<![CDATA[Bruegel - Latest Updates]]> http://www.bruegel.org Fri, 31 Oct 2014 10:33:39 +0000 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[Held og lykke, Commissioner Vestager]]> http://www.bruegel.org/nc/blog/detail/article/1470-held-og-lykke-commissioner-vestager/ blog1470

Tomorrow, new European Commissioner Margrethe Vestager will take control of the Commission’s most powerful tool: the enforcement of European Union competition law. She will have the power to block mergers or require the sale of companies’ assets for deals go through. She will be able to fine companies that breach antitrust rules up to 10 percent of their global turnover. She can oblige EU member states to take back subsidies granted to firms if the money gives an unfair advantage.

The power of the European Commissioner for Competition needs to be exercised with care

Such power needs to be exercised with care. Vestager inherits a number of high profile and sensitive cases: Google's alleged self-bias in internet search, Gazprom’s alleged excessive gas prices, the tax-sweetener cases involving Apple, Starbucks and Fiat. In addition, there are new possible merger waves and industrial restructuring and ongoing high profile cartel cases in the financial sector. Although enforcement is strictly governed by law, the Commission retains a margin of discretion in assessment; appeals are rare (more than two-thirds of antitrust abuse cases are resolved without ending up in court), meaning there is often no independent check on the Commission's analysis. Vestager’s discretionary power will therefore play a crucial role – especially in the major pending cases, in which the Commission's decisions will potentially have a huge impact on firms and markets.

But the apparent advantage of discretion can quickly turn into a burden for competition commissioners.  Given the high stakes, it exposes them to pressure to take bad decisions. For example, the Commission might be asked to act against successful foreign companies, because domestic industry fears their competition or because their prices are regarded as excessive and should thus be curbed to reduce input costs. Member states might fight hard to promote their own industries. For instance, they could claim that mergers that imply higher prices for European consumers are the only solution that allows European businesses to invest and regain prominence in global markets.

The new commissioner will only be able to negotiate the political swamp and shield her services from unsubstantiated criticism if she sends a clear, credible signal that her assessments will be guided by economics and that any decision taken will ultimately benefit consumers.

A company should be deemed guilty not merely by holding significant market power

An example is abuse of dominance cases. A company should be deemed guilty not merely by holding significant market power; it should be proved that such power is misused to penalise competitors and that ultimately consumers would suffer from it. An antitrust case against Google in the United States was cleared by the Federal Trade Commission because it found that even if Google’s algorithm penalises competitors, it might nevertheless improve American users’ experience by swiftly addressing their search queries.

Likewise, mergers that result in savings that compensate for reductions in competition should be cleared, and the existence of such efficiency gains should be duly acknowledged. At the same time the causal link between a merger and its benefits should be carefully and transparently substantiated, because higher investment levels are never obvious when market competition is reduced. For example, for more than a decade, US telecoms companies have been allowed to enjoy a significant degree of market power. In the 2003 Organisation for Economic Cooperation and Development country ranking for fixed broadband penetration, the US ranked tenth. In 2013, the US had dropped to sixteenth. Countries that implemented a pro-competition policy demonstrated a better investment performance. Vestager can reconcile business and consumer interests if operators can trust that future antitrust decisions will correctly capture the interplay between short-term effects (such as potential price increases) and dynamic/long-term effects (such as a potential supply of new or better products). Antitrust empowers consumers, who can threaten to switch suppliers, forcing companies to perform and innovate. But it also guarantees that innovative companies are fully rewarded for their efforts. Antitrust enforcement can be a resource for business, not a problem.

Antitrust enforcement can be a resource for business, not a problem

As the father of capitalism Adam Smith wrote: “consumption is the sole end and purpose of all production; the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of consumer”. By heeding Smith’s wisdom, Ms Vestager will get the most out of her new job in the interest of the European economy.

Fri, 31 Oct 2014 09:20:47 +0000
<![CDATA[Building Enterpreneurial Ecosystems in Europe]]> http://www.bruegel.org/nc/events/event-detail/event/471-building-enterpreneurial-ecosystems-in-europe/ even471

Policy makers in Europe are seeking ways to create jobs and spur economic growth. Entrepreneurship, particularly the creation of innovative young firms, is needed yet many barriers to the creation and growth of firms remain. This event will highlight some of the barriers and how to address them as well as help identify steps that policy makers can take to facilitate the development of entrepreneurial ecosystems in Europe, which in turn can spur more high growth entrepreneurship.

More information of this event will be available soon.

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Tuesday 2 December 2014, 10.00-16.00
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Thu, 30 Oct 2014 13:25:33 +0000
<![CDATA[Mapping Competitiveness with European Data]]> http://www.bruegel.org/nc/events/event-detail/event/470-mapping-competitiveness-with-european-data/ even470

Competitiveness is at the heart of policy making at the Union level and specifically within the Eurogroup. Definition of new country–level competitiveness indicators is an essential task.

This half-day workshop will discuss how to map competitiveness with European data, specifically the future potential of matching data in Europe within and across countries.

9.00-9.30 Registration and breakfast

9.30-12.30 Mapping Competitiveness with European Data

12.30-13.30 Lunch

Note that the programme for this event is still under construction.

This workshop will be held in the framework of the MAPCOMPETE Project. The aim of this project is to provide a thorough assessment of data opportunities and requirements for the analysis of comparative competitiveness in European countries.

Read more about the project.

Download MAPCOMPETE flyer -

Practical details

Partners of the project are Brussels based think tank Bruegel, Budapest based research center CERS–HAS (coordinator), Milan research centre LdA, Paris School of Economics and Sciences–Po in Paris, and Tübingen research institute IAW. Associate partners are the OECD, the ECB and several central banks in Europe.

Wed, 29 Oct 2014 11:13:43 +0000
<![CDATA[Monday blues for Italian banks]]> http://www.bruegel.org/nc/blog/detail/article/1469-monday-blues-for-italian-banks/ blog1469

On Sunday, the ECB and EBA published the results of their comprehensive assessment of banks balance sheets, and Italian banks where the worst performers. The stress tests singled out 25 banks that would be falling short of the 5.5% minimum CET1 threshold, based on data as of end 2013. But once the measures already enacted in 2014 are taken into consideration, the number of banks failing the test is reduced to 13. Of these, 4 are Italian.

Banca Monte dei Paschi di Siena, Banca Carige, Banca Popolare di Vicenza and Banca Popolare di Milano will need to raise respectively 2.1bn, 0.81bn, 0.22bn and 0.17bn, for a total of 3.31bn. It is the largest share of the total net (of capital raised in 2014) shortfall of 9.5bn identified from the test.

13 banks are found to effectively fail the ECB stress tests. 4 of them are Italian

Markets gave Italy a very rude awakening on Monday morning. Milan stock exchange closed on Monday at -2.4%. By the end of the trading session MPS had lost 21.5% and was valued at 0.79 euros, whereas Carige ended the trading day down by 17% at a value of just under 0.08 euros per share.

But leaving the market reaction aside, the truth is that beyond capital some long-lived problems of the Italian banking sector have by now been known for a while but not addressed. In this respect, the comparison with a country like Spain - where the banking system has been subject to a deeper monitoring and restructuring during the financial assistance programme of 2012-13 - may yield striking insights.

First, the Italian banking system is still keeping in place a strong liason dangereuse with the (huge) government debt. This is not at all a special feature of Italian banks (as Figure 1 shows) but with almost 80% of their sovereign long direct gross exposures concentrated on Italy, Italian banks are found in this supervisory exercise to be among the most exposed to the sovereign debt issued by the domestic sovereign. Actually, if one excludes the countries that have been or are under a EU/IMF macroeconomic adjustment programme, Italian banks are the most exposed in the Eurozone (Figure1 and Figure 2 left).

Note: Long Direct Gross Exposure

Sovereign debt accounts for 10% of Italian banks asset on average and the home bias in debt portfolio seems to have increased since the last EBA test

More interestingly, the exercise shows that this “home bias”, which is deeply at the root of the sovereign-banking vicious circle that characterised the euro crisis, has even worsened over the last three years. Domestic exposure has grown (rather than decreased) as a percentage of total sovereign exposure on the books of all those banks that were already tested in 2011 with the exception of UniCredit (Figure 2).

Note: Long Direct Gross Exposure

Sovereign debt accounts by now for around 10% of total assets of Italian banks, on average. The carry trade on these holdings might have kept banks afloat over the last 3 years, but these gains are actually concealing deeper structural issues that Italian banks have - until now - never been forced to facein full.

One such long-known problem of the Italian banking system is profitability, which is (and has been for quite a while now) very low. According to ECB data, average return on equity has been negative over the period 2010-2013 and the comparison with Spanish banks is especially striking. After the huge drop in return on equity during 2012, Spanish banks recovered, whereas Italian banks seemed to have never done it (Figure 2).

After the huge drop in return on equity during 2012, Spanish banks recovered, whereas Italian banks seemed to have never done so

Differences between Italy and Spain are evident also in the reliance on Eurosystem liquidity and the pace of reimbursement, which until very recently has been significantly slower in Italy than in Spain (Figure 3 right). Italian banks have borrowed less - in absolute terms - from the ECB facilities, but have been sticking to the central bank liquidity for longer, accelerating reimbursements only in recent months. This may be explained by the fact that their alternative funding is relatively more expensive than it is for Spanish banks. Interest rates paid by Italian banks on retail (households’) deposits is in fact still significantly above those paid by their Spanish equivalents, not to mention German banks. More interestingly (and worryingly) deposit interest rates in Italy have only very recently started to drift downwards, contrary to Spain, where convergence has started earlier and moved faster.

These few elements depicts a gloomy Italian banking system which has been spared - until now - from the deeper monitoring and restructuring that have been undergoing in Spain and other programme countries, but at the cost of finding itself stuck in a limbo where lack of capital (in some cases), low profitability (in general) and rising bad loans are hindering credit and therefore further harming the potential recovery.

Even if the economic cycle were to improve and bad loans to subside, the low profitability will stick due to structurally high costs and inefficiencies

As pointed out, among others, by RBS’ Alberto Gallo, this is not a sustainable situation. Even if the economic cycle were to improve and bad loans to subside, the low profitability will stick due to structurally high costs and inefficiencies (such as Italy’s very high concentration of bank branches and length of the judicial process, for example).

One possible answer to these issues could be consolidation, which has been important in Spain but basically absent in Italy. This is partly due to specific features of the Italian banking structure, which make such reform very difficult. In particular, as shown in figure 4, banks are closely bound together by equity cross holdings in which bank foundations play often a significant role. And bank foundations are often dominated by local politics (see for example this summary account of professional politicians presence in Italian banks’ foundation boards), which may hinder consolidation on the bases of various (not necessarily economic) interests. This suggests that a meaningful reform process in the Italian banking system can hardly go separate from a deep restructuring of this governance structure.

Needed consolidation is made difficult by a corporate governance structure that is strongly tied with local politics

All these problems are long known, but have not yet been addressed. In our (Italian) language, there exists a fascinatingly peculiar expression: La Bella Figura. While it is impossible to appropriately convey all the nuances of its meaning, it could be broadly translated with “nice appearance” and it fits well also to the attitude that has until now been kept about the Italian banking system’s need for reform. Hopefully the stress test results will act as a wake up call, forcing some to finally acknowledge the importance of  substance over form.

Tue, 28 Oct 2014 14:10:10 +0000
<![CDATA[Are the Eurozone’s fiscal rules dying?]]> http://www.bruegel.org/nc/blog/detail/article/1468-are-the-eurozones-fiscal-rules-dying/ blog1468

The European Commission and European Council have blinked.1 Reprimanding France and Italy for their transgressions of the fiscal rules was too risky. With face-saving measures, France and Italy will now break the eurozone’s prized fiscal rules.2

While unseemly in the eurozone context, this is a good economic outcome. Forcing deeper austerity upon fragile economies is destructive. Yes, sure, the French and the Italians could have better managed the balance between taxes and spending. But fine-tuning those through a collective process is absurd.

Despite the small victory for economic good sense, it is too early to cheer. Indeed, the eventual agreement with France and Italy may well entail excessive austerity: we have no good way of knowing because the discussion has been focused on numerical targets rather than on economic considerations. Regrettably, the economic mythology of austerity lives on.

When Hans-Werner Sinn asserts that the reduced austerity is a license to run up fresh debts, he speaks for many who insistently disregard the empirical evidence. The evidence is overwhelmingly clear. Single-minded austerity caused growth to stall; as a consequence, the debt/GDP ratios increased rapidly, leading to the onset of a cycle of rising debt and deflation in the most distressed member states (Mazzolini and Mody, 2014). But no matter, the instinct remains that the rules must be respected.

The reason to be cautiously optimistic is that the French and Italian revolt may encourage new challenges from other countries. Such a momentum would politically discredit the rules, leaving them to atrophy. True, such optimism is premature. Germany and France did flout the rules in 2003, undermining their credibility. But instead of withering away, the rules reasserted their grip at precisely the wrong moment, when—amidst the crisis—the distressed economies needed the oxygen of fiscal stimulus.

German interests were central to the reassertion of the fiscal rules. Germany relishes its role as Europe’s hegemon but has no appetite to pay for that privilege. So the crisis forced to the surface the central dilemma in the construction of the eurozone:

The Commission and the Council have blinked. Reprimanding France and Italy was too risky

  • Germany is unwilling to pay for the “mistakes of others.”
  • But the option of restructuring sovereign debt has been ruled out.
  • Hence, everyone is agreed on the need for more austerity, even though unending austerity makes the debt repayment burden greater, not less.

To be clear: Germany’s unwillingness to pay was part of the contract at Maastricht in 1992 and remains so in the Lisbon Treaty. Those who now fret that Germany should do more must not forget that they signed on to the deal with open eyes; presumably the hope was that Germany would see good sense when it became necessary. But that hope did not incorporate the views of the German taxpayer or the ability of a new generation of German leaders to persuade the German taxpayer. With the passage of time, the German taxpayer is less likely to be compliant.

Germany relishes its role as Europe’s hegemon but has no appetite to pay for that privilege

For this reason, the resolute German opposition to such concepts as Eurobonds should not be a surprise to anyone. Indeed, if the European Stability Mechanism (ESM) had to be considered now—knowing that official loans to Greece will be largely forgiven—it is possible that the German authorities would be less forthcoming in their support and, more seriously, the European Court of Justice (ECJ) would find it illegal under the Lisbon Treaty. The ECJ judgment requires that the loans be paid back, otherwise they violate Article 125, the so-called no bailout clause.

Eurointelligence Professional Edition, October 23, 2014.

Analysts have described the changes in response to the Commission’s demand as “cosmetic.”

Article 125 did imply— and even encourage—the idea that private creditors would bear the costs of imprudent lending to eurozone sovereigns. But as soon as the crisis began, this option was ruled out on the grounds that the ensuing mayhem would have catastrophic costs. This folklore has persisted despite the historical evidence that, notwithstanding the temporary hiccups, the cleansing effect of debt restructuring benefits both debtors and creditors (Mody, 2013a). The damage inflicted by denying this evidence was manifest when Greek debt was eventually restructured. Sovereign debt attorney Lee Buchheit remarked: “I find it hard to imagine they will now man up to the proposition that they delayed – at appalling cost to Greece, its creditors and its official sector sponsors - an essential debt restructuring …”

Thus, the response to the crisis was a patchwork of financial safety nets (which arguably contravene the Treaty), the presumption of no debt restructuring (which the Treaty encourages), and an extraordinary political compromise on counter-productive austerity rules.

This outcome was extraordinary because the economics and politics of the eurozone’s fiscal rules were always known to be flawed and potentially corrosive

This outcome was extraordinary because the economics and politics of the eurozone’s fiscal rules were always known to be flawed and potentially corrosive.  

As Eichengreen (2003) bluntly pointed out, there never was an economic basis for the fiscal rules. Jean Tirole, the most recent recipient of the Economics Nobel Prize, wrote a similarly scathing critique in 2012.

