation, with risks for the sustainability of public and private debt. Second, the ECB’s inflation forecasts and market expectations have been unable to predict significant deviations from the two percent threshold (Figure 6). When there was a sizeable deviation, ECB forecasts and market expectations both predicted a gradual return to two percent, which happened in some cases (see, for example, the December 2011 forecast of the ECB), but most of the time did not.

Figure 7: Inflation forecasts/expectations and actual inflation in the euro area

Source: Datastream, ECB. Note: The HICP is defined as a 12-month average rate of change; in panel A, the ECB Staff projections indicate a range referred to as „the projected average annual percentage changes” (see https://www.ecb.europa.eu/mopo/strategy/ecana/html/table.en.html). For simplicity, we take the average of the given range. In panel B, market-based expectations refer to overnight inflation swaps (OIS), which can be used as a proxy for future inflation expectations.

Overall, inflation has been falling significantly and so have inflation expectations. Inflation forecasts have proved consistently too optimistic about the return of inflation to the two percent threshold in the euro area. The ECB’s own forecast suggests that euro-area inflation will not return to close to two percent in the medium term, and we see a substantial risk that it will not return to this level even in the longer term.

2.2 Will the new measures announced in June by the ECB be enough to bring back inflation to the 2% threshold in the medium term?

As previously explained in Claeys et al (2014b), the ECB announced during its June 2014 press conference a broad package of measures to try to tackle the low inflation problem. The package aims to (a) ease the monetary policy stance, (b) enhance transmission to the real economy, (c) reaffirm the ECB's determination to use unconventional instruments if needed.

In our assessment, the package really aims to tackle (a) and (b) but it is not a serious attempt to change inflationary dynamics with quantitative easing. We expect that the bundle of measures will have an effect on inflation. However, it is not as aggressive as it may look at first sight and further measures will likely be needed later.

This package is really about a slight easing of monetary policy and about an attempt to improve monetary policy transmission by restoring the bank-lending channel. However, the small cut in interest rates (including putting the ECB deposit rate in negative territory) will have minor effects, while the effectiveness of the targeted longer term refinancing operation (TLTRO) will depend on whether banks will be ready to take up the liquidity. The problem with the euro area currently is, however, not the lack of liquidity but the lack of lending to the real economy. As explained earlier, banks actually pay back their previous LTROs. One of the main improvements of the TLTRO over the previous LTROs is that it will carry a fixed rate (current MRO rate + 10 basis points, i.e. 0.25% at the moment), and thereby a financial incentive to borrow from the ECB, as rates cannot go down further but instead can increase during the next four years. The other main improvement is that TLTRO is conditional on new lending to the real economy and to corporations in particular. However, all depends on the willingness of banks to use the TLTRO, but most importantly on whether there will be significant demand for credit coming from the corporate sector. In many countries, debt in the corporate sector is actually quite high and the sector is attempting to deleverage. So our take is that the TLTRO will help to reduce fragmentation but its effect on inflation may be less significant than hoped.

The decision to suspend the sterilisation of the liquidity injected under the Securities Markets Programme (SMP) is questionable. The SMP had a particular goal: to address the malfunctioning of securities markets and to restore an appropriate monetary policy transmission mechanism, while not affecting the stance of monetary policy. With this decision, its aim is now changed to affect the stance of monetary policy. Such a change of a key parameter of an ECB decision undermines the reliability of other ECB commitments, which in turn introduces uncertainty about the parameters of other longer-term ECB commitments. If the ECB wanted to inject €175 billion liquidity into euro-area money markets (the current amount of SMP holdings), it would have been preferable to announce a new asset purchase programme to this end.

In our view, the announcement of preparatory work for an ECB ABS purchase programme is more significant (even though the ECB has not provided any details about the size or the timing of those purchases). We expect this to lead to the emergence of a larger ABS market. However, the ABS market is currently very small, and the ECB intends to focus on ABS based on real loans to corporations (and not on complex derivatives, which is a good thing) and to exclude the ABS for residential mortgage-backed securities (RMBS), which is by far the largest ABS market in the euro area (as explained in the next section). So in fact, if the ECB was to decide to buy, it would very quickly buy up the entire current market. Consequently, the ECB's asset-purchase programme might be quite limited in scope. Of course, one could hope that the market will increase if the ECB starts buying, but it needs to be seen if the market can develop sufficiently quickly, as there are some regulatory barriers. The effect of this measure is again going to be mostly via better credit conditions. It will not substantially operate through a portfolio re-balancing effect. In the absence of a large-scale ABS purchase programme and with subdued demand for credit, the impact on the exchange rate could be quite limited.

The element that is still missing in the package is a monetary policy measure that would substantially kick-start inflation in the core euro-area countries. A significant QE programme would have effects on core-euro area inflation as well as periphery inflation. The current package might not do that. Even though we welcome that the ECB has finally acted with a broad package, we think that further measure will likely be needed. We continue to believe that a more aggressive quantitative easing programme would anchor inflation expectations more significantly.

2.3 Towards a large-scale asset purchase programme?

As explained in detail in Claeys et al (2014a), we believe that the only option left for the ECB to be able to bring back inflation to the 2% thresholds as soon as possible is to follow the path of the Fed and the BoE and the adopt a quantitative easing strategy. However, given the differences between the euro area and the US or the UK, asset purchase will have to take a different form than in these countries. The following section summarises our recommendations on how a significant ECB asset-purchase programme should be designed to be effective and to bring back inflation and inflation expectations towards the 2% threshold in the euro area in the medium term.

2.3.1 Asset purchase: size of the programme

Setting the appropriate size of asset purchases is far from easy. Some analysis considered the total amount of asset purchases by the Bank of England and the Fed and suggested similar magnitudes for the euro area (20 to 25% of GDP, i.e. €1.9 to 2.4 trillion).

In our view, a more relevant benchmark is the amount of purchases by the Federal Reserve in its third round of quantitative easing (QE3), announced in light of the weak economic situation of the US economy at a time when the acute face of the financial crisis was over – a situation that has similarity to the current euro-area situation. In September 2012, the Federal Reserve announced it would purchase $40 billion (€29 billion) agency mortgage-backed securities per month, an amount increased to $85 billion (€61 billion) in December 2012 (by adding $45 billion per month of Treasuries). Given that the euro area’s economy is about 30 percent smaller than the US economy, the same size, as a share of GDP, would be between €20 and €40bn per month in the euro area.

2.3.2 Asset purchase: design principles

In our view, the ECB will have to choose which assets to buy using five main criteria.

  • First, the ECB should buy assets that lead to the most effective transmission to inflation.
  • Second, there should be sufficient volume of the asset available, to ensure that the ECB can purchase appropriate quantities while not buying up whole markets.
  • Third, the ECB should try to minimise the impact on the private-sector allocation process. While QE by definition changes relative prices, the ECB should avoid buying in small markets and distorting market pricing too much. The more the ECB becomes a player in a market, the more it can be subject to political and private-sector pressures when it wants to reverse the purchases.
  • Fourth, the ECB should buy only on the secondary markets in order to allow the portfolio-rebalancing channel to work effectively. Purchasing on the primary market would imply the direct financing of entities, which should be avoided.
  • Fifth, the assets should only originate from the euro area and be denominated in euros, because of the February 2013 G7 agreement.

The Treaty gives a mandate to the ECB to maintain price stability, not to protect its balance sheet. Some criteria on riskiness should be adopted, but we recommend a reasonable low threshold for credit risk, such as restricting asset purchases only to the eligible collateral (without any additional eligibility criterion).

2.3.3 Asset purchase: composition

According to the ECB, total marketable assets eligible as collateral represented almost €14 trillion at the end of 2013 (Figure 8), equivalent to 146 percent of euro-area GDP[10]. About half of the Eurosystem’s eligible collateral pool at the end of 2013 consisted of government bonds, while the other half was split between uncovered bank bonds, covered bank bonds, corporate bonds, Asset Backed Securities and other marketable assets (which include the debts of EU rescue funds and the European Investment Bank).

A natural starting point for an ECB asset purchase programme would be euro-area wide government bonds, which do not exist. The closest proxy would be the bonds of European debt such as bonds issued by the European Financial Stability Facility (EFSF), the European Stability Mechanism (ESM), the European Union and the European Investment Bank (EIB). The total available euro-denominated pool of these bonds is around €490bn (€230bn for EFSF/ESM, €60bn for EU, €200bn for EIB). Buying such pan-European assets would not affect the relative yields of euro-area sovereign debts and would not distort the market allocation process within the private sector.

Figure 8: Eligible assets and assets used as ECB collateral (€ bns)

Source: ECB;

Note: Eligible assets are in nominal values; assets used as ECB collateral are after haircuts and valuation issues. Latest data available: 2013 Q4

National sovereign debt would be a natural step as the bond market is very large and the positive effects of such a QE would be significant, via portfolio rebalancing, as well as the exchange rate, wealth and signalling channels. However, the purchase of national government debt is more complicated for the ECB as a supranational institution without a supranational euro-area treasury as a counterpart, than it was for the Fed or the Bank of England. First, with 18 different sovereign debt markets, the ECB would have to decide, which sovereign debt to buy. The purchase would alter the spreads between countries and change the relative price of sovereign debts, which may expose the ECB to political pressure and lead to moral hazard. Second, the treaty prohibits the monetary financing of government debt, and since the goal of asset purchase will be to meet the ECB’s primary objective of price stability, purchase of government bonds would be allowed if the risk of monetary financing could be excluded. Experience proves that all ECB bond-buying programmes are controversial and politically sensitive in this respect. Third, the ECB has a well-defined sovereign bond purchase programme, the OMT, which is a tool to improve monetary policy transmission in countries under financial assistance. It is debatable whether a QE programme based on capital keys of the ECB would undermine the logic of the OMT programme, but this could be a risk and it should be avoided.

The second largest asset class is bank bonds, with €3.8 trillion available in eligible covered and uncovered bonds. Among the other effects, the reduction in market yields would also reduce the yields on newly issued bank bonds, thereby allowing banks to obtain non-ECB financing at a lower cost. This would improve bank profitability and could improve the willingness of banks to lend. However, bank bonds should be excluded from the ECB asset purchase programme until the ECB’s Comprehensive Assessment is concluded. Until then, ECB purchases would lead to serious conflicts of interest at the ECB and would make a proper assessment by the ECB more difficult. Moreover, those banks, for which the outcome of the Assessment is unsatisfactory, should continue to be excluded from the ECB’s asset purchases until they have implemented all the required changes to their balance sheets. This might take several months after the completion of the Comprehensive Assessment.

While there is no precise data on their magnitude, we estimate that the lower bound of eligible euro-area corporate bonds would be €900 billion. In addition, the supply of corporate bonds in the euro area has been growing considerably since 2009. The euro-area corporate bond market is highly concentrated (figure 9), with the main issuers of corporate bonds being French companies. However, for portfolio rebalancing to work, the origin of the corporate bonds is of less importance. The beneficial effect would come from the fact that the current owners of the corporate bonds would sell their bonds and use the cash for different purposes throughout the euro area. The purchases would encourage new issuance of corporate bonds everywhere and lead to a diversification of the sources of funding. Lower funding costs for corporations should induce more corporate investment.

Figure 9: Bonds vs. loans – financing of EU non-financial corporations (€ bns)

Source: ECB. Note: The difference between the amount reported in this figure and the total eligible corporate bonds shown on Figure 10 comes from the fact that here we only consider corporate bonds issued by euro zone corporations, whereas eligible collateral include corporate bonds issued in the whole European Economic Area (EU countries and Iceland, Liechtenstein and Norway); see here:

Another class of assets that could be bought by the ECB is asset backed securities (ABS). Yearly securitisation issuance – which peaked in 2008 – is much lower than in the US and has been decreasing since 2008. The total outstanding stock of securitised products has been stagnating at around €1.06 trillion for the euro area compared to €2.5 trillion in the US (AFME, 2014). Products eligible as collateral for the ECB amount to about €761 billion, but some of them originate from outside the euro area. We estimate that the lower bound of eligible euro-area ABS would be €330 billion. It is worth highlighting that defaults on ABS in Europe have ranged between 0.6-1.5 percent on average, against 9.3-18.4 percent for US securitisations since the start of the 2007-08 financial crisis[11]. The regulatory landscape for securitised products has also changed considerably since the crisis and made the products safer and more transparent[12].

Considering the total amount of European ABS, more than half (€612 billion) is based on residential mortgages, while SME ABS constitute a smaller part (€116 billion). That is why we think that ECB should be buying also RMBS as they represent the biggest pool of ABS and would allow the ECB to have a more significant programme without buying the whole market. As shown in Wolff (2014), the ECB should not be afraid of a potential housing bubble in Germany given that the current price increase is not financed by a rise in the volumes of mortgages in Germany.

The ABS stock outstanding is unequally distributed across countries[13], with the main issuers being different from the main issuers of corporate bonds. ABS purchases would be concentrated on the Netherlands, Spain and Italy and could therefore be a good geographical complement to corporate bond purchases, which would be concentrated in France, Germany and Italy. An ECB purchase could promote the development of securitisation in the euro area. The potential for securitisation is relevant, as many loans would qualify for securitisation and in March 2014 the outstanding amount of loans to non-financial corporation stood at €4.2 trillion and to household at 5.2 trillion in the EU[14]. From a monetary policy perspective, it would be very beneficial to create ABS that are based on a portfolio of European assets. Ideally, the credit risk should be pooled at the level of the private sector, thereby deepening cross-border financial integration. However, the ECB should not wait for developments in the ABS market to start buying securitised products.


