39Th ECONOMICS CONFERENCE 2010

OESTERREICHISCHE NATIONALBANK EUROSYSTEM

39th ECONOMICS CONFERENCE 2011

The Future of European Integration: Some Economic Perspectives ECONOMICS CONFERENCE 2011 th 39 Contents

Ewald Nowotny Welcome Address 4 Rudolf Hundstorfer The Future of European Integration – Some Economic Aspects 10

Session 1: Regaining Fiscal Strength, Restoring Growth Olli Rehn Keynote Address 16 Martin Wolf The Euro After the Crisis 22

Panel 1: Reforming Fiscal Policy Rules for the Euro Area Ernest Gnan Introductory Remarks 32 Wolfgang Franz Reforming Fiscal Policy Rules for the Euro Area 36 Daniela Schwarzer Legislative and Institutional Dynamics in Response to the Crisis 42 Klaus Liebscher Award Klaus Liebscher Award for Scientific Work on European Monetary Union and Integration Issues by Young Economists 50

Session 2: Banking and Financial Architecture in the EU Andreas Ittner Introductory Remarks 54 Lorenzo Bini Smaghi Macro-Prudential Supervision and Monetary Policy – Linkages and Demarcation Lines 58 David T. Llewellyn A Post Crisis Regulatory Strategy: The Road to “Basel N” or Pillar 4? 70

Panel 2: Enhancements in EU Financial Regulation: Have We Done Enough? Martin Summer Introductory Remarks 94 Hans-Helmut Kotz Enhancements in EU Financial Regulation: Have We Done Enough? 98 Andreas Pfingsten A Critical Assessment of the New Capital and Liquidity Requirements 110

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Session 3: Addressing Macroeconomic Imbalances Wolfgang Duchatczek Introductory Remarks 122 Anne O. Krueger Formulating International Economic Policy in the 21st Century 126 Thomas Wieser Macroeconomic Imbalances within the EU: Short and Long Term Solutions 134

Panel 3: A New Growth Strategy for Europe Harald Badinger A New Growth Strategy for Europe? 146 Stefan Collignon A New Growth Strategy for Europe 154 Contributors 164

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VOWI_Tagung_2011.indb 3 03.10.11 08:25 Ewald Nowotny Governor Oesterreichische Nationalbank

VOWI_Tagung_2011.indb 4 03.10.11 08:26 Welcome Address

Ladies and Gentlemen, its visibility, which are well known I am very pleased to welcome you to from monetary policymaking, are also the 39th Economics Conference of the present in organizing a monetary policy Oesterreichische Nationalbank here in conference. Sometimes a topic that ap- Vienna. I am proud that we have once pears to be timely and urgent in the again managed to prepare a highly inter- planning phase of a conference has lost esting program featuring distinguished some of its appeal by the time the event speakers and discussants from different actually takes place. This year, how- backgrounds in academia, policy-mak- ever, it was almost the exact opposite. ing and policy-commentating who have When we first thought about a possible in common a vital interest in economic topic for the 2011 Economics Confer- issues. I should like to thank all of them ence last fall, we did not expect – and in advance for coming to Vienna and could not have expected – how signifi- for contributing to this year’s Econom- cant and intensively debated this very ics Conference. I would also like to topic would be in May. The debt crises take the opportunity to thank the staff and institutional reforms, we have ob- members of the OeNB for their great served over the recent months have efforts in organizing this event. moved the topic of the future path of My particular welcome goes to Fed- integration to the top of both the Euro- eral Minister Rudolf Hundstorfer, who pean and the international agenda. I am will address the participants of this therefore looking very much forward year’s conference as our first speaker. I to our discussions, which promise to be am very honoured to welcome Olli lively and – hopefully – also fruitful. Rehn, Commissioner for Economic and Monetary Affairs of the European Commission, who will join us today. I am also very grateful that Lorenzo Bini Smaghi, Member of the Executive Board of the European Central Bank, has found the time to be with us today. Lorenzo Bini Smaghi is not only a dear colleague of mine on the Governing Council of the European Central Bank, he has also been one of the most elo- quent commentators on the future of the European project over the last few months. Thank you very much for joining us today. Finally, I would like to add that I am very glad to see such a densely packed audience here today. This confirms that this year’s conference topic – “The Fu- Ladies and Gentlemen, ture of European Integration” – strikes From its beginning, Europe has been a chord with many people from differ- characterized by alternating periods of ent walks of life. As you all know, a integration and disintegration. This, conference of this size is not arranged however, is not to say that every step within a couple of days. In fact, the lags toward more integration has to be fol- of transmission between a decision and lowed by a step in the opposite direc-

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tion. Historica progress does not follow Let me start by saying that I see a “dou- such a simple pattern. In the 66 years ble heterogeneity” as one of the main since the end of World War II, a model causes of our present constellation: a of European integration has developed heterogeneity of national economic de- which is – for the first time – neither velopments and a heterogeneity of su- based on strategic alliances nor on pranational institutions. Let me begin involuntary association. The connec- with the latter – the heterogeneity of in- tions between countries have become stitutions. On the one hand, a majority closer and closer over the years, even of EU Member States have handed over though this process has not been linear the responsibility for monetary policy but has had its ups and downs, its to an independent supranational insti- “speed-ups and slow-downs” so to say. tution: the European Central Bank. On Every setback, however, was typically the other hand, there is economic pol- followed by a further leap forward. If icy, which still is – in large part – the the picture of circular movements is at responsibility of the individual Member all accurate, one should think of Euro- States. This set-up follows from the pean integration not as a wavelike pro- subsidiarity principle, which aims to cess but rather as a spiral stair where respect and support local policy deci- each cycle is accompanied by an up- sions wherever they are reasonable. ward movement. We have had to realize, however, that it In recognizing this pattern, I do not is often not easy to specify the optimal wish to diminish the challenges we are level of policymaking. The lack of more facing today. Nor do I wish to suggest centralized economic governance is es- that it will be easy to find the right an- pecially noticeable when the second swers to these challenges. We have heterogeneity – the one between coun- heard many different assessments of the tries – becomes visible, as has been the causes and underlying mechanisms of case in the recent past. the current situation and equally many Cross-country heterogeneity is, in the proposals, suggestions and solution first place, a structural phenomenon. strategies. Politicians, economists and Individual countries have reached dif- commentators are in disagreement on ferent stages in their economic develop- many of the issues currently at stake. It ment; they are specialized in different is rather telling that this disparity of areas of economic production; they are positions is also reflected in the public characterized by different sets of insti- opinion and in noneconomic news- tutions and they have different prefer- paper articles. Two well-known Ger- ences regarding the reach of the market man-speaking authors, for example, and role of the welfare state. While recently expressed their views on the these structural differences reflect na- European project – and they have come tional histories, national institutions to almost diametrically opposed con- and national preferences, they are clusions. While one of them talks about nonetheless not a strictly national affair. the “Gentle Monster Brussels,” the They are not, because the idiosyncratic other praises the qualification and dedi- situation in one Member State can eas- cation of its bureaucracy. ily spill over to other countries and to In light of the already existing mul- the EU as a whole. A fiscal crisis typi- titude of opinions, let me offer just cally only breaks out at the end of a lon- some brief observations on our current ger process of unhealthy and unsustain- situation and on a possible way forward. able development, although budgetary

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distress is sometimes – but not always sible. A correct account of the crisis pe- – visible earlier on. riod is not only important for economic Cross-country differences are now- historians. It is even more important adays clearly reflected in almost any for today’s policymakers as it enables macroeconomic and financial time se- them to identify the main weaknesses ries, starting from interest rate spreads and to tackle them in an adequate way. to economic forecasts. In fact, the sig- In many respects the chronology of the nals coming from the most recent fore- recent contraction has followed the casts for the European Union are quite prototypical sequence of events charac- positive and the first quarter of 2011 teristic for severe financial crises. The has shown improvements that were main preconditions were a number of larger than expected. The outlook for slowly emerging disequilibriums on the the global economy has also improved, real side of the economy, accompanied and this synchronicity might lead to by suboptimal behavior and regulation further positive reinforcement effects in the financial sector. These real fac- for the European economy. One cannot tors include, for example, the global exclude the possibility of a slowdown in imbalances that led to the “paradox” fi- recovery, but I think that the risks of an L-shaped or a W-shaped development have decreased. The picture is particularly encouraging for Germany and for a number of smaller, export-oriented countries, while some peripheral countries are lagging behind, both in terms of GDP growth rates and of unemployment rates. Although this divergence is of course worrisome, we should not immobilize ourselves by focusing on the problematic cases alone. If we do, we might forget that on average the performance of the EU economy was good – both during and after the crisis. The nancial flows from emerging to ad- flexible way in which many countries vanced economies. This caused a rela- reacted to the unexpected events was tive abundance of available funds in the certainly facilitated by the past prog- advanced economies, which was fur- ress of European integration, which ther amplified by a rapidly growing fi- was accompanied by structural prog- nancial industry and a period of rather ress and an intensification of trade. The low global interest rates. These ele- remaining divergence in economic de- ments, among others, contributed to an velopment, however, is in my view a increase in household indebtedness and clear mandate to further reduce the in- to low private savings rates. The finan- stitutional heterogeneity of economic cial sector, on the other hand, was ea- governance. ger to satisfy the demand for apparently In order to shape the new institu- safe assets by designing and selling ex- tional landscape in the best possible otic products. At the same time, one way, it is useful to look back for a mo- could observe a deterioration of lending ment and analyze the trends and condi- standards, excessive leverage ratios and tions that made a crisis of this size pos- the extension of management contracts

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that favored short-term behavior and these areas. This is important to stress excessive risk-taking. In the financial since the events of the recent months crisis, all of these factors worked to- have put fiscal problems and the role of gether to cause a massive fall in asset the government to the fore. It goes prices, a wave of fire sales and an al- without saying that national and supra- most complete breakdown of the international bodies did not work in the most efficient way before and during the crisis and that it is necessary to improve their functioning. On the other hand, however, this is only one field that calls for reform efforts.

Ladies and Gentlemen, We have already seen some reform progress over recent months. I do not need to give you a detailed account of all the institutional adaptations and innovations which have been put into place recently or which are scheduled to be implemented in the near future. First, because most of you will have followed these events closely and second, because I am sure that we will hear much more about them in the course of this bank market. These turmoils in the fi- conference. I just want to mention nancial market then led to a loss of con- some of the innovations that are related fidence in the real sector and a plunge to all four areas that I identified before in production and trade. The shock- as the crucial targets of reform: the waves finally reached the fiscal sector modification of the Stability and and have led to a – sometimes huge – Growth Pact (to allow for a higher de- increase in deficits and in public debt. gree of automatism of – and a stricter This was particularly true for countries adherence to – the rules); the Euro which had recorded large imbalances Plus Pact, which will improve the before the crisis and which, in addition, coordination of national economic poli- had structural problems to struggle cies and help identify macroeconomic with. Often, these were problems that imbalances; the set-up of new supervi- had been present for some time but had sory authorities for securities, banking remained hidden in the periods of easy and insurance; and the establishment money, credit booms and increasing in- of the European Systemic Risk Board debtedness. and the European Stability Mechanism This short and necessarily sketchy to monitor macrofinancial stability and and incomplete account suggests that manage future sovereign debt crises. there have been weaknesses and failures At the same time we have also seen in at least four areas of economic gover- that some countries have tackled their nance: the governance of the financial own specific structural deficiencies sector, of national economic structures, to be better able to cope with the cur- cross-country balances and fiscal poli- rent crisis and with future economic cies. We need reforms in all four of shocks.

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The biggest challenge for this new positive, we should put much more em- institutional architecture is to imple- phasis on appropriate anticyclical policies ment improvements in monitoring and during periods of upswing. coordination with respect to fiscal pol- Second, given the uncharted terri- icy and macroeconomic imbalances. In both tory that we are currently exploring fields, we will have to find rules and and the many uncertainties concerning regulations to help us decide when a the functioning and the effects of each country’s budgetary or macroeconomic institutional reform, it is probably wise development looks sustainable and when to take a gradualist approach and to it seems to be on the wrong track. But gradually add new elements to the al- this task of identifying fiscal or macro- ready existing and functioning struc- economic imbalances is inherently dif- tures. Third, apart from establishing a ficult. In most cases, it is not possible to new institutional architecture, we also draw a clear line between the states of have to accomplish the more immedi- insolvency and illiquidity or between a ate task of reducing debt levels and se- macroeconomic divergence that is just curing the sustainability of public fi- the consequence of a catching-up pro- nances. Given the exceptional nature of cess and one that is the sign of an alarm- the current crisis, it is necessary to ing disequilibrium process. think carefully about a reasonable and In this context, I see a number of balanced reform package to be able to guiding principles that could be useful in distribute the costs of the crisis in an equi- defining a new structure of European table manner. economic governance. First, we tend to be particularly Ladies and Gentlemen, alerted if we see balances in the red, if Coming to the end of my remarks, I we see minus signs, negative numbers would like to emphasize that we also and apparent deficits. As a conse- need to improve – and maybe regain ac- quence, most reform activities nor- ceptance for – our unique and precious mally concentrate on the bad times and European project. I am confident that on deficit countries. But we should not European integration will proceed de- forget that the fiscal crisis has become spite the difficulties that we have faced so severe because most countries did over the past years. I look forward to not manage to restructure and improve having a day and a half with you to dis- their budgets during the good times of cuss the future of Europe from a multi- rather high growth. As it is much easier tude of perspectives. I hope you will to implement far-reaching reforms find our Economics Conference a use- when the general economic outlook is ful and an insightful event.

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VOWI_Tagung_2011.indb 9 03.10.11 08:26 Rudolf Hundstorfer Austrian Federal Minister Ministry of Labour, Social Affairs and Consumer Protection

VOWI_Tagung_2011.indb 10 03.10.11 08:26 The Future of European Integration – Some Economic Aspects

Good morning Ladies and Gentlemen, mance would suffer. That’s why we I am very pleased to be able to address need a fair system of burden sharing. you today on behalf of Federal Chancel- I believe in healthy state budgets, lor Werner Faymann, who is sorry for that is to say, budgets that can be flexi- not being here this year and sends his ble in bad times to support the econ- best wishes for a successful conference. omy, but achieve a surplus in good This year’s Economics Conference times to finance the challenges of the addresses the future of European inte- future. Having a balanced budget can- gration, a topic which is very much at the centre of political discussion these days. While we have managed to make some major steps forward in the integration process lately – such as agreeing on the Treaty of Lisbon – this process has been strongly affected by the financial crisis and its consequences. Let me start with a few thoughts on some recent developments. Europe finds itself in challenging times indeed. Greece and Portugal, in particular, are struggling with the requirements of consolidation and massive budgetary restraint. In this diffi- not be our only objective. We also need cult situation we must stand by the a fair budget to create jobs and growth. Greek and Portuguese people, not only It is clear that the consolidation of na- because of European solidarity, but also tional budgets must be tackled in line because defending the integration pro- with the state of the economy. Without cess – and especially the euro – is in growth there will be no budgetary im- our common interest. Greece and Por- provement. tugal need a perspective for growth and Despite some challenges following development. Wages are not the enemy the crisis, the EU is still in a better po- of the economy but a key motor, sition than the USA and Japan, and the prompting growth and jobs. We must euro area is less indebted than these see economic and social policies as con- countries. It is true that budget deficits nected and equally important areas of have risen considerably, but in most European integration. cases not to an alarming extent. We Consolidation measures must be have managed to preserve the stability well balanced, and they must be tolera- of the euro area and that of the EU at ble for all. They must be fair, and they large because we remembered what the must not harm economic recovery. Sus- European idea is all about, and because tainable consolidation will be based on the concept of European integration is sound economic growth. Drastic cuts strong and sustainable. However, we in social expenditure may improve the still have a lesson to learn here, and we budgetary situation in the short term. must take political measures to avoid a But in the long run, economic perfor- similar crisis in the future.

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VOWI_Tagung_2011.indb 11 03.10.11 08:26 Rudolf Hundstorfer

Our coordinated approach to boost- crisis (and not just reducing deficits and ing the single market was essential in public debt). dealing with the crisis. However, we The Europe 2020 strategy is imple- now face considerable challenges in mented for the first time this year, us- consolidating our budgets while building the new framework of the “Euro- ing a socially balanced, sustainable and pean semester”, which will contribute competitive future for Europe by im- to improved coordination and monitor- plementing the Europe 2020 strategy. ing of national economic policies. This strategy brings together two Austria’s National Reform Pro- processes which were separate in the gramme, which we have just submitted past: the monitoring of budgetary pol- together with our Stability and Conver- icy in the Stability and Growth Pact on gence Programme, shows our clear fo- the one hand, and employment, educa- cus on the aims of the Europe 2020 tion, social and environmental policies strategy, in addition to consolidation. on the other. The Euro Plus Pact, which was re- I consider this linkage as the goal of cently adopted to promote competitive- our growth strategy: it no longer rests ness, increases employment, improves exclusively on an increase in gross do- the long-term sustainability of public mestic product but also on smart, sus- finances and strengthens financial stability, provides for concrete policy measures to be set by individual Mem- ber States. For Austria it was of great importance in this context to ensure the participation of the social partners and respect for collective agreements. Aus- tria will continue to fight for a Euro- pean economic governance that serves the interests of European people, including qualitative growth, full employment and a strong European social model. We must place more and better jobs at the top of the European agenda tainable and inclusive growth. In addi- and at the heart of EU economic gover- tion to these very positive elements of nance. the Europe 2020 strategy, budgetary Regarding pensions, Austria has consolidation policy and increased successfully advocated a focus on the competitiveness clearly continue to be effective retirement age. Austria consid- on the agenda. However, two elements ers the sustainability of pensions and should be at the centre of all reforms: health services to be central to fiscal firstly, there should be a “symmetric” consolidation. However, focusing on approach to imbalances, that is, deficit sustainable public pension systems is not countries as well as surplus countries enough – we also need to make sure have to contribute. Secondly, the real that they are adequate. economy, people’s lives, must be at the Austrian pension policy will con- centre of all activities. In the case of tinue to depend on a strong first pillar, Greece and Portugal, this means help- and the recent crisis proves us right in ing these countries to grow out of the this approach. And let’s not forget that

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the issues of sustainability and popula- months now. In this field we are Euro- tion ageing not only concern public pen- pean champions. sion systems, but they are equally im- Now as the end of the crisis is in portant for company and private pen- sight, but public sectors are still heavily sion schemes. Effective supervision and burdened by measures against the cri- regulation of financial markets with a sis, we must not stop pointing out that focus on security is what we need here. excessive consolidation measures would Bold steps have been taken in the slow down the recovery of the labour field of financial regulation with new market and therefore, the entire econ- supervisory structures, the regulation omy. Special emphasis must be placed of hedge funds and the Capital Require- on youth employment, which is strongly ments Directive. But a lot of work still affected in most Member States. Em- needs to be done if we want the finan- ployment opportunities for young peo- cial sector serve the real economy. Af- ple need to be provided. Austria has ter all, it was non-transparent financial created and continues to offer a job products that caused the financial cri- guarantee for young people, because sis. Therefore, we must do more to young people need a chance of sustain- close the remaining gaps in financial able integration into the labour market, regulation and make every effort to particularly in difficult times like now. prohibit high-risk financial products. And I believe we should also work on Improved consumer protection is giving young people a legal right to get needed here, as well as better risk man- the education and training they need agement by stronger and more indepen- for this. dent supervisory bodies. We still face increasing unemploy- The need for EU action is greater ment in Europe, and many Europeans than ever in order to regain the trust of are still confronted with great social EU citizens. In this context, a financial hardship. However, these people who transaction tax will help to stabilise the are now under so much pressure did financial sector on the one hand and not cause the economic crisis. Consoli- bring in additional revenue for social dation must therefore not mean taking progress, on the other. Austria sees the even more from those who have already financial transaction tax as part of a lost so much. comprehensive financial market pack- We must improve working condi- age. I am pleased, therefore, that the tions for all European workers and fight European Council noted in March that against undeclared work, as well as so- the introduction of a financial transac- cial and wage dumping, by means of tion tax at EU level and internationally legislation and within the social dia- should be explored and further devel- logue. oped. Minimum standards have always been It is important to highlight again a core element of the European social and again the interaction between gen- model, and they are still relevant today. eral economic policy – including mon- We must work on raising these mini- etary, fiscal and wage policies - and the mum standards for all European em- development of labour markets. As ployees so that countries with high Minister of Labour, I am proud of the standards will not come under pres- fact that, together with the Nether- sure. On the contrary, our aim should lands, Austria has had the lowest unem- be a gradual increase in social standards ployment rate in the EU for several across Europe.

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VOWI_Tagung_2011.indb 13 03.10.11 08:26 Rudolf Hundstorfer

In Austria we have recently passed Allow me to say in conclusion that the law against wage- and social dump- my guiding principle for the future is to ing which is aimed at ensuring equal secure employment, improve social co- wage conditions for all employees hesion and ensure social peace. Only working in Austria. The new law, social peace can guarantee democracy which was introduced in connection and the peace project of the European with the opening of our labour market Union. on the 1st of May, will facilitate fair Ladies and gentlemen, thank you competition among Austrian compa- very much for giving me the opportu- nies, as well as with companies not es- nity to address you today. I wish you all tablished in Austria. the best for today’s conference.

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VOWI_Tagung_2011.indb 14 03.10.11 08:26 Session 1: Regaining Fiscal Strength, Restoring Growth

VOWI_Tagung_2011.indb 15 03.10.11 08:26 Olli Rehn Commissioner for Economic and Monetary Affairs European Commission

VOWI_Tagung_2011.indb 16 03.10.11 08:26 Keynote Address

Sehr geehrter Herr Gouverneur, meine forms too demanding – is the European Damen und Herren! response on the right track?” Ganz herzlichen Dank für die Ein- Yes, we are on the right track. It ladung zu Ihnen zu sprechen. has been necessary to take immediate In the past decades I have been a action of financial support and equally frequent visitor to Vienna, in particular of reform and adjustment in the coun- when I was responsible for Enlarge- tries facing a sovereign default or a ment, and I am again honoured to speak banking meltdown. We must be firm to such a distinguished and interna- in requiring full implementation of the tional audience. measures, but also be patient, as some Vienna has always been a hub be- measures may require time to show tween East and West. While the eco- effect. nomic transformation in Austria’s To understand our response, let us neighbouring countries has been a fas- take a look back in time in the euro cinating process, it is equally remark- area. Over the last decades, the Euro- able how well the Austrian economy pean economy has grown together. was able to adjust to it and to turn it Our product and financial markets in- into an East-West success story. tegrated. The Southern enlargement Let me however start with one of first and the Eastern enlargement later the Austrian founding fathers of mod- on implied that the economies in the ern economics, Joseph Schumpeter. In his book “Das Wesen des Geldes”1 – and if I read my German correctly, “Wesen” has a double meaning, first “system” but second “being” – he wrote: “Der Zustand des Geldwesens eines Volkes ist ein Symptom aller seiner Zustände.” (“The condition of the monetary system of a nation is a symptom of all its conditions.”) And Schumpeter went on to relate this to human condition: “Nichts sagt so deutlich, aus welchem Holz ein Volk geschnitzt ist, wie das, was es währungspolitisch tut.” (“Nothing shows as clearly what kind of South and in the East were catching up, wood a nation is cut from, than what it which in turn required economic ad- does in monetary policy.”) justment in the so-called old Member More than 80 years later in our eco- States. nomic and monetary union, you may The introduction of the euro pro- ask from what kind of fabric Europe is vided further benefits. For the catch- cut. Across Europe, we are seeing a ing-up economies, the euro allowed support fatigue on the one side and a better access to international capital reform fatigue on the other. Many ask: markets, while for the trade-oriented “Will this crisis never end, are the sup- economies it reduced the transaction port measures necessary, are the re- costs.

1 Schumpeter, J. A. 2008. (New Edition). Das Wesen des Geldes. Ed. Mann, F. K. Göttingen: Vandenhoeck & Ruprecht.

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VOWI_Tagung_2011.indb 17 03.10.11 08:26 Olli Rehn

In the pre-crisis period, the euro declining clearly less than output. But it area as a whole enjoyed macroeconomic also implies the recovery in production stability with stable inflation and some will now be somewhat faster than em- improvement in fiscal policy. However, ployment growth. inside the euro area, macroeconomic imbalances were built up over the last Ladies and Gentlemen, decade. Most economists agree that it is the role Our integrated financial market of the public sector to step in when so- channelled the savings from countries called tail risks materialise, i.e. risks with slow growth in domestic demand that are very rare but very large. In to countries with current account defi- fact, only the public sector has that ca- cits, where domestic demand was pacity. To do so, the public sector needs thriving. In some cases, credit flowed to be in a healthy condition itself. How- into housing and other real estate, re- ever, this was not the case in all euro sulting in unsustainable leverage and area or EU Member States. The crisis asset prices. Also wages increased faster exposed those countries where imbal- than productivity, thus weakening the ances were large, where public finances cost competitiveness of some econo- were not in a good shape, and where mies. there was a lack of structural reform. By 2007–08, the unravelling of the Therefore, it is not correct to speak subprime risks triggered the current of a crisis of the euro and the monetary crisis. At that time, those imbalances in union. It is a crisis of certain Member the EU were at their peak. The finan- States, with the potential of severe eco- cial sector in the EU Member States nomic ramifications for the rest of the could not absorb the risks it had taken. euro area. Subsequently, the public sector stepped First, the value of the euro has not in. All parts of the economy benefitted changed over the past year; the effec- from the public response, because this tive euro exchange rate was last Friday did not only involve aid to banks, but almost precisely the same as in the be- also to SMEs and to workers, for in- ginning of May 2010. Second, we have stance by subsidising shorter working contained the crisis into the three hours. The fiscal stimulus measures countries in programmes. This is evi- were coordinated in the European Eco- dent both from the sovereign bond nomic Recovery Plan. spreads and the overall economic re- Our fresh economic forecast con- covery in Europe. firms that this powerful response has While counterfactual scenarios are paid and has produced results. The eco- always difficult to construct, there is in nomic recovery of Europe is maintain- my view no doubt that, without the ing its momentum despite turbulence EMU, the global financial crisis would and tensions in financial markets. Its have unleashed a series of devastating base is broadening from exports to do- currency crises in Europe. The euro mestic demand, implying that growth has saved us from that by serving as a is becoming more balanced. In 2012, protective shield. This has also been the we will reach the pre-crisis level of case for Austria. production in the EU. With the example of Lehman, we The policy measures made the euro have seen what devastating conse- area labour market remarkably resilient quences a default can cause, not only during the recession, with employment for direct creditors but – what is im-

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portant – also for third parties who that reducing the excessive level of pub- could be hit by spill-over effects in our lic debt does indeed require major ef- integrated economy. forts on several fronts to reach the nec- Precisely to prevent another down- essary primary fiscal surplus for an ex- ward financial spiral getting out of con- tended period of time. trol, we needed to prevent Greece from defaulting in May last year. The ad-hoc financial assistance package was tied to strong conditionality of reforms and of debt reduction. But we also needed to prevent contagion. A week later, we created the temporary financial backstops – the EFSM and EFSF – to manage any further sovereign financing problems which could threaten financial stability in Europe. Later last year, we also decided on the principles of a permanent stability mechanism, which will replace the temporary ones in 2013. In December last year, the temporary facilities were brought into action when we needed to grant conditional financial assistance to Ireland. On 16 of We have relevant and positive ex- May, a similar decision was made on a amples that reforms can be done. Bel- programme for Portugal. gium in the 1990s was able to maintain The decisions, together with the a large primary surplus for an extended very substantial reform measures taken period of time. Take Latvia and Roma- in programme and in many non-pro- nia. Both receive financial assistance gramme countries – particularly on fis- tied to a programme of conditionality cal consolidation – and the very re- under a Treaty provision. sponsible policy approach taken by the Latvia faced a collapsing economy ECB, have allowed us to contain the after the burst of the construction and sovereign debt crisis into the three financial sectors, an oversized public countries. administration, ballooning deficits, and Some worry that this is not without quickly increasing debt and unemploy- risks for the creditor countries. But we ment. In spite of fiscal consolidation need to see the vastly greater risk of in- measures amounting to over 15% of action: if we had not given the compre- GDP since end-2008, growth has picked hensive policy response, devastating up in mid-2010, exports are booming risks would have materialised immedi- and unemployment is quickly decreas- ately. This is my response to those ing, though it still remains very high. weary of support: The rationale of our Romania has for example imple- strategy is to prevent the great risk of a mented a far-reaching pension reform. financial meltdown. We have contained The old system would have led to a but not banned that risk yet. gradually increasing fiscal deficit of the And my response to those weary of pension system that would have grown reform in the programme countries is from 1.3% of GDP in 2009 to 7.6% of

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GDP by 2035. The reform, in place ter than correction – not to speak of since January, stabilizes the fiscal posi- crisis management. tion of the pension system. That is why we are in the process of Romania has meanwhile been able reforming economic governance in Eu- to access financial markets. For Latvia, rope. Last September, the Commission we expect this to happen in the second introduced a legislative package con- half of this year, ahead of schedule. In sisting of three main elements: view of the engagement of the Austrian 1. to strengthen the Stability and banks in Eastern Europe, these are very Growth Pact in order to prevent unsus- encouraging developments, and I am tainable fiscal positions emerging, and glad to add that the banks have contrib- to correct such positions promptly, uted to this with their responsible be- should they nevertheless emerge, haviour, especially through the Vienna 2. to introduce surveillance of mac- Initiative. roeconomic imbalances and diver- It is the obligation of the recipients gences in competitiveness, with correc- of financial assistance to do their ut- tive actions recommended if excessive most to deliver on their programme. It imbalances are identified, and is clear that Greece has to seriously re- 3. to create a more effective en- inforce the implementation of budget- forcement mechanism, with earlier and ary savings and the economic reforms more automatic sanctions in the case of before any new steps may be taken. violation of the rules. Likewise it needs to implement its pri- Many people doubt that much will vatisation programme. This is a matter change. I have to disagree. I am fully of urgency, and I expect new measures confident that we will finally end up to be announced shortly. with tough fiscal rules and with a new It is also clear that financial assis- emphasis on high debt levels, backed up by a much stronger sanctions mechanism than up until now, and also by an effective framework to deal with broader macroeconomic imbalances. I trust that the Council and Euro- pean Parliament can agree on the package in June, so that we will have the new rules in place shortly. Strong national fiscal frameworks are also a necessary element of the governance reform. Austria provides a good example on this with its national stability pact created in 1999 and improved over time. tance is a measure only needed when other measures have failed. Its use im- Ladies and Gentlemen, plies that policies have not been appro- It has also been clear for long already priate for a long time before. This has that the current stage of the crisis is a to be addressed and it is being ad- severely intertwined combination of a dressed. sovereign debt crisis and banking sec- It sounds simple but is still essential tor fragilities. It is clear as well that we to recall that prevention is always bet- cannot solve one without solving the

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other. We need to resolve both in par- in order to prevent imprudent fiscal allel. policies and detrimental macroeco- That is what we have been doing. To nomic imbalances in the EU. conclude, let me summarise this: We are not there yet, the work goes First, we have prevented a financial on. The coming weeks before the sum- meltdown. mer recess will be crucial in terms of Second, we have contained the sov- completing our crisis response, con- ereign debt crisis into three countries, cerning the bank stress tests, the stabil- whose public finances, banking sectors ity mechanism and Greece. and growth policies are being totally There will difficult decisions ahead. revamped. But we are making significant progress. Third, we embarked on fiscal con- The most telling evidence of progress is solidation process across Europe to re- the economic recovery that we are now duce fiscal deficits and to put the debt witnessing in the great majority of the ratios on a downward path. Moreover, Member States, Austria included. I many Member States are implementing have no doubt that, with perseverance growth enhancing structural reforms and determination, we will overcome that were considered impossible just a also the remaining challenges. year ago. Hence, my response to Joseph Fourth, we have created a new ar- Schumpeter’s question “what Europe is chitecture of financial regulation and made of” is the following: supervision, with tough rules and com- „Europa ist aus hartem Holz ge- petent supervisory authorities. schnitzt.“ (“Europe is cut from tough Fifth, we are about to conclude a wood.”) major reform of economic governance, Vielen Dank!

39th ECONOMICS CONFERENCE 2011 21

VOWI_Tagung_2011.indb 21 03.10.11 08:26 Martin Wolf Associate Editor and Chief Economics Commentator Financial Times London

VOWI_Tagung_2011.indb 22 03.10.11 08:26 The Euro Area After the Crisis

The list of challenges confronting Euro- tems. That has not worked, because no- peans is long and intractable. Will the body is prepared to accept the implica- euro area exist, with all its present tions, which include, above all, labour members and several more, ten years market flexibility, sovereign default from now? If it does still exist, how and, perhaps most important, waves of radically will it have changed? Will the bank failures. If the euro area is to sur- fast-growing European economies of vive, with its current membership, it the past decade or two recover? Or will will need to become a very different countries that have been relatively slug- union. There are some big choices to be gish now outperform them? What sort made. The time has come to make of financial system should Europe seek? them. What structural reforms are necessary? I am not surprised by the difficulty. How should Europe address its It was as an English-speaking sceptic multifaceted challenge of demographic that I wrote some 20 years ago that the change? Can the new members in project for a monetary union was an Central and Eastern Europe (CEE) continue to converge on the incomes of richer older members? The challenges ahead for Europe are, then, many, various and large. Moreover, the rapid rise of China and India, each of which has more than twice the population of the entire European Union, is shifting the balance of the world economy at a rapid rate. The periphery is on its way to becoming the centre, while the centre is, in all probability, on a long journey back towards being the periphery. So which of these issues do I intend to address today? The answer is given in the example of the core principle of Greek prospectus for the conference, which tragedy: hubris (pride); ate (folly); nem- refers to “the long-term impact of the esis (destruction). The loss of the ex- crisis on the process of European inte- change rate and monetary policy safety gration”. The euro area, many will valves in moments of crisis would rob agree, needs radical reform. The ques- national governments – the focus of tion is how to carry out those reforms. politics now and in the future – of their In the process, I hope also to consider freedom of manoeuvre. But in an inte- some aspects of another question: how grated currency area, the practical con- to promote more rapid growth. sequences of defaults for confidence in It was not logically impossible for the financial system would be too severe the euro area to work well as con- to contemplate. Creditors would feel structed. But it was contingently un- forced to rescue debtors and debtors likely. The attempt was made to impose would be forced to obey creditors. In the 19th century gold standard mecha- the process, the euro area would be- nisms, in a somewhat updated guise, on come a machine for exacerbating politi- heterogeneous democracies with gener- cal frictions among member nations, ous welfare states, rigid labour markets not reducing them. These worries have and government-insured financial sys- surely been vindicated by events. With

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this background, I would like to ad- In 2007, immediately before the dress three questions. First, why did crisis, Ireland and Spain both had bud- this crisis happen? Second, is the crisis get surpluses and their net public debt being addressed in a sensible way? was 12% and 27% of gross domestic Third, what reforms are needed to se- product, respectively. It is simply cure the system in the long run and wrong, then, to argue that the differ- how do they bear on the needs of long- ence between the crisis-hit countries term growth? and those that have been crisis-free is their fiscal policies. More precisely, bad Why Did the Crisis Happen? fiscal policy is a sufficient, but not a Bad diagnosis gives bad medicine. The necessary, condition for a crisis. So crisis is not solely due to fiscal indisci- long as bank debt is treated as if it were pline, with the admittedly important off-balance sheet public debt, a banking exception of Greece whose fiscal indis- crisis will necessarily cause a fiscal crisis. cipline was egregious. But among the Moreover, so long as banks are the other Member States, fiscal policy does principal financial intermediaries, large not demarcate countries that have current account imbalances are also al- avoided crises from those that have most certain to generate banking cri- not. Thus, in the years leading up to ses, since they entail private sector fi- the crisis, Greece exceeded Maastricht nancial deficits in deficit countries that treaty limits nine times, Italy six times, are financed by rising bank credit, rela- France, Germany and Portugal five tive to incomes (chart 2). times, Austria, Ireland, Netherlands In short, large current account defi- and Spain four times, Belgium once cits generate banking crises that then and Finland and Luxembourg never ultimately generate fiscal crises. This, (chart 1). in case anybody has missed the point, is

Chart 1 Number of Breaches of the 3%-Deﬁcit-Rule

Greece

Italy

France

Germany

Portugal

Austria

Ireland

Netherlands

Spain

Belgium

Finland

Luxembourg

0 1 2 3 4 5 6 7 8 9 10

Source: Unicredit.

