European Fiscal Federalism (Part 5): Democratic deficit, Budgetary empowerment, institutional competition and shifting the status quo

Steps in this direction:

In the previous posts ( 1, 2, 3) I have described the economic logics for an EU fiscal policy and the political economy argument for delegation of such powers to the European Commission (4). In this context, I would like to highlight the recent report that a group of European Socialists are lobbying their party to pursue US style primaries to appoint their candidate for the 2015 European Commission Presidency. There is an equivalently irrefutable logic behind this type of process, which has been explored by Hix and Follesdal in a 2006 article on the EU's democratic deficit. This initiative could also be the beginning of something along the lines of the Wallstrom candidacy imagined by Hix.

European Fiscal Federalism (Part 2): OCA theory and the effects of asymmetric shocks

The first part of the comment described in the previous post belongs to a part of economics which is highly relevant for the Euro area, known as OCA (Optimum Currency Areas), their characteristics and their behaviour when faced with internally asymmetric (-like) economic shocks. Charles Wyplosz and Richard Baldwin have an extremely good book on the economics of the EU, which discusses this at length. DeGrauwe's book has a somewhat more superficial dicussion of a similar scenario, focused on the interest rate, while von Hagen and Mundschenk elaborate more thoroughly on a scenario closer to DeGrauwe's. Finally, Beetsma, Debrun and Klassen also provide some insights. The scenario discussed below is inspired by Baldwin and Wyplosz' but I've added some details.

Seven EU banks fail stress tests

According to the BBC:

"They include five Spanish banks - Diada, Espiga, Bianca Civica, Unnim and Cajasur.

The other two were Germany's Hypo Real Estate and Greece's ATEBank."

Here´s what the European Commission has to say about it, and here´s what the CEBS (Committee of European Banking Supervisors) has to say about it.

These stress tests and the transparency they endow the banking industry with are relevant to the extent that they decrease asymmetries of information, and the ensuing uncertainties about the quality of the EU´s banks´ balance sheets. They should thus revive investor confidence in EU banks, and the industry, if as expected they are, overall, good.

For those banks who fail to pass these tests, recapitalization awaits; either through a private take-over(Germany and Greece?) or through public lending (Spain?).

Jean Quatremer interviews the Greek finance minister

The full article as it was published online in his blog at the website of Libération, can be found here. I've excluded the introduction. I am impressed by the apparent serenity of the Greek official. Please check ou the original website for more content. There's a particularly intriguing article about British disinformation and the Greek isles of the Aegen sea... You do however need to read French to follow the article. Alternatively run it through google translate. Here it is:

What are PGS doing?

What are Portugal, Greece and Spain doing about their fiscal positions?

Here's an account. It is rather incomplete, but it gives some insights. For simplicity, and because it is originally in Portuguese, I include the picture below in this post. The conclusion is that they are doing something, and except the unavoidable tax hikes, the reforms seem to be quite positive for productivity, savings and growth. Hopefully some of these reforms will be permanent...

I will also try to see if I can find the links to the Stability and Growth programmes that these countries submitted to the European Commission.

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(This is a late addition to the original post)

For another overview of the situation with the PIIGS, here's what The Economist has to say.

The Southern European Problem: Not Speculation, Not Just Fiscal Profligacy, but Structural inconsistencies

Wolfgang Munchau of the FT has a very good article published online last night, about the problems in the Eurozone, particularly in its southern members. (here's a little trick for accessing restricted news reports from the FT: Copy paste the title of the relevant article on google and click on the relevant link. For some reason this grants you access to otherwise restricted articles) It says that the problem is not speculative financial attacks on the debt of these countries, nor that it is just fiscal profligacy. It argues instead that the root problem is structural, and that there is a need for economic reform of the labour market, where wages are much above productivity. As a result these countries are not competitive vis à vis its northern neighbours.

I completely agree with it. But I need data to confirm this. I'll be updating this post.

Bailing out Greece: A great business deal!!

This note was posted as a comment on the FT, Brussels Blog at http://blogs.ft.com/brusselsblog/2010/05/mother-of-all-rescue-plans-buys-europe-time-but-can-it-work/#comments:

"Germany is all “abuzzing” about the costs of bailing out “lazy” Greeks. But how much did it cost Germany to bail out Greece? Well apparently letting Greece scare the markets and then bailing it out is a good business model. As it turns out, Germany made at least a €8.6Bn profit off it. May be even as much as €25.4Bn. How? Let’s see:

The cost of bailing out Greece was €22.4 Bn over 3 years, according to Der Spiegel. (http://www.spiegel.de/international/europe/0,1518,693579,00.html)

However this saved German banks from a balance sheet hole of as much as €33Bn, due to their exposure to Greek sovereign debt. (http://www.spiegel.de/international/europe/0,1518,693579,00.html)

