Bilbao ubillos (ed ) the economic crisis and governance in the european union; a critical assessment (2014)

The Economic Crisis and Governance in the European Union This book explores the way in which the financial crisis that began in the US spread to the economy of the European Union.. Elias

The Economic Crisis and Governance

in the European Union

This book explores the way in which the financial crisis that began in the US spread to the economy of the European Union It takes a critical look at the measures adopted by EU institutions in response to that crisis, seeking to explain the rationale behind them, their context, their development and why different exit strategies were not adopted In doing this, the book makes comparisons with the measures adopted by institutions in the US and the UK

As the crisis has shown that the financial supervision frameworks prevailing

in 2007 were not fully able to deal with the largest financial crisis in history, this volume also reviews the proposals that have been designed to reform the super-visory architecture of financial services in the EU

The book concludes that the EU member states under most pressure from ancial markets do suffer from intrinsic problems, but that the economic effects

fin-of the crisis have been exacerbated by shortcomings in economic governance within the EU

This work will be highly relevant to policy makers and scholars looking at

EU integration, finance and market regulation

Javier Bilbao- Ubillos is Senior Lecturer in the Department of Applied

Eco-nomics at the University of the Basque Country, Spain

Routledge studies in the European economy

1 Growth and Crisis in the Spanish Economy, 1940–1993

Sima Lieberman

2 Work and Employment in Europe

A new convergence?

Edited by Peter Cressey and Bryn Jones

3 Trans- European Telecommunication Networks

The challenges for industrial policy

Colin Turner

4 European Union – European Industrial Relations?

Global challenges, national developments and transnational dynamics

Edited by Wolfgang E Lecher and Hans- Wolfgang Platzer

5 Governance, Industry and Labour Markets in Britain and France

The modernizing state in the mid- twentieth century

Edited by Noel Whiteside and Robert Salais

  6  Labour Market Efficiency in the European Union

Employment protection and fixed- term contracts

Klaus Schömann, Ralf Rogowski and Thomas Kruppe

7 The Enlargement of the European Union

Issues and strategies

Edited by Victoria Curzon- Price, Alice Landau and Richard Whitman

8 European Trade Unions

Change and response

Edited by Mike Rigby, Roger Smith and Teresa Lawlor

9 Fiscal Federalism in the European Union

Edited by Amedeo Fossati and Giorgio Panella

Edited by Kjell A Eliassen and Marit Sjøvaag

11 Integration and Transition in Europe

The economic geography of interaction

Edited by George Petrakos, Gunther Maier and Grzegorz Gorzelak

12 SMEs and European Integration

Internationalisation strategies

Birgit Hegge

13 Fiscal Federalism and European Economic Integration

Edited by Mark Baimbridge and Philip Whyman

14 Financial Markets in Central and Eastern Europe

Stability and efficiency

Edited by Morten Balling, Frank Lierman and Andy Mullineux

15 Russian Path Dependence

17 Macroeconomic Policy in the European Monetary Union

From the old to the new stability and growth pact

Edited by Francesco Farina and Roberto Tamborini

18 Economic Policy Proposals for Germany and Europe

Edited by Ronald Schettkat and Jochem Langkau

19 Competitiveness of New Europe

Papers from the second Lancut economic forum

Edited by Jan Winiecki

20 Deregulation and the Airline Business in Europe

Sean Barrett

21 Beyond Market Access for Economic Development

EU–Africa relations in transition

Edited by Gerrit Faber and Jan Orbie

22 International Trade, Consumer Interests and Reform of the Common Agricultural Policy

Edited by Susan Mary Senior Nello and Pierpaolo Pierani

23 Economic Governance in the EU

Willem Molle

24 Financial Integration in the European Union

Edited by Roman Matoušek and Daniel Stavárek

25 Europe and the Mediterranean Economy

Edited by Joan Costa- Font

26 The Political Economy of the European Social Model

Philip S Whyman, Mark J Baimbridge and Andrew Mullen

27 Gender and the European Labour Market

Edited by Francesca Bettio, Janneke Plantenga and Mark Smith

28 The Economic Crisis and Governance in the European Union

A critical assessment

Edited by Javier Bilbao- Ubillos

The Economic Crisis and

Governance in the European Union

A critical assessment

Edited by Javier Bilbao- Ubillos

First published 2014

by Routledge

2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN

and by Routledge

711 Third Avenue, New York, NY 10017

Routledge is an imprint of the Taylor & Francis Group, an informa business

© 2014 selection and editorial material, Javier Bilbao- Ubillos; individual chapters, the contributors

The right of Javier Bilbao- Ubillos to be identified as the author of the editorial material, and of the authors for their individual chapters, has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988.

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British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data

The economic crisis and governance in the European Union: a critical assessment / edited by Javier Bilbao-Ubillos.

pages cm

Includes bibliographical references and index.

1 Financial crises–European Union countries 2 European Union countries–Economic policy–21st century 3 European Union countries– Social policy–21st century 4 Monetary policy–European Union countries I Bilbao Ubillos, Javier, editor

3 Financial supervision reform in the EU: a comparison with

viii Contents

PART II

Praxis of European governance facing the economic crisis:

6 A critical view of the governance of the crisis in Europe: the

J A v I E R B I L B A O - U B I L L O S

7 Questioning the myth of expansive austerity: European

macroeconomic policy during the crisis and its aftermath 114

R A F A E L M U ñ O z D E B U S T I L L O

8 The European sovereign debt crisis and the new

governance: a conservative alternative to European

7.3 Estimate of the impact of fiscal policies on GDP growth for

7.4 Forecast GDP growth, different waves: Spain, Greece,

9.4 Fiscal fundamentals at beginning of crisis: ratio of fiscal

primary balance and net government debt to GDP (2009) 1599.5 Fiscal fundamentals: dynamics since start of crisis 160

9.10 Sovereign debt holdings, by type of investor (in percentage of

9.11 Change in government spending (dg) and change in GDP

9.14 Advanced economies: market induced fiscal adjustment 170

9.19 Change in debt- to-GDP ratio vs spreads since 2012: Q2 173

x Figures

9.21 Banks- sovereign contamination in wholesale markets 1759.22 Banks- sovereign contamination in retail deposits 176

9.25 Non- performing loan ratios of euro area large and complex

banking groups (percentage of total loans; maximum,

minimum, interquartile distribution and median) 178

9.27 Spread between interest rates on small and large loans

(January 2006–September 2012; three- month moving

8.1 Trends over time in unit labour costs from 1999 to 2007 147

Ricardo Aláez-Aller is Senior Lecturer of Economics at the Public University

of Navarre in Spain He specializes in wage differences, automotive industry and economic policy He has served as Head of the Economics Department at the Public University of Navarra and he has also lectured at the University of the Basque Country (Spain), the University of Bordeaux (France) and the University of Leuven (Belgium)

Isabel Argimón has held the position of Head of the Banking Analysis and

Reg-ulatory Policy Division in the Directorate General of Regulation of the Bank

of Spain since July 2007 Previously, she was chief economist of the Public Sector and Fiscal Policy Unit at the Research Department of the Bank of Spain, Manager of the economic advisers’ team at the Financial Services Authority and policy adviser at HM Treasury for public expenditure policy and financial regulation She holds a Ph.D in Economics from the Universi-dad Complutense of Madrid

Xosé Carlos Arias is Professor of Economics and Public Policies at the

Univer-sity of vigo (Spain) In recent years he has actively worked in the ment of the research program of Transaction Cost Politics He recently

develop-published the book La torre de la arrogancia Políticas y mercados después

de la tormenta (Ariel, Barcelona, 2011) jointly with Antón Costas He also co- edited Organización de gobiernos y mercados (PUv, valencia) Promi-

nent among their last papers has been, “Transaction Costs Politics in the Map

of the New Institutionalism”, in N Schofield et al (eds) Advances in Political Economy (Springer, Heidelberg, 2013), with G Caballero.