24 39th ECONOMICS CONFERENCE 2011

VOWI_Tagung_2011.indb 24 03.10.11 08:26 Martin Wolf

Chart 2 Current Account Imbalances in the Euro Area % of euro area GDP 3.0

2.0

1.0

–1.0

–2.0

–3.0 20001999 2001 2002 2003 20052004 2006 20082007 2009 2010 2011 2012 2013 20152014 Germany Netherlands France Italy Spain Portugal and Greece Rest of the euro area Euro area

Source: IMF, World Economic Outlook database, April 2011.

precisely what has happened in Ireland balance of the euro area was based on and Spain (charts 3 and 4). huge private sector surpluses in some So what did drive the crisis? The countries, particularly Germany and answer is huge accumulations of debt in huge private or public financial deficits either the private or the public sectors. in others. In effect, this is how the The notion, central to the design of the economy of the entire euro area bal- euro area, that the private sector’s fi- anced, given the monetary policy ob- nances would be inherently stable jectives of the European Central Bank. turned out to be totally false, just as it Meanwhile, vast flows of capital flowed did outside the euro area, in, for exam- from surplus countries into the private ple, the USA and UK, to name but two. and public liabilities of deficit countries More precisely, the macroeconomic via lightly capitalised banking systems.

Chart 3 Net Public Debt Relative to GDP % of GDP 180

160

140

120

100

0 Greece Italy Portugal Ireland Spain 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2015

Source: World Economic Outlook database, April 2011.

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VOWI_Tagung_2011.indb 25 03.10.11 08:26 Martin Wolf

Chart 4 General Government Deﬁcits % of GDP 5

–5

–10

–15

–20

–25

–30

–35 Portugal Spain Greece Ireland 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Source: IMF WEO database, April 2011.

This crisis, then, was created by the in- public debt is held by private financial tersection between macroeconomic institutions and insolvent private finan- imbalances, defective financial inter- cial institutions are uniformly rescued mediation and bad spending decisions, by the public sector. It is essential, in driven by profligate public or profligate fact, to forget the idea that, in current private sectors. In the end, it has made circumstances, the private and public very little difference, if any, whether sectors are distinct. They are not. the private or the public sectors were An obvious question is why these primarily at fault, not least because cumulative macroecononomic diver-

Chart 5 Spreads of 10-Year Government Bonds over Germany percentage points 14

–2 31.12.04 30.04.05 31.08.05 31.12.05 30.04.06 31.08.06 31.12.06 30.04.07 31.08.07 31.12.07 30.04.08 31.08.08 31.12.08 30.04.09 31.08.09 31.12.09 30.04.10 31.08.10 31.12.10 Portugal Italy Ireland Greece Spain UK Source: Thomson Datastream.

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gences occurred and whether, in par- very large current account deficits, de- ticular, this should be viewed as a tem- spite very weak economies: Greece, porary or a structural difficulty. One Portugal and Spain are the obvious ex- reason was that a number of countries amples. But that legacy makes the post- found themselves able to borrow on crisis adjustment far more difficult, since much more favourable terms than ever it implies both weak growth and very before (chart 5). low inflation for lengthy periods, both of This seems to have led to a “rush of which tend to worsen the debt overhang. blood to the head”. That is a one-off In these respects, the predicament of the event. A second reason was the failure countries in trouble is far worse than of markets to differentiate among bor- that of, say, Germany during its long rowing countries. Again, that will not period of “competitive disinflation”. be the case again, for at least some time. A third reason, however, is inher- How Did the Euro Area Deal with ent in a currency union: booming econ- the Crisis? omies tend to have high inflation and so When it became evident that Greece relatively low real interest rates and had lied about its true fiscal position, a vice versa. So divergences tend to cu- panic emerged in the markets. It was mulate. Then, when divergences be- quickly agreed that a default would be come extreme and the bubbles finally massively destabilising for the euro area burst, markets find themselves overex- as a whole, because of direct and indi- tended. The result is internally driven rect linkages created via the financial regional boom and bust cycles. One system. In an interconnected currency consequence of the cumulative diver- union, the crisis of one country, how- gences of the pre-crisis years should, ever small, is potentially the crisis of however, be stressed. Not only did an all. This, in short, is a system simply enormous quantity of bad debt accu- riddled with externalities. So bail outs mulate, but so, too, did huge diver- were arranged for Greece, Ireland and gences in competitiveness (chart 6). now Portugal and the European Finan- These must now be reversed. This is cial Stability Fund was created. But we particularly important for countries with can now see that these efforts have not

Chart 6 Manufacturing Unit Labour Costs Relative to Germany Index Q1 2000=100 180.0

160.0

140.0

120.0

100.0

80.0

60.0 Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1 Q3Q1 Q3Q1Q3Q1Q3Q1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 France Greece Ireland Italy Portugal Spain

Source: OECD.

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restored confidence in the private sec- rium without the right sort of support. tor, which clearly still fears insolven- Yet providing such support in a multi- cies. This difficulty has, no doubt, been country currency union is evidently exacerbated by the evident conflicts very hard, since it looks like a blank among Member States over whether cheque to the suppliers of the money. sovereign debt restructuring should be In effect, the choice becomes either considered under any circumstances, debt restructuring quite soon or official with Germany saying “yea” and most funding for the indefinite future. Both others saying “nay”. Further difficulty alternatives are horrible. The former is created by the failure to separate choice risks a financial, cum sovereign bank debt from sovereign debt, which debt crisis, of considerable magnitude. makes the potential (or actual) debt The latter means raising large amounts of burden of sovereigns so much worse, money, to finance troubled countries, with Ireland being far and away the indefinitely. (Indefinitely, though, is not most important case of this concern. In the same as forever.) It is possible – even any case, with a decision not to restruc- likely – that almost all of the debt of ture debt now, but to consider restruc- countries in trouble will end up on the turing from 2013, on new debt, private balance sheets of other Member States sector flows tend to dry up for any and the International Monetary Fund. country in difficulty: creditors can see Moreover, while it is conceivable that the quite easily that it will be extremely countries in trouble will ultimately be hard to sell debt to creditors who fear restored to fiscal health, it is far from being “bailed in” after that date. That certain. The political and economic chal- means that it may be impossible to refi- lenges for Greece, Ireland and Portugal nance any debt they purchase now. are, in different ways, all enormous. It That, in turn, makes it next to impos- is quite possible that the members who sible to finance troubled countries in finance them will lose some of their the market. As Paul de Grauwe, of Leu- money. That will be hard to explain! ven University, has noted, there is a Moreover, given the close links between zone of indebtedness where there exists the banking sectors and the governments a risk of multiple equilibria. It is ex- (table 1), a sovereign default more or less tremely easy to fall into a bad equilib- necessitates a banking crisis, as well. This will involve the European

Table 1 Central Bank or at least the system in politically embarrassing losses and the Bank’s Exposure to Public Debt End-2009 profound dilemma of what it is sup- Italy Greece Ireland Portugal Spain posed to do, after such a crisis, to re-

% of tier1 capital store the banking system to some sort Germany 48.0 12.0 8.0 7.0 21.0 of health: is it a genuine central bank or France 26.0 6.0 is it the European Monetary Fund? Italy 157.0 Greece 226.0 Lessons of the Crisis Ireland 26.0 Portugal 6.0 9.0 69.0 I do not want to comment more on how Spain 113.0 to deal with the current crisis, except to Belgium 76.0 14.0 9.0 11.0 Netherlands 14.0 note the many difficulties. It is not true, Cyprus 109.0 10.0 for example, that cutting fiscal deficits

Source: Nomura and BIS. sharply will necessarily improve the situation of vulnerable countries if the result

28 39th ECONOMICS CONFERENCE 2011

VOWI_Tagung_2011.indb 28 03.10.11 08:26 Martin Wolf

is to weaken the balance sheets of the over, the banking sector as a whole private sector and so the fragility of the needs to be far better able to cope with state-insured banking system. This has shocks. Much higher capitalisation is, in to be a concern in, say, Ireland or Spain. my view, a crucial element of such a But let us consider, in turn, some of the strengthening. It would also be very long-term lessons for reform of the helpful if more of the flow of capital euro area. Again, I am not going to look at the specific plans now under way, but the fundamental principles. First, get the diagnosis right. It is not just a fiscal policy problem. Tighter application of the Maastricht treaty fiscal rules would not have prevented the crises, except, most obviously, in the case of Greece. An essential role was played by the internal imbalances and associated flows of funds, via the banking system, into financing asset bubbles. Thus, private sector imbalances can be as dangerous to stability as public sector imbalances. Effective su- went outside the banking system and pervision and regulation of the finan- particularly in the form of equity. Fi- cial system is essential. So, too, in nancial sector reform is, in short, an es- my opinion, is the possibility of serious sential element in making the euro area discussion of macroeconomic imbal- system as a whole more robust. ances. Surplus countries need to under- Third, be able to offer substantial stand that they have to finance coun- liquidity on affordable terms to govern- tries in deficit, one way or the other. ments in temporary difficulties. The Otherwise, their surpluses will prove toughness comes in the conditions im- unsustainable. Thus a toughened growth posed not in the interest rates that and stability pact will not solve the un- need to be paid. This is the only way derlying problem. to deal with the evident problem that Second, fix the problem caused by members of the euro area are more the symbiosis between banking and like emerging countries borrowing in the state. The banking sector needs to their own currencies than countries be able to survive sovereign debt re- able to borrow in their own. Along structuring and sovereign creditwor- with Eurobonds, this should eliminate thiness needs to be able to survive the risk of severe sovereign debt crises. bank failures. One of the arguments for But, in the last resort, it will be neces- Eurobonds up to, say, 60% of GDP sary sometimes to accept debt restruc- is that it would provide banking sys- turings. It is crucial, if that is to happen tems with unimpeachable assets, so that the reforms of the banking system, protecting themselves against the fail- to separate it more fully from the state, ure of their own governments. Also have also taken place. crucial is the development of a euro Fourth, introduce systems of auto- area-wide banking system and that matic wage flexibility. In the absence of would be far better able to cope with exchange rate adjustments, the principal problems in any one country. More- adjustment must come via wages. While

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big wage falls create severe risks of debt certain. It requires movement in three deflation, the alternative is even worse. directions simultaneously: towards So it must be possible to adjust wages greater solidarity, greater flexibility swiftly when competitiveness is im- and greater discipline over both paired. Whether that is possible in Euro- private and public sector finance. The pean welfare states is, however, an open members are bound together more question. But many years of painful fully than many may have realised when wage deflation is immensely costly. This the project began. But that is now evi- sort of process has to be accelerated. dent. A crisis in one creates problems for all. The question is whether it is Conclusion politically possible to draw the neces- The survival of the euro area with its sary conclusions. current membership is very far from

30 39th ECONOMICS CONFERENCE 2011

VOWI_Tagung_2011.indb 30 03.10.11 08:26 Panel 1: Reforming Fiscal Policy Rules for the Euro Area

VOWI_Tagung_2011.indb 31 03.10.11 08:26 Ernest Gnan Counsel to the Board and Head of the Economic Analysis Division Oesterreichische Nationalbank

VOWI_Tagung_2011.indb 32 03.10.11 08:26 Introductory Remarks

From the early beginnings of the idea all three channels bore witness to a lack for European Monetary Union (EMU), of trust in the reliability of any of them. it was clear that a common currency It seems the critics unfortunately needs to be accompanied by adequate were right: Market forces, including mechanisms for fiscal policies. While their guideposts such as rating agencies, for the proponents of the coronation the- were late in detecting and appropriately ory, a common currency should only pricing in risks to fiscal unsustainabil- follow after achieving political union ity. Once they did, they acted very with a centralised fiscal policy. The abruptly and, as some argue, also ex- road actually chosen was the opposite: cessively. Peer pressure worked incom- forming a monetary union, with rather pletely or towards soft implementation limited transfer of political sovereignty of the rules. The rules themselves were in other areas of economic policy. relaxed once a sufficiently influential For fiscal policy, a three-pronged group of countries found difficulties in approach was chosen according to the adhering to them in 2005, and the Maastricht Treaty to ensure sound fiscal regulations became de facto not exe- policies in individual EMU countries, and cutable in the course of the crisis from thus ensure fiscal flexibility to absorb 2009 onwards. asymmetric shocks and to avoid negative spillovers to euro area Member States: – First, market forces were supposed to sanction governments who violated fiscal virtue and to reward those who adhered to it. To this end, monetary financing of governments by central banks, bailouts of governments by other governments and by the EU as a whole as well as privileged access of governments to financial institutions were prohib- ited by the Maastricht Treaty. – Second, peer pressure among EU finance ministers, heads of state Where do we stand now? Belief in and government and high-ranking the ability of market forces to ensure officials represented in the Eco- fiscal discipline early on has vanished nomic and Financial Committee because of markets’ failure to deliver were expected to ensure fiscal rec- early warning and because the respec- titude. tive EU rules have been compromised – And third, fiscal rules with rather by various emergency measures, since precise quantitative ceilings for fis- market forces, once hitting, were felt cal deficit and debt ratios as well as to be overwhelming and damaging. elaborate procedures in the event of Peer pressure towards fiscal soundness violations were introduced. now seems to have been replaced by To true believers, each of these three peer pressure to support fiscal rescue mechanisms theoretically should by it- packages for crisis countries, condi- self have ensured fiscal discipline. From tional on consolidation and reform the beginning, skeptics held against this packages. So, what about the remaining framework the very fact that employing device: fiscal rules?

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A comprehensive package of reform the current crisis have only been learnt has been presented several months ago. to some extent. It provides some tightening in the area The two panelists, Daniela Schwarzer of fiscal policy as well as some broaden- from the Stiftung Wissenschaft und ing to include macroeconomic imbal- Politik, Berlin, as well as Professor ances. The European Central Bank has Wolfgang Franz, ZEW, Mannheim and officially and very clearly signaled that German Council of Economic Experts, reform of the rules is called for but that will provide a more detailed analysis and the reforms envisaged by the European assessment of the reformed Stability Council fall short of what is required. and Growth Pact, the European Crisis Currently, the new framework is being Mechanisms and of the EU’s economic discussed by the European Parliament, governance framework at large. Both and also the European Parliament is contributions make clear that the cur- pushing for extending reversed quali- rent reforms, while falling short of some fied majority voting to more areas of expectations, are in principle useful, but the legislation, to facilitate decision- that further and far more fundamental making and give the rules more bite. reforms of EU economic governance On the whole, it seems the lessons from will likely (have to) follow in the future.

34 39th ECONOMICS CONFERENCE 2011

VOWI_Tagung_2011.indb 34 03.10.11 08:26 VOWI_Tagung_2011.indb 35 03.10.11 08:26 Wolfgang Franz President Centre for European Economic Research German Council of Economic Experts

VOWI_Tagung_2011.indb 36 03.10.11 08:26 Reforming Fiscal Policy Rules for the Euro Area1

Fiscal policy rules have taken centre Reform of the Stability and stage when discussing the origins and Growth Pact (SGP) consequences of the crisis in the euro The SGP needs to be tightened in such area. This is obvious for Greece and a way that timely and effective sanc- Portugal but quite a few other euro tions are imposed on countries pursu- area Member States also suffer from a ing an unsound fiscal policy. This will reckless fiscal policy in the past, i.e., also necessitate strengthening the Eu- before the economic crisis in 2009. ropean Commission’s position vis-à-vis The introduction of the euro de- the European Council. The failure of molished barriers between European capital markets, freed from currency risks. In light of the increasing capital movements, especially from rich to poor countries, governments too often showed little fiscal discipline within the euro area in spite of the Stability and Growth Pact. In fact, the Pact has never been taken seriously but has been weakened in the midst of the past decade, not least due to the demands by France and Germany. As a reaction of the crisis in the euro area, the EU enacted several voluminous rescue plans in an ad hoc manner. Not until March the SGP to ensure fiscal discipline is 2011, a European Stability Mechanism the consequence of the dominant role (ESM) was put in place. of the Economic and Financial Affairs Therefore, two major questions Council (EcoFin). Members of the arise: EcoFin can block the imposition of – How should the Stability and sanctions for reasons of political suit- Growth Pact be reformed in order ability. In fact, until 2010 the records to ensure sustainability of public of the European Union show nearly finances? hundred cases (countries and years) of – How should an ESM be designed in deficits above 3%.2 Only less than one order to really safeguard the stabil- third of these may be attributed to a ity of the euro area as a whole? large domestic recession and could In what follows, I shall deal with these therefore be justified on the basis of the questions in turn. As a basis of my con- SGP. To put it the other way around, in siderations, I use the annual report roughly two thirds of cases the SGP 2010/11 of the German Council of was violated. But sanctions have never Economic Experts (GCEE). been imposed due to several hideouts in the regulations of the SGP and due to

1 This contribution draws on the annual report 2010/11 of the German Council of Economic Experts. The opinions expressed here are not necessarily shared by all members of the Council. 2 European Economic Advisory Group (2011), p. 79.

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VOWI_Tagung_2011.indb 37 03.10.11 08:26 Wolfgang Franz

the fact that potential sinners judged be applied, if not ruled out by re- actual sinners. verse majority rule. In order to overcome this major de- The most important drawback is that in ficiency, the most promising measure the first stage the European Council would be to reform the SGP by intro- decides by qualified majority whether ducing sanctions which are automati- the state has undertaken effective ac- cally imposed on a country if certain tion. Since Council members know the thresholds regarding its public deficit consequences of this first stage decision and a deadline to sufficiently reduce it there is every reason to expect that are exceeded. But this first best solu- they are very reluctant to vote against tion is anything but realistic if not the state in question, to say the least. naïve. Therefore, the GCEE has pro- By and large, with respect to sanctions posed a second best procedure hereby we would be back to the present SGP. strengthening the role of the European In a draft report of January 2011, how- Commission. More specifically, our ever, the European Parliament is in fa- suggestion rests on a reversed voting vour of much more convincing propos- procedure: The European Commission als made by the European Commission: proposes sanctions which can only be The Commission asks for a sanction rejected by the Council with a qualified which can be rejected by the Council majority (within a given time period). only by reverse voting. It can be shown that such a reverse vot- This is not to say that the planned ing rule significantly increases the reform of the SGP does not have its probability that sanctions are imposed.3 merits. Most noteworthy is that more To what extent do the planned re- weight is put on the public debt ratio. forms of the SGP meet these require- More precisely, both the European ments? In October 2010, the European Commission and the European Parlia- Council endorsed the recommenda- ment suggest the following rule: An ex- tions by the Van Rompuy Task Force. cessive ratio of government debt to With respect to excessive deficits its gross domestic product is only to be suggested procedure is the following: considered sufficiently diminishing if – In the preventive part of the SGP, if the differential with respect to 60% has the state significantly deviates from been reduced over the previous three the adjustment path foreseen in the years at an average rate of the order of SGP and also fails to take appropri- one twentieth per year. What does that ate action within five months, the mean in practice? Take the Italian debt European Council will state this on ratio of 120% as an example. It ex- the basis of a qualified majority. ceeds the reference value for 60%. Then, by using a reversed majority Hence, Italy has to reduce its debt ratio rule, an interest-bearing deposit at an annual average rate of 3 percent- will be imposed. age points, i.e., if starting in 2011, Ita- – In the corrective part of the SGP, if ly’s debt ratio in 2014 would be 9 per- the European Council decides by a centage points lower (111%). But again, qualified majority that the Member the lack of automatic sanctions casts State has not taken effective action doubt on the effectiveness of this ambi- to correct the excessive deficit tious measure. within a given deadline, a fine will

3 German Council of Economic Experts (2010), pp. 91 (box 8).

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Reforming the SGP in an efficient (1 May, 2011), the European Parlia- manner will, indeed, make a new ment as well as national parliaments European debt crisis much less likely, are deeply concerned with the conclu- but the conclusions of the European sions of the European Council. Hence, Council cast doubt on whether a really those conclusions might be subject to tough SGP will be enacted. Moreover, changes. Indeed, serious improvements we cannot be sure that neurotic finan- of the ESM are absolutely necessary. A cial markets will attack the euro any- very brief look at the details of the ESM way. Therefore, a crisis mechanism is serves as a prerequisite for an informed warranted in addition to measures en- discussion. suring a stable private financial system According to the European Coun- (which is not my topic here). This leads cil, the ESM is to be activated if it is me to my second question, namely how indispensable to safeguard the stability to design an efficient European crisis of the euro area as a whole. Some em- resolution mechanism. phasis should be put on indispensable and euro area as a whole. While this European Crisis Mechanism phrasing is open to interpretation, rein- When the European Monetary Union terpretation, and redefining, the inten- was established, no institutional rules tion rightly aims at establishing a useful for crisis scenarios were agreed beyond safety device. the no-bail-out clause. The SGP was The funding of the ESM amounts to considered sufficient to guarantee sta- EUR 700 billion with an effective lend- ble public finances. This turned out to ing capacity of EUR 500 billion. The be a tremendous mistake. Hence, in capital base of EUR 700 billion consists May 2010 gigantic rescue shields were of EUR 80 billion paid-in capital, beset up overnight without having been ing phased in between 2013 and 2017, preceded by and based on detailed political and scientific debate. In order to obviate such abrupt and arbitrary operations in the future, it is vital to put in place a permanent European crisis mechanism to replace the temporary protective shields. This by no means is a request for simple bail-outs for countries with a reckless fiscal policy. Such a mechanism should only provide support to Member States if absolutely necessary to safeguard the euro area as a whole, to repeat: as a whole. More- over, strong conditionality and burden sharing with the private sector are in- and of EUR 620 billion callable capital, dispensable. i.e., the fund can ask shareholders to In March 2011, the European Coun- supply new capital if existing capital cil agreed upon a new permanent crisis gets wiped out. The instruments of the mechanism, the European Stability ESM are twofold: Firstly, the ESM Sta- Mechanism (ESM), assuming the Euro- bility Support (ESS) provides loans pean Financial Stability Facility (EFSF) whose maturity depends on the nature in 2013. At the time of this writing of the imbalances and the prospects of

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the beneficiary state regaining access to Collective Action Clauses (CAC) will financial markets. Secondly, there is a be included in all new euro area gov- primary market support facility to al- ernment securities. low the fund to purchase government Taken together, there is good news, bonds directly from the state at stake bad news, and really bad news. rather than on the secondary market. – Good news: A permanent crisis res- On request for financial support by olution after the EFSF is a good idea a Member State, both the EU Commis- as long as the restrictions indispens- sion and the International Monetary able and euro area as a whole are Fund (IMF) in liaison with the Euro- taken seriously. pean Central Bank (ECB) assess the ac- – Bad news: It is unclear how the tual funding needs and negotiate a problem is tackled if a Member macro-economic adjustment pro- State cannot honour its commit- gramme. The result has to be adopted ment due to excessive public debt, by the EU Council unanimously. This i.e., the “can’t pay, won’t pay”-case unanimity serves as a second safety de- (Münchau, 2011). vice. – Really bad news: The regulations Private sector involvement is car- concerning private sector involve- ried out only on a case by case basis, de- ment are completely insufficient, in pending on the outcome of a debt sus- all practical cases burden sharing tainability analysis. Sustainability re- with the private sector is out of quires that the borrower is expected to question. It is unacceptable to leave continue serving their debt without an this to a case by case basis subject to unrealistic large correction of their in- interpretation due to the choice of come and expenditure. If it is con- words such as realistic, expected, cluded, on the basis of a sustainability and the like in the conclusion of the European Council. Therefore, the ESM has to be renegoti- ated. Some guidance how to overcome the aforementioned deficiencies may be obtained from the German Council of Economic Experts’ proposal. The GCEE sets up a precise framework which does not leave much room for interpretation. The mechanism suggested by the GCEE must provide support to Member States in the event of serious capital market disruptions without giving investors the impression that the Community will always bail out analysis, that the macro-economic pro- states. More precisely, the GCEE dis- gramme cannot realistically restore tinguishes three cases: public debt to a sustainable path, the Case I:IIThe state requesting support is granting of financial assistance will not in an excessive deficit procedure. then be contingent on the beneficiary Financial support can be granted if en- state demonstrating sufficient commit- dorsed by the European Council. ment to ensure adequate and propor- Case II:IThe state is in an excessive def- tionate private sector involvement. icit procedure but not subject to sanc-

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tions. Financial support can be granted ment of the private sector is inevitably if a majority of the European Council required, the magnitude of which de- representing at least 90% of the popu- pending on the sovereign debt ratio. lation of the euro area agrees, and strict The challenge to the euro area is to macro-economic conditions are im- establish a credible rescue strategy posed. which, on the one hand, strictly binds CaseInvolvement of the private sector private investors and, on the other is warranted but not conclusive. hand, prevents the euro system from Case III: The state was subject to sanc- turbulences of a grand scale. Despite tions during the past four years. In some progress, the ESM as it stands extension to the former case, involve- does not yet meet these requirements.

References European Economic Advisory Group. 2011. The EEAG Report on the European Economy 2011. Munich: CESif. German Council of Economic Experts (Sachverständigenrat zur Begutachtung der gesamtwirtschaftlichen Entwicklung). 2010. Jahresgutachten 2010/11. Chancen für einen stabilen Aufschwung. (Annual Report 2010/11. Summary Chapter 1. Available in English). Wiesbaden. Münchau, W. 2011. A Grand Bargain that Cannot End the Crisis. Financial Times. March 28.

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VOWI_Tagung_2011.indb 41 03.10.11 08:26 Daniela Schwarzer Head of Research Division Stiftung Wissenschaft und Politik, Berlin

VOWI_Tagung_2011.indb 42 03.10.11 08:26 Legislative and Institutional Dynamics in Response to the Crisis

As an answer to the financial and eco- tergovernmental agreement, initially nomic crisis, the European Union de- designed to commit the Heads of State cided first steps to improve the regula- and Government of the euro area to an tion and surveillance of financial mar- ambitious economic and social reform kets as early as 2009. In the beginning agenda as well as budgetary austerity. of 2011, the four new Financial Market It has meanwhile been signed by 23 out Supervisory bodies were able to start of 27 EU Member States.1 In parallel their work. to these efforts, further initiatives to Meanwhile, on invitation of the improve financial market regulation European Council of March 2010, the are being pursued on the European so-called Van Rompuy Task Force elab- level and in national contexts. Unlike orated a list of suggestions on how to the USA, where most of the measures improve economic and budgetary pol- to reform financial market regulation icy coordination. The Task Force was and surveillance were actually embed- chaired by the new permanent Council ded in a single legislative initiative, the President and brought together 27 Dodd-Frank Act, financial market reg- (mostly) finance ministers. The Task ulation in the EU is improved through Force delivered its report on improved multiple initiatives on different political budgetary and economic policy coordi- levels. nation and a permanent crisis resolu- The scope and pace of these legislation mechanism in October 2010. tive and institutional dynamics convey The European Commission tabled six the (correct) impression that the euro legislative proposals (the so called area’s governance rules and procedures “Rehn package”) on September 27, are indeed undergoing substantial 2010, just before the Van Rompuy report in order to make use of its right of initiative. In March 2011, the European Coun- cil agreed that economic governance should be improved by implementing a so-called “Comprehensive Package” which includes the six legislative acts on budgetary, and economic policy coordination and national fiscal rules, the European Stability Mechanism (ESM) and the so-called Euro Plus Pact. The ESM, a permanent stabilization mechanism, is supposed to help solve future sovereign debt crisis in the euro area. change. The question yet is whether the Its implementation requires a revision reforms undertaken are capable of of Art. 136 of the Treaty on the Func- eliminating the underlying governance tioning of the European Union (TFEU). weaknesses of the previous set-up. The so-called Euro Plus Pact is an in-

1 The four non-members are the two EMU opt-out countries the UK and Denmark, as well as the likely future EMU members Hungary and the Czech Republic.

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2 Reforming an Incomplete based coordination left room for politi- Governance and Regulatory cal discretion to the Finance Ministers Framework in the Ecofin Council. The way the financial crisis has hit the Despite the various efforts to com- European Union since 2007 has re- plete the governance framework over the vealed considerable weaknesses in the years, it performed below expectations. way its economic governance mecha- Even before the crisis hit the EU in the nisms functioned since the start of the last years, fiscal performance of many European Monetary Union (EMU) in Member States did not reach the agreed 1999. Weaknesses can be identified targets and economic divergence within both in the way economic governance the euro area visibly built up. worked in the run up to the crisis and There is of course the case to make in the way the euro area handled crisis that the coordination mechanisms simply management. targeted the wrong variables. For in- First, the European Monetary stance, the recent sovereign debt crises Union was created with an incomplete in Ireland and Portugal, would not have institutional and regulatory framework. been prevented if the Stability and Initially, in parallel to the Intergovern- Growth Pact had been applied in every mental Conference (IGC) which nego- detail, not even in the new form once tiated the Maastricht Treaty, a second the “Rehn package” is passed, i.e. with ICG was held in order to equip the Eu- tougher sanctions and swifter proce- ropean Community and the future dures. The exploding deficits and pub- monetary union with a political union. lic debt levels were rather caused by the But the latter failed and the European fact that the public sector shouldered li- single currency was introduced with an abilities of the private sector. Root accompanying governance framework. causes were macro-economic imbal- It essentially consisted of rules and pro- ances, a decline of competitiveness and cedures for budgetary and economic banking crises. The question then is policy coordination judged at the time why policy makers were immune to the as being insufficient by many actors and increasing evidence that economic di- observers. So several elements of the vergence increased in the euro area and Maastricht framework were changed in that macro-economic imbalances per- different ways – long before the cur- sisted. The Broad Economic Policy rent reform process was launched and Guidelines and the Macro-economic partly even before the euro was actu- dialogue could have been used for ally introduced. These changes include closer economic policy coordination – the Stability and Growth Pact of 1997 had the political insight been there. (and it first reform in 2005), the em- A major reason for insufficient pol- ployment chapter in the Amsterdam icy co-ordination is without any doubt Treaty of 1997, the creation of the Eu- the nature of incentive structures of na- rogroup and the subsequent introduc- tional policy makers. National decision tion of the Eurogroup President, and makers in their majority have other in- well as the first euro area summit (held terests than being “good EMU gover- in 2008 under the French rotating EU nors”, they maximize utility in view of Presidency). None of the initiatives their objective to be re-elected in the substantially changed the nature of the next national election. Depending on governance mechanisms. No transfers the way the euro area and EU integra- of sovereignty occurred, and the rules- tion is perceived at home, part of their

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electoral success in national or sub-na- cedure and the Stability and Growth tional elections depends on their capac- Pact, but also in more informal and ity to fend off interference from Brus- subtle processes of policy coordination. sels and to maintain the largest possible scope for national discretionary action. If the assumption of short-termism and a focus on national constituencies holds true, this explains that the perception of EMU realities in national policy decisions is underdeveloped. Individual decision-makers either act uninformed because they simply do not grasp the interdependencies between national policy choices and euro area spill-overs, or they are cynic because they prefer to go ahead with solutions bringing short- term benefits home to domestic constituencies. Hence, for instance the possibilities for closer economic policy coordination that have existed ever since the euro was launched (e.g. through the Broad Economic Policy The Member States were unwilling to Guidelines or the Macro-Economic Di- let their agent assume its role in bud- alogue) were not made use of by the getary and economic policy co-ordina- Member States. tion in which the supranational impact Quite the opposite is the case, na- was hence limited. tional governments throughout the At the same time, market mechanisms brief history of the European Monetary as disciplining devices proved insufficient Union on several occasions stopped under the conditions of the euro area. “more EU” in policy coordination and In the run-up to the crisis, bond spreads hence also limited the impact of suprana- for a considerable time did not reflect tional actors in pushing EMU logics. the respective Member States’ fiscal Hence, in particular, the European and economic performance. So the ba- Commission encountered political ob- sic logics of EMU’s architecture, stacles in its efforts to implement bud- namely that markets would back the getary policy coordination. While the rules-based coordination, did not work. first three years of EMU gave little rea- In the sovereign debt crisis, markets in sons for doubt in the institutional set a seemingly exaggerated reaction over- up, as of the year 2002 the Commis- shot and, once again, the rationality as- sion’s political role in the coordination sumption does not hold. Since the crisis process actually eroded with the vivid sovereign debt crisis and market reac- Irish reaction to the criticism of its pol- tions peaked in April/May 2010, the icies in the Broad Economic Policy rescue packages, unclear political mes- Guidelines. In the following years it be- sages about private sector involvement came increasingly obvious that the and ongoing speculation about the like- Commission depended on the support lihood and costs of sovereign defaults of the Ecofin, not only in the formal ap- further blurred the conditions for mar- plication of the Excessive Deficit Pro- kets to sanction irresponsible policies.

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3 Methods and Actors of Pact and the reform of economic policy Economic Governance Reform co-ordination, as it attempts to impose in the EU between 2009 and more European views on the Member 2011 States. Despite the shock induced by The reform initiatives briefly outlined the financial crisis, which has revealed in the introduction have different legal the degree of interdependency in the bases, involve different actors and euro area, national considerations pre- hence underlie different legal and po- vail when it comes to questions of sov- litical restrictions which determine ereignty and interference from the EU their outcome. level, for instance with the budgetary Regarding the legal nature, a large authority of national Parliaments. From part of the reforms consists of legisla- a functional perspective “more Euro- tive action on the European level. This pean interference and coordination ca- is for instance so for the “Rehn pack- pacity” may seem to be the right way age”, the laws installing the European forward in order to reduce externali- Financial Market Supervision or the ties and improve policy output. But various initiatives to improve financial looked at from the perspective of legiti- market regulation. Part of them is macy, it becomes more and more obvious that attempts to limit national sovereignty and to transfer competencies to the EU level reach critical limits unless a sound base of legitimacy and democratic decision-making that satisfies Western European norms is guaran- teed. The European Stability Mechanism, in contrast, is based on an intergovernmental Treaty which has been signed by all euro area Member States and now has to undergo ratification in national Parliaments. In order to make the ESM compatible with the EU Treaty, Art. backed-up or completed by national 136 TFEU has been amended – another legislation, for instance national law on step that requests national ratification. financial market regulation or national From today’s perspective, it cannot be fiscal rules. excluded that the ESM Treaty or the Some of the legislative acts are amendment of the TFEU encounter passed under the ordinary legislative ratification problems in single Member procedure which makes the European States.2 Parliament (EP) a full co-legislator. The Pact for the Euro-Plus, mean- The EP has made its influence felt in while is an intergovernmental agree- both the negotiations of the Financial ment between the 24 signatory Mem- Supervisory bodies and the regulations ber States. While coordination in par- concerning the Stability and Growth ticular with the new policy coordination

2 See for instance the political power play in Slovakia which has already opted out of the EFSF. http://spectator.sme.sk/articles/view/43089/10/government_approves_esm_documents_with_sas_party_against.html (retrieved on June 15, 2011).

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mechanisms installed with the “Rehn for stronger political coordination, even package” and the European Semester is if the euro area underperforms as a supposed to be close, the Euro Plus whole. Pact still provokes the formation of a new group within the European Council Declining Solidarity and Rising excluding large players such as the UK. Polarization With the growing reluctance to partic- 4 The Political Context of ipate in the rescue mechanisms (cp. the Economic Governance Reform case of Slovakia, the True Fins and the in 2010/2011 concerns about Germany’s long-term The sheer number of initiatives under- involvement with the mechanisms) and taken in order to reform economic gov- with a (in key countries) declining sup- ernance of the euro area and the sub- port for EU membership, there is a stance of at least some of the measures concern that previous assumptions on show that a window of opportunity has necessary solidarity and cohesion in the opened with the advent of the financial E(M)U could be revised to the bottom. If crisis and in particular with the devel- this is so, this will not only have impli- opment of the sovereign debt crisis. cations for the creditor countries ad- While all reservations on political feasi- herence to the newly installed rescue bility of far reaching efforts outlined mechanisms. It would furthermore im- above apply, it can still be argued that pact the upcoming negotiations on the the political context for reform has EU’s multi-annual financial framework been rather supportive since 2009. But and hence the future of the cost-inten- the tide may very soon turn if Member sive policies such as cohesion and struc- States become even more self-inter- tural policies. ested, in particular if the economic and The crisis has provoked unparalleled social costs of the crisis continue to polarization and polemics between Member weigh on governments. States (cp. for instance the polemics The political context for EMU gov- both in Germany on the Greek and in ernance reform in 2011 can hence be Greece on the Germans). If the EU characterized as follows. As a general runs into a situation where the donor mood, on the EU level, the focus is on and recipient countries face each other risk management and prevention, but with hostility and mistrust, the politi- there is little ambition for joint policy cal and normative fundaments of the making. This attitude became apparent European integration process may be when the real economic effects of the shattered. This is particularly so as crisis hit in 2009 and there was little competitive pressures and substantial political will among the Member States’ real devaluations cause political backlash governments to coordinate the fiscal in some countries. Political fragmenta- stabilization efforts more closely or tion, the inability to construct cross- launch a European initiative. Moreover, party consensus on far reaching struc- the reluctance to link policy debates, tural changes and rising populism not e.g. in connection with the upcoming only make it questionable whether gov- EU budget negotiations and the Euro- ernments of recipient countries will ac- pean growth strategy “EU 2020”, to tually be able to stick to the condition- the question of governance reform and ality they have signed in return for rescue sovereign debt crisis resolution, is telling. packages. Polarisation will increase if Governments continue not to be open the pain of structural reform and bud-

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getary austerity is increasingly blamed current reforms stop short of creating on the “dictatorship of the donors”.3 governance structures that are likely to The evolution of public opinion in- ensure legitimacy on the input and on deed becomes a growing concern. Low the output side of the policy cycle. growth and high unemployment rates Meanwhile, the crisis management and since the beginning of European inte- the new governance structures are a gration tend to correlate with a decline substantial departure from the Maas- of support for European integration. tricht model of EMU in which the ECB Meanwhile, opinion poll data also exclusively focused on monetary stabil- shows rising expectations of the citi- ity while the governments were – at zens towards the EU’s problem-solving least in theory – assumed to have full capacity in economic and social policy. liability for budgetary policy making. Taken together, these two trends bear a So in the long run, the euro area’s risk of frustration with the EU and na- reform agenda may need to be defined in tional politics and hence may feed pop- much broader terms. Both the problems ulist tendencies in moderate parties or of the political economy of policy coor- (anti-EU) populist movements. There dination discussed above and the prob- is consequently, in the short term, a lems of legitimacy that the EU will in- rising importance of active opinion creasingly encounter, make the case for leadership and public deliberation. a much deeper questioning of the governance mechanisms than the current 5 Outlook reform projects do. In the long run, the Despite the broad economic gover- conclusion may well be that a European nance reform agenda of which the ma- currency cannot survive without an jor parts will be concluded in 2011, the European economic government whose EU is likely to stay in a transitory phase basis of legitimacy is solidly founded in for further years. The reason is that the a European democracy.

