Rethinking Global Economic Governance in Light of the Crisis

Rethinking global economic governance in light of the crisis: Rethinking Global Economic Governance in Light of the Crisis: New Perspectives on Economic Policy Foundations New perspectives on economic policy foundations Rethinking Global Economic Governance in Light of the Crisis Global governance was, to put it charitably, one of the ‘steadier’ areas New Perspectives on Economic of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into Policy Foundations uncharted waters. For scholars, these horrible events were both daunting and exciting. Cherished assumptions had to be binned, but global governance became a top-line issue for heads of state. Economic and political analysis of global governance really mattered. This Report collects a dozen essays by world-class scholars on the full range of global governance issues including macroeconomics, ﬁ nance, trade, and migration. These reﬂ ect the research of nine research teams working in an EU-funded project known as PEGGED (Politics, Economics and Global Governance: the European Dimensions).

Edited by Richard Baldwin and David Vines Rethinking Global Economic Governance in Light of the Crisis

New Perspectives on Economic Policy Foundations Centre for Economic Policy Research (CEPR)

Centre for Economic Policy Research 3rd Floor 77 Bastwick Street London, EC1V 3PZ UK

Tel: +44 (0)20 7183 8801 Fax: +4 (0)20 7183 8820 Email: [email protected] Web: www.cepr.org

ISBN (print edition): 978-1-907142-52-9 Rethinking Global Economic Governance in Light of the Crisis

New Perspectives on Economic Policy Foundations

Edited by Richard Baldwin and David Vines

This book is produced as part of the project ‘Politics, Economics and Global Governance: The European Dimensions’ (PEGGED) funded by the Socio-Economic Sciences and Humanities theme of the European Commission’s 7th Framework Programme for Research. Grant Agreement no. 217559. Centre for Economic Policy Research (CEPR)

The Centre for Economic Policy Research is a network of over 700 Research Fellows and Affiliates, based primarily in European Universities. The Centre coordinates the research activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a Euro- pean economics research organization with uniquely wide-ranging scope and activities.

The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions expressed in this report are those of the authors and not those of the Centre for Economic Policy Research.

CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026).

Chair of the Board Guillermo de la Dehesa President Richard Portes Chief Executive Officer Stephen Yeo Research Director Lucrezia Reichlin Policy Director Richard Baldwin Contents

Foreword vii

Introduction 1 Richard Baldwin and David Vines

The governance of international macroeconomic relations

The G20MAP, global rebalancing, and sustaining global economic growth 17 David Vines

Fiscal consolidation and macroeconomic stabilisation 27 Giancarlo Corsetti

The Eurozone Crisis – April 2012 35 Richard Portes

The Triffin Dilemma and a multipolar international reserve system 47 Richard Portes

Globalisation, financial stability, and global financial regulation

Financial stability: Where it went and from whence it might return 57 Geoffrey Underhill

The crisis and the future of the banking industry 67 Xavier Freixas How to prevent and better handle the failures of global systemically important financial institutions 75 Stijn Claessens

Cross-border banking in Europe: policy challenges in turbulent times 85 Thorsten Beck

Credit default swaps in Europe 95 Richard Portes

Global banks, fiscal policy and international business cycles 107 Robert Kollmann

The global trade regime

The Doha Round impasse 111 Simon J Evenett

The Future of the WTO 121 Richard Baldwin

Open to goods, closed to people? 135 Paola Conconi, Giovanni Facchini, Max F Steinhardt, and Maurizio Zanardi

International migration and the mobility of labour

The Recession and International Migration 143 Timothy J Hatton

A dangerous campaign: Why we shouldn’t risk the Schengen-Agreement 157 Tito Boeri and Herbert Brücker Foreword

This report grows out of research carried out under the auspices of the project Politics, Economics and Global Governance: The European Dimensions (PEGGED) funded by the European Union’s Framework Programme. The project, as initially conceived, involved four workstreams: the governance of international macroeconomic relations; globalization, financial stability and global financial regulation; the global trade regime; and international migration and the mobility of labour.

This research agenda was conceived in the spring of 2007. Less than five years have passed since then, but the economic and political landscape has shifted enormously, and the early years of the millennium now seem rather distant and remote. Celebrations of the Great Moderation, arguments for the desirability of independent central banks and the virtues of markets and the discipline now seem not so much incorrect as somewhat beside the point.

Faced with this seismic shift, PEGGED responded in a sensible and pragmatic way, adapting its research agenda to the needs of policymakers as they grappled first with the turmoil in US subprime markets, then the growing disruption in global financial markets, and then the collapse of institutions at the heart of the financial system, such as AIG and Lehman. The output was disseminated through PEGGED working papers for the most part, but the urgency of the crisis and the need to deliver relevant research immediately to policymakers meant that new tools were needed. Fortunately, Richard Baldwin and CEPR had created just the right tool in the summer of 2007 – VoxEU. VoxEU columns and eBooks proved to be the right way to deliver key research results in real time. Although VoxEU is a separate venture, independent of PEGGED, VoxEU has been supported by DG Education and Culture, a happy synergy between EU funding programmes.

vii Rethinking Global Economic Governance in Light of the Crisis

Richard Baldwin and David Vines have performed an important service by bringing together in this volume key results from each of the project’s four workstreams. Vines, a CEPR Research Fellow, has acted as Scientific Coordinator of the PEGGED project since its inception and has contributed in particular to the project’s work on international macroeconomic relations. Baldwin, CEPR’s Policy Director, has played an important role in PEGGED, leading its work on the global trade regime. Bringing together the results of an ambitious and wide ranging research project such as PEGGED is no easy task, and we are grateful to David and Richard for doing so.

Thanks are also due to Samantha Reid, who brought this volume to a publishable state with her customary speed and efficiency. Sam will be leaving CEPR at the end of this month. We will not be able to take advantage of her skills in future, but this volume is testimony to her skill and professionalism.

Stephen Yeo CEO, Centre for Economic Policy Research 13 April 2012

viii Introduction

Richard Baldwin and David Vines Graduate Institute, Geneva and CEPR; Balliol College, Oxford, Australian National University, CEPR, and PEGGED

A group of scholars banded together in 2007 to propose a four-year research on global governance – the Politics, Economics and Global Governance: the European Dimensions (PEGGED for short). While all the research was to be innovative and world-class, the project was most definitely sailing in familiar seas. Then the storm hit – the global crisis blew us off-course and into uncharted waters.

Born as the ‘subprime crisis’ in autumn 2007, the crisis metastasized in September 2008 via the financial system. Credit markets froze; equity prices plunged. Emergency measures by governments and central banks – loosely coordinated by the newly established G20 Leaders’ Summit – stabilised financial systems. A second Great Depression was avoided, but sharp credit contractions teamed up with precipitous declines in business and consumer confidence; the industrialised world was hurled into recession at an unexpected velocity. The shock transmitted to developing nations via trade and expectation channels again at an unparalleled pace. This was the Great Recession and the initial shock continues to reverberate – the Eurozone crisis is the latest ricochet. With its lethal combination of over-indebted governments, weak banking system, and a lack of consumer and investor confidence, the Eurozone crisis continues to threaten European and global economy with another massive shock. The global crisis is most definitely not over.

For a team of scholars, these horrible events were both daunting and exciting. Many of our initial assumptions had to be binned, but it made our work radically more relevant and pressing. For the first time in decades, global governance was at the top of the to-

1 Rethinking Global Economic Governance in Light of the Crisis

do lists of heads of state. Economic and political analysis of global governance really mattered.

While our work is far from over – the European perspective on global governance is still very much an ongoing effort – the funding and thus the formal project ends this year. We are marking this with a final PEGGED conference in Brussels on 23 April 2012.

A new ‘Bretton Woods’ moment (in slow motion)

The pre-crisis global governance system, set up in the 1940s, came at lightning speed. A few dozen meetings established: the UN to keep peace, the IMF to manage the international monetary system, the World Bank to foster development, and the GATT/ WTO to manage the global trade system. Today sees the world re-crafting this system in slow motion.

The longstanding partnership between the US and the EU and their joint dominance – the heart of the Bretton Woods governance system – are rapidly breaking down. Emerging market economies are shifting economic realities, interdependencies, and power relationships. While long in train, such sea changes were accelerated by the impact of the global financial crisis – especially its asymmetric impact on long-term prospects. Since WWII, the economic prospects have never been dimmer for the rich nation, or brighter for developing nations. The emerging economies are back on track; the industrialised nations are looking at a ‘lost decade’.

In this more complex, multipolar, world, the interests of new players need to be represented, and international cooperation must be organised in new ways. The economic impact of cross-border integration is coming to constrain national policy autonomy more than ever before.

2 Introduction

The PEGGED Research Programme

The PEGGED Research Programme has helped European policymakers to construct and project a vision for this new global system. Within the PEGGED Programme, political scientists and economists have worked together to develop workable, real- world policy solutions in four important areas of international cooperation. These four areas are:

• The governance of international macroeconomic relations

• Globalisation, financial stability, and global financial regulation

• The global trade regime

• International migration and the mobility of labour

Throughout its life, PEGGED has produced a number of working papers on each of these four topics. The Programme has also produced many policy publications on these topics, in the form of Policy Briefs, Papers, and Reports. These can all be found on http://pegged.cepr.org/. PEGGED has also held regular policy events in a number of places, including Amsterdam, Barcelona, Brussels, Florence, Geneva, London, Lisbon, Madrid, Oxford, Paris, Pisa, Rome, Tilburg, Tokyo, and Villars. Details of all of these meetings can also be found at http://pegged.cepr.org/.

In this introductory chapter we briefly describe the chapters included in this Report, grouping them by the four areas.

The governance of international macroeconomic relations

Global governance made remarkable progress with the establishment of the G20 Leaders’ Summit. The first cooperative steps – coordinated stimulus in reaction to the global crisis – were easy. Today, with monetary policy at its lower bound and fiscal policy at its upper bound in the advanced economies, global coordination is far more difficult. The chapter by David Vines outlines the main economic imbalances that require coordination: China must move towards a greater reliance on domestic demand;

3 Rethinking Global Economic Governance in Light of the Crisis

the US must secure long-term fiscal consolidation; and Europe must embrace reforms that will allow southern Europe to grow. The world now needs a group of policymakers, from a number of countries, who act together so as to carry out the necessary policy adjustments. The G20 Mutual Assessment Process is a new framework in which these policymakers may well be able to do what is required.

Initial responses to the crisis led to the accumulation of a vast stock of public liabilities. Since then, fiscal tightening has become the priority in advanced countries, and especially across Europe. In his chapter Giancarlo Corsetti asks whether governments should relent in their efforts to reduce deficits now, when the global economy is still weak, and policy credibility is far from guaranteed. He draws on two channels of recent research, which point in opposite directions. Recent work on the effects of fiscal contraction at the time of a liquidity trap suggests that multipliers may be large in these circumstances. Empirical evidence confirms this, especially at a times of recession in the presence of a banking and financial crisis. As a result, if monetary policy is constrained, there is little doubt that governments with strong credibility should abstain from immediate fiscal tightening, while committing to future deficit reduction. However there is a difficulty in following this advice when the government is charged a sovereign-risk premium, since sovereign risk adversely affects borrowing conditions in the broader economy. That will cause fiscal multipliers to be much lower. And, due to the sovereign-risk channel, highly indebted economies can become vulnerable to a self-fulfilling economic downturn. This poses a dilemma for highly indebted countries: they may be well-advised to tighten fiscal policies early, even if the effect of this will be to reduce activity. The presence of such a sovereign-risk channel provides a strong argument for focusing on ways to limit the transmission of sovereign risk into private- sector borrowing conditions. Recent unconventional steps by the ECB suggest that this is possible.

The Eurozone crisis of 2011–12 would have been much easier to contain and resolve had there been no global financial crisis, and no deep recession in the advanced countries. As a consequence, Richard Portes argues in his chapter that it is too facile to

4 Introduction

say that the Eurozone crisis is essentially due to inherent faults in the monetary union. Nevertheless, the crisis has exposed genuine problems that were neither manifest nor life-threatening before 2008–09. They would not be remedied by exit of a few countries from monetary union, which would also be deeply harmful to those countries. The predicaments of the countries at the heart of the crisis (the GIPS – Greece, Ireland, Italy, Portugal, and Spain) are varied, and, he argues, are not primarily due to membership of the single currency, nor to fiscal profligacy (except Greece). It is also wrong to reduce the causes to inadequate ‘competitiveness’ that could be cured by currency devaluation. Only from 2003–04 were these countries running large current-account deficits within the monetary union; and these were financed (some would argue caused) by equally large capital flows from the surplus countries. Germany played the same role in the Eurozone as China in the global economy. Unlike the US, however, the GIPS were not ‘free spenders’ – they saw a fall in consumption as a share of GDP and a rise in the investment share during 2000–07. And unlike China, the capital flows from Germany and France came primarily from banks – they were private not official flows. The macroeconomic problem in EMU now is the fiscal consequence of the financial crisis in bank-based financial systems. Creditor countries have been unwilling to let their banks suffer the consequences of bad loans – rather, they have managed to put the entire burden on the taxpayers of the debtor countries. This disregards the EU and Eurozone financial integration that policymakers have promoted. The longer-term refinancing operation (LTRO) was an inspired move to bypass German objections to the ECB taking on the lender of last resort (LLR) role. But it is a temporary expedient. The only stable solution is for the ECB to accept explicitly, in some form, the LLR role. To stop self-fulfilling confidence crises, the ECB should commit to cap yields paid by solvent countries with unlimited purchases in the secondary markets. Arbitrage will then bring primary issue yields down to the capped level. For the long run, debt sustainability requires economic growth. The current fiscal contraction is contractionary. Austerity policies are not the solution, but rather a major part of the problem. Moreover, fiscal contraction together with private-sector deleveraging is not feasible without a current account surplus. There will be no exit from the current debt traps and stagnation unless

5 Rethinking Global Economic Governance in Light of the Crisis

the surplus countries accept that they must allow the others to run surpluses, so that either they relax fiscal policy or they adopt policies to reduce private net savings. And the overall position would improve if the euro were to depreciate significantly – another reason for further monetary easing.

A second chapter by Richard Portes concerns the Triffin Dilemma and its implications for moves, at present, towards a multipolar international reserve system. Robert Triffin set out his supposed dilemma for the international monetary system in the 1960s. Meeting global demand for liquid reserves required continuously rising holdings of US dollars by other countries; but that would progressively undermine confidence in the dollar as a store of value. The contemporary version of this problem starts from the hypothesis that the global economy faces a shortage of reserve assets (‘safe assets’). The empirical evidence cited is persistently low real interest rates. The supply of truly safe assets – US Treasuries – rests on the backing of the US ‘fiscal capacity’. But that grows only as US GDP grows, and US GDP grows slower than world GDP, which determines the growth of demand for those assets. Hence there must be a growing excess demand for safe assets, and we need to move to a multipolar reserve currency system in which other countries also provide safe assets. But the 1960s story was wrong, conceptually and empirically, in assuming the US would run current-account deficits in order to generate foreign dollar holdings; and now, real interest rates have not been historically low, nor is there a clear definition of fiscal capacity, nor is there a global liquidity shortage. The world will move towards a multipolar reserve system, but not because of the Triffin Dilemma. Official reserve holders want to diversify their portfolios, and the correction of global imbalances will promote this. The emerging- market countries will develop their domestic financial markets and will have less need for foreign financial intermediation. Some emerging-market countries may themselves become reserve suppliers. And more international facilities centred on the IMF could reduce the demand for reserves for self-insurance. Considering the Triffin Dilemma undoubtedly helps us to understand the forces underlying the development of the international financial system. But it is not the source of the system’s problems.

6 Introduction

Globalisation, financial stability, and global financial regulation

The global and Eurozone crises seem to have undermined, perhaps even destroyed, the traditional foundations for financial stability in the US and Europe. The chapter by Geoffrey Underhill focuses on recommendations for the provision of financial stability. The three essential points are: First, there is little new here; the policy dilemmas of today are longstanding, well known, and can be informed by the host of historical experience and related research. Second, the potential and more obvious flaws of the pre-crisis system of financial governance were well known and debated pre-crisis but this did not prevent the crisis. Unfortunately, most reform proposals are based on such pre-crisis thinking and are therefore unlikely to achieve the reform goals. Worse, the Eurozone is descending into modes of crisis resolution that are known to be dysfunctional and destructive of successful economic growth and development. Third, reform that is more likely to provide financial stability for the long run requires new thinking. What Europe needs is new ‘ideational departures’ that draw on established historical experience. This should include considerable institutional innovation, a reformed policy process, and institutionalised attention to the political legitimacy and long-run sustainability of financial openness. This new thinking is needed at both the global and EU levels.

The global economic crisis wreaked enormous social and economic cost on nations in Europe and beyond. It also shattered confidence in US and European banking systems. The regulatory reform response has been aimed at curtailing the financial sector’s excessive appetite for risk. The chapter by Xaiver Frexias argues that for regulation to prevent future crises, we must understand the causes behind the excessive risk-taking in the first place. The first step is a working definition of excessive risk-taking. Drawing on recent research, the author defines it as a level of risk that corresponds to a negative net investment value. Obviously no well-run bank would knowingly engage in such projects so the question is: what went wrong to allow such investment? The chapter points to four possible answers. First managers’ incentives and corporate governance could have been wrong. Second, the business cycle risks might not have been properly

7 Rethinking Global Economic Governance in Light of the Crisis

factored in (capital is excessively cheap and lending excessively permissive in upturns with the opposite holding in downturns). Third, regulatory supervision and market discipline could have failed to curb excesses in boom times. Finally, moral hazard could explain the problem, namely the idea that banks take too much risk in anticipation of being bailed out in the event of massive losses.

Massive support has been provided in the ongoing financial crisis to banks and other financial institutions including support for failed global systemically important financial institutions (G-SIFIs). Stijn Claessens argues that the ad hoc methods which have been adopted for this support have led to much turmoil in international financial markets and worsened the real economic and social consequences of the crisis. He argues that a better approach to dealing with G-SIFIs is sorely needed. To date, international efforts have focused on the harmonisation of the rules of supervision and on increasing supervisory cooperation. Instead, he argues that what is needed is an effective resolution regime, and that there are three reform models available. The first reform model is a territorial approach under which assets are ring-fenced so that they are first available for the resolution of local claims. The second reform model is a universal approach under which all global assets are shared equitably among creditors according to the legal priorities of the home country that can help address the global problem. He argues strongly that we will be driven towards a third intermediate approach, which combines aspects of the other two. As policymakers realise all too well, however, especially in Europe today, whatever approach is adopted to the resolution of G-SIFIs, there is a danger of conflict with three other policy objectives – preserving national autonomy, fostering cross-border banking, and maintaining global financial stability.

Turning to the banking system, Thorsten Beck points out that the Eurozone crisis is not only straining banks’ balance sheets, it is straining the cohesion of the EU’s single banking market. The key source of tension is the close interaction between national banks and their governments – both through banks’ holdings of their government’s bonds and the government’s implicit insurance of their banks. This tension raises fundamental questions about the need for greater institutional underpinnings. Indeed,

8 Introduction

rather than disentangling the sovereign debt and bank crises, recent policy decisions – such as the ECB’s LTROs – have tied the two closer together.

The problem, according to the author, is that Europe, and especially the Eurozone, did too little after the 2007–08 crisis to address the institutional gaps needed to ensure a stable banking market and manage the inter-linkages between monetary policy and financial stability. EU policymakers are facing the current crisis with too few policy tools and coordination mechanisms. What is needed is additional policy tools in the form of macroprudential financial regulation. One tool – monetary policy – is simply not enough to achieve asset price inflation and consumer price inflation, especially in a currency union where asset price cycles are not completely synchronised across countries. Such regulation would have to be applied on the national, but monitored on the European, level.

Beyond the lack of proper policy tools and mechanisms, the Eurozone faces a deeper crisis – that of a democratic deficit for the necessary reforms to make this monetary union sustainable in the long run. Political resistance in both core and periphery countries against austerity and bailouts illustrates this democratic deficit. In the long term, the Eurozone can only survive with the necessary high-level political reforms.

A further chapter by Richard Portes discusses credit default swaps (CDSs) which are derivatives; financial instruments sold over the counter. They transfer the credit risk associated with corporate or sovereign bonds to a third party. The outstanding gross notional positions in this market exceeded $60 trillion in early 2007 but have since fallen to a range of ‘only’ $15-20 trillion. The market first caught policymakers’ attention when AIG had to be bailed out because it had written huge amounts of CDS protection which it could not redeem; and in Europe when Greek sovereign CDS prices rose dramatically in spring 2010, apparently contributing to a self-fulfilling crisis, then when the authorities sought to avoid triggering CDS contracts on Greece in the eventuality of Greek debt default. Portes’ empirical work on Eurozone sovereign CDS prices during 2004–11 finds that for Eurozone sovereign debt, the CDS and cash market

9 Rethinking Global Economic Governance in Light of the Crisis

prices are normally equal to each other in long-run equilibrium, as theory predicts. One interpretation is that the market prices credit risk correctly: sovereign CDS contracts written on Eurozone borrowers seem to provide new up-to-date information to the sovereign cash market. In the short run, however, the cash and synthetic markets price credit risk differently to various degrees. Second, the Eurozone CDS market seems to move ahead of the corresponding bond market in price adjustment, both before and during the crisis. And CDS contracts clearly do play a useful hedging role. An alternative interpretation of our results, however, is that the CDS market leads in price discovery because changes in CDS prices affect the fundamentals driving the prices of the underlying bonds. If the CDS spread affects the cost of funding of the sovereign (or corporate), then a rise in the spread will not merely signal but will cause a deterioration in credit quality, hence a fall in the bond price; and this mechanism could lead to a self- fulfilling vicious spiral. Recent theoretical work justifies such an interpretation and, in particular, attributes responsibility to ‘naked’ CDSs, bought by investors who do not hold the underlying bonds. Portes argues that naked CDSs are indeed destabilising, both for sovereigns and for financial institutions. The implication for policy is clear: ban them.

The crisis – which started with the 2007 subprime crisis and exploded into a wider financial crisis in September 2008 – became the global crisis when it triggered the sharpest global recession since the 1930s. This chain of events revealed a major fragility in the global economy, but it also revealed a major hole in economists’ macroeconomic toolkit. Quite simply, this crisis could not happen in standard, pre-crisis macro theory. The analytic framework just did not allow for financial intermediaries so macroeconomic shock could not emanate from the financial sector. Issues like bank balance sheets had been assumed away.

While filling this lacuna represents a challenge for economic research for years to come, Robert Kollmann describes several hole-filling elements in his PEGGED-sponsored research. He has focused on the role of global banks in business cycles in the EU and in the world economy. Banks that make loans across many nations but have their equity

10 Introduction

base in one connect the state of bank equity markets in one nation to lending and thus economic activity in many. For example, a loss on bank loans in one country reduces the global banking system’s capital which in turn triggers a global reduction in bank lending; a worldwide recession is the result.

The author points out that this economic logic provides a solid basis for policy. The key role of bank health for the overall economy suggests that government support for the banking system might be a powerful tool for stabilising real activity in a financial crisis.

The global trade regime

The chapter by Simon Evenett outlines the key factors responsible for the Doha Round impasse and argues that scholars ought to devote more attention to analysing such impasses. The emphasis here is not on the daily twists and turns of the Doha Round negotiations but on the underlying factors that have probably prevented WTO members from reaching a mutually acceptable deal.

The WTO is widely regarded as trapped in a deep malaise. Richard Baldwin argues that, in fact, the WTO is doing fine when it comes to the 20th century trade for which it was designed – goods made in one nation’s factories being sold to customers abroad. But, he argues, the WTO’s woes stem from the emergence of ‘21st century trade’ (the complex cross-border flows arising from internationalised supply chains) and its demand for beyond-WTO disciplines. The WTO’s centrality has been undermined as such disciplines have emerged in regional trade agreements. The implication is clear. Either the WTO remains relevant for 20th century trade and the basic rules of the road, but irrelevant for 21st century trade; all ‘next generation’ issues will be addressed elsewhere. Or the WTO engages in 21st century trade issues both by crafting new multilateral disciplines – or at least general guidelines – on matters such as investment assurances, and by multilateralising some of the new disciplines that have arisen in regional trade agreements. We are presented with a stark choice. The WTO can stay on the 20th century side-track on to which it has been shunted, or it can engage creatively

11 Rethinking Global Economic Governance in Light of the Crisis

and constructively in the new range of disciplines necessary to underpin 21st century trade.

Trade policy poses tough questions for policymakers, but nothing like the problems arising from migration policy choices. Economists have a hard time explaining this as they typically work with analytic frameworks where trade and migration have quite similar economic effects. The chapter by Paola Conconi, Giovanni Facchini, Max Steinhardt, and Maurizio Zanardi discusses recent research that examines the similarities and differences in voting behaviour in the US Congress on the two issues. What they find is that voting is influenced by the constituency’s skill mix (with the impact on trade and migration votes going in the same direction), and party affiliation leading to divergent voting patterns (Democrats voting in support of liberal immigration policies but against trade liberalisation). Additionally, the fiscal burden of immigrants for a constituency dampens the representative’s enthusiasm for liberal migration policies, but has no impact on trade. The ethnic composition of Congressional districts also matters with voting for immigration rising with the district’s share of foreign-born citizens. Taken together, the authors argue that these effects explain why legislators are more likely to support opening barriers to goods than to people.

International migration and the mobility of labour

Immigration policy is back in European headlines although perhaps not as much as one would expect given the dire economic straits in many European nations. The chapter by Tim Hatton admits that economists still do not fully understand how immigration policy evolves, or why it seems so different now than in the past. Current understanding is based on four factors. First, rising education levels have led to better informed attitudes towards immigration, especially as concerns competition of unskilled immigrants. Second, concerns about the cost of the welfare state are counterbalanced by the way such safety nets ease worker-specific adjustments. Third, as international cooperation becomes more pressing on must-do issues like climate change and security issues,

12 Introduction

draconian immigration rules, which could potentially harm such cooperation, are less likely to be implemented. Nevertheless, such arguments remain speculative and must be subjected to more rigorous examination.

Playing politics with migration is dangerous but dangerously attractive in today’s climate of European malaise. The chapter by Tito Boeri and Herbert Brücker examines the case for more coordinated and forward-looking migration policies in Europe. The case rests on three key points. First, uncoordinated national policies are not the right way to govern migration in an area as economically integrated as Europe. Uncoordinated policies create prisoner’s dilemma situations with every member spending inefficiently large amounts on border controls, sub-optimal asylum and humanitarian policies, and inefficiently restrictive policies on illegal immigration. Second, the resulting zero immigration policy vis-à-vis northern Africa has backfired. Now migration is based on family reunification, humanitarian migration, and illegal migration. This means immigrants are, on average, less educated than economic migrants and natives, do not generally achieve native language proficiency, and typically have a poor performance in the labour market and education system of the host country. All this feeds back into negative perceptions thus making economic and social integration even more difficult. Finally, the authors point out that today incomes in northern African are not much lower than those in central and eastern Europe at the time of the 2004 EU enlargement. Moreover much of the north African youth urban labour force is, at least on paper, relatively well educated. The authors estimate that north African immigration could create EU economic gains that are larger than those experienced from east European migration last decade. The key would be to adopt more realistic restrictions vis-à-vis northern African countries. This skilled immigration would reduce pressures for illegal migration while creating substantial economic gains in both the receiving and sending regions.

13 Rethinking Global Economic Governance in Light of the Crisis

Concluding remarks

Plainly more work is needed on this pressing set of issues. Global governance is a work in progress and scholars have an obligation to continue analysing and informing the choice governments are making on an almost daily basis. We hope that this collection of essays provides an accessible bridge to the academic work in the area as well as a stimulus to others scholars to take the research further and deeper.

5 April 2012

14 Introduction

About the authors

Richard Edward Baldwin is Professor of International Economics at the Graduate Institute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chief of VoxEU.org since he founded it in June 2007. He was Co-managing Editor of the journal Economic Policy from 2000 to 2005, and Programme Director of CEPR’s International Trade programme from 1991 to 2001. Before that he was a Senior Staff Economist for the President’s Council of Economic Advisors in the Bush Administration (1990–91), on leave from Columbia University Business School where he was Associate Professor. He did his PhD in economics at MIT with Paul Krugman. He was visiting professor at MIT in 2002/03 and has taught at universities in Italy, Germany, and Norway. He has also worked as consultant for the numerous governments, the European Commission, OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, his research interests include international trade, globalisation, regionalism, and European integration. He is a CEPR Research Fellow.