There is limited contemporary commentary on the political evolution of the rules. Of German origin, they were defined by the Delors Committee’s Report in 1989 and reaffirmed in the deliberations leading to the Maastricht Treaty in 1992. Interestingly, however, Charles Grant, Delors’ biographer, recounts that Delors himself was unhappy with the rules. In the months before Maastricht (Grant, 1994, pp. 183-184):

“The Germans continued to argue for sanctions against countries with ‘excessive deficits.’ Only the strange alliance of Delors and [Norman] Lamont [the British Finance Minister] argued against centralization of fiscal policy. Delors claimed that EC sanctions would breach subsidiarity and be unnecessary. …Lamont argued that markets would discipline profligate governments by demanding higher rates of interest.”

The fiscal rules persisted along with the equally stupid idea—one that has never been invoked—that countries in economic distress need to be helped along with sanctions

But that fight went nowhere. In October 1991, two months before the summit at Maastricht to sign the Treaty, Delors and Lamont “conceded defeat.” Delors had come so close to the monetary union that he had so desperately wanted; he was willing to make an essential compromise.

From then on, the history is well known. Romano Prodi, as president of the European Commission, pronounced the rules (recast in 1997 as the Stability and Growth Pact) to be “stupid.” But they persisted along with the equally stupid idea—one that has never been invoked—that countries in economic distress need to be helped along with sanctions.

Hence, after the onset of the crisis, the search for a more “scientific” approach offered a ray of hope. The intention was to downplay the requirement that budget deficits could not exceed 3 percent of GDP and target instead the “structural deficit.”3 The structural deficit is more apt because it sees through to the more permanent underlying deficit by filtering out the deficit due to the temporary decline in revenues and increase in social support during a recession.   

In an important sense, the 3 percent rule has never gone. The so-called excessive deficit procedure (EDP) continues to specify a date by which the 3 percent needs to be reached. So, while there may be agreement on and adherence to a structural adjustment path (with automatic stabilizers allowed to operate), if the country under scrutiny does not observe the EDP date for the 3 percent target, there is a problem.  

But this “scientific” approach was always fraught with difficulty. The simple truth is that measuring the depth of a recession—and isolating it from a more durable decline in an economy’s potential output—is an art, not a science. Plausible approaches come up with completely different estimates. For example, Robert Gordon of Northwestern University has proposed “a surprisingly simple” new method of estimating potential output, which leads him to conclude that the estimates of the Congressional Budget Office are “too optimistic.” For this reason, I wrote a year ago (Mody, 2013b, p. 18):

“[…] the shift from the SGP’s three percent of GDP budget deficit target to the ‘structurally’-balanced budget deficit is technically appropriate. But that requires assessment of a country’s potential output, a nebulous concept especially during periods of economic stress. The risks are high that the assessment to be conducted by a committee of member-country representatives will be politicised. The actions that follow from the assessment also remain subject to discretion.”

Since then, things have played out much as predicted. The various groups and committees set up to assess a country’s fiscal position have taken the traditional refuge in process, while the real debate has occurred in the political arena. Hence, Italian Prime Minister Mateo Renzi’s call for greater flexibility in the application of rules met with the anticipated retort from the German Chancellor Angela Merkel. She told the German Bundestag that the rules permitted sufficient flexibility: “The German government agrees that the Stability and Growth Pact offers excellent conditions for that, with clear guard rails and limits on the one hand and a lot of instruments allowing flexibility on the other." To good effect, she added, "We must use both just as they have been used in the past." In other words, she said, “What exactly is the problem?” Even ECB President Draghi, whose speeches have been viewed as calling for more fiscal stimulus, has been cautious:

“[…] we are operating within a set of fiscal rules – the Stability and Growth Pact – which acts as an anchor for confidence and that would be self-defeating to break.”

The call for exempting “investment” from the fiscal rules has resurfaced. That once again makes economic sense, but it is easy to see why the idea goes nowhere

Predictably also, the call for exempting “investment” from the fiscal rules has resurfaced. That once again makes economic sense, but it is easy to see why the idea goes nowhere. Over a decade ago, one commentator noted that investment is a “wonderfully elastic concept” (Righter, 2002). Even serious scholars, however, have been seduced by the possibility. Blanchard and Giavazzi (2004) offered a proposal for encouraging investment within the SGP framework but note, without irony (p. 9):  “Such rules would need to deal with the incentive to re-define current spending as public investment, and this may not be easy.”

These observations are not an argument against “flexibility” in rules or greater incentives for investment. They are argument for the political improbability of centrally applying rules to a collection of sovereign nations with widely differing economic capabilities and trajectories. Inevitably, exceptions will be needed, but they will create a sense (often incorrectly) that some nations are cheating and free-riding. The political debate will continue to be poisoned.

For this reason, the hope that France and Italy are in the vanguard of rendering these rules obsolete should be a matter of cheer. Delors was right: centralization of fiscal rules makes neither economic nor political sense. Persisting with centralized fiscal rules despite their evident costs—because all other options have been ruled out—is a grievous error.

Once centralized surveillance and enforcement of fiscal rules is consigned to the dustbin of history, there is only one way ahead: more-orderly recourse to debt restructuring combined with the forceful exercise of ECB powers to prevent financial contagion (see Mody, 2013b). Although applying this principle to the problems inherited from this crisis will require considerable improvisation, it is the only logically-consistent and politically feasible system for the future.  All other approaches will continue to run into political and economic cul-de-sacs.

The current Bundesbank President, Jens Weidmann has recently reiterated this proposal

Central to the new architecture must be system of more automated debt-restructuring. The idea was first proposed in 2011 by then Bundesbank President Axel Weber and his colleagues. Whenever a country applied to the European Stability Mechanism for financial assistance, private creditors would be required to automatically extend the maturities of all bonds issued by that country.4 This, in principle, is the right idea because it removes the discretion in sovereign debt restructuring. That discretion is always used to postpone needed restructuring because, despite all evidence to the contrary, the fear of wild contagion is invoked. Although an important step in the right direction, the trigger for maturity extension proposed by Weber et al. is not the right one. Since an ESM program is intended to kick in as “a last resort” (when the eurozone’s financial stability is threatened), the distress by then would be acute; and because the timing of the program remains uncertain, the trigger would be difficult to price. Hence, I recently outlined a proposal for automated restructuring using risk spreads as triggers.

Being wedded to an ingrained way of doing business, Berlin, Brussels, and Frankfurt may prefer to find accommodation with Paris, Rome, and others that come after them

The symbiosis between automated debt restructuring and ECB’s lender-of-last resort functions is clear: with the burden of insolvent sovereigns on the ECB eliminated, the concerns of the German Court will be reduced (Mody, 2014).  And a politically legitimate and transparent commitment to an ECB safety net should then be possible.

Those who are persuaded by this agenda—which entails discarding fiscal policy centralization, making debt restructuring integral to the policy framework, and creating a politically legitimate financial safety net—may yet argue that the task is too hard to achieve. Being wedded to an ingrained way of doing business, Berlin, Brussels, and Frankfurt may prefer to find accommodation with Paris, Rome, and others that come after them. A new normal in the rules may allow some modest, hard-fought exceptions. That will be an unfortunate response. A continued reliance on centralized fiscal policy will be like searching for lost car keys under the lamppost because it is easiest to look where the light is.

Without implicating them, I am grateful to Ajai Chopra and Guntram Wolff for their comments and suggestions.

Tue, 28 Oct 2014 07:43:41 +0000
<![CDATA[The distributional effect of quantitative easing]]> http://www.bruegel.org/nc/blog/detail/article/1467-the-distributional-effect-of-quantitative-easing/ blog1467

What’s at stake: The notion that ultralow interest rates and central-bank asset purchases have fueled a surge in asset prices, which mostly benefits the wealthy, has become quite prevalent. While the question of the redistributive impact of monetary policy is not new, it has taken on a whole new dimension with the renewed interest in inequality and the unprecedented scale of unconventional monetary policies.

A prominent source of debate

Cardiff Garcia writes that the difficult question of how unconventional monetary policies affect inequality has become a prominent source of debate. Olivier Coibion, Yuriy Gorodnichenko, Lorenz Kueng and John Silvia write that the prevalence of “End the Fed” posters at Occupy wall Street demonstrations surely reflects, at least in part, the influence of those who argue that the Fed has played a key role in driving up the relative income shares of the rich through expansionary monetary policies. The notion that expansionary monetary policy primarily benefits financiers and their high-income clients has become quite prevalent.

Complaints about the ECB favoring borrowers over savers with its low-interest-rate policy are getting ever louder

ECB Board Member Benoit Coeure writes that complaints about the ECB favoring borrowers over savers with its low-interest-rate policy are getting ever louder. In countries such as Germany there is even talk of a “cold expropriation” of those who save money for their old age.

Low interest rates and savers’ income

Paul Krugman writes that the claim the hit to interest was a major factor depressing incomes at the bottom is just false. The Survey of Consumer Finances shows that three-quarters of the wealth distribution basically has no investment income. The people in the 75-90 range have some. But even in 2007, when interest rates were relatively high, it was only 1.9 percent of their total income. The overall impact on the income of middle-income Americans was, necessarily, small; you can’t lose a lot of interest income if there wasn’t much to begin with.

ECB Board Member Benoit Coeure writes that the current low returns for savers are mainly an ongoing result of the recent deep recession and of the fragmentation of the financial market in the euro area. BoE Deputy Governor Ben Broadbent argues in a recent speech that rather than causing the decline themselves, central banks have instead been accommodating a deeper downward trend in the “natural” or “equilibrium” rate of interest.

Asset prices and inequality

William Cohan writes that the Fed’s balance sheet has grown to $4.5 trillion, from around $800 billion before the crisis. That’s a whole lot of securities bought at high, profitable prices and paid directly to Wall Street traders. The Fed might as well have been paying the traders’ seven-figure bonuses directly.

A whole lot of securities bought at high, profitable prices and paid directly to Wall Street traders

BoE Deputy Governor Ben Broadbent writes that autonomous changes in monetary policy can affect asset prices. If the central bank decided to lower interest rates arbitrarily, for no other reason than that it wanted to, real asset prices would rise. But it’s unlikely the effect would endure for a very long time. James Bullard, president of the St Louis Fed, said in June that the increase in equity prices was not sufficient proof of QE’s guilt in raising inequality because equity valuations are more normal now than they were in 2008 and 2009.

Paul Krugman suspects that the impression that QE has involved a massive redistribution to the rich come from the fact that equity prices have surged since 2010 while housing has not — and since middle-class families have a lot of their wealth in houses, this seems highly unequalizing. We expect monetary policy to have differential effects on asset prices based on longevity.  This time was, however, different for housing because it had an immense bubble in the mid-2000s, so that it wasn’t going to come roaring back. Meanwhile, stocks took a huge beating in 2008-9, but this was financial disruption and panic, and they would probably have made a strong comeback even without QE.

The net effect of monetary policy on inequality

Boston Fed President Eric Rosengreen says that there is no doubt that asset prices are one of the mechanisms on which this is transmitted, so people that own stocks are going to do better than people that didn’t own stocks. But that’s not the only measurement. The net effect is substantially weighted towards people that are borrowers not lenders, towards people that are unemployed versus people that are employed. Wealthy people are both employed and tend to lend. The people at the lower end of the distribution tend to borrow. 

The net effect is substantially weighted towards people that are borrowers not lenders

Jared Bernstein writes that a full analysis would have to net out the difference relative to a counterfactual–what would have happened absent the Fed’s actions. Olivier Coibion, Yuriy Gorodnichenko, Lorenz Kueng and John Silvia write that there are 5 channels through which monetary policy can affect inequality:


  1. Heterogeneity in income sources (wages vs. profits)
  2. Financial intermediaries and their high income clients
  3. Portfolio effects
  4. Heterogeneity in labor income responses during business cycles
  5. Borrowers vs. savers

While there are several conflicting channels through which monetary policy may affect inequality, the authors find that between 1980 and 2008 in the US, expansionary monetary policy lowered rather than increased economic inequality.

Explanation: Effect of a contractionary monetary shock

Ayako Saiki and Jon Frost look at how a decade of unconventional monetary policy in Japan affected inequality among households using survey data. Our vector auto regression results show that UMP widened income inequality, especially after 2008 when quantitative easing became more aggressive. This is largely due to the portfolio channel.

It is bound to be the rich today who have born risk in the past (and been lucky) or who have saved in the past. So today's inequality should, we think, rise

Brad DeLong writes that figuring out what we expect QE to mean for income and wealth inequality is difficult because we are not sure what QE is supposed to do for the macroeconomy. Is it a way of credibly committing to lower nominal interest and higher inflation rates in the long run by goosing the monetary base at the zero lower bound? Is it a way of reducing the supply of assets subject to risk and thus reducing the risk premium? If the first, it is the government imposing--relative to the baseline--a transfer from those who are going to save to those who are going to borrow and to those who have saved in the past. If the second, it is the government imposing--relative to the baseline--a transfer from those who are going to supply risk-bearing services to those who will lay off risks into the future and those who have already committed to bearing risk in the past. In either case, it is bound to be the rich today who have born risk in the past (and been lucky) or who have saved in the past. So today's inequality should, we think, rise.

Mon, 27 Oct 2014 08:00:53 +0000
<![CDATA[Europe’s Banking Union starts on an encouraging note]]> http://www.bruegel.org/nc/blog/detail/article/1466-europes-banking-union-starts-on-an-encouraging-note/ blog1466

Sunday, October 26 was D-Day for Europe’s banks: at noon in Frankfurt, the European Central Bank (ECB) announced the results of its “comprehensive assessment” of the euro area’s 130 largest banks, including an Asset Quality Review (AQR) and stress tests. Simultaneously in London, the European Banking Authority (EBA) announced the results of these stress tests for a larger sample of banks, including the largest banks headquartered in the EU but outside the euro area.

The comprehensive assessment is intended to draw a line over years of unsatisfactory oversight by national watchdogs, and allow the ECB to start from a high level of trust

This was meant as a cathartic watershed that would allow the ECB to take over its new role as the licensing authority of all the euro area’s banks and direct supervisor of the largest ones, a transfer of authority from national supervisors that will occur on Tuesday next week, November 4. The comprehensive assessment is intended to draw a line under years of unsatisfactory oversight by national watchdogs, and allow the ECB to start from a high level of trust.

On the face of it, these objectives appear to have been met, even though a definitive assessment will only be possible several months from now. The ECB identified 25 banks as having been undercapitalised as of end-2013; of these, 12 have raised enough capital this year to be technically compliant with capital requirements, but the other 13 need to submit recapitalization plans to the ECB within two weeks. Four of these are in Italy: Monte dei Paschi di Siena (MPS), which may have to lose its independence, Carige in Genoa, Banca Popolare di Milano, and Banca Popolare di Vicenza: this puts a cloud above the Bank of Italy’s reputation as a supervisor, especially as several other Italian banks also appear fragile. Farther west in Lisbon, Banco Comercial Portugues (BCP) is among the other institutions asked to strengthen their balance sheet, or else. In total, the assessment identified slightly more “problem banks” than expected, but did not uncover problems so massive that they may trigger systemic instability.

Perhaps more importantly, the ECB (and EBA) flooded the market under a deluge of data, the full analysis of which will take several more days. One not-so-hidden nugget of information is how the banks would have fared if a more rigorous yardstick of capital, known as fully-loaded Basel III, had been used instead of the current “phased-in” measure which it will replace in the EU in a few years. In that case, a few significant German banks would have failed the test as well. They include HSH Nordbank, a Northern German Landesbank that provides wholesale services to local savings banks (Sparkassen), in spite of the guarantees it has received for up to EUR10bn from the local governments that are also its main shareholders. This group also includes DZ Bank and WGZ Bank, the two wholesale institutions that serve Germany’s system of local cooperative banks (Volksbanken and Raiffeisenbanken) – possibly the biggest surprise of today’s entire disclosure package. The fact that Germany and Italy, two of the euro area’s biggest countries, are not immune to the ECB’s inquisitiveness suggests that the assessment has been kept reasonably independent from political pressure. In the two other largest countries, France and Spain, most banks have passed the test successfully.

