The EU and the Crisis: lessons learnedMarch 15, 2010 - nr.68
Summary of the AIV’s findings, conclusions and recommendations
‘If politicians refuse to learn from the history of the recent financial crisis, they will condemn all of us to repeat it.’
1 Performance of the EU
1.1 A positive balance
The Dutch government asked the AIV whether the current legal and other policy instruments were sufficient to deal with the crisis at the European level. This question is closely related to the more general issue of whether the EU has responded adequately to the financial and economic crisis, particularly in view of the interplay between the Commission and the member states. Inevitably, there is no simple answer. The Union’s response must be judged on its effect in a variety of policy fields (monetary, economic, internal market, financial sector, trade and external action). In these fields, the competences of the EU and the member states fall into different categories (and the involvement of different institutions varies accordingly), and a raft of policy tools, ranging from ‘hard’ to ‘soft’, are available.
Nevertheless, the significant achievements of more than 50 years of European integration have proven their value during these exceptionally difficult times. The AIV is convinced that the member states’ economies are in better shape than they would have been without the Union, thanks in part to the way in which the EU exercised its powers.
The joint participation of the EU and its member states in the World Trade Organisation (WTO), the existence of the internal market and the euro, and the regulatory powers and coordination mechanisms developed within the EU have prevented a repetition of the ruinous conditions of the 1930s. In other words, the EU has helped erect a dam against the recurrence of the costly errors made at that time: a rapid increase in protectionism and a series of devaluations to create competitive advantages.
Nevertheless, the AIV thinks the EU’s response to the crisis has displayed both strengths and weaknesses. The strengths include the way in which the European Central Bank (ECB) has implemented monetary policy (in particular its policy on discount rates and the creation of liquidity to restore interbank lending) and the way in which the Commission has ensured the smooth operation of the internal market and compliance with competition rules.
Although a detailed framework is in place to provide aid to rescue and restructure enterprises, it should be borne in mind that there was no comparable framework in the financial sector for the Commission to provide emergency aid to financial institutions or to nationalise banks. The Commission has since set criteria to assess the emergency aid granted to banks, the recapitalisation of financial institutions, the treatment of toxic assets, and the return to viability and restructuring measures in the financial sector (see section 4.4 below). To ensure that competition on the internal market is not prevented, restricted or distorted, it has also taken compensatory measures regarding the receipt of state aid. The AIV does not intend to express an opinion on the remedies proposed to restructure a number of banks but, on balance, it thinks the Commission has also succeeded in preventing serious distortion of competition on the financial markets. This is illustrated by the dramatic situation in which Ireland found itself in October 2008. Through timely intervention, the Commission managed to prevent the guarantee scheme hastily introduced by the Irish government, which was open only to Irish banks and not to foreign banks with branches or subsidiaries in Ireland. Without the Commission’s intervention, there would have been a substantial run on the foreign banks.
Only a provisional opinion can be given on the Commission’s measures in respect of banks. The fact that banks have received state aid to very different degrees, and some have in effect been nationalised, involves a potential threat to the level playing field in the EU.2 The restructuring of the financial sector triggered by the crisis also represents a new challenge to competition policy.
As noted above, the EU’s response displayed weaknesses as well as strengths. The weaknesses related to both crisis prevention, i.e. ensuring in advance that the system is strong enough to withstand a crisis (see section 1.2), and crisis management, i.e. the ability to control the scale and intensity of a crisis and minimise and mitigate its harmful economic and social consequences (see section 1.3).
1.2 Shortcomings in crisis prevention
The EU proved to be vulnerable in the important area of prudential supervision of banks and other financial institutions. The fact that financial integration has enabled dozens of banks to operate on a European scale while the supervisors that are expected to oversee their operations have remained national in scope can be regarded as a serious shortcoming. This imbalance emerged as a major problem during the crisis. With the benefit of hindsight, it could be said that, owing to the dilution of the Commission’s initial proposals, the Financial Services Action Plan (FSAP) was a missed opportunity for an effective system of regulation and supervision. The FSAP did lead to the adoption of a package of no fewer than 43 directives and regulations in 2000-2005 but they provided inadequate guidance on how to prevent the high and excessive risks that financial institutions were taking or on how to overcome their adverse consequences. In particular, there was a failure to comply with capital adequacy rules on the ratio of debt to equity and the formation of financial buffers.
Some have spoken of a ‘light touch’ approach, and this certainly applies to the FSAP. The AIV shares the opinion that the price paid for the relatively fast introduction of the FSAP was over-familiarity between national supervisors on the one hand and the financial sector they oversaw on the other.3 The FSAP was biased towards the financial institutions’ preference for light supervision and the national supervisors’ preference to retain their own sovereignty.
The EU was also ill prepared for the crisis from a macroeconomic perspective. Firstly, the rules of the Stability and Growth Pact (SGP) had been poorly enforced in the preceding years. Even before the crisis broke out, quite a few countries were running high or excessive budget deficits and debts. This subsequently restricted the scope for budgetary manoeuvre in the form of discretionary policies and the operation of automatic stabilisers. Secondly, the establishment of EMU was not accompanied by the creation of a robust mechanism for far-reaching budgetary coordination in order to address serious macroeconomic imbalances. To compensate for a substantial drop in macroeconomic demand, the EU relies heavily on the member states’ cooperation. The member states, after all, are responsible for their own budget policies subject to the SGP’s conditions on the sustainability of the single currency. Not only is the EU’s budget far too small to act as a lever to overcome a crisis but it must also always be in balance.
