Changing trade patterns, unchanging European and global governance. Bruegel Working Paper 2014/02, February 2014

The world economy is going through its biggest transformation in a relatively short space time. There have been many explanations for this phenomenon but the unprecedented scale and pace of this change and, most crucially, its implications, still seems little understood. In turn, there has been little preparation for, or adjustment to, this changing world, though if the change continues at this pace, the effectiveness of many global institutions in their current form will be threatened. We highlight the dramatic degree of the shifts taking place in world GDP and trade and include fresh projections of what world trade patterns might look like in 2020, should the trends observed over the past decade to continue. We also show the resulting shift in trade relationships for many key countries. European member states tend to have quite different trading partners’ profiles, and this heterogeneity is quite likely to become more pronounced with time. This, in turn, suggests a significant challenge for the effective functioning of the euro area and weakens the original rationale of its creation. If our projections to 2020 are broadly right, then many established frameworks for the running of the world economy and its governance are not going to be fit for purpose, and will need to change. The global monetary system itself, and global organisations such as the IMF, G7, and G20 are going to have to adapt considerably if they want to remain legitimate representatives of the world order. The alternative is their relegation to irrelevance.

The Great Transformation: Memo to the Incoming EU Presidents. Bruegel Policy Brief 2014/04, July 2014

The European Union’s leadership spent the last five years fighting an acute and existential crisis. The next five years, under your leadership, will be no less difficult. You will have to tackle difficult economic and institutional questions while being alert to the possibility of a new crisis. You face three central challenges: (1) The feeble economic situation prevents job creation and hobbles attempts to reduce public and private debt; (2) EU institutions and the EU budget need reform and you will have to deal with pressing external matters, including neighbourhood policy and the EU’s position in the world; (3) You will have to prepare and face up to the need for treaty change to put monetary union on a more stable footing, to review the EU’s competences and to re-adjust the relationship between the euro area and the EU, and the United Kingdom in particular.

Addressing weak inflation: The European Central Bank's shopping list. Bruegel Policy Contribution 2014/05, May 2014

There are clear benefits to price stability. High inflation can distort corporate investment decisions and the consumption behaviour of households. Changes to inflation redistribute real wealth and income between different segments of society, such as savers and borrowers, or young and old. Price stability is therefore a fundamental public good and it became a fundamental principle of European Economic and Monetary Union. But the European Treaties do not define price stability. It was left to the Governing Council of the European Central Bank (ECB) to quantify it: "Price stability is defined as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%"[1]. The Governing Council has also clarified that it aims to maintain inflation below, but close to, two percent over the medium term, though it has not quantified what 'closeness' means, nor has it given a precise definition of the 'medium term'[2]. The clarification has been widely interpreted to mean that the actual target of the ECB is close to, but below, two percent inflation in the medium term.

Europe between financial repression and regulatory capture. Bruegel Working Paper 2014/08, July 2014

From the Introduction. In the long shadow of the euro-area crisis, the relationship between governments and their banks has been brought to the the centre of the policy debate in Europe by the implementation of regulatory reforms, the risks associated with financial fragmentation, and the fight to sustain the flow of credit to governments and corporates. The attempt to interpret the patterns of pressure and influence running between governments and their financial system has led commentators to rediscover and give new life to concepts originating from academic debates of the 1970s such as “regulatory capture” and “financial repression”. Government agencies have been frequently described as being at the mercy of the financial sector, often allowing financial interests to hijack political, regulatory and supervisory processes in order to favouring their own private interests over the public good1. An opposite view has instead pointed the finger at governments, which have often been portrayed as subverting markets and abusing the financial system to their benefit, either in order to secure better financing conditions to overcome their own financial difficulties, or with the objective of directing credit to certain sectors of the economy, “repressing” the free functioning of financial markets and potentially the private interests of some of its participants2