Investors and the public will need to be persuaded that there are no more skeletons hiding in the banks’ cupboards

Crucially, this exercise must be seen as the beginning of a sequence of policy actions by the ECB – even as, to the thousands of professionals who participated in the process, it may feel like the endpoint of a long hard slog. To start with, investors and the public will need to be persuaded that there are no more skeletons hiding in the banks’ cupboards. This is likely to take a few months: the credibility of the EBA-led stress tests whose results were announced in mid-July 2011 was later ruined by the problems of Dexia in October 2011, then of Bankia in May 2012. Moreover, some of the AQR’s consequences will only be felt in the banks’ financial statements as of end-2014: for example, more of the EUR136bn of additional non-performing loan exposures identified in the AQR may be written down at that time. Overall, the definitive assessment on the robustness and credibility of the comprehensive assessment, and specifically of the AQR, will probably have to wait until the first quarter of 2015.

Furthermore, the ECB has a lot of follow-up work on its plate, on a number of issues it has signalled it will address gradually after its assumption of direct supervisory authority on November 4. It should gradually tighten the definition of capital to make it fully compliant with the Basel III framework, including on the contentious question of insurance subsidiaries of diversified banking groups (a point on which even today’s “fully-loaded” disclosures are based on a laxer standard than the international accord, and which is particularly sensitive for several large French banks). It should put an end to the widespread practices of geographical ring-fencing of capital and liquidity by national supervisors within the banking union area, an aim that may eventually require legislative changes in Germany and elsewhere. It should vigorously encourage those banks which keep a high home-country bias in their sovereign debt portfolios to reduce it, something that ECB top supervisor Danièle Nouy has already announced. It should encourage cross-border bank acquisitions, and investment in banks by international private equity funds, to decrease the sector’s current fragmentation along national lines. Finally, it should gradually bring smaller (mostly German, Austrian and Italian) into its supervisory fold, as Ms Nouy’s deputy Sabine Lautenschläger has indicated.

Overall, this debut of Europe’s banking union comes five years too late, but better late than never

The full economic impact of the comprehensive assessment will depend on these developments still to come. If all goes according to plan, it may unlock some of Europe’s repressed growth, by allowing most banks to lend more freely now that their creditworthiness has been duly checked – even though this will not resolve a number of other problems in Europe’s anaemic economy that contribute to depressed credit demand. Overall, this debut of Europe’s banking union comes five years too late, but better late than never. It is an encouraging start for the most transformative policy initiative that has emerged from Europe’s crisis so far. 

Mon, 27 Oct 2014 06:47:13 +0000
<![CDATA[Europe's fiscal wormhole]]> http://www.bruegel.org/nc/blog/detail/article/1465-europes-fiscal-wormhole/ blog1465

The International Monetary Fund now estimates a 30% risk of deflation in the eurozone, and growth figures within the monetary union continue to disappoint. But policymakers seem trapped in a cat’s cradle of economic, political, and legal constraints that is preventing effective action. The fulfillment of policy rules appears to be impossible without growth, but growth appears to be impossible without breaking the rules.

The fulfillment of policy rules appears to be impossible without growth, but growth appears to be impossible without breaking the rules.

German Finance Minister Wolfgang Schäuble is politically committed to outdoing his country’s tough domestic fiscal framework to secure what he calls a “black zero” budget. The French government is working to regain credibility on reform promises made in exchange for delays on fiscal adjustment, and Italy, with one of the highest debt burdens in the eurozone, has little room to use fiscal policy. Meanwhile, the European Central Bank is constrained by doubts about the legality of its “outright monetary transactions” (OMT) scheme – sovereign-bond purchases that could result in a redistributive fiscal policy.

With all of the rules pointing toward recession, how can Europe boost recovery?

A two-year €400 billion ($510 billion) public-investment program, financed with European Investment Bank bonds, would be the best way to overcome Europe’s current impasse. Borrowing by the EIB has no implications in terms of European fiscal rules. It is recorded neither as new debt nor as a deficit for any of the member states, which means that new government spending could be funded without affecting national fiscal performance.

Thus, some of the investment spending currently planned at the national level could be financed via European borrowing to relieve national budgets. Such an indirect way of dealing with strict rules would also be easier than starting long and wearying negotiations on changes to the fiscal framework.

The EIB is worried that such a scheme could come at the cost of its triple-A rating. Indeed, though it can currently borrow at 1.6% on a long maturity, it has used its recent capital-raising exercise to reduce leverage rather than substantially increase its loan portfolio, as would be warranted at a time of retrenchment in private lending. In any case, a rating change would hardly affect funding costs in the current low-yield environment, as lower-rated sovereigns have demonstrated.

In addition, the ECB could purchase EIB bonds on secondary markets, which would help to keep funding costs low – or even reduce them. More important, purchases of EIB bonds would enable the ECB to undertake quantitative easing without triggering the degree of controversy implied by intervening in 18 separate sovereign-bond markets, where concerns that ECB purchases would affect the relative pricing of sovereigns are very real.

Already, €200 billion of EIB bonds are available. Adding €400 billion would increase the pool substantially. Together with asset-backed securities, covered bonds, and corporate bonds, €1 trillion of assets – the threshold widely thought to make quantitative easing by the ECB credible – would be available for purchase.

A two-year €400 billion ($510 billion) public-investment program, financed with European Investment Bank bonds, would be the best way to overcome Europe’s current impasse

A central question, of course, concerns the type of government spending that should qualify as investment spending, and which European investment projects should be supported. It will be impossible to define new and sensible European projects worth €200 billion per year. Common projects such as the European energy union will need more time to be precisely defined. As a result, the bulk of investment now will have to come from national policymakers.

In part, this means that existing infrastructure projects that are supposed to be financed from national budgets could be funded by the EIB. By removing some of the burden from national budgets, the current decline in public investment could be reversed.

Some of the new resources could also be used to allow for budget consolidation in France without pro-cyclical cuts. France could get this helping hand in complying with the fiscal rules in exchange for serious and necessary structural reforms, as could Italy, where EIB-funded bonds would provide a much-needed growth stimulus without new government commitments. In Germany, the freed-up resources could be used to accelerate existing investment projects while still meeting its black-zero pledge.

Similar arrangements could be found for the other eurozone countries. To prevent the misuse of money, the European Commission should vet all national investment projects. More broadly, the program would be an important step toward establishing the eurozone’s missing fiscal union. That goal will be reached more quickly once the benefits of achieving it are apparent to all.

Fri, 24 Oct 2014 07:18:28 +0100
<![CDATA[Uber Economics: There is no such thing as bad publicity]]> http://www.bruegel.org/nc/blog/detail/article/1464-uber-economics-there-is-no-such-thing-as-bad-publicity/ blog1464

Last month we published a blog post examining the economics behind, and the challenges for, the Uber ridesharing company. We now want to consider how Uber might have been affected by opposition from vested interests – in Uber's case, taxi drivers – and by regulation to restrict Uber. We take into account major events involving the company, and use Germany as a case study.

Uber arrived in Germany in February 2013. In April 2014 the first regulation imposing restrictions on its activity was passed, prohibiting the company from offering its services in Berlin.

In June 2014 there was a pan-European demonstration by taxi drivers against the company, possibly contributing to its ban in Germany later in August. The ban was revoked in September.

The following graph shows the individual index of Google searches for "Uber" (orange line) and the index of searches for "Taxi" (blue line), both in Germany.

Source: Bruegel based on Google trends.

Note: The indexes are not in relative terms of each other, thus are not comparable in absolute terms.

Download .jpeg  Download.jpeg

Tue, 21 Oct 2014 09:22:12 +0100
<![CDATA[The return of market volatility]]> http://www.bruegel.org/nc/blog/detail/article/1463-the-return-of-market-volatility/ blog1463

What’s at stake: The size of the market gyrations this week took everybody by surprise. Several stories have been put forward to rationalize these movements, but the abruptness of the adjustment is puzzling and underlines that the degree of liquidity in these markets may have been overestimated.

Last week wrap-up

We are definitely back in the “risk-on-risk-off” regime again

Sober Look writes that we are definitely back in the “risk-on-risk-off” regime again. In its Global Market overview, the FT notes this morning that high volatility will likely remain the story for now especially as expectation on monetary policies shift back and forth. Luigi Speranza write that market fluctuations have reached fever pitch over the past few days, with the continued decline in equity markets accompanied by new cyclical lows in bond yields and, more recently, a sharp widening of eurozone bond spreads.

Gavyn Davies writes that on Wednesday, the US ten year treasury, perhaps the most liquid financial instrument in the world, traded at yields of 2.21 per cent and 1.86 per cent within a matter of hours. This type of volatility in the ultimate “risk free” asset has previously been seen only in 2008 and other extreme meltdowns, so it clearly cannot be swept under the carpet.

What is the market telling?

The most prominent story since the September peak seems to be a “global slowdown” with associated “deflation

Gavyn Davies writes that overall three separate factors have probably been at work:

  • a reversal of speculative positions, which has had temporary effects on asset prices;
  • a contractionary and deflationary demand shock in the euro area;
  • an oil shock that will also be deflationary, but will be expansionary for many economies.

Robert Shiller writes that the most prominent story since the September peak seems to be one of a “global slowdown” with associated “deflation.” Underlying this tale are deeper, longer-term fears. There is a name for these concerns too. It is “secular stagnation” — the idea that there is disturbing evidence that the world economy may languish for a very long time, even for generations, as the word “secular” suggests. Gavyn Davies expresses doubts about this story since this fails to show up in any recent change in consensus GDP forecasts.

Paul Krugman writes that the financial turmoil of the past few days has widened the gap between what we’re told must be done to appease the market and what markets actually seem to be asking for. We have been told repeatedly that governments must cease and desist from their efforts to mitigate economic pain, lest their excessive compassion be punished by the financial gods, but the markets themselves have never seemed to agree that these human sacrifices are actually necessary. The real message from the market seems to be that we should be running bigger deficits and printing more money. And that message has gotten a lot stronger in the past few days.

Market volatility and growth

Roger Farmer writes that that a persistent 10% drop in the real value of the stock market is followed by a persistent 3% increase in the unemployment rate. The important word here is persistent. If the market drops 10% on Tuesday and recovers again a week later, (not an unusual movement in a volatile market), there will be no impact on the real economy. For a market panic to have real effects on Main Street it must be sustained for at least three months.  And there is no sign that that is happening: Yet.

A persistent 10% drop in the real value of the stock market is followed by a persistent 3% increase in the unemployment rate

Mohamed El-Erian writes that after a period of excessive risk taking and prolonged complacency, it will probably take some time for markets to fully recalibrate – a choppy process that will be driven both by fundamentals and by technically-oriented repositionings of crowded trades. 

Liquidity, regulation and price swings

Philip Gisdakis writes in Unicredit Sunday Wrap that with some clouds on the horizon, it took only a tiny trigger to send everyone bolting for the exit. With tightened market regulation also affecting banks’ trading books, market liquidity was gone within seconds, which resulted in huge price jumps. Mohamed El-Erian writes that traders are discovering – yet again – that market liquidity is not as deep as they had hoped for, causing wild price gyrations even in the most traditional of all asset classes (for eg, witness the speed and size of Wednesday’s price movements in US equities and Treasuries).

Gillian Tett writes that the question of “liquidity” – the degree to which assets can be traded – matters hugely. What is worrying is that liquidity appears to have decreased because unorthodox monetary policy experiments have collided with financial reforms and technological upheaval in an unexpectedly pernicious way. Having lots of money in the system does not guarantee that funding will flow freely, or that traders can cut deals. Systems flooded with cash can sometimes freeze.  Sometimes this occurs because investors lose faith in each other and stop doing trades, as they did in 2008. But markets can also become illiquid because it is difficult to match buyers and sellers. In the past big investment banks often matched buyers and sellers by holding large inventories of securities. But since 2008 banks have slashed their inventories by between 30 and 80 per cent (depending on the asset class) to meet tighter rules. This reduced their ability to act as market makers, and removed shock absorbers from the system.

Mon, 20 Oct 2014 07:18:49 +0100
<![CDATA[Jean Tirole's legacy]]> http://www.bruegel.org/nc/blog/detail/article/1462-jean-tiroles-legacy/ blog1462

On October 13 the Royal Swedish Academy of Sciences awarded the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2014 to the French economist Jean Tirole for his analysis of market power and regulation.  

1 The numerous references to Laffont in the scientific background for the prize suggest that, were he still alive, he might have shared the prize with Tirole.

Jean Tirole, along with his mentor and coauthor Jean-Jacques Laffont,1 was one of the main scholars who contributed to the systematic use of game theory and mechanism design in Industrial Organization (IO), which fundamentally changed the way economists analyze oligopolistic competition, firms’ strategic behavior and market regulation. His 1988 textbook in IO is still considered “the Bible” in the field, after more than 25 years, and his 1991 textbook in game theory (coauthored with Drew Fudenberg) is still one of the main advanced references.

His contribution, however, goes well beyond elegant modelling and the robust analytical toolkit he helped to create. Several of his seminal papers had a massive impact on the way we approach relevant and delicate policy issues in the field of competition policy and market regulation. The following is a selection of some of his fundamental contributions to IO research. In a short blog post it would be impossible to describe all of Tirole’s contributions to IO and other fields (behavioral economics, corporate finance, organizational economics, etc.); however, the interested reader may visit Tirole’s personal webpage at the Institute d’Economie Industrielle, his page on IDEAS or read the slightly technical document with the scientific background for the prize.

Anticompetitive vertical mergers and restraints

Tirole developed a model in which vertical mergers (and vertical restraints) can result in market foreclosure

In his massive 82-page 1990 article with Hart, Tirole develops a model in which vertical mergers (and vertical restraints) can result in market foreclosure. Contrary to the then-common Chicago School view, that considered foreclosure an irrational strategy and efficiency gains and synergies the only motivations behind vertical practices, Tirole points out that, if contracting takes place in secret or contracts can be secretly renegotiated, the inability of an upstream supplier to make binding commitments with a downstream retailer reduces the supplier’s market power and its ability to keep prices high.

To understand why this is the case, consider an upstream supplier facing several downstream retailers and assume that there is no demand uncertainty so that both the supplier and retailers agree on the expected profits that can be made from selling the products. The supplier could promise exclusivity to one of the retailers in exchange of the profits (or parts of them, depending on the distribution of bargaining power between the two parties) that can be made from the sale of the products. However, once the deal is made, since there is no binding commitment behind the promise, the supplier has an incentive to renege on its exclusivity promise and opportunistically make a deal with another retailer (promising this time that there will be no further deals after that) for, let’s say, half of what was paid by the first retailer.

Of course, the inability to make binding commitments means that the supplier has an incentive to renege also on this promise, and iteratively repeat this scheme with all the retailers. However, anticipating the supplier’s opportunistic behavior, retailers would not accept the offer and thus the supplier loses the market power it might potentially have. A vertical merger, a legally binding exclusive contract or a retail price maintenance agreement allow the upstream supplier to “tie its hands” and retain its market power, to the detriment of consumers that have to face higher prices.

Tirole’s many contributions (see Rey and Tirole 2007, for a relatively recent one) are crucial to understand the framework in which competition authorities like the European Commission and economists more generally analyze vertical restraints and mergers which have vertical dimensions. This can clearly be seen in the guidelines of the European Commission on the assessment of vertical restraints and non-horizontal mergers.

Multi-sided platforms

2 The fact that in two-sided platform markets anticompetitive practices may be harder to identify calls for a precise definition of what a two-sided platform is, in order to avoid the case in which firms may simply try to redress the case as “two-sided platform-related” and hope in this way to avoid fines and continue their anticompetitive practices. This, however, might be a topic for another blog post.

