After the Draghi report – where next?
I recently participated in a fascinating and timely online debate, organised by the Union of European Federalists, together with Erik Nielsen, on the implementation of the recommendations in the Draghi report.
What are the chances that the Draghi report (together with the Trump 2 shock still to come) will trigger the necessary reforms within the EU to close the gap with the US and come out of the current low-productivity growth trap? The informal European Council in Budapest on 8 November issued a “Competitiveness declaration”, tasking the European Commission to present “a new and comprehensive horizontal strategy on the deepening of the Single Market, including a roadmap with clear timelines and milestones by June 2025”. There is also a unit established at the Commission tasked with specifically following up on the report. I was asked the whether this will be enough and quick enough; I am less worried about the speed (as long as we talk about months and not years or decades) but the focus on the right reforms, which might not necessarily be the ones that are politically the easiest to agree on. It is clear that many of these reforms will have to be implemented over a certain time frame, with effects only coming within a couple of years; it is important, however, to not lose momentum as well as create a positive narrative (currently completely missing).
The current internal and external situation is truly troubling. The political space for substantial reforms is limited given the anti-incumbency bias (reminding us of the quip by Juncker that ‘we all know what is the right thing to do, but don’t know how to be re-elected afterwards’). On the other hand, crisis situations often result in the EU making steps forward in creating the necessary frameworks for addressing gaps and overcoming such crisis situation. As I argued previously, Europe might very well be in a crisis situation within a few months, in case of a trade war with US (and possibly China) as well as rising geopolitical tensions in and outside Europe. Maybe that is what is needed for big steps forward!
The Draghi report is calling for a substantial increase in the investment share in GDP. But how can these investments be funded given that fiscal space is tight in most countries (though not in the largest EU economy, Germany)? One important point to be made in this debate is that public spending should not be treated the same as public investment, where the former is equivalent to consumption (which in best case might result in lower cyclical GDP variation, following the argument of countercyclical fiscal policy), while the latter can be self-financing if it results in higher growth! It is good to see that even in the German debate there is a realisation that the constitutional debt brake is hurting economic growth rather than helping it and calls for reforms are growing stronger. And it is obvious that institutions like the EIB can play an important role. A critical observation, however, is that it is not just about throwing more money at the same problems, but creating the conditions for public and private investment to complement each other and result in higher growth.
It will be difficult if not impossible to achieve consensus on the necessary reforms among the 27 member states, which is why there has been an increasing focus on ‘coalitions of the willing’ (as also recently proposed in a Spanish ‘non-paper’). The concern is, however, that this will result in some countries staying behind, with populist forces becoming even stronger there. In any case it is clear that compromises will have to be found that will be uncomfortable for quite some governments who have to cross their red lines.
One important chapter in the Draghi Report concerns the financing of the necessary investment. Europe is halfway across the ford as to the implementation of banking union and capital markets union. Can Europe deliver on a ‘financial union’ or investment and savings union (as Enrico Letta framed it)? For me, the necessary reforms to achieve a single market in financial services and achieve the necessary scales in financial markets are critical (not a surprising statement given the focus of my research and policy work 😊). As with other reforms, national interests on all levels (political, regulatory and industry) often stand against the necessary steps towards such a market. The narrative for the banking union as crisis response tool 10 years ago was clear; it is important to create a narrative for the necessary capital market reforms.