  • Chen, Han; Cúrdia, Vasco and Ferrero, Andrea (2012) ‘The macroeconomic effects of large-scale asset purchase programs’, The Economic Journal, vol. 122(564), pp. F289–315, November
  • Chung, Hess; Laforte, Jean-Philippe; Reifschneider, David and Williams, John C. (2012), ‘Estimating the macroeconomic effect of the FED’s asset purchases’, FRBSF Economic Letter 2001/03, January
  • Claeys G., Z. Darvas, S. Merler and G. Wolff (2014a), ‘Addressing weak inflation. The European Central Bank's shopping list’, Bruegel Policy Contribution, 2014/05 May
  • Claeys G., Z. Darvas, and G. Wolff (2014b), ‘ECB shows activism but falls short of true QE’, Bruegel Blog, June 5
  • Darvas, Zsolt (2013), ‘Banking system soundness is key to more SME’s financing’, Bruegel Policy contribution 2013/10, July
  • Gagnon, Joseph; Raskin, Matthew; Remache Julie and Brian Sack (2011), ‘The Financial Market Effects of the Federal Reserve’s Large- Scale Asset Purchases’. International Journal of Central Banking 7, no. 1: 3–44.
  • Hancock, Diana and Wayne Passmore (2011), ‘Did the Federal Reserve’s MBS purchase program lower mortgage rates?’, Journal of Monetary Economics, vol.58 no.5, pp.498-514
  • Krishnamurthy, Arvind and Annette Vissing-Jorgensen (2013) ‘The Ins and Outs of LSAPs’
  • Krugman, P. (1998). ‘It's baaack: Japan's slump and the return of the liquidity trap’. Brookings Papers on Economic Activity, 137-205.
  • Joyce, M., D. Miles, A. Scott, and D. Vajanos (2012), ‘Quantitative easing and unconventional monetary policy – an introduction’ The Economic Journal, 122, pp. F271-288, November
  • Meier (2009) ‘Panacea, Curse, or Nonevent?’ Unconventional Monetary Policy in the United Kingdom.’ IMF Working Paper 09/163, August
  • Papadia, Francesco (2013) ‘Should the European Central Bank do more and go negative?’, Blog post: Money matters? Perspectives on Monetary Policy
  • Sapir, André and Wolff, Guntram B. (2013), ‘The neglected side of banking union: reshaping Europe’s financial system’, Note presented at the informal ECOFIN, September
  • Weale, Martin and Tomasz Wieladek (2014), ‘What are the macroeconomic effects of asset purchases?’, Bank of England, External MPC Unit, Discussion Paper no. 42, April
  • Wolff, Guntram (2013), ‘The ECB’s OMT programme and German constitutional concerns’, in Brookings, The G20 and Central Banks in the new world of unconventional monetary policy
  • Wolff, Guntram (2014), ‘Easier monetary policy should be no worry to Germany’, Bruegel Blog, June 4

[1] Excess liquidity can be computed as (current account + deposit facility – minimum reserves) or as (MRO + LTRO + Marginal Lending – Autonomous Factors – minimum reserves)

[2] ee Angelini et al. (2011); Lenza et al. (2010); Darracq Pariès and De Santis (2013); Abbassi and Linzert (2011)

[3] See Manganelli (2012); De Pooter et al. (2012); Ghysels et al. (2012)

[4] European Central Bank, 2012. “6 September 2012 - Technical features of Outright Monetary Transactions.” Available at http://www.ecb.europa.eu/press/pr/date/2012/html/pr120906_1.en.html

[5] European Central Bank, 2013. “Introductory statement to the press conference (with Q&A)” available at http://www.ecb.europa.eu/press/pressconf/2013/html/is130704.en.html

[6] Praet P. (2013). “Forward guidance at the ECB”, http://www.voxeu.org/article/forward-guidance-and-ecb

[7] The expression credit easing is also used when private sector securities are purchased.

[8] Other papers suggest similar results: D’Amico and King (2010), Krishnamurthy and Vissing-Jorgensen (2011), Neely (2012) and Hamilton and Wu (2012).

[9] For instance Meier (2009) shows that initial QE announcements reduced gilt yields at least by 35–60 basis points whereas Joyce et al. (2011) estimated that medium-to- long-term gilt yields fell by 100 basis points overall, summing up the two-day reactions to the first round of the MPC’s announcements on QE purchases during 2009–10. They also found that similar falls occurred in corporate bond yields and that there were also announcement effects on the sterling exchange rate, therefore validating the existence of a portfolio rebalancing channel and exchange rate channel of QE.

[10] In the permanent collateral framework, only euro-denominated securities are accepted, but under the temporary collateral framework introduced during the crisis, also assets denominated in USD, JPY and GBP are accepted. See: http://www.ecb.europa.eu/pub/pdf/other/collateralframeworksen.pdf

[11] http://www.bis.org/review/r140407a.htm

[12] Retention requirements – which should induce seller of ABS to monitor carefully the underlying collateral – have been introduced in the context of the EU Capital Requirements Directive, and the EBA is working on the technical details (i.e. 5% retention requirement):

[13] See details in Claeys et al. (2014a)

[14] According to the calculation in Darvas (2013), out of these €4.2 trillion, the stock of SME loans in the EU in 2010 represents approximately €1.7 trillion and the largest stocks of SME loans were in Spain (€356bn), followed by Germany (€270bn), Italy (€206bn) and France (€201bn).

The (not so) Unconventional Monetary Policy of the European Central Bank since 2008 (English)
Wed, 09 Jul 2014 07:30:31 +0100
<![CDATA[Blogs review: The EU-USA Transatlantic Trade and Investment Partnership]]> http://www.bruegel.org/nc/blog/detail/article/1381-blogs-review-the-eu-usa-transatlantic-trade-and-investment-partnership/ blog1381

What’s at stake: The European Union and the USA are currently negotiating a free trade agreement, known as the Transatlantic Trade and Investment Partnership (TTIP). After a draft has been leaked to the public, an intensive public debate over possible advantages and disadvantages of such a deal has erupted. While there is some debate over how large the economic benefit of such a free trade agreement can be in face of already relatively low trade barriers between the EU and USA, critics claim that the deal will lower standards of consumer protection, provision of public services and environmental protection in the EU.

Possible economic benefits of TTIP

A study by CEPR London  for the European Commission models the effects of the TTIP in a computable general equilibrium (CGE) model. An ambitious deal, consisting of tariff barriers being lowered to zero, non-tariff barriers lowered by 25% and public procurement barriers reduced by 50%, would lead to an increase in EU GDP by 0.5% in by 2027. Growth effects for the rest of the world will be positive, on average 0.14% of GDP, due to increased demand from the EU and USA. Because of different compositions of trade, particularly low income countries will not be negatively affected by the TTIP.

Another, less frequently cited study by the Bertelsmann Foundation  finds larger long-term GDP per capital effects of 5% for the EU and 13.4% for the USA as a result of dismantling all tariff and non-tariff barriers. Here, gains would largely come at the expense of third countries. For Canada and Mexico, whose free trade agreements with the USA would lose value, TTIP would in the long run imply a 9.5% and 7.2% decrease in GDP per capita over the baseline scenario.

The EU Trade Commissioner Karel de Gucht, citing the CEPR numbers, writes that TTIP offers significant benefits to the EU and USA over ten years during times of hesitant economic recovery. As shared values will facilitate negotiations, results should be reached in three dimensions: market access, regulatory cooperation and trade rules. Improved market access will benefit European companies and consumers alike. Standardisation in regulation would avoid unnecessary costs for global producers.

Dean Baker argues that calls to support TTIP for its beneficial impact on jobs and growth are lies: The CEPR model assumes full employment anyway and a GDP raise of only 0.5% over 13 years will not have a discernible impact on employment. Growth effects may in fact even go in the opposite direction: Stronger patent and copyright protections may result in higher prices for goods.

Figure 1: Annual Output gains from TTIP by type of liberalization

Souce: LSEUSAblog

Gabriel Siles-Brügge and Ferdi De Ville challenge the proclaimed benefits of this much-vaunted deal. Most of the economic benefit outlined in the CEPR study is due to the dismantlement of non-tariff barriers. Yet the commission has itself pointed out that only 50% of non-tariff barriers are at all “actionable”, i.e. within the reach of policy. Eliminating half of these, as assumed by CEPR seems already highly ambitious. Furthermore, due to strong inter-sector linkages, these benefits will only materialise if liberalisation is successful in all sectors.

The global significance of bilateral agreements

Pascal Lamy writes that preferential trade agreements (PTAs) such as TTIP could be very beneficial if they helped to bring down remaining tariff barriers. However, most PTAs focus more on regulatory issues than tariffs. Some non-tariff barriers such as consumer protection serve legitimate objectives. And there exists a risk that PTAs may lock various groups into different regulatory approaches, increasing transaction costs. In the end, a functional multilateral trade system through the WTO remains vital to avoid economic fragmentation and set globally sensible rules.

Michael Boskin points out that TTIP may have consequences that extend beyond the USA and EU. After NAFTA was signed, the Uruguay round of trade talks was revived. Similarly, a successful TTIP may be a major impetus for rekindling the moribund Doha Round.  It will be of great importance, whether compromises can be found in the truly contentious issues between the EU and the USA. One of the most difficult is the EU’s limitation of imports of genetically modified foods, which presents a major problem for US agriculture. Another is financial regulation, with US banks preferring EU rules to the more stringent framework emerging at home. This is of interest to countries outside the deal, too: if the EU relaxed its rules on genetically modified food imports and translated this with careful monitoring to imports from Africa, this could be a tremendous boon to African agriculture.

Hans-Werner Sinn is not surprised that bilateral trade agreements have been gaining traction globally lately, as there is no real progress on multilateral trade negotiations. The Doha round of WTO talks basically was a flop. Currently, fear of negative effects on consumer protection in the EU is distorting the debate. In reality, consumer protection standards in the US are often much higher in the US than in the EU where, following the Cassis de Dijon ruling of the European Court of Justice, the minimum standard applicable to all countries is set by the country with the lowest standards. TTIP could bring significant economic benefits while scrapping some misguided EU regulations such as the capping of CO2 emissions on cars, which is a covert industrial policy aimed at protecting Italian and French manufacturers of smaller cars.

Non-tariff barriers to trade and the protection of intellectual property in TTIP

Paul Krugman writes that if the Trans-Pacific Partnership (TPP) agreement of the USA with 11 countries throughout the Asia-Pacific region were to fail, it wouldn’t be a major disaster. Real trade barriers – tariffs – already are pretty low. The International Trade Commission in their latest report put the cost of American import restraints at 0.01% of GDP. What these agreements tend to be really about are issues such as intellectual property rights – with far less certain advantages. Intellectual property rights create temporary monopolies. These may be necessary to spur innovation but are not connected to classical arguments in favour of free trade.

Ryan Avent thinks that Krugman hasn’t done his homework on this issue: Firstly, tariffs are not universally low. Even if the macroeconomic impact may be limited, reducing high tariffs on some goods would be microeconomically desirable. Secondly, one of the ambitions of both TPP and TTIP is the reduction in non-tariff barriers. In most cases, such as agricultural imports, these barriers are much costlier than tariff barriers.

Dean Baker is highly skeptical of the usefulness of increased protection of intellectual property: The possibility of silly patents such as one on a peanut butter sandwich in the USA only raises prices and impedes competition. The big winner may be the pharmaceutical industry, which may extend the unchecked patent monopolies it enjoys in the US to the EU, resulting in higher drug prices and lower quality healthcare. Other companies see TTIP as a way of promoting their particular interests, for example by being able to use free trade arguments to circumvent the democratic process on issues such as fracking.

Investment protection – a threat to national sovereignty?

TTIP is not about the USA’s interests dominating those of the EU, but of the interests of capital owners prevailing over those of ordinary citizens, writes Jens Jessen. Investor protection clauses in TTIP would be a vast threat to national policies on culture and education:  Public universities could no longer be supported to be more affordable than private ones. Support to a local film industry would be impossible as big companies would have the same rights to subsidies. Production companies for popular entertainment could sue states to extend to them their support for local operas and symphony orchestras and public radio stations would be under threat as well.

Karel de Gucht Karel de Gucht sharply retorts that these allegations are unfounded: The EU treaties and the UNESCO convention on cultural diversity require member states to protect cultural diversity and explicitly permit schemes such as support to local film industries, whereas audiovisual services are not at all in the scope of TTIP anyway. Investment protection treaties, of which Germany alone has signed 130, have never included compensation rights for firms in case of profit reductions. And after Poland signed an investment protection treaty with the USA in the early 1990s, its right to offer subsidies in the sector of culture or education was never called into question.

