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Rethinking Global EconomicGovernance in Light of the CrisisNew Perspectives on EconomicPolicy FoundationsEdited byRichard Baldwin and David Vines

Rethinking GlobalEconomic Governancein Light of the CrisisNew Perspectives on EconomicPolicy FoundationsEdited by Richard Baldwin and David VinesThis book is produced as part of the project ‘Politics, Economics and Global Governance:The European Dimensions’ (PEGGED) funded by the Socio-Economic Sciences andHumanities theme of the European Commission’s 7th Framework Programme forResearch. Grant Agreement no. 217559.

Centre for Economic Policy Research (CEPR)The Centre for Economic Policy Research is a network of over 700 Research Fellowsand Affiliates, based primarily in European Universities. The Centre coordinates the researchactivities of its Fellows and Affiliates and communicates the results to the publicand private sectors. CEPR is an entrepreneur, developing research initiatives with theproducers, consumers and sponsors of research. Established in 1983, CEPR is a Europeaneconomics research organization with uniquely wide-ranging scope and activities.The Centre is pluralist and non-partisan, bringing economic research to bear on theanalysis of medium- and long-run policy questions. CEPR research may include viewson policy, but the Executive Committee of the Centre does not give prior review to itspublications, and the Centre takes no institutional policy positions. The opinions expressedin this report are those of the authors and not those of the Centre for EconomicPolicy Research.CEPR is a registered charity (No. 287287) and a company limited by guarantee andregistered in England (No. 1727026).Chair of the BoardPresidentChief Executive OfficerResearch DirectorPolicy DirectorGuillermo de la DehesaRichard PortesStephen YeoLucrezia ReichlinRichard Baldwin

ContentsForewordviiIntroduction 1Richard Baldwin and David VinesThe governance of international macroeconomic relationsThe G20MAP, global rebalancing, and sustaining globaleconomic growth 17David VinesFiscal consolidation and macroeconomic stabilisation 27Giancarlo CorsettiThe Eurozone Crisis – April 2012 35Richard PortesThe Triffin Dilemma and a multipolar internationalreserve system 47Richard PortesGlobalisation, financial stability, and global financial regulationFinancial stability: Where it went and from whence itmight return 57Geoffrey UnderhillThe crisis and the future of the banking industry 67Xavier Freixas

How to prevent and better handle the failures of globalsystemically important financial institutions 75Stijn ClaessensCross-border banking in Europe: policy challenges inturbulent times 85Thorsten BeckCredit default swaps in Europe 95Richard PortesGlobal banks, fiscal policy and internationalbusiness cycles 107Robert KollmannThe global trade regimeThe Doha Round impasse 111Simon J EvenettThe Future of the WTO 121Richard BaldwinOpen to goods, closed to people? 135Paola Conconi, Giovanni Facchini, Max F Steinhardt, and MaurizioZanardiInternational migration and the mobility of labourThe Recession and International Migration 143Timothy J HattonA dangerous campaign: Why we shouldn’t risk theSchengen-Agreement 157Tito Boeri and Herbert Brücker

ForewordThis report grows out of research carried out under the auspices of the project Politics,Economics and Global Governance: The European Dimensions (PEGGED) fundedby 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 havepassed since then, but the economic and political landscape has shifted enormously, andthe early years of the millennium now seem rather distant and remote. Celebrations ofthe Great Moderation, arguments for the desirability of independent central banks andthe virtues of markets and the discipline now seem not so much incorrect as somewhatbeside 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 withthe turmoil in US subprime markets, then the growing disruption in global financialmarkets, and then the collapse of institutions at the heart of the financial system, suchas AIG and Lehman. The output was disseminated through PEGGED working papersfor the most part, but the urgency of the crisis and the need to deliver relevant researchimmediately to policymakers meant that new tools were needed. Fortunately, RichardBaldwin 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 resultsin real time. Although VoxEU is a separate venture, independent of PEGGED, VoxEUhas been supported by DG Education and Culture, a happy synergy between EU fundingprogrammes.vii

IntroductionThe PEGGED Research ProgrammeThe PEGGED Research Programme has helped European policymakers to constructand project a vision for this new global system. Within the PEGGED Programme,political scientists and economists have worked together to develop workable, realworldpolicy solutions in four important areas of international cooperation. These fourareas are:• The governance of international macroeconomic relations• Globalisation, financial stability, and global financial regulation• The global trade regime• International migration and the mobility of labourThroughout its life, PEGGED has produced a number of working papers on each ofthese four topics. The Programme has also produced many policy publications on thesetopics, in the form of Policy Briefs, Papers, and Reports. These can all be found onhttp://pegged.cepr.org/. PEGGED has also held regular policy events in a number ofplaces, including Amsterdam, Barcelona, Brussels, Florence, Geneva, London, Lisbon,Madrid, Oxford, Paris, Pisa, Rome, Tilburg, Tokyo, and Villars. Details of all of thesemeetings 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 relationsGlobal governance made remarkable progress with the establishment of the G20Leaders’ Summit. The first cooperative steps – coordinated stimulus in reaction to theglobal crisis – were easy. Today, with monetary policy at its lower bound and fiscalpolicy at its upper bound in the advanced economies, global coordination is far moredifficult. The chapter by David Vines outlines the main economic imbalances thatrequire coordination: China must move towards a greater reliance on domestic demand;3

Rethinking Global Economic Governance in Light of the Crisisthe US must secure long-term fiscal consolidation; and Europe must embrace reformsthat 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 policyadjustments. The G20 Mutual Assessment Process is a new framework in which thesepolicymakers 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, andespecially across Europe. In his chapter Giancarlo Corsetti asks whether governmentsshould relent in their efforts to reduce deficits now, when the global economy is stillweak, and policy credibility is far from guaranteed. He draws on two channels ofrecent research, which point in opposite directions. Recent work on the effects of fiscalcontraction at the time of a liquidity trap suggests that multipliers may be large in thesecircumstances. Empirical evidence confirms this, especially at a times of recessionin the presence of a banking and financial crisis. As a result, if monetary policy isconstrained, there is little doubt that governments with strong credibility shouldabstain from immediate fiscal tightening, while committing to future deficit reduction.However there is a difficulty in following this advice when the government is chargeda sovereign-risk premium, since sovereign risk adversely affects borrowing conditionsin the broader economy. That will cause fiscal multipliers to be much lower. And, dueto the sovereign-risk channel, highly indebted economies can become vulnerable to aself-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 willbe to reduce activity. The presence of such a sovereign-risk channel provides a strongargument for focusing on ways to limit the transmission of sovereign risk into privatesectorborrowing conditions. Recent unconventional steps by the ECB suggest that thisis possible.The Eurozone crisis of 2011–12 would have been much easier to contain and resolvehad there been no global financial crisis, and no deep recession in the advancedcountries. As a consequence, Richard Portes argues in his chapter that it is too facile to4

Introductionsay 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 norlife-threatening before 2008–09. They would not be remedied by exit of a few countriesfrom monetary union, which would also be deeply harmful to those countries. Thepredicaments 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 ofthe single currency, nor to fiscal profligacy (except Greece). It is also wrong to reducethe causes to inadequate ‘competitiveness’ that could be cured by currency devaluation.Only from 2003–04 were these countries running large current-account deficits withinthe monetary union; and these were financed (some would argue caused) by equallylarge capital flows from the surplus countries. Germany played the same role in theEurozone 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 theinvestment share during 2000–07. And unlike China, the capital flows from Germanyand France came primarily from banks – they were private not official flows. Themacroeconomic problem in EMU now is the fiscal consequence of the financial crisisin bank-based financial systems. Creditor countries have been unwilling to let theirbanks suffer the consequences of bad loans – rather, they have managed to put the entireburden on the taxpayers of the debtor countries. This disregards the EU and Eurozonefinancial integration that policymakers have promoted. The longer-term refinancingoperation (LTRO) was an inspired move to bypass German objections to the ECBtaking on the lender of last resort (LLR) role. But it is a temporary expedient. The onlystable solution is for the ECB to accept explicitly, in some form, the LLR role. To stopself-fulfilling confidence crises, the ECB should commit to cap yields paid by solventcountries with unlimited purchases in the secondary markets. Arbitrage will then bringprimary issue yields down to the capped level. For the long run, debt sustainabilityrequires economic growth. The current fiscal contraction is contractionary. Austeritypolicies are not the solution, but rather a major part of the problem. Moreover, fiscalcontraction together with private-sector deleveraging is not feasible without a currentaccount surplus. There will be no exit from the current debt traps and stagnation unless5

Rethinking Global Economic Governance in Light of the Crisisthe surplus countries accept that they must allow the others to run surpluses, so thateither they relax fiscal policy or they adopt policies to reduce private net savings. Andthe overall position would improve if the euro were to depreciate significantly – anotherreason for further monetary easing.A second chapter by Richard Portes concerns the Triffin Dilemma and its implicationsfor moves, at present, towards a multipolar international reserve system. Robert Triffinset out his supposed dilemma for the international monetary system in the 1960s.Meeting global demand for liquid reserves required continuously rising holdings ofUS dollars by other countries; but that would progressively undermine confidence inthe dollar as a store of value. The contemporary version of this problem starts from thehypothesis 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 trulysafe assets – US Treasuries – rests on the backing of the US ‘fiscal capacity’. But thatgrows only as US GDP grows, and US GDP grows slower than world GDP, whichdetermines the growth of demand for those assets. Hence there must be a growingexcess demand for safe assets, and we need to move to a multipolar reserve currencysystem in which other countries also provide safe assets. But the 1960s story waswrong, conceptually and empirically, in assuming the US would run current-accountdeficits in order to generate foreign dollar holdings; and now, real interest rates havenot been historically low, nor is there a clear definition of fiscal capacity, nor is therea 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 theirportfolios, and the correction of global imbalances will promote this. The emergingmarketcountries will develop their domestic financial markets and will have less needfor foreign financial intermediation. Some emerging-market countries may themselvesbecome reserve suppliers. And more international facilities centred on the IMF couldreduce the demand for reserves for self-insurance. Considering the Triffin Dilemmaundoubtedly helps us to understand the forces underlying the development of theinternational financial system. But it is not the source of the system’s problems.6

IntroductionGlobalisation, financial stability, and global financialregulationThe global and Eurozone crises seem to have undermined, perhaps even destroyed,the traditional foundations for financial stability in the US and Europe. The chapter byGeoffrey 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 todayare longstanding, well known, and can be informed by the host of historical experienceand related research. Second, the potential and more obvious flaws of the pre-crisissystem of financial governance were well known and debated pre-crisis but this did notprevent the crisis. Unfortunately, most reform proposals are based on such pre-crisisthinking and are therefore unlikely to achieve the reform goals. Worse, the Eurozoneis descending into modes of crisis resolution that are known to be dysfunctional anddestructive of successful economic growth and development. Third, reform that is morelikely to provide financial stability for the long run requires new thinking. What Europeneeds 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 offinancial 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 inEurope and beyond. It also shattered confidence in US and European banking systems.The regulatory reform response has been aimed at curtailing the financial sector’sexcessive appetite for risk. The chapter by Xaiver Frexias argues that for regulation toprevent future crises, we must understand the causes behind the excessive risk-taking inthe first place. The first step is a working definition of excessive risk-taking. Drawingon recent research, the author defines it as a level of risk that corresponds to a negativenet investment value. Obviously no well-run bank would knowingly engage in suchprojects so the question is: what went wrong to allow such investment? The chapterpoints to four possible answers. First managers’ incentives and corporate governancecould have been wrong. Second, the business cycle risks might not have been properly7

Rethinking Global Economic Governance in Light of the Crisisfactored in (capital is excessively cheap and lending excessively permissive in upturnswith the opposite holding in downturns). Third, regulatory supervision and marketdiscipline could have failed to curb excesses in boom times. Finally, moral hazard couldexplain the problem, namely the idea that banks take too much risk in anticipation ofbeing bailed out in the event of massive losses.Massive support has been provided in the ongoing financial crisis to banks and otherfinancial institutions including support for failed global systemically important financialinstitutions (G-SIFIs). Stijn Claessens argues that the ad hoc methods which have beenadopted for this support have led to much turmoil in international financial markets andworsened the real economic and social consequences of the crisis. He argues that a betterapproach to dealing with G-SIFIs is sorely needed. To date, international efforts havefocused on the harmonisation of the rules of supervision and on increasing supervisorycooperation. 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 territorialapproach under which assets are ring-fenced so that they are first available for theresolution of local claims. The second reform model is a universal approach underwhich all global assets are shared equitably among creditors according to the legalpriorities of the home country that can help address the global problem. He arguesstrongly that we will be driven towards a third intermediate approach, which combinesaspects of the other two. As policymakers realise all too well, however, especially inEurope today, whatever approach is adopted to the resolution of G-SIFIs, there is adanger 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 isnot only straining banks’ balance sheets, it is straining the cohesion of the EU’s singlebanking market. The key source of tension is the close interaction between nationalbanks and their governments – both through banks’ holdings of their government’sbonds and the government’s implicit insurance of their banks. This tension raisesfundamental questions about the need for greater institutional underpinnings. Indeed,8

Introductionrather 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, didtoo little after the 2007–08 crisis to address the institutional gaps needed to ensure astable banking market and manage the inter-linkages between monetary policy andfinancial stability. EU policymakers are facing the current crisis with too few policytools and coordination mechanisms. What is needed is additional policy tools in theform of macroprudential financial regulation. One tool – monetary policy – is simplynot enough to achieve asset price inflation and consumer price inflation, especiallyin a currency union where asset price cycles are not completely synchronised acrosscountries. Such regulation would have to be applied on the national, but monitored onthe European, level.Beyond the lack of proper policy tools and mechanisms, the Eurozone faces a deepercrisis – that of a democratic deficit for the necessary reforms to make this monetaryunion sustainable in the long run. Political resistance in both core and peripherycountries against austerity and bailouts illustrates this democratic deficit. In the longterm, the Eurozone can only survive with the necessary high-level political reforms.A further chapter by Richard Portes discusses credit default swaps (CDSs) which arederivatives; financial instruments sold over the counter. They transfer the credit riskassociated with corporate or sovereign bonds to a third party. The outstanding grossnotional positions in this market exceeded $60 trillion in early 2007 but have sincefallen 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 CDSprotection which it could not redeem; and in Europe when Greek sovereign CDS pricesrose dramatically in spring 2010, apparently contributing to a self-fulfilling crisis,then when the authorities sought to avoid triggering CDS contracts on Greece in theeventuality of Greek debt default. Portes’ empirical work on Eurozone sovereign CDSprices during 2004–11 finds that for Eurozone sovereign debt, the CDS and cash market9

Rethinking Global Economic Governance in Light of the Crisisprices are normally equal to each other in long-run equilibrium, as theory predicts. Oneinterpretation is that the market prices credit risk correctly: sovereign CDS contractswritten on Eurozone borrowers seem to provide new up-to-date information to thesovereign cash market. In the short run, however, the cash and synthetic markets pricecredit risk differently to various degrees. Second, the Eurozone CDS market seemsto move ahead of the corresponding bond market in price adjustment, both beforeand during the crisis. And CDS contracts clearly do play a useful hedging role. Analternative interpretation of our results, however, is that the CDS market leads in pricediscovery because changes in CDS prices affect the fundamentals driving the prices ofthe underlying bonds. If the CDS spread affects the cost of funding of the sovereign (orcorporate), then a rise in the spread will not merely signal but will cause a deteriorationin credit quality, hence a fall in the bond price; and this mechanism could lead to a selffulfillingvicious spiral. Recent theoretical work justifies such an interpretation and, inparticular, attributes responsibility to ‘naked’ CDSs, bought by investors who do nothold 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 widerfinancial crisis in September 2008 – became the global crisis when it triggered thesharpest global recession since the 1930s. This chain of events revealed a major fragilityin the global economy, but it also revealed a major hole in economists’ macroeconomictoolkit. Quite simply, this crisis could not happen in standard, pre-crisis macro theory.The analytic framework just did not allow for financial intermediaries so macroeconomicshock could not emanate from the financial sector. Issues like bank balance sheets hadbeen 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-sponsoredresearch. He has focused on the role of global banks in business cycles in the EU andin the world economy. Banks that make loans across many nations but have their equity10

Introductionbase in one connect the state of bank equity markets in one nation to lending and thuseconomic activity in many. For example, a loss on bank loans in one country reducesthe global banking system’s capital which in turn triggers a global reduction in banklending; a worldwide recession is the result.The author points out that this economic logic provides a solid basis for policy. The keyrole of bank health for the overall economy suggests that government support for thebanking system might be a powerful tool for stabilising real activity in a financial crisis.The global trade regimeThe chapter by Simon Evenett outlines the key factors responsible for the Doha Roundimpasse and argues that scholars ought to devote more attention to analysing suchimpasses. The emphasis here is not on the daily twists and turns of the Doha Roundnegotiations but on the underlying factors that have probably prevented WTO membersfrom reaching a mutually acceptable deal.The WTO is widely regarded as trapped in a deep malaise. Richard Baldwin arguesthat, in fact, the WTO is doing fine when it comes to the 20th century trade for whichit 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 itsdemand for beyond-WTO disciplines. The WTO’s centrality has been undermined assuch 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 addressedelsewhere. Or the WTO engages in 21st century trade issues both by crafting newmultilateral disciplines – or at least general guidelines – on matters such as investmentassurances, and by multilateralising some of the new disciplines that have arisen inregional trade agreements. We are presented with a stark choice. The WTO can stay onthe 20th century side-track on to which it has been shunted, or it can engage creatively11

Rethinking Global Economic Governance in Light of the Crisisand constructively in the new range of disciplines necessary to underpin 21st centurytrade.Trade policy poses tough questions for policymakers, but nothing like the problemsarising from migration policy choices. Economists have a hard time explaining thisas they typically work with analytic frameworks where trade and migration havequite similar economic effects. The chapter by Paola Conconi, Giovanni Facchini,Max Steinhardt, and Maurizio Zanardi discusses recent research that examines thesimilarities 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 theimpact on trade and migration votes going in the same direction), and party affiliationleading to divergent voting patterns (Democrats voting in support of liberal immigrationpolicies but against trade liberalisation). Additionally, the fiscal burden of immigrantsfor a constituency dampens the representative’s enthusiasm for liberal migrationpolicies, but has no impact on trade. The ethnic composition of Congressional districtsalso matters with voting for immigration rising with the district’s share of foreign-borncitizens. Taken together, the authors argue that these effects explain why legislators aremore likely to support opening barriers to goods than to people.International migration and the mobility of labourImmigration policy is back in European headlines although perhaps not as much as onewould expect given the dire economic straits in many European nations. The chapter byTim Hatton admits that economists still do not fully understand how immigration policyevolves, or why it seems so different now than in the past. Current understanding isbased on four factors. First, rising education levels have led to better informed attitudestowards immigration, especially as concerns competition of unskilled immigrants.Second, concerns about the cost of the welfare state are counterbalanced by the waysuch safety nets ease worker-specific adjustments. Third, as international cooperationbecomes more pressing on must-do issues like climate change and security issues,12

Introductiondraconian immigration rules, which could potentially harm such cooperation, are lesslikely to be implemented. Nevertheless, such arguments remain speculative and mustbe subjected to more rigorous examination.Playing politics with migration is dangerous but dangerously attractive in today’sclimate of European malaise. The chapter by Tito Boeri and Herbert Brücker examinesthe case for more coordinated and forward-looking migration policies in Europe. Thecase rests on three key points. First, uncoordinated national policies are not the right wayto govern migration in an area as economically integrated as Europe. Uncoordinatedpolicies create prisoner’s dilemma situations with every member spending inefficientlylarge amounts on border controls, sub-optimal asylum and humanitarian policies, andinefficiently restrictive policies on illegal immigration. Second, the resulting zeroimmigration policy vis-à-vis northern Africa has backfired. Now migration is basedon family reunification, humanitarian migration, and illegal migration. This meansimmigrants are, on average, less educated than economic migrants and natives, do notgenerally achieve native language proficiency, and typically have a poor performancein the labour market and education system of the host country. All this feeds back intonegative perceptions thus making economic and social integration even more difficult.Finally, the authors point out that today incomes in northern African are not muchlower 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 couldcreate EU economic gains that are larger than those experienced from east Europeanmigration last decade. The key would be to adopt more realistic restrictions vis-à-visnorthern African countries. This skilled immigration would reduce pressures for illegalmigration while creating substantial economic gains in both the receiving and sendingregions.13

Rethinking Global Economic Governance in Light of the CrisisConcluding remarksPlainly more work is needed on this pressing set of issues. Global governance is a workin progress and scholars have an obligation to continue analysing and informing thechoice governments are making on an almost daily basis. We hope that this collectionof essays provides an accessible bridge to the academic work in the area as well as astimulus to others scholars to take the research further and deeper.5 April 201214

IntroductionAbout the authorsRichard Edward Baldwin is Professor of International Economics at the GraduateInstitute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chief ofVoxEU.org since he founded it in June 2007. He was Co-managing Editor of the journalEconomic Policy from 2000 to 2005, and Programme Director of CEPR’s InternationalTrade programme from 1991 to 2001. Before that he was a Senior Staff Economist forthe 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 atMIT in 2002/03 and has taught at universities in Italy, Germany, and Norway. He hasalso worked as consultant for the numerous governments, the European Commission,OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, hisresearch interests include international trade, globalisation, regionalism, and Europeanintegration. He is a CEPR Research Fellow.David Vines is Scientific Coordinator of the PEGGED Programme. He is Professor ofEconomics in the Economics Department, Oxford University, and a Fellow of BalliolCollege, Oxford as well as Director of the Centre for International Macroeconomicsat Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellowat the Bank of England, he has advised a number of international organisations andgovernmental bodies. He has published numerous scholarly articles and several books,most recently The Asian Financial Crisis: Causes, Contagion and Consequences, withPierre-Richard Agénor, Marcus Miller, and Axel Weber.15

The G20MAP, global rebalancing,and sustaining global economicgrowthDavid VinesBalliol College, Oxford, Australian National University, CEPR, and PEGGED1 The global policy problemIt is clear that the world needs global rebalancing – at some stage the scale ofinternational imbalances must be reduced. As is well known, two things are necessaryfor this rebalancing: changes in relative absorption between deficit and surplus countriesin the world – including cuts in absorption in the deficit countries - and changes inrelative prices between deficit and surplus countries.But the world also needs to ensure that the recovery from the global financial crisis issustained, ie it needs a satisfactory absolute level of global growth. There are significantglobal 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 disastrouslyhigh. To solve this unemployment problem will require a sustained global recovery. Yetfinancial markets, and policymakers, are now focused on reducing public deficits anddebt. Temporary stimulus packages are unwinding, and fiscal consolidation is settingin. There is a danger that the attempts to rebalance – including the cuts of absorption indeficit countries – will add to the attempts to fiscally consolidate, add to the other risks,and put global growth prospects seriously at risk.17

Rethinking Global Economic Governance in Light of the CrisisIn response to this danger, too many countries appear to be looking for export-ledgrowth. But we cannot nearly all have export-led growth. There only a small number ofcountries with an appetite for exports. This is a systemic problem.The G20 Mutual Assessment Process, or G20MAP, is a new global institutionalstructure forum in which this systemic problem is now being tackled.2 The need for international macroeconomic cooperationIn 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 USFederal Reserve set US interest rates. The outcomes ensured satisfactory growth inboth the US, and in other advanced countries, as well as in East Asia (Adam and Vines2009). Because of high savings the real interest rate needed to be low. This system ledto the Great Moderation – the ‘Greenspan put’ emerged as a part of what happened (asis 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 themwas not a target of international policy. Such a system – with its low interest rates – alsoled to high leverage, to financial instability, and ultimately to the global crisis (Obstfeldand Rogoff 2009).Global cooperation in response to the crisis was initially easy; the outcome at the G20summit in London in April 2009 was remarkable. But it was straightforward to bringabout what happened. All countries had an interest in using monetary expansion, andthen fiscal expansion, to avoid global collapse. And the costs of the resulting fiscalexpansion – in the form of ballooning debt –– only gradually led to fiscal crises.18

