Financial Markets

The financial system around the globe faces massive changes to its regulation. Although it seems fashionable for virtually everyone outside of government to talk down the financial reforms that have been agreed upon to date, my own view is that a great deal of progress has been made and the world will be a considerably better place for it. Although there are certainly flaws in the reforms, too many of the complaints seem to be based on an unrealistic view of what regulation can achieve. There will always be booms and busts in the financial world and some of the busts will merit the label "crisis". Realistically, the job of policymakers is not to stop the cycle, which is impossible, but rather to minimize the frequency and severity of the crises and to insulate the real economy as much as reasonably possible from the problems that hit the financial economy. In my view, the combination of legislation and regulatory changes gets us about two-thirds of the way from where we were, which was deeply flawed, to where we should be. In the real world, I consider that to be a real achievement. It is not easy to reform a major part of the economy, especially not in a country like the US which is so prone to political gridlock these days.

The US financial reforms fall into three categories. First, the Dodd-Frank Act became law in the summer of 2010. This was the biggest revision by far to US financial regulation since the Great Depression and changes the law in a wide range of areas. Second, Dodd-Frank, despite its 2300+ page length, left a great amount to regulatory discretion. As a result, US regulators are extremely busy developing rules and policies in time to meet the ambitious deadlines set by Congress. Third, the US will also be implementing regulations stemming from the "Basel III" agreement on global regulatory standards that was just negotiated at the Basel Committee on Banking Supervision and ratified by the G-20 heads of government this month.

Before reviewing the regulatory changes, it is worth examining what they are trying to accomplish. Almost all of the changes are intended to eliminate problems that became apparent in the recent financial crisis, although a few items relate to potential problems that did not appear this time, but could be part of a future crisis. However, there are multiple views of what was at the core of the financial crisis. Oversimplifying for the sake of clarity, there are three broad narratives of the origins of the financial crisis1:

Flawed incentives and structures in financial institutions and markets. Policymakers, along with the media and the general public, have focused principally on problems on Wall Street and its counterparts in The City and other major financial centers. Greed, arrogance, and even the stupidity of financial executives have been major themes in the popular press although more sophisticated analyses have tended to focus less on personalities and more on the incentives that led the financial industry to take excessive risks.

Four sets of incentive problems particularly stand out:

Banker bonuses. Financial executives generally receive the great bulk of their compensation in the form of discretionary bonuses that are tied to annual profits. This creates a financial incentive for investment professionals at these firms to take positions that generate short-run profits in most years even if they are prone to occasional disastrous years in which all the "profits" are given back. Similar incentives affect the CEO and other senior executives, although this is mitigated by their large holdings of company stock.

Excessive leverage/insufficient capital. Top executives in the banking industry were pushed by numerous incentives to take on more asset risk with less capital and more debt. A similar pattern occurred in regard to liquidity management, with cheaper, but riskier, short-term funding sources increasing significantly in importance. As noted, compensation was so high in good years that it discouraged a real focus on the potential for bad years. Further, stock market investors rewarded risk taking while bond market investors did little to push back, partly due to the expectation that the government would not allow failures of major institutions.

Business model focused on origination to distribute. Key parts of the financial markets developed in ways that gave the originators and structurers of credit products the incentive to create packages of investments with considerably more risk than they appeared to have on the surface. For example, the "originate to distribute" model of mortgage banking produces incentives for financial institutions to make loans that are quite risky, as long as the risk is not obvious and they will appear to perform well in the short run. If a lender can make a loan and then package it together with other loans and sell it on in securitized form at a profit, then there is a strong temptation to loosen lending terms in order to maximize the volume on which intermediation profits can be earned. This has been blamed as a key factor driving the vast quantity of excessively risky subprime loans made at the height of the housing bubble. A similar logic led Wall Street to create ever more complex bundles of risky investments that they could sell on in the form of Collateralized Debt Obligations (CDO's) or other securities.

Credit rating agency conflicts. Credit rating agencies have an inherent conflict of interest in their business of rating securitized products, which gave them an incentive to hand out excessively high ratings. For decades, the rating agencies have been paid by the issuers of securities and not by the investors who rely on the accuracy of the ratings, since charging investors runs into a severe "free rider" problem because ratings information is easy to obtain and to pass on. This conflict seemed manageable for corporate bond ratings, since the volume of issuance was determined largely by borrowing needs rather than the level of the credit ratings. After all, the agencies had a long-term business interest in maintaining the credibility of their ratings, which is their main selling point. However, the size of the securitization market is heavily dependent on the ability to obtain "AAA" ratings, since a large segment of the investor base will not buy securitizations with lesser ratings, unlike corporate bonds where there is a robust market for all levels of creditworthiness. Therefore, the rating agencies found themselves with a strong financial incentive to issue their top ratings, which would result in a large volume of issuances on which they could charge fees. Many observers believe that the rating agencies became far too lax in their ratings methodologies as a result of this perverse incentive and that Wall Street firms put great effort into taking advantage of, and encouraging, this laxness.

Failed government interventions in the financial markets. It was not just the private sector that sowed the seeds of the crisis; flawed government policies were also at fault. In the most extreme form, some conservative commentators paint the crisis as essentially the result of the bursting of a massive housing bubble in the US which then had disastrous knock-on effects, given the centrality of housing in the financial markets and the economy as a whole. These critics believe that excessive government encouragement of home ownership and the use of flawed structures to achieve this were the major factors behind the housing bubble.

This extreme version of the argument almost certainly goes too far. It gives too much weight to the housing bubble, while ignoring many other market and economic excesses, ignores private sector incentives unrelated to government actions, and ignores global problems that were unrelated to the US housing bubble. Nonetheless, government incentives in the US were clearly a major contributor to the crisis.

Fundamentally, US government policy has strongly encouraged home-ownership for decades, including through favorable tax treatment of mortgages and of capital gains on house sales. This emphasis became even stronger under Presidents Clinton and George W. Bush, as a result various government actions helped produce ever higher homeownership rates in the US. It is clear, in retrospect, that the rates became unsustainably high. There are, after all, many people whose economic and other circumstances make homeownership too risky or unwise, given the mortgage debt load that would be required.

One of the more powerful ways in which the US aided housing was by allowing Fannie Mae and Freddie Mac to borrow with an implicit government backstop and to do so in an unsound manner, with too little capital and too little diversification. In addition to the risks created for the financial system from having these extreme cases of "too big to fail" institutions, the government directed their activities in a manner intended to ensure that they provided particular help to certain riskier classes of borrowers. Some observers have argued strongly that the way in which this was done was a major support for the unsound lending practices that arose during the housing bubble. Many of these same observers contend that the large banks were forced in a similar risky direction by provisions of the Community Reinvestment Act.

The US government, along with others, is also often blamed for creating serious "moral hazard" issues by appearing to stand behind the largest financial institutions, come what may. If creditors of these institutions believe that they will be rescued by the government if disaster strikes, then they lose much of their incentive to differentiate between riskier and less risky borrowers. The existence of moral hazard would help to explain why banks and other financial institutions were able to lever up and otherwise increase their risk-taking without suffering any serious increase in the borrowing costs demanded by investors. Given the highly levered nature of financial institutions, such a rise in borrowing costs would have been a strong disincentive to take excessive risks, since it would crimp profits significantly.

Finally, poor government regulation and supervision have been identified by many as exacerbating the crisis. Although the private sector must take primary blame for its own mistakes of judgment and excessive risk taking, it is the role of regulators to spot systemic risk arising from these choices. To the extent these problems were spotted, regulators were quite ineffective in stopping the risky actions. For example, regulators did little to force the industry to bolster what turned out to be quite insufficient levels of capital. Nor did they step in to use their authority to halt risky types of mortgage lending. For that matter, important parts of the financial sector were allowed to develop with little or no regulation, such as in the area of derivatives and in the growth of the "shadow banking" sector.