The contributions of Tirole to the research in competition policy do not stop to vertical practices and foreclosure. He (with his coauthor Jean-Charles Rochet) kickstarted the literature on two-sided platforms (Rochet and Tirole 2003a, 2006). Two-sided platforms (multi-sided if dealing with more than two customer groups) are intermediaries which allow interactions between different parties who value each other participation (or where at least one party values the other participation, think of the case of advertisers and newspaper readership). Examples of two-sided platforms are credit/debit cards, operating systems, videogame consoles, dating clubs.

Contrary to other types of intermediaries, such as retailers, platforms leave the parties with control over their interactions/transactions.  This results in a positive feedback loop between the demands of the two customer groups, in that a member of one group (usually) enjoys the presence on the platform of more members of the other group, representing for him potential possibilities of interactions. Think of payment cards, for example. Payment cards allow consumers to purchase from affiliated stores without the need to physically carry cash with themselves and are characterized by the positive feedback loop typical of two-sided platforms: the more are the merchants accepting card payments, the more are the consumers who value holding a payment card, which in turn implies that the more are the merchants willing to install card readers, and so forth.

The interdependence between the demands of the two customer groups usually tends to result in heavily skewed pricing structures

The interdependence between the demands of the two customer groups usually tends to result in heavily skewed pricing structures, where one side is used as a loss leader to attract the other side, on which the platform makes profits. This means that the two sides cannot be analyzed in isolation but must be considered jointly, otherwise a competition authority may end up wrongly punishing the platform for excessive pricing on one side and predatory pricing on the other (while in fact it is adopting normal pricing practices for its industry, which would be adopted in a competitive environment).2 

Tirole did not just develop the theoretical concept of two-sided platforms, but he also studied the idiosyncrasies characterizing some of them, such as interchange fees in credit/debit card markets (e.g. Rochet and Tirole 2003b), which have been the focus of recent antitrust scrutiny by the European Commission (e.g. Visa and Mastercard cases). 

3 In a recent article (Lerner and Tirole 2014), Tirole and his coauthor extend the framework developed in this paper to analyze standard essential patents and prove that price commitments prior to the selection of the standard deliver the same outcome as in the (fictitious) ex-ante competitive benchmark in which users need not match their technological choice with each other (meaning that in this fictitious environment a standard setting organization would not confer undue market power to holders of standard essential patents and would de facto not need to exist). However, such price commitments are unlikely to emerge in absence of regulation. The analysis in this paper provides useful insights to policy makers on how to address currently hot policy issues like standard setting organizations and standard essential patents. Recent decisions of the European Commission on standard essential patents involve Google-Motorola and Samsung (Rambus and IPCom are slightly older but still relevant).

Patent pools and cooperation arrangements

In a 2004 paper with Lerner, Tirole studies patent pools - agreements among patent owners to jointly license their patents - and provides simple but robust conditions that would help competition authorities screen anticompetitive patent pools. He first notices that, except for the extreme cases of perfect complements and substitutes, patent substitutability and complementarity depend on the current license fees. When license prices are high, patents tend to be substitutes since licensees may just want to use some of the patents, which thus compete with one another. An increase in the price of a license would then trigger the exclusion of the patent from the selected patent bundle. On the contrary, patents tend to be complements when the prices of licenses are low, with the potential licensee preferring to use all patents conditionally on the adoption of the technology. An increase in the price of a license would therefore not result in the exclusion of the patent from the basket of patents chosen by the licensee, but rather may result in a reduction in the demand for the whole basket. In such a case, he finds that patent pools increase welfare.

Determining whether patents are complements or substitutes may be tricky in practical terms, since usually competition authorities may have limited information on the demand for the patents in the pool. However, he notices that, if licensors are allowed to offer individual licenses in addition to jointly offer their patents in the pool, this fact could be used by competition authorities to screen patent pools that do not pose anticompetitive risks, since licensors would only be tempted to make such stand-alone offers in cases when bundling entails higher prices.

Although this paper focuses on patent pools and is therefore relevant for current discussions of this topic, the analysis is rather general and applies, mutatis mutandis, also to other cooperation arrangements like code-sharing agreements between airlines (examples of these arrangements are alliances such as Oneworld and Star Alliance, that have been subjects of recent antitrust investigations by the European Commission).3 Cooperation agreements are subject to specific European Commission’s guidelines.

Regulation of natural monopolies

One of the main contributions of Jean Tirole is to the field of regulation. Together with Jean-Jacques Laffont, he wrote a very influential paper in regulation (Laffont and Tirole 1986). In this paper he analyzes the regulation of a monopolist in a situation in which the regulator observes the firm’s production cost but the firm has private information on the determinants of its costs: the regulator cannot distinguish between a firm that is more efficient because, for example, it benefits from economies of scale and a firm that has actively invested in the past to make its production more efficient.

In such a situation, they find that a regulator cannot attain the first-best outcome because of the informational asymmetry between the firm and the regulator, but that the regulator can reach a satisfactory second-best outcome by carefully designing a menu of contracts – from which the firm then self-selects its contract by announcing its expected cost – minimizing the rents to the monopolist while still leaving incentives to the firm for cost reductions. The general form of the transfer in this menu of contracts consists of a fixed-price payment plus a linear (partial) cost overrun reimbursement. The contract designed for the most efficient type of firm involves just the fixed-price component (no cost-overrun reimbursement) in order to give the firm (might it happen to be that efficient) high-powered incentives to reduce costs. This is also the only contract of the menu that is able to replicate the first-best outcome.

4 Information rents are rents that the firm earns by exploiting the asymmetry of information existing between it and the regulator.

The contracts designed for less efficient types of firm offer a partial cost overrun reimbursement (and hence less powerful incentives for cost reductions) in order to reduce the information rents4 for the most efficient types. In fact, consider the case in which the regulator designs also the contracts intended for the less efficient types of firm as a fixed-price contract, in order to give them the most powerful incentives for cost reductions. In order for these potential types of firm to pick the contract, the fixed-payment should be larger, since they are less efficient. But then more efficient types of firm would have an incentive to announce a higher expected cost in order to receive a larger payment and earn additional information rents. The menu of contract is therefore optimally designed in order to trade-off the incentives to the firm to reduce its cost with the information rents for more efficient types.

Laffont and Tirole also extend this model to take into account that regulation is not a one-time occurrence but rather a process that changes over time (for instance, Laffont and Tirole 1988, which analyzes the ratchet effect arising when the regulator can only offer a short-term contract to the firm,  and Laffont and Tirole 1990, which analyzes how a long-term contract between the firm and the regulator gets renegotiated over time) and the possibility of regulatory capture (Laffont and Tirole 1991). Many of these contributions are summarized in their book on regulation and procurement (Laffont and Tirole 1993).

The contributions of Tirole to research in regulation are not limited to general modelling of regulatory games, but deal also directly with regulation in specific (and very important) industries like communications (Laffont and Tirole 2001)  and the financial sector (Dewatripont, Rochet and Tirole 2010). 

Thu, 16 Oct 2014 08:09:01 +0100
<![CDATA[China seeking to cash in on Europe’s crises]]> http://www.bruegel.org/nc/blog/detail/article/1461-china-seeking-to-cash-in-on-europes-crises/ blog1461

Last Tuesday, I posted about the increasing investment of China in Russia, wondering whether and to what extent it could help Russia smooth the economic impact of European sanctions. But as shown by a recent  analysis of the Financial Times, China has been increasingly investing in Europe as well, focusing recently on crisis-hit countries.

Chinese FDI to Europe has been very small until 2010. But since then it has been significantly increasing, reaching 27bn euro in 2012

China has traditionally been a receiver of European FDI, which according to Deutsche Bank, accounted for 18% of total China’s FDI stock. On the contrary, Chinese FDI to Europe has been very small until 2010. But since then it has been significantly increasing, reaching 27bn euro in 2012. Even so, Chinese FDI still represents a minimal share (0.7%) of total FDI stocks that EU countries receive from non-EU countries.

Between 2008 and mid-2014, China sealed more than 200 cross-border M&A or joint venture deals in the EU

According to Deutsche Bank, between 2008 and mid-2014, China sealed more than 200 cross-border M&A or joint venture deals in the EU.  Most M&A projects were undertaken in the industrial sector, consumer products, energy and basic materials (figure 2, right). Deutsche Bank also highlights the existence of different strategies across destination countries: in Germany, deals appear to have been focused mostly on machinery, alternative energy, automotive parts and equipment; in France, the target was mostly consumer industries; while in the UK target industries reflect a broad-based mix.

Germany attracted the largest number of deals (figure 2, left) - most notably Greenfield investments - followed by the UK and the Netherlands. Italy, Greece, Portugal and Spain, seem to have become more interesting to Chinese investors only from 2012 onwards.

Italy, Greece, Portugal and Spain seem to have become more interesting to Chinese investors only from 2012 onwards

The Financial Times published this week an analytical series (“Silk Road redux”) that looks more into this new wave of Chinese FDI in crisis-hit European countries. Sources quoted in the articles suggest that with the 2010 European crisis, China has indeed started to shift its foreign investment focus from mostly natural resources-related investments in Africa, Asia and Latin America, towards assets in European countries that, at the height of the crisis, were often faced with the need to privatize quickly and at relatively cheap price (figure 3).

In Italy, the FT reports that at the end of 2012, an estimated 195 SMEs (with combined total revenues of €6bn and 10,000 employees) had been wholly or partly taken over by Chinese or Hong Kong investors. China managed to secure stakes in big companies as well. In July this year, Chinese State Grid invested heavily in the Italian power grid, buying 35% in CDP Reti. Safe in turn invested estimated 2 billions in ENI and ENEL, two state-controlled energy groups, while the state Administration of Foreign Exchange bought 2% stakes in FIAT Chrysler Automobiles, Telecom Italia and Prysmian, for a total of 670 million.

In Greece, Chinese investors are focusing on shipping and tourism. In June, Greece and China signed shipbuilding deals worth $3.2bn that will be financed by the state-owned China Development Bank. The Chinese state shipping group Cosco Pacific had already acquired a concession to operate in the Piraeus port back in 2009, and is competing to buy the 67% stake currently held by the Greek State. Greece’s Transport ministry is also reportedly expecting China’s State Construction Engineering Corporation to participate in a tender to build and operate a new 800 million euro airport in Crete, which could offer the first direct connection between China and Greece. Chinese tourists are increasing in Greece, and (in 20 years time) they could possibly enjoy the huge luxury commercial centre that will be built on the coastal site of the former Athens airport. A long-term project worth 5 billion in which Chinese Fosun is participating together with Greece and Gulf state partners.

In Portugal, Chinese investment is reported to account for 45% of the total privatization conducted in the context of the EU/IMF programme

In Portugal, Chinese investment is reported to account for 45% of the total privatization conducted in the context of the EU/IMF programme. Chinese early investments were in power utility and infrastructure, with Three Gorges Corporation acquiring in 2011 a stake of 21% in Energias de Portugal and China State Grid acquiring 25% of REN, the national grid operator. In 2014, instead, investment was concentrated in financial services, with Fosun buying 80% of the Portuguese Caixa Seguros, the largest insurance company, and now bidding for BES assets.

On top of these investments, Chinese buyers are potentially revitalising the otherwise paralysed real estate market in crisis-hit countries. The FT reports that government of Portugal, Cyprus, Greece, Hungary, Latvia and Spain are managing to attract Chinese real estate buyers by offering residency permits to non-Europeans who buy local property of a certain amount. The practice is known under the name of “golden visas”. In Portugal, the golden visa requires buying a property for at least 500,000 euros, the same in Spain (which is at present reported to have 500 application pending) whereas in Greece and Hungary it takes a 250,000 sale. Portugal is reportedly the country where the scheme has been more successful, with 1360 visa issued (81% of which to Chinese nationals) and an associated 900 million real estate investments (forecasted to reach 2 billion by end-2015).

Despite the recent increase, Chines FDI to Europe are still in an infancy state and more data will be needed before drawing conclusion on whether this can qualify as a meaningful trend. But it looks like the euro crisis might have opened to China the doors of otherwise locked European investments.

Thu, 16 Oct 2014 07:15:41 +0100
<![CDATA[Developing Asia: challenges and opportunities in the global economy]]> http://www.bruegel.org/nc/events/event-detail/event/469-developing-asia-challenges-and-opportunities-in-the-global-economy/ even469

Developing Asia remains the fastest growing region globally. Slowing external demand has hurt some economies in the region but as a whole Asia and the Pacific is on track for firm growth in 2014 and 2015. Presenting the update of the Asian Development Outlook 2014 (ADO 2014), Dr Wei will argue that moving forward structural reform processes in China, India, and Indonesia—the region’s three biggest economies—will be critical in shaping their growth outlook.

Dr. Wei will discuss the impact of the winding down of unconventional United States monetary policy on Asian financial markets. Although US policy could still surprise markets if higher growth than expected pushed the Federal Reserve toward an early interest rate increase, the effect on developing Asia would be modest next to the shock caused in 2013 by anticipated tightening. Finally, he will maintain that demand and benign international commodity prices will keep inflation moderate in developing Asia. As many economies in Asia have grown by connecting with global value chains, he will argue that strengthening them could further stimulate expansion of industry and services and create jobs.

The presentation will be followed by comments by Lucian Cernat and an open discussion chaired by Reinhilde Veugelers.

The event will be live streamed on this page.


  • Dr. Shang-Jin Wei, Chief Economist, Asian Development Bank
  • Lucian Cernat, Chief Economist and Head of Unit, European Commission, DG Trade
  • Chair: Reinhilde Veugelers, Senior Fellow, Bruegel

About the speakers

Shang-Jin Wei is the Chief Economist of the Asian Development Bank (ADB). He is the chief spokesperson for ADB on economic and development trends, and leads the Economics and Research Department, which publishes ADB’s flagship knowledge products.

Mr. Wei, born in the People’s Republic of China and a national of the United States, has a long and distinguished career in academia and international finance and trade. Before joining ADB he was the N.T. Wang Chair and Director of the Chazen Institute of International Business at Columbia University, Director of the National Bureau of Economic Research’s working group on the Chinese economy, and a research fellow at the Center for Economic Policy Research (Europe).

Prior to Columbia University, Mr. Wei was an Assistant Director and Chief of Division at the International Monetary Fund (IMF) where he led the Fund’s policy research and advised on issues in international trade, investment, globalization, and related topics. He was IMF Chief of Mission to Myanmar in 2004.

Mr. Wei served as an advisor on anti-corruption policy and research at the World Bank from 1999 to 2000. He was an assistant and associate professor at Harvard University from 1992 to 1999.

Mr. Wei earned a PhD in Economics and a Master’s degree in Finance from the University of California, Berkeley; a Master’s degree in Economics from Pennsylvania State University; and a Bachelor’s degree in World Economy from Fudan University in the People’s Republic of China.

Practical information

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Monday, 10 November 2014, 12.45-14.30
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Wed, 15 Oct 2014 16:11:28 +0100
<![CDATA[Student mobility in Europe]]> http://www.bruegel.org/nc/blog/detail/article/1460-student-mobility-in-europe/ blog1460

The chart shows the percentage of students coming from other European countries, measured on the total university student population, who are enrolled in tertiary education, either in Erasmus programs or national degree programs of the hosting country.

Share of international students has increased over the past few years in most of the selected countries

Share of international students has increased over the past few years in most of the selected countries. The increase has been particularly relevant in countries such as Belgium, Denmark and the Netherlands, while traditionally popular destinations for international students, such as the United Kingdom, have displayed a more stable trend. Share of Erasmus students has instead remained quite constant over time.

The boom in student mobility may have been consequent to the gradual enhancement of integration in the European tertiary education system, following the implementation of the Bologna process, introduced in 1999 and aimed at standardizing curriculum in higher education, making it easier for students to move across the countries of the Union.

Tue, 14 Oct 2014 11:03:31 +0100
<![CDATA[Looking past the (West’s) end of the nose]]> http://www.bruegel.org/nc/blog/detail/article/1459-looking-past-the-wests-end-of-the-nose/ blog1459

What is being largely ignored is that the underlying growth trend of the world economy itself is actually rising

Following the recent IMF annual meetings, and the coincidental declines in global stock markets, gloom is back about the state of the world economy. While there is some evidence of a recent slowdown in the world economic cycle, what is being largely ignored is that the underlying growth trend of the world economy itself is actually rising.