The G20MAP, global rebalancing, and sustaining global economic growthThe 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 rapidexpansion of domestic demand. But China is necessarily doing this at a slow speed(Yongding 2009). During this period of adjustment the dollar-renminbi real exchangerate will continue to be one which leads to East Asia having a large export surplus. Atthe same time, world interest rates are too low for China, which continues to attempt todeal with this difficulty with capital controls.Europe is in danger of re-creating the global problem at the European level (Vines2010, 2011a). Countries in the southern European periphery are now embarking ondemanding austerity programmes. The difficulty of adjusting wages and prices in thesecountries of the periphery, which are greatly uncompetitive vis-à-vis Germany, createsa need for the euro to depreciate, so as to encourage growth in these countries. At thesame time, the German economy is difficulty because European interest rates need tobe low. The position in Germany would become even more unbalanced if the euro wereto depreciate further.And the US is caught in a fiscal trap. The inability of the US political system to promiselonger-term fiscal correction has made it difficult to for the US to sustain its shorter-termfiscal stimulus. The resulting fiscal withdrawal is part of the reason why unemploymentseems likely to remain so persistent in the US.Many activities in the US are now globally uncompetitive because of the depreciatedreal exchange rates of China and of other East Asian countries. The outcome may wellbe one in which the US wishes to have a lower real exchange rate against not justEast Asia, but against Europe as well. Quantitative easing has become a tool whichinfluences the dollar in this direction. But many activities in the European periphery arealso globally uncompetitive, because of the depreciated real exchange rate of Germany19

Rethinking Global Economic Governance in Light of the Crisiswithin the euro – and also because of the depreciated real exchange rate of China andother East Asian countries.All this means that Europe may wish to see the opposite outcome from that desired bythe US – a lower real exchange rate for Europe against both the US and East Asia, inorder for growth in the European periphery to resume. The LTRO of the ECB appears tobe pushing the euro in such a direction. There is, in short, a genuine possibility of policyconflict over monetary policy, and exchange rates among China, the US and Europe.Protectionism in trade is another possible response to this problem (Eichengreen andIrwin 2009). Plainly there is a pressing need for international macroeconomic policycooperation.3 The G20MAP and international macroeconomiccooperationThe G20MAP is in the process of producing a group of policymakers from G20countries who come to share the ownership of an international cooperative process.That is, it is creating policymakers who are concerned with the global problem (suchas those mentioned above), rather than being concerned only with national objectives(IMF 2011a). The aim is to produce something much better than what was achievedin the IMF’s previous process of multilateral surveillance process, or MSP. Thegovernance structure of the IMF meant that the US was able to ensure that the IMFmade no criticism of the US as part of the MSP – and was able to ensure that theIMF did not exercise any sanction on the US – as a response its large current-accountdeficit. The Fund was also unable to exercise any sanction on China as a response to itsundervalued exchange rate.The G20MAP was established at the Pittsburgh G20 summit in 2009. G20 leaders thenagreed that their aim would be to pursue growth collectively. At that meeting, and atthe Seoul summit in 2010, there was an agreement that the objective was a ‘Frameworkfor Strong Sustainable and Balanced Growth’ where ‘sustainable’ included the need20

The G20MAP, global rebalancing, and sustaining global economic growthfor 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 IMFwould provide technical analysis to support the G20MAP. 1Subsequently it was decided that the Fund would evaluate how members’ macroeconomicpolicies should fit together, providing an assessment of whether national policies, takencollectively, are likely to achieve the G20’s goals. Since then, during 2011, the IMFcarried 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. Thesecountries were the US, China, Japan, Germany, India, the UK, and France. The decisionas 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 muchattention at the time. But the most important thing about these indicators is that theuse of them enabled a decision to be made as to which countries would be analysedin detail. That decision enabled the G20MAP to be given a much clearer focus. Theanalyses were published at the time of the Cannes G20 Summit in November 2011. TheIMF 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 (IMF2011b).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 leadto a better outcome. These potential policy changes are now on the table for countries toexamine, 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 IMFwill not be immediate.1 The Framework for Strong Sustainable and Balanced Growth is not just about achieving satisfactory macroeconomicoutcomes; it is also concerned with achieving financial stability, with environmental issues, and with the raising of livingstandards in developing countries. The broader set of international discussions about that wider range of concerns isbeing assisted by technical inputs from a range of international institutions far beyond the IMF.21

Rethinking Global Economic Governance in Light of the CrisisBut 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 reasonswhich 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 thepursuit of a shared objective but instead a clearer understanding of what other playersintend to do.Such an understanding will make clearer for each player what that player needs todo. The G20MAP has engaged a number of international policymakers in a globalpolicymaking 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 arerequired will be a gradual. In that case each policymaker needs to be able to trust thatother policymakers will carry out the adjustments which are required of them. I havedescribed 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 growagain.All of these adjustments will be gradual, and all of them need to be carried out in a waywhich relies on other policymakers playing their part as well.The world now needs a group of policymakers, from a number of countries, who acttogether so as to carry out the necessary policy adjustments. The G20MAP is in theprocess of creating a new global institutional structure, one in which these policymakersmay well be able to do what is required.22

The G20MAP, global rebalancing, and sustaining global economic growthReferencesAdam, C, and D Vines (2009), “Remaking Macroeconomic Policy after the GlobalFinancial 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 thereal exchange rate within Europe”, in Buti, M, S Deroose, V Gaspar, and J NogueiraMartins (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 imbalancesbe reduced?” IMF Staff Note.Eichengreen, B and D Irwin (2009), “The protectionist temptation: Lessons from theGreat Depression for today” VoxEU.org, 17 March. Available at http://global-crisisdebate.com/index.php?q=node/3998.House, B, D Vines, and M Corden (2008), “The IMF”, New Palgrave Dictionary ofEconomics, London: Macmillan.IMF (2010), “Strategies for Fiscal Consolidation in the Post-Crisis World”, paperprepared 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 athttp://www.imf.org/external/np/g20/pdf/110411.pdf.Obstfeld, M and K Rogoff (2009), “Global Imbalances and the Financial Crisis: Productsof Common Causes”, available at http://elsa.berkeley.edu/~obstfeld/santabarbara.pdf.23

Rethinking Global Economic Governance in Light of the CrisisVines, D (2010), “Fiscal Policy in the Eurozone after the Crisis”, paper presented at aMacro Economy Research Conference on Fiscal Policy in the Post-Crisis World, heldat the Hotel Okura, Tokyo, 16 November.Vines, D (2011a), “Recasting the Macroeconomic Policymaking System in Europe”,Zeitschrift für Staats- und Europeawissenschaften (ZSE) [Journal for ComparativeGovernment and European Policy], November.Vines, D (2011b), “After Cannes: The G20MAP, Global Rebalancing, and SustainingGlobal 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”, RichardSnape, Lecture, Productivity Commission, Melbourne, November, available at http://www.eastasiaforum.org/wp-content/uploads/2010/01/2009-Snape-Lecture.pdf.24

The G20MAP, global rebalancing, and sustaining global economic growthAbout the authorDavid Vines is Scientific Coordinator of the PEGGED Programme. He is Professor ofEconomics in the Economics Department, Oxford University, and a Fellow of BalliolCollege, Oxford as well as Director of the Centre for International Macroeconomicsat Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellowat the Bank of England, he has advised a number of international organisations andgovernmental bodies. He has published numerous scholarly articles and several books,most recently The Asian Financial Crisis: Causes, Contagion and Consequences, withPierre-Richard Agénor, Marcus Miller, and Axel Weber.25

Fiscal consolidation andmacroeconomic stabilisationGiancarlo CorsettiCambridge University and CEPRThe initial response to the crisis led to the accumulation of a vast stock of publicliabilities. 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 acure-all for financial market concerns about debt sustainability. Tighter fiscal policyhas, however, coincided with renewed economic slowdown or even contraction, raisingquestions about the desirability of fiscal austerity.The key question is whether governments should relent in their efforts to reducedeficits now, when the global economy is still weak, and policy credibility is far fromguaranteed. Under what circumstances would it be wise to do this?Countries fall into three categories. At one extreme we have countries alreadyfacing a high and volatile risk premium in financial markets. At the other extremewe have countries with strong fiscal shoulders, actually enjoying a negative riskpremium. A third category includes countries not facing a confidence crisis, yet withinherent vulnerabilities – a relatively high public debt, a fragile financial sector, highunemployment. The question of how to ensure debt sustainability is vastly differentacross these.By way of example, how much of Italy’s slowdown is due to austerity and how muchis due to the near meltdown of debt last summer? There is little doubt that the creditcrunch which followed the sudden loss of credibility of Italian fiscal policy (whetheror not justified by fundamentals) has a lot to do with the severe slowdown that Italy is27

Rethinking Global Economic Governance in Light of the Crisisexperiencing. The current fiscal tightening is arguably contractionary, but the alternativeof 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 lowinterest rates. Does this mean UK policymakers are shooting themselves in the foot?Are they keeping the economy underemployed for years and thus destroying potentialoutput with their austerity drive? Or, are they wisely forestalling a bond market rebellionlike those seen on the continent that would prove much costlier?Much of the work carried out in the PEGGED project over the years provides aconceptual and analytical framework to address these issues. The question of courseis not only about restoring safer fiscal positions after the large increase in gross andnet public debt in the last few years. Rather, it is about which fiscal policy path wouldbe most effective in helping the global economy and the economy of the Eurozoneovercome 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 perfectlyviable and desirable for a country conditional on an international context, may not workin different circumstances. The outcome will depend on the degree of internationalcooperation, especially in the provision of liquidity assistance and in the establishing of‘firewalls’ against contagion.Fiscal policy at a crossroads: Self-defeating tightening in aliquidity trap?Recent contributions about the mechanism through which fiscal contraction in aliquidity 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 anunemployment and underemployment crisis. Destruction of jobs and firms today may28

Fiscal consolidation and macroeconomic stabilisationbe expected to have persistent effects on potential output in the future. These effects inturn translate into a fall in permanent income, and hence demand, today (see DeLongand Summers 2012 and Rendahl 2012).In a liquidity trap, this creates a vicious self-reinforcing circle. Today’s unemploymentcreates expectations of low prospective employment, which in turn causes an endogenousdrop in demand, reducing activity and raising unemployment even further. This viciouscycle may have little to do with price stickiness and expectations of deflation at thezero lower bound, an alternative mechanism which was stressed early on by Eggertssonand Woodford (2003) and more recently by Christiano et al (2011). Independently ofdeflation, the vicious cycle can be set in motion by expectations of lower income whenshocks create a high level of persistent underemployment. Theory suggests that thiseffect can be sizeable. The question is its empirical relevance.The empirical evidence indeed weighs towards large multipliers at a time of recessionand especially at times of banking and financial crises (Corsetti et al 2012), as opposedto very small multipliers when the economy operates close to potential and monetarypolicy is ‘unconstrained’. The point estimate of the multiplier conditional on crisesis of the order of 2 – a value not far from the one used by several governments andcommentators, but higher than most estimates in the literature that fail to distinguishacross different states of the economy. In light of these results, it can be safely anticipatedthat the current fiscal contractions will exert pronounced negative effects on output.It is worth stressing that fiscal adjustment is currently happening at different levels ofgovernment – both central and local. An analysis of spending multipliers at local levelcarried out in the context of the PEGGED model suggests that differences in cuts andbudget adjustment at subnational level can also generate sizeable contractionary effectson 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 takesadvantage of the quasi-experimental setting generated by the Italian law mandatingthe dismissal of city councils on evidence of mafia infiltration. When a city council29

Rethinking Global Economic Governance in Light of the Crisisis dismissed, the commissaries sent by the government ensure that the administrationkeeps working according to national standards, but suspend public works. Thisgenerates a spending contraction of the order of 20%. The multiplicative effects onoutput, 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 governmentswith 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 discussedin the aforementioned PEGGED paper by Corsetti et al (2010).The problem is that, in the current context, promising future austerity alone may not beseen as sufficiently effective. Keeping markets confident in the solvency of the countryhas indeed provided the main motivation for governments to respond to nervousfinancial markets with upfront tightening.The challenge: How to stabilise economies with high andvolatile sovereign riskIn a recent PEGGED paper, Corsetti et al (2012) (henceforth CKKM) highlight issuesin stabilisation policy when the government is charged a sovereign-risk premium. Theroot of the problem is the empirical observation that sovereign risk adversely affectsborrowing conditions in the broader economy. The correlation between public andprivate borrowing costs actually tends to become stronger during crises. Perhaps in acrisis period high correlation is simply the by-product of common recessionary shocks,affecting simultaneously, but independently, the balance sheets of the government andprivate firms. Most likely, however, it results from two-way causation.In the current circumstances, there are good reasons to view causality as mostly flowingfrom public to private. First, in a fiscal crisis associated with large fluctuations insovereign risk, financial intermediaries that suffer losses on their holdings of governmentbonds may reduce their lending. Second, both financial and non-financial firms face a30

Fiscal consolidation and macroeconomic stabilisationhigher 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-riskchannel of transmission’ linking public to private borrowing costs.First, if sovereign risk is already high, fiscal multipliers may be expected to be lowerthan in normal times. The presence of a sovereign-risk channel changes the transmissionof fiscal policy, particularly so when monetary policy is constrained (because, forexample, policy rates are at the zero lower bound, or because the economy operatesunder fixed exchange rates). When sovereign risk is high, the negative effect on demandof a given contraction in government spending is offset to some extent by its positiveimpact on the sovereign-risk premium.Some exercises by CKMM suggest that, typically, consolidations will be contractionaryin the short run. Only under extreme conditions does the model predict either negativemultipliers (in line with the view of ‘expansionary fiscal austerity’) or counterproductiveconsolidations (in line with the view of ‘self-defeating austerity’). To the extent thatbudget 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 becomevulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fallin output generates expectations of a deteriorating fiscal budget, causing markets tocharge a higher risk premium on government debt. Through the sovereign-risk channel,this tends to raise private borrowing costs, depressing output and thus validating theinitial pessimistic expectation.Under such conditions, conventional wisdom about policymaking may not apply. Inparticular, systematic anti-cyclical public spending is arguably desirable when policycredibility 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 ensuringmacroeconomic stability. A prospective increase in spending in a recession may lead to31

Rethinking Global Economic Governance in Light of the Crisisa loss of confidence by amplifying the anticipated deterioration of the budget associatedwith the fall in output.This possibility poses a dilemma for highly indebted countries. In light of the aboveconsiderations, countries with a high debt may be well-advised to tighten fiscal policiesearly, even if the beneficial effect of such action – prevention of a damaging crisis ofconfidence – will naturally be unobservable. From a probabilistic perspective, evena relatively unlikely negative outcome may be worth buying insurance against if itsconsequences are sufficiently momentous. In the current crisis, unfortunately, we knowthat such insurance does not come cheap.Beyond country-level fiscal correctionThe near-term costs of austerity mean we should keep thinking about alternatives, suchas making commitments to future tightening more credible (eg the reform of entitlementprogrammes). However, the presence of a sovereign-risk channel also provides a strongargument for focusing on ways to limit the transmission of sovereign risk into privatesectorborrowing conditions.Strongly capitalised banks are a key element here. The ongoing efforts, coordinatedby the European Banking Authority, to create extra capital buffers in European bankscorrespond to this logic. Another element is the attempt by monetary policymakers tooffset high private borrowing costs (or a possible credit crunch) when sovereign-riskpremium 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. Theextension of three-year loans to banks, in particular, appears to have reduced fundingstrains, with positive knock-on effects for government bond markets.These arguments are especially strong, either for countries already facing high interestrates in the market for their debt, or for countries reasonably vulnerable to confidence32

Fiscal consolidation and macroeconomic stabilisationcrises. These countries would be ill-advised to relax their fiscal stance. The argumentsapply less to governments facing low interest rates. The main issue is where to drawthe line.ReferencesAcconcia, A, G Corsetti, and S Simonelli (2011), Mafia and Public Spending: Evidenceon the Fiscal Multiplier from a Quasi-experiment, CEPR DP 8305.Christiano, L, M Eichenbaum, and S Rebelo.(2011) When is the government spendingmultiplier 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 andStatistics.Corsetti, G, K Kuester, A Meier, and G Müller (2010), “Debt consolidation and fiscalstabilisation 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 policyand macroeconomic stability”, IMF Working paper 12/33.Corsetti, G, A Meier, and G Müller (2012) “What Determines Government SpendingMultipliers?” 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 optimalmonetary policy”, Brookings Papers on Economic Activity, 1:139–211.Rendahl, P (2012), Fiscal Policy in an Unemployment Crisis, Cambridge: CambridgeUniversity Press.33

Rethinking Global Economic Governance in Light of the CrisisAbout the authorGiancarlo Corsetti is Professor of macroeconomics at the University of Cambridge. Onleave from the University of Rome III, he previously taught at the European UniversityInstitution, as Pierre Werner Chair, the Universities of Bologna, Yale and Columbia.His main field of interest is international economics. His main contributions to theliterature include general equilibrium models of the international transmissionmechanisms and optimal monetary policy in open economies, analyses of currencyand financial crises and their international contagion, and models of internationalpolicy cooperation and international financial architecture. He has published articles inmany international journals including American Economic Review, Brookings Paperson Economic Activity, Economic Policy, Economics and Politics, European EconomicReview, Journal of Economic Dynamics and Control, Journal of Monetary Economics,Quarterly Journal of Economics, Review of Economic Studies, and the Journal ofInternational Economics. He has co-authored an award-winning book on the 1992-93crisis of the European Monetary System, Financial Markets and European MonetaryCooperation. He is currently co-editor of the Journal of International Economics.Giancarlo Corsetti is Research Fellow of the Centre for Economic Policy Research inLondon, 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 ascientific consultant to the ECB and the Bank of Italy, and a visiting scholar at theFederal Reserve Bank of New York and the IMF.34

The Eurozone crisis – April 2012Richard PortesLondon Business School and CEPRThe Eurozone crisis of 2011–12 is a sequel to the financial crisis of 2008–09. It wouldhave 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, tosay that the Eurozone crisis is essentially or even mainly due to inherent faults in themonetary union. Nevertheless, the crisis has exposed genuine faults that were neithermanifest nor life-threatening before 2008–09. They might have been remedied withgradual progress towards a deeper economic union. But all that is for the economichistorians. We are where we are, and it is not pretty.Government bond yields for several of the 17 countries in the economic and monetaryunion (EMU) were unsustainable in November 2011. They then fell back, with theECB’s longer-term refinancing operation (LTRO). But they are climbing again – moreon that below. The spread over the German ten-year government bond (the Bund) wasclose to zero for most of the period from 1999 to 2008. Now, however, of the EMUgovernment bonds, only Germany is regarded as a risk-free ‘safe asset’. Even that isnot totally clear, since the credit default swap (CDS) premium for Germany was at 110basis points in November 2011 (it was 40 in July). The CDS market is by no means areliable guide to default risk, but it does give information about sovereign bond prices 1 ,and the message is disturbing.1 Portes (2010), Palladini and Portes (2011).35

Rethinking Global Economic Governance in Light of the CrisisIn late 2011, until the LTRO, there were no buyers in the markets for Eurozonesovereign debt except the ECB, sporadically, and domestic financial institutions underopen or implicit pressure from their governments. Many of those institutions haveused some of their new ECB funding for renewed purchases of their home sovereignbonds, but this simply exacerbates the already dangerous nexus between fragile banksand fragile sovereigns. The liquidity crunch of late 2011 has also moderated but couldquickly return. The European Financial Stability Fund (EFSF) could not sell some ofan 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 beenfalling 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 withouttriggering the CDS. This would have shown that the ‘insurance’ provided by CDSs isnot insurance after all. Although eventually the swaps were triggered, the markets arestill very uneasy.There are bits of good news: ECB monetary policy is still ‘credible’, on the evidenceof market inflation expectations (2.02% at a five-year horizon, 2.22% at a ten-yearhorizon, as at 4 April 2012). The underlying bad news there, however, is that theECB interest rates have been too high and are still too high despite the cut of 50 basispoints in December 2011. The technocratic prime ministers in Greece and Italy arevery experienced, very able, and fully conscious of what their countries must do torestart economic growth. That said, they are not elected politicians, and their legitimacyand authority may be correspondingly limited. Since the necessary measures wouldbe painful and challenging even with a popular mandate, one may question whethertechnocratic governments can carry them out. Resistance in both countries is verystrong.For the countries at the heart of the crisis but the geographical periphery of theEurozone, the sources of their predicaments are varied. Importantly, they are notprimarily due to membership of the single currency, nor to fiscal profligacy. Greece36

The Eurozone crisis – April 2012is of course an exception to the latter generalisation, because its fiscal excesses wereboth large and duplicitous, partly hidden from the statisticians. But its problems aredue also to major structural weaknesses, especially of its institutions 2 ; extreme politicalpolarisation; and reckless (for the lenders as well as borrowers) capital inflows that foryears 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 housingprice bubble) fed by equally reckless capital inflows through its banks into propertydevelopment and mortgage finance, lubricated by crony capitalism. The original sinwhich has led Ireland to its penance was not, however, this process itself but rather thegovernment guarantee of the bank debts thereby incurred. In a stroke, this socialisationof private debt transformed a country with one of the lowest ratios of public debt toGDP into one with an exceptionally high debt ratio.Spain too had its housing boom and capital inflow into construction. These wereexacerbated by the foolish behaviour of the politically influenced regional banks,the cajas, which fell into deep difficulties when the bubble burst. Portugal has manyeconomic ills: poor education, an uncompetitive production structure, product andlabour market rigidities. But its primary mistake was not to use the very large capitalinflow during the pre-crisis decade to modernise the economy.Three of these four countries (the GIPS) had sound fiscal positions but from 2003–04onwards were running large current-account deficits within the monetary union; Greecealso had a big current-account deficit. These were financed by equally large capitalflows from the surplus countries, especially Germany – a capital flow ‘bonanza’ 3 forthe periphery, with the usual consequences. In particular, much of the funds went intoreal-estate purchase and development. This raised the relative price of non-traded goodsand pulled resources out of tradeables. The Eurozone as a whole ran a balanced current2 Jacobides et al (2011).3 Reinhart and Reinhart (2008).37

Rethinking Global Economic Governance in Light of the Crisisaccount with the rest of the world – the imbalances were internal. Germany played thesame 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 theinvestment share during 2000–07 (the investment share fell slightly in Portugal). Andunlike 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 consequenceof the financial crisis in bank-based financial systems. Creditor countries have beenunwilling to let their banks suffer the consequences of bad loans – rather, they havemanaged to put the entire burden on the taxpayers of the debtor countries. This mayseem clever, but it is short-sighted, not to say hypocritical. It also disregards the EU andEurozone financial integration that policymakers have promoted – using an Americananalogy, should Delaware, where Citibank is incorporated, be responsible for Citibank’sliabilities?The result is that Greece is insolvent, Ireland’s debt is also excessive and should berestructured 4 , and Portugal’s IMF programme is not feasible. Spain and Italy, however,are solvent, if financial markets return to normal conditions and both countries carryout appropriate macroeconomic and structural policies. But Italy and Spain are underpressure from the markets. They fear that Spanish banks will suffer further from badreal-estate loans, and the state will have to bail them out. Italian political instabilityand irresolution has reinforced contagion from the weaker countries, and Italy too mayenter 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, anddebt service begins to look unsustainable despite the primary balance. The marketshave also been losing confidence in French banks, despite the protestations of healthfrom the banks and their regulators; this has now calmed, but that may be temporary.4 Portes (2011).38

The Eurozone crisis – April 2012Common to all these cases is an interconnected sovereign and banking crisis: the bankshold large amounts of sovereign debt that has become questionable, and the sovereignsare questioned because of the danger that they will have to rescue their banks.So we have the ‘doom loops’ represented in this useful diagram 5 and exacerbated byelements of Fisherian debt deflation:Figure 1. The European Peripherals CrisisBankSolvencyConcernsTighterFCIBailoutCostsHigher GovernmentBond YieldsHigher DebtServiceDefaultWorriesMore Banking/Financial StrainsNegativeWealth EffectLowerCorporateProfitsCreditLossesCalls for FiscalTighteningHigher GovernmentDebt/GDP RatioLower TaxReceiptsReducedLoanSupplyDeeperRecessionLowerNominal GDPThe euro (monetary union) is not the cause of this crisis, although the ECB’sinterpretation 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 country5 Goldman Sachs (2011) Global Economics Weekly 11/38, November.39