3 An expression used by Daniel Gros in a public hearing of the Budgetary Committee of the Deutscher Bundestag on March 14, 2011.

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VOWI_Tagung_2011.indb 48 03.10.11 08:26 VOWI_Tagung_2011.indb 49 03.10.11 08:26 Klaus Liebscher Award

VOWI_Tagung_2011.indb 50 03.10.11 08:26 Klaus Liebscher Award for Scientific Work on European Monetary Union and Integration Issues by Young Economists

Ladies and Gentlemen, Liebscher Award, which we give to Today it is the 7th time that we give the three outstanding young researchers Klaus Liebscher Award to three young today. The support of research and the researchers in economics. As in all the exchange with other researchers in previous years it has been an extraordi- economics is an important investment narily difficult task for the jury to se- of OeNB in its economic expertise. lect among a large number of excellent submissions the two winning papers of this year. On the occasion of the 65th birthday of Klaus Liebscher, former Governor of the Oesterreichische Nationalbank (OeNB), the bank in 2005 established the Klaus Liebscher Award. We did so in recognition of his unrelenting commitment to the cause of European integration and Austria’s participation in European Economic and Monetary Union. This award is the highest scientific distinction, the OeNB offers. It is granted every year for two excellent The first winning paper of this year papers on European economic and is co-authored by a team of two young monetary union and European integra- economists: tion issues. Young economists, up to 35 Frederike Niepmann from the Euro- years from EU member and EU candi- pean University Institute in Florence date countries are eligible. The award is and Tim Schmidt-Eisenlohr from Oxford worth EUR 10,000. The papers are University. Their joint paper has the ti- refereed by a panel of highly qualified tle: Bank Bailouts, International Linkages reviewers. and Cooperation? The OeNB, in response to its inte- Frederike Niepmann is a Ph.D. can- gration into the ESCB, has increased didate in economics at the European very much its research activities and re- Research Institute in Florence and cur- search capabilities in the last years. rently on exchange at the London Meanwhile academic publications and School of Economics under the Euro- the contributions to the system have pean Doctoral Program (EDP). Her been substantial. The efforts to increase main fields of research are international the economics and research output cer- trade and banking. Tim Schmidt- tainly also reflect the fact that we now Eisenlohr is a research fellow at the operate in a very different environment, Centre for Buisness Taxation, Univer- where the role of research for modern sity of Oxford, since October 2010. He central banking has become much more studied economics in Heiderlberg and important. The OeNB’s support for Kiel with exchange stays at the Univer- economic research is visible in numerous sity of Illinois Urbana-Champaign, the activities, like for example the Klaus University of Bergen and New York

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University. He got his Ph.D. in eco- Steffen Osterloh is a research econ- nomics from the European University omist at the Center of European Eco- Institute Florence. His main fields of nomic Research (ZEW) Mannheim. research are International Trade, Tax He has a degree in economics from Competition and Financial Stability. Mannheim University and is a Ph.D. The second winning paper of this candidate in economics at Mannheim. year is by Steffen Osterloh from ZEW His main fields of research are political Mannheim. The title of his paper is Can economy, European integration and Regional Transfers Buy Public Support? Fiscal Policy. Evidence from EU Structural Policy.

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VOWI_Tagung_2011.indb 52 03.10.11 08:26 Session 2: Banking and Financial Architecture in the EU

VOWI_Tagung_2011.indb 53 03.10.11 08:26 Andreas Ittner Executive Director Oesterreichische Nationalbank

VOWI_Tagung_2011.indb 54 03.10.11 08:26 Introductory Remarks

Ladies and Gentlemen, and especially the European Systemic Good afternoon. I am pleased to open Risk Board face? today’s afternoon session, and I am par- Let me briefly address three major ticularly pleased to welcome our distin- issues: guished speakers, Lorenzo Bini Smaghi First, the analytical challenge is and Professor David T. Llewellyn. high with regard to collecting the rele- This session is entitled Banking and vant data and employing the right tools Financial Architecture in the EU. In the to measure, analyse and prioritise course of the recent years, the banking systemic risk in a way that the ESRB and financial architecture worldwide has can make warnings and recommenda- been changing considerably as a response tions. The main new avenue to explore to the financial crisis. EU Member is improving our understanding of the States decided on a radical overhaul of interconnectedness in the financial Europe’s system of financial supervi- system, both via the direct links sion. The establishment of the Euro- between financial institutions and the pean System of Financial Supervision indirect ones created within the finan- (ESFS) comprising the three European cial system itself. Supervisory Authorities (ESAs) for the Second, the ESRB needs to develop banking sector (European Banking a macro-prudential policy framework Authority, EBA), for the securities sector in the medium-term and coordinate (European Securities and Markets Au- instruments on EU level. However, it is thority, ESMA) and for the insurance necessary that macro-prudential super- and occupational pensions sector (Euro- visors have sufficient flexibility on a pean Insurance and Occupational Pen- national level and a wide range of sions Authority, EIOPA) as well as the macro-prudential instruments at their newly created European Systemic Risk disposal to address systemic risk. In this Board (ESRB), is an important mile- stone in addressing many of the shortcomings. While the three European Supervisory Authorities continue their work on micro-prudential supervision in a more comprehensive way, the ESRB is responsible for overseeing risks in the European financial system as a whole, thus focusing on macro-prudential supervision. Successful interaction between the ESRB and the ESAs, in particular to ensure a proper meshing of macro-prudential and micro- pruden- tial instruments, will be challenging. The ESFS will foster a coordinated Euro- regard, I see a strong role for the ESRB pean approach to financial supervision in organising a coordinated EU approach and it will enhance the integration in order to strike the right balance be- process of financial markets and super- tween additional macro-prudential pol- vision, thus strengthening economic icy and a harmonised Single Rule Book. growth in the EU. Third, as we have so far only limited What challenges does the new Euro- experience regarding macro-prudential pean System of Financial Supervisors policy measures and their interaction

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with other policies and the real economy, more light on the before mentioned issue the major challenge lies in combining concerning the interaction of macro- early risk identification and counteract- prudential policy with other policies in ing measures with the medium- and his speech Macro-Prudential Supervision longer-term perspective. and Monetary Policy – Linkages and De- Let me conclude by saying that, in marcation Lines. my capacity as Vice Chair of the ESRB’s Our second speaker, David T. Advisory Technical Committee, I am Llewellyn, Professor at the renowned fully committed to assess the risks for European Loughborough University, EU financial stability and, more impor- will critically address the issue of Will tantly, to act upon them in a coordi- the New EU Financial Architecture Prevent nated and timely manner. Future Crises?; as the challenges and I am very happy that our first speaker expectations of the new supervisory Lorenzo Bini Smaghi, Member of the framework are high and the costs for Executive Board of the ECB, will shed society – if we fail – as well.

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VOWI_Tagung_2011.indb 58 03.10.11 08:26 Macro-Prudential Supervision and Monetary Policy – Linkages and Demarcation Lines1

It is a pleasure for me to contribute to the affect monetary policy. I will argue that Oesterreichische Nationalbank’s annual monetary policy can influence such Economics Conference on the future of behaviour, for instance, by affecting the economic integration. In my remarks overall level of leverage in the economy today, I would like to elaborate on the and the maturity structure of financial linkages and the dividing lines between liabilities, or by changing attitudes held macro-prudential supervision and mon- by those in the financial sector about etary policy. assuming risk. In turn, this may crucially I will structure my presentation in impact on the likelihood of asset and two parts. First, I will discuss the interactions between monetary policy and the financial system, showing how monetary policy can create the conditions for financial stability. As a matter of fact, price stability is a necessary condition for financial stability, in that asset prices and financial volumes are bound to reflect and amplify erratic swings in inflation expectations – if and when a central bank allows these to happen. But price stability is not a sufficient condition for financial stability. I will elaborate on this insufficiency paradigm and the corollary that the ECB credit bubbles forming and inflating, as derives from it. I will also argue, in- they did before the global financial crisis. versely, that financial stability is a nec- According to recent studies that essary precondition for monetary policy, have reconsidered the role of financial in that it creates the conditions for mon- intermediaries in monetary economics, etary policy to attain its objective. monetary policy may be regarded as In the second part of my presentation an extremely powerful tool. Those stud- I will illustrate the rationale for the main ies indicated that short-term policy macro-prudential tools and discuss how rates are important per se – quite inde- they interact with monetary policy de- pendently of their impact on long-term cisions. rates and on expectations of future short-term rates.2 Of course, this marks 1 Interactions between Monetary a U-turn in monetary policy thinking. Policy and the Financial System Mainstream macroeconomic doctrine Let me start by briefly considering how had long built on a finance-less con- monetary policy decisions can influ- struct in which short-term rates matter ence the financial sector’s risk-taking only to the extent that they determine behaviour, before moving on to discuss long-term rates, as risk-adjusted expec- how the financial sector may itself also tations of future short-term rates. The

1 I wish to thank Lorenzo Cappiello, Marco Catenaro, Massimo Rostagno and Carmelo Salleo for their contributions to the speech. I remain solely responsible for the opinions contained herein. 2 Adrian and Shin (2009).

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crisis has suggested that finance is not a treme forms of maturity transforma- veil. It is a critical determinant of macro- tion can become attractive, particularly economic facts; it is a source of shocks if the risk adjustment calculus fails to and an intricate – and partly unpredict- make a proper correction for the ex- able – amplifier of disturbances. A new pected gains. Business models based on series of studies and models show how “search for yield” with little or no finance and the macro-economy inter- concern for risk then become popular. act. In these models, short-term mone- In the search for a high nominal return tary policy instruments seem to be more on investment, financial institutions powerful than previously thought – and might be encouraged to buy assets, typ- therefore, more disruptive if misused. ically with long-term maturity and pos- But why would short-term rates be sibly illiquid, financing them with important in their own right? The bulk short-term liabilities, thus generating a of finance for financial institutions, large maturity and liquidity mismatch. whether banks, broker-dealers, the so- Such new and destabilising business called shadow banking system or hedge models do not apply only to securities. funds, is very much short-term. For ex- Evidence both for the euro area and the ample, broker-dealers fund themselves USA shows that banks tend to accumu- primarily in the repo market, mainly at late risk during economic upturns by overnight maturities, while shadow optimistically easing lending standards. banks fund themselves in the commer- The same evidence shows that much of cial paper market and the majority of the easing comes from supply-side commercial banks rely on retail finance adjustments. In other words, it is not – chequing and savings deposits – warranted by improvements in the bor- which usually consists of sight or short- rowers’ risk due to the more favourable maturity instruments. Wholesale fund- economic conditions in which those ing for commercial banks is, typically, borrowers operate.4 This is particularly very short-term as well. So, when a true for mortgages and is considered central bank decides on the short-term one of the factors that fuelled the real interest rate, it directly affects the estate bubble. marginal price of leverage for virtually Furthermore, research has shown the entire financial sector. that the impact on risk-taking of low Problems arise when, due to low short-term interest rates is amplified interest rates that make short-term when securitization activity is high – for funding cheap, the total debt raised by it improves banks’ capital and liquidity financial institutions goes beyond what position and reduces borrowers’ risk – may be considered as socially optimal. and when banking supervision standards This is frequently the case for the un- are weak. As for the euro area in par- regulated or so-called “shadow” banking ticular, there is some evidence that low system, not subject to the stringent re- short-term interest rates induce banks quirements of the regulated banking to lend to borrowers with a poor credit sector.3 history or none at all. Naturally, such Low funding rates can inspire risky loans also have a higher hazard rate, that business strategies. For example, ex- is to say a high probability of default.5

3 Stein (2011). 4 Maddaloni and Peydró-Alcalde (2010). 5 Jiménez, Ongena, Peydró and Saurina (2010).

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When financial intermediaries have although this is not explicitly stated in built large risks into their balance sheet the mandate of many central banks. As structures, a negative shock to confi- a matter of fact, the original motivation dence hits the financial system as a for creating central banks in many whole, in a rather undiscriminating countries was to temper the financial fashion. A negative externality to the crises associated with unregulated “free whole system will then ensue. This is banking” regimes.6 what researchers have identified as a A central bank’s task of maintaining fundamental market failure – unregu- price stability is facilitated if there is no lated private money creation can ex financial turmoil and such events are post leave the system fatally exposed to rare. Financial stability contributes to a systemic crisis. A systemic crisis is in an orderly functioning of the transmis- essence a colossal externality: fire sales sion of monetary policy to the economy and distressed de-leveraging are the and, ultimately, to prices – a precondi- correct response that each financial in- tion for a central bank to be able to dis- stitution in isolation should have to a charge its primary task of maintaining funding crisis. But in the aggregate fire price stability. Therefore, the respective sales and the concomitant shedding of policy objectives of macro-prudential exposures cause a systemic failure oversight and monetary policy, that is, which can damage institutions that contributing to financial stability and would be healthy in different macro- maintaining price stability, are mutu- environments. ally reinforcing. In a simple institutional environ- But is there an ex ante role to play ment, this externality could be addressed for the central bank alongside regulatory with conventional monetary policy, policies? Can it discourage risk-taking complemented with either deposit insurance or a lender-of-last-resort facility, acting ex post. But for policy-makers to intervene ex post is sub-optimal and ex- ceedingly reliant on instruments whose effectiveness in distress conditions is subject to a great deal of uncertainty. Ex ante policies are required to control the risk factors which can undermine the system. This provides an important rationale for deploying a broad range of measures (e.g. financial stability regulation). I will come back to this point in the second part of my remarks. What is clear from this narrative is behaviour by the financial sector before that financial (in)stability has a pro- excessive balance sheet risk is created? found role to play in creating the condi- The developments in the run-up to tions in which monetary policy operates. the global financial crisis have shown that Therefore, monetary authorities are price stability, while being a necessary very alert to developments that can precondition, is not sufficient for finan- have implications for financial stability, cial stability. Low and stable inflation

6 Goodhart (1988).

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rates before the crisis coincided with a was recognised before the crisis and de- build-up of financial imbalances, leading bated – somewhat absent-mindedly – in to an increase in systemic risk and, ulti- an academic world dominated by the mately, serious risks to price stability inflation targeting doctrine. The debate later on. More generally, as a result of had concentrated on whether asset the establishment of credible low infla- prices should be included in the central bank’s definition of the inflation target, or in their objective function, or at least as an argument, over and above inflation deviations, of their “feed-back rules”. The consensus conclusion was that asset prices should be considered only to the extent that they might help predict inflationary pressures.7 In a post-crisis world, the debate has taken a different tack. For one thing, it is not asset prices alone that should enter policy considerations. It is financial and monetary imbalances in general. This includes asset price over-valuations and measures of risk appreciation in financial instruments, of course. But it includes monetary and financial quantities as well: over-leveraging of sectors – and tion environments over the last two- of the entire economy – and excessive and-a-half decades, with firmly an- creation of cash balances. It is by now chored inflation expectations, ample established that monetary policy affects liquidity conditions and unsustainable financial stability by influencing the economic imbalances seem to manifest leverage, maturity mismatch and risk- themselves first in the build-up of finan- taking behaviour of the financial sector. cial imbalances rather than in immediate One could even argue that, in a near- inflationary pressures. One reason for paradox, it is precisely the success of this may be that economic agents find it monetary policy in taming inflation preferable, under supposedly normal and therefore being able to deliver circumstances, to assume that in the lower interest rates that introduces an future inflation will remain close to the element of instability, due mainly to central bank’s objective, but will sud- the financial sector’s misperception denly and – even rather abruptly – revise that low interest rates are associated such expectations once actual inflation with a low-risk environment. When a edges up and uncertainty about future financial crisis erupts, however, there is increases. Due to such stickiness, the a risk that monetary policy and financial potential inflationary pressure in the stability could lead to a so-called “low economy may be stronger than current interest rate trap”, in that crises require inflation expectations indicate. low interest rates to keep the financial That financial variables could be system alive; low interest rates main- important for monetary policy settings tained for long, in turn, induce too

7 Bernanke and Gertler (2001).

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much risk-taking, thereby making a new we need to understand how it interacts crisis more likely. with monetary policy in order to mini- How can financial imbalances enter mise frictions between the two and the process of monetary policy setting in exploit possible synergies. a way that makes monetary policy itself less prone to systematic mistakes? 2 Macro-Prudential Policies and The ECB has long practised a two- Monetary Policy Decisions pillar approach to policy-making. But The goals of macro-prudential policies note the difference between a mone- can be broadly defined as preserving tary pillar and a genuine lean-against- financial stability by reducing the pro- the-wind attitude, as was advocated by cyclicality of the financial sector, and the early participants in the debate that I improving its resilience to adverse was mentioning before. It was discussed shocks. However, even though the goals in a recent ECB paper.8 are clear in theory, the means to reach It is not asset prices per se that a them are still open to discussion. central bank should incorporate in its Monetary policy has been at the policy framework. After all, the equi- centre of the debate in economics for librium value of assets – particularly almost a century, and there is now a real assets, such as claims on companies high level of consensus about its goals, and houses – is difficult to compute its tools, and how to gauge its effective- and is certainly state-contingent. So, ness. However, the macro-prudential there is little merit in an unconditional framework is still fuzzy, and being monetary policy response to asset price developed with the benefit of hindsight changes. The policy response should after the crisis that started in 2007 with be conditional. And the critical condi- the bursting of the sub-prime bubble. tion that a central bank should ascer- I will describe briefly the main tools tain before judging if an asset price that are being developed, dividing them trend is policy-relevant is whether the into those that address pro-cyclicality market trend is causing – and/or is be- and those that attempt to improve resil- ing fed by – a concomitant monetary ience. I will discuss their interaction with imbalance. monetary policy and the conduct of A market bubble that progresses in that policy, and draw some tentative symbiosis with a credit bubble, and conclusions about how they reinforce which then spills over into excess each other – and where I see possible money creation, is certainly a policy- problems. relevant event. Being alert to the mon- In order to tame the pro-cyclicality etary imbalance means for a central of the financial sector, the main tool bank being better able to discriminate being devised is the aptly named counter- between benign and less-benign phe- cyclical capital buffer. Without going nomena in financial markets. into too many details, the main idea is This being said, monetary policy that as the economy booms and credit needs support in its ex ante action to is cheap, there is an inherent tendency resist the formation and build-up of to relax lending standards, take risks toxic financial imbalances. There is a and over-leverage. Subsequently, as the clear need for a corresponding policy economy slows down, over-extended framework to foster financial stability; borrowers go bust, mounting losses at

8 Fahr, Motto, Rostagno, Smets and Tristani (2011).

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banks result in capital depletion and struments, and how do they interact force them to reduce the loan supply. with monetary policy decisions? This can induce a credit crunch that The issue is one of timing and tar- turns a slowdown into an outright reces- gets. Interest rates are generally set by sion. Interest rates are generally set anti- looking at prices. Credit developments cyclically, but they might not be enough are also taken into account but mainly to to tame the swings of the financial sec- the extent that they forecast an increase tor, or might be too blunt an instru- in inflation. However, financial stability ment if the boom (and subsequent bust) might be endangered before credit ex- is concentrated in some specific sector, pansion starts spilling over into infla- for example real estate. On the other tion and might require an action that is hand, banks could be asked to build up both more vigorous and more targeted more capital per unit of risk during the than an increase in interest rates. upswing, well above minimum require- While in normal times the coordi- ments mandated by micro-prudential nation between monetary policy and supervisors. This way, on the one hand, macro-prudential policies might yield credit would become more expensive little benefit, when the shock to the and therefore might slow down, while financial system is severe there can be on the other hand, banks would not substantial gains if monetary policy need to reduce the loan supply during “lends a hand” and temporarily puts the downswing since they could run more weight on restoring financial sta- down this buffer before reaching the bility than on short-term price stability.9 binding constraint of capital regulation. This leads towards an institutional This instrument aims to limit supply- framework that involves central banks driven credit expansions and to soften in macro-prudential decisions, such as contractions. the Financial Stability Oversight Council One instrument which has similar in the United States and the European effects but is designed more for demand- Systemic Risk Board in the European driven credit booms is a ceiling on the Union. loan-to-value ratio for collateralised While monetary policy and macro- loans (and equivalently on margins and prudential policy might gain from coor- haircuts for securities lending). By forc- dination, we should also consider ing the borrower to put up more of its whether they affect each other. For ex- own funds, it makes credit more example, counter-cyclical capital buffers pensive and reduces demand. When the make banks increase their equity during demand for loans heats up, macro-pru- upswings; however, better-capitalised dential authorities can decrease the banks are less responsive to monetary loan-to-value ratio, thus increasing the policy.10 This alteration of the lending cost of credit and slowing down or channel (and the symmetric effect during stopping its growth. the downswings of the economic cycle) Both counter-cyclical capital buffers should be taken into account when and loan-to-value ratios increase the cost evaluating the impact of changes in of credit and thus limit its expansion, interest rates. Conversely, prolonged as does an increase in interest rates. So bouts of low interest rates can so alter why do we need this second set of in- the perception of risk by investors

9 Angelini et al. (2011). 10 Gambacorta and Marques (2011).

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that, in order to rein in risk-taking, Centralising transactions should re- macro-prudential brakes will have to be duce counterparty risk and allow a better applied much more vigorously than in a monitoring of financial flows, especially normal business cycle situation. There of derivatives, for which little data is is a dynamic interaction between the available in general. The extra informa- two types of policies that requires a tion should be useful for calibrating constant assessment not only of how to monetary policy. The concentration of combine them but also of their respec- transactions should reduce uncertainty tive feedbacks. about who holds what – an uncertainty Let me move on to measures that which, during a crisis, can end up increase the resilience of the financial freezing entire markets and forcing system. I will divide them into those central banks to intervene. Therefore, that strengthen institutions taking them the development of CCPs seems benefi- as given, and those that seek to change cial to the conduct of monetary policy. the structure of the industry. In the first category we have mainly levies on systemically important financial institutions (SIFIs). SIFIs are deemed to generate negative externalities for financial stability, due to their sheer size and interconnectedness. The failure of one of them would cause a financial crisis; however, this social cost is not borne by SIFIs’ shareholders only. Furthermore, moral hazard can result from the fact that they are aware of their systemic relevance. This, and the externality illustrated above, would justify ad hoc regulation The separation of commercial bank- to ensure that SIFIs are extra-safe. ing from other activities helps to protect At first sight, there should be little deposit holders by insulating them from interaction between additional require- excessive risk-taking activities by banks. ments for SIFIs and monetary policy. It can take the form of a carve-out of During a crisis, however, SIFIs would some form of narrow bank,12 or by lim- be prime candidates for liquidity injec- iting trading with own funds (some- tions by the central bank.11 thing similar to the Volcker Rule ad- In the second category of macro- opted by the United States). It is un- prudential measures that increase the clear whether this separation reduces resilience of the financial system, we the overall amount of risk in the finan- have market reforms such as a drive cial sector, or simply shifts it to institu- towards centralising exchanges wher- tions that are not deemed systemic. ever possible at central clearing counter- I would argue that if it is a mere re- parties (CCPs), and structural reforms distribution it might be dangerous: how aimed at separating commercial banking do we know that we will not have a re- from other activities. peat of 2007, when we saw that vast

11 This has more to do with the implementation of monetary policy than with its setting. 12 As suggested by Kay (2010).

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pockets of risk had gone undetected therefore solvency) but also general li- and had grown to such an extent that quidity conditions, macro-prudential they threatened the stability of the policies should also address liquidity risk. whole financial system? The whole Policies aimed at reducing liquidity point of such a separation should be to risk are lagging behind those that im- change the incentives for risk-taking. prove the solvency of financial institu- By separating two fundamentally dif- tions. From a micro-prudential per- ferent business cultures, investment spective, current proposals target li- and client services, it should be easier quidity and maturity mismatches of to redesign incentives to make the cli- individual banks. Regulators have sug- ent part a safer place.13 At the moment, gested that each bank holds sufficient however, this second part of the struc- liquidity to survive a sudden, relatively tural reforms seems missing. short-lived shock, and that it funds Such a separation would reshape the long-term assets with stable sources financial industry and affect the trans- such as long-term debt and deposits. mission channels of monetary policy in These requirements reduce liquidity ways that are hard to predict. On the risk for each institution but neglect the one hand, commercial banks would systemic dimension of liquidity, and function in a more traditional way, re- might be very costly in terms of limita- inforcing the lending channel; on the tions to maturity transformation, an other hand, they might become rela- essential function of the financial sys- tively less important within the finan- tem for which there is high demand. 14 An alternative proposal would impose liquidity risk charges or levies that pe- nalise short-term funding, still at the individual level;15 to help ease funding pressures on banks during a systemic liquidity crisis one could think of instruments with contingent maturity.16 In fact, at the moment the thinking on the prevention of liquidity crises is still ongoing; to mitigate acute liquidity shocks, as we have seen in the recent past, there is still no substitute for a determined intervention by central banks, even beyond the boundaries of their cial system, therefore reducing its im- standard activity. pact. It would be an issue for empirical, During a crisis, individual banks’ li- policy-oriented research. quidity positions matter since those So far, I have dealt mostly with sol- perceived to be more risky might be ex- vency issues. But just as monetary pol- cluded from the market;17 in this case, icy affects not only risk-taking (and only the central bank can make the

13 Giovannini (2008). 14 Caballero (2009). 15 Perotti and Suarez (2009). 16 Nicoletti Altimari and Salleo (2010). 17 Heider et al. (2009).

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market for liquidity function, by acting of the availability of funds, means that as a central counterparty. In the short macro-prudential policies cannot be set run, central bank intermediation plays in each country or region in an isolated a stabilising role; however, in the me- way. Limits to credit growth in one dium run it can increase the persistence country may entail a spillover of funds of the shock by interfering with a mar- to another country, and imbalances ket-led adjustment and can lead to building up on one side of the Atlantic moral hazard.18 can drag down the financial system on The bottom line here is that we the other side. As macro-prudential need to develop macro-prudential poli- policies are developed and become ef- cies that reduce liquidity risk ex ante in fective, there will be a need for further order to decrease the weight put on international cooperation. monetary policy tools during a crisis, Central banks have a long history of since we don’t yet know very well the exchanging views and information; long-run impact of prolonged, massive since they are very much involved in non-conventional interventions. macro-prudential bodies this is solid ground on which to build effective Conclusion mechanisms of cooperation in the Let me finish with a few remarks on in- macro-prudential field. Could there be ternational coordination. consequences for the setting of mone- Our experience with the interna- tary policy? It is too early to tell, but tional interplay of monetary policies given the various levels of interplay goes back decades. The degree of free- with macro-prudential policies that I dom given by floating exchange rates have described, and the need to coordi- allows central banks, especially for nate the latter, we need to think more large countries or areas, to target do- about the international dimension of mestic inflation rates without the need monetary policy, which may be driven for much coordination. On the other by financial stability concerns. This hand, the high degree of integration of will be on our agenda for the coming capital markets achieved over the past years. few decades, while beneficial in terms Thank you for your attention.

References Adrian, T. and H. S. Shin. 2009. Financial Intermediaries and Monetary Economics. In: Hand- book of Monetary Economics. Chapter 12. Angelini, P., S. Neri and F. Panetta. 2010. Monetary and Macroprudential Policies. In: Temi di Discussione 801. Banca d’Italia. Bernanke, B. and M. Gertler. 2001. Should Central Banks Respond to Movements in Asset Prices? In: American Economic Review. 91(2). May. 253–257. Caballero, R. 2009. The “other” Imbalance and the Financial Crisis. Baffi Lecture. Bank of Italy. 10 December. De Walque, G., O. Pierrard and A. Rouabah. 2010. Financial (In)Stability, Supervision and Liquidity Injections: A Dynamic General Equilibrium Approach: In: The Economic Journal 120. December. 1234–1261. Fahr, S., R. Motto, M. Rostagno, F. Smets and O. Tristani. 2011. A Monetary Policy Strategy in Good and Bad Times: Lessons from the Recent Past. ECB Working Paper 1336. May.

18 De Walque et al. (2010).

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Giovannini, A. 2010. Financial System Reform Proposals from First Principles. CEPR Policy Insight 45. 29 December. Goodhart, C. 1988. Evolution of Central Banks. MIT Press. Cambridge. Heider, F., M. Hoerova and C. Holthausen. 2009. Liquidity Hoarding and Interbank Market Spreads: The Role of Counterparty Risk. Discussion Paper 2009-40 S. Center for Economic Research. Tilburg University. Jiménez, G., S. Ongena, J. L. Peydró and J. Saurina. 2010. Credit Supply – Identifying Balance-Sheet Channels with Loan Applications and Granted Loans. ECB Working Paper Series 1179. Kay, J. 2009. Narrow Banking: The Reform of Banking Regulation. Centre for the Study of Financial Innovation. Maddaloni, A. and J. L. Peydró. 2010. Bank Risk-Taking, Securitization, Supervision and Low Interest Rates: Evidence from the Euro Area and the U.S. Lending Standards. ECB Working Paper Series 1248. Marqués-Ibáñez, D. and L. Gambacorta. 2011. The Bank Lending Channel: Lessons from the Crisis. In: Economic Policy 26, 66. 137–182. Nicoletti Altimari, S. and C. Salleo. 2010. Contingent liquidity. Occasional Paper 70. Banca d’Italia Perotti, E. and J. Suarez. 2009. Liquidity Risk Charges as a Macroprudential Tool. Working Paper. CEMFI and University of Amsterdam. Stein, J. 2011. Monetary policy as financial-stability regulation. NBER Working Paper Series. Working Paper 1883.

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VOWI_Tagung_2011.indb 70 03.10.11 08:27 A Post Crisis Regulatory Strategy: The Road to “Basel N” or Pillar 4?

1 Key Issus and Perspectives tween the two objectives is discussed. In the wake of the banking crisis, there A summary of the main themes of the is likely to evolve one of the biggest paper is also given. Section 2 discusses ever sets of reforms in the structure the endogeneity problem and its implica- and style of the regulatory regime and tions for regulatory strategy. Section 3 also in the basic regulatory architecture considers the instruments in a regula- in the EU. The focus of the paper is on tory regime. Section 4 reviews the alter- this post-crisis regulatory strategy. As a native means of reducing the probability structure of complex and extensive of bank failures, and section 5 considers regulation (most especially enshrined options to minimise the costs of bank in the Basel Capital Accords) did not failures. Section 6 brings together the prevent the recent crisis, the issue is main themes by outlining a holistic reg- raised as to whether the failure was due ulatory reform strategy. to fault-lines in regulation, or whether The objectives of the paper are to the problem lies with the underlying consider the structural fault-lines in the methodology. The paper discusses the pre-crisis scenario and to establish a “endogeneity problem” whereby, through general paradigm for regulatory reform. financial innovations and the incentive The main themes are summarised at structures created, problems such as the outset: excessive risk-taking by banks may be – In terms of systemic stability, the partly endogenous to the regulatory re- two objectives of the reform agenda gime itself. should be to lower the probability It is evident that, prior to the onset of bank failures (Objective 1) and to of the crisis, most countries did not have reduce the costs of those failures clearly-defined resolution arrangements that do occur (Objective 2) in place which in turn created uncer- – In particular, potential costs im- tainty about how governments would posed on tax-payers associated with respond to serious bank distress. A series bailouts is to be strictly limited of ad hoc responses were made which – To some extent there is a trade-off were generally handled well. However, between the two objectives in that a central issue is the moral hazard cre- the more the costs of failure can be ated by the massive interventions made reduced, the less intensive regula- by governments and central banks. tion to lower the probability of fail- The structure of the paper is as fol- ure needs to be lows. This section offers an opening – What will be defined as the endoge- perspective by outlining some of the neity problem suggests that crises as- structural characteristics of the pre-crisis sociated with bank failure are partly environment, some general principles endogenous to the regulatory regime. to guide the regulatory reform process, Because of this, Basel N (the ficti- and makes a distinction between incre- tious perfect model) will never be mental and strategic approaches to reform. achieved, and attempts to achieve it A Regulation Matrix is described based would generate avoidable costs on the two central objectives of any – Because of this, regulatory reform regulatory regime: lowering the proba- needs to be strategic (addressing bility of bank failures, and minimising both objectives simultaneously) rather the costs of those failures that do occur. than incremental (refining the exist- The nature of a possible trade-off being regime).

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– Within this strategic approach, tainable and themselves contributory more emphasis than in the past causes of the crisis. An underlying per- needs to be given to minimising the versity implied that bank profits were costs of bank failures privatised and yet, in the final analysis, – The paper is sceptical about the rel- risks were socialised with the tax-payer evance and practicality of many of the effectively acting as an “insurer-of-last- structural measures that have been resort” on the basis of an inefficient proposed by some analysts to lower contract as no ex ante premiums were the probability of bank failures extracted. Overall, as there was a – The case is made for a significant reluctance to require creditors to ab- rise (more than is envisaged in Basel sorb a proportionate share of the costs III) in the required equity capital of bank distress and failures, burden- ratio of banks. In response to the sharing was disproportionate with an critique that this would be dispro- excessive share borne by tax-payers portionate, and would involve a though it is yet to be determined what substantial rise in banking and con- the final cost will prove to be. In the sumer costs, the overall conclusion absence of explicit resolution arrange- is that: the costs of higher equity ments, the perception of banks being capital requirements is exaggerated Too-Big-to-Fail (TBTF) weakened the by bankers; there is a crucial dis- incentives for private monitoring. tinction between private and social Given the increased cross-border inter- costs; the benefits of more stability connectedness that developed over the are an important offset; it is appro- decade or so before the onset of the cri- priate that consumers pay for the sis, the absence of agreed cross-border benefits of lower costs associated resolution arrangements surfaced as a with more stability, and the costs of particular issue to be addressed. The low-probability-high-impact risks low level of equity capital (and high can be very high gearing) of many banks was in part a – In order to mitigate the moral haz- product of an artificially low cost of ard associated with bailouts, partic- debt compared with equity induced by ular emphasis needs to be given to favourable tax treatment of the former. creating credible, timely and pre- In the absence of credible and predictable resolution procedures in dictable resolution arrangements for the case of failing (failed) banks. failing banks being in place, in many Only if the costs associated with cases there was little choice over bank failure can be minimised will whether bailouts and official support a no-bailout policy bed credible operations for TBTF banks should be – In the context of cross-border banks, undertaken. Given the potential costs and increased connectedness of of bank failures (in the absence of cred- banks, national resolution arrange- ible resolution arrangements), rescue ments have negative international operations or bailouts may be the least- externalities which could be at least cost option in the short-run. However, partly resolved by adding a Pillar 4 given time-consistency, such bailouts to the Basel Accord create serious moral hazard for the future. There is, therefore, a distinc- Unsustainable Institutional Features tion between short-run and long-run Several structural features of the pre- optimality with respect to rescue oper- crisis environment proved to be unsus- ations. Only if the costs of bank fail-

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ures can be minimised will a no-bail- – A central requirement of any regu- out policy be credible. It is argued that latory reform strategy is to limit this is a major unsustainable feature claims on tax-payers, and to prevent that needs to be corrected. In effect, ar- risks being shifted to them rangements need to be in place to allow – As part of this, credible, predict- banks to fail without imposing substan- able, and timely resolution arrange- tial systemic costs or tax-payer liability. ments for failing institutions are Furthermore, the unsustainable “excess needed. In particular, banks should financialisation” that occurred in the be able to fail without causing dis- decade before the onset of the crisis ruption to customer services, or was largely associated with underlying imposing costs on tax-payers. Spe- factors which were themselves unsus- cial resolution regimes are needed tainable (Llewellyn, 2010): an under- for banks because of their unique estimation of risks, an under-pricing characteristics. even of underestimated risks, excess – The focus of reform should be on gearing, an artificially low cost of equity the systemic dimension rather than capital, and a collective euphoria. The myopically on the position of indi- growth of securitisation, structured in- vidual banks vestment vehicles, and the use of credit – The TBTF issue needs to be ad- risk-shifting instruments, also had the dressed because of the moral hazard effect of inducing an over expansion of it creates towards excessive risk banking business and unrealistic per- taking and potential tax-payer lia- ceptions of risk. Combined, these created bility. The moral hazard of bailouts conditions for banking activity to become is to be avoided and arrangements excessive which the supervisory pro- are needed to confer credibility on cess did little to constrain even though a “no-bailout policy” which addresses supervisory agencies expressed public the time-consistency problem concern about many of the trends that culminated in the crisis. In this regard, the crisis was as much one of weak super vision as faulty regulation.