1.3 Shortcomings in crisis management
Because the EU was ill prepared for a financial and economic crisis on this scale, its response was largely improvised. It did meet with some success, though; the ECB’s monetary policy and the Commission’s state aid policy were mentioned above. However, the member states’ coordination of appropriate stimulus measures initially left a lot to be desired.
The European Commission was criticised for being too cautious and too deferential to the large member states. However, given that an effective policy response is so highly dependent on the active cooperation of the member states the AIV notes that the euro group of finance ministers kept too low a profile during a decisive phase of the crisis. It would have been the perfect body to coordinate the member states’ stimulus measures. The euro group met in October 2008 to agree upon a joint action plan for the financial markets but the initiative was taken by the President of the country that held the EU Presidency at the time, Nicolas Sarkozy. Remarkably, the meeting was attended by heads of government and one of the attendees was Gordon Brown, the Prime Minister of Great Britain, a non-euro country. This illustrates the improvised nature of the EU’s response. In other respects, too, it was ultimately due to interventions by the French Presidency of the EU that a European Economic Recovery Plan could be agreed in December 2008 (based in part on proposals by the Commission). When looked at in detail, the plan was little more than a compilation of national policy plans. The conclusion is inescapable: European coordination took place after the event rather than before it.
One of the causes of this was the vague allocation of roles among the various actors. The main players were the European Council, the EU’s biannual rotating Presidency, the ECB and the European Commission. But it was chiefly the European Council and especially its then President (President Sarkozy) who took actual responsibility for crisis management.
1.4 Measures to eliminate shortcomings
In response to the government’s request, the AIV considered the steps that could be taken to eliminate the shortcomings wherever possible. It did so in the knowledge that calls to amend treaties or adapt existing tools would certainly not be heeded in the near future. In view of the difficulty experienced in agreeing on the Treaty of Lisbon, it is unlikely that anyone will venture to propose another treaty amendment in the near future. The best possible use must therefore be made of existing tools, and conditions must be created to encourage member states to seek European instead of national solutions where necessary and beneficial. Some improvements can be made without having to draft new treaty texts. A useful distinction can be made between measures that can be taken immediately or in the short or medium term and proposals and ideas that can succeed only in the longer term.
2 Proposed short- and medium-term improvements
2.1 Crisis management
The AIV thinks agreements need to be made in the near future to strengthen crisis management in the EU. The lesson that can be learned is that during a crisis decisions must be taken at the highest political level. This is necessary principally to restore confidence in the financial system. It is also necessary to mobilise sufficient support among the member states for European action in the form of macroeconomic stimulus measures that are then taken by national governments. The measures should be directed at offsetting a collapse in effective demand, which would also increase activity in the private sector. Only the European Council, which has evolved in the past 10 to 15 years into the most important power centre in the EU, seems to have the political weight to force a breakthrough towards effective EU coordination when individual member states are inclined to turn inwards towards narrowly defined interests. The European Council’s political weight would also be increased by, for example, cooperation between heads of state and government in the G20.
To be successful, however, the European Council must enjoy the unwavering support of a strong Commission that initiates action through persuasive analyses and timely proposals. The European Council generally cannot draw on the financial and economic expertise that the Commission can. In short, the two bodies are condemned to each other, as it were. The Treaty of Lisbon has facilitated the necessary interplay because the Commission now deals with a permanent President of the European Council instead of a new one every six months.
The AIV believes this new figure will have an important preparatory and diplomatic role to play. As the permanent President, he will be in a strong position to make timely preparations for one or more extraordinary meetings of the European Council if a crisis is looming. Of equal importance is that he will always be available to help seal the inevitable compromises, especially between the leaders of the large countries. The new Lisbon structure also facilitates the relationship with and the input into the G20, which – as already noted – operates at the level of heads of state and government.
Good interaction between the permanent President of the European Council and the President of the Commission is also of vital importance because the Treaty of Lisbon defines the competences of the institutions and their respective presidents, who are assigned executive power and the power of external representation, only in broad terms.
To this end, it would be advisable to flesh out article 121 of the Treaty on the Functioning of the European Union, which states that the member states regard their economic policies as a matter of common concern. This could be done by giving more political weight to the Commission’s periodic assessment of the ‘broad guidelines of the economic policies of the member states and the Union’ referred to in the same article. Since it is the European Council that can conclude, on a recommendation from the Commission, that the Council should adopt guidelines, it goes without saying that it should also pay ample attention to the outcome of that assessment.
The proposals outlined here should be worked out in the near future and addressed as efficiently as possible in order to strengthen the EU’s crisis management.
The AIV recommends that the government raise the proposals presented above on improving the EU’s crisis management in the appropriate consultative bodies (European Council, Ecofin and euro group).
Effective European interplay is required not only when introducing and implementing stimulus measures but also when terminating measures that are still in force. This will be relevant when economic activity recovers again in the private sector (see section 2.6 below).
2.2 Maintenance of the internal market
As can be concluded from the above, the AIV attaches great value to the greatest possible defence of the internal market. The internal market is of vital importance. It is particularly important to the Netherlands since more than half its national income is earned from foreign transactions. Dutch exports to its EU partners account for about 80% of the country’s total exports by value. Forms of state aid that are designed to maintain economic sectors or enterprises that have no long-term future should be vigorously opposed. Where protectionism has crept into the relations among the member states under the pressure of the crisis, this must be corrected. An example of this is the car industry, which is suffering from structural overcapacity.
