For the past few years, headlines in Europe have been dominated by the financial and economic developments of the crisis, first in the banking system and then in sovereign debt markets. Throughout this period the urgencies of the moment have tended to divert attention from the bigger picture, which is political. To be fair, none of the political questions raised by the sequence of events in Europe since mid-2007 is entirely new. But the crisis has shed new light on them, and may allow Europeans to consider them with more lucidity. The attempt made here is not intended to be comprehensive or even consistent, but only to stimulate more thinking on issues which may become increasingly prominent in the next few months.

Europe’s Executive Deficit

There are many causes, dimensions, and narratives of this crisis. To name but a few: the euro area as a far-from-optimal currency area; economic imbalances; supervisory failures and structural fragilities in an insufficiently integrated financial system; lack of competitiveness in the south; lapses of fiscal discipline. However, none of these explains why the crisis has become so intense. An alternative, non-economic narrative is needed and can be labeled as one of ineffective government—the inability to make decisions when they are needed. It is a truth as ancient as politics that no decision is often worse than bad decisions. From this standpoint, the succession of summits and top-level photo opportunities throughout those years in Europe has been essentially an illusion. The political leaders and heads of state and government have been on the front pages almost every day, but this has been a reflection of their collective paralysis rather than decisiveness.

This stands in stark contrast with the other extreme in the United States during the fateful weeks of crisis management in September and October 2008, when the President was literally absent from the scene. In the United States, a strong and long-established executive framework allowed the Treasury Secretary to take initiatives almost single-handedly. Conversely in Europe, the absence of a proper framework to make executive decisions meant that no sufficient progress could be made in spite of constant involvement of the principals. In other words, an executive deficit is the true core of the European crisis.

This executive deficit can be characterized even more specifically. The most basic feature of executive power is the ability to allocate pain and gain—which of course must be appropriately restrained to be kept compatible with liberty. Allocating losses is exactly what Europe has not been able to do, with the feeble exception of the Greek debt restructuring of March 2012 but not to an extent sufficient to resolve the problem at hand. The absence of a mechanism to allocate losses is why Europe’s banking crisis, identified as early as the end of July 2007, has been left unresolved and has only become deeper for half a decade. This is not a problem of the periphery, but rather of the center—started in Germany (IKB was the first canary in Europe’s banking coal mine) and still essentially unresolved.

It is not impossible that this executive paralysis may lead to the unraveling of the euro. In a provocative recent piece published on the OpenDemocracy website and reflecting on lessons from the collapse of the Soviet Union, political philosopher Ivan Krastev noted that “the belief that the union cannot disintegrate is also one of the major risks of disintegration.” European leaders often insist on the vast progress being made and typically cite the European Supervision Authorities, the “Six-Pack,” the European Semester, the Fiscal Compact, or other major initiatives of the past few years. These achievements are not to be underestimated. But they remind one of Mikhail Gorbachev boasting his Perestroika reforms: the fact that many substantial reforms are introduced does not imply that they are sufficient, given the magnitude of the challenge at hand. In his analysis, Krastev takes due note of the fundamental differences between the European Union and the Soviet Union. He quotes historian Martin Malia’s observation that the Soviet order “collapsed like a house of cards because it had always been a house of cards,” and adds that “the EU is not a house of cards.” But he also notes that “the most disturbing lesson coming out of the study of Soviet collapse is that in times of threats of disintegration, political actors should bet on flexibility and constrain their natural urge for rigidity and solutions intended to last which, if and when they fail, can accelerate the momentum to disintegration.” Whether on banking or on fiscal policy such flexibility has been scarce in the management of the crisis so far, another manifestation of Europe’s executive deficit.

Executive Deficit, Democratic Deficit, and Political Union

There are, of course, partial exceptions to Europe’s executive deficit. The European Central Bank has been able, since the very earliest days of the crisis in August 2007, to take swift and decisive action when necessary. Similarly, the European Commission, in its capacities as competition authority and trade negotiator, has a proven ability to act as an executive, including in the case of competition policy in the context of the banking crisis. However, all these cases are in policy areas where it is possible to empower independent authorities with a clear mission and mandate. The challenge is to expand such decision-making capacity at the European level to policy areas with a more direct political content, such as banking policy, fiscal policy, and perhaps also some aspects of structural reforms where consistency at the European level is needed. In these areas, no such independence can be granted to authorities as in monetary policy, competition policy, or trade negotiations. Political accountability is needed.

This suggests that Europe’s executive deficit can be seen as the flipside of its much-discussed democratic deficit. Leaders are unable to act at the European level because they do not have a European political mandate to act. Individual members of the European Council may have a mandate from their respective national citizenries, but the aggregation of national mandates which are often mutually contradictory does not result in a European political mandate. A different mechanism is needed to enable the definition and expression of a political direction that applies to European-level policies. The current institutional framework has failed to provide such a mechanism, and thus requires transformation for the crisis to be overcome. This transformation is what Europeans should envisage under the label of “political union.” This expression is not new. Four decades ago, it was mention as an aspiration in the conclusion of a European Summit in October 1972 in Paris, and had also been used earlier in the European context. But its significance in the current context should be specifically about creating accountability mechanisms that would permit the emergence of a political mandate to act, particularly in areas such as banking policy, fiscal policy, and competitiveness policy which the crisis has shown need to be more tightly integrated at the European level than is currently the case for the euro area’s monetary union to become sustainable.

The Role of European Parliament

The historical experience of the past few centuries suggests that the most promising option to achieve this aim is through representative democracy. It seems logical then to consider a central role for the European Parliament. The combination of national parliaments may be envisaged to provide a check on the European Parliament, but cannot substitute for it: as in the European Council, the addition of national political mandates cannot fulfill the need for a European one.

The European Parliament is often lambasted, and sometimes for good reason: many Members of the European Parliament (MEPs) are serial absentees, and pointless grandstanding in its hemicycle is not unheard of. But much of the criticism it receives as an institution is unfair. This includes the infamous Brussels-Strasbourg traveling circus, which is imposed by the member states not the MEPs, and could only be eliminated through a unanimous decision of the Council. Furthermore the European Parliament, in spite of its limited powers, has built a rather constructive track record through the crisis, say on the supervisory package that created the three new European Supervisory Authorities and the European Systemic Risk Board, or on the so-called “six-pack” of five regulations and one directive reforming the Stability and Growth Pact and introducing new economic surveillance mechanisms. In a recent speech in Washington, former European Central Bank President (and recently elected Bruegel chairman) Jean-Claude Trichet opined that the European Parliament was the one institution where he had encountered “the best European spirit” during his tenure at the central bank and particularly since the start of the crisis.

However, the European Parliament as it currently exists is not sufficient to provide the democratic accountability that would allow a meaningful reduction of European’s executive deficit. At this point, the most authoritative analysis of its shortcomings arguably remains the German constitutional court’s landmark ruling on the Lisbon Treaty in June 2009. It is worth quoting at some length:

Neither as regards its composition nor its position in the European competence structure is the European Parliament sufficiently prepared to take representative and assignable majority decisions as uniform decisions on political direction. Measured against requirements placed on democracy in states, its election does not take due account of equality, and it is not competent to take authoritative decisions on political direction in the context of the supranational balancing of interests between the states. It therefore cannot support a parliamentary government and organize itself with regard to party politics in the system of government and opposition in such a way that a decision on political direction taken by the European electorate could have a politically decisive effect.

The court goes on to call this situation a “structural democratic deficit.” The Karlsruhe court thus makes two main arguments, both of which need to be addressed. First, the European Parliament’s composition is unsatisfactory because European citizens are not equally represented in it. Second, its competencies are too limited for it to have determining impact on policy outcomes.

Regarding the first point about representativeness, it is undeniable that citizens of smaller member states are overrepresented in the European Parliament compared with citizens of larger member states. This impairs the ability of MEPs to collectively represent European citizens. Furthermore, the election processes vary widely across member states, as do the sizes of parliamentary districts and the number of MEPs representing each district. This results in links between voters and MEPs of variable intensity across countries. Much further harmonization of the electoral law governing European would thus be needed, together with significant progress towards equality of the number of voters represented by each MEP. Furthermore, the European Parliament should be able to adjust the perimeter of its sessions to the de facto multiplication of different geographical scopes for different policy areas. One possibility would be to introduce specific formats in which, say, only MEPs from euro area countries would vote on euro area-specific issues, while MEPs from other member states would have some possibility to participate in the discussions but without the right to vote on such matters.

On the court’s second point, what is needed is an expansion of the European Parliament to give him more direct impact on policy. Three aspects appear of particular importance in this respect. First, on legislation, it may be time to grant the European Parliament a right of initiative. Second, the Parliament should have much more direct ability to “advise and consent” on individual senior appointments to European-level executive positions. Third, the European Parliament should acquire a genuine “power of the purse” that applies not only to the European institutions’ budget but more generally to financial decisions made at the European level, particularly in a future framework of banking union and fiscal union.

Reshaping European Executive Functions

While Europe’s legislative branch needs upgrading and empowerment, the current moment does not necessary call for the creation on the executive side of a fully fledged European government. For the foreseeable future executive tasks performed at the European level will remain in discrete, specifically defined policy areas in accordance with the European principle of subsidiarity. Europe is probably not ready for an institutional framework that would place the ability to decide on the allocation of competencies (sometimes called Kompetenz-Kompetenz in reference to the German constitutional vocabulary) at the European as opposed to the national level.

In this context, executive authority may be scattered among different bodies rather than centralized within one single institution: individual ministries and executive agencies but without a prime minister, if one may put it that way. The European Commission may host some of these bodies, as it currently does in areas such as competition policy, but not all as some tasks may require a different governance structure—including but not limited to the future European authorities for banking supervision, resolution, and deposit insurance which need to be established to materialize the aim of creating a European banking union. The vision of a “scattered executive” has the advantage of preventing excessive concentrations of power at the European level while political accountability mechanisms remain in a phase of gradual buildup, and also of allowing a high degree of institutional experimentation and innovation, something that Europe evidently needs. An important aspect is to allow specialist agencies to have as much freedom as possible to hire individuals with the specialized skills they may need.

Naturally, the very notion of a scattered executive raises concerns of coordination among different executive bodies as some policy overlap between their respective remits will inevitably occur. Some kind of “interagency process” will be required, even assuming that each European executive body has wide autonomy within a precisely defined policy scope. The European Council may be the appropriate institution to play this role, provided that the frequency of such interagency decisions can be kept relatively low.

Conclusions and Observations

The crisis is forcing a redefinition of what European integration means from a political standpoint. This will inevitably result in a profound transformation of European institutions. The steps suggested here are a massive simplification of what is needed, and are submitted only to stimulate further reflection; sound constitutional design requires finely tuned checks and balances that go well beyond the expression of broad principles. New treaty arrangements will evidently be needed to implement this transformation. Before they can be envisaged, self-reform initiatives or proposals by the existing institutions themselves would be welcome: This is particularly true of the European Parliament, which as suggested above may need to play an increasingly central role in the context of a future European “political union” while the executive branch remains, at least for some time, more of a work in progress.