A severely lessened focus on risks after decades of favorable market conditions. Another, complementary, explanation of the financial crisis focuses on the behavioral aspects of finance. All of the entities in the financial and housing markets are run by human decision-making. As such, they are prone to periods of excessive optimism and excessive pessimism. It is not surprising that a quarter century of favorable financial market conditions would lead to quite excessive optimism that would be reflected in a near-universal failure to fully observe risks and a tendency to minimize the importance of those risks that were not ignored altogether. It is worth remembering that the US stock market bottomed out in 1982 at a level of 800 on the Dow and went up by a factor of close to twenty times over the next quarter of a century. Most other financial and real estate investments did exceptionally well over that period, as long as they were held through the relatively brief downturns. Similarly, the economy as a whole did so well for much of that period that the term "the Great Moderation" was coined to describe how favorable government policies and benign markets had tamed the worst aspects of the business cycle.

In this favorable environment, it is easy to see why virtually every group became lax about risk. Wall Street and its foreign counterparts loaded up on risky investments, regulators and rating agencies remained more conservative than Wall Street but not nearly as vigilant as they should have been, policymakers encouraged or allowed risky actions, and individuals collectively took on considerably too much risk in both the housing and equity markets.

These three broad views of the principal causes of the crisis can lead to quite different policy recommendations. If perverse government interventions in the housing and financial markets were the central cause, then the main lesson is not to intervene in those ways. On the other hand, if incentives in the financial markets were the key drivers of the disaster then there are a large number of specific actions that need to be taken to fix known weaknesses. The final theory, that crises of some magnitude are inevitable in the long run due to human weaknesses, would suggest that measures need to be in place to minimize the frequency and severity of these crises. This latter theory is complementary to the others, primarily underlining the importance of safety measures rather than allocating the blame between financial markets, regulators, and government policymakers.

In practice, Dodd-Frank focuses almost exclusively on the first narrative, that of bad incentives in the financial markets and the private sector more generally, and does relatively little about the government's own role in unwittingly facilitating the financial crisis. Congress and the Administration have expressed a strong desire to fix the housing finance system in upcoming legislation, which would be a considerable step forward if it actually happens and is sensibly designed. Dodd-Frank did also try to tackle some of the moral hazard issue by making "bailouts" harder to do and less appealing for the rescued institutions.

Dodd-Frank makes changes to a quite comprehensive range of financial regulations, including the following areas:

* Derivatives
* Securitization
* Credit rating agencies
* Compensation and corporate governance
* Capital requirements
* Consumer protection
* Proprietary trading
* Hedge funds and private equity funds
* Expanding the perimeter of regulation
* Limitations on the size and scope of banks
* Ability to intervene with troubled financial institutions
* Management of systemic risks
* Reorganization of regulatory bodies

The wide range of reforms, and the technical nature of many of them, make it too difficult to summarize here. In general, the reforms focus on: increasing the transparency of transactions and risks; better managing the credit risk that parties to derivatives transactions take on due to the promise of the future performance of certain actions; changing the incentives of bankers and rating agencies so that they will be more focused on risks; providing better protection for consumers overall; and giving regulators the ability to intervene more quickly and effectively when large financial institutions run into problems.

The reader can find a relatively detailed summary of US and EU actions in a report that I wrote for the Atlantic Council and Thomson Reuters, available at http://www.brookings.edu/reports/2010/1007_atlantic_council_elliott.aspx The points that I would emphasize here are that the Act changes some aspect of almost every important area of the financial markets and the institutions that participate in them. Further, it directs the various US regulators to fill in a wide range of important detail on which Congress was unable to agree or which were too detailed for it to tackle. It will be difficult to fully judge Dodd-Frank until we see what it looks like after the regulators are done with it. Unfortunately, all of these prospective changes create considerable uncertainty which has been blamed as one of the causes of low business confidence dragging down the economy. However, this level of uncertainty was virtually inevitable given the depth of the financial crisis and the need to revise so many different aspects of regulation.

The US has also participated in the negotiations at the Basel Committee on Banking Supervision as it designed new rules on capital and liquidity requirements for banks, following the direction of the G-20 heads of government given in 2009. These rules should make banks quite substantially safer by requiring them to have significantly more funds from shareholders to back up the risks they take. Rules will also be put in place to require banks to keep more cash on hand and securities that can be readily converted to cash without "fire sale" losses in a financial crisis.

Some in the banking industry have argued that the Basel III rules go too far, substantially increasing the costs of running a bank and that these costs will be passed on to borrowers and other customers, slowing the economy significantly. Directionally, these arguments are clearly correct, since the increased safety will come at a cost. However, detailed neutral analyses, including my own, have almost universally concluded that the costs are not that high and are more than justified by the benefits of greater stability. This makes intuitive sense when one considers the terrible economic losses created by the recent financial crisis. Even if these are relatively rare, it is worth quite a lot to minimize their frequency and the damage they do.

As noted earlier, I believe that the legislative and regulatory changes do considerably more good than harm and are of real value even though they do not solve all the problems and there are flaws in some aspects that will make specific things worse. (I am a strong opponent of the Volcker Rule, for example, which I think does economic harm without providing any significant increase in safety, due to a misguided approach to constraining investment risk.) Regulation will never be perfect, but I think where we are heading will represent a considerably better balance than where we started.

Event Summary
On December 1, the Brookings Center on the United States and Europe and the Heinrich Böll Foundation of North America gathered some 30 economists, experts and analysts from both sides of the Atlantic for a closed-door workshop on the challenges confronting Europe and America in the wake of the global economic crisis. Organized in partnership with the Global Economy and Development and Economic Studies programs at Brookings, the day-long workshop also benefitted from the cooperation of the Embassy of Greece in Washington and the Stavros Niarchos Foundation.

During the opening workshop session, participants assessed the competing pressures to stimulate the economy and ensure fiscal sustainability in the long term. The second panel took into consideration the regulatory reform measures that the United States and the EU have started to enact in order to address the core financial problems that led to the crisis. To encourage frank and open discussion, the sessions were held under the Chatham House Rule. However, the four working papers which served to introduce the debates are accessible on this page. Some of the most salient points of the debates are also summarized below.

Agenda

Session 1 - Getting out of the downturn while ensuring the future: United States and European macroeconomic dilemmas

Working paper #1 » (pdf) by Carlo Cottarrelli (IMF)

Working paper #2 » (pdf) by Donald Kohn (Brookings)

Session 2 - Enough to prevent the next crisis? An assessment of the state of financial regulation reform in Europe and the U.S.

Working paper #3 » (pdf) by Douglas Elliott (Brookings)

Working paper #4 » (pdf) by Nicolas Véron (Bruegel / PIIE)

America and Europe in the Ditch: How Similar Macroeconomic Dilemmas Create Convergent Global Interests

A Summary of some of the points made during the conference

The macroeconomic pressures resulting from the most acute crisis of the last decades have left the United States and Europe contemplating roughly similar policy dilemmas. Long term fiscal challenges in particular will drain substantial resources away from growth enhancing policies, which will jeopardize the economic perspectives in both areas. Fiscal positions, considering the status of the real economy, have not been so bad since the 1930s. The interesting and somehow surprising political implication is that for all their divergent views, a long term strategy of fiscal containment, inevitable in both areas, should drive Europe and America towards joint action at the global governance level, to solicit the emerging economies to support the world’s economic activity. The question, of course, is whether the Transatlantic partners will obtain sufficient demand to alleviate their predicament.

This question was among the many points discussed in the course of the Brookings Transatlantic seminar entitled "In the Wake of the Crisis". The seminar addressed the main consequences of the financial turmoil not only in the degraded fiscal position of the United States and Europe, but also in the difficult process of coordinating financial reforms and financial regulation.

