The Continuing Evolution of Europe (CESifo Seminar Series)

The Continuing Evolution of Europe

CESifo Seminar Series Edited by Hans-Werner Sinn Tax Policy and Labor Market Performance, Jonas Agell and Peter Birch Sørensen, editors Privatization Experiences in the European Union, Marko Köthenbürger, HansWerner Sinn, and John Whalley, editors Recent Developments in Antitrust: Theory and Evidence, Jay Pil Choi, editor Schools and the Equal Opportunity Problem, Ludger Woessmann and Paul E. Peterson, editors Economics and Psychology: A Promising New Field, Bruno S. Frey and Alois Stutzer, editors Institutions and Norms in Economic Development, Mark Gradstein and Kai A. Konrad, editors Pension Strategies in Europe and the United States, Robert Fenge, Georges de Ménil, and Pierre Pestieau, editors Foreign Direct Investment and the Multinational Enterprise, Steven Brakman and Harry Garretsen, editors Sustainability of Public Debt, Reinhard Neck and Jan-Egbert Sturm, editors The Design of Climate Policy, Roger Guesnerie and Henry Tulkens, editors Poverty, Inequality, and Policy in Latin America, Stephan Klasen and Felicitas Nowak-Lehmann, editors Guns and Butter: The Economic Laws and Consequences of Conflict, Gregory D. Hess, editor Institutional Microeconomics of Development, Timothy Besley and Rajshri Jayaraman, editors Dimensions of Competitiveness, Paul DeGrauwe, editor Reforming Rules and Regulations, Vivek Ghosal, editor Fertility and Public Policy, Noriyuki Takayama and Martin Werding, editors Perspectives on the Performance of the Continental Economies, Edmund S. Phelps and Hans-Werner Sinn, editors Industrial Policy for National Champions, Oliver Falck, Christian Gollier, and Ludger Woessmann, editors Illicit Trade and the Global Economy, Storti, Cláudia Costa, and Paul De Grauwe, editors See http://mitpress.mit.edu for a complete list of titles in this series.

The Continuing Evolution of Europe

edited by Thiess Buettner and Wolfgang Ochel

The MIT Press Cambridge, Massachusetts London, England

© 2012 Massachusetts Institute of Technology All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical means (including photocopying, recording, or information storage and retrieval) without permission in writing from the publisher. For information about special quantity discounts, please e-mail special_sales@mitpress. mit.edu This book was set in Palatino by Toppan Best-set Premedia Limited. Printed and bound in the United States of America. Library of Congress Cataloging-in-Publication Data The continuing evolution of Europe / edited by Thiess Buettner and Wolfgang Ochel. p. cm.—(CESifo seminar series) Includes bibliographical references and index. ISBN 978-0-262-01701-5 (hbk. : alk. paper) 1. Europe—Economic conditions—21st century 2. Europe—Social conditions—21st century. 3. Europe—Politics and government—21st century. I. Buettner, Thiess. II. Ochel, Wolfgang, 1943– HC240.C6125 2012 330.94—dc23 2011024402

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Contents

Contributors vii Series Foreword ix

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The Continuing Evolution of Europe: Introduction and Overview 1 Thiess Buettner and Wolfgang Ochel

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Financial Market Regulation in Europe Paul De Grauwe and Frank Westermann

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Global Constraints on European Integration over the Next Few Decades 33 Peter Egger and John Whalley

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Do We Need National or European Champions? Christian Gollier and Ludger Woessmann

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Reforming the European Welfare State Martin Werding and Kai A. Konrad

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Europe at a Crossroads: Reforming Political Institutions and Public Sectors 119 Massimo Bordignon, Thiess Buettner, and Frederick van der Ploeg Index

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Contributors

Massimo Bordignon

Friedrich Alexander University Erlangen-

Thiess Buettner Nuremberg Paul De Grauwe Peter Egger

Catholic University of Milan

University of Leuven

ETH, Zurich

Christian Gollier

Toulouse School of Economics

Kai A. Konrad Max Planck Research Center for Tax Law and Public Finance, Munich Wolfgang Ochel Ifo Institute for Economic Research, Munich Frederick van der Ploeg Martin Werding

University of Oxford

Ruhr University Bochum

Frank Westermann University of Osnabrueck John Whalley

University of Western Ontario

Ludger Woessmann Ifo Institute for Economic Research and University of Munich

Series Foreword

This book is part of the CESifo Seminar Series. The series aims to cover topical policy issues in economics from a largely European perspective. The books in this series are the products of the papers and intensive debates that took place during the seminars hosted by CESifo, an international research network of renowned economists organized jointly by the Center for Economic Studies at Ludwig-MaximiliansUniversität, Munich, and the Ifo Institute for Economic Research. All publications in this series have been carefully selected and refereed by members of the CESifo research network.

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The Continuing Evolution of Europe: Introduction and Overview Thiess Buettner and Wolfgang Ochel

The economic history of Europe is closely intertwined with the enlargement and deepening of the European Union. This body of institutions has evolved in rapid succession from the European Communities of the 1960s, a grouping of supranational institutions that fostered economic integration among a few Western European nations, into a new upper tier of government affecting the policies of twenty-seven member states in almost every sphere of government activities. Given this institutional setting, one might think that Europe is well prepared to face new challenges. This, however, is not the case. The financial crisis has resulted in a substantial increase in economic imbalances in Europe, necessitating the introduction of several “rescue packages” intended to stabilize financial markets in Europe, and convincing solutions to the crisis have not yet been found. At the same time, the global challenges faced by the European Union are mounting. Economic growth is relatively slow, presumably resulting from a lack of innovation, the promotion of national and European champions, labor market rigidities, the aging of the population, and overregulated markets. Finally, the European institutional framework seems inadequate to meet these challenges and often tends to hamper the implementation of new policies and reforms. With regard to the diagnosis of these problems as well as to possible remedies, the CESifo Research Network, a leading network of economists in Europe and worldwide, recently launched a project to provide a forum for the exchange of relevant ideas. This book brings together overviews of the issues and in-depth analyses of key problems and possible solutions. Rather than trying to cover all the politically relevant topics, our goal is to address key issues pertaining to the main economic challenges faced by the European Union: the financial instability, lack of growth,

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costly welfare state, inadequate institutional framework, protection of national interests, and relationship between internal and external economic integration. The following pages provide a brief overview of the main issues the book covers. The Financial Crisis: A Risk for the Euro Area While individual countries are affected differently, the financial crisis has had and still has a substantial impact on public finances in Europe. Some countries, notably Greece, entered the crisis with a huge amount of public debt and now have trouble sustaining their fiscal policies because interest rates on their government bonds have increased substantially. The attempt of European countries to stabilize their economies during the sharp recession that followed the financial crisis also caused a large increase in public debt. The real threat to the financial stability of Europe and of the eurozone, in particular, however, comes from the fragility of the European banking sector. Not only did some national governments—Ireland, in particular—provide large support packages to their struggling banks, resulting in huge public deficits. Since the whole European banking sector is struggling with the aftermath of the global financial crisis, the increased risk of sovereign debt default in Europe triggered drastic actions, especially by the eurozone. The European Central Bank was forced to compromise key principles and to buy troubled government bonds. The fiscal difficulties in the European Monetary Union reveal important deficiencies of European institutions. Currently, EU institutions are failing in three respects. The Stability and Growth Pact is not able to guarantee the stability of public finances. The Maastricht Treaty—apart from the no-bailout clause—did not provide for a crisis management mechanism. And the national boards of control are not in a position to guarantee the stability of the banking system. To address these deficiencies and to propose effective measures, the European Union created a task force that recommended steps designed to strengthen budgetary discipline among the EU member states, improve economic-policy surveillance, and forestall and manage future financial crises in Europe. However, the instability of the European financial system has been left unaddressed by the so-called Van Rompuy Task Force. In chapter 2 Paul de Grauwe and Frank Westermann focus on the financial markets, an area where regulation is crucial for stable

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development. They begin with an account of recent developments in European financial markets, then home in on the market failures responsible for the financial crisis in Europe as well as in the United States. Two policy questions arise: What is an appropriate short-term response to the current financial crisis? And how can the financial sector be reformed to reduce its vulnerability to financial crises in the future? Two long-term policy options are considered: strengthening the Basel Treaty and returning to narrow banking—that is, to the GlassSteagall Act approach. Finally, the European proposals for reform are discussed. It seems fair to say that the financial crisis resulted from excessive risk taking in the banking sector. Several market failures are responsible for this excessive risk taking. From a microeconomic perspective, information asymmetries between shareholders, bank depositors and so on, and the bank management have been decisive. From a macroeconomic viewpoint, systemic risk can arise when either currency mismatch or maturity mismatch is present in the aggregate balance sheet of the banking system. And, finally, implicit bailout guarantees create moral hazard and excessive risk taking. The financial crisis has triggered some of the largest government rescue operations in the history of several European countries. Central banks have performed massive liquidity infusions; governments have introduced state guarantees on interbank deposits and have recapitalized banks. The interventions have been successful, but will they bring the banking system back on track so that it can perform its function of credit creation? As to the future regulation of the banking system, strengthening the Basel Accords has the advantage of tackling the problem of the banks’ insufficient equity at an international level, thereby preventing competition among national regulators. Currently, however, this approach has serious shortcomings. The possibility of using internal risk models and the variety of definitions of capital create important loopholes that prevent effective monitoring of the banks. That is why the current Basel approach must be rethought. A policy option that would reduce the amount of risk taking would be a return to narrow banking. This would limit commercial banks’ ability to accumulate high-risk assets on their balance sheets. Only they would be eligible for a government bailout, while all other financial institutions would not be. High-risk activities would be reserved for investment banks, which would be required to finance these activities

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via funding in the capital markets. The opportunity to streamline regulations and supervision at the EU level has not yet been utilized. National authorities are still the main driving forces in the reform of bank regulation and supervision. This decentralized approach has important shortcomings, however. Regulatory arbitrage within the European Union remains in place. Global Constraints Getting public finances back into shape and overhauling financial market regulation and supervision should have top priority at the moment. But according to the European Commission’s program “Europe 2020,” Europe must also strengthen its economy for the future. The program calls on Europe to free up its growth potential. One element of the European Union’s strategy is to remove obstacles in the internal market to increase mobility of people, services, and investments. Obstacles still exist. The European Commission’s ambitious Service Directive may serve as an example. Launched with the aim of further reducing entry barriers to national markets, the governments’ agreement that would have helped to open the markets for services was only passed in a less ambitious form by the European Parliament. Whereas much attention in the debate about the construction of Europe is devoted to the challenges that arise from increased economic integration, Peter Egger and John Whalley in chapter 3 emphasize that European integration and growth are increasingly challenged by global constraints. Emerging economies such as those of China and India will not only play an increasingly large role in international trade but will also continue to attract huge amounts of foreign direct investment. Europe will therefore face growing external pressure toward improving the competitiveness of the European economy. Production in Europe will be subject to further internationalization and will display continued growth in international outsourcing, including countries outside the European Union, notably Asian countries. Growth in other parts of the world will tend to diminish Europe’s role in important markets, not only in financial markets but also with regard to natural resources. Europe’s diminished clout in the world economy also has implications for its potential to negotiate in important challenges such as environmental protection and global climate change. All this suggests that Europe cannot meet the challenges of the future by continu-

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ing on the inward-looking integration path that has dominated its policies for the last fifty years. Industrial Policy: The Role of National Champions Another element of the “Europe 2020” growth strategy is investments in key sectors. Such investments are supposed to create growth and jobs in the future and bring a decisive competitive advantage. Christian Gollier and Ludger Woessmann in chapter 4 focus on industrial policy. Globalization has raised pressure on European governments to protect national firms from foreign takeovers, to promote national or European champions, and more generally to reinstall a strong industrial-policy agenda. In many political circles in Europe it is assumed that national champions assisted by the state are best for promoting employment and growth. In this chapter, the economic arguments for and against an industrial policy that favors the emergence of national or European champions are reviewed. The beggar-thy-neighbor type arguments of the static model of imperfectly competitive markets are criticized because countries aim at capturing rents from other countries. In equilibrium each national government will inefficiently encourage national firms to become global champions and will end up in a prisoners’ dilemma situation. Every country would be better off with transnational coordination and supervision of champion-related policies. An “arms race” of national policies to promote their champions should be prevented. Other arguments against champion-promoting policies are based on economic-policy considerations. There are many reasons to doubt that picking winners takes place efficiently. Politicians find it difficult to resist implementing inefficient actions that benefit well-established firms with political power if the costs are borne by a large group of more or less uninformed citizens. Furthermore, they are in favor of prestigious projects and face difficulties withdrawing support once it is given. Finally, the infant-industry arguments of dynamic innovation models are not convincing either. In most cases the promotion of national champions seems less effective in creating innovation and growth than liberalizing policies that foster competition, especially since many of the “national champion” policies in EU countries are not about innovative sectors but about mature or declining sectors.

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In concluding, Gollier and Woessmann note that all these arguments tend to suggest that European countries would be better off if their governments did not promote national champions. Reforming the European Welfare State A third element of the European growth strategy consists of reforms of rigid labor markets and ineffective social protection. Martin Werding and Kai A. Konrad in chapter 5 analyze labor market regulations and public transfers, which are often perceived as having adverse effects on growth performance and as impeding adjustments to new challenges in the era of globalization. Although they acknowledge that the European welfare state is confronted with problems and needs to be reformed, they see basic merits in its potential for improving efficiency as well as for promoting an equitable distribution of income and opportunities. There is, however, a need for reforms so that the welfare state can continue to play a positive role in the future. Three major sets of issues are identified as deserving special attention with regard to reforms: labor market performance and labor market policy, the impact of an aging population on social protection schemes, and the opportunities and risks involved in extended international migration. As to the first, strategies for increasing employment should rest on two pillars. On the one hand, countries should increase the attractiveness of capital investment. On the other hand, labor market policy should be geared toward activating the unemployed. Elements of flexibility in the utilization of labor should be combined with elements of worker security and complemented by a continuous activation of the unemployed, with in-work benefits and workfare measures as the most prominent instruments. The aging of the population is considered a threat to the long-term sustainability of public pension schemes, public health funds, and public finances in general. An appropriate balance must be sought between burdens imposed on the old and the young. In recent years, many European countries have made considerable progress in reforming their unfunded systems for old-age provision, mostly by reducing benefit levels that will take effect over the next two to three decades. Similar problems involved in healthcare systems are largely unresolved. With respect to old-age provision, partial funding through higher precautionary savings of younger cohorts forms an important

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part of many reform strategies. The same approach should probably be extended to the health sector. With respect to designing migration policies in a European context, migration inside the European Union has to be distinguished from migration from outside. Within the current EU-27, the principle of free mobility of workers and their families will be applied without further restrictions starting in 2014 at the latest. Whereas fears regarding the impact of migration on labor markets in such a free-mobility regime are misguided, the impact on social protection systems can be truly harmful. Migration can result in an international “race to the bottom” of social protection. Coordination of social policy at the EU level may need to be considered. New approaches may also be needed to actively manage the immigration of non-EU citizens and to shape the size and structure of future immigrant networks. Reforming Institutions and the Public Sector The performance of the European Union has been particularly poor with regard to reforms of European institutions. Initiatives to introduce a basic constitutional framework that would improve decision making in Europe and at the same time increase the role of the parliament have been stalled by several referenda, and the success of current attempts to rescue the main provisions of the agreements is still in doubt. In chapter 6 Massimo Bordignon, Thiess Buettner, and Frederick van der Ploeg turn their attention to the role of the institutional framework in hampering or fostering the implementation of new policies. The chapter starts with a discussion of decision making in the European Parliament and other key EU institutions, highlighting voting, budgeting, and the implementation of European legislation as national law. While the European institutions can be credited with important achievements—in particular, with regard to the integration of the markets in Europe—progress in the quality of integration has slowed down considerably. Further reforms are needed to enhance innovation and growth in Europe; however, there are substantial problems with the key institutions and in the balance of power between them that explain why reforming European policies has proved so difficult. Bordignon, Buettner, and Van der Ploeg argue that a thorough reform of European institutions is a precondition for a reassignment of responsibilities between supranational, national, and local governments in Europe. Such a reform process is not only necessary from the viewpoint

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of standard prescriptions of an abstract theory of fiscal federalism but is also demanded by European citizens, as the analysis of survey data suggests. The tensions between European politics and the demands of the European people are reflected in a growing anti-European sentiment. Dismissing suggestions to transform Europe into a full-blown federal state, the authors argue that a reasonable strategy to reconnect European policies and Europe’s citizenry would be to revitalize European politics and to empower the European Parliament—for instance, by giving it the right to elect the president of the Commission. What conclusions can be drawn from the analyses presented in this book? Key findings include the following. A solution to the financial crises requires not only budgetary discipline but, above all, effective regulation of the banking system. In addition, a strategy for increasing the European Union’s growth potential needs to be implemented. Such a strategy should take global considerations into account. A purely inward-oriented integration process is not a substitute for global integration. Europe’s international competitiveness requires a competitive internal environment without the promotion of national champions. Reforms of rigid labor markets and of social welfare systems would also influence competitiveness and growth positively. Despite recent institutional changes, reforms of the decision-making processes of key European institutions and a reassignment of responsibilities between supranational, national, and local governments remain of the utmost importance. These reforms are crucial for ensuring that Europe continues to evolve into a model for international cooperation and serves as an anchor of stability, democracy, and peace in the world.

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Financial Market Regulation in Europe Paul De Grauwe and Frank Westermann

2.1

Introduction

Looking at the development of financial markets in Europe before the financial crisis in 2007–2008, it is remarkable that key macroeconomic and financial variables have been reminiscent of those in countries with well-known financial crises observed in the past twenty to thirty years. Aggregate domestic credit increased substantially and so did the share of liquid liabilities to GDP. The share of foreign currency liabilities was—particularly in Eastern Europe, but also in parts of Western Europe—as high as in some countries during the Asian and Latin American crisis episodes in the mid- and late 1990s. Also, stock markets experienced large cyclical swings, as for instance in Japan before the banking crisis in 1997–1998. All these developments have been typical leading indicators of crises that have been discussed in the literature on lending booms, currency mismatch, and maturity mismatch. Furthermore, the markets have become substantially more integrated and competitive within the euro area, and therefore the literature on contagion also appears to be relevant. If one country experiences a financial crisis, other countries are therefore likely to be affected, too. In the present chapter, we take account of these recent developments in financial markets in Europe and highlight forms of systemic risk in the banking system. We comment on the bailout of the banks and discuss longer-term reform alternatives for the world financial systems in response to the financial crisis. In particular, we discuss the pros and cons of a return to the model of narrow banking. The development of aggregate domestic credit has been strikingly similar to many well-known credit crises in the recent past. Considering the period from 1990 onward, the share of private credit of domestic money banks to GDP has increased from 40 to 160 percent in Ireland,

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from 30 to 60 percent in Greece, and from 110 to 150 percent in the United Kingdom. These increases, which largely happened during the last ten to fifteen years, can certainly be classified as lending booms. These lending booms coincide with several other aspects of typical crisis episodes.1 The share of foreign currency liabilities reaches values of 55 percent in Finland and the United Kingdom, 43 percent in Slovenia, and about 30 percent in the Netherlands and Belgium. The share of liquid liabilities to GDP increased in Germany and the United Kingdom from 60 percent to over 100 percent. All these are indicators that the amount of systemic risk taking increased prior to the eruption of the credit crisis. Because financial integration increased as well, a discussion of these issues is needed at the European level. The current financial crisis is not only the result of a realization of this systemic risk, but primarily a spillover phenomenon that resulted from a decline in housing prices in the United States. Nevertheless, there is substantial evidence that systemic risk taking in Europe has facilitated the contagion. The policy question that arises from these observations is therefore twofold: First, what is an appropriate shortterm response to the current financial crisis? And second, how can the financial sector be reformed to reduce the vulnerability to financial crises in the future? With regard to the first question, we argue that large government bailout packages are inevitable. In fact, despite the enormous efforts to stabilize the banking system, the bailout, when compared to previous crises, is still within the international and historical norm. For example, the $700 billion rescue package of the United States constitutes 5 percent of its GDP. This is significantly more than the rescue package during the U.S. savings and loans crisis two decades earlier (2–3 percent of GDP) but substantially less than the rescue operations that were needed in Finland in 1993 (11 percent), Mexico in 1994 (18 percent), Japan in 1997–1998 (20 percent), or Korea in 1997 (27 percent). Although we don’t know the final cost of the current crisis yet, there is so far no evidence that the bailout is of an unprecedented magnitude. From a longer-term perspective, one needs to ask how the banking system can be regulated in a way that prevents financial crises in the future. Here we discuss two policy options: on the one hand, a strengthening of the Basel treaty that regulates the capital basis of the banks,2 and on the other, a return to the concept of narrow banking. While the strengthening of the Basel treaty has the advantage that the problem of insufficient capital basis is tackled at an international level, and

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thereby prevents the competition among regulators of national authorities, we argue that—in its present form—it has serious shortcomings. The possibility of using internal risk models and the variety of definitions of capital create important loopholes that prevent effective monitoring of the banks. The second proposal that we discuss has a different starting point. In theoretical models of financial crisis (Tornell and Schneider 2004) bailout expectations are an important factor for systemic risk taking. A policy option that would reduce the amount of risk taking in the financial sector would be a return to the model of narrow banking. Narrow banking means that only deposit-money banks would, in times of crisis, be eligible for a government bailout, while all other financial institutions would not. A credible introduction of such a system, which would essentially be a return to the set of regulations under the GlassSteagall Act, would reduce the amount of systemic risk taking discussed above. In all proposals for reregulation, one needs to take into account that these policies have opportunity costs in terms of output growth. Systemic risk taking not only leads to crises, but also to investment through the availability of credit (Ranciere, Tornell, and Westermann 2008). However, the benefits of systemic risk taking, through the relaxation of credit constraints, are mainly present in countries characterized by institutional weaknesses that prevent the development of a wellfunctioning domestic financial market. This is a major concern in emerging markets and developing countries that are exposed to a severe underinvestment problem. Among advanced industrialized economies the link is empirically less strong. 2.2 Recent Developments: Lending Booms, Financial Integration, and Increased Competition In the precrisis period, financial markets in Europe have been expanding and integrating substantially, in particular since the introduction of the euro in 1999. In this section we highlight some of the most striking developments, with a focus on the euro area. We also look at the United Kingdom and the United States, two countries that serve as benchmarks for the sake of comparison with Europe. We start by looking at the trends of aggregate domestic credit provided by deposit-money banks. Figure 2.1 shows that the ratio of credit to GDP has been increasing in the euro area as a whole. This has been

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2.2 2 1.8 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1990

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Figure 2.1 Private credit by deposit-money banks relative to GDP. Source: Financial Structure Dataset, World Bank (2007)

particularly strong in some countries—for example, in Ireland the ratio of domestic credit to GDP has increased from less than 50 percent in the early 1990s to 167 percent in 2006, which is the highest value of all euro-area countries. It even exceeds that of the United Kingdom, which has one of the world’s largest financial centers. Most other countries have also been on an upward trend. Strong increases can be observed in Spain, Portugal, Finland, Slovenia, Greece, and Italy. The only countries that recently have experienced a downward trend are Germany3 and Malta. Parallel to the rapid expansion of domestic credit, the banking industry in Europe appears to have become more competitive in recent years. The introduction of a common currency and the advanced electronic technology for financial transfers have certainly contributed to this development, as has the worldwide competition in the banking industry. Figure 2.2 shows that the net interest margins generally follow a downward trend and have been substantially reduced in some countries. The largest decline in the interest margins appears to have taken

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Figure 2.2 Net interest margins. Source: Financial Structure Dataset, World Bank (2007)

place in countries that previously charged a rather high-risk premium in the interest rates, such as Italy and Greece. Here the common currency eliminated exchange-rate risk. While the financial system has been expanding as a whole, another key feature of Europe’s financial system relevant to the discussion of financial regulation is the fact that the share of cross-border activities of banks has reached a significant level. This is illustrated by the share of foreign ownership of domestic banks in 2005. Figure 2.3 shows that these shares range from 6.5 percent in Germany to 95 percent in Luxembourg. Countries with rather low shares are the Netherlands (8.9 percent), Spain (10.2 percent), and Italy (11.1 percent). Quite high shares can be observed in Finland (57.2 percent), Belgium (21 percent), Austria (19.4 percent), and Slovenia (19.4 percent). These numbers are within the range of the non-euro-area countries—the United States, with 8.5 percent, and the United Kingdom, with 54.2 percent. Overall, the magnitude of these numbers provides some support for the view that the degree of cross-ownership increases the need for common regulation at the supranational level (Sinn 2003). It is necessary to find a common

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United States United Kingdom Spain Slovenia Portugal Netherlands Luxembourg Italy Ireland Greece Germany France Finland Belgium Austria

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Figure 2.3 Fraction of banking system assets in banks that are more than 50 percent foreign owned. Source: Financial Structure Dataset, World Bank (2007)

regulatory response to the financial crisis at least at the European level, but preferably at the international level. Finally, we take a look at the stock market developments in the euro area in recent years. Figure 2.4 shows the stock market capitalizations relative to GDP in the eurozone and the United Kingdom. A typical boom-bust pattern is visible in the bubble period of the late 1990s that reached its peak in the year 2000. The strongest bubble episodes are visible in Finland, Luxembourg, the United Kingdom, and the Netherlands. Austria, Malta, and Slovenia remained largely unaffected by these bubble episodes. In the following section we show that these fluctuations in the stock market play an important role in the stability of the domestic banking systems. In some European countries banks are allowed to hold equity, and they do so to a substantial extent. As a result, the revaluation gains from large stock market swings translate into changes in the capital basis of the banking system, depending on the regulatory treatment of revaluation gains in these countries. Under a very similar set of regulations, the Japanese banking crisis in 1997– 1998 was preceded by a similar stock market cycle, which peaked in 1990, just a few years before the banking crisis. 2.3

Bailout Expectations and Moral Hazard

There is a growing consensus that regulation of the banking sectors will have to be reformed. To discuss the nature of the required regula-

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4.5 4 3.5 3 2.5 2 1.5 1 0.5 0 1990

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Figure 2.4 Stock market capitalization to GDP. Source: Financial Structure Dataset, World Bank (2007)

tory reform in Europe, we need to start by giving an account of the arguments for public regulation of the banking system. Although the financial industry is very competitive, it is characterized by a number of market failures that provide the basis for public regulation. There are two important arguments for regulation of the financial sector. One takes a microeconomic and the other a macroeconomic perspective. 2.3.1 A Microeconomic View One microeconomic argument for regulation focuses on the information asymmetry between the shareholders, the depositors, and the other creditors of the banks on the one hand, and the management of the banks on the other (Stiglitz and Weiss 1981). The group of economic agents that supply the liabilities of the banks have no direct control over the type of assets that the banks invest in.4 The degree of monitoring is incomplete and the bank management can invest in risky assets that have a low probability of a high return and a high probability of a small return. Sinn (1982) has demonstrated that an incentive exists

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for an excessive use of such payoff schemes. The main argument is that the bank managers have a “kinked” utility curve for taking economic risk. In the range of positive payoffs, bank managers have normal, riskaverse preferences, but in the negative range—even if they are perfectly liable for the potential damage they cause—they become less risk averse beyond a certain point. They simply cannot lose more money than they have or can plausibly repay from their income in the future. Over the whole range of possible payoffs, this generates a risk-loving “kinked” utility curve that leads managers to take excessive risk in equilibrium. Together with the information asymmetry, this generates a need to regulate the amount of risk taken by the banks, by setting minimum reserve and minimum capital requirements. This microeconomic analysis has formed the basis for the Basel minimum capital ratios. Legally, the capital requirements are set at 8 percent at the moment. However, the details on how this regulation is treated in practice vary widely across countries, even in the euro area. For example, the definition of capital and of the way the risk adjustment is done is not uniform across countries. The requirements are most easily comparable when looking at the so-called tier 1 capital ratios—that is, the actual shareholders’ equity as a ratio of the total of risk-weighted assets of banks. Figure 2.5 indicates that the numbers in 2005 varied from a value of 15 percent in Finland to merely 7 percent in Portugal. France, Germany, and Italy also failed to meet the 8 percent capital ratios. The national implementations of the Basel regulations also differ in the way countries allow the banks to compute the “tier 2” of the capitalassets ratio. Tier 2 capital is broader than tier 1 and includes, among other things, the unrealized gains from stock market variations. In 1991, when Japan joined the Basel agreement, this possibility was added to the Basel contract. Table 2.1 shows the wide variation in the definition of tier 2 capital across industrial countries. While some countries, like Luxembourg, do not allow revaluation gains to count as tier 2 capital at all, others, like Finland (the country with the highest tier 1 base), allow 100 percent of the revaluation gains to count as capital. Clearly, this is a risky practice, because negative revaluation gains would count as capital losses. In times of falling stock prices, these countries’ banking industries would come under pressure to meet the capital ratios and might be forced to cut on lending. As a result of such practices stock market fluctuations can have a particularly large

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an Fr

Fi nl an

Be

Au

st

ria lg iu m

0

Note: * no data available

Figure 2.5 Capital-asset ratios. Source: Financial Structure Dataset, World Bank (2007)

Table 2.1 Treatment of revaluation gains in the computation of tier 2 capital Belgium Denmark Finland Germany Greece Ireland Luxembourg The Netherlands Portugal

Spain Sweden United Kingdom United States

These are part of tier 2, which is capped to 100% of tier 1. 50% 100% 45% for real estate, 35% for securities As tier 2, 45% of the revaluation of fixed assets and financial assets 100% of financial and tangible fixed assets 0% Revaluation reserves are included in upper tier 2 capital. The amount of tier 2 capital is limited to the amount of tier 1 capital. 45% of the unrealized gains on investment properties and other tangible assets; 45% of unrealized gains on available-for-sale instruments; and 45% of unrealized gains in cash-flow hedges when the hedge item is an available-for-sale asset. 50% Only allowed as tier 2 capital after approval from FI 100% but limited as part of tier 2 capital 45% of tier 2 capital

Source: World Bank, Banking and Regulation Data Base

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Paul De Grauwe and Frank Westermann

procyclical effect on the real economy (Hutchison, Ito, and Westermann 2006). Most countries, however, are in an intermediate range. Germany allows for counting 45 percent of the revaluation gains for real estate and 35 percent for securities as part of tier 2 capital. The United Kingdom, which also allows for 100 percent, and in particular the United States, which allows for 45 percent, have very strict rules on the amount of equity the banking system is allowed to hold. In Belgium it is possible to count revaluation gains, but the amount is fixed to at most 100 percent of tier 1 capital. Table 2.1 shows that the official Basel capital ratio of 8 percent (as the sum of tier 1 and tier 2 capital) is presently met by all euro-area countries. However, this fact hides the wide disparity in the practical content of the official capital ratio. As a result, these capital ratios cannot easily be compared across countries. A further harmonization of the European financial market appears necessary. We make suggestions for possible reforms in section 2.6. 2.3.2 A Macroeconomic View A second motivation for the regulation of the banking system is to be found in the need to maintain macroeconomic stability. In the earlier literature, the main macroeconomic focus was on the possibility of bank runs and on the macroeconomic consequences of a collapsing banking system through the lack of deposits. This remains important. However, the more recent literature also focuses more generally on the possibility of financial crises that could be triggered by other events, such as external shocks or shifts in expectations. In this literature, two characteristics of credit markets play a key role. Systemic risk at the aggregate level can arise, when either currency mismatch or maturity mismatch is present in the aggregate balance sheet of a banking system. Currency mismatch can take different forms (Tornell and Westermann 2002). For instance, the banks could borrow in international financial markets in foreign currency and lend to domestic firms in domestic currency. In this case the currency mismatch would be on the bank side. Alternatively, the banks could denominate loan contracts in foreign currency as well and pass on the risk of exchange-rate changes to domestic firms and households. In this case, the currency mismatch would be on the firm and household side. If the firms are direct exporters and also receive their revenues in foreign currency, this mismatch problem is mitigated. As Tornell and Wester-

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19

0.6 0.5 0.4 0.3 0.2 0.1

ga l Sl ov en ia U ni Sp te ai d n Ki ng U do ni te m d St at es *

s

rtu

nd

Po

he

N

et

m xe Lu

rla

ur

g*

ly Ita

bo

d*

e

la n

Ire

ec

y*

re

an m

er G

G

ce

d

an Fr

Fi nl an

st Au

Be

ria

* lg iu m

0

Note: * no data available

Figure 2.6 Foreign currency liabilities as a share of total liabilities. Source: Financial Structure Dataset, World Bank (2007)

mann (2002) show, most lending activities of banks are focused on the domestic sector and so the exchange-rate risk directly converts to default risk, if the banks try to pass on the currency mismatch to firms and households. It is therefore very informative in both cases to look at the share of foreign currency liabilities. Figure 2.6 shows that the share of foreign currency liabilities is indeed quite high in some countries.5 In Finland and the United Kingdom it exceeds 50 percent. These numbers are very high in international comparison, because they are comparable to those in Asian countries before the financial crisis in 1997 and in Latin American countries in the twin banking and currency crisis in 1994–1995. Honkapohja and Koskela (1999) argue that the Finnish banking crisis in the early 1990s indeed was in some respects similar to those more recently observed in emerging markets, where a large exchange-rate depreciation increased the value of the firms’ and households’ debt and indirectly caused a banking crisis (see Kaminsky and Reinhart 1999 for a discussion of the twin banking and currency crises). In Belgium, the Netherlands, and Slovenia, the figures are also quite high, although most countries have values of less than 25

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Paul De Grauwe and Frank Westermann

1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 0 1990

1992

1994

Austria Greece Portugal

1996 Belgium Ireland Slovenia

1998

2000 Cyprus Italy Spain

2002

2004

France Malta UK

2006

2008

Germany

Figure 2.7 Liquid liabilities relative to GDP. Source: Financial Structure Dataset, World Bank (2007)

percent. Because the share of foreign currency liabilities is sensitive information for many central banks, it is not available for all countries in the European Union. Systemic risk that leads to balance-sheet effects, similar to the degree of foreign currency liabilities discussed above, can also arise from other sources. Bussière, Fratzscher, and Koeniger (2004), for instance, consider the issue of maturity mismatch. Banks that have short-term liabilities and long-term assets run the risk of a withdrawal of assets, similar to the bank run on deposits discussed earlier. To keep this risk to a reasonable degree, bank regulators and rating agencies monitor the amount of liquid liabilities relative to GDP in the aggregate banking systems. Figure 2.7 shows that the degree of liquid liabilities to GDP has increased steadily in the euro area over the past fifteen years. Aside from Cyprus and Malta, which have the highest share, the United Kingdom, Germany, and Spain also have very high ratios of liquid liabilities relative to GDP. They all have a ratio of liquid liabilities to GDP of more than one, while all other countries have values of less than one. Slovenia, France, and Italy are the countries with the smallest ratios.

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2.3.3 Expected Bailouts In an explanation of banking crises, a key ingredient is the existence of (implicit) bailout guaranties (Tornell and Schneider 2004). Such bailout guarantees create moral hazard and excessive risk taking.6 Implicit guarantees are difficult to document empirically. In this section we show that there have been a substantial number of bailouts and a relatively small number of closures. In a recent update of the banking regulation database, the World Bank collected the number of interventions (or takeovers) and open bank assistance (liquidity support) by European governments. According to the World Bank, there have been seven such interventions in Denmark, three in Germany, two in Greece, nine in Italy, and one in Spain. The size of theses interventions varies between 0.01 percent of the banking system’s total assets in Spain to 0.26 percent in Italy and 2 percent in Germany.7 These values refer to the past five years and were reported in a study conducted in 2008. More often than direct public interventions, private mergers or takeovers prevent banks from failing in Europe. A transfer of assets and liabilities (including purchase and assumption) or merger and acquisition, for instance, occurred twenty times in Italy, twenty-seven times in Luxembourg, and five times in the Netherlands. Germany and Luxembourg are the only countries that have seen a substantial number of closures of banks by public agencies, with seven and thirty-one instances in the last five years, respectively. The only other countries where a case of bank closure and liquidation was reported are Slovenia, Spain, and the Netherlands, with one case each. Overall, these figures suggest that a bank has a reasonable chance of surviving in several European countries, even in the case of failure. The major rescue operations in the current financial crisis seem to further confirm this pattern. 2.4 The Current Financial Crisis and Short-Term Reactions of the Authorities The recent financial turmoil that has generated renewed interest in the issue of financial regulation in Europe started as a spillover from the decline in housing prices and the subsequent subprime crisis in the United States. The disruptions of the banking system in Europe have triggered large government rescue operations in the history of several European countries. The authorities in these countries have reacted to the crisis by using three types of instruments.

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First, central banks have performed massive liquidity infusions to prevent a liquidity crisis from bringing down the banking system. Second, governments have introduced state guarantees on interbank deposits aimed at preventing a collapse of the interbank market, which would almost certainly have led to a large-scale liquidity crisis. Third, governments have reacted to bank failures by substantial recapitalizations of banks, and in a number of cases by full nationalizations. It must be said that these interventions have been successful in that they have prevented a collapse of the banking system. The issue that arises here is whether these interventions will suffice to avert future crises and to bring the banking system back on track so that it can perform its function of credit creation. The fundamental problem banks face today is that their balance sheets have increased substantially as a result of systemic risk taking in various forms, in particular currency risk, maturity risk, and equity price risk in the stock markets. Because asset prices have fallen recently, banks face a period in which their balance sheets are likely to shrink substantially. This process is unlikely to be smooth, mainly because during the shrinking a devilish interaction of solvency and liquidity crises can occur. A second effect of the massive deleveraging of the banking system is that it will give banks strong incentives not to extend new loans, thereby dragging down the real economy. How far and how long this will go nobody knows. Although there might be a quick recovery in the aggregate,8 it is not inconceivable that this will lead to a long and protracted downward movement in economic activity in some credit-constrained sectors. An example of a prolonged credit-crunch period is Japan, where the financial crisis led to a stagnation period of more than ten years. Sectoral asymmetries, in particular between tradable and nontradable goods producers as well as between large and small firms, are characteristic of many of the historic crisis episodes. The immediate reaction of the governments of the major industrial countries to the banking crisis of 2008 has been to sustain aggregate demand by increased spending in the face of dwindling tax revenues. Large budget deficits have resulted and were desirable. Attempts at balancing government budgets in the aftermath of the crisis would not have worked, because they would have lead to Keynes’s savings paradox. As private agents attempted to increase savings (because they were reducing their consumption plans), the decline in production and

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national income actually prevents them from increasing their savings. This paradox could only be solved by government dissaving. Second, in the process of recapitalizing banks, governments substituted private debt for government debt. This also was inevitable and desirable. In the aftermath of the banking crisis, agents distrusted private debt and turned to government debt deemed safer. Governments had to accommodate themselves to this desire (see Minsky 1986 on this). A failure to do so would have set in motion the kind of debt deflation process described by Irving Fisher (1933) in the 1930s. When private agents collectively try to reduce their debt levels, they have to sell assets. These asset sales bring down asset prices. As a result, the equity of financial institutions evaporates, leading these institutions to further asset sales. This debt deflation process leads to a similar paradox as the savings paradox—that is, private agents will fail to reduce their debt. There is a need for an outside institution, the government, willing to increase its debt. This makes it possible for the private sector to reduce its debt level. It is remarkable that the governments of the major industrial countries followed the medicine as prescribed by Irving Fisher. 2.5 Long-Term Policy Options: Strengthening the Basel Treaty and a Return to Narrow Banking Preventing the collapse of the banking system and making it function again are daunting tasks in the short run. Equally important is to start working on the rules for a new banking system. There are two ways to go forward. One can be called the Basel approach, the other the GlassSteagall approach. 2.5.1 The Basel Approach The Basel approach accepts as a fait accompli that banks will remain universal banks—that is, do both traditional and investment bank activities. This approach then consists in defining and implementing rules governing the risks that these universal banks can take. Its philosophy is that a suitable analysis of the risk profile of the banks’ asset portfolios allows for calculating the required capital to be used as a buffer against future shocks in credit risk. Once these minimum capital ratios are in place, credit risk accidents can be absorbed by the existing equity, preventing banks from going broke and thereby avoiding the devilish spillovers from liquidity problems into solvency problems.

