Banking, Capital Markets and Stagnation Problems in the EU


20 Years   2015

If you are interested in critical economic analysis and thought-provoking new approaches please read Welfens, P., Issues of modern macroeconomics: new post-crisis perspectives on the world economy, in: International Economics and Economic Policy, Issue 4, 2014

Prof. Dr. Paul J.J. Welfens, Jean Monnet Professor for European Economic Integration; Chair for Macroeconomics; President of the European Institute for International Economic Relations at the University of Wuppertal (EIIW, Rainer-Gruenter-Str. 21, D-42119 Wuppertal; +49 202 391371), Alfred Grosser Professorship 2007/08, Sciences Po, Paris, Research Fellow, IZA, Bonn;

Non-Resident Senior Fellow at AICGS/Johns Hopkins University, Washington DC ,                    prEregulationFinance2014welfens

EIIW 2015 = 20 years of award-winning research       October 30, 2014

Welfens has testified before the US Senate, the European Parliament, the IMF


Banking, Capital Markets and Stagnation Problems in the EU

In the wake of the Transatlantic Banking Crisis policy makers have had good reasons to impose tighter regulation on banks since so many big banks in the US, the UK and some Eurozone countries had engaged in excessive risk taking; not to mention cases of market manipulation concerning certain interest rates and exchange rates. Without doubt, many big banks should face sanctions and effective penalty payments for grave misconduct over many years. However, there is no reason to impose excessive regulation on banks and to thereby trigger enhanced regulatory arbitrage which will stimulate the expansion of shadow banking. Moreover, if there is excessive regulation of banks, this will not only raise the cost of banking but it will undermine the prospects for growth in credit and investment, respectively. Careful and adequate regulations are required along with the implementation of the new Basel III rules. While more regulation in certain fields of banking naturally is adequate, one also could remove much regulation if the three main problems of the Transatlantic Banking Crisis could be solved:

  • Banks generated excessive risk in the context of an originate and distribute model which did not involve sufficient risk-taking by the bank itself: Too many loans could be packed by the respective bank in an opaque way into Asset-Backed Securities (ABS) and too many ABS easily obtained AAA rating by the leading rating agencies so that the pricing of risk was flawed in 2003-06 (this mispricing was strongly visible in the US corporate bond market as has been emphasized by Goodhart: Journal International Economics and Economic Policy). As long as the rating agencies quality of work has not seriously improved, this problem will remain and better quality hinges on the creation of at least one major rating agency in Europe, preferably on the basis of a scientific consortium of research institutes that would work under the umbrella of a Eurozone/EU Rating Foundation. Governments of Germany, France and other EU countries could sponsor such a scientific foundation and this is a field of joint policy initiative that should easily find consensus Berlin and Paris. Given the dominance of bank financing in the Eurozone compared to the US, it would be desirable to give impulses for the growth of capital markets as well as bank lending.
  • According to recent empirical analysis, the integrity of banks as underwriters has a significantly positive impact on the rating of corporate bonds placed in the market by the respective banks. Regulations should require banks to publish codes of conduct on their websites and to report on integrity (for example in the case of balance-sheet restatements). By encouraging the quality dimension of the competition process in the banking sector, capital markets and banks’ business can be stimulated and here individual EU countries as well as the European Commission should be more active.
  • The behavior of some of the managers of big banks was doubtful in the run-up to the banking crisis and characterized not only in certain banks by breaching rules but also by visible short-termism combined with the adoption of unrealistically high targets for the rate of return on equity. As regards the problem of short-termism, the easiest way to correct this would be to introduce a tax on the volatility of the rate of return on equity so that bank managers would have strong incentives to more carefully consider which long-term bank products and expansion strategies are sustainable. EU countries could easily adopt such a new tax – possibly on the basis of a bonus/malus system.

The Banking Union has created a new framework for financial services in the Eurozone and the EU; and the stress test results from October 2014 – plus the results of the asset quality review by the European Central Bank – signal that the Eurozone’s major banks need some adjustment measures. However, the overall picture on the European banking sectors’ leading banks is rather favorable and policymakers would be wise to encourage the expansion of capital markets and banking business as a basis for more investment in all euro countries. Policy makers should not forget that excessive regulation can critically reduce overall lending and investment by firms; this in turn will contribute to lower growth, tax revenues and employment.

As much as insufficient regulation has been a problem prior to the banking crisis, the wave of new regulations in the banking sector in Germany and many other EU countries seems to be an overdose of intervention. The micro-regulation of banks is unnecessary and not contributing to a better quality of financial products and efficiency gains. Such gains should be expected from more long-term competition and a better setting of innovation standards in the financial industry. So far, the banking sector can make all kinds of innovations, however, there is no standardization, no patenting and no established procedure for evaluating financial innovations. Here reforms are urgent.