David Vines is Scientific Coordinator of the PEGGED Programme. He is Professor of Economics in the Economics Department, Oxford University, and a Fellow of Balliol College, Oxford as well as Director of the Centre for International Macroeconomics at Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellow at the Bank of England, he has advised a number of international organisations and governmental bodies. He has published numerous scholarly articles and several books, most recently The Asian Financial Crisis: Causes, Contagion and Consequences, with Pierre-Richard Agénor, Marcus Miller, and Axel Weber.

The G20MAP, global rebalancing, and sustaining global economic growth

David Vines Balliol College, Oxford, Australian National University, CEPR, and PEGGED

1 The global policy problem

It is clear that the world needs global rebalancing – at some stage the scale of international imbalances must be reduced. As is well known, two things are necessary for this rebalancing: changes in relative absorption between deficit and surplus countries in the world – including cuts in absorption in the deficit countries - and changes in relative prices between deficit and surplus countries.

But the world also needs to ensure that the recovery from the global financial crisis is sustained, ie it needs a satisfactory absolute level of global growth. There are significant global risks to this outcome:

• Continued deleveraging in many G20 countries;

• A rapid fiscal consolidation in many countries;

• The gradualness of the adjustment in East Asia;

• The macroeconomic outcome of the crisis in Europe.

Unemployment in the US, Europe, and elsewhere in the OECD remains disastrously high. To solve this unemployment problem will require a sustained global recovery. Yet financial markets, and policymakers, are now focused on reducing public deficits and debt. Temporary stimulus packages are unwinding, and fiscal consolidation is setting in. There is a danger that the attempts to rebalance – including the cuts of absorption in deficit countries – will add to the attempts to fiscally consolidate, add to the other risks, and put global growth prospects seriously at risk.

17 Rethinking Global Economic Governance in Light of the Crisis

In response to this danger, too many countries appear to be looking for export-led growth. But we cannot nearly all have export-led growth. There only a small number of countries with an appetite for exports. This is a systemic problem.

The G20 Mutual Assessment Process, or G20MAP, is a new global institutional structure forum in which this systemic problem is now being tackled.

2 The need for international macroeconomic cooperation

In the period after the Asia crisis there was high saving in emerging market economies (and elsewhere). East Asia set exchange rates to ensure export-led growth. The US Federal Reserve set US interest rates. The outcomes ensured satisfactory growth in both the US, and in other advanced countries, as well as in East Asia (Adam and Vines 2009). Because of high savings the real interest rate needed to be low. This system led to the Great Moderation – the ‘Greenspan put’ emerged as a part of what happened (as is well explained in an IMF Staff Note by Blanchard and Milesi Ferreti 2011).

• This system ensured satisfactory global growth;

• It did not require detailed international cooperation in policymaking (Vines 2011b); but

• It gave rise to global imbalances.

For a time, these imbalances were not treated as a policy problem and removing them was not a target of international policy. Such a system – with its low interest rates – also led to high leverage, to financial instability, and ultimately to the global crisis (Obstfeld and Rogoff 2009).

Global cooperation in response to the crisis was initially easy; the outcome at the G20 summit in London in April 2009 was remarkable. But it was straightforward to bring about what happened. All countries had an interest in using monetary expansion, and then fiscal expansion, to avoid global collapse. And the costs of the resulting fiscal expansion – in the form of ballooning debt –– only gradually led to fiscal crises.

18 The G20MAP, global rebalancing, and sustaining global economic growth

The world is now in a more complex position that it was immediately after the crisis, and cooperation is now much more difficult. Interest rates are at their zero bound. And, because of the high levels of public debt, there is little fiscal space.

China is rebalancing its growth model towards one in which there is a more rapid expansion of domestic demand. But China is necessarily doing this at a slow speed (Yongding 2009). During this period of adjustment the dollar-renminbi real exchange rate will continue to be one which leads to East Asia having a large export surplus. At the same time, world interest rates are too low for China, which continues to attempt to deal with this difficulty with capital controls.

Europe is in danger of re-creating the global problem at the European level (Vines 2010, 2011a). Countries in the southern European periphery are now embarking on demanding austerity programmes. The difficulty of adjusting wages and prices in these countries of the periphery, which are greatly uncompetitive vis-à-vis Germany, creates a need for the euro to depreciate, so as to encourage growth in these countries. At the same time, the German economy is difficulty because European interest rates need to be low. The position in Germany would become even more unbalanced if the euro were to depreciate further.

And the US is caught in a fiscal trap. The inability of the US political system to promise longer-term fiscal correction has made it difficult to for the US to sustain its shorter-term fiscal stimulus. The resulting fiscal withdrawal is part of the reason why unemployment seems likely to remain so persistent in the US.

Many activities in the US are now globally uncompetitive because of the depreciated real exchange rates of China and of other East Asian countries. The outcome may well be one in which the US wishes to have a lower real exchange rate against not just East Asia, but against Europe as well. Quantitative easing has become a tool which influences the dollar in this direction. But many activities in the European periphery are also globally uncompetitive, because of the depreciated real exchange rate of Germany

19 Rethinking Global Economic Governance in Light of the Crisis

within the euro – and also because of the depreciated real exchange rate of China and other East Asian countries.

All this means that Europe may wish to see the opposite outcome from that desired by the US – a lower real exchange rate for Europe against both the US and East Asia, in order for growth in the European periphery to resume. The LTRO of the ECB appears to be pushing the euro in such a direction. There is, in short, a genuine possibility of policy conflict over monetary policy, and exchange rates among China, the US and Europe. Protectionism in trade is another possible response to this problem (Eichengreen and Irwin 2009). Plainly there is a pressing need for international macroeconomic policy cooperation.

3 The G20MAP and international macroeconomic cooperation

The G20MAP is in the process of producing a group of policymakers from G20 countries who come to share the ownership of an international cooperative process. That is, it is creating policymakers who are concerned with the global problem (such as those mentioned above), rather than being concerned only with national objectives (IMF 2011a). The aim is to produce something much better than what was achieved in the IMF’s previous process of multilateral surveillance process, or MSP. The governance structure of the IMF meant that the US was able to ensure that the IMF made no criticism of the US as part of the MSP – and was able to ensure that the IMF did not exercise any sanction on the US – as a response its large current-account deficit. The Fund was also unable to exercise any sanction on China as a response to its undervalued exchange rate.

The G20MAP was established at the Pittsburgh G20 summit in 2009. G20 leaders then agreed that their aim would be to pursue growth collectively. At that meeting, and at the Seoul summit in 2010, there was an agreement that the objective was a ‘Framework for Strong Sustainable and Balanced Growth’ where ‘sustainable’ included the need

20 The G20MAP, global rebalancing, and sustaining global economic growth

for global rebalancing. Since then the G20MAP has gone through a number of stages, some of which are set out in IMF (2011a). It was decided at an early stage that the IMF would provide technical analysis to support the G20MAP.1

Subsequently it was decided that the Fund would evaluate how members’ macroeconomic policies should fit together, providing an assessment of whether national policies, taken collectively, are likely to achieve the G20’s goals. Since then, during 2011, the IMF carried out a detailed investigation of the policies of a particular set of countries, rather than just concentrating broadly on the world, or on regions of the world. These countries were the US, China, Japan, Germany, India, the UK, and France. The decision as to which particular set of countries to investigate in detail was taken in April 2011, and depended on a chosen set of indicators. The choice of indicators attracted much attention at the time. But the most important thing about these indicators is that the use of them enabled a decision to be made as to which countries would be analysed in detail. That decision enabled the G20MAP to be given a much clearer focus. The analyses were published at the time of the Cannes G20 Summit in November 2011. The IMF also carried out an analysis of how the policy projections of the seven countries, and of the rest of the world, would fit together into an overall global outcome (IMF 2011b).

These analyses revealed the risks which have been described earlier in this essay. But, importantly, the IMF was able to identify a number of policy changes which would lead to a better outcome. These potential policy changes are now on the table for countries to examine, and respond to, as part of the G20MAP which is taking place in 2012.

The G20MAP is in its early days. Decisions on the possibilities identified by the IMF will not be immediate.

1 The Framework for Strong Sustainable and Balanced Growth is not just about achieving satisfactory macroeconomic outcomes; it is also concerned with achieving financial stability, with environmental issues, and with the raising of living standards in developing countries. The broader set of international discussions about that wider range of concerns is being assisted by technical inputs from a range of international institutions far beyond the IMF.

21 Rethinking Global Economic Governance in Light of the Crisis

But what has happened already provides a number of useful insights.

• Coordination, of course, works best when countries share a common objective.

This was the case immediately after the crisis. But it has become less so, for reasons which will be obvious from the earlier part of this essay.

• What is often required for coordination is not so much an agreement to act in the pursuit of a shared objective but instead a clearer understanding of what other players intend to do.

Such an understanding will make clearer for each player what that player needs to do. The G20MAP has engaged a number of international policymakers in a global policymaking process and seems likely to lead to greater understandings of this kind. Progress of this kind will not, of course, be immediate, but it may be significant.

Such understandings are especially necessary if the processes of adjustment which are required will be a gradual. In that case each policymaker needs to be able to trust that other policymakers will carry out the adjustments which are required of them. I have described in this essay three kinds of policy adjustments which are necessary:

• That China moves towards a greater reliance on domestic demand;

• That the US moves towards longer-term fiscal consolidation; and

• That Europe moves towards reforms which enable southern Europe to begin to grow again.

All of these adjustments will be gradual, and all of them need to be carried out in a way which relies on other policymakers playing their part as well.

The world now needs a group of policymakers, from a number of countries, who act together so as to carry out the necessary policy adjustments. The G20MAP is in the process of creating a new global institutional structure, one in which these policymakers may well be able to do what is required.

22 The G20MAP, global rebalancing, and sustaining global economic growth

References

Adam, C, and D Vines (2009), “Remaking Macroeconomic Policy after the Global Financial Crisis: A Balance Sheet Approach”, Oxford Review of Economics Policy, December 25(4): 507–52.

Allsopp, C, and D Vines (2010), “Fiscal policy, intercountry adjustment, and the real exchange rate within Europe”, in Buti, M, S Deroose, V Gaspar, and J Nogueira Martins (eds), The Euro: The First Decade. Cambridge: Cambridge University Press. Also available as European Economy. Economic Papers. No 344. October 2008. http:// ec.europa.eu/economy_finance/publications/.

Blanchard, O, and J Milesi Ferretti (2011), “(Why) should current account imbalances be reduced?” IMF Staff Note.

Eichengreen, B and D Irwin (2009), “The protectionist temptation: Lessons from the Great Depression for today” VoxEU.org, 17 March. Available at http://global-crisis- debate.com/index.php?q=node/3998.

House, B, D Vines, and M Corden (2008), “The IMF”, New Palgrave Dictionary of Economics, London: Macmillan.

IMF (2010), “Strategies for Fiscal Consolidation in the Post-Crisis World”, paper prepared by the Fiscal Affairs Department, and available at http://www.imf.org/ external/np/pp/eng/2010/020410a.pdf.

IMF (2011a) “The G-20 Mutual Assessment Process (MAP)”, an IMF Factsheet, available at http://www.imf.org/external/np/exr/facts/g20map.htm.

IMF (2011b), IMF Staff Reports for the G-20 Mutual Assessment Process, available at http://www.imf.org/external/np/g20/pdf/110411.pdf.

Obstfeld, M and K Rogoff (2009), “Global Imbalances and the Financial Crisis: Products of Common Causes”, available at http://elsa.berkeley.edu/~obstfeld/santabarbara.pdf.

23 Rethinking Global Economic Governance in Light of the Crisis

Vines, D (2010), “Fiscal Policy in the Eurozone after the Crisis”, paper presented at a Macro Economy Research Conference on Fiscal Policy in the Post-Crisis World, held at the Hotel Okura, Tokyo, 16 November.

Vines, D (2011a), “Recasting the Macroeconomic Policymaking System in Europe”, Zeitschrift für Staats- und Europeawissenschaften (ZSE) [Journal for Comparative Government and European Policy], November.

Vines, D (2011b), “After Cannes: The G20MAP, Global Rebalancing, and Sustaining Global Economic Growth”, available at http://www.bruegel.org/fileadmin/bruegel_ files/Events/Event_materials/AEEF_Dec_2011/David_Vines_PRESENTATION_ UPDATE.pdf.

Yongding, Yu (2009) “China’s Responses to the Global Financial Crisis”, Richard Snape, Lecture, Productivity Commission, Melbourne, November, available at http:// www.eastasiaforum.org/wp-content/uploads/2010/01/2009-Snape-Lecture.pdf.

24 The G20MAP, global rebalancing, and sustaining global economic growth

About the author

Fiscal consolidation and macroeconomic stabilisation

Giancarlo Corsetti Cambridge University and CEPR

The initial response to the crisis led to the accumulation of a vast stock of public liabilities. Since then, fiscal tightening has become the priority in advanced countries, and especially across all of Europe. The measures adopted so far have not proved a cure-all for financial market concerns about debt sustainability. Tighter fiscal policy has, however, coincided with renewed economic slowdown or even contraction, raising questions about the desirability of fiscal austerity.

The key question is whether governments should relent in their efforts to reduce deficits now, when the global economy is still weak, and policy credibility is far from guaranteed. Under what circumstances would it be wise to do this?

Countries fall into three categories. At one extreme we have countries already facing a high and volatile risk premium in financial markets. At the other extreme we have countries with strong fiscal shoulders, actually enjoying a negative risk premium. A third category includes countries not facing a confidence crisis, yet with inherent vulnerabilities – a relatively high public debt, a fragile financial sector, high unemployment. The question of how to ensure debt sustainability is vastly different across these.

By way of example, how much of Italy’s slowdown is due to austerity and how much is due to the near meltdown of debt last summer? There is little doubt that the credit crunch which followed the sudden loss of credibility of Italian fiscal policy (whether or not justified by fundamentals) has a lot to do with the severe slowdown that Italy is

27 Rethinking Global Economic Governance in Light of the Crisis

experiencing. The current fiscal tightening is arguably contractionary, but the alternative of not reacting to the credibility loss would have produced much worse consequences.

Things are more complex for the UK; it hasn’t lost credibility and it borrows at low interest rates. Does this mean UK policymakers are shooting themselves in the foot? Are they keeping the economy underemployed for years and thus destroying potential output with their austerity drive? Or, are they wisely forestalling a bond market rebellion like those seen on the continent that would prove much costlier?

Much of the work carried out in the PEGGED project over the years provides a conceptual and analytical framework to address these issues. The question of course is not only about restoring safer fiscal positions after the large increase in gross and net public debt in the last few years. Rather, it is about which fiscal policy path would be most effective in helping the global economy and the economy of the Eurozone overcome the current crisis.

This issue requires solution both at country-level, and at regional and global level. International considerations complicate the analysis; a policy which may be perfectly viable and desirable for a country conditional on an international context, may not work in different circumstances. The outcome will depend on the degree of international cooperation, especially in the provision of liquidity assistance and in the establishing of ‘firewalls’ against contagion.

Fiscal policy at a crossroads: Self-defeating tightening in a liquidity trap?

Recent contributions about the mechanism through which fiscal contraction in a liquidity trap is counterproductive have led to an important change in perspective, relative to initial views.

A key point here is the recognition that much of the advanced world is currently in an unemployment and underemployment crisis. Destruction of jobs and firms today may

28 Fiscal consolidation and macroeconomic stabilisation

be expected to have persistent effects on potential output in the future. These effects in turn translate into a fall in permanent income, and hence demand, today (see DeLong and Summers 2012 and Rendahl 2012).

In a liquidity trap, this creates a vicious self-reinforcing circle. Today’s unemployment creates expectations of low prospective employment, which in turn causes an endogenous drop in demand, reducing activity and raising unemployment even further. This vicious cycle may have little to do with price stickiness and expectations of deflation at the zero lower bound, an alternative mechanism which was stressed early on by Eggertsson and Woodford (2003) and more recently by Christiano et al (2011). Independently of deflation, the vicious cycle can be set in motion by expectations of lower income when shocks create a high level of persistent underemployment. Theory suggests that this effect can be sizeable. The question is its empirical relevance.

The empirical evidence indeed weighs towards large multipliers at a time of recession and especially at times of banking and financial crises (Corsetti et al 2012), as opposed to very small multipliers when the economy operates close to potential and monetary policy is ‘unconstrained’. The point estimate of the multiplier conditional on crises is of the order of 2 – a value not far from the one used by several governments and commentators, but higher than most estimates in the literature that fail to distinguish across different states of the economy. In light of these results, it can be safely anticipated that the current fiscal contractions will exert pronounced negative effects on output.

It is worth stressing that fiscal adjustment is currently happening at different levels of government – both central and local. An analysis of spending multipliers at local level carried out in the context of the PEGGED model suggests that differences in cuts and budget adjustment at subnational level can also generate sizeable contractionary effects on the local economy, holding constant the macroeconomic conditions at national level. This is the paper by Acconcia et al (2011) on provincial multipliers in Italy, which takes advantage of the quasi-experimental setting generated by the Italian law mandating the dismissal of city councils on evidence of mafia infiltration. When a city council

29 Rethinking Global Economic Governance in Light of the Crisis

is dismissed, the commissaries sent by the government ensure that the administration keeps working according to national standards, but suspend public works. This generates a spending contraction of the order of 20%. The multiplicative effects on output, calculated holding monetary policy constant, are of the order of 1.2 or 1.4.

This is why, with a constrained monetary policy, there is little doubt that governments with a full and solid credibility capital should abstain from immediate fiscal tightening, while committing to future deficit reduction. The virtues of such a policy are discussed in the aforementioned PEGGED paper by Corsetti et al (2010).

The problem is that, in the current context, promising future austerity alone may not be seen as sufficiently effective. Keeping markets confident in the solvency of the country has indeed provided the main motivation for governments to respond to nervous financial markets with upfront tightening.

The challenge: How to stabilise economies with high and volatile sovereign risk

In a recent PEGGED paper, Corsetti et al (2012) (henceforth CKKM) highlight issues in stabilisation policy when the government is charged a sovereign-risk premium. The root of the problem is the empirical observation that sovereign risk adversely affects borrowing conditions in the broader economy. The correlation between public and private borrowing costs actually tends to become stronger during crises. Perhaps in a crisis period high correlation is simply the by-product of common recessionary shocks, affecting simultaneously, but independently, the balance sheets of the government and private firms. Most likely, however, it results from two-way causation.

In the current circumstances, there are good reasons to view causality as mostly flowing from public to private. First, in a fiscal crisis associated with large fluctuations in sovereign risk, financial intermediaries that suffer losses on their holdings of government bonds may reduce their lending. Second, both financial and non-financial firms face a

30 Fiscal consolidation and macroeconomic stabilisation

higher risk of loss of output and profits due to an increase in taxes, an increase in tariffs, disruptive strikes and social unrest, not to mention lower domestic demand.

There are at least two implications for macroeconomic stability of this ‘sovereign-risk channel of transmission’ linking public to private borrowing costs.

First, if sovereign risk is already high, fiscal multipliers may be expected to be lower than in normal times. The presence of a sovereign-risk channel changes the transmission of fiscal policy, particularly so when monetary policy is constrained (because, for example, policy rates are at the zero lower bound, or because the economy operates under fixed exchange rates). When sovereign risk is high, the negative effect on demand of a given contraction in government spending is offset to some extent by its positive impact on the sovereign-risk premium.

Some exercises by CKMM suggest that, typically, consolidations will be contractionary in the short run. Only under extreme conditions does the model predict either negative multipliers (in line with the view of ‘expansionary fiscal austerity’) or counterproductive consolidations (in line with the view of ‘self-defeating austerity’). To the extent that budget cuts help reduce the risk premium, there is some loss in output, but not too large.

Second, due to the sovereign-risk channel, highly indebted economies become vulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fall in output generates expectations of a deteriorating fiscal budget, causing markets to charge a higher risk premium on government debt. Through the sovereign-risk channel, this tends to raise private borrowing costs, depressing output and thus validating the initial pessimistic expectation.

Under such conditions, conventional wisdom about policymaking may not apply. In particular, systematic anti-cyclical public spending is arguably desirable when policy credibility is not an issue. In the presence of a volatile market for government bonds, however, anticipation of anti-cyclical fiscal policy may not be helpful in ensuring macroeconomic stability. A prospective increase in spending in a recession may lead to

31 Rethinking Global Economic Governance in Light of the Crisis

a loss of confidence by amplifying the anticipated deterioration of the budget associated with the fall in output.

This possibility poses a dilemma for highly indebted countries. In light of the above considerations, countries with a high debt may be well-advised to tighten fiscal policies early, even if the beneficial effect of such action – prevention of a damaging crisis of confidence – will naturally be unobservable. From a probabilistic perspective, even a relatively unlikely negative outcome may be worth buying insurance against if its consequences are sufficiently momentous. In the current crisis, unfortunately, we know that such insurance does not come cheap.

Beyond country-level fiscal correction

The near-term costs of austerity mean we should keep thinking about alternatives, such as making commitments to future tightening more credible (eg the reform of entitlement programmes). However, the presence of a sovereign-risk channel also provides a strong argument for focusing on ways to limit the transmission of sovereign risk into private- sector borrowing conditions.

Strongly capitalised banks are a key element here. The ongoing efforts, coordinated by the European Banking Authority, to create extra capital buffers in European banks correspond to this logic. Another element is the attempt by monetary policymakers to offset high private borrowing costs (or a possible credit crunch) when sovereign-risk premium is high.

Normally, the scope to do this is exhausted when the policy rate hits the lower bound. Recent unconventional steps by the ECB, however, suggest that more is possible. The extension of three-year loans to banks, in particular, appears to have reduced funding strains, with positive knock-on effects for government bond markets.

These arguments are especially strong, either for countries already facing high interest rates in the market for their debt, or for countries reasonably vulnerable to confidence

32 Fiscal consolidation and macroeconomic stabilisation

crises. These countries would be ill-advised to relax their fiscal stance. The arguments apply less to governments facing low interest rates. The main issue is where to draw the line.

References

Acconcia, A, G Corsetti, and S Simonelli (2011), Mafia and Public Spending: Evidence on the Fiscal Multiplier from a Quasi-experiment, CEPR DP 8305.

Christiano, L, M Eichenbaum, and S Rebelo.(2011) When is the government spending multiplier large? Journal of Political Economy, 119(1):78–121.

Cottarelli, C (2012), “Fiscal Adjustment: too much of a good thing?”, VoxEU.org, February 8.

Corsetti, G, A Meier and G Müller (2009), “Fiscal Stimulus with Spending Reversals”, CEPR discussion paper 7302, 2009, Forthcoming, The Review of Economics and Statistics.

Corsetti, G, K Kuester, A Meier, and G Müller (2010), “Debt consolidation and fiscal stabilisation of deep recessions”, American Economic Review: P&P 100, 41–45, May.

Corsetti, G, K Kuester, A Meier, and G Müller (2012), “Sovereign risk, fiscal policy and macroeconomic stability”, IMF Working paper 12/33.

Corsetti, G, A Meier, and G Müller (2012) “What Determines Government Spending Multipliers?” Prepared for Economic Policy Panel in Copenhagen April.

DeLong, B and L Summers (2012) Fiscal Policy in Depressed Economy,

Eggertsson, G B and M Woodford (2003), “The zero interest-rate bound and optimal monetary policy”, Brookings Papers on Economic Activity, 1:139–211.

Rendahl, P (2012), Fiscal Policy in an Unemployment Crisis, Cambridge: Cambridge University Press.

33 Rethinking Global Economic Governance in Light of the Crisis

About the author

Giancarlo Corsetti is Professor of macroeconomics at the University of Cambridge. On leave from the University of Rome III, he previously taught at the European University Institution, as Pierre Werner Chair, the Universities of Bologna, Yale and Columbia.

His main field of interest is international economics. His main contributions to the literature include general equilibrium models of the international transmission mechanisms and optimal monetary policy in open economies, analyses of currency and financial crises and their international contagion, and models of international policy cooperation and international financial architecture. He has published articles in many international journals including American Economic Review, Brookings Papers on Economic Activity, Economic Policy, Economics and Politics, European Economic Review, Journal of Economic Dynamics and Control, Journal of Monetary Economics, Quarterly Journal of Economics, Review of Economic Studies, and the Journal of International Economics. He has co-authored an award-winning book on the 1992-93 crisis of the European Monetary System, Financial Markets and European Monetary Cooperation. He is currently co-editor of the Journal of International Economics.

Giancarlo Corsetti is Research Fellow of the Centre for Economic Policy Research in London, where he serves as Director of the International Macroeconomic Programme; and a member of the European Economic Advisory Group at CESifo in Munich, publishing a yearly Report on the European Economy. Professor Corsetti has been a scientific consultant to the ECB and the Bank of Italy, and a visiting scholar at the Federal Reserve Bank of New York and the IMF.

34 The Eurozone crisis – April 2012

Richard Portes London Business School and CEPR

The Eurozone crisis of 2011–12 is a sequel to the financial crisis of 2008–09. It would have been much easier to contain and resolve had there been no global financial crisis, no deep recession in the advanced countries. It is therefore too facile, indeed wrong, to say that the Eurozone crisis is essentially or even mainly due to inherent faults in the monetary union. Nevertheless, the crisis has exposed genuine faults that were neither manifest nor life-threatening before 2008–09. They might have been remedied with gradual progress towards a deeper economic union. But all that is for the economic historians. We are where we are, and it is not pretty.

Government bond yields for several of the 17 countries in the economic and monetary union (EMU) were unsustainable in November 2011. They then fell back, with the ECB’s longer-term refinancing operation (LTRO). But they are climbing again – more on that below. The spread over the German ten-year government bond (the Bund) was close to zero for most of the period from 1999 to 2008. Now, however, of the EMU government bonds, only Germany is regarded as a risk-free ‘safe asset’. Even that is not totally clear, since the credit default swap (CDS) premium for Germany was at 110 basis points in November 2011 (it was 40 in July). The CDS market is by no means a reliable guide to default risk, but it does give information about sovereign bond prices1, and the message is disturbing.

1 Portes (2010), Palladini and Portes (2011).

35 Rethinking Global Economic Governance in Light of the Crisis

In late 2011, until the LTRO, there were no buyers in the markets for Eurozone sovereign debt except the ECB, sporadically, and domestic financial institutions under open or implicit pressure from their governments. Many of those institutions have used some of their new ECB funding for renewed purchases of their home sovereign bonds, but this simply exacerbates the already dangerous nexus between fragile banks and fragile sovereigns. The liquidity crunch of late 2011 has also moderated but could quickly return. The European Financial Stability Fund (EFSF) could not sell some of an early November bond issue and is a fragile reed. France has lost its AAA rating, and all Eurozone banks are under rating review. Deposits in Greek banks have been falling steadily for many months, and there are signs of similar but slower ‘bank walks’ in other countries deemed at risk. The sovereign CDS market itself is in question, because the authorities sought to engineer a deep restructuring of Greek debt without triggering the CDS. This would have shown that the ‘insurance’ provided by CDSs is not insurance after all. Although eventually the swaps were triggered, the markets are still very uneasy.

There are bits of good news: ECB monetary policy is still ‘credible’, on the evidence of market inflation expectations (2.02% at a five-year horizon, 2.22% at a ten-year horizon, as at 4 April 2012). The underlying bad news there, however, is that the ECB interest rates have been too high and are still too high despite the cut of 50 basis points in December 2011. The technocratic prime ministers in Greece and Italy are very experienced, very able, and fully conscious of what their countries must do to restart economic growth. That said, they are not elected politicians, and their legitimacy and authority may be correspondingly limited. Since the necessary measures would be painful and challenging even with a popular mandate, one may question whether technocratic governments can carry them out. Resistance in both countries is very strong.

For the countries at the heart of the crisis but the geographical periphery of the Eurozone, the sources of their predicaments are varied. Importantly, they are not primarily due to membership of the single currency, nor to fiscal profligacy. Greece

36 The Eurozone crisis – April 2012

is of course an exception to the latter generalisation, because its fiscal excesses were both large and duplicitous, partly hidden from the statisticians. But its problems are due also to major structural weaknesses, especially of its institutions2; extreme political polarisation; and reckless (for the lenders as well as borrowers) capital inflows that for years disguised these underlying flaws. It is wrong to reduce these factors to inadequate ‘competitiveness’ that could be cured by currency devaluation.