It is easy to dismiss this agenda as unrealistic or even irrelevant or downright dangerous. The backdrop however is that the crisis creates a historic moment for Europe, which calls both for bold institutional innovation, as in earlier moments of European history, and for a rooting of such innovation in historical awareness. Three concluding observations are offered in this perspective.

First, political organization is fluid by nature. Some political entities are very stable—Sweden is an example, even though its borders have fluctuated somewhat over the centuries. But even stable entities can disappear. As Jean-Jacques Rousseau observed long ago, “If Sparta and Rome perished, what state can hope to endure forever?” The Soviet Union disappeared much more quickly than most observers, friends, and foes thought possible. Other political entities change over time beyond recognition—a striking example is Burgundy, which was a kingdom bordering on the Mediterranean in the first millennium before gradually shifting north and ending up incorporating much of what is now Belgium and the Netherlands. While its name remains with a French region somewhere in the middle of this range, its political existence as an autonomous entity ended around five centuries ago but its political legacy is manifold. In Western Europe, the relative stability of borders, at least since the Second World War, acts to a certain extent as a misleading mental screen which hides a continuous evolution of political organization. Specifically, all federations are constantly renegotiated and never reach a fully stable point of equilibrium between the role of the center and that of the federated entities.

Second, and even though this must be stated with a lot of caution, history suggests a general direction towards larger, more complex forms of political organization. From bands to kingdoms, from city-states to empires, from the constitution of nations into states to the formation of continent-sized countries such as the United States or India, the evolution has typically been from smaller to larger. This is not a uniform trend of course. The Mongol Empire of the late 13th century remains unsurpassed by several measures; China assumed the features of a hugely sized nation-state early in history. But skeptics who say Europe cannot organize itself politically because it is too large or too diverse often suffer from a narrow historical focus. Europe itself includes multilingual entities like Finland or Belgium and multireligious ones like Germany—or both linguistic and religious diversity in the case of Switzerland, which also happens to be remarkably stable. Outside of Europe, India is a striking example of a continent-sized democracy that is by many counts more diverse linguistically, culturally, and ethnically than is Europe, and its example tends to disprove the often-heard argument that there can be no European democracy because there is no European demos. The awareness of political scale effects was a motivation of European integration from the outset. While making the case for it, Jean Monnet strikingly observed in November 1954 that “Our [European] countries have become too small for today’s world, compared with the scale brought by modern technology and with the size of America and Russia today, and of China and India tomorrow.”

Third, new forms of political organization are almost always shaped in crises, and often in a way that even the main actors had not been able to predict beforehand. While such crises are rarely painless, they are not necessarily bloody. The union of England and Scotland in 1707, the shift of the United States from confederation to federation in 1787–89, the confederation of Canada in the 1860s, and the creation of the Australian federation in 1901 are examples of sequences of political consolidation that were momentous and largely unpredicted but also essentially orderly and pacific. There can be no prediction that the present crisis will trigger a comparable moment for Europe, nor can it be ruled out as a historical possibility.

This post was originally published by the Peterson Institute and is reproduced here with permission.

Just to recap, the capital stock is a broad measure of the existing physical capital in an economy. Economic theory says that a country’s capital stock should increase as it develops and grows richer. Capital stock is usually calculated using the perpetual inventory method.  This method picks a base year where the capital stock was quite low and then adds gross fixed capital formation and subtracts some deprecation allowance.

HSBC and Dragonomics have both put forward capital stock estimates that show China still has much room for investment. Dragonomics shows that China’s capital stock was 82 trillion renminbi in 2010, a number that translates into a lower per capita amount than the United States in 1930s. The implicit conclusion here is that China’s capital stock is low when compared to the United States when it was at a similar level of development. HSBC has a higher number for China’s capital stock, 93 trillion in 2010. HSBC concludes that because China’s capital stock compared to the United States is quite low, only one-third the amount, and there is room for higher levels of investment.

There are a lot of assumptions packed into these conclusions, not all of which should be accepted unquestioningly.  The capital stock per capita in the United States in the 1930s may be of limited value in evaluating current conditions given the immense changes in technology since then. HSBC’s comparison of the United States and China in judging whether China has over invested is not very helpful. The key issue is over what period of time we should expect China’s capital stock to converge to US levels. While the per capita capital stock seems quite low, the capital-output ratio (capital stock to GDP) is not.  Using this ratio, China’s capital stock is comparable to countries at a much higher level of development (Japan, South Korea, and the United States).

Before we get too bogged down in all the details, let’s do quick thought experiment. Let’s assume that the capital stock estimates calculated by Dragonomics are correct. An important question is the speed and environment in which the capital stock has accumulated.  China’s capital stock has grown quite rapidly over the past decade, with close to two-thirds of the capital stock having been created since 2003. In 2003 there was a marked change in China’s interest rate policy where the real lending rate fell by 5 percentage points to extraordinarily low levels.

In other words, the large part of China’s capital stock has been created during a period of highly distorted interest rates.

Let’s assume that the capital stock continues to grow at the same pace as the last several years, around 15 percent. This is a fair assumption given that the 2011 GDP expenditure numbers show that investment as a share of GDP is still rising.

This would mean that China’s capital stock will double in the next five years. If you believe that prices (i.e., interest rates) are important for ensuring the efficient allocation of resources, then the fact that almost all of China’s capital stock has been created in an environment of highly distorted prices should be quite worrying.  This low lending rate contributed to the significant increase in capital formation as a share of GDP, from 41 percent in 2003 to 49 percent in 2011.

Whether China’s capital stock is appropriate given the size of its economy and level of development is a subject where there are legitimate arguments on both sides and much more research to be done. What’s not open to debate is that unless China quickly adjusts its interest rate policy, the vast majority of its capital stock will have been created in an ultra-low interest rate environment, raising the possibility of malinvestment on a massive scale. This is one example in economics of the “flow” being just as important as the “stock.”

This post originally appeared at Peterson Institute.

The future of Europe, however, will not be determined by the poor 2012 euro area second quarter economic performance. The drop in the euro’s value is good for external demand, and the likelihood of an actual Greek exit from the euro is much overblown.¹ The “informal EU Council” was never expected to produce “deliverables.” In other words, as usual, the euro gloom is exaggerated. In fact, the last week brought several encouraging developments.

Bankia’s Failure: A Manageable Problem?

First, the Spanish government is finally owning up to the full scale of its banking crisis. The new capital requirement of troubled Bankia is estimated at €23.5 billion (including €4.5 billion of government loans previously converted into equity). This number is well within the legislated financial capacity of the Spanish government’s domestic bank bailout fund, the Fund for Orderly Bank Restructuring, or FROB. The question is whether Spain will raise this new government-guaranteed debt quickly. No wonder theSpanish Prime Minister Mariano Rajoy sounded eager to get the European Central Bank (ECB) to resume purchases of Spanish government debt.

Bond markets took the news of these losses relatively calmly, however, even though new rumors circulated concerning poor provincial government finances in the economically important region of Catalonia. Spanish government bond yields were up around 30 to 40 basis points across the 2 to 10 year spectrum for the week, and 10-year rates once again approached the 6.5 percent of late last year. On the other hand, such secondary market yields may not accurately reflect the market appetite for sizable new primary bond issues by the Spanish sovereign.

The calm market reaction likely reflects its expectation of Bankia’s losses, despite earlier denials, and an appreciation of the financial system’s new transparency. But the delayed admission of Bankia losses undermined international confidence in the Spanish government and the hitherto respected Bank of Spain. Covering up banking problems is always the wrong strategy for regulators and political leaders. Assuming the economy will eventually turn around, denial prolongs the agony.

Several options are available for the Spanish government. It can try to issue additional debt in the markets and use the FROB to inject the money into Bankia and probably other Spanish banks. From the perspective of Spanish sovereignty and political pride, this would seem to be the preferred option. That is undoubtedly why Rajoy called for more ECB market interventions to help. Securities Market Program (SMP) interventions do not come with explicit policy conditionality (although in 2011 SMP purchases of Spanish debt were accompanied by a secret letter of conditions accepted by Prime Minister Jose Luis Rodriguez Zapatero). Rajoy probably thinks today that he has done his part by firing Peoples Party bigwig Rodrigo de Rato (a former head of the International Monetary Fund) as president of Bankia and finally owning up to the extent of its losses. Consequently Madrid now expects the ECB to reciprocate by   restarting the SMP program for Spain.

The SMP is unlikely to come to the table today, however. The ECB will almost certainly resist restarting its SMP purchases of Spanish debt. The reason is that euro area institutions have evolved since 2011. The new European Stability Mechanism (ESM) backed by euro area governments is scheduled to become operational by July 1, pending various national ratification processes (of which more is said below). It will then be able to purchase Spanish government debt directly at primary auctions to help keep Madrid’s funding cost down. As a result, the ECB will not likely want to restart its SMP program to help Spain. Instead the central bank will see aiding Spain as a task for the euro area’s new institutions and euro area governments.

The ECB will certainly remain the ultimate euro area firewall and intervene with overwhelming force if necessary. But from its perspective, the ESM is there to be used to provide financial assistance—and impose the policy conditionality that the ECB felt reluctant to demand itself. Any purchases by the ECB will simply be symbolic—a signal that it is still there and only side-by-side with direct ESM primary market purchases.

Another option for Rajoy would be to ask for a loan under the ESM Treaty’s Article 15, earmarked to recapitalize Spanish banks. Conditionality would again be explicit, calibrated to economic conditions and —as the treaty’s Article 12 states [pdf]—“appropriate to the financial assistance instrument chosen.” A third option would be to have the ESM recapitalize Spanish banks directly. But that choice is politically unpalatable without a broader integrated euro area banking sector resolution and regulatory union.  That project is moving along, but setting it up may take more time than Spain has at its disposal.

Thus if the markets continue to make the cost of a bank cleanup unaffordable, all roads point to the ESM. For now, a full-fledged IMF program, removing the Spanish sovereign from the markets for years, remains unwarranted.

On the other hand, the Spanish government could issue additional debt for bank recapitalization at historically high—but not necessarily ruinous—yields. Several reasons might make such a route possible. First, many euro area fund managers ought to be willing to take a chance on long-term Spanish debt yielding around 6 percent, or around 3 to 4 percent in real terms. After all, the investment alternative would be German debt, with its negative real interest rates guaranteeing destruction of wealth.  Germany’s ability to issue debt at coupons so low—when the Bundesbank is accepting higher inflation and workers are getting the highest wage increases in decades—is an indictment of the efficient market hypothesis. This German anomaly should certainly fuel demands for restrictions on financial markets’ remuneration.