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The benefit of this approach is that the Basel treaties start at a global level. As Sinn (2003) has pointed out, this is necessary to avoid the competition among governments for the least stringent set of regulations, thereby attracting worldwide capital. Furthermore, globally total credit is limited by total world savings. While in a small open economy, any attempt to reregulate the banking system will inevitably lead to capital outflows and to tight domestic credit market conditions, an increase of capital requirements at the global level would only change the ratio between internal and external finance. It would not, however, reduce the total amount of financing available, which is a crucial consideration in any single country attempt to increase capital ratios.9 The Basel approach has serious shortcomings, though. On the one hand, the Basel 1 accord has often been circumvented by banks that profited from the loopholes in the system. Closing these loopholes and inconsistencies in the details of the Basel treaty pointed out in the preceding sections would be at least as important as a general increase in the required capital ratios. On the other hand, the Basel 2 attempt to remedy this by allowing banks to use internal risk models to compute their minimum capital ratios is even more problematic. The underlying assumption is that scientific advances in risk analysis would make it possible to develop a reliable method of determining minimum capital ratios. There is one general feature in all financial markets, however, and that is that returns are not normally distributed. Returns have fat tails— that is, large changes in the prices occur with a much greater probability than the probability obtained from a normal distribution. This fat-tail feature itself is intimately linked to the occurrence of bubbles and crashes. The implication is that models based on normal distributions of returns dramatically underestimate the probability of large shocks. We show an example of this phenomenon in figure 2.8. This depicts the daily changes (returns) in the Dow Jones Industrial Average since 1928 (upper panel), and we compare these observed returns with hypothetical ones generated by a normal distribution with the same standard deviation (lower panel). The contrast is striking. We have added dotted horizontal lines in both panels. These represent the returns five standard deviations away from the mean. In a world of normally distributed returns, an observation that deviates from the mean by five times the standard deviation occurs only once every 7,000 years (given that the observations are daily). In reality (upper

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Dow Jones Industrial Average 1928–2008 0.15 0.1 0.05 0 –0.05 –0.1 –0.15 –0.2 –0.25

19 2 19 8 3 19 1 3 19 4 3 19 7 4 19 0 4 19 3 4 19 6 49 19 5 19 2 55 19 5 19 8 61 19 6 19 4 67 19 7 19 0 7 19 3 7 19 6 79 19 8 19 2 8 19 5 8 19 8 9 19 1 9 19 4 9 20 7 0 20 0 03 20 06

–0.3

Random normal process 0.15 0.1 0.05 0 –0.05 –0.1 –0.15 –0.2 –0.25

19 2 19 8 3 19 1 3 19 4 3 19 7 4 19 0 4 19 3 4 19 6 49 19 5 19 2 5 19 5 58 19 6 19 1 64 19 6 19 7 70 19 7 19 3 7 19 6 79 19 8 19 2 85 19 8 19 8 9 19 1 9 19 4 9 20 7 0 20 0 0 20 3 06

–0.3

Figure 2.8 Normally distributed returns and observed daily returns in foreign exchange market. Source: Dow Jones Indices (http://www.djaverages.com) and our calculations

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panel) such large changes occurred seventy-four times during an eighty-year period. Most of the models used to price credit default swaps and other complex financial products have been built on the assumption that returns are normally distributed. As a result, these models massively underestimated this tail risk. They did not take into account that financial markets are regularly gripped by bubbles and crashes, producing large changes in asset prices. It also follows that the markets and the regulators were lured into believing that the tail risk did not exist (or would occur only once so many thousand years). The banking crisis of 2008 has led to a significant reform of the regulatory environment. This is now known as the Basel III accord, which aims at redressing some of the problems that were created under Basel II. The main ingredients of this accord are the following. First, Tier 1 and Tier 2 capital are defined more sharply, so that in principle it should lead to better harmonization of the capital requirements. Second, capital ratios will be used in an anticyclical way, that is, capital ratios should be increased in good times and reduced in bad times. Third, in order to reduce leverage, banks will be subjected to maximum leverage ratios. Fourth, minimum liquidity ratios will be imposed. Fifth, systematically important banks may be subjected to additional capital and leverage requirements. These are certainly important changes. Unfortunately, the Basel III accord leaves unchanged the banking model that has developed since the last decade and allows banks to fully participate in the financial markets. As we argued earlier, in doing so, banks subject themselves to the endemic occurrence of bubbles and crashes. These lead to large tail risks that with our present knowledge cannot be quantified. In addition, when a liquidity crisis erupts, usually triggered by solvency problems in one or more banks, the interaction between liquidity and solvency crises is set in motion. No minimum capital ratio can stop such a spiral. Perfectly solvent banks capable of showing the best capital ratios can be caught by that spiral, eliminating their capital base in a few hours. The Basel approach does not protect the banks from this spiral (a tail risk). In addition, there is no prospect for gaining substantial knowledge about tail risks in the near future. 2.5.2 Narrow Banking An alternative approach is a return to the Glass-Steagall Act approach, or put differently, a return to narrow banking, in which the activities

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banks can engage in are narrowly circumscribed. In this approach banks are excluded from investing in equities, derivatives, and complex structured products. Investment in such products can only be performed by investment banks, which are forbidden to fund these investments by deposits (either obtained from the public or from other commercial banks). Such a policy would avoid the direct link between financial market prices, like stock prices, and the banks’ balance sheets. Furthermore, when credibly implemented, it would take away the bailout expectations that, as described above, drive to a large extent the amount of systemic risk taking in the financial system as a whole. Only the deposit-money banks would be insured against systemic risk, but the rest of the financial industry would not be. In a nutshell, a return to the Glass-Steagall Act world could be implemented as follows. Financial institutions would be forced to choose between the status of a commercial bank and that of an investment bank. Only the former would be allowed to attract deposits from the public and from other commercial banks and to transform these into a loan portfolio with a longer maturity (duration). Commercial banks would benefit from the lender-of-last-resort facility and deposit insurance, and would be subject to the normal bank supervision and regulation. The other financial institutions that do not opt for a commercial bank status would have to ensure that the duration of their liabilities is on average at least as long as the duration of their assets. This would imply, for example, that they would not be allowed to finance their illiquid assets by short-term credit lines from commercial banks. Thus while commercial banks would be barred from engaging in the activities of investment banks, the reverse would also hold—that is, investment banks would not be allowed to borrow short and to lend long, thereby taking on liquidity risks. As a result, we would return to the Glass-Steagall world, where banking activities are tightly regulated and separated from investment banking activities. This also implies that commercial banks would not be allowed to sell (securitize) their loan portfolio any longer. The reason is that securitization does not eliminate the risk for the banks. The opposite is true. First, when a commercial bank repackages loans it cannot easily eliminate its liability associated with these loans because of reputational concerns. And as we have seen, when a credit risk materializes, these securitized loans reappear on the balance sheets of the banks, greatly increasing their risks and undermining their capital base. Second, securitization leads to a buildup of a credit pyramid.

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When a bank securitizes a loan, it obtains new liquidities that can be used to grant new loans, which in turn can be used to securitize further. As a result, a credit expansion is made possible that occurs outside the supervision and control of the central bank (which, however, will be called on to buy these assets when it becomes the lender of last resort). Put differently, securitization allows the credit multiplier to increase for any given level of the money base provided by the central bank. 2.5.3 The Trade-Off between Stability and Growth Every regulation creates an opportunity cost. As discussed earlier, there have been quite a number of crises in the past century, both in emerging economies and in advanced industrial countries. On average, economies with liberalized financial markets have grown faster than those with strict regulation. This empirical observation holds when taking a long-term view that includes both, the years of financial crisis and the years of strong growth that was possible before the crisis occurred (see Ranciere, Tornell, and Westermann 2008 for empirical evidence). Several economic theories can be invoked to explain this positive relationship between risk taking and growth. One can invoke the Schumpetarian view of creative destruction, or the mean-variance trade-off highlighted by financial economists. Our favorite theory is based on credit market imperfections. In the absence of systemic risk taking, these credit market imperfections lead to underinvestment in many countries. The imperfections include the absence of a fully functioning legal system that ensures repayment of a loan when a firm defaults. The uncertainty about repayment leads to credit constraints on the firm side that prevent socially efficient investment. Tornell and Schneider (2004) and Ranciere, Tornell, and Westermann (2008) argue that systemic risk taking can be viewed as a second-best road when credit market imperfections are present and cannot be resolved in the short run. Thus any proposal to reregulate the banking system faces an opportunity cost in terms of real output growth. The empirical evidence, however, suggests that the link between systemic risk taking and economic growth is rather weak in advanced economies. As a result¸ it is unclear whether a maximum-growth path with high systemic risk taking and crisis is optimal in high-income countries. One can, therefore, argue that we might have gone too far in stimulating risk so as to achieve high real growth rates. That is why we have argued that we

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should take some steps back toward a narrow banking system with larger capital requirements, as discussed in the previous sections. 2.6

The European Dimension

It looks increasingly likely that, thanks to intense lobbying by the banking sector, reforms will not go in the direction spelled out in the previous section. Surprisingly, it is in the United States that a “light” form of narrow banking has been introduced with the so-called Volcker rule. The bank business model that has developed during the last few decades, however, will remain basically unchanged in the European Union. This is a business model that allows banks to take many different types of risk on their balance sheets and to securitize large parts of their loan portfolio. The underlying belief is that regulators and supervisors have the tools to manage this risk by imposing tighter capital and liquidity ratios, and by other regulatory measures. We doubt that such sophisticated risk management is possible, but since this is the direction in which reform is moving (see the Basel III accord) it is appropriate to discuss the current proposals in somewhat more detail. We focus on the European proposals for reform. Following up on the proposals made by the de Larosière committee (2009), the European Commission has issued its own proposals for reform. These have now been agreed upon. Two innovations stand out. First, the existing supervisory committees that coordinate national supervision in the banking, insurance, and securities markets will be upgraded into three executive agencies( the European Banking Authority, the European Insurance Authority,and the European Securities Authority). These will have some power to interfere at the national level, but this power will be severely restricted because it will not involve making decisions that could have budgetary implications for national governments. Second, a new entity, a Systemic Risk Council, will be created to monitor systemic risk. This council will be presided over by the president of the European Central Bank. Its responsibilities will be restricted to making recommendations for action when it decides systemic stability is at risk. Although these proposals are heading in the right direction, they surely do not go far enough (Lannoo 2009). The main shortcoming is that the regulation and supervision remain firmly vested in the hands of national authorities. This will continue to lead to large discrepancies in the way capital ratios are defined (see section 2.3), in the manner in

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which nonperforming loans and off-balance-sheet vehicles are treated, and so on. As a result, the minefield of regulatory arbitrage within the European Union remains in place. Thus the information that the three proposed supervisory authorities need in order to act will be deficient. In addition, the new European Risk Council will have little hard information to base its recommendations on. Proposals aimed at developing macroprudential control at the eurozone level seem to have been shelved at this time. Yet this control is crucial for the future stability of the eurozone. As was mentioned earlier, at the level of Basel III there is an agreement to use tools of macroprudential control. The question is whether at the level of the Eurozone a more intensive use of these tools will not be necessary. It is increasingly accepted that central banks are not only responsible for price stability but also for financial stability. In addition, central banks have the instruments for creating the conditions for greater financial stability. These instruments include the use of minimum reserve requirements. Thus, in a boom when bank credit tends to accelerate, thereby increasing the risk of creating asset bubbles, banks should be subjected to larger minimum reserve requirements; in recession, the opposite should occur. The European Central Bank is the only institution capable of implementing such an anticyclical policy at the level of the eurozone. The remarkable thing is that this could be done without the need to introduce changes in the statutes of the European Central Bank (De Grauwe and Gros 2009). It is surprising that changes that could be introduced most easily are disregarded, despite the fact that these changes are crucial for the maintenance of future financial stability in the eurozone. 2.7

Conclusion

The eruption of the financial crisis in the United States and in Europe has created formidable challenges for the future regulation of the banking system. Risk taking by the banking sectors of the United States and Europe has been excessive. Several market failures, both at the micro- and the macrolevel, are responsible for this excessive risk taking. We discussed the nature of these market failures. We also pointed out that correcting them, by implementing a tighter form of bank regulation, may come at the opportunity cost of a somewhat lower growth path in the long run. The policy conclusion we derived from this analysis is that risk taking by banks can best be constrained by forcing

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a return to narrow banking. This would limit commercial banks’ ability to accumulate high-risk assets on their balance sheets. In addition, by reserving these high-risk activities for investment banks, which would be constrained to finance these activities in the capital markets, the new financial system would make financial innovation possible, thereby contributing to economic growth. We realize that these changes have little likelihood of being implemented. That’s why we also analyzed the recent regulatory changes in the European Union. Our main conclusion here is that the historic opportunity to streamline regulations and supervision at the EU (or eurozone) level is being missed. Nationalism remains the main driving force of the way bank regulation and supervision are being reformed, thereby creating risks for the future smooth functioning of the eurozone. Notes 1. For a description of stylized facts of boom-bust cycles and financial crisis, see Tornell and Westermann 2005. 2. A proposal for instance made by Sinn (2003). 3. Westermann (2008) argues in the case of Germany that this is at least partly due to supply-side factors. He compares the institutional settings of Germany and Japan and finds that the institutional arrangements as well as the patterns of macroeconomic variables around the year 1990 in Japan and 2001 in Germany are strikingly similar. 4. This applies to the depositors as well as to all other agents that give their money to the banks—for instance, in the form of commercial paper or shares. 5. Note that we are only looking at the liability side here. Tornell and Westermann (2005) argue that this is more appropriate than the net values for the following reason: if banks borrow and lend in foreign currency, the net effect may be zero. However, because banks typically lend to firms that have their revenues in domestic currency, the currency risk would simply translate into default risk from the banks’ perspective. The currency mismatch will either be on the bank side or on the firm side. A more complete analysis would involve a detailed description of the structure of bank assets that goes beyond the currency denomination of the assets. 6. This argument is independent of the discussion of individual risk taking by managers and individual banks, discussed in the section on the microeconomic motivation for regulation. 7. This figure seems extremely high. It is likely that the World Bank not only counted rescue operations, but also regular changes in bank operations. Note that the total involvement of the state in the banking system is unusually large in Germany, with a share of roughly 50 percent of total assets. 8. For a recent historical analysis of the duration of banking crises see Reinhart and Rogoff 2009.

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9. A potential shortcoming of capital adequacy requirements that was pointed out by Blum and Hellwig (1995) involves the procyclical effects that can result from minimum capital standards. A negative shock can reduce the capital base of the banking system, and the reduced ability of the banks to lend will reinforce this shock.

References Blum, J., and M. Hellwig. 1995. The macroeconomic implications of capital adequacy requirements for banks. European Economic Review 39 (3–4): 739–749. Bussière, M., M. Fratzscher, and W. Koeniger. 2004. Currency Mismatch, Uncertainty and Debt Maturity Structure. Working Paper Series 409, European Central Bank. De Grauwe, P., and D. Gros. 2009. A New Two-Pillar Strategy for the ECB. Brussels: CEPS. Fisher, I. 1933. The debt-deflation theory of Great Depressions. Econometrica 1 (4): 337–357. Honkapohja, S., and E. Koskela. 1999. The economic crisis of the 1990s in Finland. Economic Policy 14 (29): 401–437. Hutchison, M., T. Ito, and F. Westermann. 2006. The great Japanese stagnation: Lessons for industrial countries. In M. Hutchison and F. Westermann, eds., Japan’s Great Stagnation: Financial and Monetary Policy Lessons for Advanced Economies, 1–32. Cambridge, MA: MIT Press. Kaminsky, G., and C. Reinhart. 1999. The twin crises: The causes of banking and balanceof-payments problems. American Economic Review 89 (3): 473–500. Lannoo, K. 2009. A Crisis Is a Terrible Thing to Waste. Brussels: CEPS. Larosière, de J. 2009. Brussels: The High-Level Group on Financial Supervision in the EU. Minsky, H. 1986. Stabilizing an Unstable Economy. New York: McGraw-Hill. Ranciere, R., A. Tornell, and F. Westermann. 2008. Systemic crises and growth. Quarterly Journal of Economics 123 (1): 359–406. Reinhart, C., and K. Rogoff. 2009. The Aftermath of Financial Crises. NBER Working Paper No. 14656. Cambridge, MA: NBER. Sinn, H.-W. 1982. Kinked utility and the demand for human wealth and liability insurance. European Economic Review 17: 149–162. Sinn, H.-W. 2003. Risk taking, limited liability and the competition of bank regulators. Finanz-Archiv 59 (3): 305–329. Stiglitz, J., and A. Weiss. 1981. Credit rationing in markets with incomplete information. American Economic Review 71: 393–410. Tornell, A., and M. Schneider. 2004. Balance sheet effects, bailout guarantees and financial crises. Review of Economic Studies 71 (248): 883–913. Tornell, A., and F. Westermann. 2002. Boom-bust cycles in middle income countries: Facts and explanation. IMF Staff Papers 49 (Special Issue): 111–155. Tornell, A., and F. Westermann. 2005. Boom-Bust Cycles and Financial Liberalization. Cambridge, MA: MIT Press.

3

Global Constraints on European Integration over the Next Few Decades Peter Egger and John Whalley

3.1

Introduction

This chapter highlights some key global constraints on future European integration that have recently intensified, given the 2008 financial crisis, the pressures on the eurozone, and the financial difficulties in Greece, Ireland, Spain, and elsewhere.1 The main argument of the chapter is that the first fifty years of implementation of the Treaty of Rome have concentrated on ever-deeper integration within Europe, following the sequenced approach set out in the 1957 treaty. Now, a half century later, Europe needs to more centrally focus on the constraints imposed on the integration process by global developments as it carries integration forward, rather than focusing largely on European integration in and of itself. The global financial system in light of the eurozone problems represents one constraint, adjustment problems (especially in labor markets) associated with continued high export growth rates from India and China are a second, and possible global responses to climate change are a third. The first fifty years of EU integration have involved within-EU tariff elimination, followed by moves to a customs union, tax union, European monetary union, and associated institutional harmonization and deepening in competition and regulatory policies. This process has also involved establishing funds for social and other objectives and an everevolving agricultural policy, as well as the adoption of common policy instruments such as the Value Added Tax (VAT). Key parts of this process in more recent years have seen moves to a single market and the introduction of the euro. The main focus of integration in Europe in this period has, in effect, been intra-Europe integration. Global constraints on global objectives in this integration scheme have been relatively downplayed. That is

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not to say that global considerations have been entirely absent. One of the elements in the initial motivation for the formation of the European Union resulting from the Treaty of Rome was enhancing the bargaining power of individual European nation-states in global bargaining, particularly through joint EU trade bargaining in the General Agreement on Tariffs and Trade (GATT). But only a small number of global considerations entered this earlier integration debate, and they were not central to the wider integration process itself. This integration process focused on harnessing the potential gains from increased European trade and other forms of integration between European member states, as well as on strengthening the economic underpinnings of an emerging political integration. Here we argue that if the major focus of the next stage of European integration remains on internal issues such as social and competition policies, it is a discussion of the future that can be compared to Hamlet without the prince, in that global constraints may well limit what can be done within Europe to reshape European integration. And as the global economy moves forward and Europe’s involvement in it both deepens and, in quantitative terms, becomes smaller, global influences will increasingly dominate European policy. This will be a world in which debt problems restrain some European governments, continued trade penetration by and adjustment to China and India beckon, and global climate policy continues to evolve. Cost competitiveness from low-wage economies will constrain social programs, global environmental considerations will influence (and even dominate) trade policy, and global capital market developments will shape the evolution of European capital markets. In what follows, we discuss some of these key considerations to illustrate our general theme of a globally encased and constrained European integration process going forward and offer some concluding remarks. 3.2

The Rise of China, India, and the South

One of the dominant influences on the European economy, both currently and potentially for the next forty to fifty years, is the rise of relatively low wage, rapidly growing high-population economies (Shenkar 2004; Stiglitz 2006; Bussolo et al. 2008). The two largest entities reflective of this are India and China, but generally the rise of the South is the underlying phenomenon of our time. China and India were effectively disconnected from the global economy until the early 1990s.

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Since then, their integration into the global economy and the resulting impact on global economic activity have been pronounced, particularly in the Chinese case. And the potential continuation of this strong growth performance for several decades raises the prospect both of major adjustments at home for Europe and a large reorientation of Europe export and foreign direct import activity. In China, growth has averaged 10 percent per year since the early 1990s. The initial growth was in agriculture from 1976 on with the adoption of the Responsibility System; since the 1990s, changes have included policy initiatives in the manufacturing sector and a demonstration of more credibility for the newly liberalized domestic policy regime. The result has been a large inflow of foreign direct investment (FDI) and rapid growth of manufacturing activity. China has emerged from the 2008 financial crisis with continued high growth, and the speed at which the gap between the EU and China is closing is accelerating. Today, nearly twenty years on, China has, in effect, become the manufacturing center of global economic activity and the dimensions of this Chinese presence are truly staggering. China’s exports are growing at 30 percent per year, China’s share of world trade (now around 10 percent) is doubling every two and a half years, and Chinese manufacturing activity (led by information technology) now accounts for 60 percent of China’s GDP. In China’s eleventh five-year plan, the announced target for growth was set at a minimum of 7.5 percent per year between 2000 and 2020, implying a quadrupling of real income per capita over these years. The annual growth rates in China in the six years before the 2008 crisis all exceeded 10 percent and China is poised to move well beyond this target for 2020. If similar growth rates were to prevail between 2020 and 2050, by 2050 real income per capita in China would have increased by a factor of 30 or more relative to 2000. In India, change has been somewhat less dramatic, but potentially in the decades to come could be even larger than in China. In India, there has been a progressive increase in growth rates since the reforms of the early 1980s. In the early 1980s growth rates were in the neighborhood of 6 percent, and in the last three years or so growth rates in India have averaged around 9–10 percent. India currently has a per capita income half that of China, but has significantly higher population growth. Currently, China’s population is 1.2–1.3 billion, and with the current one-child per family policy, there are projections that the

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population in China could drop below 1 billion by 2040 and perhaps even go as low as 900 million. In the Indian case, however, it is quite possible that by 2030–2040, India’s population may reach 1.6 billion, potentially double that of China (Batra and Beladi 2010). China’s growth has been particularly remarkable for its associated deep integration into the global economy. While China now accounts for well over 10 percent of world trade in terms of reported commodity trade, much of this trade takes place through intermediaries, with sharp increases in prices through various stages of distribution channels. The fraction of retail sales that occur in the OECD that are of Chinese origin is thus in all likelihood sharply higher than the 10 percent trade figure would suggest. China also accounts for 50 percent of all OECD FDI to non-OECD countries, and China’s exports in recent years have been growing at well over 30 percent a year, approximately three times the rate of their GDP growth. FDI flows from outside of the OECD now average around $70 billion a year. In turn, the Foreign Invested Enterprises (FIE), a legal entity in China that captures both joint ventures and standalone activities financed by FDI, account for a majority of China’s trade—around 60 percent of China’s exports and also around 60 percent of China’s imports. Also, key growth accounting studies on China conclude that much of the technical progress in China has resulted from activities by these entities. India, for now, has experienced less impact from integration into the global economy. Trade growth has averaged only 10 percent per year, and FDI flows into India are still small compared to China. In 2005, FDI flows were $5 billion per year, but they have doubled in the last two years, while FDI flows into China average around $70 billion per year. What is at stake in all of this for the OECD and Europe are both the potential adjustment consequences in Europe that may result if this growth continues for several decades, as some suggest may occur, and the likely reorientation in EU import and export activity. China’s share of world trade is roughly doubling every two and a half to three years, so if these growth rates continue, the prospect would be for China to account for maybe 40–50 percent of world trade by ten years from now. Chinese policy, in turn, is focused on maintaining Chinese integration into the world economy as a driver for growth through various policy initiatives, and the potential adjustment consequences for Europe of Chinese growth would seem to be magnified over time.

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If these trade shares increase in this way, the potential impacts on EU labor markets would seem likely to be particularly pronounced. Chinese growth is now solidly focused on quality upgrading and product innovation in both trade and production, and this has manifested itself in various ways. China has committed itself to large increases in education expenditures at tertiary levels, with substantial new funding flowing into higher-level educational institutions. The number of graduate students in China has quadrupled since 1999. There also is a focus on new international trade in ideas and on products containing ideas. The share of China’s trade in information technology has progressively increased from relatively small levels in the 1990s to well over 45 percent today, much of that in assembly-related activities and computer technology. China is also committed to large megaproject spending. It has negotiated successfully, for the first time, an indigenous standard for 3-G technology in the ITU (the telecommunications union) and it is proceeding to commercialization of that standard. Infrastructure projects such as high-speed railways, new freeways, and the space program are growing in size. Hence, the prospect is not simply one of continued export growth from China and into Europe and other OECD economies, but head-on competition in terms of product innovation and design. And growth of Chinese exports to the European Union in apparel has resulted in reduced exports from third countries (Turkey, Morocco), but new Chinese trade may more centrally involve European adjustment and involve greater and greater increases in absolute size. With relocation not just of production activity but also of product design capability to China, even larger adjustment consequences for Europe may follow. In the Indian case, dramatic change has come primarily in information technology services and outsourcing related to software and call center and information processing related tasks. There are signs now of growth in activity in the manufacturing sector in India, but the export levels involved for now are small. The adjustment consequences of these developments over the next few decades for both Europe and the OECD are potentially major and will increasingly be a constraint on policy-driven integration in Europe. Cumulative FDI into China over the last twenty years is now in the region of $750 billion, while estimates of the capital stock of the OECD range are in the area of $75–$90 trillion. These reflect a calculation of

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gross OECD product of maybe $30 trillion per year and a capital-output ratio of around 3:1. Put differently, perhaps 1 percent of the OECD capital stock has thus far been redeployed in China. While not all OECD capital may be mobile in the long run, the indications are of a process in its early days. Thus, though 40–50 percent of the world’s low-wage labor market now remains segregated from the high-wage economies in the OECD by immigration restrictions, with a joining of economies through mobility in goods and investment flows from the 1990s on, the prospect is eventually for large portions of the capital stock in the OECD to progressively move to the low-wage economies through depreciation and new investment activity in these economies. This then is a central part of the prospect that Europe faces over the next several decades, and a credible position would seem to be that the adjustments involved may only be in their infancy. This view is underscored by the observation that the Foreign Invested Enterprises in China, which today account for over 60 percent of China’s trade and around 25 percent of its GDP, for now account for only 2–3 percent of China’s workforce. The adjustment processes involved with continued Chinese and Indian growth may thus only be beginning, and if so, the subsequent adjustment consequences for Europe may be major. These would not only affect wage rates, but also restrain social programs, redistribution, and other internal European programs. There are issues with such scenarios raised by the sustainability of both Chinese and Indian growth. One issue is the sustainability of growth rates of trade and other constraints on the growth process, including increasing inequality and environmental problems in China. In some Western literature, these are viewed as constraints that will become ever more binding, so that Chinese growth rates will fall. While this may be so, many of these concerns over sustainability have been there in China since the 1990s and there has been no sign that Chinese growth has slowed. In turn, on the trade front, the most rapidly growing portion of Chinese trade is now trade outside the OECD. For instance, five years ago India was an inconsequential trading partner for China and vice versa, but today China is a major trading partner for India and, generally, trade in the South is rapidly growing. Recent UNDP estimates indicate South-South FDI is also growing rapidly and now 17 percent of all FDI globally as well as the majority of FDI from Southern countries is going into other Southern countries because of the

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similarity of products and markets. This might also help to sustain much of the trade growth of these entities. The prospect, therefore, is one of potentially large and growing adjustment consequences for Europe from enhanced growth outside Europe, and principally in India and China. This will constrain and reshape future European integration from an inward social orientation to an external competitive orientation and fundamentally constrain and limit future integration. 3.3

Geographic Mobility of Production

A further major element in European integration over the next twenty to thirty years is likely to be continued growth in offshoring and outsourcing and its associated implications for both policy design and integration schemes in Europe.2 Offshoring involves the relocation of production from one country to another, while outsourcing is simply the fragmentation of existing production, either within or across economies. More specifically, outsourcing entails the purchase of goods and services previously produced inside a company. The company providing the goods and services can be located in the same country (domestic outsourcing) or outside the country of the purchasing company (international outsourcing). Precise measures of outsourcing and offshoring are hard to obtain, but outsourcing seems to be increasing rapidly in Europe. Some of it is occurring in Eastern Europe, and much of Germany’s resurgent growth has been attributed to increased outsourcing involving Central and Eastern Europe. This is largely a reflection of the mobility of production and new investment in light of the large wage differentials between countries and the barriers to mobility between these countries. There are many variants of and elaborations across constructions of outsourcing in the literature. China’s size and low wage structure make it a major research focus. Feenstra and Hanson (2005), for instance, explicitly formalize and estimate a model of ownership and control in outsourcing to China. Grossman and Helpman (2002) emphasize the vertical disintegration of production that outsourcing seems to involve, but stress that to them outsourcing means more than the purchase of raw materials and standardized intermediate products. It also involves “finding a partner with which a firm can establish a bilateral relationship and having the

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partner undertake relationship specific investments so that it becomes able to produce goods and services that fit the firm’s particular needs.” They then model the choice of relationship-specific partners in either a technologically and legally advanced North or a low-wage South, emphasizing the search process involved, the need to convince potential suppliers to customize products to meet their requirements, and the incompleteness of contracts available for enforcement. Bhagwati, Panagariya, and Srinivasan (2004), in contrast, focus their discussion of outsourcing on services, specifically on the long-distance purchase of services by electronic media such as phone, fax, or Internet, and discuss alternative cases where providers and purchasers of services have differing degrees of mobility along the lines of Modes 1 to 4 of the General Agreement on Trade in Services (GATS). The motivation they offer is the characterization by the U.S. President’s Council of Economic Advisors in 2004 of outsourcing of professional services as a new type of trade. In a survey of outsourcing literature, the OECD (2006) points out that outsourcing and offshoring are frequently used interchangeably. Offshoring refers to the purchase of goods and services previously produced inside the purchasing company from companies in locations outside the country. As such, to them the terms include not only international outsourcing but international insourcing, with the foreign affiliates of domestic parent companies exporting to their parents. These and other notions of outsourcing in the literature in part reflect attempts to delineate and categorize the various channels through which economic integration is proceeding globally between various economies, and centrally reflect a desire to better understand the changing nature of global production processes in both manufacturing and services. How this pattern of production is changing is conjectural, and theoretical literature often relies on anecdotal support. Examples such as the global production of American cars, the globally fragmented production of Barbie dolls, and other items are frequently appealed to. But for many years large OECD manufacturing firms have had many component suppliers and outsourcing as such is not new; Boeing is reputed to use over a million components in aircraft assembly, and General Motors has long had thousands of component suppliers. The issue is how the process of working with these component suppliers is changing for large OECD manufacturers as global integration proceeds across national boundaries involving low-wage economies such as China’s.

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On the one hand, manufacturers seemingly prefer component suppliers to be geographically close so that it is easier to monitor them and communicate over product quality and dialog over the frequent small changes to components that are required in meeting changes in market tastes. Just-in-time inventory management is also easier to accomplish with geographically close suppliers, and there can be an accumulation of person-to-person links with individuals in supplying firms, which makes switching suppliers costly. But if low-wage (and hence lowcost), reliable, and high-quality component suppliers become available elsewhere, the cost savings can justify resourcing across national borders even with the geographic barriers involved. The impression of recent outsourcing activity involving China is that China’s improved legal structure and infrastructure, its growing reputation for product quality and on-time delivery, and the reliability of intermediaries to organize transactions (often via Hong Kong) are also important factors. Not only has outsourcing investment flowed into Eastern Europe, it has also flowed into India and China, potentially further constraining policy responses and future integration in Europe. Attempts to tax capital are currently embroiled in issues of tax competition between European states. But mobility of production through outsourcing potentially affects regulatory and other social programs in Europe, which would be progressively constrained by outsourcing-related activities. Public concern in Europe over outsourcing, however, stands in some contrast to the research literature. It largely focuses on potential job loss and downward wage pressures as outsourcing abroad occurs rather than seeking to provide analytics for firm decision making on vertical cross-border unbundling (or disintegration) of production processes. As such, the policy concern is over the adjustments implied by international integration, rather than on understanding exactly what form the production unbundling takes, and production disintegration via intermediate product outsourcing is but a part of this concern. Given this adjustment focus, there seems to be little reason why debate on outsourcing should limit itself to resourcing of intermediate products and components. European retailers resourcing supplies from domestic to foreign firms generate adjustment pressures in the European Union in the same way that cross-border production unbundling does. Also, more channels with a potential impact on integration processes exist than merely the resourcing of component suppliers stressed in the outsourcing literature.

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These channels include firms in low-wage countries such as China buying a European firm, keeping the firm’s distribution system in Europe but moving manufacturing back to China. One could term this insourcing, for want of a better term. Also, a considerable portion of China’s integration into the global economy has been facilitated by trade transactions orchestrated and conducted via intermediaries in Hong Kong, Taiwan, and Korea. The size of these transactions is large, as are the trade impacts. There are speculative estimates that profits from mainland China accruing to Taiwanese companies are around 70 percent of the profits of companies quoted on the Taiwanese stock exchange. This set of activities might be called through sourcing, again for want of a better term, to distinguish it from conventional outsourcing. There are often further elements of the integration process in China that involve investment funds of Chinese origin flowing abroad and returning to China to benefit from preferential policies toward foreigninvested enterprises. These include, among other things, highly preferential tax treatment for foreign-invested over domestic enterprises, but to qualify for this tax treatment threshold tests of export sales must be met. Xiao (2004) reports an estimate that the ratio of round-trip FDI via Hong Kong to total FDI inflows to China could be 40 percent. Again the transactions seem large and have significant impacts on China’s trade volumes. This could be termed roundabout sourcing, also for want of a better term. Thus not only is the definition of outsourcing in the current literature somewhat ambiguous and a little narrow; a variety of channels of interaction with the global economy also appear to be at issue and go beyond those the conventional outsourcing literature focuses on. And if the concern over outsourcing in the EU countries is with adjustment costs, more so than with changes in the nature of production processes, then all of these channels seemingly merit discussion. Attempts to both measure outsourcing and assess its impact on OECD wage rates have accompanied the analytical literature referred to above. Abraham and Taylor (1996) document an increase in the outsourcing of business services in thirteen U.S. industries. Campa and Goldberg (1997) measure outsourcing of imported intermediate inputs for various industries for Canada, Japan, the United Kingdom, and the United States. They show that except for Japan, there was a doubling in the share of imported inputs between 1975 and 1996 for all manufacturing in the United States and that the United Kingdom has dem-

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onstrated a large increase in outsourcing. Feenstra and Hanson (1996) measure all imported components used in production by U.S. firms and compute various measures of outsourcing, also arguing that all have increased since the 1970s. In terms of wage impacts from outsourcing, there are two distinct trends in the literature: one on the indirect effects on bargaining power of unions in EU labor markets from the threat to outsource production, and the other on the direct effects on EU wage rates as production increases offshore. The first of these effects is emphasized in Gaston 2002. Recent empirical work by Dumont, Rayp, and Willemé (2006) and Dreher and Gaston (2005) reports results indicating that various measures of globalization are negatively correlated with union bargaining power and union membership. In terms of impacts of outsourcing on wage rates, Feenstra and Hanson (1996) find that outsourcing has led to an increase in the wages of skilled versus unskilled labor in both the United States and Mexico. They find that U.S. outsourcing has raised not only the real wages of U.S. nonproduction workers but also the real wages of U.S. production workers. Wage impacts in the OECD for now thus seem mild and positive, reflecting efficiency gains because greater outsourcing has increased the real wages of both skilled and unskilled labor. There is also an issue of how large the initial base is around which this change is occurring, which is less well researched. Tomiura (2005) studies Japanese firms and their outsourcing activities and reports that relatively few Japanese companies outsource across national boundaries. The impression of U.S. business activity is that a large percentage of component purchases still occurs from smaller component suppliers located in relatively close geographic proximity to larger-scale manufacturing establishments so as to maintain close coordination and contact. Thus the issue is not only the rate of change of cross-border outsourcing (however it is defined), but also the initial base around which changes are occurring. Our impression (but with no firm data to confirm it) is also that more significant components of Chinese foreign trade involve final products than is true of the European Union, indicating that outsourcing as conceived of in the theoretical literature may for now be relatively limited. Significant Chinese exports occur in clothing and assembled electronics, and much Chinese export activity builds on relationships with retailers and distributors in the European Union anchored in Hong Kong, Taiwanese, and Korean, involving

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businesspeople with long experience of how these distribution systems work. There is speculation, for instance, that Wal-Mart is China’s eighth largest trading partner and may have more trade with China than with the entire United Kingdom. Thus adjustment pressures from outsourcing as well as trade surges from India, China, and the South in general are likely to be major factors in the design of European integration for several decades. 3.4

Global Environmental Considerations

Another major consideration that may influence European integration over the next several decades is the potentially elevated profile of global environmental issues and the policy responses to these issues— particularly to global warming and climate change. Related issues include forests, species biodiversity, and oceans (coral) (Olmstead and Stavins 2009, 2010). In the global warming case, prognoses are emerging from the Intergovernmental Panel on Climate Change (IPCC) and from the Stern Report (Stern 2006) that global temperature change in the next thirty to forty years may amount to 2°–3°C, causing major damage. The financial cost is estimated in the Stern Report at possibly 20 percent of global GDP by 2050. While many authors contest these estimates, including Mendelsohn (2006), pressures are now building for a global policy response, including major commitments to emission reduction. The G-8 meeting in 2010 resulted in a commitment to a 50 percent emission reduction by 2050 by all G-8 members, conditional on Chinese and Indian participation. Europe is also centrally involved in the global environmental negotiations that form part of the post-Bali Roadmap discussions for a postKyoto, post-2012 regime. These issues were the focus of major negotiating efforts in Copenhagen in December 2009 and produced the minimal content and vague two and a half pages of the Copenhagen Accord. Negotiations on these arrangements were to conclude in Copenhagen (Whalley and Walsh 2009) in 2009, and while their conclusion may be delayed, these arrangements will influence other European policies. Negotiations continued in Cancun in December 2010, to be taken further in Durban in 2011. Europe has been a leader in emissions trading with the emergence of the European Emissions Trading Scheme (EU ETS) and other interventions. Some portray evolving policy regimes as reflective of the

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need for a new industrial revolution in which clean energy will replace fossil fuel–based energy. This process has already been accelerated in certain European countries—for example, in France through nuclear programs and in Denmark with the adoption of extensive wind power. Denmark has experienced a near doubling of GDP per capita since the 1980s, with almost no increase in energy consumption and with declining emissions. The difficulties for Europe that this situation creates are, first, in the global trade regime, which will become more and more entangled with environmental considerations to the point that these considerations will potentially dominate trade issues in international economic policymaking. There has already been extensive discussion in Europe of border tax adjustments as being necessary to offset the anticompetitive and leakage effects associated with the European environmental regime. Proposals are now circulating in the European Commission for a system of border tax adjustments involving carbon-based tariffs and export subsidies on exported products (Whalley 2008; Brewer 2008). These schemes may potentially spread to other OECD economies including the United States, Canada, Australia, and New Zealand. There is now also a prospect of an evolution of low-carbon areas, involving countries taking on significant environmental commitments. However, the members of such areas will face other economies that are not willing to take on such commitments.This results in the perceived need to offset cost effects on domestic firms, and indeed, even the perceived need to use trade threats as a way of forcing participation by other countries in such environmental regimes. The world thus faces the prospect in the next few decades of potentially going green and protectionist at the same time, with Europe at the leading edge of this protectionist contingent. This situation has, not surprisingly, created concerns among developing countries, particularly Russia, China, India, and Brazil. These countries see a new prospect of markets closing on them in the name of global environmental requirements and agonize about a response. Their willingness to take on environmental commitments may be influenced, in turn, by their desire to keep markets open for their exports. Thus, constraints on European policies as deeper integration occurs in future decades will also come into play from the environmental arena. Trade policy in particular may be heavily constrained. But tax and other major policy areas will be forced to adapt to the need to meet

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major emission reduction criteria. In addition, all of the policy interventions associated with a move toward a low-carbon economy in terms of gasoline taxes and prices, regulatory schemes in natural gas pricing, policies toward renewables (wind, thermal, solar, and other technologies), and the extensive subsidy schemes that operate in Europe will all come into play. 3.5

Global Financial Structure

Another central element in European integration over the next several decades will undoubtedly be both the stability of the eurozone and Europe’s smaller negotiating role, reflecting its diminishing role in global activity and the implications of this diminished participation for the global financial structure. European financial market integration will be less and less able to occur independently of global developments in finance. The prospect of continued growth in China, Russia, India, and Brazil is such that according to Goldman Sachs, by 2050, four of the largest six entities globally will be outside of the OECD, and Europe will be ranked perhaps fifth or sixth in relative size. The financial dimensions of these changes are potentially very substantial, especially given the current deficits and surpluses that exist worldwide. The size of surpluses in the Gulf States generated by current oil prices, the large surpluses that have accrued to China through trade, and the concurrent even larger deficits in the United States will potentially cause instability in global financial markets. Growing volatility in global capital markets will pose problems for Europe in terms of the integration of global capital markets and the regulation of European financial institutions. Also associated with these trends is the rapid growth of sovereign wealth funds. These are funds under the control of national governments that increasingly involve indirect controls through government and government-linked entities that intervene in various ways in financial markets. This is manifest in the activities of some of the national funds, such as Dubai Ports, and in the activities of government-operated funds in Singapore, China, Russia, and other countries. The prospect is for global financial markets in which the government activity and government-related activity come to dominate the activities of private firms and for a global movement toward a form of government corporatism. Europe’s reliance on free and open capital markets may be constrained by these developments and further

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changed by the need to intervene and negotiate directly with some of these large entities, many of which will potentially embody political as well as economic objectives in terms of their activity. A related development is the growing dominance of energy and energy-related activities over all forms of economic activity. There are currently estimates that the capitalized value of all oil reserves worldwide is substantially in excess of $100 trillion, which in turn, exceeds by a factor of 2 the capitalized value of all stocks on major exchanges worldwide. Furthermore, with the rise of global warming concerns, there is the potential for global environmental risk to evolve as a major element in global financial markets. Bangladesh, for instance, may face the prospect of being underwater in thirty to forty years and hence, to diversify this risk, may wish to purchase global flooding bonds from financial institutions, which will involve payoffs when designated events occur in certain locations at certain points in time. Under a worst-case scenario of accelerated global warming, these financial innovations involving environmental risk may become a dominant element of global financial activity. The aftermath of the 2008 financial crisis, the indebtedness of European banks (especially in Ireland, Greece, and Spain), and the potential real estate–related financial difficulties to follow represent a further major issue. There are questions as to whether the eurozone will survive, perhaps refocused on a core group of Germany, France, Italy, and the Benelux countries. How any resulting financial disturbance will constrain European growth will be a central global preoccupation. 3.6

Migration Considerations

A further factor influencing the process of European integration into the global economy over the next few decades will clearly be migration. This dimension of European integration has two central elements. One involves migration issues with Europe connected with accession and the expansion of the European Union and the complex issues that follow with the phase-in of the transition toward a larger integrated area. The other is the wider issue of migration issues arising with the global economy. The relevance of these issues to the European integration process has been downplayed so far, but their importance will surely increasingly be recognized.