Àngel Berges and Emilio Ontiveros are professors of Finance and

Manage-ment at Universidad Autónoma de Madrid, where they have performed ing and research duties for over 30 years Additionally, they are the main partner founders of AFI, one of the largest Spanish consulting companies, specializing in advisory and consulting services on financial economics and markets, banking, risk management, as well as high level executive training From their twin duties, as academics and consultants, they have developed an exhaustive and integrated view on the handling of the crisis in Europe

teach-Javier Bilbao- Ubillos graduated in Economics (University of the Basque

Coun-try) and Law (University of Deusto), and obtained his Doctorate in 1990 He enjoyed a postdoctoral stage at the European University Institute (Florence – Italy) He currently teaches at the University of the Basque Country (Spain)

He is the author (or co- author) of 22 books and 50 articles in journals such as

European Urban and Regional Studies, Administration & Society, Economic

& Political Weekly, International Journal of Social Welfare, International Journal of Technology Management, Journal of Economic Policy Reform, Sustainable Development, Public Money and Management, Social Indicators Research, and Economic Development Quarterly.

Antón Costas is Professor of Political Economy at the University of Barcelona

He is interested in the role of ideas and interests in policy formation He has published several articles and books on these subjects His two latest books

are: La torre de la arrogancia Políticas y mercados después de la tormenta (Ariel, Barcelona, Barcelona, 2011), jointly with X C Arias, and The 2008 Crisis From Economics to Politics and Beyond (Fundación Cajamar, Almeria, 2010) He is a columnist of El País and other Spanish newspapers.

Carlos Gil- Canaleta is Lecturer of Economics at the Public University of

Nav-arre in Spain He has made contributions in regional economics and public administration He has worked on research programs focused on structural funds and European policies

Maria Luisa Leyva has been Senior Economist in the Financial Stability

Department of the Bank of Spain since January 2012 She has developed most

of her professional career in the Bank of Spain, where she has held different management posts in a wide variety of departments In particular, she was head of Division of the Cash Department of the Operations and Payment Sys-tems General Directorate and Head of the European Affairs Division at the Research Department She has written about financial institutional frame-works and financial stability She holds a degree in Economics by the Univer-sidad Complutense de Madrid, Spain

Cristina Luna has been the Senior Economist at the Financial Stability

Depart-ment, in the Directorate General of Regulation of the Bank of Spain, since

2002 Previously, she was Senior Economist at the Financial Institutions Department (1997–2001), in the same Directorate General, and Head of the Unit of Real Statistics at the Statistical Department in the Directorate General

of Economics, Statistics and Research (1989–1996) She holds a degree in Economics from the Universidad Autónoma de Madrid, Spain

Rafael Muñoz de Bustillo is Professor of Applied Economics at the University

of Salamanca He has written extensively on the labour market, income bution, the welfare state and European Integration His latest publications are:

distri-Measuring More than Money The Social Economics of Job Quality (Edward

Elgar Publishing, Cheltenham, 2011), two chapters in E Fernández-Macías,

xiv Contributors

J Hurley (eds) Transformations of the employment structure in the EU and

US, 1995–2007 (Palgrave, 2012), and a chapter in D vaugham- Whitehead (ed.) Work inequalities in crisis Evidence from Europe (Edward Elgar Pub-

lishing, 2011) He is the co- author of a widely used textbook on the EU:

Introducción a la Unión Europea Una aproximación desde la economía, 4th

edition (Alianza, 2009)

Marco Ricceri is an expert on European social and labour policies, acting as

General Secretary of the research institute EURISPES and as co- founder and coordinator of the European research group “European Social Model” (London- Bremen-Rome) He has previously worked at the National Study Office of the CISL (Free Italian Trade Union) and at the Parliamentary Groups of the Italian Chamber of Deputies, where he was Chief Officer for Economic Policies He teaches at the Link Campus University of Malta in Rome – Faculty of Political Sciences on the “History of the European Inte-gration Process” and “European Institutions”, and was honored with the

Degree Honoris Causa in European Policies by the Institute of Europe of the

Russian Academy of Sciences (IE- RAS)

Francisco Rodríguez-Ortiz is a Bachelor in Economics (Université Nanterre X,

Paris- France) and holds a Ph.d in Economics from Université Nancy 2, France He is manager of the Department of Economics at the Institute of European Studies, Universidad de Deusto (Spain), where he is also Professor

of Structure and Economic Policy An active participant in economic sions of European economic architecture, he has written many essays in eco-nomic and financial publications, and has spoken at dozens of conferences throughout Spain and France Recently (late 2012), Rodriguez Ortiz pub-

discus-lished his sixth standalone book (Las mascaras de la crisis Europa a la deriva, Editorial la catarata, Madrid) analysing from an extremely didactic

position, the current and likely future economic backdrop

1 Introduction

Javier Bilbao- Ubillos

The governance of the economic crisis in Europe has become a topic of undoubted current interest There are two main reasons for this:

• On one hand, the economies of Europe are facing a crisis of a magnitude and complexity not seen for decades: most European Union (EU) Member States have slipped back into recession in the first quarter of 2013 without having recovered from the major shrinkage that they suffered in 2009 The effects of the credit crunch can still be felt in matters such as access to funding1 and problems in the balance- sheets of banks; and what looked like the certain break- up of the euro has barely been avoided, with some coun-tries suffering a sovereign debt crisis and Cyprus hovering on the brink of abandoning the common currency in March 2013

• On the other hand, Member States have been unable on this occasion to make fully autonomous use (at national level) of a number of conventional eco-nomic policy instruments that would have helped them to tackle the recession These constraints have affected members of the Eurozone in particular (coun-tries which not only have no individual monetary and exchange policies but have also lost part of their freedom to manage their own fiscal policies).Thus, progress towards European integration has meant that the Member States

of the EU as a whole are having to face up to the economic and financial crisis with no possibility of resorting to trade policies and with fiscal policies subject

to a number of constraints that have recently been exacerbated in the formulation

of the new Stability and Growth Pact (SGP) and the entry into force of the Treaty on Stability, Coordination and Governance (TSCG) for all countries in the EU-27 except the United Kingdom and the Czech Republic But Eurozone members no longer have the option of resorting to changing their exchange rates and interest rates (methods that have traditionally proved useful in economies suffering from asymmetric shocks)

Until now, the consequences of handing over authority for economic policy

to supranational EU bodies had never been tested under adverse circumstances

ture of economic governance designed in the EU, which seems not to have

focuses on the roots and structural weaknesses that have proved condu-be difficult to achieve enough labour mobility and price/wage flexibility to tackle an asymmetric shock (Garcia- Durán and Millet 2012: 114) As pointed out by Bergsten (2012: 110), Europe embarked on a broad, but incomplete, process of monetary union backed by the euro and the European Central Bank (ECB); but the process included practically no economic union (e.g no fiscal or banking union), no institutions for sharing economic governance and no effective co- ordination of structural economic policies But besides this, Part I analyses specifically the model of economic growth of the preceding decades, the different financial supervision architectures, the institutional framework of the Eurozone in terms of attaining short- term macroeconomic policy objectives, and the way in which decision- making processes are regulated.