Above all, the AIV would note that the European Commission must be able to act effectively when implementing its core task of enforcing competition policy. Publicly supporting the Commission’s role and the substance of competition law is also of fundamental importance, especially when compliance with the rules restrains local industry.
The AIV applauds the fact that the President of the European Commission, José Manuel Barroso, asked the former competition commissioner, Mario Monti, to issue a study on the future of the internal market. The study must also ask whether competition would be distorted if the member states started a race to reduce corporation tax and capital gains tax rates.4 Should the report conclude that competition would be distorted, the AIV would favour fiscal harmonisation in the form of standard tax bases and minimum rates. The financial crisis also revealed the unique character of the banking industry and the scale of systemic risks. The AIV thinks the Monti study should also consider the correct application of competition rules in a situation of financial instability.
2.3 Back to the SGP criteria
The member states’ average budget deficit in 2007 was 0.8% of GDP; in 2008 it was 2.3%. According to the most recent estimates, it will amount to 7% in 2009, 7.5% in 2010 and 7% (again) in 2011.5 The crisis has forced all countries participating in monetary union to loosen the budgetary reins to such an extent that almost none of them have been able to comply with the rules of the SGP, in particular with the budget deficit ceiling of 3% of GDP.6 The crisis is so serious that use of the SGP’s exception clause is certainly justified, but the budget deficits being run up in those member states that were already exceeding the 60% national debt ceiling before the crisis are particularly worrying. The figure below shows the relative size of the budget deficits and the debt positions of the EU member states (2009 expected figures).
Budget situation in the euro area (see figure in advisory report).
There would have been more protection against the tidal wave of the financial crisis if agreements had been better observed in the preceding years. Virtually no member state satisfied the requirement that public finances should be more or less in balance or even in surplus.7 The AIV found that the euro-area member states had not always satisfied the stability pact's criteria on budgetary policies. There was also a suspicion that the smaller member states (which have to observe the rules) were being treated differently from the larger member states (which can take more liberties).
This is confirmed by a judgment of the European Court of Justice in 2004. The Commission had complained that the Council had failed to follow up its recommendations to take action against the excessive deficits of both France and Germany.8 Deficits had been incurred in 2002 (Germany) and 2003 (France). The Council had concluded that there had been excessive deficits in both cases but the two countries ignored its recommendations to clear them as quickly as possible. The Commission subsequently recommended that the Council instruct the two countries again to address their excessive deficits. Ecofin could not reach agreement on the Commission’s recommendation. The Council then decided to provisionally suspend the excessive deficit procedure. The Court quashed the Council’s decision to suspend the excessive deficit procedure on the grounds that it contravened article 104 of the EC Treaty. The Court took no decision, though, on the Commission’s claim that the Council was obliged to take a decision if a member state continued to refuse to implement the Commission’s recommendation. In this case, therefore, France and Germany were able to ignore both the Commission’s recommendation and the Council’s conclusion that there was an excessive deficit.
Poor compliance with the SGP has made it considerably more difficult to conduct an appropriate anti-cyclical policy in the exceptional circumstances of the current crisis and even more challenging to implement a well-thought-out exit strategy. Furthermore, by not taking its own obligations seriously, the EU compromises its ability to work credibly with the rest of the world on crisis prevention. It must first set its own house in order. The AIV believes the lesson learned is that the monetary and, in particular, the economic restraints the EU countries have set themselves must be enforced more strictly. The lack of macroeconomic coordination represents a real risk to the stability of the euro. Sooner or later coordination will have to be tightened. This may not be possible without treaty amendment.
The AIV therefore thinks everything must be done to return the EU countries to the path of balanced budgets. The member states must observe the existing excessive deficit procedures taking into account the medium-term economic and budgetary situation.
According to the AIV, a lesson to be learned from the crisis is that budgetary discipline is a necessary but by itself insufficient condition to ensure a country’s financial health. This is illustrated by events in Spain and Ireland. These two countries had balanced budgets before the crisis but were nevertheless hit hard by the collapse of a speculative property market in the former and a banking industry holding completely inadequate capital buffers in the latter.
The AIV therefore favours a widening of the criteria applied to assess a country’s financial and economic health. Article 136 of the Treaty on the Functioning of the European Union offers several opportunities to do so. A country’s external balance (balance of payments position) and developments in asset markets might also be taken into account. Widening the assessment criteria, however, must not lead to a relaxation in budgetary discipline.
In this context, the AIV would also refer to economist Jacques Pelkmans’ opinion that the desirability of a tighter budgetary coordination framework came to the fore in the course of the crisis. Such a framework would be particularly useful in times of serious macroeconomic imbalance.9 There are currently no binding powers in this area at EU level. Nevertheless, the AIV believes it is a matter of some urgency that the Commission be able to place budgetary coordination of stimulus measures on the Council’s agenda during a recession, as Pelkmans has proposed. Without specific Treaty powers, the Commission will remain dependent on the member states’ willingness to cooperate.