Rethinking Global Economic Governance in Light of the Crisiscould default on its debt. The agreement of 21 July 2011 to restructure Greek debtwas, of course, recognition of default, regardless of whether the restructuring wouldbe ‘voluntary’ or not. The ECB told Ireland in autumn 2008 (backed by the threat ofwithdrawal of repo facilities) that it was not allowed to consider debt default. Whereelse in the world can a central bank tell a government what it can or cannot do in fiscalmatters?Politicians share responsibility, however, with their indecision and endlessly repeated‘too little, too late’ measures – such as the agreement of 21 July 2011, which wasrecognised only three months later to be wholly inadequate. Moreover, the FrenchPresident and German Chancellor have made two egregious errors with disastrousimpact on the markets: the Deauville statement of October 2010 that introduced inan ill-considered manner the possibility of private sector involvement in dealing withEurozone country debt; and the Cannes statement a year later that explicitly proposedthat an EMU member country could exit the euro. There is no legal basis for this 6 , andit had been regarded as a taboo. Some have drawn an analogy with the statement bythe President of the Bundesbank in early September 1992 that “devaluations cannot beruled out” in the EMS – which was followed immediately by the exit of Italy and theUK.Several ways out have been proposed. If the banks’ capital is inadequate, then theyshould be recapitalised. But with what external funding, if government participation isexcluded? Part of the problem is that the markets have been denying even short-termfunding to the banks. Consequently, the banks are deleveraging by selling assets andnot rolling over loans, with dangerous consequences worldwide. At one point, therewas talk of expanding or ‘leveraging’ the EFSF. But non-euro countries would notcontribute, leveraging through borrowing from the ECB is not allowed, and Eurozonecountries simply do not want to put up more funds.6 See W Munchau (2012), Financial Times, 9 April.40

The Eurozone crisis – April 2012The extreme way out is to get out: might an exit of Greece from the Eurozone end theinstability? No, for it would immediately lead to devastating bank runs in all countriesthat might conceivably be thought candidates to follow Greece. What firm or householdin Portugal, Ireland, Spain, Cyprus, would not seek to avoid even a low probabilitythat its bank deposits might be devalued overnight? The likely outcome would bemultiple exits, quite possibly the breakup of the monetary union. And that would bedisastrous not only for the exiting ‘weak’ countries but also for those that would thensuffer massive exchange-rate appreciation and the economic dislocation consequent onmassive contract uncertainty. The various plans for exit or Eurozone breakup are alldeeply 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 alternativelyregard this as a form of quantitative easing.) This does come within the MaastrichtTreaty mandate:In accordance with Article 105(1) of this Treaty, the primary objectiveof the ESCB shall be to maintain price stability. Without prejudice to theobjective of price stability, it shall support the general economic policies inthe Community…5. The ESCB shall contribute to the smooth conduct of policies pursuedby the competent authorities relating to the prudential supervision of creditinstitutions and the stability of the financial system.Treaty of Maastricht (1992), Article 2 and Protocols Art. 105.5 (numberingchanges in Lisbon Treaty, but no change in text)It would not violate the ‘no bailout clause’ (which does, however, exclude ECBpurchases of Eurozone sovereign debt on the primary market). And in fact, the ECBhas been purchasing member state bonds on the secondary market since May 2010,without any successful legal challenge.41

Rethinking Global Economic Governance in Light of the CrisisTo stop self-fulfilling confidence crises, therefore, the ECB should commit to cap yieldspaid by solvent countries with unlimited purchases in the secondary markets. Arbitragewill then bring primary issue yields down to the capped level. Note ‘solvent’: the thenGovernor of the Bundesbank was right to oppose such purchases for Greece in May2010, 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 ECBis that of moral hazard: it clearly views ‘market discipline’ as the only way to bringabout the macroeconomic policies it favours. The evidence? Berlusconi’s departure andreplacement by Monti; and a technocratic government in Greece led by the formerECB Vice-President, willing to accept the harsh austerity policies demanded by theIMF-ECB-EC troika. Financial market pressures have been consciously used to drivegovernments to implement austerity and reforms.Thus the ECB does only ad hoc government debt purchases under its Secondary MarketProgramme, in the guise of ‘normalising the monetary transmission mechanism’ that isimpaired by debt-market instability. Even those have ceased, for the time being. This isa version of the ‘constructive ambiguity’ beloved of central bankers – but in this case,it is manifestly destructive rather than constructive. The piecemeal approach, actingonly under pressure and with delay, has proved very costly. In effect, the ECB hasbeen playing a game of ‘chicken’ with the politicians and the markets. It is particularlydangerous both because there are three players, of which two have no single decisionmaker;and because the parameters defining the game are not well defined, since no onecan tell when a vicious spiral may turn into an overwhelming confidence crisis that theauthorities 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 onlyway to preserve the monetary union. And the ECB would also need to receive explicit42

The Eurozone crisis – April 2012indemnities (guarantees) from Finance Ministers of the 17 against capital losses thebank might incur on its sovereign bond purchases. Both the US Federal Reserve and theBank of England have received such indemnities in respect of their quantitative easingprogrammes.When that guarantee has been secured, the ECB should make an expectations-changingannouncement of the new policy, just as the Swiss National Bank did when it movedto cap the value of the Swiss franc. As that example shows, it is highly likely that if thecommitment were made, the markets would recognise that betting against the bonds(a speculative attack) could not succeed, because the ECB would then have unlimitedcapacity 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 plansfor fiscal stability and integration, as well as by the issue of Eurobonds (issued at theEurozone 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 majorcountries 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: fiscalcontraction is contractionary 7 . The evidence accumulates daily, for the UK as well as forEurozone countries. The only counterexample is that of Ireland in the 1980s. But this isa 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 anexceptionally favourable environment for foreign direct investment; and exploiting awell-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, but7 Guajardo et al (2011)43

Rethinking Global Economic Governance in Light of the Crisisrather a major part of the problem. They are driving the Eurozone into a new recession. 8The debt of several Eurozone countries is not sustainable if they contract.Moreover, fiscal contraction together with private-sector deleveraging is not feasiblewithout a current-account surplus. We teach this in first-year macroeconomics:CA = (S p– I p) + (T – G)The current account must equal the sum of private-sector net saving and governmentnet saving. In the Eurozone, the surplus countries are those with the most ‘fiscalspace’. There will be no exit from the current debt traps and stagnation unless thesurplus countries are willing to accept that they must allow the others to expand. Thisrequires that they either relax their fiscal policy or adopt other policies that will reduceprivate net savings. The overall position would improve if the euro were to depreciatesignificantly – another reason for further monetary easing. But that is true for the USand Japan as well. 9The LTRO was an inspired move to bypass German objections to the ECB taking on theLLR role. But it is a temporary expedient. There is no evident exit strategy, even thoughthe President of the Bundesbank is calling for exit much sooner than the specified threeyearhorizon. Moreover, channelling funding to the banks and relying on them to buysovereign bonds simply raises the weight of those bonds in their assets and worsens theunhealthy interdependence between banks and sovereigns. 10 And it reduces the pressureon the banks to rationalise their portfolios and improve their business models.Germany and France have benefited greatly from the single currency over its firstdecade. Their business communities see this. One must still hope that the core Eurozonecountries will eventually act in their own best interests. The global financial crisis need8 See http://eurocoin.cepr.org/ , where the Eurocoin coincident indicator has been firmly in negative territory over the pastseveral months.9 This is not to say that ‘competitive quantitative easing’ at the zero lower bound for interest rates will be ineffective or‘beggar-thy-neighbour’ policies – see Portes (2012).10 See De Grauwe (2012) and Wyplosz (2012).44

The Eurozone crisis – April 2012not lead to the demise of the single currency through a Eurozone crisis. This crisis couldbe resolved successfully if policymakers were to change course.ReferencesDe Grauwe, P (2012), “How not to be a lender of last resort”, CEPS Commentary 23March.Goldman Sachs (2011), Global Economics Weekly 11/38, November.Guajardo, J, D Leigh, and A Pescatori (2011) “Expansionary austerity: new internationalevidence”, IMF Working Paper 11/158.Jacobides, M, R Portes, and D Vayanos (2011), “Greece: the way forward”, WhitePaper, 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 theEurozone”, 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 Paper6996, October.Wyplosz, C (2012), ‘The ECB’s trillion-euro bet’, VoxEU.org 13 February45

Rethinking Global Economic Governance in Light of the CrisisAbout the authorRichard Portes, Professor of Economics at London Business School, is Founder andPresident of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes atthe Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairmanof the Board of Economic Policy. He is a Fellow of the Econometric Society and ofthe British Academy. He is a member of the Group of Economic Policy Advisers tothe President of the European Commission, of the Steering Committee of the Euro50Group, and of the Bellagio Group on the International Economy. Professor Portes was aRhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton,Harvard, and Birkbeck College (University of London). He has been DistinguishedGlobal Visiting Professor at the Haas Business School, University of California,Berkeley, and Joel Stern Visiting Professor of International Finance at ColumbiaBusiness School. His current research interests include international macroeconomics,international finance, European bond markets and European integration. He has writtenextensively on globalisation, sovereign borrowing and debt, European monetary issues,European financial markets, international capital flows, centrally planned economiesand transition, macroeconomic disequilibrium, and European integration.46

The Triffin Dilemma and a multipolarinternational reserve systemRichard PortesLondon Business School and CEPRExplanations of the breakdown of the Bretton Woods exchange-rate system oftenrefer to the Triffin Dilemma. Recently, proposals for a multipolar reserve system haveinvoked a supposed new form of the Triffin Dilemma (Farhi et al 2011), as a reason formoving towards a multipolar reserve system. But the Triffin Dilemma did not describethe problems of the international monetary system in the late 1960s, and it does notdescribe the present-day problems of that system. The world will move towards amultipolar reserve system, but for reasons unrelated to the Triffin Dilemma.1 Triffin Dilemma definitionsThere are at least two rather different formulations of the Triffin Dilemma in recentdiscussions. The definition that is perhaps closer to what Triffin had in mind is thatincreasing demand for reserve assets strains the ability of the issuer to supply sufficientamounts while still credibly guaranteeing or stabilising the asset’s value in terms of anacceptable numéraire (see Obstfeld 2011 as well as Farhi et al 2011). An alternativeperspective from a policymaker is that the dilemma is founded on a tension betweenshort-run policy incentives in reserve-issuing and reserve-holding countries, on the onehand, and the long-run stability of the international financial system on the other hand(Bini Smaghi 2011).47

Rethinking Global Economic Governance in Light of the Crisis2 The Triffin Dilemma of the 1960sA dilemma is a difficult choice between alternatives. The first posited that the USwould stop providing more dollar balances for international finance. In that case, tradewould stagnate and there would be a deflationary bias in the global economy – a globalliquidity shortage. The second was that the United States would continue to providemore of the international reserve currency, leading ultimately to a loss of confidence inthe dollar, as US obligations to ‘redeem’ foreign holdings with gold would be seen tobe unsustainable.Some writers have identified the second alternative with continued US current-accountdeficits. But this is not correct, either empirically or conceptually.3 Another interpretation of the 1960sThe US current account was actually in surplus throughout the 1960s. Moreover, muchof the growth of dollar reserves from 1955 onwards was driven by foreign demand formoney (recall the ‘dollar shortage’ of the late 1940s and early 1950s) and posed nothreat 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 worldbanker (see also Gourinchas and Rey 2007). It borrowed short (issuing riskless assets)and lent long (buying risky assets). The source of the dollar balances accumulatedabroad was net capital outflows, not current-account deficits.More generally, “current accounts tell us little about the role a country plays ininternational borrowing, lending, and financial intermediation…” (Borio and Disyatat2011). 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 supplyingfinancial intermediation to a Europe whose financial system was still incapableof providing that intermediation itself. The lack of ‘confidence’, they suggested,48

The Triffin Dilemma and a multipolar international reserve systemreflected a failure to understand this intermediary role. Hence, they argued, there wasa straightforward policy response: develop and integrate foreign capital markets, whileseeking to moderate foreign asset holders’ insistence on liquidity. This minority viewof 1966 was the correct one. It was put forward in the same year in which ValeryGiscard d’Estaing spoke of the ‘exorbitant privilege’. It resonates with today’s policydiscussions 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 theUS would maintain a stable value of the dollar with appropriate monetary and fiscalpolicies. If the US had done that, then dollar holders would have had no incentive todemand gold (Obstfeld 1993) – unless it were to destroy the exorbitant privilege, asperhaps 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 theglobal economy faces a chronic, severe shortage of reserve assets, which are identifiedwith ‘safe assets’ (Caballero 2006). The empirical evidence cited for this shortage is thepersistently low level of real interest rates.There are several formulations of the problem which is supposed to be raised bythe assumed shortage of safe assets. First, excess demand for safe assets leads to adeterioration of the creditworthiness of the safe asset pool – leading up to the 2008financial crisis, we saw a wide range of assets rated at AAA that subsequently wererevealed as very unsafe indeed.Second, the supply of truly safe dollar assets – US Treasuries – rests on the backing ofthe US ‘fiscal capacity’. But that grows only as US GDP grows, and US GDP growsslower than world GDP, which determines the growth of demand for those assets.Hence there must be a growing excess demand for safe assets.49

The Triffin Dilemma and a multipolar international reserve systemKingdom, Norway, and Switzerland are also held in substantial amounts by foreigninvestors. A further critique of the ‘safe asset shortage view’ can be found in Borio andDisyatat (2011).Suppose the US had maintained the fiscal balance it achieved in 1999–2000. The netsupply 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 USTreasuries, then the constraint on the supply of these (reserve) assets would not havebeen US fiscal capacity, but US fiscal rectitude – no Triffin Dilemma, as set out byFarhi et al.And finally, note that it is not clear that the US current-account deficits of the 2000swere due to a demand for additional reserve assets from the rest of the world. Thatdemand could have been met by net private capital outflows, as in the 1960s.5 The policy implicationsThe world will move towards a multipolar reserve system. But this will happen notbecause of the Triffin Dilemma and a shortage of safe assets in the current dollardominatedsystem. It will happen because official reserve holders want to diversifytheir portfolios. (See Papaioannou et al 2006). And the correction of global imbalanceswill promote this.For policymakers, the message is to try to convince surplus countries that reserve assetsare not as safe as they think, so that they reduce their demand for these assets (Chinahas 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 bydoing the opposite of creating more ‘safe assets’ – that is, by raising the risk premiumon the supposedly safe assets, so that countries accumulating reserves cut their demandfor them, shifting their portfolios towards other assets (for example sovereign wealth51

Rethinking Global Economic Governance in Light of the Crisisfunds). (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 willdevelop their domestic financial markets and will have less need for foreign financialintermediation (cf. Despres et al). Some emerging-market countries may themselvesbecome reserve suppliers. And the development of more international facilities centredon the IMF could reduce the demand for reserves for self-insurance (Farhi et al).Considering the Triffin Dilemma undoubtedly helps us to understand the forcesunderlying the development of the international financial system. But it is not thesource of the system’s present-day problems.Author’s note: This essay is based on my contribution to the conference “TheInternational Monetary System: sustainability and reform proposals” held in Brusselson 3–4 October 2011, to commemorate the 100 th anniversary of the birth of RobertTriffin. I am grateful for comments from Maurice Obstfeld. I am also indebted toTommaso Padoa Schioppa for many discussions of these issues over 25 years and toHélène Rey for more recent extended discussions – even though, in both cases, wesometimes had to agree to disagree, as will be evident from the text.52

The Triffin Dilemma and a multipolar international reserve systemReferencesAlogoskoufis, G, L Papademos, and R Portes (1991), External Constraints onMacroeconomic 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 nolink?”, BIS Working Paper 346.Caballero, R (2006), “On the macroeconomics of asset shortages”, NBER WorkingPaper 12753.Despres, E, C Kindleberger, and W Salant (1966), “The dollar and world liquidity: aminority view”, The Economist, 6 February.Farhi, E, P-O Gourinchas, and H Rey (2011), Reforming the International MonetarySystem, CEPR eBook, French version published by Conseil d’Analyse Economique.Goodhart, C A E (2011), “Global macroeconomic and financial supervision: wherenext?”, 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 CurrentAccount Imbalances: Sustainability and Adjustment, Chicago: University of ChicagoPress for NBER.Mendoza, E, and J Ostry (2008), “International evidence on fiscal solvency: Is fiscalpolicy ‘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 ChicagoPress for NBER.53

Rethinking Global Economic Governance in Light of the CrisisObstfeld, 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 inInternational 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 forEconomic Policy Research.54

The Triffin Dilemma and a multipolar international reserve systemAbout the authorRichard Portes, Professor of Economics at London Business School, is Founder andPresident of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes atthe Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairmanof the Board of Economic Policy. He is a Fellow of the Econometric Society and ofthe British Academy. He is a member of the Group of Economic Policy Advisers tothe President of the European Commission, of the Steering Committee of the Euro50Group, and of the Bellagio Group on the International Economy. Professor Portes was aRhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton,Harvard, and Birkbeck College (University of London). He has been DistinguishedGlobal Visiting Professor at the Haas Business School, University of California,Berkeley, and Joel Stern Visiting Professor of International Finance at ColumbiaBusiness School. His current research interests include international macroeconomics,international finance, European bond markets and European integration. He has writtenextensively on globalisation, sovereign borrowing and debt, European monetary issues,European financial markets, international capital flows, centrally planned economiesand transition, macroeconomic disequilibrium, and European integration.55

Financial stability: Where it went andfrom whence it might returnGeoffery UnderhillUniversity of AmsterdamThe global crisis which has been ricocheting around the global economy since late2007 seems to have undermined, perhaps even destroyed, the traditional foundationsfor financial stability in the US and Europe. This chapter focuses on recommendationsfor the provision of financial stability, and in doing so builds some bridges between twoof the PEGGED themes – financial stability and macroeconomic governance. Thereare three essential points to be drawn from the range of research findings from thePEGGED 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 ahost of historical experience and literature to draw upon going forward.• The potential and more obvious flaws of the pre-crisis system of financial governancewere well-known and debated in the many rounds of reform that precededthe financial collapse. Our analysis reveals that the ideas upon which the reformshave been built remain largely stuck in the pre-crisis mode and are thus unlikely toachieve their goals. Worse, the Eurozone is descending into modes of crisis resolutionthat are known to be dysfunctional and destructive of successful economicgrowth and development.• Reform that is more likely to provide financial stability for the longer run requiresnew ideational departures drawing on established historical experience, considerableinstitutional innovation, a reformed policy process, and institutionalised attentionto the political legitimacy and long-run sustainability of financial opennessglobally and in the EU.57

Rethinking Global Economic Governance in Light of the CrisisThe points are developed more fully in turn.Financial openness: Beneficial but inherently instabilityHistorical experience has shown that financial liberalisation and market integrationproduce benefits, if asymmetric. Theory (Minsky 1982) and historical experience(Bordo et al. 2001) told us financial markets had a strong tendency towards instabilityand crisis. Avoiding persistent market failure requires robust systems of governance atthe level appropriate to the extent of market integration.This implies regional and international institution-building. The dilemmas of suchinstitutional design and the appropriate policy mix have been well-known since the1920s 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 ofliberalisation from the 1980s on, a crisis-reform-crisis cycle only led to the complacencyof the Great Moderation (Helleiner 2010). Financial globalisation was furthermoreknown to be particularly problematic for developing countries (Cassimon et al, 2010,and Ocampo and Griffith-Jones 2010). The institutional and economic weaknesses ofthe European monetary union were likewise well-known and exhaustively discussed inthe literature (Underhill 2011a).Systemic flaws known before the crisisOur system of debt-crisis workout has long pointed the finger at debtors. IMFprogrammes available to debtors seeking to avoid default to public and private creditorsinvolved a combination of emergency loans, enhancing the debt burden, and structuraladjustment measures. These latter often come with substantial distributional costs forthe borrowing nation, often its poorest citizens. There is substantial evidence that theseprogrammes have too often failed to stimulate economic recovery and growth (Vreeland2003). The argument that structural adjustment leads to a ‘catalytic’ restoration ofprivate investor confidence likewise does not appear to hold (de Jong and van de Veer58

Financial stability: Where it went and from whence it might return2010). The Argentine default in 2001-2 saw the country emerge from crisis as well orbetter 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 ofBasle II in 2004 – relied on self-supervision by large banks. The key tool was internalrisk assessment and attendant controls. In essence, it was a micro approach to riskmanagement based on market price signals, risk ratings and weightings, and a range offinancial ‘governance’ standards.This market-based approach to the financial sector, or “governance light”, was amplycriticised as procyclical and dangerous (Persaud 2000, Ocampo and Griffith-Jones),and it neglected the macroprudential dimensions of systemic risk (Claessens andUnderhill 2010). The system furthermore provided direct competitive advantages to thesame large-bank constituency that had proposed the idea in the first place. Moreover, itinvolved a substantial rise in the cost of capital for poor countries and their populationswho had no access to the decision-making forum (Claessens et al. 2008).The theories and argument pools from which the new policies were drawn becametilted towards particularistic interests; state officials and the private sector came to shareinterests and approaches to governance in a club-like setting (Tsingou 2012). There wasa 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 ideasetson stability of the market skewed as result (Baker 2010). As a result, regulationbackfired. Policies adopted to secure financial stability were those least likely toachieve it! Rather, they provided material advantages to the large financial institutionsthat benefited most from financial liberalisation in the first place.So the 30 years of global financial integration lurched from crisis to skewed reformto crisis once again. Much of the burden of reform was on the emerging markets anddeveloping countries that experienced crises most frequently. Their experience ledthem, particularly after the Asian crisis, to question the market-based approach to59

Rethinking Global Economic Governance in Light of the Crisisfinancial governance and to choose a different path. Most took liberalisation seriously,implementing reforms in their own way (Zhang 2010; Walter 2010) often whileintroducing 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 thechallenge of reform, avoiding the recipe of the advanced financial centres and largelyavoiding 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 largebanks, the underlying market-based approach to financial governance and supervisionhas not changed (Underhill 2012). There are still many reforms in the pipeline, but ifthey 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 approachaimed at better management of the systemic dimensions of risk. Yet it is not at all clearthat there is yet a coherent set of ideas, least of all concrete measures. Successfullyoperationalising macroprudential oversight requires institutional innovations acrossnational and international levels to “join the dots” among policy domains. Until now,such domains have been treated all too separately, for example:• Global imbalances and macroeconomic adjustment.• Monetary policy in relation to asset markets.• Multilateral surveillance mechanisms.• Debt loads (public and private).• Financial system monitoring.• Firm-level risk management.60

Rethinking Global Economic Governance in Light of the Crisisand other forms of compensation for the vulnerable (Burgoon et al. 2012). Centre-leftparties in stable democracies have often sponsored financial liberalisation traded offagainst a functioning health care and welfare system. Developing countries that receivecompensation in the form of international aid flows also support financial opennessmore readily. Nurturing these underpinnings of open finance requires the very policyspace that recession and austerity based workouts are closing down.Meanwhile, electorates are rebelling against solutions that “pool” sovereignty just asmarket integration makes national policy less effective. The risk is that failure to thinksystematically about the emerging legitimacy deficit could lead to a rapid politicalradicalisation.Centrifugal populist political forces have already been generated by the process,sometimes deliberately by politicians but more often by the nature of the solutionsdeveloped. This context will continue to aggravate the difficulties of reaching workablesolutions to governing Eurozone or global finance and may call into question theinstitutional and ideational plumbing of the system: the benefits of openness, theautonomy of regulatory of agencies and central banks, and eventually the ability ofstates to cooperate to reform financial governance.In short, we need a financial system and Eurozone that not only saves banks, but alsocitizens!ReferencesBaker, Andrew (2010). “Deliberative international financial governance and apexpolicy forums: where we are and where we should be headed”, in G Underhill, J Blomand D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform toCrisis, Cambridge University Press.Bordo, M, B Eichengreen, D Klingebiel and M. Martinez-Peria (2001), “Is the crisisproblem growing more severe?” Economic Policy 16(32), 51-82.62