Ireland’s woes arise from an extraordinary housing boom (incontestably a housing price bubble) fed by equally reckless capital inflows through its banks into property development and mortgage finance, lubricated by crony capitalism. The original sin which has led Ireland to its penance was not, however, this process itself but rather the government guarantee of the bank debts thereby incurred. In a stroke, this socialisation of private debt transformed a country with one of the lowest ratios of public debt to GDP into one with an exceptionally high debt ratio.

Spain too had its housing boom and capital inflow into construction. These were exacerbated by the foolish behaviour of the politically influenced regional banks, the cajas, which fell into deep difficulties when the bubble burst. Portugal has many economic ills: poor education, an uncompetitive production structure, product and labour market rigidities. But its primary mistake was not to use the very large capital inflow during the pre-crisis decade to modernise the economy.

Three of these four countries (the GIPS) had sound fiscal positions but from 2003–04 onwards were running large current-account deficits within the monetary union; Greece also had a big current-account deficit. These were financed by equally large capital flows from the surplus countries, especially Germany – a capital flow ‘bonanza’3 for the periphery, with the usual consequences. In particular, much of the funds went into real-estate purchase and development. This raised the relative price of non-traded goods and pulled resources out of tradeables. The Eurozone as a whole ran a balanced current

2 Jacobides et al (2011). 3 Reinhart and Reinhart (2008).

37 Rethinking Global Economic Governance in Light of the Crisis

account with the rest of the world – the imbalances were internal. Germany played the same role in the Eurozone as China in the global economy. Unlike the United States, however, the GIPS were not ‘free spenders’ – Ireland and Spain had housing booms, but they and Greece all saw a fall in consumption as a share of GDP and a rise in the investment share during 2000–07 (the investment share fell slightly in Portugal). And unlike China, the capital flows from Germany (and some other countries, like France) came primarily from banks – they were private not official flows.

Correspondingly, the macroeconomic problem in EMU now is the fiscal consequence of the financial crisis in bank-based financial systems. Creditor countries have been unwilling to let their banks suffer the consequences of bad loans – rather, they have managed to put the entire burden on the taxpayers of the debtor countries. This may seem clever, but it is short-sighted, not to say hypocritical. It also disregards the EU and Eurozone financial integration that policymakers have promoted – using an American analogy, should Delaware, where Citibank is incorporated, be responsible for Citibank’s liabilities?

The result is that Greece is insolvent, Ireland’s debt is also excessive and should be restructured4, and Portugal’s IMF programme is not feasible. Spain and Italy, however, are solvent, if financial markets return to normal conditions and both countries carry out appropriate macroeconomic and structural policies. But Italy and Spain are under pressure from the markets. They fear that Spanish banks will suffer further from bad real-estate loans, and the state will have to bail them out. Italian political instability and irresolution has reinforced contagion from the weaker countries, and Italy too may enter a self-fulfilling vicious spiral: rising debt-service costs hurt the fiscal position (Italy is close to primary fiscal balance), that hits market confidence, spreads rise, and debt service begins to look unsustainable despite the primary balance. The markets have also been losing confidence in French banks, despite the protestations of health from the banks and their regulators; this has now calmed, but that may be temporary.

4 Portes (2011).

38 The Eurozone crisis – April 2012

Common to all these cases is an interconnected sovereign and banking crisis: the banks hold large amounts of sovereign debt that has become questionable, and the sovereigns are questioned because of the danger that they will have to rescue their banks.

So we have the ‘doom loops’ represented in this useful diagram5 and exacerbated by elements of Fisherian debt deflation:

Figure 1. The European Peripherals Crisis

Tighter Higher Government FCI Bond Yields Default Worries Bank Solvency Bailout Concerns Higher Debt Costs Service

More Banking/ Higher Government Financial Strains Debt/GDP Ratio Lower Corporate Prots Calls for Fiscal Negative Tightening Credit Lower Tax Wealth E ect Losses Receipts

Reduced Lower Loan Deeper Nominal GDP Supply Recession

The euro (monetary union) is not the cause of this crisis, although the ECB’s interpretation of its role has been blocking a solution. The ECB has been ‘in denial’, maintaining as late as May 2011 that it was inconceivable that a Eurozone country

5 Goldman Sachs (2011) Global Economics Weekly 11/38, November.

39 Rethinking Global Economic Governance in Light of the Crisis

could default on its debt. The agreement of 21 July 2011 to restructure Greek debt was, of course, recognition of default, regardless of whether the restructuring would be ‘voluntary’ or not. The ECB told Ireland in autumn 2008 (backed by the threat of withdrawal of repo facilities) that it was not allowed to consider debt default. Where else in the world can a central bank tell a government what it can or cannot do in fiscal matters?

Politicians share responsibility, however, with their indecision and endlessly repeated ‘too little, too late’ measures – such as the agreement of 21 July 2011, which was recognised only three months later to be wholly inadequate. Moreover, the French President and German Chancellor have made two egregious errors with disastrous impact on the markets: the Deauville statement of October 2010 that introduced in an ill-considered manner the possibility of private sector involvement in dealing with Eurozone country debt; and the Cannes statement a year later that explicitly proposed that an EMU member country could exit the euro. There is no legal basis for this6, and it had been regarded as a taboo. Some have drawn an analogy with the statement by the President of the Bundesbank in early September 1992 that “devaluations cannot be ruled out” in the EMS – which was followed immediately by the exit of Italy and the UK.

Several ways out have been proposed. If the banks’ capital is inadequate, then they should be recapitalised. But with what external funding, if government participation is excluded? Part of the problem is that the markets have been denying even short-term funding to the banks. Consequently, the banks are deleveraging by selling assets and not rolling over loans, with dangerous consequences worldwide. At one point, there was talk of expanding or ‘leveraging’ the EFSF. But non-euro countries would not contribute, leveraging through borrowing from the ECB is not allowed, and Eurozone countries simply do not want to put up more funds.

6 See W Munchau (2012), Financial Times, 9 April.

40 The Eurozone crisis – April 2012

The extreme way out is to get out: might an exit of Greece from the Eurozone end the instability? No, for it would immediately lead to devastating bank runs in all countries that might conceivably be thought candidates to follow Greece. What firm or household in Portugal, Ireland, Spain, Cyprus, would not seek to avoid even a low probability that its bank deposits might be devalued overnight? The likely outcome would be multiple exits, quite possibly the breakup of the monetary union. And that would be disastrous not only for the exiting ‘weak’ countries but also for those that would then suffer massive exchange-rate appreciation and the economic dislocation consequent on massive contract uncertainty. The various plans for exit or Eurozone breakup are all deeply flawed.

The only stable solution, therefore, is for the ECB to accept explicitly, in some form, the role of lender of last resort (LLR) for the monetary union. (One might alternatively regard this as a form of quantitative easing.) This does come within the Maastricht Treaty mandate:

In accordance with Article 105(1) of this Treaty, the primary objective of the ESCB shall be to maintain price stability. Without prejudice to the objective of price stability, it shall support the general economic policies in the Community… 5. The ESCB shall contribute to the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system. Treaty of Maastricht (1992), Article 2 and Protocols Art. 105.5 (numbering changes in Lisbon Treaty, but no change in text)

It would not violate the ‘no bailout clause’ (which does, however, exclude ECB purchases of Eurozone sovereign debt on the primary market). And in fact, the ECB has been purchasing member state bonds on the secondary market since May 2010, without any successful legal challenge.

41 Rethinking Global Economic Governance in Light of the Crisis

To stop self-fulfilling confidence crises, therefore, the ECB should commit to cap yields paid by solvent countries with unlimited purchases in the secondary markets. Arbitrage will then bring primary issue yields down to the capped level. Note ‘solvent’: the then Governor of the Bundesbank was right to oppose such purchases for Greece in May 2010, because it was evidently insolvent.

There is no more inflation risk in such a policy than there is in quantitative easing – and that risk is negligible, as shown by the examples of the US, the UK, and Japan. The ECB can always tighten as and when necessary. The risk preoccupying the ECB is that of moral hazard: it clearly views ‘market discipline’ as the only way to bring about the macroeconomic policies it favours. The evidence? Berlusconi’s departure and replacement by Monti; and a technocratic government in Greece led by the former ECB Vice-President, willing to accept the harsh austerity policies demanded by the IMF-ECB-EC troika. Financial market pressures have been consciously used to drive governments to implement austerity and reforms.

Thus the ECB does only ad hoc government debt purchases under its Secondary Market Programme, in the guise of ‘normalising the monetary transmission mechanism’ that is impaired by debt-market instability. Even those have ceased, for the time being. This is a version of the ‘constructive ambiguity’ beloved of central bankers – but in this case, it is manifestly destructive rather than constructive. The piecemeal approach, acting only under pressure and with delay, has proved very costly. In effect, the ECB has been playing a game of ‘chicken’ with the politicians and the markets. It is particularly dangerous both because there are three players, of which two have no single decision- maker; and because the parameters defining the game are not well defined, since no one can tell when a vicious spiral may turn into an overwhelming confidence crisis that the authorities will be unable to control.

On the other hand, the ECB does need political backing to take on the LLR role overtly. The German and French leaders would have to make the case that this is the only way to preserve the monetary union. And the ECB would also need to receive explicit

42 The Eurozone crisis – April 2012

indemnities (guarantees) from Finance Ministers of the 17 against capital losses the bank might incur on its sovereign bond purchases. Both the US Federal Reserve and the Bank of England have received such indemnities in respect of their quantitative easing programmes.

When that guarantee has been secured, the ECB should make an expectations-changing announcement of the new policy, just as the Swiss National Bank did when it moved to cap the value of the Swiss franc. As that example shows, it is highly likely that if the commitment were made, the markets would recognise that betting against the bonds (a speculative attack) could not succeed, because the ECB would then have unlimited capacity to resist. Hence it would not have to buy much if at all.

Ideally, this short-run stabilising policy would be complemented by long-run plans for fiscal stability and integration, as well as by the issue of Eurobonds (issued at the Eurozone level with ‘joint and several liability’). That would establish the kind of ‘convergence play’ that drove the markets smoothly into EMU at the end of the 1990s. There are several Eurobond proposals now on the table, but the leaders of the major countries have so far rejected them.

Although the ECB policy proposed above could buy time for economic reforms to work, long-run debt sustainability requires economic growth. But we should be clear: fiscal contraction is contractionary7. The evidence accumulates daily, for the UK as well as for Eurozone countries. The only counterexample is that of Ireland in the 1980s. But this is a very special case: a rather backward country catching up to the technological frontier; exporting into a boom in its major trading partners (especially the UK); creating an exceptionally favourable environment for foreign direct investment; and exploiting a well-educated diaspora willing to return.

The austerity policies championed by Germany and other apostles of fiscal rectitude, implemented enthusiastically by the European Commission, are not the solution, but

7 Guajardo et al (2011)

43 Rethinking Global Economic Governance in Light of the Crisis

rather a major part of the problem. They are driving the Eurozone into a new recession.8 The debt of several Eurozone countries is not sustainable if they contract.

Moreover, fiscal contraction together with private-sector deleveraging is not feasible without a current-account surplus. We teach this in first-year macroeconomics:

CA = (Sp – Ip) + (T – G)

The current account must equal the sum of private-sector net saving and government net saving. In the Eurozone, the surplus countries are those with the most ‘fiscal space’. There will be no exit from the current debt traps and stagnation unless the surplus countries are willing to accept that they must allow the others to expand. This requires that they either relax their fiscal policy or adopt other policies that will reduce private net savings. The overall position would improve if the euro were to depreciate significantly – another reason for further monetary easing. But that is true for the US and Japan as well.9

The LTRO was an inspired move to bypass German objections to the ECB taking on the LLR role. But it is a temporary expedient. There is no evident exit strategy, even though the President of the Bundesbank is calling for exit much sooner than the specified three- year horizon. Moreover, channelling funding to the banks and relying on them to buy sovereign bonds simply raises the weight of those bonds in their assets and worsens the unhealthy interdependence between banks and sovereigns.10 And it reduces the pressure on the banks to rationalise their portfolios and improve their business models.

Germany and France have benefited greatly from the single currency over its first decade. Their business communities see this. One must still hope that the core Eurozone countries will eventually act in their own best interests. The global financial crisis need

8 See http://eurocoin.cepr.org/ , where the Eurocoin coincident indicator has been firmly in negative territory over the past several months. 9 This is not to say that ‘competitive quantitative easing’ at the zero lower bound for interest rates will be ineffective or ‘beggar-thy-neighbour’ policies – see Portes (2012). 10 See De Grauwe (2012) and Wyplosz (2012).

44 The Eurozone crisis – April 2012

not lead to the demise of the single currency through a Eurozone crisis. This crisis could be resolved successfully if policymakers were to change course.

References

De Grauwe, P (2012), “How not to be a lender of last resort”, CEPS Commentary 23 March.

Goldman Sachs (2011), Global Economics Weekly 11/38, November.

Guajardo, J, D Leigh, and A Pescatori (2011) “Expansionary austerity: new international evidence”, IMF Working Paper 11/158.

Jacobides, M, R Portes, and D Vayanos (2011), “Greece: the way forward”, White Paper, 27 October, summarised at www.VoxEU.org, 30 November.

W Munchau (2012), Financial Times, 9 April.

Palladini, G, and R Portes (2011), “Sovereign CDS and bond pricing dynamics in the Eurozone”, CEPR Discussion Paper 8651, NBER Working Paper 17586, November.

Portes, R (2010), “Ban naked CDS”, at www.eurointelligence.com, 18 March.

Portes, R (2011), “Restructure Ireland’s debt”, www.VoxEU.org, 26 April.

Portes, R (2012), “Monetary policies and exchange rates at the zero lower bound”, Journal of Money Credit and Banking, forthcoming.

Reinhart, C, and V Reinhart (2008), “Capital flow bonanzas”, CEPR Discussion Paper 6996, October.

Wyplosz, C (2012), ‘The ECB’s trillion-euro bet’, VoxEU.org 13 February

45 Rethinking Global Economic Governance in Light of the Crisis

About the author

Richard Portes, Professor of Economics at London Business School, is Founder and President of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes at the Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairman of the Board of Economic Policy. He is a Fellow of the Econometric Society and of the British Academy. He is a member of the Group of Economic Policy Advisers to the President of the European Commission, of the Steering Committee of the Euro50 Group, and of the Bellagio Group on the International Economy. Professor Portes was a Rhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton, Harvard, and Birkbeck College (University of London). He has been Distinguished Global Visiting Professor at the Haas Business School, University of California, Berkeley, and Joel Stern Visiting Professor of International Finance at Columbia Business School. His current research interests include international macroeconomics, international finance, European bond markets and European integration. He has written extensively on globalisation, sovereign borrowing and debt, European monetary issues, European financial markets, international capital flows, centrally planned economies and transition, macroeconomic disequilibrium, and European integration.

46 The Triffin Dilemma and a multipolar international reserve system

Richard Portes London Business School and CEPR

Explanations of the breakdown of the Bretton Woods exchange-rate system often refer to the Triffin Dilemma. Recently, proposals for a multipolar reserve system have invoked a supposed new form of the Triffin Dilemma (Farhi et al 2011), as a reason for moving towards a multipolar reserve system. But the Triffin Dilemma did not describe the problems of the international monetary system in the late 1960s, and it does not describe the present-day problems of that system. The world will move towards a multipolar reserve system, but for reasons unrelated to the Triffin Dilemma.

1 Triffin Dilemma definitions

There are at least two rather different formulations of the Triffin Dilemma in recent discussions. The definition that is perhaps closer to what Triffin had in mind is that increasing demand for reserve assets strains the ability of the issuer to supply sufficient amounts while still credibly guaranteeing or stabilising the asset’s value in terms of an acceptable numéraire (see Obstfeld 2011 as well as Farhi et al 2011). An alternative perspective from a policymaker is that the dilemma is founded on a tension between short-run policy incentives in reserve-issuing and reserve-holding countries, on the one hand, and the long-run stability of the international financial system on the other hand (Bini Smaghi 2011).

47 Rethinking Global Economic Governance in Light of the Crisis

2 The Triffin Dilemma of the 1960s

A dilemma is a difficult choice between alternatives. The first posited that the US would stop providing more dollar balances for international finance. In that case, trade would stagnate and there would be a deflationary bias in the global economy – a global liquidity shortage. The second was that the United States would continue to provide more of the international reserve currency, leading ultimately to a loss of confidence in the dollar, as US obligations to ‘redeem’ foreign holdings with gold would be seen to be unsustainable.

Some writers have identified the second alternative with continued US current-account deficits. But this is not correct, either empirically or conceptually.

3 Another interpretation of the 1960s

The US current account was actually in surplus throughout the 1960s. Moreover, much of the growth of dollar reserves from 1955 onwards was driven by foreign demand for money (recall the ‘dollar shortage’ of the late 1940s and early 1950s) and posed no threat to US liquidity (Obstfeld 1993).

One analysis at the time took a different line (Despres et al 1966) – a ‘minority view’, as the authors put it. They argued that the US ‘deficit’ arose from its role as the world banker (see also Gourinchas and Rey 2007). It borrowed short (issuing riskless assets) and lent long (buying risky assets). The source of the dollar balances accumulated abroad was net capital outflows, not current-account deficits.

More generally, “current accounts tell us little about the role a country plays in international borrowing, lending, and financial intermediation…” (Borio and Disyatat 2011). Moreover, Despres et al argued that the key issue was not external (global) liquidity but rather internal liquidity in Europe. That is, the United States was supplying financial intermediation to a Europe whose financial system was still incapable of providing that intermediation itself. The lack of ‘confidence’, they suggested,

48 The Triffin Dilemma and a multipolar international reserve system

reflected a failure to understand this intermediary role. Hence, they argued, there was a straightforward policy response: develop and integrate foreign capital markets, while seeking to moderate foreign asset holders’ insistence on liquidity. This minority view of 1966 was the correct one. It was put forward in the same year in which Valery Giscard d’Estaing spoke of the ‘exorbitant privilege’. It resonates with today’s policy discussions of global imbalances (Portes 2009).

In sum, the ‘dollar problem’ of the 1960s was not founded on the Triffin Dilemma. Rather, it was simply a result of the US inability to convince dollar holders that the US would maintain a stable value of the dollar with appropriate monetary and fiscal policies. If the US had done that, then dollar holders would have had no incentive to demand gold (Obstfeld 1993) – unless it were to destroy the exorbitant privilege, as perhaps was the main French objective.

4 Is there a Triffin Dilemma now?

The leading current version of the Triffin Dilemma starts from the hypothesis that the global economy faces a chronic, severe shortage of reserve assets, which are identified with ‘safe assets’ (Caballero 2006). The empirical evidence cited for this shortage is the persistently low level of real interest rates.

There are several formulations of the problem which is supposed to be raised by the assumed shortage of safe assets. First, excess demand for safe assets leads to a deterioration of the creditworthiness of the safe asset pool – leading up to the 2008 financial crisis, we saw a wide range of assets rated at AAA that subsequently were revealed as very unsafe indeed.

Second, the supply of truly safe dollar assets – US Treasuries – rests on the backing of the US ‘fiscal capacity’. But that grows only as US GDP grows, and US GDP grows slower than world GDP, which determines the growth of demand for those assets. Hence there must be a growing excess demand for safe assets.

49 Rethinking Global Economic Governance in Light of the Crisis

Third, it is the “ability to provide liquidity in times of global economic stress [that] defines the issuer of the reserve currency” (Farhi et al 2011). This again rests on US fiscal capacity.

Fourth, global reserve growth requires an ongoing issuance of gross US government debt, which requires either fiscal deficits or issuing debt to buy riskier assets. Global reserve growth is therefore driven by fiscal deficits, not balance-of-payments deficits, and the resulting government debt will eventually outrun US fiscal capacity.

Farhi et al do not define fiscal capacity, but they seem to mean the sustainability of government domestic debt or the solvency of a government. What debt level is ‘sustainable’ is a matter of considerable controversy, whether it applies to domestic or international debt (eg, Mendoza and Ostry 2008, Alogoskoufis et al 1991), and it is not straightforward to make the intertemporal budget constraint operational in order to investigate this. In the sovereign debt and default literature, these are old issues, concerning the difficulties of distinguishing for a sovereign ‘can’t pay’ from ‘won’t pay’ or illiquidity from insolvency.

Moreover, even setting these problems aside, the empirical evidence for this version of the Triffin Dilemma seems weak. We see no global liquidity shortage, no deflationary bias from that source. Even during the financial crisis of 2008–09, the only manifestation of inadequate global liquidity (as opposed to particular securities markets) was a short- run lack of dollars to finance dollar positions. This was met by short-term currency swaps, which briefly rose to high levels but were quickly wound down.

The main evidence cited for the shortage of safe assets is low real interest rates. It is indeed correct that real interest rates fell steadily from the 1980s and early 1990s to levels that seemed historically low in the 2000s. But they were not historically low – real interest rates were lower in the 1960s and 1970s (the average real interest rate on the sovereign borrowing of the 1970s was significantly negative). Are we supposed to believe that there was a shortage of safe assets both pre- and post-1971? Finally, the US is not the only source of safe assets – the government bonds of Germany, the United

50 The Triffin Dilemma and a multipolar international reserve system

Kingdom, Norway, and Switzerland are also held in substantial amounts by foreign investors. A further critique of the ‘safe asset shortage view’ can be found in Borio and Disyatat (2011).

Suppose the US had maintained the fiscal balance it achieved in 1999–2000. The net supply of US Treasuries was stable or falling, but private investment exceeded savings, so there was a current-account deficit, with a rising foreign demand for reserves. What would the foreigners have bought? If the dominant source of safe assets was US Treasuries, then the constraint on the supply of these (reserve) assets would not have been US fiscal capacity, but US fiscal rectitude – no Triffin Dilemma, as set out by Farhi et al.

And finally, note that it is not clear that the US current-account deficits of the 2000s were due to a demand for additional reserve assets from the rest of the world. That demand could have been met by net private capital outflows, as in the 1960s.

5 The policy implications

The world will move towards a multipolar reserve system. But this will happen not because of the Triffin Dilemma and a shortage of safe assets in the current dollar- dominated system. It will happen because official reserve holders want to diversify their portfolios. (See Papaioannou et al 2006). And the correction of global imbalances will promote this.

For policymakers, the message is to try to convince surplus countries that reserve assets are not as safe as they think, so that they reduce their demand for these assets (China has already suffered a large capital loss because of dollar depreciation in the 2000s). The asymmetry between pressures on surplus and on deficit countries might be met by doing the opposite of creating more ‘safe assets’ – that is, by raising the risk premium on the supposedly safe assets, so that countries accumulating reserves cut their demand for them, shifting their portfolios towards other assets (for example sovereign wealth

51 Rethinking Global Economic Governance in Light of the Crisis

funds). (Goodhart 2011 appears to be advocating policies that would have this effect.) Such a trend could accelerate if the dollar were to continue to depreciate.

As the world moves towards a multipolar reserve system, emerging market countries will develop their domestic financial markets and will have less need for foreign financial intermediation (cf. Despres et al). Some emerging-market countries may themselves become reserve suppliers. And the development of more international facilities centred on the IMF could reduce the demand for reserves for self-insurance (Farhi et al).

Considering the Triffin Dilemma undoubtedly helps us to understand the forces underlying the development of the international financial system. But it is not the source of the system’s present-day problems.

Author’s note: This essay is based on my contribution to the conference “The International Monetary System: sustainability and reform proposals” held in Brussels on 3–4 October 2011, to commemorate the 100th anniversary of the birth of Robert Triffin. I am grateful for comments from Maurice Obstfeld. I am also indebted to Tommaso Padoa Schioppa for many discussions of these issues over 25 years and to Hélène Rey for more recent extended discussions – even though, in both cases, we sometimes had to agree to disagree, as will be evident from the text.

52 The Triffin Dilemma and a multipolar international reserve system

References

Alogoskoufis, G, L Papademos, and R Portes (1991), External Constraints on Macroeconomic Policy, Cambridge: Cambridge University Press for CEPR.

Bini Smaghi, L (2011),” The Triffin Dilemma revisited”, 3 October, at http://www.ecb. int/press/key/date/2011/html/sp111003.en.html, and in this volume.

Borio, C, and P Disyatat (2011), “Global imbalances and the financial crisis: Link or no link?”, BIS Working Paper 346.

Caballero, R (2006), “On the macroeconomics of asset shortages”, NBER Working Paper 12753.

Despres, E, C Kindleberger, and W Salant (1966), “The dollar and world liquidity: a minority view”, The Economist, 6 February.

Farhi, E, P-O Gourinchas, and H Rey (2011), Reforming the International Monetary System, CEPR eBook, French version published by Conseil d’Analyse Economique.

Goodhart, C A E (2011), “Global macroeconomic and financial supervision: where next?”, paper for Bank of England–NBER conference.

Gourinchas, P-O, and H Rey (2007), “From world banker to world venture capitalist: the US external adjustment and the exorbitant privilege”, in Clarida, R (ed), G7 Current Account Imbalances: Sustainability and Adjustment, Chicago: University of Chicago Press for NBER.

Mendoza, E, and J Ostry (2008), “International evidence on fiscal solvency: Is fiscal policy ‘responsible’?”, Journal of Monetary Economics 55: 1081–93.

Obstfeld, M (1993), “The adjustment mechanism”, in Bordo, M, and B Eichengreen (eds), A Retrospective on the Bretton Woods System, Chicago: University of Chicago Press for NBER.

53 Rethinking Global Economic Governance in Light of the Crisis

Obstfeld, M (2011), “The international monetary system: living with asymmetry”, forthcoming in Feenstra, R C and A M Taylor (eds), Globalization in an Age of Crisis: Multilateral Economic Cooperation in the Twenty-First Century.

Papaioannou, E, R Portes, and G Siourounis (2006), “Optimal Currency Shares in International Reserves: The Impact of the Euro and the Prospects for the Dollar”, Journal of the Japanese and International Economies 20: 508–47.

Portes, R (2009), “Global imbalances”, in Dewatripont, M, X Freixas and R Portes (eds), Macroeconomic Stability and Financial Regulation, London: Centre for Economic Policy Research.

54 The Triffin Dilemma and a multipolar international reserve system

About the author

Financial stability: Where it went and from whence it might return

Geoffery Underhill University of Amsterdam

The global crisis which has been ricocheting around the global economy since late 2007 seems to have undermined, perhaps even destroyed, the traditional foundations for financial stability in the US and Europe. This chapter focuses on recommendations for the provision of financial stability, and in doing so builds some bridges between two of the PEGGED themes – financial stability and macroeconomic governance. There are three essential points to be drawn from the range of research findings from the PEGGED political economy team:

• The policy dilemmas and choices confronted by the contemporary system of global/ EU financial and monetary governance are longstanding, well-known, and there is a host of historical experience and literature to draw upon going forward.

• The potential and more obvious flaws of the pre-crisis system of financial governance were well-known and debated in the many rounds of reform that preceded the financial collapse. Our analysis reveals that the ideas upon which the reforms have been built remain largely stuck in the pre-crisis mode and are thus unlikely to achieve their goals. Worse, the Eurozone is descending into modes of crisis resolution that are known to be dysfunctional and destructive of successful economic growth and development.

• Reform that is more likely to provide financial stability for the longer run requires new ideational departures drawing on established historical experience, considerable institutional innovation, a reformed policy process, and institutionalised attention to the political legitimacy and long-run sustainability of financial openness globally and in the EU.

57 Rethinking Global Economic Governance in Light of the Crisis

The points are developed more fully in turn.

Financial openness: Beneficial but inherently instability

Historical experience has shown that financial liberalisation and market integration produce benefits, if asymmetric. Theory (Minsky 1982) and historical experience (Bordo et al. 2001) told us financial markets had a strong tendency towards instability and crisis. Avoiding persistent market failure requires robust systems of governance at the level appropriate to the extent of market integration.

This implies regional and international institution-building. The dilemmas of such institutional design and the appropriate policy mix have been well-known since the 1920s at least (Germain 2010), and certainly since the Bretton Woods conference. Despite this knowledge and the frequency of episodes of financial crisis in the 30 years of liberalisation from the 1980s on, a crisis-reform-crisis cycle only led to the complacency of the Great Moderation (Helleiner 2010). Financial globalisation was furthermore known to be particularly problematic for developing countries (Cassimon et al, 2010, and Ocampo and Griffith-Jones 2010). The institutional and economic weaknesses of the European monetary union were likewise well-known and exhaustively discussed in the literature (Underhill 2011a).