Did the German court do Europe a favor? Bruegel Working Paper 2014/09, July 2014

The European Central Bank’s Outright Monetary Transactions (OMT) programme was a politically-pragmatic tool to diffuse the euro-area crisis. But it did not deal with the fundamental incompleteness of the European monetary union. As such, it blurred the boundary between monetary and fiscal policy. The fuzziness of this boundary helped in the short-term but pushed political and economic risks to the future. Unless a credible commitment to enforcing losses on private creditors is instituted, these conundrums will persist. The German Federal Constitutional Court has helped by insisting that such a dialogue be conducted in order to achieve a more durable political and economic solution. A study of the European Union Court of Justice’s Pringle decision (Thomas Pringle v Government of Ireland, Ireland and The Attorney General, Case C-370/12, ECJ, 27 November 2012) suggests that the ECJ will also not rubber-stamp the OMT – and, if it does, the legal victory will not resolve the fundamental dilemmas.

Asset-backed securities: The key to unlocking Europe's credit markets? Bruegel Policy Contribution 2014/07, 24 July 2014

The European market for asset-backed securities (ABS) has all but closed for business since the start of the economic and financial crisis. ABS (see Box 1) were in fact the first financial assets hit at the onset of the crisis in 2008. The subprime mortgage meltdown caused a deterioration in the quality of collateral in the ABS market in the United States, which in turn dried up overall liquidity because ABS AAA notes were popular collateral for inter-bank lending. The lack of demand for these products, together with the Great Recession in 2009, had a considerable negative impact on the European ABS market. The post-crisis regulatory environment has further undermined the market. The practice of slicing and dicing of loans into ABS packages was blamed for starting and spreading the crisis through the global financial system. Regulation in the post-crisis context has thus been relatively unfavourable to these types of instruments, with heightened capital requirements now necessary for the issuance of new ABS products. And yet policymakers have recently underlined the need to revitalise the ABS market as a tool to improve credit market conditions in the euro area and to enhance transmission of monetary policy. In particular, the European Central Bank and the Bank of England have jointly emphasised that: “a market for prudently designed ABS has the potential to improve the efficiency of resource allocation in the economy and to allow for better risk sharing... by transforming relatively illiquid assets into more liquid securities. These can then be sold to investors thereby allowing originators to obtain funding and, potentially, transfer part of the underlying risk, while investors in such securities can diversify their portfolios... . This can lead to lower costs of capital, higher economic growth and a broader distribution of risk” (ECB and Bank of England, 2014a). In addition, consideration has started to be given to the extent to which ABS products could become the target of explicit monetary policy operations, a line of action proposed by Claeys et al (2014). The ECB has officially announced the start of preparatory work related to possible outright purchases of selected ABS1. In this paper we discuss how a revamped market for corporate loans securitised via ABS products, and how use of ABS as a monetary policy instrument, can indeed play a role in revitalising Europe’s credit market. However, before using this instrument a number of issues should be addressed: First, the European ABS market has significantly contracted since the crisis. Hence it needs to be revamped through appropriate regulation if securitisation is to play a role in improving the efficiency of resource allocation in the economy. Second, even assuming that this market can expand again, the European ABS market is heterogeneous: lending criteria are different in different countries and banking institutions and the rating methodologies to assess the quality of the borrowers have to take these differences into account. One further element of differentiation is default law, which is specific to national jurisdictions in the euro area. Therefore, the pool of loans will not only be different in terms of the macro risks related to each country of origination (which is a ‘positive’ idiosyncratic risk, because it enables a portfolio manager to differentiate), but also in terms of the normative side, in case of default. The latter introduces uncertainties and inefficiencies in the ABS market that could create arbitrage opportunities. It is also unclear to what extent a direct purchase of these securities by the ECB might have an impact on the credit market. This will depend on, for example, the type of securities targeted in terms of the underlying assets that would be considered as eligible for inclusion (such as loans to small and medium-sized companies, car loans, leases, residential and commercial mortgages). The timing of a possible move by the ECB is also an issue; immediate action would take place in the context of relatively limited market volumes, while if the ECB waits, it might have access to a larger market, provided steps are taken in the next few months to revamp the market. We start by discussing the first of these issues – the size of the EU ABS market. We estimate how much this market could be worth if some specific measures are implemented. We then discuss the different options available to the ECB should they decide to intervene in the EU ABS market. We include a preliminary list of regulatory steps that could be taken to homogenise asset-backed securities in the euro area. We conclude with our recommended course of action.