Financial stability: Where it went and from whence it might returnBurgoon, B, P Demetriades and G Underhill (2012), “Sources and Legitimacy ofFinancial Liberalisation,” European Journal of Political Economy 28(2), 147-161.Cassimon, Danny, Panicos Demetriades and Björn Van Campenhout (2010).Finance,globalisation and economic development: the role of institutions, in Global FinancialIntegration Thirty Years On. From Reform to Crisis, Underhill, Blom and Mügge (eds.),Cambridge University Press.Claessens, S, G Underhill and X Zhang (2008), “The Political Economy of Basle II: thecosts for poor countries”, The World Economy 31(3), 313-344.Claessens, Stijn and Geoffrey R. D. Underhill (2010). The political economy of BaselII in the international financial architecture in G Underhill, J Blom and D Mügge (eds.)Global Financial Integration Thirty Years On. From Reform to Crisis, CambridgeUniversity Press.De Jong, Eelke and Koen van der Veer (2010). The catalytic approach to debt workoutin 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 YearsOn. From Reform to Crisis, Cambridge University Press.Dieter, Heribert (2010). Monetary and financial co-operation in Asia: improvinglegitimacy and effectiveness in G Underhill, J Blom and D Mügge (eds.) GlobalFinancial Integration Thirty Years On. From Reform to Crisis, Cambridge UniversityPress.Germain, R (2010), “Financial governance in historical perspective: lessons from the1920s”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration ThirtyYears On. From Reform to Crisis, Cambridge University Press.Helleiner, Eric and Stefano Pagliari (2010). “Between the storms: patterns in globalfinancial governance 2001–7”, in G Underhill, J Blom and D Mügge (eds.) Global63

Rethinking Global Economic Governance in Light of the CrisisFinancial Integration Thirty Years On. From Reform to Crisis, Cambridge UniversityPress.Klagsbrunn, Victor (2010), “Brazil and Argentina in the global financial system:contrasting approaches to development and foreign debt”, in G Underhill, J Blom andD Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis,Cambridge University Press.Leijonhufvud, Axel (2011), “Shell game: Zero-interest policies as hidden subsidies tobank”, VoxEU.org column, 25 January 2011.Minsky, H (1982), “The Financial-Instability Hypothesis: Capitalist processes and thebehaviour of the economy,” in Kindleberger and Laffargue (eds.), Financial Crises:theory, history, and policy, New York: Cambridge University Press.Ocampo, José and Stephany Griffith-Jones (2010). “Combating procyclicality inthe international financial architecture: towards development-friendly financialgovernance” in G Underhill, J Blom and D Mügge (eds.) Global Financial IntegrationThirty Years On. From Reform to Crisis, Cambridge University Press.Persaud, A. (2000), “Sending the Herd Off the Cliff Edge,” The Journal of Risk Finance2(1), 59 –65.Tsingou, E (2012), “Club Model Politics and Global Financial Governance: the case ofthe Group of Thirty”, (unpublished PhD Thesis, University of Amsterdam).Underhill, G. (2010), “Theory and the Market after the Crisis: the Endogeneity ofFinancial Governance,” CEPR Discussion Paper CEPR-DP8164, DecemberUnderhill, G. (2011) Reforming global finance: Coping better with the pitfalls offinancial innovation and market-based supervision, PEGGED Policy Paper, December2011, available online at http://pegged.cepr.org/index.php?q=node/389.64

Financial stability: Where it went and from whence it might returnUnderhill, G. (2011a) “Paved with Good Intentions: Global Financial Integration, theEurozone, and the Hellish Road to the Fabled Gold Standard,” in D.H. Claes and C. H.Knutsen (eds.), Governing the Global Economy: Politics, Institutions and Development,Routledge , 110-130.Underhill, G. (2012), The Emerging Post-Crisis Financial Architecture: the pathdependencyof ideational adverse selection,” Paper presented to the annual JointSessions of the European Consortium for Political Research, University of Antwerp,10-15 April.Underhill, G and J Blom (2012), “The International financial Architecture: plus cachange…,” in R Mayntz (ed.), Crisis and Control: Institutional change in FinancialMarket Regulation, Campus Verlag/MPifG Social Science Series.Underhill, G, J Blom and D Mügge (eds.) (2010), Global Financial Integration ThirtyYears On. From Reform to Crisis, Cambridge University Press.Underhill, G and X Zhang (2008), “Setting the Rules: Private Power, PoliticalUnderpinnings, and Legitimacy in Global Monetary and Financial Governance,”International Affairs 84(3), 535-554.Vreeland, James R (2003), The IMF and Economic Development, Cambridge UniversityPress.Walter, Andrew (2010), “Assessing the Current Financial Architecture (How Well Doesit Work?”, in G Underhill, J Blom and D Mügge (eds.) Global Financial IntegrationThirty Years On. From Reform to Crisis, Cambridge University Press.Zhang, Xiaoke (2010), “Global markets, national alliances and financial transformationsin East Asia”, in G Underhill, J Blom and D Mügge (eds.) Global Financial IntegrationThirty Years On. From Reform to Crisis, Cambridge University Press.65

Rethinking Global Economic Governance in Light of the CrisisAbout the authorGeoffrey Underhill is Chair of International Governance is a political economist whoworks closely and co-authors with economists and political scientists alike. He is aspecialist on the financial governance, macroeconomic adjustment and governance, andinternational trade work packages, and will work with Burgoon on the issue of thesustainability and legitimacy of (trade and financial) liberalisation.66

The crisis and the future of thebanking industryXavier FreixasUniversitat Pompeu Fabra and CEPRThe global economic crisis – which has been unfolding in various forms since thesubprime bubble burst in late 2007 – has come at a high social and economic cost. Ithas also shattered confidence in US and European banking systems and questioned thecapacity of financial markets to channel resources to their best use.After all, financial industry investments have proven ex post to be excessively riskyand the generally accepted view is that their risks were not ex ante sound. The listof examples includes the subprime mortgages in the US and mortgages to marketscharacterised by real estate bubbles in Europe.The regulatory reforms that have taken place since the beginning of the crisis haveintended, among other objectives, to curtail this excessive appetite for risk. Yet, forregulation to prevent future crises, one must know what caused the excessive risktakingin the first place.What is excessive risk-taking?To explore its causes, the first step is to give a more precise definition of ‘excessiverisk-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 havemade the net present value of the bank’s investment project negative.1 This draws heavily on the Introductory chapter in Dewatripont and Freixas (2012) written by the two editors.67

Rethinking Global Economic Governance in Light of the CrisisThis view of ‘excessive risk-taking’ has the advantage of preserving the option for banksto invest in high-risk ventures provided they result in a corresponding high return anddo not jeopardise the continuity of the bank as a going concern. It does not emphasisefinancial institutions’ possibly overoptimistic expectations but rather the risk-adjustedcost 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 inthe banking industry supported by a tradition of bailouts by the Treasury where evenuninsured 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 lendingexcessively permissive in upturns with the opposite holding in downturns);• Failure of regulatory supervision and market discipline to curb excesses in boomtimes;• Moral hazard, whereby banks take too much risk in anticipation of being bailed outin the event of massive losses.Findings and analysisFirst of all, excessive risk-taking is directly related to corporate governance. 2 Thedecisions a bank takes regarding risk levels are ultimately the responsibility of managersand boards of directors. Whether in their strategic decisions managers consider theirown bonuses, short-term stock price movements, shareholders’ short-run interests(rather than stakeholders’ long-run ones) or simply the financial institution’s culture ofrisk, these are all decisions that are substantiated by the board and therefore result fromthe structure of financial institutions’ corporate governance.2 For details, see Mehran et al (2012).68

The crisis and the future of the banking industryMehran et al (2012) argue that corporate governance may be especially weak due to themultiplicity of stakeholders (insured and uninsured depositors, the deposit insurancecompany, bond holders, subordinate debt holders, and hybrid securities holders), andthe complexity of banks’ operations. Moreover the moral hazard created by the toobig-to-failsituation may have led boards to encourage risk-taking as they knew that biglosses would be paid largely by taxpayers rather than stakeholders.Second, the issue of excessive risk-taking may also be related to managers’ andshareholders’ understatement of the business cycle risk of downturn, as the procyclicalityof capital may lead to excessive lending, the emergence of bubbles and a financialaccelerator effect. 3 The fact that banks did not have enough capital once the crisisunravelled is not only a failure of the Basel II regulatory framework and the models itis based on, but also evidence of how critical the issue of procyclicality is for financialstability. The regulatory proposal of Basel III on countercyclical buffers is intendedto solve this issue. Still, rigorous analysis of the procyclicality of banks’ capital mayindicate that the issue is more complicated than it seems.Repullo and Saurina (2012) focus on one aspect of this, namely the question of whetherand how much additional capital should be required during excessive credit growthphases, and how these excessive credit growth phases are to be identified. They studyhow the Basel III regulatory framework proposes to tackle the issue and the extent towhich the rules accomplish their objectives.The Basel III countercyclical provisions require higher capital-loan ratios when thecredit-to-GDP ratio deviates from its trend. Their analysis, however, shows this worksthe wrong way for a majority of nations; the deviations are negatively correlated withGDP growth. In short, banks that follow the deviation from trend rule may actually bepursuing a procyclical rather than a countercyclic capital policy. The authors propose asimpler rule – the credit growth rate.3 For details, see Repullo and Saurina (2012).69

Rethinking Global Economic Governance in Light of the CrisisThird, it may be argued that the curtailing of excessive risk-taking was the jointresponsibility of supervision and market discipline, and that neither did a proper job. 4Theoretically both firms and gatekeepers are supposed to provide accurate informationto the market and to supervisory agencies. This information transmission issue has beena key one in the analysis of the crisis, as it has been argued that it was the opacity ofsome 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 beenstated that the use of fair-value accounting by banks aggravated the crisis. So it isclearly important to assess to what extent these claims are valid.The market’s main sources of information are firms’ financial reports and credit ratingagencies. Freixas and Laux (2012) address a number of reproaches levelled at thesesources. On the financial reporting, the use of fair-value analysis has come in for strongcriticisms as it caused firms to write down asset falls as the markets collapsed, with thisleading to eroded capital and heightened uncertainty. The authors, however, argue thatfair value is not much to blame as it only affects banks’ trading portfolios and there issubstantial 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 theseprofit-maximising firms are in an institutional setting that inadequately deals withconflicts of interests. They call for more regulation of credit rating agencies to redressthis.Fourth, excessive risk-taking may be the result of another form of market disciplineif all banks in distress are to be bailed out. 5 This would, of course, be taken intoaccount by a bank’s managers and board of directors and completely distort the bank’sdecision since, in this case, bankruptcy threats are no longer credible. Consequently,how regulatory agencies and Treasuries organise banks’ resolutions will determinefuture moral hazard. It is therefore worth considering how a bank in distress can be4 Freixas and Laux (2012).5 Freixas and Dewatripont (2012).70

The crisis and the future of the banking industryrestructured in an orderly way, whether it is to be closed or bailed out in such a way asto preserve banks’ incentives and be credible while limiting contagion to other banks.Freixas and Dewatripont (2012) argue that the first objective of regulation is thereforeto reduce the cost of bankruptcies; this is the main focus of the last chapter. Bankingresolution should be thought of as a bargaining game between shareholders andregulators. Shareholders want to maximise the value of their shares while regulatoryauthorities’ main objective is to preserve financial stability at the lowest possible cost.Given this, time plays against the regulatory authority. The authors thus argue forbankruptcy rules that are specially crafted for the banking sector (and different fromthose applying to non-financial corporations).In this game, time is of the essence – even with the perfectly efficient bankruptcyprocedure. Banks in distress should be quickly closed or quickly bailed out. Thechapter’s examination of banking crises in different countries shows great variety inthe procedures followed and concludes that theory has no clear-cut recommendationsto offer.Plainly the design of the bank resolution mechanisms is critical. One proposal is to adda layer of capital to prevent future crises, but the authors defend the possibilities openedby contingent capital and by bail-ins. They argue that these types of mechanisms wouldpreserve the best characteristics of debt and therefore limit moral hazard. The authorsconclude by considering cross-country resolution and the challenges it implies anddiscuss the recent changes in the European banking resolution framework.ReferencesDewatripont, M and X Freixas, eds (2012), The Crisis Aftermath: New RegulatoryParadigms, London: Centre for Economic Policy Research.71

Rethinking Global Economic Governance in Light of the CrisisMehran, H, A Morrison and J Shapiro (2012). “Corporate Governance and Banks: WhatHave 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: ACritical 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”, inDewatripont, 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” inDewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms,London: CEPR.72

The crisis and the future of the banking industryAbout the authorXavier Freixas (Ph D. Toulouse 1978) is Professor at the Universitat Pompeu Fabrain Barcelona (Spain) and Research Fellow at CEPR. He is also Chairman of the RiskBased Regulation Program of the Global Association of Risk Professionals (GARP).He is past president of the European Finance Association and has previously beenDeutsche Bank Professor of European Financial Integration at Oxford University,Houblon Norman Senior Fellow of the Bank of England and Joint Executive DirectorFundación de Estudios de Economía Aplicada FEDEA), 1989-1991, Professor atMontpellier 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, Journalof Political Economy,…).He has been a consultant for the European Investment Bank, the New York Fed, theECB, the World Bank, the Interamerican Development Bank, MEFF and the EuropeanInvestment 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 andthe lender of last resort and the He is well known for his research work in the bankingarea, that has been published in the main journals in the field, as well as for his bookMicroeconomics of banking (MIT Press, 1997), co-authored with Jean-Charles Rochet.73

How to prevent and better handlethe failures of global systemicallyimportant financial institutionsStijn ClaessensIMF, University of Amsterdam, and CEPR1 IntroductionWhen the dust settles and the final numbers are tallied up, it should be of no surpriseif the massive support provided in the (ongoing) crisis to banks and other financialinstitutions – directly in the form of assistance from governments and central banks,and indirectly through support from international organisations, including to sovereignsunder stress – has meant that taxpayers, especially in Europe, have engaged in the largestcross-border transfer of wealth since the Marshall Plan. The crisis has also shown thatthe ad hoc solutions typically used to deal with failed globally systemically importantfinancial institutions (G-SIFIs) 1 lead to much turmoil in international financial marketsand worsen the real economic and social consequences of crises.Importantly, events have made abundantly clear (again) that, for all the efforts investedin the harmonisation of rules and agreements to share more information, supervisorshad little incentive to genuinely cooperate before the crisis and did too little to helpprevent the weaknesses and failures of many G-SIFIs. These facts, together with theongoing turmoil in Europe and elsewhere, remind us of the high costs from not havinga 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 policyefforts are underway (by individual countries, the Basle Committee on Banking1 While it is hard to define exactly what a G-SIFI is, and there can obviously not be a final list, the FSB (2011) lists 29“G-SIFIs” for which certain resolution-related requirements will need to be met by end-2012.75

Rethinking Global Economic Governance in Light of the CrisisSupervision, the Financial Stability Board, the IMF, and others) to strengthen regulatoryand supervisory frameworks, improve the robustness of these institutions, and enhanceactual supervision internationally to prevent distress. At the same time, any approachhas 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 aweak financial institution is (in part) liquidated, closed, broken up, sold, or recapitalised.Specifically, the rules governing who is in charge of the restructuring and liquidationprocess and how losses are allocated when a G-SIFI runs into trouble are crucial. Theendgame strongly affects supervisory incentives and market behaviour long beforedifficulties arise. And the endgame rules affect the time-consistency problem, whetheror not an ad hoc bailout is, ex post, the most efficient solution.As policymakers realise all too well, however, especially in Europe today, approachesto the resolution of G-SIFIs can conflict with three other policy objectives – preservingnational autonomy, fostering cross-border banking and maintaining global financialstability. These three objectives are not always mutually consistent; they create afinancial 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 reviewthree approaches to improving cross-border resolution which address the financialtrilemma head on, acknowledging that solutions are to be found in partly giving upfiscal and legal sovereignty or putting restrictions on cross-border banking.2 Diagnosis of the current problemThe recent financial crisis has had multiple causes, with their relative importance stillbeing debated (for analyses and views, see the financial crisis issues of the Journal ofEconomic Perspectives, Winter and Fall 2010; Winter 2009). One of the (approximate)causes, however, was surely the behaviour of G-SIFIs (Claessens, Herring andSchoenmaker, 2010). In part because of weak oversight, G-SIFIs took too much risk76

Failures of global systemically important financial institutionsbefore the crisis. Moreover, during the crisis, a relatively small group of 30–50 G-SIFIsbecame important causes of financial turmoil and channels for cross-border contagion.Both through direct links, as in the case of interbank exposures, and through otherchannels, such as the affect on asset prices and other financial markets and the threat toessential financial infrastructures (for example, the payments system), their actions andfinancial problems added to the overall real costs of the crisis.Interventions in, and support for, weak G-SIFIs were aggravating the financial turmoiland creating large fiscal and real costs. Many G-SIFIs have been the recipient of muchdirect public support, in the forms of explicit guarantees and official recapitalisation,and other forms of (implicit/indirect) support, such as when G20 governmentsexplicitly announced in the fall of 2008 that they would be protected or when centralbanks provided more ample liquidity. As in other crises, this support has been verycostly and, while often hidden from the public view, has involved large transfersbetween countries. Examples include the payouts made to foreign banks while the USgovernment 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 otherofficial 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 morerobust to shocks and less prone to insolvency (through higher capital adequacy andliquidity requirements and surcharges, and better liability structures). These reforms aredesirable. They can, however, come with some drawbacks in the form of higher costsof 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 partsof the financial system (eg, the shadow banking system), creating new systemic risksin 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 asdeficiencies exist in frameworks for resolving G-SIFIs and as long as resolution is77

Rethinking Global Economic Governance in Light of the Crisisinternationally inconsistent. This view becomes obvious once one considers the state ofinternational financial integration and works backwards from the endgame of resolution.Countries have become increasingly intertwined financially as cross-border claimshave grown much faster than trade and GDP. Much is this is due to a small numberof 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, closeto 1,000 subsidiaries, of which some 70% operate abroad and some 10% in offshorefinancial centres (Claessens, Herring and Schoenmaker, 2010). Complexity not onlymakes many G-SIFIs difficult to manage, but can also cause them to have systemicconsequences. 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 ifa G-SIFI deeply involved in a wide range of countries were permitted to fail, this wouldhave repercussions that would affect financial systems and national economies aroundthe world. Indeed, as noted, many G-SIFIs were supported for this reason. Supportingthem was considered to be, ex post, the most efficient thing to do, given the likelycosts of letting them fail. Those few that did not get support created great havoc ininternational financial markets.What to do going forward when a G-SIFI runs into difficulties and potentially needs tobe 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 anycosts, 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 theneed 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 berectified is not surprising, given its causes.National authorities will have a natural inclination to focus on the impact of a G-SIFIfailure on their domestic systems (ie, to just consider national externalities) and to ignore78

Failures of global systemically important financial institutionsthe wider impact on the global financial system (ie, the cross-border externalities). Thedominance 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 costsassociated with final resolution, are borne by domestic taxpayers. Second, insolvenciesand 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 tocoordination failures, where each national authority only looks after its own interestand 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 trilemmaarises in dealing with G-SIFIs. This financial trilemma (Schoenmaker, 2011) impliesthat three policy objectives – preserving national autonomy, fostering cross-borderbanking 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 sovereigntyor putting restrictions on cross-border banking. So far, countries have not chosen in acoherent manner, leading to problems.The theoretical possibility of coordination failure is born out in practice. In most crossborderbank failures during the recent financial crisis, there was no, or at best partial,coordination, which undermined confidence in the international financial system andincreased the costs borne by domestic taxpayers. The failures of Fortis, Lehman and theIcelandic banks illustrate how damaging the lack of an adequate cross-border resolutionframework can be for global financial stability. The restructuring of many G-SIFIs ona 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) financialstability, and shows the difficulties in achieving coordinated solutions. Only in somecases have authorities reached a cooperative solution, as when they facilitated thecontinuation of Western bank operations in Central and Eastern Europe, with relatively79

Rethinking Global Economic Governance in Light of the Crisisgood outcomes. In the case of Dexia, which appeared for some time to have been agood cooperative solution, the bank ended up being dissolved.3 Possible solutionsTo date, international supervisory efforts have focused on the harmonisation of rulesand increasing supervisory cooperation, while resolution – the endgame – has beenlargely neglected. The crisis shows this approach is wrong. For all the harmonisation,supervisors had little incentive to really cooperate, exchange information and intervene ina coordinated manner. Rather, policymakers addressed most weak financial institutionson their own, often with little regard for international consequences. A better solutionis to start from the endgame, resolution, since who is in charge and how losses areallocated strongly affect incentives and behaviour long before difficulties arise.Most countries, however, lack an effective framework for resolving even purelynational financial institutions. All too often, as in the recent crisis, the endgame isinstead determined under crisis conditions through frantic improvisations over a chaoticweekend, with often no choice but to rescue the institution concerned at great cost. Theinternationally operating SIFIs make this a global problem. While national reforms haveto be the starting point, there are three reform models that can help address the globalproblem. 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-fencedso that they are first available for the resolution of local claims. There is no need forburden-sharing or coordination, as each country manages the resolution of its own partof the cross-border SIFI. This approach creates inefficiencies – a financial institutionhas to manage capital and liquidity separately in each country – and compromises thecross-border integration dimension of the financial trilemma. I reject this approach,given the benefits from and the de facto state of financial integration.80

Failures of global systemically important financial institutionsThe second reform model is a universal approach under which all global assets areshared 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 andPazarbasioglu, 2010), which can further strengthen the incentives for coordination inresolution and supervision. In this model, in terms of the financial trilemma, nationalautonomy is partly given up. This universal approach is probably only feasible anddesirable among closely integrated countries, such as those in the European Union.The third reform model is a modified universal approach, ie, an intermediate approachto address the financial trilemma. The modified universal approach implies thatcountries need to adopt improved and converged resolution rules and require G-SIFIsto have better resolution plans. While not giving up national sovereignty, countries doneed to agree to expand the principles for international supervision and possibly adoptan enhanced set of rules governing cross-border resolutions (as in, say, a new BaselConcordat on ‘Coordination of Supervision and Resolution of Cross-Border Banks’).Of the three approaches to the resolution of G-SIFIs that address the trilemma, theuniversal approach may be feasible, but only among closely integrated countries. Theterritorial approach impedes efficient international financial integration. But followingthe territorial approach is what, in many countries, the local regulators of the differentparts of a G-SIFI are actually required to do . Attention is largely focused on these twooptions, but they represent either end of a spectrum, and neither can work effectivelyin general. More realistic for most countries is a modified universal approach, whichrequires G-SIFIs to put in place effective resolution plans, each country to adoptimproved resolution rules, and countries to jointly adopt a set of rules governing crossborderresolutions that enhance predictability of official actions in a crisis and increasemarket discipline before crisis conditions emerge.For all approaches, there will be a need for a new paradigm in international policycoordination. Efforts should move from a focus on whether national authorities can81

Rethinking Global Economic Governance in Light of the Crisiscooperate in international supervision and resolution, as reflected in the currentharmonisation model, to whether national authorities will cooperate. This will requireadopting a much more incentives-based approach, integrating regulation, supervisionand resolution policies and enshrining them in a new Concordat. With this, the globalfinancial system can become more predictable and safer, resolution in a crisis moreefficient and, through enhanced market discipline, crises less likely.ReferencesClaessens, S., R.J. Herring and D. Schoenmaker (2010), ‘A Safer World FinancialSystem: Improving the Resolution of Systemic Institutions’, Geneva Reports on theWorld 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 BackgroundMaterial G-20 Report (Eds. joint with Michael Keen and Ceyla Pazarbasioglu), IMF,Washington, DC, September.Financial Stability Board (2011), Policy Measures to Address Systemically ImportantFinancial Institutions, November 4.Freixas, X. (2003), “Crisis Management in Europe,” in J. Kremers, D. Schoenmakerand P. Wierts (eds), Financial Supervision in Europe, Cheltenham: Edward Elgar, 102-19.Herring, R.J. and J. Carmassi (2010), “The Corporate Structure of InternationalFinancial Conglomerates: Complexity and Its Implications for Safety and Soundness,”in The Oxford Handbook of Banking, edited by A. Berger, P. Molyneux and J. Wilson.Journal of Economic Perspectives, Symposium Volumes (2010), Winter and Fall;(2009), Winter.82

Failures of global systemically important financial institutionsRodrik, D. (2000), “How Far Will International Economic Integration Go?” Journal ofEconomic Perspectives 14, 177-186.Schoenmaker, D. (2011), ‘The Financial Trilemma’, Economics Letters, 111, 57-59.About the authorStijn Claessens is Assistant Director in the Research Department of the IMF wherehe leads the Financial Studies Division. He is also a Professor of International FinancePolicy 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 theWharton School of the University of Pennsylvania (1986) and M.A. from ErasmusUniversity, Rotterdam (1984). He started his career teaching at New York Universitybusiness school (1987) and then worked earlier for fourteen years at the World Bankin various positions (1987-2001). Prior to his current position, he was Senior Adviserin 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 Asiaand to transition economies. His research has been published in the Journal of FinancialEconomics, Journal of Finance and Quarterly Journal of Economics. He had editedseveral books, including International Financial Contagion (Kluwer 2001), Resolutionof Financial Distress (World Bank Institute 2001), and A Reader in InternationalCorporate Finance (World Bank). He is a fellow of the London-based CEPR.83