Until the summer of 2010, the European and American positions were considered quite distant from one another. The United States seemed reluctant to withdraw stimulus-oriented fiscal policies, while Europe was urging an exit from fiscal largesse. In due time, in both the United States and Europe, worries about fiscal sustainability have come to gain priority. A general agreement has emerged about the necessity to dispose of a medium-term fiscal framework granting stability to governments’ public accounts and anchoring fiscal credibility even for those countries that for different reasons need to exploit further margins of tax reductions or public expenditures.

Unfortunately, no such medium term framework seems available yet. In advanced economies, while public debt has reached disturbingly high levels, most governments have announced plans for adjustments extending only over the next few years. The weak U.S. economy and the outbreak of the debt-crisis in the euro area have deterred most countries from announcing longer term fiscal strategies. Aside from Greece and Ireland, whose policies are now dictated by international agreements, structural reforms affecting fiscal balances have been held back in most of the euro area, and only France enacted a pension reform after the crisis. No European country is tackling the worrisome looming deficits of health systems burdened by rapidly aging populations. In the United States, where the fiscal balance deteriorated even more than in Europe over the 2007-2011 period, political commitment toward consolidation seems weaker while the net fiscal effect of the 2010 healthcare reform remains disputed.

In these conditions, should the fiscal tightening begin right away, in 2011? A proposed criterion for answering this question is to assess the size of the output gap (the shortfall between current output and its potential level) in each economy. Countries suffering from market pressures like Greece, Ireland, Portugal Spain, Italy or the UK, should ensure that fiscal restraint remains credible, while other countries like the United States, Japan or Germany should start tightening now– even though not by the same degree as the others. The case of the United States, however, is a matter of debate, as some observers – most of them in America, not in Europe – think that there is no way to liken the US fiscal credibility to that of any other country. With a Central bank that can simply print dollars and monetize public debt, the United States is in a different position, they argue, than any other country whose currency is not at the same time a national currency and a reserve currency. Therefore, the cost-benefit analysis of increasing public debt in the United States should take into account a much lower cost than in the European balance.

Some Europeans tend to dispute this view, asserting that a loss of credibility is always possible – even for the dollar. The possibility to depreciate one's currency may even become a source of instability in an environment of very nervous financial investors and of frequent market overshooting. Greece itself revealed the extremes of market reaction: the spread between Greek and German interest rates widened from 100 basis points to 1000, in only a matter of months.

Still, when addressing future public debt trajectory, Americans focus more on supporting growth than on keeping deficits under control. But concerns about future tax levels and spending are creating uncertainty for economic investors and this could affect growth significantly. Furthermore, when dealing with growth-friendly policies, attention must be paid to the composition or "quality" of the stimulating policies – which public expenditures are cut and by how much, or which tax is raised and by what rate. Indeed, it seems encouraging that in the current policy debate, a number of suggestions regarding fiscal reforms put the accent primarily on the issue of broadening the tax base, therefore creating scope for lowering the marginal taxes. While a focus on public policies brings into account the need for Europe to reduce the burden of regulation, it emphasizes for the U.S. the need to support investments. There seems to be no doubt that the U.S. has to rely less on consumption, residential spending and financial innovation and more on competitive production in investment goods that can enhance the American export capacity.

In both the United States and the EU, fiscal policy adjustments should therefore remain growth friendly while avoiding distortions. But the net contractionary effect of fiscal retrenchment leaves unanswered the question of where global demand will come from. Indeed the experience of the fiscal crisis is likely to leave most European countries inclined to avoid current account deficits, exactly as the Asian countries did in the aftermath of the Asian crisis, and try instead to accumulate current account surpluses. The objective is to reduce their capital dependence on the rest of the world and the drawbacks of an abrupt change in market assessment of risk aversion. But since the U.S. itself is projecting a transformation of its economic model towards an export-driven economy, and for at least the years required to achieve the deleveraging process, the EU and U.S. economies will indeed need the rapidly developing emerging economies to support their domestic demand.

Considering emerging economies to be a homogeneous group is misleading, however. Currently not only India, but also Turkey, bear substantial deficits on their balance of payments. Therefore the attention of the EU and the United States is expected to turn primarily towards China. It is very likely that the common interest of the new—though perhaps unintentional—U.S.-EU convergent strategy will be to induce China to strengthen its domestic demand and to support the global demand through an increase in its domestic consumption. This could happen primarily through a reinforcement of China’s social safety network. By spending an additional 1% of its GDP on healthcare and pension provisions, via additional deficit, it is calculated that China would increase domestic consumption by 1.5%.

In this perspective, an alignment of American and European interests seems within reach and even likely. But, in order to reinforce each other’s strategy, the current rhetoric on both sides of the Atlantic must change and abandon a frequent populist streak that has marred bilateral economic relations. There are indeed divergent tones in the assessment of many common economic problems, including the size of output gap; the effects of fiscal policy on economic growth; the nature of the incentives needed to foster investments; the perception of the U.S. default risk; and the credibility of national or supranational fiscal institution. But what seems to be creating more hurdles is the deterioration of bilateral communication on economic policy issues. In this regard, the margin for improvement is huge and likely to be exploited in the next years.

Financial regulation reform

One of the most important test cases of Transatlantic cooperation concerns financial regulation. Structural differences between Europe and America have led to insufficient coordination of banking regulations, and even in banking, a traditional transatlantic industry, multipolarity is the new name of the game. United States and EU regulations should not refrain from considering emerging financial markets as strong actors and real competitors. The new composite reality of global markets suggests the need to distinguish between what really needs to be globally regulated and what does not need strict convergence or harmonization. Therefore the drive to heterogeneity— and maybe to reduced ambitions—in regulation remains most likely.

In fact, little by little, the sense of urgency derived from the crisis and the need to get back to normalcy have weakened the appetite for radical reform. Increasingly, signs of regulatory capture are in the air, whereby national authorities are inclined to protect, rather than to discipline, the industries they supervise. This is a further reason why interdependence of different regulations should be considered a valuable form of checks and balances against national regulatory captures. In the United States, a vast reform was approved, but less has been done about regulatory reform than about the private sector. In Europe, a sense of financial protectionism is lingering after the banking systems have proven to be both the epicenter and the weak spot of the current debt crisis.

What seems to keep Europe behind the curve in financial regulation overhaul is the lack of an available narrative to drive the vision of comprehensive reform. During the era of deregulation, a strong narrative was available —that of the Single Market, which was consistent with the idea of economic and political integration. But once achieved, the same narrative seems less convincing in an age of re-regulation. On the other hand, historically European “negative integration”, i.e. the abatement of national regulatory barriers, has been easier than “positive integration”, i.e. focus on new shared objectives and the national legislation or institutions instrumental to achieve them. Still the financial crisis should continue to stimulate new legislation, for instance on the size of financial firms, and the process in Brussels is ongoing and in some aspect even promising. Eventually the EU and U.S. visions will need to be reconciled with the work of the Financial Stability Board and the IMF that was instrumental in shaping a global vision, but which is now facing the challenge of translating their background work into shared and effective legislation.

Global financial regulation will be a crucial test-case for the lessons of the crisis, and Europe and the U.S., where the crisis originated, should demonstrate their determination to avoid similar occurrences in the future by leading supranational coordination.

A revealing aspect of the enduring consequences of the crisis, and of the national interests affected by new regulatory interventions, is that new legislations are favoring financial investments in sovereign bonds instead of other financial assets. The issue is being raised in the EU as well as in the U.S. by new pieces of legislation (insurance industry solvency, new rating criteria and others) that provide incentives for financial firms investing in sovereign bonds. Paradoxically, this will reduce the policy strains of financing public debts by strengthening the connections between financial and sovereign risks that were a hallmark of the global crisis, and not only in Europe. It will also prove once more the delicate equilibrium between politics and finance, in a world that seems condemned to face a future with increasing public debts.