2.4 Financial supervision
Strengthening the EU’s supervision of the financial services and capital markets by means of the new European System of Financial Regulators (ESFR) is of no less importance. The AIV considers the Commission’s proposals pertaining to the De Larosière report to be just the first step towards true European supervision. The proposals include the establishment of a European Systemic RiskBoard (ESRB) for macro-prudential supervision and a European System of Financial Supervisors (ESFS) to supervise individual financial institutions. The ESFS will consist of a network of national supervisors and European supervisory authorities. Since national supervisors will continue to play an important role in the new system, the AIV thinks further centralisation of supervision is as essential as financial integration and stability. An integrated and stable financial system in the internal market is incompatible, however, with policy and (micro-prudential) supervision that is organised along predominantly national lines.10
The new legislation must also be implemented in practice, as must a series of technical proposals made by the Commission on the criteria and their supervision. The AIV would note that a weak compromise, as in the case of the FSAP, would represent a danger. If the relationship between national supervisors and the financial sector remains too close, coordination of the supervision of cross-border banks will be inadequately safeguarded during a crisis. National supervisors will continue to play an important role in the proposed system of European supervision. That there are grounds to be wary of this danger can be seen from decisions taken by the Ecofin Council in early December 2009. At the instigation of Great Britain, the European supervision regulations proposed by the Commission were amended so as to increase the member states’ ability to opt out. It is still unknown how the European Parliament will respond to the amended proposals. Where there are signs of economic recovery, the members of the European Parliament rapidly seem to lose their sense of urgency. They are taking their time by appointing no fewer than five rapporteurs. A debate is not expected before June 2010.
As noted above, the AIV considers the current proposals to strengthen the supervision of financial institutions a necessary but insufficient first step. Further integration of EU-wide supervision is necessary to keep pace with the cross-border integration of financial institutions and markets. The AIV thinks it would be inappropriate for the development of supervisory mechanisms in the EU to lag behind developments the United States, where far-reaching proposals in the field of financial regulation have already been made.11 To achieve the goal of effective prudential supervision, however, several obstacles must be overcome: political resistance to the transfer of powers to the EU, too narrow an interpretation of the Meroni doctrine, and burden sharing when emergency aid is provided to banks. These points are considered below.
The UK is not expected to abandon its very reluctant stance on stricter supervision of financial institutions in the immediate future. Germany, too, will remain firmly opposed to the transfer of national supervisory powers to European supervisors, if only because of a recent decision by the Federal Constitutional Court, the Bundesverfassungsgericht.12 Spain fears that its strict national supervision, which has proven more crisis resilient than that of some other countries, will be weakened.
Another obstacle to the strengthening of supervision is the European Court of Justice’s Meroni doctrine, which limits the ability to transfer discretionary powers13 to private-law institutions. In the notes to the current proposals the Commission refers to a recent judgment by the Court (case C-217/04) that, under article 95 TEC, an agency or institution with power to approximate national laws can be established on condition that the activities are closely related to the subject-matter of approximation.
In the AIV’s opinion, the development of the law in recent decades has shown that there is more scope to delegate such powers than assumed by policymakers, who are usually interested parties. The AIV notes that the Meroni judgments of 1958 comprise an opinion, in the context of the ECSC Treaty, on the former High Authority’s delegation of discretionary powers to private-law institutions. Partly in the light of the subsequent development of the law, these judgments can no longer be interpreted, in the context of EMU, as meaning that powers may be delegated in individual cases only. Regulatory powers may also be delegated provided they are clearly defined and the exercise of the powers is subject to strict review in the light of objective criteriaset by the Council and/or the Commission.14 Where powers are delegated to a supervisor which works at some distance from the political institutions, it is not automatically appropriate to consider applying case law whose rationale was based largely on the entirely different institutional relations of the ECSC.
Transfer of powers is unacceptable only if an institution not provided for in the Treaty is granted discretionary powers, andpolicy choices have to be made on the basis of political value judgments. The AIV advises the government to adopt this opinion in its stance on the matter.
Another obstacle is the allocation of the cost of future cross-border rescue measures. Without a European safety net, the supervision of financial institutions and crisis management will remain a predominantly national prerogative. Effective and coherent EU supervision to prevent a future crisis will thus remain out of reach. (We return to this subject in section 3.2.)
The measures required in the short term include actions to prevent free-riding. As can be seen from the sections below, there has been free-riding in several areas in the EU, both in the member states’ budgetary policies and in the way in which advantage has been taken of the benefits of the internal market. The scope offered by the Treaty to take action against free-riding varies from case to case.
This means that a general and unambiguous answer cannot be given to the government’s question of whether the available tools are sufficient to prevent free-riding.
As guardian of the Treaties and as supervisor, the Commission is in a relatively strong, independent position to take measures against member states making unjustified use of state aid or otherwise breaching competition rules. As noted above, the AIV believes the Commission deserves the Dutch government’s unqualified support in this respect. Countries that succumb to the temptation of protectionism, usually under pressure from domestic interest groups, benefit from unimpeded access to the internal market without being subject to the discipline of participating in the necessary reallocation of factors of production and maintaining a level economic playing field. The Commission must therefore be able to take measures against all forms of protectionism in the internal market. In accordance with the policy rules laid down in the Commission communication on the return to viability and the assessment of restructuring measures in the financial sector,15 it must also oversee the termination of state aid to banks in order to return to fair competition.
The Commission and the Council (in this case Ecofin) are on relatively weak ground where member states are unwilling or unable to satisfy the requirement of balancing their budgets throughout the entire economic cycle (see section 2.3 above). These countries have profited in recent years from the discipline exercised by countries with tight budgetary policies while indulging in higher public expenditure or lower taxes, often to ward off the perceived risk of an election defeat.