Second, unlike standard deficit spending, expenditures devoted to bank nationalizations shift assets, however impaired, on to the government’s balance sheet. As a result, net Spanish government debt levels may not go up as much as gross debt levels. The worth of nationalized banking assets will not be known for many years, when presumably the Spanish government will want to sell their bank shares.

Third, it is not clear if current Spanish yields have already priced in the worst case scenario for the cost of bailing out the banking system. Markets have been concerned about that cost for months. If yields at more than 6 to 6.5 percent already reflect a market estimate of banking cleanup costs, the perception of risk for Spanish debt may not rise.

Finally, the cost of bailing out Bankia will be determined by the implications for the health of the rest of Spain’s banking system. We will not know the extent of the problem for months, when Oliver Wyman and Roland Berger publish their independent audit of the entire system. If Bankia turns out to be the most rotten apple—then Bankia’s nationalization and cleanup should be affordable. If Bankia is indicative of the entire apple barrel of Spanish banks, then surely the ESM awaits.

Germany ’s Politics: A Step Toward One Form of Euro Bonds?

The second piece of positive news last week was the first harbinger of a likely new German “Grand Coalition” after the next federal elections in 2013, and how such a  grouping will respond to the euro area challenges. As Chancellor Angela Merkel begins the political horse trading necessary to pass the Fiscal Compact and ESM treaties with a super majority in the full German parliament, her Christian Democrats and the Christian Social Union allies engaged for the first time with the Social Democrats (SPD) over a proposal from last year for a European Redemption Fund (ERF) as proposed by a team of German “wise men.” The fund would convert euro area government debt in excess of 60 percent of GDP into de facto eurobonds. These bonds would be senior to the remaining 60 percent of national sovereign debt, creating €2.3 trillion of such securities. Member states would be obliged to redeem the ERF bonds over 25 years.

The ERF has recently become an official SPD proposal [pdf]. Some version of it may become the official German response to the renewed calls for eurobonds from other states. More discussions are planned for mid-June, but a big announcement would speed ratification of the Fiscal Compact/ESM treaties in Germany—a major development for the euro area!

The SPD’s embrace of the ERF sets the German Social Democrats apart from President Francois Hollande and his Socialists in France, with their call for eurobonds now. Hollande is unlikely to moderate his rhetoric until after the French parliamentary elections in a few weeks. But economic realities in the euro area are likely to compel him to work with the SPD, perhaps embracing its approach.

Many advocates of eurobonds will see the ERF as a poor substitute—too little too late to secure long-term stability.  Recall, however, that many of these same pundits declared in 2011 that the euro area would be crushed by its imminent bank and sovereign debt rollovers and cease to function by mid-2012. In fact, while an ERF might be temporary, it would create a permanent new de facto joint liability of eurobonds.  The reality is that the euro area will not abandon the economic benefits derived from this large pool of senior joint liability bonds. Together they will make up a new risk free benchmark asset for the banking system and a pool of debt to rival the US Treasury market for liquidity. No less important, they will serve as coercive political instruments to force—or provide incentives for—member states to implement structural reforms and sound fiscal policies to retain access to the ERF.

Twenty-five years is a long time in European politics. In that timeframe, treaties can be changed and institutions can be created to secure a stronger political integration of Europe and pave the way for actual euro bonds. An ERF would therefore constitute the ultimate example of the euro area buying time to sort out the messy politics of continental integration.

The European Council: Heading to More Integration?

Third, the informal European Council session last week marked another policy step towards integration similar to the signing of the Fiscal Compact Treaty earlier this year. Many will ridicule the reports prepared by Herman van Rumpoy, the European Council president, for the heads of state and governments to discuss further. That would be a mistake. The reports should be viewed as a scaled-down and expedited “crisis version” of the policy process with which the EU changes its treaty, known as the European Intergovernmental Conferences (ICGs).

The last time van Rumpoy was charged with preparing such a report was at the EU Council on October 23, 2011 [pdf], when the purpose was to “reflect on further strengthening of economic convergence within the euro area and on improving fiscal discipline and deepening economic union.” The intention then was to change the EU Treaty, although that was thwarted by the myopic opposition of Prime Minister David Cameron of Britain. The outcome was the inter-governmental Fiscal Compact Treaty.

Van Rumpoy was directed to [pdf] “report [at the EU Council] in June, in close cooperation with the President of the Commission, the President of the Euro Group and the President of the European Central Bank, on the main building blocks and on a working method to achieve this objective [the need to strengthen the economic union to make it commensurate with the monetary union]. Colleagues expressed various opinions on issues such as eurobonds in a time perspective, more integrated banking supervision and resolution, and a common deposit insurance scheme.”

This is how policy is made in Europe these days. Considering how the ECB has begun to campaign for a “European Banking Union,” it is a safe bet that its president, Mario Draghi, will ensure that it is on the agenda at the next EU Council. The ECB has been direct in its demand for more integration. Draghi has been relatively opaque in his calls for a “10-year plan for the euro,” but other ECB executive board members have been more clear. Jörg Asmussen, on May 24, said: “We have to move closer to a financial markets’ union. A European bank resolution authority and a European deposit insurance scheme are two elements that could be used to address the nexus between sovereigns and banks.”

The next day, May 25, Peter Praet was similarly unambiguous: “Europe needs to move towards a ‘financial union,’ with a single euro area authority responsible for the supervision and resolution of large and complex cross-border banks. This authority should also be responsible for a euro area deposit insurance scheme. With bank resolution and deposit insurance funded primarily by private sector contributions, taxpayers would be shielded from picking up the bill for future banking crises. Essentially, I envision an authority similar to the Federal Deposit Insurance Corporation in the United States.”

The ECB’s record in securing the financial stability of the euro area—and its willingness to extract political concessions from elected leaders—have made progress on integration of the euro area banking system increasingly likely.² Doom will get the headlines, but this is a more important development than whether the ECB must undertake another Long Term Refinancing Operation (LTRO) or other new emergency measures in coming months.

As for the role of the International Monetary Fund (IMF), the recent, perhaps impolitic comments by the fund’s managing director, Christine Lagarde, could roil the waters by stirring fresh resentment in Greece. In a wide-ranging interview with the Guardian, she said: “I think more of the little kids from a school in a little village in Niger who get teaching two hours a day, sharing one chair for three of them, and who are very keen to get an education. I have them in my mind all the time. Because I think they need even more help than the people in Athens…. Do you know what? As far as Athens is concerned, I also think about all those people who are trying to escape tax all the time—all these people in Greece who are trying to escape tax.”

Such blunt words, especially for an IMF managing director, are sure to figure in the upcoming election campaigns in Greece and Lagarde’s native France. But it would be unfortunate if they dominated the news story, because she pointed her finger to two important but overlooked issues. Greece has indeed received more economic support per capita than probably any program recipient of the IMF, when the regional support from the euro area is also included. Second, as Dimitris Drakopoulos of Nomura in London has pointed out to me, Greek tax revenues indeed remain a key policy problem. The revenue intake has again collapsed in recent weeks, raising doubts about whether any Greek government can continue to finance itself after the Greek elections on June 17.

Beyond the troubles of Greece, however, the bigger picture of the outlook of the European currency union remains. It is often said that the long-term viability of a political entity is dictated by the vigor of its arguments over fundamentals, including the design and role of its government institutions and the directions of its values. That is often said of the United States.

A closer look behind the surface squabbles, at what is actually going on in the euro area, makes this author optimistic over its future.

Notes

1. I have discussed this recently here on RealTime.

2. German Chancellor Merkel was on the same page at a recent speech in Berlin on May 22.

This post originally appeared at Peterson Institute.

Unfortunately, the decision of the finance ministers announced on May 15 reflected a compromise that set back the cause of reform, risking further instability for the banking system in Europe and the global economy generally. The European Parliament should demand significant changes before approving this very flawed measure.

It has been reported that in the debates, the United Kingdom, Sweden, and Spain, with the support of the European Central (ECB), favored a “yes” answer to all three of the questions cited above. For convenience, I call this position the Osborne View—named after perhaps its most ardent proponent, George Osborne, the UK Chancellor of the Exchequer. Another group of EU countries, reportedly led by Germany and France, with the support of the European Commission, opposed that position. I call this position the Schaeuble View (after Germany’s Minister of Finance, Wolfgang Schaeuble).

The compromise of May 15, at a meeting of EU Finance Ministers (ECOFIN), was endorsed unanimously. (Council of Economic Union, 2012). All the details have not been published, but the main features can be summarized as follows. Measured against banks’ total exposure, EU members will need EU approval to implement in their national banking legislation minimum (risk-weighted) bank capital ratios that exceed the Basel III minimum by more than 300 basis points. For domestic and non-EU exposure, the threshold for EU approval will be higher, at 500 basis points. These thresholds would allow the United Kingdom to implement the recommendations of the Independent Commission on Banking (2011, also known as the Vickers Report) – including the ring-fencing of the retail operations of banks and a minimum equity capital ratio of 10 percent, without any approval by the EU.

The May 15 accord also permits EU banks to count as equity capital several financial instruments with dubious loss-absorbency, including the so-called “silent participations” of German banks and the minority stakes of French banks in insurance companies. Such a step weakens the Basel III guidelines on the quality of bank capital. In one of the few concessions to the Osborne View, the agreement adheres to the Basel III time schedules for the leverage ratio and the two liquidity standards. Finally, to provide additional macro-prudential tools against asset-price bubbles in real estate, member countries will be allowed to modify (increase) the bank capital risk-weights against exposures to residential and commercial property.

Over the next few weeks, the European Parliament will discuss these steps and negotiate a final version with EU Finance Ministers. There are reports that the European Parliament may demand restrictions on bonus payments (in bank compensation policies) before approving the package, however.

From a narrow procedural perspective, the May 15 ECOFIN decision is a step forward on financial sector reform. After all, the Basel III bank capital standards cannot go into effect until they are embedded in national banking legislation and the May 15 ECOFIN decision advances their implementation.

But fundamentally the May 15 decision is a setback for reform. The main purpose of Basel III was to enhance financial stability and to limit the liability of taxpayers for bank losses by putting much more high-quality bank capital into banking systems around the world. The decision taken by EU Finance Ministers makes that objective harder in two ways. First, requiring EU countries to win approval of the European Union for minimum capital ratios much in excess of the modest standards in Basel III will discourage urgently needed strong capitalization (and recapitalization) of banks in the euro area. Second, watering down the Basel III standards for the quality of bank capital may encourage a race to the bottom on the loss-absorbency of bank capital. Such a development would weaken limits on taxpayer liability for bank losses.

I base my conclusion on five main points: (i) EU banks are currently under-capitalized; (ii) cross-country differences within the EU on the vulnerability to bank losses—including the size of too-big-to-fail banks and the absence of a pan-EU bank deposit and resolution regime—call for cross-country differences in minimum bank capital ratios; (iii) the minimum capital ratios agreed under Basel III are too low; (iv) allowing EU banks to include low-quality components in the definition of equity capital will unjustifiably shift the burden of bank failures on taxpayers and weaken Basel III beyond the EU; and (v) the arguments that allowing higher minimum capital standards in individual EU countries would harm economic growth and jeopardize the Single Market are unpersuasive.