Cross-border banking in Europe:Policy challenges in turbulent timesThorsten BeckTilburg University and CEPRThe ongoing sovereign debt crisis in Europe continues to put strain not only onbanks’ balance sheets, but also on the single European banking market. Rather thandisentangling the sovereign debt and bank crises, recent policy decisions might havetied the two even closer together. The use of the additional liquidity provided throughLTROs 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 andself-fulfilling prophecies of sovereign insolvency, there are still no proper mechanismsin 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) inwhich the authors argued that policy reforms in micro- and macro-prudential regulationand macroeconomic policies are needed for Europe to reap the important diversificationand efficiency benefits from cross-border banking, while reducing the risks stemmingfrom large cross-border banks. While the authors finalised this report in April 2011, theorganised default by Greece and the continuing doubts over the debt sustainability ofPortugal and concerns over some other peripheral states have reinforced the messagesin the report. The ongoing crisis has also reinforced regulatory instincts to focus onnational interests and stakeholders when it comes to cross-border banking.85

Rethinking Global Economic Governance in Light of the CrisisHow did we get here?The monetary union was supposed to be the crowning element for a single economicarea, eliminating exchange rate uncertainty and thus further boosting economicexchange across borders and free flows of capital and labour. At the same time, aregulatory framework for cross-border banking within Europe was established. Theintroduction of the euro in 1999 eliminated currency risk and provided a further push forfinancial integration (Kalemli-Ozcan et al 2010). Figure 1 illustrates this trend towardsincreasing importance of cross-border banks across European financial systems.Figure 1. Cross-border banking in the European Union70Share of Foreign Banks60504030201995 1997 1999 2001 2003 2005 2007 2009YearEuropean economiesSource: Claessens and van Horen (2012)European non-transition economiesEuropean transition economiesWhen the 2007 crisis erupted in the US, cross-border banks were an importanttransmission channel. In a financially integrated world, where large shares of assetsare traded on international markets and with high amounts of inter-bank claims acrossborders, the contagion effects were pronounced and immediate, going through directcross-border lending, local lending by subsidiaries of large multinational banks andlower access of local banks to international financing sources. While central banks86

Cross-border banking in Europe: Policy challenges in turbulent timescoordinated well to address the liquidity crisis in the international financial markets,regulators did not coordinate well when it came to dealing with failing financialinstitutions, as became obvious in the cases of the Benelux bank Fortis and the Icelandicbanks. Over time, coordination improved, as was made most obvious by the Viennainitiative (De Haas et al 2012).The benefits and risks of cross-border bankingThe benefits and risks of cross-border banking have been extensively analysed anddiscussed by researchers and policymakers alike. The main stability benefits stem fromdiversification gains; in spite of the Spanish housing crisis, Spain’s large banks remainrelatively solid, given the profitability of their Latin American subsidiaries. Similarly,foreign banks can help reduce funding risks for domestic firms if domestic banksrun into problems. However, the costs might outweigh the diversification benefits ifoutward or inward bank investment is too concentrated. Several central and easternEuropean countries are highly dependent on a few western European banks, and theNordic and Baltic region are relatively interwoven without much diversification. At thesystem level, the EU is poorly diversified and is overexposed to the US (Schoenmakerand Wagner 2011). While regulatory interventions into the structure of cross-borderbanking would be difficult if not counter-productive, a careful monitoring of theseimbalances is called for.There are different market frictions and externalities that call for a special focus ofregulators on cross-border banks. First, cross-border banking increases the similaritiesof banks in different countries and raises their interconnectedness which, in turn, canincrease the risk of systemic failures even though individual bank failures becomeless likely due to diversification benefits (see, eg Wagner 2010). Second, nationalsupervision of cross-border banks gives rise to distortions as shown by Beck, Todorovand Wagner (2011). The home-country regulator will be more reluctant to intervene ina cross-border bank the higher the share of foreign deposits and assets, and more likely87

Rethinking Global Economic Governance in Light of the Crisisto intervene the higher the share of foreign equity. The reason for this is that a higherasset and deposit share outside the area of supervisory responsibility externalises partof the failure costs, while a higher share of foreign equity reduces the incentives toallow the bank to continue, as the benefits are reaped outside the area of supervisoryresponsibility.The crisis of 2008 has clearly shown the deficiencies of both national resolutionframeworks, but especially of cross-border resolution frameworks. In the wake of thecrisis, attempts have been made to address these deficiencies, both on the national andthe European level. Following the de Larosière (2009) report, the European BankingAuthority (EBA) was established to more intensively coordinate micro-regulationissues, while the European Systemic Risk Board (ESRB) is in charge of addressingmacro-prudential issues. Further-reaching reform suggestions, such as creating aEuropean-level supervisor with intervention powers or a European deposit insurancefund with resolution powers modelled after the US FDIC or the Canadian CDIC, wererejected, however, mostly based on arguments of the principle of subsidiarity, nationalsovereignty over taxpayer money that might be needed for resolution of large crossborderbanks, and the need to amend European treaties.Given the biased incentives of national regulators, however, there is a strong casefor a pan-European regulator with the necessary supervisory powers and resources.While different institutional solutions are possible, a European-level framework fordeposit insurance and bank resolution is critical in order to enable swift and effectiveintervention into failing cross-border banks, reduce uncertainty, and strengthen marketdiscipline. 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 resolutionauthorities. In addition, resolution plans for cross-border banks should be developed toallow for an orderly winding down of (parts of) a large systemic financial institution.As large financial institutions have multiple legal entities, interconnected throughintercompany 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 institutions88

Cross-border banking in Europe: Policy challenges in turbulent timesand the liquidation of other parts. In this context, ex ante burden-sharing arrangementsshould be agreed upon to overcome coordination failure between governments in themoment of failure and ineffective ad hoc solutions. By agreeing ex ante on a burdensharingkey, 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 atthe global level, it can only be enforced with a proper legal basis. That can be providedat the EU level, or at the regional level. A first example, albeit legally non-binding, isthe Nordic Baltic scheme.Linking financial and macro-stabilityThe Eurozone crisis is as much a sovereign debt and banking crisis as it is a crisis ofgovernance. As pointed out by many commentators, the aggregate fiscal position ofthe Eurozone is stronger than that of the UK, the US, or Japan. However, the necessaryinstitutions to address macroeconomic imbalances within the Eurozone are missing.While this holds true for many policy areas, most prominently fiscal policy, this hasbecome especially clear in the area of cross-border banking.The crisis has raised fundamental questions on the interaction of monetary andfinancial stability. While the inflation-targeting paradigm treated monetary andfinancial stability as separate goals, with monetary policy aiming at monetary stabilityand micro-prudential policy aiming at financial stability, the crisis has changed thisfundamentally. Inflation targeting was also behind the original Growth and StabilityPact 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 creditbubbles. Examples from the crisis are Spain and Ireland, both of which fulfilled theMaastricht criteria going into the crisis, but experienced real estate bubbles. In thecurrent policy debate, Germany is worried that low interest rates by the ECB, adequate89

Rethinking Global Economic Governance in Light of the Crisisto counter recessionary fears across most of the Eurozone, might fuel an asset bubblein Germany.This calls for the use of macroprudential regulation as additional policy tools. Whilemonetary 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 whereasset price cycles are not completely synchronised across countries. Macroprudentialregulation cannot serve only to counter the risk of asset price bubbles, but also thatof asset concentration and herding. Such regulation would have to be applied on thenational, but monitored on the European level.Another important issue is the close interlinkages between sovereign debt and bankingcrises in the Eurozone. With banks holding a large share of government bonds (andthese bonds constituting a large share of banks’ assets), a sovereign debt restructuringas just happened in Greece leaves banks undercapitalised, if not insolvent. In timesof crisis, incentives to hold government bonds (still considered risk-free thus withno capital charges) increase as the risk profile of real sector claims increases (a trendexacerbated 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 politicalbias towards financial repression to reduce the costs of government debt, with furtherpressure for financial institutions to hold domestic government debt (Kirkegaard andReinhart 2012). This close interaction between banks and sovereigns also influencespolicy stances, such as that of the ECB until late last year when it opposed even anytalk about sovereign debt restructuring as this would prevent it from accepting Greeksovereign 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 creatinga 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 securitieswhose payoffs are the joint payoffs of the bonds in its portfolio. If one member country90

Cross-border banking in Europe: Policy challenges in turbulent timesdefaults or reschedules its debt, this will likewise affect the payoff of these syntheticEurobonds, but in proportion to the overall share in its portfolio. As Greek’s share wouldbe small (it makes up about 2% of Eurozone GDP), its default would not have posed asignificant 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 forbanks’ 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 discussedabove. In the case of a sovereign debt crisis, a formal insolvency procedure should beput in place, while at the same time a better firewall is needed to prevent a liquiditycrisis in sovereign bonds turning into a self-fulfilling solvency crisis.ConclusionsDon’t let a good crisis go to waste! This has been a popular cri de guerre following the2007–08 crisis. Europe, and especially the Eurozone, did too little after the 2007–08crisis to address the institutional gaps in the framework that is needed for (i) a stableEuropean banking market, and (ii) the interlinkages between monetary and financialstability. It has left policymakers with too few policy tools and coordination mechanismsduring the current crisis.Beyond the lack of proper policy tools and mechanisms, the Eurozone faces a deepercrisis – that of a democratic deficit for the necessary reforms to make this monetaryunion sustainable in the long run. Political resistance in both core and peripherycountries against austerity and bailouts illustrates this democratic deficit. In the longterm, 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 thereforms outlined in this column will be significantly easier to implement.91

Rethinking Global Economic Governance in Light of the CrisisReferencesAllen, F, T Beck, E Carletti, P Lane, D Schoenmaker and W Wagner (2011), Crossborderbanking in Europe: implications for financial stability and macroeconomicpolicies, CEPR, London.Beck, T, H Uhlig and W Wagner (2011), “Insulating the financial sector from theEuropean debt crisis: Eurobonds without public guarantees”, VoxEU.org, 17 SeptemberBeck, 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’sfinancial architecture”, VoxEU, 25 October.Claessens, S, and N van Horen (2012), “Foreign Banks: Trends, Impact and FinancialStability”, IMF Working Paper WP/12/10.De Haas, R, Y Konniyenko, E Loukoianova, E and A Pivovarsky (2012) “Foreign banksand the Vienna Iniative turning sinners into saints”, EBRD Working Paper 143.De Larosière (2009), Report of the High-Level Group on Financial Supervision in theEU, Brussels: European Commission.Kalemli-Ozcan, S, E Papaioannou and J Peydró (2010), “What Lies Beneath theEuro’s Effect on Financial Integration? Currency Risk, Legal Harmonization or Trade”,Journal of International Economics 81, 75–88.Kirkegaard, J F and C Reinhart (2012), “Financial Repressions: Then and Now”,VoxEU.org, 26 March.Repullo, R and J Suarez (2012), “The Procyclical Effects of Bank Capital Regulation”,CEMFI mimeo.92

Cross-border banking in Europe: Policy challenges in turbulent timesSchoenmaker, D and W Wagner (2011), “The Impact of Cross-Border Banking onFinancial Stability”, Duisenberg School of Finance, Tinbergen Institute DiscussionPaper, TI 11-054 / DSF 18.Wagner, W (2010), ‘Diversification at Financial Institutions and Systemic Crises’,Journal of Financial Intermediation 19, 272-86.93

Rethinking Global Economic Governance in Light of the CrisisAbout the authorThorsten Beck is Professor of Economics and Chairman of the European BankingCentER at Tilburg University. Before joining Tilburg University in 2008, he workedat the Development Research Group of the World Bank. His research and policy workhas focused on international banking and corporate finance and has been published inJournal of Finance, Journal of Financial Economics, Journal of Monetary Economcisand Journal of Economic Growth. His operational and policy work has focused onSub-Saharan Africa and Latin America. He is also Research Fellow in the Centre forEconomic Policy Research (CEPR) in London and a Fellow in the Center for FinancialStudies in Frankfurt. He studied at Tübingen University, Universidad de Costa Rica,University of Kansas and University of Virginia.94

Credit default swaps in Europe *Richard PortesLondon Business School and CEPRCredit default swaps (CDSs) are derivatives, financial instruments sold over the counter(OTC). They transfer the credit risk associated with corporate or sovereign bonds to athird party, without shifting any other risks associated with such bonds or loans.According to Trade Information Warehouse Reports on OTC Derivatives MarketActivity, the outstanding gross notional value of live positions of CDS contracts stoodat $15 trillion on 31 August 2011 across 2,156,591 trades. The original use of a CDScontract was to provide insurance against unexpected losses due to a default by acorporate or sovereign entity. The debt issuer is known as the reference entity, and adefault or restructuring on the predefined debt contract is known as a credit event. Inthe most general terms, this is a bilateral deal where a ‘protection buyer’ pays a periodicfixed 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 paidper year as a percentage of the notional principal is known as the CDS spread. Mostfeatures of sovereign CDSs are identical to those of corporate ones, except that forsovereigns there may be fewer asymmetries of information among market participants,as most relevant information about the health of the economy and public finances iscommon knowledge.While CDS contracts written on sovereign names accounted for half the size of theCDS market in 1997, in the early 2000s this ratio declined to 7%. The market share of*The discussion here in good part summarises research that is joint with Giorgia Palladini and is available as CEPRDiscussion Paper 8651, “Sovereign CDS and Bond Price Dynamics in the Eurozone”, November 2011, and financedby PEGGED. We used data from CMA for our empirical analysis. But Giorgia Palladini is not responsible for myinterpretations of our results, nor for my assessment of the role of naked CDSs.95

Rethinking Global Economic Governance in Light of the Crisissovereign CDSs dropped to 5% at the end of 2007, with contracts written on emergingeconomies accounting for over 90% of the global volume of trade. Since the Eurozonedebt crisis began, however, the share of sovereign CDSs has risen sharply. At the endof May 2010, the gross notional value of the whole CDS market accounted for $14.5trillion, with about 2.1 million contracts outstanding. The sovereign segment of themarket reached $2.2 trillion, with 0.2 million contracts. Hedge funds, global investmentbanks, and non-resident fund managers seem to be the most active participants in themarket.Before the introduction of credit derivatives, there was no way to isolate credit riskfrom the underlying bond or loan. The CDS market has filled this gap, and it may beregarded as a useful financial innovation, subject to (a) verification that it performsthis function efficiently; (b) assurance that it has not been transformed into a highlyspeculative market in ‘naked CDSs’ that perform no hedging function and serve inparticular merely to make bets on the future of financial firms and sovereigns that candestabilise them. We address these issues in turn.The CDS market has drawn increasing attention from practitioners, regulators, andeven politicians. Yet much of the existing research used data from the early period of themarket’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, becausethe 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 startingin spring 2010 that drove subsequent action by the European Commission and theEuropean Parliament.As Duffie (1999) and related literature point out, a theoretical no-arbitrage conditionbetween the cash and synthetic price of credit risk should drive investment decisionsand tie up the two credit spreads in the long run. Insofar as credit risk is what theyprice, cash and CDS market prices should reflect an equal valuation, in equilibrium. Ifin the short run they are affected by factors other than credit risk, such elements may96

Credit default swaps in Europepartially obscure the comovement between bond yield spreads and CDS premia. Thefirst contribution of our research has therefore been to check the accuracy of credit riskpricing in the CDS market. Does the market perform an important role in providinguseful information to market participants and other observers?We proceed by comparing the theoretically implied CDS premia with the onesestablished by the market. The existence of a stable relationship between the two creditspreads implies a long-run connection between bonds and CDS contracts on the samereference entity, in our case a sovereign. On the one hand, this rules out the possibilitythat credit risk is priced in unrelated ways in the derivative and cash markets. On theother, we cannot discard the hypothesis that large common pricing components ratherthan credit risk affect both prices to some extent.Our research has also addressed the relative efficiency of credit risk pricing in thebond and CDS market. Here we are concerned with the ‘price discovery’ relationshipbetween CDS and bond yield spreads. In particular, can the CDS market anticipate thebond market in pricing, or does it merely adapt to the cash market valuation of creditrisk?Several recent papers study the credit derivative markets. The majority focus on CDScontracts written on corporate bonds 1 , and their data do not cover the past several years,in which the CDS market grew rapidly and then went through the financial crisis. Ofthe few papers devoted to the study of sovereign CDS spreads, most focus on emergingmarkets. We know of only two papers on sovereign credit risk in the European Unionbased on CDS market data. 2 The size of the markets, the intrinsic interest of the recentperiod, and the policy relevance of CDS market performance would seem to justify ourfurther work using a different approach.1 Hull et al (2004) and Blanco et al (2005).2 Arce et al (2011) and Fontana and Scheicher (2010).97

Rethinking Global Economic Governance in Light of the CrisisOur sample period runs from 30 January 2004 through 11 March 2011. The time spancovered by the regression analysis is equal for each country, at the price of using fewerobservations. We restricted our analysis to six countries for which daily estimates offive-year government bond yields are available on DataStream market curve analysis, tomake sure that market data are reasonably comparable. Stored government bond yieldcurves were available for nine EU countries. Among those, CDS quotes for Spain wereavailable 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 areAustria, Belgium, Greece, Ireland, Italy, and Portugal.Our empirical analysis confirms that that the two prices are equal to each other inlong-run equilibrium, as theory predicts. One interpretation is that the derivative marketcorrectly prices credit risk: sovereign CDS contracts written on Eurozone borrowersseem to be able to provide new up-to-date information to the sovereign cash marketduring the period 2004–11. We find, however, that in the short run the cash and syntheticmarkets price credit risk differently to various degrees. Note also that even if the CDSmarket prices credit risk ‘correctly’ in the long run, that does not mean that credit riskas 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 thebond market in price discovery. This goes in line with the results of Zhu (2006), butcontrasts with Ammer and Cai (2011), suggesting that the dynamics for developing anddeveloped 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 developedcountries’ corporate credit risk than to developing economies’ sovereign risk.A second aspect of our empirical work provides information about the dynamicsof adjustment to the long-term equilibrium between sovereign CDS and bond yieldspreads. Deviations from the estimated long-run equilibrium persist longer than ifmarket participants in one market could immediately observe the price in the other,consistent with the hypothesis of imperfections in the arbitrage relationship between98

Credit default swaps in Europethe two markets. Probably due to its liquid nature, the Eurozone CDS market seemsto move ahead of the corresponding bond market in price adjustment, both before andduring the crisis.There is an alternative causal interpretation of our results. The CDS market may leadin price discovery because changes in CDS prices affect the fundamentals driving theprices of the underlying bonds. If the CDS spread affects the cost of funding of thesovereign (or corporate), then a rise in the spread will not merely signal but will cause adeterioration 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 channelit into collateral to support speculative positions. The resulting shift in the cost of debtcan 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 determinantscan affect the spreads (as in Tang and Yan 2010) and therefore the fundamentals of thereference entity. To confront this hypothesis with the data will require a dynamic modeladmitting multiple equilibria. Research along these lines is just beginning (eg, Fosteland Geanakoplos 2012).We now turn to naked CDSs. The CDS market began in the late 1990s as a pureinsurance market that permitted bondholders to hedge their credit exposure – anexcellent innovation. But then market participants realised that they could buy andsell ‘protection’ even if the buyer did not hold the underlying bond. This is a nakedCDS, which offers a way to speculate on the financial health of an issuing corporate orsovereign without risking capital, as short-selling would do. That was so attractive thatsoon the market was dominated by naked CDSs, with a volume an order of magnitudegreater than the stock of underlying bonds.Like almost all the financial innovations in recent years, naked CDSs are said to bea beneficial move towards more complete markets. And speculation, we are told, is99

Rethinking Global Economic Governance in Light of the Crisisessential to the proper functioning of markets. This is simply market fundamentalismthat ignores masses of research on destabilising speculation as well as a key lesson ofthe financial crisis, that some innovations have been dysfunctional and dangerous.A much more serious justification of naked CDSs is that the overall CDS market, ofwhich these are the dominant component, improves pricing efficiency. The CDS marketleads the cash bond market in price discovery and in predicting credit events. Ourempirical results appear to bear this out, at least for sovereign bonds in several countriesof the Eurozone. Smart traders in the market reveal information, and the CDS marketcan provide information when the bond markets are illiquid. Still, ‘leadership’ may bethe result not of better information, but of the effect of CDS prices on the perceivedcreditworthiness of the issuer. We return to this key issue below.CDS prices have many defects as information. They are often demonstrably unrelatedto default probabilities – as when the German or UK sovereign CDS price rises; orwhen corporate prices are less than those for the country of residence, even though thecorporate bond yield is much higher than that on the country’s government bond. Manyhighly variable factors influence the CDS-bond spread: liquidity premia, compensationfor volatility, accumulating counterparty risk in chains of CDS contracts. What dopricing efficiency and the informational content of prices mean in a highly opaquemarket, 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 ofoutstanding government bonds, ‘the tail can’t wag the dog’, so the CDS market can’t beresponsible for the rising spreads on the bonds. This of course contradicts the argumentthat the CDS market leads in price discovery because of its superior liquidity. Moreimportant, it is nonsense. Over a period of several days in September 1992, GeorgeSoros bet around $10 billion against sterling, and most observers believe that thissignificantly affected the market – and the outcome. But daily foreign exchange tradingin sterling then before serious speculation began was somewhat over $100 billion. TheSoros trades were small relative to the market, yet they had a huge impact, just as the100

Credit default swaps in EuropeCDS market can move the market for the underlying now. The issue is how CDS pricesaffect market sentiment – in particular, whether they serve as a coordinating device forspeculation. We return to this below.Perhaps the weakest argument is that banning naked CDSs “would also confine hedgingto a world of barter, requiring one to find those with opposite hedging needs” (FinancialTimes 2010). If the insurer doesn’t want to take on the risk, it shouldn’t be sellinginsurance.Some say that naked CDSs are justified because they add liquidity to the market. But isthe extra liquidity worth the costs? And we now turn to these.The most obvious argument against naked CDSs is the moral hazard arising when itis possible to insure without an ‘insurable interest’ – as in taking out life insurance onsomeone 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 aspeculative instrument, may be a key link in a vicious chain. Buy a CDS low, push downthe underlying (eg, short it), and take a profit from both. Meanwhile, the rise in CDSprices will raise the cost of funding of the reference entity – it normally cannot issue ata rate that will not cover the cost of insuring the exposure. That will harm its fiscal orcash flow position. Then there will be more bets on default, or at least on a further risein the CDS price. If market participants believe that others will bet similarly, then wehave the equivalent of a ‘run’. And the downward spiral is amplified by the credit ratingagencies, which follow rather than lead. There is clearly an incentive for coordinatedmanipulation, and anyone familiar with the markets can cite examples which look verymuch 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 Cohenand Portes, 2006).The mechanism of CDSs is like that of reinsurance. The fees are received up front, therisks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will101

Rethinking Global Economic Governance in Light of the Crisisthen hedge its position by buying CDSs. So the net is much less than the gross, but thechain is based on the view that each party can and will make good on its contract. Ifthere is a failure, the rest of the chain is exposed, and fears of counterparty risk can causea drying-up of liquidity. The long chains may create large and obscure concentrationrisks 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 therebysubstantially increase the losses that come from defaults. And the leverage comes at lowcost – nothing equivalent to capital requirements, no reserve requirement of the kindinsurers must satisfy.What are the policy implications? We do find that for Eurozone sovereign debt, theCDS 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 riskcorrectly: sovereign CDS contracts written on Eurozone borrowers seem to be ableto provide new up to date information to the sovereign cash market during the period2004–11. In the short run, however, the cash and synthetic markets price credit riskdifferently to various degrees. Second, the Eurozone CDS market seems to move aheadof 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 todate information to the sovereign cash market during the period 2004–11. And CDScontracts clearly do play a useful hedging role. None of this, however, justifies nakedCDSs, which appear to play a destabilising role both in theory and in various episodesof the financial crisis.102