Discipline brought peace on the monetary front and kept inflation close to the target of 2%. After the introduction of the euro, countries with relatively high budget deficits initially hitched a free ride on the good reputation of financially sound member states and accordingly did not need to pay higher interest rates on government loans. This is a second example of free-riding.
When the financial markets reacted, countries that were guilty of running excessive deficits were forced to pay higher interest rates. Following the publication of alarming figures on its budget deficit, which it had partially concealed, Greece entered the financial danger zone again at the end of 2009.16
Figures published by the European Commission17 also reveal significant differences in the fiscal stimuli that individual member states have administered to their economies to overcome the crisis. This might represent a third form of free-riding. In general, the EU institutions are relatively powerless if some member states let other member states bear the brunt of economic recovery measures yet profit from the leakage of such measures across national borders.
In those cases in which the EU institutions cannot impose formal sanctions against certain forms of free-riding, maximum use should be made of informal forms of influence, such as peer pressure, peer review, publication of rankings and blacklists, and naming, shaming and praising. Publicity is of key importance. The AIV therefore recommends that the Netherlands insist on ample use being made of the Treaty of Lisbon’s provisions on the publication of Council meetings.
2.6 Exit strategy
An exit strategy is understood to mean a policy proposal to reverse the monetary and budgetary consequences of the credit crisis.
In monetary policy, this means withdrawing the temporary special facilities that the ECB introduced in response to the crisis, raising interest rates to a more customary level and reducing liquidity facilities to what is necessary in normal circumstances.
In budgetary policy, this means adjusting the sharply higher government deficits and debts. Some of the increased budget deficit will automatically disappear when growth returns. But this will not be the case where deficits are the result of government measures or of negative growth that cannot be recouped in a recovery. The question is how, when and at what pace the adjustments have to be made. If they are made too early, economic recovery might be inhibited. If they are delayed too long, loss of confidence in government intentions might also endanger economic recovery.
The AIV thinks the Council of Ministers should adopt a common exit strategy, based on Commission proposals, that enables the member states to return to the SGP agreements. The strategy could build on the excessive deficit procedure. With the aid of the broad economic policy guidelines, account must be taken of the consequences for the EU as a whole of the policies pursued by individual member states. The guidelines should also ensure that the necessary budgetary consolidation is accompanied wherever possible by structure-strengthening policy or is achieved through the return of sustainable growth.18 The new Lisbon Strategy for 2010-2020 provides a good framework for such a policy.
The Social and Economic Council (SER) has indicated in an extensive and thorough advisory report19 what issues the Lisbon Strategy should address.20 It argues that the EU’s main goal should be to increase labour participation and labour productivity. Innovation and entrepreneurship should be encouraged through the efficient operation of the internal market and a further reduction in the administrative burden on entrepreneurs. The European Knowledge Area should also be strengthened. The SER’s call to release more funds through transfers in the EU budget in order to invest in education and research is consistent with recommendations the AIV has made in the recent past.21 As part of a forward-looking structural economic policy, government subsidies would also be acceptable if they enabled or encouraged entrepreneurs to contribute to ‘greening’ the economy.22
The AIV recommends that the government should seek to link, within the framework of the Lisbon Strategy, the exit strategy to new stimuli for structural economic policies that are conducted primarily at national level. Particular attention should be paid to the structural imbalances in the euro area and the corresponding risks to the sustainability of the internal market/euro. In particular, the weaker south European countries (the ‘Club Med’ countries) must face the challenge of radically reforming their economies (labour market, productivity, etc.). If they succeed, they, and the EU as a whole, will be in a much stronger position to withstand a following crisis. Increased scope for budgetary manoeuvre and a more flexible economy should be seen as necessary conditions for a successful strategy on crisis prevention and crisis management.
2.7 External representation
In the short term, high priority should be given to coordination of the EU and the euro member states within international financial and economic organisations and forums. Ineffective coordination of the member states’ positions weakens European input as a whole. Coordination should take place within the EU ahead of international consultation. The AIV thinks the Presidents of Ecofin and the euro group, in close consultation with the permanent President of the European Council and the President of the European Commission (and the President of the ECB), have a special responsibility to encourage the convergence of positions and actions. A first step towards streamlining the external representation of the EU and its member states in the longer term would be to have them act as representatives of the EU in those bodies that most closely correspond to their duties.
The AIV recommends that the government make maximum use of its influence in the IMF, World Bank, FSF/FSB, G20, etc. to increase the consistency of the Union’s external actions.
3 Long-term vision
3.1 The viability of EMU
The AIV’s answer to the government’s question of whether improved cooperation within the EMU is necessary and possible in view of the recent economic developments and corresponding policy responses is set out below. It may be appropriate to recall the famous words of John Maynard Keynes, which have frequently been quoted in recent times: ‘in the long run we are all dead’. Nonetheless, the AIV thinks the government should not neglect to develop a long-term vision as well as working on short- and medium-term measures.
In the AIV’s opinion, a considerable strengthening of the economic governance system is unavoidable to ensure the viability of the EMU in the longer term.
Since the EMU project is far from consolidated, the absence of legislation to strengthen it may entail unforeseeable risks. In other words, there is a real need to improve cooperation. A comparison with the ‘unsinkable’ Titanic is not entirely out of place given EMU’s current situation. The precarious financial positions of Greece and also of Portugal and Spain come to mind. Many of the weaknesses that have emerged are attributable to the nature of the chosen legal structure: a currency union with a minimum of binding restrictions on the member states’ budgetary policies and an open-ended commitment to economic policy coordination.