The investment chapter in TTIP is less of a threat to EU and US democracy than often alleged, writes Robert Basedow . Critics claim that investor-state dispute settlement clauses will allow investors to sue states before supranational arbitrational tribunals for the annulment of social, health or environmental protection laws. However, due to the existence of a multiplicity of bilateral treaties with financial hubs like Hong Kong or Singapore, investors with holdings in these jurisdictions already have this right today. Indeed, TTIP offers the chance to make such arbitration proceedings more transparent and legitimate. 

Tue, 08 Jul 2014 11:55:46 +0100
<![CDATA[Antitrust risk in EU manufacturing: A sector-level ranking]]> http://www.bruegel.org/publications/publication-detail/publication/836-antitrust-risk-in-eu-manufacturing-a-sector-level-ranking/ publ836

Based on a dataset of manufacturing sectors from five major European economies (France, Germany, Italy, Spain and the United Kingdom) between 2000 and 2011, we identify a number of key sector-level features that, according to established economic research, have a positive impact on the likelihood of collusion. Each feature is proxied by an ‘Antitrust Risk Indicator’ (ARI).

We rank the sectors according to their ARI scores. At 2-digit level, sectors that appears more exposed to collusion risk are those that tend to score high in most of the ARIs: Tobacco, Pharmaceuticals, Beverages, Chemicals. The 4-digit analysis suggests higher anticompetitive risk in Tobacco products, Spirits, Sugar, Railway Locomotives and Aircraft (high concentration and fixed costs), Coating of Metals and Printing (low import penetration), Tobacco products, Meat products, Footwear and Clothing (high market stability), Plastic products and Spinning/Weaving of textiles (high symmetry of market leaders).

We then rank sectors according to the distribution of antitrust intervention by the European Commission between 2000 and 2013, in terms of merger control and anti-cartel enforcement. Tobacco, Paper and paper products, Pharmaceuticals and Food products are the sectors for which a notified merger has a greater likelihood of being deemed problematic by the Commission. There has been a greater incidence of anti-cartel action in Chemicals, Tobacco, Beverages, Electric equipment and Rubber and plastic.

Antitrust investigations are based on the identification of narrow product markets. The characteristics of these markets are not necessarily well represented by average measures at sector level. Nevertheless, a simple comparison exercise shows that the European Commission’s interventions have been largely consistent with sector rankings based on market concentration


The object of this paper is twofold: to provide a broad descriptive analysis of the risk of collusive behaviour throughout Europe in the manufacturing sector; and to identify those manufacturing sectors in which the European Commission has been more active in the past in its capacity of antitrust authority.

This paper is close in spirit to industry and market studies, although our target is wider and encompasses the whole manufacturing sector in Europe, as explained further below. Our methodology resembles Ilzkovitz et al (2008), in which the authors couple a variety of product market indicators to measures of antitrust enforcement to determine whether an economic sector is characterised by weak competition. In the manufacturing sector they identify Basic metals and Motor vehicles as the sectors in which competition issues are more likely to arise. Symeonidis (2003) asks in which United Kingdom manufacturing industries collusion is more likely, finding no clear link with industry concentration (industries where collusion had a higher incidence were Basic metals, Building materials and Electrical engineering). Yet Symeonidis's (2003) analysis is based on observed collusive agreements that were considered lawful during the period of observation1. Our aim instead is to investigate potential infringements of competition law that could be pursued by an antitrust authority. During our observation period, collusion is illegal and therefore participating to a cartel is risky: the inability to coordinate in an explicit and transparent manner between market players and the threat of antitrust intervention make collusion instable. We are looking after market characteristics that help counter-balancing those effects and make collusion more likely in this context.

The exercise that we propose in this paper, ranking economic sectors according to their predisposition to collusion, has an intrinsic limitation. The antitrust definition of a market (our theoretical subject of study – referred to in this paper as 'antitrust market') is conventionally based on tests, such as the SSNIP test2, that identify the boundaries of a market by measuring the degree of competition that different products exert on each other. If two products are very good substitutes – such that a significant proportion of demand and/or of supply would shift to one product if the price of the other is changed - then the products are considered to belong to the same market. This often leads to markets the boundaries of which are much narrower than those captured by product classification at sector level.

However, macroscopic analysis such as the one proposed in this paper, is necessarily based on sector data: that is, data that aggregate information from multiple markets that are grouped together for statistical purposes. In fact, we are only able to capture an imperfect link between antitrust markets and the observable average performance of the sectors they belong to. Previous research has been confronted with the same challenge (see, for example, Griffith et al, 2010, on the effect of the EU Single Market Programme on mark-ups and productivity).

To partially mitigate that problem, we focus on market characteristics that we presume could be shared by the majority of products within the same statistical sector. This would be the case if, for example, antitrust product markets within a certain sector share regulatory features (eg similar barriers to entry), production features (eg similar levels of economies of scale) or demand characteristics (eg a customer base which is largely the same).

To rank sectors according to their predisposition to collusion we follow the common wisdom in economic literature concerning the role of market’s structural features (see, for an exhaustive overview: Ivaldi et al, 2003, or Motta, 2004). The general intuition is that the more concentrated, stable and transparent markets are, the easier is for players to coordinate on a collusive price and stick to it without yielding to the temptation of undercutting the rivals and break the cartel agreement.

On the basis of the available data (see Section 2 below), we are able to measure proxies and account for the following factors: (1) market concentration; (2) likelihood of entry; (3) stability of demand and supply; (4) market symmetry3. The treatment and measurement of each factor is described in the next Section.

In the second part of our analysis we look at antitrust intervention by the European Commission. We look specifically at merger investigations and cartel infringement decisions. Both types of competition policy interventions give insights about the treatment of collusion likelihood by a competition authority. Regarding merger control, a merger has a higher chance to be considered 'problematic' from a competition policy perspective if it occurs in an already malfunctioning market where concentration levels are high, likelihood of entry is low, and supply and demand are relatively inelastic. A crucial determinant of a merger decision is, moreover, whether a merger has 'coordinated effects' ie whether the merger will make future collusion more likely.

Finally we propose and discuss a simple comparison exercise: the European Commission’s antitrust action is matched with the ranking of manufacturing sectors according to their collusion risk. Gual and Mas (2011) have an approach broadly similar to ours. They focus on Commission antitrust investigations only (ie they do not look at merger decisions), between 1999 and 2004 and check whether the probability of dropping the investigation is lower when industry characteristics suggest a lower likelihood of antitrust infringement. They find positive and weakly significant links consistent with theoretical prediction. For example, higher industry concentration rates are positively correlated with the probability of antitrust sanctioning.

It is important to stress that this exercise suffers from the fundamental limitation described above: that sector data does not necessarily convey information for antitrust product markets. Therefore, while the exercise can provide for an interesting consistency check between antitrust action and status of competition at sector level and deliver suggestions for follow-up inquiries, it should not in itself be used in a normative fashion to judge the quality of antitrust intervention. An ad-hoc case-by-case ex-post analysis should instead be performed for that purpose (see Neven and Zenger, 2008, for a good overview of the literature).

The paper is organised as follows. We first provide an illustration of the Antitrust Risk Indicators. We then describe our data sample in Section 2. Section 3 reports the sectors’ rankings and discusses the results. Section 4 concludes.

1. The Antitrust Risk Indicators

Below we report and explain the construction of the Antitrust Risk Indicators (ARIs) used to rank sectors’ predisposition to collusion. A good summary of the underlying economic theory can be found in Motta (2004). Note that the indicators are computed at European wide level (ie they are cross-country averages) and on a 10 years-wide time period (with two exceptions described below). We are in fact interested in capturing the probability of potential cartels with boundaries that are wider than national, to identify true 'European' issues4. Moreover the time period of observation has to be sufficiently long as anti-competitive behaviours are usually put in place for years (for example: the average duration of an international cartel is between 6 and 14 years – See Mariniello, 2013). We note that market structures are generally stable over time; in other words, to give an example: the average market performance within the tobacco sector during the period 2000 and 2011 is a good proxy of the performance of the tobacco sector at any point of time during that period. Again, this is the case if, despite changes prompted by regulatory intervention, sectors tend to preserve their key structural features over time, at least in relative terms if compared with other sectors of the economy. The literature reports consistent findings5.

(1) Market concentration

A higher degree of market concentration is associated with higher likelihood of collusion. It is easier to coordinate and reach a collusive agreement within a smaller group of players. Also, if concentration is high, deviation from a collusive equilibrium is less profitable: the remaining slice of the market a player would grab by undercutting rivals is smaller if compared to a market where many players are active. This means that cartels are generally more stable when markets are more concentrated.

We use three measures to proxy the average level of market concentration within a sector: the average price-cost margin for the period 2000 – 2011, the industry concentration ratio for 2010 and the Herfindal-Hirschman Index (HHI) for 2010.

Price-cost margins have been widely used in the literature to proxy the degree of market concentration (See Griffith et al, 2010), as the companies’ ability to extract rents and increase the gap between marginal costs and prices is decreasing in the level of competition in the market. They are, however, imperfect indicators: margins may be high, for example, because companies are more efficient or because they benefit from economies of scale, but calculating exact firm-level marginal cost is an extremely difficult exercise affected by other limitations (see Altomonte et al, 2010, for an example of such an exercise). We resort to use sector-wide production value and average variable costs as proxy of marginal costs; that is: we use the sum of the costs of labour, capital and all intermediate inputs as in Griffith et al (2010)6.

In order to accommodate for the limitations of price-cost margins measures, we complement that indicator with industry concentration ratios and HHI indexes, calculated respectively as the simple sum of companies’ market shares and the sum of the square of companies’ market shares. These are also widely used measures of concentration (see Ilzkovitz et al, 2007), even if they are possibly even more subject to the fundamental limitation that affect macro-analysis as described above: market shares at sector level are not necessarily a good proxy of market shares at market level. In our case, moreover, market shares are available only for the biggest 4 companies in the sector and only for year 2010. We construct the indicators accordingly: C4 is the sum of the market shares of the four biggest companies in the sector in 2010; HHI4 is the sum of the square of the market shares of the four biggest companies in the sector in 2010.

(2) Entry

Entry has a disruptive effect on collusive behaviour. The mere threat of entry makes collusion less sustainable: when effective entry is likely, incumbent players may find it difficult to maintain high prices in the market without risking sudden loss of customers. Moreover, a high firms’ turnover implies that coordination is less likely: instability in the identity and in the number of counterparts make collusive agreements more difficult to reach. Sectors where entry is more likely should therefore ceteris paribus be associated with lower probability of collusion.

Our dataset does not contain information that can directly help measuring the likelihood of entry; likewise, it does not contain information on the pattern of actual entries by new companies that occurred in the period of observation. The data report just the change in number of companies and do not disentangle entry from exit. Low growth rates may therefore mean low entry rates or high entry rates accompanied by equally high exit rates. The change in the number of companies cannot therefore be used to proxy entry. We nevertheless can exploit the information available in our dataset to measure proxies that provides indications on the degree of a sector’s openness to outside competitive pressure.

To do so, we build 2 indicators: (a) firms’ size and (b) import penetration. Firms’ size is computed as the average size of companies within the sector during the period of observation (2000-2011).

Relatively bigger sizes imply the existence of economies of scale, possibly due to higher fixed costs and barriers to entry. Bigger average size should therefore imply lower likelihood of entry7.

Import penetration is the yearly average of sector imports divided by sector production. This indicator is again computed over the period 2000-2011. A high ratio of imports over total production suggests that the sector tends to have relatively lower barriers to entry to foreign competitors. Moreover, it is reasonable to assume that reaching a collusive agreement with exporters is comparatively more difficult: exporters, for example, tend to be exposed to different costs shocks. Therefore it would be more difficult for local producers to explain price changes by exporters and detect potential deviation from collusive outcomes that may not be justified by change in production costs.

(3) Market stability

Stable markets are more predisposed to collusion. Collusive agreements crucially rely on players’ ability to capture other players’ deviation from the agreed price. When markets are subject to frequent and unpredictable demand or supply shocks, attributing a change in price to a deviation is more difficult, therefore collusion is less stable.

We compute two indicators to capture markets’ stability: (a) variance in market size and (b) variance in import penetration. Variance in market size is computed as the variance of the yearly growth rate of production values in nominal terms. Variance in import penetration is the variance of the yearly growth rate of the ratio of imports over total production. The two variables are calculated over the full period of observation 2000-2011. High variance levels are presumed to indicate lower market predictability and lower likelihood of collusion.

(4) Market symmetry

The last dimension of analysis is market symmetry. Symmetric markets where players hold similar market shares tend to be more predisposed to collusion. Symmetry aligns players’ incentive to stick to a cartel agreement. Conversely, if a company is much smaller than the others, it may have a relatively higher incentive to deviate, undercut its rivals and enjoy all market’s profits. To test for symmetry we compute an Asymmetry Indicator based on Gini’s coefficient8. In our case we employ it on the distribution of the production shares of the top four companies in each sector for year 2010. If the asymmetry indicator is 0, that indicates that the four observed companies have identical production shares ie the market is perfectly symmetric. When the indicator instead approaches 100 that meansthat there exists a huge gap between the market share held by the biggest company and the one held by the smaller ones9.