Systemic flaws known before the crisis

Our system of debt-crisis workout has long pointed the finger at debtors. IMF programmes available to debtors seeking to avoid default to public and private creditors involved a combination of emergency loans, enhancing the debt burden, and structural adjustment measures. These latter often come with substantial distributional costs for the borrowing nation, often its poorest citizens. There is substantial evidence that these programmes have too often failed to stimulate economic recovery and growth (Vreeland 2003). The argument that structural adjustment leads to a ‘catalytic’ restoration of private investor confidence likewise does not appear to hold (de Jong and van de Veer

58 Financial stability: Where it went and from whence it might return

2010). The Argentine default in 2001-2 saw the country emerge from crisis as well or better than orthodox Brazil, which took the full ‘medicine’ (Klagsbrunn 2010).

The system of international banking supervision was equally flawed. The first effort – from the Market Risk Amendment to Basle I in 1996 through to the finalisation of Basle II in 2004 – relied on self-supervision by large banks. The key tool was internal risk assessment and attendant controls. In essence, it was a micro approach to risk management based on market price signals, risk ratings and weightings, and a range of financial ‘governance’ standards.

This market-based approach to the financial sector, or “governance light”, was amply criticised as procyclical and dangerous (Persaud 2000, Ocampo and Griffith-Jones), and it neglected the macroprudential dimensions of systemic risk (Claessens and Underhill 2010). The system furthermore provided direct competitive advantages to the same large-bank constituency that had proposed the idea in the first place. Moreover, it involved a substantial rise in the cost of capital for poor countries and their populations who had no access to the decision-making forum (Claessens et al. 2008).

The theories and argument pools from which the new policies were drawn became tilted towards particularistic interests; state officials and the private sector came to share interests and approaches to governance in a club-like setting (Tsingou 2012). There was a serious policy rent-seeking and capture problem in the financial policy community – the input side of the policy process was flawed (Claessens and Underhill) and idea- sets on stability of the market skewed as result (Baker 2010). As a result, regulation backfired. Policies adopted to secure financial stability were those least likely to achieve it! Rather, they provided material advantages to the large financial institutions that benefited most from financial liberalisation in the first place.

So the 30 years of global financial integration lurched from crisis to skewed reform to crisis once again. Much of the burden of reform was on the emerging markets and developing countries that experienced crises most frequently. Their experience led them, particularly after the Asian crisis, to question the market-based approach to

59 Rethinking Global Economic Governance in Light of the Crisis

financial governance and to choose a different path. Most took liberalisation seriously, implementing reforms in their own way (Zhang 2010; Walter 2010) often while introducing innovative forms of capital controls aimed at ensuring greater stability. Asian countries began to go their own regional way in terms of regional cooperation (Dieter 2010). In the end, only the emerging market countries genuinely rose to the challenge of reform, avoiding the recipe of the advanced financial centres and largely avoiding the global financial crisis of 2007-9 as a result.

Financial Stability: From whence might it return?

Despite proposed improvements in the level and quality of capital required of large banks, the underlying market-based approach to financial governance and supervision has not changed (Underhill 2012). There are still many reforms in the pipeline, but if they are to be enduring and successful, new policy idea-sets must be developed.

The most innovative turn in the reform process is towards a macroprudential approach aimed at better management of the systemic dimensions of risk. Yet it is not at all clear that there is yet a coherent set of ideas, least of all concrete measures. Successfully operationalising macroprudential oversight requires institutional innovations across national and international levels to “join the dots” among policy domains. Until now, such domains have been treated all too separately, for example:

• Global imbalances and macroeconomic adjustment.

• Monetary policy in relation to asset markets.

• Multilateral surveillance mechanisms.

• Debt loads (public and private).

• Financial system monitoring.

• Firm-level risk management.

60 Financial stability: Where it went and from whence it might return

This requires a more integrated institutional setting for policymaking and implementation. Linked to the issue of macroprudential oversight, there is little sign of a much-needed debt-workout regime in either the Eurozone or the global financial system.

New ideas are unlikely as long as there is no substantial shift on the input side of the policy process.

• A broader range of stakeholders must become systematically involved in decision- making if policy output is to change.

For instance, citizens whose pensions are at considerable risk should have a say (Leijonhuvud 2011).

• Institutional change in the policy process could also provide insulation from the threat of policy capture.

The interests of those who ultimately underwrite financial bailouts – the taxpayer – must be far more robustly defended by public authorities.

• The sharing of responsibility and of the burden of adjustment imposed on debtors versus creditors needs to be seriously rebalanced.

This is especially the case in the Eurozone, where the benefits of monetary union are so skewed towards the surplus/creditor countries whose banks finance debt, both public and private.

Yet this rethink is not happening. The Eurozone crisis is being managed under the principle of IMF structural adjustment on steroids. Policy space is being dramatically diminished, instead of being enhanced through the pooling of reserves and risks.

Why does this matter so much? The answer has to do with the long-run sustainability and legitimacy of financial openness and capital mobility and whether we wish to have continued access to the benefits it offers. The issue requires institutionalised attention in a reformed policy process. Our research has shown that financial liberalisation is better sustained in economies that mitigate the risks of liberalisation through welfare

61 Rethinking Global Economic Governance in Light of the Crisis

and other forms of compensation for the vulnerable (Burgoon et al. 2012). Centre-left parties in stable democracies have often sponsored financial liberalisation traded off against a functioning health care and welfare system. Developing countries that receive compensation in the form of international aid flows also support financial openness more readily. Nurturing these underpinnings of open finance requires the very policy space that recession and austerity based workouts are closing down.

Meanwhile, electorates are rebelling against solutions that “pool” sovereignty just as market integration makes national policy less effective. The risk is that failure to think systematically about the emerging legitimacy deficit could lead to a rapid political radicalisation.

Centrifugal populist political forces have already been generated by the process, sometimes deliberately by politicians but more often by the nature of the solutions developed. This context will continue to aggravate the difficulties of reaching workable solutions to governing Eurozone or global finance and may call into question the institutional and ideational plumbing of the system: the benefits of openness, the autonomy of regulatory of agencies and central banks, and eventually the ability of states to cooperate to reform financial governance.

In short, we need a financial system and Eurozone that not only saves banks, but also citizens!

References

Baker, Andrew (2010). “Deliberative international financial governance and apex policy forums: where we are and where we should be headed”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Bordo, M, B Eichengreen, D Klingebiel and M. Martinez-Peria (2001), “Is the crisis problem growing more severe?” Economic Policy 16(32), 51-82.

62 Financial stability: Where it went and from whence it might return

Burgoon, B, P Demetriades and G Underhill (2012), “Sources and Legitimacy of Financial Liberalisation,” European Journal of Political Economy 28(2), 147-161.

Cassimon, Danny, Panicos Demetriades and Björn Van Campenhout (2010).Finance, globalisation and economic development: the role of institutions, in Global Financial Integration Thirty Years On. From Reform to Crisis, Underhill, Blom and Mügge (eds.), Cambridge University Press.

Claessens, S, G Underhill and X Zhang (2008), “The Political Economy of Basle II: the costs for poor countries”, The World Economy 31(3), 313-344.

Claessens, Stijn and Geoffrey R. D. Underhill (2010). The political economy of Basel II in the international financial architecture in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

De Jong, Eelke and Koen van der Veer (2010). The catalytic approach to debt workout in practice: coordination failure between the IMF, the Paris Club and official creditors, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Dieter, Heribert (2010). Monetary and financial co-operation in Asia: improving legitimacy and effectiveness in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Germain, R (2010), “Financial governance in historical perspective: lessons from the 1920s”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Helleiner, Eric and Stefano Pagliari (2010). “Between the storms: patterns in global financial governance 2001–7”, in G Underhill, J Blom and D Mügge (eds.) Global

63 Rethinking Global Economic Governance in Light of the Crisis

Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Klagsbrunn, Victor (2010), “Brazil and Argentina in the global financial system: contrasting approaches to development and foreign debt”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Leijonhufvud, Axel (2011), “Shell game: Zero-interest policies as hidden subsidies to bank”, VoxEU.org column, 25 January 2011.

Minsky, H (1982), “The Financial-Instability Hypothesis: Capitalist processes and the behaviour of the economy,” in Kindleberger and Laffargue (eds.), Financial Crises: theory, history, and policy, New York: Cambridge University Press.

Ocampo, José and Stephany Griffith-Jones (2010). “Combating procyclicality in the international financial architecture: towards development-friendly financial governance” in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Persaud, A. (2000), “Sending the Herd Off the Cliff Edge,” The Journal of Risk Finance 2(1), 59 –65.

Tsingou, E (2012), “Club Model Politics and Global Financial Governance: the case of the Group of Thirty”, (unpublished PhD Thesis, University of Amsterdam).

Underhill, G. (2010), “Theory and the Market after the Crisis: the Endogeneity of Financial Governance,” CEPR Discussion Paper CEPR-DP8164, December

Underhill, G. (2011) Reforming global finance: Coping better with the pitfalls of financial innovation and market-based supervision, PEGGED Policy Paper, December 2011, available online at http://pegged.cepr.org/index.php?q=node/389.

64 Financial stability: Where it went and from whence it might return

Underhill, G. (2011a) “Paved with Good Intentions: Global Financial Integration, the Eurozone, and the Hellish Road to the Fabled Gold Standard,” in D.H. Claes and C. H. Knutsen (eds.), Governing the Global Economy: Politics, Institutions and Development, Routledge , 110-130.

Underhill, G. (2012), The Emerging Post-Crisis Financial Architecture: the path- dependency of ideational adverse selection,” Paper presented to the annual Joint Sessions of the European Consortium for Political Research, University of Antwerp, 10-15 April.

Underhill, G and J Blom (2012), “The International financial Architecture: plus ca change…,” in R Mayntz (ed.), Crisis and Control: Institutional change in Financial Market Regulation, Campus Verlag/MPifG Social Science Series.

Underhill, G, J Blom and D Mügge (eds.) (2010), Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Underhill, G and X Zhang (2008), “Setting the Rules: Private Power, Political Underpinnings, and Legitimacy in Global Monetary and Financial Governance,” International Affairs 84(3), 535-554.

Vreeland, James R (2003), The IMF and Economic Development, Cambridge University Press.

Walter, Andrew (2010), “Assessing the Current Financial Architecture (How Well Does it Work?”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

Zhang, Xiaoke (2010), “Global markets, national alliances and financial transformations in East Asia”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University Press.

65 Rethinking Global Economic Governance in Light of the Crisis

About the author

Geoffrey Underhill is Chair of International Governance is a political economist who works closely and co-authors with economists and political scientists alike. He is a specialist on the financial governance, macroeconomic adjustment and governance, and international trade work packages, and will work with Burgoon on the issue of the sustainability and legitimacy of (trade and financial) liberalisation.

66 The crisis and the future of the banking industry

Xavier Freixas Universitat Pompeu Fabra and CEPR

The global economic crisis – which has been unfolding in various forms since the subprime bubble burst in late 2007 – has come at a high social and economic cost. It has also shattered confidence in US and European banking systems and questioned the capacity of financial markets to channel resources to their best use.

After all, financial industry investments have proven ex post to be excessively risky and the generally accepted view is that their risks were not ex ante sound. The list of examples includes the subprime mortgages in the US and mortgages to markets characterised by real estate bubbles in Europe.

The regulatory reforms that have taken place since the beginning of the crisis have intended, among other objectives, to curtail this excessive appetite for risk. Yet, for regulation to prevent future crises, one must know what caused the excessive risk- taking in the first place.

What is excessive risk-taking?

To explore its causes, the first step is to give a more precise definition of ‘excessive risk-taking’.1 One working definition of excessive risk-taking is a level of risk such that, had it been known and taken into account ex ante by banks’ stakeholders, it would have made the net present value of the bank’s investment project negative.

1 This draws heavily on the Introductory chapter in Dewatripont and Freixas (2012) written by the two editors.

67 Rethinking Global Economic Governance in Light of the Crisis

This view of ‘excessive risk-taking’ has the advantage of preserving the option for banks to invest in high-risk ventures provided they result in a corresponding high return and do not jeopardise the continuity of the bank as a going concern. It does not emphasise financial institutions’ possibly overoptimistic expectations but rather the risk-adjusted cost of funds, as well as the lack of transparency that characterises investment in banks: lending to a financial institution on the basis of a reputation of safe investments in the banking industry supported by a tradition of bailouts by the Treasury where even uninsured debt holders have been protected from the bankruptcy losses.

With this definition in mind, four possible ‘culprits’ stand out:

• Managers’ incentives and corporate governance;

• Understatement of the business cycle risks (capital is excessively cheap and lending excessively permissive in upturns with the opposite holding in downturns);

• Failure of regulatory supervision and market discipline to curb excesses in boom times;

• Moral hazard, whereby banks take too much risk in anticipation of being bailed out in the event of massive losses.

Findings and analysis

First of all, excessive risk-taking is directly related to corporate governance.2 The decisions a bank takes regarding risk levels are ultimately the responsibility of managers and boards of directors. Whether in their strategic decisions managers consider their own bonuses, short-term stock price movements, shareholders’ short-run interests (rather than stakeholders’ long-run ones) or simply the financial institution’s culture of risk, these are all decisions that are substantiated by the board and therefore result from the structure of financial institutions’ corporate governance.

2 For details, see Mehran et al (2012).

68 The crisis and the future of the banking industry

Mehran et al (2012) argue that corporate governance may be especially weak due to the multiplicity of stakeholders (insured and uninsured depositors, the deposit insurance company, bond holders, subordinate debt holders, and hybrid securities holders), and the complexity of banks’ operations. Moreover the moral hazard created by the too- big-to-fail situation may have led boards to encourage risk-taking as they knew that big losses would be paid largely by taxpayers rather than stakeholders.

Second, the issue of excessive risk-taking may also be related to managers’ and shareholders’ understatement of the business cycle risk of downturn, as the procyclicality of capital may lead to excessive lending, the emergence of bubbles and a financial accelerator effect.3 The fact that banks did not have enough capital once the crisis unravelled is not only a failure of the Basel II regulatory framework and the models it is based on, but also evidence of how critical the issue of procyclicality is for financial stability. The regulatory proposal of Basel III on countercyclical buffers is intended to solve this issue. Still, rigorous analysis of the procyclicality of banks’ capital may indicate that the issue is more complicated than it seems.

Repullo and Saurina (2012) focus on one aspect of this, namely the question of whether and how much additional capital should be required during excessive credit growth phases, and how these excessive credit growth phases are to be identified. They study how the Basel III regulatory framework proposes to tackle the issue and the extent to which the rules accomplish their objectives.

The Basel III countercyclical provisions require higher capital-loan ratios when the credit-to-GDP ratio deviates from its trend. Their analysis, however, shows this works the wrong way for a majority of nations; the deviations are negatively correlated with GDP growth. In short, banks that follow the deviation from trend rule may actually be pursuing a procyclical rather than a countercyclic capital policy. The authors propose a simpler rule – the credit growth rate.

3 For details, see Repullo and Saurina (2012).

69 Rethinking Global Economic Governance in Light of the Crisis

Third, it may be argued that the curtailing of excessive risk-taking was the joint responsibility of supervision and market discipline, and that neither did a proper job.4 Theoretically both firms and gatekeepers are supposed to provide accurate information to the market and to supervisory agencies. This information transmission issue has been a key one in the analysis of the crisis, as it has been argued that it was the opacity of some of the structured products, asset-backed securities, collateralised debt obligations, and so on, that was in part responsible for the first stages of the crisis. It has also been stated that the use of fair-value accounting by banks aggravated the crisis. So it is clearly important to assess to what extent these claims are valid.

The market’s main sources of information are firms’ financial reports and credit rating agencies. Freixas and Laux (2012) address a number of reproaches levelled at these sources. On the financial reporting, the use of fair-value analysis has come in for strong criticisms as it caused firms to write down asset falls as the markets collapsed, with this leading to eroded capital and heightened uncertainty. The authors, however, argue that fair value is not much to blame as it only affects banks’ trading portfolios and there is substantial discretion for banks to suspend it if the losses are considered temporary. They are more critical when it comes to credit rating agencies, concluding that these profit-maximising firms are in an institutional setting that inadequately deals with conflicts of interests. They call for more regulation of credit rating agencies to redress this.

Fourth, excessive risk-taking may be the result of another form of market discipline if all banks in distress are to be bailed out.5 This would, of course, be taken into account by a bank’s managers and board of directors and completely distort the bank’s decision since, in this case, bankruptcy threats are no longer credible. Consequently, how regulatory agencies and Treasuries organise banks’ resolutions will determine future moral hazard. It is therefore worth considering how a bank in distress can be

4 Freixas and Laux (2012). 5 Freixas and Dewatripont (2012).

70 The crisis and the future of the banking industry

restructured in an orderly way, whether it is to be closed or bailed out in such a way as to preserve banks’ incentives and be credible while limiting contagion to other banks.

Freixas and Dewatripont (2012) argue that the first objective of regulation is therefore to reduce the cost of bankruptcies; this is the main focus of the last chapter. Banking resolution should be thought of as a bargaining game between shareholders and regulators. Shareholders want to maximise the value of their shares while regulatory authorities’ main objective is to preserve financial stability at the lowest possible cost. Given this, time plays against the regulatory authority. The authors thus argue for bankruptcy rules that are specially crafted for the banking sector (and different from those applying to non-financial corporations).

In this game, time is of the essence – even with the perfectly efficient bankruptcy procedure. Banks in distress should be quickly closed or quickly bailed out. The chapter’s examination of banking crises in different countries shows great variety in the procedures followed and concludes that theory has no clear-cut recommendations to offer.

Plainly the design of the bank resolution mechanisms is critical. One proposal is to add a layer of capital to prevent future crises, but the authors defend the possibilities opened by contingent capital and by bail-ins. They argue that these types of mechanisms would preserve the best characteristics of debt and therefore limit moral hazard. The authors conclude by considering cross-country resolution and the challenges it implies and discuss the recent changes in the European banking resolution framework.

References

Dewatripont, M and X Freixas, eds (2012), The Crisis Aftermath: New Regulatory Paradigms, London: Centre for Economic Policy Research.

71 Rethinking Global Economic Governance in Light of the Crisis

Mehran, H, A Morrison and J Shapiro (2012). “Corporate Governance and Banks: What Have We Learned from the Financial Crisis?”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.

Repullo, R and J Saurina (2010), “The Countercyclical Capital Buffer of Basel III: A Critical Assessment”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.

Freixas, X and C Laux (2012), Disclosure, Transparency and Market Discipline”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.

Dewatripont, M and X Freixas (2012), “Bank Resolution: Lessons from the Crisis” in Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.

72 The crisis and the future of the banking industry

About the author

Xavier Freixas (Ph D. Toulouse 1978) is Professor at the Universitat Pompeu Fabra in Barcelona (Spain) and Research Fellow at CEPR. He is also Chairman of the Risk Based Regulation Program of the Global Association of Risk Professionals (GARP).

He is past president of the European Finance Association and has previously been Deutsche Bank Professor of European Financial Integration at Oxford University, Houblon Norman Senior Fellow of the Bank of England and Joint Executive Director Fundación de Estudios de Economía Aplicada FEDEA), 1989-1991, Professor at Montpellier and Toulouse Universities.

He has published a number of papers in the main economic and finance journals (Journal of Financial Economics, Review of Financial Studies, Econometrica, Journal of Political Economy,…).

He has been a consultant for the European Investment Bank, the New York Fed, the ECB, the World Bank, the Interamerican Development Bank, MEFF and the European Investment Bank.

He is Associate Editor of Journal of Financial Intermediation, Review of Finance, Journal of Banking and Finance and Journal of Financial Services Research.

His research contributions deal with the issues of payment systems risk, contagion and the lender of last resort and the He is well known for his research work in the banking area, that has been published in the main journals in the field, as well as for his book Microeconomics of banking (MIT Press, 1997), co-authored with Jean-Charles Rochet.

How to prevent and better handle the failures of global systemically important financial institutions

Stijn Claessens IMF, University of Amsterdam, and CEPR

1 Introduction

When the dust settles and the final numbers are tallied up, it should be of no surprise if the massive support provided in the (ongoing) crisis to banks and other financial institutions – directly in the form of assistance from governments and central banks, and indirectly through support from international organisations, including to sovereigns under stress – has meant that taxpayers, especially in Europe, have engaged in the largest cross-border transfer of wealth since the Marshall Plan. The crisis has also shown that the ad hoc solutions typically used to deal with failed globally systemically important financial institutions (G-SIFIs)1 lead to much turmoil in international financial markets and worsen the real economic and social consequences of crises.

Importantly, events have made abundantly clear (again) that, for all the efforts invested in the harmonisation of rules and agreements to share more information, supervisors had little incentive to genuinely cooperate before the crisis and did too little to help prevent the weaknesses and failures of many G-SIFIs. These facts, together with the ongoing turmoil in Europe and elsewhere, remind us of the high costs from not having a system that can effectively and efficiently deal with G-SIFIs under stress.

A better approach to dealing with G-SIFIs is therefore sorely needed. Many policy efforts are underway (by individual countries, the Basle Committee on Banking

1 While it is hard to define exactly what a G-SIFI is, and there can obviously not be a final list, the FSB (2011) lists 29 “G-SIFIs” for which certain resolution-related requirements will need to be met by end-2012.

75 Rethinking Global Economic Governance in Light of the Crisis

Supervision, the Financial Stability Board, the IMF, and others) to strengthen regulatory and supervisory frameworks, improve the robustness of these institutions, and enhance actual supervision internationally to prevent distress. At the same time, any approach has to be based on clear analysis of the underlying problem and not on wishful think(er) ing. Logic suggests starting from the endgame, ie, resolution – the process of how a weak financial institution is (in part) liquidated, closed, broken up, sold, or recapitalised. Specifically, the rules governing who is in charge of the restructuring and liquidation process and how losses are allocated when a G-SIFI runs into trouble are crucial. The endgame strongly affects supervisory incentives and market behaviour long before difficulties arise. And the endgame rules affect the time-consistency problem, whether or not an ad hoc bailout is, ex post, the most efficient solution.

As policymakers realise all too well, however, especially in Europe today, approaches to the resolution of G-SIFIs can conflict with three other policy objectives – preserving national autonomy, fostering cross-border banking and maintaining global financial stability. These three objectives are not always mutually consistent; they create a financial trilemma, and approaches to resolution have to operate within this trilemma. In this paper, I examine the causes for the resolution problem of G-SIFIs and review three approaches to improving cross-border resolution which address the financial trilemma head on, acknowledging that solutions are to be found in partly giving up fiscal and legal sovereignty or putting restrictions on cross-border banking.

2 Diagnosis of the current problem

The recent financial crisis has had multiple causes, with their relative importance still being debated (for analyses and views, see the financial crisis issues of the Journal of Economic Perspectives, Winter and Fall 2010; Winter 2009). One of the (approximate) causes, however, was surely the behaviour of G-SIFIs (Claessens, Herring and Schoenmaker, 2010). In part because of weak oversight, G-SIFIs took too much risk

76 Failures of global systemically important financial institutions

before the crisis. Moreover, during the crisis, a relatively small group of 30–50 G-SIFIs became important causes of financial turmoil and channels for cross-border contagion. Both through direct links, as in the case of interbank exposures, and through other channels, such as the affect on asset prices and other financial markets and the threat to essential financial infrastructures (for example, the payments system), their actions and financial problems added to the overall real costs of the crisis.

Interventions in, and support for, weak G-SIFIs were aggravating the financial turmoil and creating large fiscal and real costs. Many G-SIFIs have been the recipient of much direct public support, in the forms of explicit guarantees and official recapitalisation, and other forms of (implicit/indirect) support, such as when G20 governments explicitly announced in the fall of 2008 that they would be protected or when central banks provided more ample liquidity. As in other crises, this support has been very costly and, while often hidden from the public view, has involved large transfers between countries. Examples include the payouts made to foreign banks while the US government provided support to AIG, public support to international banks like RBS, ABN-Amro and the like, and the large implicit transfers – through the ECB and other official support – to the sovereigns and banking systems of crisis-affected countries, such as Greece, Ireland, Portugal and others.

In the aftermath of the crisis, reform efforts are focusing on how to make G-SIFIs more robust to shocks and less prone to insolvency (through higher capital adequacy and liquidity requirements and surcharges, and better liability structures). These reforms are desirable. They can, however, come with some drawbacks in the form of higher costs of financial intermediation, and may not necessarily make the systems more robust. They can create incentives for more risk-taking and lead to risk shifting to other parts of the financial system (eg, the shadow banking system), creating new systemic risks in the process. Importantly, while much is being done to improve the (international) supervision of G-SIFIs, many of the supervisory challenges will remain as long as deficiencies exist in frameworks for resolving G-SIFIs and as long as resolution is

77 Rethinking Global Economic Governance in Light of the Crisis

internationally inconsistent. This view becomes obvious once one considers the state of international financial integration and works backwards from the endgame of resolution.

Countries have become increasingly intertwined financially as cross-border claims have grown much faster than trade and GDP. Much is this is due to a small number of G-SIFIs that operate across the globe. Many of these institutions are very complex (Herring and Carmassi, 2010). For example, the top 30 G-SIFIs have, on average, close to 1,000 subsidiaries, of which some 70% operate abroad and some 10% in offshore financial centres (Claessens, Herring and Schoenmaker, 2010). Complexity not only makes many G-SIFIs difficult to manage, but can also cause them to have systemic consequences. Importantly, a G-SIFI can be very difficult to wind down and become ‘too big to fail’. Many, not just the G-SIFIs themselves, argued during the crisis that if a G-SIFI deeply involved in a wide range of countries were permitted to fail, this would have repercussions that would affect financial systems and national economies around the world. Indeed, as noted, many G-SIFIs were supported for this reason. Supporting them was considered to be, ex post, the most efficient thing to do, given the likely costs of letting them fail. Those few that did not get support created great havoc in international financial markets.

What to do going forward when a G-SIFI runs into difficulties and potentially needs to be resolved has thus become of crucial importance to a safer global financial system. Clarity over the responsibilities in the resolution stage, including the allocation of any costs, greatly matters for the incentives of relevant stakeholders in the preventive stages. These stakeholders importantly include – besides various financial market participants – the multiple supervisors responsible for G-SIFIs. By focusing insufficiently on the need to improve the frameworks for cross-border resolution, ie, the endgame, however, they may have failed to address the deeper problem. That this big lacuna is yet to be rectified is not surprising, given its causes.

National authorities will have a natural inclination to focus on the impact of a G-SIFI failure on their domestic systems (ie, to just consider national externalities) and to ignore

78 Failures of global systemically important financial institutions

the wider impact on the global financial system (ie, the cross-border externalities). The dominance of the national perspective arises for two reasons (Freixas, 2003). First, the financing typically required for dealing with a weak G-SIFI, and any direct costs associated with final resolution, are borne by domestic taxpayers. Second, insolvencies and bankruptcies are dealt with by national courts and resolution agencies that, in turn, derive powers from national legislation. The resolution of a G-SIFI can then lead to coordination failures, where each national authority only looks after its own interest and nobody addresses the global interest.

Similar to the trilemma in international macroeconomics of a fixed exchange rate, independent monetary policy and free capital mobility (Rodrik, 2000), a trilemma arises in dealing with G-SIFIs. This financial trilemma (Schoenmaker, 2011) implies that three policy objectives – preserving national autonomy, fostering cross-border banking and maintaining global financial stability – are not always mutually consistent. Solutions to the trilemma are to be found in partly giving up fiscal and legal sovereignty or putting restrictions on cross-border banking. So far, countries have not chosen in a coherent manner, leading to problems.

The theoretical possibility of coordination failure is born out in practice. In most cross- border bank failures during the recent financial crisis, there was no, or at best partial, coordination, which undermined confidence in the international financial system and increased the costs borne by domestic taxpayers. The failures of Fortis, Lehman and the Icelandic banks illustrate how damaging the lack of an adequate cross-border resolution framework can be for global financial stability. The restructuring of many G-SIFIs on a national basis led to major disruptions. The ongoing restructuring of European banks (and sovereigns) in periphery countries (Greece, Iceland, Ireland, etc) involves large (implicit) transfers, motivated in large part by the desire to preserve (regional) financial stability, and shows the difficulties in achieving coordinated solutions. Only in some cases have authorities reached a cooperative solution, as when they facilitated the continuation of Western bank operations in Central and Eastern Europe, with relatively

79 Rethinking Global Economic Governance in Light of the Crisis

good outcomes. In the case of Dexia, which appeared for some time to have been a good cooperative solution, the bank ended up being dissolved.