It also turns out that a weak Euro, caused by Greek fiscal profligacy probably helped German exports. It is hard to say by how much, but given that exports had grown by 1% on average over the last year or so, and that they grew by 21% in March, I have generously considered that 14.81Bn out of the total 85.6Bn of German Export may have been caused by the low value of the Euro. (http://www.ft.com/cms/s/0/f6e35528-5c1f-11df-95f9-00144feab49a.html ) Finally it seems that the DAXX regained all the losses it incurred last week. (http://markets.ft.com/ft/tearsheets/performance.asp?s=569857&ss=WSODIssue)

So I propose two estimates of the German economic profit from rescuing Greece:

If you think that my estimated effect of the low Euro is exaggerated, which it probably is, then at worse, the bail out saved German banks from incurring those losses. As such Germany made an economic profit of as much as €8.6Bn from saving Greece.

None the less the low value of the Euro must have had some impact on Germany’s. Although the effect might not have been as high as to account for a whole €14.8 Bn worth of added exports, I guess one could establish that as a decent ceiling of how good the devalued Euro might have been for Germany. If that’s so, then we have to accept that Germany might have made a total of up to €25.4Bn from rescuing Greece.

Not such a bad deal after all… "

uau!! €500Bn is a lot of money!!

As Jean Quatremer (notice the reference to the IMF) of Liberation writes the Eu revolutionized itself last night, by creating the puffiest safety cushion on earth:

Markets rally on €750bn EU bail-out - FT

EU Crafts $962 Billion Show of Force to Halt Crisis - Bloomberg

EU Turns to 'Nuclear Option' to Halt Euro Speculation - Der Spiegel

“Mother of all rescue plans” buys Europe time - but can it work? - Tony Barber from Brussels Blog at the FT

Wolfgang Muchau of the FT joins his colleague on a gloomy analysis of the Fiscal package. He makes two interesting points. One about fiscal union and another about national economic reform:

On the first he says that "this deal is going to be ineffective beyond the very short term, unless it is followed up by substantive reforms – the introduction of a single European bond, an agenda to co-ordinate economic reforms with specific relevance for the monetary union, policies to reduce economic imbalances, much tighter supervision of fiscal policies that kick in well before budgets have already been announced, and, in my view also a kernel of a fiscal union – in essence all the things over which the EU has been, and still is, in denial."

I guess I must take issue with this. It As I have shown in this post, there is already a single European Bond, which has existed in theory since 1988. The ECOFIN already is a forum for coordinating economic reforms, and it is expected to be revamped by the commissions' proposals to be presented in two days. This will probably see the implementation of tighter supervision.

I agree that this is not tantamount to fiscal Union, but it leads the way for it, under enhanced cooperation.

Regarding to economic reform, Mr Munchau says that "the private sector [in Portugal is and in Spain ]massively indebted. The prices of assets that serve as collateral are still falling. The Spanish government, as guarantor of the banking sector, will be lumbered with rising debts at a time of stagnating economic growth. We should remember that solvency is not primarily related to financial markets’ willingness to lend. That’s liquidity. You are solvent when you can stabilise your debt as a proportion of income. Southern Europe’s solvency position is thus unaffected by the billions."

Here I must agree with it, but according to the general argument this is a problem intrinsic to the Eurozone. Because there is only one interest rate for all 16 countries, it cannot effectively target everyone. As a result the rates are too low to contain inflation in Portugal and Spain and too high for Germany and the Benelux. However there's a problem with this argument, it completely disregards the fact, that banks as intermediators should price debt better than they do in Portugal and Spain. Just because they can borrow cheaply, it does not mean that they cannot lend more expensively. My guess is that this has been possible in Portugal because a lot of people were guaranteed to pay their debts because so many people work for the state. In Spain the mechanism must have had something to do with the economic growth and the real estate boom. However this conjuncture has been changed and with the reforms to be implemented, it should change even more. As unemployment increases, as civil servants' salaries are frozen and as other such austerity measures are implemented (please stop hiring new civil servants!!) banks should start to price risk at a higher rate and thus the cost of borrowing should increase, thus increasing the rate of savings in countries like Portugal and Spain. More over it should also force them to move their money abroad, to less risky investments. This is of course if publicly owned banks don't loan at lower rates than those of the market for political and electoral reasons. The hope is that this won't lead to a debt deflationary crisis.

Before I go though, here's the council communiqué from last night about the fund/Financial Stability Facility in question. As you can see it is sparse on details and qualitative clarity. It is very clear quantitatively though!

What do you think?

Eurozone inevitably an Optimum Currency Area (OCA)?

I posted the following comment on Prof. Krugman's blog for the New York Times. What do you think?