Guiding Principles Before considering regulatory reform, the context is set by outlining some guiding principles: – The regulatory regime has two key objectives: to lower the probability of bank failures (Objective 1), and to lower the cost of those failures that do occur (Objective 2). Both dimensions need to be considered – The perversity of the privatisation of in future regulatory strategy bank profits and the socialisation of – As much (if not more) focus needs to bank risk (without ex ante insurance be given to Objective 2 as to Objec- being paid) needs to be reversed tive 1 and it is in this sense that a stra- – Burden-sharing between the various tegic rather than incremental approach stakeholders in the event of bank to regulatory reform is advocated failure needs to be explicit, fair and

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coherent. The costs of any bank Chart 1 failure are to be borne by private Regulation Matrix: Probability versus stakeholders (mainly bank share- Cost Trade Off holders and unsecured creditors) rather than tax-payers PROBABILITY OF FAILURE – Regulatory strategy needs to be based on the principle of competitive neutrality: all institutions (and not LOW HIGH exclusively banks) that can potentially LOW create systemic stability problems p need to be included within the orbit of regulation: the boundary issue.

COST OF FAILURE OF COST CRISES X Systemic risks need to be addressed HIGH POTENTIAL irrespective of where they emanate. This does not mean, however, that all banks are to be treated in the Source: Author’s compilation. same way as their potential contribution to systemic problems varies those incurred directly or indirectly – The loss-absorbing powers of (at by, inter alia, the system as a whole (the least) systemically important insti- systemic stability dimension), tax-payers tutions (SIFIs) need to be increased who might be called upon to finance – Clearly-defined crisis management rescue operations, depositors, deposit strategies are needed with an added protection funds, and customers in dimension when cross-border insti- general if banking services are dis- tutions are involved rupted and uncertainty is created. – The role of market discipline within The matrix suggests the possibility the overall regulatory regime needs of a trade-off between the two: if the to be enhanced costs of failure can be lowered, there need be less concern about the probabil- Objectives of Regulation: Strategic ity of failures. In the extreme (totally versus Incremental unrealistic) case, if the costs of bank For regulatory reform to be strategic failures could be reduced to zero, the rather than incremental, a different par- probability of failures would be of no adigm is needed compared with incre- concern, there would be no potential mental reform which restricts itself to tax-payer liability, no need for bailouts, refining existing regulatory require- and no moral hazard attached to bail- ments. Abstracting from issues of con- outs. Furthermore, there would be no sumer protection, the two broad objec- need for regulation to reduce the prob- tives of any regulatory regime are: ability of bank failures. Of course, such – to reduce the probability of bank a utopia is just that! Nevertheless, it failures, and serves to illustrate the nature of a trade- – to lower the cost of those failures off implicit in the Regulation Matrix. that does occur. Historically, the focus has been In a Regulation Matrix (chart 1), the more on reducing the probability of probability of a bank failing is measured failures rather than minimising their on the horizontal axis, and the costs of costs. Indeed, in many countries the failure are identified on the vertical second issue has only been addressed in axis. The costs of bank failures relate to a serious way since the current crisis.

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There may, therefore, be less need process. In which case a problem is ob- for measures to lower the cost of fail- served and a regulatory response is ures if their probability were to be re- made to deal with it: i.e. to reduce the duced to a low level. Conversely, if this probability of it happening. Exogeneity were to be either impossible (or achiev- is a bold assumption as problems may able only with draconian and high-cost be at least partly endogenous to regula- regulation), the greater will be the tion, i.e. caused by the very regulation need to have in place measures to mini- designed to reduce the probability of mise the costs of those bank failures problems emerging. This arises as that do occur. The central strategic is- banks seek to circumvent regulation sue in any holistic regulatory reform through financial innovation and by programme is the positioning to be changing the way that business is con- made on the Regulation Matrix. ducted. This in turn calls forth more Given that all regulatory measures regulation: Kane’s regulatory dialectic to reduce the probability of bank fail- (Kane, 1987). ures have costs, and that the costs that As regulation responds to the endo- would arise in seeking to reduce the geneity problem by successive adjust- probability of failure to zero (supposing ments, the cost of regulation is likely to it were at all possible even with the rise. As the costs of regulation to lower most draconian regulatory impositions) the probability of bank failure rise, the would be substantial, the trade-off be- trade-off between the two objectives tween the two dimensions is central to changes in favour of minimising the decisions about the optimal intensity of cost of bank failures rather than their regulation. Greater emphasis needs to probability. The endogeneity problem be given to Objective 2: (1) the more is likely to raise the cost of effective intensive regulation has to be in order regulation because it engenders a rules- to lower the probability of bank fail- escalation process. By raising regulatory ures, (2) the greater are the costs of costs, this becomes part of the trade- such regulation, and (3) the greater the off between the two core objectives. extent to which the costs of bank fail- As the process of regulatory arbi- ure can be minimised. The central stra- trage diverts the nature of the problem, tegic issue in any holistic regulatory regulation is often shooting at a moving and institutional reform is the position- target, and the target moves partly being to be made on the Regulation cause of regulation itself. For instance, Matrix. The less confidence there is the Basel II capital regime (hailed at the that the probability of bank failures can time as a decisive breakthrough in the be reduced by regulation, the greater is regulation of banks) created incentives the need for institutional arrangements to remove assets from banks’ balance designed to reduce the costs of failures. sheets, for securitisation, the creation In practice, a combined strategy is likely of Structured Investment Vehicles to be optimal. (SIVs) and other off-balance sheet vehicles, excess gearing, complexity and 2 Regulatory Strategy: The opaqueness of instruments, and the use Endogeneity Paradigm of credit risk-shifting derivatives. All of Regulatory strategy conventionally as- these featured as central aspects of the sumes that the problems to be ad- banking crisis (Llewellyn, 2010). It is dressed (e.g. excessive risk-taking by evidently the case that detailed rules at banks) are exogenous to the regulatory the time did not prevent the crisis.

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The limits of regulation can be seen There is a further danger in detailed in the Basel capital regime. Many of the and prescriptive regulation in that it banks that got into serious trouble en- tends to create a more homogenous tered the crisis with excess regulatory banking model and undermine model capital: sometimes by as much as 100%. diversity which means that all banks Experience also suggests that capital will be affected in the same way to par- can disappear very quickly as shown in ticular shocks. Thus, while banks indi- vidually may secure the advantages of diversification and the application of new risk and business models, if all change in the same way the system becomes less diversified. The endogeneity problem can be considered in the context of the history of the Basel Capital Accord. The original Basel regime was established in 1988 and was revised in Basel II and again in 2010 in Basel III. One interpretation is that subsequent adjustments imply moving towards the perfect model (Basel N) by correcting the case of Northern Rock which failed for past errors. An alternative inter- within weeks of announcing it would pretation is that there are fault-lines be repaying “excess” capital to share- in the regulatory process itself and that holders. An IMF study compared suc- the methodology is flawed because cessful and unsuccessful banks during banks will always engage in regulatory the crisis and found no significant dif- arbitrage. In this sense, the view that ference in capital ratios immediately “regulators are always behind the prior to the onset of the crisis (IMF, curve” is not a critique of regulators 2009). Apart from the potential for but is endemic to the regulatory process. regulatory arbitrage, under some cir- Successive adjustments over time have cumstances capital requirements may not solved the problem of periodic crises. induce banks into more risky business. This suggests that the traditional in- Blundell-Wignall et al. (2008) show a cremental approach may not be appro- positive correlation between losses and priate, and alternative paradigm might banks’ Tier 1 risk-weighted capital ratio, be more fruitful: rather than focus on although a negative correlation between incremental measures designed to re- losses and the leverage ratio. This sug- duce the probability of bank failures, gests that the risk-weight approach to more emphasis to be given to designing capital adequacy may induce banks to features of the regulatory regime designed incur more risk through increased to reduce the costs of those bank failures leverage. Regulatory arbitrage will always that do occur. Given the weaknesses be a major feature of bank business and limitations of regulation, whilst rules models. As noted in Haldane, et al. may be a necessary part of the regula- (2010), “risks migrate to where regulatory regime, they are not sufficient. An tion is weakest, so there are natural alternative approach is to lower the cost limits to what regulatory strategies can of bank failures by keeping risks private reasonably achieve.” rather than, as has massively been the

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case in the recent crisis, socialised by 3 Instruments in a Regulatory shifting risks to tax-papers. Regime In practice, both approaches are With respect to the two core objectives needed: lowering the probability of of reducing the probability of bank fail- bank failure, and limiting the costs of ures and lowering the costs of those failures. The debate about the role of failures that do occur, eight broad strategic regulation and supervision for financial options are summarised in table 1 though stability is about the appropriate weight not all will be discussed in any detail: to be given to the two dimensions. – Structural regulation (such as Glass- Whilst both approaches are needed, Steagall-type measures and Narrow our theme is that more emphasis than Banks) designed to limit the size in the past needs to be given to Objec- and/or allowable business of banks tive 2 than Objective 1. Given that, how- – Behavioural regulation (such as capital ever carefully constructed, regulation and liquidity requirements) designed will never prevent bank failures and to lower the probability of failure neither should it attempt to do so. – Supervision by official agencies – Intervention measures (such as Struc- tured Early Intervention and Reso- lution (SEIR) regimes) designed to

Table 1 Regulatory Regime Instruments

Lower Probability of Failure Reduce Costs of Failure

Structural Measures * Glass Steagall * Limits on size * Narrow Banks * Focus on SIFIs * Equity Banks * Glass Steagall * Narrow Bank * Ring Fencing Behavioural Measures * Capital * Capital * Liquidity * Connectedness * Remuneration * Connectedness * Funding rules * Macro-prudential focus Supervision * Interventionist Intervention Measures * Prompt corrective action (PCA)/structured early intervention resolution (SEIR) Taxation and Insurance * Taxation of banks * Ex ante insurance Resolution Measures * Bank insolvency laws * Ring Fencing * Pillar 4 * Private purchase of banks * Bridge Bank * Bad bank * Nationalisation * Business transfers Living Wills * Recovery measures * Resolution measures * Wind-up plans Market Discipline * Disclosure * Use of market metrics

Source: Author’s compilation.

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maintain a failing bank as a going than the way business is conducted. concern Only a brief critique of such measures – Tax and Insurance whereby banks is outlined here as a more detailed pay ex post to recoup the costs of review is given elsewhere (Llewellyn, past bailouts (tax), and/or ex ante to 2011). One in particular is considered: cover possible future interventions measures to define and limit the (insurance), and to compensate the allowable business of banks (various tax-payer for the implicit subsidy versions of the Glass Steagall model). given to TBTF institutions Others are reviewed elsewhere – Resolution arrangements for closing (Llewellyn, 2011). banks and their subsequent resolu- Our theme is that in practice most tion (bank bankruptcy laws, etc., of the proposed structural measures designed to minimise the costs of are either impractical or largely irrele- bank failures vant. The evidence of the crisis indi- – Living Wills (or Recovery and Reso- cates that a wide range of different lution plans) designed to make explicit types of banks failed: large, small, how banks will respond to prob- highly diversified, focused, commercial lems that threaten solvency (Recov- banks and investment banks. In the ery), and how, in the event that a UK, for instance, the first bank failure bank fails, different parts of the in the recent crisis was that of North- business are to be separately identi- ern Rock which was quintessentially a fied so that some can be rescued retail commercial bank even though it while others are not (Resolution) made heavy use of securitisation and – Market Discipline which relates not wholesale funding (Llewellyn, 2008). only to transparency and disclosure Equally, not all universal banks encoun- (Pillar 3) but also to the use of mar- tered serious problems in the crisis. ket data in the supervisory process This raises three general issues about conducted by official agencies structural measures: whether, in prac- We refer to this eight-fold paradigm, tice, a clear distinction can be made for and the instruments within it, as the regulatory purposes between different Regulatory Regime. A wider definition types of institution and business; (including the role of market discipline) whether it is possible to define institu- is given in Llewellyn (2001). tions that are systemically important, and whether issues of size and business 4 Objective 1: Lowering the lines are the key issues. Prohibiting Probability of Bank Failures commercial banks from conducting The main instruments of policy to some forms of speculative activity lower the probability of bank failures would not reduce it in total but shift are: regulation, supervision, interven- that activity elsewhere in the system, tion and market discipline (table 1). and there can be little confidence that Regulation can in turn be categorised the institutions conducting this business as either structural or behavioural. would not be systemically significant even though they may not be conduct- Structural Regulation ing core commercial banking business: Structural measures relate to regula- Lehman Brothers was not a commercial tion that prescribes the nature, struc- bank conducting core banking busi- ture and allowable business of banks ness, and yet its failure clearly imposed and other financial firms, rather substantial systemic costs.

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Several problems are associated structural measures are designed to ad- with structural measures: it is not al- dress. A higher degree of regulatory in- ways clear what an optimal structure is tensity could be applied to such banks (e.g. the allowable business mix of such as calibrating regulatory capital banks), and arbitrage will often be able requirements on the basis of institu- to circumvent them (e.g. the various tions’ contribution to systemic risk ways around the Glass-Steagall Act). (Acharya and Richardson, 2009, Brun- The practical difficulties of making a nermeier et al., 2009 and Bernanke, formal separation are formidable and 2009). The Financial Services Board the distinction between different types has also proposed a global capital charge of business is fuzzy at the margins. In on Systemically Important Banks. The fluid markets, and with constant finan- BIS has argued that the rationale of a cial re-engineering, it is difficult in Systemic Capital Charge would be to practice to separate different types of create a distribution of capital that re- risks. In particular, a Glass Steagall- flects the systemic risk posed by indi- type approach is based on a faulty diag- vidual firms (BIS, 2010). Chan-Lau nosis of the causes of the crisis which (2010) suggests a practical methodol- were more to do with, inter alia, excess ogy for levying capital charges based on gearing, inter-connectedness, and degrees of interconnectedness. These cross-sector contagion which a Glass would be based on a bank’s incremental Steagall approach would not in itself ad- contribution to systemic risk and its dress. Furthermore, it is unlikely that contribution to increased risk of other Glass-Steagall would protect against institutions. The approach is designed systemic risk between firms when a as a way of internalising negative exter- crisis strikes. In a world of network ex- nalities associated with too-connected- ternalities and high connectedness, to-fail institutions. even the failure of relatively small banks can create systemic problems. Objective 1: Behavioural Regulation Some of the proposed structural mea- Most regulation is behavioural in that it sures (such as Narrow Banks (Kay 2009 imposes requirements that affect the and 2009a), Equity Banks (Kotlikoff, way business is conducted and is de- 2010 and Kotlikoff and Leamer, 2009), signed to create incentives for prudent and measures to drastically reduce matu- behaviour. Because of its central im- rity transformation by banks, amount portance, we focus on the role of bank almost to solving the problem of bank (equity) capital. failures by abolishing banks. Maturity transformation, for example, is an integral Bank Capital part of the functioning of banks in the A central issue is the extent to which financial system. The question arises as imposed capital requirements are a real to whether it is appropriate for regula- cost either to banks or society gener- tory and structural reform to under- ally. It is often claimed (mainly by mine the basic functionality of banks. bankers) that to impose higher capital Furthermore, there are often supe- requirements would lead to a rise in the rior behavioural alternatives. For in- costs of banking and financial interme- stance, differential capital require- diation services, lower bank lending, ments, and reformed resolution and and lower rates of return on equity. Living Wills arrangements can be supe- We argue the case for a substantial rise rior ways of addressing the issues that in bank (equity) capital as a major con-

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tribution to lowering the probability of this reason, a phase-in period is op- bank failures. This is based in part on timal as proposed in the Basel III the proposition that many of the con- arrangements. cerns about imposing higher equity – Even if there were to be net costs capital requirements are unfounded arising from higher imposed equity when the systemic perspective is ad- capital ratios, the benefits of a opted, and when a distinction is made potentially more stable banking between private and social costs. system need to be considered as – Various versions of the standard part of the equation of balancing Modigliani-Miller theorem (e.g. costs and benefits. Admati et al. 2010) suggest that a – Such benefits include avoidance of rise in equity capital ratios should the output losses of bank crises, produce an offsetting fall in risk greater confidence in the banking premia (both in equity and debt) as system which should also contrib- the bank becomes less risky. This in ute to lowering the cost of capital, turn lowers the required rate of re- and lower costs to tax-payers asso- turn on equity to satisfy sharehold- ciated with bank failures. This ers. Furthermore, higher equity would amount to the consumer capital on the balance sheet should, paying the higher costs of bank in- to the extent that it lowers per- termediation as the price of a more ceived risk, lower the cost of debt stable system (Llewellyn, 2010). for banks. Overall, therefore, the – Whilst this might mean that con- impact of higher equity ratios on sumers pay more for banking ser- the overall cost of capital might be vices from such institutions, there modest. However, the offset is un- would in principle be an offsetting likely to be total (Llewellyn, 2011). welfare gain by lowering the proba- – Empirical research (conducted, for bility of failure (and hence the costs instance, by the Basel Committee, of failures) of systemically impor- the Bank of England, Financial Ser- tant banks. vices Authority in the UK, and the – There is a systemic benefit in lower- National Institute of Economic and ing the cost of bank failures given Social Research) supports such an the higher equity cushion: a higher intermediate position. The most proportion of potential losses are comprehensive empirical analysis is met by equity shareholders. given in Miles et al. (2011). Most – Higher equity ratios are likely to empirical studies suggest that the create more powerful incentives for macro-economic costs of higher private monitoring as equity hold- equity ratios are modest most espe- ers have more to lose which com- cially when viewed in the context of pensates for the cost of monitoring. the trade-off with enhanced sys- Moral hazard in terms of risk-tak- temic stability. However, there is a ing should also be moderated to the distinction between the stock-ad- extent that shareholders have more justment effect (moving from low to lose with high equity capital to high equity capital) and the new ratios. Low capital ratios can be an steady-state outcome: the costs of incentive for shareholders to take moving from one capital regime to (or tolerate) high risk strategies. another are likely to be greater than – Banks could benefit through lower the new steady-state outcome. For costs of their monitoring of bank

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counterparties to the extent that they The key point is that a distinction is also have higher equity cushions. made between private and social costs – There is currently a bias in favour of when adjusting regulatory capital re- debt financing of banks because of quirements. The cost of capital is likely the different tax treatment of debt to rise if the perception is that risks are and equity, and the expectation of shifted from tax-payers to shareholders. bailouts. A rise in required equity Social costs are not increased if banks capital ratios can be viewed as a are required to pay for the subsidies and contribution to minimising this implicit guarantees they receive. Our perverse bias. Again, while this will overall assessment is that higher (per- be a cost to banks, it is not a social haps substantially higher and in the re- cost to the extent that it corrects gion of 15%) capital requirements are for market distortions. Thus, while likely to imply little social cost but sig- a reduction in the tax benefit is a nificant systemic benefits. cost to banks (and hence one reason The overall conclusion is fivefold: why they prefer high gearing) this is the costs of higher equity capital require- not a social cost. ments is probably exaggerated by bank- Admati et al. (2010) argue that higher capital requirements are likely to produce more stable returns to bank shareholders albeit lower in buoyant times but higher in distressed times because of a lower appetite for risk. Bankers have argued that the proposed rise in equity requirements under Basel III is disproportionate and excessive as they are based on low-probability risks, and will result in a disproportionate decline in lending and a higher cost of credit. The argument here is that the costs are exaggerated. It can also be argued that banks were extending too ers, there is a crucial distinction be- much credit in the years prior to the tween private and social costs, the ben- crisis because risks were being under- efits of more stability are an important estimated and under-priced. In any case, offset, it is appropriate that consumers the costs associated with low-probabil- pay for the benefits of lower costs asso- ity-high-impact (LPHI) risks can be very ciated with instability, and the costs of substantial when they do occur even LPHI risks can be very high. though may not happen very frequently. The benefits of avoiding these occa- Objective 1: Intervention sional costs may be greater than the A key component of any strategy to higher costs in normal times created by reduce the probability of failures is the the requirement to hold more equity. nature, timing and form of Intervention The volatility of credit is a further con- in the event of a failing bank. Interven- sideration as this also imposes costs. tion strategies can be based on Prompt Low capital in banks means that when a Corrective Action programmes (i.e. in- bank incurs losses (as opposed to failure) tervention being made early), and SEIR it is likely to cut back on lending. regimes as in the USA. These are similar

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to the Recovery and Resolution ar- guards against hazards associated with rangements within Living Wills dis- risk-averse regulators who themselves cussed in a later section. might be disinclined to take action for Intervention arrangements have in- fear that it will be interpreted as a reg- centive and moral hazard effects which ulatory failure, and the temptation to potentially influence future behaviour allow a firm to trade-out of its diffi- of banks and their customers. These culty: a policy that amounts to the reg- arrangements may also have significant ulator “gambling for resurrection”. implications for the total cost of inter- Kane (2000) argues that officials may vention (e.g. initial forbearance often forbear because they face different has the effect of raising the eventual incentives from those of the market: cost of subsequent intervention), and their own welfare, the interests of the the distribution of those costs between agency they represent, political inter- tax-payers and other agents. The issue ests, reputation, future employment focuses on when intervention is to be prospects, etc. Thirdly, a rules-based made. The experience of banking crises approach removes the danger of undue in both developed and developing coun- political interference in the disciplining tries indicates that well-defined strate- of banks. Fourthly, a rules approach gies for responding to the possible in- guards against supervisors focusing on solvency of financial institutions are the short- term costs of intervention. needed. Fifthly, it guards against a “collective A key issue relates to rules versus euphoria” syndrome whereby all agents discretion in the event of bank distress: (including supervisors) are swept along the extent to which intervention should by a common euphoria (Llewellyn, be circumscribed by clearly-defined 2010). Finally, and related to the first, a rules (so that intervention agencies have rules approach to intervention is likely no discretion about whether, how and to have a beneficial impact on ex ante when to act), or whether there should behaviour of financial firms, and create always be discretion simply because rel- incentives for management to manage evant circumstances cannot be set out banks prudently so as to reduce the in advance. The obvious prima facie probability of insolvency. advantage for allowing discretion is that Above all, a rules approach is de- it is impossible to foresee all future cir- signed to address the time-consistency cumstances and conditions for when a problem and add credibility to a no-bail- bank might become distressed and out strategy and thereby create appro- close to insolvency. priate incentives within banks. There are, however, strong argu- The Prompt Corrective Action (PCA) ments against allowing discretion and rules in the USA specify graduated inter- in favour of a rules approach to intervention by supervisors with pre-deter- vention. Firstly, a rules approach en- mined responses triggered by, inter alia, hances the credibility of the interven- capital thresholds. Several other coun- tion agency in that market participants tries have such rules of intervention. have a high degree of certainty that action will be taken. Secondly, allow- Objective 1: Market Discipline ing discretion is likely to increase the The role of market discipline needs to probability of forbearance which usu- be addressed and enhanced not only via ally eventually leads to higher costs the elements already within Pillar 3 of when intervention is finally made. It the Basel Accord, but also by the use of

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market metrics and the use of market rangements for the allocation of losses, signals in triggering discretionary su- resolution will always be delayed. pervisory intervention. Market ap- Some of the structural measures proaches have the advantage of simplic- discussed above in relation to Objective 1 ity, transparency, being observable in are equally relevant for Objective 2 and real time, are model-free, are more are not repeated here although they timely than many of the indicators cur- might be more relevant to Objective 2. rently used by supervisors. In contrast, the quest for enhanced risk-sensitivity Objective 2: Ring Fencing of capital requirements has created An earlier section discussed various complexity, opacity and has to some structural measures including the Glass extent impaired the incentives for mar- Steagall model of total separation be- ket discipline. They also create incen- tween commercial and investment tives for monitoring and shareholder banking business. An alternative ap- activism. proach (outlined, for instance, in the The role of market discipline, and the Interim Report of the UK’s Indepen- role of transparency and market incen- dent Commission on Banking (ICB, tives, is enshrined within the existing 2011), and subsequently endorsed by Basel regime. In addition, there is a po- the Chancellor of the Exchequer), is to tentially powerful role to use market allow the two activities to be conducted metrics in the supervisory process. within the same bank but to have an in- There is some evidence that market- ternal separation between the two. based capital ratios and measures of This would imply, for instance, having Tobin Q yield useful information to dedicated capital assigned to the two supervisors which can be utilised in the parts of the business. Under the ICB supervisory process, and that market- approach, any excess capital within ei- based measures of capital have higher ther business can be transferred to the predictive value than do book-based other business providing the required measures. Haldane (2011) observes that minima are kept in each. The principle market-based metrics perform well in is that, in the event of distress, the in- distinguishing between good and more vestment banking part of the business vulnerable in that they give advance would not be rescued though the core warning of distress. commercial banking arm (however that is defined) could be rescued. The cen- 5 Objective 2: Minimising the tral idea is two-fold: commercial bank- Costs of Bank Failures ing operations should not be contami- This section considers measures de- nated by the risks in investment bank- signed to minimise the costs of bank ing, and the ring-fenced commercial failures given that however realistically banking operation would be rescued. constructed measures to reduce the The central advantage of ring-fenc- probability of failures will not guaran- ing is that commercial banking opera- tee there will no bank failures. With tions of a financial conglomerate would respect to Objective 2, the main ele- be rescued whilst the investment bank ments are: (1) structural measures; (2) would not be. This could be achieved ring-fencing within conglomerate banks; while also maintaining any economies (3) taxation; (4) explicit and predict- of scale and scope advantages that might able Resolution arrangements; and (5) exist within a financial conglomerate. Living Wills. Without predictable ar- Specifically, resolution would be made

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easier because of a simplified business The rationale for imposing special structure, and there would be no im- taxation on banks is three-fold: (1) to plicit subsidy to investment banking ac- recoup the costs of past bailouts tivity by virtue of a bank being judged and intervention, (2) to compensate to be TBTF. In principle, the overall for the effective subsidy received by cost of a bank failure is reduced as one banks by virtue of possible future part of the bank can be allowed to fail bailouts and being TBTF, and, (3) to without undermining core commercial create incentives to alter funding banking activity. structures, and perhaps against becoming “too big”. The incentive structure Objective 2: Taxation with regard to funding is seen in the The wide range of intervention mea- UK case where a new tax relates to sures applied by governments and cen- each bank’s balance sheet size minus tral banks in the wake of the crisis the sum of core capital, insured (retail) involved a substantial tax-payer com- deposits, and cash raised against hold- mitment. Tax payers became what ings of government bonds: this is, in ef- amounted to an “insurer of last resort” fect, a tax on wholesale market bor- but with an inefficient insurance rowing. It amounts to a systemic risk contract in that no ex ante premiums levy whereby the tax internalises to were paid by the insured entities. The banks the social (systemic) costs they contract was implicit. In effect, tax- potentially create. payers became exposed to bank credit The IMF has made two proposals: a risks that they themselves had no part Financial Stability Contribution and a in creating and for which no ex ante Financial Activity Tax. In the former premiums were received. In order to case, banks would be required to make minimise the net cost to tax-payers, payments ex ante through a levy on their banks could be required to pay ex ante balance sheets. This would imply premiums and/or ex post for the costs of payments to cover intervention and res- rescue operations. The distribution im- olution costs. plications of such a move would be Objective 2: Resolution Arrangements Prior to the onset of the recent crisis, many countries did not have clearly- defined resolution arrangements in place, or a legal structure giving powers of intervention before insolvency is reached. This meant that uncertainty was created about how governments would respond to serious bank distress. Exceptions were Canada, Italy and Norway with the last-mentioned having put in place special resolution arrangements following the banking crisis in difficult to unravel although each the 1990s. To avoid this, credible, bank’s liability to pay could in principle predictable, and timely resolution ar- be related to a measure of its systemic rangements for failed institutions need significance. to be in place so as to limit the potential

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liability imposed on tax-payers, main- resolution. Two further considerations tains systemic stability, and protects in the case of cross border banks is the depositors. extent to which countries have differ- The objective is to allow banks to ent resolution regimes, and how bur- “fail” without disturbing business and den sharing is to be distributed. customer relationships, and to ensure To address this, we argue for the that the costs of failure fall on private addition of a fourth Pillar to the Basel stakeholders (equity and bond holders Capital Accord: whilst Pillars 1 to 3 fo- and other unsecured creditors) rather cus predominantly on reducing the than tax-payers. Bailouts are to be probability of bank failures, Pillar 4 avoided as they impose costs on tax- would focus on resolution arrange- payers, create serious moral hazard, ments designed to lower the cost of may support inefficient banks, and bank failures. Competitive distortions weaken market discipline. Banks need between different nationalities of banks to be put into a resolution procedure if can arise just as much through different they are unable to survive without pub- approaches to resolution as with differ- lic support, and cannot refinance ma- ent rules and procedures within Pillars turing debt. A key objective is to mini- 1 to 3. mise the moral hazard created by bank Given the strong presumption in fa- rescues. vour of clearly-defined, explicit and The ultimate objective is for resolu- predictable resolution procedures to be tion arrangements to be in place to deal in place, a set of key criteria are out- with distressed banks with the mini- lined for constructing such a regime: mum of costs and disruption. This im- – Minimal, or zero, loss or risk to plies allowing banks to fail without tax-payers disturbing customer business or com- – Banks that cannot survive without promising systemic stability. A basic public support to be placed in the principle in reducing the cost of bank resolution procedure failures is for problems of a failed bank – Resolution to be activated before a to be addressed quickly. This means bank becomes technically insolvent: that insolvency and bankruptcy proce- this should have the beneficial effect dures need to be clear and appropriate of enhancing market discipline for the special position of banks. – Resolution procedures to be acti- Problems emerge when resolution vated very quickly so as not to jeop- arrangements are not clear. Firstly, it ardise customers’ banking arrange- creates uncertainty for all stakeholders ments: there should be no disrup- including depositors and other banks in tion to the business of the bank for the system. Secondly, it creates time- its customers consistency problems (and hence credi- – Any pay-outs to insured depositors bility issues) as governments may be in- to be made with minimal delay duced to behave differently over time. – Shareholders never to be protected Thirdly, stakeholders are inclined to – Non-insured creditors to share in bargain for economic rents often (if not any costs of insolvency usually) at the expense of the tax-payer. – Resolution arrangements not to Fourthly, as argued above, it can lead to create moral hazard for the future political pressures for forbearance and – The arrangements need to credibly the moral hazard attached to it, and can sustain financial stability and public lead to costly and unnecessary delays in confidence

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– Minimal distortion to competitive “resilient to shocks and one that assures neutrality between banks: for EU that banks are not too big or too intercon- Member States this also implies ad- nected to fail.” Living Wills seek to pre- herence to EU competition require- vent the failure of one bank having ments broad systemic consequences leading to – Large, and systemically significant, the failure of other innocent banks. As banks to be required to construct put by Huertas (2010): “Living wills of- their own resolution plans (Living fer the prospect that society can create Wills as discussed below) a lower impact/lower cost solution to – The avoidance of any potential for the problem posed by large, systemi- stakeholders (most especially banks) cally important banks.” to bargain for economic rents The two key components of Living Several elements can be included in res- Wills are Recovery and Resolution ar- olution arrangements: the facility for rangements with the resolution compo- private sector purchases of failed banks, nent kicking in when the recovery com- transfer of engagements to a Bridge ponent has failed. In principle, clearly- Bank, partial transfer of assets and lia- defined and credible recovery plans bilities to other institutions, temporary should lower the probability that reso- public ownership, the ability to re- lution will be needed because such structure claims of an institution (e.g. plans outline how a bank is to respond debt-equity conversions, and the writ- to distress situations. They are designed ing down of unsecured creditors’ to maintain banks as going-concerns. claims), forced merger/acquisitions Living Wills dictate that a bank has in without shareholder consent, the cre- place a clear recovery plan by requiring ation of Bad Banks, and the suspension it to outline in advance what is to be or termination of powers. Above all, done in the event that it falls into ex- they should allow for resolution even treme stress. As put by Huertas (2010): when the bank has positive capital. “The bank is forced to think through in A basic principle in reducing the cost of advance what it would do if the bank bank failures is that it should be possi- were to fall under extreme stress.” In ble for the problems of a failed bank to particular, banks are required to have be addressed quickly. This means insol- plans in place to ensure that, in such vency and bankruptcy procedures be- circumstances, they can maintain ade- ing clear and appropriate for the special quate capital and liquidity. The require- position of banks. There is a strong ment to have Convertible Bonds as part case for treating banks differently in of a bank’s capital base could be part of this regard because the uncertainty Living Will arrangements with the cir- surrounding a drawn-out procedure cumstances under which the conver- can create uncertainty for the financial sion takes place being specified in ad- system as a whole. vance. Other possible routes to recovery include selling parts of the business, Objective 2: Living Wills exiting from some business lines, run- Prior to the recent crisis, most coun- ning down the scale of the bank, selling tries did not have in place the necessary the entire business, etc. tools to wind down their domestic The essence of Living Wills is that financial conglomerates. Huertas there are clearly-defined and credible (2010) argues that Living Wills can in recovery plans in advance, resolution theory create a financial system that is arrangements are made explicit, and

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arrangements are in place to enable a large, conglomerate banks creates par- bank to be broken up when in distress ticular problems for the resolution so as to protect core depositors’ busi- regime most especially when the objec- ness. They amount to a form of SEIR. tive is to separate the essential parts of There are further advantages to Living a bank (which are to be sustained) from Wills in the case of complex and poten- its other activities. Living Wills can be tially systemically important institu- designed to give information about how tions. Firstly, to the extent that they in- any wind-down would be executed in duce simplified structures in complex practice. They are also designed to in- banks, interconnectedness might be clude mechanisms to separate the com- lowered. Secondly, they are designed ponents of a financial firm that are crit- to lower the probability of failure ical as opposed to those that are not, through the recovery component. (Hupkes, 2009): “In particular, depos- Thirdly, systemic costs of any failures its, some lending business, and pay- that occur should be lowered because ments services are to be ring-fenced in clear and credible resolution plans are the event of a resolution.” This suggests put in place in advance. Fourthly, the having simple structures so that parts resolution process should be made of the bank can easily be sold (Tucker, easier and less complex. Fifthly, they 2010). The main purpose is to lower would give more information to super- the cost, and speed up the process, of visors in the process of Resolution oper- resolution by making it easier to sell ations. Finally, there would be advantages different parts of the bank, and to pro- through reducing the need for rescues tect the tax-payer by giving an alterna- or bailouts because credible and explicit tive to bailouts. It needs to be clear alternative resolution mechanisms which parts of a bank’s business are to would be in place. This should enhance be supported and kept solvent. A key the credibility of a no-bailout policy. feature is that core business should be The ultimate rationale is that the effectively ring-fenced in the event of “recovery” component should lower the bank distress. probability that a bank would require The British government has im- intervention by the regulatory authori- posed a requirement on large banks to ties, and the resolution part should create Recovery and Resolution Plans lower the costs to society of a bank (Living Wills) which explain how a failure. bank is to be broken up in the event of Living Wills make recovery and resolution. The Group of Thirty has resolution plans more explicit. Banks made a similar proposal in order to “de- are particularly complex organisations velop internationally consistent firm- and generally have more subsidiaries specific resolution plans” (Group of than most other types of company. Thirty, 2009). The UK Financial Ser- Banks can be horrendously complex vices Authority requires that such plans with subsidiaries, structured invest- should: be capable of execution within ment vehicles (SIVs), special purpose a fairly short period and with a high de- vehicles (SPVs), and with complex rela- gree of certainty; be of a size that would tionships between different parts of the have a substantial impact and be capable business. HSBC, for instance, has in ex- of turning round a distressed institu- cess of two thousand entities although tion, and contain a wide range of alter- in many cases they are separately capi- native options to bolster capital and talised. The structural complexity of liquidity when necessary.