2. The Dataset

Our dataset contains a number of widely-used data for European manufacturing sectors from 2000 to 2011 for 5 European countries: France, Germany, Italy, Spain and UK. The 5 economies together represent 71 percent of the EU GDP10, in 2011, while the manufacturing sector in the five countries observed represents on average 12.5 percent of a country’s GDP11. The primary sources for data are National Accounts, Structural Business Statistics and International Trade databases. The aggregate statistics were compiled by Euromonitor12. The market features variables contained in our database are: total production, value added, gross operating surplus, market size, imports, exports, production and number of firms by employment size, production value and production shares of up to five top companies (all monetary data is recorded in euro)13. Using Eurostat NACE 2-digit classification14, the manufacturing sector can be split in 22 categories: Food products, Tobacco, Textiles, Wearing apparel, Leather products, Wood and wood products, Paper and paper products, Reproduction of recorded media, Chemicals, Pharmaceuticals, Rubber and Plastics, Other non-metallic mineral products, Basic metals, Fabricated metal products, Computers and electronics, Electrical equipment, Machinery and equipment, Motor vehicles, Other transport equipment, Furniture, Other manufacturing15. The 4-digit disaggregation results in 92 sub-categories.

The below table provides an overview of the database with few key descriptive statistics relative to 2010 for 2-digit sectors aggregated across the five economies. As it can be noted the total manufacturing production for our database amounted to €3.5 trillion, with the Food, Motor vehicles and Fabricated metal sectors topping the list in terms of production and value added. As for the demand-side, the five economies consumed €3.9 trillion with the Food and Motor vehicles sectors again on the top 3 by market size, and Computers and electronics coming third. The latter sector is ranked first also in terms of imports. Noticeably, imports and exports are originally defined at country level and therefore these aggregates include intra-group trade. The smallest sectors are Tobacco, Electrical equipment and Wood16 by either production or value added. The highest numbers of companies are in the Fabricated metal and Food sectors, with more than 180 thousands firms.

3. Results

3.1 Sector ranking – Antitrust Risk Indicators

Table 2 and Table 3 above report the ranking of all sectors according to each of the ARI indicators (table 2 reports ranking based on 2-digit aggregation data, table 3 on 4-digit). In terms of market concentration, there is a general consistency between the three indicators, price-cost margins, C4 and HHI4, particularly in pointing to the most concentrated sectors: Tobacco, Beverages and Pharmaceuticals. Reproduction of recorded media and Chemicals, Motor vehicles and Electrical equipment score high respectively in terms of price cost margins and HHI(4) and C4. Divergences between indicators are possibly due to differences in cost structures (this should be the case for Motor vehicles and Other transport equipment for example)17 or differences in the size of antitrust markets. For example, Reproduction of recorded media scores very low for HHI(4) and C4. That is possibly due to the fact that products in these sectors tend to be more heterogeneous and therefore less substitutable to each other. Therefore, even if several players are active in the sector (hence market shares at sector level are low), each player can still enjoy a certain degree of market power (hence price-cost margins are high), because the products sold may not have immediate close substitutes, or be perceived as such by customers. The opposite holds for Electrical equipment and Basic metals: if price-margins are relatively low despite high market shares, that may be due to a higher degree of substitutability between products.

Table 3 provides a more disaggregated insight by ranking 2-digit sectors according to the highest score reached by any of their 4-digit sub-sectors. No great difference is noted with the NACE-2 results. Tobacco, Pharmaceuticals and Beverages (Spirits and Beer) still rank high. Interestingly, Food climbs up the concentration ranking thanks to the low level of competition detected in the Sugar market. Other transport equipment (Locomotives and Aircrafts) scores high in terms of market share concentration.

Concerning entry, we note that, consistently with intuition, the firm size indicator is highly correlated with concentration. Tobacco, Motor Vehicles, Pharmaceutical, Chemicals, Beverages, Electric equipment, Basic metals are in the upper half of the ranking. This is not surprising given the relevance of research and development or high fixed entry costs and economy of scale featuring most of the products manufactured in these sectors. The NACE-4 analysis confirms Sugar (Food category) as a potentially problematic market, together with Tobacco, Aircraft and Spacecraft (Motor Vehicles), Plastic (Chemicals). The other entry indicator we use, “import penetration”, scores low for sectors were production tends to have a more narrow geographic scope (Reproduction of recorded media and in particular at 4-digit level, Printing) or has a stronger local dimension (Tobacco, Fabricated/Coated Metals, Other Non-metalic/Cement, Beverages/Soft drinks), while import penetration is high where multinational companies tend to be more present: Computer and electronics, Pharmaceuticals, Chemicals, Motor vehicles.

In terms of market stability, Tobacco, Food, Beverages and Pharmaceutical are amongst the sectors where demand varied the least during the period of observation (beside Wearing apparel, a result driven by the stability of the Clothing sector, as the 4-digit analysis shows). Import penetration is stable the most in Rubber and plastics, Wearing apparel, Electrical equipment, Wood and wood products. The lack of overtime variability may be due to the relevance of products where demand is notoriously less elastic (Meat products, Clothing, Tobacco, Beer and Footwear, Clothing, Pulp, paper and paper board, Plastic products, respectively for market size and import penetration variance at 4-digit level). Finally, the least “asymmetric” sectors according to our Gini-indicator seem to be Rubber and plastic, Textile, Electrical equipment and Tobacco.

3.2 Sector ranking – European Commission Merger and Anti-Cartel Decisions

Table 4 above reports the ranking of manufacturing sectors on the basis of European Commission’s merger and cartel investigations during the period 2000 - 2013.18 The database was assembled downloading the decisions’ record from the Commission’s website and allocating them to sectors according to the reported economic classification. If more than one sector was reported, all indicated sectors were compiled as affected by the decision.

For merger investigations we collected three types of information: the number of mergers that were unconditionally cleared in ‘first phase’ ie after a preliminary inquiry usually requiring 1 month of investigation; the number of mergers that were cleared in first phase but did instead require the parties to commit to certain conditions; the number of mergers for which a deeper investigation (‘second phase’, usually lasting approximately 4 months) was deemed necessary. We define as ‘potentially problematic’ a merger that was deemed as such at the end of the first phase investigation by the European Commission either imposing conditions or requiring further scrutiny in second phase.19 The ratio between potentially problematic mergers and the total number of scrutinised cases is the likelihood indicator used to rank sectors.

Sectors display a high heterogeneity in terms of incidence of merger control. The sector where merger scrutiny took place most often is Chemicals with an overall count of 259 decisions, while only 6 mergers were scrutinised in the Tobacco and the Leather sectors during the period of observation.

Since most of mergers are cleared without conditions, the likelihood that a merger is deemed potentially problematic by the European Commission is on average low (approximately 11 percent for the manufacturing sector as a whole). The index however varies substantially across sectors. Sectors where the index scores higher are Paper and paper products (25.4 percent), Pharmaceuticals (25 percent), Chemicals (15.1 percent), Other manufacturing (14.6 percent). At the other end, the risk of a finding of problematic merger by the European Commission is lower in Motor vehicles (1.9 percent), Wearing apparel (5.6 percent), Electric equipment (6.5 percent). Tobacco (50 percent) and Furniture and Leather (0 percent) are clearly outliers (these results are due to idiosyncratic factors and the small number of observations).

As for hard-core cartels, the Commission took decisions concerning 16 of the 22 sectors during the period of analysis. Chemicals account for the majority of rulings, 27 out of 65. Sectors with no uncovered cartels are Leather, Wood, Recorded media, Other transport equipment, Furniture and Other Manufacturing. To rank the sectors, we weighed the number of cartels to the size of the market as a share of total production in manufacturing. In the resulting ranking the sectors where the incidence of anti-cartel action was stronger in the period of observation are Chemicals, Beverages, Electrical equipment and Other non-metallic mineral products. Tobacco scores high as well, but again this might as well be due to the very small size of the sector compared to the other sectors, since just one cartel in Tobacco was sanctioned by the EC during the period of observation.

It is interesting to note that the likelihood that a merger is deemed problematic and the weighed incidence of anti-cartel enforcement are highly and significantly correlated: 51.5 percent (5 percent significance level). This provides comfort that economic sectors’ features affecting the probability of collusion play a role in determining the outcome of merger decisions.

3.3 Sector ranking - comparative exercise

We now proceed with an illustrative comparative exercise. Figure 1 below attributes colours to sectors according to their performance with respect to the different computed indicators. The idea is to give a graphical glimpse of the consistency between Antitrust Risk Indicators and the action of the European Commission. As explained above, this exercise is useful to check whether antitrust intervention is more frequent where it is expected to according to from a macro-economic perspective. It is important to keep in mind, though, that this exercise cannot provide indications as regards the quality of antitrust intervention, given the fact that sector data are not disaggregated enough to capture the boundaries of product markets as defined in the course of antitrust investigations.

The coloured squares in figure 1 reflect the ranking of the sectors ordered according to their anticompetitive risk or the intensity of antitrust action: red corresponds to the seven sectors at the top, green to the seven sectors at the bottom, and yellow to the eight sectors in the middle. Red sectors in terms of “problematic merger risk” are, as described above: Tobacco, Pharmaceuticals, Chemical, Food and Paper; in terms of risk of cartel conviction, red sectors are: Tobacco, Beverages, Other non-metallic, Chemicals, Electric equipment, Rubber and plastic, Wearing apparel.

Figure 1 suggests a significant degree of consistency between European Commission’s action both in terms of merger control and anti-cartel enforcement and ARIs related to market concentration and firm’s average size (simple correlation analysis point to significant correlation coefficients between 45 percent and 75 percent). A much lower degree of consistency is observed as regards the other ARIs and correlation results are all not statistically significant. The variance of market size (a negative proxy of market stability) is however broadly consistent with merger decisions for what concerns negative decisions ie: sectors such as Tobacco, Food products, Pharmaceuticals, Paper and paper products are ranked top both in terms of lack of market variance and of probability of negative merger decision. Cartels discovery seems also overall consistent in the top ranking for what concern import penetration (Tobacco, Other non-metallic mineral products and Beverages), variance of market size (Wearing apparel, Tobacco and Beverages), variance of import penetration and market symmetry (Rubber and plastic, Wearing apparel, Electrical equipment and Other non-metallic mineral products).

4. Conclusions

In this paper we have analysed features of European manufacturing sectors. We ranked sectors according to their performance based on indicators that economic wisdom suggests positively affect the likelihood of collusive behaviour by market players.

At 2-digit level, sectors that appear more exposed to collusion risk are Tobacco, Pharmaceuticals, Beverages, Chemicals. The 4-digit analysis suggests higher anticompetitive risk in Tobacco products, Spirits, Sugar, Railway Locomotives and Aircrafts (high concentration and fixed costs), Coating of Metals and Printing (low import penetration), Tobacco products, Meat products, Footwear and Clothing (high market stability), Plastic products and Spinning/Weaving of textiles (high symmetry of market leaders).

We also have ranked sectors according to the distribution of European’s Commission’s antitrust intervention between 2000 and 2013 in terms of merger control and anti-cartel enforcement. Tobacco, Paper and paper products, Pharmaceuticals, Food products, are the sectors in which a notified merger has a greater likelihood of being deemed problematic by the Commission. The incidence of anti-cartel action has been higher in Chemicals, Tobacco, Beverages, Electric equipment and Rubber and plastic.

We then checked the consistency of the European Commission’s action with the prediction of economic theory based on sector data, bearing in mind that sector data cannot provide for indications on the quality of antitrust intervention given the fact that antitrust investigations are based on very narrow product market definitions. The comparison exercise suggests that, by and large, both merger control and anti-cartel action have been focusing on sectors displaying a higher level of market concentrations and economic rents or economy of scale.

This paper has a descriptive nature and should be taken as a starting point for a deeper reflection on the choice of appropriate instruments to foster competition in European manufacturing sectors and the definition of intervention priorities. Without appropriate regulatory intervention, ex-ante monitoring by the antitrust authority is warranted. The action of the European Commission is sometimes considered to be too much 'case-driven'. Cartels are discovered through whistle-blowers, abuse of dominance or anti-competitive agreements’ investigations are prompted by complaints. Because of such an approach, the restoration of normal competitive conditions that antitrust intervention is supposed to bring comes often with a significant delay with respect to the starting of the infringement. Uncovered cartels’ duration, for example, fluctuates between 6 to 14 years (see Mariniello, 2013) from their commencement. During that time, cartels affect the economy through a higher burden on customers and ultimately on consumers. It would thus be more efficient to anticipate the breaking down of cartels by investing resources in uncovering cartels to monitor markets in which infringements are more likely. The European Commission already has the tools to perform such a job through so-called 'sector inquiries'; an appropriate use of those tools in the identified sectors could yield significant social benefit.


1 Symeonidis (2003) uses agreements between competitors that were formally registered in compliance with UK Restrictive Trade Practice Act of 1956 as indication of an industry’s propensity to collusion; those agreements were at the time considered lawful.

2 See Amelio and Donath, 2009.

3 There are other factors which may be relevant to explain the likelihood of collusion in a certain market: for example, the existence of cross-ownership links between players or the frequency of their multi-market contacts. However, to our knowledge those factors are not available at sector level and are therefore excluded from our analysis.