Credit default swaps in EuropeReferencesAmmer J and F Cai (2011), “Sovereign CDS and Bond Pricing Dynamics in EmergingMarkets: Does the Cheapest-to- Deliver Option Matter?”, Journal of InternationalFinancial Markets, Institutions and Money, 21(3):369–87.Arce O, S Mayordomo, and J I Pena (2011), “Do sovereign CDS and Bond MarketsShare the Same Information to Price Credit Risk? An Empirical Application to theEuropean Monetary Union Case”, Federal Reserve Bank of Atlanta Working Paper.Bilal, M and M Singh (2012), “CDS Spreads in European Periphery - Some TechnicalIssues to Consider”, IMF Working Paper WP/12/77.Blanco R, S Brennan, and I W Marsh (2005), “An Empirical Analysis of the DynamicRelation between Investment-Grade Bonds and Credit Default Swaps”, Journal ofFinance 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 andTheir Relation with Government Bonds” ECB Working Paper Series No. 1271.Fostel A and J Geanakoplos (2012), “Tranching, CDS and Asset Prices: HowFinancial Innovation can Cause Bubbles and Crashes”, American Economic Journal:Macroeconomics 4(1): 190–225.103

Rethinking Global Economic Governance in Light of the CrisisHull J, M Predescu, and A White (2004), “The Relationship Between Credit DefaultSwap Spreads, Bond Yields, and Credit Rating Announcements”, Journal of Bankingand Finance 28(11): 2789–2811.Tang D and H Yan (2010), “Does the Tail Wag the Dog? The Price Impact of CDSTrading”, mimeo.Zhu H (2006), “An Empirical Comparison of Credit Spreads between the Bond Marketand the Credit Default Swap Market”, Journal of Financial Services Research 29 (3):211–35.104

Credit default swaps in EuropeAbout the authorRichard Portes, Professor of Economics at London Business School, is Founder andPresident of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes atthe Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairmanof the Board of Economic Policy. He is a Fellow of the Econometric Society and ofthe British Academy. He is a member of the Group of Economic Policy Advisers tothe President of the European Commission, of the Steering Committee of the Euro50Group, and of the Bellagio Group on the International Economy. Professor Portes was aRhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton,Harvard, and Birkbeck College (University of London). He has been DistinguishedGlobal Visiting Professor at the Haas Business School, University of California,Berkeley, and Joel Stern Visiting Professor of International Finance at ColumbiaBusiness School. His current research interests include international macroeconomics,international finance, European bond markets and European integration. He has writtenextensively on globalisation, sovereign borrowing and debt, European monetary issues,European financial markets, international capital flows, centrally planned economiesand transition, macroeconomic disequilibrium, and European integration.105

Global banks, fiscal policy andinternational business cyclesRobert KollmannECARES, Université Libre de Bruxelles and CEPRThe worldwide financial crisis that erupted in 2007 has revealed the fragility of majorfinancial institutions, and triggered the sharpest global recession since the 1930s. Beforethe crisis, standard macro theory largely abstracted from financial intermediaries, andmacro forecasting models ignored information on bank balance sheets. The dramaticevents 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 ofmy PEGGED research projects have addressed this challenge, by presenting noveltheoretical and empirical analyses of the role of global banks for business cycles in theEU and in the world economy. These contributions also highlight the stabilising role ofgovernment support to banks, during a financial crisis.A tractable framework for analysing the interaction between banks and the real economyis provided by Kollmann, Enders and Müller (2011). That study incorporates a globalbank into a two-country macroeconomic simulation model. The bank collects depositsfrom households and makes loans to entrepreneurs, worldwide. It has to finance afraction of loans using equity. In equilibrium, the loan rate exceeds the deposit rate – theloan rate spread is a decreasing function of the bank’s capital. Hence, bank capital is akey state variable for domestic and foreign real activity. The simulation model predictsthat a loan loss shock originating in one country lowers the capital of the global bankingsystem; this raises lending rate spreads worldwide, triggering a global reduction in banklending and a worldwide recession. That framework can thus account for the fact thatthe financial crisis originated in the US, but spread very rapidly to the EU and the restof the world – the key role of globally active European banks in the transmission of the107

Rethinking Global Economic Governance in Light of the Crisiscrisis is highlighted by that fact that credit losses of European banks during the crisiswere largely due to foreign (US) loans.In Kollmann (2012), I estimate the two-country model of Kollmann, Enders andMüller (2011); the statistical results confirm the key role of global banks in the crisistransmission. The study finds that Eurozone investment is especially sensitive toshocks to the health of global banks – about 50% of the fall in EZ investment duringthe crisis can be explained by shocks to the banking system. Kollmann and Zeugner(2011) present further empirical evidence that underscores the role of bank balancesheet conditions for real activity. Specifically, that study analyses the predictive powerof bank leverage for real activity. The key result is that bank leverage is negativelycorrelated with the future growth of real activity – the predictive capacity of leverageis roughly comparable to that of the standard macro and financial predictors used byforecasters. Kollmann and Zeugner also document that leverage is positively linked tothe volatility of future real activity and of equity returns. This finding is consistent withthe view that higher bank leverage amplifies the effect of unanticipated macroeconomicand financial shocks on real activity and asset prices, i.e. that higher leverage makes theeconomy more fragile.The key role of bank health for the overall economy suggests that government supportfor the banking system might be a powerful tool for stabilising real activity in a financialcrisis. In fact, an important dimension of fiscal policy during the crisis was massive stateaid for banks, e.g. in the form of purchases of bank assets and of bank recapitalizsationsby governments. Kollmann, Roeger and in’t Veld (2012) point out that, in the US and theEU, these “unconventional” fiscal interventions were larger than “conventional” fiscalstimulus measures (temporary increases in government purchases and social transfers,tax cuts). Conventional fiscal stimulus measures in the US amounted to 1.98% and1.77% of US GDP in 2009 and 2010. In the EU, the conventional stimulus amountedto 0.83% and 0.73% of EU GDP in 2009 and 2010, respectively. Bank rescue measuresmainly occurred in 2009. In the EU, government purchases of impaired (“toxic”)bank assets and bank recapitalisations in 2009 amounted to 2.8% and 1.9% of GDP,108

Global bBanks, fiscal policy and international business cyclesrespectively. 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 ofbank support measures thus amounted to 4.7% of GDP, in 2009. Table 1 documents thetime profile of cumulated state aid for banks in the Eurozone, between February 2009and April 2011.Table 1. Eurozone state aid for banks (cumulative, as % of GDP)Purchases ofimpaired bank assetsFeb2009May2009Aug2009Dec2009Oct2010Dec2010Apr20110.43 0.45 0.75 2.84 2.15 2.00 1.94Recapitalisations 1.09 1.45 1.67 1.88 2.17 2.21 2.11Total bank aid 1.52 1.90 2.42 4.72 4.32 4.21 4.05Source: in’t Veld and Roeger (2011) Laeven and Valencia (2011).Surprisingly, the macroeconomic effects of these sizable bank support measures havereceived 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, byadding 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 isfinanced 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 itlowers the spread between the bank lending rate and the deposit rate, which stimulatesinvestment and output; the macroeconomic efficacy of state bank aid hinges on itsability to lower the lending spread. Investment drops sharply in financial crises. Hence,government support for banks helps to stabilise a component of aggregate demandthat is especially adversely affected by financial crises. By contrast, most conventionalfiscal stimulus measures (e.g. government purchases of goods and services) crowd outinvestment. Kollmann, Ratto, Roeger and in’t Veld (2012) and Kollmann, Roeger andin’t Veld (2012) show that the GDP multiplier of state aid to banking is in the samerange as conventional government spending multipliers.109

Rethinking Global Economic Governance in Light of the CrisisReferencesin’t Veld, J. and Roeger, W. (2011), “Evaluating the Macroeconomic Effects of StateAids to Financial Institutions in the EU”, Working Paper, European Commission.Kollmann, R., Enders, Z. and Müller, G. (2011), “Global banking and internationalbusiness cycles”, European Economic Review 55, 407-426.Kollmann, R. and Zeugner, S. (2011), “Leverage as a Predictor for Real Activity andVolatility,” 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 andProceedings), forthcoming.Kollmann, R., Ratto, M., Roeger, W. and in’t Veld, J. (2012), “Banks, Fiscal Policy andthe Financial Crisis”, Working Paper, ECARES, Université Libre de Bruxelles.Kollmann, R. (2012), “Global Banks, Financial Shocks and International BusinessCycles: Evidence from an Estimated Model”, Working Paper, ECARES, UniversitéLibre de Bruxelles.Laeven, L. and Valencia, F. (2011), “The Real Effects of Financial Sector InterventionsDuring Crises”, Working Paper 11/45, IMF.About the authorRobert 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 aremacroeconomics, international finance and computational economics.110

The Doha Round impasseSimon J EvenettUniversity of St. Gallen and CEPRBy 2012, it has been widely accepted that the Doha Round of multilateral tradenegotiations, launched in 2001, has reached an impasse. Even in 2011, when it was nolonger credible to deny the prospect of failure, governments were unable to break theimpasse (see Singh Bhatia 2011). That a multilateral trade negotiation has reached animpasse is not new, at least one occurred during the Uruguay Round. Moreover, it ismisleading to think of impasses as only affecting the final stage of a multilateral tradenegotiation. 1 Arguably, WTO members have been unable to agree at three juncturesduring the Doha Round, namely:• Failure to agree to launch the Doha Round (1995–September 2001, including theacrimonious WTO ministerial meeting in Seattle).• Failure to agree on a negotiating agenda for the Doha Round (from 2002 up to the“July package” of 2004, and including the failed Cancun meeting of WTO ministers).• Failure to conclude the negotiation (at a minimum from the mid-2008 breakdown innegotiations through to the present day).What is new is the pervasive sense that it may not be possible to find steps that commandbroad enough support among the WTO membership to break the current negotiatingdeadlock. This leaves the WTO flying on one less engine, it is now being powered bythe dispute settlement function and weaker transparency and deliberative functions.1 The WTO’s Director-General, Mr. Pascal Lamy, noted, in remarks to the WTO General Council on 29 April 2011, that“this Round is once more on the brink of failure.”111

Rethinking Global Economic Governance in Light of the CrisisThis paper describes the underlying sources of the impasse and considers what thosefindings imply for how scholars, in particular international trade economists, mightanalyse multilateral trade negotiations. As will be argued below, there has been far toomuch analysis in recent years on the logic underlying successfully negotiated tradeagreements and too little on understanding the factors that might impede or facilitateidentifying the basis of the deal in the first place. Fortunately, game theorists andinternational relations scholars have given more attention to the study of impasses, andthis might provide a useful point of departure for further research.The realities of multilateral trade negotiations and nationalimperativesWhen presented with a possible trade agreement by his staff, it is said that the formerUS 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 fromthe deal, and is there a compelling logic for who gains what? This approach serves as auseful reminder that successful trade negotiations involve contributions by each majorparty (having influence requires foreswearing free riding and being seen to do so bytrading partners), and that whatever negotiating rules are adopted (such as the singleundertaking and less than full reciprocity in favour of developing countries) do noteliminate 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 thetrade negotiator has at home, namely, to maintain support for the trade negotiation andgenerate enough support for the final deal. The temptation, when managing domesticconstituencies, is for trade negotiators to assure some constituencies that their nation’sconcessions will be minimised while assuring others that a deal will be unacceptableunless other countries don’t make more concessions.112

The Doha Round impasseAll too often, this amounts to characterising their nation’s negotiating position todomestic audiences as demanding “something for nothing.” While the trade negotiatoris undertaking this delicate dance at the national level, they are also trying to senda different signal to their foreign counterparties, specifically, their willingness andcapacity to negotiate. All of this happens in a world where the many nations’ mediareport statements made by foreign trade officials! Throughout the Doha Round, manytrade negotiators have given the impression that they could effectively spot “landingzones” among the “smoke and mirrors,” a claim that may need to be revisited in thelight of a prolonged impasse. This time around, perhaps trade negotiators were tooclever by half. The potential for miscalculation cannot be ruled out.Yet trade negotiators are not the only relevant players. Defensive domestic constituencieshave grown wise to trade negotiators’ tactics and incentives 2 , by and large distrustthem, and have taken steps to protect their interests. One such step is to insist that atrade negotiator’s ministerial masters or the national legislature impose a negotiatingmandate that officials dare not breach. Not only do negotiators resent the encroachmenton their freedom to negotiate, but surely this makes it harder to reach a mutuallyacceptable deal? Not necessarily, as Nobel Laureate Thomas Schelling argued in hisfamous “conjecture” on international negotiations (Schelling 1960). Schelling arguedthat if one major party to a negotiation could credibly commit not to offer concessionsbeyond a certain point and, at that point, the other parties are materially better off bymaking the deal than not making the deal, then the former party’s commitment devicecan shift the negotiating outcome in its favour.Unfortunately, Schelling also noted that if many players attempt the same tactic (tyingthe hands of their negotiators) then an impasse is likely. Given how low trade ministriestend to be in the pecking order of most governments—certainly lower than manycountries’ agricultural ministries, which frequently have an opposing stake in any Doha2 Trade negotiators like doing deals; it is good for their professional reputations. Just take a look at the webpages of aformer senior trade negotiator that has moved into the private sector.113

Rethinking Global Economic Governance in Light of the CrisisRound outcome—and given the speed with which information on negotiating positionscan be transmitted back to national capitals, these factors alone may contribute to thefollowing features observed during the Doha Round: trade negotiators from leadingjurisdictions signal their willingness to negotiate, 3 but when the focus is on particularlysensitive sectors (like agriculture) and more information is revealed about the truenature 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’slimited mandates (imposed because of strong domestic constituencies), suspect or inferthat other heads of government have imposed similarly restrictive negotiate mandates,and, unless presented with compelling pressures to the contrary, sustain the statusquo. Consequently, such heads of government resist the elevation of Doha Roundnegotiations to international forums, such as the G20. National constraints are projectedon to the international negotiation, in a manner that Schelling foresaw and some tradenegotiators openly acknowledged. Speaking in Washington, DC in 2005, the then-EUTrade Commissioner Peter Mandelson said:“I do not underestimate the constraints imposed by domestic politics on both sidesof the Atlantic but we have a wide set of joint interests in the Doha Round. Atthe end of the day, we are two very large Continental players with different, butsimilar economic structures and specialisations. We should not be in the businessof pre-cooking and imposing outcomes. But it is essential that we work to buildcommon or coordinated policy platforms. If we cannot agree on basic approachesthen nothing will happen. It’s as simple as that.” (Mandelson 2005).3 After all, no negotiator wants to exclude themselves from a major negotiation by admitting they can give little or nothing.114

The Doha Round impasseWhy can’t the limited negotiating mandates be overcome?Arguing that interests opposed to foreign competition have limited the mandates oftrade 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 accordswere not able or willing to counter the opponents. Several structural explanations followand all but the final two can be found in Evenett (2007a, b).• First, an important source of commercial support for the Doha Round never cameabout because negotiations over stronger rules and greater market openness in servicesectors did not take off.Here, a less appreciated factor is that the service sector negotiating mandates of manycountries’ trade officials are influenced—if not outright determined—not just byincumbent firms, but also by independent national service sector regulators, many ofwhom resist the restriction on their freedom often implied by binding multilateral tradeaccords.It may be the case that “national politics” was taken out of national regulation throughthe creation of independent regulators, but it does not imply that these regulatorsare cosmopolitan in outlook. With service sector reform effectively taken out of thenegotiating set, along with the removal of almost all of the Singapore issues in 2004, theprincipal remaining negotiating trade-off was agricultural trade reform (in industrialisedcountries) in return for greater access to manufactured goods markets (in developingcountries). This was the basis upon which any deal had to be based.• Second, several factors diminished the value that representatives from industrialisedcountries attached to offers to open up manufacturing goods markets in developingcountries.Before the global financial crisis, with the exception of the United States and Japan,industrialised countries experienced export growth rates faster than those seen duringthe Uruguay Round negotiation. The incremental export growth expected from the115

Rethinking Global Economic Governance in Light of the Crisisoffers made in Doha Round were perceived as relatively small and, in the eyes of someleading exporters, not worth fighting for.• Third, with the exception of China, all the developing countries with large marketshave engaged in enough unilateral tariff reform since the conclusion of the UruguayRound that their maximum allowed tariffs (bound tariffs) exceed their applied tariffrates, on average (Evenett 2007a).Contrary to much economic thinking about the uncertainty-reducing benefits of tariffbindings, leading European and American associations of manufacturers and exportersargued that the unilateral tariff reductions in developing countries were irreversible andthat “binding” tariffs at existing applied levels would generate no additional commercialbenefits.Only if large developing countries agreed to accept bindings on their tariffs belowexisting applied rates would enough market opportunities for industrialised countryexporters be created, it was argued. For the largest developing countries, the latterwould typically amount to a 60–70% cut in the bound rate, a percentage cut nearlydouble the rate seen in previous multilateral trade rounds. Developing countries insistedthat the demands made of them were excessive and pointed out that the same logic wasnot accepted by industrialised countries in agricultural negotiations where, for manycommodities, applied subsidy levels currently stand well below bound subsidy levels.• Fourth, the impressive expansion in the share of world exports supplied by the Chineseduring the past decade fuelled fears in many countries—both developing andindustrialised—that any tariff cuts on manufacturers would predominately benefitChinese exporters.The fear was that this would intensify import competition even further, and threatenjobs.The sustained Chinese export surge also led to pessimism among other nations’exporters about the prospects of holding on to their overseas market shares. Together,116

The Doha Round impassethese factors further skewed the domestic political calculus away from supporting DohaRound deals that extended benefits to China which, under the Most Favoured Nationprinciple, they must.• Fifth, no mechanism with sharp incentives to bring closure to the Doha Round hasbeen introduced.In the Uruguay Round, the larger trading nations made it clear that any reluctance to signall of the accords negotiated in 1993 would preclude a country from membership of thethen-to-be-created WTO. Fearing the consequences of becoming second class citizensin the world trading system, each member of the then-GATT overcame their objectionsand signed the Uruguay Round accords. The central prerequisite for employing sucha tactic is agreement on a final accord between the leading trading nations—whichexisted in 1992-3 but not in 2011.Concluding remarksUltimately, numerous factors—some of which could not have been anticipated when theDoha Round was launched in 2001—account for the inability to bring this multilateraltrade negotiation to a successful conclusion. The roots of many of these factors liein national political choices including sustained unilateral tariff reforms in manydeveloping countries, prevailing global economic conditions, the rise of China, and alack of a decisive mechanism to stop negotiators from postponing difficult choices to alater day. If this analysis is correct, it suggests that institutional fixes at the WTO alonewould not have avoided the Doha Round impasse.The approach taken here represents a marked point of departure from much of the moderneconomic literature on the WTO. For nearly 20 years, trade economists have sought todevelop theoretical rationales for the WTO, which are predicated on the assumptionthat there is a basis for a deal among negotiating parties. For sure, understanding theincentives created by WTO accords once nations can agree is important. However, theprincipal feature of the Doha Round has not been accord—it has been impasse. More117

Rethinking Global Economic Governance in Light of the Crisisresearch is needed to understand why impasses can arise after a negotiation has begunwith high hopes, what factors and strategies can overturn impasses, and how impassesthemselves may influence subsequent state behaviour.ReferencesBaldwin, R and S Evenett (eds.) (2011), Why world leaders must resist the false promiseof another Doha delay, VoxEU.org eBook.Singh Bhatia, Ujal (2011), “Can the WTO be Decoupled From the Doha Round?” inNext 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 tariffcutting so hard?” www.voxeu.org. 24 June.Evenett, S (2007b), “Reciprocity and the Doha Round Impasse: Lessons for the NearTerm and After.” Aussenwirtshaft.Mandelson, P (2005), “The Right Choices for the Doha Round,” speech at the NationalPress Club, Washington DC, 15 September.Schelling, T (1960), The Strategy of Conflict, Harvard University Press.118

The Doha Round impasseAbout the authorSimon J. Evenett is Professor of International Trade and Economic Development atthe University of St. Gallen, Switzerland, and Co-Director of the CEPR Programmein International Trade and Regional Economics. Evenett taught previously at Oxfordand Rutgers University, and served twice as a World Bank official. He was a nonresidentSenior Fellow of the Brookings Institution in Washington. He is Member of theHigh Level Group on Globalisation established by the French Trade Minister ChristineLaGarde, Member of the Warwick Commission on the Future of the Multilateral TradingSystem After Doha, and was Member of the the Zedillo Committee on the GlobalTrade and Financial Architecture. In addition to his research into the determinantsof international commercial flows, he is particularly interested in the relationshipsbetween international trade policy, national competition law and policy, and economicdevelopment. He obtained his Ph.D. in Economics from Yale University.119

The Future of the WTORichard BaldwinGraduate Institute, Geneva and CEPRThe 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 woesstem from the emergence of “21st century trade” (the complex cross-border flows arisingfrom internationalised supply chains) and its demand for beyond-WTO disciplines.The WTO’s centrality was undermined as such disciplines emerged in regional tradeagreements. The future will either see multi-pillar global trade governance with WTOas the pillar for 20th century trade, or a WTO that engages creatively and constructivelywith 21st century trade issues.1 IntroductionThe WTO is widely regarded as trapped in a deep malaise. Exhibit A is its inability toconclude the multilateral trade negotiations known as the Doha Round, despite 10 yearsof talks. This failure is all the more remarkable since it does not reflect anti-liberalisationsentiments – quite the contrary. The new century has seen massive liberalisation oftrade, investment, and services by WTO members – including nations like India, Brazil,and China that disparaged liberalisation for decades. WTO members are advancingthe WTO’s liberalisation goals unilaterally, bilaterally or regionally – indeed almosteverywhere except inside the WTO (see Figure 1).121

Rethinking Global Economic Governance in Light of the CrisisFigure 1. Global trade liberalisation, 1947–20075016%4514%403513%12%12%302510%9%10%8%20151056%6%4%2%019471949195119531955195719591961196319651967196919711973197519771979198119831985198719891991199319951997199920012003200520070%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 to1988, then World DataBank (weighted tariffs all products)This chapter argues that the WTO is in excellent shape when it comes to the type oftrade it was designed to govern. Indeed, this is why WTO membership remains sopopular (29 new members have joined since 1995). The WTO’s woes stem rather fromthe emergence of a new type of trade – call it 21st century trade. This new trade – whichis intimately tied to the unbundling of production – requires disciplines that go farbeyond those in the WTO’s rulebook. To date, virtually all of the necessary governancehas emerged spontaneously in regional trade agreements or via unilateral ‘pro-business’policy reforms by developing nations. The real threat, therefore, is not failure of theWTO, but rather the erosion of its centricity in the world trade system.This line of reasoning suggests the WTO’s future will take one of two forms.1. The WTO remains relevant for 20th century trade and the basic rules of the road,but irrelevant for 21st century trade; all ‘next generation’ issues are addressed elsewhere.122

The Future of the WTOIn the optimistic version of this scenario, which seems to be where the current trajectoryis 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 firstpillar (basically the disciplines agreed in treaties up the 1992 Maastricht Treaty) wassupplemented by two new pillars to cover new areas of cooperation. 1 In the pessimisticversion of this first scenario, the lack of progress undermines political support and theWTO disciplines start to be widely flouted; the bicycle, so to speak, falls over whenforward motion halts.The second scenario involves a reinvigoration of the WTO’s centricity.2. The WTO engages in 21st century trade issues both by crafting new multilateral disciplines– or at least general guidelines – on matters such as investment assurancesand by multilateralising some of the new disciplines that have arisen in regionaltrade agreements.There are many variants of this future outlook. The engagement could take the formof plurilaterals – following the lead of agreements like the Information TechnologyAgreement, the Government Procurement Agreement and the like (where only a subsetof WTO members sign up to the disciplines). It could also take the form of an expansionof the Doha Round agenda to include some of the new issues that are now routinelyconsidered in regional trade agreements.In this short essay, I support these conjectures by first discussing why the GATT had somany wins while the WTO’s had so many woes, then explaining why 21st century tradeemerged and how it is different. Finally, I pull the threads together in the concludingsection.Note that I straightforwardly ignore many of the standard issues that crop up in essaysabout the WTO’s future: the rising number of WTO members and its consensus decision-1 The pillar structure was removed by the 2009 Lisbon Treaty but its effect was maintained Article by Article.123

