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.

Ukraine, Belarus and Moldova and the Chinese economic expansion in Eastern Europe. OSW Commentary No. 79, 2012-05-28

The countries of Eastern European and China have been increasingly interested in deepening bilateral contacts over the past few years. In the case of Ukraine, Belarus and Moldova this has been caused by the bad economic situation which was in part caused by the consequences of the global economic crisis of 2008 and the desire to establish closer political relations with a country whose significance on the international arena is continually growing. Each of these countries has different expectations regarding the scale and the nature of co-operation with China. Chisinau wishes only to boost trade, whereas in Minsk and Kyiv, Beijing is also presented as a strategic partner whose investments may not only help the indebted economies recover but also strengthen the position of these countries in their dealings with the EU, and especially with Russia. Beijing sees co-operation with these countries in differently, and its offer is much more modest than Belarus and Ukraine are expecting. Eastern Europe is one of the last parts of the world with which China is activating its co-operation. This is not a priority region for Beijing. China wants to derive economic benefits and to diversify the markets on which it invests its financial surplus, and it does not intend to extend its political dialogue with Ukraine, Belarus and Moldova beyond the framework which determines its economic interests. The main reason for this is the nature of relations between Russia and China. Beijing sees its partnership with Moscow as more beneficial, and will not offer these countries support in their relations with Russia since in its opinion they belong to Russia’s sphere of influence. Minsk and Kyiv are pinning too much hope on their co-operation with Beijing, while China offers no real counterbalance to the Russian and EU influences in these countries. Nevertheless, it should be expected that China will capitalise on the beneficial political climate in Ukraine, Belarus and Moldova to reinforce its influence in a region whose location will facilitate its expansion to the EU and the Customs Union markets. In the medium term, Beijing may become a major economic player in Eastern Europe. In a decade’s time this may translate into political influence. Meanwhile, in the short term, China’s financial engagement in Ukraine, Belarus and Moldova will contribute to increasing the debts and deepening the foreign trade deficits of these countries.

Russia in Crisis: Year One. OSW Report, January 2010

Economic conditions which had favoured Russia’s development suddenly changed in mid-2008. The Russian economy was hit, on the one hand, by a drastic slump in oil prices (which fell from nearly US$150 to US$50 between July 2008 and January 2009), and on the other by the outflow of investors (a net of US$130 billion of capital left Russia in the fourth quarter of 2008). Within several months, the financial crisis became an economic crisis affecting the entire economy. The financial reserves accumulated in times of prosperity (more than US$162 billion in the stabilisation funds and nearly US$598 billion in the currency and gold reserve) alleviated the negative impact of the crisis, although this failed to prevent the deep declines in macroeconomic indicators. Russia is one of the states most severely affected by the crisis. In the first half of 2009, its GDP fell by 10.4% compared to the same period in the previous year, while industrial production dropped by nearly 15%, and a decrease in investments of over 18% was reported. The poor economic performance has strongly affected the Russian budget, which reported a deficit for the first time in ten years in 2009. During the first year of the crisis (August 2008 – September 2009), Russia’s financial reserves were seriously reduced as a result of the government’s anti-crisis policy and interventions from the central bank: the reserve fund decreased by nearly 45% to US$76 billion, and the central bank’s reserves shrunk by nearly US$200 billion to US$409 billion. Meanwhile, however, the money in the National Welfare Fund, which had been intended almost entirely to subsidise the Pensions Fund between 2010 and 2015, rose almost three-fold (to US$90 billion). According to government forecasts, the money from the reserve fund is also supposed to be spent fully in 2010. The financial crisis has triggered a dynamic outflow of capital from the Russian market. So-called speculative capital was the first to demonstrate the lack of confidence in the Russian market. In the first half of 2009, the growth rate of long-term investments also decreased noticeably, although no spectacular withdrawal of direct investments from Russia has been observed. The economic crisis has also halted the foreign expansion of Russian private capital, while state-owned capital strengthened its position as an investor. Russia’s raw materials companies continue to be the main category of foreign investors; however, new technologies are gaining prominence as the second main direction of Russian investments.

After the Euro Crisis: The President of Europe, A new paradigm for increasing legitimacy and effectiveness in the EU. EuropEos Commentary No. 12, 1 June 2012

The crisis in the eurozone– which became worse in Europe at the same time that the Lisbon Treaty entered in force at the end of 2009 – has presented the first test of the crisis management capabilities of the intergovernmental approach. As provided under the Lisbon Treaty, the European Council has been the true decision-making centre for the policies adopted in response to the financial crisis, with the Commission playing a technical role. This commentary finds, however, that this institutional set-up has been unsatisfactory and unable to overcome the three fundamental dilemmas of the integration process: the dilemma of veto power, the dilemma of enforcement of the agreements and the dilemma of decision-making legitimacy. While it remains to be seen whether the election of François Hollande as President of France signals the beginning of a new political cycle characterised by new ideas on the institutional future of the EU, if that were to materialise, this paper aims to contribute to the debate on those new ideas.