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The reality, in the modern world, is that several divides exist in economic structure among nation-states, including among those integrating into or assimilating to larger entities. They centrally involve various forms of visa and work-permit restrictions, which have the effect of segmenting global economies and inducing arbitrage opportunities in terms of goods, services, and investments. One of the most critical areas involves the large labor pool in India and China, where immigration restrictions effectively keep a low-wage labor pool in those economies, preventing their movement into the richer parts of the world, and this generates trade in goods and services and the like. This remains a major driving force behind the increasing integration of the flow of goods and services into the global economy that Europe will experience in the decades ahead, although this process may be slowed due to the financial crisis, and the European response to this trend will also be critical. Europe generally has had a migration policy more heavily skewed toward allowing some degree of inward labor mobility from former colonial states, and on a country-by-country basis rather than across countries. But the need for coordination across countries and the need for a realistic assessment of the economic benefits of inward migration (traded off against the potential social consequences and the issues of assimilation and pressure on social services) will come into play. An overall approach, therefore, to future European integration would include these elements. 3.7 Future European Integration as a Process Influenced by Global Considerations All the factors we outline above clearly have implications for the overall European integration process. Thus far, European integration has been largely seen as the integration of European member states with each other, not as Europe as an entity integrating with the world economy. The discussion above emphasizes how, over the next few decades, Europe will face the challenge of interfacing with the world economy. Clearly, formalizing this new element of European integration in a more precise way poses difficulties. Which regions of the world should integration focus on, in which economic areas (trade, finance, and so on), through what kinds of institutional structures, and at what speed? And how does all this mesh with existing multilateral institutions? Is it useful to continue to expand the monetary union in Europe into an emerging global monetary order in light of emerging monetary integra-

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tion in Asia? There may even be discussions of wider monetary integration between Europe and North America. Should Europe approach this global process by attempting to design and influence a global structure it would fit into, or should it proceed incrementally on top of existing institutional and other arrangements and structures? These are indeed wide-ranging and challenging issues, but Europe will have to face them because it will inevitably be dealing with a changing global order and may be seeking global integration.3 At present, however, this integration process also has to take into account responses to the global financial crisis, which is now evolving into a government financial crisis from the banking crisis of September and October 2008. If parallels to the 1930s are any indication, this could be a long-lived event, with deep consequences that could prevail for a period of years and even possibly decades. It could also be a shallower event in which recovery occurs more quickly. But its lasting imprint on both European integration and Europe’s involvement in the world would seem critical. The European reaction thus far has been to stress the need to maintain openness in the global economy and the need for strengthened global financial regulation. These trends will also have major implications for European integration. 3.8

Conclusion

The prognosis we offer, therefore, is one in which European integration will increasingly be influenced by global considerations for several decades. Ignoring these elements—which will both constrain European action and sharply influence European interaction—will be difficult, and the notion that integration of social programs and regulatory schemes in Europe can proceed independently of global developments like the rise of India and China seems naive. In turn, integration policies that ignore environmental considerations, given the dominance of global environmental problems, would also seem misplaced. The relative economic decline of Europe and the potentially new elements of instability in world financial market activity would seemingly come into play as well. In short, European integration almost certainly cannot proceed for the next fifty years as in the last fifty, in isolation from an ever-changing and now enveloping global order. The evidence suggests that this global order is likely to increasingly dominate economic activity in Europe.

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Notes 1. We are grateful to Kun Peng and Sean Walsh for their assistance and feedback. 2. This section draws, in part, on Whalley 2008. 3. The challenges for smaller countries are discussed in Brixiova, Morgan, and Wörgötter 2010.

References Abraham, K. G., and S. K. Taylor. 1996. Firms’ use of outside contractors: Theory and evidence. Journal of Labor Economics 14 (3): 394–424. Batra, R., and H. Beladi. 2010. A simple two sector model of outsourcing. Review of Development Economics 14 (1): 64–73. Bhagwati, J., A. Panagariya, and T. N. Srinivasan. 2004. The muddles over outsourcing. Journal of Economic Perspectives 18 (4): 93–114. Brewer, T. 2008. US climate policy—trade policy intersections, current status, prospects and implications for carbon leakage. Presentation at the Climate Strategies Carbon Leakage Workshop, Paris, February 4. Brixiova, Z., M. H. Morgan, and A. Wörgötter. 2010. On the road to euro: How synchronized is Estonia with the euro zone? European Journal of Comparative Economics 7 (1): 203–227. Bussolo, M., R. E. de Hoyos, D. Medvedev, and D. van der Mensbrugghe. 2008. Global Growth and Distribution: Are China and India Reshaping the World? Working Papers RP2008/29. Helsinki: World Institute for Development Economic Research (UNU-WIDER). Campa, J., and L. Goldberg. 1997. The Evolving External Orientation of Manufacturing Industries: Evidence from Four Countries. NBER Working Papers 5919. Cambridge, MA: NBER. Dreher, A., and N. Gaston. 2005. Has Globalization Really Had No Effect on Unions? Working Paper No. 110. Zurich: Swiss Institute for Business Cycle Research (KOF). Dumont, M., G. Rayp, and P. Willemé. 2006. Does internationalization affect union bargaining power? An empirical study for five EU countries. Oxford Economic Papers 58 (1): 77–102. Feenstra, R., and G. H. Hanson. 1996. Globalization, outsourcing and wage inequality. American Economic Review Papers and Proceedings 86: 240–245. Feenstra, R., and G. H. Hanson. 2005. Ownership and control in outsourcing to China: Estimating the property rights theory of the firm. Quarterly Journal of Economics 120 (2): 729–761. Gaston, N. 2002. Unions and the decentralization of collective bargaining in a globalized world. Journal of Economic Integration 17: 377–396. Grossman, G., and E. Helpman. 2002. Integration versus outsourcing in industry equilibrium. Quarterly Journal of Economics 117 (1): 85–120.

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Mendelsohn, R. O. 2006. Is there a case for aggressive, near-term mitigation of greenhouse gases? A critique of the Stern Report. Environment Regulation, Winter. OECD. 2006. The internationalization of production, international outsourcing, and OECD Labour Markets. Economics Department, March, mimeo. Olmstead, S. M., and R. N. Stavins. 2009. An Expanded Three-Part Architecture for Post-2012 International Climate Policy. Working Paper Series rwp09-036. Cambridge, MA: John F. Kennedy School of Government, Harvard University. Olmstead, S. M., and R. N. Stavins. 2010. Three Key Elements of Post-2012 International Climate Policy Architecture. Discussion Papers dp-10–34. Washington, DC: Resources for the Future. Shenkar, O. 2004. The Chinese Century: The Rising Chinese Economy and Its Impact on the Global Economy, the Balance of Power, and Your Job. Upper Saddle River, NJ: Wharton School Publishing. Stern, N. H. 2006. The Stern Review. London: UK Government. Stiglitz, J. E. 2006. China and the global economy: Challenges, opportunities, and responsibilities. In L. H. Ho and R. Ash, eds., China, Hong Kong and the World Economy: Studies on Globalization. Basingstoke, UK: Palgrave Macmillan. Tomiura, E. 2005. Foreign outsourcing and firm-level characteristics: Evidence from Japanese manufacturers. Journal of the Japanese and International Economies 19: 225–271. Whalley, J. 2008. China and outsourcing. In D. Trefler, ed., Outsourcing. Ottawa: Industry Canada, Government. Whalley, J., and S. Walsh. 2009. Bringing the Copenhagen global climate change negotiations to conclusion. CESifo Economic Studies 55 (2): 255–285. Xiao, G. 2004. People’s Republic of China’s Round-Tripping FDI: Scale, Causes, and Implications. ADB Institute Discussion Paper No. 7. Manila: Asian Development Bank.

4

Do We Need National or European Champions? Christian Gollier and Ludger Woessmann

4.1

Introduction

The rapid march toward a more globalized economy over the last decade has generated a wave of anxiety among Western consumers, employees, businesspeople, and politicians. This has created more pressure on national governments to protect national firms from foreign takeovers, to promote national or European champions, and more generally to reinstall a strong industrial policy agenda, for the sake of national prosperity. Globalization requires adjustment and makes change necessary. This generates potential winners and losers. Potential losers want markets to be shielded from foreign competition through trade barriers, technical obstacles, health regulations, and subsidies. This evolution has been particularly visible among prominent members of the European Union. To illustrate, in December 2005, the French government defined eleven “sensitive sectors,” from casinos to biotechnology to defense, where foreign direct investment is subject to prior approval by the government. This decision was triggered by Pepsi’s interest in Danone. Subsequently, the proposed takeover of Suez by Enel was promptly opposed by the French government, which instead proposed a merger of Suez and Gaz de France to create a national champion in the energy sector. For its part, in May 2008 the Italian government was very active in resisting the takeover of Alitalia by Air France–KLM, trying to keep it under the control of national shareholders in spite of the company’s financial distress. In Germany, successive governments have expressed their rejection of protectionism, as in the takeover of Aventis by Sanofi. At the European Union level, the issue of national champions remains as undecided as ever: The Europe 2020 strategy (European Commission 2010) contains the

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vision of an “industrial policy for the globalization era” as a “flagship initiative,” but the concrete suggestions are vague enough to ensure that the issue will remain open to political juggling. National patriotism also affects the United States. The Committee on Foreign Investment, an institution that evaluates whether a merger involving a foreign acquirer is against their national interest, made international news when it rejected a Chinese takeover bid for the American oil company Unocal and a bid by Dubai Ports World for the management of six American seaports. Another illustration is the congressional opposition to the takeover bid for Unocal (USA) by CNOOC (PR China), and the subsequent takeover by Chevron. The financial crisis has provided additional momentum to the issue of national champions: the failure of Lehman Brothers and its aftermath was viewed by many policymakers as threatening the global financial system, leading to the subsidization of large banks all over the world with reference to their system-relevant role in a tightly interwoven financial sector. The emergence of sovereign funds that acquired large shares from Citigroup, Morgan Stanley, and Merrill Lynch created much anxiety early in the subprime crisis. During the subsequent worldwide recession, the attempt to save national champions in the automobile industry led to interesting and diverse debates in the United States, Japan, and Europe. In some governments, fears that the bankruptcy of firms with dense networks of input-output relations might initiate bandwagon effects induced calls for the protection of large firms in the national interest. Given this recent topicality, this chapter chooses an explicit focus on the specific theme of promotion of national and European champions, rather than covering the whole area of industrial policy. The topic of national champions is clearly high on the agenda of current European policymaking. By contrast, it is both beyond current policy topicality and beyond the scope of an accessible policy chapter to cover the broader topics of industrial policy in full. The common wisdom in many political circles in Europe is that national champions assisted by the state are best for promoting employment and growth. Whether this wisdom is sustained by hard evidence or not remains an open question. It is easy to find counterexamples. Billions of francs have been wasted by the French government on the unsuccessful development of an ultrasonic civil plane (Concorde) or of a computer company (Bull). Similarly, Germany unsuccessfully tried to promote its former monopoly on fixed-line telecommunication ser-

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vices in its attempt to prevent the eventual success of data-exchange networks based on the U.S. TCP/IP protocols. The proponents of national champions usually argue for public support. Typically, this support is proactive and policymakers are urged to create national champions in key sectors. But the requested support can also be directed at those so-called champions who have already emerged, be it through national natural-monopoly conditions, through state aid, or through lax competition policy. In this chapter, we review the main arguments for and against an industrial policy favoring the emergence of national champions. A large majority of the academic community of economists favors competition as the best policy to enhance long-term growth and employment. They believe that competition provides the necessary incentives for firms to improve efficiency and to innovate. By providing subsidies to or trade barriers for domestic champions, a country can preserve domestic firms and their jobs, but only in the short run. By doing so, it only delays necessary adjustments and limits the virtuous circle of creative destruction. When public policies reduce the competitive pressure, more efficient companies cannot replace less efficient ones. As Porter (1990, 662) claims, creating domestic champions “rarely results in international competitive advantage. Firms that do not have to compete at home rarely succeed abroad.” 4.2

Extracting Monopoly Rent Abroad

The globalization of our economies has dramatically increased the size of markets. If economies of scale are important, this transformation should induce the creation of large corporations in order to reduce production costs. In such sectors, as in network industries (telecommunication, energy) or in high-tech industries (pharmacy, environment), there is a first-mover advantage for countries able to merge their firms to create national champions. Succeeding in doing so allows these big firms to improve productive efficiency to take over smaller firms abroad and to consolidate as global champions. However, this strategy yields a welfare loss due to the extraction of the monopoly rent. When a domestic firm charges monopoly prices at home, the monopoly profit is a transfer from consumers to shareholders that has no effect on welfare. The presence of a deadweight loss due to the wedge between the marginal production cost and the willingness to pay of the marginal consumer makes it socially desirable to promote more

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competition in that market. Because the welfare of foreign residents is not taken into account by national governments, the problem is radically transformed when considering a domestic firm extracting a monopoly rent on foreign markets. In such a situation, it is in the best interest of national residents to promote competition at home and monopoly abroad. Brander and Spencer (1985) have examined this classical strategic trade argument in favor of national champions. But it could turn out to be a negative-sum game where national welfare rises at the expense of someone else’s. Domestic competition policy thus tends to be too permissive toward mergers, because it does not take into account the negative impact of lower competition outside the country bloc. The cases of Microsoft and Boeing are often invoked to illustrate this “transfer effect.” The emergence of Airbus as a competitor of Boeing for European residents has been beneficial to them through the transfer of some duopoly rents on European soil. But Europeans did not take into account the economic loss for Boeing, and the potential lost economies of scale of the new industry structure. Neither did they count the benefit for consumers around the world who experienced lower prices, as Neven and Seabright (1995) explain. Symmetrically, it is desirable for the national government to fight a foreign firm operating at home with monopoly power. This may induce it to deregulate its markets unilaterally if these markets are controlled by foreign champions, thereby eliminating monopoly rents at home while domestic firms can still extract rents abroad. However, the argument may be reversed if it is anticipated that deregulation will trigger the entry of foreign competitors, thereby reducing the rent of domestic firms, which is usually the case. This argument in favor of an industrial policy promoting national champions is based on national egoism. It is expected to generate a prisoners’ dilemma. In equilibrium, each nation will dissipate resources to create firms that in most cases will fail to emerge as global champions. Like arms races, the race to support national champions usually leads to a massive escalation in expenditure with little substantial effect. This coordination failure of nationalistic policies being offset by nationalistic policies of the competing countries is quite striking in the case of European deregulation. Each country has an incentive to delay its own deregulation. In equilibrium, however, every country delays deregulation, and consumers pay the high monopoly price for too long.

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This is why it would raise global welfare if a global social planner, or at least one at the European level, were able to counter these globally inefficient national patriotisms. This transnational regulatory body has to be endowed with enough incentive to count all costs and benefits of industrial policies, in particular the cost imposed to local consumers by foreign firms. This argument for national champions relies on the fuzzy notion of corporate nationality. It assumes that a German firm extracting a monopoly rent abroad will be beneficial to its stakeholders, who are assumed to be German citizens. These benefits are assumed to take the form of larger dividends for shareholders, higher wages for employees, and smaller prices for domestic customers. However, this picture is far from corresponding to reality. Véron (2006) examines the national shares of revenues and employment among Europe’s 100 largest listed companies. The share of their national customer base is on a rapidly declining trend from 50.2 percent in 1997 to 36.9 percent in 2005. The move is particularly striking in sectors like energy, telecommunications, pharmaceutics, and chemicals. The share of the national employment base of the top 100 European firms was also less than 40 percent in 2005. For example, Renault and Volkswagen produce cars in Brazil or Romania. EADS plans to assemble planes in China. Concerning the nationality of shareholders, data are more difficult to collect. In theory, households should fully diversify their portfolio by investing most of their financial wealth in foreign assets, in particular because of the positive correlation between labor incomes and the returns of domestic assets (Baxter and Jermann 1997). French and Poterba (1991) estimated the percentage of aggregate stock market wealth invested in domestic equities in the late 1980s. Their estimate is well above 90 percent for the United States and Japan, and around 80 percent for European countries. This is the so-called home-bias puzzle. But the wave of cross-border takeovers experienced since then has reduced the intensity of this bias. Today, 44 percent of the capitalization of the firms in the French stock market index CAC40 is controlled by foreign investors. The emergence of foreign sovereign funds, in particular from the Middle East, has reinforced this globalization process. However, one should not overestimate the role of these new players, since their capitalization (around $2.5 trillion) is far below pension funds (around $20 trillion) or banks ($60 trillion).

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In spite of the globalization of corporate identities, policymakers still perceive a convergence of “national” champions and their respective nations. The recent takeover attempts by foreign interests of Alitalia, Endesa, Danone, Alstom, Aventis, or Suez illustrate this discrepancy between political views and the real world. In reality, protecting these “national” corporations is preserving interests that are only partially domestic. The same point can be made to a lesser extent at the European level, since the share of European sales of the top 100 European corporations represents only 65 percent of their total revenue (Véron 2006). A related question concerns the government’s attitude toward the acquisition of national champions reaping monopoly profits from abroad. There is no doubt that this means more domestic profits being exported. But there is no reason to believe that financial markets do not work properly in this context, so that the buyer will pay the net present value (net of the risk premium) of these future profits to the domestic initial owners. The acquisition is thus just an intertemporal reallocation of revenues with no loss of discounted value for the seller. The analysis must be adapted if an efficient national monopoly using marginal pricing is sold to a foreign owner who is expected to raise domestic prices as a consequence. The higher share price that the buyer will be willing to pay is thus a transfer from domestic consumers to domestic taxpayers, with no net effect on welfare, but only the redistributive effect. 4.3

Protecting Employment

Another common belief is that foreign enterprises are less concerned than national champions with the goal of preserving domestic employment. The Belgians have been particularly aware of this since the closing of the production site of Renault at Vilvoorde in 1997, when it was claimed that Renault was not sensitive to the Belgian unemployment problem. A similar matter emerged in France when Mittal merged with Arcelor in 1997, which was followed in 1998 by the announcement of a plan to close a steel mill in Gandrange in Alsace, in spite of the increase in the corporation’s profitability. A possible explanation for this trend to reduce employment after a foreign takeover is that indeed domestic firms are under government pressure to preserve domestic jobs until this becomes financially unsustainable. The transfer of ownership rights to foreign hands is then an

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easy strategy to let them do the “dirty work.” More generally, one may suspect that there is a selection bias when considering the effect of foreign takeovers on employment. The question is thus what the role of employment is in shaping industrial policy. If labor markets functioned properly, the marginal productivity of labor would be equalized across sectors and firms at the social cost of labor, guaranteeing an efficient allocation of labor in the economy. An industrial policy trying to promote employment in a specific sector would just disturb this equilibrium in an inefficient way. Usually, this is done by providing state subsidies to failing firms. This means blocking the transfer of workers from low-productivity sectors to higher-productivity jobs. It also maintains the equilibrium wage higher than would be efficient, thereby destroying socially productive jobs. Of course, the premise that labor markets function properly in Europe is questionable. Too many workers are unemployed, in spite of the fact that the social cost of their labor is smaller than their marginal productivity if employed, thereby wasting an enormous amount of potential value creation. Worse, a large fraction of this unemployment corresponds to a subgroup of less skilled workers facing long unemployment spells. Viewed ex ante, this critical risk is only partially insurable, generating a second source of deadweight loss. These market failures yield a rationale for an industrial policy aimed at protecting domestic employment. Because there is a wedge between the private and social cost and benefit of employment, firms produce negative externalities when reducing employment. These externalities are borne by laid-off workers and by the unemployment insurance. In this situation, it may be more efficient to force firms to retain their workers, in spite of the fact that the private cost is larger than the private benefit of these jobs for firms. One difficulty here is to be able to stop the subsidy to the loser once the cost-benefit analysis of the implicit job protection is negative. However, we may question whether industrial policy is the best instrument to fight inefficient unemployment. For example, Blanchard and Tirole (2008) propose reforming the unemployment insurance system by imposing an experience rating system on contributions paid by employers, to give them the right incentives to internalize the social cost of unemployment. It is clear that imposing such a policy reform on the labor market would be better than any industrial policy aimed at protecting employment. However, Blanchard and Tirole show that only a second-best solution can be attained, because of the

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impossibility of raising the employer ’s contribution when the firm is in a situation of financial distress. The internalization of the social cost of layoffs will thus be only partial, which can leave some room for offering a marginal role for employment in the shaping of an industrial policy. However, the existing empirical evidence tends to suggest that this approach does not work. If anything, the employment effect of protecting national champions and protecting firm ownership in national hands seems to be negligible or negative rather than positive in the medium to long run. For example, Nicoletti and Scarpetta (2005) find that an indicator of restrictive product-market regulation that depicts entry barriers and state control, including attempts to defend national champions, is negatively associated with employment in a sample of OECD countries over 1980–2002 (see Berger and Danninger 2007 for similar evidence). Fogel, Morck, and Yeung (2008) show that stability of the group of a country’s biggest businesses, which may be viewed as an indicator of protected national “champions,” is unrelated to unemployment and negatively related to productivity and economic growth. In India, which had protected its industry for a long time, for example, by hindering entry, Aghion et al. (2008) find that a substantial liberalizing reform that threatened previously protected national firms did not affect average employment (as might be expected if fostering national firms indeed protected employment) and even positively affected employment in states that had “pro-employer” labor market institutions. 4.4

Innovative Champions?

The well-known infant-industry argument suggests that restricting competition and entry is favorable for industrial sectors and countries whose growth relies on capital and human accumulation and imitation. The standard infant-industry argument involves learning by doing, yielding a downward-sloping cost curve. However, many industrial sectors in Europe experience growth based on R&D and innovation. For those sectors, it is not clear whether the emergence of national or European champions is good news for the speed at which innovations will fuel the economic growth of the sectors and the prosperity of the Union. Let us consider the biotechnological industry as an illustration. Many U.S. biotechnology firms, often linked to universities, emerged

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from government-funded agencies conducting research in molecular biology. Only since the 1980s has private venture capital either replaced or complemented public financing. These small firms are responsible for the U.S. lead in biotechnology. The U.S. government financed the scientific base but did little to promote the industrial development and exploitation of biotechnology. Commercialization has instead been the result of a partnership between universities and venture capital. In the stage of emerging development in 1994, the U.S. biotechnology industry contained 1,300 firms, of which approximately 265 were publicly owned. Of these, 37 percent had fewer than 50 employees, 18 percent had between 51 and 135 employees, and 12 percent had between 135 and 299 employees (Crampes and Hollander 1998). In contrast, large firms have tended to prevail in Europe, especially multinationals in the pharmaceutical and chemical sectors. In this section, we address the question of which market structure is better able to foster innovation and growth. Two theories provide contradictory predictions, which are nicely summarized by Aghion and Griffith (2005). Under the Darwinian theory, competition and entry foster productivity growth by eliminating firms that do not innovate enough. Their desire to avoid bankruptcy forces them to innovate. Hart (1983) formalized this idea that weak competition yields the survival of “satisfying” managers, who seek a quiet life subject to ensuring that they keep their job. Suppose that a manager ’s efforts to maximize profits are not observable by the owners of the firm. A wage schedule contingent on the firm’s profits should be designed in order to give the manager an incentive to increase his efforts. But concerning R&D, immediate profits are a very poor signal of the agent’s efforts, which implies that monetary incentive schemes are no longer efficient. Hart (1983) shows that a better scheme is to rely on the agent’s career concerns together with product market competition—in other words, on the manager ’s fear of losing his job in the case of bankruptcy. Weak competition, soft budget constraints, and the expectation of public subsidies in the case of weak performance would act against this incentive scheme, and would result in less productivity growth, less innovation, and smaller growth in sectors subject to such agency problems. Jagannathan and Srinivasan (1999) have tested whether firms that operate in less competitive markets are more likely to use free cash flow to undertake less profitable investments, thereby buying themselves a quiet life. Using data on U.S. firms, their results suggest a statistically

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significant impact of competition on total factor productivity. Nickell, Nicolitsas, and Paterson (2001) show that firms tend to introduce better managerial practices and new technologies more frequently when performance is worsening than when it is improving. Another empirical finding that supports Hart’s model is provided by Aggerwal and Sandwick (1999), who look at the relationship between executive compensation packages and the degree of competition. They find that as competition increases, executive pay becomes less sensitive to the firm’s own performance. This suggests that competition is a substitute for incentive schemes based on wage compensation. The alternative theory is Schumpeterian and was developed in the early 1990s by Romer (1990), Grossman and Helpman (1991), and Aghion and Howitt (1992). In all these models, an increase in product market competition has a negative impact on productivity growth. The main idea is the “rent dissipation” effect of competition—that is, competition reduces postinnovation profits in knowledge-based economies and sectors, thereby reducing ex ante incentives to innovate. By reducing the expected rents from innovation, intense competition discourages investment in R&D and inhibits productivity growth. Moreover, Schumpeter (1943) assumes that R&D activities exhibit strong economies of scale, which would provide another argument in favor of national/global champions.1 To sum up, either the economy is dominated by profit-maximizing firms, in which case competition should have a negative effect on growth due to the rent dissipation effect in the Schumpeterian paradigm, or the economy is dominated by large champions facing agency problems, in which case competition should have a positive effect on growth due to the incentive generated by the fear of bankruptcy in the Darwinian paradigm. When examining the question of the link between the nature of competition policy and innovation, it is also important to understand the motivation of the different potential innovators to invest in R&D. Following Tirole (1988, chap. 10), consider a national champion engaged in a race to innovate with a potential entrant. Who has the strongest incentive to innovate? The rent dissipation effect states that the incumbent has more incentive because it has more to lose (the difference between its monopoly rent and the duopoly rent) than the potential entrant. But there is an opposite “replacement effect” based on the idea that new innovations destroy the value of earlier innovations (creative destruction): from the point of view of the incumbent, the economic

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value of the innovation must be computed net of the value of the previous innovation that it will replace, whereas there is nothing to replace from the point of view of the entrant. This replacement effect thus tends to cause the entrant to invest more in R&D. Whether this effect dominates the rent dissipation effect or not will determine who is more likely to innovate. Another element that should be taken into account is the better position of big shareholding firms, more likely to be incumbents than potential entrants, to diversify the large risks associated with the R&D activities. Since Schumpeter (1943), many cross-sectional studies surveyed by Cohen and Levin (1989) considered the relationship between innovation and market concentration or firm size. These studies show that larger firms are also more innovative. However, Scherer (1965) documents a diminishing impact at larger sizes, thereby raising doubts that champions are “as efficient an engine of technological change as disciples of Schumpeter have supposed it to be. Perhaps a bevy of factmechanics can still rescue the Schumpeterian engine from disgrace, but at present the outlook seems pessimistic.” More recent findings have reinforced the empirical tide against Schumpeter. For example, Nickell (1996) uses UK firm-level panel data to show that tougher competition, lower concentration, and lower levels of rents yield larger growth rates in total factor productivity (TFP). He is able to estimate differences in TFP due to differences in the intensity of competition across various industries, holding everything else constant. His findings are summarized in table 4.1. For example, TFP growth in metal manufacturing in the United Kingdom was 1.7 percentage points lower on average due to limited competition in the sector. More recently, Aghion and Griffith (2005) have enriched the analysis of the effect of competition on economic efficiency by decomposing it Table 4.1 Percentage point TFP growth rate differentials generated by differences in competition Electrical engineering

−2.4

Metal goods (other)

0.8

Other manufacturing

−2.2

Textiles

0.9

Metal manufacture

−1.7

Clothing and footwear

1.0

Vehicles

−1.3

Mechanical engineering

1.0

Chemicals

−0.8

Timber and furniture

1.6

Instrument engineering

−0.6

Paper, printing, and publishing

1.9

Food, drink, and tobacco

−0.2

Bricks, pottery, and glass

2.0

Source: Nickell 1996, table 3

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7

Citation weighted patents

6

More neck-and-neck

5 All industries

4 3 2 1 0 0.85

0.9

0.95

1

1 - Lerner Figure 4.1 Relationship between the intensity of product market competition and innovation. Source: Aghion et al. 2005

into pre- and postinnovation effects. Because the incentive to innovate depends on the difference between preinnovation and postinnovation rents, it may be possible in some circumstances that product market competition reduces the preinnovative rent more than it reduces the postinnovation rent, thereby raising the incentive to innovate. In more recent models in which innovation is perceived as a strategy to escape fierce competition, competition can thus be good for innovation and growth. Aghion et al. (2005) examine data on the patenting activity of a panel of UK firms. They typically obtain an inverted-U relationship as represented in figure 4.1 between innovation, as measured by a citation-weighted patent volume, and the intensity of competition, as measured by one minus the Lerner index of market power. This suggests that the “escape competition effect” and the Darwinian effect tend to dominate for low initial levels of competition, whereas the Schumpeterian rent dissipation effect tends to dominate when competition is fiercer. To what extent this effect of market concentration on innovation is a cause for government intervention by industrial policy is unclear. If anything, it suggests that an industrial policy protecting national champions is favorable to innovation and productivity growth only for sectors or countries with a very high level of product market com-

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petition. Figure 4.1 also indicates that the subgroup of industries that are more neck and neck (as measured by a relatively smaller technological gap between the most technologically advanced firm and its followers) have a higher level of innovation activity at all intensities of competition, and that the inverted-U curve is more pronounced. 4.5

Spillovers, Clusters, and Poles

The presence of some knowledge-based firms can serve as a hub in local networks of innovative firms. These pockets of activity are often called “clusters,” and they range from the justly celebrated Silicon Valley in California to Route 128 in Boston. Many governments around the world have been inspired by these examples to create poles of innovative excellence. Creating a geographic cluster involving a number of rival firms in a particular sector, together with various upand downstream supporting activities, may, to some extent, be interpreted as being close to creating a national champion. But under Hart (1983)’s argument, clusters close to the technological frontier may work better than large, centrally managed labs. Geographic proximity facilitates information transmission that creates competitive incentives (Geroski 2006). The crucial engine of clusters is the speed at which technological knowledge is diffused in the network. But we have seen in the previous section that knowledge diffusion generates a diffusion of the innovation rents. Too-rapid knowledge diffusion undermines the hoarding of rents by the innovator, reducing the incentive to innovate. The success of clusters like Silicon Valley may be linked to common assets such as basic knowledge, peer-group pressure, pools of skilled workers, and distribution platforms. These positive externalities combined with the “escape competition effect” and with the business culture of “coopetition” (cooperation and competition) could explain the fast growth generated by these knowledge poles. 4.6

The Political Economy of Picking Winners

In competitive markets with entry, only the most efficient firms can survive, so that a Darwinian process determines the winners. In theory, a public body could duplicate this system to pick those firms, preferably domestic, to become national champions through some specific

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discriminatory industrial policy. For Rodrik (2004), the industrial policy should be “a discovery process—one where firms and the government learn about underlying costs and opportunities and engage in strategic coordination.” But most economists remain skeptical about whether public intervention can entail the economic capability to pick the winners efficiently. According to Geroski (2006, 40), There are two ways of identifying a potential champion: the right way and the wrong way. The right way is to think carefully about which sectors (if any) are key sectors that are strategically important for the economy, and then to ask whether some kind of support (and if so, which kind) for these sectors is absolutely necessary to ensure that they survive and fulfill their competitive potential. The wrong way to choose a national champion is to succumb to lobbying by a large, domestically powerful firm that is going through a period of poor performance or is operating in a market that has suddenly begun to mature or decline.

There are many reasons to believe that the selection of winners is subject to arguments far away from pure efficiency considerations. First, a standard political-economy insight is that politicians find it hard to resist implementing inefficient actions that benefit a small minority of agents if their costs are disseminated to a large group of (uninformed) citizens. The sad fact is that the case for consolidation is almost always made for the wrong reasons. Large, wellestablished firms have political access (and certainly much more access than firms in tomorrow’s sunrise sectors), and the possibility that they might decline or fail usually has major employment implications. It is easy for policymakers to believe that their failure is due to mysterious (and probably malign) competitive forces out there somewhere in the global marketplace, or to nefarious foreign governments that are already propping up their own national champions in a way that creates a nonlevel playing field. The urge to act is reinforced by the apparent simplicity of the support required—support for consolidation plus, perhaps, a few soft loans or a few soft procurement contracts. And, in the end, a possibly well-meaning policy designed to nurture the sunrise sectors of the future ends up propping up the sunset sectors of the past, littering the industrial landscape with dinosaurs whose ability to compete for political patronage turns out to be far superior to their ability to compete in their own markets. Second, the pressure to achieve visible successes at high electoral frequency is hardly compatible with the long-term horizon that most

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large industrial projects require. A bias toward highly visible and prestigious projects favored by political leaders can distort the process of project selection. Third, discriminatory industrial public strategies induce rent seeking by firms. They will allocate some of their resources to lobbying in order to influence political decisions in their favor. This process wastes collective resources. Fourth, politicians may have a hard time withdrawing support once it is given. They may be reluctant to admit that some of their projects have failed unless they are absolutely forced to by some spectacular and very public event. Or, they may continue providing subsidies even when the firm has become a viable national champion. 4.7

Conclusion

In this chapter, we have reviewed the economic arguments for and against policies that promote national or European champions. The different arguments may be organized in three groups (Falck, Gollier, and Woessmann 2011): static ones (extracting monopoly rent abroad; protecting employment), political-economy ones, and dynamic ones (innovative champions; spillovers, clusters, and poles). Taking the perspective of global welfare (and taking the liberty of a policy paper to ignore many details of the arguments), we conclude that, as a rough generalization, these three types of arguments in favor of champion-promoting policies are bad, bad, and mostly bad, respectively. The beggar-thy-neighbor type arguments of the static models of imperfectly competitive markets are, in general, bad from a global perspective, because they tend to aim at “stealing” rents from other countries. Countries end up in a prisoners’ dilemma situation where in equilibrium, each national government will inefficiently—and, for sure in all but one case, unsuccessfully—try to prop up a national firm to become a global champion. When taking a global—or even EUlevel—perspective, such arguments tend to suggest that everyone would be better off with transnational coordination and supervision of champion-related policies. At the EU level, a clear case can be made based on such models in favor of international cooperation that prevents countries from entering an “arms race” of national policies to reciprocally foster their national champions with negative consequences for aggregate European welfare.

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The political-economy type arguments in favor of championpromoting policies tend to be bad from any perspective other than the politicians’ (and the protected firms’). As such, the list of arguments in this field refers to cases where trying to pick winners is economically inefficient. In these cases, interventionist governments that create huge and inefficient corporations do not even promote national well-being to the detriment of foreign countries, but inadvertently reduce net national welfare, thereby hurting their own country. What’s more, the political economy of interventions that support national champions suggests that it may be very hard to stop such policies, even when they have been shown to have failed in economic terms (see Seabright 2005 for a related argument). The infant-industry type arguments of the dynamic models of innovation and growth may be interpreted as suggesting that policies that try to prop up national champions are “mostly bad.” There are exceptions, and situations can be identified where temporary or targeted champion-promoting policies can be beneficial. However, both theory and—especially—evidence suggest that such situations are “extreme” (Aghion 2011), referring, for example, to temporary protection in small, technologically backward countries and specific industrial niches. In most cases, though, liberalizing policies that foster competition rather than national champions seem to be superior in creating innovation and growth. What’s more, while the case for promoting champions can easily be made in theory, implementing such policies in practice is associated with very large problems that can easily undo any potential benefit (EEAG 2008, chap. 4). In addition, it should be pointed out that many of the “national champion” policies that we see in different EU countries are not at all about innovative sectors, but about mature or declining sectors. Such policies are hard to defend on the grounds of dynamic innovation models. And when it comes to the disruptive innovations that make truly dynamic high-tech sectors emerge—in contrast to the incremental innovations occurring in more mature sectors, which tend to be realized in (competitive) larger firms (Falck 2009)—the current high-tech giants in the United States were not created out of existing giants, but tended to evolve from tiny to large in a competitive process. All of these arguments tend to suggest that, in general, European countries would be better off if their governments refrained from trying to foster national or European champions, leaving the decision to consumers and markets.