A slightly different matter is whether it is actually possible to improve cooperation within EMU. Again, the AIV is aware that radical proposals requiring near-term treaty amendments will not be heeded at a time when national sovereignty in Europe is being vigilantly guarded under the pressure of public opinion. It would nonetheless like to make some suggestions to advance the discussion. It is encouraged by the programme of the current Spanish Presidency, which is seeking ways to strengthen the member states’ commitment to European policy.
3.2 The idea of an EU emergency facility
In the longer term, the prospect of a more centralised policy on the financial sector would be improved by concrete discussion in the EU of the creation of an EU financial facility for use in emergencies. The facility could mobilise funds in an acute crisis to prevent the collapse of banks that could bring down the entire financial system. Against the background of a financial trilemma – the incompatibility of financial stability, an integrated financial system as part of the internal market and the continued existence of national policy and supervision – the AIV is in favour of such a facility. Without it, effective European supervision is inconceivable. Such a facility is also necessary to prevent a recurrence of the detrimental events of the current crisis: national governments eagerly rescued their ‘own’ banks using taxpayers’ money and only later were their actions tested against European rules, resulting in painful decisions to restructure certain banks in order not to distort competition. The EU facility would be outside the EU budget and could be financed through the European Investment Bank (EIB) or by means of special EU bonds guaranteed by the member states.23 To prevent squabbling between the member states, the facility should be managed wherever possible by independent experts. They could be provided, for example, by the ECB.
The AIV recommends that the government study the practicalities of establishing an EU emergency facility to bail out major banks during a crisis.
3.3 The idea of central financing of budget deficits
A long-term measure to strengthen the EU’s grip on the member states’ budgetary policies would be the establishment of an EMU fund for the central financing of budget deficits.24 The underlying reasoning is that the market often responds inadequately or too slowly to differences in the member states’ debt positions. As a result, differences in interest rates are not infrequently too small to entice governments, in the face of high financing costs, to clear or at least significantly reduce their budget deficits. The establishment of an EMU fund to finance budget deficits would probably lead to a reduction in the transaction costs of government bonds. The fund could finance itself by issuing euro bonds and other debt paper on the capital market.
Member states that respect the European budgetary rules rather than just pay lip service to them would be eligible for financing from the fund. The ability to borrow from the fund on more favourable conditions than elsewhere would be an incentive for responsible budgetary policies that a fragmented government bond market cannot always provide. The fund would not compromise the member states’ autonomy to set budgetary policies but it would increase the cost of poor performance. One requirement, however, is that the parameters and sanctions must be set in advance.
The AIV commends the idea of establishing an EMU fund for the central financing of budget deficits to the government.
3.4 Decision-making rules
Finally, the AIV would suggest another means to strengthen the common budget regime. It is debatable whether decision-making rules on the excessive deficit procedure and, in particular, the imposition of sanctions on defaulting member states should be changed in the long term. The AIV is inclined to think they should. At present, the Council can decide whether an excessive deficit exists and impose corresponding punitive measures only by qualified majority (pursuant to article 126 Treaty on the Functioning of the EU).
It could be proposed that the Council should automatically adopt the Commission’s proposals unless a qualified majority opposes them.
An intermediate step would be to replace the requirement for a qualified majority with a requirement for a simple majority. Other forms of sanction could in any event be considered instead of fines, for example temporary exclusion from the structural funds, framework programmes and agricultural subsidies. This would make it more difficult for member states that do not take the budgetary rules seriously to ignore them.
The AIV is not blind to the fact that deep-seated political problems cannot be resolved by techniques or rule changes alone. If necessary, governments must be named and shamed to emphasise that they are damaging the long-term interests of their own countries by placing themselves outside the frameworks agreed within the EU. As the well-known American columnist Thomas Friedman recently wrote, ‘People do not change when we tell them they should; they change when their context tells them they must.’25
4 The EU in the world
The crisis also made the EU aware of the shortcomings in the international architecture, especially in financial matters. Thanks in part to the French Presidency of the EU, the irrelevant G8 was in effect replaced with the G20 at the end of 2008. All the major emerging countries are represented in the G20, which, with more than 20 members, including the Netherlands, holds meetings at head of state and government level. The emerging countries are also demanding a greater say in the IMF (which is growing in importance again) and the World Bank. This will eventually require that the Western participants, including the European and North American members, take a step back. The IMF has played a very welcome stabilising role by providing emergency loans, often to smaller countries, and is still doing so, sometimes in collaboration with the EIB and the European Bank for Recovery and Development (EBRD). It will remain an indispensable institution in the longer term, too.
In the field of monetary policy, global imbalances have been a cause of serious concern. They were at the root of the financial crisis and culminated in persistent high deficits on the current account of the balance of payments of one country (US) and ever-higher dollar reserves in another (China). This problem can only be addressed by lower consumption and a higher savings ratio in the US and a corresponding but opposite turnaround in China. The value of the US dollar and the Asian currencies pegged to it is a particular concern to Europe. The Asian countries will become even more competitive than they already are if the dollar depreciates further against the euro. This is very likely given the structural deficit on the US balance of payments (which has already been referred to elsewhere) and the fact that the US still has no trouble financing its deficit because the dollar is an international reserve currency. As a result, the United States is not subject to the same policy discipline as other countries. Should countries with balance of payment surpluses become even more reluctant to increase their dollar reserves, a depreciation of the dollar (hard landing) and an international crisis cannot be ruled out. The EU would not be spared the consequences.