4 We presume that the average markets’ performance across the 5 countries reported in our dataset is a good approximation of the average performance of a cross-border market within the European Union. For the sake of illustration, consider the following example: we assume that averaging out the concentration ratio within the tobacco sector in UK, France, Germany, Italy and Spain yields a good approximation of the average concentration ratio of a market within the tobacco sector that has an international dimension (that is: it is not confined to just one European country and therefore falls in the competence of the European Commission). The validity of this presumption crucially depends on the degree of commonality that sectors have across countries in Europe. If the tobacco sector is very open to competition in UK while little competition in the same sector occurs in Italy, then the cross-country average may bear little indication as to the level of competition of a hypothetical tobacco market affecting Italy and UK. Instead, if cross-country variability is limited, this would suggest that sectors have intrinsic characteristics that, despite idiosyncratic country characteristics (such as domestic regulatory policy) are conducive to similar market structures. For example: a production process typically implemented in a certain sector may give raise to sector-specific economies of scale, resulting in more concentrated markets. Strong and highly significant pairwise correlations between EU-wide and national indicators in our dataset support such presumption. Confirmations are also found in the empirical literature. Hollis (2003) for example finds that concentration ratios in 82 sectors are very similar across five European economies (Belgium, France, Germany, Italy and the UK), the US and Japan.

5 Veugelers (2004) analyses 67 manufacturing sectors in the EU15, finding that concentration ratios tend to be quite stable over time. Persistency checks ran on our database point to strong and highly significant cross-year correlations for price-cost margins, import penetration and firm size.

6 We implement Griffith’s methodology except that we do not subtract for the capital costs because of data availability.

7 Alternative measures could be used to proxy entry (such as ‘business’ churn rate’ ie the sum of firms’ birth and date rate) using Eurostat and OECD datasets. However, we believe that using average firm size as an indication of barriers to entry is a better option. First, because the data on firm size are reported at a higher level of disaggregation (up to 4-digit in our dataset, while business’ churn rate is limited to 2-digit in the Eurostat/OECD dataset). Second, because the number of companies that enter or exit a sector is less informative about the disruptive power that those firms can exert on potential collusive agreements. A high number of small firms entering small markets within a sector affect positively the sector’s business’ churn rate, but this is unlikely to represent a threat to collusive agreements between bigger companies in wider markets. An extended discussion on alternative indicators to measure entry likelihood is reported in the Appendix.

8 The Gini index expresses inequality among values of a frequency distribution and ranges from 0 (complete equality) to 100 (extreme inequality).

9 Formally, we compute the Gini index as follows: Index = 1- (7*x4 + 5*x3 + 3*x2 + x1)/4; where x1 is the production share of the top company normalized to the production share of the four companies (or concentration ratio).

10 Source: Eurostat.

11 Source: The World Bank.

12 Euromonitor International (link) is a research and data company that collects and aggregate data at sector level from official sources as well as through market research. The data obtained through market research in our dataset consists of production value and production shares for the year 2010 of up to five top companies for all manufacturing sectors in the 5 target economies for our analysis.

13 Total production is the total revenue of all locally-registered companies, excluding taxes and subsidies on products like VAT; valued added equals total production minus intermediate consumption; the gross operating surplus equals value added minus labour costs and taxes less subsidies on production and therefore includes the remuneration of equity and the depreciation of capital; market size consists of the value of all goods and services sold, either from local or foreign producers and recorded at purchaser prices; imports consist of the value of goods delivered at the frontier and consumed in the country; exports consist of the value of goods shipped out of the country, excluding re-exports; the number of firms is made up by all locally-registered companies, including 0 employees enterprises and single-employed; production values and shares of top companies refer to the revenues made by companies from industry-specific products.

14 epp.eurostat.ec.europa.eu/portal/page/portal/nace_rev2/introduction

15 Two 2-digit sectors – Coke and refined petroleum products, and Repair and installation of machinery and equipment – are left out of our analysis.

16 The great difference between market size and production for the Tobacco sector is given by secondary production, i.e. production of Tobacco products made by companies falling in other categories.

17 Profit margins are calculated with respect to estimation of marginal costs that includes intermediate goods and services. As explained above, this is a standard methodology in the literature, although alternative measures could rely on labour costs only – depending on what is considered a better approximation of total marginal costs. The methodology used in this paper therefore tends to bias downwards profit margins of sectors that rely heavily on intermediate goods and services, such as motor vehicles or other transport equipment.

18 Data were retrieved from the website of the European Commission’s Directorate-General of Competition through the case search tool: link.

19 We opted for this definition in order to guarantee the maximum degree of statistical compatibility between merger decisions, since the ones used for the indicators are taken all at the end of a first phase investigation. Alternative definitions could also be possible. For example it could be possible to further segment mergers that were investigated in ‘second phase’ in mergers cleared with conditions, mergers cleared with no conditions and blocked mergers. A problematic merger could then be defined as a merger for which conditions were imposed at the end of either first or second phase investigation or a blocked merger. However, this would have implied mixing decisions taken after different administrative processes and with different depth of scrutiny. It should be said in any case that the ranking of sectors is not affected by the choice between the two different definitions.

20 According to the Eurostat definition, “the enterprise is the smallest combination of legal units that is an organisational unit producing goods or services, which benefits from a certain degree of autonomy in decision-making, especially for the allocation of its current resources”. Births and deaths account for the creation or dissolution of entreprise units, thus excluding mergers, break-ups or restructuring of a set of enterprises.


Altomonte, C., Nicolini, M., Rungi, A., and Ogliari, L. (2010) 'Assessing the Competitive Behaviour of Firms in the Single Market: A Micro-based Approach', Economic Papers No. 409, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission

Amelio, A., and Donath, D. (2009) 'Market definition in recent EC merger investigations: The role of empirical analysis', Concurrences No. 3

Buccirossi, P., Ciari, L., Duso, T., Spagnolo, G., and Vitale, C. (2013) 'Competition policy and productivity growth: An empirical assessment', Review of Economics and Statistics No. 95.4: 1324-1336

Combe, E., Monnier, C., and Legal, R. (2008) 'Cartels: The probability of getting caught in the European Union', BEER paper No. 12

Davies, S. W., and Geroski, P. A. (1997) 'Changes in concentration, turbulence, and the dynamics of market shares', Review of Economics and Statistics No. 79.3: 383-391.

Griffith, Rachel, Rupert Harrison and Helen Simpson (2010) 'Product Market Reform and Innovation in the EU*', The Scandinavian Journal of Economics No. 112.2: 389-415.

Gual, Jordi, and Núria Mas (2011) 'Industry characteristics and anti-competitive behavior: evidence from the European Commission’s decisions', Review of Industrial Organization No. 39.3: 207-230.

Ilzkovitz, F., Dierx, A., and Sousa, N. (2008) 'An analysis of the possible causes of product market malfunctioning in the EU: First results for manufacturing and service sectors', Economic Papers No. 336, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission

Ivaldi, M., Jullien, B., Rey, P., Seabright, P., and Tirole, J. (2003) 'The economics of tacit collusion', IDEI Working Paper 186

Kee, H. L., and Hoekman, B. (2007) 'Imports, entry and competition law as market disciplines', European Economic Review No. 51.4: 831-858

Kelchtermans, S., Cheung, C., Coucke, K., Eyckmans, J., Neicu, D., Schaumans, C., Sels, A., Vanormelingen, S., and Verboven, F. (2011) 'Monitoring of Markets and Sectors Report', AGORA-MMS project, Katholieke Universiteit Leuven

Konings, J., Van Cayseele, P., and Warzynski, F. (2001) 'The dynamics of industrial mark-ups in two small open economies: does national competition policy matter?' International Journal of Industrial Organization No. 19.5: 841-859.

Mariniello, Mario (2013) 'Do European Union fines deter price-fixing?' Policy Brief 2013/04, Bruegel

Motta, M. (2004) Competition policy: theory and practice, Cambridge University Press

Neven, D., and Zenger, H. (2008) 'Ex post evaluation of enforcement: a principal-agent perspective', De Economist No. 156(4): 477-490

Symeonidis, G. (2003) 'In which industries is collusion more likely? Evidence from the UK', The Journal of Industrial Economics No. 51(1): 45-74

Veugelers, R., Davies, S., De Voldere, I., Egger, P., Pfaffermayr, M., Reynaerts, J., Rommens, K., Rondi, L., Vannoni, D., Benfratello, L., and Sleuwaegen, L. (2002) 'Determinants of industrial concentration, market integration and efficiency in the European Union', chapter 3 in Dierx, A; Ilzkovitz, F. and K. Sekkat (eds)

European Integration and the functioning of product markets, European Economy, Special Report Number 2, EC, DG ECFIN: 103-212

Appendix 1 – Alternative ways to measure likelihood of entry

In this paper we have used firm size as an indication of entry costs. Firms in sectors with higher barriers to entry are expected on average to be bigger in size. Another way to proxy likelihood of entry consists in measuring the actual number of enterprise births and deaths using the Business Demography datasets of Eurostat and the OECD20. A summary indicator for firms’ turnover is the business churn, obtained as the sum of the birth rate and the death rate over the number of active enterprises in a given year. The higher is the churn rate, the easier is for firms to enter or exit a sector. Table A below reports the indicator used in this paper, firm size, and business churn in two separate columns at two-digits NACE 2.

As it can be noted, the sectoral disaggregation of the two indicators differs. In particular, the Eurostat Business Demography/OECD dataset provides data at a more aggregated level than the level of analysis used in this paper. This makes the comparison between the two indicators difficult as sectors included in the same group in the Business Demography dataset may have very heterogeneous firms’ size. For example, the Tobacco sector has the highest average firm size but Tobacco is aggregated with Food and Beverages in Eurostat and OECD datasets, which have average firm size about 10 times smaller. A rough comparison yields mixed results. Sectors with the highest business churn (ie Textiles, Wearing apparel, and Leather products) have very low firm sizes – consistently with the approach adopted in our analysis. However, sectors with higher firm sizes (eg Motor vehicles and Transport Equipment) also display relatively high churn rates. A possible explanation for this divergence is that high entry and exit rates may be due to high flows of small companies in narrow markets within a sector. If a high number of small companies enter or exit small markets in a sector, this significantly increases the sector’s reported average churn rate. However, the ‘disruptive’ effect on collusion brought about by these companies can be very limited, given their small size. For that reason, we believe that using firm size is a better measure to indicate the exposure of the sector to external competition for the purposes of the analysis reported in this paper.

Another way to measure barriers to entry is to use sector capital and R&D intensity as in Gual and Mas (2011) and Symeonidis (2003). A high capital intensity, as measured by investment in tangible goods over value added, might imply that firms need to make expensive investments in order to operate at an efficient scale. Similarly, a high R&D intensity, as measures by R&D spending over value added, may point to high costs incurred to differentiate or improve their products. Thus, capital and R&D costs may represent fixed or sunk costs that reduce likelihood of entry. The two indicators are also displayed in Table A.

Again testing the similarity between these alternative measures and firm size is difficult due to the different level of aggregation of the sectors. Nevertheless, a rough comparison suggests a higher degree of consistency compared to what observed in the case of business churn rate. Excluding Tobacco, the correlations between capital intensity and firm size and between R&D intensity and firm size are respectively as high as 44 percent and 72 percent. Taking the sum of the capital and the R&D intensity the correlation with firm size reaches 89 percent.

Antitrust risk in EU manufacturing: A sector-level ranking (English)
Tue, 08 Jul 2014 08:13:22 +0100
<![CDATA[Cold water on Europe’s digital dream]]> http://www.bruegel.org/nc/blog/detail/article/1380-cold-water-on-europes-digital-dream/ blog1380

This Opinion was published by Handelsblatt on 4th July 2014.

Cold water was poured on Europe’s digital dream on Wednesday this week. The decision that European Commissioner for Competition Joaquín Almunia just announced, the conditional clearance of the Telefonica/E-Plus merger in Germany, could be the worst of his entire term. It might not only imply higher prices for German users. It could have painful consequences for all European citizens, dispelling hopes of a “connected continent” where cheap and reliable access to fast telecom services would be guaranteed everywhere to everyone in Europe.

The Telefonica/E-Plus decision reduces the number of mobile network operators from four to three in Germany, where users are already charged amongst the highest tariffs in Europe. The decision relies on remedies that will not prevent price increases and will not incentivise future investment in new infrastructure. The decision is a landmark because it sets a dangerous precedent: that a significant reduction in competition is acceptable, despite weak remedies offered by the merging companies. It opens the door for a new consolidation wave in other European national telecom markets.

When assessing a merger the Commission needs to answer a simple question: will the merger harm consumers? Finding the right answer entails the appraisal of a tradeoff: the reduction in competition might be compensated for by other effects, such as a reduction in costs because of a more efficient allocation of network capacity, or a greater incentive to invest in new infrastructure, which can benefit users through higher quality of service or even lower prices. This is normally not an easy call for the Commission. But in the Telefonica/E-Plus case, all indications seem to point to a setback for consumers and an unexpected victory for operators’ shareholders.

According to the comments of antitrust officials reported in the press, price rises as a consequence of the merger could be up to 17 percent for an average mobile plan, with peaks of up to 37 percent in the pre-paid market, in which the two companies have a market share of approximately 60 percent. To counter such effects, the Commission will require the parties to release up to 30 percent of their wireless spectrum capacity to “virtual operators” that is mobile operators that do not have their own network but purchases network access wholesale. According to the Commission, currently Telefonica holds approximately 15 percent of the German market. The merger between the two will create the biggest network operator in Germany with around 30 percent market share. Releasing 30 percent of the capacity of the new company will therefore amount to approximately 9 percent of the market. Even in the most optimistic scenario where one virtual operator would buy access to the total spectrum divested,  it seems unlikely that it will be able to guarantee the same level of competition that existed before the merger with slightly more than half of the market capacity previously supplied by Telefonica.