The world economy grew faster in the decade 2001-10 despite the fact that there were two major global economic crises

Many observers seem to be unaware of the fact that the world economy grew faster in the decade 2001-10 despite the fact that there were two major global economic crises, the bursting of the dot-com bubble in 2000-01 and the global credit crisis in 2008-09.  According to revised IMF data (displayed in Table 1 above), which incorporates the recent new PPP estimates from the International Comparison Programme (ICP), world GDP growth in 2001-10 rose by around 4.0 percent, up from 3.7 percent based on the old weights, which was already stronger than generally appreciated. This GDP growth rate was already higher than the 3.4 and 3.2 percent growth of the previous two decades, and of course, the higher growth rate reflects the stronger weights of the rising emerging economies such as China and India, and their own stronger growth rates. What is probably even less known is that despite the various challenges around the developed and developing world so far this decade, in the years 2011-13, world GDP growth was around 3.6pct, which although down from the last decade’s heady growth, is also higher than the two previous decades.

The table 2 below shows the growth rates by decade since the 1980’s for major regions, the world in general, as well as this decade to date, and what we have been assuming the world’s potential would be for this full decade, 2011-20. 

Note: *forecasts

While all four of the BRIC economies have slowed decade to date, the MINT countries have actually accelerated as a group

What is clear is that the stronger underlying trend is due to the rising weight of the so-called BRIC countries, especially China, and to a more modest degree, the next largest group of emerging economies, that I call the MINT countries. While all four of the BRIC economies have slowed decade to date, the MINT countries have actually accelerated as a group, and seem set to have a stronger growth rate this decade than the last. While the BRIC countries will experience slower growth this decade, it is only really Brazil and Russia that have significantly disappointed, which in both cases, reflects their own significant challenges, of which at the core, is their excessive dependence on commodities and the benefit of rising prices. While India has been softer than assumed so far, there is a reasonable chance that economic growth will accelerate again under the current Indian leadership. As far as China is concerned, while it is likely to continue to show softer growth than the previous decades, for many, including myself, this growth is not anything less than assumed. In fact, as can be seen, it is the one country within the BRICs that decade to date has grown stronger than assumed, despite slowing. And the rising weight of China, now bigger than the US in PPP terms, contributes more and more to world GDP growth.

Even the IMF itself appears to refer to disappointments about the emerging world, suggesting that their over prediction of world GDP forecasts for each of the past 3 years is greatly due to excessive optimism about the larger emerging economies. That might be true for Brazil and Russia, but hardly elsewhere.

Looking at the so-called developed world, relative to their underlying trend, it is hard to express too much disappointment about either of the US or UK, nor indeed Japan. Decade to date, Japan has grown close to its assumed trend, and although each of the UK and US has currently grown by less than the decade’s assumed trend, their current 2014 is above that assumed, and another year similar to this one for both , would take them close to trend.

This decade to date is –so far- higher than both the 1980’s and 90’s despite the adjustment challenges post crisis

What is also the case, that seems to be often overlooked by those talking about the persistent disappointments, is as pointed out, this decade to date is –so far- higher than both the 1980’s and 90’s despite the adjustment challenges post crisis. If it is indeed the case that some pessimists argue, that the absence of the unconstrained credit binge of the “Noughties” is hindering growth, it is surely quite encouraging that growth although softer than that decade is, at least globally, higher than the previous two. Indeed, if the strength of the 4pct growth of the previous decade was partially due to the excesses that led to the global credit crunch, and not sustainable, seen in this light, the growth maintained from 2011-13 is quite respectable.

A further substantive point which many pessimists seem to overlook, is that each of the US and China has moved to a much more desired external balance of payments position than existing before the crisis, with the US current account deficit likely to be close to 2 percent of GDP in 2014, down from around 6.5 percent in 2008. China has seen its current account surplus drop sharply from close to 10 percent of GDP to somewhere between 2-3 percent of GDP. For both these economies to make such an adjustment and for their own growth rates to have performed in the manner they have is quite impressive.

What is more genuinely disappointing is that the Eurozone has shown such persistently weak growth this decade

What is more genuinely disappointing is that the Eurozone has shown such persistently weak growth this decade, significantly below its assumed- weak- trend, and is the main explanation as to why global GDP growth has stayed below its- rising –potential. Moreover, unlike the US or China, the Eurozone has seen its external current account surplus widen significantly, probably a partial reflection of the weakness in domestic euro area growth.

For the world as a whole to achieve its better BRIC and MINT induced potential, it can only occur if Euro Area policymakers can be more determined to pursue policies that both boost their cyclical economic performance, and perhaps do more to boost their own weak underlying trend.

Mon, 13 Oct 2014 13:39:53 +0100
<![CDATA[Infrastructure investment is a no-brainer]]> http://www.bruegel.org/nc/blog/detail/article/1457-infrastructure-investment-is-a-no-brainer/ blog1457

What’s at stake: For countries with infrastructure needs, the combination of low interest rates and mediocre growth mean that it’s time for an investment push. While Brad DeLong and Lawrence Summers already laid out the theoretical case in a 2012 Brookings paper, the empirical case was laid out this week in Chapter 3 of the latest IMF World Economic Outlook.

Lawrence Summers writes that in a time of economic shortfall and inadequate public investment, there is for once a free lunch – a way for governments to strengthen both the economy and their own financial positions. Greg Mankiw writes that the free-lunch view is certainly theoretically possible (just like self-financing tax cuts), but we should be skeptical about whether it can occur in practice (just like self-financing tax cuts). 

Disinvestment madness

In advanced economies, public investment was scaled back from about 4% of GDP in the 1980s to 3% of GDP at present

Abiad and al. write on the IMF blog that the evolution of the stock of public capital suggests rising inadequacies in infrastructure provision. Public capital has declined significantly as a share of output over the past three decades in both advanced and developing countries. In advanced economies, public investment was scaled back from about 4 percent of GDP in the 1980s to 3 percent of GDP at present (maintenance spending has also fallen, especially since the financial crisis).

This makes a very strong case for sharply increasing public investment in a depressed economy

Paul Krugman writes that this is disinvestment madness. Real interest rates are extremely low, indicating that the private sector sees very little opportunity cost in using funds for public investment. There has been a lot of slack in the labor market, so that many of the workers one would employ in public investment would otherwise have been idle — so very little opportunity cost there either. This makes a very strong case for sharply increasing public investment in a depressed economy; a case that doesn’t rely on claims that there is a large multiplier, although there’s every reason to believe that this is also true.

Methodology for identifying investment shocks

The authors of the WEO’s chapter 3 write that in contrast to the large body of literature that has focused on estimating the long term elasticity of output to public and infrastructure capital using a production function approach, the IMF analysis adopts a novel empirical strategy that allows estimation of both the short- and medium-term effects of public investment on a range of macroeconomic variables. Specifically, it isolates shocks to public investment that can plausibly be deemed exogenous by following the approach of smooth transition VARs of Auerbach and Gorodnichenko (2012, 2013), where the shocks are identified as the difference between forecast and actual investment. In the WEO chapter, the forecasts of investment spending are those reported in the fall issue of the OECD’s Economic Outlook for the same year.

The positive effects of increased public infrastructure investment are particularly strong when public investment is undertaken during periods of economic slack and monetary policy accommodation

The authors of the WEO’s chapter 3 write that a problem in the identification of public investment shocks is that they may be endogenous to output growth surprises. But the public investment innovations identified are only weakly correlated (about –0.11) with output growth surprises. Another possible problem in identifying public investment shocks is a potential systematic bias in the forecasts concerning economic variables other than public investment, with the result that the forecast errors for public investment are correlated with those for other macroeconomic variables. To address this concern, the measure of public investment shocks has been regressed on the forecast errors of other components of government spending, private investment, and private consumption.

Main results

Abiad and al. write on the IMF blog that the benefits depend on a number of factors. The authors find that the positive effects of increased public infrastructure investment are particularly strong when public investment is undertaken during periods of economic slack and monetary policy accommodation, where additional public investment spending is not wasted and is allocated to projects with high rates of return and when it is financed by issuing debt has larger output effects than when it is financed by raising taxes or cutting other spending.

Infrastructure investment in Europe

Mario Monti writes that while a simplistic stability pact may have been the right choice when the euro was in its infancy, Europe can no longer afford to stick with such a rudimentary instrument. By failing to recognize the proper role of public investment, it has pushed governments to stop building infrastructure just when they should have built more. What is needed is not the flexibility to deviate from the rules, but rules that are economically and morally rigorous. The new Commission should announce a proposal for updating the rules on fiscal discipline, to reflect the role of productive public investment. The commission would then enforce the existing stability pact while allowing for the favorable treatment of public investment within the limits set out in 2013.

Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps

Lawrence Summers writes that Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps. This may be possible through the expansion of the European Investment Bank or more use of capital budget concepts in implementing fiscal reviews.

Mon, 13 Oct 2014 06:11:32 +0100
<![CDATA[Crowdfunding: Broadening Europe’s capital markets]]> http://www.bruegel.org/nc/blog/detail/article/1456-crowdfunding-broadening-europes-capital-markets/ blog1456

The rising financing gap for SMEs as well as high growth firms is a serious concern for Europe battered by financial fragility. These firms, particularly young innovative firms, are the drivers of job creation and economic growth, much needed to break through the economic malaise across Europe.

Note: Figures refer to the preliminary results of the OECD DYNEMP project based on data from Austria, Belgium, Brazil, Finland, France, Hungary, Italy, Japan, Luxembourg, the Netherlands, New Zealand, Norway, Spain, Sweden and the United States.

In the U.S., the majority (70%, according to IRSG) of corporate fundraising is through the securities market while in Europe, companies have traditionally relied on bank lending

In the U.S., the majority (70%, according to IRSG) of corporate fundraising is through the securities market while in Europe, companies have traditionally relied on bank lending.

The curtailing of bank lending over the past several years due to the financial crisis has created a huge constraint for these firms, particularly as non-bank capital is less prevalent in Europe. In the U.S., the majority (70%, according to IRSG) of corporate fundraising is through the securities market while in Europe, companies have traditionally relied on bank lending.

NoteScale from 1 to 7 from hardest to easiest, weighted averages.

At a time when banking intermediation is under pressure, it is important for European Union policymakers to further explore alternative forms of financial intermediation. Commission President Jean-Claude Juncker recently spoke about the need to improve financing in Europe by “further developing and integrating capital markets” and reducing the dependence on bank funding. He and his new team should address regulatory fragmentation in financial markets head on in order to facilitate efficient funding and growth of innovation in Europe.

The European capital markets are highly fragmented making it difficult for innovative young firms to access the necessary financing

For innovative young firms, equity capital can be particularly important to fuel growth across borders, yet the European capital markets are highly fragmented making it difficult for these firms to access the necessary financing. Different rules and regulations apply to various types of financial instruments and financial intermediaries across European countries.  Financial intermediation plays a critical role for young firms as information asymmetries make it difficult for investors to identify and evaluate the potential of these firms.

Venture capital and angel investment are playing an increasingly important role in Europe but activity is still overshadowed by the U.S. where the capital markets are more developed. 

Note: Data for the United States refer to market statistics, data for Europe refer to industry statistics. Europe includes here Austria, Belgium, Bosnia-Herzegovina, Bulgaria, Croatia, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Former Yugoslav Republic of Macedonia, Montenegro, Netherlands, Norway, Poland, Portugal, Romania, Serbia, Spain, Slovak Republic, Slovenia, Sweden, Switzerland, Ukraine and United Kingdom.

Over the past decade, European venture capital investment has been approximately one-fifth to one-third the size of investment in United States but this figure has dropped further in recent years. Also, the number of venture capital deals in Europe is higher than in the United States, showing that venture capital firms in Europe are, on average, dispersing funds more broadly through smaller deals. In fact, according to the data above, deals in the United States have been on average almost double the size of European deals.

Over the past decade, European venture capital investment has been approximately one-fifth to one-third the size of investment in United States

Angel investment has been playing an increasingly important role in the financing innovative young firms but remains primarily local due to the fact that the majority of angel investments are made individually to entrepreneurs within the investors’ communities. A growing number of angel investors are investing through groups, networks and syndicates but the majority of these investments also remain local or national.

As analysed in a paper just published by Bruegel, Crowdfunding is increasingly attracting attention, most recently for its potential to provide equity funding to start-ups.

Equity crowdfunding can open up additional channels for new ventures to access finance at a time when securing funding is difficult, however, policy makers should carefully assess the risks of this new financial intermediation tool. The challenges that equity crowdfunding poses are distinct and more complex than those of the other forms of crowdfunding and the risks also differ from other forms of seed and early stage equity finance, such as angel investment and venture capital. Unlike other forms of equity financing, crowdfunding is intermediated by online platforms. These platforms differ in terms of the role they play in screening and evaluating companies. Also, their role during the investment and post-investment stages can vary dramatically.

Due to exemptions in legislations, Europe has been at the forefront of equity crowdfunding globally

Due to exemptions in legislations, Europe has been at the forefront of equity crowdfunding globally. However, the market is highly deregulated with few legal protections provided to funders.  In response, some member states have introduced ad hoc legislations for crowdfunding, while some others will introduce new laws soon. Being internet based, equity crowdfunding has the potential to contribute to a pan-European seed and early stage financial market to support European start-ups. However, in order to maximise this benefit, policies to address equity crowdfunding models should be adopted homogeneously by all member states. This approach would maximise the benefits of equity crowdfunding and help to reduce the risks. It would also help to address some of the fragmentation in Europe’s financing markets and encourage new forms of financial intermediation. The Commission should work with Member States to address the current patch-work of national legal frameworks which constitute an obstacle to the appropriate development of this nascent model of funding across Europe as part of the work towards a Capital Market Union.

Fri, 10 Oct 2014 09:30:32 +0100
<![CDATA[Developing an underlying inflation gauge for China]]> http://www.bruegel.org/publications/publication-detail/publication/853-developing-an-underlying-inflation-gauge-for-china/ publ853

This paper develops a new underlying inflation gauge (UIG) for China which differentiates between trend and noise, is available daily and uses a broad set of variables that potentially influence inflation. Its construction follows the works at other major central banks, adopts the methodology of a dynamic factor model that extracts the lower frequency components as developed by Forni et al (2000) and draws on the experience of the People’s Bank of China in modelling inflation.

Developing an underlying inflation gauge for China (English)
Thu, 09 Oct 2014 11:45:30 +0100
<![CDATA[European banks’ business models evolving under crisis pressure]]> http://www.bruegel.org/nc/events/event-detail/event/468-european-banks-business-models-evolving-under-crisis-pressure/ even468

Bruegel would like to invite you to a Finance Focus Breakfast on “European Banks’ Business Models Evolving under Crisis Pressure.” Initial presentations by Jean-François Neuez and Simon Ainsworth will be followed by an open discussion chaired by Nicolas Véron.

The business models of European Banks are evolving under a number of interrelated factors: the crisis and corresponding deleveraging & risk repricing, regulatory initiatives that have been enacted but are at various stages of implementation, the gradual buildup of Europe’s banking union, regulatory initiatives that are under discussion and may or may not materialize, and rapid technological change, to name only a few. Policy debates about banking reform are often at least partly based on somewhat abstracted considerations. By contrast, this session will provide an opportunity to take stock on current shifts from the observation of actual developments in the banking sector.