"

Prof. Krugman,

As you say the arguments on the shortcomings of European EMU as an OCA have been known ever since the early 1990s. If a group of economies are very open and trade in differentiated products, then as they are exposed to asymmetric shocks, they must have flexible wages and prices, high labour mobility, or alternatively, there must be some form of homogeneity and/or solidarity to ensure that transfers from one country to another balance the asymmetric shock. Otherwise one group of countries benefits from the union at the detriment of another. This is simple enough and it is what is taught in every decent manual on the economics of the EU. Moreover, it is easy to see how France and Germany might initially have benefitted from Greece's fiscal crisis. After all a cheaper € makes for more competitive exports.

What no one seems to focus a tremendous amount is on the merits of the Euro. First of all, the public and the commentators seem to have forgotten about all the exchange rate crises of the 1970s-1990s. Increased trade interdependencies expose EU member states to each other's bad governance, forcing to create arrangements to protect themselves from each other. The ERMs and the EMS were the first attempts at dealing with this issue, but proved incomplete at best, leading to the creation of the €. If the latter was to disappear, then we'd be back to the early 1990s.

Finally, speaking as a Portuguese and as a social scientist I must also admit that the euro also presents a welcomed pressure for necessary economic reform. By creating a tighter system of monitoring between the member states, it divulges more information about the quality of their performance. If for the € to work, it requires a strengthening of internal monitoring and if this increases the pressures for rationalisation of policy making and reform, then I can only conclude that the € is positive for its less efficient member states.

It seems that European integration happens through trial and error along a fairly clear integrationist path. As with any other polity, decision makers tweak and fine tune the machine. When each monetary mechanism failed after another, the argument for the € became more and more credible. Now that the consequences of the shortcomings of the Stability and Growth Pact have been brought to light, the structure will be kept with enhanced powers and institutional support, and my guess is that sooner rather than later there will be a certain amount of fiscal powers transferred to Brussels in order to fulfil the OCA.

On the USA though, by the standard of its time the country would not have been seen as any more homogenous than the Hapsburg Empire, with all its religions and languages (English, German, French). Moreover until the Civil War most Americans considered themselves first and foremost Virginians, New Yorkers, etc, and only after that Americans. Yet the dollar, fragile though it may have been, existed before the 1870s. The EU in that sense is not very different from the early USA or India, although we do not have a military threat as a catalyst for integration.

Before I conclude, I would like to add that the issue of labour mobility is limited first and foremost by language diversity. This however seems to be a decreasing problem as the vast majority of Europeans are now adopting English as their second language, thus making it the continent's "lingua Franca". This should solve the issue of labour mobility in the next 2 to 3 generations.

To conclude, just because the €zone is not an OCA, it is not automatically undesirable. Moreover just because it is now a second best option, it does not mean that it will not become a first best option in the future, as labour mobility will increase and as geographical automatic stabilizers will start to play a bigger role "

Upcoming EU Debates and Reforms

I'm going to do something everyone loves and no one is good at. I'm going to try to predict what the next big debates in the EU will be given what little information we have now. My logic is that future reform will follow the same path as previously and as such will be economic and intergovernmental crisis driven, with a bit of a functional institutionalist steering. I propose that two main policy areas will be discussed and that one major institutional issue will be raised. The first two refer to economic governance and to defence. The latter reffers to the possibility of a dual presidency of EU institutions under the same president.

1) POLICIES

a)Economic Governance: This is the perennial EU reform, caused by some ongoing crisis, and typically is path dependent, in that it is the latest step in European economic integration. Looking back at the Greek crisis which has spawned it, one is faced with the fact that this was almost inevitable. The geographical proximity of European countries and the transaction and transportation costs of the mid 20th century tie European countries to each other through trade, despite Political and security fears. These in turn motivate the ECSC(1951) and the CAP(1960), which then lead to the Common market. This increased level of integration increases intra-European trade, which leaves national producers more exposed to competition.unable to restrict access, national governments turn to artificially increasing competitiveness through exchange rate manipulation. This then causes a number of attempts from high productivity countries to control the others. Alternatively in order to avoid a race to the bottom in exchange rates countries decide to cooperate and coordinate their exchange rates. Independently of the mechanism, increased trade brings the need to coordinate exchange rates and so in 1979 is born the Exchange Rate Mechanism (ERM). Incidentally the main lines of EMU are first proposed a decade earlier in the Werner Report of 1969. From this and the subsequent imperfect agreements it is only a matter of time before those imperfections are made evident by speculative attacks. This, supported by enlargement, the profits that it brings and the impetus it gives to further integration and the countries adapt their interactive institutional framework, perfect the common market into the Single Market and inevitably implement the Euro. However this is still an imperfect setting and requires fiscal integration and delegation to give the monetary union more credibility and shield the member states from speculative attacks.