A virtual operator, moreover, cannot be expected to impose the same competitive threat as a network owner, which is in full control of its future business strategies. Network owners can, for example, price more aggressively today while planning to expand the network in the future. The virtual operator's access to the network is guaranteed by the merger remedy, but the virtual operator nevertheless remains dependent. When the remedy expires, it is unlikely that the virtual operator will access the network on the same conditions, and its ability to compete at retail level could be hampered.

The most puzzling aspect of the Commission’s decision, however, is the (non)existence of any value added from the merger from a user perspective, because the benefits of a larger network could be achieved in other ways. In several other markets (UK, Denmark, Sweden, to mention some) “network sharing agreements” allow users to access a bigger network as in the case of a merger. If well crafted, these agreements can ensure cost-savings and incentives for investment. However, since the operators sharing their network are still separate entities, they retain an incentive to compete at retail level. Therefore, consumers can still benefit from the wider network without necessarily experiencing higher prices. In the past Telefonica and E-Plus were reported to have engaged in talks to enter into a network sharing agreement. It would therefore have been plausible for the Commission to consider this as a most likely alternative scenario in the event of a prohibition of the merger.

From the perspective of operators, clearly a merger is more profitable. That should not concern the Commission; the Commission should just be concerned with finding the best way to incentivize investment while protecting users from price increases. With the Telefonica/E-Plus decision, the Commission is instead effectively encouraging all network operators in Europe to merge instead of entering into network sharing agreements, meaning less competition with no increased investment incentive.

The Telefonica/E-Plus decision is particularly unwelcome because it concerns one of the least competitive telecom, and most profitable mobile, markets in Europe. 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.

Fri, 04 Jul 2014 10:45:55 +0100
<![CDATA[T-(rompe-l’Oeil)-LTRO]]> http://www.bruegel.org/nc/blog/detail/article/1379-t-rompe-loeil-ltro/ blog1379

Yesterday the ECB’s Governing Council unveiled further technical details on its new programme of Targeted Long-Term Refinancing Operations (TLTRO). This was announced on the 5th of June and at present it constitutes the main hope for the ECB to be able to fight the risk of deflation in the euro area, given that no asset purchase programme has yet been announced. I already pointed out that several important points were quite vague in the initial ECB announcement. Some of these have been clarified, but the most important issue is still unaddressed - how (if at all) will banks be prevented from using the funds to buy government bonds?

The first clarification concerns the criteria behind the allocation of funds. As a reminder from my previous piece, the TLTRO will work in two phases. Under the first phase, banks will be able to borrow up to an initial allowance, in two operations in September and December 2014. The Initial allowance is defined as 7% of the outstanding amounts of loans to euro area non-financial corporations and households, excluding loans to households for house purchase, as of 30 April 2014.

This was known since the beginning, but it is interesting to learn that banks will be given the possibility to participate to the TLTRO as standalone borrowers or in “TLTRO groups”, provided they can qualify as sufficiently “closely linked”. This can potentially leverage the effectiveness of the TLTRO. The borrowing limits applicable to the leading institution of a TLTRO group will be calculated on the basis of the outstanding amounts of eligible loans and eligible net lending granted by all members of the TLTRO group in aggregate. The funds will then be presumably spread out across the members of the group, so that some members could benefit from a larger amount of funds than they could get if they were participating as standalone borrowers.

More interesting are the criteria that will apply for the second phase of the TLTRO, the one that should allows “leveraging” the measure beyond the initial allowances and at the same time imposing the incentive for banks to actually use the funds for lending to the economy. Between March 2015 and June 2016, banks will in fact be able to borrow additional amounts that can cumulatively reach up to three times each bank’s net lending provided between 30 April 2014 and the respective allotment reference date, in excess of a specified benchmark. It goes without saying that the definition of the benchmark is crucial for the success of the programme.

The  ECB has specified yesterday how the benchmark will be computed, and as anticipated, it looks rather generous. In particular, the benchmark will differ depending on the net lending position of banks. For banks that had positive or zero eligible net lending in the 12-month period up to 30 April 2014, the benchmark will be set at zero eligible net lending (see Chart 1). This basically means that in order to qualify for the 6 TLTROs conducted from 2015 on, banks will just need not to shrink their balance sheet and perhaps do a little bit better than they did over last year, depending on how much they wish to leverage in the second phase (the bigger their net lending from now on, and the larger the amount they will be able to borrow under the second wave of TLTROs).

For banks that instead had negative eligible net lending over last year, the benchmark will be a function of the average monthly eligible net lending achieved in the twelve months to 30 April 2014 (so a negative bechmark) until June 2015, then it will be set to zero as for the other banks.

Source: ECB

In practice, this is nothing but a complicated way to say that it should be rather easy for banks to qualify for the funds. “Virtuous” banks, who were already increasing their lending to the economy over last year will be required basically not to shrink their balance sheet or do a little better than they were doing. Banks that were instead contracting their balance sheet will be allowed some more time before having to turn to positive net lending. Over that period they will be just required to deleverage at a slower pace than they were doing until now, but they will be able to borrow.

Up to here, positive news that should favour a big take up of the TLTRO - Draghi proved optimist in the press conference, anticipating that banks could decide to borrow in the order of 1trn. However, one point remains apparently unaddressed and it is a crucial one. The ECB in fact has not added clarity about how (if at all) banks will be prevented from using the funds to buy government bonds. Banks could use part of the funds borrowed in Phase 1 to buy government bonds and still qualify for Phase  2, but even in case they were not to qualify the only consequence at the moment appears to be that they would be forced to repay the funds earlier but could still enjoy the profits of a carry trade in the meantime. More generally, there seems to be no specific constraints once the funds are borrowed and, as noted by several analysts, there seems to be no penalties in view for the banks that do not meet the benchmarks. This is definitely not a second order issue, as it could be appreciated over the last 2 and ½ years, and it constitutes an important flaw of the previous LTRO operations.

Until there is a clear solution to the issue of monitoring the use of funds, the additional “T” is just a Trompe-l'œil.

Fri, 04 Jul 2014 08:18:10 +0100
<![CDATA[New investment approaches for addressing social and economic challenges]]> http://www.bruegel.org/publications/publication-detail/publication/833-new-investment-approaches-for-addressing-social-and-economic-challenges/ publ833

This paper aims to provide an introduction and overview about the social investment market for OECD member countries. Social investment is becoming increasingly important as a way to address both social and economic challenges. Several OECD member countries have been active in creating policies and support mechanisms for social investment. This paper seeks to provide background information on social investment, demonstrate how the market is evolving and highlight the role that policy makers can play in facilitating the development of the market.

The OECD wishes to thank the Bertelsmann Foundation for their generous support of this work.

Paper at the OECD

New investment approaches for addressing social and economic challenges (English)
Fri, 04 Jul 2014 07:19:19 +0100
<![CDATA[Launch of the Memos to the new EU leadership]]> http://www.bruegel.org/nc/events/event-detail/event/450-launch-of-the-memos-to-the-new-eu-leadership/ even450

The new Commission, European Parliament and President of the European Council will enter office at a challenging time for Europe, the EU and the Commission itself. The results of the European elections, combined with the ongoing economic challenges, clearly call for the delivery of effective change and impacting measures.

At this event Bruegel will launch its Memos on Europe's economic priorities for the next mandate of the European Institutions. These Memos, addressed to the next Presidents of the European Institutions and to new European Commissioners, are written by different Bruegel Scholars and focus on the crucial economic aspects of the EU policy-making.

Focusing on the most important economic questions at the EU level, the individual memos are intended to be a strategic to do list, outlining the state of affairs, the key challenges and priorities our individual scholars consider central in the next five years.

Note that the programme is still under construction and will be updated regularly.

Programme Download

10:00 Welcome by Guntram Wolff

10:10-10:30 Overview of policy recommendations by André Sapir and Guntram Wolff

10:30-11:30 Which way for growth?

Presentation of memos to Commissioners Digital Agenda, Competition Policy, Research, Knowledge and Education, Single Market

  • Scholars presentations: Mario Mariniello, Reinhilde Veugelers, Karen Wilson
  • Discussants: Wolfgang Kopf, Senior Vice President for Public and Regulatory Affairs, Deutsche Telekom and Antoine Aubert Head of Brussels Policy Team, Google
  • Moderator: André Sapir

11:30-12:00 The macro-financial agenda and employment challenge

Presentation of memos to Commissioners Economic and Monetary Affairs, Employment and Social Affairs, Financial services

  • Scholars presentations: Zsolt Darvas, Nicolas Veron,
  • Discussant: Inigo Fernandez de Mesa (tbc)
  • Moderator: Guntram B. Wolff

12:00 – 12:45 Europe and the global challenges

Presentation of memos to Commissioners Trade, Neighborhood Policy, Climate Policy, Energy, Migration

  • Scholars presentations: Jim O’ Neil, Suparna Karmakar and Georg Zachmann
  • Discussants: Suman Bery, Shell (tbc)
  • Moderator: André Sapir

IN PARALLEL Press Corners organized for in-depth interviews between scholars and the specialized press

12.45 Sandwich Lunch

Event materials

Read the first Memo: The great transformation: Memo to the incoming EU Presidents

<iframe width="560" height="315" src="//www.youtube.com/embed/MCewmK9NBow" frameborder="0" allowfullscreen></iframe>

Practical details

  • Venue: The Hotel, Boulvard de Waterloo 38, 1000 Brussels
  • Time: Thursday 4 September 2014, 10.00-12.45.
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Thu, 03 Jul 2014 15:07:16 +0100
<![CDATA[The Financial Stability Board’s work in progress on ending Too-Big-To-Fail]]> http://www.bruegel.org/nc/events/event-detail/event/449-the-financial-stability-boards-work-in-progress-on-ending-too-big-to-fail/ even449

The financial crisis has highlighted the longstanding challenge of resolving large and complex financial institutions which tend to be, as the saying goes, “international in life but national in death”. While this challenge is partly addressed within the EU by the Single Resolution Mechanism and the Bank Recovery & Resolution Directive, it raises different questions at the global level. The Financial Stability Board is tackling it through ground-breaking work on “ending TBTF”, including the distinction between single-point-of-entry and multiple-points-of-entry resolution approaches and the introduction of minimum requirements for “gone-concern loss-absorbing capital” (GLAC) which are still being debated.


  • Andrew Gracie, Executive Director for Resolution, Bank of England
  • Wilfred Nagel, Chief Risk Officer, ING Group and ING Bank
  • Waleed El Amir, Head of Group Strategic Funding, UniCredit
  • Chair: Nicolas Véron, Senior Fellow, Bruegel

About the speakers

Andrew Gracie joined the Bank of England in 1988 and has worked there in Financial Stability, Markets, and Banking Supervision. Between 2006 and 2011 he left the Bank to create a specialist consultancy, Crisis Management Analytics. He came back to the Bank in 2011 to run its Special Resolution unit, and is leading the Bank’s participation in FSB proceedings in this area.

Wilfred Nagel joined ING in 1991 and has been a member of its Executive Board since May 2012. After various executive positions in Asia and the Americas, he became head of Group Credit Risk Management in 2002, CEO of ING Wholesale Bank Asia in 2005, and CEO of ING Bank Turkey in 2010. He holds a Master’s Degree in Economics from VU University Amsterdam, and started his banking career at ABN Amro in 1981.

Waleed El Amir oversees UniCredit’s funding across entities and liability management, and manages the bank’s structural and strategic investment portfolios. He is also Vice Chairman of UniCredit Luxembourg. Prior to joining UniCredit in 2012, he had worked for 16 years at Merrill Lynch and Bank of America in New York, London, and Dubai. He holds a Master’s Degree in Biochemical Engineering from the University of Surrey and an MBA from NYU Stern.

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Bruegel
  • Time: Thursday 3 July 2014, 8.15-10.00
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Thu, 03 Jul 2014 10:41:27 +0100
<![CDATA[The great transformation: Memo to the incoming EU Presidents]]> http://www.bruegel.org/publications/publication-detail/publication/832-the-great-transformation-memo-to-the-incoming-eu-presidents/ publ832

Bruegel Policy Brief 04/2014 is addressed to the incoming Presidents of the European institutions. It is the first in a series of memos to the new European leadership to be launched in September, which will address individual Commissioners with priorities for their portfolio. Take part in the debate using hashtag #EU2DO.

The European Union’s leadership spent the last five years fighting an acute and existential crisis. The next five years, under your leadership, will be no less difficult. You will have to tackle difficult economic and institutional questions while being alert to the possibility of a new crisis. You face three central challenges:

  1. The feeble economic situation prevents job creation and hobbles attempts to reduce public and private debt;
  2. EU institutions and the EU budget need reform and you will have to deal with pressing external matters, including neighbourhood policy and the EU’s position in the world;
  3. You will have to prepare and face up to the need for treaty change to put monetary union on a more stable footing, to review the EU’s competences and to re-adjust the relationship between the euro area and the EU, and the United Kingdom in particular.