I. EU Banks Are Under-Capitalized

EU banks remain undercapitalized when evaluated by the appropriate metrics. The most reliable metric of capital adequacy – warts and all – is the simple unweighted leverage ratio (the ratio of equity to total assets). All the risk-weighted measures of bank capital have been distorted by political pressures, conflicts of interests, and gaming of the regulations by banks (Helwig, 2010, Admati et al, 2011). Exhibit A: with all the questions about debt sustainability in some EU periphery countries, the sovereign debt of EU countries still receives a zero risk weight for the purpose of calculating risk-weighted assets, the denominator in all risk-weighted capital ratios. Experience in the run-up to the global economic and financial crisis of 2007-2009 also demonstrated the poor quality of risk-weight calculations for banks’ trading assets, securitized instruments, credit ratings of complex financial instruments, and the estimation of risk-weighted assets in banks’ internal models (Goldstein, 2012). For this reason alone, the stress tests conducted by the European Banking Authority (EBA), which focus on risk-weighted capital ratios, ought to be viewed skeptically. Indeed, concern over deficiencies of risk-weighted capital metrics led the authors of Basel III to include a minimum (unweighted) leverage ratio over the objection of the banking industry.

The April 2012 issue of the IMF’s Global Financial Stability Review reports that the leverage ratio (the ratio of Tier 1 common capital to adjusted tangible assets) for euro area banks in 2011 was a little more than 4 percent—versus about 5 percent for UK banks and roughly 6 1/2 percent for US banks (IMF, 2012a). Enria (2012a), using a slightly different measure of bank leverage (namely, the ratio of tangible equity to tangible assets) and a somewhat different sample of banks, reports similar findings: the 70 EU banks participating in the EBA recapitalization exercise had a leverage ratio in 2011 of 4.5 percent; this was much below the leverage ratio of 7.8 percent for the top 10 US banks. Moreover, US banks had increased their leverage ratios by more than EU banks over the 2005-2011 period. While structural factors merit some consideration in interpreting these leverage comparisons, they do not negate the fact that EU banks have thin equity cushions.

Other measures of bank fragility point to the weakness of EU banks. The IMF (2011) estimated that between end-2009 and August 2011, euro area banks had a €200 billion increase in credit risk associated with holdings of the stressed sovereign debt of Greece, Ireland, Portugal, Belgium, Italy, and Spain. Inter-bank exposures to these countries brought the increase in credit risk to €300 billion. No wonder that IMF Chief, Christine Lagarde, speaking in August 2011, emphasized the urgent need for recapitalization of EU banks (Lagarde 2011). Domestic depository institutions’ claims on general government as a share of 2012 GDP have now reached 23 percent in Belgium, 17 percent in France, 21 percent in Germany, 29 percent in Greece, 32 percent in Italy, and 26 percent in Spain – versus 7 percent in the United States and 8 percent in the United Kingdom (IMF, 2012a). Euro area banks also rely more heavily on wholesale financing than US or UK banks, with loan-to-deposit ratios hovering at 125 – versus 105 for UK banks and less than 80 for US banks. The vulnerability of relying on wholesale funding was of course dramatically underlined in the second half of 2011, when wholesale funding strains for European banks compelled the ECB to launch its three-year Long-Term Refinancing Operation (LTRO) – a two-stage rescue effort that has risen to more than a trillion euros. While necessary to prevent large-scale liquidity problems from generating massive deleveraging and exacerbating solvency concerns, the LTRO has produced undesirable side effects. Specifically, it has facilitated a carry trade on peripheral sovereign debt that has led banks in those countries to load up even more sovereign debt, aggravating the adverse feedback loop between bank debt and sovereign debt. In addition, by tying up large amounts of collateral, the LTRO has further imperiled the position of unsecured bank creditors in the medium term. Spanish banks alone have enormous exposures to real estate. Despite a Spanish housing bubble bigger than the recent one in the United States, property prices in Spain have fallen from their peak by less than in the United States. On top of all this, the IMF (2012a,b) has estimated that euro area banks are likely to face pressures to deleverage more than $2 trillion of bank assets by the end of 2013. The fund has also warned that such deleveraging would slow EU economic activity and reduce the health of its banks.

In the face of such obvious banking fragility in the EU, the May 15 ECOFIN decision on bank capital seems divorced from realities. With potentially large future EU bank losses on the horizon, constraining the ability of regulators in some EU countries to set minimum bank capital standards in excess of the Basel III minimums is imprudent. Doing so would prevent banks in some EU countries from having enough “self-insurance” to handle potential losses. Consequently, the burden of financing those losses would again fall unfairly on taxpayers and lead to greater dependence on the ECB for liquidity.

II. Cross-Country Differences in the Size of Too-Big-to-Fail Banks Call for Cross-Country Differences in Minimum Capital Standards

The May 15 ECOFIN decision also does not adequately address differences among EU countries in the extent of the too-big-to-fail problem and the implications for minimum bank capital ratios. The combined assets of the five largest banks relative to GDP are three times as high in the United Kingdom and the Netherlands (at about 450 percent of GDP) as in Germany and Italy (Goldstein and Véron, 2011). The greater the size of too-big-to-fail banks in an individual country, the more pressing the need to provide adequate self-insurance against losses in those institutions. Such self-insurance must come from higher bank capital. It is thus no accident that two countries where the combined assets of the few largest banks are particularly large relative to home-country GDP – Switzerland and the United Kingdom—have already moved to enact national minimum bank capital standards tougher than those in Basel III (Goldstein, 2011). The May 15 ECOFIN agreement constrains the ability of EU countries to set such rational self-insurance requirements for their banks. Those EU countries with large banks (relative to home-country GDP) will henceforth face two unpalatable choices. Either they will have to break-up their largest banks to minimize the government’s prospective liability – something that they have so far (unfortunately) refused to consider seriously—or they will have to accept (implicitly) the reality that if these very large banks do come under acute distress, the cost of saving or liquidating them will fall predominantly on taxpayers. European leaders have pledged repeatedly to spare taxpayers from that burden. More generally, it makes no sense to constrain differences in minimum bank capital ratios across EU countries when there is no pan-EU deposit insurance and bank resolution regime in place and when there are sizeable differences in banking risk across these economies. Such differences reflect troubled legacy assets, sovereign debt burdens, cyclical positions, and longer-term structural factors (like the size of too-big-to-fail banks).

III. The Minimal Capital Ratios in Basel III Are Way Too Low

The minimum capital standards agreed under Basel III itself, while better than those in Basel II, are still way too low. Thus, individual countries – whether or not they are members of the EU – need the latitude to exceed those Basel III minimums in their own national legislation. Such freedom supports the spirit of successive Basel bank capital agreements, which have always aimed to set minimum standards to prevent a race to the bottom and to avoid maximum standards that would discourage a race to the top. Costly banking crises occur when banks have too little capital – not when they have ample capital.

The literature suggests several approaches for estimating the minimum or optimal ratio of bank capital. One derives from the fact that banks typically hold bank capital in excess of the Basel minimums even at the bottom of the business cycle. Banks arguably behave that way because the markets – nervous about the near-death experience of some banks in the previous crisis – pressure them to do so. The following question is then posed: if we want banks to remain solvent after suffering credit and trading losses in severe crises and still have enough capital to meet the market imposed minimum at the bottom of the cycle, how high would the minimum capital ratio have to be at the top of the cycle? A recent study by Hanson, Stein, and Kashyap (2010) noted that U.S. banks lost roughly 7 percent of assets during the 2007-2010 period and that very large U.S. banks had a common tier one capital ratio (relative to risk-weighted assets) of about 8 percent in the first quarter of 2010 (near the bottom of the cycle). From that, they concluded that the minimum capital ratio needed to be about 15 percent at the top of the cycle – far above Basel III’s minimum 7 percent ratio (for common core tier 1 capital) or its 9 ½ percent ratio for the globally most systemically-important banks. Applying this approach to other countries’ bank-loss experience and to banks’ capital holdings at different times generates estimates of minimum (common equity) capital ratios in the 12-25 percent range. Again, these levels are far higher than the Basel III minimums.

A second approach is to employ a cost-benefit framework to the estimation of optimal bank capital ratios. On the benefit side, higher capital reduces the probability of a systemic bank crisis that would depress economic growth and undermine government fiscal positions. On the cost side, higher capital is assumed to increase bank funding costs, lower loan volumes, and impede economic growth. A recent study done at the Bank of England (Miles, 2011) applied such a cost-benefit approach and concluded that the optimal bank capital ratio (as a percentage of risk-weighted assets) was about 20 percent – more than double the Basel III minimum for even the most systemically-important banks. Also employing a cost-benefit approach, a group of twenty distinguished professors of finance (Admati et al, 2010a) concluded that the minimum unweighted leverage ratio for banks ought to be at least 15 percent – five times the minimum leverage ratio (3 percent) included in Basel III. The main reason why the cost-benefit approach leads to (optimal) minimum capital ratios higher than those in Basel III is that while the social benefits of higher bank capital are substantial, the social costs of higher bank capital turn out to be modest.

The yawning gap between the minimum standards in Basel III and the minimum standards derived from the best empirical evidence makes it counterproductive to prevent countries from imposing standards higher than those in Basel III.

IV. The Quality of Bank Capital Matters, Along with the Quantity

Basel III was not just about increasing the quantity of bank capital. It was also about improving the quality of that capital so that it would be truly loss-absorbing. In this regard, the Basel Committee on Banking Supervision (BCBS) was responding to one of the main lessons of the global economic and financial crisis: when banks are permitted to count financial instruments as regulatory capital that either are not fully loss-absorbing or are loss-absorbing only if and when the bank is being liquidated, de facto bank capital can be much less than regulatory capital and the government winds-up having to inject funds as common equity into the rescue. To avoid repeating that mistake and to limit the future public-sector liability, Basel III emphasized the highest quality bank capital—namely, equity capital. It also restricted (to 15 percent of the common equity component) the combined weight of lower-quality financial instruments that had been previously allowed. These components included deferred tax assets, mortgage servicing rights, and significant investments in common shares of unconsolidated financial institutions (including insurance companies).

The parts of Basel III dealing with the quality of bank capital represent a compromise in which the United States, Japan, and the European Union each agreed to restrict a low-quality component of bank capital that was viewed as attractive by their own banks. For example, Japanese banks were reluctant to disqualify tax deferred assets, U.S. banks wanted to hold on to their mortgage servicing rights, and EU banks – particularly those with large insurance subsidiaries—wanted to retain their minority stakes in unconsolidated subsidiaries.