Insurance companies and banks could have a bigger role for investment financing in trans-European infrastructure network projects if there would be common standards for joint private public partnership (PPP) financing of big infrastructure projects. The main interest of governments could be not only to obtain additional private sector financing but also to get rid of critical risk, e.g. operational risk. The largely negative critique against PPP by the Federal Court of Auditors (Bundesrechnungshof) in Germany is not adequate, since ex post evaluation of project performance is easy while the adequate point of reference are the perceived risks and expected cash flows from the project; the typical view of the Bundesrechnungshof to fully ignore the expected risks in major infrastructure projects is an analytical pitfall from an economists’ perspective. If there would be more PPPs at the EU level, this could also be a natural starting point for supranational euro bonds. Whether or not those would later be a basis for quantitative easing by the ECB in the Eurozone is an open question. If such supranational bonds are to be launched, one should do this on the basis of an exclusive long-term maturity spectrum – member countries of the euro area should skip this specific range of maturities and rely both on more medium-term and more very long-term financing. Such an approach would allow to jump-start a highly liquid supranational bonds segment; the additional backing of such bonds through reserves/gold would be useful.

The US economic recovery after 2009 has been much stronger than in the Eurozone. The cumulated transatlantic growth gap in the period of 2008-2015 (forecast values) is about 10% for the comparison between the US and Eurozone. Based on the US recovery, one may argue that there is a lack of about €1,000 bill. between 2008-2015, or about €1,000 per household. Reforms in the US banking sector, the restructuring of banks through the USFDIC – some 450 between 2008 and 2013 – and the established capital market lead of the US have contributed to the stronger US recovery. The EU and Eurozone countries should quickly draw major conclusions from these observations. Excessive regulation in the EU will contribute to stimulating the growth of the shadow banking system and will generate insufficient credit growth for a strong recovery.


New EU Integration as Basis for Stability in the 21st Century


Prof. Dr. Paul J.J. Welfens, Jean Monnet Professor for European Economic Integration; Chair for Macroeconomics; President of the European Institute for International Economic Relations at the University of Wuppertal, (Rainer-Gruenter-Str. 21, D-42119 Wuppertal; +49 202

4391371), Alfred Grosser Professorship 2007/08, Sciences Po, Paris,

Research Fellow, IZA, Bonn,

Non-Resident Senior Fellow at AICGS/Johns Hopkins University, Washington DC ,                        File prEeuWorldEconomy2015

EIIW 2015 = 20 years of award-winning research         October 20, 2014

  • EU Integration: Facing Responsibility in the World Economy
  • Bold and Broader Reforms in the European Union Needed

New EU Integration as Basis for Stability in the 21st Century

So far about 80 billion people have lived on this earth. In 2015/2016, the half billion of people in the EU28 are facing key challenges in contributing to sustained growth, stability and prosperity in Europe and indeed worldwide. The transatlantic banking crisis, the euro crisis and the Ukraine-Russia crisis represent three serious problems which have undermined the stability of the Europe. The banking crisis was caused by an overlap of highly ineffective banking regulation in the US, the UK and Ireland; by 2014 the US has overcome most of the short-term problems, but the debt-GDP ratio has increased by about 30 percentage points in the period from 2008-2013. In the UK the government debt-GDP ratio has increased by almost 40 points in the same period and Ireland stands for +80%. The European Union and the USA stood on the brink of a collapse after the bankruptcy of September 15, 2008 – that bankruptcy was allowed to happen by the Bush Jr. Administration and it brought about a massive reduction in investors’ appetite for risk. My conclusion in October 2008 (the date of finishing the manuscript of my book Transatlantische Bankenkrise) was that the euro area was going to face a crisis in Greece, Portugal, Spain and Italy, as these countries had high debt-GDP ratios, high deficits or high foreign indebtedness; and I mailed the manuscript on October 30, 2008 to the German chancellor’s chief economic advisor. While the US has partly adopted adequate reforms for the banking system, the overall reforms are inadequate as the institution, which in the Summer of 2006 wrote that Ireland’s banking system was sound, has not made any relevant reforms (the so-called FSAP update on Switzerland a few years ago also missed the point, as UBS was identified as a sound bank): Obviously, the IMF’s approach to its own Financial Sector Assessment Programme is inadequate and needs urgent reform. Have the EU countries called for any reforms here? Not at all. An IMF reform is urgent now.