The EU needs to adapt its economies to the global Great Transformation by deepening the single market, improving product markets and improving governance. This strategy needs to be combined with measures to boost the public capital stock to reap demand and supply-side benefits. A reform of the EU budget is imperative to orientate it more towards growth, while reform of the Commission should deliver a more coherent approach to growth policies. Neighbourhood policy should be redesigned to allow for different forms of collaboration and global trade should be promoted.

Finally, the treaty reform will have to focus on concrete measures to create a fiscal capacity with appropriate legitimacy and a new relationship with the UK.

State of affairs

Your predecessors as presidents of the European Commission, European Council and European Parliament spent a good part of their mandate fighting the financial crisis and creating mechanisms – primarily the European Stability Mechanism and the European Banking Union – that were left out of the Maastricht design of Economic and Monetary Union (EMU). Your terms of office will be no less challenging. You will have to solve deep and difficult economic and institutional problems, while being alert in case of a new crisis. The European Council of 26-27 June 2014 defined a broad political agenda for the next five years, but you will have to take the lead in spelling out a more precise agenda.

You face three challenges. First is the economic situation. The financial crisis is receding but huge economic problems remain. Unemployment in Europe is at record highs and goes a long way to explain voter dissatisfaction with national and European leaders. Debt levels are historically high. Economic growth has turned positive again but remains far too feeble to alleviate the high joblessness or meaningfully reduce public debt, in particular in countries with high debt levels.

But it would be a mistake to think that Europe’s economic challenge stems only from the crisis. All European Union countries need to adapt their economies and even societies to the Great Transformation resulting from the combined forces of globalisation, demographic, technological and environmental change. This transformation started well before the crisis. European leaders agreed already in 2000 to modernise their societies: the Lisbon Agenda to create a competitive knowledge-based economy with sustainable growth, more and better jobs and greater social cohesion. Had Europe implemented the Lisbon Agenda, it would probably not have avoided the crisis, but it would have been in much better shape to rebound more strongly and quickly.

Unlike Europe, emerging countries remained relatively immune to the financial crisis. They continue to forge ahead. In this respect it is good to consider two key facts: in 2013 emerging and developing countries together accounted – for the first time since at least 1850 – for more than 50 percent of global GDP; meanwhile, the average public debt-to-GDP ratio of these countries dropped below 40 percent, while it nearly reached 110 percent in the advanced economies.

Your second challenge is twofold: reforming the functioning of the EU institutions while dealing with pressing external matters. You must deal with growing scepticism about the EU and tackle pressing strategic questions that have remained unresolved for several years. The success of eurosceptic parties in the European elections will force you to focus on results for citizens. For this, the work on economic growth is necessary but not sufficient. The EU is still perceived as wasteful, bureaucratic and undemocratic. You will have to improve the internal working of the EU and of its institutions, manage the relationship between the euro area and the EU countries outside it (the United Kingdom in particular). You will also have to rethink the EU’s neighbourhood strategy and strengthen the EU's place in the world.

Your third challenge is to face up to the need for EU treaty change. The economic and financial crisis has resulted in calls for ‘More Europe’ but also for ‘Less Europe’. These contradictory demands are not necessarily addressed to the same areas of competences that are centralised or not at European level. Many citizens might be in favour of ‘More Europe’ in some areas and ‘Less Europe’ in others. A more fruitful approach is to seek a ‘Better Europe’, with some further competences allocated to European level while others remain at, or are even repatriated to, national level. This implies greater clarity in the division of responsibility between Europe and its member states, and also greater effort to ensure that Europe delivers better results in the areas for which it has clear responsibility.

The crisis has shown that euro-area countries need deeper banking, economic, fiscal and therefore political integration than envisaged by the Maastricht treaty. Some of your predecessors suggested the creation of a ‘Genuine Economic and Monetary Union’ that would go well beyond the existing EU treaty and the inter-governmental treaties put in place to strengthen the euro area’s architecture. Although there might be a natural tendency to put aside this discussion while the pressure from the financial crisis hopefully continues to decrease, it would be a severe mistake to wait for the next crisis to reopen the discussion.

Such deeper integration among euro-area countries inevitably raises urgent questions about the relationship between the EU and the euro area.

You will need to work in parallel on these challenges but the timing of their outcomes should be different. The economic challenge is the most urgent. Europe needs to deliver growth and jobs soon to regain the trust of its citizens. You will need to put forward a credible growth strategy in time for the December 2014 European Council and start implementing the strategy by mid 2015. You will also have to settle some of the governance issues very soon, ideally by spring 2015. You should strive to have the June 2015 European Council adopt a Declaration on the Future of the European Union, involving a Committee on the Future of the European Union, which would make proposals for treaty changes relating to the governance of the euro area and the relationship between the EU and the euro area.

It goes without saying that the challenges in front of you are immense. Success will only be achieved if the three of you work closely together and with the heads of state and government of the member states. Nevertheless it would be rational that the Commission, which has executive and surveillance responsibilities, leads on the economic issues and on the reform of the Commission, while all three lead on pressing external issues, and the European Council and Parliament lead on the institutional track. The rest of this memo will deal with each issue in turn.

A European strategy for growth

You will constantly have to remind your European Council colleagues that Europe is losing relative weight, and that its demographic developments are unfavourable. Europe needs a growth strategy based on deeper global trade integration, more openness to immigration, improved educational systems and a better functioning internal market. It will also need to step up public investment and domestic demand.

In particular, your growth agenda must provide a convincing response to Europe’s immediate and medium-term economic challenges. This entails both closing the output gap and increasing potential output. The strategy therefore needs demand measures to increase aggregate demand and close the output gap, and supply measures to increase potential output. Investment, which remains depressed in most EU countries, is key. Boosting investment would increase aggregate demand in the short term and increase potential growth in the medium term. The focus of the European growth strategy should therefore be to improve the investment climate in Europe. In this respect, much of what needs to be done is ultimately the responsibility of member states. But Europe has its own instruments, which matter for investment and growth.

Member states can and must implement structural measures in several areas. The first is the functioning of product markets, into which entry by new suppliers often remains hampered by various barriers. This is especially true in services. Second are labour market and social policies (including basic education, training and life-long learning), which badly need to be modernised. Greater flexibility and better security for workers are essential features in the age of Great Transformation. Third is the functioning of the state, including the justice system and public administration. Finally, higher education systems in many countries remain ill-adapted for the economies of the twenty-first century and continental Europe still lacks global top-notch universities.

Although all EU countries need to implement structural measures, some will require your special attention because of their size: France, Germany and Italy. They account for two-thirds of euro-area and half of EU GDP. Germany is healthy with low unemployment and its public finances under control. Yet German investment remains fairly weak, which is a pity first and foremost for Germany, which could use more private investment to boost its competitive position and more public investment in education and in infrastructure. But it is also unfortunate for the rest of Europe, which would benefit from more aggregate demand and higher medium-term growth in the EU’s largest economy. The situation in France and Italy is much less promising. There, unemployment is dangerously high and public finances are over-stretched. Further economic difficulty in one of these two countries could reignite problems in the euro area, where the economic situation remains fragile.

You have relatively little leverage over these three countries. For France and Italy, the Commission has the arsenal of fiscal rules at its disposal, but the size of the countries gives them bargaining power and everyone knows it. For Germany, which has large and persistent current account surpluses, the Commission has used and can use again the Macroeconomic Imbalance Procedure to demand reforms that would expand domestic aggregate demand. But again there are clearly limits to what can be achieved. Your real power lies not so much in the use of formal procedures, though clearly they should be used like for any EU country, but in your capacity to convince the three big countries to act in their own interests, and that not doing so would damage the euro area and the entire EU. Of Europe's own instruments, the most important is the single market. It is simply unacceptable that 30 years after the launch of the single market programme, and more than 20 years after it was supposed to have been completed, the single market is still far from reality in vital areas such as services, digital sectors, energy and research. Your commitment to complete the single market would be an important signal that Europe is again serious about fostering investment and growth.

The second instrument is the EU budget, which needs substantial reform to enhance growth. Although the 2014-20 multiannual financial framework (MFF) contains useful tools to improve Europe's investment climate, you will have the opportunity to leave your mark in 2016 when the MFF is reviewed. The review should not just consider changes in expenditure, but also in the way the EU budget is financed. Moving away from national contributions, currently the main source of financing, is essential to turn the EU budget into a budget for Europe rather than one dominated by a national, ‘juste retour’ logic. This would allow the budget to be refocused on European public goods, for example energy security, energy efficiency, a digital single market and EU-wide mobility schemes for young workers, instead of ineffective redistribution. Luckily, your predecessors appointed a High-Level Group on EU Own Resources, which will make proposals in time for the 2016 MFF review.

The EU budget, along with regulation, can and should be used to promote better the single market in industries that require trans-European networks to link regional and national infrastructure. This includes interconnection and interoperability, mainly for transport and energy, but also for information and telecommunications technology. In this respect, it would be important to expand the European Commission-European Investment Bank Project Bond Initiative, launched on a pilot basis in 2012.

But the EU budget should also be used to promote structural reform in EU countries. This could include, for example, making the disbursement of Structural Funds conditional on administrative reform. The European Social Fund should be used primarily for the modernisation of labour markets and move social policies towards greater flexibility and better security. The European Regional Development Fund should be used as a matter of priority to improve the administrative capacity and effectiveness of regional and national public bodies.

But these instruments alone will be insufficient to provide a meaningful demand stimulus to kick-start EU growth. You should broker a deal in the European Council to get a European investment boost. Public investment should be increased by about €100 billion in 2015 and 2016. About half of this should be the product of national fiscal policies, by increasing public investment and creating new incentives for private investment. You should also ask member states with fiscal space to stop over-performing on the achievement of fiscal targets. The other half of the investment programme should be conducted at EU level, by boosting the capital base of the EIB and implementing project bonds. Economically weaker, high unemployment countries should benefit disproportionally.

This growth strategy will be critical for achieving higher growth, which will be paramount for employment creation and for the sustainability of public and private debt in Europe. Failure to achieve higher real and nominal growth would render debt trajectories problematic in countries with currently high debt levels.

Reforming the EU Institutions and dealing with pressing external matters

The European Commission needs reform to implement the growth strategy. This mostly concerns the European Commission president, but the European Council and Parliament presidents will also have to agree on certain issues.

  • An effective Commission would have only a dozen policy areas in which it would take action. While the number of commissioners cannot easily be reduced, you should acknowledge that not every commissioner can have a full portfolio without leading to inconsistency of policy and excessive activism. A solution would be for every commissioner to have the full rights of a commissioner with full vote in the College. However, not every commissioner would be responsible for a distinct portfolio. An alternative constellation would consist of several clusters of competences for which several commissioners would be jointly responsible.
  • Reducing and focusing the activities of commissioners would also allow you to pre-empt the criticism from many member states that the Commission is too active and involved in too many areas. While the assignment of competences cannot be changed without treaty change, you as Commission president could apply a more rigorous internal review of whether any new initiative is really necessary and whether major spillovers across the union justify it. You should ensure the strict application of the subsidiarity principle.
  • You as the new Commission president should appoint a senior vice president without portfolio responsible for the European growth strategy. The senior vice president would oversee all the relevant Commission activities to ensure that policies are implemented to their maximum effectiveness to promote growth. There would be a particular focus on single market and industry, digital agenda, science and research, education and skills, and regional policy. The senior vice president would have a small staff, consisting essentially of the part of the General Secretariat currently in charge of the Europe2020 strategy.
  • The enterprise and single market portfolios should be merged into a single market and industry portfolio to emphasise that European industrial policy should be about framework conditions and deepening the single market while reducing national regulatory fragmentation. Industrial policy based on subsidies and support for national champions is not the right approach for more growth and jobs in Europe.
  • Your economic and financial affairs commissioner must play a central role in the growth strategy, including by shaping the EU-wide fiscal stance, but she will have to operate independently of the many requests from within the Commission and focus on her mandate and the need to keep fiscal policy credible.
  • The rigorous enforcement of competition rules is central for economic performance. Attempts to make competition policy subject to narrow industrial policy interests are unwarranted, as are claims that it prevents the emergence of European champions. Many sectors remain dominated by national operators in the different national markets, and substantial regulatory barriers still prevent companies, in particular in the services sector, offering their products in other EU countries. The single market agenda is therefore more relevant than ever.
  • It is worth reflecting on competition policy decision making. Acknowledging the inherently complex nature of competition policy, a high-level committee of five impartial experts should be appointed to review once a year the actions of the European Commission, and give independent advice on the direction of competition policy. Their reports should be public and should be submitted to the European Parliament. Their recommendations would not be binding, but would guide the European Commission’s strategy and increase public awareness.

The three of you have the daunting task of rethinking and improving Europe’s neighbourhood policy, in particular with eastern and southern neighbours. The association agreements promising a ‘deep and comprehensive free trade area’ with Ukraine, Georgia and Moldova are interpreted ambiguously by different EU countries and the three countries themselves. The relationship with Turkey is still seen only through the prism of potential EU membership. You will have to seek Council backing for a broader approach, that also includes the possibility of other types of institutional relationship with the EU, which would offer more options to stabilise trade relationships while respecting broader geopolitical goals. You will also have to define an immigration policy that not only makes sense from a European point of view but also respects the humanitarian values for which the EU stands, and you will have to re-think the various financial instruments that the EU has for its neighbourhood.