3 Possible solutions

To date, international supervisory efforts have focused on the harmonisation of rules and increasing supervisory cooperation, while resolution – the endgame – has been largely neglected. The crisis shows this approach is wrong. For all the harmonisation, supervisors had little incentive to really cooperate, exchange information and intervene in a coordinated manner. Rather, policymakers addressed most weak financial institutions on their own, often with little regard for international consequences. A better solution is to start from the endgame, resolution, since who is in charge and how losses are allocated strongly affect incentives and behaviour long before difficulties arise.

Most countries, however, lack an effective framework for resolving even purely national financial institutions. All too often, as in the recent crisis, the endgame is instead determined under crisis conditions through frantic improvisations over a chaotic weekend, with often no choice but to rescue the institution concerned at great cost. The internationally operating SIFIs make this a global problem. While national reforms have to be the starting point, there are three reform models that can help address the global problem. The first two are corner solutions. The third is an intermediate approach.

The first reform model is a territorial approach under which assets are ring-fenced so that they are first available for the resolution of local claims. There is no need for burden-sharing or coordination, as each country manages the resolution of its own part of the cross-border SIFI. This approach creates inefficiencies – a financial institution has to manage capital and liquidity separately in each country – and compromises the cross-border integration dimension of the financial trilemma. I reject this approach, given the benefits from and the de facto state of financial integration.

80 Failures of global systemically important financial institutions

The second reform model is a universal approach under which all global assets are shared equitably among creditors according to the legal priorities of the home country. This approach can be combined with agreements for burden-sharing between countries, including through some form of financial sector taxation (Claessens, Keen and Pazarbasioglu, 2010), which can further strengthen the incentives for coordination in resolution and supervision. In this model, in terms of the financial trilemma, national autonomy is partly given up. This universal approach is probably only feasible and desirable among closely integrated countries, such as those in the European Union.

The third reform model is a modified universal approach, ie, an intermediate approach to address the financial trilemma. The modified universal approach implies that countries need to adopt improved and converged resolution rules and require G-SIFIs to have better resolution plans. While not giving up national sovereignty, countries do need to agree to expand the principles for international supervision and possibly adopt an enhanced set of rules governing cross-border resolutions (as in, say, a new Basel Concordat on ‘Coordination of Supervision and Resolution of Cross-Border Banks’).

Of the three approaches to the resolution of G-SIFIs that address the trilemma, the universal approach may be feasible, but only among closely integrated countries. The territorial approach impedes efficient international financial integration. But following the territorial approach is what, in many countries, the local regulators of the different parts of a G-SIFI are actually required to do . Attention is largely focused on these two options, but they represent either end of a spectrum, and neither can work effectively in general. More realistic for most countries is a modified universal approach, which requires G-SIFIs to put in place effective resolution plans, each country to adopt improved resolution rules, and countries to jointly adopt a set of rules governing cross- border resolutions that enhance predictability of official actions in a crisis and increase market discipline before crisis conditions emerge.

For all approaches, there will be a need for a new paradigm in international policy coordination. Efforts should move from a focus on whether national authorities can

81 Rethinking Global Economic Governance in Light of the Crisis

cooperate in international supervision and resolution, as reflected in the current harmonisation model, to whether national authorities will cooperate. This will require adopting a much more incentives-based approach, integrating regulation, supervision and resolution policies and enshrining them in a new Concordat. With this, the global financial system can become more predictable and safer, resolution in a crisis more efficient and, through enhanced market discipline, crises less likely.

References

Claessens, S., R.J. Herring and D. Schoenmaker (2010), ‘A Safer World Financial System: Improving the Resolution of Systemic Institutions’, Geneva Reports on the World Economy 12, CEPR/ICMB.

Claessens, S., Michael Keen and Ceyla Pazarbasioglu (2010), Financial Sector Taxation: The IMF’s Report to the G-20 (A Fair and Substantial Contribution) and Background Material G-20 Report (Eds. joint with Michael Keen and Ceyla Pazarbasioglu), IMF, Washington, DC, September.

Financial Stability Board (2011), Policy Measures to Address Systemically Important Financial Institutions, November 4.

Freixas, X. (2003), “Crisis Management in Europe,” in J. Kremers, D. Schoenmaker and P. Wierts (eds), Financial Supervision in Europe, Cheltenham: Edward Elgar, 102- 19.

Herring, R.J. and J. Carmassi (2010), “The Corporate Structure of International Financial Conglomerates: Complexity and Its Implications for Safety and Soundness,” in The Oxford Handbook of Banking, edited by A. Berger, P. Molyneux and J. Wilson.

Journal of Economic Perspectives, Symposium Volumes (2010), Winter and Fall; (2009), Winter.

82 Failures of global systemically important financial institutions

Rodrik, D. (2000), “How Far Will International Economic Integration Go?” Journal of Economic Perspectives 14, 177-186.

Schoenmaker, D. (2011), ‘The Financial Trilemma’, Economics Letters, 111, 57-59.

About the author

Stijn Claessens is Assistant Director in the Research Department of the IMF where he leads the Financial Studies Division. He is also a Professor of International Finance Policy at the University of Amsterdam where he taught for three years (2001-2004). Mr. Claessens, a Dutch national, holds a Ph.D. in business economics from the Wharton School of the University of Pennsylvania (1986) and M.A. from Erasmus University, Rotterdam (1984). He started his career teaching at New York University business school (1987) and then worked earlier for fourteen years at the World Bank in various positions (1987-2001). Prior to his current position, he was Senior Adviser in the Financial and Private Sector Vice-Presidency of the World Bank (from 2004- 2006). His policy and research interests are firm finance; corporate governance; internationalization of financial services; and risk management. Over his career, Mr. Claessens has provided policy advice to emerging markets in Latin America and Asia and to transition economies. His research has been published in the Journal of Financial Economics, Journal of Finance and Quarterly Journal of Economics. He had edited several books, including International Financial Contagion (Kluwer 2001), Resolution of Financial Distress (World Bank Institute 2001), and A Reader in International Corporate Finance (World Bank). He is a fellow of the London-based CEPR.

Cross-border banking in Europe: Policy challenges in turbulent times

Thorsten Beck Tilburg University and CEPR

The ongoing sovereign debt crisis in Europe continues to put strain not only on banks’ balance sheets, but also on the single European banking market. Rather than disentangling the sovereign debt and bank crises, recent policy decisions might have tied the two even closer together. The use of the additional liquidity provided through LTROs to stock up on government bonds by some banks has has certainly had this effect. Moreover, while first steps have been taken to address sovereign debt illiquidity and self-fulfilling prophecies of sovereign insolvency, there are still no proper mechanisms in place to address either.

Last June, CEPR published a policy report titled Cross-border banking in Europe: implications for financial stability and macroeconomic policies (Allen et al 2011) in which the authors argued that policy reforms in micro- and macro-prudential regulation and macroeconomic policies are needed for Europe to reap the important diversification and efficiency benefits from cross-border banking, while reducing the risks stemming from large cross-border banks. While the authors finalised this report in April 2011, the organised default by Greece and the continuing doubts over the debt sustainability of Portugal and concerns over some other peripheral states have reinforced the messages in the report. The ongoing crisis has also reinforced regulatory instincts to focus on national interests and stakeholders when it comes to cross-border banking.

85 Rethinking Global Economic Governance in Light of the Crisis

How did we get here?

The monetary union was supposed to be the crowning element for a single economic area, eliminating exchange rate uncertainty and thus further boosting economic exchange across borders and free flows of capital and labour. At the same time, a regulatory framework for cross-border banking within Europe was established. The introduction of the euro in 1999 eliminated currency risk and provided a further push for financial integration (Kalemli-Ozcan et al 2010). Figure 1 illustrates this trend towards increasing importance of cross-border banks across European financial systems.

Figure 1. Cross-border banking in the European Union

s 60

30 nk Ba Foreign of Share

1995 1997 1999 2001 2003 2005 2007 2009 Year European economies European transition economies Source: Claessens and van Horen (2012) European non-transition economies When the 2007 crisis erupted in the US, cross-border banks were an important transmission channel. In a financially integrated world, where large shares of assets are traded on international markets and with high amounts of inter-bank claims across borders, the contagion effects were pronounced and immediate, going through direct cross-border lending, local lending by subsidiaries of large multinational banks and lower access of local banks to international financing sources. While central banks

86 Cross-border banking in Europe: Policy challenges in turbulent times

coordinated well to address the liquidity crisis in the international financial markets, regulators did not coordinate well when it came to dealing with failing financial institutions, as became obvious in the cases of the Benelux bank Fortis and the Icelandic banks. Over time, coordination improved, as was made most obvious by the Vienna initiative (De Haas et al 2012).

The benefits and risks of cross-border banking

The benefits and risks of cross-border banking have been extensively analysed and discussed by researchers and policymakers alike. The main stability benefits stem from diversification gains; in spite of the Spanish housing crisis, Spain’s large banks remain relatively solid, given the profitability of their Latin American subsidiaries. Similarly, foreign banks can help reduce funding risks for domestic firms if domestic banks run into problems. However, the costs might outweigh the diversification benefits if outward or inward bank investment is too concentrated. Several central and eastern European countries are highly dependent on a few western European banks, and the Nordic and Baltic region are relatively interwoven without much diversification. At the system level, the EU is poorly diversified and is overexposed to the US (Schoenmaker and Wagner 2011). While regulatory interventions into the structure of cross-border banking would be difficult if not counter-productive, a careful monitoring of these imbalances is called for.

There are different market frictions and externalities that call for a special focus of regulators on cross-border banks. First, cross-border banking increases the similarities of banks in different countries and raises their interconnectedness which, in turn, can increase the risk of systemic failures even though individual bank failures become less likely due to diversification benefits (see, eg Wagner 2010). Second, national supervision of cross-border banks gives rise to distortions as shown by Beck, Todorov and Wagner (2011). The home-country regulator will be more reluctant to intervene in a cross-border bank the higher the share of foreign deposits and assets, and more likely

87 Rethinking Global Economic Governance in Light of the Crisis

to intervene the higher the share of foreign equity. The reason for this is that a higher asset and deposit share outside the area of supervisory responsibility externalises part of the failure costs, while a higher share of foreign equity reduces the incentives to allow the bank to continue, as the benefits are reaped outside the area of supervisory responsibility.

The crisis of 2008 has clearly shown the deficiencies of both national resolution frameworks, but especially of cross-border resolution frameworks. In the wake of the crisis, attempts have been made to address these deficiencies, both on the national and the European level. Following the de Larosière (2009) report, the European Banking Authority (EBA) was established to more intensively coordinate micro-regulation issues, while the European Systemic Risk Board (ESRB) is in charge of addressing macro-prudential issues. Further-reaching reform suggestions, such as creating a European-level supervisor with intervention powers or a European deposit insurance fund with resolution powers modelled after the US FDIC or the Canadian CDIC, were rejected, however, mostly based on arguments of the principle of subsidiarity, national sovereignty over taxpayer money that might be needed for resolution of large cross- border banks, and the need to amend European treaties.

Given the biased incentives of national regulators, however, there is a strong case for a pan-European regulator with the necessary supervisory powers and resources. While different institutional solutions are possible, a European-level framework for deposit insurance and bank resolution is critical in order to enable swift and effective intervention into failing cross-border banks, reduce uncertainty, and strengthen market discipline. Depending on the choice of resolution authority (supervisor or central bank), the new EBA or the ECB could be given this central power in the college of resolution authorities. In addition, resolution plans for cross-border banks should be developed to allow for an orderly winding down of (parts of) a large systemic financial institution. As large financial institutions have multiple legal entities, interconnected through intercompany loans, it is most cost effective to resolve a failing bank at the group level. This can imply a splitting-up of the group, the sale of parts to other financial institutions

88 Cross-border banking in Europe: Policy challenges in turbulent times

and the liquidation of other parts. In this context, ex ante burden-sharing arrangements should be agreed upon to overcome coordination failure between governments in the moment of failure and ineffective ad hoc solutions. By agreeing ex ante on a burden- sharing key, authorities are faced only with the decision to intervene or not. In that way, authorities can reach the first-best solution. While burden-sharing should be applied at the global level, it can only be enforced with a proper legal basis. That can be provided at the EU level, or at the regional level. A first example, albeit legally non-binding, is the Nordic Baltic scheme.

Linking financial and macro-stability

The Eurozone crisis is as much a sovereign debt and banking crisis as it is a crisis of governance. As pointed out by many commentators, the aggregate fiscal position of the Eurozone is stronger than that of the UK, the US, or Japan. However, the necessary institutions to address macroeconomic imbalances within the Eurozone are missing. While this holds true for many policy areas, most prominently fiscal policy, this has become especially clear in the area of cross-border banking.

The crisis has raised fundamental questions on the interaction of monetary and financial stability. While the inflation-targeting paradigm treated monetary and financial stability as separate goals, with monetary policy aiming at monetary stability and micro-prudential policy aiming at financial stability, the crisis has changed this fundamentally. Inflation targeting was also behind the original Growth and Stability Pact in the Maastricht Treaty and is the background for the recent Fiscal Compact. This ignores, however, the close interaction between banking and the official sector, including through banks holding governments bonds and the effects of asset and credit bubbles. Examples from the crisis are Spain and Ireland, both of which fulfilled the Maastricht criteria going into the crisis, but experienced real estate bubbles. In the current policy debate, Germany is worried that low interest rates by the ECB, adequate

89 Rethinking Global Economic Governance in Light of the Crisis

to counter recessionary fears across most of the Eurozone, might fuel an asset bubble in Germany.

This calls for the use of macroprudential regulation as additional policy tools. While monetary policy should take into account asset, and not only consumer, price inflation, one tool is simply not enough to achieve both goals, especially in currency unions where asset price cycles are not completely synchronised across countries. Macroprudential regulation cannot serve only to counter the risk of asset price bubbles, but also that of asset concentration and herding. Such regulation would have to be applied on the national, but monitored on the European level.

Another important issue is the close interlinkages between sovereign debt and banking crises in the Eurozone. With banks holding a large share of government bonds (and these bonds constituting a large share of banks’ assets), a sovereign debt restructuring as just happened in Greece leaves banks undercapitalised, if not insolvent. In times of crisis, incentives to hold government bonds (still considered risk-free thus with no capital charges) increase as the risk profile of real sector claims increases (a trend exacerbated by Basel II, as pointed out by many observers, eg Repullo and Suarez 2012). The government debt overhang in many industrialised countries also creates a political bias towards financial repression to reduce the costs of government debt, with further pressure for financial institutions to hold domestic government debt (Kirkegaard and Reinhart 2012). This close interaction between banks and sovereigns also influences policy stances, such as that of the ECB until late last year when it opposed even any talk about sovereign debt restructuring as this would prevent it from accepting Greek sovereign debt as collateral for banks.

One possibility to separate sovereign debt and banking crises was suggested by Beck, Uhlig and Wagner (2011) and Brunnermeier et al (2011). Beck et al suggest creating a European debt mutual fund, which holds a mixture of the debt of Eurozone members (for example, in proportion to their GDP). This fund then issues tradeable securities whose payoffs are the joint payoffs of the bonds in its portfolio. If one member country

90 Cross-border banking in Europe: Policy challenges in turbulent times

defaults or reschedules its debt, this will likewise affect the payoff of these synthetic Eurobonds, but in proportion to the overall share in its portfolio. As Greek’s share would be small (it makes up about 2% of Eurozone GDP), its default would not have posed a significant risk to the Eurobond. Brunnermeier et al (2011) suggest a similar structure, though with two tranches of senior and junior debt, with only senior debt being used for banks’ refinancing operations with the ECB. Obviously, such a synthetic Eurobond, or “ESBie”, would only help separate the two crises, but would not solve either of them. In the case of banking distress, a proper resolution framework is needed, as discussed above. In the case of a sovereign debt crisis, a formal insolvency procedure should be put in place, while at the same time a better firewall is needed to prevent a liquidity crisis in sovereign bonds turning into a self-fulfilling solvency crisis.

Conclusions

Don’t let a good crisis go to waste! This has been a popular cri de guerre following the 2007–08 crisis. Europe, and especially the Eurozone, did too little after the 2007–08 crisis to address the institutional gaps in the framework that is needed for (i) a stable European banking market, and (ii) the interlinkages between monetary and financial stability. It has left policymakers with too few policy tools and coordination mechanisms during the current crisis.

91 Rethinking Global Economic Governance in Light of the Crisis

References

Allen, F, T Beck, E Carletti, P Lane, D Schoenmaker and W Wagner (2011), Cross- border banking in Europe: implications for financial stability and macroeconomic policies, CEPR, London.

Beck, T, H Uhlig and W Wagner (2011), “Insulating the financial sector from the European debt crisis: Eurobonds without public guarantees”, VoxEU.org, 17 September

Beck, T, R Todorov, and W Wagner (2011), “Supervising Cross-Border Banks: Theory, Evidence and Policy”, Tilburg University Mimeo.

Brunnermeier, M, L Garicano, P R. Lane, M Pagano, R Reis, T Santos, D Thesmar, S Van Nieuwerburgh, and D Vayanos (2011), “ESBies: a realistic reform of Europe’s financial architecture”, VoxEU, 25 October.

Claessens, S, and N van Horen (2012), “Foreign Banks: Trends, Impact and Financial Stability”, IMF Working Paper WP/12/10.

De Haas, R, Y Konniyenko, E Loukoianova, E and A Pivovarsky (2012) “Foreign banks and the Vienna Iniative turning sinners into saints”, EBRD Working Paper 143.

De Larosière (2009), Report of the High-Level Group on Financial Supervision in the EU, Brussels: European Commission.

Kalemli-Ozcan, S, E Papaioannou and J Peydró (2010), “What Lies Beneath the Euro’s Effect on Financial Integration? Currency Risk, Legal Harmonization or Trade”, Journal of International Economics 81, 75–88.

Kirkegaard, J F and C Reinhart (2012), “Financial Repressions: Then and Now”, VoxEU.org, 26 March.

Repullo, R and J Suarez (2012), “The Procyclical Effects of Bank Capital Regulation”, CEMFI mimeo.

92 Cross-border banking in Europe: Policy challenges in turbulent times

Schoenmaker, D and W Wagner (2011), “The Impact of Cross-Border Banking on Financial Stability”, Duisenberg School of Finance, Tinbergen Institute Discussion Paper, TI 11-054 / DSF 18.

Wagner, W (2010), ‘Diversification at Financial Institutions and Systemic Crises’, Journal of Financial Intermediation 19, 272-86.

93 Rethinking Global Economic Governance in Light of the Crisis

About the author

Thorsten Beck is Professor of Economics and Chairman of the European Banking CentER at Tilburg University. Before joining Tilburg University in 2008, he worked at the Development Research Group of the World Bank. His research and policy work has focused on international banking and corporate finance and has been published in Journal of Finance, Journal of Financial Economics, Journal of Monetary Economcis and Journal of Economic Growth. His operational and policy work has focused on Sub-Saharan Africa and Latin America. He is also Research Fellow in the Centre for Economic Policy Research (CEPR) in London and a Fellow in the Center for Financial Studies in Frankfurt. He studied at Tübingen University, Universidad de Costa Rica, University of Kansas and University of Virginia.

94 Credit default swaps in Europe*

Richard Portes London Business School and CEPR

Credit default swaps (CDSs) are derivatives, financial instruments sold over the counter (OTC). They transfer the credit risk associated with corporate or sovereign bonds to a third party, without shifting any other risks associated with such bonds or loans.

According to Trade Information Warehouse Reports on OTC Derivatives Market Activity, the outstanding gross notional value of live positions of CDS contracts stood at $15 trillion on 31 August 2011 across 2,156,591 trades. The original use of a CDS contract was to provide insurance against unexpected losses due to a default by a corporate or sovereign entity. The debt issuer is known as the reference entity, and a default or restructuring on the predefined debt contract is known as a credit event. In the most general terms, this is a bilateral deal where a ‘protection buyer’ pays a periodic fixed premium, usually expressed in basis points of the reference asset’s nominal value, to a counterpart known by convention as the ‘protection seller’. The total amount paid per year as a percentage of the notional principal is known as the CDS spread. Most features of sovereign CDSs are identical to those of corporate ones, except that for sovereigns there may be fewer asymmetries of information among market participants, as most relevant information about the health of the economy and public finances is common knowledge.

While CDS contracts written on sovereign names accounted for half the size of the CDS market in 1997, in the early 2000s this ratio declined to 7%. The market share of

* The discussion here in good part summarises research that is joint with Giorgia Palladini and is available as CEPR Discussion Paper 8651, “Sovereign CDS and Bond Price Dynamics in the Eurozone”, November 2011, and financed by PEGGED. We used data from CMA for our empirical analysis. But Giorgia Palladini is not responsible for my interpretations of our results, nor for my assessment of the role of naked CDSs.

95 Rethinking Global Economic Governance in Light of the Crisis

sovereign CDSs dropped to 5% at the end of 2007, with contracts written on emerging economies accounting for over 90% of the global volume of trade. Since the Eurozone debt crisis began, however, the share of sovereign CDSs has risen sharply. At the end of May 2010, the gross notional value of the whole CDS market accounted for $14.5 trillion, with about 2.1 million contracts outstanding. The sovereign segment of the market reached $2.2 trillion, with 0.2 million contracts. Hedge funds, global investment banks, and non-resident fund managers seem to be the most active participants in the market.

Before the introduction of credit derivatives, there was no way to isolate credit risk from the underlying bond or loan. The CDS market has filled this gap, and it may be regarded as a useful financial innovation, subject to (a) verification that it performs this function efficiently; (b) assurance that it has not been transformed into a highly speculative market in ‘naked CDSs’ that perform no hedging function and serve in particular merely to make bets on the future of financial firms and sovereigns that can destabilise them. We address these issues in turn.

The CDS market has drawn increasing attention from practitioners, regulators, and even politicians. Yet much of the existing research used data from the early period of the market’s development, and there is little focus on the segment of greatest policy interest, the Eurozone sovereign bond market. That policy focus may itself be misplaced, because the CDS market may be more destabilising for financial firms than for sovereigns. Regardless, it was the politicians’ concern about the role of CDSs on Greece starting in spring 2010 that drove subsequent action by the European Commission and the European Parliament.

As Duffie (1999) and related literature point out, a theoretical no-arbitrage condition between the cash and synthetic price of credit risk should drive investment decisions and tie up the two credit spreads in the long run. Insofar as credit risk is what they price, cash and CDS market prices should reflect an equal valuation, in equilibrium. If in the short run they are affected by factors other than credit risk, such elements may

96 Credit default swaps in Europe

partially obscure the comovement between bond yield spreads and CDS premia. The first contribution of our research has therefore been to check the accuracy of credit risk pricing in the CDS market. Does the market perform an important role in providing useful information to market participants and other observers?

We proceed by comparing the theoretically implied CDS premia with the ones established by the market. The existence of a stable relationship between the two credit spreads implies a long-run connection between bonds and CDS contracts on the same reference entity, in our case a sovereign. On the one hand, this rules out the possibility that credit risk is priced in unrelated ways in the derivative and cash markets. On the other, we cannot discard the hypothesis that large common pricing components rather than credit risk affect both prices to some extent.

Our research has also addressed the relative efficiency of credit risk pricing in the bond and CDS market. Here we are concerned with the ‘price discovery’ relationship between CDS and bond yield spreads. In particular, can the CDS market anticipate the bond market in pricing, or does it merely adapt to the cash market valuation of credit risk?

Several recent papers study the credit derivative markets. The majority focus on CDS contracts written on corporate bonds1, and their data do not cover the past several years, in which the CDS market grew rapidly and then went through the financial crisis. Of the few papers devoted to the study of sovereign CDS spreads, most focus on emerging markets. We know of only two papers on sovereign credit risk in the European Union based on CDS market data.2 The size of the markets, the intrinsic interest of the recent period, and the policy relevance of CDS market performance would seem to justify our further work using a different approach.

1 Hull et al (2004) and Blanco et al (2005). 2 Arce et al (2011) and Fontana and Scheicher (2010).

97 Rethinking Global Economic Governance in Light of the Crisis

Our sample period runs from 30 January 2004 through 11 March 2011. The time span covered by the regression analysis is equal for each country, at the price of using fewer observations. We restricted our analysis to six countries for which daily estimates of five-year government bond yields are available on DataStream market curve analysis, to make sure that market data are reasonably comparable. Stored government bond yield curves were available for nine EU countries. Among those, CDS quotes for Spain were available for only 1,556 days, instead of 1,879 as for the rest of the sample. Therefore, Spain has been excluded from the analysis. The countries in our resulting sample are Austria, Belgium, Greece, Ireland, Italy, and Portugal.

Our empirical analysis confirms that that the two prices are equal to each other in long-run equilibrium, as theory predicts. One interpretation is that the derivative market correctly prices credit risk: sovereign CDS contracts written on Eurozone borrowers seem to be able to provide new up-to-date information to the sovereign cash market during the period 2004–11. We find, however, that in the short run the cash and synthetic markets price credit risk differently to various degrees. Note also that even if the CDS market prices credit risk ‘correctly’ in the long run, that does not mean that credit risk as priced by either the CDS or the cash market reflects ‘fundamentals’.

In general, our results show that the derivative market seems to move ahead of the bond market in price discovery. This goes in line with the results of Zhu (2006), but contrasts with Ammer and Cai (2011), suggesting that the dynamics for developing and developed economies may be very different as far as sovereign credit risk is concerned. According to our findings, Eurozone sovereign risk seems to behave closer to developed countries’ corporate credit risk than to developing economies’ sovereign risk.

A second aspect of our empirical work provides information about the dynamics of adjustment to the long-term equilibrium between sovereign CDS and bond yield spreads. Deviations from the estimated long-run equilibrium persist longer than if market participants in one market could immediately observe the price in the other, consistent with the hypothesis of imperfections in the arbitrage relationship between

98 Credit default swaps in Europe

the two markets. Probably due to its liquid nature, the Eurozone CDS market seems to move ahead of the corresponding bond market in price adjustment, both before and during the crisis.

There is an alternative causal interpretation of our results. The CDS market may lead in price discovery because changes in CDS prices affect the fundamentals driving the prices of the underlying bonds. If the CDS spread affects the cost of funding of the sovereign (or corporate), then a rise in the spread will not merely signal but will cause a deterioration in credit quality, hence a fall in the bond price (see Bilal and Singh 2012). Such a mechanism could be destabilising; we discuss this further below. Moreover, speculative use of CDS may ‘divert capital away from potential borrowers and channel it into collateral to support speculative positions. The resulting shift in the cost of debt can result in an increased likelihood of default and the amplification of rollover risk’ (Che and Sethi 2011).

Indeed, the change in spread may not signal at all: various non-fundamental determinants can affect the spreads (as in Tang and Yan 2010) and therefore the fundamentals of the reference entity. To confront this hypothesis with the data will require a dynamic model admitting multiple equilibria. Research along these lines is just beginning (eg, Fostel and Geanakoplos 2012).

We now turn to naked CDSs. The CDS market began in the late 1990s as a pure insurance market that permitted bondholders to hedge their credit exposure – an excellent innovation. But then market participants realised that they could buy and sell ‘protection’ even if the buyer did not hold the underlying bond. This is a naked CDS, which offers a way to speculate on the financial health of an issuing corporate or sovereign without risking capital, as short-selling would do. That was so attractive that soon the market was dominated by naked CDSs, with a volume an order of magnitude greater than the stock of underlying bonds.

Like almost all the financial innovations in recent years, naked CDSs are said to be a beneficial move towards more complete markets. And speculation, we are told, is

99 Rethinking Global Economic Governance in Light of the Crisis

essential to the proper functioning of markets. This is simply market fundamentalism that ignores masses of research on destabilising speculation as well as a key lesson of the financial crisis, that some innovations have been dysfunctional and dangerous.