Rethinking Global Economic Governance in Light of the Crisismaking; the rise of new trade giants, especially China, who are both poor and too bigto ignore; the agriculture-manufacturing imbalances in the existing system, etc. In myview, these are all important, and indeed critical when thinking about how the WTOshould defend its centrality, but I think these factors are less important in understandingthe fundamental sources of the WTO’s difficulties and its options for the future.2 Why GATT won the war on tariffsThe GATT’s remarkable success in lowering tariffs globally rested on two politicaleconomy 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 politicaleconomy forces within each nation so that each government found it politically optimalto lower tariffs. The key is the GATT’s reciprocity principle – “I cut my tariffs if youcut 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 marketaccess). In short, reciprocity switched each nation’s exporters from bystanders to protradeactivists. This made every government more interested in lowering tariffs thanthey were before the reciprocal talks started.Liberalisation continued over the decades, since each set of reciprocal tariff cutscreated political economy momentum. That is, a nation’s own cuts downsized itsimport-competing industries (weakening protectionist forces) and foreign cuts upsizedits exporters (strengthening pro-liberalisation forces). In this way, governments foundit politically optimal to further reduce tariffs in the next GATT Round (held five toten years down the road after industrial restructuring reshaped the political economylandscape in a pro-liberalisation direction).124

The Future of the WTOThe second pillar was the fact that developing nations were allowed to free ride onthe resulting rich-nation tariff cuts. 2 This is what lets a large, diverse, consensus-basedorganisation operate as if it were run by a small group of self-appointed, like-mindedbig economies. Countries whose markets were too small to matter globally – mainlythe developing nations in the GATT decades – were not expected to cut their own tariffsduring Rounds. 3 Yet the GATT’s principle of “most favoured nation” (MFN) meant thattheir exporters enjoyed the fruits of any tariff-cutting by large economies. Developingnations had a stake in the success of GATT rounds and nothing to gain from failure. Fordeveloping nations, GATT was a “don’t obey, don’t object” proposition. Of course, thisfudged, rather than solved, the consensus problem.3 Why GATT magic does not work for WTOThe juggernaut worked exceedingly well in the economies that dominated the tradesystem in the 20th century – the so-called Quad (US, EU, Japan and Canada) – andon the goods of interest to their exporters (mostly manufactures). By the time of theWTO’s founding in 1995, Quad tariffs were very low on all but a small number ofgoods (notably agriculture). The dynamo, however, ran low on fuel as Quad tariffsfell. To keep exporters interested in fighting protectionists in their national capitals,the GATT broadened the negotiating agenda for the Uruguay Round (launched in1986). Guarantees of intellectual property rights, disciplines on the use of investmentrestrictions, and the liberalisation of services market were added (known as TRIPs,TRIMs and Services). 4 To balance the agenda, agriculture and textiles barriers werealso 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 increasinglyexplicit from the 1956 GATT “review session”; the Haberler Report (1958) provided intellectual backing that eventuallyled 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; itbecame explicit with GATT Article XVIII when formulas began to be used.4 TRIPs and TRIMs are short for Trade Related Intellectual Property Rights and Trade Related Investment Measures.125

Rethinking Global Economic Governance in Light of the CrisisA problem with this agenda-broadening was it was inconsistent with “don’t obey, don’tobject”, which would have allowed developing nations to opt out of TRIPs, TRIMs andServices 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” carrotwith the Single Undertaking stick. That is, the final Uruguay Round package set up anew institution – the WTO – and made membership a take-it-or-leave-it proposition. Allmembers, developed and developing alike – even those that had not participated activelyin the negotiations – were obliged to accept all of the Uruguay Round agreements asone package. 5 The old days of developing nation free-riding were over. Refusing tosign would not cancel a member’s rights under the old GATT, but if the big economieswithdrew, the GATT would be an empty vessel. As history would have it, everyonejoined the WTO. To enforce the Single Undertaking, the flexibility of the GATT’sdispute settlement procedures was greatly reduced. The new adjudication procedure –known as the Dispute Settlement Understanding – meant that everyone would have toobey.Long story short: the Uruguay Round’s closing tactics unbalanced the GATT’s winningformula. Developing countries now had to obey, so they would have to object to thingsthat threatened their interests. The Single Undertaking and hardened dispute settlementprocedure 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 DohaRound 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-makingavoiding outcomes like the Tokyo-Round Codes.6 Inspired by Mundell’s exchange-rate trilemma, Ostry (1999) proposed a ‘trade trilemma’ that Rodrik (2000, 2002) maderigorous.126

The Future of the WTO4 The nature of international commerce changes:Production unbundlingWithout the GATT’s winning formula, one might have expected trade liberalisation togrind to a halt. It did not. The reason is that world trade and the politics of liberalisationchanged radically in the 1990s. The cause was the information and communicationtechnology (ICT) revolution, but understanding this requires some background.4.1 Globalisation as two unbundlingsGlobalisation is often viewed as driven by the gradual lowering of natural and manmadetrade barriers. This is a serious misunderstanding. Globalisation made a giantleap when steam power slashed shipping costs; it made another when ICT decimatedcoordination 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 profitabilityshipped internationally. Production had to be nearby consumption; each village mademost of what it consumed. Steam power changed this by radically lowering transportcosts. The result was ‘the first unbundling’, i.e. the spatial unbundling of productionand consumption. GATT rules where designed to provide the international disciplinesnecessary to underpin this sort of trade, i.e. goods that were made in one nation beingsold to customers in another nation.The first unbundling, however, created a paradox – production clustered into factorieseven as it dispersed internationally. The paradox is resolved with three points: (i) cheaptransport favours large-scale production, (ii) such production tends to be very complex,and (iii) proximity lowers the cost of coordinating complexity. Think of a stylisedfactory with several production bays. Coordinating the manufacturing process demandscontinuous, two-way flows among bays of things, people, training, investment, and127

Rethinking Global Economic Governance in Light of the Crisisinformation. Productivity-enhancing changes keep the process in flux, so the flowsnever die down.Some of proximity’s cost-savings are related to communications. As the ICT revolutionsloosened the “coordination glue”, it became feasible to spatially separate some types ofproduction stages, i.e. to spatially unbundle the factories. Since some production stageswere labour intensive, rich-nation firms reduced costs by offshoring them to low-wagenations. This was the second unbundling. 7The second unbundling transformed international commerce for a very simplereason. Offshoring internationalised the two-way flows among production bays – thethings, people, training, investment, and information mentioned above. Quite simply,international commerce became much more complex and diverse, creating ‘21stcentury trade’. The heart of this new commerce is what I call the “trade-investmentservices-intellectualproperty” nexus. 8 Specifically, the nexus reflects the intertwiningof (i) trade in parts and components, (ii) international movement of investment inproduction facilities, key technical and managerial personnel, training, technology,and long-term business relationships, and (iii) demand for services to coordinate thedispersed production.In the 20th century, the trading system was mostly important on the ‘demand side’; itwas about helping firms sell abroad products they made at home. In the 21st century, itis also important on the ‘supply side’, helping firms produce goods quickly and cheaplywith 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 Feenstraand Hanson (1997) on the North American case.8 See Baldwin (2011).128

The Future of the WTO4.2 The nature of trade barriers and trade policies changesEmergence of the trade-investment-services-IP nexus meant that trade now involvedtwo new necessities – connecting factories, and doing business abroad. Underpinningthese involved rules on things that were never considered trade issues in the GATT era.1. Connecting factories involves assurances on business-related capital flows, worldclasstelecoms, air cargo, overnight parcel services, customs clearance services,short-term visa for managers and technicians, and infrastructure (ports, road, railand electricity reliability, etc.). Of course, tariffs and other border measures alsomatter.2. Doing business abroad involves a whole range of formerly domestic policies – socalledbehind-the-border barriers such as competition policy, property rights, rightsof establishment, the behaviour of state-owned enterprises, the protection of intellectualproperty, and assurances on investor rights. All of these are important todoing 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 nationswanted the offshored industrial jobs and technology, rich-nation firms wanted accessto lower-cost labour. Both pushed for disciplines to underpin the trade-investmentservices-IPnexus. The result was “deep” regional trade agreements and unilateral probusinessreforms by developing nations. The result can be seen in Figure 1 – the WTO’sdifficulty 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 “foreignfactories for domestic reforms”. Developing nations were willing to reform all sorts ofbehind-the-border barriers in exchange for factories and industrial jobs that came fromjoining a rich-nation’s supply chain.129

Rethinking Global Economic Governance in Light of the CrisisThe WTO’s centrality suffered. As there are no factories on offer in Geneva, the newrule-writing shifted to bilateral deals. If a developing nation wants US, EU, or Japanesefactories, 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 LatinAmerican and Africa), but the most dynamic aspect of trade today is the developmentof international value chains.5 Concluding remarksWhen 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 politicalprice to join the organisation.• The global crisis created protectionist pressures, but most of the new protectionconformed 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 tradebarriers it was designed to govern, i.e. 20th century trade (the sale of goods made infactories in one nation to customers in another).Where the WTO’s future seems cloudy is on the 21st century trade front. The demandsfor new rules and disciplines governing the trade-investment-services-IP nexus arebeing formulated outside the WTO. Developing nations are rushing to unilaterallylower their tariffs (especially on intermediate goods) and unilaterally reduce behindthe-borderbarriers to the trade-investment-services-IP nexus. All of this has markedlyeroded the WTO centrality in the global trade system.130

The Future of the WTOThe implication of this is clear. The WTO’s future will either be to stay on the 20thcentury side-track on to which it has been shunted, or to engage constructively andcreatively in the new range of disciplines necessary to underpin 21st century trade.ReferencesAndo, Mitsuyo and Fukunari Kimura (2005), “The Formation of International Productionand Distribution Networks in East Asia,” in T. Ito and A. Rose (eds) International Tradein East Asia, NBER-East Asia Seminar on Economics, Volume 14, pp 177-216.Baldwin, Richard (2011), “21st Century Regionalism: Filling the gap between 21stcentury 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-GrowthCorrelation Change after 1950?“, Journal of Economic Growth 9(1), 5-46.Evenett, Simon (2011), “Did the WTO Restrain Protectionism During The RecentSystemic Crisis?”, www.globaltradealert.org.Federal Reserve Bank of Dallas (2002), “Maquiladora Industry: Past, Present andFuture”, Issue 2.Feenstra, Robert and Gordon Hanson (1997), “Foreign direct investment and relativewages: Evidence from Mexico’s maquiladoras,” Journal of International Economics42(3-4), 371-393.Gaulier, Guillaume, Francoise Lemoine and Deniz Unal-Kesenci (2007), “China’semergence and the reorganisation of trade flows in Asia,” China Economic Review18(3), 209-243.Haberler, Gottfried (1958), “Trends in International Trade, Report of a Panel ofExperts”, Geneva: GATT Secretariat.131

Rethinking Global Economic Governance in Light of the CrisisKimura, Fukunari, Yuya Takahashi, and Kazunobu Hayakawa (2007), “Fragmentationand parts and components trade: Comparison between East Asia and Europe”, TheNorth American Journal of Economics and Finance 18(1), 23-40.Ostry, Sylvia (1999), “The Future of the WTO”, Brookings Trade Forum, edited byDani Rodrik and Susan Collins, Washington, DC: Brookings Institution.Athukorala, Prema-chandra (2006), “Multinational Production Networks and the NewGeo-economic Division of Labour in the Pacific Rim,” Departmental Working Papers2006-09, Australian National University, Arndt-Corden Department of Economics.Rodrik, Dani (2000), “How Far Will International Economic Integration Go?” Journalof Economic Perspectives 14(1), 177–186.Rodrik, Dani (2002), “Feasible Globalizations”, NBER Working Paper 9129.132

The Future of the WTOAbout the authorRichard Edward Baldwin is Professor of International Economics at the GraduateInstitute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chiefof Vox since he founded it in June 2007. He was Co-managing Editor of the journalEconomic Policy from 2000 to 2005, and Programme Director of CEPR’s InternationalTrade programme from 1991 to 2001. Before that he was a Senior Staff Economist forthe 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 atMIT in 2002/03 and has taught at universities in Italy, Germany and Norway. He hasalso worked as consultant for the numerous governments, the European Commission,OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, hisresearch interests include international trade, globalisation, regionalism, and Europeanintegration. He is a CEPR Research Fellow.133

Open to goods, closed to people?Paola Conconi, Giovanni Facchini, Max F Steinhardt, andMaurizio ZanardiUniversité Libre de Bruxelles (ECARES) and CEPR; Erasmus University Rotterdam,Universita’ degli Studi di Milano ,and CEPR; Hamburg Institute for InternationalEconomics; Université Libre de Bruxelles (ECARES)To policymakers in most nations, there is a world of difference between trade andmigration policies. The theoretical literature in economics, by contrast, has focused ontheir similarities (Mundell 1957). In standard trade models, liberalising trade in goodsand removing barriers to labour (or capital) mobility is beneficial for world welfare– when goods move freely across borders, countries can gain by exporting what theyproduce 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 thatworkers from low-pay nations can move and earn higher wages, and employers in thehigh-wage country can hire foreign workers at a lower cost.More specifically, the theory argues that if the only difference between countries liesin their relative labour abundance, commodity trade and labour mobility are substitutes(Razin and Sadka 1997). Freer trade should lead poorer countries to specialise in theproduction of labour-intensive goods. In turn, this should lead to a rise in wages ofunskilled workers, decreasing their incentives to move abroad. Trade liberalisationshould then decrease the need for labour migration. This argument was often raisedduring the negotiations of the North American Free Trade Agreement (NAFTA).Policymakers argued that the agreement would allow Mexico to export “goods and notpeople” (Fernández-Kelly and Massey 2007).135

Rethinking Global Economic Governance in Light of the CrisisWhy are policy attitudes so different?If labour migration and international trade have similar implications for global efficiencyand factor markets, why are immigration policies so much more restrictive than tradepolicies? Through successive rounds of negotiations, average industrial tariffs ratesaround the world have fallen steadily since WWII. By contrast, immigration policieshave 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 openlabour migration dwarf those from freer trade. As Dani Rodrik puts it, “the gains fromliberalising labour movements across countries are enormous, and much larger than thelikely benefits from further liberalisation in the traditional areas of goods and capital. Ifinternational policymakers were really interested in maximising worldwide efficiency,they would spend little of their energies on a new trade round or on the internationalfinancial architecture. They would all be busy at work liberalising immigrationrestrictions” (Rodrik 2002, p. 314).However, unless we have a better understanding of why trade and migration policiesdiffer so much, it is difficult to know whether migration reforms are likely to besuccessful. If the gains from liberalising international migration generate such largeworldwide gains, why does migration lag so far behind international trade in terms ofpermissible mobility?To address this question, we examine the determinants of the voting behaviour ofUS legislators on all major trade and migration reforms voted in Congress duringthe period 1970-2006. In terms of trade reforms, we include in all our analysis voteson the implementation of multilateral trade agreements (Tokyo and Uruguay Roundrounds of the GATT) and preferential trade agreements (e.g. the Canada-US Free TradeAgreement and NAFTA) negotiated in this period, as well as the votes on the conferraland extension of fast track trade negotiating authority to the president, which makes136

Open to goods, closed to people?it easier to negotiate trade agreements (see Conconi, Facchini and Zanardi 2012). 1 Interms of migration votes, they include two different categories: general immigrationand illegal migration (see Facchini and Steinhardt 2011), and we restrict the analysis tothose that have a direct (positive or negative) impact on the size of the unskilled labourforce in the US.We match House roll call voting data on trade and migration reforms with informationabout legislators’ names, states and congressional districts, which enables us to uniquelyidentify the legislators and link them to their constituency. We also collect systematicinformation about the representatives (e.g. party affiliation, age, gender, incumbencygains as well as on economic and non-economic characteristics of their constituencies(e.g. skill composition, fiscal burden of immigrants, percentage of foreign-bornpopulation).From a methodological point of view, we first run probit regressions on the full sampleof votes, studying the determinants of individual legislators’ decisions on trade andmigration reforms. We then focus our analysis on a subsample of trade and migrationreforms that have taken place during the same Congress. This allows us to control forunobserved characteristics of legislators, which might affect their voting behaviour ontrade and migration bills. Finally, we estimate bivariate probit regressions, allowinglegislators’ decisions on trade and migration to be interrelated.Emprical resultsOur empirical analysis shows both similarities and differences in congressmen’s votingbehaviour on these policy issues. In line with the predictions of standard internationaltrade models, we find that a constituency’s skill composition affects representatives’voting behaviour on trade and migration liberalisation bills in the same direction. In1 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 onactual policy choices by legislators.137

Rethinking Global Economic Governance in Light of the Crisisparticular, representatives of districts with relatively more highly skilled labour aremore likely to support liberalising unskilled migration as well as trade with labourabundantcountries. Party affiliation has instead opposite effects – Democrats are morelikely to support liberal immigration policies but to oppose trade liberalisation.Voting differences between the two issues are also driven by districts’ characteristicsthat affect decisions on immigration policy but do not influence the voting behaviouron trade.• We find that the higher the fiscal burden of immigrants for a constituency, the lesslikely 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 oppositionto immigration is the concern that admitting low-skilled foreigners raises the net taxburden on US natives (Hanson, Scheve and Slaugther 2007, Facchini and Steinhardt2011).• Districts’ ethnic composition also affects voting behaviour on immigration reforms– support for these reforms increases with the share of foreign-born citizens in aconstituency.This finding confirms the importance of network effects, which has been emphasised inrecent studies (e.g. Munshi 2003).Our study can help to explain the gap between the global regulation of labour migrationand that of trade flows. In line with standard international trade models, our empiricalanalysis suggests that trade and migration have parallel impacts on factor markets.However, the flow of human beings has political, cultural, social, and economic effectsthat clearly differ from those from the flow of goods. These effects can explain whylegislators are more likely to support opening barriers to goods than to people.138

Open to goods, closed to people?ReferencesConconi, P., G. Facchini, and M. Zanardi (2012). “Fast Track Authority and InternationalTrade 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 ofNAFTA in Mexico-US Migration”, Annals of the American Academy of Political andSocial Science 610, 98-118,Hanson, G. H., K. Scheve, and M. J. Slaugther (2007). “Public Finance and IndividualPreferences over Globalization Strategies”, Economics and Politics 19, 1-33.Hatton, T. J. (2007). “Should We Have a WTO for International Migration?” EconomicPolicy 22, 339-383.Faini, R. (2002). “Development, Trade, and Migration”, Revue d’Économie et duDéveloppement, Proceedings from the ABCDE Europe Conference, 1-2: 85-116.Mayda, A. (2008). “Why are People more pro Trade than pro Migration?” EconomicsLetters 101, 160-163.Mundell, R. (1957). “International Trade and Factor Mobility”, American EconomicReview 47, 321-335.Munshi, K. (2003). “Networks in the Modern Economy: Mexican Migrants in the USLabor Market”, Quarterly Journal of Economics 118, 549-599.Razin, A., and E. Sadka (1997). “International Migration and International Trade”, inHandbook of Population and Family Economics 1, 851-887.139

Rethinking Global Economic Governance in Light of the CrisisRodrik, D. (2002). “Comments at the Conference on Immigration Policy and theWelfare State”, in Boeri, T., G. H. Hanson, and B. McCormick (eds.), ImmigrationPolicy and the Welfare System, Oxford University Press.About the authorsPaola Conconi holds is a B.A. in Political Science from the University of Bologna, anM.A. in International Relations from the School of Advanced International Studies ofJohns Hopkins University, and a M.Sc. and a Ph.D. in Economics from the Universityof Warwick. Her main research interests are in the areas of international trade,international migration, regional integration and political economy. Her contributionto the project will be on governance of trade institutions, on which she has publishedvarious papers in international journals such as the Journal of International Economicsor the Journal of Public Economics.Giovanni Facchini is a Professor of Economics at Erasmus University Rotterdam andat the University of Milan, having taught previously at the University of Essex, theUniversity of Illinois at Urbana Champaign and at Stanford. His research focuses oninternational trade and factor mobility. He has published in journals such as the Journalof the European Economic Association, the Review of Economics and Statistics, theJournal 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 FacultyAffiliate at the Institute for Government and Public Affairs at the University of Illinois-Urbana Champaign. He coordinates research on international migration at the CentroStudi Luca d’Agliano in Milan. He obtained a PhD in Economics from StanfordUniversity in 2001.Max Friedrich Steinhardt is a Senior Researcher in “Demography, Migration andIntegration” at the Hamburg Institute of International Economics (HWWI). Hisresearch interests lie in the fields of labour economics, economics of migration,applied microeconometrics and regional economics. He studied economics at the140

Open to goods, closed to people?University of Hamburg. 2009 he finished his doctoral dissertation with a thesis aboutthe economics of migration. Within the TOM Marie Curie Training Networks Dr. MaxFriedrich Steinhardt stayed at the Centro Studio Luca D’Agliano (LdA) in Milan and atthe European Center for Advanced Research in Economics and Statistics (ECARES) inBrussels. Furthermore, he worked as an external consultant for the OECD.Maurizio Zanardi is an Associate Professor of Economics at the Universite Libre deBruxelles and a member of ECARES. His research interests include international tradeand political economy. He received his PhD in Economics from Boston College andBA in Economics from the Catholic University of Milan.141

The recession and internationalmigrationTimothy J HattonAustralian National University, University of Essex, and CEPRIntroductionThe current recession, concentrated in Europe and North America, has raised questionsabout immigration policy. When labour markets are slack, attitudes towards immigrantsbecome more negative, the case for keeping the door ajar gets weaker, and politicalimperatives for tougher immigration policy get stronger. Yet in the current recession,anti- immigration policy has been muted – and all the more so when compared withthe 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 thistime?Recessions and immigration — past and presentInternational migration has always been sensitive to the ebb and flow of the businesscycle. 1 This was so in the 19th century and it remains true today. If immigrants aredeterred by high unemployment and existing migrants go home, then such responses1 See, for example, Özden et al (2011).143

Rethinking Global Economic Governance in Light of the Crisismay attenuate labour market competition and mute the clamour for restriction. But isthat 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 policieswere vastly less restrictive than today, migration flows were very volatile (Hatton andWilliamson 1998). The effects of unemployment at home and abroad can be seenclearly for emigration from the UK from 1870 to 1913. Analysis shows that fluctuationsin home unemployment had smaller effects on emigration than unemployment abroad.Return migration was also influenced by host country labour market conditions and sonet 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 netimmigration to the US, Canada, and Australia fell even more dramatically as previousimmigrants headed for home (Hatton and Williamson 1998). The same thing happenedagain in the Great Depression – in the US, net migration turned negative as outflowsexceeded inflows.How big are these effects? Where immigration policies are not too restrictive, historytells us that every 100 jobs lost in a high-immigration country results in 10 fewerimmigrants. This 10% rule described countries like Canada and Australia in the GreatDepression, and it worked pretty well for other periods too. For countries of emigration,recession worked in the opposite direction – as the global depression deepened, theirlabour 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% rulestill applies. For example, unemployment rose by about one percentage point between1997 and 2000 and net immigration fell by one per thousand of the US population.Between 2000 and 2002, immigration recovered as employment fell (Hatton andWilliamson 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 rosefrom 7.2% to 9.0% and net migration fell from 2.6 to 1.4 per thousand.144

The recession and international migrationThe overall EU-wide fluctuation in unemployment is relatively small, but what aboutthe countries that have been hardest hit by the recession? Figure 1 shows the relationshipbetween the unemployment rate and gross immigration in Ireland and Spain. ForIreland, the steep rise after 2004 was mainly due to immigration from the A8 accessioncountries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, andSlovenia). The classic relationship between unemployment and immigration is clearlyvisible in the recession, however, and it would be even stronger for net immigration, asout-migration from both countries doubled between 2007 and 2009 (Papademetriou etal. 2010)Figure 1. Gross immigration per thousand and unemployment percentage25.0Ireland25.0Spain20.020.015.015.010.010.05.05.00.00.02000200120022003200420052006200720082009201020002001200220032004200520062007200820092010I RateU RateI RateU rateSource: OECD StatExtracts at: http://stats.oecd.org/Index.aspxThus, the responsiveness of immigration to the business cycle has remained at aboutits historical level, despite the fact that policy is much more restrictive than it was (atleast for the Atlantic economy) in the 19th century. On the other hand, transport costsare lower and there are many channels of entry such as temporary worker schemes andillegal immigration. Even the numbers of family reunification migrants and asylumseekers are influenced by economic conditions.145