But Europe’s interests extend, of course, far beyond the neighbourhood. You should further promote global trade integration and develop a strategy to deal with China’s rising trade power. By 2020, the end of your term, China will be the most important trading partner for several EU member states; already it is the second most important export partner for the EU as a whole. The Transatlantic Trade and Investment Partnership has the potential to deepen trade with the US, the EU's most important current trading partner, but does not give a convincing answer to global trade questions. Yet, for the EU as an open continent, the further development of global trade is central.

Finally, the three of you have the task of reforming the EU’s administration to reduce costs and perceived inefficiency. This should include a review of its staffing needs, including at the Council, salary structures and conditions of entry, the organisation of the European Parliament, including the question of its double seat. Some of the current hostility to Brussels comes from negative perceptions of its administration. While overall the EU institutions are rather cheap and efficient, you should deal proactively with the perceptions, and not hold back from dealing with inefficiencies.

Towards a new architecture for the EU and EMU

Solving the pressing growth and unemployment problems and adjusting the current EU neighbourhood strategy, while improving the functioning of the EU institutions, is, however, unfortunately not enough. Arguably many of the problems you will have to fire-fight are the result of the still incomplete overall EU architecture and the lack of consensus on what the EU is and what it is not. You should initiate and drive a discussion on further constitutional change in the EU. Europe still needs a grand new bargain. Many of the growth reforms and other pressing reforms are only possible if you broker a deal on the need for a broader revision of the EU’s treaty base. Conversely, the broader revisions of the treaty base are only possible if citizens believe that further EU integration in some areas is actually to their benefit. You thus face the formidable challenge of solving many currently pressing problems while working on the long-term solutions.

Reforms to the EU's architecture are critical because failure would mean that monetary union is based on an incomplete institutional set-up. In particular, fiscal mechanisms are critical for three reasons:

  • Without a fiscal union, the European Central Bank's policy measures will continue to be more controversial than those of a national central bank, because the ECB without a fiscal counterpart is more restrained in actions that could have distributional effects across different jurisdictions. In fact, arguably, the ECB’s mandate was designed by the fathers of the Maastricht treaty to prevent it from engaging in policies that could have fiscal consequences.
  • For the financial system to become fully integrated across borders, a banking union with a common fiscal backstop is necessary. While the banking union currently foresees some mutualisation of the risk that remains after significant bail-ins, there is no mutualisation of major risks, and the deposit insurance system remains fragmented along national lines. As a consequence, the financial system will remain fragmented, with banks and depositors behaving differently based on their location. More financial integration combined with the right regulation would be beneficial for growth and the efficiency of the EU economy.
  • During the crisis, fiscal policy reacted quite pro-cyclically in many instances because of the increasing market pressure on countries in distress. Moreover, the amount of aggregate fiscal stabilisation has been insufficient because coordination has proven inadequate across the union.

It is time to significantly advance this discussion on a fiscal capacity and stronger mechanisms for economic reform. The first important step should be a serious review of the EU budget with a view to adapt its expenditures towards more growth. You should undertake this immediately within the existing treaties. Other elements should include (a) resolving the unresolved questions about burden sharing in case of ECB losses; (b) agreeing on how to increase the back-stop for the banking union – a potential measure could be to accept that taxation of banks becomes completely European; (c) working on a concrete measure that would support unemployed people – the creation of a European unemployment insurance mechanism could be envisaged if labour market institutions concurrently become Europeanised. This would also answer the pressing question of how to overcome the inconsistency between monetary union and national structural and labour market policies. Many of these changes would require treaty change to create the democratic legitimacy needed to justify moving such policies to the EU level.

While fundamental reform of the architecture of monetary union is crucial, it will be equally important that you address the substantial mistrust between euro-area countries and some of the countries that do not want to join the euro, in particular the UK. The UK’s economy is of great importance to the single market and the UK is a vital EU member. EU reform is part of the answer and the UK is right that such reforms are in the interests of all EU members. But the question of the place of the UK in the EU will be core for the debate on treaty change. A result of treaty reform could be that the UK stops participating in the EU budget, while remaining in the single market for goods, services and capital, and ideally also labour. The UK would have to be granted some basic minority rights but should not be able to block vital steps needed to strengthen the single market. Such a 'second tier' EU membership could also offer a more realistic option for countries such as Turkey.

This treaty debate on deepening EMU and adjusting the relationship with the UK will inevitably be connected with a review of EU competences. Reviews of competences have been started by a number of member states, most notably the UK. You should welcome such input. All EU countries would benefit from a better allocation of competences.

You should therefore propose to the European Council in June 2015 that it adopts a Declaration on the Future of the European Union and that it appoints a High-Level Committee to make proposals for a new architecture for the EU and for the euro area. The High-Level Committee should conclude its work and report back to the European Council in December 2016.

The High-Level Committee would address three sets of questions.

  1. Does a monetary union require a fiscal and economic union and what exactly would this imply? The following themes would need to be explored:
    • What kind of fiscal backstop does a genuine banking union require?
    • Does monetary union require a fiscal stabilisation mechanism?
    • Are the current fiscal rules adequate?
    • Is a mechanism for sovereign debt restructuring necessary? How can the no-bail-out clause be made credible?
    • Should the European Stability Mechanism and the European Resolution Mechanism become EU mechanisms and be part of a euro-area budget managed by a euro-area treasury? Is the EU budget reform a condition for the creation of a euro-area fiscal capacity?
    • Does the euro area require a ‘finance minister’ with veto power over national budgets and national structural and labour market policies? Should some of these policies become EU policies?
    • What mechanisms of political accountability should be put in place to oversee the euro-area treasury and finance minister and give them political legitimacy?
  2. What should the relationship be between euro-area and non-euro area EU countries? What safeguards should non-euro area countries receive and how closely should they be linked to the main EU decision-making processes? Should their involvement in the EU be more narrowly based on the single market only?
  3. Is the current assignment of EU competences adequate? Is the current method for assignment of competences adequate? The treaty specifies that limits to EU competences are governed by the principle of conferral. The use of EU competences is governed by the principles of subsidiarity and proportionality, the application of which is specified in a protocol. Has the time come to revisit this protocol?

It is time to review all of these aspects thoroughly and come to a broader agreement about the EU's development path. Many of the essential topics are far-reaching and complex. But failure to tackle these issues would undermine progress on current problems, and could also leave the EU unprepared for new crises. The aim of the High-Level Committee would be to create a clear roadmap. Obviously not all the proposed treaty changes would need to be put in place at once; gradual change is conceivable. You should aim to have or at least to initiate a new treaty before the end of your mandate.


[1] ‘Strategic agenda for the Union in times of change’, European Council conclusions, 26-27 June 2014, available at www.consilium. europa.eu/uedocs/cms_Data/docs/pressdata/en/ec/143478.pdf.

[2] Also, the President of the European Parliament should accept that national parliaments use the subsidiarity review more often.

The great transformation: Memo to the incoming EU Presidents (English)
Thu, 03 Jul 2014 08:48:22 +0100
<![CDATA[Fact of the week: A spam newsletter caused a bank run in Bulgaria]]> http://www.bruegel.org/nc/blog/detail/article/1378-fact-of-the-week-a-spam-newsletter-caused-a-bank-run-in-bulgaria/ blog1378

It’s been a tense week in Bulgaria. Two bank runs occurred last week, with depositors withdrawing the equivalent of 10% and 20% of the assets held by two important national banks. An emergency line of 3.3bn Bulgarian levs (€1.7bn) was approved by the European Commission on Monday, and tensions in the country seem to have eased since then. The modalities and motives of this mini financial crisis are not entirely clear yet, but it seems to be deeply rooted in a long-standing domestic business and political feud.

It all started last week. After a run by depositors, the Bulgarian National Bank took control of the country’s fourth lender, Corporate Commercial Bank (KTB). The operations were frozen, the directors suspended and the bank put under special administration, in the attempt to stop what the Central Bank described as “an attempt to destabilise the state through an organised attack against Bulgarian banks”.

Two days later, the bank has been nationalised, but it was not enough. Tensions spilled over from KTB to First Investment Bank (FiB), an even bigger domestic bank. According to the Financial Times, depositors withdrew 800m lev (about $556m) on Friday from First Investment Bank, and funds appear to have been moved to the foreign-owned banks in the country.

The Bulgarian banking system is in fact dominated by foreign lenders, especially Italian Unicredit, Hungarian DSK, Austrian Raiffeisen (figure 1).


Source: Wall Street Journal

The worsening of this situation triggered the introduction of a set of emergency measures by the Central Bank and the approval by the European Commission of a 3.3 billion levs (€ 1.7bn) credit line to ensure the necessary liquidity support to the banks. Sources quoted by the FT suggest that 1.3 Lev have already been raised on Monday through a special bond issue, mainly covered by foreign banks.

In its press release, the Commission stressed that that Bulgaria's banking system is: "well capitalised and has high levels of liquidity compared to its peers in other member states". So how and why were these two banks exposed to a run?

Concerning the “how”, the Bulgarian run is interesting because it basically shows how a bank run could look like in the tech and social networking era. Both the government and the central bank have in fact claimed that the run was ignited by a “cyber attack”, for which six people have already been arrested.

According to the Bulgarian National Security Agency (see here, for a reporting in English), an investment company that “built a network of associated companies for marketing services” that was used to diffuse panic by means of an alert, uncomfortably titled “Information Bulletin of on the Risk of Deposits in Bulgarian Banks”. The “bulletin” claimed – Bloomberg reports – KTB was undergoing a liquidity shortage. The message apparently also said that the government deposit guarantee fund was under-capitalised to meet possible repayments, that banks could go bankrupt and that the peg of the currency with the euro could be broken.

Allegedly, the alert was diffused by text, email and even Facebook messages, thus ensuring a very widespread outreach. In a country that in 1997 underwent a very serious banking crisis featuring all these characteristics – whose memory is still fresh – this was enough to spur panic.

Source: Reuters

Concerning the why, the story is extremely complicated. Different interests prevail according to different versions, making it quite difficult to reach a clear conclusion, but it certainly seems to have little to do with economics and a lot to do with politics.

KTB bank – the first to all in trouble last week – is the ultimate hotspot where business feuds, personal issues, corruption, political uncertainty, tensions with Russia and pressures from Bruxelles all come together into an explosive mix. KTB bank is known to have very strong and complex political connection. According to the Financial Times, 30% of KTB is controlled by Oman and a 10% by the Russian bank VTB. The largest shareholder owning a larger than 50% stake (which, incidentally, will be written off as a consequence of the state recapitalisation) is Tsvetan Vassilev, linked to the ruling party. Several sources, including New York Times and Financial Times attribute the bank run to the unfolding of a complicated  “feud” between Tsvetan Vassilev and Delyan Peevski, another controversial prominent Bulgarian businessman owner of a media empire as well as Member of the Parliament.

The two fellows’ businesses appear to share a number of connections. The tycoon’s empire is in fact reportedly built on loans approved by the now-troubled KTB bank itself. At the same time, the successful expansion of KTB bank is partly due to the fact that the bank was able to attract an extremely large amount of deposits from state-controlled companies, offering at the same time exceptionally high interest rates on retail deposits.

This “business model” had caught government’s attention last year already, leading to a strong regulatory reaction. In May 2013, in fact, a law was approved according to which those companies in which the government had a stake of more than 50 per cent should diversify the allocation of their deposits, with a maximum of 25 per cent per bank.

Bulgarian news reports Prime Minister Marin Raykov as saying that in 2013 54 per cent of state-owned companies’ deposits were held by one bank. While Raykov declined to name the financial institution, the Sofia Globe argues that the most likely guess – and one widely made by Bulgarian media – is Corporate Commercial Bank (KTB).

Several analysts’ and news reports attribute the bank run and last week mini-crisis to the unfolding of a latent war between Peevski and Vassilev. In particular, the trigger of the crisis at KTB (controlled by Vassilev) has possibly been the withdrawal of a large amount of money by Peevski.

According to this version of the story, the money would have been moved exactly to FIB, which would have later come under pressure when allies of Vassilev retaliated by spreading rumours about its solidity. While these can be considered speculations, the relationship between the two businessmen is certainly not good now, and they repeatedly accused each other of various wrongdoings.

On top of the internal feud, the run comes at the end of a period during which political uncertainty has been mounting in Bulgaria. This is partly due to the fact that Bulgaria – which is a major transit route for Russian gas – has been caught in the crossfire between Russia and Europe over the country’s participation in South Stream.

The Prime Minister announced his resignation and the country will most likely see anticipated elections, while Standard & Poor’s cut Bulgaria’s sovereign rating to triple-B minus, citing political instability as the main concern. Such nervous and precarious political environment, coupled with the fact that Bulgaria is one of the countries most affected by corruption, offers little protections against the unfolding of business and political feuds like the one that appears to have been behind the bank run of last week.

Luckily, contagion seems to have been stopped before turning these embers could ignite a more serious fire.

Wed, 02 Jul 2014 14:43:05 +0100