This event will be held under the Chatham House Rule


  • Jean-François Neuez, Senior Analyst European Financial Research, Goldman Sachs
  • Simon Ainsworth, Group Credit Officer EMEA Banks, Moody's
  • Chair: Nicolas Véron, Senior Fellow, Bruegel

Practical details

  • Venue:Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time:Friday, 24 October, 8:30 - 10:00
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Wed, 08 Oct 2014 10:44:35 +0100
<![CDATA[Immigration, Intra-EU Mobility, and Sustainable economic growth]]> http://www.bruegel.org/nc/events/event-detail/event/466-immigration-intra-eu-mobility-and-sustainable-economic-growth/ even466

Recent research demonstrates that immigration into the European Union and intra-EU mobility may promote economic growth in several ways: Bilateral trade and investment with the immigrants' home countries tend to grow, probably because migrants facilitate communication across borders. Immigrants may supply complementary skills to current residents and help to increase residents' productivity and income. Immigrants may also help aging European societies to age less rapidly. Commissioner Andor will discuss the growth effects of immigration and mobility in the EU and reflect on options for immigration policies at the community and member state levels that promote sustainable growth. Greg Wright will highlight recent research findings on the impact of immigration and Melissa Siegel will focus on how migrants would be affected by immigration policies that emphasize host country welfare. Finally Vit Novotný will comment on what has been discussed and talk about the ongoing political discussion on improving immigration policies.

Event materials

Event summary -


  • László Andor, European Commissioner for Employment, Social Affairs and Inclusion
  • Greg C. Wright, University of California at Merced
  • Melissa Siegel, United Nations University - MERIT
  • Vít Novotný, Senior Research Officer at the Wilfried Martens Centre for European Studies
  • Chair: Guntram Wolff, Director, Bruegel

About the speakers

László Andor is an economist and has been Commissioner for Employment, Social Affairs and Inclusion since 2010. He is on unpaid leave from professorial appointments at the Economics Department of Corvinus University of Budapest King Sigismund College. He was on the board of directors of the European Bank for Reconstruction and Development (EBRD) from 2005 to 2010. Before that, he was involved in several research projects in the area of labour markets and European integration and was also an economic advisor to the Hungarian Prime Minister’s Office, among other institutions.

Greg Wright is an Assistant Professor at the University of California at Merced and was previously Lecturer at the University of Essex from 2011 to 2013. His research deals with the labour market impact of globalization through trade and immigration. He was educated first in astrophysics (B.A., UC Berkeley 1998) and then obtained a master's degree and Ph.D. in economics at UC Davis. His recent publications include “Immigration, Offshoring and American Jobs”, with G. Peri and G. Ottaviano, American Economic Review 2013.

Melissa Siegel is an Associate Professor and Head of Migration Studies at the Maastricht Graduate School of Governance and UNU-MERIT. She heads the Migration and Development research group of UNU-MERIT and the Migration and Development research theme of the Maastricht Center for Citizenship, Migration and Development (MACIMIDE). She has headed research projects on migration and development in countries ranging from Surinam to Afghanistan and is also regularly involved in migration-related trainings for national governments and international organizations.

Vít Novotný is a senior research officer at the Wilfried Martens Centre for European Studies. In charge of research cooperation with the Centre's member foundations, he has edited the volumes From Reform to Growth: Managing the Economic crisis in Europe (2013) and Opening the Door? Immigration and Integration in the European Union (2012). These books create European centre-right policy narratives in their fields. Vít Novotný is also responsible for research clusters on ethics, values and religion and new societal challenges. He has previous experience working in the education, private, public and non-profit sectors in the UK (2004-10). His education includes postgraduate degrees in clinical pharmacy, European studies, public administration and politics from universities in Czechia, the US and the UK. He has published widely on politics and current issues in Czech and English-language press.

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Monday 20 October 2014, 12.30-14.30
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

This event is held in the framework of the project Europe’s Global Linkages and the Impact of the Financial Crisis. This project is led by IAW and the other partners are: Tübingen University, Institut für Weltwirtschaft, Fondazione Enrio Mattei, FEEM, Keio University, Maastricht University, University of California Davis and researchers from China. The VW foundation supports this project within its program “Europe and Global Challenges

Wed, 08 Oct 2014 10:36:19 +0100
<![CDATA[How I learned to stop worrying about TARGET2 and love the ECB]]> http://www.bruegel.org/nc/blog/detail/article/1455-how-i-learned-to-stop-worrying-about-target2-and-love-the-ecb/ blog1455

There always comes a time we have to face our past. For economists, it often happens when updating data long left sitting in a remote corner of our desktops

There always comes a time we have to face our past.

For economists, it often happens when updating data long left sitting in a remote corner of our desktops.

It happened to me recently. I refreshed an old chart and suddenly realized how—and why—an issue that spooked economists and financial markets alike back in 2011 and 2012 has faded so far into the background.

During the height of the European financial crisis, economists and journalists eagerly followed the latest updates on a mysterious-sounding data series known as TARGET2, which needed to be unearthed from the depths of the websites of each and every national central bank in the euro area.

In 2012, roughly €2.5 trillion worth of transactions were made on the TARGET2 system each day

TARGET2 stands for Trans-European Automated Real-time Gross settlement Express Transfer. (It is the second iteration of the system, thus the “2.”) Essentially, this a European Union payment system used by large institutions—mostly banks—to make large, cross-border euro-denominated payments throughout the course of the day. These are large amounts of money. In 2012, roughly €2.5 trillion worth of transactions were made on the TARGET2 system each day.

In practice, during the crisis the system worked more as a transfer system between countries that were seeing capital flow into or out of the country.

Here’s how it worked. Imagine a CFO at a corporation in say, Spain, back in 2011 when the crisis was intensifying. Yields on Spanish government debt were rising as markets were starting to lose confidence. There were serious doubts about the possibility that Spain might be forced to request an EU/IMF assistance program. The CFO became reasonably nervous about the safety of the bank where her company kept its money. So she decides to move the company’s account to a stronger bank in, say, Germany.

She directs her Spanish bank to transfer the company’s money, say €100 million, to the new German bank. This implies to opposite things: Deposits at the Spanish bank go down by €100 million, and deposits at the German bank go up by €100 million.

Now, like all banks, the Spanish bank doesn’t have that company’s €100 million just sitting around in a vault somewhere. (Banks make money by lending out deposits.) And the CFO of our company, most likely, is not the only one who had the brilliant idea to move money to safety. So the Spanish bank probably finds itself in a situation where its deposit base is naturally shrinking.

Deposits at the Spanish bank go down by €100 million, and deposits at the German bank go up by €100 million

But still, assets and liabilities on bank balance sheets must match. That means the Spanish bank must raise the money it needs to send to the German bank, if it wants to avoid raising additional doubts about its solvency. If such doubts grow unchecked, they could trigger a full-on bank run. Now, in normal times the Spanish bank could borrow needed cash cheaply and easily from other banks. But 2011 and 2012 were not normal times.

The interbank market—where banks lend money to one another—was basically frozen. The Spanish bank might have come up with the money by selling assets, such as the bonds or other investments the bank owned. But that would have taken too long. And borrowing from depositors was not an option. Remember, this was a situation where depositors were pulling money out of the bank, not depositing more in.

So what is to be done? Luckily for the banks in the euro zone countries that ended up under highest stress, the European Central Bank had a solution. The ECB would provide cheap, long-term loans in exchange for collateral, via its Longer-Term Refinancing Operations (LTROs). The ECB launched two extraordinary version of these operations (on December 2011 and February 2012 ) offering to lend cash for three years. European banks jumped on the offer, borrowing roughly €1 trillion (paywall).

Through this program the ECB essentially acted as a conduit between countries that were experiencing constant outflows and those where capital was constantly flowing in, in search of safety.

This is reflected in the chart. Countries where banks were constantly borrowing from the ECB—the actual system through which the money was transferred in LTROs was our old friend TARGET2—such as Greece, Ireland, Portugal, Italy and Spain were net borrowers of the Central Bank’s liquidity. As a result the accumulated a TARGET2 deficit vis à vis the ECB.

Through this program the ECB essentially acted as a conduit between countries that were experiencing constant outflows and those where capital was constantly flowing in, in search of safety

On the other hand, banks in countries like Germany were receiving large flows of that safety-seeking cash. As it started to pile up, these German banks didn’t see a lot of good places to immediately invest it. (After all the European economy was in turmoil.) So they simply started to deposit their excess reserves at the ECB—again using our TARGET2 payment system—driving their account TARGET2 balance at the ECB into a giant surplus.

And that’s how things continued to develop until 2012.

Since then, things have changed dramatically. Why?

Well, the most clear development came in August 2012, when the ECB announced it was willing to buy government bonds on the secondary market, if the country asked for help, via a program known as outright monetary transactions (OMT). The possibility of a buyer like the ECB, which had theoretically bottomless pockets—although there were some constraints on the maturities of securities it said it would buy—stopped the European government bond selloff in its tracks.

Over the next few years, prices for European bonds issued by troubled countries rose sharply, dissipating some of the doubts about the immediate solvency of the banking systems in those countries. The return of confidence eased concerns of depositors and other lenders, making it easier and cheaper for those banks to raise money.

Banks that saw deposit outflow, such as our imaginary Spanish bank, were better able to raise the money they needed. They therefore returned some or all of the money they borrowed from the ECB. In other words, conditions have been normalizing. (Although this is happening very slowly and we are still far from pre-crisis balance.)

So, is that it? Problem solved?

While short-term issues of financial stability have improved markedly, the wild ride of TARGET2 balances in recent years highlights a new problem for the ECB

Not exactly. While short-term issues of financial stability have improved markedly, the wild ride of TARGET2 balances in recent years highlights a new problem for the ECB. As I recently pointed out here, the ECB’s approach to unconventional monetary is ultimately outside the central bank’s control, because it is driven by banks’ demand for (and decision to reimburse) the money created by the central bank. In other words, during the worst phase of the crisis, the ECB effectively outsources the central bank’s balance sheet management to banks in the private sector.

Why is this a problem? You need only look at the recent readings of dangerously low inflation in the euro zone to understand why. If the ECB truly wants to keep the risk of falling into a Japanese-style deflationary trap at bay, it must act decisively to expand its balance sheet—as the US Federal Reserve did—on its own.

Tue, 07 Oct 2014 16:31:20 +0100
<![CDATA[Making Argentina's Debt Debacle a Rarity]]> http://www.bruegel.org/nc/blog/detail/article/1453-making-argentinas-debt-debacle-a-rarity/ blog1453

United States courts—having confirmed Elliot’s claims under U.S. law—have also blocked payment to the other bondholders unless Elliot is paid. This has led Argentina back into default

After defaulting on its debt in January 2002, the Argentine government wore down its bondholders into accepting a 75 percent reduction on their claims. Among the few who refused the deal, Elliot Management Corporation aggressively pursued its legal rights for full repayment.

United States courts—having confirmed Elliot’s claims under U.S. law—have also blocked payment to the other bondholders unless Elliot is paid. This has led Argentina back into default.

While almost no one has sympathy for the rogue Argentine government, U.S. courts have been criticized for undermining global financial stability. Elliott vs Argentina may have severely narrowed the options for reducing the debt obligations of distressed sovereigns. Official international institutions will need to provide greater financial support, stretching their resources.   

Criticism of U.S. courts is not warranted. They were only interpreting and enforcing a contract, not trying to promote international public policy. Sovereign debt contracts have an inherent contradiction. The contract creates a firm commitment to timely repayments but renegotiation requires that the contract not be so firm after all.

For this reason, sovereign debt restructuring has had inevitable legal and financial uncertainties, making the process messy and fractious. Policy makers have therefore been inclined to delay the default decision, as recently was the case in Greece. The delays have increased the eventual cost of the default and created huge inequity in the eventual arbitrary imposition of losses.

But all proposals for resolving the built-in conundrum of sovereign debt continue to fiddle on the margins. The latest by the International Capital Market Association (ICMA) involves writing a complex set of covenants, which will remain subject to interpretation and challenge.

A durable and predictable system requires that the possibility of change in repayment terms must be built into the contract rather than being the outcome of renegotiation

A durable and predictable system requires that the possibility of change in repayment terms must be built into the contract rather than being the outcome of renegotiation.

The economic basis for this radical change is compelling. As many—among them Nobel Laureate, Christopher Sims—have pointed out, the phrase “sovereign debt” is a misnomer. The value of equity held in a private company falls when economic conditions deteriorate. Sovereigns need similar, contractually-transparent leeway to deal with the inevitable adversities. In such eventualities, forgiving some part of the debt makes sense even from the creditor’s perspective because that makes it more likely that the rest of the debt will be repaid. That is why bondholders eventually do renegotiate. But, because they can gain by holding out for full repayment, especially when others are likely to do so, the process is chaotic.

Here is how a more flexible sovereign debt contract may work. The debtor would have the option to defer repayment when, say, the 100-day average risk premium on its debt (the excess interest rate above US treasuries or German bunds) rises above a pre-agreed threshold. Thus repayment obligations would be automatically and predictably eased to handle contingencies, avoiding the angst associated with renegotiating the contract. Such contingent sovereign contracts (“cocos”) would be similar to those in increasing use by banks.

The built-in risk of payment standstill in the cocos would require that the sovereign debtors pay higher risk premia, which would be a prime benefit, not a flaw. The pressure would be to reduce public debt ratios and practice greater fiscal discipline. The present system generates unreasonably low premia on the sacrosanct “sovereign debt” because of the implicit but unreasonable reassurance of full repayment in those contracts. The consequence is that governments pay higher premia on their other obligations—or worse, payment obligations proliferate under the illusion of low premia, creating an unsustainable burden. When eventually all payments cannot be made, losses are imposed on such vulnerable groups as pension holders while well-heeled bondholders pay no, or a small, penalty.

The cocos would also eliminate the endemic incentives to delay restructuring. Under the current system delays occur, in part, because the threshold at which debt restructuring should occur is fuzzy. That fuzziness is compounded by prolonged and uncertain negotiations, which elevates the further risk of contagion to other sovereigns. For these reasons, international financial institutions are inclined to legitimize the delays with optimistic forecasts. The theme always is: restructuring is a good idea, but not in the midst of this crisis. The eventual restructuring imposes higher costs on all.

Sovereign cocos will prevent delays by pre-specifying the threshold at which a payments’ standstill can be initiated by the debtor

Sovereign cocos will prevent delays by pre-specifying the threshold at which a payments’ standstill can be initiated by the debtor. The standstill would need to be triggered well before insolvency is imminent and, hence, the likelihood of a return to normalcy is high. Economists Charles Calomiris and Richard Herring have made a similar observation for cocos issued by banks. Thus, the process would be incremental and automatic instead of arbitrary and spasmodic.

For example if a risk premium threshold of, say, 5 percent had been in place, Ireland, Portugal, and Spain could have initiated standstills and hence required less fiscal austerity, with reduced hardship on the most vulnerable and a more rapid return to growth. Creditors would have waited but would have eventually benefited by lending to more robust debtors. The sovereigns would have paid a penalty via higher risk premia for their new borrowing and, hence, would have been subject to the more reliable market vigilance rather than being guided by the illogical and fractious centralized system based in Brussels. Perhaps, the European Central Bank’s legally and politically fragile Outright Monetary Transactions would have been unnecessary.

With cocos, it would be in the sovereign’s interest to prevent the risk premium from reaching the threshold and, once reached, to restrain from exercising the option. If the threshold is reached often and standstill triggered, the terms of future access to the market will worsen. Official financial agencies called on to help if standstills persist will also have an incentive for credible monitoring rather than indulging in serially optimistic forecasts.   

Today, the elevation of the sovereign bondholder to a privileged creditor reflects a self-serving mystique fostered by financial lobbies and policy elites. As such, undoing the system will meet more than the usual resistance. However, the technical challenges of introducing sovereign cocos are no greater than that of the ICMA proposal. In fact, cocos are much simpler in design. The novelty of cocos will make the pricing initially more difficult, but will lead ultimately to greater public and private benefit.

The eurozone nations will gain much-needed flexibility in their rigid macro management apparatus by fostering a critical mass of cocos. While the existing overhang of eurozone debt cannot be so resolved, the further tendency to over accumulate debt can be curbed and a more mature future relationship with creditors can be established.