INTRODUCTION

Brazil has made great improvements in its fiscal governance over the last 15 years. While these improvements have led to fiscal adjustments and positive economic outcomes, they have encouraged incumbent politicians in Brazil to make use of "creative accounting" in order to facilitate the government meeting its budget deficit ceiling. That is, the use of fiscal window-dressing as a response to fiscal constraints might undermine the sustainability of fiscal balance.
In 2000, Brazil implemented a hard-budget constraint legislation – the Fiscal Responsibility Law (FRL) – which was applicable to all levels of government regardless of their prior economic conditions. The FRL illustrates the kinds of policy outcomes that reflect the power of Brazil’s executive to implement its policy preferences in the federal political game. In its relations with the state governments, a powerful president and a strong finance minister have managed to recentralize fiscal authority in the country, curbing state level fiscal autonomy. Brazil’s executive branch was able to implement its preferences because of its institutional prerogatives and because there were gains-from-trade in federal-state relations. State governors developed an interest in reforms in the wake of the approval of the re-election amendment and in view of the compensation mechanisms involved in the reform process.

There is no question about the positive effect of the FRL with regard to the fiscal situations of Brazil’s states, which have improved considerably since the enactment of the Fiscal Responsibility Law. Whereas all states faced a deficit prior to the law, the consolidated state accounts have systematically presented a surplus roughly equivalent to 4 percent of GDP after the law was enacted. A similar success story can be told regarding public debt. A succession of primary surpluses enabled the government to effectively reduce the GDP/debt ratio. Since 2002, when the GDP/debt ratio peaked at 55 percent, there has been a reduction in net debt as measured by percent of GDP, which is estimated to be below 36 percent in 2008.

he sovereign debt crisis in Europe has sparked a heated debate about how to finance rescue packages without creating incentives for fiscal misbehavior by EU member governments and how to place some of the bailout burden on private investors who buy the sovereign bonds of countries running unsustainable budget deficits.
While the debate on financing rescue packages seems to be moving in a sensible direction, however, the debate on “bailing in” bond investors could lead to a deeply damaging result.

Starting with the rescue operation for Greece in May, and more recently for the bailout of Ireland, the EU has created a funding mechanism—the European Financial Stability Facility—in a form that has worked well in resolving sovereign debt crises in emerging market countries for 30 years. The EFSF is a pool of official funding with disbursements linked to policy reforms (conditionality) negotiated with the International Monetary Fund and the stricken country’s EU partners. The debate here revolves around the size of the pool, allocating country contributions, and embedding the mechanism in the EU treaty. A workable solution seems well within reach.

The issue with bond investors is reminiscent of the debate a decade ago about “private sector involvement” in emerging market debt crises, such as Argentina’s massive default at the end of 2001. Private investors—not just banks and institutional investors but also many “innocent” households—had been purchasing emerging market bonds because of their high yields. The yields were high because the risks of default were elevated. Thus, when some of these countries defaulted, it made sense for the bondholders to take a “haircut” in the form of a reduction of principal or interest. An important precedent here was the Brady Plan that resolved the 1980s debt crisis by negotiating write-downs on the excessive commercial bank lending that had contributed materially to the defaults.

The problem with using this “bail-in” approach in the EU context is that it would in effect transform the advanced democracies of Europe into Third World countries.

The mess in Europe is not the fault of bond investors. They simply believed the claims of the Eurozone governments that a workable monetary union had been created. The responsibility to make it work lay with the participating governments, not the private investors. The problem arose because the governments let down the investors, not because the investors sabotaged the governments.

Otmar Issing, the distinguished former member of the European Central Bank’s executive board, is one of the leading proponents of haircuts for the investors in bonds of European countries that need to be bailed out of a financial crisis. In a Financial Times op-ed last week, Mr. Issing advocated creating a debt restructuring mechanism—targeting private bond investors in particular—as part of the EU’s new crisis resolution arrangement.

Creating a mechanism to impose haircuts on bondholders is tantamount to saying that the monetary union has failed. It cannot be reconciled with the vision of a sustainable monetary union.

The EU made a terrible mistake. It allowed its own fiscal rules to be breached by too many countries without convincing corrective measures. Now the EU has only two real choices. It can pay the price for affirming the original vision of a zone offering a virtually risk free sovereign bond benchmark for its capital market—because of the firm commitment of its members to maintain sound macropolicies. Or it can abandon the vision in an orderly manner by pushing overly-indebted members out of the Eurozone.

Trying to muddle through this is likely to lead to the breakup of the Eurozone by default, leaving potentially deep and long-lasting scars extending beyond Europe and into the international financial system.
Add Your View

At the December 16th EU Council, European leaders missed yet another chance to contain the spread of the current debt crisis, which continues to threaten the sustainability of the historical achievements witnessed in European integration since the end of World War II. The leaders failed to acknowledge the systemic nature of the crisis and to act accordingly by implementing a “shock-and-awe” response through a credible financial safety net that could be extended simultaneously on a precautionary basis and in a flexible way to euro area countries that might be hit next.
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A large euro sign installation is seen in front of the European Central bank headquarters.

A large euro sign installation is seen in front of the European Central bank headquarters.
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Reuters/Kai Pfaffenbach
Instead, they focused on the state of European affairs after the crisis, leaving the current framework to fight this increasingly systemic problem unaltered. Certainly, focus on the long-run viability of the euro is badly needed, and Mario Monti elegantly summarized the most relevant issues in this respect in a recent article.

However, it is very concerning that the EU Council fell short of upgrading the current crisis framework amidst the increasing economic turmoil hitting Portugal, Spain and even Italy, after Greece and Ireland. Proposals to strengthen the framework, which is centered on the European Financial Stability Facility (EFSF), included increasing its financial size as well as its flexibility in allocating funds.

To be fair, the refusal to increase the financial capability of the EFSF would have made little difference, as financial markets have shown few signs of confidence since the establishment of the EFSF this summer. The EFSF, in fact, summarizes financial markets’ deepest concerns rather than dispelling them. Here are the major ones:

Governance. The EFSF reflects a purely intergovernmental approach to the management of the euro area crisis with lending decisions having to be approved unanimously by all the euro area countries. More broadly, the intergovernmental approach also shapes the composition of the current European defense lines consisting of up to EUR 750 billion: EUR 440 billion (or 59 percent) through the EFSF’s intergovernmental mechanism; EUR 250 billion (or 33 percent) through the supranational IMF funding component; and only EUR 60 billion (or 8 percent) through the “federalist” mechanism entrusted to the EU Commission. One of the key reasons for the current crisis is precisely the fact that markets have very deep reservations about the credibility of a monetary union run on the basis of an intergovernmental approach rather than a federalist one.

Financial Capability. The EFSF funds its lending programs by issuing bonds guaranteed by its euro area shareholders. This has two implications: 1.) the interest rates charged to the borrowing country tend to be higher, thus further compromising the fiscal sustainability of the troubled European borrower; 2.) subscriptions to the EFSF’s bond issuances cannot be taken for granted in the case of a systemic crisis, where contagion to otherwise healthy national financial markets is a serious possibility. Another area where there has been lack of clarity is the AAA rating of the EFSF bonds. The top rating only applies to potential issuances covered by the guarantees of AAA euro area countries. As a result, the true extent of the AAA rating only applies to some half of the overall EFSF’s EUR 440 billion. In other words, the EFSF can issue AAA bonds to rescue Ireland but not Spain or Italy.

What’s Next? The rigorists continue to emphasize a national approach to the crisis by underscoring individual country responsibilities in the current context against the need for a better and stronger systemic response to this crisis. But the rigor may have ill-adverse effects. In fact, if the rigorists get their way, the European Central Bank (ECB) may well fill the institutional and financial vacuum it has been filling up to now, thus jeopardizing its very narrow mandate to focus on long-run price stability.