The May 15 EU agreement threatens to unravel the Basel III compromise on the quality of bank capital – largely to appease some German and some French banks, which do not want to go to the market to raise high-quality bank capital in order meet higher capital requirements under both Basel III and the EBA stress tests. Instead, these banks pressured their governments to convince other EU members that various low-quality capital components should satisfy such capital requirements. In that way, these EU banks can continue to pay dividends and dole out excessive compensation packages to employees. If these concessions were not forthcoming, these banks would likely be judged as under-capitalized. For German banks, the main bone of contention involves so-called “silent participations” – non-voting, financial hybrids with characteristics of both bonds and equity. These instruments were used by the German authorities to recapitalize some banks during the last financial crisis. They should be excluded from equity capital because most of them become loss-absorbing only after a decision has been made to liquidate the bank. They also do not meet all the Basel III requirements for a fully loss-absorbing component of capital. French banks would like to include their minority stakes in their unconsolidated insurance subsidiaries, even though treating these stakes as capital in both the parent group and the subsidiary involves double counting.

The Schaeuble View on the quality of bank capital should be seen for what it is: an effort to use smoke and mirrors to weaken the Basel III restrictions on the definition of high-quality bank capital. Some EU ministries of finance may also see short-term advantage in carrying the banks water on this issue. Recapitalizing the banks via government injections of capital, after all, would increase already high sovereign debt levels and would anger voters fed up with government bail-outs of the financial sector.

The EU retreat on the quality of bank capital is likely to have two costly consequences. First, French and German banks will have less real, high-quality bank capital than advertised, putting French and German taxpayers on the hook for bank losses in excess of available, truly loss-absorbing capital. Markets will see through this tactic, so there will be little if any advantage in funding costs. Second, giving French and German banks a pass from an important part of Basel III will almost surely encourage U.S. and Japanese banks, among others, to press for similar concessions from their national regulators, invoking other low-quality components of bank capital relevant to their balance sheets. If successful, such efforts will weaken the effectiveness of the overall Basel III agreement and thwart one of its main objectives – forcing banks to become responsible for financing their own losses, without inflicting costs on innocent bystanders.

V. Unpersuasive Arguments about the Effect of Higher Bank Capital Requirements on Economic Growth and the Single Market

In campaigning against higher bank capital standards, the banking industry argues that a higher capital ratio will be a calamity in terms of increased bank funding costs, lower loan volumes, and slower economic growth. Unfortunately, most EU finance ministers seem to have bought into that fallacy. In addition, the Schaeuble camp trotted out the equally weak argument that permitting EU countries to implement much higher minimum capital ratios than the Basel III minimums would jeopardize Europe’s Single Market.

Perhaps the best rebuttal of this contention has been made by Anat Admati and her colleagues at Stanford Business School and at the Max Planck Institute (Admati et al, 2010a, 2010b, 2011). A summary of their reasoning, which I strongly support, goes as follows. The cost of capital depends on the risk to which the capital is put. Relying more heavily on equity unambiguously reduces the volatility of the return on equity and lowers the risk premium on equity. The required return on equity must therefore decline with an increase in equity. The end result is that the bank’s overall cost of capital is likely to be little affected by increasing its capital ratio. Nor does a higher capital requirement necessarily imply a reduction in loan growth unless banks are allowed to meet that requirement by shedding assets. Unlike liquidity requirements over bank assets, capital requirements deal with the liability side of bank balance sheets and with funding choices. Banks do not hold the securities they issue; investors do. Capital is therefore not put in a strongbox. Many successful non-financial corporations fund themselves more heavily from equity than banks; yet these companies are not constrained by that funding choice in expanding their investments. Historically, the most severe credit crunches – like the 2007-2009 global crisis –occur when bank capital is very low, not when it is high. When leverage is low, such as the bursting of the internet bubble, the consequences for the macro-economy are much more benign that when leverage is high.

The empirical evidence on the effect of bank capital on bank funding costs and economic growth also supports the Admati View. For the U.S. and U.K. economies it is possible to get time-series data on bank capital than go back to the 1840s. Over this long history, leverage ratios for bank capital varied widely. At times the ratio was more than four times higher than they are today. Yet statistical tests show no link between higher bank capital ratios and higher bank funding costs or weaker macroeconomic performance (Hanson, Kashyap, and Stein, 2010, and Miles, 2011). The cross-section evidence goes in the same direction. Small banks in the United States routinely have much higher capital ratios than large banks, yet this difference has hardly led to their demise. The average capital ratio for non-financial companies in the United States is 70 percent. Yet there no reason to believe that such a funding mix has hurt their performance.

The Schaeuble View on the impact of bank capital requirements on bank lending also appears to run counter to that of the sitting Chairman of the European Banking Authority (EBA), Andrea Enria. In a recent (April 2012) speech, Enria (2012b, p. 10) said:

“On this, I want to be blunt. I do not believe that high levels of capital are a deterrent to new lending. On the contrary, banks with low capital levels—or perceived by the market as being so – are those that have had problems in increased lending. They either face major funding difficulties – which in turn do not allow them to grant loans – or focus primarily on preserving their meager capital. Banks with large capital positions, by contrast, are less sensitive to cyclical shocks and more likely to pursue lending growth strategies.”

The way in which higher capital requirements are implemented also matters. As argued in Goldstein (2012), when revealing the results of its stress tests and designing bank recapitalization guidelines, the EBA should have included a firm policy on bank dividends and executive compensation. Any bank that did not meet the minimum capital ratio should have been directed to suspend dividend payments until it reached the target and was no longer in danger of falling below the target over the next year. The EBA should also have included an adverse macroeconomic scenario for the euro zone to strengthen confidence in the stress test results. Last but not least, the target capital ratio should have been translated into a target for increases in bank capital alone. That step would have avoided giving banks an incentive to meet the target by decreasing the denominator (asset shedding) rather increasing the numerator (raising new capital).

To sum up, denying EU countries the scope to raise minimum capital levels above the Basel III minimums, ostensibly to sustain lending and economic growth in the region, flies in the face of both economic theory and the evidence. Here too, the Schaeuble View is merely another sop to the banks.

The argument that large differences in minimum bank capital ratios among EU countries would risk splintering the Single Market likewise has little foundation. As maintained by Véron (2012), the largest distortion to the EU market for financial services is that the framework for supervision and resolution of financial institutions remains predominantly national. For this reason, the financial health of banks is tied to the health of their home-country sovereigns. If EU finance ministers want to strengthen the single market for financial services, they should implement an EU-wide framework for deposit insurance and bank resolution, going if necessary beyond the European Financial Stability Facility (EFSF) and European Stability Mechanism (ESM) (Roubini, 2012), along the lines of the Federal Deposit Insurance Corporation (FDIC) in the United States. Tinkering with cross-country differences in minimum bank capital ratios will do little to advance the Single Market. And if the concern is that individual EU countries with high minimal bank capital ratios would use those minimums to shed assets outside their home market, this should be addressed by negotiating an EU-wide coordination agreement on cross-border bank lending, like the Vienna Initiative of 2009. A “convoy approach” to bank capital – in which EU countries seeking safer banking systems are barred from doing so out of fear of pressure on other EU countries with weaker regimes—will not promote the Single Market. As in the case of Japan’s banking crisis (Posen, 2000), such a convoy approach will delay addressing the problem of under-capitalized banks and weaken economic recovery in the euro zone.

VI. Conclusion

The decision by European finance ministers on EU implementation of Basel III on May 15 is a setback for financial regulatory reform not only in Europe but globally. The priority ought to have been focused on increasing the quantity and quality of bank capital to deal with the under-capitalization of EU banks and reducing the potential for an adverse feedback loop between bank debt and sovereign debt. Instead, EU finance ministers went in the opposite direction by constraining the ability of EU countries to do more than Basel III on the quantity of bank capital and by weakening Basel III on the quality of that capital. Their action will further undermine confidence in the solvency of EU banks and make resolution of the EU debt crisis more difficult. In addition, it will impede efforts to implement capital reforms of Basel III in the United States and Japan, as banks in those countries try to engage in a regulatory race to the bottom.

Fortunately, EU Finance Ministers still must negotiate and agree on a final text of the EU bank capital rules with the European Parliament. The Parliament should take seriously its responsibilities in this area. It should demand significant changes to the May 15 ECOFIN draft agreement. Specifically, the Parliament should press ECOFIN: (i) to raise the (no-EU approval-required) threshold on national bank capital minimum above the Basel III minimum to at least 700 basis points (for total exposure); (ii) to reinstate the Basel III restrictions on what can be counted as equity capital; and (iii) to introduce the amendment that any EU bank failing an EBA stress test with regard either to the common Tier 1 capital ratio or to the leverage ratio should be prohibited from either paying dividends or employee bonuses until it reaches the bank capital target and is (in the EBA’s judgment ) not in danger of falling below the capital target over the next year. If these negotiations between the Parliament and EU Finance Ministers take a month or two, so be it: better to take the time to hammer out an agreement that promotes reform on bank capital than to rush into a compromise that undermines it.

References

Admati, Anat, and others, 2010a, “Healthy Banking System Is the Goal: Not Profitable Banks,” Financial Times, November 9.

Admati, Anat, 2010b, “Fallacies, Irrelevant Facts, and Myths in the Discussion Of Capital Regulation,” Working Paper, Stanford Graduate School of Business, August.

Admati, Anat, 2011, “Fallacies, Irrelevant Facts, and Myths in the Discussion of Of Capital Regulation: Why Bank Equity is Not Expensive,” Powerpoint Presentation, NBER Corporate Finance Panel, April 30.

Council of the European Union, 2012, “Bank Capital Rules: General Approach Agreed Ahead of Talks with Parliament,” Brussels, May 15.

Enria, Andrea, 2012a, “Supervisory Policies and Bank Deleveraging: A European Perspective,” 21st Annual Hyman Minsky Conference, “Debt, Defecits, and Financial Instability, New York City, April 11-12.

Enria, Andrea, 2012b, “Developing a Single Rulebook in Banking,” Conference on Financial Regulation, Central Bank of Ireland, April 27.

Goldstein, Morris, 2011, “Integrating Financial Regulatory Reform with Reform of The International Monetary System,” Working Paper No. 11-5, Peterson Institute for International Economics, February.

Goldstein, Morris, 2012, “Stop Coddling Europe’s Banks,” VoxEU, January 11. Goldstein, Morris and Nicholas Véron, 2011, “Too Big To Fail: The Transatlantic Debate,” Working Paper No. 11-2, Peterson Institute for International Economics, January.

Hanson, Samuel, Anil Kashyap, and Jeremy Stein, 2010, “A Macroprudential Approach to Financial Regulation, Journal of Economic Perspectives

Helwig, Martin, 2010, “Capital Regulation After the Crisis: Business as Usual?” Max Planck Institute for Research on Public Goods, Bonn.

Independent Commission on Banking (Vickers Report), 2011, Final Report and Recommendations, London, September.

International Monetary Fund, 2011, Global Financial Stability Report, September.

