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Edited by Richard Baldwin and David Vines Rethinking Global Economic Governance in Light of the Crisis New Perspectives on Economic Policy Foundations
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Page 1: Rethinking Global Economic Governance in Light of the ...Rethinking Global Economic Governance in Light of the Crisis 2 do lists of heads of state. Economic and political analysis

Edited by Richard Baldwin and David Vines

Rethinking Global Economic Governance in Light of the Crisis New Perspectives on Economic Policy Foundations

Rethinking global economic governance in light of the crisis: New perspectives on economic policy foundations

Global governance was, to put it charitably, one of the ‘steadier’ areas of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into 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).

Rethinking Global Econom

ic Governance in Light of the Crisis: N

ew Perspectives on Econom

ic Policy Foundations

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Rethinking Global Economic Governance in Light of the Crisis

New Perspectives on Economic Policy Foundations

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Centre for Economic Policy Research (CEPR)

Centre for Economic Policy Research3rd Floor77 Bastwick StreetLondon, EC1V 3PZUK

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

© Centre for Economic Policy Research, 2012

ISBN (print edition): 978-1-907142-52-9

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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.

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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 re-search 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 ex-pressed 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 DehesaPresident Richard PortesChief Executive Officer Stephen YeoResearch Director Lucrezia ReichlinPolicy Director Richard Baldwin

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Contents

Foreword vii

Introduction 1Richard Baldwin and David Vines

The governance of international macroeconomic relations

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

Fiscal consolidation and macroeconomic stabilisation 27Giancarlo Corsetti

The Eurozone Crisis – April 2012 35Richard Portes

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

Globalisation, financial stability, and global financial regulation

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

The crisis and the future of the banking industry 67Xavier Freixas

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How to prevent and better handle the failures of global systemically important financial institutions 75Stijn Claessens

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

Credit default swaps in Europe 95Richard Portes

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

The global trade regime

The Doha Round impasse 111Simon J Evenett

The Future of the WTO 121Richard Baldwin

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

International migration and the mobility of labour

The Recession and International Migration 143Timothy J Hatton

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

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vii

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.

Foreword

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viii

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

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1

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-

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

Introduction

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2

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.

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Introduction

3

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;

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Rethinking Global Economic Governance in Light of the Crisis

4

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

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Introduction

5

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

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6

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.

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Introduction

7

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

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Rethinking Global Economic Governance in Light of the Crisis

8

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,

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Introduction

9

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

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Rethinking Global Economic Governance in Light of the Crisis

10

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

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Introduction

11

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

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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,

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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.

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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

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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.

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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.

David VinesBalliol College, Oxford, Australian National University, CEPR, and PEGGED

The G20MAP, global rebalancing, and sustaining global economic growth

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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.

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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

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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

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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.

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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 play-

ers 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.

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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.

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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.

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About the author

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.

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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

Giancarlo CorsettiCambridge University and CEPR

Fiscal consolidation and macroeconomic stabilisation

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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

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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

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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

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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

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32

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

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Fiscal consolidation and macroeconomic stabilisation

33

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.

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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.

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Richard PortesLondon Business School and CEPR

The Eurozone crisis – April 2012

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).

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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

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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).

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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).

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39

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

Higher Government Bond Yields

Higher Government Debt/GDP Ratio

Deeper Recession

More Banking/ Financial Strains

Bank Solvency Concerns

Calls for Fiscal TighteningNegative

Wealth E�ect

Reduced Loan

Supply

Lower Nominal GDP

Default Worries

Higher Debt Service

Bailout Costs

Lower Corporate

Pro�ts

Credit Losses

Lower Tax Receipts

TighterFCI

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.

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40

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.

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41

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.

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42

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

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43

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)

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44

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 – I

p) + (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).

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45

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

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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.

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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).

Richard PortesLondon Business School and CEPR

The Triffin Dilemma and a multipolar international reserve system

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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,

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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.

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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

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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

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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.

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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.

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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.

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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.

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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 govern-

ance 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 reso-

lution 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, consider-

able institutional innovation, a reformed policy process, and institutionalised at-

tention to the political legitimacy and long-run sustainability of financial openness

globally and in the EU.

Geoffery UnderhillUniversity of Amsterdam

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

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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

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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

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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.