No contract is perfect. The current system, however, generates egregious outcomes

No contract is perfect. The current system, however, generates egregious outcomes. And all the so-called reform proposals retain the traditional implicit guarantees of repayment along with the contractual uncertainties and incentives to delay restructuring. In contrast, sovereign cocos would induce more realistic pricing of debt and help reduce public debt ratios. By automatically triggering a standstill, cocos would diminish the likelihood of reaching the point of no return. Paradoxically, the greater flexibility of cocos will create more predictability—and, hence, greater efficiency and equity.



Tue, 07 Oct 2014 16:15:03 +0100
<![CDATA[A compelling case for Chinese monetary easing]]> http://www.bruegel.org/nc/blog/detail/article/1452-a-compelling-case-for-chinese-monetary-easing/ blog1452

A successful Chinese economy needs both structural reforms on the supply side, and a nimble monetary policy on the demand side

Despite unmistakable signs of messy but meaningful monetary easing since last May, a puzzling debate is still raging over whether China should persist with painful but eventually rewarding economic reform or ease monetary policy to stabilise short-term growth. The puzzling question is why one should have to make a stark choice between them instead of sensibly combining the two. In my view, a successful Chinese economy needs both structural reforms on the supply side to enhance potential growth, and a nimble monetary policy to fully exploit such potential on the demand side. I discuss below six reasons why China ought to ease its monetary policy stance.

This policy debate is everywhere in the Chinese media, with the two most powerful Chinese official news agencies China Xinhau News and People’s Daily pitching two opposing views. Against a broad background of a slowing economy, low inflation and increased financial stress in China, the contrast between the two competing camps is crystal clear.

One camp believes that monetary accommodation hampers economic reforms, worsens the imbalances in the Chinese economy and simply promotes unsustainable short-term pseudo-growth at the expense of sustainable long-term development. This camp's main arguments appear to be that economic reforms and structural adjustments are necessarily painful and that the recent slowdown is mainly structural and healthy. Thus monetary easing is not only a show of no confidence in economic reform but also an attempt to sabotage economic reform — a scary accusation in China nowadays.

The opposite camp thinks that sensible monetary easing complements economic reforms, supports growth, facilitates structural adjustments and mitigates financial risks. Reform is not a sacred cow but a means to improve living standards for the majority of the Chinese population. Cyclically or structurally, there a very strong case for timely and measured monetary accommodation as risk management. The Chinese economy is unbalanced, but one doesn’t need to strangle it in order to rebalance it. Indeed, quite the contrary.

This ongoing controversy in China looks odd and even a bit funny, especially viewed through the lens of the US, the euro area and Japan, where the consensus view is that both aggressive demand support policy measures and strong structural reforms on the supply side should go hand-in-hand. And why not?

A similar case can also be made for China, in my view.

First, in the wake of the global financial crisis, the Chinese central bank (PBC) has unquestionably tightened the most relative to the big four central banks of the US Fed, European Central Bank, Bank of Japan and Bank of England. In other words, the PBC has been quite restrained, while the other big four central banks have pursued aggressive monetary accommodation. There is little doubt that the relatively tight Chinese monetary policy has considerably redistributed global demand away from domestic to foreign products. Thus to loosen its relatively tight monetary policy, China ought to ease.

Second, China’s financial conditions have also tightened the most since the global financial crisis among the big five economies of the US, euro area, Japan, the UK and. The financial condition indices here are a weighted sum of short and long-term interest rates, exchange rate and stock market indices. The tighter Chinese financial conditions could in part be policy-induced and in part relate to other institutional and fundamental changes in the Chinese economy, potentially contributing to slower economic growth. In any case, as an insurance policy, China ought to ease.

Third, the famed Taylor rule suggests that Chinese monetary policy was too tight before its latest easing. China undershoots it inflation target. Whether the economic slowdown is structural or cyclical, the equilibrium real interest rate should decline, but instead actual real rates have been rising for quite a while, as can be seen from the higher and more volatile real long-term Chinese government bond yields. Although the Taylor rule is silent on the weight attached to financial stability, the recent increased financial stress, as witnessed by increasing shares of non-performing loans and more debt defaults, intuitively calls for a more accommodative monetary policy to assist the risky deleveraging process. Sticking to a tight policy in the face of increased financial fragility makes little sense. Thus in light of growth, inflation and financial stability, China ought to ease.

Fourth, monetary policy measures need to be taken early in order to counter the headwinds that the Chinese economy faces, because it would typically take 2 to 4 quarters for a change in policy stance to have an effect on the real economy. Indeed, timely policy response is the best way to avoid excessive monetary stimulus. The market tends to underappreciate the fact that the mind-boggling credit binge in 2008, mostly related to local government borrowing, was in part a sad response to the already emerging panic partially triggered by the decisively late monetary policy actions at that time. So China ought to ease in a timely way.

Fifth, monetary policy should take the lead before fiscal policy turns more expansionary. The fiscal automatic stabilisers have already kicked in, as witnessed by a marked slowdown in Chinese tax revenues. When needed, discretionary fiscal policy actions can also affect the economy faster and more directly in China’s case. The experiences of the global financial crisis inform us that it is vital for China to preserve its capacity for future fiscal interventions, which could be much needed in times of crisis. Therefore, to maintain a strong fiscal position, China ought to ease monetary policy.

Finally, an accommodative monetary policy and neutral fiscal policy can combine to best promote fuller exchange rate flexibility of the Chinese renminbi, especially against a global background of near zero interest rates at major central banks. A standard Fleming-Mundell model would inform us that as the renminbi gains greater flexibility, a Chinese mix of tight monetary policy and expansionary fiscal policy could be tantamount to suicide. Both policy stances entice further capital inflows and/or add to currency strength in today’s global environment. To facilitate both growth and currency flexibility at the same time, China ought to ease monetary policy.

The latest monetary easing by the PBC is well justified

Conclusion: the latest monetary easing by the PBC is well justified – and still more can be done.

Of course, controversy remains. One issue is the evolving Chinese potential growth rate, which itself is unobservable and in part cyclical. Various arguments and estimates can be put forward to justify a case or no case for monetary easing. While this policy debate is mostly healthy, I also find it disturbing, as those arguing for monetary easing have often been labelled by some of their opponents as the vested interests hostile to economic reforms and resistant to structural adjustments. My best advice to those who do the labelling: come down from your high horse, please.



Tue, 07 Oct 2014 15:58:47 +0100
<![CDATA[The euro area: an unbalanced rebalancing?]]> http://www.bruegel.org/nc/events/event-detail/event/465-the-euro-area-an-unbalanced-rebalancing/ even465

This event will feature a presentation by Mahmood Pradhan and Petya Koeva Brooks based on the recently published IMF World Economic Outlook and other IMF research into Euro area external rebalancing. The presentation will be followed by comments by Philippe Weil and an open discussion chaired by Guntram Wolff.

Since the global financial crisis, external imbalances have declined, both globally and within the euro area. However, within the euro area, the rebalancing has been highly asymmetric. While most debtor countries, such as Greece, Ireland, and Spain, have seen substantial current account improvements, this partly reflects cyclical factors and stock imbalances remain large. At the same time, creditor countries, such as Germany and the Netherlands, have maintained very large and persistent surpluses, partly reflecting weak domestic demand. The presentation will analyze the factors that are holding back a more balanced recovery, and set out a policy agenda to support sustainable growth in the euro area and contribute to global rebalancing.


  • Mahmood Pradhan, Deputy Director of the IMF’s European Department,
  • Petya Koeva Brooks, Assistant Director of the IMF’s European Department
  • Philippe Weil, Professor of Economics, Université libre de Bruxelles
  • Chair: Guntram Wolff, Director of Bruegel

Event materials

Practical details

  • Venue: Bruegel, Rue de la Charité 33, 1210 Brussels
  • Time: Wednesday 22 October 2014, 12.30-14.00. Lunch will be served ahead of the event at 12.30 after which the event will begin at 12.45.
  • Contact: Matilda Sevón, Events Manager - registrations@bruegel.org

Tue, 07 Oct 2014 11:50:52 +0100
<![CDATA[Whose is Russia’s external debt?]]> http://www.bruegel.org/nc/blog/detail/article/1451-whose-is-russias-external-debt/ blog1451

Note: for Banks, “loans” includes also debt liabilities to direct investors and to direct investment enterprises

Data from the Central Bank of Russia show that, as of 1st Quarter of 2014, 90% of the country’s external debt was attributable to banks and other sectors, whereas government debt accounted for about 7.5% of the total. However, given that publicly-owned banks and companies are not singled out in this data, the actual government share is most likely higher. For both banks and other sectors’ external debt, loans and liabilities to direct investors are the biggest component.

And when is this debt coming due?

54% of Russia’s external debt has maturity of over two years (unspecified); 10% is between 1 and 2 years whereas about 23% has maturity of 1 year or less. For part of the external debt, the schedule is not available or inexistent (debt without schedule). Of that part of debt that is coming due within 1 year, the biggest redemptions will be in December 2014 - with 32 USD billions of banks and other sectors’ debt coming due - and Q5-2015, with 28 billion.

Tue, 07 Oct 2014 07:30:06 +0100
<![CDATA[Remerge: regression-based record linkage with an application to PATSTAT]]> http://www.bruegel.org/publications/publication-detail/publication/852-remerge-regression-based-record-linkage-with-an-application-to-patstat/ publ852

We further extend the information content in PATSTAT by linking it to Amadeus, a large database of companies that includes financial information. Patent microdata is now linked to financial performance data.

Source code on Github.

Download data.

Remerge: regression-based record linkage with an application to PATSTAT (English)
Tue, 07 Oct 2014 07:14:37 +0100
<![CDATA[A scaleable approach to emissions-innovation record linkage]]> http://www.bruegel.org/publications/publication-detail/publication/851-a-scaleable-approach-to-emissions-innovation-record-linkage/ publ851

PATSTAT has patent applications as its focus. This means it lacks information on the applicants and/or the inventors. In order to have more information on the applicants, we link PATSTAT to the CITL database. This way the patenting behavior can be linked to climate policy. Because of the structure of the data, we can adapt the de-duplication algorithm to use it as a matching tool, retaining all of its advantages.

Source code on Github.

Download data.

A scaleable approach to emissions-innovation record linkage (English)
Tue, 07 Oct 2014 07:12:05 +0100
<![CDATA[A flexible, scaleable approach to the international patent 'name game']]> http://www.bruegel.org/publications/publication-detail/publication/850-a-flexible-scaleable-approach-to-the-international-patent-name-game/ publ850

The inventors in PATSTAT are often duplicates: the same person or company may be split into multiple entries in PATSTAT, each associated to different patents. In this paper, we address this problem with an algorithm that efficiently de-duplicates the data. It needs minimal manual input and works well even on consumer-grade computers. Comparisons between entries are not limited to their names, and thus this algorithm is an improvement over earlier ones that required extensive manual work or overly cautious clean-up of the names.

Source code on Github.

Download data.

A flexible, scaleable approach to the international patent 'name game' (English)
Tue, 07 Oct 2014 07:08:22 +0100
<![CDATA[The Fed and the Secular Stagnation hypothesis]]> http://www.bruegel.org/nc/blog/detail/article/1450-the-fed-and-the-secular-stagnation-hypothesis/ blog1450

What’s at stake: Larry Summers made a big splash in late 2013 when he re-introduced the secular stagnation hypothesis to explain the disappointing recovery from the Great Recession. Experts have since debated whether we should worry about systemic saving-investment mismatches and what to do about them. But the extent to which monetary policymakers have already revised their views about the long-run equilibrium interest rate has remained quite unnoticed so far.

The new secular stagnation hypothesis

Barry Eichengreen writes that the idea that America and the other advanced economies might be suffering from more than the hangover from a financial crisis resonated with many observers. Coen Teulings and Richard Baldwin write that this ill-defined sense that something had changed was given a name when Larry Summers re-introduced the term ‘secular stagnation’ in late 2013.

Secular stagnation usually refers to a situation in which saving can only equal investment at a negative real interest rate

Juan F. Jimeno, Frank Smets and Jonathan Yiangou write that secular stagnation usually refers to a situation in which saving can only equal investment at a negative real interest rate – an equilibrium that cannot be achieved because of the zero lower bound (ZLB) constraint on interest rates and low inflation. Laurence Summers writes that the ‘new secular stagnation hypothesis’ responds to recent experience and the manifest inadequacy of conventional formulations by raising the possibility that it may be impossible for an economy to achieve full employment, satisfactory growth, and financial stability simultaneously simply through the operation of conventional monetary policy.

Secular stagnation and the pace of policy normalization

David Beckworth writes that the FOMC projections that are available show a pronounced downward trend in the "longer run" forecast of the federal funds rate. Alex Rosenberg writes that when it comes to what the markets ultimately care about in the short term—Fed policy—there's one thing nearly everyone can agree on: fresh concerns about secular stagnation are likely to make the Fed even more nervous about reducing accommodation too soon.

During the latest FOMC press conference, Steven Beckner pointed out that the Summary of Economic Projections assessments of appropriate funds rate levels show the funds rate getting up to that 3.75 percent normal level at the end of 2017. If you look at the SEP projections of unemployment, inflation, and so forth, they seem to get back to those mandate-consistent levels by the end of 2016, if not much sooner. So what is the justification for waiting that much longer to get back to normal?

In her response, Janet Yellen said that the story is […] not that the Fed is behind the curve in failing to return the funds rate to normal levels when the economy is recovered. It is rather that, in order to achieve such a recovery in 2016 or by the end, that it’s necessary and appropriate to have a somewhat more accommodative policy than would be normal in the absence of [several] headwinds. [A] common view on this is that there have been a variety of headwinds resulting from the crisis that have slowed growth, led to a sluggish recovery from the crisis, and that these headwinds will dissipate only slowly.

How to model secular stagnation?

Paul Krugman writes that if you look at the extensive theoretical literature on the zero lower bound since Japan became a source of concern in the 1990s, you find that just about all of it treats liquidity trap conditions as the result of a temporary shock.

Something – most obviously, a burst bubble or deleveraging after a credit boom – leads to a period of very low demand, so low that even zero interest rates aren’t enough to restore full employment

Something – most obviously, a burst bubble or deleveraging after a credit boom – leads to a period of very low demand, so low that even zero interest rates aren’t enough to restore full employment. Eventually, however, the shock will end. The idea that the liquidity trap is temporary has shaped the analysis of both monetary and fiscal policy.

Simon Wren-Lewis writes that a basic idea behind secular stagnation is that the natural real rate of interest might become negative for a prolonged period of time. A simple way to model this would be to allow the steady state real interest rate to become negative. But that cannot happen in basic representative agent models since the steady state real interest rate is pinned down by the discount factor of the representative agent.

Gauti Eggertsson and Neil Mehrotra write that in representative agent models the natural rate of interest can only temporarily deviate from this fixed state of affairs due to preference shocks or some similar alternatives. Changing the discount rate permanently (or assuming a permanent preference shock) is of no help, since this leads the intertemporal budget constraint of the representative household to ‘blow up’ and the maximization problem of the household to no longer be well defined. Moving away from a representative savers framework to one in which households transition from borrowing to saving over their lifecycle can, however, open up the possibility of secular stagnation. The key here is that households shift from borrowing to saving over their lifecycle. If a borrower takes on less debt today (due to the deleveraging shock), then tomorrow he has greater savings capacity since he has less debt to repay. This implies that deleveraging will reduce the real rate even further by increasing the supply of savings in the future.

Mon, 06 Oct 2014 07:01:03 +0100
<![CDATA[Austerity Tales: the Netherlands and Italy]]> http://www.bruegel.org/nc/blog/detail/article/1449-austerity-tales-the-netherlands-and-italy/ blog1449

In 2008 and early-2009, most euro area countries joined in an internationally-coordinated stimulus of the global economy to ward off the menacing crisis. But by late-2009, especially after the Greek fiscal hole was revealed in October, the focus shifted to reducing public debt. This shift was encouraged by the global economy’s brief display of economic strength in 2010, which lulled policymakers everywhere into believing that the crisis was largely over. Since then, the euro area countries have single-mindedly pursued the objective of debt reduction.