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Note 1. However, the fact that a large investment in R&D is required to be viable does not necessarily mean that it has to be centrally organized.

References Aggerwal, R., and A. Sandwick. 1999. Executive compensation, strategic competition, and relative performance evaluation: Theory and evidence. Journal of Finance 54: 1999–2043. Aghion, P. 2011. Some thoughts on industrial policy and growth. In O. Falck, C. Gollier, and L. Woessmann, eds., Industrial Policy for National Champions. Cambridge, MA: MIT Press. Aghion, P., N. Bloom, R. Blundell, R. Griffith, and P. Howitt. 2005. Competition and innovation: An inverted-U relationship. Quarterly Journal of Economics 120 (2): 701–728. Aghion, P., R. Burgess, S. J. Redding, and F. Zilibotti. 2008. The unequal effects of liberalization: Evidence from dismantling the license Raj in India. American Economic Review 98: 1397–1412. Aghion, P., and R. Griffith. 2005. Competition and Growth: Reconciling Theory and Evidence. Cambridge, MA: MIT Press. Aghion, P., and P. Howitt. 1992. A model of growth through creative destruction. Econometrica 60: 323–351. Baxter, M., and U. J. Jermann. 1997. The international diversification puzzle is worse than you think. American Economic Review 87: 170–180. Berger, H., and S. Danninger. 2007. The employment effects of labor and product market deregulation and their implications for structural reform. IMF Staff Papers 54: 591–619. Blanchard, O., and J. Tirole. 2008. The optimal design of unemployment insurance and employment protection: A first pass. Journal of the European Economic Association 6 (1): 45–77. Brander, J., and B. Spencer. 1985. Export subsidies and international market share rivalry. Journal of International Economics 18: 83–100. Cohen, W., and R. Levin. 1989. Empirical studies of innovation and market structure. In R. Schmalensee and R. Willig, eds., Handbook of Industrial Organization, vol. 2, 1059–1107. Amsterdam: Elsevier Science. Crampes, C., and A. Hollander. 1998. Biotechnological innovation and industrial performance. In B. Knoppers and A. Mathios, eds., Biotechnology and the Consumer. Amsterdam: Kluwer. European Commission. 2010. Europe 2020: A European Strategy for Smart, Sustainable and Inclusive Growth. Communication from the Commission, 3.3.2010. Brussels: European Commission. European Economic Advisory Group (EEAG—L. Calmfors, G. Corsetti, M. Devereux, G. Saint-Paul, H.-W. Sinn, J.-E. Sturm, and X. Vives). 2008. The EEAG Report on the European Economy 2008: Europe in a Globalised World. Munich: CESifo.

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Falck, O. 2009. Routinization of innovation in German manufacturing: The David-Goliath symbiosis revisited. Industrial and Corporate Change 18 (3): 497–506. Falck, O., C. Gollier, and L. Woessmann, eds. 2011. Industrial Policy for National Champions. Cambridge, MA: MIT Press. Fogel, K., R. Morck, and B. Yeung. 2008. Big business stability and economic growth: Is what’s good for General Motors good for America? Journal of Financial Economics 89 (1): 83–108. French, K. R., and J. M. Poterba. 1991. Investor diversification and international equity markets. American Economic Review 81 (2): 222–226. Geroski, P. 2006. Competition policy and national champions. In P. Geroski, ed., Essays in Competition Policy, 37–42. London: Competition Commission. Grossman, G., and E. Helpman. 1991. Innovation and Growth in the Global Economy. Cambridge, MA: MIT Press. Hart, O. 1983. The market mechanism as an incentive scheme. Bell Journal of Economics 14 (1): 366–382. Jagannathan, R., and S. B. Srinivasan. 1999. Does product market competition reduce agency costs? North American Journal of Economics and Finance 10: 387–399. Neven, D., and P. Seabright. 1995. European industrial policy: The Airbus case. Economic Policy 21: 313–358. Nickell, S. 1996. Competition and corporate performance. Journal of Political Economy 104: 724–746. Nickell, S., D. Nicolitsas, and M. Paterson. 2001. Does doing badly encourage management innovation? Oxford Bulletin of Economics and Statistics 63: 5–28. Nicoletti, G., and S. Scarpetta. 2005. Product Market Reforms and Employment in OECD Countries. OECD Economics Department Working Papers No. 472. Porter, M. E. 1990. The Competitive Advantage of Nations. New York: Free Press. Rodrik, D. 2004. Industrial Policy for the Twenty-First Century. Mimeo. Cambridge, MA: John F. Kennedy School of Government, Harvard University. Romer, P. 1990. Endogenous technological change. Journal of Political Economy 98: 71–102. Scherer, F. 1965. Firm size, market structure, opportunity, and the output of patented inventions. American Economic Review 55: 1097–1125. Schumpeter, J. 1943. Capitalism, Socialism and Democracy. London: Allen & Unwin. Seabright, P. 2005. National and European champions—burden or blessing? CESifo Forum 6 (2): 52–55. Tirole, J. 1988. The Theory of Industrial Organization. Cambridge, MA: MIT Press. Véron, N. 2006. Farewell National Champions. Bruegel Policy Brief 4.

5

Reforming the European Welfare State Martin Werding and Kai A. Konrad

5.1

Introduction

European-style approaches to designing policies of “the” welfare state have often attracted attention, though not necessarily unanimous support, from an international audience of researchers and policymakers. According to a simplified but widely held view, Europeans tended to place excessive emphasis on security, at the expense of other objectives, in the 1960s and 1970s when the welfare state expanded virtually everywhere in the developed world. Some observers may have admired or even envied that, for it has given rise to relatively high levels of social protection for everyone covered by these systems. From the early 1980s until very recently, however, such an orientation seemed less fashionable. Labor regulations and public transfers were often perceived to have adverse effects for the growth performance of many European economies, to impede adjustments to new challenges in the era of globalization, and to create a divide between insiders and outsiders with respect to employment as well as social inclusion in a broader sense. If nothing else, the fiscal consequences of persistent, high levels of unemployment and imminent demographic shifts necessitated some retrenchment in the generosity of European welfare states at some point in time during this period. In this process, European lawmakers adopted less interventionist policies and practices based—why not?— on experience gathered elsewhere. The financial crisis, followed by an economic crisis and a public debt crisis in Europe, has now reinforced awareness that credible rules matter, both for the functioning of markets and the functioning of government. Typically, the “welfare state” encompasses a core set of labor market regulations and public, or mandatory, social protection schemes for

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unemployment, illness, disability, and old age covering a sizable fraction of the population, often augmented with additional interventions in related areas, such as education and the economic conditions of families with dependent children, individuals with disabilities, and last but not least, the poor. There is certainly no uniform, “European” model of designing these institutions and the welfare state in their entirety. In fact, all the “worlds” of welfare capitalism that have been distinguished in the literature (see Esping-Andersen 1990 for one type of classification) originate from within Europe. Nevertheless, there is a kind of “family resemblance” between welfare systems in European countries, in that none looks exactly like any other but many have similar traits.1 To discuss key issues and promising paths for reforming the welfare state, we will have to deal with the challenges it is facing. First, we discuss the positive role of the European-style welfare state: its potential for improving efficiency as well as for promoting an equitable distribution of income and opportunities (see section 5.2). We then turn to a number of problems in the implementation of the welfare state, organizing our main ideas around three major subthemes that we consider most prominent, namely (1) boosting employment and activating the unemployed (see section 5.3); (2) dealing with the implications of an aging population (see section 5.4); and (3) managing international migration (see section 5.5). These problems may have been overshadowed by the recent financial crisis, but they have not disappeared and will move back to the forefront of the policy debate soon. We do not expect to come up with a one-size-fits-all reform agenda. European nations need to respect path dependencies and complementarities between welfare institutions and other institutional features in their countries. Also, some competitive pressure between nation-states may be desirable to generate a willingness to experiment and to open political windows of opportunity for innovation and reform. At the same time, all European countries face a set of common challenges, making the direction of desirable reforms potentially similar in many of these countries. 5.2

The Welfare State’s Economic Rationale

Many different institutions and types of regulations together constitute what is usually considered “the welfare state.” Under contemporary conditions, the most prominent tasks often assigned to the welfare state

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include (1) the design of wage bargaining and other labor market regulations; (2) stabilizing intergenerational exchange in terms of support for children as well as support for the elderly since, because of the timing of these transactions over a typical life cycle, some of this support cannot be built on private contracts; (3) removing credit constraints that may impede human capital formation; (4) stepping in where information asymmetries give rise to adverse selection, potentially important applications being health insurance coverage and financial provisions for the “risk” of longevity; (5) dealing with information externalities and consumers’ coordination failure in markets with product uncertainty, experimentation, and imitation; and (6) policies that aim at redistribution between the economically well off and those not doing well because of bad luck, lack of ability or qualifications, or physical or mental disabilities. This list shows that some components of the welfare state can be seen as a means of correcting market failures, whereas others aim at changing the distribution of income in a broad sense, including the creation of equal opportunities, and providing a safety net against various kinds of risks. If the welfare state were mainly about taking away from some and giving to others, the concept would not have the same appeal that it actually has. It has been argued—by thinkers as diverse as Harsanyi (1953, 1955), Rawls (1971), and Brennan and Buchanan (1985)—that behind a “veil of ignorance” about one’s actual position in the distribution of income, wealth, goods, and so on, individuals could all agree that there should be some redistribution of these outcomes of market interactions as an instrument of mutually beneficial insurance. This interprets redistribution in the welfare state from an efficiency perspective, in fact as a simple insurance mechanism: in a situation in which individuals do not know what abilities they will have, or whether their specific physical or mental abilities will be rewarded in the society they are born into, these individuals would like to cushion their risks if they are risk averse. Moreover, as Sinn (1997) has pointed out, even though individuals may want this type of insurance behind the veil of ignorance, as unborn children or infants they are unable to purchase it in the market. Considering redistribution as insurance ex ante is a powerful normative basis for the welfare state as an efficient arrangement at the constitutional level. Yet it does not help much for practical purposes when redistribution is actually carried out ex post. It neither provides guidelines for how much redistribution an assembly of all individuals

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would have legislated not knowing who will be rich and who will be poor, nor does it limit the losses in static and dynamic efficiency arising from taxes, public transfers, and the public provision or subsidization of goods and services. Furthermore, actual implementation of the welfare state is a political choice. There is no almighty benevolent government that simply implements the programs that are considered efficiency enhancing from a constitutional or ex ante perspective. The government consists of agents who primarily serve their own goals, and the level of redistribution considered fair or equitable is highly controversial in a heterogeneous society. At the same time, civilized societies may find themselves unable to do entirely without any ex post redistribution, because they typically subscribe to a norm according to which each individual should at least have access to a minimum, or subsistence, level of consumption of a number of vital goods. To limit conflicts between efficiency and distributive goals, putting strong emphasis on an equitable distribution of market outcomes may nevertheless not be ideal. Instead, looking at an equitable distribution of opportunities for everyone to engage in market interactions and to do so successfully may be a lot more promising.2 True, these opportunities have to be real (i.e., providing them has a material dimension), as Sen (1985) explicitly stresses in his related notion of human “capabilities.” And true, there is never an original situation where public intervention only affects opportunities, not actual decisions. Still, activities of the welfare state addressing, for example, equitable access to education and labor markets should be considered superior to a redistribution of income and goods purely guided by inequalities in market outcomes ex post. Access to education and training is particularly important with respect to young people, most of all to children of less educated parents. Guaranteeing access to labor markets is an issue that is particularly relevant—for different reasons—for women, migrants, and low-skilled workers. Note that, in spite of some efficiency losses involved in financing appropriate measures, establishing more equitable opportunities may directly improve efficiency and material well-being. Utilizing and enhancing the human capital of the disadvantaged according to their abilities, not their background, increase productivity and alleviate all kinds of adjustments in a dynamic environment. This is actually a major reason why the European welfare state was initiated in the first place, one of the very first steps toward its creation being the prohibi-

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tion of child labor, which was legislated in the first half of the nineteenth century in a number of Western European countries. Children who had ruined their health working under harsh conditions for years were physically unable to perform well as workers (or, at that time, as soldiers) once they had grown up. Sending them to compulsory elementary schooling instead was thus a measure to protect their physical capacities and, at the same time, to invest in their mental capacities in some basic fashion. Similar things happened in the same, early period in a number of states in New England. The effects for the growth performance in both regions were immediate and considerable—even if one does not fully accept the long-term trends and figures (covering almost 2,000 years) reported in Maddison 2001. A more recent argument that the welfare state brings about actual material gains relates to the fact that risk taking is effectively a factor of production, just like machinery, raw labor, and professional skills. Irrespective of whether the state takes action for efficiency reasons, offering credit and insurance where markets fail, or whether it mainly engages in redistribution, there is always an insurance-like effect ex ante, not just at the constitutional level. In both cases, individuals may be encouraged to take on larger risks, which may directly increase the (expected) rate of growth.3 On average, individuals may thus end up with a higher income—gross as well as net of taxes, assuming that the latter are needed to finance the welfare state’s activities—while income could in fact be less evenly distributed than without any insurance or redistribution as a seemingly paradoxical result (Sinn 1995, 1996). The welfare state of the twenty-first century has more elaborate tasks to accomplish and can have more far-reaching beneficial effects than when it first came into being in the nineteenth century. At the same time, it may have to limit its size against the days of rapid expansion in the second half of the twentieth century. Providing a minimum standard of living under reasonable conditions for those who cannot afford it may inevitably remain on the welfare state’s agenda. Still, under real-world conditions it often fails to function as well as it could. Design features that seemed useful or, at least, harmless when they were introduced may turn out to have negative side effects that were not anticipated or are stronger than expected. The welfare state may not just alter individual behavior (Buchanan 1975), but—as some argue—even individual preferences (Lindbeck 1995a, 1995b) in an unfavorable fashion, undermining its own foundation over time. Hence, it may need to be overhauled from time to time, with an eye on

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its primary role in addressing relevant cases of market failure in the context of labor markets, intergenerational exchange, human capital formation, old-age provision, and healthcare, as set out above. This process is in fact well underway. 5.3

Boosting Employment and Activating the Unemployed

Labor force participation shows substantial variation across Europe, and the dynamics of job creation have not been particularly strong since 1995 in a number of countries (see figures 5.1 and 5.2). At the

Japan

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Figure 5.2 Employment dynamics (civilian employment, 1995 = 100), 1995–2009. Sources: OECD; authors’ calculations

same time, the downturn in employment since 2007 has often been weaker in Europe than elsewhere. For the moment, it is certainly difficult to disentangle short-term effects of the current crisis from lasting consequences. The same applies to temporary impressions versus more fundamental lessons from the crisis regarding how to operate the welfare state. As we see it, the welfare state offers instruments for dealing with the crisis, rather than being suspected of having caused it. Thus far, new views on what is important in this respect have not been assessed rigorously. We therefore focus on what we

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still think is relevant for striking the right balance between social protection and competitiveness, between security and flexibility, in the long run. A discussion of how to increase employment in Europe has to begin with a number of fundamental issues, such as competition for FDI and how it interacts with the welfare state. Besides the traditional framework for labor markets in Europe, with strict employment protection and generous unemployment benefits, a new type of arrangement has emerged in a number of European countries that is labeled “flexicurity” and that deserves particular attention in this context. Activation of the unemployed, especially those with low skills, through in-work benefits, “workfare,” benefit sanctions, and so on is an important ingredient in this approach that we will also discuss. Last but not least, we will take a look at wage-setting systems that have long been a matter of some concern with respect to employment trends in Europe. Over the last decades, Western European economies have seen a lot of outward FDI. Important target regions were highly developed countries around the world but also emerging markets in East Asia and transition countries in Eastern Europe. Broadly speaking, there are two types of FDI, namely “horizontal” FDI, which essentially expands existing operations to new markets, and “vertical” FDI, which relocates parts of the production chain to other countries. While the firm-level motive for the first type of FDI is usually an increase in sales, the second type tends to be motivated by a reduction in costs. Correspondingly, the consequences of outward FDI for GDP, domestic value added, and employment can vary substantially, depending on which of the two motives dominates the picture. In any case, high amounts of outward FDI are not necessarily a problem for the source countries, because they may reflect domestic firms’ strength in gaining access to new consumers or, at least, improvements in their competitiveness regarding the activities they maintain at home. Still, in recent years there have been considerable net losses in jobs in the manufacturing industry in a number of European countries that have been attributed to outward FDI. The losses were effectively concentrated among low-skilled workers who have little competitive edge over low-skilled workers elsewhere in the world. Building on new data linking information regarding outward FDI and domestic employment performance at the firm level, these trends have been subjected to empirical investigation taking Swedish and German

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manufacturing companies as examples (Becker et al. 2005; Muendler and Becker 2010). The results show that much of observed outward FDI, especially investment in other developed countries, is not particularly responsive to wages in either source or target countries. By contrast, the stock of FDI from Western Europe accumulated in Eastern Europe appears to be strongly driven by international wage differentials. Furthermore, this stock has grown extremely fast since the mid-1990s, indicating substantial substitution effects with respect to labor inputs in this particular direction. At the same time, domestic employment performance appears to be better in firms that embrace the option of becoming a multinational enterprise than in those that do not operate subsidiaries abroad (Becker and Muendler 2008). A phenomenon that is conceptually similar to outward, vertical FDI is international outsourcing by which firms partly disintegrate their production chain and buy intermediate products at lower costs from external suppliers located in other countries. This type of response to a new, globalized environment is probably even more widespread than FDI, but it is much more difficult to pin down empirically. It shows up, first, in trade statistics for intermediate inputs and in the share of domestic value added in final products. Over the last two decades, trade from Eastern Europe and other developing regions to the highly developed countries in Western Europe has become much more significant, and the value added in domestic manufacturing in the latter countries has fallen substantially relative to the total value of output (Sinn 2007, chap. 2). Once again, some involvement in these changes in the international division of labor should be expected to be beneficial, for firms as well as at an aggregate level. But there are also indications that the processes sketched here may fail to extract all gains from larger trade and deeper economic integration. What is probably most revealing is the situation in factor markets, most notably labor markets, in some countries in Western Europe. Structural unemployment has reached very high levels in the larger, continental economies during the late 1990s and early 2000s, while capital has moved away through various channels over the same period. These unfavorable trends in unemployment may have been reversed more recently, but there is room for further improvement. Also, more profound adjustments may be needed in the international patterns of production, demand, and trade to obtain a stable model of economic development for the postcrisis era.

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There is actually little research on how the welfare state interacts with the process of globalization. One strand in the literature reexamines the conventional propositions of trade theory for the case of countries with strictly regulated labor markets (Saint-Paul 1997, Davis 1998, or Blanchard and Wolfers 2000). These studies essentially show that in its presence the welfare-enhancing effects of international trade are no longer unambiguously valid. They also offer explanations for the differences in the employment performance in Europe and the United States over the last two decades (see also Nickell 1997, 2006). The basic story behind these analyses is that a number of relevant rules—mainly the framework for wage settlements and employment protection, plus the design of “passive” benefits for the unemployed— may reinforce each other in reducing the flexibility of wages and, more specifically, in driving up wages at the lower end of the pay scale.4 Payroll taxes needed to finance unemployment compensation and other branches of social protection may add to these overall effects. As a final result, the countries affected are continually losing jobs in the course of regular structural changes and in the transition to a new international division of labor, but they are lacking the incentives to create a sufficient number of new jobs in other sectors at the same time (see, e.g., Phelps 2006). An important caveat vis-à-vis these stylized conclusions, which are often based on rough representations of the welfare state’s core institutions, is that the design of these institutions can matter a lot (Atkinson 1999, 9–11). For instance, measuring the strictness of employment protection in a comprehensive and internationally comparable fashion is an art of its own. It can produce slightly diverging, yet essentially robust results (see, e.g., the latest release of the EPL index in OECD 2004, chap. 2, versus Allard 2005), showing that there is considerable diversity in this respect. Benefits for the unemployed and related contingencies can be designed as an unconditional wage replacement, thus defining an implicit minimum wage (Sinn et al. 2006, chap. 1), or they can entail various measures meant to avoid moral hazard (i.e., premature quits, slack job search, etc.) and to promote entry into a new job. Likewise, instruments of “active” labor market policies, such as training programs, wage subsidies, and so on, can be used mainly to remove program participants from unemployment registers on a temporary basis, probably with a renewal of benefit entitlements exceeding attainable wages in regular jobs. Or they can be applied to increase the employability of participants and to

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build a bridge into regular employment (see Calmfors 1994 or Boone and Van Ours 2004). When trying to identify institutional arrangements that appear to be favorable for employment, Denmark, Austria, and the Netherlands have been given special attention in recent years. What is unusual about these countries, at least at a first glance, is that they reflect combinations of relatively low levels of employment protection and relatively high levels of unemployment benefits. Because this is said to combine the flexibility for quick adjustments in the utilization of labor and a sufficient level of income security for workers, the approaches applied in these countries have been labeled “flexicurity.” Furthermore, flexicurity has been praised as a benchmark for labor market regulation in other developed countries (OECD 2006; EU Commission 2007). There are indeed reasons why these two elements might be particularly useful for better labor market performance. Not regulating dismissals too strictly, or just attaching a price tag to them through transparent rules for severance pay, may in fact increase employment since it can encourage a larger number of hires whenever a firm or a sector of industry is expanding. Offering unemployment benefits with high replacement rates for quite a while is not just a measure to render lax rules regarding dismissals socially acceptable. These benefits may also contribute to higher labor productivity, because they remove pressure on the unemployed to accept any job at once and facilitate a search for better matches between jobs and workers. There are well-known counterarguments. Strict rules against dismissals may stabilize employment in a recession, so that all in all they could simply reduce cyclical fluctuations. They may also increase labor productivity in ongoing employment relationships, because they allow for higher amounts of firm-specific investment in human capital. At the same time, generous benefits paid over a long period may weaken, or even suspend, jobsearch incentives as a predominant effect, thus creating a trap for those who become unemployed. Empirical research suggests that, overall, the strictness of employment protection legislation has a negative impact on employment and the way it responds to economic growth (see Lazear 1990; Nickell 1997; OECD 1999, chap. 2; Caballero et al. 2004; or Flaig and Rottmann 2009). Unemployment benefits with high replacement rates do not necessarily turn out to be harmful (Nickell 1997; Blanchard and Wolfers 2000); rather, it is long durations of (high-level) benefits that appear to be detrimental for employment (Meyer 1990; Katz and Meyer 1990; Hunt

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1995; Lalive 2008). Taken together, these findings seem to confirm that flexicurity is a promising approach that could guide labor market reforms in many other European countries. On closer inspection, however, another key for favorable employment trends appears to be “activation” as a fundamental orientation of benefit schemes and other programs operated by the welfare state—a point strongly emphasized by Andersen and Svarer (2007).5 Activation effectively comprises a bundle of measures and design features that are all meant to prevent unemployment benefits from creating an “unemployment trap” in which individuals lack an incentive and, as more time elapses, the means to escape. In applying one or more of these features to their national benefit systems, European countries followed examples such as the U.S. welfare reforms prepared in the first half of the 1990s or the labor market reforms created in New Zealand a bit earlier. Three major “activating” elements of benefit schemes that have spread across Europe are in-work benefits, work obligations (“workfare”), and benefit sanctions attached to this and other obligations the beneficiaries are expected to meet. In-work benefits are an instrument to make work more attractive vis-à-vis the option of receiving “passive” benefits only. Depending on how they are provided, they can also serve as a targeted wage subsidy for low-skilled workers whose wages are specifically under pressure from increased international competition. In a sense, the United States invented in-work benefits when it introduced the Earned Income Tax Credit (EITC) in 1975. In the course of the welfare reforms of the 1990s, the EITC was expanded substantially to become the largest program of cash benefits for low-income households operated at the federal level. What is peculiar about the EITC, which is first phased in over a considerable range of low wages, then phased out, is that it really involves a marginal subsidy for low-paid work (as is highlighted, and questioned, in Keen 1997).6 The British version of in-work benefits, introduced in 1999 and called the Working Tax Credit since 2003, is a bit different: it becomes effective only if individuals work at least some minimum number of hours per week, and it is then gradually phased out as wages increase. As a limiting case, in-work benefits can also be integrated into programs of income support or social assistance by phasing out these benefits against beneficiaries’ own wage earnings at transfer withdrawal rates of less than 100 percent. In this sense, in-work benefits have also existed in Germany since 2005, when a major reform of unemployment benefits became effective,

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which clearly contributed to the improved labor market performance that followed. This reform was modeled, at least partly, on a proposal that was even closer to the U.S. and UK precedents (Sinn et al. 2006, chap. 5). Work obligations constitute another measure to influence the relative attractiveness of pure benefit receipt versus work at low pay. The idea is that welfare recipients who do not find a regular job should do some kind of community service in return for receiving financial support. Taking up a regular job is then no longer a matter of giving up many hours of leisure—or, as it may be, many hours of labor in the shadow economy—in order to earn only slightly more than one could get in unconditional benefits. Workfare measures can take various forms. They can be run as an almost universal obligation for all benefit recipients who are fit for work, effective at least after a certain period of unemployment, as in Denmark. Alternatively, workfare measures are sometimes restricted to specific target groups, above all young people, as in the United Kingdom. They can also be used as a willingness-to-work test for selected benefit recipients, or as a basic training program in which participants can get accustomed again to the rhythms of a standard workday and gain some self-confidence when confronted with regular duties and external demands. In reality, the latter two variants are often difficult to tell apart. By and large, they are in use in some U.S. states, in Sweden, and, most recently, also in Germany. While the welfare effects of introducing workfare against a status quo where it is lacking are disputed (Frederiksson and Holmlund 2006b; Andersen and Svarer 2008; Holzner, Meier, and Werding 2010), it is seen as an important and promising complement of unemployment benefits in an applied context (Frederiksson and Holmlund 2006a). Violating work obligations and other requirements can lead to benefit sanctions as a third ingredient of activation policies. Sanctions, such as a temporary reduction, suspension, or termination of benefits, are difficult to handle in practice. Their use requires hard evidence of misconduct by benefit recipients—a requirement the latter may soon learn to deal with. Also, case managers or others in charge of monitoring the beneficiaries’ behavior may hesitate to impose sanctions, or to transmit relevant information, for reasons regarding, for example, their family background, health status, and so on. To increase credibility, sanctions should therefore take effect rather automatically, based on transparent and plausible rules. Some of this automatism could even

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be carried over to the benefit schedule, so that people who do not participate in workfare measures effectively self-select into lower cash benefits, or are transferred to a program with benefits in kind. The effects of benefit sanctions are difficult to assess, because they may mainly consist of changes in beneficiaries’ behavior by which actual sanctions need not be applied. Nevertheless, microlevel studies based on Dutch and Swiss data have found a more active use of benefit sanctions to increase the exit rate from unemployment and lead to shorter unemployment spells (Abbring, Van den Berg, and Van Ours 2005; Lalive, Van Ours, and Zweimüller 2005). In a macrolevel assessment, which should also capture indirect effects, regional variation in the use of benefit sanctions was shown to have a significant, favorable impact on regional labor market outcomes in Germany (Holzner, Munz, and Buettner 2009). Combining the elements discussed here—flexible rules of employment protection, benefits that rather generously support job seekers during short spells of unemployment, and strict activation for those who remain unemployed for a longer time—should create an environment in which domestic employment, output, and aggregate income will increase. Firms will be less reluctant to make hiring decisions, and individuals who get laid off are bought some time to find suitable new jobs, but they have to keep trying if this turns out to be difficult. This can also end long careers of benefit receipt, which are sometimes even transmitted to children who grow up in a household depending on welfare. The main mechanism that makes this strategy work is a reduction in reservation wages of the unemployed, in particular of those who are low-skilled. The dispersion of gross wages may become wider in this scenario, as is already the case in most European countries. The forces of global competition at work in this process cannot be overruled, though, by activities of the welfare state. But if wages paid at the bottom end of the wage distribution are topped up through in-work benefits, ensuring that these jobs are there at all and offer a living to those who fill them, this situation will be more efficient and more equitable than a continuous decline in employment opportunities for low-skilled workers. Empirical assessments of U.S. welfare reform show that, against a different institutional background in which being a member of the “working poor” was probably more of a problem than being stuck in long-term unemployment, the reforms made at the federal and state level have dramatically reduced welfare dependency and even

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more dramatically increased employment. Currently, things may look different due to the recent crisis. But after the first ten years, the average income of those targeted by the reforms had risen substantially, and poverty rates among them had fallen accordingly (Blank 2002; Burkhauser et al. 2008). Turning to wage-setting systems as another important branch of the welfare state in which social partners often play a stronger role than politicians, there are a number of surprising results regarding how wage bargaining interacts with a flexicurity regime and how it may affect outsourcing decisions in a globalized economy (Lommerud and Straume 2008; Lommerud, Meland, and Straume 2009). Compared to a scenario with strict employment protection, flexicurity increases firms’ incentives to adopt new labor-saving technologies, even if managers have to take into account a response in union wage setting. If unions are given some direct influence on the technology to be adopted, they may even be more willing to accept technological change. Deunionization or, in fact, any reduction in the pressure on wages exerted by trade unions may effectively propel outsourcing and consequential job losses. The point is that, for those still employed in domestic plants, strong trade unions are able to extract the extra profits involved in producing at lower costs elsewhere. In a unionized firm with aggressive wage bargaining, outsourcing will thus only take place if it creates the opportunity to buy inputs at prices below the domestic reservation wage. If unions are weak or absent, however, managers face stronger incentives to go for higher profits, hence they will outsource more inputs. Things are different, of course, if international outsourcing is primarily about cost reductions to remain competitive vis-à-vis customers in terms of prices, hence ultimately a matter of the firm’s survival. There are other reasons why exercising or inducing wage moderation may have its limitations with regard to employment and output. Typically, seeking to moderate wages is considered useful if trade unions are aggressively negotiating for higher wages, while firms determine employment. However, things may be different if firms themselves have an interest in driving up wages to induce employees to work with stronger efforts that are not directly observable (Koskela and Schöb 2007). Combining such an “efficiency-wage” element with a bargaining model, wage moderation has ambiguous effects on labor demand through lower wage costs on the one hand and a reduction of individual workers’ effort and productivity on the other. In the

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combined model, wage moderation can in fact be taken too far, so that the adverse effects on effort become large, and employment and output fall. Again, these results may not be equally relevant for all sectors and all situations. They apply, first of all, to firms where workers are much more productive than workers in other sectors or other countries, or where unobservable effort plays a very important role in production. A potential lesson from these considerations is that, at least for those in the upper half of the wage distribution, there are no general lessons regarding principles and institutions of wage setting that are unambiguously beneficial in technologically advanced economies and in a globalized world. European countries are more or less far away from the particular setup of labor market regulation we have discussed here, with an eye on improving their employment performance. Considering the systemic character of national regulation and the path dependencies involved, it might not be useful for all of them to converge to a uniform model. Still, analyzing existing bottlenecks that specifically show up in their employment trends, they may wish to fit some of these elements, in varying blends and strengths, into their national systems. Countries that have an edge in adjusting their labor market policies may recover faster from the current crisis and may eventually be able to further reduce unemployment against earlier figures. In many countries in Europe, this is clearly a meaningful task in itself. Besides, it will be very important to prepare for the challenges through large-scale demographic aging that are going to materialize over the next two to four decades. 5.4

Dealing with the Aging Problem

Population aging is going on in virtually all European countries and will soon enter an acute phase in many of them (see figures 5.3 and 5.4). Expected shifts in the demographic structure are the result of two major trends, namely a long-term decline in birth rates that gained considerable momentum after the temporary baby boom following World War II, and a continuous increase in life expectancy through reductions in age-specific mortality that now mainly concentrate at higher ages. Together, these trends imply that there is a shrinking number of people entering their active lifespan, a large number of people at working age who are now approaching retirement, and a growing number of older people who tend to live longer and longer.

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1.86

Ireland Slovakia

1.25

Poland

1.24

2.17* 2.14* 1.94 2.04

France 1.31

Hungary

2.03* 2.06 2.02

USA 1.77

Sweden 1.28

Czech Rep.

2.01 2.01*

1.80

Finland

1.95 1.78 1.93 1.80 1.88 1.71 1.85

UK Denmark Netherlands 1.40

Portugal

1.84

1.26

Japan

1.84 1.35

Spain

1.74 1.64 1.74

Belgium 1.41

Austria

1.32

Italy

1.68* 1.67

1.34

Germany 0.0

2.47

*

1.65

0.5

1.0

1.5

Total fertility rate (2005) Cohort fertility (women born 1960) (women born 1961)

2.0

2.5

3.0

Total fertility rates/Cohort fertility rates Figure 5.3 Total fertility rates and cohort fertility rates, 2005. Sources: Eurostat; U.S. and Japan: national statistical offices

Little can be done to avoid these demographic shifts, which have been underway for quite a while. Rather, the welfare state will have to deal with a number of distinct problems that arise regarding the financial sustainability of existing social protection schemes and the prospects for future employment and growth. The sustainability of public pension schemes and other branches of social protection has long been considered an essentially political concept. However, building on two elements of economic theory, the notion of sustainability of public finances, or the lack thereof, can be given some economic content. The relevant bits of theory are the notion of an “implicit public debt” involved in unfunded social protection

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Japan

25

Italy Spain

24

Portugal

24

Austria Poland

54 51

32

16

51

27 25

Hungary

22

Finland

22

47

31

36

22 17

19

40

2000 2025 2050

38

31 34

29

20

40 40

34

23 24

10

45

35

Sweden

UK

45

40

27

Denmark

47

36

20

Netherlands

47

37

26

Belgium

0

54

32

France

USA

61

34

20

Ireland

61

40 35

18

Slovakia

64

32

23

Czech Rep.

64

39

25

Germany

76

50

27

30

40

50

60

70

80

Polulation 65+ / Population 15–64 (in %) Figure 5.4 Old-age dependency ratios, 2000, 2025, 2050. Source: United Nations (2009; World Population Prospects, 2008 revision, constant-fertility variant)

schemes and the concept of an “intertemporal budget constraint” of the government. No one should probably claim originality for the view that benefit entitlements that are linked to contributions already made, but that will become effective only at some point in the future, constitute another type of public liability that adds to explicit public debt (Hagemann and Nicoletti 1989; Van den Noord and Herd 1993, 1994). There are effectively several ways of defining and measuring the burden involved in this implicit type of debt (Holzmann, Palacios, and Zviniene 2004). Also, one should keep certain differences between explicit and implicit public debt in mind (Haveman 1994; Disney 2001), the most important point being that the latter can be altered rather easily through political

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decisions—for example, on pension reform. Nevertheless, the notion of an implicit public debt is extremely useful in understanding the welfare state’s financing in general, and the way it will be affected by population aging in particular. As long as the government’s power to tax is seen as a reliable source of future revenues, there are no binding limits on the amount of public expenditure in a single fiscal year. The only constraint that governments really have to observe is an intertemporal budget constraint by which they must be able to cover all current and future expenditures plus the current amount of outstanding debt from all current and future revenues collected over a virtually infinite time horizon (Blanchard 1990; Auerbach, Gokhale, and Kotlikoff 1991). In any given year, the government is thus free to issue some amount of fresh debt considering, for example, the need for public investment and public services, or the cyclical situation of the economy. But because the series of annual deficits, or surpluses, accumulates over time, while the government at least has to pay interest on the existing amount of debt in each year, it must keep the aggregate level of debt within reasonable limits. Taken together, the notion of implicit debt and the concept of an intertemporal budget constraint imply that, when making decisions about future entitlements vis-à-vis the welfare state, the government must always have an eye on the expected time trends of how these entitlements will materialize and how they can be financed. Whether officially accounted for or not, implicit government debt will become explicit debt over time if the corresponding benefit entitlements are not covered from contributions, or from general taxation, as soon as they become effective. They may then lead to increases in the level of debt that would result in an explosion of the debt-to-GDP ratio. Such a scenario becomes all the more likely through a number of consequences of population aging: slower growth of GDP resulting from slower growth, or even a reduction, in the number of active individuals; and strong increases in old-age dependency through lower fertility and higher longevity, specifically accentuated through the relative size of the aging baby-boom generation. Against this background, the only ways of rendering the welfare state sustainable in the long run are reductions in future benefit entitlements, reductions in other public expenditures, increases in contribution rates and tax rates, or any feasible combination of these three approaches. In any case, the prospects of aging are already imposing tight restrictions on public finances in many European countries.7 This is a development that ought to be

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acknowledged before we turn to discussing specific problems relating to single branches of the welfare state. When the prospects of aging first became apparent, including the problems it meant for financing public pension schemes, many economists expressed a profound discontent with the widespread form of unfunded pensions prevailing in the first pillar of national systems of old-age provision (see, for instance, Feldstein 1977 or Townley 1981). In their view, unfunded pensions were mainly seen as securing some amount of minimum provisions for old age for everyone, at the cost of offering an inefficiently low rate of return. Through the absence of assets and a consequential loss of compound interest, the low rate of return appeared to be directly linked to the pay-as-you-go mechanism. Therefore, many economists recommended a transition—at once or as a gradual conversion—from unfunded to fully funded pensions. However, closer scrutiny revealed that this view was flawed. The expectation that it should be possible to cover all existing benefit entitlements (i.e., the implicit debt involved in unfunded schemes), by taxing away part of the higher returns accruing in a new, funded system turned out to be wrong (Breyer 1989; Fenge 1995).8 Instead, unfunded pension schemes were shown to be mainly an instrument of intergenerational redistribution that is basically efficient (for a straightforward demonstration, see Sinn 2000). Important qualifications of this result are only required if aspects of the demographic process are considered endogenous. One of the most intriguing aspects of population aging and its impact on the welfare state’s finances is that, to some extent, the aging process may be caused by the introduction of unfunded public pensions that shift resources over the life cycle and redistribute between subsequent generations. If fertility is taken to be endogenous,9 with the motive to have children being linked to some kind of intergenerational exchange, an external stabilization of this arrangement may be needed to make it viable, at least under the conditions of modern society (Samuelson 1958; Rangel 2000; Cigno 2006). Large and liquid capital markets enable individuals to build up funds for their old age and to turn them into consumption by selling them to others, typically the next generation. This may substitute for the traditional role of children as “capital goods”—that is, as a possible source of old-age income. Conventional pay-as-you-go pension schemes—and also pay-as-yougo financed healthcare systems, and so on—offer another instrument for transferring purchasing power from working age to old age. Both

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types of innovations should thus reduce the incentives to have children and to invest in their education (Cigno 1993; Werding 1998, chap. 5; Cigno and Werding 2007, chaps. 5 and 6). At the same time, pay-asyou-go schemes of social protection are funded—by the human capital embodied in the next generation of taxpayers. Depending on their generosity, systems of this type socialize a considerable portion of the returns to human capital investment, thus creating a fiscal externality to parental fertility choices and all kinds of childrearing activities. Since these systems were first established and then expanded to their current coverage, children are less and less needed at an individual level as a means of securing support in old age, while at an aggregate level the schemes still rely on the existence and the productivity of a new generation. Empirical studies suggest that this distortion may not explain all of the fertility decline in developed countries observed since the late nineteenth century, but that public pension schemes, by their size and by the amount of intergenerational distribution involved, have a significant, negative impact on fertility (Cigno and Rosati 1996; Cigno, Casolaro, and Rosati 2003; Ehrlich and Zhong 1998; Ehrlich and Kim 2007; Werding, Munz, and Gács 2008). In a critical assessment, Konrad and Richter (2005) point to a number of difficulties in fully developing the implications of this view for efficiency. First of all, endogeneity of the population size invalidates any conventional Paretian welfare analysis accounting for the welfare of (potential) children (Kolmar 1997). Also, if children are seen as an investment good, designing an appropriate framework for all kinds of investment decisions, including a proper design of systems of old-age provision, is essentially a problem of second-best taxation. Whether and, if so, how much childrearing should be taxed is then simply a matter of how elastically they are supplied compared to other tax bases. Nevertheless, the low fertility rate causes a practical challenge for the sustainability of pay-as-you-go financed pension systems. Solving this problem is not easy—and will in any case be too late to avert the aging problem altogether. As an immediate response, there are good reasons for scaling back unfunded pension schemes to make the burden of financing them under increasing dependency ratios bearable for younger generations, now and over the next thirty years or so. To make up for the reduction in benefit levels for those entering retirement in this period, partial prefunding clearly becomes useful—for instance, through the introduction of “demographic buffer funds” inside public pension schemes or in terms of supplementary private savings.