Eurozone Debt Crisis: Reckless debtors or misguided rescuers? EuropEos Commentary No. 10, 26 May 2011

Based on the latest round of difficulties to emerge from the Greek financial assistance programme, this commentary concludes that there are serious flaws in the design of the eurozone’s crisis management system that periodically push the members to the brink of financial meltdown. He warns that the same is bound to happen again with Ireland and Portugal, and each time with higher risks that the fabric of cooperation within the eurozone will tear irreparably. In order to fix them, he proposes three basic changes to the crisis management arrangements and the design of the European Stabilty Mechanism (ESM) decided in March by the European Council.

The role of politicians in inciting financial markets to attack the eurozone. EuropEos Commentary No. 4, 21 June 2010

While acknowledging that the sustainability of sovereign debt is a serious issue that must be confronted, this EuropEos Commentary finds that financial markets have blown the problem completely out of proportion, leading to a full-scale confidence crisis. The authors present evidence suggesting that politicians’ public disagreements and careless statements at critical junctures may have added oil to incipient fire. By creating the impression that domestic political interests would take precedence over orderly management of the Greek debt crisis, they raised broader doubts about their ability to address fundamental economic divergences within the area, which are the real source of debt sustainability problems in the medium term.

The sovereign debt crisis that isn't: Or, How to turn a lending crisis into a spending crisis and pocket the spread. ACES Cases No. 2014.1

It’s a testament to the power of ideas in politics that the ongoing policy disaster in Europe is still referred to, by academic as well as popular commentators, as the European Sovereign Debt Crisis. That there was a crisis in European sovereign debt markets in 2010 through the middle of 2012 is not in doubt. That is was a crisis of European sovereign debt markets generated by ‘too much spending’ should be very much in doubt. The ongoing European economic crisis is in fact a transmuted private sector banking crisis first exacerbated and then calmed by central bank policy, the costs of which have been asymmetrically distributed across European mass publics.

The Euro blame game and its implications for policy and financial markets. ACES Cases No. 2012.2

The recent financial crisis in some of the eurozone member countries has received a great deal of attention by investors, policy makers and commentators alike. Often these events are interpreted as a failure of the euro and the sustainability of the eurozone is called into question. This paper shows that this analysis and its emphasis are flawed. Fiscal imbalances and financial market imperfections are at the core of the problem, and they need to be addressed directly to prevent future crises.

The Eurozone crisis and the erosion of democratic legitimacy: Lessons from the gold standard. ACES Cases No. 2013.3

This paper makes four propositions. First, it argues that the euro’s institutional design makes it function like the interwar gold exchange standard during periods of stress. Just like the gold exchange standard during the 1930s, the euro created a ‘core’ of surplus countries and a ‘periphery’ of deficit countries. The latter have to sacrifice their internal domestic economic equilibrium in order to restore their external equilibrium, and therefore have no choice but to respond to balance of payments crises by a series of deflationary spending, price and wage cuts. The paper’s second claim is that the euro’s institutional design and the EU’s response to its ‘sovereign debt crisis’ during 2010-13 deepened the recession in the Eurozone periphery, as EMU leaders focused almost exclusively on austerity measures and structural reforms and paid only lip service to the need to rebalance growth between North and South. As Barry Eichengreen argued in Golden Fetters, the rigidity of the gold standard contributed to the length and depth of the Great Depression during the 1930s, but also underscored the incompatibility of the system with legitimate national democratic government in places like Italy, Germany, and Spain, which is the basis for the paper’s third proposition: the euro crisis instigated a crisis of democratic government in Southern Europe underlining that democratic legitimacy still mainly resides within the borders of nation states. By adopting the euro, EMU member states gave up their ability to control major economic policy decisions, thereby damaging their domestic political legitimacy, which in turn dogged attempts to enact structural reforms. Evidence of the erosion of national democracy in the Eurozone periphery can be seen in the rise of anti-establishment parties, and the inability of traditional center-left and center-right parties to form stable governments and implement reforms. The paper’s fourth proposition is that the euro’s original design and the Eurozone sovereign debt crisis further widened the existing democratic deficit in the European Union, as manifested in rising anti-EU and anti-euro sentiment, as well as openly Eurosceptic political movements, not just in the euro periphery, but also increasingly in the euro core.

Debating the European debt crisis: Government leadership, party ideology and supranational integration as focal points of parliamentary debates in Austria, Germany and the United Kingdom. ACES Cases No. 2012.3

Parliamentary debates about the resolution of the EU debt crisis seem to provide a good example for the frequently assumed “politicizationˮ of European governance. Against this background, the paper argues that in order to make sense of this assumption, a clearer differentiation of three thematic focal points of controversies – with regard to the assessment of government leadership, concerning the debate between competing party ideologies within the left/right dimension, and with regard to the assessment of supranational integration – is needed. Applying this threefold distinction, the paper uses a theory of differential Europeanization to explain differences in the thematic structure of debates in the Austrian Nationalrat, the British House of Commons, and the German Bundestag. Empirically, the paper is based on data gained from the computer-based coding of plenary debates about the resolution of the European debt crisis between 2010 and 2011.