For instance, if market conditions were to prevent a successful subscription to an EFSF bond issuance, then pressure would mount for the ECB to act as a lender of last resort by underwriting unwanted bond issuances and/or supporting public debt bonds of distressed European countries.

The ECB has already shown itself to be more pragmatic and proactive than ever before in filling the current vacuum. But this interim role of crisis manager of last resort that the EU Council has implicitly entrusted to the ECB is the greatest challenge for the sustainability of the euro.

The uneasy economy continued to dominate the headlines in 2010. Unemployment rates, climate change, the Federal Reserve and sovereign debt were among the top stories. Brookings experts Karen Dynan, Gary Burtless, Alice Rivlin, Henry Aaron, Donald Kohn, Douglas Elliott and Adele Morris weigh in on the year’s most compelling economic news and offer recommendations going forward.
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The Fed's QE2 — Unsurprising Move but Surprising Reaction
Karen Dynan, Vice President and Co-Director, Economic Studies

With fiscal policy limited by our long-run federal debt challenges, monetary policymakers took action to address the lackluster economy in 2010. In early November, the Federal Reserve announced a plan to purchase $600 billion of longer-term Treasury securities by mid-2011. The plan has come to be known as "QE2" because it represents a second wave of the Fed's so-called quantitative easing program, the first installment of which involved purchases of up to $1¾ trillion in longer-term assets during 2009 and early 2010.

QE2 was not a "big" economic event in the sense of being exotic. For some time, the Fed has not been able to increase monetary stimulus by lowering the short-term federal funds rate, its traditional policy lever, as that rate has been close to zero since late 2007. The next logical step has been to ease financial conditions by lowering still-positive longer-term interest rates; purchasing longer-term assets is simply a means to that end.

Nor was QE2 surprising. By law, the Federal Reserve has a mandate to set monetary policy so as to promote the dual goal of stable prices and maximum employment. With underlying inflation now well below the mandate-consistent target of 1½ to 2 percent and a gap between actual employment and full employment that is perhaps as large as 12 million, neither objective is currently being met. The Fed's decision to implement QE2, a policy designed to both spur economic growth and return inflation to a more desirable long-run level, represented a step toward meeting its dual mandate.

What has been notable about QE2 is the considerable backlash that it has spurred. Critics abroad have argued that the U.S. is exporting its economic problems, as quantitative easing (like traditional Fed policy) puts downward pressure on the foreign exchange value of the dollar and and upward pressure on prices of foreign assets. This is a particular problem for emerging market economies that have rebounded faster than industrial economies and are now at risk of asset price bubbles and overheating more generally. Domestically, some skeptics worry that the weaker dollar and larger Fed balance sheet could put the U.S. economy at risk of excessive inflation.

These concerns merit serious discussion but reasonable counter-arguments can be made. On the international front, a more vigorous and sustainable U.S. recovery would have important benefits for the rest of the world. With regard to the domestic concerns, falling inflation (and its capacity to foster economic stagnation) has been a larger concern than rapidly rising inflation.

The backlash to QE2 bears watching because it lends support to those who wish to reduce Federal Reserve independence. While the Fed should be held accountable for its actions, excessive political oversight of monetary policy could prove very harmful to the U.S. economy. It would open the door to attempts to win over with voters by boosting growth and employment over the short run at the cost of higher inflation over the long run.

A Growing Gap between the Outlook for the Employed and the Unemployed
Gary Burtless, Senior Fellow, Economic Studies

In 2010 the job market began to emerge from the most severe downturn since the Great Depression. U.S. employment is up, the layoff rate is down, and the average wage (after adjusting for inflation) has improved modestly. Progress toward full job market recovery has been achingly slow, however. The most striking feature of the past year has been the widening gap between the outlook for Americans who've held on to their jobs and their less fortunate peers who got laid off.

Hourly wages and the average work week have improved over the past year, boosting the pre-tax earnings of employees. Equally important for workers' well-being, the chances of a layoff have declined. Since the end of last year, weekly new claims for unemployment insurance have fallen 12%. Employers say they are reducing the monthly number of layoffs. Between December 2009 and October 2010 the reported layoff rate fell almost a fifth. Since the peak of layoffs in late 2008 and early 2009, the layoff rate has dropped more than a third. Workers who worried at the beginning of 2010 about their chances of keeping their jobs could breathe a little easier by year's end.

The improvement in employees' economic outlook has fueled a modest rebound in consumption, which in turn has boosted employers' need for workers. A sizeable fraction of this need has been met with temporary workers. Since December 2009 almost one-third of the net gain in U.S. payroll employment has been in the temporary help services industry. In addition, employers have added to the work week of employees who are already on their payrolls. The work week has increased a half hour since last December, or 1½%. Neither of these employer strategies helps laid off workers in their search for a permanent job.

The situation of the unemployed has not improved much over the past year. To be sure, the unemployment rate and the number of unemployed workers have edged down, but this is mainly because of the drop in the number of newly laid off workers each month. For workers who were jobless at the start of the year or who entered unemployment during the course of the year, chances of finding a job remain depressingly low. At the end of 2009, 40% of the unemployed had been without work for 6 months or longer. By November 2010, 42% of the unemployed had been jobless for at least 6 months. Unemployed workers can take consolation from the fact that this statistic is now heading in the right direction. Since late spring the average duration of on-going unemployment spells has dropped about 4%.

The prospects of the unemployed nonetheless remain bleak. In the years between 1945 and 2007, the number of jobless Americans with unemployment spells longer than 6 months never exceeded 26% of the total unemployed. In May 2010 the long-term unemployed represented 46% of the unemployed. Even though this percentage has fallen since May, it remains far higher than it was in the 1981-1982 recession, when the U.S. unemployment rate reached a post-war peak.

The basic problem facing job seekers is that employers are offering few job openings compared with the number of unemployed. The number of job openings has risen since the low point in early 2009, but job availability is not nearly high enough to put a major dent in unemployment. The Bureau of Labor Statistics (BLS) conducts a poll of employers every month to determine the number of job openings, new hires, and recent job separations. This survey offers the best gauge of U.S. job availability. Even with the recent improvement in job vacancies, the BLS survey shows that job openings are currently running almost one-sixth below the average rate over the 2000-2007 period. That 8-year period included a mild recession and a prolonged period of anemic job growth, so it should be clear that today's vacancy rate is too low to generate rapid gains in payroll employment.

In a couple of respects, laid off workers were provided better protection in this recession compared with earlier ones. The most notable difference is that Congress funded up to 73 weeks of extended unemployment compensation after workers exhaust the 26 weeks of regular unemployment benefits. The total duration of benefits - up to 99 weeks in the states hardest hit by unemployment - is considerably longer than the maximum provided in past recessions (65 weeks). For workers laid off between September 2008 and May 2010 the federal government also offered to subsidize two-thirds of the cost of employer-sponsored health insurance premiums for workers covered by an employer health plan. In no previous recession did Congress provide laid off workers with this kind of subsidy. For many unemployed workers the subsidy is not generous enough. A large proportion of laid off workers cannot afford to pay a third of the cost of their insurance premiums. When they lose their jobs, they lose their health insurance, too.

In sum, 2010 was a year of only slight progress for the unemployed but real gains for workers who still have jobs. Without a surge in demand for goods and services produced in the United States, it is hard to see much improvement in the outlook for the unemployed. The pace of economic growth must increase before we can see a sizeable drop in unemployment. The growing gap between the fortunes of those with and without jobs is matched by the widening divide between Americans who work for others and the businesses that employ them. Measured in nominal dollars, corporate profits now exceed their pre-recession levels. Business profitability has returned, but total wage and salary disbursements remain lower than they were before the recession began. The political danger facing the unemployed is that surging business profitability and the improving fortunes of employees will cause voters to lose sight of the daunting problems confronting the long-term unemployed.