A much more serious justification of naked CDSs is that the overall CDS market, of which these are the dominant component, improves pricing efficiency. The CDS market leads the cash bond market in price discovery and in predicting credit events. Our empirical results appear to bear this out, at least for sovereign bonds in several countries of the Eurozone. Smart traders in the market reveal information, and the CDS market can provide information when the bond markets are illiquid. Still, ‘leadership’ may be the result not of better information, but of the effect of CDS prices on the perceived creditworthiness of the issuer. We return to this key issue below.

CDS prices have many defects as information. They are often demonstrably unrelated to default probabilities – as when the German or UK sovereign CDS price rises; or when corporate prices are less than those for the country of residence, even though the corporate bond yield is much higher than that on the country’s government bond. Many highly variable factors influence the CDS-bond spread: liquidity premia, compensation for volatility, accumulating counterparty risk in chains of CDS contracts. What do pricing efficiency and the informational content of prices mean in a highly opaque market, where much of the information is available only to a few dealers?

Some argue that because net CDS exposures are only a few percent of the stock of outstanding government bonds, ‘the tail can’t wag the dog’, so the CDS market can’t be responsible for the rising spreads on the bonds. This of course contradicts the argument that the CDS market leads in price discovery because of its superior liquidity. More important, it is nonsense. Over a period of several days in September 1992, George Soros bet around $10 billion against sterling, and most observers believe that this significantly affected the market – and the outcome. But daily foreign exchange trading in sterling then before serious speculation began was somewhat over $100 billion. The Soros trades were small relative to the market, yet they had a huge impact, just as the

100 Credit default swaps in Europe

CDS market can move the market for the underlying now. The issue is how CDS prices affect market sentiment – in particular, whether they serve as a coordinating device for speculation. We return to this below.

Perhaps the weakest argument is that banning naked CDSs “would also confine hedging to a world of barter, requiring one to find those with opposite hedging needs” (Financial Times 2010). If the insurer doesn’t want to take on the risk, it shouldn’t be selling insurance.

Some say that naked CDSs are justified because they add liquidity to the market. But is the extra liquidity worth the costs? And we now turn to these.

The most obvious argument against naked CDSs is the moral hazard arising when it is possible to insure without an ‘insurable interest’ – as in taking out life insurance on someone else’s life (unless she is a key executive in your firm, say).

The most important concern is related to this moral hazard. Naked CDSs, as a speculative instrument, may be a key link in a vicious chain. Buy a CDS low, push down the underlying (eg, short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that will not cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations (see Cohen and Portes, 2006).

The mechanism of CDSs is like that of reinsurance. The fees are received up front, the risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will

101 Rethinking Global Economic Governance in Light of the Crisis

then hedge its position by buying CDSs. So the net is much less than the gross, but the chain is based on the view that each party can and will make good on its contract. If there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause a drying-up of liquidity. The long chains may create large and obscure concentration risks as well as volatility, since uncertainty about any firm echoes through the system.

Naked CDSs increase leverage to the default of the reference entity. They can thereby substantially increase the losses that come from defaults. And the leverage comes at low cost – nothing equivalent to capital requirements, no reserve requirement of the kind insurers must satisfy.

What are the policy implications? We do find that for Eurozone sovereign debt, the CDS and cash market prices are normally equal to each other in long-run equilibrium, as theory predicts. One interpretation is that the derivative market prices credit risk correctly: sovereign CDS contracts written on Eurozone borrowers seem to be able to provide new up to date information to the sovereign cash market during the period 2004–11. In the short run, however, the cash and synthetic markets price credit risk differently to various degrees. Second, the Eurozone CDS market seems to move ahead of the corresponding bond market in price adjustment, both before and during the crisis. CDS contracts written on Eurozone borrowers seem to be able to provide new up to date information to the sovereign cash market during the period 2004–11. And CDS contracts clearly do play a useful hedging role. None of this, however, justifies naked CDSs, which appear to play a destabilising role both in theory and in various episodes of the financial crisis.

102 Credit default swaps in Europe

References

Ammer J and F Cai (2011), “Sovereign CDS and Bond Pricing Dynamics in Emerging Markets: Does the Cheapest-to- Deliver Option Matter?”, Journal of International Financial Markets, Institutions and Money, 21(3):369–87.

Arce O, S Mayordomo, and J I Pena (2011), “Do sovereign CDS and Bond Markets Share the Same Information to Price Credit Risk? An Empirical Application to the European Monetary Union Case”, Federal Reserve Bank of Atlanta Working Paper.

Bilal, M and M Singh (2012), “CDS Spreads in European Periphery - Some Technical Issues to Consider”, IMF Working Paper WP/12/77.

Blanco R, S Brennan, and I W Marsh (2005), “An Empirical Analysis of the Dynamic Relation between Investment-Grade Bonds and Credit Default Swaps”, Journal of Finance 60(5): 2255–81.

Che, Y-K and R Sethi (2011), “Credit derivatives and the cost of capital”, mimeo, Columbia University.

Cohen, D and R Portes (2006), “A lender of first resort”, IMF Working Paper P/06/66.

Duffie, D (1999), “Credit Swap Valuation”, Financial Analysts Journal 55(1): 73–87.

Financial Times (2010), “Europe’s sovereign credit default flop”, editorial, 10 March.

Fontana A and M Scheicher (2010), “An Analysis of Eurozone Sovereign CDS and Their Relation with Government Bonds” ECB Working Paper Series No. 1271.

Fostel A and J Geanakoplos (2012), “Tranching, CDS and Asset Prices: How Financial Innovation can Cause Bubbles and Crashes”, American Economic Journal: Macroeconomics 4(1): 190–225.

103 Rethinking Global Economic Governance in Light of the Crisis

Hull J, M Predescu, and A White (2004), “The Relationship Between Credit Default Swap Spreads, Bond Yields, and Credit Rating Announcements”, Journal of Banking and Finance 28(11): 2789–2811.

Tang D and H Yan (2010), “Does the Tail Wag the Dog? The Price Impact of CDS Trading”, mimeo.

Zhu H (2006), “An Empirical Comparison of Credit Spreads between the Bond Market and the Credit Default Swap Market”, Journal of Financial Services Research 29 (3): 211–35.

104 Credit default swaps in Europe

About the author

105

Global banks, fiscal policy and international business cycles

Robert Kollmann ECARES, Université Libre de Bruxelles and CEPR

The worldwide financial crisis that erupted in 2007 has revealed the fragility of major financial institutions, and triggered the sharpest global recession since the 1930s. Before the crisis, standard macro theory largely abstracted from financial intermediaries, and macro forecasting models ignored information on bank balance sheets. The dramatic events since 2007 require a rethinking of the role of global finance for real activity, and will represent a challenge for economic research for years to come. Several of my PEGGED research projects have addressed this challenge, by presenting novel theoretical and empirical analyses of the role of global banks for business cycles in the EU and in the world economy. These contributions also highlight the stabilising role of government support to banks, during a financial crisis.

A tractable framework for analysing the interaction between banks and the real economy is provided by Kollmann, Enders and Müller (2011). That study incorporates a global bank into a two-country macroeconomic simulation model. The bank collects deposits from households and makes loans to entrepreneurs, worldwide. It has to finance a fraction of loans using equity. In equilibrium, the loan rate exceeds the deposit rate – the loan rate spread is a decreasing function of the bank’s capital. Hence, bank capital is a key state variable for domestic and foreign real activity. The simulation model predicts that a loan loss shock originating in one country lowers the capital of the global banking system; this raises lending rate spreads worldwide, triggering a global reduction in bank lending and a worldwide recession. That framework can thus account for the fact that the financial crisis originated in the US, but spread very rapidly to the EU and the rest of the world – the key role of globally active European banks in the transmission of the

107 Rethinking Global Economic Governance in Light of the Crisis

crisis is highlighted by that fact that credit losses of European banks during the crisis were largely due to foreign (US) loans.

In Kollmann (2012), I estimate the two-country model of Kollmann, Enders and Müller (2011); the statistical results confirm the key role of global banks in the crisis transmission. The study finds that Eurozone investment is especially sensitive to shocks to the health of global banks – about 50% of the fall in EZ investment during the crisis can be explained by shocks to the banking system. Kollmann and Zeugner (2011) present further empirical evidence that underscores the role of bank balance sheet conditions for real activity. Specifically, that study analyses the predictive power of bank leverage for real activity. The key result is that bank leverage is negatively correlated with the future growth of real activity – the predictive capacity of leverage is roughly comparable to that of the standard macro and financial predictors used by forecasters. Kollmann and Zeugner also document that leverage is positively linked to the volatility of future real activity and of equity returns. This finding is consistent with the view that higher bank leverage amplifies the effect of unanticipated macroeconomic and financial shocks on real activity and asset prices, i.e. that higher leverage makes the economy more fragile.

The key role of bank health for the overall economy suggests that government support for the banking system might be a powerful tool for stabilising real activity in a financial crisis. In fact, an important dimension of fiscal policy during the crisis was massive state aid for banks, e.g. in the form of purchases of bank assets and of bank recapitalizsations by governments. Kollmann, Roeger and in’t Veld (2012) point out that, in the US and the EU, these “unconventional” fiscal interventions were larger than “conventional” fiscal stimulus measures (temporary increases in government purchases and social transfers, tax cuts). Conventional fiscal stimulus measures in the US amounted to 1.98% and 1.77% of US GDP in 2009 and 2010. In the EU, the conventional stimulus amounted to 0.83% and 0.73% of EU GDP in 2009 and 2010, respectively. Bank rescue measures mainly occurred in 2009. In the EU, government purchases of impaired (“toxic”) bank assets and bank recapitalisations in 2009 amounted to 2.8% and 1.9% of GDP,

108 Global bBanks, fiscal policy and international business cycles

respectively. US government asset purchases and recapitalisations represented 1.6% and 3.1% of GDP in 2009, respectively. In both the US and the EU, these two types of bank support measures thus amounted to 4.7% of GDP, in 2009. Table 1 documents the time profile of cumulated state aid for banks in the Eurozone, between February 2009 and April 2011.

Table 1. Eurozone state aid for banks (cumulative, as % of GDP)

Feb May Aug Dec Oct Dec Apr 2009 2009 2009 2009 2010 2010 2011 Purchases of 0.43 0.45 0.75 2.84 2.15 2.00 1.94 impaired bank assets Recapitalisations 1.09 1.45 1.67 1.88 2.17 2.21 2.11 Total bank aid 1.52 1.90 2.42 4.72 4.32 4.21 4.05

Source: in’t Veld and Roeger (2011) Laeven and Valencia (2011).

Surprisingly, the macroeconomic effects of these sizable bank support measures have received little attention in the economics literature. Kollmann, Roeger and in’t Veld (2012) and Kollmann, Ratto, Roeger and in’t Veld (2012) seek to fill this gap, by adding a government to the banking model of Kollmann, Enders and Müller (2011). Government support for the banking system is modelled as a transfer to banks that is financed by higher taxes. Kollmann, Ratto, Roeger and in’t Veld (2012) and Kollmann, Roeger and in’t Veld (2012) show that state aid to banks boosts bank capital, and that it lowers the spread between the bank lending rate and the deposit rate, which stimulates investment and output; the macroeconomic efficacy of state bank aid hinges on its ability to lower the lending spread. Investment drops sharply in financial crises. Hence, government support for banks helps to stabilise a component of aggregate demand that is especially adversely affected by financial crises. By contrast, most conventional fiscal stimulus measures (e.g. government purchases of goods and services) crowd out investment. Kollmann, Ratto, Roeger and in’t Veld (2012) and Kollmann, Roeger and in’t Veld (2012) show that the GDP multiplier of state aid to banking is in the same range as conventional government spending multipliers.

109 Rethinking Global Economic Governance in Light of the Crisis

References in’t Veld, J. and Roeger, W. (2011), “Evaluating the Macroeconomic Effects of State Aids to Financial Institutions in the EU”, Working Paper, European Commission.

Kollmann, R., Enders, Z. and Müller, G. (2011), “Global banking and international business cycles”, European Economic Review 55, 407-426.

Kollmann, R. and Zeugner, S. (2011), “Leverage as a Predictor for Real Activity and Volatility,” Journal of Economic Dynamics and Control, forthcoming.

Kollmann, R., Roeger, W. and in’t Veld, J. (2012), “Fiscal Policy in a Financial Crisis: Standard Policy vs. Bank Rescue Measures”, American Economic Review (Papers and Proceedings), forthcoming.

Kollmann, R., Ratto, M., Roeger, W. and in’t Veld, J. (2012), “Banks, Fiscal Policy and the Financial Crisis”, Working Paper, ECARES, Université Libre de Bruxelles.

Kollmann, R. (2012), “Global Banks, Financial Shocks and International Business Cycles: Evidence from an Estimated Model”, Working Paper, ECARES, Université Libre de Bruxelles.

Laeven, L. and Valencia, F. (2011), “The Real Effects of Financial Sector Interventions During Crises”, Working Paper 11/45, IMF.

About the author

Robert Kollmann is a Professor of Economics at the Universite Libre de Bruxelles. He obtained his PhD from the University of Chicago in 1991. His research interests are macroeconomics, international finance and computational economics.

110 The Doha Round impasse

Simon J Evenett University of St. Gallen and CEPR

By 2012, it has been widely accepted that the Doha Round of multilateral trade negotiations, launched in 2001, has reached an impasse. Even in 2011, when it was no longer credible to deny the prospect of failure, governments were unable to break the impasse (see Singh Bhatia 2011). That a multilateral trade negotiation has reached an impasse is not new, at least one occurred during the Uruguay Round. Moreover, it is misleading to think of impasses as only affecting the final stage of a multilateral trade negotiation.1 Arguably, WTO members have been unable to agree at three junctures during the Doha Round, namely:

• Failure to agree to launch the Doha Round (1995–September 2001, including the acrimonious WTO ministerial meeting in Seattle).

• Failure to agree on a negotiating agenda for the Doha Round (from 2002 up to the “July package” of 2004, and including the failed Cancun meeting of WTO ministers).

• Failure to conclude the negotiation (at a minimum from the mid-2008 breakdown in negotiations through to the present day).

What is new is the pervasive sense that it may not be possible to find steps that command broad enough support among the WTO membership to break the current negotiating deadlock. This leaves the WTO flying on one less engine, it is now being powered by the dispute settlement function and weaker transparency and deliberative functions.

1 The WTO’s Director-General, Mr. Pascal Lamy, noted, in remarks to the WTO General Council on 29 April 2011, that “this Round is once more on the brink of failure.”

111 Rethinking Global Economic Governance in Light of the Crisis

This paper describes the underlying sources of the impasse and considers what those findings imply for how scholars, in particular international trade economists, might analyse multilateral trade negotiations. As will be argued below, there has been far too much analysis in recent years on the logic underlying successfully negotiated trade agreements and too little on understanding the factors that might impede or facilitate identifying the basis of the deal in the first place. Fortunately, game theorists and international relations scholars have given more attention to the study of impasses, and this might provide a useful point of departure for further research.

The realities of multilateral trade negotiations and national imperatives

When presented with a possible trade agreement by his staff, it is said that the former US Trade Representative, Robert Zoellick, would ask “What is the basis of the deal?” In short, what does each party contribute to the deal, what does each party gain from the deal, and is there a compelling logic for who gains what? This approach serves as a useful reminder that successful trade negotiations involve contributions by each major party (having influence requires foreswearing free riding and being seen to do so by trading partners), and that whatever negotiating rules are adopted (such as the single undertaking and less than full reciprocity in favour of developing countries) do not eliminate all of the possible mutually acceptable deals.

The need to be seen to contribute to deals—which in trade policy, if not strictly economic, terms means making “concessions” to liberalise own markets—cuts against the task the trade negotiator has at home, namely, to maintain support for the trade negotiation and generate enough support for the final deal. The temptation, when managing domestic constituencies, is for trade negotiators to assure some constituencies that their nation’s concessions will be minimised while assuring others that a deal will be unacceptable unless other countries don’t make more concessions.

112 The Doha Round impasse

All too often, this amounts to characterising their nation’s negotiating position to domestic audiences as demanding “something for nothing.” While the trade negotiator is undertaking this delicate dance at the national level, they are also trying to send a different signal to their foreign counterparties, specifically, their willingness and capacity to negotiate. All of this happens in a world where the many nations’ media report statements made by foreign trade officials! Throughout the Doha Round, many trade negotiators have given the impression that they could effectively spot “landing zones” among the “smoke and mirrors,” a claim that may need to be revisited in the light of a prolonged impasse. This time around, perhaps trade negotiators were too clever by half. The potential for miscalculation cannot be ruled out.

Yet trade negotiators are not the only relevant players. Defensive domestic constituencies have grown wise to trade negotiators’ tactics and incentives2, by and large distrust them, and have taken steps to protect their interests. One such step is to insist that a trade negotiator’s ministerial masters or the national legislature impose a negotiating mandate that officials dare not breach. Not only do negotiators resent the encroachment on their freedom to negotiate, but surely this makes it harder to reach a mutually acceptable deal? Not necessarily, as Nobel Laureate Thomas Schelling argued in his famous “conjecture” on international negotiations (Schelling 1960). Schelling argued that if one major party to a negotiation could credibly commit not to offer concessions beyond a certain point and, at that point, the other parties are materially better off by making the deal than not making the deal, then the former party’s commitment device can shift the negotiating outcome in its favour.

Unfortunately, Schelling also noted that if many players attempt the same tactic (tying the hands of their negotiators) then an impasse is likely. Given how low trade ministries tend to be in the pecking order of most governments—certainly lower than many countries’ agricultural ministries, which frequently have an opposing stake in any Doha

2 Trade negotiators like doing deals; it is good for their professional reputations. Just take a look at the webpages of a former senior trade negotiator that has moved into the private sector.

113 Rethinking Global Economic Governance in Light of the Crisis

Round outcome—and given the speed with which information on negotiating positions can be transmitted back to national capitals, these factors alone may contribute to the following features observed during the Doha Round: trade negotiators from leading jurisdictions signal their willingness to negotiate,3 but when the focus is on particularly sensitive sectors (like agriculture) and more information is revealed about the true nature of domestic political constraints, then suddenly negotiating flexibility shrivels, and an impasse results.

Moreover, prime ministers and presidents are well aware of their own negotiator’s limited mandates (imposed because of strong domestic constituencies), suspect or infer that other heads of government have imposed similarly restrictive negotiate mandates, and, unless presented with compelling pressures to the contrary, sustain the status quo. Consequently, such heads of government resist the elevation of Doha Round negotiations to international forums, such as the G20. National constraints are projected on to the international negotiation, in a manner that Schelling foresaw and some trade negotiators openly acknowledged. Speaking in Washington, DC in 2005, the then-EU Trade Commissioner Peter Mandelson said:

“I do not underestimate the constraints imposed by domestic politics on both sides of the Atlantic but we have a wide set of joint interests in the Doha Round. At the end of the day, we are two very large Continental players with different, but similar economic structures and specialisations. We should not be in the business of pre-cooking and imposing outcomes. But it is essential that we work to build common or coordinated policy platforms. If we cannot agree on basic approaches then nothing will happen. It’s as simple as that.” (Mandelson 2005).

3 After all, no negotiator wants to exclude themselves from a major negotiation by admitting they can give little or nothing.

114 The Doha Round impasse

Why can’t the limited negotiating mandates be overcome?

Arguing that interests opposed to foreign competition have limited the mandates of trade negotiators is, at best, only part of the explanation for the Doha Round impasse. What must also be explained is why the potential beneficiaries of Doha Round accords were not able or willing to counter the opponents. Several structural explanations follow and all but the final two can be found in Evenett (2007a, b).

• First, an important source of commercial support for the Doha Round never came about because negotiations over stronger rules and greater market openness in service sectors did not take off.

Here, a less appreciated factor is that the service sector negotiating mandates of many countries’ trade officials are influenced—if not outright determined—not just by incumbent firms, but also by independent national service sector regulators, many of whom resist the restriction on their freedom often implied by binding multilateral trade accords.

It may be the case that “national politics” was taken out of national regulation through the creation of independent regulators, but it does not imply that these regulators are cosmopolitan in outlook. With service sector reform effectively taken out of the negotiating set, along with the removal of almost all of the Singapore issues in 2004, the principal remaining negotiating trade-off was agricultural trade reform (in industrialised countries) in return for greater access to manufactured goods markets (in developing countries). This was the basis upon which any deal had to be based.

• Second, several factors diminished the value that representatives from industrialised countries attached to offers to open up manufacturing goods markets in developing countries.

Before the global financial crisis, with the exception of the United States and Japan, industrialised countries experienced export growth rates faster than those seen during the Uruguay Round negotiation. The incremental export growth expected from the

115 Rethinking Global Economic Governance in Light of the Crisis

offers made in Doha Round were perceived as relatively small and, in the eyes of some leading exporters, not worth fighting for.

• Third, with the exception of China, all the developing countries with large markets have engaged in enough unilateral tariff reform since the conclusion of the Uruguay Round that their maximum allowed tariffs (bound tariffs) exceed their applied tariff rates, on average (Evenett 2007a).

Contrary to much economic thinking about the uncertainty-reducing benefits of tariff bindings, leading European and American associations of manufacturers and exporters argued that the unilateral tariff reductions in developing countries were irreversible and that “binding” tariffs at existing applied levels would generate no additional commercial benefits.

Only if large developing countries agreed to accept bindings on their tariffs below existing applied rates would enough market opportunities for industrialised country exporters be created, it was argued. For the largest developing countries, the latter would typically amount to a 60–70% cut in the bound rate, a percentage cut nearly double the rate seen in previous multilateral trade rounds. Developing countries insisted that the demands made of them were excessive and pointed out that the same logic was not accepted by industrialised countries in agricultural negotiations where, for many commodities, applied subsidy levels currently stand well below bound subsidy levels.

• Fourth, the impressive expansion in the share of world exports supplied by the Chi- nese during the past decade fuelled fears in many countries—both developing and industrialised—that any tariff cuts on manufacturers would predominately benefit Chinese exporters.

The fear was that this would intensify import competition even further, and threaten jobs.

The sustained Chinese export surge also led to pessimism among other nations’ exporters about the prospects of holding on to their overseas market shares. Together,

116 The Doha Round impasse

these factors further skewed the domestic political calculus away from supporting Doha Round deals that extended benefits to China which, under the Most Favoured Nation principle, they must.

• Fifth, no mechanism with sharp incentives to bring closure to the Doha Round has been introduced.

In the Uruguay Round, the larger trading nations made it clear that any reluctance to sign all of the accords negotiated in 1993 would preclude a country from membership of the then-to-be-created WTO. Fearing the consequences of becoming second class citizens in the world trading system, each member of the then-GATT overcame their objections and signed the Uruguay Round accords. The central prerequisite for employing such a tactic is agreement on a final accord between the leading trading nations—which existed in 1992-3 but not in 2011.

Concluding remarks

Ultimately, numerous factors—some of which could not have been anticipated when the Doha Round was launched in 2001—account for the inability to bring this multilateral trade negotiation to a successful conclusion. The roots of many of these factors lie in national political choices including sustained unilateral tariff reforms in many developing countries, prevailing global economic conditions, the rise of China, and a lack of a decisive mechanism to stop negotiators from postponing difficult choices to a later day. If this analysis is correct, it suggests that institutional fixes at the WTO alone would not have avoided the Doha Round impasse.

The approach taken here represents a marked point of departure from much of the modern economic literature on the WTO. For nearly 20 years, trade economists have sought to develop theoretical rationales for the WTO, which are predicated on the assumption that there is a basis for a deal among negotiating parties. For sure, understanding the incentives created by WTO accords once nations can agree is important. However, the principal feature of the Doha Round has not been accord—it has been impasse. More

117 Rethinking Global Economic Governance in Light of the Crisis

research is needed to understand why impasses can arise after a negotiation has begun with high hopes, what factors and strategies can overturn impasses, and how impasses themselves may influence subsequent state behaviour.

References

Baldwin, R and S Evenett (eds.) (2011), Why world leaders must resist the false promise of another Doha delay, VoxEU.org eBook.

Singh Bhatia, Ujal (2011), “Can the WTO be Decoupled From the Doha Round?” in Next Steps: Getting Past the Doha Round Crisis, Baldwin, R and S Evenett (eds.), VoxEU.org eBook, 2011.

Evenett, S (2007a), “Doha’s near death experience at Potsdam: why is reciprocal tariff cutting so hard?” www.voxeu.org. 24 June.

Evenett, S (2007b), “Reciprocity and the Doha Round Impasse: Lessons for the Near Term and After.” Aussenwirtshaft.

Mandelson, P (2005), “The Right Choices for the Doha Round,” speech at the National Press Club, Washington DC, 15 September.

Schelling, T (1960), The Strategy of Conflict, Harvard University Press.

118 The Doha Round impasse

About the author

Simon J. Evenett is Professor of International Trade and Economic Development at the University of St. Gallen, Switzerland, and Co-Director of the CEPR Programme in International Trade and Regional Economics. Evenett taught previously at Oxford and Rutgers University, and served twice as a World Bank official. He was a non- resident Senior Fellow of the Brookings Institution in Washington. He is Member of the High Level Group on Globalisation established by the French Trade Minister Christine LaGarde, Member of the Warwick Commission on the Future of the Multilateral Trading System After Doha, and was Member of the the Zedillo Committee on the Global Trade and Financial Architecture. In addition to his research into the determinants of international commercial flows, he is particularly interested in the relationships between international trade policy, national competition law and policy, and economic development. He obtained his Ph.D. in Economics from Yale University.

119

The Future of the WTO

Richard Baldwin Graduate Institute, Geneva and CEPR

The WTO is doing fine when it comes to the 20th century trade it was designed for – goods made in one nation’s factories being sold to customers abroad. The WTO’s woes stem from the emergence of “21st century trade” (the complex cross-border flows arising from internationalised supply chains) and its demand for beyond-WTO disciplines. The WTO’s centrality was undermined as such disciplines emerged in regional trade agreements. The future will either see multi-pillar global trade governance with WTO as the pillar for 20th century trade, or a WTO that engages creatively and constructively with 21st century trade issues.

1 Introduction

The WTO is widely regarded as trapped in a deep malaise. Exhibit A is its inability to conclude the multilateral trade negotiations known as the Doha Round, despite 10 years of talks. This failure is all the more remarkable since it does not reflect anti-liberalisation sentiments – quite the contrary. The new century has seen massive liberalisation of trade, investment, and services by WTO members – including nations like India, Brazil, and China that disparaged liberalisation for decades. WTO members are advancing the WTO’s liberalisation goals unilaterally, bilaterally or regionally – indeed almost everywhere except inside the WTO (see Figure 1).

121 Rethinking Global Economic Governance in Light of the Crisis

Figure 1. Global trade liberalisation, 1947–2007

50 16%

45 14%

40 13% 12% 12% 35

10% 30 10% 25 9% 8%

20 6% 6%

15 4% 10

2% 5

0 0% 1947 1949 1951 1953 1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007

New RTAs (number of agreements) New WTO members (number of nations) GATT/WTO Round in progress World average tariff (right scale)

Sources: RTAs: WTO online databases & Hufbauer-Schott RTA database; tariffs: Clemson and Williamson (2004) up to 1988, then World DataBank (weighted tariffs all products) This chapter argues that the WTO is in excellent shape when it comes to the type of trade it was designed to govern. Indeed, this is why WTO membership remains so popular (29 new members have joined since 1995). The WTO’s woes stem rather from the emergence of a new type of trade – call it 21st century trade. This new trade – which is intimately tied to the unbundling of production – requires disciplines that go far beyond those in the WTO’s rulebook. To date, virtually all of the necessary governance has emerged spontaneously in regional trade agreements or via unilateral ‘pro-business’ policy reforms by developing nations. The real threat, therefore, is not failure of the WTO, but rather the erosion of its centricity in the world trade system.

This line of reasoning suggests the WTO’s future will take one of two forms.

1. The WTO remains relevant for 20th century trade and the basic rules of the road, but irrelevant for 21st century trade; all ‘next generation’ issues are addressed elsewhere.

122 The Future of the WTO

In the optimistic version of this scenario, which seems to be where the current trajectory is leading us, the WTO remains one of several pillars of world trade governance. This sort of outcome is familiar from the EU’s three-pillar structure, where the first pillar (basically the disciplines agreed in treaties up the 1992 Maastricht Treaty) was supplemented by two new pillars to cover new areas of cooperation.1 In the pessimistic version of this first scenario, the lack of progress undermines political support and the WTO disciplines start to be widely flouted; the bicycle, so to speak, falls over when forward motion halts.