• Part II examines the praxis of economic governance as actually carried out

in the EU during the management of the economic crisis, and takes a critical look at the dysfunctions that have led to its disappointing economic results

To that end it looks at the economic policy guidelines that have prevailed in the strategies drawn up for exiting the crisis, at the effectiveness of the deci-sions made by the EU and at the way in which the debt and banking crises have been handled It also examines what some authors have called “con-flicts between national interests” (Comín 2012: 37): it is argued that such conflicts may have given rise to asymmetries in the capacity for political influence in joint decision- making and in the possibility of adapting the

“rules of play” to the needs of each country

The chapters that make up the two parts have been put together as follows: Part

Ipean integration, looks mainly at institutional points and at matters of context in the formulation of economic policies, including the distribution of authority among Community bodies and national institutions Accordingly, the four chap-ters in Part I are set out as follows:

, which is clearly focused on the historical development of the process of Euro-• Chapter 2 analyses the model of economic growth of the preceding decades, paying particular attention to the changes made in the theories of economic

policy and the lesser degree of freedom that results from the formidable external restrictions imposed by ever more voluminous and internationalised financial markets, which make it harder for many countries to draw up more autonomous policies.

pects envisioned for the next decade, there are powerful reasons that point towards a certain return to the idea of active, changing macroeconomic pol-icies That is to say, public and market policies should advance towards a new, more stable balance This will require greater autonomy for policy and the reintroduction of pragmatic controls on transnational movements of capital Should this not be done, it is very likely that the international economy will face further, highly serious crises

Some authors argue that, in the context of the economic and social pros-• Chapter 3 reviews the different arrangements in place for the supervision of the financial sector and the proposals for reforming this architecture of the supervision put forward from 2007 onwards in some countries; it compares and assesses how well they are suited to the needs identified in the relevant jurisdictions The European Banking Union (with the initial launch of the Single Supervision Mechanism), the abolition of the single supervisor in the

UK and its replacement by a twin peak supervision model and the Dodd- Frank Act (which implements regulatory and supervisory reform in the US) are described and analysed Progress in the area of financial stability has been generalised as evidenced by the changes introduced in the three juris-dictions, which have provided financial authorities with instruments to develop a macro- prudential policy

• Chapter 4 analyses the shortcomings in the institutional framework of the Eurozone in terms of attaining short- term macroeconomic policy objectives Special attention is paid to the distribution of areas of authority between national governments and supranational bodies in matters of monetary policy, control of fiscal policy instruments, supervision of the financial system and management of government debt

• Finally, Chapter 5 looks at the structural limits of economic governance in the EU, focusing primarily on the way in which decision- making processes are regulated, which hampers the early diagnosis of problems and prevents sufficiently fast and flexible responses from being made It is argued that the seriousness of the crisis, combined with the economic and demographic prospects, will force a rethinking of the conditions for the pursuit of profit and lead to progress towards a new, sustainable concept of development and

a reorganisation of the welfare state

Part II takes a critical look at the response strategy implemented by the EU in managing the economic crisis, and seeks to expose the shortcomings in terms of governance and the dysfunctions inherent in the measures taken (and in the failure to take others), which have exacerbated the problems and furthered a lack

of confidence among financial operators The chapters look first at general aspects (the drawing up of exit strategies in the governance of the crisis in

4 J Bilbao-Ubillos

Europe, the economic policy benchmarks that have guided decision- making and the consequences of the actions taken in terms of economic policy) and then at more specific points, i.e points which are highly important but which affect spe-cific aspects of economic intervention (such as the way in which sovereign debt crises have been treated)

These chapters are structured as follows:

• Chapter 6 starts from the premise that there were structural shortcomings in the design of the Eurozone (comprising as it did countries with widely dif-fering fabrics of production and levels of competitiveness that did not con-

stitute an optimum monetary area) and then sets out a reasoned argument

asserting that the architecture of economic governance in the EU has serious failings in its ideological aspects (design of a coherent exit strategy) and in its institutional aspects (procedures, irreversibility and implementation periods of the decisions made)

tant and sometimes lacking in sufficient force There have also been contra-dictory measures taken over the course of the management of the crisis, as evidenced in the brusque changes of exit strategy and the low level of observance of some of the decisions made by the EU (e.g the first bail- out agreement for Cyprus deliberately contravened Directive 2009/14/CE of the European Parliament and the Council of 11 March 2009, which guaranteed deposits up to €100,000 and was transposed into the legislation of the various Member States; moreover, it envisaged the enforcement of controls

As a result, the EU’s response to the crisis has been late in coming, hesi-on movement of capital, a move which was highly exceptional in terms of

EU regulations)

Thus, the intrinsic problems of some Member States (strong budgetary or external trade imbalances, vulnerable financial systems, economic stagna-tion and poor labour market operation) have been exacerbated by the lack of confidence shown by the markets in the operation of the euro and in EU institutions as a whole

• Chapter 7 gives an interpretation of the successive measures adopted from the viewpoint of the economic policy paradigms that have served as bench-marks for them At the start of the economic crisis in 2008, most EU gov-ernments (and the European Commission) embraced what could be considered as the standard Keynesian economic response, albeit with differ-ent levels of enthusiasm Two years later there was a general, radical U- turn, which placed fiscal consolidation at the forefront of economic policy Although this change can be partly explained by the increasing pressure exerted by the financial markets on the weakest countries, there was a general belief at the time (that still persists today) that fiscal consolidation could lead, even in the short run, to economic growth The chapter reviews the likeli-hood of such an event from theoretical and empirical perspectives, the hypo-thesis of expansive austerity and the implications of the adoption of such an interpretation of the functioning of markets for the recovery of the EU

• Chapter 8ility that governments may seek to break the deficit/debt circle by further lowering working conditions, salaries and social welfare conditions, whose detrimental effects on growth can no longer be counteracted by borrowing Rather than opting for a federalisation of European economic policy, which would take into account the interests of the different states and create mech-anisms for solidarity, the exit strategy implemented seems to consist of imposing new rules of governance that tilt the balance of power further towards the market and away from the state These new rules of governance comprise a “Europisation of conservative German policies”.

, written from a political economy viewpoint, warns of the possib-• Chapter 9 focuses on the management of the sovereign debt crises and seeks

to explain the behaviour of the financial markets, based on their assessment

of the economic situation of each country and the potential for getting back

to the path to growth

At the beginning of the crisis, Spain had a much lower level of public debt than most EMU countries; less, indeed, than the UK, the US and Japan

ization for Economic Cooperation and Development) countries, yet Spain is one of the countries whose public debt has been penalised most by the markets The reason is the high level of private debt in Spain, the great majority of which is intermediated through the banking system As long as doubts remain concerning the health of the Spanish banking system, markets will be increasingly worried that some of that private debt might eventually

In fact, even today its public debt is below the average for OECD (Organ-be converted into public debt

This represents a “diabolical loop” that is magnified by the single- minded approach that is currently being imposed to correct the imbalances within the Eurozone According to this view, all adjustments should rely on austerity measures taken by debtor countries The present book argues that, far from helping to correct those imbalances, over- reliance on austerity measures deepens the vulnerability of the Spanish banking system and therefore threat-ens the long- term economic potential and sustainability of public finances.The critical tone employed here should be seen as an invitation to hold a broad discussion in academic circles and indeed among decision- makers concerning the various options for finding an exit from the crisis, and the consequences of each one in terms of growth, employment, financial stability, social and territor-ial cohesion and support for the European project Some theoretical benchmarks orienting exit strategies from the crisis in Europe that have prevailed in the face

of all the empirical evidence need to be called into question, not just because of the poor results that they have attained to date but also because of the scant attention that has been paid to other more ambitious, firmer measures taken else-where (e.g in the US, the UK and, more recently, Japan), and because of their negative consequences in terms of the feeling of belonging to the EU in various countries (there has been an alarming upsurge in euro- scepticism in many countries)

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The constraints imposed on the ECB by basic Community regulations have forced it to focus on price stability as its sole objective (Art 127 of the Treaty on the Functioning of the European Union – TFEU) – set and obsessively held at a mystical figure of 2 per cent2 – and prohibited it from providing direct funding to public sectors (Art 123–124 TFEU) For a long time this has theoretically deprived the ECB of any significant capability to intervene on a discretional basis in support of the liquidity of financial systems, the solvency of govern-ments or the soundness of the euro (thus discouraging speculation), given that interest rates are now so low that other, less orthodox ways of stimulating growth from monetary policy must be found

In its Global Financial Stability Report, published in April 2013 (IMF 2013a), the IMF (International Monetary Fund) refers to the combination of

exceptionally low policy interest rates and unconventional policy measures as

“MP- plus” to indicate that these policies go beyond conventional monetary

policy in terms of tools and objectives The IMF classifies these measures –

which have been implemented by several major central banks, but especially by the Federal Reserve, the Bank of England and, more recently, the Bank of Japan – into four groups:

1 prolonged periods of very low interest rates, sometimes combined with

forward guidance on the length of time for which rates are expected to remain low;