Excerpt: The Return to Fiscal Sanity Began in 2010—Or Did It?
Alice Rivlin, Senior Fellow, Economic Studies

Historians of our era may describe 2010 as the year Americans finally woke up to the fact that their federal budget was on a dangerous course, hurtling toward a debt crisis that threatens American prosperity and international leadership. They may, but we won’t know until we see whether the political system responds with decisive action in 2011.

But once the election was history, the ultra-partisan rhetoric subsided and public discourse on fiscal matters shifted toward pragmatism. Two bipartisan commissions contributed to the more constructive tone by reporting compromise plans for bring deficits steadily under control and stabilizing the growth of debt. I was privileged to serve on both of them and the experience left me fairly optimistic that our political system can pull itself together and reach a bipartisan compromise in time to avert a debt catastrophe.

The National Commission on Fiscal Responsibility and Reform, ably led by Erskine Bowles and Alan Simpson, included a dozen high-ranking Senators and Representatives from both parties. (Brookings Trustee Ann Fudge and I were among the six public members). The Commission, appointed by President Obama, was charged with crafting a plan, to be released right after the election, for reducing the deficit to manageable proportions by 2015 and controlling future debt. The Commission with the support of a small staff spent months digging into the problem. Despite the fact that most of the members were busy campaigning, they came together in a constructive and collegial spirit to discuss a broad array of spending and tax options, including all the "third rail" political no-no's that pundits declare untouchable. Until the election was over, no votes were taken. Indeed, nothing was written down for fear some leaked draft document would be misused on the campaign trail.

Shortly after the election the co-chairs produced a bold draft plan for the Commission to discuss. It included all the "third rails"-cuts in domestic and defense appropriations, curbing growth in Medicare, Medicaid, and Social Security benefits, drastic reform of the corporate and individual income taxes to simplify the structure and raise more revenue. Commission members, all of whom disagreed with some elements of the plan, welcomed it as a courageous effort to find middle ground without copping out on the assignment. After vigorous interaction with the co-chairs a somewhat altered plan was adopted by 60 percent of the members. Most of those not voting for it, nonetheless expressed their admiration for the effort and some offered their own alternatives. There were no "deficit deniers."

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What Lies Ahead for the Affordable Care Act
Henry J. Aaron, Senior Fellow, Economic Studies

Analysts disagree on whether the Affordable Care Act (ACA), signed into law by president Obama on March 23, 2010 should be regarded as a major economic event of 2010, the most important social legislation in decades, both, or neither. A good case can be made for each of these views.

The case for why the ACA was a major economic event is straightforward. Health care spending accounts for one-sixth of the U.S. economy. It has grown faster than income for half a century and is projected to continue indefinitely. Many billions of dollars each year go for procedures of little or no value, many of which cost far more to provide in the United States than they do in other countries. Projected increases in federal health care spending account for more than all of the anticipated increases in federal budget deficits. Thus, slowing the growth of spending and improving the efficiency of health care delivery is of enormous economic significance. The ACA sustains existing methods for slowing the growth of health care spending. It begins to implement virtually every major new idea for improving the efficiency of health care delivery and for slowing the growth of spending that analysts have proposed. To be sure, some of these ideas should have been pursued more aggressively than the ACA does. But the ACA is the law of the land. If implemented vigorously, it holds the promise of gradually slowing the growth of total and federal health care spending and reforming the way health care is delivered.

No one thinks that the spending slow down will come fast enough to avoid the need for tax increases or other reductions in government spending, but no other proposed strategy for controlling health care spending would do so either. No one thinks that the efficiency of health care delivery will improve rapidly. Thus, the ACA is just a first step-but an extremely significant one-in a long-term program to slow the growth of U.S. health care spending, something that is a necessary precondition for restoring long-term fiscal balance and an important component of a program to improve economic efficiency. That other steps will be necessary in no way diminishes the crucial role that the ACA can play.

The case for the ACA as landmark social legislation is equally strong. For nearly a century, presidents from both parties have sought to extend health insurance coverage to all Americans. The ACA takes a giant step toward achieving that goal. It promises to cut the proportion of Americans without health insurance by more than half. Every legal resident of the United States with income below the official poverty threshold would be insured either through Medicaid or private insurance. Those with incomes up to four times official poverty thresholds would be eligible for subsidies to hold the costs of health insurance below specified fractions of income. Everyone would be required to carry health insurance. Most businesses would be required to offer it to their employees as a largely-employer-financed fringe benefit. Limits would be placed on premiums that insurance companies could charge the elderly or those with preexisting conditions. They would be barred from cancelling insurance policies regardless of how much care the insured require. Given current budget deficits and the inescapable cost of extending insurance coverage-with attendant increases in use of health care services-the ACA went as far in extending coverage as current political and economic conditions would permit.

Of course, both of these claims for the ACA may be valid. There is no reason why the claims for the economic importance of the ACA should diminish its status as its status as social legislation. Paradoxically, however, both sets of claims may turn out to be if not false, then premature. The campaign to extend health insurance and reform the delivery of health care did not begin when president Obama announced his legislative program in 2009. Nor did it end with the signing ceremony on March 23, 2010 Rather, it will continue at least until 2013 and probably for many years after that.

Republicans fought vigorously to prevent passage of the ACA. They tried hard to persuade the American public that the bill was flawed. Public opinion polls indicate that they enjoyed considerable success. The ACA passed Congress without a single Republican vote. While Republican successes in the 2010 mid-term elections owed much to public dissatisfaction with the state of the U.S. economy, unease about health care reform also played a part. The Republican leadership has sworn to seek repeal of the ACA. That objective that is almost certainly out of reach as long as Democrats control the Senate and president Obama can veto any repeal legislation. But the ACA is likely to be a central issue in the 2012 elections. Should Republicans win the White House and a Senate majority, repeal may be possible. Meanwhile, the Republican leadership has pledged to stymie implementation. That goal may be achievable, as the House, which is now under Republican control, may be able to deny appropriations necessary to plan and carry out implementation.

Furthermore, even if funding is adequate, the administration and the states face extremely challenging obstacles in implementing the ACA. Success of the ACA hinges on the capacity of states to sign up 16 million new Medicaid enrollees and to assure that, once enrolled, they can find service providers. All fifty states need to set up health insurance exchanges to provide subsidies to millions of Americans. The federal government must design practical rules not only to guide the states in providing subsidies but also to enable the Internal Revenue Service to recapture over-payments made to people who turn out not to be eligible for them. This last challenge is particularly delicate, as subsidies will be paid to insurance companies on behalf of families and individuals deemed to be eligible based on current income, but overpayments must be collected from the families themselves based on their annual income.

For all of these reasons, the 2010 signing ceremony for the ACA, although indisputably a historic moment, was the just one event in a multi-year drama that began decades ago and will continue for many years. Future historians may hail the signing of the ACA as an epochal achievement in extending health insurance coverage, initiating measures to improve the efficiency of health care delivery, and creating reforms to slow the growth of health care spending. They may see it as yet another failed effort to enforce changes in a system virtually all observers see as flawed and seriously dysfunctional. Which of these two stories comes to be written will depend on events to be played out over the next few years.