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Members of the generations that, on average, had lower expenditures on children, simply because they had fewer of them, then would have to spend more on the alternative way of providing for old age through capital accumulation (Sinn 2000). To take care of parental fertility incentives and considerable heterogeneity in fertility across households, one could go even further, linking unfunded pension benefits to the number, and probably also the productivity, of each beneficiary’s children (Cigno and Werding 2007, chaps. 7 and 8). In fact, France, Germany, Sweden, and a few other countries have already moved in this direction (Cigno and Werding 2007, chap. 4). But the effect of these measures on total benefit entitlements is still rather small. Also, if they really increase fertility, this will only affect the financial situation of unfunded pension schemes in about thirty years’ time. In European and other OECD countries, numerous approaches have been taken to adapt national pension systems to the challenges involved in aging. (For a review of such policies and an assessment of their impact on the intergenerational distribution in a limited number of countries, see Fenge and Werding 2004.) Virtually everywhere, incremental changes have been made, often more than once, in eligibility rules and in the rules for benefit assessment and up-ratings in order to scale down benefit levels over time. Given the very large, and relatively old, generation of its baby boomers, the United States was actually the first developed country to respond to aging through large-scale social security reform. As early as 1983, the United States decided to introduce an element of prefunding into its public pension scheme, via the Social Security Trust Funds, to “tunnel” the temporary peak load resulting from the retiring baby boomers without reducing pension benefits very drastically. Since aging starts later, but is more rapid and longlasting, in most European countries, bringing down rather generous benefit levels has been unavoidable there in many cases. Italy (in 1995, though with a very long transition period), Sweden (in 2000), and, up to a point, also Germany (in 2004) have gone as far as converting their old public pension schemes with defined levels of benefits to schemes with “notionally defined contributions,” making future benefit levels essentially a function of demographic indicators. In addition, prefunding for future benefit entitlements has been strengthened in various ways. Finland (in 1997), France and Ireland (in 1999), and Spain (in 2001) have followed the United States in establishing demographic buffer funds in their public pension systems. Denmark (in 1999) and Sweden (in 2000) have introduced mandatory but very flexible systems

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for supplementary savings that are located exactly on the borderline between public and private provisions. Germany (in 2001) and France (in 2003) have started to subsidize private, voluntary provisions. To tighten public pension schemes, a number of further measures have been taken that aim at strengthening actuarial fairness within these schemes. Before these reforms, benefit assessment was often based on a limited number of “best years,” or on “end-of-career” values of covered wages. The number of relevant years was then extended, sometimes to approach the full length of the working life. Reforms of this kind were made, for example, in Italy (in a first round of reforms enacted in 1992), in France (in 1993), or, more recently, in Austria (in 2003). Another point that belongs to the same category of reforms is the abolition of incentives to retire early—an important issue in many European countries, because the effective retirement age is often rather low there (for in-depth analyses, see Fenge and Pestieau 2005). For a while, artificial incentives in favor of early retirement had been used as an instrument to fight unemployment, the idea being that older people should make way for higher employment among young workers. This strategy did not work, since firms and workers mainly used these rules as a socially accepted way of reducing staff and giving up work backed by generous third-party payments. It was later terminated and even reversed. Europeans appear to have a strong preference for an early exit from the labor market. But reductions in benefits in all cases of early retirement now address the third-party payment problem, and even though these reductions are not always actuarially fair, they have already had a considerable impact on effective retirement ages. Another approach to dealing with the aging problem in the context of old-age provision is to increase the statutory retirement age, or the age for claiming full benefits, in line with the ongoing increase in life expectancy. Provided that it really leads to an increase in the effective retirement age, this approach is potentially powerful in reducing financial strains through aging: reducing the number of pensioners and at the same time increasing the number of active individuals, it can substantially reduce the systems’ dependency ratio. It may thus allow for higher levels of benefits—that is, more adequate provisions—for any year spent in retirement without driving up contribution rates. It also has beneficial side effects for financing other social protection schemes if their funding is based on payroll taxes. Furthermore, it may increase the gross domestic product as an important yardstick for most of the measures of fiscal sustainability of the entire system of social

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protection. Thus far, the United States has taken action on this front (beginning in 2000, based on a gradual scheme enacted in 1983), and Germany is currently following (beginning in 2012, as set out in 2007). In both cases, the age for claiming full benefits will go up from sixtyfive to sixty-seven for males and females alike over a period of twentyfour years (in the United States) and eighteen years (in Germany).In Denmark, the statutory retirement age will be increased from sixty-five to sixty-seven (enacted in 2009, taking effect from 2024 to 2027) and will then be linked to the conditional life expectancy at age sixty. Given the expected increase in life expectancy until around 2030—and given the size of the aging problem—more European countries may have to follow and there may be room to go even further in this direction. Following several rounds of reforms with respect to old-age provision, there are now growing concerns about the consequences of these reforms in terms of the adequacy of future provisions and the fairness of new arrangements. Old-age poverty may indeed become a much more prominent issue in the next few decades than it has been so far. New dimensions of potential inequities may become apparent if pension schemes are tightened following one or more of the routes sketched above. A particularly important aspect is the variation in life expectancies that appears to have some systematic features, being positively linked to levels of income, education, and labor-force participation, but also differing strongly between males and females. New approaches to assessing pension benefits for different groups of individuals may thus deserve closer inspection (see, e.g., Breyer and Hupfeld 2009). A particularly interesting detail in this context relates to the definition of benefit reductions in cases of early retirement. If life expectancies vary systematically by income or years with covered earnings, deduction schedules based on uniform (or gender-specific) life tables may in fact be inappropriate to establish actuarial fairness, and they may also violate some basic notions of equitable redistribution. Instead, deductions inversely related to covered earnings might be called for (Breyer and Hupfeld 2010). While a lot has been done to increase the fiscal sustainability of public pension schemes in light of the aging of the population, things are different with respect to financing public healthcare and public schemes providing for long-term care. Usually, these schemes are also unfunded, being financed from current tax revenues, earmarked payroll taxes, or a combination. Expenditures for these schemes typically have a pronounced age-related profile, in long-term care much more so than

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in healthcare, with the average cost of services per insured individual strongly increasing from about age sixty onward. Older individuals typically continue to contribute to financing these schemes, but the age profiles of average net benefits are basically similar to those of a pension scheme. Consequently, a shrinking number of young and middle-aged people and a growing number of older people will create similar tensions regarding the relevant schemes’ financial balance as aging unfolds. Nevertheless, purely demographic trends need not mean a threat to the existence and financial viability of public healthcare systems (see, e.g., EU Commission and Economic Policy Committee 2009, chap. 3). The ongoing increase in longevity may translate into a higher number of years spent in relatively good health, implying a shift in the agerelated profiles of average costs and net benefits. At the same time, simulating future expenditures for healthcare and long-term care involves much higher uncertainty than running projections for future pension expenditures. The reason is that health insurance mainly offers coverage for a package of benefits in kind that may consist of different components and may be priced in a very different way in the future compared to the status quo. The components of these packages as well as their price tags are heavily influenced by a specific kind of technical progress that, so far, appears to be a major driver of total costs. Assuming that the extra increase in expenditures per insured individual will remain as high as in the past, it is easy to construct less optimistic scenarios for the future course of public health expenditures in most European countries, which would become very burdensome for those who have to absorb the costs. It is thus important not to forget about these uncertainties and to prepare for the eventuality of strong upward trends in health costs and expenditures on long-term care. At the same time, both the provision of health insurance and the delivery of health services are fields that are rife with market failure and that have a massive distributive impact, so that purely market-based solutions were not even attractive if one could solve the transition problems from the current situation with strict regulations and many other instances of public involvement to deregulated, private schemes. Instead, seeking to install an intelligent framework for “managed competition” (Endhoven 1993, 2004), with a strong role for a small number of purchasers, may be the way to go. Dealing with the prospects of increasing health costs in such a framework can mean one of three things, or any combination. First, efforts can be made to reduce existing inefficiencies that inflate current health

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costs, in order to make room for a nonwasteful increase in health expenditures. Second, to the extent that the direction of technical progress in healthcare is endogenous, there may be options for redirecting it in the future. For instance, less invasive forms of treatment that expand the scope for outpatient care may spread around, saving money when this becomes a top priority in healthcare funding. In spite of any such changes, however, the future agenda in health policy may be shaped by the search for a balance between keeping healthcare finances sustainable and making new and costly high-quality services available for as many people as possible. Problems of rationing will therefore become more prominent than they are now. Third, and partly addressing this problem, establishing some kind of partial prefunding for future health costs may also become an important issue, as it already is in old-age provision. Prefunding for health costs could be brought about by introducing two layers or two pillars of health insurance. In a two-layer strategy, public health funds might be restricted to providing some kind of basic coverage, while supplementary private insurance would be needed to get access to a full range of up-to-date health services. In a two-pillar strategy, richer individuals could be forced to buy private coverage, including an element of prefunding for higher health costs at higher ages, while they would also have to pay for redistribution toward the poor involved in public schemes if contributions to the latter are being subsidized from general income taxation. Note that public healthcare systems typically offer lifelong coverage, implicitly insuring individuals against the health-status risk. In private health insurance, this is far from being standard, although it should clearly increase welfare. To preserve this element in private, prefunded systems, contracts with long-term commitments are one alternative (Pauly, Kunreuther, and Hirth 1995; Baumann, Meier, and Werding 2008). Contracts that explicitly insure for the risk of health-status change are a more elegant solution (Cochrane 1995), but may have too high transaction costs. Many health economists agree about the aforementioned principles and the basic alternatives for reforming current healthcare systems. However, given the diversity of arrangements that exist at the national level, there is no agreement regarding actual steps to be taken. In turn, politicians have mostly confined themselves to enacting a number of incremental changes, but they have rarely considered more fundamental reforms in this area. Fixing the problems in financing healthcare and

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long-term care of an acceptable quality during the upcoming period of overt population aging is therefore largely unresolved. Aging not only affects social protection systems, even though the resulting problems in this field are most visible and also best explored. That slower growth, or even a reduction, in the labor force will reduce aggregate economic growth along its “extensive” margin is one of the obvious consequences and, at least from an economist’s point of view, not particularly disturbing in itself. With increasing dependency ratios, this will most likely translate into a reduction in “intensive” or per capita growth rates. The key question is whether there is any systematic impact of a shrinking labor force on the productivity of those who will still be active when aging is progressing. Empirical research shows that capital deepening may not be particularly effective in keeping up growth rates (Brander and Dowrick 1994; Ahituv 2001). At the same time, there is evidence for strong adverse effects of the age composition of the labor force on the growth performance in economies with an aging population (Lindh and Malmberg 1999, 2007; Feyrer 2007; Werding 2008). The reason, it seems, is a pronounced age-related profile of contributions to growth in total factor productivity that could be related to innovations, entrepreneurship, or the education-experience mix represented in work teams and total staff at the level of firms or whole sectors of industry. But this clearly needs closer inspection—for example, based on firm-level data. Still, it could be bad news for countries that are aging fast, because weaker growth performance will make it even more difficult to keep social protection systems economically viable and to solve political conflicts regarding reforms of the welfare state. Many of the unfavorable consequences of population aging may be reinforced through their implications for public decision making. Winning political support for adjustments in existing institutions that have been discussed in this section could become difficult with an aging electorate. Taking pension reform as a prominent example, Sinn and Uebelmesser (2003) show that reductions in the generosity of the German pension scheme that also reduce contribution rates for active workers will no longer be politically feasible soon after 2020. The reason is that, given the age structure of the population, the median voter will then be too old to benefit from reforms of this kind, while underage individuals (and future generations) who would benefit are not participating in the political process. The same reasoning applies, probably with a different timing regarding the impossibility of political

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changes, to all types of public activities that create age-specific benefits (Montén and Thum 2008). Once a country has reached this stage of a “gerontocratic” society in which the old generation constitutes a majority, a few more effects may limit the level of pension benefits even if the old generation is perfectly selfish. First, endogenous labor supply typically renders aggregate pension contributions Laffer-curve shaped, leading to a contribution rate much smaller than 100 percent (Breyer 1994). Second, the old generation may have an interest in making productivity-enhancing investments in their children that may even exceed the socially efficient amount of investment, thereby increasing the tax base for pension contributions (Konrad 1995b). Third, emigration constitutes another important break against an unconstrained increase in the contribution rate. However, the threat of emigration also distorts investment behavior of the old in a gerontocracy (Konrad 1995a). Since human capital is mobile, whereas physical assets are immobile, a gerontocracy will invest more strongly in physical assets and may underinvest in the human capital of the next generation. 5.5

Managing International Migration

For many European countries, managing international migration more carefully than they have in the past is an important issue, both with respect to improving their employment performance and with respect to handling the problems related to population aging. Traditionally, most European countries have not imposed active immigration policies, seeking to attract migrants with a focus on their skills and employability. In the postwar period, they have nevertheless received a substantial amount of migration based on historical links, for instance, to former territories and former colonies. During the 1950s and 1960s, countries in Western Europe actively recruited workers from Southern Europe and Turkey in order to avoid a labor shortage, but did not pay much attention to the qualifications and the long-term labor market prospects of these “guest workers.” Later on, when growth slowed, they usually attempted to close the doors on this kind of migration, but immigration was often allowed to continue based on family reunification and other humanitarian factors. The size and structure of the current immigrant populations in European countries (see figures 5.5 and 5.6) are therefore the outcome of complex processes that were partly driven by the choices of potential migrants and partly by histori-

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USA

14.5

Sweden

14.4 13.8

Austria 12.5

Germany

19.5*

12.0

Belgium

11.7

France

11.2

Netherlands

11.0

Ireland 9.4

UK

9.0

OECD 7.4

Denmark

6.7

Portugal 5.5

Spain

5.2

Czech Rep. 4.1

Italy 3.2

Hungary

2.9

Slovakia

2.7

Finland

* Including ethnic Germans from Central or Eastern Europe, estimated

2.4

Poland Japan 1.1 0

5

10

15

20

Migrants among total population aged 15+ (in %) Figure 5.5 Immigrants’ share in total population, 2000. Sources: OECD (DIOC database); authors’ calculations

cal contingencies. Political decisions made in potential destination countries also played a role, but up until the 1990s these decisions were not really based on an active management of migration and a deeper understanding of the motives of migrants and their impact on labor markets and social life in the destination countries. As a fundamental principle of the treaties establishing the European Communities, all member countries agreed at a very early stage to give free mobility to workers and job seekers with EU citizenship, as well as their families. As long as European integration was essentially a Western European project, the amount of migration covered by these provisions was limited. Things changed when the Iron Curtain fell and the period of economic transition in Central and Eastern Europe began.

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41.9

OECD 29.5 36.9

Denmark

41.1 54.7

Portugal 49.2

Netherlands

52.6

Finland

54.8

France 29.3

Slovakia

45.8

Germany

Primary Secondary Tertiary

Austria 0%

24.3

46.2

24.3

39.2

23.9 23.0 21.1

39.1

19.8

25.9

19.3

31.6

19.2

28.5

18.9

27.2

18.1

55.0

15.7

39.3

14.9

38.6

Czech Rep. Italy

33.8

22.6

56.3

Spain

26.1

23.8

53.3

Belgium

Hungary

30.0

34.7

39.2

Sweden

34.8

44.2

25.9

USA

Poland

41.1 24.5

40.6

UK Japan

29.3

29.6

Ireland

20%

48.7

12.8

33.5

12.2

47.9

40.3

11.9

49.4

39.3

11.3

54.3

40%

60%

80%

100%

Per total migrant population aged 15+ (in %) Figure 5.6 Immigrant population by educational attainments, 2000. Source: OECD (DIOC database)

Once the borders between East and West were opened that had been blocked for several decades, huge migration flows set in that lasted for a short time. Fears related to high levels of unemployment and potential pressure on domestic wages led many Western European countries to restrict this wave of migration. Later, when the European Union expanded to the East, transitional arrangements were devised enabling governments in the old EU-15 to suspend free mobility vis-à-vis the major accession countries for a few more years. However, beginning in 2011 (2014 in the cases of Romania and Bulgaria), free mobility of labor is now fully established within the extended European Union.10 Because the EU-level legal framework prohibits the use of selective immigration policies, this may necessitate the design of a new type of migration

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policy in many European countries, focusing on “self-selection” processes among those who are considering moving in a particular direction rather than on legal barriers and administrative procedures. In recent years, political intentions regarding migration have shifted somewhat. In many developed countries, awareness has grown that attracting migrants, especially skilled ones, may be important for maintaining economic growth, strengthening businesses in international competition, and keeping social protection systems financially viable. In fact, as their populations age, many EU and OECD countries will be competing for talent from all over the world. Countries that are losing ground in this competition may face a brain drain to other advanced economies—a phenomenon that may already have set in from Europe to the United States, if only on a small scale (Saint-Paul 2004; Geis, Uebelmesser, and Werding 2011). At the same time, there are still concerns that large inflows of unskilled migrants may increase unemployment, mainly among native workers who are covered by the welfare state, and may overburden the receiving countries’ social protection systems in many other ways (Richter 2002, Sinn 2005; for an empirical survey on welfare tourism, see Brueckner 2003). For migration policies to become more active and at the same time more selective, as far as the EU-level legal framework permits, it is important to understand how migrants are choosing between potential destination countries. Thus far, economic theory and extensive empirical research have established a core set of determinants of migrants’ location choices. From the perspective of potential migrants, wage differentials between their countries of origin and the destination countries, employment prospects in the destination countries, and networks of earlier migrants from the same countries of origin or the same ethnic groups are seen as the most important factors driving international mobility and directing migrants to particular destination countries. It is also clear that the destination countries’ immigration policies, especially rules regarding entry, residence permits, and work permits, play an important role on the “demand” side for actual migration. Due to a lack of appropriate data,11 however, many other issues have not been investigated in much detail thus far that could have a bearing on decisions to live and work abroad, either temporarily or permanently. In particular, little is known about the role of the institutional settings in destination countries with respect to their attractiveness for potential migrants. One would assume that factors such as labor market regulations and the design of social protection schemes have some

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influence on migrants’ choices, directly or through their impact on wages and employment opportunities. Still, the direction and strength of such effects are a priori open. To the extent that labor market institutions lead to higher wages and create job security, they may add to a country’s attractiveness for migrants. On the other hand, to the extent that the same rules create insider-outsider problems and, while being beneficial for incumbent jobholders, impede the migrants’ access to jobs, the reverse may hold true as well. Depending on how they are designed, generous but expensive welfare systems may have similarly ambiguous effects for attracting migrants. Furthermore, these effects may differ strongly for different groups of migrants. For instance, rules and benefits that are particularly attractive for migrants with low skills may be irrelevant for migrants with higher skills or may actually deter them, leading to an unfavorable selection of migrants in countries employing these institutions. In a sense, this is the essence of the “welfare-magnet” hypothesis originally established with respect to internal migration within the United States, focusing on differences in welfare benefit entitlements between different states (Borjas 1999). In existing work on international migration, which is mainly based on macrolevel data, the welfare-magnet hypothesis has been tested in a rough fashion only. It is sometimes found to be insignificant (Pedersen, Pytlikova, and Smith 2007) and sometimes confirmed (Docquier, Lohest, and Marfouk 2008), the main limitation being that there are no good aggregate-level measures for the generosity of welfare benefits and services for migrants, taking into account all kinds of heterogeneity that matter in this area. Also, the effects of the relevant rules may be obscured by legal restrictions, preventing many migrants from choosing the institutional setting that would be most desirable for them. Preliminary evidence based on microdata for a narrow set of potential destination countries (i.e., the United States, Germany, France, and the United Kingdom) also lends some support to the welfare-magnet hypothesis, showing that better healthcare and better education systems tend to have a positive impact on the probability that migrants will choose a particular destination country, while higher pension benefits tend to have a negative impact (Geis, Uebelmesser, and Werding 2008). The same set of estimates also indicate that stricter employment protection appears attractive for migrants, but there are also indications of insider-outsider issues involved in migrants’ willingness to enter countries with inflexible labor markets. More research based on richer data is certainly needed in this area, since the above results regarding the

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role of labor market institutions in directing migration flows are still unique, and the debate on the empirical significance of the welfaremagnet hypothesis is not fully settled. Still, labor market institutions as well as social protection systems may effectively form part of a broader set of potential tools for managing international migration, especially in a free-mobility framework. In turn, one should carefully consider the effects of migrants, differentiated by relevant socioeconomic characteristics, on the functioning of national labor markets, tax systems, public pension schemes, and so on. Given the huge variation in average income and also in welfare systems across the enlarged European Union, the welfare-magnet hypothesis may become an issue in Europe in the future, following the transition to full free mobility of workers in the EU-27. The same may apply to the extended mobility rights linked to EU citizenship that have been established in recent years (see the Directive 2004/38/ EC on the EU citizens’ right to move and reside freely within the territories of the member states). Behind the question of whether the welfare-magnet hypothesis is, or will be, relevant for the European Union, there is effectively a more fundamental problem for the European welfare state. While, for an economist, many fears of the general public regarding the impact of immigrants on labor markets are exaggerated or misguided, the impact on social protection systems can be really detrimental. In other words, while migration driven by wage and productivity differentials is basically welfare-enhancing, migration induced by public transfers is distortive and can lead to an erosion of the welfare state. Unfunded public pension schemes represent an important exception to this proposition, all the more so when these schemes are based on a strong tax-benefit link. Under reasonable assumptions, migrants can be expected to make considerable net contributions to public pension schemes operated in their destination countries (Sinn 2001; Werding and Munz 2005).12 However, depending on their employment status and wage earnings, hence mainly on their qualifications, migrants can benefit substantially from the redistribution involved in many other branches of social protection (see, e.g., Sinn et al. 2003, chap. 4). In the absence of legal obstacles, they may decide to go where they create the largest net fiscal burden for the receiving country’s welfare system. In turn, to deter these migrants as well as to prevent richer individuals from escaping the system, adjustments may have to be made in national social protection systems which, intentionally or not, form part of an international “race to the bottom” (for a

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rigorous analysis, see Sinn 2003, chaps. 3 and 4). The fundamental problem is thus that the redistributive tasks the European-style welfare state is expected to accomplish are incompatible with free mobility—at least, if free mobility of workers, or even all persons with EU citizenship, is taken to imply immediate inclusion in the destination country’s welfare system. Redistribution can only be agreed on by, and can only be applied to, a well-defined group of individuals. If the number of people at the receiving end of the tax-transfer system can grow indefinitely through free mobility, the welfare state is no longer operational and, more profoundly, loses its justification. Up to a point, international competition may be useful for triggering reforms of existing welfare systems that perform poorly in terms of efficiency. However, there is certainly a “hard core” of redistributive activities of the welfare state that cannot be improved on, but will disappear when exposed to competition.13 In this situation, scaling back the welfare state is not a solution, but effectively part of the problem. From the point of view of richer countries, the same applies to an international harmonization of welfare standards at very low levels, such as those provided in poorer source countries. Harmonization at higher levels is impossible, because the poor countries could not afford this. Therefore, to protect some core activities of the welfare state against the erosive forces of systems’ competition, one must either restrict free mobility, or one must carefully limit the inclusion of immigrants in the destination country’s welfare system. A solution of this type has been proposed by Sinn et al. (2003, chap. 5; strongly supported by De Ménil 2005). They recommend a delay in the inclusion of immigrants in the destination country’s welfare system—specifically, in a core set of tax-financed income-support measures and housing subsidies—by five to seven years. During this period, immigrants should be treated based on the country-of-origin principle to make sure that migration choices are mainly driven by incentives arising from economic fundamentals, not by differences in benefit entitlements. In practical terms, this solution amounts to establishing “transition periods” at an individual level, not between groups of countries, such as the EU-15 and the CEE-8, and to allowing free mobility of workers immediately, not after several years. It may thus be more in the spirit of the European integration than the transitional arrangements defined for EU Eastern enlargement, even if it may be difficult to reconcile with the current principles for EU-level coordination of social law.

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While the fiscal effects of unrestricted migration in an enlarged European Union may be a cause for concern, there are good reasons to think about new approaches to attracting migrants with higher skill levels, both from inside and outside the European Union. With respect to attracting qualified migrants from other European countries, much of what has been said earlier about boosting employment and fully utilizing the potential labor force among natives (see section 5.3) may also matter. What is useful for improving the labor market performance through a better institutional framework within potential destination countries is essentially also a way of managing migration in a freemobility-of-labor regime. With respect to migrants from outside the European Union, the legal framework leaves much more room for an active selection of immigrants who are welcome. Nevertheless, the determinants of potential migrants’ willingness to move to a specific destination country should also play a larger role in this context. For instance, if network effects are very strong, so that the composition of existing immigrant populations must be considered a strong predictor for the characteristics of future immigration, migration policy should soon start to actively cultivate the “sprouts” of promising new networks. Keeping national borders and domestic labor markets closed until current demographic processes turn into an accelerating decrease in the working-age population, and then expecting an ideal selection of migrants to wait for access, may be ill-advised or even foolish. Attempts should soon be made to encourage high-skilled people to immigrate, not restricting their employment options to a narrow set of sectors and “specialized” occupations, combined with high limits for minimum earnings they must be able to attain in their destination countries. Rather, these individuals should be given a long-term perspective for staying in the destination countries together with their families. Also, countries foreseeing a future need for qualified migrants should soon start to devise ways of identifying those they are willing to admit. International experience suggests that flexible “score systems” valuing age, formal qualifications, job experience, and language skills are probably most suited to getting a grip on the long-term employability of potential immigrants—more so than traditional priority lists and quotas for specific source countries and professions or for specific target regions and industry branches (Ochel 2000a, 2000b). To address short- and medium-term shortages in the labor supply, even new approaches based on auctions of visa and work permits, among

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immigrants or among domestic employers, might be of interest (Ochel 2001). Considering the substantial degree of disagreement in the general public and the conflicting interests of various lobbying groups, such as trade unions, employers in different sectors, and so on, political decisions in this area can take a long time to arrive at and to be implemented. From a global perspective, the “international competition for brains” may induce inefficiencies similar to the ones involving mobile capital that have been studied extensively in the tax competition literature. However, from the point of view of individual countries in Europe, rational immigration policies ought to be implemented soon enough to leave time for further adjustments if needed. Quite a few European countries are still lagging behind in the prospective international competition for skilled migrants. 5.6

Conclusion

In most developed countries, political agendas are currently shaped by the desire to deal with the financial crisis that evolved in 2008 and turned into a deep recession in the real economy. The way this crisis arose has demonstrated that the state has an important role to play in market-based economies in creating and maintaining an economic order—that is, a fundamental governance structure with ramifications in many sectors of economic activity. The crisis may also have strengthened the feeling that the welfare state is basically desirable in a system of decentralized competition that is both efficient and socially balanced. Apart from these general lessons, some of the issues discussed in this chapter may now be perceived as less urgent. However, where they exist, the structural problems impeding job creation and higher employment, or impairing the long-term sustainability of social protection systems, will certainly not disappear with the crisis. Nor will the policy implications outlined here become invalid. We have identified three major sets of issues that deserve special attention with regard to reforming the welfare state as it typically exists in European countries. These are (1) labor market performance and labor market policy, (2) the impact of population aging on social protection schemes and public finances, and (3) the opportunities and risks involved in extended international migration. As to the first area, strategies for increasing employment should ultimately rest on two pillars. On the one hand, countries need to consider with some care their attractiveness for capital investment, both

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from domestic sources as well as from abroad. While some amount of outsourcing and outward FDI is not necessarily harmful, a continuous outflow of capital and jobs should be seen as alarming. On the other hand, labor market policy should be geared toward activating the unemployed, especially those with low skills, who are affected most strongly by increased international competition. A key factor with respect to both these issues is the design of labor market institutions. Ideally, their overall bundle as well as the various details involved should combine elements of flexibility in the utilization of labor and elements of security for workers and job seekers, complemented by a continuous activation of the unemployed. Together, these elements should create an environment in which firms are more willing to hire and individuals who get laid off are bought some time to find suitable new jobs, but they have to keep trying if this turns out to be difficult. Consequently, domestic employment, output, and aggregate income increase. The aging of the population is obviously a threat to the long-term sustainability of public pension schemes, public health funds, and public finances in general, at least in countries that are particularly hard hit. Since ongoing shifts in the population structure have been underway since the 1970s, there is no way of simply suspending these shifts within a short time. Dealing with the consequences is now essentially a matter of intergenerational redistribution, where an appropriate balance has to be sought between burdens imposed on the old and the young. In recent years, many of the countries affected have made considerable progress in reforming their systems of old-age provision, mostly by reducing benefit levels that will be effective over the next two to three decades. Similar problems involved in healthcare systems are largely unresolved. A distinct problem in this area relates to the future affordability of high-quality medical treatment, because the cost of technical progress may add substantially to purely demographic trends. With respect to old-age provision, partial funding through higher precautionary savings of younger cohorts forms an important part of many reform strategies. Attracting migrants, mainly skilled ones, can be helpful for many developed countries, both in improving their labor market performance and in dealing with the aging problem. With respect to designing migration policies in a European context, one has to distinguish between migration inside the European Union and immigration from other countries. Within the current EU-27, the principle of free mobility

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of workers and their families will be applied without any further restrictions beginning in 2014 at the latest. Using the traditional tools of immigration policies to actively select among potential immigrants from these countries will thus be impossible. While widely held fears regarding the impact of migrants on labor markets in such a freemobility regime are misguided, the impact on social protection systems can be harmful. Generous welfare systems can lead to an unfavorable self-selection of those migrating to a particular destination country. In turn, this can trigger an international “race to the bottom” in the coverage provided by the welfare state. Changes in the EU-level social laws may therefore need to be considered. At the same time, countries seeking to attract migrants with better skills—from within the EU as well as from elsewhere—should also study with some care the incentives directing potential migrants in their location choices. Attractiveness for migrants who would be welcome may thus become an interesting subissue in designing or reforming a given country’s institutional setting. Vis-à-vis non-EU citizens, new approaches may seem attractive from a single-country or a European perspective, in order to actively manage their immigration and to shape the size and structure of future immigrant networks. A more general theme arising from many of the issues considered in this chapter is that, as a consequence of globalization and economic integration, competition among nations is becoming a major source of problems in terms of operating the traditional European welfare state. The various attempts to address these challenges offer a number of examples where European countries could learn from each other. However, harmonizing or even centralizing labor market policies and social protection systems across Europe is, in our view, not a meaningful answer. In some cases, seeking solutions at a national level may prove insufficient or even misguided, because it may lead to precisely the “race to the bottom” in the welfare state’s activities that needs to be avoided. In addition to conventional solutions along these lines, the nationstates may try to devise new means for stabilizing their current institutional setup by enhancing their citizens’ loyalty in a more and more competitive environment. Much like customer loyalty in the competition between firms, a “friendly” type of patriotism may serve a similar purpose.14 Geys, Konrad, and Qari (2011), for instance, show empirically that countries with more patriotic citizens are able to charge higher taxes. There is at least piecemeal evidence that some countries

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already apply such measures and actively use their ability to design education policy to strengthen this type of loyalty (Konrad and Qari 2011). Given that nationalism is the nasty cousin of patriotism, and even patriotism itself may have a number of undesirable side effects, we clearly would not like to recommend such a policy. Still, it is important to note that governments pushed by their financial needs have to think about ways to promote identification with, and loyalty toward, a particular state with a specific set of national institutions in an attempt to preserve and remodel the welfare state for the twenty-first century. Notes 1. The Austrian philosopher Wittgenstein (1953, part I, remark no. 67) coined the phrase “family resemblance” for the way in which many words can have differing yet related meanings in any spoken language. We may borrow this notion here as a heuristic device by which we can avoid discussing historical and systemic links. 2. Reference to these two major variants of distributive objectives is not meant to be exhaustive. A multitude of normative concepts could in fact be invoked and discussed here. For convenience, we restrict attention to the two notions we consider most relevant for the design of current policies for a meaningful reorientation of the welfare state. 3. What may vary across the two regimes of genuine insurance or untargeted redistribution is the amount of “moral hazard” incurred in each case. In other words, the probabilities of a positive impact on income and social welfare may differ. Keep in mind that, unlike many other instances of market failure, moral hazard is an imperfection that cannot be overcome through state intervention. Rather, it may become even stronger under public compulsion than in voluntary, contractual arrangements. 4. The effects of binding minimum wages—whether they are legally defined, collectively agreed on, or implicit in benefit entitlements for the unemployed—are discussed in Brown 1999 and Kahn 2000. Joint effects of these and several other labor market institutions are covered, for example, in Neumark and Wascher 2004, Belot and Van Ours 2004, Nickell, Nunziata, and Ochel 2005, as well as Garibaldi and Violante 2005. 5. Andersen and Svarer (2007) specifically stress that employing the same system in terms of employment protection and the level and structure of benefits, the Danish had much higher unemployment rates before they deliberately added a number of activating measures beginning in the mid-1990s. 6. The United States also differs from most European welfare states in that the EITC does not modify the incentives of an otherwise generous system of benefits for the unemployed. Operated besides unemployment benefits that are paid for up to six months and the Temporary Assistance for Needy Families program, which is offered only to households with dependent children and is also effective only for a limited duration, the EITC is the only cash benefit scheme in which anyone is eligible after a longer unemployment spell—provided he or she returns to regular employment in a low-paid job. 7. Essentially, this is the result of all plausible scenarios in large-scale simulation exercises such as the one initiated by the OECD (2001, chap. 4) in cooperation with the EU Economic Policy Committee (2001). Since then, the European Union has adopted such

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simulations as an instrument of long-term budgetary surveillance vis-à-vis its member countries (see, e.g., EU Commission and Economic Policy Committee 2009). 8. All alternative results that can be found in the literature (see, e.g., Homburg 1990; Feldstein 1995; Kotlikoff, Smetters, and Walliser 1998) ultimately rest on the removal of other inefficiencies, arising from distortions of labor supply or intertemporal consumption choices, which could be dealt with through other reforms and are not linked to the pay-as-you-go mechanism proper. 9. Philipson and Becker (1998) consider a scenario with endogenous life expectancy. They find similar incentives for moral hazard as in the endogenous-fertility case discussed here. 10. In the first round of EU Eastern enlargement in May 2004, transitional rules applied to the CEE-8 countries (Poland, Czech Republic, Slovakia, Hungary, Slovenia, and the Baltic states). At that time, the United Kingdom, Ireland, and Sweden were the only incumbent EU member states to open their labor markets immediately. Since 2006, many other countries have lifted the restrictions, sometimes gradually (on a sectoral basis, etc.). In fact, only Germany and Austria definitely held on to the restrictions until April 2011. Things are different with respect to the second round of enlargement of January 2007 (Romania and Bulgaria). In this case, only Sweden and Finland opened their labor markets immediately, Spain, Greece, Portugal, and Denmark followed in 2009 and 2010. All other countries appear to be reluctant to opt for the removal of restrictions, even a gradual one, in the near future. 11. An ideal database for empirically investigating migration would consist of an international, longitudinal set of microdata, making it possible to track migrants from their countries of origin to their destination countries and to compare them with other individuals at home and abroad, with detailed information regarding the socioeconomic characteristics of all individuals covered and their social and economic situation in each country. Such a database does not exist. A recent innovation in this field is the Database on Immigrants in OECD Countries (DIOC, accessible online via http://www.oecd.org) with macrodata on the size of immigrant populations by countries of origin and qualifications, available for more than twenty OECD countries. Microdata are usually restricted to observing individuals in just one country, but there are attempts to combine microdata from different countries to obtain a fuller picture of who migrates where (see, e.g., Geis, Uebelmesser, and Werding 2008, 2011). 12. In fact, the migrants’ net contributions will be largest in countries where they are needed most urgently to stabilize the pension scheme against the consequences of population aging. Taken in isolation, this may effectively bar potential migrants from going there, rather than attracting them, as indicated in the empirical estimates by Geis, Uebelmesser, and Werding (2008). 13. In a sense, the United States offers a useful example. There, free mobility is guaranteed and a strong federal system stipulates inclusion. The result is that a European-style welfare system never developed. In the early 1970s, generous welfare benefits granted in New York City proved to be a genuine welfare magnet for the low-skilled; these benefits were scaled back after the city nearly went bankrupt in 1974. Similar things happened in California in the 1990s. 14. One could think of a patriotism that, rather than nationalism that partially rests on xenophobic impulses and chauvinist attitudes, builds on a positive identification with a given country’s institutions—based on individual freedom, respect for other individuals, whether they are exercising their own freedom or whether they are in need of support,

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acknowledgment of the principle of law, and a willingness to accept specific legal obligations. It is certainly difficult to indicate how the state could use its coercive power to accomplish these tasks, because this power in fact already rests on their accomplishment. As European tradition has it, “moribus plus quam legibus res stat romana” (the Roman republic is built on morals much more than on laws). Note that economic incentives may also prove insufficient in this context, because an alternative version reads: “virtute quam pecunia res romana melius stetit” (it was more effectively backed by virtue than by money). In several variants, these views were passed on by authors such as Ennius, Cicero, and Tacitus, all living between the third century BC and the first century AD.

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Cigno, A., and F. C. Rosati. 1996. Jointly determined saving and fertility behaviour: Theory and estimates for Germany, Italy, UK and USA. European Economic Review 40 (8): 1561–1589. Cigno, A., and M. Werding. 2007. Children and Pensions. Cambridge, MA: MIT Press. Cochrane, J. H. 1995. Time-consistent health insurance. Journal of Political Economy 103 (3): 445–473. Davis, D. 1998. Does European unemployment prop up American wages? National labor markets and global trade. American Economic Review 88 (3): 478–494. De Ménil, G. 2005. Enlargement: The challenge of migration from the new member states. CESifo Forum No. 3/2004: 36–41. Disney, R. 2001. How should we measure pension liabilities in EU countries? In T. Boeri, A. Börsch-Supan, A. Brugiavini, and R. Disney, eds., Pension: More Information, Less Ideology, 95–112. Dordrecht: Kluwer Academic Publishers. Docquier, F., O. Lohest, and A. Marfouk. 2008. What Determines Migrants’ Destination Choice? Photocopy. Louvain: IRES, Université Catholique de Louvain. Ehrlich, I. B., and J. Kim. 2007. Has Social Security Influenced Family Formation and Fertility in OECD Countries? An Economic and Econometric Analysis. NBER Working Paper No. 12869. Ehrlich, I. B., and J.-G. Zhong. 1998. Social security and the real economy: An inquiry into some neglected issues. American Economic Review 88 (2): 151–157. Endhoven, A. C. 1993. The history and principles of managed competition. Health Affairs 12 (Suppl. 1): 24–48. Endhoven, A. C. 2004. Market forces and efficient health care systems. Health Affairs 23 (2): 25–27. Esping-Andersen, G. 1990. The Three Worlds of Welfare Capitalism. Cambridge: Polity Press. EU Commission. 2007. Towards Common Principles of Flexicurity: More and Better Jobs through Flexibility and Security. Doc. No. COM(2007) 359 final. Luxembourg: EU Commission. EU Commission and Economic Policy Committee. 2009. 2009 Ageing Report: Economic and Budgetary Projections for the EU-27 Member States (2008–2060). European Economy No. 2/2009. EU Economic Policy Committee. 2001. Budgetary Challenges Posed by Ageing Populations: The Impact on Public Spending of Pensions, Health and Long-Term Care for the Elderly and Possible Indicators for the Long-Term Sustainability of Public Finances. Doc. No. EPC/ ECFIN/655/01-EN final. Feldstein, M. 1977. Social security and private savings: International evidence in an extended life-cycle model. In M. S. Feldstein and R. P. Inman, eds., The Economics of Public Services, 174–205. London: Macmillan. Feldstein, M. 1995. Would Privatizing Social Security Raise Economic Welfare? NBER Working Paper No. 5281.