2 quantitative easing (QE), which involves direct purchases in government

bond markets to reduce yield levels or term spreads when the policy rate is

at, or close to, the lower bound;

3 indirect credit easing (ICE), in which central banks provide long- term

liquidity to banks (sometimes with a relaxation in access conditions), with the objective of promoting bank lending; and

4 direct credit easing (DCE), when central banks directly intervene in credit

markets – such as through purchases of corporate bonds or mortgage- backed securities – to lower interest rates and ease financing conditions (and pos-sibly mitigate dysfunction) in these markets

Up to the end of 2011 (two waves of euro “quantitative easing” by December

2011 and February 2012), the ECB did not take part in this intensive, proactive use of monetary policy, and indeed it continues to express reservations concern-ing some measures This is especially true for the acquisition of sovereign debt

(the announcement of outright monetary

transactions by the ECB – in second-ary, sovereign bond markets, under certain conditions,3 involving bonds issued

by Eurozone Member States – was made on 2 August 2012 and concretised by September) Moreover, the ECB is to sterilise all its purchases so that its price stability objective is not affected

The treaties also sanction the prohibition on any country answering for the debts and financial obligations of another Member State (Art 125 TFEU), which has formally prevented any mutualisation of sovereign debt and any extraordinary

provision of resources to draw up a truly compensatory budget at the European level that might have been able to mitigate at an early stage the economic prob-lems of countries that have subsequently had to be bailed out.

The vested interests of some Member States (e.g Germany, the Netherlands and Finland) in defending a literal interpretation of the treaties and intergovern-mental agreements has prevented the attainment even of the minimal flexibility that would have enabled the aforesaid solutions to be implemented as altern-atives to the rigid official position That official position has begun to change only very gradually since the risk of the break- up of the euro and of insolvency

on the part of governments and financial systems has become evident (i.e as from May 2010)

These constraints and self- imposed limitations have shaped the ideological component of economic governance of the crisis in the EU, with the emphasis being on austerity in the public sector and full confidence in the efficient working

of the markets, especially the financial markets In the terms used by Susan

Strange, this block, headed by Germany, could be said to have exerted structural power in the EU, in that it has been capable of dominating the world of ideas

and imposing a hegemonic interpretation of events that is not open to argument

It thus indirectly determines what economic policy decisions are made and what priorities are discussed (Steinberg 2013)

De Grauwe and Ji (2013: 2) rightly describe the logic behind this dominant approach as follows:

( .) the surging spreads observed from 2010 to the middle of 2012 were the result of deteriorating fundamentals (e.g domestic government debt, exter-nal debt, competitiveness, etc.) Thus, the market was just a messenger of bad news Its judgement should then be respected The implication of that theory is that the only way these spreads can go down is by improving the fundamentals, mainly by austerity programs aimed at reducing government budget deficits and debts

However, as the same authors point out, when in September 2012 the ECB finally found the will to act4 – following the announcement by Draghi on July 26 that “the ECB will do what’s needed to preserve euro” – spreads decreased sharply It can therefore also be argued that had it acted earlier, much of the panic in the markets may not have occurred and excessive austerity programmes may have been avoided As stated by Begg, “where individual Member States have no option but to consolidate public finances, there is a danger of a col-lective deflationary bias” (Begg 2012: 4)

Nor should it be forgotten that the austerity programmes prescribed for the public sectors of Member States with sovereign debt problems coincided with a tendency towards deleveraging among businesses and households in those same states, and with a strong euro on the currency markets (with the EU failing to react to movements by the bigger countries in pursuit of more favourable exchange rates that would lead to an upturn in demand through exports) It is

8 J Bilbao-Ubillos

precisely in this context that Begg’s warning of the risk of deflation takes on its full meaning, especially since those EU countries that could have found more room for manoeuvre in budgetary terms (because they were close to balancing their public- sector accounts or because their debt levels were increasing more slowly) failed to act as drivers to activate economic recovery throughout the area and refused to implement fiscal stimulus programmes

Finally, the EU also failed effectively to combat tax avoidance (the effects of which have been felt most in southern European countries, where taxable bases have decreased steadily) or to make real progress in dealing with tax havens, banking secrecy and harmful tax competition

If these failures are considered jointly (explained implicitly or explicitly by the ideological standpoint of economic governance as implemented to date) it can be seen why the EU is the area that is finding it hardest to emerge from the crisis, the area that the IMF considers to be at most risk of financial instability and the area where the polarisation (core/periphery) of economies is greatest However, as argued in various chapters of this book, it is not only the ideo-logical aspect of governance that must be questioned: the institutional or organ-isational component of European economic government must also be revised in

an attempt to increase its speed, consistency and efficiency in decision- making, and in pursuit of a clearer, more legitimate leadership of Europe with rules of play based on accountability and the assumption of responsibility Tardiness in reaching a common diagnosis of the problems faced, delays in implementing the decisions made and frequent changes of plan, have prevented effective responses from being made to the challenges posed

nomic integration to support the euro, assuring the solvency of the public sectors and financial systems of Member States and, at the same time, ensuring a joint vision of Europe’s problems in the medium and long term that looks beyond the interests of individual governments (conditioned by electoral calendars and public opinion) The economies of Europe are closely interlinked, and the prob-lems of one country inevitably end up affecting the rest5 through foreign trade or through their effects on confidence in the euro, the balance of income and move-ments of capital

To sum up, what is urgently needed now is a higher level of political and eco- ThisTo sum up, what is urgently needed now is a higher level of political and eco- perspectiveTo sum up, what is urgently needed now is a higher level of political and eco- mustTo sum up, what is urgently needed now is a higher level of political and eco- notTo sum up, what is urgently needed now is a higher level of political and eco- beTo sum up, what is urgently needed now is a higher level of political and eco- lostTo sum up, what is urgently needed now is a higher level of political and eco- byTo sum up, what is urgently needed now is a higher level of political and eco- subjectingTo sum up, what is urgently needed now is a higher level of political and eco- itTo sum up, what is urgently needed now is a higher level of political and eco- toTo sum up, what is urgently needed now is a higher level of political and eco- “moralTo sum up, what is urgently needed now is a higher level of political and eco- hazard”To sum up, what is urgently needed now is a higher level of political and eco- siderations and game theory or by trusting exclusively in the working of the markets If the rate of fiscal consolidation in the most vulnerable economies is not adjusted to the gradual recovery of demand in Europe and indeed worldwide, and if measures to stimulate recovery are not taken at the same time, then the risk of a long- lasting recession, or even of deflation, will be very real As Darvas, Pisani- Ferry and Wolff (Bruegel Institute) conclude:

con-The European Union’s weak long- term growth potential and unsatisfactory recovery from the crisis represent a major policy challenge Over and above

the structural reform agenda, which is vitally important, bold policy action

is needed The priority is to get bank credit going Banking problems need

to be assessed properly and bank resolution and recapitalisation should be pursued Second, fostering the reallocation of factors to the most productive firms and the sectors that contribute to aggregate rebalancing is vital Addressing intra- euro area competitiveness divergence is essential to support growth in southern Europe Third, the speed of fiscal adjustment needs to be appropriate and EU funds should be front loaded to countries in deep recession, while the European Investment Bank should increase investment.

(Darvas, Pisani- Ferry and Wolff 2013: 1, my emphasis)

Notes

1 The Commission itself mentions “inefficiencies in the intermediation chain” in its

Working Document Accompanying the Document/Green Paper “Long- term Financing

of the European Economy” (European Commission 2013a: 12).

2 Referring to the way in which monetary policy should be conducted in a non- optimal currency area, Palley warned as early as 2003 that higher inflation would be required to avoid higher unemployment (Palley 2003: 98).

3 Mainly the signing beforehand of a Memorandum of Understanding (MoU) with strict conditions with the issuing country, in which the ECB always maintains a get- out option in case the Member State is observed not to meet its commitments, so that the programme is cancelled.

4 gramme of sovereign debt purchases (on the secondary market, for bonds up to three years) with a view to reducing the high financing costs of troubled Eurozone countries and putting a stop to the debt crisis.

