Not Just Another Recession
Why the Global Economy May Never Be the Same
The European Central Bank’s recently released stress test results aim to clean up the eurozone’s banks before the launch of Europe’s vaunted banking union. But Jean-Claude Juncker, the newly inaugurated European Commission president, has set a different financial priority for his first five-year term, one that has received decidedly less attention: the creation of a European capital markets union.
It is not yet clear what this project means or how it would benefit the EU. To a large extent, Juncker’s capital markets union is still a slogan in search of a policy program. But it is easy to imagine a set of initiatives designed to help Europe develop healthy nonbank sources of finance and to let capital flow freely across the continent’s national boundaries. If so, it could be hugely beneficial for Europe.
BREAKING THE BANK MONOPOLY
Europe needs nonbank finance because its banks—which have traditionally been the continent’s main source of finance for business—have become considerably weaker since the onset of the euro crisis. They have been weighed down by bad loans and, in some cases, suffered losses on bonds issued by struggling governments. In the years ahead, European banks will be forced to shrink as the European Commission and European Central Bank (ECB) subject them to tougher regulation and supervision. As such, they will be unable to finance a European recovery on their own. The situation is particularly acute in peripheral eurozone countries such as Italy.
Of course, there is a vast array of possible alternatives for those in need of financing: public equity; private equity; venture capital; loans made by entities that are not banks, often called “shadow banks”; loans that start on bank balance sheets but are then packaged up and traded in financial markets—so-called securitization; corporate bond issues; private bond placements; hedge funds; and so on.
Although all of these already exist in the EU, the markets for them are typically much smaller than equivalent activities in the United States. Indeed, according to an analysis by the think tank New Financial, Europe’s capital markets are roughly half as large relative to GDP as those in the United States. This is the flip side of the fact that the EU is much more bank-centric than its counterpart. Its lenders’ balance sheets amount to four times its GDP; in the United States, they are only 80 percent of GDP.
The term “capital markets union” was consciously chosen to echo the EU’s new banking union. But there are important differences between the two. In particular, the banking union was envisaged primarily as a eurozone project, although non-euro countries can also join it. The idea was to help shore up the single currency by untethering banks from the governments of the countries where they are based.
A capital markets union, by contrast, is designed to develop the European single market, not to patch up the single currency. That is to say, it will be an EU-wide project rather than a eurozone one. Indeed, it should be viewed as completing a goal central to the Treaty of Rome of 1957: free movement of capital across the region. And this means that unlike the banking union, the capital markets union will include the United Kingdom, home to the City of London, which is by far the largest capital market in Europe.
A drive to complete the single capital market could be a generational opportunity for the City of London similar to the so-called eurodollar revolution from the late 1950s onward, when huge amounts of offshore dollars spawned new financial markets centered in the United Kingdom and the explosion of activity unleashed by former Prime Minister Margaret Thatcher’s 1986 deregulation drive. This would be good for British jobs, wealth creation, and tax collection. In that sense, Juncker’s capital markets union gives British residents a strong reason to stay in the EU if the question is posed to them in a referendum, as Prime Minister David Cameron has promised to do by the end of 2017 (assuming he is reelected prime minister in next year’s general election).
The EU’s current bank-centricity does not just threaten to undermine the continent’s fragile economic recovery. It also serves to magnify the original crisis. Some governments that rescued their banks, notably Ireland, were dragged down themselves because the cost of the bailout overwhelmed their public finances. But not rescuing banks wasn’t a good option either, as Cyprus discovered: bank failures inflicted heavy losses on depositors, resulted in stringent capital controls, and ultimately drove that country’s economy into a deep recession.
If Europe develops deeper capital markets, it will not be so exposed the next time it suffers an economic shock. Although banks might still get into trouble, they would be smaller and thus easier for governments, central banks, and supervisors to manage.
Another advantage of a capital markets union is that it could lead to more effective monetary policy. Following Lehman Brothers’ bankruptcy in 2008, the U.S. Federal Reserve embarked on an aggressive program of quantitative easing that is partly credited with the United States’ swift recovery from recession. By contrast, the European Central Bank waited until September 2014 before agreeing on a fairly modest form of quantitative easing. One reason for the discrepancy is that the Fed had a rich array of capital market instruments that it could buy. Because Europe’s capital markets are underdeveloped, the ECB did not have the same options. This is not to suggest that a capital markets union will do much to help the eurozone recover from its current malaise: developing markets takes time, and it could take a decade before Europe meaningfully closes the gap on the United States.
Even if there are clear benefits to having a capital markets union, creating it will be a challenge. There is no single policy that can bring such a union into effect. Rather, Juncker would need to push through dozens of detailed initiatives dealing with the whole range of capital markets, from equities to bonds, venture capital, shadow banking, securitization, and so forth. The action plan would be similar, in that sense, to the many steps that were needed to create the EU’s single market in 1992. Although there is broad agreement among EU governments on the desirability of such a plan, the devil will be in the details. This might bring forth opposition from either vested interests, which would stand to be hurt by more open markets, or politicians who think that capital markets encourage greed and are the source of financial instability.
Despite this complexity, it is possible to identify two high-level principles that should guide this policy. First, the emphasis should be on lifting the existing barriers that prevent both the growth of capital markets within member states and the development of integrated pan-European markets. For example, shadow banks should be given a “passport” that would allow them to operate across the EU’s 28 countries, provided they are appropriately regulated in their home country. Similarly, countries should agree to phase out any provisions in their tax systems that encourage companies to fund themselves with debt rather than equity. (At present, European countries tend to privilege debt, because interest payments are considered tax-deductible whereas dividends typically are not.)
Markets, of course, do need regulation. But the main thrust of a capital markets union should be about liberating, not controlling, them. In fact, some of the regulations put in place in the wake of the financial crisis will need to be revised because they are preventing the healthy development of nonbank finance. Earlier this month, for example, the European Commission announced plans to deregulate so-called high-quality securitizations. This market is virtually dead in Europe, despite defaults being less than a tenth of those in the United States.
Second, the principle of subsidiarity—under which the EU is supposed to take action only if it can do so more effectively than a member state—should be strictly respected. There is, for example, no need to have a single supervisor for the EU’s capital markets. At present, the European Securities and Markets Authority sets a rule book for the single market and seeks to ensure consistent supervision across the 28 states. But national supervisors police the rules. This policy should be continued. Any attempt to centralize power in a single supervisor would, apart from anything else, provoke an outcry in the United Kingdom, which might otherwise be an enthusiastic supporter of a capital markets union.
An effective EU capital markets union would mark an important advance. It would give the EU more ways of funding jobs and growth, help it to weather macroeconomic shocks, and enable it to pursue more effective monetary policy. As a bonus, it would also cut the risks of the United Kingdom quitting the EU.
The benefits will not all flow immediately. But over the coming decades, a capital markets union can make a significant contribution to the EU’s economic prospects. The most effective European Commissions are generally remembered for their major initiatives, whether the single market, monetary union, or enlargement of the EU to former Warsaw Pact countries. The Juncker Commission should be pleased if it goes down in history as the father of Europe’s capital markets union.