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Fenge, R. 1995. Pareto-efficiency of the pay-as-you-go pension system with intragenerational fairness. Finanzarchiv N.F. 52 (3): 357–363. Fenge, R., and P. Pestieau. 2005. Social Security and Early Retirement. Cambridge, MA: MIT Press. Fenge, R., and M. Werding. 2004. Ageing and the tax implied in public pension schemes: Simulations for selected OECD countries. Fiscal Studies 25 (2): 159–200. Feyrer, J. 2007. Demographics and productivity. Review of Economics and Statistics 89 (1): 100–109. Flaig, G., and H. Rottmann. 2009. Labour market institutions and the employment intensity of output growth: An international comparison. Jahrbuecher fuer Nationaloekonomie und Statistik 229 (1): 22–35. Frederiksson, P., and B. Holmlund. 2006a. Improving incentives in unemployment insurance: A review of recent research. Journal of Economic Surveys 20 (3): 357–386. Frederiksson, P., and B. Holmlund. 2006b. Optimal unemployment insurance design: Time limits, monitoring, or workfare. International Tax and Public Finance 13 (5): 565–585. Garibaldi, P., and G. L. Violante. 2005. The unemployment effects of severance payments with wage rigidities. Economic Journal 115 (506): 799–832. Geis, W., S. Uebelmesser, and M. Werding. 2008. How Do Migrants Choose Their Destination Country? An Analysis of Institutional Determinants. CESifo Working Paper No. 2506. Geis, W., S. Uebelmesser, and M. Werding. 2011. Why go to France or Germany, if you could as well go to the UK or the US? Selective features of immigration to the EU “Big Three” and the United States. Journal of Common Market Studies 49 (4): 767–796. Geys, B., K. A. Konrad, and S. Qari. 2011. Patriotism, taxation and international mobility. Public Choice, DOI: 10.1007/011127-011-9765-3. Hagemann, R. P., and G. Nicoletti. 1989. Population Ageing: Economic Effects and Some Policy Implications for Financing Public Pensions. OECD Economic Studies, No. 12. Harsanyi, J. C. 1953. Cardinal utility in welfare economics and in the theory of risktaking. Journal of Political Economy 61 (5): 434–435. Harsanyi, J. C. 1955. Cardinal welfare, individualistic ethics, and interpersonal comparisons of utility. Journal of Political Economy 63 (4): 309–321. Haveman, R. H. 1994. Should generational accounts replace public budgets and deficits? Journal of Economic Perspectives 8 (1): 95–111. Holzmann, R., R. Palacios, and A. Zviniene. 2004. Implicit Pension Debt: Issues, Measurement and Scope in International Perspective. World Bank Social Protection Discussion Paper Series No. 403. Holzner, C., V. Meier, and M. Werding. 2010. Workfare, monitoring and efficiency wages. Journal of Macroeconomics 32 (1): 157–168. Holzner, C., S. Munz, and T. Buettner. 2009. Evaluating the Organisational Performance of Local Job Centers. Photocopy. Munich: Ifo Institute of Economic Research. Homburg, S. 1990. The efficiency of unfunded pension schemes. Journal of Institutional and Theoretical Economics 146 (4): 640–647.

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Lindh, T., and B. Malmberg. 2007. Demographically based global income forecasts up to the year 2050. International Journal of Forecasting 23 (4): 553–567. Lommerud, K. E., F. Meland, and O. R. Straume. 2009. Can deunionization lead to international outsourcing? Journal of International Economics 77 (1): 109–119. Lommerud, K. E., and O. R. Straume. 2008. Employment Protection versus Flexicurity: On Technology Adoption in Unionised Firms. CESifo Working Paper No. 2472. Maddison, A. 2001. The World Economy: A Millennial Perspective. Paris: OECD. Meyer, B. D. 1990. Unemployment insurance and unemployment spells. Econometrica 58 (4): 757–782. Montén, A., and M. Thum. 2010. Ageing municipalities, gerontocracy and fiscal competition. European Journal of Political Economy 26 (2): 235–247. Muendler, M. A., and S. O. Becker. 2010. Margins of multinational labor substitution. American Economic Review 100 (5): 1999–2030. Neumark, D., and W. Wascher. 2004. Minimum wages, labour market institutions and youth unemployment: A cross-national analysis. Industrial and Labor Relations Review 57 (2): 223–248. Nickell, S. J. 1997. Unemployment and labor market rigidities: Europe versus North America. Journal of Economic Perspectives 11 (3): 55–74. Nickell, S. J. 2006. A picture of European unemployment: Success and failure. In M. Werding, ed., Structural Unemployment in Western Europe: Reasons and Remedies, 9–51. Cambridge, MA: MIT Press. Nickell, S. J., L. Nunziata, and W. Ochel. 2005. Unemployment in the OECD since the 1960s: What do we know? Economic Journal 115 (500): 1–27. Ochel, W. 2000a. Immigration policies: Competing for skills. CESifo Forum 1 (4): 27–33. Ochel, W. 2000b. Recruitment of highly skilled labour abroad: The practice of selected OECD countries. CESifo Forum 1 (2): 48–52. Ochel, W. 2001. Selective immigration policies: Point system versus auction model. CESifo Forum 2 (2): 48–52. OECD. 1999. Giving Youths a Better Start: Employment Outlook 1999. Paris: OECD. OECD. 2001. Economic Outlook No 69 (June). Paris: OECD. OECD. 2004. Reassessing the OECD Jobs Strategy: Employment Outlook 2004. Paris: OECD. OECD. 2006. Boosting Jobs and Incomes: Policy Lessons from Reassessing the OECD Jobs Strategy. Paris: OECD. Pauly, M. V., H. Kunreuther, and R. Hirth. 1995. Guaranteed renewability in insurance. Journal of Risk and Uncertainty 10 (2): 143–156. Pedersen, P. J., M. Pytlikova, and N. Smith. 2007. Selection and network effects— migration flows into OECD countries 1990–2000. European Economic Review 52 (7): 1160–1186.

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6

Europe at a Crossroads: Reforming Political Institutions and Public Sectors Massimo Bordignon, Thiess Buettner, and Frederick van der Ploeg

6.1

Introduction

The process of reforming the European Union (EU) institutions appears to be once again in jeopardy.1 The shock and the political impasse generated by the results of the French and Dutch referenda in 2005 effectively killed the constitutional process initiated with the Convention in 2003 (and in itself a result of the general disaffection with the current Treaty of Nice (2000, ratified in 2004)). Furthermore, existing EU institutions seem unfit to rule an enlarged Europe (Baldwin et al. 2001), but European governments eventually found a working solution with the Lisbon Treaty of December 2007. While formally renouncing all symbols of a European statehood (the flag, the motto, the title of Foreign Minister for the High Representative, etc.), the Lisbon Treaty in fact retained the whole package of badly needed institutional reforms advocated by the convention: the double-majority rule (required support by fifteen member states representing at the same time at least 65 percent of the Union’s population) for most decisions in the council (although the implementation of this rule has been postponed until 2014); a permanent presidency for the European Council; the High Commissioner for Foreign Affairs (who is also the vice president of the commission); and a greater role of the European Parliament in approving legislation and appointing the commission. Indeed, according to several observers, the Lisbon Treaty improves on the text approved by the European governments in June 2004 and rejected by the French referendum. At the price of some cosmetic changes and renouncing a “Constitution for Europe,” it has the beneficial effect of making clearer the role of the Union versus member states, reinforcing the national parliaments, and facilitating the introduction of further reforms in the future (Gros and Micossi 2007). After a decade of continuous debate and two waves of enlargement, a

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more stable and efficient configuration in the institutional workings of the European Union also seems to be a necessary step in order to make the Union better able to meet the formidable problems it is presently facing. These problems range from pressing shorter-term issues such as the current financial and economic crisis, to long-term issues such as the environment, the energy supply, or the reshaping of the international political and economic relationships induced by globalization (Hix 2008). But the ratification of the Lisbon Treaty was halted by the Irish referendum of June 2008, and this has again made the movement toward a more stable institutional equilibrium in Europe uncertain. As a consequence, in June 2009, Europeans—including the electorates of Bulgaria and Romania for the first time—were asked to vote for the new parliament. Astonishingly, the electorates of the EU member states needed to cast their vote without actually knowing which functions this body would perform in the future (whether the previous ones, as defined in the Treaty of Nice, or the new ones, as defined by the Lisbon Treaty) or indeed, even its national composition or the total number of its members (because the Treaties of Nice and Lisbon specify different numbers and a different composition for the European Parliament). Even if the Irish resistance has been overcome, it is a fact, and a disturbing signal about the state of the Union, that every time Europeans have been directly asked to express a judgment on the European Union, they have tended to be skeptical. This calls for a reconsideration of the problems of the Union, its standing in the eyes of European citizens, the workings of the present European institutions and their relationship with the member states, and the prospects for reform. In the following pages, we take a fresh look at some well-known problems in the European institutions, such as the effective balance of power between the three fundamental bodies (the commission, the council, and the European Parliament), and touch on new issues in the analysis of democratic institutions (is the European Parliament a “parliament”?). We also discuss achievements and future challenges faced by the European institutions, shed light on the different national attitudes toward the European integration process, and ask whether there are reasonable suggestions in the literature on fiscal federalism that offer guidance. Finally, we discuss the problems related to the implementation of the Lisbon Agenda and the implications of the recent financial and economic crisis. Although we are not aiming at a comprehensive treatment of the European situation, this overview of the European institutions and the challenges they face

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nevertheless offers insight into the present state of the European Union and allows us to draw conclusions about promising routes for the future. 6.2 Voting in the European Union: Ideology, Party Discipline, and Allegiance We start with a discussion of the legislative framework in the European Parliament. Roland (2009) addresses important questions like “Do EU legislators vote along national lines or ideological lines?”, “When do members of the European Parliament vote with their party and when not?”, “If they toe the party line, do they do this because they share the same preferences or because they are disciplined?”, and “How do coalitions arise in EU politics?” Many such questions have been addressed econometrically using roll-call votes in the United States, but much less so in the European context, where parliamentarians are loyal to their country, to their national party, and to their European party group. A big difference from the United States is that the turnout in European elections is very low, votes can rarely be cast for a European party group, and EU politics—with its decision making by the commission—can hardly be described as parliamentary system, so one would expect less disciplined voting in the European Parliament. Roland (2009) discusses and reviews empirical evidence presented by Hix, Noury, and Roland (2007) based on over 15,000 votes during five elected European parliaments in the period 1979–2004. This evidence suggests that members of the European Parliament rarely vote along national lines and much more along party lines and that party discipline is strong and increasing. Some stylized empirical evidence on the trends in the workings of the European Parliament is provided by figure 6.1. It shows that the agreement index of the parliament has been steadily decreasing since 1994, from around 70 percent to slightly over 50 percent. Figure 6.2 indicates that cohesion in the European Parliament as measured by the agreement index decreased substantially after 1994. Cohesion of parties has over the years become much higher than that of countries. Interestingly, newspaper coverage suggests national cohesion is much higher because the national news misleadingly focuses on voting by parliamentarians of the respective country only. Although factionalization has gone up with the enlargement of the Union, party cohesion has in fact also increased, probably

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Cohesion of the EP as a whole

0.8

0.7

0.6

0.5

0.4 Jul-79

Jul-84

Jul-89

Jul-94

Jul-99

Jul-04

Figure 6.1 Evolution of the agreement index of the European Parliament as a whole. Note: The agreement index equals 1 if all party members vote together and 0 if the votes are equally assigned to the voting options. Source: Hix, Noury, and Roland 2007

1.4 1.3

Parties

Cohesion

1.2 1.1 1 0.9

Member states

0.8 0.7 1979

1984

1989

1994

1999

2004

Legislature Figure 6.2 Changes in political group and member-state cohesion. Source: Hix and Noury 2009

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due to the increased powers granted by the Treaties of Maastricht and Amsterdam to the European Parliament. Roland also suggests that roll-call votes are not representative—with few votes on women’s rights and equal opportunities and lots of votes on bills from the committees on Citizens’ Freedoms and Rights, Home Affairs, Constitutional Affairs, and Economic and Monetary Affairs. The Greens demand lots of votes on amendments, whereas the European People’s Party systematically calls for roll-call votes on final legislative actions. Roll-call votes may be requested to discipline a party’s own members, when voting outcomes are uncertain, and when there is less agreement on issues. Roll-call votes are thus not only not random, but also strategic. The evidence suggests that coalition formation is not determined by party size, but by ideological closeness. Yet ideology does not affect party cohesion much. Most voting can be reduced to only two dimensions, the main one being left-right and the other having to do with attitudes toward European integration. Much of this research begs the question of why votes in European elections cannot be cast for European rather than national parties, especially because there are no constitutional obstacles to this. Electoral competition between European parties would definitely enhance the attractiveness of European politics. It is interesting to supplement this empirical analysis of the European Parliament with a more game-theoretic analysis of the distribution of power in the European Union. Widgrén (2009) first uses indexes of power derived from cooperative game theory to analyze the distribution of power inside the council, and then reverts to noncooperative game theory and the Nash bargaining solution to study the allocation of power between the council and the parliament, both at present, under the Qualified Majority Voting (QMV) rules of the Treaty of Nice, and then in the future, when the new rules of the Lisbon Treaty will be in place. The voting scheme for the Council of Ministers inherent in the Treaty of Rome remained virtually unchanged until the Treaty of Nice, which took effect in November 2004. Table 6.1 gives the number of votes and population size for each member state of the EU-27. Effectively, the Nice Treaty reallocated voting rights from the smallest to the biggest member states. That treaty increased the majority quota from 71 percent to 73.9 percent of the votes—that is, 255 of the 345 votes. Also, for a proposal to pass it must have a simple majority of member states (i.e., fourteen members) and at least 62 percent of the EU population,

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Table 6.1 The council votes in EU-27 under the Treaty of Nice rules Member state

Population in 100,000s

Nice weight

Belgium Bulgaria Czech Republic Denmark Germany Estonia Greece Spain France Ireland Italy Cyprus Latvia Lithuania Luxembourg Hungary Malta Netherlands Austria sPoland Portugal Romania Slovenia Slovakia Finland Sweden United Kingdom Total

10396.4 7801.3 10211.5 5397.6 82531.7 1350.6 11041.1 42345.3 61684.7 4027.5 57888.2 730.4 2319.2 3445.9 451.6 10116.7 399.9 16258.0 8114.0 38190.6 10474.7 21711.3 1996.4 5380.1 5219.7 8975.7 59651.5 488111.6

12 10 12 7 29 4 12 27 29 7 29 4 4 7 4 12 3 13 10 27 12 14 4 7 7 10 29 345

N.A

255

QMV Source: Widgrén 2009

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but these two requirements have little effect on possible winning coalitions. Roughly speaking, indexes of power measure the strength of a country in terms of its expected probability of being pivotal in negotiations, and Widgrén (2009) discusses the pros and cons of different alternatives used in the theoretical literature to capture this idea, from the Shapley-Shubik index to the Banhzaf one. His main conclusion, supported by empirical analysis of the correlation between these different indexes and the distribution of European funds across countries, is that the Shapley-Shubik index better captures the effective allocation of power inside the council. Using the latter, he then shows the effects of adopting the double-majority mechanism prescribed by the Lisbon Treaty. It turns out that the large incumbent members of the Union gain the most, while small incumbents and all the new Eastern entrants (except Romania) all lose with respect to the rules of the Nice Treaty. This may indicate that the new mechanisms not only make it easier to reach decisions in the council, but they have also been carefully designed to strengthen the grip of the large European incumbents on the decision making of the enlarged Union. A problem remains with the new voting mechanism introduced by the Lisbon Treaty. When electing the national government, Germany has more voters than Finland does, for instance. So Germans need to be compensated in terms of power to guarantee that each German has exactly the same power in Brussels as a Finn. Widgrén suggests that the so-called Penrose idea that compensation should be made in proportion to the square root of a country’s population size may not be a bad compromise. If everything in the European Union is decided by holding a referendum, compensation would be strictly proportional to the population—“one person, one vote.” But because the European Union has two types of majority voting, the square-root rule appears to work better. Hence, 65 percent of the square root of populations plus 55 percent of the members appears desirable. Since it is rather difficult to change from 55 to 50 percent, this may be a good compromise. But the Lisbon Treaty not only changes the Qualified Majority Voting rules inside the council. It also gives more functions and strengthens the legislative role of the parliament, by extending the scope for codecision in approving new legislation. This then raises the question whether decision rules inside the council are that important, as after the Lisbon Treaty the parliament will play a larger role, and peoples, rather than countries, are represented in the parliament.. According to Widgrén

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(2009) the answer is negative. According to his computations, although the Lisbon Treaty would considerably reinforce the parliament, the effective power of the latter would remain marginal. The basic reason is that the distribution of power between the two bodies is measured in terms of their bargaining stance inside the Conciliation Committee, a final two-party decision body that is invoked when the codecision procedure fails to produce an agreement. As rational agents, both the parliament and the council should not expect to obtain from the earlier negotiations more than they could get if the Conciliation Council were eventually set up. And in this conciliation body, the council has the upper hand, for the simple reason that any agreement reached there needs to be approved again by the parliament and the council, and the latter decides by qualified majority. Put differently, precisely because it is more difficult to modify decisions in the council, it has a better bargaining stance in negotiations with the parliament. 6.3 Budget Approval and National Implementation of EU Legislation In a work featuring rich historical and institutional detail on the approval process for the European budget and supported by a gametheoretic analysis, Giuriato (2009) reaches a similar conclusion. Budget procedures in the European Union are notorious for their contentiousness and gridlock. The introduction of the five- and seven-year Financial Perspectives in 1988 and 1993 was a way to move the decision to the highest intergovernmental body, the European Council, thus tying the hands to the other bodies in the annual negotiations. The Lisbon Treaty now offers a larger role to the parliament in drafting the budget, granting it jurisdiction over all types of expenditures and modeling the procedure for budget approval on legislative codecision. This has been greeted as a major step forward in strengthening the role of the European Parliament and in making it more similar to other democratic parliaments (after all, what does a parliament do if it is not sovereign on the budget?). But Giuriato is very skeptical. She notes that the council, deciding by unanimity, still retains a monopoly in the setting up of the total resources. Moreover, on closer examination, done by using the tools of modern bargaining theory, the anticipated codecision rule and the actual budgetary process show a very similar structure, which is highly inefficient, according to the author, because it maximizes conflict between the parties.

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A peculiarity of most European legislation (actually all, except for the so-called decisions and regulations) is that approval by the European bodies is not sufficient to make it effective. It also needs to be transposed into national legislation by the member countries. This process is often delayed and, in some cases, the European Court of Justice could become involved in forcing member states to adopt the approved European directives. An understanding of this process also requires one to consider the different options that member states have in implementing EU directives (Treutlein 2009). A basic distinction is between primary transposition, where the national parliament issues a new law, and secondary transposition, where only the executive branch of the government is involved. In fact, based on a large empirical database capturing the process of transposing EU directives among the EU-15 for different policy areas, Treutlein shows that the secondary transposition is the dominant form of adoption. In ten of the EU-15 member states only 20 percent of EU directives pass national parliaments; in the other member states the share is still far below 50 percent. While this might contribute to what is often referred to as the democratic deficit of EU policies, an explanation would also have to take account of strong differences, in particular, between policy areas. However, Treutlein emphasizes that more research is needed to improve our understanding of the relationship between EU directives and national law. 6.4

Political Economy and the Failure of Structural Reforms

Despite the success in terms of the creation of a common market and a common currency as well as the quick process of enlargement, it has to be acknowledged that the performance of the European economy in the last decade has not met expectations. In particular, the slow growth of the largest European economies as compared to other regions in the world has led European member states to intensify efforts to foster growth and jobs, as the Lisbon Agenda indicates. Besides, further steps toward broader economic integration in Europe face considerable resistance. An example is provided by the EU service directive aimed at removing legal and administrative barriers to service activities between member states, enacted only after the commission’s proposal was significantly watered down by the European Parliament. The need for further economic integration is underscored by the lack of market integration in European countries, because studies document

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a significant home bias for local products and for equity. While the lack of integration has been noted by studies in the time period before the establishment of the common currency (e.g., Nitsch 2000; Wolf 2000), recent studies (e.g., Balta and Delgado 2009) indicate that significant home biases still persist after the introduction of the euro. Somewhat disappointingly, comparing the period from 1997 to 2000 with the more recent period from 2001 to 2004, the later study does not find a decline in the home biases for goods and services. These findings confirm the lack of market integration in goods and, in particular, in services. Yet for equity a substantial decrease in the home bias is observed. But as the authors note, this might not only reflect integration in Europe but also the more general process of global financial integration. Whether the decrease in the home bias for equity sustains the 2008 financial crisis remains to be seen, however. The empirical evidence suggests that economic integration in Europe still has a long way to go. This is an important observation in light of the likely reshaping of global economic relationships in the aftermath of the current economic crisis. After the crisis and for several years ahead, Europe will no longer be able to rely on the strength of the American economy to support growth, as happened, albeit to an insufficient degree, during the previous fifteen years. The structural global imbalances that lie at the heart of the present crisis, and in particular the large current U.S. deficits, will have to be addressed, involving a reduction of the U.S. demand for international goods, including European ones. Presumably, the new engines of growth for Europe will have to be found in technological development, or in more widespread adoption of new information technologies, in the openings of new markets, especially in the fast-growing Asian economies, and in an increase in internal demand. For Europe, this basically means an increase in the level of economic integration of member countries, increasing competition and reducing the existing home bias in goods and services. The danger is that the crisis may have the opposite effect of inducing European countries to step back from the level of economic integration already reached, in futile attempts to defend national jobs and firms through protectionism. Some worrying signals have already started to appear, as we discuss below. On technological developments, it also has to be acknowledged that the Lisbon Agenda has so far failed to deliver on its promises. Europe is not becoming the most competitive and dynamic knowledge-based economy in the world. In fact, after several years of catching up, over

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the last decade its per capita income has begun to decline relative to that of the United States, although this comparison needs to be interpreted in light of the debt-driven and other unsustainable characteristics of the U.S. growth in the last decade. The consensus formulated by the well-known Sapir Report (Sapir et al. 2004) is that as Europe reaches the world-technology frontier, reproduction of large-scale technologies needs to be replaced by highly innovative production processes (e.g., Aghion 2006). This requires a move away from tolerating cartels to stimulating competition and entry into product markets. Also, the economy wide benefits from higher education and research increase as Europe approaches the world-technology frontier. Further, more flexible labor markets and more developed financial systems and markets as well as compensation for the losers of innovation and industrial change are needed. A state-of-the-art theoretical analysis by Ruta (2009) sheds new and interesting light on why Europe has failed so far to introduce these reforms—for example, to implement the Lisbon Agenda. The reforms that Europe needs in order to promote competition and to boost innovation and productivity growth face opposition from the incumbents who benefit from their current market power. Especially when there are substantial policy spillover effects, national governments appear to be more easily captured by special vested interests because they fail to internalize the benefits of the reforms for the rest of the European Union. Peer pressure of national governments and weak political governance at the European level will then not suffice to get reforms necessary for the Lisbon Agenda implemented. There is thus little hope of completing the internal agenda in heavily regulated sectors such as energy, transport, telecom, post, and financial and professional services, where the benefits of stronger competition would be especially perceived at the EU level. This is a key reason for the failure of the Lisbon process and explains why Jean-Claude Juncker, president of the Eurogroup, sighed that “we all know what to do, but we just don’t know how to get reelected after we have done it.” Structural reforms should thus be decided at the level of the European Union in Brussels rather than in the national seats of government. So far, there has been little chance of that and thus little prospect of realizing the productivity growth ambitions of the Lisbon Agenda. A related question is whether the Maastricht budgetary criteria and the stricter fiscal requirements of the Stability and Growth Pact are an impediment or a catalyst for structural reforms in Europe. Some argue

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that adherence to strict fiscal rules demonstrates a government’s reputation for being tough and will thus facilitate structural reform. This is also known as the Brussels-Frankfurt consensus. Others argue that extra funds are needed to pacify the losers of structural reform and so are needed to build political support for structural reforms. Buti, Röger, and Turrini (2009) discuss the trade-offs and complementarities between fiscal discipline and structural reforms in the European Union and provide a stylized game-theoretic model to discuss the trade-offs between the costs and benefits of macropolicies and structural reforms. The main result is that, if governments are forward-looking, reforms and fiscal discipline are likely to be substitutes. If governments are myopic, they are likely to be more complementary. Empirical evidence over the last three decades for the EU-15 countries does not reject this last hypothesis. The introduction of the Maastricht fiscal rules in the early 1990s does not appear to have affected the probability of labor market reforms, a finding also confirmed by Alesina, Ardagna, and Galasso (2008), who however also suggest that the introduction of the common currency has instead increased the pace of structural reforms in product markets. Besides, the Maastricht rules seem to have a positive and significant effect on the number of structural reforms realized by member states with governments facing elections in the current or forthcoming year of the implementation of the reforms. Hence, strict fiscal discipline can nudge countries that are facing elections to implement structural reforms. For those countries there is thus support for the Brussels-Frankfurt consensus. 6.5 Race to the Bottom and the Neoliberal Success of the European Union: What’s Next? The main success of the European project has been the liberalization of markets for labor, goods, and capital across Europe. Although the liberalization of markets for services such as provision of health or education is not proceeding as smoothly and Europe is still hooked onto excessive agricultural subsidies, burdening the taxpayer and the environment, the common market for Europe has undoubtedly benefited citizens throughout Europe. The fall in trading costs has induced more competition within Europe, which has led to lower prices and thus an increase in welfare. There may also have been dynamic gains in trade, which could have boosted the rate of economic growth beyond what it would have been otherwise. The static and dynamic advantages

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of free trade have been reinforced by the introduction of a common currency. Because Europe has much less labor mobility (think of the linguistic and cultural diversity on the European continent) and much less wage and price flexibility than the United States, many warned that Europe is not an optimum currency area. The problems of not being able to adjust exchange rates within Europe would be worse, since Europe lacks automatic stabilization through a federal tax and transfer system, which the United States does have. But interestingly, country-specific shocks to member states do not seem to have led to persistent differences in unemployment, while the advantages of low inflation throughout Europe and a strong euro are undeniable. Hence, it seems that the Europe project has been a neoliberal success, especially because not much progress has been made on a common social policy or a common environmental policy (e.g., Van der Ploeg 2004). At least, that was until the global financial crisis hit the world economy. Many years of low interest rates followed the collapse of the dot-com bubble. They have fueled what turned out to be unsustainable debt-financed consumption booms, mainly in the United States and the United Kingdom but also in countries on the periphery of the European Union, including Greece, Portugal, Spain, and Ireland. China was prepared to finance the U.S. debt by buying up dollar assets, propping up the dollar and ensuring cheap exports from a relatively poor country such as China to richer parts of the world. Russia, trying to stave off some of the worsening competitiveness arising from the booming sales of gas exports, has also been happy to finance a large part of the U.S. debt. Other surplus countries like Germany and the Netherlands did their bit as well and have played an important role in financing the debt of peripheral EU countries. European institutions as such have been relatively uninvolved in the management of the crisis, basically letting the individual member countries do their bit by themselves. The European monetary and fiscal institutions, built on the idea that sound public finance and strict monetary rules would have been enough to support stable growth on the continent, are somewhat powerless in dealing with the financial crisis and in fighting the recession triggered by this crisis, which has also severely affected the European banking and financial sector. This became more and more obvious at the end of 2009, when bad news about the Greek fiscal situation led to a dramatic surge in interest rates for the government bonds of Greece and other peripheral

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European countries. European governments, with some support from the European Commission and the International Monetary Fund, eventually set up a €750 billion rescue fund intended to provide loans to governments facing difficulty issuing government bonds. In that way, European governments tried to combat fears that Greece and other countries in the eurozone could default on their debt. While this fund is only temporary and ends in 2013, the intention has been to provide European governments with time to work out a resolution to the financial difficulties faced by member states. However, the deterioration of the fiscal situation in Ireland and Portugal has made clear that the time to come up with a new financial architecture is very limited, and that fears of contagion could extend to other weak-euro members as well, such as Spain, and Italy. 6.6

The Crisis and the European Economy

Even if Europe were successful in stopping the debt crises in some of its member states, the many ad hoc measures launched to stop the financial crisis in Europe certainly take time and energy away from realizing further structural reforms. But, because expansions of demand need the support of more market-oriented political parties in many countries, one might have hoped that this would open up the opportunity for a deal in which expansions of demand are approved, provided further structural reforms are realized. Many more fiscal reforms are needed to broaden the tax base and shift from income to consumption and green taxation (e.g., Vermeend, Van der Ploeg and Timmer 2008). The current global financial crisis raises, in any case, questions about whether Europe is really doing so badly compared with the United States. The housing market, the economy, and the currency of the United States seem to be in a much more dire state than in Europe. The United States may thus have to reconsider its reckless history of overspending and overborrowing and may have to take a more long-term approach to the economy. So far, many have warned that, unless Europe takes serious action, economic and political decline are inevitable (e.g., Alesina and Giavazzi 2006). But these warnings may have to be reconsidered in light of the current crisis. It is probably true that without comprehensive reform, continental Europe’s overprotected, overregulated economies will continue to grow at a slow pace and its global political influence will diminish. And it is also true that Germany,

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France, and Italy have still many opportunities for structural reform, but this does not mean that Europe needs to move to an Anglo-Saxon laissez-faire economy, because the market economy and especially the financial sectors need to be regulated to avoid excessive greed and systemic collapse. Indeed, what we are observing as a result of the crisis is a move away from the two polar systems of Anglo-Saxon capitalism on the one hand and continental social capitalism on the other hand. With the decision by the British and U.S. governments to have the public sector massively intervene in the economy, the two models now look much more similar than even in the recent past. This may be good news for Europe, because the competition between the two polar models has so far been one of the main obstacles to further integration. Further, it is not even clear that continental European voters really want to give up their vacations, their short workweek, their tradition of early retirement, and their resistance to market competition. Still, given that Europe is facing an influx of immigrants and gradually becoming more of a melting pot as well, it may be forced to adopt more structural reforms and move a little in the direction of a social market economy, with checks and balances to ensure that power cannot be abused and inequality between citizens does not become excessive. However, beyond the pressing issues raised by the financial and economic crisis, the process of European integration raises more fundamental questions about the role of the government and the public sector. 6.7

Redesigning the Public Sector in Europe

European countries are operating large public sectors and social security systems and impose many regulations on the private sector. These government responsibilities require substantial taxation efforts and laws that regulate private agents’ actions in many ways. However, due to the process of European economic integration, tax systems and national law are increasingly challenged by the removal of borders between the European Union’s member states. To see why, note that besides barriers and tollgates, borders define the space within which the member states’ policies are implemented. With open borders, location changes for economic activities might be associated with large arbitrage opportunities. An illustration is provided by the consequences of labor laws. As Holmes (1998) shows, attempts by U.S. state governments to enforce stricter labor laws cause employers to shift

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employment into adjacent states with laxer rules. Similar problems arise in environmental protection and give rise to competition in environmental standards (Fredriksson and Millimet 2002). Also, police protection exerts spillover effects resulting from criminal activities (Hakim and Rengert 1981), since deterrence by increased law enforcement in other countries causes an influx of crime. Adverse mobility effects are also discussed in the area of welfare aid, where attempts to extend support to the poor are often feared to cause an influx of recipients. Increased cross-border mobility is not only challenging specific policies. Mobility quite generally affects revenue-raising capacities and, therefore, exerts effects throughout the budget. The observation that mobility gives rise to all sorts of spillover effects and externalities from individual governments’ policies is not new and is also not confined to the European Union. It plays an important role in the assignment of competencies in federal countries. In the United States, for instance, where the states enjoy substantial autonomy in taxation, the right to oversee interstate commerce was from the beginning assigned to the federal government (Hamilton 1787). It has been much more recently, however, that the role of spillover effects and externalities in the assignment of responsibilities in a federation of states was systematically explored. The theory of fiscal federalism associated with Oates (1972) emphasizes that the central government can play an important role in mitigating the consequences of spillover and externality effects. For instance, if a subnational government’s responsibility for certain policies causes important spillover effects, it is useful to assign this responsibility to the central government. Alternatively, the central government may improve incentives for subnational governments to pursue certain policies by cofinancing these policies. Federal fiscal constitutions can also contribute to reducing adverse effects of mobility on the revenue-raising capacity of governments by assigning revenues to the central government and transferring funds to subnational governments. After having made important steps toward economic integration and extending the group of EU countries, the member states’ policies are now increasingly subject to externalities and spillover effects from other member states. Thus, because Europe has been quite successful in implementing a process of economic integration, the public sectors of member states are facing important adjustment challenges and tough choices. So far, the race to the bottom in terms of taxes on mobile factors of production such as capital has not resulted in the erosion of tax

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revenues, as feared by many (e.g., Sinn 2003), although there is some empirical evidence that tax competition has distorted sources of revenue and patterns of spending. Moreover, the process of competition is still going on. Due to mobility in Europe, various policies tend to become more costly for the policymakers of the EU member states. Without adjustments, member states are forced to cut back on public spending and social security and give up on their aim to regulate the private sector in many ways. To limit increases in the cost of their policies, the member states would have to reform policies so as to better conform to conditions of mobility. Following the theory of fiscal federalism, these challenges can be alleviated by intervention at the EU level. However, to date no central government exists in Europe that has the competencies and means to solve the problems arising from international spillover effects and externalities of government policies by the tools discussed in the theory of fiscal federalism. While EU institutions have helped to reach agreements that do limit specific problems associated with spillover effects and externalities, progress has been very slow. As an example, consider the EU savings directive adopted in 2003 that deals with the taxation of savings of a country’s residents that are held in accounts of other European countries’ banks. With the debate starting in the 1980s, it took decades to establish this directive, which installs an information exchange that will be fully effective after a transitional period in 2012. Important loopholes still exist, and the European Commission has suggested amending the savings directive. Not only is the European solution to specific policy problems slow, but EU law often makes the alternative adjustments in member states’ policies unnecessarily difficult as it imposes further constraints on the national policies. The gap between the European institutions’ possible role in coordinating policies and reducing inefficiencies from spillover effects and externalities and their ability to reach corresponding decisions and to implement reasonable policies has long been recognized. While many attempts are underway to reform these institutions, as referenda throughout Europe have shown, the public does not generally favor improving the situation by adding competencies to the European institutions. Yet since centralization is not an option for Europe, it is helpful to consider institutional settings where a substantial portion of government activities are decentralized. This calls for a brief look at the prescriptions of fiscal federalism.

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Prescriptions of Fiscal Federalism

Some features of the European Union resemble the conditions usually observed in federal countries: people enjoy some basic freedoms to choose a place of residence and to decide where to work. Companies are free to sell and buy within the internal market irrespective of where the partner is located. There are no tariffs imposed on cross-border trade in goods and services, and, with the Schengen Agreement, border controls are removed. Moreover, some, not all, European countries share the same currency. All these features match the conditions faced by the states of a federation as well as by other subnational governments. As the literature on fiscal federalism emphasizes, mobility has various consequences for the public sector. A first implication is that residents and companies of other states might use public services without sharing the tax burden. The importance of this type of problem and the possible solutions depend very much on the specifics of each case. A good example is the road infrastructure. Some countries provide roads toll free and use vehicle licenses to obtain financial contributions from road users. In this case, vehicles registered elsewhere have a free ride—that is, they use the road infrastructure but do not have to pay for it. As a consequence, member states that provide important transnational routes have resorted to various toll systems. Installing and operating these systems is not without cost, including distortions in transport routes. Within member states, problems of benefit spillover effects and externalities have been solved by the assignment of responsibilities. Continuing with the example of road infrastructure, important highways that connect different parts of a country are often provided by the central government, and highways that connect different regions in the same part of a country are sometimes provided by subnational, provincial governments. On the other end of the spectrum, roads that connect individual settlements with cities or villages are usually provided by local or municipal governments. Furthermore, roads are often cofinanced by different levels of governments, possibly reflecting their role in serving local as well as more general purposes. Applying this logic to a deepening economic integration in Europe, large transnational highways might be provided and/or cofinanced by a central European government—which is already the case albeit on a limited scale.