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Where is Pillar 4? – There remains a temptation for Many of these issues are particularly national authorities to adopt bail- relevant in the case of the EU. What out strategies which create moral might be termed an incompatible trinity hazard has three elements: (1) integrated cross- – Banks are global in nature and border banking markets with strong hence a degree of coordination and externalities, (2) global financial stabil- compatibility in resolution arrange- ity, and (3) autonomous national regu- ments is desirable because of the lation and supervision. The incompati- negative externalities associated bility arises as any two can be chosen with interconnectedness but not all three. As argued in Mascian- – The international dimension raises daro et al. (2011): “A fragmented su- difficult issues of burden-sharing pervisory structure is increasingly in- when cross-border banks in the ab- adequate to fully internalise the nega- sence of internationally agreed res- tive externalities stemming from olution procedures cross-border banking”. A central prob- – Resolution requires quick and pre- lem in many cases is that banks are dictable action which is likely to be cross-border in terms of business oper- difficult in the case of global banks ations while resolution arrangements – Information sharing between dif- tend to remain national. In this sense ferent national agencies is essential the regulatory regime has not kept pace and yet this is not always practiced with business structures. – Uncertainty is created regarding The Basel Capital Accord has three how different countries will react pillars: in essence, regulation, supervi- to banks in distress sion, and market discipline. A crucial – Different countries have differing element in any regulatory regime (the legal powers with respect, for in- resolution arrangements) is not explicitly stance, to bankruptcy laws covered in the Basel Accords and yet – Countries are tempted to adopt this is an area which needs as much in- national interests ternational coordination as do the three – Resolution can be particularly time- existing pillars. Different national reso- consuming when negotiations are lution arrangements have as much poten- needed about procedures between tial to create competitive distortions different countries (this was dem- between different nationalities of banks onstrated in the case of Fortis bank) as would different capital adequacy Clearly, difficult political and logistical rules within Pillar 1. A Pillar 4 in the issues are involved with a co-ordinated Basel Accord would contribute to mak- approach. Nevertheless, the advantages ing the overall regulatory regime more of more predictability and compatibil- competitively neutral as between coun- ity in resolution arrangements are clear. tries. There are currently formidable prob- There are several problems with not lems with respect to coordinated resolu- having an internationally agreed Pillar tion arrangements with regard to cross- 4 within the Basel Capital Accord: border banks: some supervisory agencies – There is potential for non-competi- are constrained in their ability to share tive neutrality as between countries information with agencies in other juris- in resolution arrangements which dictions, there are major differences be- could, under some circumstances, tween countries with respect to resolution lead to regulatory arbitrage powers and procedures, legal structures

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(including with regard to bankruptcy be achieved without major structural procedures) vary considerably, and measures or ever-more refinements to co-ordination can be time-consuming. the existing regime, but through a All of these, together with a require- combination of: ment for there to be a degree of convergence in resolution regimes, need to be addressed if an effective and efficient cross-border resolution and burden- sharing regime is to be established. A set of basic requirements (most especially within the EU) needs to be agreed and enforced with regard to key elements: each country should have effective resolution powers and instruments; a degree of harmonisation of bankruptcy laws; an agreed framework for co-ordination in the case of cross- border banks; a reasonable degree of convergence in resolution arrangements – A significant rise in equity capital between countries; living wills to simply requirements based on a simple the resolution procedure; the free ex- gearing ratio rather than further de- change of information between national tailed refinements to the Basel risk- supervisory agencies with the removal weight methodology. Capital regu- of some current legal impediments; a lation should also include explicit consistent approach to SEIR, and an “bail-in” requirements, and contin- agreed model to determine burden gent capital. Overall, banks need to sharing. have greater loss-absorbing power – Regulation to be based on economic 6 Summary of the Argument: substance rather than arbitrary def- A Regulatory Strategy initions of institutions. A substan- A central theme has been that several tial rise in required capital ratios for dimensions to regulatory strategy need banks is likely to induce a process of to be considered which involve more disintermediation through, for in- than piece-meal reforms to existing ap- stance, Shadow Banks. This implies proaches focused on the Basel capital that the “boundary issue” needs to arrangements. Regulatory reform needs be extended to encompass all insti- to be strategic rather than incremental tutions that are likely to become and cover the full range of instruments systemically important and structures within a regulatory regime – Differential capital requirements to address the twin objectives of lower- applied to banks that are regarded ing the probability of bank failures and as systemically significant limiting their costs. A matrix approach – Cyclically adjusted capital require- recognises the potential trade-offs be- ments and loan-loss provisioning tween the costs of regulation and the – More stringent liquidity require- two objectives of the regulatory regime. ments on banks related both to asset The conclusion regarding regulatory holding and funding positions strategy is that most, if not all, of the – More timely and intensive super- objectives of the regulatory regime can vision of banks

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– Measures to make Pillar 3 of the – Resolution arrangements at the in- Basel Accord more effective includ- ternational level to be covered in a ing a focus on internal incentive Pillar 4 of the Basel Capital Accord structures within banks, and more Above all, more emphasis needs to be use of market metrics in super- given to supervision focussing on business visory and intervention processes models and strategies, the testing and – Tax and insurance impositions on monitoring of risk analysis and manage- banks ment systems of banks, earlier direct in- – Ring-fencing within banks with a tervention by supervisory agencies, resultant more simple organisa- governance arrangements of banks, inter- tional structure. While stopping nal incentive structures, and a particu- short of breaking up banks or ap- lar focus on high-impact institutions. plying a rigid Glass Steagall-type This strategy implies greater em- approach, one structural measure phasis and effectiveness of Pillars 2 and 3, to be incorporated in Living Wills and the addition of a Pillar 4. Pillars 1 would be “subsidiarisation” whereby to 3 focus predominantly on Objective banks that are deemed to be poten- 1, while the proposed Pillar 4 is rele- tially systemically significant would vant for Objective 2. have dedicated capital allocated to We have been sceptical about the different areas of the business relevance and practicality of many of – A commitment to PCA and SEIR the structural measures that have been strategies implying early and decisive proposed to reduce the probability of direct intervention by supervisory bank failures. Given the “endogeneity agencies problem”, more emphasis needs to be – The requirement for major banks to given to designing features of a regula- have Living Wills incorporating tory regime to reduce the costs of those recovery and resolution plans bank failures that do occur. Lowering – Clearly-defined and credible resolu- the cost of failures implies internalising tion arrangements. The objective is risks rather than, as is often the case if to allow banks to fail without dis- bank distress, passed to tax-payers. turbing business and customer rela- Given the weaknesses and limitations tionships, and to ensure the costs of of regulation, whilst rules may be nec- default fall on equity and bond hold- essary as part of an overall regulatory ers and other non-secured creditors regime, they are not sufficient.

References Acharya, V. and M. Richardson. 2009. Government Guarantees: Why the genie needs to be put back in the Bottle. In: The Economists Voice. The Berkeley Electronic Press. November. Admati, A., P. DeMarzo, M. Hellwig and P. Pfeiderer. 2010. Fallacies, Irrelevant Facts and Myths in the Discussion of Capital Regulation: Why Bank Equity Capital is not Expensive. Rock Centre for Corporate Governance. Stanford University Working Paper 86. Graduate School of Business. Stanford University. Bernanke, B. 2009. Financial Regulation and Supervision after the Crisis – The Role of the Federal Reserve. Speech at the Federal Reserve Bank of Boston 54th Economic Conference. October.

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BIS. 2010. Annual Report. Bank for International Settlement. Basel. June. Blundell-Wignall, A., P. Atkinson S. G. Lee. 2008. The Current Financial Crisis: Causes and Policy Issues. OECD Financial Market Trends. OECD: Paris. Brunnermeier, M., A. Crockett, C. Goodhart, A. Persaud and H.-S. Shin. 2009. The Fundamental Principles of Financial Regulation. Geneva Reports of the World Economy. Chan-Lau, J. A. 2010. Regulatory Capital Charges for Too-Connected-to-Fail Institutions: A Practical Proposal. IMF Working Paper. International Monetary Fund: Washington. Group of Thirty. 2009. Financial Reform: A Framework for Financial Stability. Group of Thirty. New York. Haldane, A. 2009. Banking on the State. Speech to the Federal Reserve Bank of Chicago International Banking Conference on The International Financial Crisis: Have the Rules of Finance Changed? September. Retrieved on September, 5: http://www.bankofengland.co.uk/publications/speeches/2009/speech 409.pdf Haldane, A. 2010. The $100 billion Question. Comments at the Institute of Regulation and Risk, Hong Kong. March. Available on the Bank of England website. Herring, R. 2010. Bank Wind-down Plans. EBR Advisory Board Report. Italian Bankers Association. Rome. Huertas, T. F. 2010. Living Wills: How Can the Concept be Implemented. Speech to Wharton School of Management. 12th February. www.fsa.gov.uk (Retrieved on 22 July 2010). Hupkes, E. 2009. Too Big, Too Interconnected, and Too International to Resolve? How to deal with Global Financial Institutions in Crisis. Mimeo. Independent Commission on Banking. 2011. Interim Report. London, April. Available on the ICB website). International Monetary Fund. 2009. Global Financial Stability Report. April. Kane, E. 1987. Competitive Financial Regulation: an International Perspective. In: Portes, R. and A. Swoboda (eds.). Threats to Financial Stability. Cambridge University Press. Cambridge. Kay, J. 2009. Narrow banking: the reform of banking regulation. www.johnkay.com/2009/09/15/narrow-banking (Retrieved on 22 July 2011). Kay, J. 2009a. Narrow Banking: The Reform of Banking Regulation. Centre for the Study of Financial Innovation, London. Kotlikoff, L. 2010. Jimmy Steward is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking. Wiley: London. Kotlikoff, L. and E. Leamer. 2009. A Banking System We Can Trust. Forbes. 23rd April. Llewellyn, D. T. 2001. A Regulatory Regime for Financial Stability. In: Kaufman, G. (ed.). Bank Fragility and Regulation: Evidence from Different Countries. JAI: Amsterdam. Llewellyn, D. T. 2008. The Failure of Northern Rock: A Crisis Waiting to Happen. In: Journal of Financial Regulation and Compliance. March. Llewellyn, D. T. 2010. The Global Banking Crisis and the Post-Crisis Banking and Regulatory Scenario. Topics in Corporate Finance. Amsterdam Centre for Corporate Finance, University of Amsterdam. October. Masciandaro, D., M. J. Nieto and M. Quintyn. 2011. The European Banking Authority: Are Its Governance Arrangements Consistent with Its Objectives? VOX. 7th February. Miles, D., Jing Jang and G. Marcheggian. 2011. Optimal Bank Capital. External MPC Discussion paper 31. Bank of England. January. Tucker, P. 2010. Remarks to European Commission’s Conference on Crisis Management. Avail- able on the Bank of England website.

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VOWI_Tagung_2011.indb 93 03.10.11 08:27 Martin Summer Head of Division Oesterreichische Nationalbank

VOWI_Tagung_2011.indb 94 03.10.11 08:27 Introductory Remarks

Ladies and Gentlemen, issues with us: Hans-Helmut Kotz and The recent financial crisis has induced Andreas Pfingsten. several regulatory changes and initia- Hans-Helmut Kotz is a Senior Fellow tives to enhance the current framework at the Goethe University’s Center for and build better safeguards against fu- Financial Studies as well as an Honor- ture crisis. In this session, we want to ary Professor in the Faculty of Eco- ask two high profile experts in banking nomics and Behavioral Sciences of and finance whether they think that we Freiburg University. During the fall have done enough. Maybe it would also term 2010, he was visiting Harvard be interesting to pose the question a bit University, teaching a course in its De- differently and ask: Have we done the partment of Economics and working at right thing? Harvard’s Center for European Stud- So what has happened so far? ies. Between 2002 and 2010, he was a New institutions were created; the Member of the Executive Board of European Systemic Risk Board (ESRB) Deutsche Bundesbank, over time in and the European Banking Authority charge of Departments of Financial (EBA) are the two most prominent ex- Stability, Markets, IT, Statistics and amples. In the discussions preceding Trainingand Education. He was a mem- the creation of these institutions one ber of a number of committees of the sometimes got the impression that the BIS, the Financial Stability Board, as financial crisis was mainly a problem of well as the OECD, where he chaired coordination and information sharing the Financial Markets Committee. He among supervisors. But was this really was also the Central Bank Deputy for at the core of the crisis? the G7 and the G20 process. Between New rules for hedge funds have 2002 and 2005, he served in a personal been initiated. But there is little evi- capacity on an Expert Panel of the dence that this crisis was somehow fun- European Parliament on Financial damentally linked to hedge funds. Markets. He has published widely in Charges and taxes on financial insti- scholarly journals and is also a regular tutions have been imposed as if these charges would finance future rescues. Resolution tools were created in some countries, as for instance in the UK in Germany and in the USA but the international problems in resolution have remained unaddressed. The Basel framework got an overhaul which does not fundamentally change the approach in place and leads to very modest and small increases in equity requirements for banks. Does this mean that actually little has happened, are there issues that remain unaddressed, do we need to do media commentator on financial regu- more or do we need to do other things? lation issues. His current research fo- I am very happy to welcome today cuses on monetary policy’s role in un- two prominent experts who will derwriting financial stability, on sus- share their views and discuss these tainable levels of bank profitability and

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on the politics of international rule banking at the University of Münster making. where he is teaching and doing research Andreas Pfingsten is Professor of there since then. From 1998–2004, he Banking and Finance at the University was a member of the Oliver Wyman of Münster in Germany. He was edu- Institute and since 1999 he is a mem- cated as an economist and an operation ber of the Nordrhein-Westphälische research specialist at the Universities Academy of Sciences. of Karlsruhe and Vancouver, British He has published widely in econom- Columbia. His career started as a pro- ics, operations research, banking, and fessor of economics at the Universities finance and risk management. He is of Siegen and Graz with some times also co-author of a famous textbook on also spent in the private sector as a banking together with Hartmann- banker and a controller. In 1994, Wendels and Weber. The book is mean- Andreas Pfingsten took up a chair in while in its 4th edition.

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VOWI_Tagung_2011.indb 98 03.10.11 08:27 Enhancements in EU Financial Regulation: Have We Done Enough?

Nous entrons dans l’avenir à reculons. Chart 1 Paul Valéry (1962). Interbank Money Market – Unsecured versus Secured Funds 1 1 Where Do We Come From? Spread in basis points There had been carefully laid-out plans 200 on how to organize the institutional in- 160 frastructure of European financial mar- 120

kets. In fact, the Financial Services 80 Action Plan, a key plank in the Lisbon Program of the early 2000s, was noth- 40 ing less than a Grand Design. It followed 0 a principled philosophy, the modern Jan. 07 July 07 Jan. 08 July 08 Jan. 09 July 09 Jan. 10 one: the perimeter of capital markets Unsecured versus secured, 3 months should be enlarged. Direct intermedia- Source: ECB. tion (between ultimate savers and final users of funds) was to be fostered. Reg- Concurrently, market liquidity evapo- ulators should content with providing rated in all but the most transparent as- the institutional infrastructure for this sets – which therefore, being held on ever more integrating financial land- the trading book, took the largest hits. scape. Supervision, also in the intra- While Basel II was barely operative – European cross-border dimension, could and in some jurisdictions not imple- be delivered effectively in a decentral- mented at all – this, of course, should ized mode. This was deemed to be on not have happened, never. purpose since rule books were largely Ever since August of 2007, liquidity harmonized. All of this was, in fact, a demand was rising substantially in process which began with the Euro- the aggregate. This reflected, firstly, pean Banking Directives and culmi- a heightened perceived counterparty risk. nated in the Capital Adequacy Direc- Write-downs, indicating mounting de- tive III. fault probabilities in particular of struc- But then, almost out of blue skies, tured products, were increasing with this story fell apart. In late summer an accelerating pace (chart 2). There- 2008, after a wrenching year of mount- fore, possible repercussions through ing tensions – in officialese, one did the tightly knit net of connections not speak of a financial crisis until well within the banking system made mar- into the summer of 2008 – interbank ket participants suspicious. Trust was money markets almost ground to a halt. especially undermined as the relation The increased roll-over risk – funding to the off-balance sheet (so-called liquidity – had shown up in signifi- structured investment vehicles, con- cantly widening spreads between unse- duits) and non-bank sphere was opaque. cured versus secured funds (chart 1). This suggested substantial caution to This reduced confidence also translated participants in interbank markets – or into drastically falling trading volumes. less trust. Adding to this, banks also

1. E-mail: [email protected]. These notes are written in a purely personal capacity for a panel contribution at OeNB’s 39th Economics Conference, Vienna, May 23. I benefited from discussions with Ernest Gnan, Jan Krahnen, David Llewellyn, Peter Mooslechner, Ewald Nowotny, Andreas Pfingsten, Martin Summer and Martin Weber – without any intention to implicate them in positions argued here.

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Chart 2 Chart 3 Writedowns of International Banks Allotment over Benchmark Bio US dollar Bio EUR 160 500

140 400

120 300

100 200

80 100

60 0 Jan. 07 July 07 Jan. 08 July 08 Jan. 09 July 09 Jan. 10 40 Source: ECB. 0 1 2 4 6 8 10 12 14 16 18 20 22 Writedowns of 22 international banks, as of March 4, 2011. Source: Bloomberg. to that funds with longer duration were also made available. Ultimately, with trading volumes maintained higher precautionary bal- going down strongly, again, in particu- ances, in order to be prepared, sec- lar in the longer maturities, as well as ondly, to honor the back-up lines they spreads between secured and unse- had offered to off-balance sheet entities cured funds widening out to unprece- (in fact, puts they had written, or liquid- dented levels, the ECB launched in mid ity insurance they had provided, which October 2008 its policy of satisfying all ex post had proven hugely under- and any liquidity demand at a fixed rate priced). ( full allotment at a fixed rate), given It is here, in money markets, where appropriate collateral could be posted. Central Banks in the North-Atlantic re- Moreover, the ECB also broadened its gion where first forced to intervene in – already large – list of eligible collat- their financial market stability function eral and it also reduced the minimum (see for an excellent overview Turner, required credit quality from. Essen- 2010). The ECB responded rapidly and tially, the ECB was accepting an inter- forcefully, somehow in a first-mover mediary role using its enlarged balance fashion. Diagnosing things as they sheet to underwrite financial market evolved early on as a run – in this case, stability. It was somehow substituting a obviously, not of the retail but the “missing market”, missing for reasons wholesale variety – the ECB allotted of lack of trust or confidence. These base money beyond the system’s needs “enhanced credit support measures”, as under standard conditions (chart 3, see the ECB came to call them, were of also Kotz, 2008). Initially, in the first course extraordinary – which implies, as phase of the crisis, in order to keep in- a logical corollary, that the ECB would terbank rates in close vicinity of its like get back to normal (ordinary) policy rate, the ECB only frontloaded operational procedures as soon as pos- liquidity supply – but only temporarily, sible. absorbing surplus liquidity over the Evolutions in money markets are of course of the reserve maintenance interest in our case, since it is here, in period. In the course of the crisis, the a stressed and ultimately dysfunctional dysfunctionality became more perti- environment, where the urge for nent along the yield curve. In response re-considering the regulatory landscape

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forcefully emerged. There was there- And results are already on display: fore a certain Naipaulian Enigma of Basel III is up for deployment, though Arrival in evidence in the fall of 2008 with a long phasing-in period. More- – which led to a fundamental reassess- over, in Europe a new institutional in- ment of rules as well as their institu- frastructure to control the application tional delivery. In providing liquidity, of the new rules of the game is in place. the “social function” of which, accord- This, finally, begs the concluding (as ing to John Hicks, is “to provide time well as the starting) question: Does it for thinking”, central banks gave room all suffice – or is it too much? of maneuver – to profoundly rethink the prevailing rule-set. It is thus very 2 Basel II – Why Such an Early practical and appropriate to take stock Reappraisal? and address, as this panel does, the In response to a rule-set being seen as question of whether we have done too simplistic and also vulnerable to enough. This question obviously begs a gaming, Basel II, evolving over a long number of nagging sub-questions, some development period, was more com- of which we will try to address, admit- plex and more sophisticated. (Almost tedly, in a rather broad-brush way. by construction this opened arbitrage Focusing in the following on the re- opportunities, as any set of regulations regulation of banking markets, we will does.) In short, Basel II was understood first very briefly outline the Basel II philosophy in order to understand why there is now the universally shared view that this needs a reappraisal. Quite directly, this also leads to the second question, namely, what lessons can we draw or what have we learned? Or, in the same vein: Where do we want to get to? How should a robust, cost-effective financial system look like? Thirdly, given the strong integration of financial markets, being most evident in the European domain, the new rules of the game call for a forceful international cooperation – in rule- making as well as rule-implementation. as state of the art and up to the task of delivering stability. It rested solidly on Chart 4 three pillars. The first of them were Deposit Facility capital requirements, for the advanced Bio EUR banks finely attuned to the supposed 400 riskiness of assets. In addition, in order 300 to cope with specifics, a structured and

200 disciplined supervisory process was conceived. Then, finally, based on 100 transparent information disclosure, 0 market agents were also enlisted as su- Jan. 07 July 07 Jan. 08 July 08 Jan. 09 July 09 Jan. 10 July 10 pervisors. In total, this structure should Source: ECB. support a fundamentally sound set of

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banking institutions. As an immediate menting the machinery long before. In corollary Basel II should simultane- fact, they had been advising these ap- ously underwrite systemic stability – proaches for a good decade. And the which thus was seen as a derived product. foundation models were in the public The most important building block domain, very literally: downloadable. was the one detailing capital require- Therefore, with this structure in place, ments. This emphasis also testified to what we have seen simply should not the underlying philosophy: The objec- have happened. But it did. And it did tive was to achieve a close alignment not happen completely inadvertently. between economic (or bank-individual) Indeed, most of the issues which are with regulatory capital. The system now to be mended with Basel III had was, as industry associations had al- been raised before – ever since the ways called-for, almost on an auto-pi- debate on Basel II was launched. In lot. This was also very much in line particular four points bear repeating with the prevailing zeitgeist: Supervi- since they also come up with Basel III. sion was delegated by design. Self-reg- The purportedly sophisticated ulation was seen as most effective models to compute risk weightings since, in its most advanced version, it (ultimately, risk-weighted assets) were built from sophisticated bank internal not only challenged with very significant data limitations. Defaults for most instruments are rather rare events hence the need for data covering at number of credit cycles (de Servigny and Zelko, 2001). But they were simply not available. For this small sample bias, Monte Carlo simulations are no substitute. These risk-assessment models were in particular conceptually fragile. Here, uncertainty referred especially to the flaws of the value at risk approach. By construction, such a perspective implies and underestimation of low probability events (which were models. Supervisors had but a certifi- in reality of course not as unexpected er’s role. And how could they be as- as the normal assumption would make sumed to know better than those us believe; Herring, 1999). More im- highly incentivized to take care of their portantly, the systemic dimension, own fate? What concerned institutions arising from the interaction of the joint with not as advanced risk-modeling ca- application of these models, was left pacities, the second tier banks, they unattended. This meant a complete had a robust fall-back option: Rating disregard of common downside risks. agencies, mindful of their reputational In the same vein and more generally, capital being on the line, would pro- the endogeneity of risk was not acknowl- vide them with reliable risk assess- edged (Brunnermeier et al., 2009). ments. Moreover, while the criticism con- While it is true, that Basel II was cerning pro-cyclicality was accepted just barely in force when the crisis early on – it was never addressed in broke, banks of course had been imple- earnest. One reason for this possibly

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was that dealing with the issue would struments, indispensable. But, given have also implied, as far as cycles are recent experience, one also might think not correlated, that the playing field about having more of an involvement of would have been un-leveled along disinterested academics – were it only national or regional dimensions. Then, as a countervailing factor, challenging there is quite obviously a very nagging received wisdom. diagnosis problem: How does one conclude on the amount of the cyclical de- 3 What Lessons Have We viation from trend and how does one Learned by Now? deploy an instrument to deal with that? Or, before, where do we want to get Nonetheless, in reality the issue did not to? While it appears more than obvi- remain moot. ous, the financial sector does not find Thirdly, and most puzzlingly, liquid- its purpose in itself. Rather, it is quite ity problems were largely ignored in literally a service industry. Essentially, the Basel II environment. Or, to put it financial institutions should perform more benignly, they were deemed to two functions – the allocation of scarce be sufficiently dealt with indirectly, savings and the management of the at- through sophisticated capital require- tendant risk, at acceptable cost. This ments. This argument is of course not implies a pertinent question: “…how completely beside the point. After all, well is our financial system serving us, the distinction between liquidity and and at what cost” (Friedman 2010, p. 9). solvency is somehow elusive, especially What is most puzzling: we do not really in turbulent times. The financial crisis have a good idea about this indeed fun- has however palpably shown that capital damental issue: Are society’s resources requirements alone do not suffice. But used justifiably? It goes without saying it was also never expected to be that way. that here a substantial effort has to be This reads very much like “We told made in order to achieve a necessary you so”. And, in fact, there is a substan- understanding of the balance of costs and tial literature on all points mentioned benefits of finance (Haldane et al., 2009). above, detailing the critique – as it was At a minimum, we have however an raised during the consultation phase of idea about the possible destructive Basel II, in the early 2000s, or even potential of dysfunctional financial in- before (Danielson et al., 2001; Hellwig, stitutions. These potential side-effects 1996; Gehrig, 1996; Kotz, 2001 etc.). were of course always palpable, in devel- This begs questions about the political oping as well as developed countries, economics of rule making which we for too long to ignore (Kindleberger, here only highlight in a very cursory 1986). Meanwhile it is undeniable: fashion:2 Who has a say and an impact Such a calamity can also happen in the on rules beyond the very diligent and North-Atlantic area. The losses of today’s public-minded civil servants? How does ongoing crisis are inadequately cap- one deal with the – not exclusively pub- tured if one only looks at write-downs lic-spirited – but completely legitimate in banking books (chart 2), though influence of industry groups? Their in- they are very substantial. The massive volvement is, of course, legitimate in a destabilization of numerous public sec- pluralistic society and, in light of their tor budgets, subsequent to the crisis, be- comprehensive knowledge about in- longs on the list also. In addition,

2. For a significantly more critical view see Claessens and Underhill (2010).

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opportunity cost, of course, also include In addition to more conservative the gigantic mis-allocation of resources, capital requirements and cautious risk- their wealth-reducing deployment. weighting coefficients, Basel III also This is important to recall because adds an overall leverage constraint. against this background and for obvious This obviously throws all assets indis- reasons, rule makers and supervisors criminately into one risk bucket, hence have become more conservative. is avowedly simplistic. However, this Now, what lessons have been garde fou is an honest way of accepting drawn? Early on, in the fall of 2009, our state of knowledge, given the sub- the Financial Stability Board (FSB) has stantial model uncertainty the purport- produced a comprehensive list of steps edly sophisticated bank internal rating to be taken to make the financial sys- models come with. tem more safe and effective in deliver- At least with hindsight, the lack of ing on its ultimate purpose, supporting an appropriate regulatory treatment of welfare creation (Vinals, 2010). This liquidity was a glaring flaw. In the run- ambitious program has, most impor- up to the crisis, numerous international tantly, been endorsed by G-20 leaders. banks increased the gap between the With regard to the banking sector, on duration of their assets and liabilities to which we focus here, rather reassur- unprecedented levels (Shin, 2010). Re- ingly, the agenda list concerning Basel lying moreover on wholesale markets, III included all of the above-mentioned what was in former times called: critical points. Thus, capital require- “bought deposits”, made these institu- ments will be reinforced. More specifi- tions especially vulnerable. Northern cally, this holds in particular for the Rock, funding almost half of its assets, quality of capital. Funds last in line, with a duration above 4 years, in over- with a claim on the residual only, hence night, wholesale money markets was an those with the first obligation to take exemplary case (Shin, 2009). Now, losses, will have to be increased sub- two new ratios should, going forward, stantially. While it might appear that contain or limit such threats: The this is about common equity only, it short-term liquidity coverage ratio calls would not be justifiable if funds equally for a stock of high-quality, liquid assets capable of absorbing losses were not to be larger than the projected net cash- treated identically. Function or sub- outflow over a 30 day period. With re- stance dominates form. Otherwise, gard to longer-term maturity transfor- rule makers would be prescribing the mation the net stable funding ratio re- institutional set-up of banking systems, quires available reliable funding to be determining “the” model: which would greater than cash-flow requirements. then be a private, purely shareholder Then, at the interface between the based one. This, very clearly, would micro-prudential and the macro or sys- impede the development of public temic dimension, Basel III also copes sector savings banks or cooperative with problems of pro-cyclicality. Capi- banks which, for sure, not only have tal adequacy requirements, by necessity not been major actors in the crisis but, based on backward-looking time series on the contrary, have been, as a result of default probabilities and historic of their business models, very much a market prices, produce positive, self- stabilizing force – at least in the amplifying feed-back effects. This is German and Austrian case (OeNB, also an issue with marked-to market or 2009; Deutsche Bundesbank, 2009). fair-value accounting, with margin re-

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quirements and haircuts – all of them In our case, the regulation of cross- endogenously and as a rule abruptly border (in particular: intra-European) creating potentially systemic problems financial activities, cooperation goes (CGFS, 2010). The most important innovation however is that the macro- or systemic dimension now has been acknowledged. For almost a decade, in particular economists from the BIS had argued this case (Borio, 2003). If need be, the crisis has forcefully made clear that it was a non-negligible fallacy of composi- tion to assume that by underwriting the (apparent) safety of individual institutions problems arising from interaction would fade away. Claudio Borio put this in an enlightening econometric metaphor: Systemic issues arise from substantially beyond the exchange of cross-sectional as well as time-series in- information. It entails the formulation terdependencies. Macro problems might, of common policies – against the back- for example, develop when too many ground of the typical problems of con- institution – the crosses – are engaged verging on a joint approach: partici- in the same activities. Trouble frequently pants pursue objectives, not always also builds and accumulates over time completely in line. For example, some (CGFS, 2010; Hanson et al., 2010). would accept a higher risk of financial market instability if it comes, on aver- 4 Why International – Especially age, with stronger expected growth of European – Cooperation? GDP. Then there is uncertainty about Most explicitly, Basel II was – like the robustness of risk-control models to its predecessor – the result of negotia- be applied. And all official negotiators tions amongst the members of the involved, while interacting in a supra- Basel Committee on Banking Supervison national environment, of course have to (Claessens and Underhill, 2010). The transport results to a national context. safety and soundness of financial insti- This two-level game aspect is a decisive tutions, the bigger one of which are reason for why the U.S. – though very predominantly active in a cross-border much part of the negotiation process – dimension, can only be underwritten never implemented Basel II. But it has internationally. Rule-setting as well as promised to apply Basel III. rule implementation therefore has to In the case of the most recent re- acknowledge “structural interdepen- design of international rules two insti- dence”, a phenomenon already diag- tutional aspects deserve an emphasis. nosed for macroeconomic policies by There is, first, the new, very much Richard Cooper in the 1970s. There enhanced role of the already mentioned are significant and unavoidable spill- Financial Stability Board (FSB). Its mis- overs. These externalities arise inexo- sion is to “coordinate at the interna- rably from financial institutions re- tional level the work of national financial sponding to rules and their implemen- authorities and international stand- tation. ard setting bodies” (FSB Charter, Art. 1).

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This is of course an ambitious objective tralized set-up of European financial – in scope, since it goes in the institu- markets, the European dimension tional dimension for very good reasons gained in importance. Proximity and beyond banking, encompassing all stan- efficiency strongly argue in favor of the dard setting bodies, as well as in the en- subsidiarity principle, if applied on the compassing task, going much beyond basis of a common rule book. To be coordination. The FSB had an impres- sure, up to the crisis this decentralized sive start. set-up – a mixed-form home-host coun- In fact, looking back at its diagnosis try control with memorandums of un- from the fall of 2009, also outlining the derstanding and colleges of supervisors blueprint for actions to be taken, the – was deemed to be appropriate for Europe’s specific context, for reasons of supervisory proximity and effectiveness of information processing but also because Europe’s banking markets are still dominantly nationally oriented (Houben et al., 2008). However, in particular the home-host relation was seen as problematic in the case of branches (as opposed to subsidiaries) with a systemic (financial stability) relevance in the host country. But before the crisis this was perceived as an only remote problem, to be dealt with best if and when it arises. Recent events FSB has very much delivered on its tar- now have however forcefully shown gets. But then, quite rapidly, a debate that, reflecting the ever deeper integra- about the “closing window of opportu- tion of European financial markets, the nities” developed. Unsurprisingly, with prevailing set-up of loosely coordinated the immediacy of the crisis fading, supervisory institutions was not up to there was quite some push-back, for the problems (Bini Smaghi, 2007; obvious reasons in particular from Schoenmaker, 2010). members of the industry to be regu- This structural flaw has been con- lated. While in public debates the slow vincingly diagnosed in the de Larosière process of international rule making report. And, possibly reflecting the was often criticized as almost border- dramatic background, the suggestions ing on inactivity, voices from industry of this report have been largely taken became ever more critical. It was on board. Thus, the three European claimed that regulations pondered Supervisory Authorities now have a would be too rigorous and ultimately substantially increased influence in the too costly, implying lost opportunities case of conflict between national for growth and employment. We will supervisors. Given the dense network come back to that. of intra-European repercussions this is The second important international a strong positive. Otherwise we would as well as institutional innovation is of have remained stuck in a situation course what we now have as a new su- where the best response of participants, pervisory landscape in Europe. In prin- given the expected reaction of others, ciple, whilst acknowledging the decen- would on average have generated sub-

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par outcomes. In fact, this is also an im- (Cecchetti, 2011). A number of aca- provement for supervisees who now have demics hold that in particular capital a dedicated point of reference. Most requirements are not demanding importantly, however, the creation of a enough – by far. More specifically they new European Systemic Risk Board posit, with reference to the Modigliani- (ESRB), charged with the macro-pru- Miller capital-structure indifference dential dimension, is a significant step argument, almost the foundation stone in the right direction (Grande, 2011). of modern finance, that a higher capital The ESRB has an ambitious objective, cushion would not come with the as- namely to diagnose possible systemic serted negative social consequences problems as they arise, and, most im- (Admati et al., 2010; Miles et al., portantly, to suggest ways and means 2010). While high operating leverage how to correct them. This is an impor- (in particular as a result of the differen- tant improvement relative to what we tial tax treatment of debt and equity) had before – when even the problem was might interesting from an individual not acknowledged. Given that financial rationale (allegedly boosting RoE), as a stability is inextricably linked to mone- result of the inexorably implied exter- tary policy (e.g., CGFS 2010), being nalities this could go beyond a collec- joint-products, it is also of the essence tively rational level – what calls for that the ECB and national central banks higher capital requirements (Hanson et are involved in a decisive way. al., 2010). This argument is also but- tressing a position which, for example, 5 Does It All Suffice – is It too the Swiss National Bank made early on, Much? forcefully arguing for more self-insur- Putting an overall judgment on the ance of banks. current state of financial rule-making, There are a number of open issues. as we are asked to do, can only be ven- They are, on the one hand, micro-pru- tured with reference to a yardstick. To dential in origin and have in particular reiterate: The financial system should to do with the level and structure of be resilient, efficient and provide its in- capital (convertible debt?) and liquidity termediating services in a cost-effective requirements (sovereign debt?). They way. also concern their interaction with This impact assessment is still quite ongoing regulatory developments in contentious. There is, on the one hand, closely related further fields (insur- the industry evaluation (IIF 2011) ance, accounting), not touched upon which concludes on very high macro- here. But the major challenges are sys- economic costs: lost opportunities for temic. They concern systemically im- growth and employment as a result of a portant institutions (too-big/too-inter- reduced systemic capacity to manage connected to fail), cross-border bank risk. The work done by the BIS-orga- resolution schemes (living wills, func- nized Macroeconomic Assessment tional subsidiarization). This is, first of Group does, on the contrary, conclude all, an analytical problem, for example that macroeconomic costs will be com- concerning tractable indicators of sys- paratively low – and hence that, set temic importance (where simple indi- against the opportunity costs from cators of size seem to perform rather financial market calamities (measured well, e.g. Drehmann and Tarashev, in large underperformance relative to 2011). But then it also entails very dif- potential), net benefits are significant ficult issues of implementation. Cycles,

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in particular such in asset prices, as a monetary policy can only deliver one rule have a significant regional dimen- policy rate, that banking policies might sion. They are difficult to diagnose, ex serve such a purpose also. With a sec- ante. Then, it takes often very long to ond objective this obviously calls for a build a consensus. Which leads, as seen second instrument also. It is unfortu- from ex post, to the too-less-too-little- nately too easy to imagine the difficul- too-late syndrome. This speaks in favor ties of a highly political decision-taking of simple, automatic rule (not unlike process. But, given the experience we the Spanish statistical provisioning con- made, taking this direction appears to cept). Responding to this a-synchronic- be unavoidable. ity with differentiated capital require- As a general upshot, going forward ments would moreover imply cost of the international financial playing field doing business differentiated along a re- will probably be less level. The national gional dimension, of course, also or regional dimension will again in- within Europe’s single market. This crease in importance – possibly even in would obviously not be an unintended Europe and even in EMU, just think of consequence but engineered on pur- the liquidity ring-fencing which is pose, as an appropriate response to di- deemed to be called for in order to vergent regional economic background cope with challenges arising from conditions. emergency bank stabilization measures While this would, for sure, compli- in the home-host relation. In a way, we cate things for banks, we do have such are advancing in retreating – to pick-up regionally differentiated effects in many the aphorism of Paul Valéry, which we other dimensions, most obviously in used as motto. the tax field. With monetary policy Be that as it may, one can conclude “Europeanized”, a well working EMU that innovations in rules, rule-making always required that functional substi- as well as in institutional implementa- tutes to the nominal exchange rate to tion, acknowledging previously disre- adapt to regional imbalances would garded externalities (in particular those gain in importance. National fiscal pol- with a systemic impact), are heading in icies were explicitly seen in this capac- the right direction. At least when com- ity. We now acknowledge, given that pared to where we are coming from.