Benefits and drawbacks of European Unemployment Insurance. Bruegel Policy Brief 2014/06, September 2014

The issue: Unemployment in Europe has increased to high levels and economic growth has remained subdued. A debate on additional policy instruments to address the situation is therefore warranted. Fiscal stabilisation mechanisms have not provided adequate fiscal stabilisation during the crisis in some countries nor in the euro area as a whole. Different preferences and historical developments mean that national labour markets are differently organised, which sometimes hinders the efficient working of the monetary union. European Unemployment Insurance (EUI) has been proposed as a measure to contribute to fiscal policy management and improve labour markets. | Read more at Bruegel http://www.bruegel.org/publications/publication-detail/publication/847-benefits-and-drawbacks-of-european-unemployment-insurance/

So far apart and yet so close: Should the ECB care about inflation differentials? Bruegel Policy Contribution, Issue 2014/10 September 2014

Inflation rates can differ across regions of monetary unions. We show that in the euro area, the US, Canada, Japan and Australia, inflation rates have been substantially and persistently different in different regions. Differences were particularly substantial in the euro area. Inflation differences can reflect normal adjustment processes such as price convergence or the Balassa-Samuelson effect, or can reflect the different cyclical position of regions. But they can also be the result of economic distortions resulting from segmented markets or unsustainable demand and credit developments fueled by low real interest rates. In normal times, the European Central Bank cannot influence such developments with its single interest rate instrument. However, unconventional policy measures can have different effects on different countries depending on the chosen instrument, and should be used to reduce fragmentation and ensure the proper transmission of monetary policy. The new macro prudential policy tools are unlikely to be practical in addressing inflation divergences. It is crucial to keep the average inflation rate close to two percent so that inflation differentials are possible without deflation in some parts of the euro area, which in turn might endanger area-wide financial stability and price stability.

Policy recommendations for the new European Commission: priorities for stabilising EMU. EPC Discussion Paper, 30 September 2014

The euro area crisis exposed substantial structural flaws in the currency area’s architecture. Addressing these flaws this discussion paper explores the ways in which the European Institutions can re-evaluate and overcome challenges for a more positive European future. To do this, Janis A. Emmanouilidis, Jan David Schneider, and Fabian Zuleeg recommend that the coming European Commission should develop a new framework to assess the real returns to growth of public and social investment, which could open the path for more flexibility on deficits in future. In close coordination with the European Parliament, the Commission should also review the Country Specific Recommendations with a stronger focus on a smaller number of key priorities for each country. The construction of a fiscal capacity should be made a priority in the new political cycle to resolve the absence of a mechanism to provide effective ex ante fiscal risk sharing in the Eurozone. Furthermore, to boost growth, there is a need to encourage private, public and social investment through a European Investment Programme (EIP) in the short term. Finally, the Commission should ensure that the implementation of an EIP is compatible with the long term goals of a fiscal capacity.

The case of the disappearing Fiscal Compact. CEPS Commentary, 5 November 2014

Following the Commission’s autumn forecast showing that only five euro-area countries exhibit a fiscal balance better than the 0.5% of GDP deficit allowed by the Fiscal Compact, Daniel Gros and Cinzia Alcidi attempt to explain in this new Commentary why there is precious little policy debate over these flagrant treaty violations. They find that it is not possible to put fiscal policy in a legal straightjacket and that the tight rules enshrined in the new Treaty and in national constitutions are discarded as soon as they become politically inconvenient.

Was the ECB’s Comprehensive Assessment up to standard? CEPS Policy Brief No. 325, 10 November 2014

The Comprehensive Assessment conducted by the European Central Bank (ECB) represents a considerable step forward in enhancing transparency in euro-area banks’ balance sheets. The most notable progress since the previous European stress test has been the harmonisation of the definition of non-performing loans and other concepts as well as uncovering hidden losses, which resulted in a €34 billion aggregate capital-charge net of taxes. Despite this tightening, most banks were able to meet the 5.5% common equity tier 1 (CET1) threshold applied in the test, which suggests that the large majority of the euro-area banks have improved their financial position sufficiently that they should no longer be constrained in financing the economy. As shown in this CEPS Policy Brief by Willem Pieter de Groen, however, the detailed results provide a more nuanced picture: there remain a large number of the banks in the euro area that are still highly leveraged and in many cases unable to meet the regulatory capital requirements that will be introduced in the coming years under the adverse stress test scenario.