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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

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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

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policy forums: where we are and where we should be headed”, in G Underhill, J Blom

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Burgoon, B, P Demetriades and G Underhill (2012), “Sources and Legitimacy of

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Cassimon, Danny, Panicos Demetriades and Björn Van Campenhout (2010).Finance,

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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

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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

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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.

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Xavier FreixasUniversitat Pompeu Fabra and CEPR

The crisis and the future of the banking industry

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.

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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).

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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).

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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).

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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.

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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.

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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.

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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.

Stijn ClaessensIMF, University of Amsterdam, and CEPR

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

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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

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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

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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

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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

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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.

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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

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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.

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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.

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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.

Thorsten BeckTilburg University and CEPR

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

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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

20

30

40

50

60

70

Sha

re o

f For

eign

Ban

ks

1995 1997 1999 2001 2003 2005 2007 2009

Year

European economies European transition economies European non-transition economies Source: Claessens and van Horen (2012)

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

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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

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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

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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

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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

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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.

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.

It is in the context of such a political transformation of the Eurozone that many of the

reforms outlined in this column will be significantly easier to implement.

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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.

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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.

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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.

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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

Richard PortesLondon Business School and CEPR

Credit default swaps in Europe*

* 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.

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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

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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).

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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

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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

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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

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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

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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.

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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.

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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.

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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.

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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

Robert KollmannECARES, Université Libre de Bruxelles and CEPR

Global banks, fiscal policy and international business cycles

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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,

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Global bBanks, fiscal policy and international business cycles

109

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 2009

May 2009

Aug 2009

Dec 2009

Oct 2010

Dec 2010

Apr 2011

Purchases of impaired bank assets

0.43 0.45 0.75 2.84 2.15 2.00 1.94

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.

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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.

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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 minis-

ters).

• 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.”

Simon J EvenettUniversity of St. Gallen and CEPR

The Doha Round impasse

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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.

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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.

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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.

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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 serv-

ice 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

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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,

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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

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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.

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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.

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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).

Richard BaldwinGraduate Institute, Geneva and CEPR

The Future of the WTO

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Figure 1. Global trade liberalisation, 1947–2007

13%

12%

10%9%

6%

0%

2%

4%

6%

8%

10%

12%

14%

16%

0

5

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1947

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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 else-

where.

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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 dis-

ciplines – 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.

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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).

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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.

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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.

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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

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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).

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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 intel-

lectual 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.

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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 politi-

cal 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.

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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.

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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.

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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.

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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).

Paola Conconi, Giovanni Facchini, Max F Steinhardt, and Maurizio ZanardiUniversité 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)

Open to goods, closed to people?

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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

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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.

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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.

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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.

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Développement, Proceedings from the ABCDE Europe Conference, 1-2: 85-116.

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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

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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

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141

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.

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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).

Timothy J HattonAustralian National University, University of Essex, and CEPR

The recession and international migration

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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.

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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

0.0

5.0

10.0

15.0

20.0

25.0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Spain

I Rate U rate

0.0

5.0

10.0

15.0

20.0

25.0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Ireland

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.

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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

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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.

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

Undermine cultural

life

Threat to society

Make crime worse

Take jobs away

Strain on welfare

Too many immigrants

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 3.2Great Britain

6.4 7.2 6.5 6.8 7.6 3.8

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

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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

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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

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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

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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.

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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.

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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

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migrationpolicy.org/pubs/MPI-BBCreport-2010.pdf.

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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.

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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

Tito Boeri and Herbert BrückerBocconi University and CEPR; IAB

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

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• 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 need-

ed, members’ border control measures supplemented and supported by other mem-

ber 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 (1985–95)

post-Schengen (1996–2007)

% Variation

European Countries not in the Schengen Area

2417.964 1130.986 -53%

Countries in the Schengen Area

12104.84 19393.5105 60%

Difference 113%

Source: OECD, International Migration Dataset.

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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,

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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

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161

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 restric-

tive 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.

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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

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163

(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.

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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.

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Edited by Richard Baldwin and David Vines

Rethinking Global Economic Governance in Light of the Crisis New Perspectives on Economic Policy Foundations

Rethinking global economic governance in light of the crisis: New perspectives on economic policy foundations

Global governance was, to put it charitably, one of the ‘steadier’ areas of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into 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).

Rethinking Global Econom

ic Governance in Light of the Crisis: N

ew Perspectives on Econom

ic Policy Foundations


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