On September 6, 2012 the ECB agreed to start up a new, potentially unlimited pro-5 In its Spring 2103 report on the global situation, the International Monetary Fund (IMF ) confirms that the crisis located in the Eurozone periphery countries has spread to the core, and forecasts a 0.3 per cent contraction of GDP (gross domestic product) in the Eurozone (IMF 2013a).

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2 The great recession and economic policy

Roots and consequences

Xosé Carlos Arias and Antón Costas

The great economic crisis that struck in 2008 has called into question important elements of the model of economic growth of the preceding decades Notable among these is the idea of economic policy While the economic policy process

is always subject to a complex set of conditions, in the years prior to the crisis one condition imposed itself over the others: the formidable external restriction imposed by ever more voluminous and internationalised capital markets After

2008, the decisions made by democratic governments opened the way towards defining more autonomous policies Soon, however, contradictions and back- pedalling occurred, which thwarted those initial steps from progressing towards

a new model of policy- making All of this is examined in the first two sections

of this chapter In the third section, we go further, attempting to analyse what the consequences of the crisis might be on the nature of policy in the long term

1 Economic policy in the age of the triumph of global

financial markets, 1980–2007

Beginning in 1980, financial markets played a key role in the evolution of the world economy, both in their qualitative and quantitative aspects In respect to the former, the profound change was the consequence of a combination of dif-ferent processes related to innovation, securitisation and deregulation All of this occurred within an environment of internationalisation of capital accounts all over the world

In the final analysis, the driving force behind all of this was the information revolution sparked by the new information technologies: the thousand- fold mul-tiplication of the speed of transmitting the unit of information, along with the thousand- fold reduction in its cost, was unquestionably the primary motor of the massive innovation of financial products and services, with derivatives acting as the primary protagonists in the last decade In fact, it should be pointed out that few sectors have made the transforming potential of the knowledge society a reality to the extent that finance has, with all of the opportunities such a trans-formation implies, but also with all of its significant risks This large- scale, technological dynamic of transformation has meant that financial markets are very different from what they were in 1990, when they still had a recognisable

14 X Carlos Arias and A Costas

form and geographical location Today, in contrast, financial operations occur outside of a tangible space of negotiation, and in a context of temporal frag-mentation, that is to say, within a context of constant and growing acceleration The extraordinary dynamic of innovation of financial products and services was one of the decisive factors driving the strong trend towards deregulation But this trend was also fuelled by the emergence of an entire economics liter-ature that preached the natural efficiency of financial markets The consequence

of the sum of both was that everywhere in the developed world an extremely permissive system of control of finances was imposed that might be termed

“light touch” financial regulation

All of that qualitative change has been accompanied by an enormous itative leap Whereas financial assets in circulation in 1980 represented 109 per cent of the world’s GDP, that percentage rose to 343 per cent in 2007 (more than ten times the volume of international commerce) The crisis, furthermore, has dra-matically revealed that a very significant portion of financial assets was – and still

quant-is today – outside of any possibility of accountable identification: thquant-is quant-is the world

of shadow banking In some of the principal economies, the total level of debt, public and private, greatly exceeds the value of the annual GDP (more than 500 per cent in Japan and the United Kingdom; 300 per cent in Spain, Italy and France, and near that percentage in the United States) (McKinsey Global Institute 2012) It can be said, therefore, that the economy of recent decades has witnessed the hatch-ing of a new and original stage of evolution: one of hyper- financial capitalism in which debt instruments play a much more important and active role than at any time in the past Furthermore, as national regulatory structures have been drasti-cally reduced, it is a stage in which financial flows have remained beyond the effective capacity of policymakers to control them, and – despite the removal of capital controls – without any type of mechanisms appearing for their global gov-ernance This is a central element in the origin of the Great Recession

These large, highly sophisticated markets that lack the former public control mechanisms and which in practice are globalised, were transformed into a struc-turing vector for the entire economy They furthermore became a central element

in the processes that defined public policies That is to say, the interaction space between policies and markets has experienced a historical mutation over the past decades, and has become one of the principal aspects of modern globalisation This new relationship has been marked by the idea that markets have an enormous capacity to influence the formation of the political agendas of States to the extent that such agendas can be conditioned by a true “golden straitjacket”

In respect to macroeconomic policies, the development of global markets would appear to have put an end to the old notion of national sovereignty We could thus be ultimately witnessing the historical disappearance of the Westphalian order in as far as defining economic policies is concerned All of this has greatly influenced the transformation of economic policy theory over the last two decades (Arias and Costas 2012)

The notion that financial markets are not only omnipotent and omnipresent, but also fundamentally omniscient, plays an important role in this entire branch

of thought That is to say, it is presumed that financial market operators have great capacity to capture all types of signals emitted by policymakers in any part

of the world and to respond to them immediately All of the above obviously rests on the presumed institutional virtue of such markets, i.e they operate in a world where operations are registered correctly, contracts are resolved efficiently and there are no significant information problems Such markets are perceived as fully transparent

In this model, the financial markets themselves provide the mechanisms needed to measure the credibility of a policy, in real time and in an accurate manner Such mechanisms would behave as true referees to evaluate the quality – a notion directly associated with credibility – of any macroeconomic policy It

is supposed that markets therefore pronounce objective judgements through a complex process that is then translated into a simple and instantly recognisable variable: its mere follow- up over time would provide any observer with a precise measure of such an assessment The first of such instruments is comprised of the sovereign debt spreads The other one is the assessment of the sovereign debt of

a country by qualified rating agencies A clear manifestation of their power is that the ratings of the three big agencies have been authorised as an effective instrument for public regulation in many countries (for example, by the US Securities Exchange Commission)

This set of phenomena linked to the relationship between markets and icies has influenced the evolution of contemporary economic reasoning, and has especially led to a strong reorientation of economic policy theory As a starting point, the acceptance of the ultra- rationality idea of financial operators has pro-vided great credibility to theoretical developments, the so- called dynamic macro-economics, associated with the presumed rational expectations In this case, and

pol-in an pol-infrequent manner with respect to how relations between policy and theory are established, the evolution of real facts would lead to the validation of an argument that at first seemed to be debatable (Persson and Tabellini 2000)

In this context, a new economic policy theory (the so- called theory of ility policy) was constructed Its central idea is that a simple, but fundamental, evaluation criterion exists that makes it possible to define the optimal macro-economic policy: the one that provides greatest credibility to the market This latter argument has increasingly occupied the field over the last two decades, and not only in the literature but also as far as its effective capacity to influence policymakers is concerned, especially with respect to the proposals for central bank independence and policy rules (Chari and Kehoe 2006) Moreover, this has very significantly contributed towards creating a mentality, within the heart of the academic community and amongst senior civil servants, of a general mistrust

credib-of public intervention, not because it may be detrimental but because it is vant This represents one of the main manifestations of the Hirschman hypo-thesis of futility (Hirschman 1991)

Mechanisms such as the ones described above arise as fastening bars for the

“golden straitjacket” and have led to some fundamental changes Two generally well- known consequences are: (1) the appearance of important transnational

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spillover effects (with important consequences, such as the appearance of a eralised fiscal competition, especially with respect to corporate taxes) and the elimination of ideological bias in macroeconomic policies An important mani-festation of the latter can be seen in the adaptation of the social democratic parties to market logic after the 1980s; and (2) changes in the institutional regime of policies: There are two such changes worth highlighting (for the liter-ature generated around them and for their practical influence) namely, the use of the rule option as opposed to discretion when establishing the agenda, and the growing independence of central banks

Rules rather than discretion Generally speaking, these kinds of arguments fit

in with the contemporary trend of auto- restricting the volitional capacity of group subjects, in order to avoid rationality problems derived from the full exer-cise of freedom, which Jon Elster (1979) illustrated using Homer’s tale of