The AIV therefore recommends that the Netherlands, together with the other EU member states, initiate a debate within the framework of the IMF on the restructuring of the international monetary system. The objective would be to increase the policy discipline applicable to all countries, including the US. All countries should be made to realise that more balanced global monetary relations are in their own interests.
The euro’s potential to become an international reserve currency might be a means to exert pressure on the US. This might lead to the development of a multicurrency system,26 in which the IMF carries out its current task of supervising the member states’ exchange rate policies more effectively than in the past.
Apart from the question of exchange rates, attention should also be paid to developments in world trade. Although there was some recovery in 2009, the volume of world trade in October 2009 was still 13.2% lower than in April 2008.27 This sharp downturn was the outcome of the recession in combination with the credit crunch. In this respect, worldwide anti-protectionism measures are of eminent importance to the EU as a whole and especially to the Netherlands, whose economy is highly dependent on exports. Trade restrictions have increased since the outbreak of the crisis but with less intensity than might have been feared, thanks in part to WTO rules and G20 agreements. But there is certainly no cause for self-satisfaction. The global political forces pressing for protectionism on their home markets are usually well organised.
According to the AIV, incipient protectionism should continue to be combated through effective enforcement of the WTO rules. The AIV thinks the most effective political signal would be the rapid completion of the protracted Doha Round negotiations.
Finally, the AIV would again underline the unique value of the G20 as a global forum. In the first instance it is the most appropriate body to debate the coordination of the main economic players’ policies, for example with regard to bank supervision in order to prevent irresponsible banking activities. Attention should also be paid to the timely management of bubbles. It is hoped that the G20 will successfully address the most fundamental problem of global imbalances. The problems of the poor countries, which in many respects are being hit the hardest by the economic crisis, must not be disregarded. Decisions in the G20 must be worked out and implemented in existing multilateral institutions: the IMF, World Bank, WTO and also the OECD if it is enlarged to include emerging nations. If the EU, a major economic and financial player, does not want to run the risk of being marginalised, it must organise itself so as to speak with one clear voice in the global debate on such issues.
1 In his column ‘Disaster and denial’, The New York Times,13 December 2009.
2 See: Professor L.H. Hoogduin, ‘Voorbij de crisis’, ESB 95 (4576), 8 January 2010, pp. 20-21.
3 Professor J. Pelkmans, De rol van de EU in de financiële en economische crisis, Netherlands Institute of International Relations Clingendael, The Hague, October 2009, p. 9
4 There is no tax on capital gains in the Netherlands.
5 Figures from the European Commission, referred to in a letter to parliament, Toekomst van het Stabiliteits- en Groeipact, 23 November 2009.
6 Only Finland and Luxembourg are expected to remain below 3% in 2009.
7 Professor A. Szász, De Euro, p. 278.
8 Case C-27/04, 13 July 2004, European Commission/Council.
9 Professor J. Pelkmans, op. cit., p. 23. See also: André Sapir (ed.), Memos to the new Commission, Brussels: Bruegel, pp. 23-24.
10 Schoenmaker D., Toekomst van de financiële sector in Europa, ESB, volume 94, no. 4563S, pp. 69-74.
11 See: Karel Lannoo, Comparing EU and US Responses to the Financial Crisis, ECMI Policy Brief, Brussels, CEPS, 2010.
12 BVerfG, 2 BvE 2/08 of 30.6.2009, Leitsätze zum Urteil des Zweiten Senats vom 30 Juni 2009, See: http://www.bundesverfassungsgericht.de/entscheidungen/es20090630_2bve000208.html.
13 Powers that can be exercised as thought fit.
14 For a formulation in this sense, see: paragraph 90, judgment in case C-154-155/04, Alliance for natural health, Jur. 2005, I-6541.
16 See: ‘Greece faces ratings downgrade over its spiralling budget deficit’, Financial Times, 8 December 2009. The President of Germany’s Bundesbank, Axel Weber, has already hinted that the ECB might refuse Greek government bonds as security for loans to commercial banks.
17 European Commission, 2009, op. cit., p. 67ff.
18 See also: European Sustainability Programme, in Memos to the New Commission, p. 23.
19 SER advisory report, Europe 2020, The New Lisbon Strategy, The Hague, 2009.
20 The Social and Economic Council is an advisory body to the Dutch government and Parliament, in which both employers, employees and independent members appointed by the Crown are represented.
21 See AIV advisory report number 58, The Finances of the European Union, The Hague, December 2007. The second recommendation was: ‘The single market needs to be supplemented with a European research area. This requires more money to be spent on knowledge and innovation’, p. 43.
22 Also according to Lord Peter Mandelson in a speech to the Bruegel think-tank, Brussels, 6 November 2009.
23 The AIV is indebted here to the ideas of Professor J. Pelkmans.
24 W.W. Boonstra also came to this conclusion in his article ‘Het EMU-fonds: institutionele versterking door centrale financiering van overheidstekorten’, Internationale Spectator, September 2009, pp. 422-425.
25 Thomas Friedman, ‘This I believe’, The New York Times, 2 December 2009, p. A35.
26 See: C. Fred Bergsten, ‘The dollar and the deficits’, Foreign Affairs, November/December 2009.
27 See: http://www.cpb.nl/nl/research/sector2/data/trademonitor.pdf.
Mr F. Korthals Altes
Chairman of the Advisory Council
On International Affairs
2500 EB Den Haag
Date 20 July 2009
Re Request for advice on the EU and the financial and economic crisis
Dear Mr Korthals Altes,
I kindly request the advice of the Advisory Council on International Affairs (AIV) on the following subject.