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So-called benefit spillover effects will arise in many other policy areas. The prescription of fiscal federalism, therefore, gives rise to a vertically structured system of multiple layers of governments, each of which is responsible for the provision of public services to their own constituency. Efficiency dictates, however, that the number of different layers of governments is restricted in order to reap some cost savings. Moreover, while helpful for internalizing horizontal externalities, each additional layer of government adds to the vertical complexity. And the associated problems of governance might lead to rather inefficient outcomes (Kessing, Konrad, and Kotsogiannis 2007). Most European countries already display a sophisticated vertical structure of the public sector with territorial units of government at the local level, such as municipalities and cities, as well as at the regional level. Some countries even feature larger subnational units of government. The sheer number of governments in Europe is tremendous. With more than 120,000 units of governments, Europe has two to three times more units compared with the United States (according to the Census of Governments, there are about 40,000 governments, excluding school and special districts). Vertically, the citizens in Europe face between three and six layers of government. Solving problems of benefit spillover effects in Europe by changing the assignment of competencies would require a substantial reorganization of the vertical structure of the public sector. Given the increased importance of spillover effects and externalities between member states, this seems to imply a centralization of policies in Europe. However, it is important to note that the European government is already engaged in a number of policy areas that are not in accordance with the normative assessment of assignments. Alesina, Angeloni, and Schuknecht (2005) note that strong EU involvement in areas such as agriculture and social protection is hard to justify in terms of beneficial spillover effects and externalities. A reorganization of assignments might, therefore, not only include the centralization but also the devolution of some competencies. This is also one of the conclusions of the Sapir Report, mentioned earlier (Sapir et al. 2004). From the fiscal federalism perspective, a second set of implications of the increasing openness of European countries refer to the revenue side of public budgets and to taxation in particular. The basic problem is probably best described by noting that taxation becomes more costly under conditions of mobility. To see this point, note that taxation not only has a direct cost to the taxpayer in terms of the taxes due and the

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cost of compliance. In addition, taxes are costly because they create incentives to change decisions in order to lower the tax burden: households want to choose to locate in places where the burden of income taxes is moderate even if the location is not that appealing, firms tend to invest where business taxes are more favorable even if profit opportunities are slightly weaker, and trade might be diverted to places where trade and excise taxes are low even if trading at other places would involve lower transaction costs. The degree to which decisions are affected and, thus, the indirect cost of taxation, depend, however, on the type of tax. Taxes on immovable property, such as real estate, exert few mobility effects. But source taxes on interest, for instance, might cause huge capital movement. Redistributive taxes such as progressive income taxes might also exert strong mobility effects. These mobility effects generate important fiscal externalities between governments and change the cost of public-service provision. As in the case of benefit spillover effects, these problems together with the specific administrative issues of the various taxes can be alleviated by assigning the taxes to different layers of government. Within countries, property taxes, for instance, are usually assigned to local or municipal governments, income taxes are assigned to subnational or national governments, and VAT with its emphasis on business-to-business transactions is usually assigned to the central government. A typical feature of subnational taxation that allows cost savings in terms of reduced compliance cost is to impose surtaxes or piggyback taxes on federal taxes. Since smaller units of government often face significant problems in administering taxes and face high indirect taxation costs, several countries also engage in substantial vertical revenue sharing where upper-level governments collect taxes and share the revenues with lower-level governments by means of unconditional grants. With regard to taxes, in Europe the situation is very different from the prescriptions of fiscal federalism. The European government is actually not raising any taxes but receives unconditional transfers from the member states. The question of whether the European Union should have autonomous sources of revenue and which ones is still pending. The desire of the member states to retain autonomy with regard to income taxes has blocked attempts to solve the dilemma of corporate taxation in Europe. Here intense competition has driven down tax rates substantially, but corporations are still facing a complex intertwined tax space spanned by twenty-seven tax systems and many more

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double-taxation treaties. While the European Commission is trying to keep this important issue on the agenda with its proposal for a common consolidated tax base, it is often overlooked that a uniform tax code with formula apportionment would need to be enforced by a central agent. A solution consistent with fiscal federalism would be a European corporate tax, where the member states levy surtaxes on their share allocated on the basis of a uniform formula. This does not necessarily mean that Europe receives more funds, if the revenues were to replace the current system of GNP contributions. Also, the VAT system in Europe suffers from a wrong assignment of taxing powers. As Keen (2007) notes, the EU member states’ problem with so-called carousel fraud arises, basically, from the tax exemption of cross-border sales in Europe, and would largely disappear with the implementation of a European VAT. Fiscal federalism has further implications for the subcentral governments’ ability to engage in tax and expenditure smoothing and for related issues of fiscal policy. Partly because of mobility, access to debt is usually more limited for local governments. Hence, the capacity to deal with revenue fluctuations is rather limited at the local level. Again this problem can be solved by assignment, if strongly fluctuating revenues are collected by the central government, which in turn uses debt to engage in tax and expenditure smoothing. A related issue is the capacity for discretionary fiscal policy. As subnational governments experience limits in the access to debt, they will tend to be reluctant in incurring public debt. Moreover, given close economic integration, discretionary fiscal policy will exert strong spillover effects at the subnational level, and, therefore, might be regarded as less effective in generating demand by the subnational governments. For those reasons, fiscal federalism has assigned discretionary fiscal policy to the central government. In the current fiscal constitution of Europe the European government is not allowed to issue debt. Hence, it cannot engage in discretionary fiscal policy, and the member states’ governments assume the revenue risks. While it seems that the public sector in Europe would benefit from a substantial reorganization following the prescriptions of fiscal federalism, it should not be overlooked that the normative views on the fiscal relations between governments rest on rather restrictive assumptions. This includes the strategic choices of the various governments. In fact, upper-level government intervention in the standard view of fiscal federalism ignores strategic choices of local governments

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(Bordignon, Manasse, and Tabellini 2001). A more general consideration would have to take account of possibly serious disincentives for local policies, including issues of soft budget constraints (Bordignon 2006) and lobbying behavior (Bordignon, Colombo, and Galmarini 2008). Moreover, by assuming that governments are benevolent, political-economy considerations are lacking. This is important, since what is needed is a design of the public sector that obtains reasonable results in a context where policymakers follow their own objectives. To assess the prospects for reorganizing the public sector, it is also important to take into account the views of the European citizens themselves. 6.9 It?

What Should Europe Do and What Do Europeans Think about

One of the key principles of the European Union is the principle of subsidiarity: political decisions should be made at the lowest level possible in order to take the preferences of local electorates into account as much as possible. Of course, while it has a different origin, this principle conforms to the basic views of fiscal federalism. However, the latter view also implies that if there are strong spillover effects from one member state to another and European-wide concerns are important, there is a role for deciding on this at the EU level. The completion of the internal market and the realization of a common currency are remarkable achievements, given differences in preferences. On the one hand, there are countries like the United Kingdom, the Netherlands, and the Nordic member states with their predilection for bottom-up reforms and a competitive and level playing field. On the other hand, there are countries like France and Italy with their wish for a more “dirigist” style of policy formulation and an industrial policy based on picking economic winners (e.g., Alesina and Perotti 2004). Yet the European Union has found it difficult to pursue a common foreign or defense policy, an area of politics that really should be conducted at the EU level. European countries still speak with a different voice in all the international arenas where they are represented; border controls and immigration should also be dealt at the European level to avoid free-riding behavior by member countries. Finally, progress on environmental and climate change policy has only been modest. On the other hand, the European Union has a tendency to meddle in all kinds of social and cultural spheres at the national, regional, or even local

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level. One could thus argue that it is doing too many things it should not be and at the same time is not active in areas where it should be. The common market for goods, labor, and capital needs to be further reinforced, and EU tasks should be expanded outside the first pillar (foreign and defense policies, internal security, immigration), all of which require more action at the EU level (Tabellini 2003). On the other hand, regional redistribution (including structural funds and the social charter) and agricultural policies need to be scaled back. A recent study based on Eurobarometer data from 1995 to 2003 extends previous work by Alesina et al. (2005) and offers a detailed empirical analysis of Europeans’ preferences for the allocation of competencies between the Union and the member states (Cerniglia and Pagani 2009). It turns out that the more pro-European countries are those from Southern Europe, while the Scandinavian countries and Luxembourg are less pro-European. Further, this difference in the “degree of Europeanism” across European countries is relatively stable, suggesting that it is not much affected by what Europe actually did during the period. Behind this difference in attitudes toward Europe, it is suggested, there is essentially a different degree of trust in national institutions; understandably, people who have little faith in the quality of their home governments tend to rely more on European institutions than others do. But leaving aside this national bias, Europeans seem to have, in many policy areas, common ideas on what should be centralized at the European level and what should be left to the member states. For instance, most agree that fighting terrorism is a European task, while education should be left to the national authorities. Somewhat larger differences of opinion appear on other subjects (immigration, defense, foreign policy). But on the whole, it is remarkable that citizens’ preferences about centralization at the European level seem to fit quite well with the traditional fiscal federalism arguments recalled above. Furthermore, even the most anti-European nations are strongly in favor of Europe in some areas, like say the Swedish on environmental issues. Cerniglia and Pagani’s (2009) study is innovative in that it also tends to correlate, using econometric techniques, citizens’ attitudes toward Europe with individual indicators. It turns out, for example, that EU citizens are more likely to be pro-European if they are better educated, better informed, white collar, and inclined to be leftwing. It would be interesting to check, in further studies, if this distribution of preferences only has to do with information and ideological bias, or also with the

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effects that Europe and the European common market have had on the economic position of the subjects (see below). A general conclusion that emerges from these studies is that there are policy areas where most Europeans would seem ready to support further harmonization, but other areas where only a subset of the countries has a majority of citizens in favor of more centralization at the European level. Perhaps this is not surprising, given the very high level of heterogeneity in the twenty-seven-member Union. But this would suggest a more extensive use of flexible forms of integration, where, given harmonization on a common set of policies (the “hard-core of European integration”; Dewatripont et al. 1995), only a subset of members of the Union may go on with further harmonization on other policies, while the others opt out, at least for the time being. Under the evocative name of “enhanced cooperation agreements,” explicit procedures for the formation of these subunions have been introduced in the European Union, starting with the Amsterdam Treaty. But they have been surprisingly little used so far, and there is relatively little analysis of the pros and cons of these procedures for the future of the Union (Bordignon and Brusco 2006; Bordignon 2007). 6.10 Extremist Parties on Left and Right and Public Euroskepticism The process of European integration has suffered from a downward spiral and a concomitant increase in opportunities for the public to express their misgivings. “Euroskepticism” is therefore rearing its head; manifestations include the rejection of the constitution in France and the Netherlands, as well as the Irish referendum on the Lisbon Treaty and the well-documented drops in popular support for the European project. Some have termed this the “post-Maastricht blues” (Eichenberg and Dalton 2007). European citizens no longer seem to share the view that Europe is good, but appear to increasingly question the nature of the European project itself. We are also seeing the advent of both populist leftwing parties and populist rightwing parties—a development that is both feeding on and fueling Euroskepticism (Steenbergen, Edwards, and De Vries 2007; De Vries and Edwards 2009). Rightwing extremist parties oppose European integration with the defense of national sovereignty and successfully mobilize national identity organizations against the European Union. Examples of such rightwing extremist parties are the Danks Folkeparti, the Freiheitliche Partei Österreichs, the Belgian Vlaams Blok (Vlaams Belang), the Italian

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Lega Nord, and the French Front National, but the Conservative Party in the United Kingdom can also be increasingly viewed as a rightwing Euroskeptic party after the creation of the EMU. Leftwing extremist parties oppose the European project on the basis of the neoliberal character of the project and effectively turn voters against the European Union by means of economic-insecurity arguments. These parties include the SP in the Netherlands as well as the communist parties in France, Greece, Italy, and Germany. The empirical results in De Vries and Edwards 2009 suggest that exclusive national identity, economic anxiety, a high misery index, and especially dissatisfaction with national democracies contribute to Euroskeptic sentiments. Controlling for these effects, there is strong and statistically significant evidence for the following two interaction effects. First, the effect of exclusive national identity on Euroskepticism is especially strong when invoked by rightwing Euroskeptic parties. Second, economic anxiety feeds more strongly into Euroskepticism when stimulated by leftwing Euroskeptic parties. Europhoria was prevalent among the political and bureaucratic elites of Europe, but is coming under increasing pressure because of economic anxiety, weakening national identities, and dissatisfaction with national democracies. This erosion of support for the European project is reinforced by the increasing popularity of extremist leftwing and rightwing political parties. Established parties cannot operate with a “cordon sanitaire.” They need to face the issues raised by extremist parties and engage in debate with them. 6.11

How Can European Politics Be Given a New Lease on Life?

What can finally be said about reforming the political institutions in Europe? One of the most exciting analyses and proposals on how to make the European Union work again is provided by a leading political scientist (Hix 2008). After the strong vetoes of the European Union’s “constitution” by the French and Dutch electorates in spring of 2005, it is clear that the Europe project suffers from a severe lack of popular legitimacy. However, it is a mistake to think that these actions were simply due to anti-Chirac or anti-Muslim sentiments in the postFortuyn era. In fact, evidence from the Eurobarometer suggests that people who believe market integration harms their interests oppose the European Union, while those who believe it works in their favor tend to support the European Union. Hence, winners like the unskilled

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workers from Central and Eastern Europe and higher-income earners in the older member states support the European Union, while losers such as manual workers and civil servants in the older member states distrust it. Similarly, given that the European Union has eroded social protection in France and increased it in Britain, leftwing British and rightwing French citizens might be supportive, while the right in Britain and the left in France are antagonistic. More transparency and better communication on unpopular policies, such as extending the process of liberalization to health, education, and other services, will harm the already dangerously low and declining level of popular legitimacy throughout the European Union. This dramatic decline in support may be further exacerbated by the wellknown perceived democratic deficit. But the European Union has representative institutions, free and fair elections, and sufficient checks and balances on the exercise of power. The real problem seems to be that there is no serious battle for political power between rival parties with clearly defined policy agendas for Europe. Voters are also fed up with the “enlightened elites” of Brussels who claim to know what is best for them. And it does not help that national politicians blame the European Union for all things unpopular. Hix (2008) convincingly argues that the popular Euroskeptic position of handing power back to the member states and the Eurofederalist goal of transforming the European Union into a full-blown federal state are, respectively, misguided and wholly unrealistic as well as unnecessary. Yes, as we argued above, it helps to apply the subsidiarity principle vigorously and hand cultural and other policies back to the local level, where they can be better matched to local preferences. However, given the huge global challenges pertaining to climate change, the security of energy supplies, terrorism, the integration of minorities, and financial crises, the European Union is more necessary than ever. Like the United States, it enjoys all the prosperity fruits of a common market, and for all the possible critiques of European politics, it is better than the authoritarian continental regimes of Russia and China and also better than the patchwork of small sovereign states that are economically not viable, as is the case in Africa. Further, war in Europe seems unimaginable. Despite all the anti-European sentiments, this is quite an achievement. However, if politicians wanted to take Europe in new directions, they would be held back by severe policy gridlock. Extension of qualified-majority voting in the council, more power for the European

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Parliament, and the rules for electing the commission have already moved the European Union from a consensual to a partially majoritarian system. This should make it easier to pass less watered-down deals and to get more things done in Europe. But this has not proved true, because some parties want to move in one direction and others in another. Hix (2008) sees this as a golden opportunity to politicize the European Parliament by electing the president of the commission for a five-year rather than a two-and-a-half year term and abandoning the proportional system for allocating chairs by granting larger political groups more chairs. Progress must be made in creating a more effective decision-making process and avoiding gridlock. It will also help to make the EU Council much more transparent by making all legislative documents publicly available and opening all legislative deliberations to the public, including the voting record. It would also help to ensure that the European Commission and Council have a much more compact set of tasks, focusing on what should be done at the European level and no longer doing what should be done at the local or national level according to the subsidiarity principle. The European Parliament should become the arena in which the debates take place about issues that really matter to Europe, including whether European cooperation should become more or less intense. By having these debates in the European rather than the national parliaments, European politics can get a new lease on life and become more attractive to the citizens of Europe when they cast their votes. Euroskepticism is in large part fed by national politicians blaming European institutions for cheap political gain, thereby undermining the legitimacy of the European project. The conflict between national interests defended in the council and EU fanaticism in the commission needs to be addressed before European politics can become more attractive to Europe’s citizens. Most important of all is to get rid of backroom politics and have an open contest for the new commission president, with candidates setting out their policy agenda for the next five years and having lively debates. Unfortunately, this has not happened so far. In 2009, for instance, President José Manuel Barroso was reelected without a proper mandate from the people of Europe. This was a lost opportunity, because it could have been a chance to get European politics reconnected to the people. This will make it more difficult for the council to override the parliament on matters that should be left in the hands of European citizens. This conflict has already arisen with the Sixth legislative period, from

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2004 until 2009. Initially, the European Parliament wanted Chris Patton to be president of the commission, but their choice was pushed aside and Barroso got the job. True, the European Parliament managed to get rid of Rocco Buttiglione. But in order to move ahead, Europe should follow the German practice where major parties nominate their candidates and announce them before the elections, then there is a campaign for him or her. Analogously, Christian Democrats in the European Parliament might say, “Our candidate for president of the commission is Mr. So and So,” and the Socialists might announce, “Our candidate is going to be Mrs. So and So.” Since the council has the right to propose the candidate for president of the commission, it can always override candidates. However, with nominations coming from the European Parliament and a lively campaign for president, it would be much more difficult for the council to ignore the European Parliament’s choices. The commission and council are likely to have less power relative to the European Parliament. The commission’s role as gatekeeper in putting forward legislation and the council’s role as ultimate decider may change. The role of the parliament will be significantly enhanced with codecision powers. With the service directives, for instance, the role of the commission was minor because the parliament and council came to an agreement. The commission thus has to rethink its role with the new elements of the presidency and the High Representative, who is part of both the council and the commission. This is the beginning of reinventing Europe. We are in favor of a more politicized role for the commission, although this may conflict with its role as gatekeeper of the treaty. When the European Union set up institutions like an independent central bank and realized market integration, technocrats were perhaps not so bad. But as the focus shifts toward policy, political differences are unavoidable. Hix’s (2008) fix therefore makes much more sense than that of the Panglossians, who want to do nothing, or others who argue that all problems will be resolved with better public relations and more procedural reforms. The European Union needs lively political debates, both in the parliament and in the media, with a focus on commitment to policy delivery. 6.12

Summing Up

Summing up our previous disscussion, the following points deserve emphasis:

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• While the reform of Europe an institutions is still in jeopardy because they are unfit to govern an enlarged Europe, the Lisbon Treaty is a step forward.

The European Parliament is a parliament. European legislators have increasingly voted along ideological party lines rather than national lines and party discipline is strong and increasing. Furthermore, coalition formation is increasingly determined by ideological closeness rather than party size. •

Nevertheless, European politics do not seem to resonate, because turnout in European elections is still disappointingly low and people rarely vote for European party groups. •

• The Nice Treaty reallocated votes in the council from the smallest to the largest member states compared with arrangements under the Treaty of Rome. Game theory suggests that adopting the doublemajority voting mechanism prescribed in the Lisbon Treaty will, compared with the Nice Treaty, give the large member states even more power, while existing and new small member states lose power. The Lisbon Treaty has thus been designed to strengthen the grip of the big European incumbent states. • The Lisbon Treaty enlarges the legislative role of the parliament, but game-theoretic analysis suggests that this will not change the balance of power much between the parliament and the council because the council still has the most say in the Conciliation Committee.

The Lisbon Treaty also gives the parliament more power via legislative codecision to draft the budget, but the council still maintains a monopoly in the setting up of resources. Hence, the reform would lead to more conflict between parliament and council. •

Secondary transposition of European legislation into national rules involving only the executive branch of government is much more prevalent than primary transposition, where national parliaments issue a new law. This speeds up the process of adoption but also contributes to the often-lamented democratic deficit. •

The main success of the European project—the common market for goods, labor, and capital, fostered by the common currency—is thoroughly neoliberal. It has boosted economic activity and given the poorer member states a chance to catch up to the richer member states. However, the severe financial difficulties in the peripheral countries raise doubts as to whether the catching up is sustainable. •

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• The euro has certainly protected the member countries from the fallout from the present economic crisis. Yet the severe financial troubles of some member states indicate that the establishment of a common currency cannot be counted as a success, so far. Even if the financial problems of the peripheral countries could be resolved, further structural reforms are needed. Unfortunately, they are met with fierce resistance by vested interests, even though consumption baskets (especially services) and equity holdings still display substantial home biases. In the postcrisis era, removing the home bias in services and products is the main avenue to increase competitiveness and support growth in Europe.

The Lisbon objective of having Europe become the most competitive and dynamic knowledge-based economy has failed. Innovation should be driven by fierce competition, substantial investments in higher education and R&D, and better and more reliable financial systems, but little is being done about that. Further reforms are needed because Europe cannot keep up by simply replicating large-scale production processes. •

• Further structural reforms are blocked by special interests, especially if there are sizable policy spillover effects. The current global climate is not conducive to further reforms, either. Structural reforms are also badly needed to make full use of the increasing numbers of first- and second-generation immigrants in the labor market. • The Brussels-Frankfurt consensus, which says that further reforms are more likely to be realized with a tough stance on fiscal deficits, especially in countries with upcoming elections, is under attack, although there is no evidence of a trade-off between the reforms and fiscal rules. The global financial crisis is driven by lack of effective demand, so Maastricht criteria will have to be violated for good reasons. But this may undermine the credibility of governments in undertaking further structural reforms. • The rhetoric about the race to the bottom—declining taxes on labor, lower benefits, and lower taxes on capital—does not seem to have become as much of a reality as people feared. However, the global financial crisis has exposed a failed and often-corrupt class of people with exorbitant pay that is no longer tolerated by politicians and the electorate. • The G-20 has failed to address the global imbalances facing the world economy. Spending one’s way out of a recession will fail if rich,

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borrowing-giddy, reckless countries like the United States under President Barack Obama and the United Kingdom under Prime Minister Gordon Brown spend more, while rich surplus countries such as Germany and the Netherlands and poorer countries like China and Russia do not spend more. Europe has so far failed to coordinate appropriate responses. Individual European countries have taken action, but European institutions as such have been mostly silent on the management of the crisis. We have lost an opportunity for coordination. This is worrying because the intrinsic fragility of the dollar and pound will continue to contribute to the risk of global financial instability. Despite the promises of the G-20, fears of protectionism remain. The European Commission has failed to take the lead in strengthening pan-European financial supervision. In fact, Europe has been too absent in many sectors, including pollution, climate change, antiterrorism, immigration, defense in the former Yugoslavia, and foreign policy, where it should have had a much more forceful coordinated role. At the same time, Europe has meddled in many social and cultural dossiers that should have been tackled at the local or regional level. •

The finances of the public sector in the member states and in particular of the European government are very different from the prescriptions of fiscal federalism. The European government is actually not raising any taxes, but receives unconditional transfers from the member states. As a consequence, there is no central government that could enforce certain taxes uniformly and engage in discretionary fiscal policies. Nor does the central government have to justify itself to the electorate about these transfers, thus contributing to Europe’s democratic deficit. While it seems that the public finances in Europe would benefit from a substantial reorganization following the prescriptions of fiscal federalism, the crucial precondition is to reform the European Union and to increase trust in European institutions. •

• European citizens, even staunch anti-Europeans like the Swedes, support basic fiscal-federalism principles. The violation of the subsidiarity principle has thus undermined support for the European project. • Throughout Europe, Euroskepticism is fueled by the rise of populist leftwing parties that oppose the neoliberal reforms of the European project and rightwing parties that defend national sovereignty and identity. Exclusive national identity, economic anxiety, and especially

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dissatisfaction with national democracies contribute to Euroskeptic sentiments and are reinforced by populist parties. Old arguments in favor of the European Union (“no more war”) fail to impress populist politicians and also many young Europeans. A “cordon sanitaire” around populist parties will be counterproductive. There is a need to battle them in open debates. Unskilled workers from Central and Eastern Europe and higherincome earners in older member states support the European Union, while manual workers and civil servants in the older member states are more skeptical. The European Union has eroded social protection in France and increased it in Britain, so leftwing British and rightwing French citizens tend to back the Union, while the right in Britain and the left in France attack it. On the other hand, a consequence of the crisis has been a reduction in the distance between the Anglo-Saxon laissez-faire model and the continental social market one. This may offer a better chance for European integration in the future. The problem is that popular legitimacy for the European project is low and falling, and it will get even worse due to a perceived democratic deficit. •

• Without an open political battle between rival parties about things that matter for Europe, things will get worse in a period when European politics is more necessary than ever. People may no longer want to continue along the path of further structural reforms, but so much more is needed to tackle terrorism, climate change, pollution, and the integration of minorities at the European level. What is needed to appeal to European electorates is thus a more compact and different set of tasks for the European Union, in line with the subsidiarity principle and a focus on policy delivery. • Institutional reforms are needed to resolve the severe policy gridlock, move the European Union from a consensual to a partially majoritarian system, and make European politics much more transparent, accountable, and appealing. The president of the European Union should personify the institution and should be elected for five years and be nominated by the large pan-European parties in the European Parliament. And the commission should become more politicized. Following the elections for the European Parliament, Europe could then look forward to a lively U.S.-style campaign for the presidency.

Notes 1. Parts of this chapter are based on Bordignon, Buettner, and Van der Ploeg 2009.

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Index

Abbring, J. H., 84 Aggerwal, R., 62 Aghion, P., 61–64, 68, 129 Aging problem. See Old age provision Ahituv, A., 97 Airbus, 56 Air France-KLM, 53 Alesina, A., 130, 132, 137, 140–141 Alitalia, 53, 58 Allard, G. J., 80 Alstom, 58 Amsterdam Treaty, 142 Andersen, T. M., 82 Angeloni, I., 137 Arcelor, 58 Ardagna, S., 130 Asset prices, 22–23, 26 Atkinson, A. B., 80 Auerbach, A., 89 Australia, 45 Austria, 13–14, 81, 93 Automobile industry, 54 Aventis, 53, 58 Bailouts expectations and, 11, 14–21, 27 guaranteed, 3, 21 Maastricht Treaty and, 2 macroeconomic view of, 18–20 market regulation and, 9–11, 14–15, 21, 27 microeconomic view and, 15–18 moral hazard and, 3, 14–21 rescue packages and, 1, 10 Baldwin, R. E., 119 Bali Roadmap, 44 Balta, N., 128

Banhzaf index, 125 Bankruptcy, 54, 61–62, 110n13 Banks bailout expectations and, 11, 14–21 Basel approach and, 3, 10, 16, 18, 23–30 central, 2–3, 20, 22, 28–30, 146 contagion and, 9–10, 132 crisis and, 21 (see also Crisis) currency mismatch and, 3, 9, 18–19, 31n5 deleveraging of, 22 fragility of European sector, 2 Glass-Steagall Act and, 3, 11, 23, 26–27 government guarantees and, 3 increased competition and, 11–14 lender-of-last-resort and, 27–28 lending booms and, 9–14 maturity mismatch and, 3, 9, 18, 20 moral hazard and, 14–21 narrow banking and, 3, 9–11, 23–31 regulation and, 9–31 rise of cross-border activities of, 13 risk and, 3 (see also Risk) securitization and, 27–29 Bargaining, 34, 43, 73, 85, 123, 126 Barroso, José Manuel, 145–146 Basel Treaty, 3 Basel III accord and, 26, 30 insufficient capital and, 10–11 market regulation and, 10, 16, 18, 23–30 tier 2 capital and, 16 Batra, R., 36 Baumann, F., 96 Baxter, M., 57 Becker, S. O., 79 Beladi, H., 36

156

Belgium market regulation and, 10, 12–20 national champions and, 58 welfare state reform and, 76–77, 87–88, 99–100 Benelux countries, 47 Berger, H., 60 Bhagwati, J., 40 Biodiversity, 44 Biotechnology, 53, 60–61 Birth rates, 86 Blanchard, O., 59–60, 80–81, 89 Blank, R., 85 Boeing, 40, 56 Boone, J., 81 Bordignon, Massimo, 7–8, 119–153 Brander, J. A., 56, 97 Brazil, 45–46, 57 Brennan, G., 73 Brewer, T., 45 Breyer, F., 90, 94 Brown, Gordon, 149 Brueckner, J. K., 101 Brusco, S., 142 Brussels-Frankfurt consensus, 130, 148 Bubbles, 14, 24, 26, 30, 131 Buchanan, J. M., 73, 75 Budget approval European Council and, 126 European Parliament and, 126 financial perspectives and, 126 national legislation and, 126–127 Buettner, Thiess, 1–8, 84, 119–153 Bulgaria, 100, 120 Bull, 54 Burkhauser, R. V., 85 Bussière, M., 20 Bussolo, M., 34 Buti, M., 130 Buttiglione, Rocco, 146 Caballero, R. J., 81 Calmfors, L., 81 Campa, J., 42 Canada, 42, 45 Capital Basel Treaty and, 16 global integration constraints and, 34, 37–38, 41, 46 increasing investment and, 6 market regulation and, 10–11, 14, 16–18, 23–24, 26–31, 32n9 national champions and, 60–61

Index

political reform and, 130, 134, 138, 141, 147–148 venture, 61 welfare state reform and, 73–76, 79, 81, 90–92, 97–98, 106–107 Carbon-based tariffs, 45 Cash flow, 61–62 Casolaro, L., 91 CEE-8 countries, 104, 110n10 Census of Governments, 137 Cerniglia, F., 141 Chevron, 54 China, 4 agricultural growth and, 35 economic isolation of, 34–35 foreign direct investment (FDI) into, 37–38 global integration constraints and, 33–39, 41–42, 44–46, 48–49 growth and, 34–39 Hong Kong and, 41–43 improved legal structure of, 41 ITU and, 37 national champions and, 54, 57 political reform and, 131, 144, 149 rise of, 34–39 U.S. debt and, 131 Wal-Mart and, 44 world trade share of, 35 Christian Democrats, 146 Cigno, A., 90–92 Citigroup, 54 Citizen’s Freedoms and Rights, 123 Climate change, 4 global integration constraints and, 33–34, 44 Intergovernmental Panel on Climate Change (IPCC) and, 44 political reform and, 140, 144, 149–150 Stern Report and, 44 Clusters, 65, 67 CNOOC, 54 Coalitions, 121, 123, 125, 147 Cochrane, J. H., 96 Cohen, W., 63 Colombo, L., 140 Committee on Foreign Investment, 54 Competition banks and, 11–14 cash flow and, 61–62 cooperation and, 8, 65, 67, 109n7, 142, 145 crisis and, 11–14

Index

Darwinian theory and, 61–65 efficiency effects of, 63–64 escape competition effect and, 64 global integration constraints and, 33–34, 37, 39, 41, 45 innovation and, 6–8, 62 Lerner index and, 64 market concentration and, 63–65 market regulation and, 9, 11–14, 24 monopolies and, 54–58, 62, 67, 126, 147 national champions and, 53–69 politics and, 123, 128–141, 148 reform and, 72, 78, 82, 84–85, 95, 101, 104–108, 123, 128–141, 148 rent dissipation effect and, 62 taxes and, 138–139 total factor productivity (TFP) and, 63 Conciliation Committee, 126 Concorde, 54 Conservative Party, 143 Constitutional Affairs, 123 Contagion, 9–10, 132 Cooperation, 8, 65, 67, 109n7, 142, 145 Copenhagen Accord, 44 Cordon sanitaire, 143, 150 Council of Ministers, 123 Creative destruction, 28, 55, 62 Credit creation of, 3, 22 GDP ratio and, 11–12 market regulation and, 9–12, 18, 22–30 pyramids and, 27 welfare state reform and, 73, 75, 82 Crime, 134 Crisis, 1 bailout expectations and, 11, 14–15, 21, 27 current financial, 21–23 euro risk and, 2–4 financial integration and, 11–14 global integration constraints and, 33, 35, 47–49 increased competition and, 11–14 increased systemic risk taking and, 10 lending booms and, 9–14 liquidity and, 21–23, 26–27, 29 market regulation and, 9–11, 14, 19–23, 26, 28, 30 national champions and, 54 reform and, 26, 71–72, 77, 79, 85–86, 106, 120, 128, 131–133, 148–150 rescue packages and, 1, 10

157

short-term reactions of authorities and, 21–23 solvency and, 22–23, 26 stability/growth trade-off and, 28–29 Currency liabilities, 9–10, 19–20 Currency mismatch, 3, 9, 18–19, 31n5 Currency risk, 2–4, 22, 31n5 Cyprus, 12–13, 15, 20 Dalton, R. J., 142 Dansk Folkeparti, 142 Danninger, S., 60 Danone, 53, 58 Darwinian theory, 61–65 Davis, D., 80 Debt default and, 2, 19, 26, 28, 31n5, 132 global integration constraints and, 34, 47 market regulation and, 19, 23 political reform and, 129–133, 139 welfare state reform and, 71, 87–90 Debt-to-GDP ratio, 89 Default, 2, 19, 26, 28, 31n5, 132 De Grauwe, Paul, 2–3, 9–32 Delgado, J., 128 De Ménil, G., 104 Democracy, 8 European Parliament and, 120, 126–127 Euroskepticism and, 143 political reform and, 143–150 reinvigorating political institutions and, 144–146 Demographic structure decline in birth rates and, 86 increase in life expectancy and, 86 Denmark global integration constraints and, 45 market regulation and, 17, 21 welfare state reform and, 76–77, 81, 83, 87, 92–94, 99–100, 110n10 Deregulation, 56, 95 De Vries, C. E., 142–143 Dewatripont, M., 142 Disney, R., 88 Docquier, F., 102 Dow Jones Industrial Average, 24 Dowrick, S., 97 Dreher, A., 43 Dubai, 46, 54 Dumont, M., 43 Duopolies, 56, 62

158

EADS, 57 Earned Income Tax Credit (EITC), 82, 109n6 Economic and Monetary Affairs, 123 Economic history of Europe, 1 Economic issues aging problem and, 86–98 bailouts and, 2–3 (see also Bailouts) cash flow and, 61–62 contagion and, 9–10, 132 cooperation and, 8, 65, 67, 109n7, 142, 145 creative destruction and, 28, 55, 62 currency mismatch and, 3, 9, 18–19, 31n5 extracting rent abroad and, 55–58, 62, 67 financial integration and, 11–14 fiscal federalism and, 8, 120, 134–141, 149 global financial structure and, 46–47 intergenerational exchange and, 73, 76, 90–92, 107 Keynesianism and, 22–23 lending booms and, 9–14 maturity mismatch and, 3, 9, 18, 20 offshoring and, 39–40, 43 outsourcing and, 4, 37, 39–44, 79, 85, 107 pensions and, 6, 57, 83, 87–98, 102–103, 107, 110n12 private savings and, 91–93, 107 race to the bottom and, 7, 103–104, 108, 130–132, 134, 148 rescue packages and, 1, 10 welfare state and, 72–76 (see also Welfare state) Education global integration constraints and, 37 political reform and, 129–130, 141, 144, 148 welfare state and, 72, 74, 91, 94, 97, 102, 109 Edwards, E. E., 142–143 Egger, Peter, 4–5, 33–51 Ehrlich, I. B., 91 Eichenberg, R. C., 142 Endesa, 58 Endhoven, A. C., 95 Enel, 53 Environmental issues Bali Roadmap and, 44 biodiversity and, 44 carbon-based tariffs and, 45

Index

climate change and, 4, 33–34, 44, 140, 144, 149–150 Copenhagen Accord and, 44 European Emissions Trading Scheme (EU ETS) and, 44–45 fuel-based energy and, 45 G-8 countries and, 44 global integration constraints and, 44–46 Intergovernmental Panel on Climate Change (IPCC) and, 44 Kyoto Protocol and, 44 markets and, 44–46 Stern Report and, 44 EPL index, 80 Equity international issues and, 3 market regulation and, 14, 16, 18, 22–23 political reform and, 128, 148 Esping-Andersen, G., 72 Euro global integration constraints and, 33 market regulation and, 9, 11–14, 16, 18, 20 political reform and, 128, 131–132, 148 Eurobarometer, 141 Eurogroup, 129 Europe 2020, 4–5, 53 European Banking Authority, 29 European Central Bank, 2, 29–30 European Commission, 4, 29, 45, 53, 132, 135, 139, 145, 149 European Communities, 1, 99 European Council, 119 European Court of Justice, 127 European Emissions Trading Scheme (EU ETS), 44–45 European Insurance Authority, 29 European integration, 33–34, 48–49 European Monetary Union, 2, 33 European Parliament, 4, 7–8 democracy and, 120, 126–127 Lisbon Treaty and, 119, 125–126 political reform and, 119–123, 126–127, 145–147, 150 voting and, 120–123 European People’s Party, 123 European Risk Council, 30 European Securities Authority, 29 European Union, 2 agreement index and, 121 anti-Chirac sentiments and, 143 anti-Muslim sentiments and, 143

Index

automatic stabilization and, 131 Brussels-Frankfurt consensus and, 130, 148 budget approval and, 126–127 Citizen’s Freedoms and Rights and, 123 coalitions and, 121, 123, 125, 147 common tax base for, 139 Conciliation Committee and, 126 Constitutional Affairs and, 123 Council of Ministers and, 123 debt crisis and, 129–133, 139 directives implementation and, 127 Economic and Monetary Affairs and, 123 enlargement of, 1 enlightened elites and, 144 enlivening political life of, 143–146 extremist parties and, 142–144 failure of structural reforms and, 127–130 Financial Perspectives and, 126 fiscal federalism and, 136–140 French and Dutch referenda and, 119, 143 global integration constraints and, 4, 33–37, 42–44 growth potential of, 8 Home Affairs and, 123 ideology and, 121–126 internal market and, 4, 136, 140 legislation implementation and, 126–127 Lisbon Treaty and, 119–120, 123, 125–129, 142, 147–148 meddling by, 140–141 migration and, 7 (see also Migration) misery index and, 143 neoliberal success of, 130–132 party discipline and, 121–126 political economy and, 127–130 post-Fortuyn era and, 143 power indexes and, 123, 125 race to the bottom and, 130–132, 134, 148 redesigning public sector in, 133–135 reform and, 7, 100 (see also Reform) Sixth legislative period and, 145–146 special interest groups and, 148 subsidiarity and, 140, 144–145, 149–150 Treaty of Nice and, 119–120, 123–125, 147 Treaty of Rome and, 33–34, 123, 147 voting in, 121–126

159

Euroskepticism, 142–145, 149–150 EU Services Directive, 4, 127, 146 Experience rating system, 59 Falck, O., 67–68 Federalism, 8, 120, 149 fiscal policy and, 139 political reform and, 134–141 taxes and, 134–139 Feenstra, R., 39, 43 Feldstein, M., 90 Fenge, R., 90, 92–93 Fertility, 89–92, 110n9 Feyrer, J., 97 Financial crisis banking crisis, 9, 14, 19, 22–23, 26, 49 decline in housing prices and, 10, 21 Europe and, 3, 30, 48, 71, 132 United States and, 3, 30 Financial deficits and surpluses, 46 Financial market, 46–47 Finland banking crisis of 1990s and, 19 market regulation and, 10–19 political reform and, 125 welfare state reform and, 76–77, 87–88, 92, 99–100, 110n10 Fiscal federalism, 137 Fisher, Irving, 23 Flaig, G., 81 Flexicurity, 81–82 Fogel, K., 60 Foreign direct investment (FDI) Germany and, 78–79 global integration constraints and, 35–38, 42 horizontal, 78 labor and, 78–79 Sweden and, 78–79 vertical, 78–79 welfare state reform and, 78–79, 107 Foreign Invested Enterprises (FIE), 36, 38 France EU referendum of, 119, 143 global integration constraints and, 45, 47 market regulation and, 12–20 national champions and, 53–54, 57–58 political reform and, 133, 140, 142–144, 150 welfare state reform and, 76–77, 87–88, 92–93, 99–100, 102

160

Fratzscher, M., 20 Fredriksson, P. G., 134 Free-mobility-of-labor regime, 105 Freiheitliche Partei Österreichs, 142 French, K. R., 57 Front National, 143 G-20 countries, 148–149 G-8 countries, 44 Gács, V., 91 Galasso, V., 130 Galmarini, U., 140 Gaston, N., 43 Gaz de France, 53 Geis, W., 101–102 General Agreement on Tariffs and Trade (GATT), 34 General Agreement on Trade in Services (GATS), 40 General Motors, 40 Germany, 83 expected bailouts and, 21 foreign direct investment (FDI) and, 78–79 global integration constraints and, 47 market regulation and, 10, 12–21, 31nn3,7 national champions and, 53–55 political reform and, 125, 131–132, 143, 149 TCP/IP protocols and, 55 welfare state reform and, 76–78, 82–84, 87–88, 92–94, 99–100, 102, 110n10 Gerontocratic society, 98 Geroski, P., 65–66 Geys, B., 108 Giavazzi, F., 132 Giuriato, L., 126 Glass-Steagall Act, 3, 11, 23, 26–27 Global integration constraints, 5 Bali Roadmap and, 44 capital and, 34, 37–38, 41, 46 China and, 33–39, 41–42, 44–46, 48–49 Copenhagen Accord and, 44 crisis and, 33, 35, 47–49 debt and, 34, 47 Denmark and, 45 environmental issues and, 44–46 euro and, 33 European Union and, 4 financial structure and, 46–47