The euro crisis is the next crisis in the western OECD which undermines stability in Europe and the world economy. The euro countries and some of the other EU countries – not including the UK – have accepted a new Fiscal Pact that is supposed to make sure that in future budget deficit rules are better observed than under the Stability and Growth Pact with its 3% deficit-GDP limit. The limit in the new Pact is 0.5% of a structural deficit-GDP ratio; here structural means that business cycle effects are filtered out. It will hardly be possible to implement this limit and it might even be at odds with the maximum 3% limit under the Stability and Growth Pact. The euro integration should bring about major economic benefits for all member countries, almost 1% of GDP in the long run – every year, provided that the Eurozone can provide a euro that holds a larger share in world currency reserves: a share of about 35% should be possible, up from the 28% in 2007, the year immediately prior to the crisis. Among economists and politicians there is broad confusion about the euro and the requirements for stability and long-term success. France and Italy as well as other euro countries are reluctant to stick to either the old or new limits of the deficit-GDP ratio and the EU’s rule that the difference between the debt-GDP ratio and the 60% limit for that ratio should be reduced by 1/20 every year is largely ignored. Some long-term consolidation is needed but consistent EU-wide public investment – driving economic growth – is also critical for economic stabilization, since the reduction of the debt-GDP ratio should naturally also come from economic growth; this is quite obvious in a period in which Germany and France face a real interest rate of only about 1%. The euro area cannot return to stability if three elements are not adopted:

  • A switch to a more explicit policy coordination which should go along with a supranational virtual expenditure-GDP ratio of about 6% where the main focus would be on infrastructure investment – about 2% of GDP – and military expenditures (another 2% of GDP) plus promotion of innovation and life-long learning (about 1% of GDP) plus the current 1%. The first six months of unemployment compensation should come from Brussels in the long run. A virtual joint budget of 6% of GDP could easily be introduced, but it requires in the medium term that all euro countries’ ministers of finance would use the same budget software – solving this issue should not be a matter of years (!). The supranational policy layer must be big enough that the bankruptcy of a member country of the euro area could be a valid political option: a bigger supranational government in the eurozone will make it possible to, for example, let Greece go bankrupt should politicians in Athens try a second massive deficit fraud as was the case in the election year of 2009. With a bigger supranational government, even the bankruptcy of a country will not bring about an end to all government activities in a euro member country!
  • The long-term creation of a euro political union on the basis of democracy, the rule of law and social market economy. There would be euro bonds placed in the market and based upon some discretion of the eurozone government and the respective Parliament. National governments should have the option of a structural deficit-GDP ratio of not more than 0.25% of GDP, 0.5% of GDP would be the maximum structural deficit-GDP ratio at the supranational policy layer. Assuming a trend growth rate of output of 1.5 %, the long run debt-GDP ratio in the eurozone would thus not exceed 50%. These rules must be incorporated in national constitutions.
  • There should be eurozone political parties; otherwise the natural goal of leading national politicians will not be to become the head of the respective eurozone party and the head of the eurozone government. Never would a political deficit fraud of the type of the Greek problem of 2009 occur in a US state, since notifying ¼ of the true deficit-GDP figure to Washington would mean the immediate end of a national party career for the respective representative of that state.

If the eurozone countries would shift towards such deeper integration policies, the euro countries should be able to achieve at least 2% of economic growth provided that the expansion of information and communication technology is adequately promoted. The share of real ICT investment – based on nominal ICT investment figures deflated by the relevant price index (EU Klems database) – in real GDP is more than twice as high as looking at nominal ICT-nominal GDP shares suggest (see WELFENS/IRAWAN/PERRET, 2014: For a euro area with solid growth, low inflation and full employment, there will be strong pressure on the other European countries to join; this would hold particularly true for the UK whose debt-GDP ratio is likely to exceed that of the euro area within a few years. This assumes that the current timidity in EU integration is overcome. There is not much doubt that the UK will leave the EU after a referendum in 2017 which, however, would be totally counter to its own economic and security interest. The UK can have no interest in leaving the EU with a shaky euro area in which Germany dominates economically, while military security is inadequate in both the eurozone and Western Europe. With the Ukraine-Russia crisis lingering, Western Europe has every interest in not letting the EU disintegrate. If the UK should leave, Brussels should raise the price for that non-solidarity much higher, beyond the refutation of the free mobility of labour with the EU as was the case with Switzerland in 2014.

If the EU falls apart, the blueprint for integration in other parts of the world would be damaged. Asia, Latin America, Africa and Europe need integration schemes that work, otherwise regional and global economic and political chaos will start spreading.