Ulysses and the Sirens In particular, by assuming the rational expectation

hypo-thesis, the idea of “rules rather than discretion” arises as a solution to the

problem that a policy considered to be optimal at time t, may not absolutely be

so at time t + 1: when adaptive expectations are present, there will be an inflation

bias in all discretional policies that expand output beyond the level marked by the “natural unemployment rate” (Kydlan and Presscott 1977) Rules provide the necessary reputation (and the optimal rule would be that of zero inflation) in order to confront problems related to the time- consistency of policies; note that the expected inflation bias strongly influences the orientation of such an argu-ment This contribution was decisive in the construction of the political credib-ility theory (Forder 2001)

As far as independent central banks are concerned, a very simple mechanism has been developed – a mere change in the legal status of the bank – which enables it to obtain credibility gains for policies: the inflation bias that is attrib-uted to the time- inconsistency problem disappears without any apparent costs in terms of GDP evolution In consequence, a stream of economic literature emphasises a strong and direct association between the ideas of “credibility” and

“central bank” or “monetary policy” The spread of independence laws has been increasingly associated with the fight against inflation as the exclusive objective

of monetary policy

The practical implications of this view of economic policy have been quite significant: in terms of fiscal policy, it has led to the idea being imposed of minimal intervention strictly subject to rules limiting the margins of public defi-cits or debt; already in the 1980s, a rule of this type was included in the Gramm- Rudman Act regarding the budget deficit of the United States; of much greater transcendence, however, was the inclusion of deficit and debt limits in the Stability and Growth Pact of the Eurozone Monetary polices were closely tied

to goals of price stability – inflation targeting, with references to very low tion, around 2 per cent – with a simple rule also operative in some cases (the so- called Taylor rule)

We thus see that if anything characterises the dynamic of contemporary balisation, it is its very imbalanced nature, for it represents the genuine triumph

glo-of global financial markets, and not only in economic terms but also in the ical realm Such a situation, however, would not have been possible without the progressive consolidation of a collective mentality dominated by the sense of having at last reached a state of general rationality and long- term stability of economic and social life As demonstrated by such economics historians as Kindleberger, a mentality of this type is characteristic of the stages of financial euphoria (Kindleberger 1989); regardless of the fact that the same thing has led

polit-to catastrophes in the past, the identical pattern is repeated over and over again, with the idea that “this time is different” holding decisive sway over the beha-viour of a good number of economic agents (Reinhart and Rogoff 2010) None-theless, despite reproducing a very well- known historical moment, on this occasion the view that a supposed natural order of things would lead to a line of uninterrupted progress was based on a much more consistent element than in the past: the previously mentioned information revolution and the generalised impression that it brought with it access to unlimited information, accompanied

by a full capacity to process that information, while ignoring the fact that the one might openly contradict the other

In reality, the establishment of that mentality of a stable world clearly dicted the fact that since the 1980s a chain of financial crises had taken place, some of notorious intensity, such as those that hit Mexico in 1995 and Asian countries in the summers of 1997 and 1998 These episodes, furthermore, had particularly negative connotations, such as how they spread through processes of contagion between economies In most cases, however, these episodes of finan-cial instability presented a common characteristic: they originated in developing countries with weak institutional structures, which made their weak financial systems vulnerable In industrialised countries, on the other hand, the idea of stability was very much associated with an unquestionable achievement of that period, price stability; indeed, this achievement gave rise to the expression: the Great Moderation, to describe the period This term now appears as a somewhat trivial idealisation, particularly when keeping in mind that another class of important economic problems occurred in those years, for example, the real estate bubble and a notable increase in income inequality.1

The “stable world” mentality was reinforced by the prevailing views in some social sciences, predominately economics As we’ve mentioned, the rational expectations theory and the supposed ultra- rationality of its agents dominated the macro- economy and economic policy theory in recent decades And along with it, the theory of the efficiency of the markets – which takes as a given that the prices of financial assets incorporate at all times all of the necessary informa-tion for their efficient exchange – dominated financial theory Using these funda-mental analytical tools, a general argument was formulated in which the idea of cyclical behaviour in the economy and, of course, the possibility of economic collapse, were simply ignored In this context, Robert Lucas’ formulation in

2003 sums up better than anyone this view of the world: “the central problem of depression- prevention has been solved” (Lucas 2003) That is to say, the ultra- scientific drift of expert knowledge and its significant errors was one of the

18 X Carlos Arias and A Costas

primary causes of the disaster following 2008 (Engelen et al 2012; Arias and

Costas 2012) It is important to point out, however, that, far from being limited solely to the social sciences, this conception was fully assumed by most policy-makers Alan Greenspan is, of course, the best- known example, but many others, such as Gordon Brown, expressed opinions similar to those of Lucas (Skidelsky 2009) In this intellectual environment, little credence was given to the warnings that such significant thinkers as Jürgen Habermas and Amartya Sen made con-cerning the perverse meta- economic implications presented by this model of the relationship between public policies and financial markets, above all regarding its inconsistency with a genuine idea of democracy (Habermas 2001; Sen 2002)

2 Economic policy after 2008

After the bankruptcy of Lehman Brothers, everything was very different in the economic policies panorama In general terms, between 2008 and 2013, it is important to distinguish between two very distinct stages of the orientation of macroeconomic policies: 2008–2009, with an ultra- expansive orientation; and after 2010, when, above all in Europe, the obsession for extreme fiscal consoli-dation took hold

2.1 First stage: expansive policies to avoid another Great Depression

The initial reaction of central governments in the face of the immense financial crisis that ensued in the autumn of 2008 was to try and sidestep what was billed

as a dramatic transfer of its effects onto the real economy, with the enormous credit crunch as the transmission mechanism As the crisis progressively revealed the falseness of the supposed, long- term stability of the economy, emer-gency comparisons with previous crises began to be established The only real possibility of comparison was soon seen to be the 1930s From this moment onward, the need to avoid another Great Depression led governments in almost all countries, developed and emerging, to set in motion a set of policy measures that seemed to embody everything that economics textbooks for decades had considered mere populism, to be avoided at all costs

The memory of this tragic past history inspired very intense and improvised action in all areas of public activity In the case of fiscal policy, stimulus pro-grammes in public spending and contracts grew to levels that had not been seen

in a long time If we focus on the European Union, public spending, as a sequence of these programmes, increased its weight in the GDP (gross domestic product) by almost four percentage points in 2009 (rising from 46.8 to 50.7 per cent), accompanied by a tax reduction of 0.5 per cent of GDP The immediate consequence of this was the appearance of public deficits above 10 per cent of GDP in a good number of countries Contributing decisively to this were also the bank salvaging operations that became generalised at that time In terms of monetary policies, they reached extraordinary levels of heterodoxy Apart from reducing interest rates to near- zero levels, in countries such as the US previously

con-forbidden strategies of money creation were set in motion, such as the tion of the deficit and direct lending to companies by the Federal Reserve Certain policymakers played essential roles in making the new policies feas-ible, such as Gordon Brown, Prime Minister of the United Kingdom, Ben Bern-anke (president of the Federal Reserve) and Cristina Romer (president of the Council of Economic Advisers), of the United States The case of these last two

monetisa-is interesting in that both are prominent academic experts on the Great sion, which may have influenced their decisions Furthermore, these stimulus programmes were given the green light by all of the governments at the Wash-ington G- 20 summit meeting, which also called for the avoidance of protection-ist stances that had produced fatal consequences in the 1930s Despite this, however, hardly any steps towards effective international coordination were taken

Given their totally improvised character, the ultra- expansive policies of 2008–2009 were unquestionably riddled with mistakes In Spain, for example, the government set in motion a poorly planned public works programme, which produced very few results in terms of social profitability Above all, these pol-icies left a negative legacy in terms of macroeconomic imbalances, among which the most important was to set the sovereign debt of many countries onto an unsustainable path Seen from a general perspective, however, it is necessary to point out that this strategy achieved its primary goal: the avoidance of general economic collapse, which was a very real possibility during the first semester of

