Growth and crisis
Following the Covid-19 epidemic, the European economy has once more been shaken by the arrival of war in Ukraine. How can these ‘asymmetric’ shocks, affecting member states in different ways, be managed? Economists Gilles Dufrénot, Jean-Baptiste Gossé et Caroline Clerc argue the case for financial integration. Financial markets can reduce the adverse effects of financial crises by sharing the risk across European economies.
Confronted with the pandemic, European member states acquired massive debts to finance the purchase of vaccines and compensate for the sudden decrease in economic activity. The Russian invasion of Ukraine in February 2022, as well as provoking a humanitarian crisis, has further jeopardised already fragile socio-economic conditions in Europe. Furthermore, sanctions imposed on Russia have led to an increase in gas prices. Nonetheless, the repercussions are different for each member state, hence the use of the term ‘asymmetric shocks.’ So, how can European member states join forces to withstand these shocks?
Risk-sharing over financial markets
Mechanisms for risk-sharing operate through two main channels. The first brings together all private channels from banks to private transfers coming from abroad, while the second is related to public channels, such as community funds or stabilisation funds. In Europe, there is no central budgetary stabilising system as in the United States, meaning that risk-sharing will operate principally via private channels. How then can the movement of capital be made easier to facilitate risk-sharing?
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In a recent article, economists Gilles Dufrénot, Jean-Baptiste Gossé and Caroline Clerc show how the degree of financial integration influences the degree of risk-sharing between European countries. Indeed, financial integration facilitates the movement of capital from one country to another. If the integration of financial markets is limited, a French bank will have more difficulty in lending to a German bank, for example. On the contrary, when markets are well-integrated and a crisis is experienced, banks with insufficient liquid assets to lend to their clients can rely on the transfer of funds from banks in other countries.
For this reason, the authors of the article highlight the importance of taking private channels into account when considering the issue of risk-sharing. This provides knowledge as to whether such channels are sufficient in number to compensate for the absence of a central budgetary mechanism such as the one in the United States. Monitoring their efficiency can provide insights as to whether budgetary federalism is indispensable to the smooth running of the monetary union.
A shock wave on the markets: the 2008 crisis
To calculate the degree of financial integration, the authors of the article examine several indices. Prices are considered first, because the more freely capital can circulate, the more interest rates will fall. Next, they monitor quantities, which indicate the volume of monetary flow between European banks. Lastly, they consider activity in bond and stock markets between different countries. With this data, they can observe the “degree of shocks which are unsmoothed” by financial integration: the impact of shocks which cannot be lessened by capital transfer between countries.
According to their observations, prior to the 2008 crisis, 66% of asymmetric shocks could be absorbed by monetary transfers between countries. After the crisis, only 51% can be absorbed. This shows the influence of the crisis on the degree of financial integration between countries. Indeed, before the crisis, banks lent to households because they were able to borrow easily from other countries, but the shock wave of 2008 curbed this activity, and they were increasingly unwilling to lend to each other. The main channel for shock absorption was therefore savings: households and businesses dipped into their savings, instead of relying on international channels. As a result of this, risk-sharing was made more difficult.
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Although financial integration improves risk-sharing, it can also amplify the risk of financial contagion, which explains the reluctant attitude of National Banks following the financial crisis in 2008. Nevertheless, methods do exist which allow financial integration to be strengthened whilst reducing risk.
Regulating financial integration
All European countries have an interest in strengthening financial integration, since it can address the discrepancies between countries: countries who are in surplus can invest their excess savings by finding borrowers in countries in deficit. Where the situations of countries differ too greatly, however, it can have a negative impact on financial integration.
For this reason, the European Union introduced mechanisms to prevent inequalities between countries from becoming too pronounced. Along with establishing the monetary union, the Treaty of Maastricht in 1992 allowed European states to put in place rules to ensure that the single market was introduced in optimum conditions. In order to avoid dangerous fluctuations, thresholds were established which were not to be exceeded: these were known as the ‘convergence criteria’, notably with relation to exchange, interest, and inflation rates. From this developed the famous ‘3% of deficit’ rule, which indicates the key objective: the deficit of a country must not exceed 3% of their GDP, and public debt must remain below 60% of GDP.
Many tools exist to bolster the integration of financial markets, and moving towards a banking union is one of them. Although the European union is the only supranational entity which has a monetary union, there is no talk yet of common banking regulation. In addition, banking regulations differ widely between states, which may limit the movement of capital. Beyond this, member states could also create a market of European public debt. Generally, when countries take on debt, national bonds are issued, and one of the ways in which financial integration could be improved would be to issue more bonds at the European level, a process which remains ad hoc at present.
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In analysing the situation after the 2008 crisis, the economists Gilles Dufrénot, Jean-Baptiste Gossé et Caroline Clerc noted that two channels played an essential role in risk-sharing: stock, and FDI (Foreign Direct Investments). They observed that countries that were in recession and received significant FDI, or where businesses sold a large volume of stock on foreign markets, were able to weather the shocks more readily. The authors conclude that Europe-wide risk-sharing could be enhanced by greater integration of stock and bond markets in Europe. The question remains, then, as to which channels could help in absorbing the impacts of the war in Ukraine.
Compromise and flexibility
The Maastricht criteria and notably, the 3% rule, have been called into question by economists and some European decision-makers. These measures offer a touchstone for stability but are not an end in themselves. In fact, it is the sustainability of a state – that is, its capacity to reimburse any debt it may acquire – which provides an insight into the stability of its economy and thereby, the confidence that potential lenders may have to invest. The debt of the Japanese state in 2020, for example, has reached 259% without ringing alarm bells on financial markets.
European states have not hesitated, therefore, in suspending the application of these measures via an escape clause since the beginning of the pandemic in 2020. States are thus allowed to distance themselves from their obligations in “an orderly and coordinated manner” when faced with a systemic crisis. Thanks to this easing measure, states could inject money into their economies in response to the health emergency. Public debt levels reached their highest levels at 8.5% of GDP in the first trimester of 2021 but stabilised at 3.9% later the same year. Departures from the rule such as this have served to support economic recovery, and the European Union must continue to adapt to withstand such shocks. As such, although states had planned an end to the use of the escape clause, a joint decision was taken to prolong the easing measure until the end of 2023 to allow for potential repercussions of the war in Ukraine.
European regulations, and departures from them, have resulted in higher levels of confidence and commitment between European states, and the subsequent strengthening of financial integration. Whilst the Russian invasion has caused widespread incertitude on financial markets, several mechanisms have been implemented by the European Union in order that risk can be shared between its member economies.