International Monetary Fund, 2012a, Global Financial Stability Report, April.

International Monetary Fund, 2012b, World Economic Outlook, April.

Lagarde, Christine, 2011, “Global Risks Are Rising But There Is a Path to Recovery,” Jackson Hole Symposium, Federal Reserve Bank of Kansas City, August 27.

Miles, David, 2011, “What Is the Optimal Leverage for a Bank?” VoxEU, April 27.

Posen, Adam, 2000, “Introduction: Financial Similarities and Monetary Differences,” In A. Posen (editor), Japan’s Financial Crisis and Parallels to the U.S. Experience, Peterson Institute for International Economics.

Roubini, Nouriel, 2012, “What’s On Nouriel’s Mind: Greece Should Default and Exit the Euro through an Orderly Divorce Process, RGE, May 14.

Véron, Nicolas, 2012, “The European Debate About Bank Capital Is Not Just About Europe,” VoxEU, May 4.

This post originally appeared at Peterson Institute and is posted with permission.

Two main scenarios for Greece in the coming weeks depend on politics and the elections.

Scenario 1: Greece has a “second TARP vote” on June 17

The abrupt deterioration of Greece’s economic situation arose from the unexpected lack of a pro-IMF program majority in the Greek parliament after the May 6 elections. The voters delivered a stinging rejection of Greece’s established parties, instead putting on center stage the populist Syriza Party and its leader Alexis Tsipras, who advocates voiding the IMF program and the memorandum of understanding (MOU) with the fund, the European Central Bank (ECB), and the euro leadership, known as the Troika.

But the Syriza victory on June 17 is far from clear. In May the party got only 1 million votes, or 16.8 percent of the electorate, which is less than the 1.2 million Greeks voted for parties or candidates that fell short of the 3 percent of the votes that constitute the threshold for representation in parliament. In the next balloting, these votes could consolidate behind others. Moreover, the turnout on May 6 was low, just 65.1 percent. A higher turnout would not necessarily favor Syriza.

Euro area leaders are doing their utmost to turn the next Greek election into a referendum on whether Greeks wish to remain in the euro area, and not Greek austerity. As I have argued here before, the European Union will no doubt take a hard line toward Greek voters, telling them that they would be welcome to stay with the euro but that the decision is up to them—and the euro area is actively taking precautionary actions in the event of a Greek decision to exit.

Any acute instability in the Greek economy before the election date resulting from an accelerating bank run will probably strengthen the pro-IMF program parties, because it will demonstrate the potential economic costs of populist policies like Syriza’s and thus likely affect the outcome of the election. These circumstances might make it more difficult for Syriza to sustain its electoral success next month.

Many things can go wrong, but I believe that Greece will have a pro-IMF program parliamentary vote after June 17, much as the United States House of Representatives changed its mind in 2008 on the Troubled Asset Relief Program (TARP), which it backed after the financial markets reacted violently to the initial rejection. A victorious functioning pro-IMF program government might very well get minor changes in the IMF program, particularly related to austerity, provided it remains committed to implementing the structural reform components.

Are bank runs that might cause voters to change their mind worth the risk? Unambiguously yes. The euro area cannot negotiate with Greek populists now, lest such talks inspire copy-cat Tsipras’s to make demands in Spain, Portugal, or Italy, all of which would stir a backlash in Northern Europe opposing any fiscal transfers to help them with their troubles. Running on irresponsible populist platforms in the euro area must be shown to other countries as dangerous for their economies.

Second, many of the things that euro area leaders will be forced to contemplate if events in Greece escalate are actually not bad ideas. If banking troubles spread to Spain, who would oppose Madrid approaching the European Stability Mechanism (ESM) for capital support? In the extreme case of bank runs spreading across Europe, who would oppose a pan-euro area deposit insurance scheme as a remedy? No such actions will help the growth of ailing countries in this quarter, but the euro area always needs acute pressure to take the right necessary decisions.

Scenario 2: Syriza Wins and Greece Becomes Montenegro for a While

If Syriza wins on June 17, and it forms a new anti-IMF program government, the outlook for the Greek economy grows murkier—though an actual euro exit in the short run remains unlikely.

It is impossible to know the likely policies of a Syriza-led government once it comes to power. But even populists listen to the opinions of the electorate, and Tsipras is a skilled populist. He is probably sincere in saying that he and Syriza want to stay in the euro. The reason is simple. An overwhelming majority of Greeks consistently agree with that view.  This choice will of course dismay a great number of euro-skeptic macroeconomists, who claim that by staying inside the euro area Greece will forego the export-led riches associated with the huge competitive devaluation from a reintroduction of the drachma. Yet that view is only shared by a small minority of Greek voters.

The idea that Greece will somehow prosper from a competitive devaluation outside the euro area is delusional intellectual snake oil. But even a populist Syriza-led Greek government is unlikely to go against the vast majority of Greek voters and immediately take Greece out of the euro area. This matters profoundly. The European Union has no legal route to kick Greece out. Even if the euro area wanted to oust Greece, any negotiations would be lengthy, and they would occur while Greece remained inside the area.

Tsipras has offered Greek voters an appealing platform of repudiating the IMF program and also ending austerity and reform in Greece. This position would cost Greece its bailout funding. Since Greece runs a 1 to 2 percent primary deficit (€2 billion to -€4 billion) it would probably run out of money by August without outside assistance. Faced with that likelihood, a Syriza government intent on staying inside the euro area would face a choice of implementing additional immediate austerity, issuing €-denominated IOUs as California did in 2009, or seizing private assets to make ends meet. (The third choice is not impossible, given that Tsipras seems a pretty doctrinaire communist.) As California did when it sent out IOUs as personal tax refunds, a leftist regime in Athens would probably force its IOUs down the throat of public workers or other groups that it could coerce into receiving them. Seizing private assets in a country of rampant tax evasion and disguising income and assets from authorities would be very complex. In short, no options for balancing the budget will be popular among Greeks—which constitutes a serious problem for a populist government.

A further complication if Syriza repudiates the IMF program is that Greece’s banks, overwhelmed by bank runs, would lose access to ECB liquidity and repo transactions and eventually any further support from Bank of Greece emergency liquidity support, which would probably be vetoed by the ECB governing council. It is difficult to see how Greek banks could operate normally after a Syriza victory.

Without access to either bailout funds or the ECB, a Syriza-led Greece would become like Montenegro—that is, a country that uses the euro as its currency, but that lacks direct access to any economic support from euro area institutions.¹

Running Greece as Montenegro is likely to be an extremely unpleasant political experience for Syriza, which campaigned on the fanciful idea that it could retain access to bailout funds without adopting  austerity and reform. Once it became clear that—contrary to the pre-election assertions of Tsipras—the euro area actually didn’t collapse from the declaration of a Greek debt moratorium or a bank holiday a Syriza government would not survive long in office. It would probably be replaced quickly by a new pro-IMF coalition or a new technocratic government, which would also attempt to reengage with the Troika and reopen Greece’s access to the ECB and financial support. The rest of the euro area would not welcome a Montenegro-like status for Greece. But even Tsipras talks a “suspension” in payments to  creditors, rather than an all-out default and debt repudiation. Fences could thus be mended once Greece changes its mind.

Scenario 2 might take longer to play out, perhaps a couple months. But the result would be the same: no Greek exit from the euro. Thus the issue facing Greece is not whether to stay in the euro, but how long to prolong its agony before making the inevitable choice.

Note

1. Kosovo is another example of such a country. See http://ec.europa.eu/economy_finance/euro/world/outside_euro_area/index_en.htm

This post originally appeared at Peterson Institute and is posted with permission.

Many academic observers now agree that a banking union, together with some form of fiscal union, is a necessary condition for a sustainable euro area monetary union and for a resolution of the current crisis. But in spite of the creation of a European Banking Authority last year, the action taken so far has been modest. Spain is a case in point: Madrid could have appealed to the European Financial Stability Facility (EFSF) for a loan specially targeted at recapitalizing its banks, but it has preferred to go it alone with the nationalization of ailing champion Bankia, and a new round of property-related write-downs that have provoked much market skepticism.

Several reasons explain why banking policy integration is difficult. The United Kingdom, Europe’s dominant financial hub, is not a euro area member and resists any encroachment on its supervisory sovereignty. Some member states remain committed to bolstering national banking champions or to protecting links between local banking and political communities—links that effectively make the banks instruments of the state’s industrial policies. The ability of debt-burdened governments to pressure domestic banks into buying their sovereign debt, also known as financial repression, is another impediment to change. Of course, a banking union would potentially involve controversial financial risk-sharing or cross-border transfers.

These constraints prevent Europe from moving in one step to a consistent architecture for its banking union. European leaders eager to discuss how to prevent the next crisis are often in denial about the current one. Their rhetoric tends to evoke an imaginary world in which finance is stable, economic incentives are aligned with social responsibilities and moral sentiments, and public authorities understand the financial system perfectly. From a policy perspective, such flights of fancy are an increasingly unaffordable luxury, especially in light of the urgent need for crisis management and survival.

Three priorities are obvious. First, the banks must share risks as widely as possible. It is unreasonable for European governments to reimburse all creditors of failed banks, including senior unsecured creditors in all cases to date (except for two banks in Denmark and a few very tiny ones elsewhere) and subordinated creditors in almost all cases in Continental Europe. In the United States, by contrast, almost all restructuring processes have forced creditors to take heavy losses, except for a handful of prominent cases (Bear Stearns, Fannie Mae, Freddie Mac, AIG, and the carmakers). A European approach should avoid the perverse incentives that have held taxpayers hostage to failed banks’ creditors. There are many complex legal and financial issues at stake, but ultimately the choice is political.

Second, Europe needs an operating capability to restructure banks without having to rely on national authorities that have failed their supervisory duties. This objective requires building up an effective temporary task force of restructuring professionals who can intervene quickly on behalf of the entire euro area and manage corresponding legacy assets. Such tools do not currently exist. The Swedish Bank Support Authority of 1992, or in a different context Germany’s post-unification Treuhandanstalt, are relevant precedents.

Third, and most urgent, retail bank runs must be prevented. The best way would be for the EFSF or its successor fund to explicitly guarantee all national deposit insurance systems in the euro area. Such “deposit reinsurance” would bolster the integrity of the euro area and immediately enhance trust in its banks. Of course, strong European-level supervisory structures should eventually be built to prevent moral hazard. It will take more time to combine these different pieces into a consistent European banking policy framework. The current moment calls not for perfect fine-tuning, but for swift and bold commitments.

This post originally appeared at Peterson Institute and is posted with permission.

The World Bank achievements are considerable. First, it is the best institution for development economics and public policy in the world, with a staff consisting of thousands of specialists with PhDs from the best universities. Second, it is a universal governmental organization including all significant countries. Third, its mandate is to be in charge of global economic development.