2009 As pointed out by Eichengreen and O’Rourke (2009), during those months, as much in the principal countries as in the international sphere gener-ally, fundamental economic variables such as industrial output, the volume of international commerce and global stock markets, moved towards a collapse greater than the one experienced in the early 1930s This is what justifies the use

of the term “Great Recession” to refer to this period In contrast to what pened eight decades ago, however, these recessive trends reversed relatively quickly By mid- 2009, most of the above- mentioned variables recovered a trend towards growth, which, though slight, was nonetheless real Behind this swift change in direction was a novel factor: the quick recovery of emerging countries However, it is also necessary to recognise the significant role of the large- scale national stimulus plans For example, in the case of the US, Blinder and Zandi (2010) have estimated that in 2010, the response by the government avoided an additional fall of the GDP of that country of 11.5 per cent It was, at any rate, a moment in which the golden straitjacket of the financial markets relaxed its pres-sure on active policymaking to an extraordinary degree, which, suddenly, was considered once again to be essential

hap-2.2 Changing course: the European policy of uncompromising

austerity

The second stage of great financial unrest was of a very different nature from the earlier one It was marked by the sovereign debt crisis of the Eurozone The

20 X Carlos Arias and A Costas

episode of Greek insolvency made manifest not only the unsustainable cies of public debt, but also that this debt could be greater than what had previ-ously been imagined, even if, in the case of the Greek government, that increase was due in part to the fact that the country’s bookkeeping had earlier been falsi-fied to keep it more in line with the rules demanded by the EMU (Economic and Monetary Union)

All of this generated an enormous wave of distrust, which grew as Ireland and Portugal successively asked for financial bail outs (as did Spain to deal with the collapse of part of its banking system) After May 2010, the policy response of the governments of the Eurozone and some others, such as Great Britain’s, was

to force a strategy of adjustment at all costs, maximising the pace of deficit reduction and leaving no margin for any other type of policy The pressure of the markets became more visible at this moment than at any other time in the past

A story was constructed, originating in central Europe, according to which pean economies could only be saved by a policy of generalised and obligatory austerity Spending cuts were applied in practically all countries, even in those, such as Germany, that had margins to continue introducing some type of stimu-lus to demand, although the cuts were much more intense and indiscriminate in the countries of the European periphery

The opposing policies of 2008–2009 and 2010–2012 nonetheless shared some common characteristics: both were set in motion in a totally improvised way to deal with unforeseen financial catastrophes; both were disproportionate and lacked any form of counterweight; and both had very negative collateral effects Two significant differences, however, stand out between them The first is that in

2009 the actions of most governments, including those of the principal emerging countries, were oriented in the same direction, while from 2010 onwards important differences appeared between them The second is that, despite all of its problems, the policy of 2009 at least managed to achieve the goal of avoiding another Great Depression, while the same cannot be said of the policy of uncom-promising austerity Although in most countries deficits have been reduced during these years, even if at a pace much slower than what was sought, the rel-evant figure by which the policy of austerity should be judged is that it has sent almost all of the economies of the EU back into a situation of recession It has been more than five decades since such a generalised situation of double- dip recession has occurred It is a recession, furthermore, with the nature of an authentic social depression in the countries of southern Europe The indiscrimi-nate character of the cuts in spending is not only severely damaging the welfare state, but also, by seriously affecting programmes (e.g educational programmes) and investment in R&D, it is creating obstacles to long- term economic growth Notable among the arguments used to justify this policy is the notion of

“expansive austerity” This argument is very closely linked to the principle of Ricardian equivalence, which is widely accepted by modern neo- classical eco-nomics A considerable proportion of recent literature addressing this question, however, reveals that this argument is seriously in error A crucial element dem-onstrating this has been the revision of the value of fiscal multipliers Various

authors and, in an institutionalised way, the IMF (International Monetary Fund), initially attributed very low contractionary impacts to fiscal consolidation pro-grammes (around 0.5 per cent) New calculations, however, point to the fact that the contractionary effect has been much greater during the crisis years, with the multiplier having a value of 1.5 per cent (Blanchard and Leigh 2013) This revi-sion affirms the estimates of other authors (De Long and Summers 2012; Auer-bach and Gorodnichenko 2012), but especially interesting is the fact that it has led to a radical change in the position of the IMF, incorporated into the World Economic Outlook, 2012.

Some interesting conclusions can be drawn from all of this First, that it is an error to assume the same value of the multiplier for any economic situation, whether expansionary or contractionary This calls into question the general application of Ricardian equivalence Second, it becomes possible to establish a conclusive connection between fiscal cuts and a return to recession that explains why the goals of fiscal consolidation have not been reachable: as contraction in productivity provokes a fall in the revenue capacity of States and an inevitable increase in spending on some public entitlement programmes – such as unem-ployment – it forces additional cuts in spending to achieve the deficit goal, by which the process begins again Austerity causes a vicious circle that calls to mind the old syllogism of Achilles and the tortoise: no matter how much we run

to reach the goal, it always escapes us Or, expressed differently, large and costly fiscal efforts become necessary to achieve very small successes in the fight against the deficit The cause lies in the fact that negative effects on demand dominate over positive ones on the debt and the deficit

Along with contractionary policies, European policy has imposed on eral countries the obligation of implementing structural reforms with the aim of achieving gains in competitiveness Some of these reforms are reasonable, although hardly opportune The economic context in which they are being enacted makes them in some cases – such as that of the labour market – difficult

periph-to sustain from a social point of view In contrast periph-to what happened, for example,

in Germany with its reforms of a decade ago (the so- called Agenda 2010), which took place within a context of expansionary policies, the application of the current reforms coincides with a sharp contraction that has been induced by the self- same public authorities The result has been an increase in all forms of social discontent and conflict Such unrest is nothing new, given that it has been

an historical constant in similar situations throughout the twentieth century.2

As for the other major macroeconomic policy, the monetary one, it was kept within a barely expansive trend except during specific moments At the end of

2008, rates were set at historically low levels, around 1 per cent, but always above the markets for the central banks of the United States, the United Kingdom and Japan The main difference, however, is that while these latter at all moments operated in effect as lenders of last resort, the European Central Bank (ECB) established the maintainance of the anti- inflationary credibility of its monetary policy as its absolute priority And this, despite inflation having remained at generally low levels during those years and, in fact, with deflationary pressures

22 X Carlos Arias and A Costas

being present instead Its anti- inflationary obsession led the ECB to commit toric errors in the summers of 2008 and 2001: it raised interest rates just when recessionary processes were on the verge of breaking out

Up until the end of 2011, the ECB barely contributed to maintaining liquidity within the Eurozone, at a time when the deleveraging process was already having a serious effect on the functioning of the real economy With its attitude

of “lethal inhibition”, the Eurobank was a necessary collaborator for many months in the deterioration of the continent’s financial situation (Eichengreen 2012) Since December of 2011, however, its attitude has changed The three waves of massive purchasing of bonds of European countries – through the Out-right Monetary Transactions programme (OMT) – while not compensating for the draining of economic activity provoked by the fiscal policies, at least con-tributed to alleviating some of their worst contractionary effects By avoiding what would very likely have been a new and very serious financial disaster, they played a tranquilising role in the capital markets

During this entire stage, the orientation of the macroeconomic policy of the United States was quite different from that of Europe American fiscal strategies were undermined by two serious problems On the one hand, the large imbalance

in public accounts that ensued in 2009; a deficit of 10 per cent of GDP, that remained above 8 per cent in the following years And on the other, the constant political struggle over the government deficit and debt fought between the two large political parties, between the Congress, with its Republican majority, and the Democratic administration This conflict opened the possibility of a fiscal cliff, which, if it became a reality, would have terrible consequences for the global economy At least, however, American fiscal policy did not suffer the sui-cidal drift that was very present in the European policy

In the United States, the leading role in the fight against contractionary dencies corresponded to monetary policy, where we find a clear line of con-tinuity between 2008 and 2013 This is what we might call the “Bernanke effect” Since the beginning of the present crisis, the FRS (Federal Reserve Sysytem) has sought by all means possible to avoid a repetition of the error it made in 1930 On that occasion, the maintaining of a timid monetary policy allowed the credit crunch to multiply, thus favouring depressive tendencies Ben Bernanke dedicated a good deal of his academic work to the study of monetary policy during the Great Depression For this reason, in 2008, he gave priority to the Fed’s function of lender of last resort, thereby prioritising the goal of growth over that of price stability To do so, he maintained interest rates between 0 and

ten-0.25 per cent and, above all, drove a constant line of quantitative easing, whose

most immediate result was the tripling of the entity’s balance sheet between June

of 2007 and March of 2010 The FRS has repeatedly claimed that economic weakness will force it to maintain this policy until at least 2015 Nonetheless, there are signs that this strategy has reached its limits and that the possibilities of its halting economic deterioration are increasingly reduced For this reason, despite the problems derived from the budget cliff, it seems inevitable that monetary policy will cede its leading role to fiscal policy One way could be

through selective fiscal incentives, as has been repeatedly called for by ican economists such as Joseph Stiglitz and Paul Krugman.