On Global Imbalances
Donald Kohn, Senior Fellow, Economic Studies

As the crisis phase of financial and economic turmoil receded in the latter part of 2009 and 2010 (though for an exception to this see the Forum posting on sovereign debt problems), attention of global economic policymakers turned increasingly to global imbalances-large and persistent current account deficits and surpluses. Continuation of these imbalances was seen as posing challenges for economic recovery and for the stability of employment and activity once economies returned to full employment. With many advanced economies hobbled by continuing balance sheet problems, full global recovery will require a greater push from domestic demand in emerging market economies. And, although global imbalances earlier in the 2000s did not directly cause the economic crisis as many had feared, and banking crises can readily occur in countries running large surpluses as Japan demonstrated in the 1990s, imbalances contributed to the conditions that led to the financial crisis in the United States and other industrial economies. The capital flows arising from the surpluses in emerging market economies held down interest rates in advanced economies encouraging leveraging and rising house and other asset prices. And the borrowing corresponding to the U.S. current account deficit was reflected in unsustainable increases in the debt of the household and government sectors here. Gaps and lapses in regulation and supervision in the United States and Europe allowed the resulting leverage, lax lending practices, and maturity transformation to build to dangerous levels that proved all too vulnerable to a softening in house prices and onset of borrower repayment problems.

There is broad agreement that the recovery of the global economy cannot rest on the U.S. consumer or on demand by governments in industrial countries. Financial and economic stability require a higher level of domestic saving in the United States by households and governments than we had a few years ago, balanced by higher investment and net exports. The other side of that coin is that other economies cannot rely on exports to U.S. and other industrial countries as the main drivers of increases in production and employment. Instead more global demand must come from increased purchases by the residents of those economies currently in large surplus positions, especially where those surpluses reflect not economic fundamentals but rather artificial restraints on exchange rates or capital flows. Fundamental shifts in saving and spending patterns will be required for rebalancing; government policies to encourage private and public saving in the United States and other deficit countries and to boost spending in surplus countries will be critical elements in achieving a more sustainable configuration of trade flows. But relative prices will also have to change to make exports by the United States relatively less expensive on world markets and those from the surplus countries relatively more expensive; it will be far less painful and disruptive to do that through movements in exchange rates than through inflation in surplus countries and deflation in deficit countries. In that regard, greater exchange rate flexibility by China is a critical element in fostering a smooth transition to higher levels of production globally and a more sustainable pattern of trade.

The uneven pattern of recovery from the "Great Recession" is straining global relationships. The sluggish growth of the advanced economies, coupled with the imperative for fiscal consolidation in many places, means that interest rates there are very low and are likely to be extraordinarily depressed for some time to come. At the same time, many emerging market economies are growing strongly, are much closer to full employment, and are concerned about inflation and asset price bubbles arising from the inflows of capital from the advanced economies. More flexibility in exchange rates will help with these problems too because these economies would be better able to tighten monetary policies as suited to their individual circumstances and investors will be faced with more tow-way risk in exchange rates. Nonetheless, the surplus countries could still encounter difficulties maintaining economic and financial stability in the face of large capital inflows. Still, they should guard against putting into place the types of capital controls that will distort the global allocation of resources over time; deficit countries for their part must resist any protectionist pressures that may intensify as unemployment remains high.

The G-20 has made dealing with imbalances a high priority and has enlisted the IMF in a Mutual Assessment Process to help countries understand the spillover effects of their policies and devise consistent strategies to advance the goals of higher, more balanced, and more sustainable global output. To date, they have been unable to move beyond agreement on obvious generalities. In fact, the global financial system is not well constructed to apply adjustment pressure to surplus and deficit countries alike. The French, who lead the G-20 in 2011, have made achieving progress on imbalances and on reforming the system a high priority for next year.

On Sovereign Debt Problems
Donald Kohn, Senior Fellow, Economic Studies

2010 was the year the difficult challenge of putting government debts and deficits on a more sustainable path over the long-run came much more clearly into focus. In the United States we saw several bi-partisan efforts to lay out paths to fiscal sustainability. But nowhere did the issues become more pressing than in Europe, where the governments of several countries faced growing doubts about their ability to meet their obligations now or in the future. These doubts resulted in sharply higher spreads on their debt and questions about their continued access to markets, precipitating a crisis that required intervention by other countries of the European Union, the European Central Bank, and the IMF.

The reasons for the actual and expected large borrowing needs and associated severe market problems differed somewhat across countries, but they included: revenue shortfalls and spending increases associated with the deep recession, which in some cases came on top of fiscal shortfalls even in the preceding good times; the pledge of governments to stand behind the debt of home-country banks that have mammoth losses from the bursting of housing bubbles in several European countries; long-run issues related the demands of an aging population on the social safety net; and the erosion of competitive positions in several peripheral countries after they joined the European Monetary Union, which made them dependent on external capital inflows while depriving them of devaluation as a way to restore competitiveness.

Intervention by European and international authorities was sparked by fears of contagion if one country was forced to restructure its debt. Channels for contagion included the potential for spreading doubts about the value of the debt of other European countries with stressed fiscal positions, and the losses that would be absorbed by many European banks if the value of a significant amount of European sovereign debt needed to be marked down. The forms of intervention included liquidity help for European banks from the ECB, which continued to accept sovereign debt as collateral even after it had been downgraded by credit rating agencies; ECB purchases of sovereign debt in the open market; and the establishment of back up facilities by the European Union and the IMF to lend to countries that lost access to markets. These back up facilities were activated for Greece and Ireland. The quid pro quo for this help was sharp cut backs in government spending and increases in taxes by countries in need of assistance; other countries moved pre-emptively in the same direction to head off market problems. Fiscal austerity by troubled countries would reduce government borrowing needs and over time level out debt-to-GDP ratios, and it also could help to restore greater competitiveness through decreases in government wages and pensions, which could spill over to reduce costs in the private sector as well. But it also implied higher odds on very weak economic performance in the short- to medium-term while austerity was being phased in.

As the year drew to a close, how these developments would play out remained in doubt. Spreads on the debt of a number of European countries continued to be very wide. And political backlash was in evidence--against austerity and associated economic weakness in the troubled peripheral countries, and, in Germany, against providing taxpayer support for these countries. Moreover the path to substantially increased competitiveness and reduced reliance on external credit for many of the countries was far from clear. The European authorities were devising structures to impose greater and more consistent fiscal discipline within the European Union and to make the back up facility permanent, albeit with the loses shared by the future holders of the debt of any country that needed to access the facility.

Many observers saw the European experience as underlining the need for the United States to take action now to put its own fiscal house in order. Acting expeditiously would reduce the risk that, like a number of European countries, it would be forced to take very harsh actions in a short period of time to avoid losing access to markets.

2010: A Year to Remember in Financial Regulation
Douglas J. Elliott, Fellow, Economic Studies, Initiative on Business and Public Policy

This year, America made the biggest changes in three-quarters of a century to how it regulates banks and other financial institutions, and the markets in which they operate. Not since the Great Depression has legislation so altered the rules of finance. Nor was this movement confined to the United States; most countries hosting major financial centers also moved forward, notably the United Kingdom and the European Union more broadly. (Please see http://www.brookings.edu/reports/2010/1007_atlantic_council_elliott.aspx for a detailed summary of changes in the United States and Europe.)

The United States passed the "Dodd-Frank Act" this summer, legislation which comprehensively rewrote the rules across a wide range of financial activities. There are far too many changes to even summarize here, but the breadth of change is as important as the long list of individual items. The terrible financial crisis, whose adverse effects we are still feeling, highlighted a host of flaws in finance and its regulation and therefore Congress found it necessary to tackle a myriad of problems in the form of the Dodd-Frank Act. The interconnections between these problems added further complications.

There are those who attack Dodd-Frank for doing too much and those who say it did too little. Many conservatives believe that government interference in the housing markets was the real core of the problem and that the financial system would have worked reasonably well if we had avoided the massive shock of the bursting housing bubble. There are respectable arguments for this, but they disregard the clear evidence of the myriad of other problems in the system. Even if we accepted that the government committed the equivalent of arson, the resulting fire still showed us a host of vulnerabilities that needed to be fixed. (Please see http://www.brookings.edu/papers/2009/1123_narrative_elliott_baily.aspx for a longer discussion of this.)