Index

foreign direct investment (FDI) and, 35–38, 42 Foreign Invested Enterprise (FIE) and, 36, 38 France and, 45, 47 General Agreement on Tariffs and Trade (GATT) and, 34 General Agreement on Trade in Services (GATS) and, 40 geographic mobility of production and, 39–44 Germany and, 47 government and, 34, 44, 46, 49 Greece and, 33, 47 growth and, 4, 33–39, 46–47 India and, 33–39, 41, 44–46, 48–49 innovation and, 37, 47 insourcing and, 40, 42 Ireland and, 33, 37 Italy and, 47 Japan and, 42 Kyoto Protocol and, 44 labor and, 33, 37–38, 43, 48 Mexico and, 43 migration and, 38, 47–48 national champions and, 54, 57, 68 OECD countries and, 36–38, 40–46 rise of South and, 34–39 roundabout sourcing and, 42 Spain and, 33, 47 stability and, 46, 49 Stern Report and, 44 tariffs and, 33–34, 45 taxes and, 33, 41–42, 45 technology and, 35, 37, 40, 46 through sourcing and, 42 union bargaining and, 43 United Kingdom and, 42–44 United States and, 42–46 Value Added Tax (VAT) and, 33 welfare state reform and, 76–77, 87–88, 92–93, 99–100 Globalization industrial policy for, 5, 53–56, 59–60, 64, 66, 140 integration constraints and, 33–50 national champions and, 5, 53–70 political reform and, 120 welfare state reform and, 6, 71, 79–80, 85–86, 108 Gokhale, J., 89 Goldberg, L., 42

Index

Goldman Sachs, 46 Gollier, Christian, 5–6, 53–70 Government bailouts and, 2–3 (see also Bailouts) banks and, 3 (see also Banks) Census of Governments and, 137 clusters and, 65 fears of bankruptcy and, 54 financial crisis and, 2–4 foreign takeovers and, 5, 53–59 global integration constraints and, 34, 44, 46–47, 49 intertemporal budget constraint and, 88–89 interventions and, 3, 21–22, 44–46, 64–68, 71–74, 109n3, 135, 139 (see also Policy) local, 7–8, 136–141, 144–145, 149 market regulation and, 10–11, 21–24, 29 (see also Regulation) national champions and, 5–6, 53–58, 61, 64–68 preservation of domestic jobs and, 58–59 research funding and, 61 revenue-raising capacity of, 134 short-term reaction of authorities and, 21–23 supranational, 1, 7–8, 13 welfare of foreign residents and, 56 Greece, 2 expected bailouts and, 21 global integration constraints and, 33, 47 market regulation and, 10–21 political reform and, 131–132, 143 welfare state reform and, 110n10 Green Party, 123 Griffith, R., 61, 63–64 Gros, D., 30, 119 Grossman, G., 39, 62 Growth, 6–8 China and, 34–39 Darwinian theory and, 61 global integration constraints and, 4, 33–39, 46–47 India and, 34–39 innovation and, 1, 5, 29, 31, 37, 47, 60–65, 68, 97 institutional reform and, 127–131, 148 intertemporal budget constraint and, 88–89

161

national champions and, 5, 54–55, 60–65, 68 regulation and, 11, 28–31 Responsibility System and, 35 risk and, 28 stability and, 1–2, 28–29, 129 welfare state reform and, 71, 75, 81, 87–89, 97–98, 101 Gulf States, 46 Hagemann, R. P., 88 Hakim, S., 134 Hamilton, A., 134 Hanson, G. H., 39, 43 Harsanyi, J. C., 73 Hart, O., 61–62, 65 Haveman, R. H., 88 Health issues, 6–7 healthcare reform and, 96–97 long-term care and, 94–97 national champions and, 53 old age provision and, 76, 90, 94, 96, 107 political reform and, 130, 144 welfare state and, 73, 75–76, 83, 90, 94–96, 102, 107 Helpman, E., 39, 62 Herd, R., 88 Hirth, R., 96 Hix, S., 120–121, 144–145 Holmes, T. J., 133 Holzmann, R., 88 Holzner, C., 84 Home Affairs, 123 Home bias, 57, 128, 148 Hong Kong, 41–43 Honkapohja, S., 19 Howitt, P., 62 Human capital, 73–74, 76, 81, 91, 98 Hunt, J., 81–82 Hupfeld, S., 94 Hutchison, M., 18 India, 4 China and, 48 economic isolation of, 34–35 global integration constraints and, 33–39, 41, 44–46, 48–49 growth and, 34–39 migration and, 48 national champions and, 60 rise of, 34–39

162

Industrial policy Employment and, 5, 55, 59–60 national champions and, 5, 53–56, 59–60, 64, 66 Infant-industry argument, 5, 60, 68 Information asymmetry, 3, 15–16, 73 Innovation Aghion-Griffith model and, 63–64 clusters and, 65, 67 competition and, 6–8, 62 Darwinian theory and, 61–65 dynamic models for, 5 enhancement of, 7 firm size and, 63 global integration constraints and, 37, 47 growth and, 1, 5, 29, 31, 37, 47, 60–65, 68, 97 market concentration and, 63–65 market regulation and, 29–31 national champions and, 55, 60–68 poles and, 65, 67 reform and, 72, 91, 97, 110n11, 129, 141, 148 rent dissipation effect and, 62 replacement effect and, 62–63 spillover and, 10, 21, 23, 65, 67, 129, 134–140, 148 Insourcing, 40, 42 Institutional setting, 101–102 Institutions, 11 democratic, 8, 120, 126–127, 143–150 global integration constraints and, 33, 37, 46–49, 54, 60 market regulation and, 23, 27, 30, 31n3 political reform and, 7–8, 119–120, 126, 131, 135, 141–150 public sector and, 7–8, 133–140, 149 supranational, 1, 7–8, 13 welfare state and, 72, 80–81, 84, 86, 97, 101–109, 110n14 Interest, 2 market regulation and, 12–13 welfare state reform and, 89–90 Intergenerational redistribution, 73, 76, 90–92, 107 Intergovernmental Panel on Climate Change (IPCC), 44 International issues competition and, 8–15, 24, 33–34 cooperation and, 8, 65, 67, 109n7, 142, 145 equity and, 3

Index

global integration constraints and, 33–50 migration and, 6–7, 38, 47–48, 72, 98–108, 110n11, 140–141, 149 national champions and, 54–55, 67 outsourcing and, 4, 37, 39–44, 79, 85, 107 race to the bottom and, 7, 103–104, 108, 130–132, 134, 148 regulation and, 10–11, 14, 18–19 trade and, 4 Internationalization, 4 International Monetary Fund (IMF), 132 Intertemporal budget constraint, 88–89 Ireland, 2 global integration constraints and, 33, 37 Lisbon Treaty and, 120 market regulation and, 9, 12–20 political reform and, 131–132 welfare state reform and, 76–77, 87–88, 92, 99–100, 110n10 Iron Curtain, 99 Italy, 92 expected bailouts and, 21 global integration constraints and, 47 market regulation and, 12–21 political reform and, 132–133, 140, 143 Ito, T., 18 Jagannathan, R., 61–62 Japan global integration constraints and, 42 market regulation and, 9–10, 16, 22, 31n3 national champions and, 54, 57 welfare state reform and, 76–77, 87–88, 99–100 Jermann, U. J., 57 Juncker, Jean-Claude, 129 Kaminsky, G., 19 Katz, L. F., 81 Keen, M., 82, 139 Kessing, S., 137 Keynesianism, 22–23 Kim, J., 91 Koeniger, W., 20 Kolmar, M., 91 Konrad, Kai A., 6–7, 71–118, 137 Korea, 10, 42 Koskela, E., 19, 85 Kotlikoff, L. J., 89 Kotsogiannis, C., 137 Kunreuther, H., 96 Kyoto Protocol, 44

Index

Labor activating unemployed and, 76–86 aging problem and, 86–98 benefit sanctions and, 83–84 boosting employment and, 76–86 cross-border mobility and, 133–134 Darwinian theory and, 61–65 Earned Income Tax Credit (EITC) and, 82 efficiency-wage element and, 85–86 EPL index and, 80 fertility rates and, 89–92, 110n9 flexicurity and, 81 foreign direct investment (FDI) and, 78–79 global integration constraints and, 33, 37–38, 43, 48 high-skilled, 105, 107–108 industrial policy and, 5, 53–56, 59–60, 64, 66, 140 international division of, 79 low-skilled, 74, 78, 82, 84, 110n13, 143–144, 150 market rigidities and, 1, 6, 8 migration and, 6–7, 38, 47–48, 72, 98–108, 110n11, 140–141, 149 national champions and, 57–60 offshoring and, 39–40, 43 old age provision and, 72, 76, 86–98, 107 outsourcing and, 4, 37, 39–44, 79, 85, 107 ownership rights and, 58–60 participation rates and, 76–77 passive benefits and, 80 pensions and, 6, 57, 83, 87–98, 102–103, 107, 110n12 poverty and, 85, 94 protecting employment and, 58–60, 67 rating systems and, 59–60 retirement and, 86, 91–94, 133 severance pay and, 81 social protection schemes and, 71–72, 78, 80–81, 84–87, 91–94, 97, 101–103, 106–108, 109n5 stricter U.S. laws of, 133–134 unemployment and, 6, 58–60, 71–72, 76–86, 93, 100–101, 107, 109nn4,5,6, 131 unions and, 43, 85, 106 wage bargaining and, 73, 85–86 welfare-magnet hypothesis and, 102–103, 110n13 welfare state reform and, 6–7, 71–86, 93–94, 97–108, 109n4, 110nn8,10

163

workfare and, 6, 78, 82–84 working poor and, 84 Working Tax Credit and, 82 work permits and, 48, 101, 105–106 Laffer curve, 98 Lalive, R., 82, 84 Lannoo, K., 29 Larosiere committee, 29 Lazear, E., 81 Lega Nord, 143 Left wing parties economic insecurity arguments and, 143 neoliberal reforms of the European project and, 142–143 Lehman Brothers, 54 Lender-of-last resort, 27–28 Lending booms, 9–14 Lerner index, 64 Levin, R., 63 Life expectancy. See Longevity Lindbeck, A., 75 Lindh, T., 97 Liquidity infusions of, 3 market regulation and, 21–23, 26–27, 29 Lisbon Treaty double majority rule and, 119, 125 European Parliament and, 119, 125–126 failure of structural reforms and, 127–129 Irish referendum and, 120 national symbols and, 119 political reform and, 119–120, 123, 125–129, 142, 147–148 Qualified Majority Voting rules and, 125 Loans bailout expectations and, 14–21 default and, 2, 19, 26, 28, 31n5, 132 lender-of-last-resort and, 27–28 lending boom and, 11–14 market regulation and, 18, 27–29 narrow banking and, 3, 9–11, 23–31 securitization and, 27–29 Local government, 7–8, 136–141, 144–145, 149 Lohest, O., 102 Lommerud, K. E., 85 Longevity, 73, 86–87, 89, 94–95, 110n9 Luxembourg market regulation and, 13–17, 19, 21 political reform and, 141

164

Maastricht Treaty, 2, 123, 129–130, 142, 148 Maddison, A., 75 Majoritarian system, 145, 150 Malmberg, B., 97 Malta, 12–15, 20 Manasse, P., 140 Marfouk, A., 102 Markets, 33–34, 45, 136 asset prices and, 22–23, 26 bailouts and, 9–11, 14–15, 21, 27 Belgium and, 10, 12–20 bubbles and, 14, 24, 26, 30, 131 capital and, 10–11, 14, 16–18, 23–24, 26–31, 32n9 competition and, 9, 11–14, 24 cooperation and, 8, 65, 67, 109n7, 142, 145 credit and, 9–12, 18, 22–30 crisis and, 9–11, 14, 19–23, 26, 28, 30 debt and, 19, 23 Denmark and, 17, 21 Dow Jones Industrial Average and, 24 environmental issues and, 44–46 equity and, 14, 16, 18, 22–23 euro and, 9, 11–14, 16, 18, 20 Finland and, 10–19 France and, 12–20 geographic mobility of production and, 39–44 Germany and, 10, 12–21, 31nn3,7 Greece and, 10–21 interest and, 12–13 Ireland and, 9, 12–20 Italy and, 12–21 Japan and, 9–10, 16, 22, 31n3 Lerner index and, 64 liquidity and, 21–23, 26–27, 29 loans and, 18, 27–29 long-term policy options and, 23–29 Luxembourg and, 13–17, 19, 21 macroeconomic view of, 18–20 Mexico and, 10 microeconomic view of, 15–18 Netherlands and, 10, 13–15, 17, 19, 21 Portugal and, 12–20 regulation and, 9–31 revaluation gains and, 14, 16–18 rigidities and, 1, 6, 8 risk and, 9–31 (see also Risk) securitization and, 27–29 shocks and, 18, 23–24, 32n9, 131

Index

Slovenia and, 10–15, 17, 19–21 solvency and, 22–23, 26 Spain and, 12–21 stability and, 14, 18, 28–30 United Kingdom and, 10–14, 17–20 United States and, 10–14, 17–19, 21, 29–30 Maturity mismatch, 3, 9, 18, 20 Meier, V., 96 Meland, F., 85 Mendelsohn, R. O., 44 Mergers, 21, 53–54, 56 Merrill Lynch, 54 Mexico, 10, 43 Meyer, B. D., 81 Micossi, S., 119 Microsoft, 56 Migration, 7 aging problem and, 107 brain drain, 101 citizenship and, 98, 103–104 global integration constraints and, 38, 47–48 internal, 102 Iron Curtain and, 99 job security and, 102 labor market performance and, 105, 107 managing international, 98–106 pensions and, 103 race to the bottom and, 103–104 redistribution and, 103–104 reform and, 72, 98–108, 110n11, 140–141, 149 risk and, 6 score systems and, 105 self-selection processes and, 101 skilled labor and, 105–108, 150 social protection schemes and, 101–103, 106 visas and, 48, 105–106 wage differentials and, 101 welfare-magnet hypothesis and, 102–103, 110n13 welfare state and, 98–106 work permits and, 105–106 Millimet, D. L., 134 Minsky, H., 23 Mittal, 58 Mobility externalities and, 134, 138 public services and, 136 spill-over effects and, 134

Index

taxation and, 133, 137–138 tax competition and, 41, 106, 135 Monopolies duopolies and, 56, 62 extracting rent abroad and, 55–58, 62, 67 national champions and, 54–58, 62, 67 political reform and, 126, 147 replacement effect and, 62–63 transfer effect and, 56 Montén, A., 98 Moral hazard bailouts and, 3, 14–21 macroeconomic view of, 18–20 market regulation and, 14–15, 21 microeconomic view and, 15–18 risk and, 3, 14–15, 21, 80, 109n3, 110n9 welfare state reform and, 80, 109n3, 110n9 Morck, R., 60 Morgan Stanley, 54 Morocco, 37 Muendler, M. A., 79 Municipal government. See Local government Munz, S., 84, 91, 103 Narrow banking, 3 Glass-Steagall Act and, 26–27 market regulation and, 9–11, 23–31 securitization and, 27–29 National champions automobile industry and, 54 capital and, 60–61 cash flow and, 61–62 China and, 54, 57 competition and, 53–56, 60–69 Darwinian theory and, 61–65 extracting rent abroad and, 55–58, 62, 67 France and, 53–54, 57–58 Germany and, 53–55 global integration constraints and, 34, 37, 41–43, 47 growth and, 5, 54–55, 60–65, 68 home-bias puzzle and, 57 India and, 60 industrial policy and, 5, 53–56, 59–60, 64, 66 infant-industry argument and, 5, 60, 68 innovation and, 55, 60–68 international issues and, 54–55, 67 Japan and, 54, 57 labor and, 57–60

165

market regulation and, 20, 29–31 monopolies and, 55–58, 62, 67 offshoring and, 57 ownership rights and, 58–60 patriotism and, 54, 57 picking winners and, 65–68 political economy and, 65–68 protecting employment and, 58–60, 67 replacement effect and, 62–63 risk and, 58–59, 63 sensitive sectors and, 53 spillover and, 65, 67 support for, 55–56, 66–68 takeovers and, 53–54, 57–59 TCP/IP protocols and, 55 technology and, 50, 55, 63–65, 68 unemployment and, 58–60 United Kingdom and, 63–64 United States and, 54, 57, 68 National government, 2, 5, 29, 46, 53, 56–57, 67, 125, 129, 138 National implementation of EU legislation, 127, 147 Nationalism, 31, 56, 109, 110n14 Netherlands EU referendum of, 119, 143 market regulation and, 10, 13–15, 17, 19, 21 political reform and, 131, 140, 142–143, 149 welfare state reform and, 76–77, 81, 87–88, 99–100 Neven, D., 56 New Zealand, 45, 82 Nickell, S., 63, 80, 81 Nicoletti, G., 60, 88 Nitsch, V., 128 Noury, A., 121 Oates, W. E., 134 Obama, Barack, 149 Ochel, Wolfgang, 1–8, 105–106 Offshoring, 39–40, 43, 57 Old age provision birth rates and, 86 fertility and, 89–92, 110n9 gerontocratic society and, 98 healthcare and, 76, 90, 94, 96, 107 intertemporal budget constraint and, 88–89 longevity and, 73, 86–87, 89, 94–95, 110n9

166

pensions and, 6, 57, 83, 87–98, 102–103, 107, 110n12 poverty and, 85, 94 private savings and, 91–93, 107 retirement and, 86, 91–94, 133 Social Security Trust Funds and, 92 welfare state and, 72, 76, 86–98, 107 Olmstead, S. M., 44 Organisation for Economic Co-operation and Development (OECD) countries global integration constraints and, 36–38, 40–46 welfare state reform and, 80–81, 92, 101, 109n7, 110n11 Outsourcing, 4 geographic mobility of production and, 39–44 global integration constraints and, 37, 39–44 welfare state and, 79, 85, 107 Ownership, 13, 39, 58–60 Pagani, L., 141 Palacios, R., 88 Panagariya, A., 40 Paretian analysis, 91 Patriotism, 54, 57, 108–109, 110n14 Patton, Chris, 146 Pauly, M. V., 96 Pedersen, P. J., 102 Pensions actuarial fairness and, 93 best years assessment and, 93 contributions to, 88–89 demographic buffers and, 92–93 end-of-career values and, 93 increased retirement age and, 93–94 intertemporal budget constraint and, 88–89 pay-as-you-go, 90–91 poverty and, 85, 94 Social Security Trust Funds and, 92 sustainability of, 87–88 taxes and, 89 unfunded, 87, 90–94, 103 welfare state and, 6, 57, 83, 87–98, 102–103, 107, 110n12 Pepsi, 53 Perotti, R., 140 Pestieau, P., 93 Phelps, E. S., 80 Poles, 65, 67

Index

Policy banks and, 3 (see also Banks) Basel approach and, 3, 10, 16, 18, 23–30 climate change and, 4, 33–34, 44, 140, 144, 149–150 cooperation and, 8, 65, 67, 109n7, 142, 145 Copenhagen Accord and, 44 environmental issues and, 44–46 Europe 2020 and, 4–5, 53 European Emissions Trading Scheme (EU ETS) and, 44–45 fiscal federalism and, 8, 120, 134–141, 149 General Agreement on Tarrifs and Trade (GATT) and, 34 General Agreement on Trade in Services (GATS) and, 40 Glass-Steagall Act and, 3, 11, 23, 26–27 industrial, 5, 53–56, 59–60, 64, 66, 140 internationalization and, 4 (see also International issues) interventions and, 3, 21–22, 44–46, 64–68, 71–74, 109n3, 135, 139 Lisbon Treaty and, 119–120, 123, 125–129, 142, 147–148 local, 7–8, 136–141, 144–145, 149 long-term options for, 23–29 Maastricht Treaty and, 2, 123, 129–130, 142, 148 migration and, 6–7, 38, 47–48, 72, 98–108, 110n11, 140–141, 149 narrow banking and, 3, 9–11, 23–31 offshoring and, 39–40, 43 outsourcing and, 4, 37, 39–44, 79, 85, 107 reform and, 71–72, 79–82, 85, 98–108, 110n11, 120, 128, 132, 135, 140 Stability and Growth Pact and, 2, 129 subsidiarity and, 140, 144–145, 149–150 Treaty of Nice and, 119–120, 123–125, 147 welfare state and, 71 Political economy national champions and, 65–68 picking winners and, 65–68 structural reform failure and, 127–130, 140 Politics agreement index and, 121 anti–Muslim sentiments and, 143 Brussels-Frankfurt consensus and, 130, 148

Index

capital and, 130, 134, 138, 141, 147–148 China and, 131, 144, 149 Citizen’s Freedoms and Rights and, 123 coalitions and, 121, 123, 125, 147 competition and, 123, 128–141, 148 Conciliation Committee and, 126 connecting with people and, 145–146 Constitutional Affairs and, 123 Council of Ministers and, 123 debt crisis and, 129–133, 139 decline of U.S. and, 132 democracy and, 8, 120, 126–127, 143–150 Economic and Monetary Affairs and, 123 enlightened elites and, 144 equity and, 128, 148 euro and, 128, 131–132, 148 European Parliament and, 4, 7–8, 119–123, 126–127, 145–147, 150 EU voting and, 121–126 extremist parties and, 142–144 factionalization and, 121 federalism and, 8, 120, 134–141, 149 Finland and, 125 France and, 133, 140, 142–144, 150 Germany and, 125, 131–132, 143, 149 Greece and, 131–132, 143 Home Affairs and, 123 ideology and, 121–126 interest rates and, 131–132, 138 Ireland and, 131–132 Iron Curtain and, 99 Italy and, 132–133, 140, 143 labor and, 129–134, 141, 147–148 Luxembourg and, 141 misery index and, 143 monopolies and, 126, 147 national champions and, 53–70 nationalism and, 31, 56, 109, 110n14 Netherlands and, 131, 140, 142–143, 149 party discipline and, 121–126 patriotism and, 54, 57, 108–109, 110n14 Portugal and, 131–132 post-Fortuyn era and, 143 power indexes and, 123, 125 protectionism and, 128, 134, 137, 144, 149–150 Qualified Majority Voting (QMV) and, 123, 125–126 race to the bottom and, 130–132 reinvigoration of European, 143–146 roll-call votes and, 121, 123

167

Spain and, 131–132 special interest groups and, 148 taxes and, 131–139 terrorism and, 141, 144, 149–150 Treaty of Nice and, 119–120, 123–125, 147 Treaty of Rome and, 33–34, 123, 147 unemployment and, 131 United Kingdom and, 131, 140, 143, 149 United States and, 121, 129, 131–132, 134, 137, 144, 149 voting in European Union and, 121–126 Portugal market regulation and, 12–20 political reform and, 131–132 welfare state reform and, 76–77, 87–88, 99–100, 110n10 Post-Maastricht blues, 142 Poterba, J. M., 57 Poverty, 85, 94, 149 PR China, 54 Production competition and, 61–62 (see also Competition) efficiency-wage element and, 85–86 foreign direct investment (FDI) and, 78–79 free cash flow and, 61–62 geographic mobility of, 39–44 global integration constraints and, 37, 39–44 insourcing and, 40, 42 labor and, 85 (see also Labor) market concentration and, 63–65 national champions and, 55–58 outsourcing and, 4, 37, 39–44, 79, 85, 107 political institutions and, 129, 134, 148 regulation and, 22 roundabout sourcing and, 42 through sourcing and, 42 total factor productivity (TFP) and, 62–63, 97 welfare state and, 75, 78–79, 86 Protectionism, 2 European economy and, 132–133 political reform and, 128, 134, 137, 144, 149–150 welfare state and, 71–72, 78, 80–81, 84–87, 91–94, 97, 101–103, 106–108, 109n5 Public sector, 7–8, 133–140, 149 Pytlikova, M., 102

168

Qari, S., 108–109 Qualified Majority Voting (QMV), 123, 125–126 Race to the bottom, 7, 103–104, 108, 130–132, 134, 148 Ranciere, R., 11, 28 Rangel, A., 90 Rawls, J., 73 Rayp, G., 43 Redistribution global integration constraints and, 38 as insurance, 73–74 migration and, 103–104 national champions and, 58 political reform and, 138, 141 taxes and, 138 welfare state and, 58, 73–75, 90, 94, 96, 103–104, 107, 109n3 Reform Basel Treaty and, 26 Belgium and, 76–77, 87–88, 99–100 bottom-up, 140 bubbles and, 131 capital and, 73–76, 79, 81, 90–92, 97–98, 106–107, 130, 134, 138, 141, 147–148 China and, 131, 144, 149 competition and, 72, 78, 82, 84–85, 95, 101, 104–108, 123, 128–141, 148 credit and, 73, 75, 82 crisis and, 26, 71–72, 77, 79, 85–86, 106, 120, 128, 131–133, 148–150 debt and, 71, 87–90, 129–132, 139 Denmark and, 76–77, 81, 83, 87, 92–94, 99–100, 110n10 equity and, 128, 148 euro and, 128, 131–132, 148 failure of, 127–130 Finland and, 76–77, 87–88, 92, 99–100, 110n10, 125 foreign direct investment (FDI) and, 78–79, 107 France and, 76–77, 87–88, 92–93, 99–100, 102, 133, 140, 142–144, 150 Germany and, 76–78, 82–84, 87–88, 92–94, 99–100, 102, 110n10, 125, 131–132, 143, 149 Greece and, 110n10, 131–132, 143 growth and, 6–8, 71, 75, 81, 87–89, 97–98, 101, 127–131, 148

Index

healthcare, 96–97 industrial policy and, 140 innovation and, 72, 91, 97, 110n11, 129, 141, 148 interest and, 89–90, 131–132, 138 international, 71–72, 79–82, 85, 98–108, 110n11, 120, 128, 132, 135, 140 Ireland and, 76–77, 87–88, 92, 99–100, 110n10, 131–132 Italy and, 76–77, 87–88, 92–93, 99–100, 132–133, 140, 143 Japan and, 76–77, 87–88, 99–100 labor and, 71–86, 93–94, 97–108, 109n4, 110nn8,10, 129–134, 141, 147–148 Lisbon Treaty and, 119–120, 123, 125–126, 142, 147 local government and, 136–141, 144–145, 149 Luxembourg and, 141 migration and, 72, 98–108, 110n11, 140–141, 149 moral hazard and, 80, 109n3, 110n9 Netherlands and, 76–77, 81, 87–88, 99–100, 131, 140, 142–143, 149 pensions and, 89, 97 political economy and, 127–130, 140 political institutions and, 119–120, 126, 131, 135, 141–150 Portugal and, 76–77, 87–88, 99–100, 110n10, 131–132 public sector and, 7–8, 133–140, 149 risk and, 73, 75, 96, 106, 139, 149 shocks and, 131 Slovenia and, 110n10 Spain and, 76–77, 87–88, 92, 99–100, 110n10, 131–132 special interest groups and, 148 spillover and, 129, 134–140, 148 stability and, 2, 129, 149 taxes and, 82, 89, 91, 94, 98, 103–104, 106, 131–139 technology and, 85–86, 128–129 Treaty of Nice and, 119–120, 123 United Kingdom and, 83, 102, 110n10, 131, 140, 143, 149 United States and, 80, 82, 92–94, 101–102, 109n6, 110n13, 121, 129, 131–132, 134, 137, 144, 149 welfare state and, 6–7 (see also Welfare state)

Index

Regulation, 2 asset prices and, 22–23, 26 bailouts and, 9–11, 14–15, 21, 27 banks and, 3–4, 8, 9–31 Basel approach and, 3, 10, 16, 18, 23–30 Belgium and, 10, 12–20 bubbles and, 14, 24, 26, 30 capital and, 10–11, 14, 16–18, 23–24, 26–31, 32n9 credit and, 9–12, 18, 22–30 crisis and, 9–11, 14, 19–23, 26, 28, 30 debt and, 19, 23 Denmark and, 17, 21 equity and, 14, 16, 18, 22–23 euro and, 9, 11–14, 16, 18, 20 Finland and, 10–19 France and, 12–20 Germany and, 10, 12–21, 31nn3,7 Glass-Steagall Act and, 3, 11, 23, 26–27 Greece and, 10–21 growth and, 28–31 innovation and, 29–31 interest and, 12–13 international issues and, 10–11, 14, 18–19 Ireland and, 9, 12–20 Italy and, 12–21 Japan and, 9–10, 16, 22, 31n3 liquidity and, 21–23, 26–27, 29 loans and, 18, 27–29 local, 7–8, 136–141, 144–145, 149 long-term policy options and, 23–29 Luxembourg and, 13–17, 19, 21 macroeconomic view of, 18–20 Mexico and, 10 microeconomic view of, 15–18 Netherlands and, 10, 13–15, 17, 19, 21 Portugal and, 12–20 protectionism and, 132–133 securitization and, 27–29 shocks and, 18, 23–24n, 32n9 short-term reactions of authorities and, 21–23 Slovenia and, 10–15, 17, 19–21 solvency and, 22–23, 26 Spain and, 12–21 spillover and, 10, 21–23 stability and, 14, 18, 28–30 supranational, 1, 7–8, 13 taxes and, 22 technology and, 12

169

United Kingdom and, 10–14, 17–20 United States and, 10–14, 17–19, 21, 29–30 welfare state and, 71–72 Reinhart, C., 19 Renault, 57–58 Rengert, G. F., 134 Rent dissipation effect, 62–64 Replacement effect, 62–63 Rescue packages, 1, 10 Research, 1 biotechnology and, 60–61 Darwinian theory and, 61–65 global integration constraints and, 39–43 government funding for, 61 political reform and, 123, 127, 129 rent dissipation effect and, 62 welfare state reform and, 71, 80–81, 97, 101–102 Responsibility System, 35 Retirement, 86, 91–94, 133 Revaluation gains, 14, 16–18 Richter, W. F., 91, 101 Rightwing parties, 142 Rigidities, 1, 6, 8 Risk. See also Stability asset bubbles and, 30 Basel 2 and, 24 contagion and, 9–10, 132 currency, 2–4, 22, 31n5 default and, 2, 19, 26, 28, 31n5, 132 environmental, 47 euro and, 2–4 European Risk Council and, 30 global integration constraints and, 47 growth and, 28 kinked utility curve and, 16 liquidity and, 27, 29 longevity and, 73, 89, 95 market regulation and, 9–31 migration and, 6 moral hazard and, 3, 14–15, 21, 80, 109n3, 110n9 national champions and, 58–59, 63 political reform and, 139, 149 securitization and, 27–29 systemic, 3, 9–11, 18, 20, 22, 27–29 tail, 26–27 welfare state reform and, 73, 75, 96, 106 Rodrik, D., 66 Röger, W., 130

170

Roland, G., 121, 123 Roll-call votes, 121, 123 Romania, 57, 100, 120 Romer, P., 62 Rosati, F. C., 91 Rottmann, H., 81 Roundabout sourcing, 42 Route 128, Boston, 65 Russia, 45–46, 131 Ruta, M., 129 Saint-Paul, G., 80, 101 Samuelson, P. A., 90 Sandwick, A., 62 Sanofi, 53 Sapir, A., 129, 137 Scarpetta, S., 60 Schengen Agreement, 136 Scherer, F., 63 Schneider, M., 11, 21, 28 Schöb, R., 85 Schuknecht, L., 137 Schumpeter, J., 28, 62–63 Seabright, P., 56 Securitization, 27–29 Sen, A., 74 Shapley-Shubik index, 125 Shenkar, O., 34 Shocks market regulation and, 18, 23–24, 32n9 reform and, 131 Silicon Valley, 65 Singapore, 46 Sinn, H.-W. market regulation and, 13, 15, 24 political reform and, 135 welfare state reform and, 73, 75, 79–80, 83, 90, 92, 97, 101, 103–104 Slovenia market regulation and, 10–15, 17, 19–21 welfare state reform and, 110n10 Smith, N., 102 Social protection schemes, 6, 71, 87, 93, 101, 106 Social Security Trust Funds, 92 Solvency, 22–23, 26 Spain global integration constraints and, 33, 47 market regulation and, 12–21 political reform and, 131–132

Index

welfare state reform and, 76–77, 87–88, 92, 99–100, 110n10 Spencer, B., 56 Spillover benefit effects and, 137 clusters and, 65 mobility effects and, 134 national champions and, 65, 67 poles and, 65 reform and, 129, 134–140, 148 regulation and, 10, 21–23 Square-root rule, 125 Srinivasan, S. B., 61–62 Srinivasan, T. N., 40 Stability bailouts and, 2 (see also Bailouts) banks and, 10 (see also Banks) global integration constraints and, 46, 49 growth and, 1–2, 28–29, 129 Maastricht Treaty and, 2 market regulation and, 14, 18, 28–30 national champions and, 60 political reform and, 129, 149 rescue packages and, 1, 10 securitization and, 27–29 solvency and, 22–23, 26 Van Rompuy Task Force and, 2 welfare state and, 73 Stability and Growth Pact, 2, 129 Standard of living, 75 Stavins, R. N., 44 Steenbergen, M. R., 142 Stern Report, 44 Stiglitz, J., 15, 34 Straume, O. R., 85 Subsidiarity, 140, 144–145, 149–150 Suez, 53, 58 Svarer, M., 82–83, 109n5 Sweden foreign direct investment (FDI) and, 78–79 political reform and, 149 welfare state and, 78–79, 83, 92–93 Systemic risk, 3, 9–11, 18, 20, 22, 27–29 Tabellini, G., 140–141 Tail risk, 26–27 Taiwan, 42–43 Takeovers bailout expectations and, 21 foreign, 5, 53–54, 57–59

Index

home-bias puzzle and, 57 national champions and, 53–54, 57–59 World Bank data on, 21 Tariffs, 33–34, 45, 136 Taxes common EU base for, 139 competition and, 138–139 Earned Income Tax Credit (EITC) and, 82, 109n6 erosion of revenues and, 134–135 federalism and, 134–139 global integration constraints and, 33, 41–42, 45 indirect cost of, 138 market regulation and, 22 pensions and, 89 political reform and, 131–139 public services and, 136 Value Added Tax (VAT) and, 33, 138–139 welfare state reform and, 82, 89, 91, 94, 98, 103–104, 106 Working Tax Credit and, 82 TCP/IP protocols, 55 Technology biotechnology, 53, 60–61 global integration constraints and, 35, 37, 40, 46 Lisbon Agenda and, 128–129 national champions and, 50, 63–65, 68 reform and, 85–86, 128–129 regulation and, 12 TCP/IP protocols and, 55 Terrorism, 141, 144, 149–150 Through sourcing, 42 Thum, M., 98 Timmer, J. W., 132 Tirole, J., 59–60, 62 Tomiura, E., 43 Tornell, A., 11, 18–19, 21, 28 Total factor productivity (TFP), 62–63, 97 Townley, P. G. C., 90 Transfer effect, 56 Treaty of Maastricht, 2, 123, 129–130, 148 Treaty of Nice, 119–120, 123–125, 147 Treaty of Rome, 33–34, 123, 147 Turkey, 37 Turrini, A., 130 Uebelmesser, S., 97, 101–102 Unemployment, 6

171

national champions and, 58–60 passive benefits and, 80 political reform and, 131 welfare state and, 71–72, 76–86, 93, 100–101, 107, 109nn4,5,6 Unions, 43, 85, 106 United Kingdom, 150 Brown and, 149 Conservative Party and, 143 extremist parties and, 144 global integration constraints and, 42–44 market regulation and, 10–14, 17–20 national champions and, 63–64 political reform and, 131, 133, 140, 143, 149 welfare state reform and, 83, 102, 110n10 Working Tax Credit and, 82 United States, 3 automobile industry and, 54 biotechnology and, 60–61 China’s financing debt of, 131 currency issues of, 132 Earned Income Tax Credit (EITC) and, 82, 109n6 global integration constraints and, 42–46 housing market and, 132 internal migration and, 102 market regulation and, 10–14, 17–19, 21, 29–30 national champions and, 54, 57, 68 Obama and, 149 patriotism and, 54 political reform and, 121, 129, 131–132, 134, 137, 144, 149 reckless economic history of, 132 rescue packages and, 1, 10 Russian financing of, 131 Social Security Trust Funds and, 92 stricter labor laws in, 133–134 TCP/IP protocols and, 55 welfare state reform and, 80, 82, 92–94, 101–102, 109n6, 110n13 Unocal, 54 Value Added Tax (VAT), 33, 138–139 Van den Berg, G. J., 84 Van den Noord, P. J., 88 Van der Ploeg, Frederick, 7–8, 119–153 Van Ours, J. C., 81, 84

172

Van Rompuy Task Force, 2 Vermeend, W., 132 Véron, N., 57–58 Visas, 48, 105–106 Vlaams Blok, 142 Volkswagen, 57 Wage bargaining, 73, 85–86 Wal-Mart, 44 Walsh, S., 44 Weiss, A., 15 Welfare-magnet hypothesis, 102–103, 110n13 Welfare state, 7, 109 activating unemployed and, 76–86 aging problem and, 86–98 automatism and, 83–84 Belgium and, 76–77, 87–88, 99–100 birth rates and, 86 boosting employment and, 76–86 capital and, 73–76, 79, 81, 90–92, 97–98, 106–107 children and, 72–75, 84, 90–92, 98, 109n6 cost of, 2 credit and, 73, 75, 82 debt and, 71, 87–90 Denmark and, 76–77, 81, 83, 87, 92–94, 99–100, 110n10 designing policies of, 71 disability and, 72–73 Earned Income Tax Credit (EITC) and, 82, 109n6 economic rationale for, 72–76 EPL index and, 80 Finland and, 76–77, 87–88, 92, 99–100, 110n10 flexicurity and, 81 foreign direct investment (FDI) and, 78–79, 107 France and, 76–77, 87–88, 92–93, 99–100, 102 Germany and, 76–78, 82–84, 87–88, 92–94, 99–100, 102, 110n10 gerontocratic society and, 98 globalization and, 6, 71, 79–80, 85–86, 108 Greece and, 110n10 health issues and, 73, 75–76, 83, 90, 94–96, 102, 107 human capital and, 73–74, 76, 81, 91, 98 information asymmetries and, 73

Index

institutions and, 72, 80–81, 84, 86, 97, 101–109, 110n14 interest and, 89–90 intergenerational exchange and, 73, 76, 90–92, 107 intertemporal budget constraint and, 88–89 Ireland and, 76–77, 87–88, 92, 99–100, 110n10 Italy and, 76–77, 87, 88, 92–93, 99–100 Japan and, 76–77, 87–88, 99–100 labor and, 71–86, 93–94, 97–108, 109n4, 110nn8,10 longevity and, 73, 86–87, 89, 94–95, 110n9 migration management and, 98–106 Netherlands and, 76–77, 81, 87–88, 99–100 OECD countries and, 80–81, 92, 101, 109n7, 110n11 old age provision and, 72, 76, 86–98, 107 Paretian analysis and, 91 pensions and, 6, 57, 83, 87–98, 102–103, 107, 110n12 Portugal and, 76–77, 87–88, 99–100, 110n10 poverty and, 85, 94 race to the bottom and, 108 redistribution and, 58, 73–75, 90, 94, 96, 103–104, 107, 109n3 retirement and, 86, 91–94, 133 Slovenia and, 110n10 social protection schemes and, 71–72, 78, 80–81, 84–87, 91–94, 97, 101–103, 106–108, 109n5, 150 Social Security Trust Funds and, 92 Spain and, 76–77, 87–88, 92, 99–100, 110n10 stability and, 73 standard of living and, 75 taxes and, 82, 89, 91, 94, 98, 103–104, 106 unemployment and, 71–72, 76–86, 93, 100–101, 107, 109nn4,5,6 United Kingdom and, 83, 102, 110n10 United States and, 80, 82, 92–94, 101–102, 109n6, 110n13 wage bargaining and, 73, 85–86 workfare and, 6, 78, 82–84 Working Tax Credit and, 82 Werding, Martin, 6–7, 71–118

Index

Westermann, Frank, 2–3, 9–32 Whalley, John, 4–5, 33–51 Widgrén, M., 123, 125–126 Willemé, P., 43 Woessmann, Ludger, 5–6, 53–70 Wolf, H. C., 128 Wolfers, J., 80–81 Workfare, 6, 78, 82–84 Working Tax Credit, 82 Work permits, 48, 101, 105–106 World Bank, 21, 31n7 Xiao, G., 42 Yeung, B., 60 Zhong, J.-G., 91 Zviniene, A., 88 Zweimüller, J., 84

173