The second scenario involves a reinvigoration of the WTO’s centricity.

2. The WTO engages in 21st century trade issues both by crafting new multilateral disciplines – or at least general guidelines – on matters such as investment assurances and by multilateralising some of the new disciplines that have arisen in regional trade agreements.

There are many variants of this future outlook. The engagement could take the form of plurilaterals – following the lead of agreements like the Information Technology Agreement, the Government Procurement Agreement and the like (where only a subset of WTO members sign up to the disciplines). It could also take the form of an expansion of the Doha Round agenda to include some of the new issues that are now routinely considered in regional trade agreements.

In this short essay, I support these conjectures by first discussing why the GATT had so many wins while the WTO’s had so many woes, then explaining why 21st century trade emerged and how it is different. Finally, I pull the threads together in the concluding section.

Note that I straightforwardly ignore many of the standard issues that crop up in essays about the WTO’s future: the rising number of WTO members and its consensus decision-

1 The pillar structure was removed by the 2009 Lisbon Treaty but its effect was maintained Article by Article.

123 Rethinking Global Economic Governance in Light of the Crisis

making; the rise of new trade giants, especially China, who are both poor and too big to ignore; the agriculture-manufacturing imbalances in the existing system, etc. In my view, these are all important, and indeed critical when thinking about how the WTO should defend its centrality, but I think these factors are less important in understanding the fundamental sources of the WTO’s difficulties and its options for the future.

2 Why GATT won the war on tariffs

The GATT’s remarkable success in lowering tariffs globally rested on two political economy mechanisms: the juggernaut effect and the “don’t obey, don’t object” principle. The juggernaut mechanism draws on a political economy view of tariffs. To put it starkly, GATT did not work via international cooperation, it worked by rearranging political economy forces within each nation so that each government found it politically optimal to lower tariffs. The key is the GATT’s reciprocity principle – “I cut my tariffs if you cut yours”. This enabled governments to counterbalance import-competing lobbies (protectionists) with export lobbies (who do not care directly about domestic tariffs, but who know they must fight domestic protectionists to win better foreign market access). In short, reciprocity switched each nation’s exporters from bystanders to pro- trade activists. This made every government more interested in lowering tariffs than they were before the reciprocal talks started.

Liberalisation continued over the decades, since each set of reciprocal tariff cuts created political economy momentum. That is, a nation’s own cuts downsized its import-competing industries (weakening protectionist forces) and foreign cuts upsized its exporters (strengthening pro-liberalisation forces). In this way, governments found it politically optimal to further reduce tariffs in the next GATT Round (held five to ten years down the road after industrial restructuring reshaped the political economy landscape in a pro-liberalisation direction).

124 The Future of the WTO

The second pillar was the fact that developing nations were allowed to free ride on the resulting rich-nation tariff cuts.2 This is what lets a large, diverse, consensus-based organisation operate as if it were run by a small group of self-appointed, like-minded big economies. Countries whose markets were too small to matter globally – mainly the developing nations in the GATT decades – were not expected to cut their own tariffs during Rounds.3 Yet the GATT’s principle of “most favoured nation” (MFN) meant that their exporters enjoyed the fruits of any tariff-cutting by large economies. Developing nations had a stake in the success of GATT rounds and nothing to gain from failure. For developing nations, GATT was a “don’t obey, don’t object” proposition. Of course, this fudged, rather than solved, the consensus problem.

3 Why GATT magic does not work for WTO

The juggernaut worked exceedingly well in the economies that dominated the trade system in the 20th century – the so-called Quad (US, EU, Japan and Canada) – and on the goods of interest to their exporters (mostly manufactures). By the time of the WTO’s founding in 1995, Quad tariffs were very low on all but a small number of goods (notably agriculture). The dynamo, however, ran low on fuel as Quad tariffs fell. To keep exporters interested in fighting protectionists in their national capitals, the GATT broadened the negotiating agenda for the Uruguay Round (launched in 1986). Guarantees of intellectual property rights, disciplines on the use of investment restrictions, and the liberalisation of services market were added (known as TRIPs, TRIMs and Services).4 To balance the agenda, agriculture and textiles barriers were also added – items that were viewed as being of interest to developing nations.

2 Right from the start, the developed nations were accorded special treatment in the GATT. This became increasingly explicit from the 1956 GATT “review session”; the Haberler Report (1958) provided intellectual backing that eventually led to “special and differential treatment” embodied in the GATT by Article XVIII on Trade and Development. 3 Non-reciprocity happened automatically under the principle-supplier structure of Rounds in the 1940s and 1950s; it became explicit with GATT Article XVIII when formulas began to be used. 4 TRIPs and TRIMs are short for Trade Related Intellectual Property Rights and Trade Related Investment Measures.

125 Rethinking Global Economic Governance in Light of the Crisis

A problem with this agenda-broadening was it was inconsistent with “don’t obey, don’t object”, which would have allowed developing nations to opt out of TRIPs, TRIMs and Services disciplines while benefiting from agriculture and textile tariff cuts via MFN. In short, the consensus problem could no longer be fudged, it had to be solved directly.

The Uruguay Round’s endgame tactics replaced the “don’t obey, don’t object” carrot with the Single Undertaking stick. That is, the final Uruguay Round package set up a new institution – the WTO – and made membership a take-it-or-leave-it proposition. All members, developed and developing alike – even those that had not participated actively in the negotiations – were obliged to accept all of the Uruguay Round agreements as one package.5 The old days of developing nation free-riding were over. Refusing to sign would not cancel a member’s rights under the old GATT, but if the big economies withdrew, the GATT would be an empty vessel. As history would have it, everyone joined the WTO. To enforce the Single Undertaking, the flexibility of the GATT’s dispute settlement procedures was greatly reduced. The new adjudication procedure – known as the Dispute Settlement Understanding – meant that everyone would have to obey.

Long story short: the Uruguay Round’s closing tactics unbalanced the GATT’s winning formula. Developing countries now had to obey, so they would have to object to things that threatened their interests. The Single Undertaking and hardened dispute settlement procedure pushed the WTO into decision-making’s “impossible trinity” – consensus, universal rules, and strict enforcement.6 This is one key reason why the WTO’s Doha Round is so much more difficult to negotiate than the GATT rounds were.

5 Some developing countries welcomed the Single Undertaking as it reduced their marginalisation in the rule-making avoiding outcomes like the Tokyo-Round Codes. 6 Inspired by Mundell’s exchange-rate trilemma, Ostry (1999) proposed a ‘trade trilemma’ that Rodrik (2000, 2002) made rigorous.

126 The Future of the WTO

4 The nature of international commerce changes: Production unbundling

Without the GATT’s winning formula, one might have expected trade liberalisation to grind to a halt. It did not. The reason is that world trade and the politics of liberalisation changed radically in the 1990s. The cause was the information and communication technology (ICT) revolution, but understanding this requires some background.

4.1 Globalisation as two unbundlings

Globalisation is often viewed as driven by the gradual lowering of natural and man- made trade barriers. This is a serious misunderstanding. Globalisation made a giant leap when steam power slashed shipping costs; it made another when ICT decimated coordination costs. These can be called globalisation’s first and second unbundlings. Consider the 1st unbundling.

When clippers and stage coaches were high-tech, few items could be profitability shipped internationally. Production had to be nearby consumption; each village made most of what it consumed. Steam power changed this by radically lowering transport costs. The result was ‘the first unbundling’, i.e. the spatial unbundling of production and consumption. GATT rules where designed to provide the international disciplines necessary to underpin this sort of trade, i.e. goods that were made in one nation being sold to customers in another nation.

The first unbundling, however, created a paradox – production clustered into factories even as it dispersed internationally. The paradox is resolved with three points: (i) cheap transport favours large-scale production, (ii) such production tends to be very complex, and (iii) proximity lowers the cost of coordinating complexity. Think of a stylised factory with several production bays. Coordinating the manufacturing process demands continuous, two-way flows among bays of things, people, training, investment, and

127 Rethinking Global Economic Governance in Light of the Crisis

information. Productivity-enhancing changes keep the process in flux, so the flows never die down.

Some of proximity’s cost-savings are related to communications. As the ICT revolutions loosened the “coordination glue”, it became feasible to spatially separate some types of production stages, i.e. to spatially unbundle the factories. Since some production stages were labour intensive, rich-nation firms reduced costs by offshoring them to low-wage nations. This was the second unbundling.7

The second unbundling transformed international commerce for a very simple reason. Offshoring internationalised the two-way flows among production bays – the things, people, training, investment, and information mentioned above. Quite simply, international commerce became much more complex and diverse, creating ‘21st century trade’. The heart of this new commerce is what I call the “trade-investment- services-intellectual property” nexus.8 Specifically, the nexus reflects the intertwining of (i) trade in parts and components, (ii) international movement of investment in production facilities, key technical and managerial personnel, training, technology, and long-term business relationships, and (iii) demand for services to coordinate the dispersed production.

In the 20th century, the trading system was mostly important on the ‘demand side’; it was about helping firms sell abroad products they made at home. In the 21st century, it is also important on the ‘supply side’, helping firms produce goods quickly and cheaply with international supply chains.

7 See, for example, Ando and Kimura (2005), Kimura, Takahashi, and Hayakawa (2007), Gaulier, Lemoine and Unal- Kesenci (2007), and Athukorala (2005) in the East Asian case, and Federal Reserve Bank of Dallas (2002) or Feenstra and Hanson (1997) on the North American case. 8 See Baldwin (2011).

128 The Future of the WTO

4.2 The nature of trade barriers and trade policies changes

Emergence of the trade-investment-services-IP nexus meant that trade now involved two new necessities – connecting factories, and doing business abroad. Underpinning these involved rules on things that were never considered trade issues in the GATT era.

1. Connecting factories involves assurances on business-related capital flows, world- class telecoms, air cargo, overnight parcel services, customs clearance services, short-term visa for managers and technicians, and infrastructure (ports, road, rail and electricity reliability, etc.). Of course, tariffs and other border measures also matter.

2. Doing business abroad involves a whole range of formerly domestic policies – so- called behind-the-border barriers such as competition policy, property rights, rights of establishment, the behaviour of state-owned enterprises, the protection of intellectual property, and assurances on investor rights. All of these are important to doing business abroad.

In this new world, any policy that hinders the nexus is now a trade barrier.

The second unbundling created a de novo impulse for liberalisation – developing nations wanted the offshored industrial jobs and technology, rich-nation firms wanted access to lower-cost labour. Both pushed for disciplines to underpin the trade-investment- services-IP nexus. The result was “deep” regional trade agreements and unilateral pro- business reforms by developing nations. The result can be seen in Figure 1 – the WTO’s difficulty with the Doha Round did nothing to slow global trade liberalisation.

The political economy of liberalisation also changed. It was no longer the juggernaut’s “I’ll open my market if you open yours”, but became a reciprocal deal based on “foreign factories for domestic reforms”. Developing nations were willing to reform all sorts of behind-the-border barriers in exchange for factories and industrial jobs that came from joining a rich-nation’s supply chain.

129 Rethinking Global Economic Governance in Light of the Crisis

The WTO’s centrality suffered. As there are no factories on offer in Geneva, the new rule-writing shifted to bilateral deals. If a developing nation wants US, EU, or Japanese factories, they talk directly with Washington, Brussels, or Tokyo.

Of course, 20th century trade is still with us, and is important in some goods (e.g. primary goods) and for some nations (international supply chains are still rare in Latin American and Africa), but the most dynamic aspect of trade today is the development of international value chains.

5 Concluding remarks

When it comes to 20th century trade and trade issues, the WTO is in rude health.

• The basic WTO rules are almost universal respected.

• The decisions of the WTO’s court are almost universally accepted.

• Nations – even big, powerful nations like Russia – seem willing to pay a high political price to join the organisation.

• The global crisis created protectionist pressures, but most of the new protection conformed to the letter of the WTO law (Evenett 2011).

In short, the WTO is alive and well when it comes to the types of trade and trade barriers it was designed to govern, i.e. 20th century trade (the sale of goods made in factories in one nation to customers in another).

Where the WTO’s future seems cloudy is on the 21st century trade front. The demands for new rules and disciplines governing the trade-investment-services-IP nexus are being formulated outside the WTO. Developing nations are rushing to unilaterally lower their tariffs (especially on intermediate goods) and unilaterally reduce behind- the-border barriers to the trade-investment-services-IP nexus. All of this has markedly eroded the WTO centrality in the global trade system.

130 The Future of the WTO

The implication of this is clear. The WTO’s future will either be to stay on the 20th century side-track on to which it has been shunted, or to engage constructively and creatively in the new range of disciplines necessary to underpin 21st century trade.

References

Ando, Mitsuyo and Fukunari Kimura (2005), “The Formation of International Production and Distribution Networks in East Asia,” in T. Ito and A. Rose (eds) International Trade in East Asia, NBER-East Asia Seminar on Economics, Volume 14, pp 177-216.

Baldwin, Richard (2011), “21st Century Regionalism: Filling the gap between 21st century trade and 20th century trade rules”, CEPR Policy Insight No. 56, London: CEPR.

Clemens, Michael A. and Jeffrey G. Williamson (2004), “Why Did the Tariff-Growth Correlation Change after 1950?“, Journal of Economic Growth 9(1), 5-46.

Evenett, Simon (2011), “Did the WTO Restrain Protectionism During The Recent Systemic Crisis?”, www.globaltradealert.org.

Federal Reserve Bank of Dallas (2002), “Maquiladora Industry: Past, Present and Future”, Issue 2.

Feenstra, Robert and Gordon Hanson (1997), “Foreign direct investment and relative wages: Evidence from Mexico’s maquiladoras,” Journal of International Economics 42(3-4), 371-393.

Gaulier, Guillaume, Francoise Lemoine and Deniz Unal-Kesenci (2007), “China’s emergence and the reorganisation of trade flows in Asia,” China Economic Review 18(3), 209-243.

Haberler, Gottfried (1958), “Trends in International Trade, Report of a Panel of Experts”, Geneva: GATT Secretariat.

131 Rethinking Global Economic Governance in Light of the Crisis

Kimura, Fukunari, Yuya Takahashi, and Kazunobu Hayakawa (2007), “Fragmentation and parts and components trade: Comparison between East Asia and Europe”, The North American Journal of Economics and Finance 18(1), 23-40.

Ostry, Sylvia (1999), “The Future of the WTO”, Brookings Trade Forum, edited by Dani Rodrik and Susan Collins, Washington, DC: Brookings Institution.

Athukorala, Prema-chandra (2006), “Multinational Production Networks and the New Geo-economic Division of Labour in the Pacific Rim,” Departmental Working Papers 2006-09, Australian National University, Arndt-Corden Department of Economics.

Rodrik, Dani (2000), “How Far Will International Economic Integration Go?” Journal of Economic Perspectives 14(1), 177–186.

Rodrik, Dani (2002), “Feasible Globalizations”, NBER Working Paper 9129.

132 The Future of the WTO

About the author

Richard Edward Baldwin is Professor of International Economics at the Graduate Institute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chief of Vox since he founded it in June 2007. He was Co-managing Editor of the journal Economic Policy from 2000 to 2005, and Programme Director of CEPR’s International Trade programme from 1991 to 2001. Before that he was a Senior Staff Economist for the President’s Council of Economic Advisors in the Bush Administration (1990-1991), on leave from Columbia University Business School where he was Associate Professor. He did his PhD in economics at MIT with Paul Krugman. He was visiting professor at MIT in 2002/03 and has taught at universities in Italy, Germany and Norway. He has also worked as consultant for the numerous governments, the European Commission, OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, his research interests include international trade, globalisation, regionalism, and European integration. He is a CEPR Research Fellow.

133

Open to goods, closed to people?

Paola Conconi, Giovanni Facchini, Max F Steinhardt, and Maurizio Zanardi Université Libre de Bruxelles (ECARES) and CEPR; Erasmus University Rotterdam, Universita’ degli Studi di Milano ,and CEPR; Hamburg Institute for International Economics; Université Libre de Bruxelles (ECARES)

To policymakers in most nations, there is a world of difference between trade and migration policies. The theoretical literature in economics, by contrast, has focused on their similarities (Mundell 1957). In standard trade models, liberalising trade in goods and removing barriers to labour (or capital) mobility is beneficial for world welfare – when goods move freely across borders, countries can gain by exporting what they produce more efficiently and importing what other nations produce at a lower price. Likewise, all countries can gain if migration barriers are removed between them, so that workers from low-pay nations can move and earn higher wages, and employers in the high-wage country can hire foreign workers at a lower cost.

More specifically, the theory argues that if the only difference between countries lies in their relative labour abundance, commodity trade and labour mobility are substitutes (Razin and Sadka 1997). Freer trade should lead poorer countries to specialise in the production of labour-intensive goods. In turn, this should lead to a rise in wages of unskilled workers, decreasing their incentives to move abroad. Trade liberalisation should then decrease the need for labour migration. This argument was often raised during the negotiations of the North American Free Trade Agreement (NAFTA). Policymakers argued that the agreement would allow Mexico to export “goods and not people” (Fernández-Kelly and Massey 2007).

135 Rethinking Global Economic Governance in Light of the Crisis

Why are policy attitudes so different?

If labour migration and international trade have similar implications for global efficiency and factor markets, why are immigration policies so much more restrictive than trade policies? Through successive rounds of negotiations, average industrial tariffs rates around the world have fallen steadily since WWII. By contrast, immigration policies have remained tight and, in many countries, they have become tighter (Faini 2002, Hatton 2007). As a result, many economists argue that potential gains from more open labour migration dwarf those from freer trade. As Dani Rodrik puts it, “the gains from liberalising labour movements across countries are enormous, and much larger than the likely benefits from further liberalisation in the traditional areas of goods and capital. If international policymakers were really interested in maximising worldwide efficiency, they would spend little of their energies on a new trade round or on the international financial architecture. They would all be busy at work liberalising immigration restrictions” (Rodrik 2002, p. 314).

However, unless we have a better understanding of why trade and migration policies differ so much, it is difficult to know whether migration reforms are likely to be successful. If the gains from liberalising international migration generate such large worldwide gains, why does migration lag so far behind international trade in terms of permissible mobility?

To address this question, we examine the determinants of the voting behaviour of US legislators on all major trade and migration reforms voted in Congress during the period 1970-2006. In terms of trade reforms, we include in all our analysis votes on the implementation of multilateral trade agreements (Tokyo and Uruguay Round rounds of the GATT) and preferential trade agreements (e.g. the Canada-US Free Trade Agreement and NAFTA) negotiated in this period, as well as the votes on the conferral and extension of fast track trade negotiating authority to the president, which makes

136 Open to goods, closed to people?

it easier to negotiate trade agreements (see Conconi, Facchini and Zanardi 2012).1 In terms of migration votes, they include two different categories: general immigration and illegal migration (see Facchini and Steinhardt 2011), and we restrict the analysis to those that have a direct (positive or negative) impact on the size of the unskilled labour force in the US.

We match House roll call voting data on trade and migration reforms with information about legislators’ names, states and congressional districts, which enables us to uniquely identify the legislators and link them to their constituency. We also collect systematic information about the representatives (e.g. party affiliation, age, gender, incumbency gains as well as on economic and non-economic characteristics of their constituencies (e.g. skill composition, fiscal burden of immigrants, percentage of foreign-born population).

From a methodological point of view, we first run probit regressions on the full sample of votes, studying the determinants of individual legislators’ decisions on trade and migration reforms. We then focus our analysis on a subsample of trade and migration reforms that have taken place during the same Congress. This allows us to control for unobserved characteristics of legislators, which might affect their voting behaviour on trade and migration bills. Finally, we estimate bivariate probit regressions, allowing legislators’ decisions on trade and migration to be interrelated.

Emprical results

Our empirical analysis shows both similarities and differences in congressmen’s voting behaviour on these policy issues. In line with the predictions of standard international trade models, we find that a constituency’s skill composition affects representatives’ voting behaviour on trade and migration liberalisation bills in the same direction. In

1 Previous studies trying to understand differences between trade and migration policies have used surveys of individuals’ opinions on these issues (e.g., Hanson, Scheve and Slaughter, 2007; Mayda, 2008). Ours is the first study to focus on actual policy choices by legislators.

137 Rethinking Global Economic Governance in Light of the Crisis

particular, representatives of districts with relatively more highly skilled labour are more likely to support liberalising unskilled migration as well as trade with labour- abundant countries. Party affiliation has instead opposite effects – Democrats are more likely to support liberal immigration policies but to oppose trade liberalisation.

Voting differences between the two issues are also driven by districts’ characteristics that affect decisions on immigration policy but do not influence the voting behaviour on trade.

• We find that the higher the fiscal burden of immigrants for a constituency, the less likely the representative of the constituency is to support liberal migration policies.

This is in line with previous studies showing that one of the reasons for the opposition to immigration is the concern that admitting low-skilled foreigners raises the net tax burden on US natives (Hanson, Scheve and Slaugther 2007, Facchini and Steinhardt 2011).

• Districts’ ethnic composition also affects voting behaviour on immigration reforms – support for these reforms increases with the share of foreign-born citizens in a constituency.

This finding confirms the importance of network effects, which has been emphasised in recent studies (e.g. Munshi 2003).

Our study can help to explain the gap between the global regulation of labour migration and that of trade flows. In line with standard international trade models, our empirical analysis suggests that trade and migration have parallel impacts on factor markets. However, the flow of human beings has political, cultural, social, and economic effects that clearly differ from those from the flow of goods. These effects can explain why legislators are more likely to support opening barriers to goods than to people.

138 Open to goods, closed to people?

References

Conconi, P., G. Facchini, and M. Zanardi (2012). “Fast Track Authority and International Trade Negotiations”, American Economic Journal: Economic Policy, forthcoming.

Facchini, G., and M. F. Steinhardt (2011). “What Drives US Immigration Policy?,” Evidence from Congressional Roll Call Votes”, Journal of Public Economics 95, 734- 743.

Fernández-Kelly, P., and D. S. Massey (2007). “Borders for Whom? The Role of NAFTA in Mexico-US Migration”, Annals of the American Academy of Political and Social Science 610, 98-118,

Hanson, G. H., K. Scheve, and M. J. Slaugther (2007). “Public Finance and Individual Preferences over Globalization Strategies”, Economics and Politics 19, 1-33.

Hatton, T. J. (2007). “Should We Have a WTO for International Migration?” Economic Policy 22, 339-383.

Faini, R. (2002). “Development, Trade, and Migration”, Revue d’Économie et du Développement, Proceedings from the ABCDE Europe Conference, 1-2: 85-116.

Mayda, A. (2008). “Why are People more pro Trade than pro Migration?” Economics Letters 101, 160-163.

Mundell, R. (1957). “International Trade and Factor Mobility”, American Economic Review 47, 321-335.

Munshi, K. (2003). “Networks in the Modern Economy: Mexican Migrants in the US Labor Market”, Quarterly Journal of Economics 118, 549-599.

Razin, A., and E. Sadka (1997). “International Migration and International Trade”, in Handbook of Population and Family Economics 1, 851-887.

139 Rethinking Global Economic Governance in Light of the Crisis

Rodrik, D. (2002). “Comments at the Conference on Immigration Policy and the Welfare State”, in Boeri, T., G. H. Hanson, and B. McCormick (eds.), Immigration Policy and the Welfare System, Oxford University Press.

About the authors

Paola Conconi holds is a B.A. in Political Science from the University of Bologna, an M.A. in International Relations from the School of Advanced International Studies of Johns Hopkins University, and a M.Sc. and a Ph.D. in Economics from the University of Warwick. Her main research interests are in the areas of international trade, international migration, regional integration and political economy. Her contribution to the project will be on governance of trade institutions, on which she has published various papers in international journals such as the Journal of International Economics or the Journal of Public Economics.

Giovanni Facchini is a Professor of Economics at Erasmus University Rotterdam and at the University of Milan, having taught previously at the University of Essex, the University of Illinois at Urbana Champaign and at Stanford. His research focuses on international trade and factor mobility. He has published in journals such as the Journal of the European Economic Association, the Review of Economics and Statistics, the Journal of International Economics, the Journal of Public Economics, among others. Giovanni is a CEPR Research Affiliate, a fellow of CES-Ifo and IZA, and a Faculty Affiliate at the Institute for Government and Public Affairs at the University of Illinois- Urbana Champaign. He coordinates research on international migration at the Centro Studi Luca d’Agliano in Milan. He obtained a PhD in Economics from Stanford University in 2001.

Max Friedrich Steinhardt is a Senior Researcher in “Demography, Migration and Integration” at the Hamburg Institute of International Economics (HWWI). His research interests lie in the fields of labour economics, economics of migration, applied microeconometrics and regional economics. He studied economics at the

140 Open to goods, closed to people?

University of Hamburg. 2009 he finished his doctoral dissertation with a thesis about the economics of migration. Within the TOM Marie Curie Training Networks Dr. Max Friedrich Steinhardt stayed at the Centro Studio Luca D’Agliano (LdA) in Milan and at the European Center for Advanced Research in Economics and Statistics (ECARES) in Brussels. Furthermore, he worked as an external consultant for the OECD.

Maurizio Zanardi is an Associate Professor of Economics at the Universite Libre de Bruxelles and a member of ECARES. His research interests include international trade and political economy. He received his PhD in Economics from Boston College and BA in Economics from the Catholic University of Milan.

141

The recession and international migration

Timothy J Hatton Australian National University, University of Essex, and CEPR

Introduction

The current recession, concentrated in Europe and North America, has raised questions about immigration policy. When labour markets are slack, attitudes towards immigrants become more negative, the case for keeping the door ajar gets weaker, and political imperatives for tougher immigration policy get stronger. Yet in the current recession, anti- immigration policy has been muted – and all the more so when compared with the past.

This chapter draws on historical experience to answer four questions.

• How flexible is the response of migration to the business cycle?

• Do immigrants bear a disproportionate burden in recessions?

• What drives public opinion on immigration, especially at times of recession?

• How does immigration policy respond in recessions and why is it different this time?

Recessions and immigration — past and present

International migration has always been sensitive to the ebb and flow of the business cycle.1 This was so in the 19th century and it remains true today. If immigrants are deterred by high unemployment and existing migrants go home, then such responses

1 See, for example, Özden et al (2011).

143 Rethinking Global Economic Governance in Light of the Crisis

may attenuate labour market competition and mute the clamour for restriction. But is that migration response more or less elastic in the present than in the past?

In the great European migrations of the late 19th century, when immigration policies were vastly less restrictive than today, migration flows were very volatile (Hatton and Williamson 1998). The effects of unemployment at home and abroad can be seen clearly for emigration from the UK from 1870 to 1913. Analysis shows that fluctuations in home unemployment had smaller effects on emigration than unemployment abroad. Return migration was also influenced by host country labour market conditions and so net emigration was even more cyclically sensitive than gross migration (Hatton, 1995).

In the slump of the early 1890s, gross immigration to the US fell by half and net immigration to the US, Canada, and Australia fell even more dramatically as previous immigrants headed for home (Hatton and Williamson 1998). The same thing happened again in the Great Depression – in the US, net migration turned negative as outflows exceeded inflows.

How big are these effects? Where immigration policies are not too restrictive, history tells us that every 100 jobs lost in a high-immigration country results in 10 fewer immigrants. This 10% rule described countries like Canada and Australia in the Great Depression, and it worked pretty well for other periods too. For countries of emigration, recession worked in the opposite direction – as the global depression deepened, their labour markets became even more glutted as fewer left and more returned.

How do recent times compare? For the US over the period 1990 to 2004, the 10% rule still applies. For example, unemployment rose by about one percentage point between 1997 and 2000 and net immigration fell by one per thousand of the US population. Between 2000 and 2002, immigration recovered as employment fell (Hatton and Williamson 2009). For the EU27 in the current recession the same pattern re-emerges, in a slightly muted form. From 2008 to 2010, the EU-wide unemployment rate rose from 7.2% to 9.0% and net migration fell from 2.6 to 1.4 per thousand.