Many critics on the left argue that Dodd-Frank essentially preserved the current system -- one that they believe is rigged in favor of the banks and fraught with the danger of future blow-ups and taxpayer rescues. For example, they believe that the largest banks remain "too big to fail" and therefore free to take excessive risks, knowing they'll be rescued if real problems develop. There are respectable arguments here, too. The premise is clearly right in a key sense - the core approach to the financial system remains in place. I draw an analogy with Franklin Roosevelt's actions in the Great Depression. He reformed the relationship between business and government, but kept capitalism in place, rather than replacing it with socialism or fascism or some other "-ism." Similarly, Dodd-Frank rebalances and realigns the financial system, but does not switch to a radically different approach. At the same time, I would argue that the extent of the reforms is fairly massive and that it is a mistake to view the post-Dodd-Frank world as just the continuation of business as usual.

Overall, I was pleased with Dodd-Frank. It has its flaws, such as a failure to boldly realign the institutional structure of regulation by combining some of the excessive number of regulatory bodies that exist now. There are also aspects that do more harm than good, such as the Volcker Rule. However, the total effect is to buy us considerably greater safety at a relatively modest cost to the economy.

2010 Climate Change Policy Retrospective
Adele Morris, Fellow, Economic Studies

Some of the disparate moving parts of climate policy came to a halt in 2010, but other parts chugged on. Senate efforts to produce a cap-and-trade measure to control greenhouse gas (GHG) emissions failed, leaving a 2009 House-passed climate bill stranded. In an election year marked by persistently high unemployment, Republican opponents successfully characterized the effort as a "job-killing energy tax," despite Democrats hailing its potential to build a green-job-creating "new energy economy." Sadly, neither side made a case for a sensible, predictable, deficit-reducing economy-wide price signal on carbon.

The 2010 elections strengthened the ranks of opponents of climate change policy on the Hill, and Senate Majority Leader Harry Reid says cap-and-trade won't be on the Senate agenda for the next Congress. There are nascent signs of a bipartisan coalition for other energy legislation, such as a clean energy standard that requires electricity generation of at least a certain percentage from technologies with low carbon emissions, including nuclear power. However, the Tea Party caucus and other conservatives are likely to strongly resist such intervention.

In 2010, the U.S. Environmental Protection Agency (EPA) forged ahead with new climate regulations under the Clean Air Act, despite efforts by Senator Jay Rockefeller (D-WV) and others to kill funding for the work. Early in 2011, a rule takes effect that requires facilities that will significantly increase their GHG emissions to obtain Prevention of Significant Deterioration (PSD) permits. Among other things, these permits will require "best available control technology" limits on emissions. This permitting process is a major new responsibility for states and the EPA. In 2011, EPA plans to impose new standards for major emissions sources. However, EPA's ambitions in 2011 may be tempered by House efforts to limit its funding, question the scientific basis for its actions, and generally scrutinize the regulatory process.

Despite the recession, states continue to experiment with climate policy. For example, California's pursuit of implementation of its climate law, A.B. 32, survived a fall ballot measure that would have delayed the rules until the unemployment rate dropped to no more than 5.5 percent. A.B. 32 will spawn a multi-sector cap-and-trade program and possibly extend its reach to other state and Canadian provincial programs through the Western Climate Initiative.

Finally, international negotiations moved forward incrementally in 2010. The two-week meeting of the United Nations Framework Convention on Climate Change in Cancún, Mexico, ended in mid-December with a modest agreement to monitor and verify emissions pledges made under the Copenhagen Accord last year. The parties also agreed on measures to protect rainforests and share technology, and they established a fund to help poor countries lower emissions and adapt to climate change. Arguably one of the most useful ingredients to the pragmatic outcome was the low expectations that followed 2009's rancorous meeting in Copenhagen. Given the vast differences among the 200+ countries involved, few expect sweeping new commitments under the UN umbrella until the US adopts a domestic climate law, and perhaps not even then.

The sovereign debt crisis in the euro zone has shaken bond markets everywhere. At their latest meeting in Brussels, euro zone governments strengthened their commitment to central bank support for the bonds of member states that come under siege. This monetary solidarity is useful, but some degree of fiscal unity is also needed. The core point of disagreement among governments is how far to go toward making euro bonds a sovereign responsibility of the currency union itself and how to enforce fiscal discipline on individual nations if bonds become a joint responsibility.
A bank employee counts Euro notes.

A bank employee counts Euro notes.
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Reuters/Sukree Sukplang
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The following plan pushes individual nations toward fiscal prudence and reduces the risk that shocks destabilize euro bond markets in the future. It does so by strengthening the impact of market forces in non-crisis times rather than relying on rigid rules and penalties, which are likely to be clumsy at best and onerous across sovereign states. The plan also aids the transition from the present crisis and moves gradually toward a limited form of fiscal unity for the euro zone.

The proposal creates a two tier framework for sovereign borrowing. The first tier consists of bonds issued to cover annual deficits up to some specified size limit—say 2 percent of a nation’s GDP (and to roll over maturing bonds of this tier). Such a percentage is sustainable in the long run and consistent with steady or declining ratios of debt to GDP. Call these Eurobonds. Any borrowing above this limit must be done by issuing second tier bonds. Call them national bonds. The euro bonds are the responsibility of the borrowing nation but backed by the currency union and issued by its bond authority. The national bonds are conventional, backed and issued by individual nations.

Some analysts and politicians have suggested a different kind of two tier system based on ratios of bonds outstanding to GDP. When the ratio is above a specified limit, bonds carry a risk premium. However at present this ratio ranges widely, from over 130 percent to under 30 percent. There is no reasonable starting point and little guidance on what level is optimal. For any chosen target, there is little if any incentive for countries so far above it that attainment is many years away, and no incentive for countries already below it.

The large incentive effects of the plan presented here are present in each annual budget cycle. With euro bonds senior to national bonds in the conventional sense, a lending nation under duress would suspend payments on national bonds and renegotiate them if necessary before suspending payments on euro bonds which, in any case, would have the backing of the euro authority. With some debt consisting of euro bonds, any prospective risk of nonpayment would now be born entirely by the smaller number of national bonds outstanding, so the loss to each national bond would be greater. The interest differential between euro and national bonds is correspondingly widened, increasing the incentive to reduce deficits.

These economic incentives will be buttressed by political effects that may be even more potent. With only conventional national bonds, there is little evidence of how much is being charged for incremental borrowing. In the new framework, the marginal cost of incremental borrowing will be clear and conspicuous for each nation.
The 2 percent limit on national borrowing is in the useful range for the longer run once economic conditions are more normal. Deficits of that size would be sustainable and would gradually reduce debt to GDP ratios in most countries. In the mid-2000s, most small euro nations were near budget balance, with Greece and Cyprus conspicuous exceptions. Germany, France and Italy had deficits in the 3 to 4 percent range and Spain, Belgium, the Netherlands and Ireland were all near balanced budgets. Today deficits across the euro area average 6.5 percent.

Because of present economic and bond market conditions in the euro zone, incentives to reduce deficits are already compelling. So the size limit could start higher, say at 4 or 5 percent, and decline over several years to the eventual 2 percent. Countries now confront high borrowing costs because markets question their ability to meet interest payments. By financing part of any new debt with euro bonds the proposed system would immediately reduce interest costs and lower the risk of nonpayment. Though euro bonds are initially a very small part of the total, the effects would be considerable, reflecting all future benefits of the dual tier framework.

The introduction of the new framework need not favor troubled economies over more stable ones. Member nations whose deficits would not otherwise reach their limit on euro bond issuance could do so by using euro bonds to retire outstanding national bonds. And since Eurobonds only gradually become a feature of the currency union, the benefits of this modest degree of fiscal union are achieved without politically divisive fiscal cost.