Rethinking Global Economic Governance in Light of the CrisisImmigrants in the labour marketOne reason why immigration slows down in a recession is that immigrants typicallydo badly in the labour market as unemployment increases. Table 1 shows thatunemployment rates among immigrants are typically much higher than for nationals.As unemployment increases, the ratio of unemployment rates of immigrants to nativesremains remarkably stable (except in Greece). This means that the difference inunemployment rates (and hence in employment probabilities) between immigrants andnatives increases.Table 1. Unemployment rates in western EuropeMale unemployment 2008 Male unemployment 2010Native Foreign F/N Native Foreign F/NAustria 2.9 3.8 1.3 7.3 8.8 1.2Belgium 5.3 6.7 1.3 14.3 17.5 1.2Germany 6.6 7.0 1.1 12.3 12.6 1.0Demark 2.7 7.7 2.8 6.4 15.1 2.4Spain 8.8 17.3 2.0 16.4 31.1 1.9Finland 5.9 9.2 1.6 12.4 18.9 1.5France 6.3 8.4 1.3 11.4 13.6 1.2Great Britain 6.1 8.8 1.4 6.8 9.2 1.4Greece 5.2 8.8 1.7 5.0 14.7 2.9Ireland 7.0 16.5 2.3 8.2 19.2 2.3Italy 5.6 7.3 1.3 5.9 9.7 1.6Netherlands 2.1 3.8 1.8 5.3 8.5 1.6Norway 2.4 3.5 1.4 6.0 9.8 1.6Portugal 6.8 10.2 1.5 7.8 12.7 1.6Sweden 5.1 7.4 1.4 11.5 15.9 1.4Source: OECD StatExtracts at http://stats.oecd.org/Index.aspxThe impression from Table 1 is supported by detailed analysis. For the UK andGermany, Dustmann et al. (2010) find that unemployment is more strongly cyclical forimmigrants than for natives, and especially for immigrants from outside the OECD.Partly, this reflects differences in skill levels but even within skill groups, immigrants are146

The recession and international migrationmore vulnerable to changes in unemployment than non-immigrants. Thus immigrantsare 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. Someof them go home (or decide not to come) and those who remain shoulder more of theburden of unemployment.Public opinion towards immigrantsIt is well known that popular opinion is, on the whole, anti-immigration. Table 2 providesevidence 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 scalewhere 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 averageopinion is fairly neutral on the issue of whether immigrants undermine the cultural lifeof a society, it is rather more negative on whether immigrants are a threat to society andeven more so on whether immigrants worsen the problem of crime.The next two columns indicate that, while people are broadly neutral on whetherimmigrants take away jobs, they tend to be somewhat more negative on whetherimmigrants impose a welfare burden. The final column is on a scale where five is totalagreement with the statement that there are ‘too many immigrants’ and one is totaldisagreement. Hence a neutral score would be 3.0. For 14 out of 16 countries, the scoreis at least three but less than four. While these figures conceal widely divergent views,opinion is negative on average, but not extremely so.147

Rethinking Global Economic Governance in Light of the CrisisTable 2. Public opinion on immigration in western Europe, 2008UndermineculturallifeThreat tosocietyMakecrimeworseTake jobsawayStrain onwelfareToo manyimmigrantsAustria 6.4 6.7 7.6 6.4 7.5 3.7Belgium 5.7 6.6 6.7 5.8 6.9 3.6Denmark 4.5 5.5 7.2 3.1 6.6 2.7Finland 4.0 5.8 6.9 4.9 6.5 3.0France 5.0 5.8 5.2 4.7 6.1 3.2Germany 6.0 6.4 7.5 6.4 7.6 3.4Greece 5.5 7.0 7.3 6.7 6.7 4.4Ireland 5.8 6.7 6.3 6.8 7.5 3.7Italy 4.9 6.1 7.3 5.4 6.1 3.6Netherlands 5.2 5.9 6.7 5.3 6.1 3.1Norway 4.9 5.9 7.4 4.3 6.9 3.0Portugal 4.7 5.8 6.2 6.3 6.0 3.3Spain 4.9 5.6 6.3 5.7 5.5 3.6Sweden 4.3 5.0 6.3 3.9 5.6 3.0Switzerland 5.0 5.6 7.0 4.9 6.7 3.2GreatBritain6.4 7.2 6.5 6.8 7.6 3.8Source: European Values Study 2008 at http://zacat.gesis.org/webview/.Detailed analysis of public opinion often reveals that negative sentiment towardsimmigration is strongest among those with low education, among males and olderpeople, and among those that are not themselves first or second generation immigrants.Those with higher levels of education have greater tolerance towards minorities andare more positive about ethnic and cultural diversity (Dustmann and Preston 2007,Hainmueller and Hiscox 2007). They are also less likely to be concerned about thepotential 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 importanceof concerns about the fiscal cost of immigration (Facchini and Mayda 2009, Boeri2010). In particular, they point to fears that higher immigration will lead to a higher taxburden. Boeri (2010) finds that the net fiscal contribution of immigrants is positive for148

The recession and international migrationsome EU countries but is more likely to be negative where there is a higher proportionof low-skilled immigrants. The evidence also suggests that opinion is more negative thegreater the fiscal drain (Boeri 2010).Not surprisingly, some studies also suggest that the scale of immigration is an importantdeterminant of negative attitudes, either at the aggregate level (Lahav 2004) or as aresult of concentration in the respondent’s local community (Dustman and Preston2001). Even before the current recession, public opinion became more negative incountries such as Ireland and Spain as the number of immigrants surged. In Spain, theproportion of respondents in the World Values Survey wanting immigration prohibitedor 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 forcesin both directions. Over the long run, average education has strongly increased (whichshould 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 hasdecreased on trend since the 1980s (Hatton and Williamson 2009). In the short run, asnoted earlier, the fall in net immigration and the increased immigrant unemploymentburden has cushioned the effect of the recession on the native employment. But on theother hand, the increase in immigrant welfare dependency has worked in the oppositedirection. This last effect is likely to be all the more important when budget deficits arelarge and fiscal austerity is headline news.Immigration policy: Past and presentHistory suggests that recessions have sometimes been occasions for the introductionof restrictive immigration policy; sometimes but not always. A policy backlash ismore likely, and when it occurs is more draconian, when it follows an extended periodof high immigration. As the stock of migrants increases, popular attitudes becomemore negative – the more so the greater are the cultural and socioeconomic differencesbetween immigrants and non-immigrants. Thus a recession can be the trigger that149

Rethinking Global Economic Governance in Light of the Crisisconverts growing anti-immigrant sentiment into a decisive tightening of immigrationpolicy. This process can be illustrated with three historical examples.In the US, anti-immigrant sentiment was on the rise from the 1880s onwards as thenumber of immigrants mounted and more of them came from the then poorer countriesof southern and eastern Europe. After several unsuccessful attempts, starting in thedeep 1890s recession, Congress finally introduced a literacy test in 1917. Labourmarket conditions were important (Goldin 1994), and no doubt the First World Waralso fostered changing attitudes. But the decisive policy shift came with the EmergencyQuota Act in 1921, which became the basis of immigration policy until the 1960s. Theintroduction of quotas occurred just as the unemployment rate rose from 5.2% in 1920to 11.7% in 1921.A decade later, the Great Depression saw a rapid retreat from open door immigrationpolicies in a number of countries including Australia, Canada, Brazil, Argentina, andSingapore. These reverses occurred in the aftermath of the economic shock and sothey contributed marginally to the downturns in net immigration noted earlier. A thirdexample comes from Europe in the 1970s. From the late 1950s, a number of countries(most prominently Germany) adopted guestworker programmes that admitted migrantsfrom southern and eastern Europe, Turkey, and North Africa. As the number ofimmigrants grew and economic growth slowed down, attitudes to immigration soured.In the early 1970s, rapidly deteriorating economic conditions and the first oil priceshock brought these policies to an abrupt end (Hatton and Williamson 2005).These historical examples would lead us to expect a sharp turn to restrictive immigrationpolicies. After all, the global financial crisis was preceded by two decades of risingimmigration to OECD countries, and especially to EU countries. And as we have seen,the climate of opinion towards immigration was moderately negative even before thecrisis struck. So what has happened?Observers often point to the rise of right-wing anti-immigration parties and theirinfluence (either direct or indirect) on immigration policy. Across Europe, such parties150

The recession and international migrationhave raised the salience of immigration policy but, with a few exceptions, their gainsin electoral support predate the global financial crisis. Nevertheless, there have beensome well-publicised policy shifts. These include a sharp shift to restriction on workpermits and student visas in the UK, increased border enforcement measures in Franceand Italy, incentives for return migration for unemployed immigrants in Spain, and aclampdown on immigrant welfare services in Denmark.However, these must be put into perspective. Tougher rules were imposed in somecountries even before the recession, for example those on family reunification in Franceand the Netherlands. And across the OECD, policy on asylum seekers became tougherfor at least a decade before 2007 (Hatton 2011). Although much of the focus has beenon policies towards the integration of immigrants (and sometimes the explicit rejectionof multiculturalism), the Migrant Integration Policy Index (MIPEX) suggests that forthe 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 havebecome tougher. And even for a single country, different strands of policy often shift indifferent directions.ConclusionWe might expect a deep recession to be the occasion for a sharp tightening ofimmigration policies, especially after a long period of rising immigration. So far thathas not happened – at least not a severely as history would lead us to expect. One lasthistorical comparison is useful – international trade. During the Great Depression andat other times of severe economic shocks, tariffs and other trade barriers also increasedsharply. In the current recession, some observers have noted the rising use of temporarytrade barriers and policies that restrict trade under other guises (Bown 2011). Butcompared with historical experience, the increase in protection has been mild.With regard to trade, one argument is that seriously protectionist policies are simply notpossible within the WTO framework. The commitment of G20 governments and other151

Rethinking Global Economic Governance in Light of the Crisisinternational leaders to the global trading framework has protected it from a potentiallycatastrophic collapse that could have reversed half a century of progress. Sucharguments do not apply with the same force to migration. Although the EU has a rangeof 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 beenmuted.The truth is that we still do not fully understand how immigration policy evolves, andwhy it seems so different now than in the past. Nevertheless, we can point to some keyfactors.• With rising education, attitudes to immigration are better informed and there is alsoless to fear from the competition of unskilled immigrants.Thus, with a few exceptions, there is no pre-existing upward trend in anti-immigrantsentiment overall.• While people may be concerned with the cost of the welfare state, unlike the moredistant past, it also provides them with a safety net.• At the international level cooperation has increased, within the EU and beyond, anddraconian immigration rules could potentially be inimical to negotiations on otherissues.But such arguments must remain speculative until they can be subjected to morerigorous examination.152

The recession and international migrationReferencesBoeri, 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 ofTemporary Trade Barriers, London: CEPR Policy Report.Dustmann, C. and Preston, I. (2001), «Attitudes to Ethnic Minorities, Ethnic Contextand Location Decisions,” Economic Journal, 111, 353-373.Dustmann, C. and Preston, I. (2007), “Racial and Economic Factors in Attitudes toImmigration,” Berkeley Electronic Journal of Economic Analysis and Policy, 7, Article62.Dustmann, C., Glitz, A. and Vogel, T. (2010), “Employment, Wages and the EconomicCycle: Differences between Immigrants and Natives,” European Economic Review, 54,pp. 1-17.Facchini, G. and Mayda, A. M. (2009), “Does the Welfare State Affect IndividualAttitudes toward Immigrants?” Review of Economics and Statistics, 91, pp. 295–314.Goldin. C. D. (1994), “The Political Economy of Immigration Restriction in the UnitedStates,” in C. Goldin and G. Libecap (eds.), The Regulated Economy: A HistoricalApproach to Political Economy, Chicago: University of Chicago Press.Hainmueller, J. and Hiscox, M. J. (2007), “Educated Preferences: Explaining IndividualAttitudes toward Immigration in Europe,” International Organization, 61, pp. 399–442.Hatton, T. J. (1995) “A Model of UK Emigration, 1871-1913,”Review of Economicsand Statistics, 77, pp. 407-415._____ (2011), Seeking Asylum: Trends and Policies in the OECD, London: Centrefor Economic Policy Research, at: http://www.cepr.org/pubs/books/cepr/Seeking_Asylum.pdf.153

Rethinking Global Economic Governance in Light of the CrisisHatton, T. J. and J. G. Williamson (1998), The Age of Mass Migration: Causes andEconomic Impact, New York: Oxford University Press._____ (2005), Global Migration and the World Economy: Two Centuries of Policy andPerformance, Cambridge, Mass.: MIT Press._____ (2009)” Global Economic Slumps and Migration” VOX EU at: http://voxeu.org/index.php?q=node/3512Lahav, G. (2004), “Public Opinion toward Immigration in the European Union: Does itMatter?” Comparative Political Studies, 37, pp. 1151–1183.Mayda, A. M. (2006), “Who Is Against Immigration? A Cross-Country Investigationof 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 Attitudestowards Immigration’, European Journal of Political Economy, 22, pp. 838–61.Papademetriou, D. G., Sumption, M. and Terrazas, A. (2010), “Migration andImmigrants Two Years after the Financial Collapse: Where do we Stand?” at www.migrationpolicy.org/pubs/MPI-BBCreport-2010.pdf.154

The recession and international migrationAbout the authorTim Hatton is Professor of Economics at the University of Essex and at the AustralianNational University. His current research interests include the causes and effectsof international migration, and immigration and asylum policy. He has publishedextensively on the economic history of labour markets, including the history ofinternational migration. His most recent books include Seeking Asylum: Trends andPolicies in the OECD (CEPR, 2011) and (with Jeffrey G Williamson) Global Migrationand the World Economy: Two Centuries of Policy and Performance (MIT Press, 2005).He is a Fellow of the IZA and of CEPR.155

A dangerous campaign:Why we shouldn’t risk the SchengenAgreementTito Boeri and Herbert BrückerBocconi University and CEPR; IABPlaying politics with migration is dangerous but dangerously attractive in today’s climateof European malaise. Nicolas Sarkozy, for example, tried to achieve new momentum inhis 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-stepelection. His political and economic rationale, by contrast, remains opaque to say theleast.• 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 andother persons across the EU member states?More generally, uncoordinated national policies are not the right way to governmigration in an area as economically integrated as Europe. Uncoordinated policieswill give rise a prisoner’s dilemma situation where all members spend inefficientlylarge amounts on border controls, sub-optimal asylum and humanitarian policies, andinefficiently restrictive policies on legal migration.What is Schengen?The Schengen Agreement and the related legal framework – the “Schengen acquis” inEU jargon – have three main dimensions (EC 2009):• Removal of border controls for persons moving within the Schengen area157

Rethinking Global Economic Governance in Light of the Crisis• Coordination on short-term visitors for third-countries’ citizens, i.e. the “Schengenvisa” that lets them travel freely within the Schengen area (applying only oncerather than for each Schengen country they want to visit).• Coordination on border control measures vis-à-vis third countries and, when needed,members’ border control measures supplemented and supported by other memberstates (via the agency Frontex).Critically, the Schengen Agreement also establishes information systems that facilitatepolice cooperation among members, especially as concerns illegal migrants.The benefits of the Schengen Agreement are obvious to travellers in Europe – it savestime and money (by reducing information and transaction costs) for citizens and noncitizenswith Schengen visas. But there are other benefits:• Schengen has gone hand in hand with an increase of net immigration to the Schengenarea – an increase not experienced by the countries outside the area. As Table1 shows, non-Schengen nations have experienced a decline in immigration flows.• Job opportunities offered by an individual country in the Schengen area are moreattractive as they come with the option of freely moving across the entire area.• Schengen has also eased the conditions for doing business in Europe; travellersfrom abroad perceive the Schengen area as a common market, which is much moreattractive to businesses than the fragmented situation before the agreement.Table 1. Inflows of migrants, thousands of peopleEuropean Countriesnot in the SchengenAreaCountries in theSchengen Areapre-Schengen(1985–95)post-Schengen(1996–2007)% Variation2417.964 1130.986 -53%12104.84 19393.5105 60%Difference 113%Source: OECD, International Migration Dataset.158

A dangerous campagin: Why we shouldn’t risk the Schengen AgreementQuantifying the gains of Schengen for businesses, consumers, and tourists is difficult,if not altogether impossible. Given the high and increasing tendency of travelling allover the Schengen countries and into the area, removing Schengen is like introducing atax on economic integration. It would also have negative consequences on the shapingof a common European identity, hence on social and political integration just at a timein which the public debt crisis and fiscal spillovers across jurisdictions require strongercross-country policy coordination in the EU.Does Schengen increase illegal migration?The Schengen Agreement does not reduce incentives for the enforcement of bordercontrols in each country. It actually encourages tight border controls vis-à-vis thirdcountries. According to the so-called Dublin II directive, the first EU nation a refugeeenters 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 thirdnationborders. If refugees apply for asylum in other member countries, they will besent 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 borderprotection. 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 areespecially affected by illegal migration from sub-Saharan Africa and northern Africa. Inspite of the severe recessions experienced by southern Europe, the political revolutionand the subsequent economic downturn in northern Africa further increased thesepressures.The figures of illegal migrants which entered Italy and Spain via the sea look rathermoderate compared to previous waves of immigrants fostered by political instability,159

Rethinking Global Economic Governance in Light of the Crisisfor example in the Balkans. In Italy they were, on average, of the order of 20,000 peryear, except in 2011 when they jumped to about 50,000. Bilateral agreements withnorthern African countries to prevent transit migration from sub-Saharan Africa and theblood toll on the sea contributed to discourage larger flows. However, there are otherchannels to entry so that actual figures might be much larger, and there are no data onillegal migration across countries in the Schengen area.Border controls are expensive and the treatment of asylum cases can be even morecostly. Italy is bound to spend more than €1 billion in 2012 just for the daily allowancesof asylum seekers who applied for this status in 2011. These costs are, in our view, acritical issue and the threat to the sustainability of the Schengen Agreement.The foul play of BerlusconiLast year, the government headed by Silvio Berlusconi made a populist moveundermining the principles of the Schengen Agreement and the Dublin II directive. Itprovided tourist visas to refugees and encouraged them to cross the border with othercountries, notably France. This clearly violates the purpose of the Dublin II directive.Although these measures were withdrawn within a couple of days, they seriouslydamaged cross-country cooperation in enforcing the Schengen Agreement. Well beforethe Sarkozy campaign, the Danish government announced its intention to re-imposecontrols on its frontiers with Germany and Sweden.It should be stressed that the problem will not be solved by re-introducing bordercontrols. If the Schengen Agreement and the Dublin II directive are abolished, theincentives for border protection in the most affected countries are reduced sincegovernments may hope that illegal migrants find their way to other EU countries if theyare sufficiently tough with migrants. This would create unfortunate knock-on effects – arace to the bottom in humanitarian standards and high costs of border controls acrossSchengen countries. Moreover, border controls for third-country nationals also require160

A dangerous campagin: Why we shouldn’t risk the Schengen Agreementborder controls for citizens of the Schengen countries, and this would involve higheconomic and social costs.Sharing the costs of border controls?The countries most affected by illegal migration perceive the other countries in theSchengen area as free riders in terms of border controls. As mention, their third-nationcontrols provide a public good for the whole area. A reform of the Schengen acquistherefore has to address this issue. The most natural way to take these concerns intoaccount is to share at least some of the costs of border enforcement.EU governments ought to acknowledge that cross-country spillovers of migrationpolicies are unavoidable. The case of the French-Italian border is not the first, nor willit be the last. Here are a few precedents.• Finland tightened up its restrictions on immigration in 2004, reacting to the morerestrictive stance taken by Denmark in 2002 which was inducing many more peopleto go to Finland.• Portugal adopted more restrictive provisions in 2001, just after a similarly restrictivereform implemented by Spain in 2000.• Ireland chose a more restrictive approach in 1999, after two reforms in the UK thathad tightened up migration restrictions in 1996 and 1998.The lesson from all of these episodes is that uncoordinated national policies cannotgovern migration. They can only give rise to a race to the top in putting nominalrestrictions on migration, systematically violated by illegal migrants coming in fromsomewhere 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 humanitarianpolicy, possibly integrated into a points-based system.161

Rethinking Global Economic Governance in Light of the CrisisAddressing the fundamental migration problemsAt present, France and most other EU member states pursue a zero immigration policyvis-à-vis the countries in the northern Africa. The consequence of these policies is thatfamily reunification, humanitarian migration, and illegal migration become the mainchannels of entry. These immigrants are, on average, less educated than economicmigrants and natives, do not generally achieve native language proficiency andtypically have a poor performance in the labour market and education system of thehost country. This in turn feeds into negative perceptions of natives as to the fiscal costsof immigration (Boeri, 2009), and makes economic and social integration more difficultespecially at times of slow growth, let alone deep recessions. These problems cannot beaddressed by a reform of the Schengen Agreement. They require a fundamental reformof immigration policies, restoring a key role for labour migration.Learning from the EU eastern enlargementPer capita incomes in most northern African countries are not much lower than thoseof the new EU Member States when they joined (Bruecker et al. 2009). While theystand between 25 and 35% of GDP per capita in the EU measured at purchasing powerparities, the GDP of the new member states varied between 35 and 55% of those in theEU15 when they joined. Moreover, substantial parts of the youth urban labour force innorth Africa are, at least on paper, relatively well educated. Thus, the experience of theeastern enlargement of the EU can be rather instructive in assessing the consequencesof increased immigration from northern Africa.From the eight new member states, which joined the EU in 2004, we have seen anannual net migration inflow of about 210,000 persons, another 200,000 moved annuallyfrom Bulgaria and Romania (Baas and Bruecker, 2012). The education levels of theseyoung migrants are similar or higher than those of natives, and in many countries theirunemployment rates are below the national average. According to our simulations, netimmigration from the ten new members so far generated an increase of GDP for the162

A dangerous campagin: Why we shouldn’t risk the Schengen Agreement(enlarged) EU of the order of 0.7%, or €74 billion. This result is not negligible intimes of slow growth in the entire EU area. More benefits will come as the assimilationof immigrants proceeds and they get jobs fitting their competences, rather thandowngrading their skills.Given the larger size and the slightly lower per capita income in the Mediterraneancountries neighbouring the EU, the economic gains from potential migration fromnorthern Africa are even larger. Clearly, it is much too early to consider a freemovement of workers from these countries similar to the eastern enlargement of theEU. But adopting more realistic restrictions vis-à-vis northern African countries andencouraging skilled immigration from Egypt, Tunisia, and other countries in that areacan reduce pressures for illegal migration and create substantial economic gains in boththe receiving and sending regions.ReferencesBaas, 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 enlargementand the functioning of the transitional arrangements, European Integration Consortium.Hatton, T. (2005) European Asylum Policy, National Institute Economic Review 194(1), 106-119.EC (2009). “Official Journal of the European Communities - The Schengen Acquis”,2009.163

Rethinking Global Economic Governance in Light of the CrisisAbout the authorsTito Boeri is Professor of Economics at Bocconi University, Milan and acts asScientific Director of the Fondazione Rodolfo Debenedetti. He is research fellow atCEPR, IZA and Igier-Bocconi. His field of research is labour economics, redistributivepolicies and political economics. His papers have been published in the AmericanEconomic Review, Journal of Economic Perspectives, Economic Journal, EconomicPolicy, European Economic Review, Journal of Labour Economics, and the NBERMacroeconomics Annual. He published 7 books with Oxford University Press and MITPress. After obtaining his Ph.D. in economics from New York University, he was senioreconomist at the Organisation for Economic Co-operation and Development from 1987to 1996. He was also consultant to the European Commission, IMF, the ILO, the WorldBank and the Italian Government. He is the founder of the economic policy watchdogwebsite 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 andEuropean Integration at the IAB since 2005 and Professor of economics at theUniversity of Bamberg since 2008. He completed a degree in sociology at the Universityof Frankfurt in 1986 and attained subsequently his doctorate from the University ofFrankfurt in 1994. In 2005 Herbert Brücker received his habilitation in economicsfrom the University of Technology in Berlin. From 1988 to 2005 he held researchpositions at the University of Frankfurt, the German Development Institute (GDI) andthe German Institute for Economic Research (DIW) in Berlin. Herbert Brücker wasVisiting Professor at the Aarhus School of Business from 2004 to 2005.164

Rethinking global economic governance in light of the crisis:New perspectives on economic policy foundationsGlobal governance was, to put it charitably, one of the ‘steadier’ areasof economic research. Then the storm hit — the global crisis capsizedexisting concepts — pushing economists and political economists intouncharted waters.For scholars, these horrible events were both daunting and exciting.Cherished assumptions had to be binned, but global governancebecame a top-line issue for heads of state. Economic and politicalanalysis of global governance really mattered.This Report collects a dozen essays by world-class scholars on the fullrange of global governance issues including macroeconomics, finance,trade, and migration. These reflect the research of nine researchteams working in an EU-funded project known as PEGGED (Politics,Economics and Global Governance: the European Dimensions).