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Cecchetti, S. and B. Cohen. 2010. Strengthening the financial system: The benefits outweigh the costs. In: VOX www.voxeu.org/index.php?q=node/5426, retrieved on August 25. Committee on the Global Financial System. 2010. Macroprudential instruments and frameworks: a stocktaking of issues and experiences. CGFS Paper 38 (chair: Lex Hoogduin). Basel: BIS. Deutsche Bundesbank. 2009. Finanzstabilitätsbericht. Frankfurt Danìelsson, J., P. Embrechts, C. Goodhart, C. Keating, F. Muennich, O. Renault and H. Song Shin. 2001. An academic response to Basel II. In: LSE Financial Markets Group. Special Paper 130. Drehmann, M. and N. Tarashev. 2011. Systemic importance: some simple indicators BIS Quarterly Review. March. 25–37. Friedman, B. 2010. Is our financial system serving us well? In: Daedalus. Fall 2010. 9–21. Grande, M. 2011. Le Comité européen du risque systémique : l’approche européenne du risque systémique. In: Revue d’Économie Financière 101. 175–192 Gehrig, T. 1996. Market Structure, Monitoring and Capital Adequacy Regulation. In: Swiss Journal of Economics and Statistics 132. 685–702. Haldane, A., S. Brennan and V. Madouros. 2010. What is the contribution of the Financial sector: Miracle or mirage? In: The Future of Finance. The LSE Report. London: LSE. Hanson, S., A. Kashyap and J. Stein. 2011. A macroprudential approach to financial regulation. In: Journal of Economic Perspective 25.1. 3–28. Hellwig, M. 1996. Capital adequacy rules as Instruments for the regulation of banks. In: Schweizerische Zeitschrift für Volkswirtschaft und Statistik 132. 609–612. Houben, A. , I. Schrijvers and T. Willems. 2008. Supervising cross-border banks in Europe. In: Journal of Banking Regulation 9/2008. 227–246. Kindleberger, C. 1996. Manias, Panics, and Crashes. A History of Financial Crises. New York: Wiley. Kotz, H.-H. 2000. Basel II – Neue Anforderungen an die Bankenaufsicht. In: Zeitschrift für das gesamte Kreditwesen 12/2000. 20–24. Kotz, H.-H. 2008. Finanzmarktkrise – eine Notenbanksicht. In: Wirtschaftsdienst H 5. 291–296. Naipaul, V. S. 1987. The Enigma of Arrival. Viking Press. Oesterreichische Nationalbank. 2009. Rückläufige Finanzierungsvolumina der realwirtschaftli- chen Sektoren. Finanzmarktstabilitätsbericht 18. 24–36. Schoenmaker, D. 2010. Le «partage de la charge»: de la théorie à la pratique. In: Revue d’Économie Financière 100. 163–185. Semmler, W. 2006. Asset Prices, Booms and Recessions. Berlin: Springer. 2nd edition. Summer, M. 2003. Banking Regulation and Systemic Risk. In: Open Economies Review 14. 1. 43–70. de Servigny, A. 2001. Le risque de crédit. Nouveau enjeux bancaires. Paris: Dunod. Tirole, J. 2011. Illiquidity and All Its Friends. In: Journal of Economic Literature 49 2. 287–325.

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VOWI_Tagung_2011.indb 109 03.10.11 08:27 Andreas Pfingsten Professor University of Münster

VOWI_Tagung_2011.indb 110 03.10.11 08:27 A Critical Assessment of the New Capital and Liquidity Requirements

1 Introduction The basic idea of capital regulation Following the collapse of Lehman- is twofold. On the one hand, more cap- Brothers, we have seen an unprece- ital means that owners have more at dented effort to save the worldwide fi- stake and therefore strong incentives to nancial system from a meltdown. Gov- limit risk-taking. On the other hand, ernments, central banks, and regulators more capital means that in a case of de- throughout the world have come up fault more funds, other things equal, with new measures intended to im- are available to cover creditors’ claims. prove the resilience of the financial sys- The natural first question is how we tem with respect to external shocks should define capital in order to serve and endogenous failures. I was asked to contribute to the question whether or not the participants have done enough to reduce the likelihood that the past will not happen again. Yet when curing a disease it is not only an issue of taking enough medicine, but one of choosing the right medication in the first place. Therefore, I will interpret my task a bit more freely and point out some of those implications of the new rules that may give rise to harmful, probably unintended consequences. At the climax of the crisis, authorities had to act strongly and rapidly. both purposes as good as possible. The When shaping the new and hopefully answer is not obvious, not even easy. more level playing field now, they ought The Basel Committee has decided that to perform a reasonably detailed cost fewer instruments will be recognised benefit analysis before implementing as core capital. A number of properties the new order. The purpose of my con- are required to make a capital instru- tribution is to raise some concerns. ment eligible as core capital (BCBS, They may simply indicate unavoidable 2010a). The required features sound side effects but may also induce us to very reasonable: core capital cannot be search for alternative treatments. withdrawn and it must not receive a fixed income, to name but two of them. 2 Capital Regulation Unfortunately, the Basel Committee The changes in capital regulation devel- has chosen a principle based approach, oped by the Basel Committee on Bank- but has not adhered to it completely. ing Supervision (BCBS) and finally As one example consider the coop- codified in the Basel III agreement erative banks as they exist in Germany. (BCBS, 2010a) can be divided into At present, their shares are recallable three categories: stricter capital defini- by the members within certain periods. tions, changes in specific capital re- Thus, one important requirement for quirements, and introduction of the core capital is violated. Consequently, leverage ratio. We will examine these the cooperative banks, who as a group aspects in turn. have not really been involved in the re-

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cent financial crisis, need to make a companies and pension funds, within number of changes in their bylaws in the limits of their regulation, are natu- order to make their shares core capital ral candidates. Alas, increased banking and thereby protect their successful stability may be achieved through more business model. and stronger ties with other players In another case, the requirements from the financial system. Eventually, are also not neutral with respect to the enhanced stability of the banking sys- legal form of banks. Certain types of tem has to be paid for by reducing the capital are, if a number of requirements stability of the financial system as a are met, acknowledged as core capital whole. for example in the case of state banks, The shortage of bank capital is fur- but not for listed banks. It seems ques- ther increased by a number of changes tionable to treat capital instruments in capital requirements for different differently depending on the legal form bank activities. As a general feature, of the bank (Gaumert et al., 2011). capital required for the credit business The amount of core capital needed increases. Therefore, many more firms in the future is rather large, unless than today have to look for other ways banks shift their activities towards less of access to the capital markets. For capital-intensive lines of business. The some banks, this means that additional increased capital requirements in com- opportunities arise because a number bination with other restrictions dis- of investment banking activities require cussed below make it quite likely that less capital than loan origination and returns on bank capital will go down. also carry less risk. Since capital mar- This may lower capital supply further. kets are more likely to provide funds However, a countervailing effect should for less risky firms, it is conceivable be observed. An increased capital base that the average quality of banks’ loan makes banks less prone to materialising portfolios deteriorates over the next risks. couple of years. This would be clearly The Modigliani and Miller (1958) at odds with the objective of making propositions, derived in a setting of banks safer. perfect markets, need not hold for Reduced credit availability will cer- banks because their mere existence in- tainly put an upward pressure on inter- dicates market imperfections. Still, the est rates. This comes along with the ef- reduced risk as stipulated by the new fects known from the Stiglitz and Weiss Basel-Accord may be such that inves- (1981) model of credit rationing. Some tors accept lower bank returns in ex- firms will increase their risk taking be- change for less risk. Yet if investors do cause low risk projects may not be value not accept low returns, banks may be increasing anymore if interest rates go tempted to increase returns by engag- up. Similarly, firms with little risk may ing in particularly risky activities, i.e. (have to) withdraw their applications risk shifting à la Jensen and Meckling for loans altogether. Their real invest- (1976). In this case, the societal bene- ments then may go down and the usual fits of forcing banks to hold more capi- negative effects of a decline in real in- tal become less visible. vestments on the economic well-being However, even without this risk of a country would result. To estimate shifting a major problem remains: Who the impact of the new capital regulation, can supply the huge amounts of capital a Macroeconomic Assessment Group needed over the next years? Insurance was established by the Financial Stabil-

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ity Board and the Basel Committee on possible at all. Therefore, secondly, Banking Supervision. Its report (BCBS, firms will have to retain and manage 2010d) finds that most likely only mi- more basis risks than before. Thirdly, nor effects on GDP growth will result. many of the more exotic derivatives A study for Germany basically comes to may vanish completely. For pricing and the same conclusion (Deutsche Bundes- hedging purposes, they were more or bank, 2010, pp. 112–113). less duplicated by standard derivatives Much more capital than before is al- anyway. The combination of several ba- ready needed for the banks’ own trad- sic derivatives into one product did not ing books (BCBS, 2009). This obvi- necessarily make the administration ously will continue to affect banks’ easier, because each and every product incentives for proprietary trading ad- has to be included in all kinds of book- versely. In my opinion, this is a side ef- keeping. It is conceivable that some of fect of the therapy that should not con- the more exotic derivatives more or less cern us too much. In many of the mar- only exist to exploit regulatory arbi- ket segments where bank trading trage or to demonstrate a bank’s abili- occurs it is not easy to see why and how ties in financial engineering. The disap- a particular bank should be able to fore- pearance of such derivatives would not cast price changes systematically better really be a loss. than other players in that market. Given When assessing the impact of capi- the costs of professional trading depart- tal requirements, in particular the ments, the net effect is far from obvi- higher capital charges on OTC deriva- ous. Reduced proprietary trading tives, we must also consider the ac- would only be harmful for the economy counting consequences. Standardised as a whole if the time span in which derivatives are less likely to work as new information permeates the mar- perfect hedges, i.e. the efficiency of kets increased. Significantly more capital will also be needed for over-the-counter (OTC) derivatives. This will most likely induce banks to use exchanges and similar central counterparties to a greater extent. Increased transparency and less default risk are among the desirable consequences, for more see Llewellyn (2010, pp. 69–70). Trading on exchanges requires more standardisation of contracts. The implications are manifold. Firstly, the volume in those products that are finally available at exchanges will proba- hedges declines. Banks following IFRS bly increase, meaning that bid/ask may not be happy with the resulting ef- spreads should come down. This may at fect. In particular, earnings volatility least partly compensate the cost in- may increase when more and more creases implied by the integration of a hedges violate the conditions for hedg- third party, the exchange. Standardised ing effectiveness. derivatives also mean that perfect As another measure to increase hedges will become more difficult, if banking stability, the leverage ratio is

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about to be introduced as an additional Germany, for example, specialized restriction for banking activities. In a banks financing real estate loans would nutshell, it says that banking activities be hit particularly hard because their may not exceed a certain multiple of its loans carry relatively little risk but also capital. When calculating the relevant have low margins such that a high lever- activities, among others, collateral and age was needed in the past to make this other instruments for risk mitigation business profitable. Quite generally, are not taken into account. The idea be- holding riskless government bonds (if hind this very conservative approach is they should turn out to remain riskless) evident. Before the financial crisis, becomes fairly unattractive, too. It is many banks had invested into different hard to tell how these effects will even- kinds of securities, including CDOs, tually rearrange the portfolio composi- ABCPs, and so on, which had been as- tions of banks, maybe even towards signed AAA-Ratings. These ratings more risk-taking (Gaumert et al., were interpreted as if the correspond- 2011). 3 Liquidity Requirements On perfect capital markets, liquidity is not an issue. Solvent banks with profitable business models will always have excess to sufficient liquidity. During the most recent financial crisis, however, liquidity was a major issue. It turned out that not the solvency, but the perceived solvency of banks mat- tered for their access to liquidity. Since the allocation of so-called poisonous securities across banks was not known, banks became sceptical with respect to ing securities were basically riskless. basically all other banks. The default Over the recent years, we have learned, risk of securities materialised in the however, that many of these assess- form of a global liquidity crisis. Thanks ments were wrong. Neither including to the prompt and competent reaction risk ratings nor accepting risk mitiga- of the ECB, flooding the capital mar- tion apparently is deemed to protect kets with liquidity and relaxing the against some kind of model risk. If conditions for repos, an illiquidity-in- seemingly riskless facilities for which duced meltdown of the banking system little capital is needed should once again was prevented. turn sour largely then the limits posed Not surprisingly, regulators want to by the leverage ratio are a second line of avoid this to happen again. Therefore, defence against bank insolvencies. they have come up with a set of rules If risk weighted capital ratios and that are intended to make each bank the leverage ratio have to be fulfilled at more resilient with respect to liquidity the same time, then this opens another shocks (BCBS, 2010a and 2010b). To this arena for regulatory arbitrage (Blundell- end, two ratios are introduced as mea- Wignall and Atkinson, 2010). More- sures of short-term and medium-term over different business models will feel to long-term liquidity, respectively. In the restrictions in different ways. In the short run, liquid funds must be suf-

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ficient to cover the one-month net tween long-term capital demand and outflow under stress conditions. This short-term capital supply, can fulfil this requirement is captured in the Liquid- role of banks in the future. ity Coverage Ratio, which must always exceed 100 %. In the medium and long 4 Summary and Outlook term, a bank is required to be in The tone of my contribution is some- some kind of structural financing what sceptical. I have a raised a number equilibrium. The Net Stable Funding of more or less serious concerns pointing Ratio implements this idea. The avail- at potential shortcomings of the new able stable funding must be greater regulatory regime. I am far from sure than or equal to the required stable that the effects on the financial system funding. and the real economy will be as bad as Without going into any details here, the points I have made suggest and I one can of course say that an increase in a certainly hope that none of my fears will bank’s liquidity will very likely contrib- come true. Indeed, some recent empir- ute to a more stress resistant banking ical studies (BCBS, 2010c and d; system. But again, there is a price to be Deutsche Bundesbank, 2010; Slovik paid. One of the basic services banks pro- and Cournède, 2010) assert that the vide to their customers is maturity trans- new regulation will harm economic formation. This function, in effect one growth only a little and will overall raison d’être for banks, is about to get have a positive net benefit. lost. It is by no means obvious whether or Governments, central banks, and not others are better suited to incur this regulators had to take a number of risk which is the by-product of a higher actions very fast. They also have come standard of living (Hellwig, 2009). up with a new regulatory setting very The Liquidity Coverage Ratio in- fast, maybe too fast. Given the struc- duces a preference for government tural changes, which may result bonds over SME loans (Blundell- from the introduction of new mea- Wignall and Atkinson, 2010). In addi- sures, it seems reasonable to me to give tion, the Net Stable Funding Ratio re- the new regulatory framework another stricts long term lending considerably. close look. Llewellyn (2010) adds a For countries like Germany and its wide range of complementary and SMEs, with a less developed bond mar- substitutional measures, respectively. ket and a long and strong tradition of Some of the proposals, even those that long-term bank lending, this will most are already part of Basel III, should be likely be more harmful than for coun- reconsidered from a theoretical per- tries where firms directly use the capi- spective and backed with more empiri- tal markets to obtain long term fund- cal data. If my paper contributes to this ing. If the longevity of the funding of endeavour, it has achieved its objective. real investments constitutes a major Issues like a level playing field and the concern for firms then the introduction move of previous banking activities to a of the Net Stable Funding Ratio may less regulated or even unregulated part eventually become another obstacle for of the financial system are much too corporate investments. We do not serious to be accepted without scrutiny know yet whether the capital markets, as the necessary price for the restabili- without a financial intermediary be- sation of the banking system.

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References Basel Committee on Banking Supervision. 2009. Revisions to the Basel II market risk framework. Bank for International Settlements. Basel. Basel Committee on Banking Supervision. 2010a. Basel III: A global regulatory framework for more resilient banks and banking systems. Bank for International Settlements. Basel. Basel Committee on Banking Supervision. 2010b. Basel III: International framework for liquidity risk measurement, standards and monitoring. Bank for International Settlements. Basel. Basel Committee on Banking Supervision. 2010c. An assessment of the long-term economic impact of stronger capital and liquidity requirements. Bank for International Settlements. Basel. Basel Committee on Banking Supervision. 2010d. Assessing the macroeconomic impact of the transition to stronger capital and liquidity requirements. Basel. Blundell-Wignall, A. and P. Atkinson. 2010. Thinking beyond Basel III: Necessary solutions for capital and liquidity. Financial Market Trends. Issue 1. 9–33. Deutsche Bundesbank. 2010. Finanzstabilitätsbericht 2010. Frankfurt. Gaumert, U., Götz, S. and J. Ortgies. 2011. Basel Ill – eine kritische Würdigung. Die Bank. Issue 5. 54–60. Hellwig, M. H. 2009. Systemic risk in the financial sector: An analysis of the subprime-mortgage financial crisis. De Economist 157. 129–207. Jensen, M. C. and W. H. Meckling. 1976. Theory of the firm: Managerial behavior, agency costs, and ownership structure. Journal of Financial Economics 3. 305–360. Llewellyn, D. T. 2010. The global banking crisis and the post-crisis banking and regulatory scenario. Amsterdam. Modigliani, F. and M. H. Miller. 1958. The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review 48. 261–297. Slovik, P. and B. Cournède. 2011. Macroeconomic Impact of Basel III. OECD Economics Department. Working Paper 844. Paris. Stiglitz, J. E. and A. Weiss. 1981. Credit Rationing in Markets with Imperfect Information. American Economic Review 71. 393–410.

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VOWI_Tagung_2011.indb 119 03.10.11 08:28 VOWI_Tagung_2011.indb 120 03.10.11 08:28 Session 3: Addressing Macroeconomic Imbalances

VOWI_Tagung_2011.indb 121 03.10.11 08:28 Wolfgang Duchatczek Vice Governor Oesterreichische Nationalbank

VOWI_Tagung_2011.indb 122 03.10.11 08:28 Introductory Remarks

Dear distinguished speakers, Union and – especially – on the euro dear participants! area. Thomas Wieser is Director Gen- I would like to welcome you to the sec- eral for Economic Policy and Financial ond day of our economics conference. Markets at the Austrian Ministry of This morning, we will discuss so-called Finance. Until recently, he has been the “macroeconomic imbalances”. It will be president of the Economic and Finan- clarified in both following presenta- cial Committee (EFC) of the European tions what is meant by this expression. Union. This body was set up to pro- For the moment it will suffice to say mote policy coordination among the that such imbalances are macroeco- Member States of the EU. It does pre- nomic developments that are not sus- paratory work for the Council of the tainable in the medium or long run and European Union on a diverse range of that are likely to result in an economic matters: assessments of the economic crisis – in a single country, a large re- and financial situation of Member gion or even worldwide if economic States, of financial markets, and the policy does not take action in time. dialogue between the Council and the This session will be dealing with European Central Bank. Mr. Wieser macroeconomic imbalances on a re- was thus deeply involved in mitigating gional scale – the European Union – the consequences of the great recession and on the global level. It is an honor to present our first speaker, distinguished professor Anne Krueger from the John Hopkins School of Advanced Interna- tional Studies (SAIS) in Washington, DC, who will focus on longer-term and global aspects of macroeconomic imbalances. She will discuss the role of international or multilateral bodies for financial regulation and the question of what lessons can be drawn from the Great Recession in terms of reforming these multilateral bodies and of developing new instruments, e. g. at the IMF or at the level of the G-20 heads of gov- 2008/2009 and in developing the pol- ernments. icy reactions at the EU and the national The consequences of the Great Re- level. cession will certainly be on the policy Mr. Wieser’s speech will cover the agenda in the years to come. I refer to history of policy coordination in the substantial levels of government debt European Union. The need for such co- in many developed countries. There are ordination and economic surveillance hotly debated issues such as the U. S. to prevent macroeconomic imbalances current account balance and Chinese was always recognized at the central exchange rate policy. And there are bodies of the EU. However, as he will further challenges ahead arising from describe in more detail, actual eco- population aging in a number of coun- nomic policy at national levels did not tries. match the policy recommendations Our second speaker is Thomas prepared at the EU level. The great Wieser who will focus on the European recession and the ongoing fiscal and

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financial turmoil show us painfully pean Financial Stabilization Mechanism where such inaction can lead. (EFSM) as well as the future European Furthermore, Mr. Wieser will dis- Stability Mechanism (ESM). Finally, he cuss the crisis management, especially will discuss the new instruments of fis- the creation of the European Financial cal and macroeconomic surveillance Stability Facility (EFSF) and the Euro- and the longer run policy implications.

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VOWI_Tagung_2011.indb 124 03.10.11 08:28 VOWI_Tagung_2011.indb 125 03.10.11 08:28 Anne O. Krueger Professor Johns Hopkins University Washington

VOWI_Tagung_2011.indb 126 03.10.11 08:28 Formulating International Economic Policy in the 21st Century

The entire world has had its most suc- tial for trade to flourish. Indeed, the cessful growth experience in all of his- Articles of Agreement of the Interna- tory over the past 60 years. The most tional Monetary Fund state that a major spectacular growth performance has purpose of the Fund is to “facilitate the been that of some of the emerging mar- expansion and balanced growth of in- kets, but living standards and related ternational trade”. indicators (health, education, and so The three global multilateral eco- on) have also risen markedly in most nomic institutions – the International low-income countries. Moreover, in- Monetary Fund (IMF), the World dustrial countries have experienced Bank, and the World Trade Organiza- more rapid growth than they did at any tion (WTO) – have all been important earlier time in their history. over the past 60 years in enabling the The success of the world economy international economy to function as is due to many things, but the growth well as it did. The IMF certainly con- of international trade in goods AND in tributed to international monetary co- services has certainly been a key factor operation, to the removal of exchange (e.g. Bordo and Rousseau, 2011, NBER controls (especially on current account Working Paper 17024). under Article VIII) and to international Growth in international trade financial stability. The World Bank’s spurred economic growth and eco- role in increasing understanding of the nomic growth spurred international challenges and policies for economic trade. In addition, an important stimu- development, and in financing has been lus to the expansion of trade was the important as well. And the World lowering of trade barriers (tariff and Trade Organization (earlier the GATT) nontariff). Quantitative restrictions on provided a forum for negotiations for trade in goods have virtually disap- multilateral tariff reductions, a locus peared and tariff barriers have fallen for setting rules and procedures for sharply, not only in the industrial countries, but also in emerging markets. As a result of trade liberalization (both multilateral and unilateral) and technical change which greatly lowered transport and communications costs and time, the international economy has become increasingly integrated. In- terdependence has grown markedly, as parts and components are produced in many different places and shipped to the place of final assembly. But greater interdependence has increased the importance of a smoothly operating international economy. trade (such as uniform customs decla- Trade and finance go together, of ration) and a mechanism for dispute course, as the recent Great Recession settlement, each of which was crucial amply demonstrated. A well-function- for the lowering of trade barriers that ing and stable financial system is essen- contributed so much to growth.

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In addition to these crucial func- mits more rapid growth of trade, while tions, each of the three multilaterals more rapid growth of trade enables ac- provided a pivotal forum in which celeration of economic growth and views could be exchanged, lessons higher growth rates for low-income could be learned from comparative ex- countries. More rapid growth of low- perience, and cooperative solutions income countries in itself increases could be sought. All of these were vital global growth, but it also enables faster to the successful growth of the past growth of industrial countries and sixty years. emerging markets. Going forward, the very fact that Some of the challenges are specific interdependence in the world economy to individual institutions, while others has increased so much makes these in- cut across institutions. I will address stitutions even more important for the the specific challenges first, and then 21st century. Each institution has a role conclude by addressing the two most to play, and a key determinant of the important common issues, support for multilateralism and governance. Turning first to the international financial system, no one reading a daily newspaper could fail to be aware of the cracks in the system that were revealed by the Great Recession. Moreover, the cracks cast the spotlight on the importance of multilateralism. Two challenges are the most urgent: determining standards for financial regulation and finding means to contain global imbalances to a manageable level. With respect to regulation, it is evident to all that if some countries adopt progress of the global economy is how relatively strict financial regulation well these roles can be carried out. while others do not, the financial insti- Multilateral solutions are essential for tutions in the countries with weak reg- addressing many of the ills that beset ulation will have an unfair competitive the international financial system dur- advantage. Their institutions will have ing the Great Recession. Future growth lower capital requirements and be able can be enhanced both by further trade to extend credit at lower interest rates liberalization especially in agriculture or make higher profits than their com- and services through the WTO and by petitors in countries with tighter regu- accelerated growth of the low-income lation, but, of course, they will be tak- countries supported by the World ing on more risk. Bank. The three international eco- There is widespread agreement that nomic organizations are the most care must be taken so that an appropri- promising fora for those issues to be ad- ate balance is struck between maintain- dressed. ing financial stability and providing Moreover, the effectiveness of each competition and incentives for financial institution will be enhanced by the suc- innovation. It is not necessary that all cessful efforts of the other two. A sta- countries have identical financial regu- ble and effective financial system per- lation, but a common framework is re-

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quired. Such a framework would re- pressures take longer to be felt and usu- quire agreement across all countries, in ally arise mainly through inflation. part because some will not agree unless When the deficit country was the others do and in part because when U.S.A. and the surplus country China there are significant holdouts the objec- (and the oil exporters after about tive of financial stability is less likely to 2004), however, the two sides were be achieved. To date, despite agree- mutual enablers. China’s willingness to ment on the desirability of a global reg- invest the surplus enabled current ac- ulatory framework, and steps taken un- count deficits to continue without the der Basel III, further multilateral agree- pressures that would have resulted had ment has proven elusive. the surplus been invested internally or There are a number of other issues had the rest of the world been more or regarding financial regulation, which, less in macroeconomic balance. The while not as significant as the regula- U.S.A.’s current account deficits would tory one, still deserve global attention. have been far more difficult to finance These concern understandings regard- without currency depreciation or ing the regulation of behavior of cross- higher nominal and real interest rates border subsidiaries and branches, on had it not been for the Chinese sur- the one hand, and of jointly owned pluses. It is estimated that Chinese con- banks, on the other. Again, the desir- sumption is currently not much more ability of such agreement is evident, but than 35% of GDP, surely a record low achieving such a framework has to date except during wartime, if then. proved elusive. The result of these mutually en- But if the issue of financial regula- abling global imbalances was very low tion is difficult, it pales in comparison (and even negative) real interest rates. with the difficulty of achieving a Low interest rates always encourage meaningful way of preventing global consumers to consume more, and espe- imbalances from recurring. There is cially to borrow to finance residential widespread recognition that global im- housing. They also encourage financial balances at a minimum greatly intensi- institutions and other investors to ac- fied, and perhaps even were the chief cept more risk in a search for yield, thus culprit in bringing on the Great carrying portfolios subject to more Recession. danger when circumstances change. It has long been recognized that And the search for yield also encour- there are far greater pressures on coun- ages other risky behavior, through such tries with unsustainable current ac- mechanisms as the “carry trade” as for count deficits to adjust than there are example when investors borrowed Jap- on surplus countries. In the case of def- anese yen at virtually zero interest rates icit countries, financing runs out or to invest in New Zealand dollar assets threatens to run out and the deficit which carried much higher interest country must take action or else be rates. At a minimum, a result of global confronted with a crisis. In the latter imbalances and the low real interest case, it may seek support from the IMF rates they engendered was a bigger and or other foreign agencies, but must in longer-lasting construction boom and a return take policy actions designed to larger portfolio of nonperforming loans prevent a recurrence of the crisis and when the downturn came. permit sustainability over time. But Even in 2005-06, the then-Manag- when a country runs a surplus, the ing Director of the IMF, Rodrigo de

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Rato, sought to bring together the large There is yet another set of financial deficit and surplus countries in a pro- issues looming on the horizon in the cess of multilateral consultations with a 21st century, which time limitations view to achieving agreement across prevent me from discussing. That is, at countries as to how to reduce the im- the present time, there is no interna- balances to more sustainable levels. The tional regime governing capital flows. participating six all agreed that imbal- Countries are free to discriminate be- ances were dangerous and that action tween countries, to tax capital flows, should be taken. Each side, however, or to impose any regime they wish to believed that the necessary corrective upon them. As capital flows increase in measures should be taken by the other. importance, and as the world economy As a result, nothing happened. The becomes increasingly integrated, these IMF had, and has, no legal authority to issues will become increasingly serious. bring about any needed adjustments. As yet, they are not at all addressed ex- For a period during the Great cept in bilateral and plurilateral agree- Recession, global imbalances receded. ments, many of which are potentially The U.S. current account deficit, which discriminatory. had risen to over 6% of GDP, fell to The increasing breadth and depth of 2.9% in 2009. But as the upturn has the international financial system proceeded, it appears that global imbal- served the real economy well, at least ances are once again starting to increase. for the last half of the 20th century. After the initial shock of the Great That, in turn, enabled the rapid growth Recession, the G-20 also sought to find of trade. International trade in goods a corrective mechanism for global im- and services was spurred by growth, by balances. They asked the IMF to under- falling transport and communications take a mutual assessment process costs, and by trade liberalization, both (MAP), under which the large coun- unilateral and multilateral under the tries would have their current and pro- GATT, and then the WTO. spective macroeconomic policies scru- Because transport and communica- tinized by the others, in the hope that tions costs had already fallen so much this would bring about the necessary prior to 1950, the biggest spur to in- changes. creased trade (in addition to growth it- It is too soon to assess the effective- self) was the virtual elimination of ness of the MAP. To date, however, quantitative restrictions and reduction there is little evidence that any of the of tariffs, at least on manufactured large countries have adjusted any of goods, to levels less than one tenth of their macroeconomic policies because those (even among the industrial coun- of peer pressure under the MAP. The tries) prevailing at the end of the Sec- problem is all the more urgent because ond World War. of the looming demographic pressures That trade liberalization required on fiscal balances in the countries with an international organization, both as a aging populations. The least painful forum for reciprocal tariff reductions policies for addressing these imbalances and as a means for dispute settlements will be those for achieving more rapid and agreement on trade rules. The growth; yet the reemergence of global GATT/WTO served the world so well imbalances could bring about the oppo- that many countries, now successful site result, and perhaps even another emerging markets after having followed crisis. protectionist policies in earlier years,

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liberalized unilaterally in the past two with no evident progress), the author- decades. ity of the WTO itself is eroded just at a However, there is a great deal more time when it needs enhancement. to be done. As the global economy has Moreover, there are looming prob- progressed, business services have be- lems that will require multilateral solu- come increasingly important, and there tions that will greatly affect the world are huge gains to be made if services and the world economy. Chief among trade can be significantly liberalized. these is concern about the environ- This presents a challenge because many ment. This is intimately linked to trade of the barriers to trade in services (li- because of the costs imposed on pro- censing requirements, domestic regula- ducers of various mitigation activities. tion of insurance companies, etc.) are Unless agreements can be reached uni- not border measures. But the scope for gains is great indeed. Likewise, while trade in manufac- tures is now fairly open (although there remain tariff peaks and some countries that have retained fairly high walls or protection), world agriculture is in dis- array. The restraints on domestic subsi- dization, price supports, and other interventions are few. Most agricultural economists believe that this results in great inefficiencies in world agriculture. This in itself is a serious problem for the world economy, but with the emerging concerns about rising food versally, producers in countries whose prices and possible food shortages, producers experience higher costs be- there is a real risk that, in the absence cause of mitigation requirements will of international agreements commit- understandably seek protection from ting exporting countries to continue foreign imports, arguing that foreign exporting in times of high prices and producers have an unfair cost advantage importing countries to reduce or re- when not subject to the same regime. move their barriers to imports, protec- Attention needs to turn to these 21st tion in agriculture will actually in- century issues, but failure to complete crease. That would not only exacerbate the Doha Round stands as a roadblock problems for consumers, but it would to focusing on those important con- likely reduce the growth potential of cerns. the overall global economy. It seems evident that the Doha The undoubted potential gains from Round should be completed not only liberalizing trade in agriculture and because of the gains to be had (includ- services still further were a major rea- ing those already negotiated) under the son for starting the Doha Round of agreement but to move forward to the trade negotiations under the WTO in next set of issues, which will be espe- 2001. But those negotiations have foun- cially difficult. dered to date. With the negotiations Finally, I come to the role of the dragging on (there was a ministerial World Bank. Its greatest contribution meeting in Geneva at the end of April lies in supporting efforts by low income

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countries to achieve self-sustaining trade has increased. Yet their shares of economic growth. For those countries, the votes in the World Bank and the private capital markets are not willing IMF remained unchanged for a long pe- to invest, often for reasons pertaining riod. (The WTO is in a different cate- to the absence of an appropriate legal gory here because, to date, WTO deci- framework or because safeguards for sions must be unanimous). Changes are investments are inherently unreliable. taking place, but relatively slowly. The While, as I said at the beginning, the need for voting power to reflect more world economy has been enormously appropriately the relative importance successful over the past sixty years, of the various member countries is evi- some countries have been left behind or dent. left out. The challenge for the World A cry has also been raised about the Bank (and for the countries themselves, traditions under which the heads of the bilateral donors, and all the multilateral IFIs have traditionally been American organizations) is to improve under- at the World Bank and European at the standing of the barriers to more rapid IMF. Many have called for an opening development, and to extent the types of of the selection process to nationals of support that can accelerate growth in all countries. the low-income countries. Success in Doing this is clearly desirable if a that endeavor would in itself be a desir- means can be found for insuring that able outcome but, in addition, would the selection proceed is designed to spur global growth. find the best qualified person, and not Before concluding, let me turn to simply a person from a given region or the two challenges that confront all nationality. The Bank, the Fund, and three multilateral international eco- the WTO, have survived as well as they nomic organizations for the 21st cen- have in significant part because they tury. They are crucial for successfully have been, and are, meritocracies. addressing the challenges, I have al- Finding a selection mechanism under ready outlined. which candidates are screened on the The first, and more concrete, is the basis of qualifications and aptitude for problem of governance. As China, In- the job, rather than simply on the basis of geographic origin, is eminently desirable, but may be difficult. However, I have saved the biggest challenge until last. I hope, I have said enough to convince everyone that growth in the 21st century will be much more satisfactory if the multilateral institutions can meet the issues associated with financial regulation, global imbalances, capital flows, trade in services and in agriculture, and much more. Those problems will be difficult, if not impossible, to address satisfactorily in the absence of multilateral agreements dia, Brazil, and other countries have and undertakings. achieved more rapid rates of growth, But addressing these issues requires their share of global real income and a commitment on the part of countries

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and their citizens to the multilateral remained entirely concentrated on sub- system. At the present time, and persistence agriculture, as had been the haps in part because of the Great Re- case before plantations and would prob- cession, there appears to be considerably have happened in the absence of able disenchantment with multilateral- globalization! To be sure, they would ism and a tendency to blame the have been better off still if the terms of international economy for many ills. trade had not deteriorated, but that While the international economy only says that the gains from globaliza- and its governance is far from perfect, tion had been somewhat reduced, not the world, and almost all the people in that they had been negated. it, are far better off than they were Many of the complaints about glo- fifty, a hundred, or two hundred years balization seem to be of a similar na- ago. I once attended a meeting where a ture: Things could be better. And that representative of an African country is surely true. But they will be better complained that his great grandfather when globalization is made to work had moved to work on a plantation in better, and the problems confronting us the late 1800s, and that the family’s have been solved. livelihood had come from that planta- They will not be better if globalization ever since; however, because glo- tion is reversed. Multilateral solutions balization had hurt the country’s terms and policies have served the interna- of trade, the ten members of the cur- tional economy very well over the past rent generation employed on the plan- two hundred years. One can only hope tation had had one month’s less work that recognition of this, and support for that year than in the past and it was the multilateralism, will enable the inter- fault of globalization. Without knowing national economic institutions to re- the particulars, one was left wondering solve the key issues I have discussed and how well off that entire generation be prepared to address the future issues – the ten plus their families – would that are sure to arise with continued have been had the country’s economy successful world economy growth.