144 The recession and international migration

The overall EU-wide fluctuation in unemployment is relatively small, but what about the countries that have been hardest hit by the recession? Figure 1 shows the relationship between the unemployment rate and gross immigration in Ireland and Spain. For Ireland, the steep rise after 2004 was mainly due to immigration from the A8 accession countries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and Slovenia). The classic relationship between unemployment and immigration is clearly visible in the recession, however, and it would be even stronger for net immigration, as out-migration from both countries doubled between 2007 and 2009 (Papademetriou et al. 2010)

Figure 1. Gross immigration per thousand and unemployment percentage

Ireland Spain 25.0 25.0

20.0 20.0

15.0 15.0

10.0 10.0

5.0 5.0

0.0 0.0 00 01 02 03 04 05 06 07 08 09 10 00 01 02 03 04 05 06 07 08 09 10 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20

I Rate U Rate I Rate U rate

Source: OECD StatExtracts at: http://stats.oecd.org/Index.aspx Thus, the responsiveness of immigration to the business cycle has remained at about its historical level, despite the fact that policy is much more restrictive than it was (at least for the Atlantic economy) in the 19th century. On the other hand, transport costs are lower and there are many channels of entry such as temporary worker schemes and illegal immigration. Even the numbers of family reunification migrants and asylum seekers are influenced by economic conditions.

145 Rethinking Global Economic Governance in Light of the Crisis

Immigrants in the labour market

One reason why immigration slows down in a recession is that immigrants typically do badly in the labour market as unemployment increases. Table 1 shows that unemployment rates among immigrants are typically much higher than for nationals. As unemployment increases, the ratio of unemployment rates of immigrants to natives remains remarkably stable (except in Greece). This means that the difference in unemployment rates (and hence in employment probabilities) between immigrants and natives increases.

Table 1. Unemployment rates in western Europe

Male unemployment 2008 Male unemployment 2010 Native Foreign F/N Native Foreign F/N Austria 2.9 3.8 1.3 7.3 8.8 1.2 Belgium 5.3 6.7 1.3 14.3 17.5 1.2 Germany 6.6 7.0 1.1 12.3 12.6 1.0 Demark 2.7 7.7 2.8 6.4 15.1 2.4 Spain 8.8 17.3 2.0 16.4 31.1 1.9 Finland 5.9 9.2 1.6 12.4 18.9 1.5 France 6.3 8.4 1.3 11.4 13.6 1.2 Great Britain 6.1 8.8 1.4 6.8 9.2 1.4 Greece 5.2 8.8 1.7 5.0 14.7 2.9 Ireland 7.0 16.5 2.3 8.2 19.2 2.3 Italy 5.6 7.3 1.3 5.9 9.7 1.6 Netherlands 2.1 3.8 1.8 5.3 8.5 1.6 Norway 2.4 3.5 1.4 6.0 9.8 1.6 Portugal 6.8 10.2 1.5 7.8 12.7 1.6 Sweden 5.1 7.4 1.4 11.5 15.9 1.4

Source: OECD StatExtracts at http://stats.oecd.org/Index.aspx The impression from Table 1 is supported by detailed analysis. For the UK and Germany, Dustmann et al. (2010) find that unemployment is more strongly cyclical for immigrants than for natives, and especially for immigrants from outside the OECD. Partly, this reflects differences in skill levels but even within skill groups, immigrants are

146 The recession and international migration

more vulnerable to changes in unemployment than non-immigrants. Thus immigrants are classic ‘outsiders’ – they have lower levels of tenure, often on insecure contracts, and are more concentrated than natives in cyclically sensitive sectors and age groups (Papademetriou et al. 2010).

So immigrants cushion the effects of recession on native workers for two reasons. Some of them go home (or decide not to come) and those who remain shoulder more of the burden of unemployment.

Public opinion towards immigrants

It is well known that popular opinion is, on the whole, anti-immigration. Table 2 provides evidence from the European Values Survey for 2008 (the most recent available).

The first five columns of numbers are the average of responses arranged on a scale where ten is complete agreement with the statement and one is complete disagreement. Hence a neutral score would be 5.5. The first three columns show that, while average opinion is fairly neutral on the issue of whether immigrants undermine the cultural life of a society, it is rather more negative on whether immigrants are a threat to society and even more so on whether immigrants worsen the problem of crime.

The next two columns indicate that, while people are broadly neutral on whether immigrants take away jobs, they tend to be somewhat more negative on whether immigrants impose a welfare burden. The final column is on a scale where five is total agreement with the statement that there are ‘too many immigrants’ and one is total disagreement. Hence a neutral score would be 3.0. For 14 out of 16 countries, the score is at least three but less than four. While these figures conceal widely divergent views, opinion is negative on average, but not extremely so.

147 Rethinking Global Economic Governance in Light of the Crisis

Table 2. Public opinion on immigration in western Europe, 2008

Undermine Make Threat to Take jobs Strain on Too many cultural crime society away welfare immigrants life worse Austria 6.4 6.7 7.6 6.4 7.5 3.7 Belgium 5.7 6.6 6.7 5.8 6.9 3.6 Denmark 4.5 5.5 7.2 3.1 6.6 2.7 Finland 4.0 5.8 6.9 4.9 6.5 3.0 France 5.0 5.8 5.2 4.7 6.1 3.2 Germany 6.0 6.4 7.5 6.4 7.6 3.4 Greece 5.5 7.0 7.3 6.7 6.7 4.4 Ireland 5.8 6.7 6.3 6.8 7.5 3.7 Italy 4.9 6.1 7.3 5.4 6.1 3.6 Netherlands 5.2 5.9 6.7 5.3 6.1 3.1 Norway 4.9 5.9 7.4 4.3 6.9 3.0 Portugal 4.7 5.8 6.2 6.3 6.0 3.3 Spain 4.9 5.6 6.3 5.7 5.5 3.6 Sweden 4.3 5.0 6.3 3.9 5.6 3.0 Switzerland 5.0 5.6 7.0 4.9 6.7 3.2 Great 6.4 7.2 6.5 6.8 7.6 3.8 Britain Source: European Values Study 2008 at http://zacat.gesis.org/webview/. Detailed analysis of public opinion often reveals that negative sentiment towards immigration is strongest among those with low education, among males and older people, and among those that are not themselves first or second generation immigrants. Those with higher levels of education have greater tolerance towards minorities and are more positive about ethnic and cultural diversity (Dustmann and Preston 2007, Hainmueller and Hiscox 2007). They are also less likely to be concerned about the potential labour market competition from low-skilled immigrants (Mayda 2006, O’Rourke and Sinnott 2006).

Consistent with the figures in Table 2, recent studies have also pointed to the importance of concerns about the fiscal cost of immigration (Facchini and Mayda 2009, Boeri 2010). In particular, they point to fears that higher immigration will lead to a higher tax burden. Boeri (2010) finds that the net fiscal contribution of immigrants is positive for

148 The recession and international migration

some EU countries but is more likely to be negative where there is a higher proportion of low-skilled immigrants. The evidence also suggests that opinion is more negative the greater the fiscal drain (Boeri 2010).

Not surprisingly, some studies also suggest that the scale of immigration is an important determinant of negative attitudes, either at the aggregate level (Lahav 2004) or as a result of concentration in the respondent’s local community (Dustman and Preston 2001). Even before the current recession, public opinion became more negative in countries such as Ireland and Spain as the number of immigrants surged. In Spain, the proportion of respondents in the World Values Survey wanting immigration prohibited or strictly limited rose from 28% in 1995 to 44% in 2008.

What do such studies say about long-run trends in popular opinion? There are forces in both directions. Over the long run, average education has strongly increased (which should reduce anti-immigrant sentiment) but so has the share of immigrants. For the US (the only available long-run series), the proportion wanting immigration reduced has decreased on trend since the 1980s (Hatton and Williamson 2009). In the short run, as noted earlier, the fall in net immigration and the increased immigrant unemployment burden has cushioned the effect of the recession on the native employment. But on the other hand, the increase in immigrant welfare dependency has worked in the opposite direction. This last effect is likely to be all the more important when budget deficits are large and fiscal austerity is headline news.

Immigration policy: Past and present

History suggests that recessions have sometimes been occasions for the introduction of restrictive immigration policy; sometimes but not always. A policy backlash is more likely, and when it occurs is more draconian, when it follows an extended period of high immigration. As the stock of migrants increases, popular attitudes become more negative – the more so the greater are the cultural and socioeconomic differences between immigrants and non-immigrants. Thus a recession can be the trigger that

149 Rethinking Global Economic Governance in Light of the Crisis

converts growing anti-immigrant sentiment into a decisive tightening of immigration policy. This process can be illustrated with three historical examples.

In the US, anti-immigrant sentiment was on the rise from the 1880s onwards as the number of immigrants mounted and more of them came from the then poorer countries of southern and eastern Europe. After several unsuccessful attempts, starting in the deep 1890s recession, Congress finally introduced a literacy test in 1917. Labour market conditions were important (Goldin 1994), and no doubt the First World War also fostered changing attitudes. But the decisive policy shift came with the Emergency Quota Act in 1921, which became the basis of immigration policy until the 1960s. The introduction of quotas occurred just as the unemployment rate rose from 5.2% in 1920 to 11.7% in 1921.

A decade later, the Great Depression saw a rapid retreat from open door immigration policies in a number of countries including Australia, Canada, Brazil, Argentina, and Singapore. These reverses occurred in the aftermath of the economic shock and so they contributed marginally to the downturns in net immigration noted earlier. A third example comes from Europe in the 1970s. From the late 1950s, a number of countries (most prominently Germany) adopted guestworker programmes that admitted migrants from southern and eastern Europe, Turkey, and North Africa. As the number of immigrants grew and economic growth slowed down, attitudes to immigration soured. In the early 1970s, rapidly deteriorating economic conditions and the first oil price shock brought these policies to an abrupt end (Hatton and Williamson 2005).

These historical examples would lead us to expect a sharp turn to restrictive immigration policies. After all, the global financial crisis was preceded by two decades of rising immigration to OECD countries, and especially to EU countries. And as we have seen, the climate of opinion towards immigration was moderately negative even before the crisis struck. So what has happened?

Observers often point to the rise of right-wing anti-immigration parties and their influence (either direct or indirect) on immigration policy. Across Europe, such parties

150 The recession and international migration

have raised the salience of immigration policy but, with a few exceptions, their gains in electoral support predate the global financial crisis. Nevertheless, there have been some well-publicised policy shifts. These include a sharp shift to restriction on work permits and student visas in the UK, increased border enforcement measures in France and Italy, incentives for return migration for unemployed immigrants in Spain, and a clampdown on immigrant welfare services in Denmark.

However, these must be put into perspective. Tougher rules were imposed in some countries even before the recession, for example those on family reunification in France and the Netherlands. And across the OECD, policy on asylum seekers became tougher for at least a decade before 2007 (Hatton 2011). Although much of the focus has been on policies towards the integration of immigrants (and sometimes the explicit rejection of multiculturalism), the Migrant Integration Policy Index (MIPEX) suggests that for the EU15 there was very little change overall between 2007 and 2011 (MIPEX 2011). This is partly because some countries have become more generous while others have become tougher. And even for a single country, different strands of policy often shift in different directions.

Conclusion

We might expect a deep recession to be the occasion for a sharp tightening of immigration policies, especially after a long period of rising immigration. So far that has not happened – at least not a severely as history would lead us to expect. One last historical comparison is useful – international trade. During the Great Depression and at other times of severe economic shocks, tariffs and other trade barriers also increased sharply. In the current recession, some observers have noted the rising use of temporary trade barriers and policies that restrict trade under other guises (Bown 2011). But compared with historical experience, the increase in protection has been mild.

With regard to trade, one argument is that seriously protectionist policies are simply not possible within the WTO framework. The commitment of G20 governments and other

151 Rethinking Global Economic Governance in Light of the Crisis

international leaders to the global trading framework has protected it from a potentially catastrophic collapse that could have reversed half a century of progress. Such arguments do not apply with the same force to migration. Although the EU has a range of directives that set minimum standards on issues such as immigrant employment, access to welfare, family reunification and asylum policy, these do not apply elsewhere. Yet even outside the EU, any shift towards restrictive immigration policy has been muted.

The truth is that we still do not fully understand how immigration policy evolves, and why it seems so different now than in the past. Nevertheless, we can point to some key factors.

• With rising education, attitudes to immigration are better informed and there is also less to fear from the competition of unskilled immigrants.

Thus, with a few exceptions, there is no pre-existing upward trend in anti-immigrant sentiment overall.

• While people may be concerned with the cost of the welfare state, unlike the more distant past, it also provides them with a safety net.

• At the international level cooperation has increased, within the EU and beyond, and draconian immigration rules could potentially be inimical to negotiations on other issues.

But such arguments must remain speculative until they can be subjected to more rigorous examination.

152 The recession and international migration

References

Boeri, T. (2010), “Immigration to the Land of Redistribution,” Economica, 77, pp. 651–87.

Bown, C. P. (ed.) (2011), The Great Recession and Import Protection: The Role of Temporary Trade Barriers, London: CEPR Policy Report.

Dustmann, C. and Preston, I. (2001), «Attitudes to Ethnic Minorities, Ethnic Context and Location Decisions,” Economic Journal, 111, 353-373.

Dustmann, C. and Preston, I. (2007), “Racial and Economic Factors in Attitudes to Immigration,” Berkeley Electronic Journal of Economic Analysis and Policy, 7, Article 62.

Dustmann, C., Glitz, A. and Vogel, T. (2010), “Employment, Wages and the Economic Cycle: Differences between Immigrants and Natives,” European Economic Review, 54, pp. 1-17.

Facchini, G. and Mayda, A. M. (2009), “Does the Welfare State Affect Individual Attitudes toward Immigrants?” Review of Economics and Statistics, 91, pp. 295–314.

Goldin. C. D. (1994), “The Political Economy of Immigration Restriction in the United States,” in C. Goldin and G. Libecap (eds.), The Regulated Economy: A Historical Approach to Political Economy, Chicago: University of Chicago Press.

Hainmueller, J. and Hiscox, M. J. (2007), “Educated Preferences: Explaining Individual Attitudes toward Immigration in Europe,” International Organization, 61, pp. 399–442.

Hatton, T. J. (1995) “A Model of UK Emigration, 1871-1913,”Review of Economics and Statistics, 77, pp. 407-415.

_____ (2011), Seeking Asylum: Trends and Policies in the OECD, London: Centre for Economic Policy Research, at: http://www.cepr.org/pubs/books/cepr/Seeking_ Asylum.pdf.

153 Rethinking Global Economic Governance in Light of the Crisis

Hatton, T. J. and J. G. Williamson (1998), The Age of Mass Migration: Causes and Economic Impact, New York: Oxford University Press.

_____ (2005), Global Migration and the World Economy: Two Centuries of Policy and Performance, Cambridge, Mass.: MIT Press.

_____ (2009)” Global Economic Slumps and Migration” VOX EU at: http://voxeu.org/ index.php?q=node/3512

Lahav, G. (2004), “Public Opinion toward Immigration in the European Union: Does it Matter?” Comparative Political Studies, 37, pp. 1151–1183.

Mayda, A. M. (2006), “Who Is Against Immigration? A Cross-Country Investigation of Attitudes towards Immigrants,” Review of Economics and Statistics 88, pp. 510–30.

MIPEX (2011), Migrant Integration Policy Index III, at: http://www.mipex.eu/.

Özden, Ç., C. Parsons, M. Schiff and T. Walmsley (2011), “Where on earth is everybody? Global migration 1960-2000”, VoxEU.org, 6 August.

O’Rourke, K. H. and Sinnott, R. (2006), ‘The Determinants of Individual Attitudes towards Immigration’, European Journal of Political Economy, 22, pp. 838–61.

Papademetriou, D. G., Sumption, M. and Terrazas, A. (2010), “Migration and Immigrants Two Years after the Financial Collapse: Where do we Stand?” at www. migrationpolicy.org/pubs/MPI-BBCreport-2010.pdf.

154 The recession and international migration

About the author

Tim Hatton is Professor of Economics at the University of Essex and at the Australian National University. His current research interests include the causes and effects of international migration, and immigration and asylum policy. He has published extensively on the economic history of labour markets, including the history of international migration. His most recent books include Seeking Asylum: Trends and Policies in the OECD (CEPR, 2011) and (with Jeffrey G Williamson) Global Migration and the World Economy: Two Centuries of Policy and Performance (MIT Press, 2005). He is a Fellow of the IZA and of CEPR.

155

A dangerous campaign: Why we shouldn’t risk the Schengen Agreement

Tito Boeri and Herbert Brücker Bocconi University and CEPR; IAB

Playing politics with migration is dangerous but dangerously attractive in today’s climate of European malaise. Nicolas Sarkozy, for example, tried to achieve new momentum in his re-election campaign by calling for a revision of the Schengen Agreement. His goal, obviously, was to win right-wing voters in the crucial first round of France’s two-step election. His political and economic rationale, by contrast, remains opaque to say the least.

• Is it an attempt to reduce migration particularly from the northern African countries?

• Or is it all about reducing illegal migration?

• Or is the intention of the French president to hinder the free mobility of workers and other persons across the EU member states?

More generally, uncoordinated national policies are not the right way to govern migration in an area as economically integrated as Europe. Uncoordinated policies will give rise a prisoner’s dilemma situation where all members spend inefficiently large amounts on border controls, sub-optimal asylum and humanitarian policies, and inefficiently restrictive policies on legal migration.

What is Schengen?

The Schengen Agreement and the related legal framework – the “Schengen acquis” in EU jargon – have three main dimensions (EC 2009):

• Removal of border controls for persons moving within the Schengen area

157 Rethinking Global Economic Governance in Light of the Crisis

• Coordination on short-term visitors for third-countries’ citizens, i.e. the “Schen- gen visa” that lets them travel freely within the Schengen area (applying only once rather than for each Schengen country they want to visit).

• Coordination on border control measures vis-à-vis third countries and, when needed, members’ border control measures supplemented and supported by other member states (via the agency Frontex).

Critically, the Schengen Agreement also establishes information systems that facilitate police cooperation among members, especially as concerns illegal migrants.

The benefits of the Schengen Agreement are obvious to travellers in Europe – it saves time and money (by reducing information and transaction costs) for citizens and non- citizens with Schengen visas. But there are other benefits:

• Schengen has gone hand in hand with an increase of net immigration to the Schen- gen area – an increase not experienced by the countries outside the area. As Table 1 shows, non-Schengen nations have experienced a decline in immigration flows.

• Job opportunities offered by an individual country in the Schengen area are more attractive as they come with the option of freely moving across the entire area.

• Schengen has also eased the conditions for doing business in Europe; travellers from abroad perceive the Schengen area as a common market, which is much more attractive to businesses than the fragmented situation before the agreement.

Table 1. Inflows of migrants, thousands of people

pre-Schengen post-Schengen % Variation (1985–95) (1996–2007) European Countries not in the Schengen 2417.964 1130.986 -53% Area Countries in the 12104.84 19393.5105 60% Schengen Area Difference 113%

Source: OECD, International Migration Dataset.

158 A dangerous campagin: Why we shouldn’t risk the Schengen Agreement

Quantifying the gains of Schengen for businesses, consumers, and tourists is difficult, if not altogether impossible. Given the high and increasing tendency of travelling all over the Schengen countries and into the area, removing Schengen is like introducing a tax on economic integration. It would also have negative consequences on the shaping of a common European identity, hence on social and political integration just at a time in which the public debt crisis and fiscal spillovers across jurisdictions require stronger cross-country policy coordination in the EU.

Does Schengen increase illegal migration?

The Schengen Agreement does not reduce incentives for the enforcement of border controls in each country. It actually encourages tight border controls vis-à-vis third countries. According to the so-called Dublin II directive, the first EU nation a refugee enters is responsible for the handling (and costs) of the asylum procedure (Hatton, 2005). This gives nations an incentive to shore up weak border protection on third- nation borders. If refugees apply for asylum in other member countries, they will be sent back to those countries where they entered the EU in the first place.

In this way, Schengen and the Dublin II directive created strong incentives for border protection. It also meant, however, that certain members were providing a public good – namely, border control – for the entire area. It is easy to identify such countries: Italy, Spain, and Malta in the south; Poland, Bulgaria, and Romania in the east.

Migration pressures are particularly strong in the south and, here, Spain and Italy are especially affected by illegal migration from sub-Saharan Africa and northern Africa. In spite of the severe recessions experienced by southern Europe, the political revolution and the subsequent economic downturn in northern Africa further increased these pressures.

The figures of illegal migrants which entered Italy and Spain via the sea look rather moderate compared to previous waves of immigrants fostered by political instability,

159 Rethinking Global Economic Governance in Light of the Crisis

for example in the Balkans. In Italy they were, on average, of the order of 20,000 per year, except in 2011 when they jumped to about 50,000. Bilateral agreements with northern African countries to prevent transit migration from sub-Saharan Africa and the blood toll on the sea contributed to discourage larger flows. However, there are other channels to entry so that actual figures might be much larger, and there are no data on illegal migration across countries in the Schengen area.

Border controls are expensive and the treatment of asylum cases can be even more costly. Italy is bound to spend more than €1 billion in 2012 just for the daily allowances of asylum seekers who applied for this status in 2011. These costs are, in our view, a critical issue and the threat to the sustainability of the Schengen Agreement.

The foul play of Berlusconi

Last year, the government headed by Silvio Berlusconi made a populist move undermining the principles of the Schengen Agreement and the Dublin II directive. It provided tourist visas to refugees and encouraged them to cross the border with other countries, notably France. This clearly violates the purpose of the Dublin II directive. Although these measures were withdrawn within a couple of days, they seriously damaged cross-country cooperation in enforcing the Schengen Agreement. Well before the Sarkozy campaign, the Danish government announced its intention to re-impose controls on its frontiers with Germany and Sweden.

It should be stressed that the problem will not be solved by re-introducing border controls. If the Schengen Agreement and the Dublin II directive are abolished, the incentives for border protection in the most affected countries are reduced since governments may hope that illegal migrants find their way to other EU countries if they are sufficiently tough with migrants. This would create unfortunate knock-on effects – a race to the bottom in humanitarian standards and high costs of border controls across Schengen countries. Moreover, border controls for third-country nationals also require

160 A dangerous campagin: Why we shouldn’t risk the Schengen Agreement

border controls for citizens of the Schengen countries, and this would involve high economic and social costs.

Sharing the costs of border controls?

The countries most affected by illegal migration perceive the other countries in the Schengen area as free riders in terms of border controls. As mention, their third-nation controls provide a public good for the whole area. A reform of the Schengen acquis therefore has to address this issue. The most natural way to take these concerns into account is to share at least some of the costs of border enforcement.

EU governments ought to acknowledge that cross-country spillovers of migration policies are unavoidable. The case of the French-Italian border is not the first, nor will it be the last. Here are a few precedents.

• Finland tightened up its restrictions on immigration in 2004, reacting to the more restrictive stance taken by Denmark in 2002 which was inducing many more people to go to Finland.

• Portugal adopted more restrictive provisions in 2001, just after a similarly restrictive reform implemented by Spain in 2000.

• Ireland chose a more restrictive approach in 1999, after two reforms in the UK that had tightened up migration restrictions in 1996 and 1998.

The lesson from all of these episodes is that uncoordinated national policies cannot govern migration. They can only give rise to a race to the top in putting nominal restrictions on migration, systematically violated by illegal migrants coming in from somewhere else. A coordinated policy for legal migrants at the EU level is warranted. In this context, it would be wise also to consider a European asylum and humanitarian policy, possibly integrated into a points-based system.

161 Rethinking Global Economic Governance in Light of the Crisis

Addressing the fundamental migration problems

At present, France and most other EU member states pursue a zero immigration policy vis-à-vis the countries in the northern Africa. The consequence of these policies is that family reunification, humanitarian migration, and illegal migration become the main channels of entry. These immigrants are, on average, less educated than economic migrants and natives, do not generally achieve native language proficiency and typically have a poor performance in the labour market and education system of the host country. This in turn feeds into negative perceptions of natives as to the fiscal costs of immigration (Boeri, 2009), and makes economic and social integration more difficult especially at times of slow growth, let alone deep recessions. These problems cannot be addressed by a reform of the Schengen Agreement. They require a fundamental reform of immigration policies, restoring a key role for labour migration.

Learning from the EU eastern enlargement

Per capita incomes in most northern African countries are not much lower than those of the new EU Member States when they joined (Bruecker et al. 2009). While they stand between 25 and 35% of GDP per capita in the EU measured at purchasing power parities, the GDP of the new member states varied between 35 and 55% of those in the EU15 when they joined. Moreover, substantial parts of the youth urban labour force in north Africa are, at least on paper, relatively well educated. Thus, the experience of the eastern enlargement of the EU can be rather instructive in assessing the consequences of increased immigration from northern Africa.

From the eight new member states, which joined the EU in 2004, we have seen an annual net migration inflow of about 210,000 persons, another 200,000 moved annually from Bulgaria and Romania (Baas and Bruecker, 2012). The education levels of these young migrants are similar or higher than those of natives, and in many countries their unemployment rates are below the national average. According to our simulations, net immigration from the ten new members so far generated an increase of GDP for the

162 A dangerous campagin: Why we shouldn’t risk the Schengen Agreement

(enlarged) EU of the order of 0.7%, or €74 billion. This result is not negligible in times of slow growth in the entire EU area. More benefits will come as the assimilation of immigrants proceeds and they get jobs fitting their competences, rather than downgrading their skills.

Given the larger size and the slightly lower per capita income in the Mediterranean countries neighbouring the EU, the economic gains from potential migration from northern Africa are even larger. Clearly, it is much too early to consider a free movement of workers from these countries similar to the eastern enlargement of the EU. But adopting more realistic restrictions vis-à-vis northern African countries and encouraging skilled immigration from Egypt, Tunisia, and other countries in that area can reduce pressures for illegal migration and create substantial economic gains in both the receiving and sending regions.

References

Baas, T., Bruecker, H. (2012), The macroeconomic impact of migration diversion: Evidence from Germany and the UK, Structural Change and Economic Dynamics (forthcoming),

Boeri, T. (2009), “Immigration to the Land of Redistribution”, Economica 77(308). 651-687.

Bruecker, H. et al. (2009), Labour mobility within the EU in the context of enlargement and the functioning of the transitional arrangements, European Integration Consortium.

Hatton, T. (2005) European Asylum Policy, National Institute Economic Review 194 (1), 106-119.

EC (2009). “Official Journal of the European Communities - The Schengen Acquis”, 2009.

163 Rethinking Global Economic Governance in Light of the Crisis

About the authors

Tito Boeri is Professor of Economics at Bocconi University, Milan and acts as Scientific Director of the Fondazione Rodolfo Debenedetti. He is research fellow at CEPR, IZA and Igier-Bocconi. His field of research is labour economics, redistributive policies and political economics. His papers have been published in the American Economic Review, Journal of Economic Perspectives, Economic Journal, Economic Policy, European Economic Review, Journal of Labour Economics, and the NBER Macroeconomics Annual. He published 7 books with Oxford University Press and MIT Press. After obtaining his Ph.D. in economics from New York University, he was senior economist at the Organisation for Economic Co-operation and Development from 1987 to 1996. He was also consultant to the European Commission, IMF, the ILO, the World Bank and the Italian Government. He is the founder of the economic policy watchdog website www.lavoce.info and he is scientific director of the Festival of Economics, taking place every year in Trento.

Herbert Brücker is Head of the Department for International Comparisons and European Integration at the IAB since 2005 and Professor of economics at the University of Bamberg since 2008. He completed a degree in sociology at the University of Frankfurt in 1986 and attained subsequently his doctorate from the University of Frankfurt in 1994. In 2005 Herbert Brücker received his habilitation in economics from the University of Technology in Berlin. From 1988 to 2005 he held research positions at the University of Frankfurt, the German Development Institute (GDI) and the German Institute for Economic Research (DIW) in Berlin. Herbert Brücker was Visiting Professor at the Aarhus School of Business from 2004 to 2005.

164 Rethinking global economic governance in light of the crisis: Rethinking Global Economic Governance in Light of the Crisis: New Perspectives on Economic Policy Foundations New perspectives on economic policy foundations Rethinking Global Economic Governance in Light of the Crisis Global governance was, to put it charitably, one of the ‘steadier’ areas New Perspectives on Economic of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into Policy Foundations uncharted waters. For scholars, these horrible events were both daunting and exciting. Cherished assumptions had to be binned, but global governance became a top-line issue for heads of state. Economic and political analysis of global governance really mattered. This Report collects a dozen essays by world-class scholars on the full range of global governance issues including macroeconomics, ﬁ nance, trade, and migration. These reﬂ ect the research of nine research teams working in an EU-funded project known as PEGGED (Politics, Economics and Global Governance: the European Dimensions).

Edited by Richard Baldwin and David Vines