Banking Sector Soundness, Innovation, and Development: Emerging Europe and South Asia. ACES Working Papers, 2012

While most academic and practitioner researchers agree that a country’s commercial banking sector’s soundness is a very significant indicator of a country’s financial market health, there is considerably less agreement and substantial confusion surrounding what constitutes a healthy bank in the aftermath of 2007+ financial crisis. Global banks’ balance sheets, corporate governance, management compensation and bonuses, toxic assets, and risky behavior are all under scrutiny as academics and regulators alike are trying to quantify what are “healthy, safe and good practices” for these various elements of banking. The current need to quantify, measure, evaluate, and compare is driven by the desire to spot troubled banks, “bad and risky” behavior, and prevent real damage and contagion in the financial markets, investors, and tax payers as it did in the recent crisis. Moreover, future financial crisis has taken on a new urgency as vast amounts of capital flows (over $1 trillion) are being redirected to emerging markets. This study differs from existing methods in the literature as it entail designing, constructing, and validating a critical dimension of financial innovation in respect to the eight developing countries in the South Asia region as well as eight countries in emerging Europe at the country level for the period 2001 – 2008, with regional and systemic differentials taken into account. Preliminary findings reveal that higher stages of payment systems development have generated efficiency gains by reducing the settlement risk and improving financial intermediation; such efficiency gains are viewed as positive financial innovations and positively impact the banking soundness. Potential EU candidate countries: Albania; Montenegro; Serbia

Preventing another Euro Area Crisis: EU Economic Governance ‘Six Pack’ – a case of too little, too late? Paper from the Colloquium: The Politics and Economics of the Euro Crisis, Institute for European Studies, University of Malta, 2 December 2011

Summary: The ‘Six Pack’ forms part of the economic governance reforms which are being implemented in order to prevent a repeat of the current sovereign debt crisis in the Euro Area. This legislative package involves strengthening the Stability and Growth Pact, with stronger financial sanctions and more focus on debt; a new directive on national budgetary frameworks and a new framework to monitor and correct macroeconomic imbalances. Furthermore, the implementation of the ‘Six Pack’ also involves procedural reforms, in particular reverse majority voting, as well as more oversight by the European Parliament. Inter-institutional negotiations on the ‘Six Pack’ took over a year. In the meantime, the sovereign debt crisis had deepened and broadened, implying that the ‘Six Pack’ may have come ‘too late’. The ‘Six Pack’ has also proved to be ‘too little’ to address the crisis and by the time it entered into force, further measures and proposals to strengthen economic governance had to be made. Nevertheless, the ‘Six Pack’ comprises some positive developments. In particular, recognising that fiscal policy is a matter of national sovereignty, it sets a new approach which relies on institutional reforms at national level. As such, it constitutes a first, small step to improve economic governance in the Euro Area.

Closing financial institutions on both sides of the Atlantic: Are there differences in approach? CEPS Commentary, 25 February 2015

In the aftermath of the Great Financial Crisis both the EU and the US have implemented resolution procedures for their largest and most systemic financial institutions. This Commentary examines the main differences between the two frameworks. The EU framework allows, inter alia, action to prevent the failure of a credit institution, while the US regulatory framework requires that all systemic banks subject to resolution must be closed and resolved. The greater flexibility under the EU resolution framework allows action to be taken to preserve a credit institution without putting it through an insolvency process, which makes limiting moral hazard less obvious. Moreover, the scope of the EU framework is still narrow, since it does not allow the recovery of non-bank financial institutions, whereas the US framework does.

A macro-financial analysis of the euro area sovereign bond market. National Bank of Belgium Working Paper No. 259, June 2014

We estimate the 'fundamental' component of euro area sovereign bond yield spreads, i.e. the part of bond spreads that can be justified by country-specific economic factors, euro area economic fundamentals, and international influences. The yield spread decomposition is achieved using a multi-market, no-arbitrage affine term structure model with a unique pricing kernel. More specifically, we use the canonical representation proposed by Joslin, Singleton, and Zhu (2011) and introduce next to standard spanned factors a set of unspanned macro factors, as in Joslin, Priebsch, and Singleton (2013). The model is applied to yield curve data from Belgium, France, Germany, Italy, and Spain over the period 2005-2013. Overall, our results show that economic fundamentals are the dominant drivers behind sovereign bond spreads. Nevertheless, shocks unrelated to the fundamental component of the spread have played an important role in the dynamics of bond spreads since the intensification of the sovereign debt crisis in the summer of 2011

Discussions in Europe on Variable Compensation in the Financial Sector. EU Centre Singapore Working Paper no. 20, February 2014

Bonuses – which are often used to mitigate principal-agent problems and to encourage employees to work harder – have increased tremendously in the financial sector during the last decade, and have often been seen as a contributing factor to the financial crisis of 2008. The recent European Union (EU) action to adopt a policy that restricts bonuses paid to bankers may seem promising at first, but this does not address the real issues behind variable rewards. Compensation policies should be changed to encourage responsible risk-taking and decision-making through the implementation of broader performance metrics, forfeitable holdbacks and hybrid bonds. Furthermore, a change in organisational culture is needed to improve ethical behaviour leading to a re-balancing of stakeholders’ interests in the financial sector.