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VOWI_Tagung_2011.indb 133 03.10.11 08:28 Thomas Wieser Director General Austrian Federal Ministry of Finance

VOWI_Tagung_2011.indb 134 03.10.11 08:28 Macroeconomic Imbalances within the EU: Short and Long Term Solutions

What is an Imbalance? tion of countries, and may have impor- What is a macroeconomic imbalance? tant spillover effects. It has an array of And do macroeconomic imbalances lending instruments at its disposal that matter? Two easy questions. Put them can be utilized if imbalances lead to to an economist and she or he will most capital flows that are inadequate for likely give you an authoritative descrip- satisfying the external financing needs tion or definition of such an imbalance; of a country. The G 20 process has re- and will then proceed to authoritatively discovered this issue in the light of tell you that they either matter enor- global imbalances in current account mously, or not at all. A pattern will positions, and has agreed on a surveil- emerge: first, the definitions or de- lance exercise. scriptions will not be consistent with each other; second: if they matter, then usually abroad. I will start off with a simple definition: a macroeconomic imbalance is the (negative or positive) position of a domestic, external or financial variable in relation to a certain norm. This position may – if uncorrected over time – make the national savings/investment balance so untenable that it self-corrects abruptly, thereby causing significant adjustment shocks domestically; in the case of large economies also abroad. Imbalances are caused by economic policies, or by their absence. They are Addressing Potential Imbalances in the Euro Area therefore a lagged indicator of other variables that developed at a pace or in a Within the European Union risks of direction that is not commensurate macroeconomic imbalances were rec- with the overall balanced development ognized in the Treaty. A set of eco- of an economy. At stake therefore is the nomic policy coordination tools was issue of sustainability and liquidity. A designed in order to prevent such dis- deficit or a surplus per se may well be a equilibria; and a balance of payments desirable equilibrium outcome and thus support facility was set up in order to not an imbalance, for instance reflect- assist in overcoming such a crisis. ing an efficient international allocation The design of the euro area as per of capital. the Maastricht Treaty followed the As imbalances influence develop- principles that ments in partner countries they are an – at entry, fulfillment of and adher- important factor in international policy ence to the fiscal, financial, mone- making. At the global level the main tary and exchange rate criteria task of the IMF has been and is focused would guarantee that the relevant on preventing, detecting or mitigating economic parameters that could en- national economic imbalances that may gender imbalances were largely in lead to an unsustainable external posi- balance,

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– market discipline will be sufficient Upon entry into monetary union for nudging the public sector to- and the elimination of exchange rate wards prudence and sustainability risk, risk premia moved downward by prohibiting monetary financing with great speed, by a good 800 basis and a privileged access of the public points for some Member States com- sector to the financial sector, and pared to only a couple of years previ- by a rule on not bailing out Member ously. Subsequent developments of States, rapid credit growth and accelerating – loose economic policy cooperation private indebtedness were undoubtedly and more stringent fiscal policy co- a result of these developments. There is ordination through the relevant a bright side to this, as increased private Treaty Article and (later) the Stabil- sector leverage post-1998 may have had ity and Growth Pact (SGP) would a one-off “convergence euphoria” com- be sufficient for keeping these vari- ponent. ables on track, together with an in- Economic policy cooperation in the dependent monetary policy geared euro area institutionally takes place exclusively towards price stability, (only) in the Eurogroup – the (monthly) – and such was the conviction that no meeting of euro area Finance Minis- imbalances could emerge that no fi- ters, the ECB President and the Com- nancial safety net was designed to missioner responsible for Economic and provide balance of payment support Financial affairs. It is prepared in the to euro area Member States in dif- Economic and Financial Committee/ ficulties. the Eurogroup Working Group. When setting up monetary union the For well over a decade the debates question of asymmetric shocks received were contentious primarily when it wide attention, as this was seen as the came to applying the SGP. Greece ac- weak flank of a monetary union with ceded EMU on a wrong statistical fiscal basis. Nearly ten years ago the Pact faced its first stern test in view of excessive deficits in Germany and France. With the decisive meetings taking place under Italian Presidency the SGP was watered down. Beyond fiscal coordination a monitoring of overall economic developments takes place; Ireland in 2002/03 actually received a warning for expan- sive fiscal policies fuelling inflation that were considered to be untenable if not corrected. This produced political reactions from the Irish side that were so less than perfect factor mobility across negative that other euro area Member national borders, and autonomous fiscal States were possibly shocked into a pol- policies. The issue of divergent devel- icy of non-interference especially in opments of competitiveness were less non-fiscal policy areas. widely discussed, and seen as a lesser In the meantime financial integra- order problem. tion was proceeding strongly after the adoption of the euro, and cross-border

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capital flows into government debt, – and, finally, that the euro area had a non-tradeable sectors and interbank quasi-coercive policy instrument in markets were significant. The asset the form of the SGP, but no other price increases in the non-tradeable policy tool at its disposal that could sectors (mainly real estate) were ana- realistically be expected to influ- lyzed and discussed extensively, but ence policy behavior of national ac- with the exception of Spain policy reac- tors. As all other policies were tions were muted. And even the Span- firmly anchored in national respon- ish reaction to the real estate develop- sibility, from wage to financial poli- ments did not suffice, as later develop- cies the incentives were skewed ments showed. Stronger reactions were against policy coordination. Policy prevented by domestic interest groups cooperation in and of the euro area or simply due to analytical failure of was firmly confined to the Euro- domestic policy makers. The domestic group meetings of Finance Minis- imbalances were largely seen as consti- ters, and thus reflected the fiscal tuting a problem of the Member State approach to policy coordination as concerned, not of the euro area as a laid down in the Treaty. whole. The build up of negative current ac- Addressing Imbalances in the EU count positions of euro area Member In the European Union of 27 economic States over the last decade was on the policies, even though a matter of com- other hand – with a few exceptions – mon responsibility according to the not seen as critical. By contrast, the Treaty, were in reality not closely coor- drifting apart of competitive positions dinated. ECOFIN work tends to be fo- as measured by diverging relative unit cused on legislative acts required for labor costs was increasingly seen as a completing and deepening the Internal centrifugal issue for the euro area by Market. The Treaty based Economic the European institutions. President Policy Guidelines, beloved by their au- Trichet regularly attempted to con- thors and drafters, are decided upon by vince Finance Ministers that these de- Ministers without substantial discus- velopments were unsustainable, but the sion, and successfully shelved after the Ministers concerned did not act or re- traditional pre-summer decision. Pro- act sufficiently. The reasons for this cess produces papers, not substance, complacency were diverse, but could unless there is a negative externality as- include the following, namely sociated with policy inertia. – that imbalances in a currency area The issue of external imbalances ac- were considered to be self-correct- tually received increasing visibility ing through medium-term nominal amongst policy makers, inter alia in the adjustments that would, admit- context of the ERM II procedures as tedly, take some time to occur (but some new Member States prepared for occur they would – more or less au- or attempted entry into Monetary tomatically – as losses of price com- Union. petitiveness triggered the appropri- The most visible case of imbalances ate price/quantity adjustments), was that of Latvia, where euro area of- – that sovereign risk differentials in a ficials engaged in intensive debates with currency union virtually ceased to the authorities on the causes of their exist and as there was no risk there current account deficit, and appropri- would be no punishment, ate remedies. Seemingly, there were al-

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ways good reasons for the large deficits sector was seen as being a consequence not being a concern – ranging from id- of high growth, and not a cause of over- iosyncratic shocks due to the import of heating and thus unsustainable growth; railway stock to the nearly tautological and increasing contingent liabilities due effect of growth differentials in the to forex exposures were seen as provid- catching up process. In those days ev- ing cheap (long term) finance for pri- ery policy maker could recite Balassa- vate households where domestic capital Samuelson effects even if asleep. markets had no long-term instruments Discussions with many New Mem- available. ber States from 2004 onwards focused In the end, the conditionality in on: balance of payment support programs – External Imbalances: current ac- addressed these issues, but we could count positions and real exchange have gotten there more easily with a rate movements received closest at- higher degree of better policy coordi- tention, international reserve posi- nation and cooperation. tions were hardly ever analyzed; In these programs, the issue of ex- – Financial imbalances: credit growth change rate adjustment was a highly and foreign exchange credit growth contentious one: a traditional approach were addressed, but were inten- would have called for a rapid exchange sively discussed only when the sus- rate adjustment in order to kick start tainability of fiscal and financial po- export activity; with balance sheets sitions in CEE were already at the largely denominated in euro this would forefront of international attention; have bankrupted many domestic credit there was no meaningful ongoing holders, and consequently would have dialogue between supervisors and significantly increased the write off re- macro-economic authorities at the quirements of the banking system European level at an early stage that (widely foreign owned). A mixture of could have contributed to crisis pre- economic interests and analytical dis- vention or mitigation; agreement produced differing policy – Structural weaknesses in product prescriptions, but mainly in favor of ex- and factor markets, linked increas- change rate stability. This required ingly to issues of competitiveness rapid internal devaluations through the – Fiscal imbalances were continu- wage and price mechanism. Ironically, ously monitored, but the policy ad- the countries outside the euro adopted vice of the EU was not taken seri- similar adjustment strategies to those ously by all policy makers to whom within the euro area. The obvious ex- warnings were addressed; a good ception is the UK where we have seen example is Hungary which has re- sterling devalue against the euro area as mained in an excessive deficit pro- the UK attempts to address its external cedure from the outset of its mem- and internal imbalances. bership without major political problems. What Is New in Our Tool Kit, and Increasing external disequilibria due to Why? a loss of competitiveness through As the financial crisis turned more and steadily rising real unit labor costs were more into a sovereign debt crisis for pe- seen by national policy makers as being ripheral euro area economies our as- largely caused by growth differentials; sessment of weaknesses in our toolkit increasing indebtedness of the private evolved. Our understanding of the me-

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chanics of the euro area changed as tegrated financial market with decen- markets also changed their perception tralized fiscal backstops and supervi- of risk differentials within the euro area. sors. Given the “industrial policy” type Progress in our toolkit therefore behavior of national governments to- builds on the (relatively new) fact that wards their financial sectors market within a currency area with decentral- based solutions to financial crisis are ized fiscal policies there is room for dif- more difficult in the EU than in other ferentiated sovereign risk assessments by markets. This in turn has led to access to markets being contingent on investors being convinced of the sustainability of policies. At the outset of monetary union there had been attempts to produce “shadow” market mechanisms in order to discipline Member States into fiscally and financially responsible behavior. Now, we have what we wanted. As some examples showed, quite dramatically, fiscal discipline in the EU and especially in the euro area had not been adequately stringent, thus large economies that have symmetrical leading to inter-temporally unsound responsibilities for financial and fiscal fiscal positions. This was not due to issues. recognition lags (with the one or the other notable exception) but due to the The Safety Net political economy involved in collabor- As already mentioned the euro area did ative decision making and the loss of not have an adequate safety net for market discipline as sovereign risk be- Member States facing external financ- came only a lower-order function of ing constraints until 2010. The com- debt and deficits. plete tale of the debates on whether At the same time the widening of such a mechanism should be based on differentials in competitiveness oc- EU, Community or intergovernmental curred as wage and price developments methods needs to be told separately. were not oriented towards stable (no- After lengthy and very principled tional) real exchange rates within the debates Greece received a loan from euro area. National wage and structural (most of ) the euro area Member States policies need to better reflect this, as well as one from the IMF. The policy which is especially interesting given the conditionality was and is strict, and the autonomy of decision making of policy pricing of the euro area loan was de- actors, especially in the field of wage signed so as to prevent moral hazard, setting. i.e. so as not to incite others to enter And, lastly, the contribution of the such a program. These concerns were financial sector to imbalances shows fairly rapidly seen as naïve. The pricing clearly that financial regulation, but es- has been changed in the meantime. pecially supervision need to be geared Contrary to some expectations more to a highly but not completely in- markets were not convinced by the

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Greek adjustment program that all that proaches to policy failures and prob- needed to be done had been done, and lems, and would ensure that regional spreads continued to remain high for solutions did not cause global imbal- many euro area Member States. In May ances. 2010, after lengthy and politically charged negotiations, the EFSF and Fiscal and Macroeconomic EFSM were set up. These two facilities Surveillance were designed to have a volume of EUR Within the EU, and especially within 440 and 60 billion respectively. Lend- the euro area, a lot of reflection has ing from these two facilities, in con- gone into the design of systems that junction with the IMF, is ongoing for should ensure that a repeat of the fiscal Ireland and Portugal. imbalances of the past decade can be Recognizing that these temporary avoided. A set of 6 legislative acts has facilities did not answer the need for a been agreed on by Ministers, and is permanent and more structured safety presently being negotiated with the net the decision was taken in March European Parliament. These acts should strengthen the SGP by a variety of measures: it should become more difficult to politicize (and thus bring to a halt) an excessive deficit procedure; there should be a higher degree of quasi-automaticity in some of the procedures and sanctions at an earlier stage; not bringing down debt levels at a steady pace towards and under 60% of GDP should give rise to sanctions; and the quality of national fiscal frameworks should be enhanced. Sanctions should be more easily imposed, and should be gradual in the 2011 to have, as of mid-2013, a perma- sense that Member States should not be nent euro area safety net, the European automatically threatened with the Stability Mechanism. It will dispose of “atomic bomb option” of the highest paid-in capital of EUR 80 billion, and financial sanctions. an overall lending volume of EUR 500 Additionally, the EU has designed a billion. As its predecessors it is ex- macro-economic surveillance process pected to lend in conjunction with the that should detect the emergence of ex- IMF. ternal and internal imbalances at an The latter issue is an important early stage. A wide range of indicators point in the global discussions on re- will be used in an alert mechanism in gional safety nets: whilst it appears in- order to give early warnings. Such creasingly necessary to have regional warnings will be issued to the Member solutions for regional problems it would State concerned, and in the case of be politically and economically coun- excessive imbalances with an invi tation terproductive if they were not all linked to correct the emerging imbalance to a global instrument. This would en- through appropriate policy action. If no sure a hub and spokes system with qual- policy action is taken, sanctions could ity assurance, comparability of ap- be applied. This reflects the lessons

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learned over the last years that a wide stability groups we hope to reduce the range of policies may have area-wide probability of such occurrences by in- destabilizing influences, whilst policy creasing the quality and timeliness of responsibility remains firmly at the na- mutual information across relevant tional level. Producing processes that markets. satisfy both constraints is and will be The myopia of supervisors confined the challenge as we emerge from the to seeing only small parts of important crisis. market developments outside their ju- risdiction was an issue in the crisis. Financial Stability Instruments Through the establishment of the three Within the EU the financial sector is European authorities for banking, in- especially closely interconnected, even surance and securities we hope to though financial integration is incom- achieve better supervisory cooperation, plete and uneven. The growth of cross and a larger and more consistent set of border activities has been pronounced single or very similar rules and prac- over the past two decades as a conse- tices. Over time we will need to move quence of Internal Market legislation, towards a European supervisor, but the and later of the single currency. Imbal- politics of Europe are not ready for this ances in the financial sector have gener- step yet. And then the question of bur- ally been pronounced in industrialized den sharing and back stopping needs to economies in the past years, and espe- be more clearly solved. cially in the EU the process of cleaning Whilst micro-prudential progress up balance sheets is not over yet. Due has been achieved by building on exist- to these strong inter-linkages contagion ing groups, macro-prudential surveil- risks play an important role in Europe. lance in the EU has started from Not so long ago this interconnectedness scratch. The European Systemic Risk was seen as an important stability fac- Board (ESRB) was set up last year, and tor through risk diversification. Both has become operational as of the begin- may be true, though not at the same ning of this year. It is closely associated time. with, but separate from, the ECB. Its A specific feature of the EU finan- function is to detect and warn about cial sector is that due to the dense web emerging imbalances, with a strong fo- of branches and subsidiaries the ques- cus on financial sector imbalances. But tion of fiscal responsibility for banking its surveillance function can obviously sector support is less clear than in other not be confined to the financial sector, parts of the world. Is the home govern- and needs to encompass all those pa- ment “responsible” for all activities of rameters and sectors which could cause its banks? Or is it responsible for activi- such imbalances to emerge. An exam- ties of its banks, including branches ple would be a real estate bubble which, abroad, but not of subsidiaries? Or is it if uncorrected, would cause imbalances only responsible for domestic activities? in the real economy and the financial As the governments of Iceland, the UK sector of the country concerned. And and the Netherlands know, this is more possibly beyond. We will need to work than an academic question! on the inter-linkage of the work of the The issue of burden sharing has still ESRB and the EU’s macroeconomic not been completely clarified, and may imbalance procedure so that they com- never be completely clarified ex ante. plement each other and do not overlap With the introduction of cross border or underlap. We will need to avoid un-

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necessary duplications with the IMF have the processes at the European FSAPs. And we will need to find an ap- level. How do we now get the results? propriate way of channeling advice to As we have seen policy areas well policy makers in a manner that maxi- outside the domain of central bankers mizes the probability that they will act. and Finance Ministers have contributed to existing imbalances. Time and again Does this Suffice? What Are the Finance Ministers return from Brussels Politics of the Longer Run? with advice about their fiscal plans that The EU has reacted impressively so as the Commission and the Council have to decrease the probability of future carefully worked out, and at home they crisis. It has also set up a safety net that do not have an audience. And for the should be available for those Member policy fields that are somewhat re- States that despite all surveillance exer- moved from fiscal policies this holds cises fail to correct their imbalances in even more true. a timely manner. Does this suffice? Better institutions for supervision As set out above a number of new of a European financial sector will be procedures have been set up. They are part of the long term solution, building administered by Finance Ministers, and around a single European supervisor. If in some instances the reports and anal- this is achieved, the financial sector ysis go the Heads of State. But do they will increasingly become a sector which address the root causes of recent imbal- can contribute to European growth ances? with lesser risks of regional instability. The euro area is set up as a decen- Then the vision of risk diversification tralized policy space with a single mon- will have become more of a reality than etary policy. The purpose of many of it is at present. The political and fiscal the new EU policy processes and mea- implications of such a solution are com- sures is to incite nominally (largely) in- plex, and therefore will not come about dependent policy makers to behave in a in the short run. responsible manner, i.e. to ensure the Looking at wage and price develop- sustainability of their policies, and thus ments in a number of Member States it is clear that external constraints have historically played and still play a smaller role in some countries than, say, in Germany or Austria. This is un- derstandable as the diverse national institutions come from a different background of exchange rate policies, and thus a different tradition of wage and price policies. We will therefore need to develop a common understanding of national actors and institutions of what is required in terms of mutually compatible policies across a large range of policy areas. also share in the responsibility for the It will be necessary that social part- sustainability of the euro area. ners from all Member States share an One element obviously is that we analysis of prospective developments need better national policies. We now of growth, productivity and prices.

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Wage formation and price develop- In short: the euro area needs to be- ments need to have a clearer focus on come a truly political and broadly based stability and sustainability than they policy area. It needs to move beyond have had in the past. In some Member the narrow confines of fiscal coordina- States of the euro area it could be tion and start economic policy coordi- argued that some social partners have nation. The political process needs to not yet joined monetary union. It will be opened up to a larger class of policy be a crucial element of European policy coordination other than monthly making, with an important role for the meetings of finance ministers. There- President of the Euro group to bring fore, guidance but also responsibility about this historic change. of Heads of State must become the Policy makers responsible for struc- norm without micro-management, and tural policies need to understand the with a truly broad based and well role and function of their policy mea- prepared discussion. If this is achieved sures in the context of intra-euro area the euro area will be able to play an imbalances. At present this is still not the portant role at the global level. If this is case. Policy makers responsible for the not achieved, then the processes we design and parametrics of retirement have designed will not suffice to stop policies for example need to under- imbalances emerging in the future stand the euro area aspects of intertem- through an adequate mix of process and poral imbalances. policy.

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VOWI_Tagung_2011.indb 145 03.10.11 08:28 Harald Badinger Professor Vienna University of Economics and Business

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1 Introduction strategies does not help. We had better Does Europe need a growth strategy? proceeded with the implementation of And if so, does it need a new growth existing strategies; and certainly more strategy? These are the two questions I focus is warranted. In the following, I will address in the following. will summarize what I believe we know In midth of the most severe eco- about a proper EU growth strategy, nomic crisis ever since the Great emphasizing what I regard as particu- Depression, this year’s economic forum larly important. in Davos has come up with an astonish- ingly optimistic scenario. According to 2 A Few Words on the Crisis a study by the Global Research Division In the aftermath of the financial and of the Standard Chartered Bank (Lyons economic crisis, restoring confidence is et al., 2010), we are about to experi- and remains the top priority. The “lon- ence a “super-cycle” of historically high ger uncertainty is allowed to linger, the growth over the next decades, pro- greater the damage to confidence.” pelled by booming trade, investment (Eichengreen, 2010, p. 25). We cannot and urbanization. The 2004 Nobel lau- go on with business as usual. The roots reate Ed Presott predicts that the of the financial and economic crisis “whole world’s going to be rich by the have not yet been eliminated. The re- end of this century.” quired steps have been spelled out in a There are reasons to be skeptical of recent VoxEU book by a group of lead- this overly optimistic forecast, but even ing economists in that field (see Bald- if we were to believe that a new golden win, Gros, and Laeven, 2010). Since area is ahead of us, pushing average this is not the topic of this paper let me GDP per capita up to unprecedented levels, this does not render thinking about growth strategies irrelevant. An equally distributed outcome is highly unlikely, and the successful post-war growth performance of EU Members States holds no promise for the future. This is not only an economic issue: The EU has a political role to play in this world, and its assertiveness will also depend on its economic weight in the world economy. Hence, the EU definitely needs a growth strategy to keep its position as a relevant player in the world economy. just restate the key conclusions of the The question that remains to be ad- “eurozone rescue” report (Baldwin and dressed is whether the EU needs a Gros, 2010, p. 18): new growth strategy. In the following, In the field of monetary policy: I will argue that it does not. While I am i) embedding financial stability consid- far from claiming that the field of erations into the ECB’s policy mix, proper growth strategies is fully re- ii) clarifying the fact that the ECB is not searched, I am convinced that we do a fiscal institution. know enough about where to go. Re- In the field of fiscal policy: i) clari- peatedly reinventing official growth fying the operational and legal frame-

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work of the Special Purpose Vehicle, – Boost investment in knowledge including limits on the amount of fiscal – Improve the macroeconomic policy transfers, ii) making the process of framework for EMU longer-term fiscal consolidations credi- – Redesign policies for convergence ble through the establishment of inde- and restructuring pendent national fiscal boards, which – Achieve more effectiveness in deci- are coordinated at the European level. sion-taking and regulation In the field of banking and financial – Refocus the EU budget. market regulation: i) improving trans- Unfortunately, it is no exaggeration to parency by public release of stress tests, say that the report had no substantial ii) acknowledging losses early, recapi- impact on policy making of the EU and talizing financial institutions with ap- its Member States. For space con- propriate loss sharing by the private straints, I am not able to address each of sector, ii) improved regulation at a Euro- its recommendations. Rather I will pick pean level to deal with cross-border out three of them, which I regard as bank failures, iii) introducing a Euro- particularly important, highlight some pean Debt Resolution mechanism. recent research and consider the cur- In the field of competitiveness: i) rent state of the EU’s economy policy repairing macroeconomic imbalances in the respective field. through wage adjustments, facilitated by labor market reforms, ii) dampening 3.1 Make the Single Market national wage and price developments More Dynamic undermining their competitiveness. The Single Market is and remains the And finally, accelerating structural re- cornerstone of European economic in- forms of goods and labor markets to tegration. A functioning Single Market enhance economic growth.1 This leads fosters competition within the EU, me to the key topic of my talk. thereby increasing productivity and helping to improve the EU’s competi- 3 An Agenda for a Growing Europe tiveness in the world economy. The EU We do need an agenda for a growing is certainly on the right way here, but it Europe but we do not need a new one. needs to accelerate. The Single Market, Such an agenda has already been worked launched in the mid-1980s, eventually out in considerable detail by a group came into force on 1 January 1993. Evi- of distin guished economists, headed by dence suggests that the Single Market André Sapir, on request of Romano had its intended effect in manufactur- Prodi, president of the European Com- ing industries, but not for services mission at that time. The conclusions (Badinger, 2007; European Commis- of the so-called Sapir report are still sion, 2002). The EU Services Directive valid today and call for an active imple- should have been the next step in this mentation. respect. A heavily revised version of the The Sapir report lists a six-point European Commission’s original pro- agenda for the EU and its Member posal was ultimately adopted in De- States (Sapir et al., 2004): cember 2006 and came into force at the – Make the Single Market more dy- end of 2009. This is more than 15 years namic after the Single Market should have

1 A detailed discussion and priorization of this long list is contained in Baldwin, Gros, and Laeven (2010) and the essays therein.

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been in place already! Even worse, re- best performing country), the gains cent studies suggest that the macroeco- would be even larger, more than six nomic effect of the highly diluted Ser- times of the current GDP. Of course, vice Directive will be fairly modest one can challenge these point estimates, (Badinger and Maydell, 2009; Badinger but taking half of the lower bound esti- et al., 2008). While I do not want to mates, the effects are still enormous. downplay the achievements in EU inte- An as a non-negligible by-product, gration over the last two decades, I recent research on the non-economic conclude that we are still far from hav- effects of human capital has confirmed ing established a functioning Single what one might intuitively suspect. Ed- Market. A Services Directive II is ucation generates numerous benefits highly warranted; and we have to speed that go beyond increases in productivity up significantly. Similar arguments and economic growth: more education could be made with respect to the state can i) lower crime, ii) improve health, of the European labor market. and iii) increase voting and democratic participation (Lochner, 2011). 3.2 Boost Investment in Knowledge 3.2.1 Human Capital Let me hightlight the results of some recent research on the growth effects of human capital, which has turned to more elaborate measures of human capital in terms of cognitive skills, drawing on results of the PISA-type studies. Woessmann and Hanushke (2010) harmonize data on individual test scores in math, science, and reading over the period 1964–2003, aggregate them to the country level for a sample of OECD countries, and in- In the light of these results one clude these measures in a growth would expect policy to have a clear-cut regression framework. Having esti- priority. At least in some EU Member mated the growth effects of human States, the opposite is happening: bud- capital they do some interesting simula- gets are reduced in real terms; true au- tions on the long-run growth effects tonomy is refused to educational insti- of educational reforms over the period tutions, and structural reforms are of- 2010–2090. In a nutshell, the simula- ten hindered by ideological prejudice. tion predicts that a uniform increase in The outcome is not unexpected: The EU all countries’ human capital by a quar- has achieved only one of its five educa- ter of one standard deviation, would tional targets laid down in the Lisbon yield a growth rate that is on average strategy and concludes that EU Member 0.47% higher than in the counterfac- States would need to invest an average tual scenario of maintaining the status EUR 10,000 more per student per year quo. Accumulating these income ef- in higher education to catch up with the fects, their present value in year 2010 USA. (Council of the EU, 2010). amounts to 288% of GDP. Bringing all I wish to add that installing appro- countries to the level of Finland (the priate budgets for the education system

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is only half of the story. Optimizing ef- Where is the emphasis in current ficiency and effectiveness of our educa- growth policies of EU Member States? tion system is the other half of it. The The Lisbon strategy spelled out the target results of the literature2 suggest several to raise total R&D expenditures to 3% of GDP and the Europe 2020 strategy sticks with this target. Helmers et al. (2009) consider the evaluation of total and business R&D and R&D capital in EU Member States since 2000 and conclude that R&D expenditures are stable and below target over time. The EU has not moved closer to its Lisbon target. The recent progress report on Europe 2020 does not suggest that this trend is about to change: “The compilation of all provisional national targets indicates an aggregated level of 2.7% or 2.8% of GDP, which is below the expected tar- measures: investments in teachers’ get of 3% GDP invested in R&D, but quality, autonomy in process and per- which represents a significant effort, sonnel decisions (combined with ac- particularly in the current budgetary countability), introduction of choice and context.“ (European Commission, competition between schools and univer- 2011, Annex 1, p. 7). Resorting to bud- sities (and between students). Educa- getary constraints is no satisfactory an- tional checks are an old idea dating back swer. There are resources that could to Milton Friedman – why not give it a free up by structural reforms that are try at the European level? Why not take postponed from year to year, and there up recent proposals to finance higher are resources that could be rechanneled education and educational reforms from projects with much smaller returns. through deferred graduate retirement? (Barakat, 2011) Some visionary policy 3.2.3 Human Capital R&D and perspectives are highly warranted here. Technology Transfer Apart from being the most important 3.2.2 R&D and Innovation propelling forces of economic growth, There is a large body of evidence on the human capital and R&D are also growth effects of R&D. To mention important determinants of the absorp- just one example, Griffith, Redding, tive capacity of countries and regions, and Van Reenen (2004) provide an as- facilitating technology transfer and sessment of the role of R&D (and hu- catching up. Benhabib and Spiegel man capital) as determinants of TFP (1994), Griffith et al. (2004), as well as growth in 12 OECD countries, and Kneller and Stevens (2006) provide find a dominant role of R&D and hu- strong and convincing evidence on this man capital. They conclude that the second face of human capital and R&D. “emphasis on human capital and R&D In this respect, we should not forget in modern growth theory is well about information and communication placed.” (Griffith et al., 2004, p. 893). technologies. Wolff (2011), using data

2 See Woessman and Hanushek (2010b) for a survey on the determinants of schooling quality.

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for the USA over the period 1958 to Inevitably, a better macroeconomic- 2007, finds strong evidence that the policy framework with enhanced coor- magnitude of R&D spillovers has in- dination, monitoring, and enforcee- creased sizably over time, a result which ment will require more supra-national- he attributes to the penetration of the ity in EU politics. This may still sound US economy with ICT technologies. utopian, but we should not forget that No good news from this side as well: some decades ago, the present state of “Europe’s gap is even larger in ICT and the EU would have also appeared uto- other non-transport equipment indus- pian at that time. Of course, it is a tries.“ (Helmers et al., 2009, p. 42), a highly complex question how can we fact the EU Commission is well aware improve the EU’s capability to act while of. The “Commission will propose at the same time hold up a proper measures to speed up and modernize balance of institutions and democratic standard setting in Europe, including legitimacy and I do not pretend to have for ICT.” (European Commission, An- a simple answer on that. This is clearly nex 1, p. 5). Again, the key question is a field where more interdisciplinary whether the proposed measures will be research is needed. implemented by EU Member States. 5 Conclusions 4 Improving the Macroeconomic Europe needs a growth strategy but it Policy Framework, more does not need a new one. Apart from Effectiveness in Decision-Taking dealing with the aftermath of the crisis, The uncoupling of monetary policy there are two main priorities: complet- from short-run considerations by the ing the Single Market and boosting establishment of independent but ac- investment into human capital and countable central banks is one of the R&D. These are the key instruments to great success stories in recent economic generate long-run growth and to history, and we should work hard on facilitate positive spillover effects. We establishing – at least to some extent – should not forget, however, that most a similiar framework for fiscal policy as “of these measures have to be executed well. In light of the recent experiences, at the national level. The EU – in its I think that EU Member States need fis- current state – can only provide a cal rules, established at a constitutional framework and coordination.” (Bald- level, not only the ensure sustainability win and Gros, 2010, p. 25). Hence, of fiscal policy, but also to limit the we should not blame the EU for room for discretionary fiscal policy, the omissions of its Member States. which has been shown to increase out- Both the EU and its Member States put volatility and thereby to reduced must commit themselves to act and economic growth.3 No rule fits every to “finish the job of restoring stability situation, of course. The way forward and prosperity in Europe. The Euro- would be to combine “judgment and pean flotilla may have run aground, but discipline” by the establishment of in- it needs not sink. This will require dependent fiscal councils and their co- coordination, teamwork, and disci- ordination at a European level (see pline. All hands on deck!“ (Baldwin Fatás and Mihov, 2010; Lane, 2010). and Gros, 2010, p. 21).

3 See the seminal paper by Fatas and Mihov (2004) and Badinger (2008) for evidence on OECD countries.

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References Badinger, H. 2007. Has the EU’s Single Market Programme fostered competition? Testing for a decrease in markup ratios in EU industries. In: Oxford Bulletin of Economics and Statistics 69(4). 497–519. Badinger, H. 2009. Fiscal rules, discretionary fiscal policy, and macroeconomic stability: an empirical assessment for OECD countries. Applied Economics 41(7). 829–847. Badinger, H. and N. Maydell. 2009. Legal and economic issues in completing the EU Internal Market for services: an interdisciplinary perspective. In: Journal of Common Market Studies 47(4). 693–717. Badinger, H., Breuss, F., Sellner, R. and P. Schuster. 2008. Macroeconomic effects of the services directive. In: Breuss, F., Fink, G. and S. Griller (eds.). Completing the EU Internal Market for Services. Wien/NewYork: Springer. 125–165. Baldwin, R., Gros, D. and L. Laeven. (eds.). 2010. Completing the Eurozone Rescue: What More Needs to Be Done? A VoxEU.org publication. Center for European Policy Research. June. Barakat, B. 2011. Time is money. Could deferred graduate retirement finance higher education. Working Paper 5/2011. Vienna Institute for Demography, Austrian Academy of Sciences. Benhabib J., Spiegel M. 1994. The role of human capital in economic development: Evidence from aggregate cross-country data. Journal of Monetary Economics, 34(2). 143–173. Council of the European Union. 2010. Joint Progress Report of the Council and the Commission on the implementation of the Education & Training 2010 work programme. Key competences for a changing world. EIB. 2009. R&D and the financing of innovation in Europe. Stimulating R&D, innovation and growth. EIB papers 14(1). Eichengreen, B. 2010. Drawing a line under Europe’s Crisis. In: Baldwin, R., Gros, D. and L. Laeven (eds.). Completing the Eurozone Rescue: What More Needs to Be Done? A VoxEU.org publication. Center for European Policy Research. June. 25–27. European Commission. 2002. The State of the Internal Market for Services. Report from the Commission to the Council and the European Parliament. COM(2002) 441 Final. European Commission. Brussels. European Commission. 2011. Progress report on Europe 2020. Brussels, COM(2011)11 – A1/2. Fatás, A. and I. Mihov. 2010. Fiscal policy at a crossroads: The need for constrained discretion. In: Baldwin, R., Gros, D. and L. Laeven (eds.). Completing the Eurozone Rescue: What more needs to be done? A VoxEU.org publication. Center for European Policy Research, June. 69–73. Griffith, R., Redding, S. and J. Van Reenen. 2004. Mapping the two faces of R&D: productivity growth in a panel of OECD countries. Review of Economics and Statistics 86(4). 883–895. Hanushek, E. and L. Woessman. 2010a. How much do educational outcomes matter in OECD countries. CESifo Working Paper No. 3238. November. Hanushek, E. and L. Woessmann. 2010b. The economics of international differences in educational achievement. NBER Working Paper No. 15949. April 2010. Helmers, C., Schulte, C. and H. Strauss. 2009. Business R&D expenditure and capital in Europe. EIB papers 14(1). 36–61. Kneller, R. and P. A. Stevens. 2006. Frontier technology and absorptive capacity: Evidence from OECD manufacturing industries. Oxford Bulletin of Economics and Statistics, 68(1). 1–21. Lane, P. 2010. Rethinking National Fiscal Policies in Europe. In: A VoxEU.org publication. Center for European Policy Research. June. 59–62.

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Lochner, L . 2011. Non-production benefits of education: crime, health, and good citizenship. NBER Working Paper 16722. January 2011. Lyons et al. 2010. The Super-Cycle Report. Standard Chartered Bank. Sapir, Á. , Aghion, P., Bertola, G., Hellwig, M., Pisani-Ferry, J., Rosati, D., Vinals, J. and H. Wallace. 2004. An Agenda for a Growing Europe. The Sapir Report. Oxford: Oxford University Press. Wolff, E. N. 2011. Spillovers, linkages, and productivity growth in the US economy, 1958 to 2007. NBER Working Paper 16864.

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VOWI_Tagung_2011.indb 153 03.10.11 08:28 Stefan Collignon Professor Sant’Anna School of Advanced Studies, Pisa Centro Europa Ricerche, Rome

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The global financial crisis of September of the euro in 2010. The year 2011 is 2008 was the equivalent of an eco- now the year of cleaning up. How can nomic earthquake of global dimensions. this be done? It has caused subsequently Tsunami-like devastation in the public finances of Growth in the Euro Area most industrial economies and in par- The global financial crisis has caused a ticular in the European Union. Unco- one-off reduction of income in all major operative behaviour by European gov- economies. For most countries, the ernments nearly caused total meltdown shock lasted from the third quarter

Chart 1 European GDP Levels Germany Austria 850,000 100,000 Euro Lehman Euro Lehman 800,000 90,000 750,000 80,000 700,000 70,000 650,000

600,000 60,000

550,000 50,000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 GDP DE TREND 1999 – 2008 DE GDP AT TREND 1999 – 2008 AT USA France 4.000,000 650,000 Euro Lehman Euro Lehman 3.600,000 600,000

3.200,000 550,000

2.800,000 500,000

2.400,000 450,000

2.000,000 400,000

1.600,000 350,000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 GDP USA TREND 1999 – 2008 USA GDP FR TREND 1999 – 2008 FR Greece Ireland 90,000 80,000 Euro Lehman Euro Lehman 80,000 70,000

70,000 60,000

60,000 50,000

50,000 40,000

40,000 30,000

30,000 20,000

20,000 10,000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

GDP GR TREND 1999 – 2008 GR GDP IE TREND 1999 – 2008 IE Source: Centro Europa Ricerche, Rome.

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Chart 1 continued European GDP Levels Portugal Spain 56,000 400,000 Euro Lehman Euro Lehman 52,000 350,000

48,000 300,000

44,000 250,000

40,000 200,000

36,000 150,000

32,000 100,000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 GDP PT TREND 1999 – 2008 PT GDP ES TREND 1999 – 2008 ES Non-Euro Member States Poland Slovenia 350,000 10 Euro Lehman Euro Lehman 9 300,000 8 250,000 7 200,000 6 5 150,000 4 100,000 3 50,000 2 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 GDP PL TREND 1999 – 2008 PL GDP SI TREND 1999 – 2008 SI Czech Republic Hungary 1,000 5,500 Euro Lehman Euro Lehman 900 5,000 800 4,500 700 4,000 600 3,500 500 3,000 400 2,500 300 2,000 200 1,500 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 GDP CZ TREND 1999 – 2008 CZ GDP HU TREND 1999 – 2008 HU

Source: Centro Europa Ricerche, Rome.