b)Defence: This is the latest in a number of articles which seem to me as though they indicate a certain willingness to move towards a much more integrated defence system for the EU. First I noticed Italy had been pushing for this (here's some more info), then obviously so did France, (and France again), as well as Germany (and again here). It seems natural. The USA is repositioning itself in light of the emergent powers in the East, looking at India and China as the next big partners/opponents in the geopolitical scene. It is also in decadence (not the one that makes your country disappear, but the one that makes it close a couple of military bases around the world and rethink cowboying around the world in the future.). So it must make some savings. Russia wont invade Europe, despite CEECs fears. Energetic disputes are mostly regional beyond the interest and influence of the USA. At the same the EU is very stable within itself, so the USA don't need to worry about developments here. It's not just that we are too many to deal with. Obama does not come to Europe because he doesn't need to.Thus the USA start pushing for a NATO which is less dependent on their own expenditure and ask us Europeans to share the bill. I don't like war and war-related business but this is an argument I have some difficulty arguing against.

However there is a more fundamental reason for the EU to integrate it's military organisations better, Economies of scale. Basically, as this article argues, and as should be apparent to anyone aware of the EU's non super power role, we spend almost 9 times as much as the Chinese in the military yet we get absolutely no value for money. The extent to which there must be duplication of efforts must be ridiculous for a block of countries who will never fight against each other again. Plus if we all get together, we are bigger, and as economics tells us, bigger markets bring higher levels of specialization which in turn creates higher efficiencies. This is a typical case of being able to get much much more for the same amount of money. Plus if integration in the defence sector takes place, the European defence market becomes a monopsony of procurement with all the advantages that creates for bargaining power for the EU and for all the specialization it creates in the supply side. The obvious downside to this is that we'll create a bigger and newer interest group with more nefarious interests. I mean the last thing we want is a militaristic Europe 100 years after the first world war. So maybe it should be so that this further step in defence integration should follow fiscal integration thus allowing the EU to buy a veto in the administration of war related businesses. In this sense the Germans and the French could sell their shares in the EADS to the EU. Either way something ought to be done to at least try to prevent this sort of development from taking place. After all, it would be a pity to have to continue to follow the USA's initiative. Wouldn't it be amazing if the next internet-like invention came from Europe rather than the USA? (and yes I know the first version of the web came from CERN...).

I don't know how long all of this will take, but it shouldn't be much longer. How long will largely depend on the UK and on the next period of persistent economic growth. The UK is the EU's largest spender on defence. Without it France would have to prop Germany up more than what it might like to. The UK would provide the necessary tie breaker. Finally in order to go through this process it is necessary to have two things: Democratic support and the economic resources to pay for it, so getting out of the crisis would help. It seems to me that the momentum is there. All that's missing is an opportunity.

2)Dual Presidency

Here and here are some discussions of the possibility and implications of merging the roles of the Council and of the Commission presidents. On the face of it, it is not a particularly bad idea. It would decrease the number of Mr/Mme Europe, which seems to have become a major embarrassment for post-Lisbon EU. But is it really such a good idea?

I am on the fence on this. I think that there's that argument in favour of it, but are the roles really compatible? The only example of this is the present situation of Lady Ashton. She's a servant to two masters: The commission of which she is a vice president and commissioner for foreign affairs, and the Council of which she is the president of the committee for foreign affairs and defence and security. How is she handling it? Well it's still a bit early to tell, but she's struggling. The problem to me seems to be that the Commission is an executive body, who is fairly political, and follows or leads the parliament, which is also political. The council however is intergovernmental. Might there be some conflict of interests? Not forcefully and actually this position could actually help put an end to the rivalry between the two institutions. But it would have to be well done... Whoever would be in charge would have to have a lot of staff. Though I would add that in good truth it seems to me as though the best arrangement would be the one where all council "committees" are modeled after the Commissariates and the European Parliament's committees so that the council's meetings are all presided over by the relavant comissioner. Finally, I do agree that at one point or another, the concentration of power will be such that the president of the EU position should either be made to be directly elected or so that the relevant politician must be a member of the lists of the majority party in the European parliament. Both would have political legitimacy, but the latter would do so with added simplicity. It would only require the addition of a small number of articles redefining the role of the president of the commission as closer to the role of the prime minister of a federation (say Merkel or the Prime minister of Canada, India or Australia), to ensure that the candidates would be apparent to everyone, thus forcing him/her to actively campaign. The fear here is that if there is no such transparency incentive, then we may end up with no apparent leader during the campaign, leading to the president being chosen ex-post in the corridors rather than ex-ante or during the voting, as is supposed to be the case.

So what do you think?