There was reason to be concerned about the rapid increase in euro area public debt. But the policy pursued had serious unforeseen consequences. This article documents the unusually severe and persistent austerity, which has yet to make a dent in the debt burdens but has slowed growth and created deflationary tendencies. The emerging link between frustrated debt reduction efforts and deflation in the most stressed economies is particularly worrisome. Specifically, we find:

Because austerity caused growth rates to fall, public debt ratios today are much higher than in 2010 and private debt ratios are no lower

  • Even making allowance for their high public debt-to-GDP ratios, euro area countries adopted significantly greater austerity than on average in other advanced economies.
  • The austerity response within the euro area was remarkably similar across countries: Netherlands (with a relatively low public debt ratio) and Italy (with a high ratio) responded with equal aggressiveness.
  • Because austerity caused growth rates to fall, public debt ratios today are much higher than in 2010 and private debt ratios are no lower.
  • Public debt ratios have not only increased but they have exceeded forecasts. The higher-than-projected debt ratios have gone hand-in-hand with lower-than-projected inflation, highlighting the operation of a country-specific debt-deflation cycle. As an incomplete monetary union, the eurozone has no tools to deal with such country-specific pathologies.

Even within the eurozone’s operational constraints, the outcomes could have been better. Our findings reflect the balance in the deployment of macroeconomic management tools. In the euro area, the most proactive tool for addressing the crisis was fiscal policy pursued under the framework of the Stability and Growth Pact (the SGP). The unwavering commitment to fiscal austerity—despite its adverse growth consequences—arose from a “wait-and-watch” approach in the use of other macroeconomic policy instruments. Unlike their counterparts in the United States and the United Kingdom, the euro area authorities have remained unwilling to use monetary policy aggressively to provide economic stimulus—indeed, interest rates were raised at moments of critical weakness. And there has been only token effort—restricted to the most egregious cases—in dealing with unviable banks. Moreover, the euro area does not have well-developed systems to address household and personal financial distress (Claeys, Darvas and Wolff, 2014).  Thus, despite occasional calls to make it more “flexible,” the traditional SGP emphasis on the perceived vulnerability arising from high public debt and the emphasis on deficit reduction have had long-lasting, possibly irreversible, effects.

Measuring Austerity

The crisis caused public debt ratios to rise sharply in much of the advanced world, and especially in the euro area (Figure 1). Hence, fiscal austerity to lower these ratios seemed prudent.

Because tax receipts fall and government expenditures for social safety nets rise, the fiscal balance decreases (equivalently, the fiscal deficit increases) when output falls below the economy’s potential. For this reason, the traditional measure of austerity is the increase in the structural fiscal balance, which is the improvement in the balance after making allowance for the shortfall due to the recessionary conditions.

The degree to which the primary budget surplus is increased (equivalently, the primary deficit is decreased) relative to the public debt ratio is a measure of the fiscal austerity that allows for the objective of lowering the debt-to-GDP ratio

But the change in the structural balance may also inappropriate when comparing two countries with very different debt ratios. A country with a higher debt ratio may be more concerned with the risk that the debt ratio may become unsustainable (spiral out of control). Debt sustainability requires that a rise in the public debt-to-GDP ratio be countered by an improvement in the primary budget balance (the balance that does not include interest expenses).  The degree to which the primary budget surplus is increased (equivalently, the primary deficit is decreased) relative to the public debt ratio is a measure of the fiscal austerity that allows for the objective of lowering the debt-to-GDP ratio (Bohn, 1998).

In determining the relationship between the primary balance and the public debt-to-GDP ratio, it is necessary to control for the economy’s position relative to its potential. For, as noted above, if output is below potential, revenues will be depressed and income transfer and unemployment support payments will be elevated, depressing the primary balance. This procedure leads to the following equation, so-called “solvency equation:"

PBi,tβ0β1Di,t-1 + β2Ÿi,t + ciεi,t

Where PBi,t is the primary balance, Di,i-1 is the (lagged) gross debt over GDP, Ÿi,t is the output gap. A higher β1—the metric of austerity—implies a stronger response to the debt ratio. The term c1 controls for country characteristics that do not change over time and εi,t is error term representing unmeasured variables.

Austerity in and outside the Euro Area

Regression results are reported in Table 1. A positive β1, the coefficient on the debt-to-GDP ratio, indicates that the rise in primary surplus in response to public debt will eventually achieve debt sustainability. A larger coefficient implies greater deference to the debt reduction objective.

Notes: The dependent variable is primary fiscal balance/GDP; t-statistics in brackets; *** p<0.01, ** p<0.05, * p<0.1. The data point for primary balance in 2010 in Ireland is dropped from regression (2) (2008-13), as that country had to deal with an extraordinarily high deficit (-27.2) due to banks bailouts.

A finer view of the time variation in the responsiveness to debt, β1, is reported in Figure 2, which reports the coefficient on debt for each five-year period ending in that year.

Note: The rolling regressions are estimated as in Table 1, and the coefficient on debt-to-GDP ratio is for the year in which the five-year sample ends.

Before the crisis (2003-2007), the countries in the euro area increased their primary balance by about 0.06 percent of GDP for a 1 percent increase in their public debt ratios. There was no notable difference between the euro and non-euro countries during this period. During the years 2009 and 2010, the world was preoccupied a coordinated fiscal stimulus to stave off another Great Depression (Eichengreen and O’Rourke, 2012), and (quite rightly) the concern with public debt diminished. However, that concern reemerged soon thereafter and vigorously so in the euro area.

For the five-year period ending in 2013 (which includes the stimulus years), the rise in euro area primary balance was about 0.15 percent of GDP for a one-percent increase in the public debt-to-GDP ratio

For the five-year period ending in 2013 (which includes the stimulus years),  Table 1 and Figure 2 show that the rise in euro area primary balance was about 0.15 percent of GDP for a one-percent increase in the public debt-to-GDP ratio. As the stimulus years are left behind, the preoccupation with debt is more starkly evident, and the coefficient on debt reached 0.20 in the five-year period ending in 2014. The concern with rising debt ratios also increased in other advanced economies, but to a much lower degree and with less persistence.

The Netherlands and Italy

In Figure 3, we ask if the responsiveness of the primary balance to public debt was similar across the euro area countries. The finding is represented in a so-called “partial plot,” the relationship between the primary balance and public debt, controlling for the output gap, for the period 2008-2013, as in Table 1. The figure is normalized so that the mean debt-to-GDP ratio for each country is zero. The dots mark the different member states in the different years, and show that the countries behaved more-or-less similarly around their mean debt ratios.

Note: Based on Table 1, column 2. The axes values are deviations from the country mean and are expressed as percentage of GDP.

We focus on the Netherlands, where the public debt-to-GDP ratio in 2009 was 61 percent of GDP and Italy, where it was 116 percent of GDP.  The lines connecting the dots for Italy (blue) and the Netherlands (red) tell us that, around their respective mean debt ratios, both countries displayed the same tendency to increase their primary balances in response to their rising debt ratios. This is also true if the same picture is examined for later years.

While fiscal austerity does reduce debt over a period of time, it has an almost immediate impact on reducing growth

But while fiscal austerity does reduce debt over a period of time, it has an almost immediate impact on reducing growth. Blanchard and Leigh (2013) have proposed a method to assess the growth impact of austerity. If a country’s GDP fell “unexpectedly” below its forecast, they suggest that a likely cause was an underestimation of the “fiscal multiplier”—the extent to which austerity hurts growth. Their paper reports extensive robustness tests to test for biases due to omitted variables and influential observations (and the spirit of their findings has been confirmed by several scholarly studies). They find that in the period 2010-2012, an extra 1 percent of GDP fiscal consolidation was correlated with between a 0.6 and 1.0 percentage shortfall in growth relative to the forecast.

We do not undertake new analysis in this regard, but present a graphical version of the Blanchard-Leigh relationship in Figure 4. Over the years 2011 to 2013, the unexpected growth of a country is the actual growth minus the growth that was projected in the IMF’s April 2011 World Economic Outlook. The unexpected growth of several advanced economies is plotted against the fiscal consolidation over the same period. The negative relationship shows that greater consolidation (austerity) was associated with actual growth that was lower than projected.

Note: The average annual unexpected growth is calculated as the difference between the average annual realized growth between 2011 and 2013, as reported in the 2014 WEO data release, and the average annual expected growth projected for the same period in the April 2011 WEO data release.

The growth shortfall in Italy and the Netherlands bore about the same proportion to austerity as in Greece

Notice that in Figure 4 the Netherlands and Italy fall on the regression line, which extends to Greece. Italy and (more so) the Netherlands had lower debt-to-GDP ratios than did Greece, so they undertook less austerity. However, the growth shortfall in Italy and the Netherlands bore about the same proportion to austerity as in Greece.

Notice also that the United States and, to a lesser extent, the United Kingdom, are above the regression line, implying that austerity was less costly in terms of foregone output growth. It is likely that the more aggressive monetary policy in these two countries and the early efforts to restore banks to health created alternative avenues of growth. In the euro area, monetary policy remained stodgy (Mody, 2014) and bank restructuring and recapitalization was delayed (Reichlin, 2014).

1 Recent revisions of the Italian data have lowered the entire trajectory of the Italian debt ratio by about 5 percentage points.

Because austerity in the euro area caused growth to slow, the debt ratios continued to rise—and faster than the projected. Figure 5 reports the time paths of debt ratios for the Netherlands and Italy, as seen in April 2011 (blue line) and April 2014 (red line). As austerity was stepped up in 2011, the projection was for debt ratios to stabilize. However, the ratios continued to rise. The debt ratio for the Netherlands now appears to be stabilizing, but that for Italy is unlikely to start falling as projected.1

Note: Dashed lines refer to projections at the time.

In sum, we see a consistent pattern of fiscal austerity, slower than expected growth, and higher than expected debt ratios.

Where do we stand?     

Today, the Netherlands has to deal with a more serious public debt problem than in 2011 and with an undiminished private debt burden

For the Netherlands, the austerity was gratuitous. At its relatively low level of public debt ratio, the Netherlands could have afforded fiscal stimulus. GDP growth would have been higher and, it is possible, that the public debt ratio may have been lower. In the Netherlands, the costs of austerity were especially high because the private debt burden was substantial (since households had borrowed extensively to buy homes). In such a circumstance, a more stimulative fiscal policy is particularly desirable since the increased incomes help to pay down debt, which in turn opens the space for further spending and economic growth. Today, the Netherlands has to deal with a more serious public debt problem than in 2011 and with an undiminished private debt burden. Together, these will continue to dampen growth as the necessary deleveraging occurs over time.

The Netherlands example has a more general echo through the euro area: even as the public debt ratios rose while fiscal austerity was pursued, the private debt burdens did not fall (Figure 6a). In contrast, household debt ratios fell across virtually every state in the United States (Figure 6b) While U.S. commentators have been critical of the insufficient policy effort to alleviate mortgage-related distress (see Mian and Sufi, 2014), the extent of such efforts was substantially greater than in the euro area.

Today, the Italian debt ratio has just crossed 135 percent of GDP, and the warning applies with greater force

In Italy, with its high debt ratio, the options were more limited and more painful. In 2010, an IMF paper argued that the Italian debt ratio of over 120 percent of GDP had become unsustainable for practical purposes (Ostry et al, 2010). While the debt could, in principle, be reduced through fiscal consolidation, the authors warned that the austerity needed was so large even by Italian historical norms that it would be politically unacceptable. Today, the Italian debt ratio has just crossed 135 percent of GDP, and the warning applies with greater force.

The euro area authorities have ruled out the restructuring of public debt, except if a Greek-like situation repeats itself. Their concern is that restructuring would cause widespread contagion and damage to the European (and global) economies and financial systems. Thus, the strategy is to persevere with austerity. The projections of reduced debt ratios starting in 2015 rely overwhelmingly on the continuation of historically severe levels of austerity. The risk is that the primary surpluses will not materialize, growth will be compromised, and the debt ratios will continue to rise (see Darvas, 2013).

Debt and Deflation

Finally, we examine the relationship between debt and deflation. Figure 7 is a plot of the unexpected rise in debt-to-GDP ratio in the latest 2014 estimates versus those projected in 2011 against the unexpected fall in inflation over the same period. Notice that in virtually every country the debt ratio was higher than projected and inflation was lower. Moreover, these two errors are strongly correlated. A clear negative correlation emerges: higher levels of unexpected debt correspond to higher deflation. Once again, both Italy and The Netherlands fall along the regression line. The implication is that fiscal austerity had had far reaching unforeseen consequences: not only was growth lower (as described in Figure 4 above), but debt was higher, and the prospect of deflation was not even considered.

Note: The unexpected inflation is calculated as the difference between the realized inflation in 2014, as reported in the 2014 WEO data release, and the projected inflation for 2014, as reported in the 2011 WEO data release. The unexpected debt-to-GDP ratio is computed similarly. If Cyprus is included, the relationship is even stronger.

The importance of this finding is that the deflationary tendencies in the euro area are neither uniform nor randomly distributed. Rather, they are associated with the rise in debt: as debt has risen, the policy of austerity has thus far failed to rein in the desired increase, but it has weakened demand and, hence, reduced inflation rates. The latest data suggest that prices are actually falling in some of the high debt countries. And, since the cycle of higher debt and lower prices will not correct itself, a strong stimulatory policy with a country-specific focus will be needed.


A policy of more modest austerity everywhere in the eurozone, with active stimulus in a few countries, would have paid dividends

A policy of more modest austerity everywhere in the eurozone, with active stimulus in a few countries, would have paid dividends. Such an approach would have created a more stimulative overall fiscal policy stance throughout the euro and would have been particularly beneficial since European economies trade so much with each other (Figure 8): the boost to domestic demand would have been amplified through trade. The growth performance throughout the euro area would have been superior, which would have helped debt reduction with less austerity.

Instead, simultaneous austerity caused a drag on all countries. For the Netherlands, there was no trade-off: less austerity would have been unambiguously better. For Italy, an early effort to engineer a restructuring of public debt, while a controversial decision, would have allowed more space to lower the burden of austerity and create the conditions for stronger growth. Foregoing this choice would be particularly unfortunate if debt restructuring is eventually rendered inevitable.

Austerity might be driving the eurozone into a debt-deflation cycle, as higher debt and deflation feed off each other

The damage may not be over. Austerity might be driving the eurozone into a debt-deflation cycle, as higher debt and deflation feed off each other. Earlier this year, the ECB viewed the dip in inflation as temporary (Mody, 2014). Even now, ECB officials regard deflation to be unlikely. And the safeguards that they are glacially moving towards take a eurozone-wide view rather than differentiating across countries. Yet, the analysis in this article warns that the deflation is likely to be a country-specific phenomenon, requiring counter measures at the country level. The eurozone, by its construction, has no instruments to deal with a country debt-deflation threat.

We are very grateful to Ajai Chopra, Zsolt Darvas and Guntram Wolff for their helpful comments.



Blanchard, O.J., 2013, “Growth forecast errors and fiscal multipliers,” National Bureau of Economic Research Working Paper 18779.

Bohn, H., 1998, “The behavior of US public debt and deficits,” Quarterly journal of economics, 949-963.

Claeys, G., Darvas, Z., & Wolff, G. B., 2014, “Benefits and drawbacks of European unemployment insurance,” Bruegel Policy Brief, Bruegel.

Darvas, Z., 2013, “The Euro Area’s tightrope walk – debt and competitiveness in Italy and Spain,” Policy Contribution, Bruegel.

Eichengreen, B. and O’Rourke, K. H. (2009). A tale of two depressions.  VoxEu

Mian, A., & Sufi, A., 2014, “House of Debt,” Chicago: The University of Chicago Press.

Mody, A., 2014, “The ECB is much too stodgy.”

Ostry, J. D., et al., 2010, “Fiscal space,” International Monetary Fund, Research Department.

Reichlin, L., 2014, “Monetary policy and banks in the Euro Area: the tale of two crises,” Journal of Macroeconomics, 39, 387-400.

Fri, 03 Oct 2014 09:27:06 +0100