Eurosystem collateral policy and framework: Was it unduly changed? Bruegel Policy Contribution 2014/14, 17 November 2014

All Eurosystem credit operations, including the important open market operations, need to be based on adequate collateral. Liquidity is provided to banks against collateral at market prices subject to a haircut. The Eurosystem adapted its collateral framework during the crisis to accept lower-rated assets as collateral. Higher haircuts are applied to insure against liquidity risk as well as the greater volatility of prices of lower-rated assets. The adaptation of the collateral framework was necessary to provide sufficient liquidity to banks in the euro area periphery in particular. In crisis countries, special emergency liquidity assistance was provided. More than 80 percent of the European Central Bank’s liquidity (Main Refinancing Operations and Long Term Refinancing Operations) is provided to banks in five countries (Greece, Ireland, Italy, Portugal and Spain). The changes in the collateral framework were necessary for the ECB to fulfil its treaty-based mandate of providing liquidity to solvent banks and safeguarding financial stability. The ECB did not take on board excessive risks.

The twenty-first century needs a better G20 and a new G7+. Bruegel Policy Contribution 2014/13, 14 November 2014

During the 2008 financial crisis, the G20 was hastily elevated to ‘global economic steering committee’. In the early stages of the crisis, the G20 was an effective forum for crisis containment. As the crisis has eased, however, the G20 has lost both direction and momentum. Governments and policymakers have felt less need to act in unison and have rather refocused on their national agendas, as is their duty and primary function. However, effective global governance is needed permanently, not just in crisis times. It is desirable to have more representative and effective global governance that, among other things, is equipped to prevent crises rather than just react to them. In an environment of rapid change in global patterns of trade and wealth creation, a new revamped (but highly representative) grouping should be created within the G20, to provide leadership on key economic policy matters. Euro-area members should give up their individual seats in this G7+, allowing room for China and other large emerging economies. Without euro-area countries taking such a step, it would be impossible to reconcile effectiveness and representation in this new G7+, which would take charge of decision making on global economic imbalances, financial and monetary issues. All existing G20 countries, including individual euro-area countries, would however remain in the G20, which could potentially expand and would remain the prime forum for discussion on all remaining matters at global level.

State of the Union and key challenges for Europe's future. CHALLENGE EUROPE Issue 22 - Challenges and new beginnings: Priorities for the EU's new leadership, September 2014.

In the last five years deep cracks have appeared in the European project. The 'euro-area crisis' triggered by a severe global financial and economic crisis has put European integration to a major test, more profound than ever before. The experience of recent years has revealed and exacerbated significant deficiencies in the European Union's (EU) economic and political construction. At time it has cast doubt on fundamentals of the European project and raised questions about whether Europe will be able to deal effectively not only with the immediate crisis, but also with the many other serious socio-economic, politico-institutional, societal and global challenges that Europe is and will be confronted with. At the start of a new institutional-political cycle (2014-2019) and while the crisis situation has for a number of reasons improved significantly since the summer of 2012, at least in systemic terms, the Union's new leadership and Member States will now have to take strategic decisions about the future of European integration.

A stronger, growth-oriented surveillance for EMU. EuropEos Commentary No. 1, 19 April 2010

This Commentary finds that the recent adjustment measures taken by the Greek government in combination with the financial support proffered by the Eurogroup may not be sufficient to deal with the risk of instability in EMU in the longer term. The author argues that other imbalances, most notably the current account imbalances within EMU, need to be addressed to avoid a deflation spiral that would aggravate sustainability problems in highly indebted countries. The Greek crisis highlights the need to take steps to strengthen the economic governance of the euro area. A key component of these steps would be a stronger, growth-oriented, surveillance.