Well, if the situation is that good, what is the problem? The World Bank is swiftly becoming financially irrelevant. Its share of financing to the developing world is quickly shrinking as huge private financing is becoming available and the World Bank stays put. Services of the World Bank are considered to beboth expensive and inefficient by people who work with the bank. The World Bank has been compared to Gosplan, the old Soviet state planning agency, which demanded some 50 plan indicators because 50 different bureaucrats all wanted their own plan indicator. Worse, the World Bank is often unable to provide relevant answers. These concerns of declining quality and relevance need to be addressed.

The dilemma of the World Bank is all the more obvious if we compare it with the IMF. Before the global financial crisis of 2008, some considered the IMF irrelevant. Managing Director Dominique Strauss-Kahn got rid of one-quarter of the qualified professional staff in the spring of 2008, believing that no financial crisis was likely to occur any time soon. This was an amazingly foolhardy mistake.

Even so, in October 2008 the IMF got into action. By April 2009, the G-20 decided to quadruple the financial resources of the IMF. The IMF is back and few question its relevance. The IMF is the master of about one trillion dollars, while the World Bank is able to lend $20 billion in one crisis year. Nobody doubts that an IMF mission can be in place within a week if necessary, while it can take months before a World Bank mission arrives.

The World Bank has expanded its lending during the crisis, but its role remains uncertain, and its financing equally so. What does the Bank really stand for and how leisurely can it afford to be? A new president of the World Bank needs to offer a clear vision of what the World Bank should do and how. Professor Jeffrey Sachs of Columbia University—previously an adviser to the United Nations and many transition and developing countries—has put his name forward for the bank presidency and also outlined such a vision.

The fundamental dilemma of the World Bank is that it faces myriad issues. It should, however, concentrate on a limited number of these issues related to its outstanding competence. In practice, however, the Bank does everything that its members ask it to do. By contrast, the IMF is disciplined and sticks to its core competence.

The World Bank has an objective function that looks like a hedgehog,  with hundreds of programs and a matrix organization shooting off in different directions. Such an organization cannot work. Among the bank’s former presidents, only two are considered to have been able to manage it: Robert McNamara, the former Defense Secretary and architect of the unsuccessful Vietnam War, who served from 1968 to 1981, and James Wolfensohn, the Australian-born investment banker who served from 1995 to 2005.  The other presidents floated on top of the bank, while the bank managed itself.

A new president of the World Bank needs to do three things: first, clarify the mandate of the institution so that it concentrates on key tasks; second, reorganize the World Bank to make it manageable; and third, change personnel policy to enhance quality.

The Bank should focus on three core areas: economic development, state reform; and combating poverty.

Economic development is the oldest and most basic objective of the World Bank. In the original interpretation, this amounted to development of agriculture, energy, and infrastructure. Economically and financially, these are straightforward issues, and there is no reason not to continue the strength of the World Bank in these areas. Public investment in infrastructure is a serious development issue, and sound government policy is needed for the development of agriculture and energy.

Reform of the state has received too little attention in the World Bank, but this is a core World Bank area, without much competition from other organizations, with the exception of the United Nations Development Program. In all too many countries, the government suffers from the greatest malfunction. In the past the Bank has been too timid in its efforts to build governing institutions, civil society, and judicial systems. In the 1990s, the Bank had clear answers in the so-called Washington Consensus, which favored reasonably free market economies. But in the late 1990s, Joseph Stiglitz disputed this consensus as chief economist of the Bank. Yet he had nothing to offer to replace what he was criticizing, only vague suggestions that the issues were much more complicated.

None of these problems should deter the bank from its pursuit of reforming the states that receive its funds and attention, and to concentrate on a limited number of achievable goals. If a development agency is to be relevant, it has to master the ability of meaningful simplification. As Goethe put it: “A master proves himself in the limitation.” This requires a clear vision of the new president and political support by the membership.

In the last two decades, one of the most successful World Bank activities has been pension reform. This was a case of the Bank working at its best. To begin with, it carried out comparative empirical research throughout the world. After having done so, it established a lucid model, its three-pillar model with a basic public pension, compulsory private pension saving, and voluntary private pension saving. In 1994, it published a normative book Averting Old Age Crisis, with clear recommendations. Ever since, the Bank has promoted this model with considerable success through much of the world.

In fact, the ideological differences over the building of the state have rarely been smaller in the world at large. Old-style state-oriented socialism in the developing world is virtually dead. Countries seeking to grow economically have become even more forceful advocates of normal market economics than the Western world, even if large state companies remain prominent. Europe is dominated by moderate center-right governments. This is a good time to revive and reformulate the Washington Consensus as a program for World Bank activity. In order to do so forcefully, the Bank needs to redirect larger resources to its research, which has been watered down during the last decade and a half. All answers must be based on up-to-date empirical research, and when the outcome of the research changes, the answers must change.

As soon as the new World Bank mandate has been formulated and adopted by its board, its organization needs to be streamlined so that the institution becomes manageable again. That will not be easy, but it is vital for the Bank’s survival.

In addition, the Executive Board and its role need to change. At present, its 24 executive directors, each with a significant staff, meet almost continuously, acting like a duplicate management board. Instead, the Executive Board should become a normal supervisory board that meets once a quarter or so and decides on strategy rather than each detail.

The most sensitive issue is personnel policy. While the IMF consists of an elite corps recruited after graduate or doctoral studies at the best universities in the world, that route is only one of three recruitment streams at the World Bank. It has substantial local recruitment around the world, and thousands of staff have been promoted because of seniority and not on merit or hard work. A third stream consists of short-term consultants, many of whom become full employees eventually. They are often too insecure to work well.

This personnel policy has serious drawbacks. Since the competence of the World Bank staff varies greatly, the quality of its work varies correspondingly. Because of a large share of the staff is substandard, the highly qualified staff have to work all the harder, effectively punished for their competence. Because of the lack of clear lines of management, promotion depends to an inordinate extent through networking, which seems to be the dominant pastime at the Bank. This renders the Bank much more closed to the outside world than the IMF with its clear, hierarchical organization. The Bank needs to go back to basics, making recruitment of highly qualified young professionals the all-dominant source of employees once again.

In conclusion, the World Bank needs a president with a clear vision of economic development and of what role the Bank should play. This vision must also clarify what the Bank should not do. No standard retired politician or businessman is able to fulfill this criterion. An empirical economist with substantial knowledge of development is desired.

The second criterion is great personal and political strength, which is necessary if the president is to impose such a policy on a difficult and reluctant organization. Such strength is also need to maintain substantial support from both recipient and donor governments. Nobody benefits from another president being effectively ousted by the staff, which happened with Paul Wolfowitz in 2007. The legitimacy of the president would rise if the requirement of American citizenship was ended, but it would be even better to abandon any affirmative action and opt for meritocracy. The candidates should present themselves openly, as Jeffrey Sachs so appropriately has done, rather than being imposed by the US Treasury, a strategy which has fortunately not presented any candidate as yet.

That said, it’s still possible that China’s fast growing SMEs are demanding more financing (and on better terms) than banks are able to offer in the current credit-tightening monetary environment.

The problem facing small and medium enterprises has not escaped the attention of the Chinese government and has been a topic of interest at the National People’s Congress (Chinese language). The Ministry of Industry and Information Technology (MIIT), estimates that only 15 percent (Chinese language) of SMEs have been able to get loans from banks, and the ones that do typically pay a penalty interest rate of 20 to 30 percent greater than large enterprises, sometimes as much as 50 percent greater.

For years, Chinese regulators have called on banks to make more loans to SMEs. There have also been several government initiatives aimed specifically at increasing access to financing for SMEs, such as the collective bonds and credit guarantee programs. One of these efforts, the promotion of small loan companies (小额贷款公司), also known as microcredit/microfinance lenders, stands out as a somewhat overlooked success.

Between 2008 and 2011 the number of small loan companies increased seven fold. Quarterly data shows that over the past year and a half the industry has progressed rapidly in terms of both loans outstanding and number of companies.

Funding for small loan companies come primarily from three sources: shareholders, loans from banks, and donations. Loans are typically below 2 million renminbi and the tenors of the loans are quite short. Seventy percent of loans made are three- or six-month loans and only 30 percent are one year or longer.

Despite these signs of progress, the reputation of the industry was damaged by the crisis that swept through private lending in China last year. High interest rates and high-profile takedowns of private loan brokers, typified by the Wu Ying saga, have shaken confidence in private lending and cast a cloud of regulatory uncertainty over the industry. That small loan companies have continued to grow quickly while operating in such a challenging environment speaks to the intense demand from small companies for loans.

Comments made recently (Chinese language) by Zhejiang Vice Governor Mao Guanglie may be indicative of the government’s approach to transforming the industry. Mao was colorfully quoted as saying his approach to private finance was to “open the front door, close the back door, and smash the doors used for dishonest practices.” He elaborated that government’s strategy was to bring private finance out from the underground and let small loan companies transform into official village banks.

Transforming into village banks, of which there were 349 at the end of 2010, might be a good step forward in increasing transparency and reducing fraud.  It would also increase the ability of small loan companies to extend credit by allowing them to accept more deposits. Currently, small loan companies are currently prohibited by law from taking deposits from the general public and their capital from financial institutions may not exceed 50 percent. Becoming village banks, however, would reduce their interest rate flexibility as village banks are only allowed to charge up to two and a half times the benchmark rate, compared to four times for small loan companies.

Small loan companies are still small potatoes when compared to the massive state-owned commercial banks, but they are growing quickly and may help alleviate the much-acknowledged small, micro, and medium enterprise financing gap.

This post originally appeared at the Peterson Institute.

Growing unconventional oil production—tight oil in the US mid-continent and tar sands in Canada—is rapidly remaking the North American energy map. US output has increased by 20 percent over the past three years, after more than 35 years of steady decline. And Canadian output has grown by 16 percent, most of which is exported to the United States. Infrastructure bottlenecks have left much of this supply stranded in Middle America, creating a significant price disparity between interior states and those on the coast.

This week average US gasoline prices reached $3.76 per gallon—dangerously close to the psychologically important $4 threshold. But the national average covers up a more than $1.20 per gallon price range across states, with drivers in my home state of Wyoming paying $3.21 a gallon while motorists in California and Hawaii are shelling out $4.34 and $4.38 a gallon, respectively. In figure 1, I’ve mapped what each state pays for gasoline (y-axis) against their position on political guru Charlie Cook’s Partisan Voting Index (x-axis). Circle size represents each state’s electoral college votes and the color indicates Gallup’s view on the state’s contestability in the 2012 presidential election.

Figure 1 The bluer the state the higher the price
Average gasoline price (y-axis), partisan voting index (x-axis), and electoral votes (circle size)

All but three states considered electoral locks for President Obama face gasoline prices higher than the national average, and all but three Republican strongholds pay less than average at the pump. While this isn’t good news for Democrats’ pocket books, it doesn’t necessarily harm their election prospects this November. What matters is how swing states are faring, and here the picture is more mixed. Florida, Pennsylvania, Michigan, and Nevada are paying more than the national average, and these four account for 71 electoral college votes (table 1). The remaining eight swing states pay less than national average (though not much less in the case of Ohio, North Carolina, and Wisconsin) for a total of 80 Electoral College votes.