It is interesting to mention the behaviour of another large industrial economy, Japan’s, which, after the country’s change in government at the end of 2012, has begun to advance along lines very different from those of other countries It has chosen to try and leave behind its already very prolonged deflationist lethargy through a stimulus policy of massive public spending and purchases, above all in infrastructures, to the value of 10,300 billion yen Moreover, the Japanese gov-ernment is not hiding the pressure it is applying on the Bank of Japan to make this supposedly independent entity raise its inflation target

Mentioning the case of Japan is important, because, while the results are still unknown, it could be an important indication that we are moving towards a third stage in the search for solutions to the crisis At any rate, in early 2013, the simultaneous presence of three very different orientations in the economic pol-icies of industrialised countries is visible: severely contractionary in Europe; more changing and modulated in the United States, although very undermined

by important imbalances and with a bias towards monetary stimulus; and edly expansionary in Japan

decid-3 Underlying trends: towards a new balance between

macroeconomic policy and capital markets?

What happened to the golden straitjacket of the financial markets during the years of the crisis? The relationship between events and policies examined in the previous section leads one to conclude that in the first stage of the crisis, 2008–2009, this golden constraint was displaced by the need to address the serious economic problems that were taking place But then, after 2010, there was a “return to order” that was especially visible in Europe In fact, market pressure on policy- making acted in an even more intense way than it had before the crisis

It was precisely after 2010 that an important segment of society discovered what in fact had been a reality for a few decades: the enormous power of con-straint imposed by the decisions of international investors on the policies of democratic nations Between 2010 and 2012, there were many important mani-festations of this: the attention governments and central banks paid to the devel-opment of spreads had never been so intense, nor had conditioned their decisions

to such a degree; in various countries of the Eurozone – the most important being Italy – technocratic governments were imposed that expressly tried to sidestep the limits that democratic procedures introduced in policy- making; and

in a number of European countries, even stricter rules were imposed on the budget, giving them more constitutional status

We have also noted, however, that in greater or lesser degree, diverse ations existed on the international scene Above all, more recent experiences indicate that the straitjacket model is plagued with contradictions For example,

situ-it is clear that investors penalise any budgetary policy that strays from the dogma

24 X Carlos Arias and A Costas

of austerity by increasing the spread of its sovereign debt However, given that applying generalised cuts impedes growth – and without growth it isn’t possible

to pay back the contracted debts – a policy of intense fiscal adjustment can also unleash adverse reactions in the markets The result is that the relationship between policies and markets is less clear than in the past In any case, we have already mentioned the very real possibility that a third stage of public response

to the crisis is imminent, with changes in the orientation of macroeconomic policy and the financial straitjacket

In this section, we shall try to go a little bit further, beyond the short- term prospects, to systematise some reflections in order to formulate a clear argument and a reasoned prediction of how to depict the idea of a longer- term macro-economic policy that extends at least to the next decade We shall try to answer such questions as: Will the constraint imposed by capital markets ease up? Are

we moving towards more active and changing macroeconomic policies? Will the idea be maintained of an optimal economic policy strictly tied to obtaining cred-ibility gains, or will we move beyond this concept? Will the inverse situation occur at some point, that is to say, will democratic policy control the trans-national movements of capital, with all of the consequences that such a control implies?

After the experience of the last two years, numerous reasons exist to consider

it more likely that continuity will win out over the possibilities of change Despite the scientific crisis that the Great Recession has brought to the macro- economy or to the theory of finances, the doctrinal inertias in favour of the pure mechanics of the market continue to be very strong in academia Equally, cul-tural resistances to government actions or the trend towards individualism, which has so characterised Western societies since the 1980s, continue to be very present Moreover, it is necessary to take into account the significant disparage-ment felt for the very idea of polity in our democracies and the growing mistrust

of politicians, generally poorly thought of by citizens Such sentiments, to be sure, are related to the original problem of politicians’ visible subordination to the logic of the markets: a circular argument

And yet despite the above, some truly important underlying motives lead us

to envision the possibility of a profound restructuring of the relationship between politics and markets As a starting point, and before going on to present these reasons in a systematic way, it is worth mentioning that since 2008 a significant amount of economic literature has been produced that challenges some of the most established ideas and principles in recent decades regarding fiscal and monetary policy and financial regulation It is interesting to point out that some

of these new analyses and proposals have emerged from research carried out by large multi- lateral agencies, such as the IMF or the BIS (Bank for International Settlements) of Basel This is especially significant for two reasons: first, because

of the great influence these entities wield in the effective formulation of policies around the world; and second, because these same entities were at the centre of the generation and diffusion of ideas driving minimal and passive policy in the period of the Great Moderation

This set of renovated theoretical arguments offers clues to what a new balance between public policies and capital markets might look like The revision is pro-found in the case of fiscal policies Various widely distributed contributions put

the emphasis on the countercyclical use of tools, as stated by Blanchard et al

2010a: “countercyclical fiscal policy is an important tool”, although the need for public accounts to rest on a sustainable base in the medium to long term must be kept in mind.3 The goal would be to look for a balance between fiscal consolida-tion and the obtaining of margins for active policies that make it possible to fight against the imbalances of the cycle; all of this within the context of the already- mentioned revision of the principle of Ricardian equivalence

In respect to monetary policies, a new consensus is forming around two ideas First, the need to substitute, or move beyond, inflation- targeting, with most papers proposing the inclusion of nominal output in the goals of the new monetary policy Second, the urgency of integrating monetary policy and pru-dential regulation Other arguments, although they haven’t reached the same degree of consensus, have also become increasingly widespread On the one hand, the broadening of the inflation target (to 4, or even 6 per cent, depending

on the author); on the other, the reintroduction of capital controls, or even the revision of the statute of the independence of central banks We shall return later

to these last two questions.4

Reflecting more deeply on the subject, we can speak of five reasons ing a change in economic policy that is in good measure free of the golden strait-jacket model: (1) the failure of the supposed omniscience of the markets; (2) the emergence of serious problems of consistency in some of the key institutional features of that model, such as the rules option; (3) the demands that arise from the existence of important trade- offs between goals; (4) the possibility that trans-national markets are moving towards increased segmentation; and (5) the ever more explosive incompatibility of that model with a genuine idea of democracy

support-We shall examine these factors in greater detail below

The failure of the supposed omniscience of the markets The idea of the

infal-libility of the markets, accepted without criticism until 2007, has been cally called into question by the crisis For example, defending large credit rating agencies as objective referees is now impossible After having been identified as one of the great villains of this entire sad story by official reports of all kinds, including those of international bodies, such as the indispensable report by the

categori-US Congress on those held to be responsible for the crisis (FCIC 2011), the notion of the infallibility of the markets is indefensible After all, we cannot forget that before the summer of 2007, the three large rating agencies granted maximum ratings to 80 per cent of the US subprime packets (Shiller 2008) Even more revealing was the internal investigation by the IMF of the 2004–2007 period, which concluded that “the ability to correctly identify the mounting risks was hindered by a high degree of group- think, intellectual capture, a general mindset that a major financial crisis in large advanced economies was unlikely, and by inadequate analytical approaches” (IEO- IMF 2011) Under these assump-tions, the model of “light- touch” financial regulation in fact made possible the