8. December 2024
Interesting papers - November 2024
Even during these turbulent times, the research process has to go on, including attending interesting conferences, meeting old and making new friends and learning about novel research. Herewith a run-down on some recent papers I found interesting
The research cluster Finance and Society at the EUI organised its first Finance and political economy conference last month. Lots of interesting papers. One was by my former PhD student Etienne Lepers that explores under which institutional arrangements macroprudential policies are most likely to be triggered in case of credit booms. One would think that it is more likely to happen under an independent macro-prudential authority. What Etienne finds, is that it is rather under an institutional arrangement of financial stability councils, with participation of government ministers. Is institutional independence over-rated? Maybe it is all about committee decisions to make macroprudential more credible. This would be in parallel to an earlier literature that shows that stronger checks and balances in a political system can actually make reforms more
Last month I also participated in a highly interesting conference organised by ESMA on sustainable finance and financial markets. While a lot of emphasis has been (not surprisingly) on banking and sustainable finance, investment funds and financial markets, more broadly, play an important role in the attempt to shift more funding towards the mitigation of climate change). The following three papers give a bit of a flavour of this literature. Kevin Birk, Stefan Jacob and Marco Wilkens find that in addition to sustainability ratings, prospectus information and self-declared sustainability objectives, have an impact on both retail and institutional investor flows into investment funds. Margherita Giuzio, Sujit Kapadia, Giulio Mazzolini, and Dilyara Salakhova shed doubts on the impact of the ESG investment fund sector. Specifically, they find that ESG funds identified by Morningstar or classified as such according to the European Sustainable Finance Disclosure Regulation perform better in metrics related to financed activities and carbon emissions than non-ESG funds, while self-marketed funds show less consistent results. However, even being classified as ESG fund results in a relatively limited impact that investment funds currently have in financing the transition to a net-zero economy. Finally, focusing on individual firms, Stefano Battiston, Irene Monasterolo and Maurizio Montone find that adopting sustainable technologies leads to a long-run improvement in firms’ fundamentals, which is only partially reflected in stock prices. Focusing on five-year periods, firms with greener technologies achieve higher returns and are better positioned for the transition to a low-carbon economy. These effects are especially pronounced in financially developed countries and among firms with better climate-related disclosure.
There is an expansive literature (both theoretical and empirical) that explores the relationship between political structure in a country and financial sector policies and institutions. A recent working paper by Yuemei Ji and Clement Minaudier and Orkun Saka adds to this literature and explores the effect of term-limits on post-crisis financial sector policies. Using data on financial policies and crises in 88 democratic countries between 1973 and 2015, the authors show that both term- and non-term-limited politicians revert financial liberalisation after a crisis, but the former more than the latter. Politicians facing a binding term limit are more likely to pass policies that favour financial institutions in the aftermath of financial crises, including higher barriers to entry in the banking sector, bailing out troubled banks and relaxing bank supervision. Using a theoretical model, the authors explain these findings with two opposing forces in the aftermath of financial crises: an increase in the salience of financial policies to voters and the emergence of a window of opportunity for legislators. They provide evidence that politicians in their final term may give policy favours to the banking sector in return for jobs in the financial sector; political allies of term-limited leaders who served in the aftermath of a financial crisis are indeed more likely to pursue a career in the private financial sector after leaving government. This is an important contribution to the debate on political accountability and political factors driving financial sector policies.
Finally, a very interesting paper by Hannah Winterberg on what to expect from more developed capital markets in Europe. Assuming (and showing)t that access to bond finance is primarily a function of firm size and collateral availability, Hannah shows that even if all European firms had access to the public capital market like similar firms in the U.S. have, their aggregate bond funding share would remain significantly smaller than in the US. This suggests that two thirds of the difference between US and EU in total bond funding is actually driven by different firm size distributions rather than less efficient capital markets in Europe. While this result might be somewhat sobering for advocates of a Capital Market Union in Europe, it is important to stress that Hannah assumes an exogenously given firm-size distribution, while this distribution might also react to changes in the efficiency of capital markets. But certainly an important signal to not have too high immediate expectations from more efficient capital markets in Europe.
30. November 2024
The German coalition falls – where next?
There was not much time last week to digest Trump’s re-election, as the German chancellor decided to pull the plug on three years of coalition between Social Democrats, Greens and Liberals. The coalition had started with big hopes in late 2021, but the debt brake spoiled the party; more specifically, when the Constitutional Court put an end to the over- if not abuse of ‘Sondervermoegen’ (special funds) to circumvent the debt brake, there was not enough money for the three parties’ very different priorities. But this is also another example of an incumbent government that has not survived the post-pandemic pain of higher inflation, recession and geopolitical changes. It also suffered from the backlash against the necessary adjustment due to climate change and the promised transition to net zero; the sad reality is that once it affects people’s bank accounts, climate change mitigation declines on voters’ priority list. Finally (and a point I will get back to), the government suffered from the legacy of the Merkel year and its neglect of infrastructure and defence.