Before Republicans get too excited about figure 1, it’s not the price of gasoline alone that matters to drivers, but how much they buy. And while my parents in Wyoming get the cheapest gas in the country, they have to drive six hours each way to find a half-decent shopping mall. If you map gasoline expenditures as a share of personal income against the Partisan Voting Index (as I have done in figure 2), you get a much different picture than the one displayed above. High gas prices are hurting Republicans more than Democrats, even though Republicans pay less per gallon at the pump. Among swing states, Michigan, North Carolina, and Iowa are getting hit hardest, while Colorado and Pennsylvania are faring relatively well.

Figure 2 The redder the state the higher the bill
Gasoline expenditures as a share of personal income (y-axis), partisan voting index (x-axis), and electoral votes (circle size)

Now for some states, higher gasoline prices are not all bad: they mean more revenue for local oil producing firms. Indeed, some energy analysts see a point in America’s future where the benefits to domestic oil producers of high prices offset the costs to US oil consumers. While I am skeptical the country as a whole will reach that point within the next couple decades, it may have already occurred for a handful of US states. Figure 3 maps the net monthly impact of a $10 increase in crude oil prices on state per capita income against the Partisan Voting Index, assuming all oil production revenue is kept in-state. This is an unrealistically optimistic assumption—much, if not most, of the revenue upside from an oil price spike gets passed to shareholders who are scattered around the country and the world. On the consumption side this is a simple arithmetic calculation based on state-by-state oil demand data, not a macroeconomic modeled outcome. And within a given state, the people paying more at the pump aren’t necessarily the same ones benefiting from a booming oil patch. But it’s a useful additional variable when analyzing state-to-state differences.

While the vast majority of US states lose from higher oil prices—and lose big—six states could potentially gain. Five are Republican strongholds—Alaska, North Dakota, Wyoming, Mississippi, and Alabama. And in another three Republican states—Texas, Louisiana, and Montana—oil revenue could mitigate a meaningful amount of the pain from higher oil prices. There is no meaningful oil production in Democratic states save California, which means that adding in oil production balances out the picture painted in figure 2. Among swing states, Colorado and New Mexico have good sized oil operations which, in New Mexico’s case, might be enough to come out ahead when oil prices rise. For the real political junkies, I’ve provided specific estimates for all three variables discussed above (gasoline prices, gasoline expenditures relative to income, and per capita oil production) in table 1.

Figure 3 Do some states gain from high oil prices?
Net impact on monthly per capita state income of a $10 increase in crude oil prices, assuming all production revenue stays in the state and excluding macroeconomic effects.

For Portugal, Another Program Is Likely

With the risk free status of euro area sovereign bonds widely seen as in tatters, where does the euro area go from here? The euro area has repeatedly maintained that Greece is a unique case and that euro area sovereign bonds should still be considered as without credit risk. Needless to say, private bond investors are likely to take some persuasion before they will accept that argument. The key issues concern Portugal and Ireland, which like Greece are removed from the markets and reliant on International Monetary Fund (IMF) programs. They are scheduled to return to the markets in late 2013. Irish five-year bond yields are currently at 5.25 percent, indicating that the ability to refinance Ireland’s debt at affordable and sustainable rates with private creditors is not that far off. Comparable Portuguese five-year rates, on the other hand, are at 16.75 percent, suggesting that Lisbon remains far from regaining private bond investors’ trust.

Superficially, this enormous yield differential might seem strange. Both Ireland and Portugal have just received good remarks from the IMF for the implementation of their programs. Portugal’s immediate growth outlook and structural economic problems, which are far worse than Ireland’s, clearly play a role. However, it looks like Portugal’s somewhat worse economic outlook is amplified by the markets’ desire to see the euro area back their claim of Greece’s unique status with sufficient financing for other troubled countries. Ironically, Portugal’s compliance with its IMF program, entitling it to more official sector financing, means that it cannot now regain private financing access.

Because of the deep structural nature of its problems, Portugal is unlikely to return to strong growth for at least a couple years. Portugal can regain some confidence by getting another fully IMF program without any write-down of its private debt, or private sector involvement (PSI). Apart from Greece, Portugal probably has the worst economic fundamentals in the euro area. It will thus be the test case that markets will use to see whether the euro area is serious about banishing the future use of private sector haircuts. The euro area is caught in a bind. Without having first financed a new Portuguese program, European leaders cannot credibly banish the Greek PSI stigma from Portugal on the way to restoring the risk free status of euro area sovereign bonds. Barring an unlikely Portuguese economic miracle, a new program without PSI for Portugal is certain later in 2012.

For Ireland, Lingering Concerns Over the Seniority of Creditors

The case of Ireland is less straight forward. Since it is relatively close to regaining market access, presumably a modest additional dose of financial assistance from the euro area would secure such access. Ireland’s persistent adherence to its IMF program presents the euro area with an interesting timing issue: Write Ireland another relatively small check now to virtually ensure market access in 2013, or risk having to fully fund another Irish program later on. As I have discussed before, the planned referendum in Ireland on the Fiscal Compact Treaty in a few months might help persuade the euro area to strike a deal now on the difficult and complex technical issues like the refinancing of the promissory notes given to Anglo Irish Bank in 2010.¹ (Note this is usually euro code for a stealth fiscal transfer.)

Meanwhile, providing more euro area funds to Portugal and Ireland aggravates lingering market concerns over the seniority structure of the remaining sovereign debt. At present, private creditors might fear becoming ever more subordinated by growing official sector debt. As a result, giving Portugal a new wholly euro area funded program to show that PSI is off the table might ironically increase the perception of riskiness of Portuguese debt for some private investors. These investors are still not certain what the euro area might do in the future.

A new wholly funded program without PSI for Portugal might not improve its market access for longer-term debt. Whether additional IMF funding to Portugal can be secured beyond the current program is an open question. Given the structural nature of Portugal’s economic challenges, which will with certainty take several years to improve, as well as these lingering effects of Greek PSI, at least the euro area looks set to provide its financing for Portugal for a long time even if Lisbon does all its homework. The fact that the euro area will consequently likely end up having to finance Portugal even if it—as seems likely—successfully “does all its homework” is important. Even euro area members that undertake successful reform may need future financial support. The issue of seniority for creditors is different for Ireland’s promissory notes. The Irish government is essentially asking that the expensive debt issued by the National Asset Management Agency (NAMA) bad bank in 2010 (to recapitalize the Anglo Irish Bank and other troubled banks) be restructured at less expensive interest rates. This step would save money for NAMA and improve the Irish net government debt position. Such a restructuring will not raise any seniority concerns like those that hit Portugal, because no new official sector debt will be added. Instead, the cost of Ireland’s current debt would be reduced. Consequently, the euro area should without delay grant Ireland a deal on these promissory notes. Having to finance a new Irish program would raise the seniority concerns affecting Portugal.

For Greece, Fears of Another ‘Default’

Then there is the issue of Greece’s new long-term bonds, thrust on the country’s hapless private creditors in last week’s coercive bond swap. They have begun trading at north of 20 percent yields. In what is probably an illiquid market, these yields suggest that markets expect a second Greek default against private creditors. The question, however, is whether this is a foregone conclusion, even if Greece requires additional euro area funding. If Greece “defaults” again, requiring more euro area taxpayer money, why would the euro area force another default on private creditors? Coupon payments are merely 2 percent on the new bonds until 2015, so the cash savings of defaulting on these bonds during the next 3 years would be relatively small.

Meanwhile, such a default would undoubtedly result in further losses in the euro area banking system, where most participating banks probably book these new bonds at their par value. Such losses would not likely be in the general interest of euro area governments. Their banking systems will still be adding to risk capital levels in coming years. Moreover, a second Greek default against private creditors would further undermine any notion of risk free status for sovereign euro area bonds, reigniting potential contagion to other markets. Renewed contagion would make a mockery of attempts to restore the market credibility of euro area sovereign bond markets.

The only scenario in which another default against remaining private Greek creditors and their newly swapped bonds will be sanctioned by the euro area is one in which Greece exits the euro. (Note that Greece, which is living with a euro area-sponsored escrow account, no longer has the fiscal sovereignty to declare such a default independently.) As discussed earlier, that risk is not zero. A future populist Greek leadership might seek an exit to safeguard national sovereignty, despite what would be an accompanying economic disaster. The prospect of an exit is also not nearly as high as current Greek bond yields suggest, however. Greece’s new bonds will not likely exist until the last ones are redeemed in 2042. More likely they will be converted into eurobonds, perhaps in 20 years, rather than be defaulted against again.

For the Euro Area, Markets and Political Leaders Misunderstand Each Other

Breaking the risk free taboo of sovereign bonds have stirred fears of irreparable damage to the euro area debt markets and caused their cost of capital to rise. But euro area leaders say they are determined to restore pre-PSI status quo of euro sovereign debt.

Ironically, euro area leaders’ insistence on PSI for Greece might have created a self-filling prophecy with respect to the loss of risk free status of their sovereign debt. Markets prefer not to have to think hard about such complex issues. They prefer the analytical shortcuts conferred by market conventions about “risk free status” or rating agencies that have too easily granted AAA-ratings because the markets then avoid the trouble of making their own proper risk assessment. The status of sovereign debt for years as “risk free” gave the markets a misleadingly convenient benchmark by which to price all sorts of other financial assets.

Eliminating the sacrosanct risk free status of their debt has exposed euro area leaders to the markets’ myopia and simplistic understanding of euro area politics. Current euro area economic research from various investment banks is full of long-term political judgments like this: “PSI cannot be ruled out at a later stage. As time goes by, reform fatigue may become a problem and support for more radical political parties may emerge.”²

One has to wonder about the empirical foundation for such purely political pontification by Wall Street and City of London economists. This weekend in Slovakia, the pro-euro center-left Social Democratic (SMER) party won an overwhelming electoral victory, securing an absolute majority in parliament. The far-right populist Slovak Nationalist Party (SNS) failed to clear the parliamentary threshold. After elections across the euro area periphery in Ireland, Portugal, and Spain, one has to ask: Where are the storied euro area populists actually coming to power? Upcoming Greek elections represent a new risk of populist gains, but such an outcome would go against a broad-based trend, setting Greece ever more apart from the rest Europe.

The Greek PSI, along with long-lived Anglo-Saxon stereotypes about the 1930s in Europe and the emergence of the US Tea Party, have all fed into the financial markets crying wolf about populists taking the reins of power. The wolf remains off in the distance, if it exists at all.

Notes

1. Meanwhile, everyone in Dublin denies the obvious link between these issues.

2. Quoted in Bloomberg.

This post originally appeared at the Peterson Institute.