2008 to the second quarter 2009. Since pre-crisis years. This is the case for then, most economies have started to Germany, the USA and possibly grow again, although with different dy- Slovenia. namics. – After a sharp recession, the econ- We can distinguish three post-crisis omy has returned to previous growth adjustment models: rates, but not managed to compen- – The reduction in output was sharp, sate for lost output. This is the case and so was the rebound. Economic for most economies in Europe, in- growth has accelerated relative to the cluding Austria.

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Chart 2 Chart 3 Employment Euro Area-15 Debt to GDP Ratio Number of employees % 185,000 90 Euro Lehman Euro Crisis 180,000 85

175,000 80 75 170,000 70 165,000 65 160,000 60 155,000 60% target 55 150,000 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Euro area-12 Euro area-17 Austria

Source: AMECO. Source: AMECO.

Chart 4 Contribution to the Change in the Budget Position for Greece % 25

–5

–10

–15

–20 Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1Q3Q1 2004 2005 2006 2007 2008 2009 2010 2011 2012 Expenditure year-on-year growth GDP year-on-year growth Revenues year-on-year growth Deﬁcit year-on-year growth

Source: Author‘s calculations, Centro Europa Ricerche.

– The reduction of output was not before in history), 5 million were only deep, but also long lasting. The lost again in the euro area during the economy did not pick up rapidly and crisis. the levels of income are still far Public debt ratios have also exploded behind pre-crisis levels. This is the everywhere: case for the crisis shaken economies The deterioration of public finances in Europe’s south (chart 1). has been essentially a problem of revenue The crisis has two mirror images: high and growth. Most spectacularly this is unemployment and rising debt. After documented by Greece. Chart 4 shows adding 15 million jobs in the first the contribution to the change in bud- decade of the euro (more than ever get position for Greece.

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procedure. However, this is the wrong indicator. First, the current account is not the same as net exports because it contains factor incomes and transfers. Second, net exports may shift according to comparative advantages in the single market. Third, the current account is a meaningless concept in monetary union. In different currency areas, the current account positions indicate a change in external indebtedness in foreign currency. Together with capital Hence, it is clear: accelerating eco- flows the current account determines nomic growth must be the top policy the foreign exchange reserves of a priority in Europe. Accelerating growth country. Loss of reserves makes the requires the interaction of long term maintenance of exchange rate stability supply side policies and macroeconomic unsustainable. As a consequence, inves- demand policies, which need to define tors look at a country risk as a currency an efficient short to medium term policy risk. This is why monetary union was a mix that defines coherently monetary, necessary complement to the creation fiscal and wage policies. In this context, of Europe’s single market. a new issue has emerged: competitive- In the same currency area liquidity ness. is provided by the central bank. Banks borrow from the central bank and lend Competitiveness to the real economy, namely to firms The debate among policy makers suffers and governments. Because the ECB is from a major category mistake; it mea- the lender of last resort, solvent banks sures competitiveness by current account can always count on obtaining the balances. The European Commission necessary liquidity from the ECB and even wants to use a target of current no “Member State” can run out of re- accounts for its excessive imbalance serves of its own euro currency. Any

Chart 5 Unit Labour Cost Developments in the Euro Area Index 1.4 Lehman 1.3

1.2

1.1

1.0

0.9 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Euro area-12 Austria Belgium Finland Greece France Germany Ireland Italy Luxembourg Netherlands Portugal Spain Source: AMECO.

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Chart 6

Average Eﬃciency of Capital GDP to capital stock in % Austria Belgium Finland 34 40 44 Bretton EMS ERM Euro Woods crisis 40 32 38 36 30 36 32 28 34 28

26 32 24 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 France Germany Greece 35 36 6 34 34 5 33 32 32 4 31 30 3 30 29 28 2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Ireland Italy Netherlands 36 38 40 38 36 34 36 34 34 32 32 32 30 30 30 28 28 28 26 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Portugal Spain Euro area-12 50 44 36

45 40 34 40 36 32 35 32 30 30 28

25 24 28 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: AMECO.

“current account” position between This does not mean that in a mone- Member States is therefore sustainable. tary union, borrowing is unlimited and It makes no difference whether the unconstrained or that repayment does lender is a “domestic” or a “foreign” not matter. It means that the borrowing bank in the euro area. The open and risk is debtor specific. The issue is the unlimited access to liquidity for Mone- solvability of debtors. Each debtor must tary Financial Institutions (i.e. banks) is be assessed for solvency in terms of the the defining feature of a monetary net present value of future cash flow union. Hence, European Monetary streams. Hence, it is a category mistake Union is not a fixed exchange rate area; to use the category of Member States and it is an “economic country”. their current accounts in EMU, because

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Chart 7 only banks can borrow from the ECB National Levels of Unit Labour and not States (Treaty on the Function- Cost Relation ing of the European Union art. 123).

Austria If current account positions are not Index appropriate, how else can we measure 1.15 competitiveness? What matters for Euro Lehman 1.10 firms are relative prices and relative unit labour costs (ULC). Typically, 1.05 they are estimated by some index like 1.00 in chart 5. 0.95 But such an index is also a flawed

0.90 concept, because what matters are ULC levels, and an index cannot represent 0.85 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 these levels. So, what is the right level? Austria equilibrium unit labour cost relation Should ULC all be the same in equilib- Austria unit labour cost relation rium? Not necessarily because labour Italy cost is only one element in the total Index cost of producing output. The other is 1.15 the cost of capital. In equilibrium, and Euro Lehman 1.10 assuming efficient markets, the rates of 1.05 return on capital should equalise. Hence, the competitiveness benchmark 1.00 must depend on ULC and on capital 0.95 productivity. When capital productiv- 0.90 ity is low, ULC must fall; when capital

0.85 productivity is high, ULC can rise. Chart 6 shows the development of 0.80 the average capital efficiency in several 0.75 euro area Member States. 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 Given the developments of average Italy equilibrium unit labour cost relation Italy unit labour cost relation capital efficiency and labour productivity, we can calculate the equilibrium Germany Index unit labour cost relation (the red line in 1.100 chart 7) and compare it to actual ULC Euro Lehman (the blue line). The chart is drawn to 1.075 reflect the national levels relative to the 1.050 euro area. A value of 1 indicates that 1.025 ULC in the country of reference are

1.000 equal to the euro area. We can then calculate our Compet- 0.975 itiveness Index as the difference be- 0.950 tween actual and equilibrium ULC rel- 0.925 ative to the euro area. Equipped with

0.900 this index, we can now try to assess the 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 impact of competitiveness on other Germany equilibrium unit labour cost relation Germany unit labour cost relation variables.

Source: Centro Europa Ricerche, Rome.

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Chart 8 Competitiveness Indicators ULC relative to equilibrium Austria Belgium Finland 0.16 0.05 0.3

0.12 0.00 0.2 –0.05 0.08 0.1 –0.10 0.04 0.0 –0.15 0.00 –0.1 –0.20

–0.04 –0.25 –0.2 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 France Germany Greece 0.08 0.08 0.3 0.2 0.04 0.04 0.1 0.00 0.00 0.0 –0.1 –0.04 –0.04 –0.2 –0.08 –0.08 –0.3 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Ireland Italy Luxembourg 0.1 0.08 –0.1

0.0 0.04 –0.2

–0.1 0.00 –0.3

–0.2 –0.04 –0.4

–0.3 –0.08 –0.5

–0.4 –0.12 –0.6 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Netherlands Portugal Spain 0.15 0.3 0.10

0.10 0.2 0.05

0.05 0.1 0.00

0.00 0.0 –0.05

–0.05 –0.1 –0.10

–0.10 –0.2 –0.15 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Source: Centro Europa Ricerche, Rome.

Does Competitiveness Matter and competitiveness. We find private for Economic Growth in the Euro investment drives growth, public in- Area? vestment is not significant, but compet-

To answer this question, we estimate itiveness and the yield curve have be- economic growth as a function of private come highly significant in EMU as the and public investment, the yield curve table shows.

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Table 1 Drivers of Economic Growth

1971–2010 EU-15 EMU NMS Pre-EMU 1993–2010

0.136 0.283* 0.525*** –0.054 –0.090 0.310 0.100 0.672*** 0.636*** 0.025 ∆ lnGDPt–1 (1.27) (1.95) (3.79) (–0.30) (–0.41) (1.20) (0.81) (3.74) (3.90) (0.20) –0.003 – 0.011 –0.009 –0.002 –0.003 0.001 0.018 0.003 –0.017 0.049** ∆ (GovI/GDP)t (–0.32) (–1.01) (–0.85) (–0.20) (–0.31) (0.12) (1.12) (0.20) (–1.24) (2.01) 0.008*** 0.008*** 0.005** 0.009*** 0.009*** 0.006** 0.015*** 0.013*** 0.009*** 0.016*** ∆ (PrivI/GDP)t (3.98) (3.62) (2.53) (3.53) (3.41) (2.16) (5.89) (4.50) (3.74) (4.04) –0.002*** –0.002*** –0.002** –0.001 –0.003 –0.004** ∆ yieldt (–2.66) (–2.63) (–2.57) (–1.48) (–1.16) (–2.23) –0.308*** –0.253*** –0.438*** ∆ lnCompt (–6.28) (–3.54) (–8.32) time dummies no no no no no no no no no no R2 0.380 0.425 0.493 0.335 0.341 0.410 0.483 0.642 0.738 0.338 N 511 456 456 315 274 274 196 182 182 152 Under id. 33.8 *** 29.7 *** 30.7 *** 13.9 *** 15.1 *** 9.3 *** 10.7 *** 10.2 *** 9.7 *** 5.4 ** Weak id. 15.5 *** 12.1 *** 12.5 *** 5.5 ** 5.5 ** 3.1 * 4.7 ** 4.9 ** 4.4 * 2.0

Note: Fixed Effects Instrumental Variables estimates. T statistics in parenthesis; * significant at 10% level; ** significant at 5% level; *** significant at 1% level. Instrument used: lag 1 of DlnGDP, lag 2 of govI/GDP and privI/GDP. For under identification and weak identification we report the Kleibergen-Paap rk LM and Wald statistics.

Fiscal Policy and Competitiveness estimates expect that under normal Competitiveness might also influence conditions the primary surplus will re- fiscal policy by raising growth and turn in approximately 5 years time. revenue, by lower revenue through tax However, even under those circum- cuts and by raising expenditure to stances Spain will not reach a primary subsidise competitiveness. To assess the surplus sufficient to service its debt. In effect, we have estimated revenue and fact, in the pessimistic scenario it will primary expenditure functions and even take 10 years until it is returning calculated the expected future primary to a balanced primary budget, which budget positions. Of course, debt sus- means that public debt is unsustainable. tainability requires a primary surplus However, with the improvement of sufficient to service debt. economic growth in competitiveness We look at three scenarios: – The medium scenario with constant Chart 9 competitiveness and slow growth Spain: the Typical Case convergence to the most likely % growth rate (see charts above). 12

– High scenario at a 0.5% higher 8 growth rate and 0.5% competitiveness improvement per annum. 4 – Low scenario at a 0.5% lower 0 growth rate and 0.5% competitive- –4

ness deterioration per annum. –8 The results are illustrated in charts 9 to 12: –12 Spain is a typical case. One observes 1970 1975 1980 1985 1990 1995 200520002010 2015 2020 20252030 the dramatic loss of income after the Medium High Low financial crisis hit in 2008. Primary Source: Author’s calculations. surpluses have become a deficit and our

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Chart 10 public debt becomes sustainable and France: the Worrisome Case will stabilize in the early 2020s. % France is a worrisome case. We see 6 that even with the medium scenario 4 this country will not return to positive 2 primary surpluses, and in fact under the low growth-(low) competitiveness 0 scenario they will even deteriorate fur- –2 ther. On the other hand, if France –4 would improve its growth and compet-

–6 itiveness under our model assumption, 1970 1975 1980 1985 1990 1995 200520002010 2015 2020 2025 2030 it will not be sufficient to bring French Medium High Low debt dynamics under control. Hence, Source: Author’s calculations. one has to be concerned about the capacity of France to sustain its public Chart 11 debt position. Portugal: the Hopless Case Although competitiveness improves % the expenditure side of Portugal’s 6 budget, it is not enough to yield a sur-

4 plus sufficient to service the public

2 debt. We find a negative relation between 0 competitiveness improvements and tax –2 revenues. Presumably, Greece im- –4 proved competitiveness by keeping –6 wages low or by mitigating tax in- –8 creases on labour. 1970 1975 1980 1985 1990 1995 200520002010 2015 2020 2025 2030 Medium High Low Conclusion: What to Do? Source: Author’s calculations. Europe needs higher growth. It needs to improve competitiveness, which means Chart 12 higher productivity of capital and labour. Greece: the Weird Case However, it is often overlooked that % capital efficiency is negatively affected 6 by low interest rates. On the other hand, 4 higher labour productivity depends in

2 the short run on wage increases and in the long run on R&D. To sustain pro- 0 ductivity improvements, Europe needs –2 higher investment. That will only hap- –4 pen if uncertainty in capital markets is

–6 reduced. This will require more coherent macroeconomic management and –8 ultimately the creation of a deep market –10 of eurobonds. 1970 1975 1980 1985 1990 1995 200520002010 2015 2020 2025 2030 Medium High Low Source: Author’s calculations.

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Contributors

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Harald Badinger Department and an associate of the Harald Badinger, born in 1974, is cur- Minda de Gunzburg Centre for Euro- rently occupied as Full Professor at the pean Studies at Harvard. He has also Department of International Econom- taught at the University of Hamburg, ics of the Vienna University of Eco- the Institut d’Etudes Politiques in Paris nomics and Business Administration, and Lille, at the College of Europe in where he also earned his doctorate de- Bruges and at the Free University of gree in economics in 2001. In 2009 and Berlin (1997–2000). Stefan Collignon until February 2010, he worked for the has served as Deputy Director General Oesterreichische Nationalbank at the for Europe in the Federal Ministry of Economic Studies Division. In 2007 Finance in Berlin 1999–2000. He was and 2008, Mr. Badinger was employed also member of the Supervisery Board as research fellow at the Center for Glunz AG (1999–2010). Economic Studies (CES, University of Stefan Collignon received his Ph.D. Munich). He started his academic ca- and Habilitation from the Free University reer as research assistant at the Euro- of Berlin. He also studied at the Institut painstitut of the Vienna University of d’Etudes Politiques (Paris), the Univer- Economics and Business Administra- sity of Dar es Salaam, Queen Elizabeth tion in 1999 and in 2002, Harald House in Oxford and the London Badinger was appointed assistant pro- School of Economics. Since 1990 he has fessor (2007 Associate Professor) at the Europainstitut. In 2010, he was ranked 13 in “Top 100 researchers under 40 years old” and 34 in “Top 100 researchers since 2005” in the Handelsblatt ranking of Economists (Germany, Aus- tria, Switzerland). His main research interests include economic growth, international trade and European economic integration. Stefan Collignon Stefan Collignon has been engaged as ordinary Professor of political economy at Sant’Anna School of Advanced Stud- been president of the Association ies Pisa, since October 2007, and as In- France-Birmanie. He joined the First ternational Chief Economist of the National Bank in Dallas in 1975, Centro Europa Ricerche (CER), Roma, worked with the German Volunteer since July 2007. He is the founder of Service in Tanzania (1977–1979) and the Euro Asia Forum at Sant’Anna was Chairman and Managing Director school of advanced studies. Previously, of Dorcas Ltd. London (1980–1989). he was Centennial Professor of Euro- From 1989 to 1998, Mr. Collignon was pean Political Economy at the London Director of Research and Communica- School of Economics and Political Sci- tion at the Association for the Mone- ence (LSE) from January 2001 to 2005. tary Union of Europe (Paris). Professor Between 2005–2007, he was Visiting Collignon is author of numerous books Professor at Harvard University, Fac- on monetary economics, and the politi- ulty of Arts and Sciences, Government cal economy of regional integration.

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Wolfgang Duchatczek two years at Harvard and at the National Wolfgang Duchatczek has been serving Bureau of Economic Research in Cam- as Vice Governor of the Oesterreichische bridge, Mass. In 1981, he habilitated on Nationalbank (OeNB) since 2003. He the problem of youth unemployment. joined the OeNB in 1976 and the Office His career path led him first from a of the Governor in 1978. He was position as professor at the Johannes appointed Chief of the Office of the Gutenberg-University in Mainz to the Governor in 1982 and Deputy Execu- University of Stuttgart in 1984 before tive Director of the Foreign Research he accepted a chair at the University of Department in 1987. In addition, he Konstanz, where he received an award served as Representative of the OeNB by the Federal State of Baden-Würt- on the EC Integration Committee of temberg for outstanding university the Austrian Federal Government. Mr. teaching (“Landeslehrpreis”). Although, Duchatczek was appointed Director of he was offered chairs at the Swiss Fed- the Area International Relations of the eral Institute of Technology Zurich and OeNB in 1992 and represented the Humboldt University in Berlin, Franz OeNB during Austria’s EU accession stayed in Konstanz until 1 April 1997. negotiations. He was nominated Chair- He then took on the position of presi- man of the European Commission’s dent of the Centre for European Eco- Committee on Monetary, Financial and nomic Research (ZEW) in Mannheim Balance of Payments Statistics (CMFB) and at the same time accepted a chair and served as the OeNB’s Second of economics at the University of Alternate on the Committee of Alter- Mannheim. In March 2009, Franz be- nates of the European Monetary Insti- came chairman of the German Council tute (EMI). In 1997, he was appointed of Economic Experts, which advises to the OeNB’s Board of Executive the German Government and Parlia- Directors as Deputy Chief Executive ment on economic policy issues. Franz Director of the Liquidity and Portfolio is a member of the Heidelberg Acad- Management and Internal Services emy of Sciences and Humanities and Department, and in 1998 he joined the also heads the section Economics and OeNB’s Governing Board as Executive Empirical Social Sciences at the Leop- Director of the Money, Payment oldina, the German Academy of Sci- Systems and Information Technology ences. Furthermore, he is a member of Department. Mr. Duchatczek holds a the Scientific Advisory Board of the doctorate in economics and social Federal Ministry of Economics and sciences and has been awarded the Technology. He was key advisor for Grand Decoration of Honor in Gold for economics at the German Research Services to the Republic of Austria. Foundation (DFG) and co-editor of several magazines on economics. His Wolfgang Franz main research areas are macroeconom- Wolfgang Franz was born in 1944 and ics, labor economics, and empirical studied economics at the University of methods in economics. Franz has pub- Mannheim. Afterwards, he worked as a lished numerous books and scientific research associate at the University of articles on these topics. Franz was con- Mannheim and obtained a doctorate in ferred with an honorary doctorate by 1974 on a macroeconometric analysis both the European Business School of the German labor market. As a (ebs) and the University of Magdeburg research fellow Wolfgang Franz spent in 2003.

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Ernest Gnan FSG) from 2003 to 2006 and was Ernest Gnan has been head of the elected chairman of the GdG in March Economic Analysis Division of the 2007. Rudolf Hundstorfer was a mem- Oesterreichische Nationalbank in Vienna ber of Vienna’s Provincial Diet and City since 1999. He is a member of the Council from 1990 to 2007 and first European Central Bank’s Monetary chairman of Vienna’s City Council Policy Committee, and is also an adjunct from 1995 to 2007. In 2003, Rudolf Professor at Webster University in Hundstorfer was elected vice president Vienna, teaching courses on economic of the Austrian Trade Union Federation analysis. During 1998, Ernest Gnan (Österreichischer Gewerkschaftsbund served as deputy head of the Foreign – ÖGB). In 2006, he followed Fritz Research Division of the Oesterreichische Verzetnitsch as executive president of Nationalbank, and from 1995 to 1997, the ÖGB and became its president as as an economist in the Secretariat of well as member of the executive com- the Foreign-Exchange Policy Sub- mittee in 2007 with a key responsibil- Committee at the European Monetary ity for social affairs. In December Institute (a forerunner of the European 2008, Rudolf Hundstorfer was sworn Central Bank). He is a former national in as Minister of Social Affairs and expert in the Directorate General for Consumer Protection of the Republic Monetary and Financial Affairs at the of Austria. Since February 1st 2009, he European Commission in Brussels, and has also been responsible for Labor a former investment fund manager Affairs. at Genossenschaftliche Zentralbank in Vienna. Ernest Gnan received a mas- Andreas Ittner ter’s degree in commercial sciences and Andreas Ittner is a Member of the a Ph.D. in economics at the University Governing Board of the Oester- of Economics and Business Administra- reichische Nationalbank (OeNB). He tion in Vienna. studied economics and social sciences at the Vienna University of Economics Rudolf Hundstorfer and Business Administration between Rudolf Hundstorfer was born in 1951 1976 and 1980. Mr. Ittner started his in Vienna and started his trade union activities as youth spokesman in the administration of the City of Vienna. As from 1975, Mr. Hundstorfer was responsible for youth affairs in the Union of Municipal Employees (Gewerkschaft der Gemeindebediensteten – GdG) where he became expert on organisa- tional questions in 1983 before being elected secretary general and, in 1998, chairman of the “Landesgruppe Wien” (Vienna’s faction at the GdG). In 2001, he was elected executive chairman of the GdG. Mr. Hundstorfer served as chairman of the Social Democratic professional career with the Ittner Trade Unionists (Fraktion Sozialde- retail business in Vienna in 1978. In mokratischer GewerkschafterInnen – 1983, he joined the OeNB and began to

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work in the Banking Analysis and Financial Stability, Markets, IT, Statis- Credit Supervision Office. In 1997, he tics and Training and Education. He became head of the Secretariat for the was a member of a number of commit- President in the OeNB and in 1987, tees of the BIS, the Financial Stability Andreas Ittner was appointed Director Board, as well as the OECD, where he of the Financial Stability and Bank In- chaired the Financial Markets Commit- spections Department of the OeNB. tee. He was also the Central Bank Mr. Ittner is among other engagements Deputy for the G7 and the G20 process. an Acting Member of the Banking Between 2002 and 2005, he served in a Supervision Committee of the ESCB, personal capacity on an Expert Panel Vice President of the Centre for Secure of the European Parliament on Finan- Information Technology, Member of cial Markets. He is also a member the Supervisory Board of the Austrian of the board of the Konstanz Seminar Financial Market Authority as well as on Monetary Theory, of the Conseil Member of the Financial Market Com- d’Orientation, Revue d’Economie Finan- mittee established under the Austrian cière, Paris, of the Advisory Board, Banking Supervision Act. Blekinge Institute of Technology, Sweden, of the Conseil Scientifique, Centre Hans-Helmut Kotz Cournot pour la Recherche en Écono- Hans-Helmut Kotz is a Senior Fellow at mie, Paris and of the Scientific Council Goethe University’s Center for Finan- of the Hamburg World Economic Insti- cial Studies as well as an Honorary Pro- tute (HWWI), Hamburg. He has pub- fessor in the Faculty of Economics and lished numerous articles in e. g. the Re- Behavioral Sciences of Freiburg Uni- vue d’Economie Financière (recently versity, where he received the 2010 editing two special issues on Systemic Risk), Kredit und Kapital, Zeitschrift für Betriebswirtschaft, Wirtschafts- dienst and Intereconomics – Review of European Economic Policy. He has also written for a number of newspapers (e.g. Frankfurter Allgemeine Zeitung) and he is a long-standing columnist with the French weekly Option Finance. His current research focuses on monetary policy’s role in underwriting financial stability, on sustainable levels of bank profitability and on the politics of international rule making.

University Teaching Award. During Anne O. Krueger the fall term 2010, he was visiting Anne Krueger is Professor of Interna- Harvard University, teaching a course tional Economics at the School for in its Department of Economics and Advanced International Studies, Johns working at Harvard’s Center for Euro- Hopkins University. She is a Senior pean Studies. Between 2002 and 2010, Fellow of the Stanford Center for Inter- he was a Member of the Executive national Development (of which she Board of Deutsche Bundesbank, over was the founding Director) and the time in charge of Departments of Herald L. and Caroline Ritch Emeritus

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Professor of Sciences and Humanities London, Visiting Professor at the Swiss in the Economics Department at Stan- Finance Institute in Zurich and at the ford University. Anne Krueger was the Vienna University of Economics and First Deputy Managing Director of the Business Administration. He is Consul- International Monetary Fund from tant Economist to ICAP pic. Recently, 2001 to 2006. Prior to that, she had he has been working with several cen- taught at Stanford and Duke Universi- tral banks on aspects of the global ties. From 1982 to 1986, she was Vice financial crisis and resolution strategies. President, Economics and Research at Previous career appointments include the World Bank. She had earlier been serving as an economist at Unilever Professor of Economics at the Univer- (Rotterdam), HM Treasury (London) sity of Minnesota. Professor Krueger and the International Monetary Fund has held visiting Professorships at a (Washington). Between 1994 and 2002, number of universities, including the he was a Public Interest Director of the Massachusetts Institute of Technology, Personal Investment Authority. He Northwestern University, Bogazici serves as a consultant to financial firms, University (Istanbul), the Indian Coun- management consultancy firms and cil for Research on International Eco- regulatory agencies in several countries. nomic Relations (ICRIER), Monash In addition, Mr. Llewellyn has been a University and the Australian National consultant to the World Bank and the University, and the Stockholm Institute International Monetary Fund, and is for International Economics. She holds currently a member of an IMF interna- a B.A. from Oberlin College and a tional advisory committee on gover- Ph.D. from the University of Wiscon- nance in supervisory agencies. He is a sin. Professor Krueger is a Distin- member of the Advisory Board of the guished Fellow and past President of European Banking Report at the Italian the American Economic Association, a Bankers Association. Since 2004, he Senior Research Fellow of the National has been a member of the Banking Bureau of Economic Research, and a Panel of Bank Indonesia. In addition, he member of the National Academy of was a member of the Pricewaterhouse Sciences, the American Academy of Coopers team investigating the macro- Arts and Sciences, the Econometric economic impacts of the Basel II Accord Society, and the American Philosophi- for the European Commission. He is a cal Society. She has published exten- member of the Council of Management sively on economic development, inter- of SUERF – The European Money and national trade and finance, and eco- Finance Forum and was President nomic policy reform. In addition to her thereof between 2000 and 2006. David writings on these topics, she has writ- T. Llewellyn has written extensively on ten a number of books and articles on the analysis of banking and financial economic growth, international trade, markets and their regulation. and economic policy in India, South Korea, and Turkey. Ewald Nowotny Ewald Nowotny is the Governor of the David T. Llewellyn Oesterreichische Nationalbank (OeNB) David T. Llewellyn is Professor of and a Member of the Governing Money and Banking at Loughborough Council of the European Central Bank University, Honorary Visiting Profes- (ECB). Before taking on his current sor at the CASS Business School in position in September 2008, Ewald

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Nowotny held a number of high-level textbook Der öffentliche Sektor – Einfüh- positions in financial institutions. He rung in die Finanz wissenschaft was pub- was CEO of the Austrian BAWAG lished in 2008. Ewald Nowotny was an P.S.K. banking group from 2006 to elected Member of the Austrian Parlia- 2007, served as Vice President and ment from 1979 to 1999 and served as Member of the Executive Board of the chairman of the parliamentary Finance European Investment Bank (EIB) in Committee from 1985 to 1999. Ewald Luxembourg from 1999 to 2003 and, Nowotny is married and has a son. between 1971 and 1979, he was a Member and then President of the Andreas Pfingsten Governing Board of Österreichische Andreas Pfingsten has been Professor of Postsparkasse (P.S.K.). Moreover, from Business Administration and chairman 1992 to 2008 Ewald Nowotny served as of the Institute of Banking (Finance member of the supervisory board of Center Münster) at the University of several banks and corporations and was Münster since 1994. In the years be- a member of the OeNB’s General tween 1997 and 2002, he was also in- Council from 2007 to 2008. Ewald volved in additional engagements as for Nowotny was born in Vienna, Austria, example as visiting scholar at the Uni- in 1944. He studied law and govern- versity of Illinois, as visiting professor ment sciences at the University of at the University of Calgary, as Dean Vienna and economics at the Institute of the Münster School of Business of Advanced Studies in Vienna. In 1967, and Economics. Mr. Pfingsten studied he received his doctorate in law from Industrial Engineering and Manage- the University of Vienna. After work- ment at the Karlsruhe Institute of Tech- ing as assistant to Professor Kurt nology (1977–1982) and economics at W. Rothschild at the Economics De- the University of British Columbia partment of the University of Linz, (Canada). Between 1983 and 1988, he Austria, from 1968 to 1973, Ewald was engaged as research assistant and Nowotny received his postdoctoral later as assistant professor at the qualification (Habilitation) in General Department of Economic Theory and Economics and Public Economics in Operations Research at the Karlsruhe 1973 and subsequently held research Institute of Technology. Mr. Pfingsten tenures and professorships at Harvard holds a doctoral degree (1985) from the University, Technische Universität Faculty of Economics and Management Darmstadt, Germany, and the University at the Karlsruhe Institute of Technol- of Linz, Austria. From 1981 to 2008 ogy and habilitated in 1988. Subse- Ewald Nowotny served as Full Professor quently, he started working as depar- at the Vienna University of Economics ment manager for academic relations, and Business, where he also held the controlling and strategic planning at position of Vice Rector from 2003 to Fiducia IT AG in Karlsruhe. In 1990, he 2004. In 2008, Ewald Nowotny received was appointed Professor of Economics a honorary doctorate in Social and Eco- at the University of Siegen. Andreas nomic Sciences from Alpen-Adria Pfingsten has been awarded with numer- Universität Klagenfurt, Austria. Ewald ous honors during his career e.g. most Nowotny has published numerous arti- recently with the Finnish Economic cles in refereed journals. He is also the Papers Prize (2011) and the Best Paper author or coauthor of nine books; the fifth Award at the 2nd Rostock Conference edition of his internationally renowned on Service Research.

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Olli Rehn French Institute for International Rela- Olli Rehn (born 31 March 1962) is cur- tions ifri in Paris. From 1999 until rently serving as European Commis- 2004, she served as editorialist and sioner for Economic and Monetary France correspondent for the Financial Affairs. He had previously served as Times Deutschland. Prior to this, be- Commissioner for Enlargement. He has tween 1996 and 1999, she was chargée held a variety of political positions in de mission and later Head of the Infor- European institutions as well as in mation Department at the Association Finland. From 2003 to 2004, Mr. Rehn for the European Monetary Union in was Economic Policy Adviser to the Prime Minister of Finland. Before, he held the position of Professor and Director of Research at the Depart- ment of Polictical Science & Centre of European Studies at the University of Helsinki. His career at the European level started in the years between 1995 and 1996 as a Member of European Parliament, later (1998–2002) as Head of Cabinet of the European Commis- sion. Mr. Rehn studied economics, international relations and journalism at Macalester College, Saint Paul, Minne- sota, USA. He took a master’s degree in political science from the University Paris. She is the co-founding editor of of Helsinki in 1989, and a Ph.D. from www.eurozonewatch.eu (2006) and of the the University of Oxford in 1996 on European Political Economy Review the subject of Corporatism and Indus- (2003). She regularly serves as a guest trial Competitiveness in Small Euro- lecturer in German and international pean States. universities. Daniela Schwarzer studied political science and linguistics in Daniela Schwarzer Tübingen, Reading (UK) and at Science Daniela Schwarzer is currently the Po, Paris. She holds a Ph.D. in political Head of the Research Division EU Inte- economy from the Freie Universität gration at the German Institute for Berlin, co-supervised by the London International and Security Affairs, Stif- School of Economics. tung Wissenschaft und Politik (SWP) in Berlin. She joined the Institute in Lorenzo Bini Smaghi 2005. In 2010, she became a member Lorenzo Bini Smaghi has been a Mem- of the team of academic advisors to ber of the Executive Board of the Euro- the Polish Secretary of State for Euro- pean Central Bank since June 2005. pean Affairs in preparation of Poland’s Before becoming a Member of the EU Council Presidency in 2011. In ECB’s Executive Board, he held also 2007/2008 she was a member of the the position of Deputy Director Gen- working group Europe of the White- eral for Research at the ECB in 1998. book Commission on Foreign and Between 1998 and 2005, Mr. Bini European Policy in the French Foreign Smaghi served as Director General for Ministry and a visiting researcher at the International Relations at the Italian

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Ministry of the Economy and Finance. worked as a visiting researcher at the His earlier appointments include: Head Bank of England and the Financial of Policy Division, European Monetary Markets Group of the London School of Institute, Frankfurt (1994–1998) and Economics in 2004. His research inter- Head of Exchange Rate and Interna- ests are banking regulation and sys- tional Trade Division of Banca d’Italia temic risk, financial stability and finan- (1988–1994). Lorenzo Bini Smaghi was cial economics. educated at the Lycée Français de Brux- elles, graduating in 1974. Afterwards, Thomas Wieser Mr. Bini Smaghi began to study eco- Thomas Wieser was born 1954 in nomics at the Université Catholique de Betheseda, Md. USA. He holds a degree Louvain, completing his studies with an in economics from the University of MA in economics from the University Innsbruck and completed his studies of Southern California and a Ph.D. in eco- with post-graduate studies at the Uni- versity of Colorado, Boulder (Fulbright scholarship) and at the Institute for Advanced Studies, Vienna. He started his professional experience at the Inter- nationale Bank für Außenhandel as Head of Export Financing in 1982. In 1984, he began his research work on industrial policies in Austria in cooperation with WIFO. From 1986 to 1989, he was employed as economist at EFTA (Geneva), where the main focus of his work was on macro-economic country analysis, trade questions and state aid questions. Since 1989, Mr. Wieser has nomics from the University of Chicago been employed at the Austrian Ministry in 1988. In 1982, he started his profes- of Finance, where he was contracted sional career with an Internship at the as a senior economist dealing with in- Central Banking Department of the ternational economic policy questions. IMF; subsequently in 1983, he began to In 1995, he became Deputy Director work as an economist for the Interna- General responsible for economic tional Section of the Research Depart- policies, international financial institu- ment of Banca d’Italia. Lorenzo Bini tions and EU affairs. Subsequently in Smaghi is the author of several articles 1999, he became Director General for and books on international and Euro- International Affairs, Economic Policy, pean monetary and financial issues. Customs and Excise and in 2002 Direc- tor General for Economic Policy and Martin Summer Financial Markets. Martin Summer is Head of the Eco- nomic Studies Division at the Austrian Martin Wolf Central Bank (OeNB). Before joining Martin Wolf is Associate Editor and the OeNB in 2000, he worked as a Chief Economics Commentator at the lecturer at the University of Vienna, Financial Times, London. He was the University of Birmingham and the awarded the CBE (Commander of the University of Regensburg. He also British Empire) in 2000 for services to

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financial journalism. Mr. Wolf is an 1st December 2005, he was given First honorary fellow of Nuffield College, Magazine’s Special Advocacy Award at its Oxford University, of Corpus Christi annual Award for Responsible Capitalism. College, Oxford University and of the In January 2008, Mr. Wolf won the Oxford Institute for Economic Policy AMEC Lifetime Achievement Award at the (Oxonia), a special Professor at the Workworld Media Awards for 2007. University of Nottingham and a mem- He won the Commentator of the Year ber of the Board of Governors of the award at the Business Journalist of the Ben Gurion University of the Negev, in Year Awards of 2008. He was also Israel. He has been a forum fellow at placed among the world’s 100 leading the annual meeting of the World public policy intellectuals by the British Economic Forum, in Davos, since 1999 magazine Prospect and the US magazine and is a member of its International Foreign Policy in May 2008. He was Media Council. He won the RTZ David placed 15th in Foreign Policy’s list of the Watt memorial prize 1994, granted an- Top 100 Global Thinkers in December nually “to a writer judged to have made 2009 and 37th in the same list for 2010. an outstanding contribution in the Eng- He was appointed a member of the UK lish language towards the clarification government’s Independent Commission of national, international and political on Banking in June 2010. His most issues and the promotion of their recent publications are Why Globaliza- greater understanding”. He won the tion Works and Fixing Global Finance. Accenture Decade of Excellence at the China Business News named Fixing Business Journalist of the Year Awards Global Finance its Financial Book of the of 2003. He won the Newspaper Year for 2009. Mr. Wolf was educated Feature of the Year Award at the at Oxford University. Workworld Media Awards 2003. On

39th ECONOMICS CONFERENCE 2011 173

VOWI_Tagung_2011.indb 173 03.10.11 08:29 The Economics Conference hosted by the OeNB is an international platform for exchanging views on monetary and economic policy as well as financial market issues. It convenes central bank representatives, economic policy decision makers, financial market players, academics and researchers. The conference proceedings comprise all papers.

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