Euro reform Not Such a Capital Idea

To help to overcome the Greece crisis and bypass resistance to a stronger fiscal union, European policymakers are advocating a move towards more strongly integrated capital markets. But evidence suggests the plan is flawed.
The three presidents, Donald Tusk (E.U. Council), Jean-Claude Juncker (E.U. Commission) and Mario Draghi (ECB), may have to rethink their plans.

When the euro was first conceived in the 1990s, it was mainly Anglo-Saxon economists who warned Europe that a monetary union without a fiscal union wouldn’t work. They reasoned that if a monetary policy tailored to the national economy could no longer be implemented, member states would drift apart without a common fiscal policy to help countries in trouble.

The E.U.'s leaders shrugged off the criticism. The European strategy was to launch the monetary union and use the tailwind to convert it into a political  and fiscal union afterwards.

We now know the gamble didn't pay off. Greece’s financial woes have brought the monetary union to the brink of collapse. Efforts to spread the pain felt by Athens among European Union nations is still being met with fierce opposition in Germany and elsewhere.

The idea of "fiscal union" – combining national budgets, or introducing a European finance minister, or shedding sovereignty over some budget decisions to Brussels – has become politically toxic amidst the major infighting.

Given the difficulties, European policymakers and their advisers have come up with a new strategy: They're even betting that more strongly integrating capital markets – a task that seems more politically feasible – will make a fiscal equalization scheme superfluous.

Jens Weidmann, president of Germany’s central bank, the Bundesbank, is a fan. “It would be short-sighted to confine the debate to the fiscal dimension,” he said recently.

The knight in shining armor, the capital market, may still be hopelessly overwhelmed by the monetary union’s structural problems.

His reasoning is simple: “In the United States, for example, studies show that fiscal policy cushions only 10 to 20 percent of economic shocks, meaning that a local income shock does not translate into a drop in consumption to the same extent.”

He pointed out that integrated capital markets played a far larger role – smoothing out around 40 percent of cyclical fluctuations.

Mario Draghi, the president of the European Central Bank, made a similar argument last November. It can also be found in the so-called Five Presidents’ Report, a major effort by the leaders of the E.U.'s five top institutions to develop ideas for completing Europe’s economic and monetary union and led by Jean-Claude Juncker, the president of the European Commission.

This report stresses the urgency of more strongly integrating Europe's capital markets, in part by revitalizing the loan securitization market – a market that collapsed in the aftermath of the 2008 financial crisis. And Germany’s Council of Economic Experts, a panel that advises the government, has referred to “studies in the U.S.” over the benefits of strong capital markets to fend off calls for greater fiscal integration.

Still, there are reasons for any euro-skeptics out there to worry about the latest plans. That's because studies of capital markets in other countries are decidedly more mixed than their supporters let on. The biggest problem: Capital markets may help cushion the blow for the wealthy, but not necessarily for the poorer income brackets.

The U.S. study referred to by the German panel is a case in point. Published by Asdrubali, Sørensen and Yosha back in 1996, with data from 1963 to 1990, it looks at what happens when the net value added in one state drops by 100 percent. The authors found that disposable income, to which the cross-border interest and dividend payments were either added or subtracted, only sank on average by 61 percent.

Washington helped cushion the blow further: Net income after cross-border taxes and transfer payments sank by only 48 percent. This means the central government had mitigated the decline in income by another 13 percent (61 less 48).

Additional bank loans taken on by households helped cushion the blow even further: Consumer spending dropped by just 25 percent. According to this, additional debt cushioned the income shock by 23 percent (48 minus 25).

“When the owners of a company are spread out across various states, the losses in a shock hitting the company’s home state are also distributed over different states,” explained Mr. Weidmann.

But that doesn't mean everyone benefited equally. The method used by the study implicitly assumes that every income category considered – whether capital income, transfers or loans – has the same impact on private spending.

This is not necessarily the case. Capital gains are concentrated in the richest 10 percent of the population, who save a lot more from an additional dollar dividend than an unemployed worker does from a dollar of unemployment benefits.

This means the capital market mainly provides for the stabilization of the already very stable consumption of those who draw capital income. In other words, the wealthier members of any population benefit. But that is hardly the main focus of the study's economic discussion about balancing out financial streams.

By contrast, stabilizers from capital markets don't last when it comes to the poor or the middle class. The 25 percent that is evened out by increased bank loans, for example, is brought about by the residents and companies in a poor economic region borrowing to keep up their spending levels.

However, the authors of the 1996 study pointed out that this works only for short-lived income fluctuations. The effect reverses with longer-lasting problems, because the creditworthiness of the people in the region suffers as a result.

Instead of being able to take out more loans, the poor eventually have to pay back the loans out of their dwindling income. This effect also has a negative impact on the smoothing out of trans-border capital income; when the interest rises, the state and private people in the problem region have to pay more.

More recent studies also had a difficult time finding an income-equalizing effect of financial market integration. Hélène Rey from the London School of Economics, who was awarded the Carl Menger Prize for her work by the Bundesbank in 2014, wrote about the issue in her essay, Dilemma not Trilemma.

“As attested by the most recent surveys reviewing a long list of empirical papers, it is hard to find robust evidence of an impact of financial openness on growth or on improved risk-sharing,” she wrote.

Even the co-author of the 1996 study, Bent Sørensen, comes to sobering conclusions in a new study with Kalemli-Ozcan and Luttini. Although border-crossing capital gains in the ailing euro states smoothed out consumption until 2007, in the first financial crisis years of 2008 and 2009, there was no longer any equalization.

In 2010, the decline in net capital gains even exacerbated the drop in spending. Mr. Sørensen found that this isn't a feature specific to the euro crisis, noting that capital gains also intensified the decline in consumer spending during the Scandinavian bank crisis of 1991 to 1994.

So the knight in shining armor, the capital market, may still be hopelessly overwhelmed by the monetary union’s structural problems, even when armed with the Juncker-Draghi-Weidmann strategy.


Norbert Häring is a Handelsblatt editor focusing on monetary policy and financial markets. To contact the author: [email protected]