The European economy has been hard hit by the financial and economic crisis. The turbulence in the financial sector in the second half of 2008 and the deep recession in which the EU finds itself in 2009 demand rapid and effective European cooperation. The crisis requires coordinated emergency measures to safeguard the proper functioning of the financial system and restore the confidence of the economic players. To dampen the effects of the credit crisis on the real economy, coordinated measures for economic recovery have been decided at European level (the European Economic Recovery Plan), which are chiefly being implemented by the member states. Bearing all this in mind, I believe that it is time to make a provisional assessment of the functioning of the European institutions in this time of crisis.
The key question is whether the EU has the legal and other instruments it needs to respond adequately to a financial and economic crisis on this scale. How can possible institutional obstacles be circumvented? How effectively have the Commission and the member states interacted? Is there any way to stop individual member states from acting as ‘free-riders’?
The rapid pace of events during the crisis has raised questions about the EU’s effectiveness, and about the relationships between the various EU bodies (e.g. the Council and the Commission). Although it should be noted that the member states have primary responsibility for economic policy, they also regard their economic policies as a matter of common concern (under article 99 of the Treaty establishing the European Community). As guardian of the Treaties, the Commission has a major independent responsibility to monitor compliance with the rules of the internal market.
With regard specifically to cooperation in the EMU, we may note that the financial and economic crisis has led to diverging interest rates on public debt. Furthermore, a meeting at heads of state and government level of the euro countries was held for the first time under the French Presidency. I would like to know what lessons the AIV may draw from the cooperation within the EMU and what changes and improvements could be made.
With respect to the role of the EU Presidency, President Sarkozy clearly showed leadership in the course of the French Presidency. A strong Presidency seems important as a catalyst for decision-making. The rapid application of the Lisbon Treaty could also facilitate decision-making in the future. There are those however who see the intergovernmental tendencies on financial and economic issues as a downside of the strong French Presidency; the big EU countries did in fact play a more prominent role in the decision-making process.
The government requests that the AIV respond to the following questions.
- Are the EU’s existing legal and other instruments sufficient to deal with the crisis at European level? Are these tools sufficient to prevent free-riding?
- In view of recent economic developments and the corresponding policy response, is improved cooperation within the EMU necessary and possible?
I look forward to receiving your advisory report.
Minister of Foreign Affairs
The AIV did not receive a government response on this report.
AIV: IN A FINANCIAL CRISIS, EUROPEAN COUNCIL MUST TAKE THE LEAD
26 February 2010
On balance, the European Council has played a positive role in responding to the financial and economic crisis. At the same time, a number of important weaknesses have come to light. Supervision of banks has been inadequate and the EU has only partly succeeded in coordinating measures by member states aimed at economic recovery.
These findings by the Advisory Council on International Affairs (AIV) have been presented in an advisory report to the Dutch government. The AIV offered a series of recommendations for strengthening the EU’s crisis management capabilities, combating protectionism and state aid, and introducing stricter European supervision of banks and financial institutions. The AIV also called for the consistent application of the criteria relating to national budget deficits and national debt.
The achievements of more than 50 years of European integration have proved their worth in these highly testing times. Thanks mainly to the existence of the euro and the internal market, Europe has avoided a repeat of the disastrous events of the 1930s. Other important factors are the options for regulation, imposing sanctions and mutual consultation that have been developed at EU level. At the same time, the crisis has highlighted a number of weaknesses. The EU has proved extremely vulnerable in the crucial area of supervising banks and other financial institutions. The rules that were applied provided insufficient scope either for preventing banks from taking major – and sometimes excessive – risks, or for dealing with the consequences afterwards. What’s more, European coordination of member states’ crisis measures has been more reactive than proactive. The EU proved poorly prepared for a crisis of this magnitude. There was very little room for manoeuvre on budgetary stimulus packages and the precarious situation of government finances in Ireland and the southern European member states gives serious cause for concern about the long-term feasibility of monetary union.
In its report the AIV first urges that the EU’s crisis management capabilities be strengthened, arguing that in the future crisis management must be led at the highest possible political level. While the euro group has played an important coordinating role, only the European Council of Heads of State or Government has the political weight to persuade member states to align their national crisis measures and so maximise their effectiveness in the Union as a whole. To be successful, the Council will need to be able to count on a decisive Commission that uses convincing analysis and timely proposals to spur member states to action.
Second, the Commission must remain in a position to vigorously enforce European rules on undistorted competition in order to prevent forms of national protectionism through state aid. It is essential that the Dutch government support the Commission publicly in this task, especially when compliance with the rules on competition imposes restrictions on the Netherlands’ own business community.
Third, the proposals, adopted in December 2009, for strengthening prudential supervision of financial institutions should be seen as a necessary first step that doesn’t yet go far enough. Despite strong resistance from other member states, the Dutch government should lobby hard for the further concentration of EU-level supervision in order to keep pace with the cross-border integration of financial institutions and markets.
Finally, the AIV considers that strengthening European mechanisms for enforcing compliance with the Stability and Growth Pact criteria will be unavoidable in the longer term. EMU countries that continue to fail, over a sustained period, to address excessive budget deficits, should find it more difficult to escape EU sanctions. With this in mind, the AIV has proposed changes to the decision-making rules in this area.