The options for a post-election governments are somewhat limited. Based on current polls, the current government parties vote share will add up to 30%, far away from any majority. A ‘Jamaica coalition’ of Christian Democrats, Greens and Liberals might have enough votes (assuming that the Liberals make it back into Parliament), but the Christian Democrats’ election campaign seems so targeted against the Green Party that one wonders whether they can find together after the election. One policy area where they could find together would be the support of Ukraine (although even here the East German part of the CDU is wobbly). But the Liberals’ obsession with the debt brake makes another joint government between Greens and Liberals rather unlikely. The option that remains is the ‘Grand Coalition’ between Christian and Social Democrats, which governed for 12 of Angela Merkel’s 16 years as chancellor. Not very promising given what they did NOT deliver during these years! What about the Putinist side of the German political spectrum? The firewall against the AfD seems to hold so far, but less so the one that should be in place against Sahra Wagenknecht (the Left party will most likely drop out of Parliament). The worst case scenario would be for me a scenario where all democratic parties have to join government and only Putinist parties are left in opposition.
To say that Germany faces enormous economic challenges would be an understatement. During the Merkel years, Germany benefitted from an export boom, cheap Russian gas and being the safe haven of the Euro area, The first two are gone, with China having adapted much better to new demands for cleaner automobiles, for example. Cheap Russian gas is gone, for obvious reasons. At the same time, the Merkel years were wasted in terms of public and private investment. The constitutional debt brake and the ordoliberal obsession with balanced budgets prevented investment into the future. The ill-judged exit from nuclear energy was an additional bad choice. The new government has an enormous in-tray of tasks, which is probably even too big for a rather homogenous government, not to speak of a government made up of very different parties.
Where Germans often regarded the EU and the euro area as holding back Germany during the 2010s and complained that they had to ‘bail-out’ peripheral countries, the only opportunity for Germany to get out of the doldrums is Europe – the Draghi and Letta reports have set the agenda. If the German polity is looking for a medium- to long-term path to get out of a long-term stagnation and decline, this path leads through Europe, the strengthening of the Single Market (including banking and capital market unions) and a move away from the heavy reliance on China (economically) and US (for security). One can only hope that the next German government overcomes its ordoliberal arrogance and its ‘we know better than you’ attitude towards the rest of the EU and takes again the leadership role towards strengthening Single Market and strategic autonomy.
12. November 2024
Trump 2 – brace for impact
I still remember the morning after the 2016 US elections, when I woke up in a hotel in Frankfurt, turned on the TV to see the (then) surprising results that made Trump 45th US president, and felt very depressed. The following years turned out to be chaotic, to put it mildly. Many expect another four years of chaos – that would be the best-case scenario. Unless in 2016, Trump and his team are well prepared, to do maximum damage to institutions and democracy in the US, not only closing borders but massive deportation waves, imposing tariffs, increasing budget deficits, and ‘coming to an arrangement with Putin’ on Ukraine. Yes, there are still checks-and-balances in the US (most importantly the judiciary on the lower level that can delay policy actions, less so the Supreme Court) and not everything might turn out as bad as I described it. 2nd term presidents are often lame ducks as they cannot run for re-election, but even so it will be an important test for US democracy. At a minimum, no one on the other side of the Atlantic can say that they did not know what they voted for!
For Europe, the situation is at the same time grey, but at the same time offers enormous opportunities. It is clear that the Trump election will encourage Putin even further. Without even stronger European support, Ukraine will lose this war and Putin will be at the doors of NATO and the EU. If the ‘peacemongers’ still think that he will stop there, they might be in for a surprise. Adding a strong defence component to the EU (clearly overlapping with the European part of NATO) is one important element. Focusing even more on strategic autonomy across economic sectors another. Given the tendency towards economic isolationism and away from international trade (and this is something that is now popular on both sides of the political divide in the US), strengthening the European Single Market is critical. Some of us have been asking whether it takes another crisis to get the CMU (now being renamed as Investment and Savings Union) moving forward – well , it seems we are just getting this crisis served on a silver tray.
Critical to understand is that the European idea, including openness and democracy is facing enemies within. The upcoming elections in Germany will offer a clear contrast between anti-democratic Putinists from left and right against democratic pro-European parties. Several Central European countries are being governed by right-wing populists that will try to put the brakes on any further integration and strengthening of the EU. Coalitions of the willing seems to be the way to go (the ESM was established as intergovernmental organisation given UK resistance). This is an important wake-up call for Europe! May we not waste this crisis!
6. November 2024