Volume 13, Issue Supplement

It has become common to insist that contemporary international economic problems require a great increase in the extent of “global governance” of economic affairs. This desire, understandable as it may be, confronts a series of major obstacles. First, the normative case for global governance is more difficult to justify, and more complex, than is usually recognized, and requires consideration of both economic and political-economy principles. Second, in practice, the provision of governance at the supra-national level - that is, of international public goods - depends largely on support from powerful and concentrated interests. Third, this dynamic means that the types of international public goods provided, the way they are provided, and the governance structures erected around them are biased in favor of their strongest supporters, and are therefore likely to be a source of continuing controversy.

The conduct of fiscal policy has been altered considerably in the context of the global financial crisis, that is, at times when financial markets conditions were extraordinary turbulent. Yet financial market conditions determine how fiscal impulses are transmitted through the economy and, eventually, the size of the fiscal multiplier. I develop a comprehensive perspective on how financial market conditions alter the effects of fiscal policy on economic activity within a New Keynesian framework. Drawing on historical as well as systematic considerations, I distinguish a scenario of 1) “normal times” characterized by smoothly operating financial markets, 2) financial markets characterized by tight credit conditions in the private sector and constraints on monetary policy and 3) financial markets, in addition, characterized by high sovereign risk. I argue that the size and even the sign of the multiplier may differ across these scenarios.

The Great Recession of 2008 hit the international economy harder than any other peacetime recession since the Great Contraction after 1929. Soon enough, analogies with the Great Depression were presented, and conclusions were drawn regarding the political response to the slump. This paper is an attempt to sort out real and false analogies and to present conclusions for policy. Its main hypothesis is that the Great Recession resembles the final phase of the Great Contraction between 1931 and 1933, characterized by a fast spreading global financial crisis and the breakdown of the international Gold Standard. The same is also true of the political responses to the banking problems occurring in both crises. The analogy seems less robust for the initial phase of the Great Depression after 1929. The monetary policy response to the Great Recession largely seems to be informed by the monetary interpretation of the Great Depression, but less so by the lessons from the interwar financial crises. As in the Great Depression, policy appears to be on a learning curve, moving away from a mostly monetary response toward mitigating counterpart risk and minimizing interbank contagion.

Economic policy design frequently assumes that markets, reacting instantaneously to news, rapidly discipline countries’ unsustainable policies. Interest rates would rise immediately. The recent financial crisis calls this assumption seriously into question. The countries at the European periphery accumulated competition problems and enormous current-account deficits for one and a half decades before the spreads reacted. As the rating-agencies’ did no better job and their assessments are strongly correlated with the spreads, the paper uses their published reasons for downgrading countries to explain the changes of spreads. It appears that limited information in a complex situation forces financial-market participants as well as observers to reduce complexity to simple plausible ‘stories’ which can be easily communicated. These ‘stories’ concentrate on financial aspects and are highly persistent, but over-react if they are forced to shift to a new ‘story’.

In the aftermath of the Great Recession and during the debt crisis in the euro area yields on German federal bonds have been exceptionally low. This analysis tries to calculate the profits that the federal government makes due to these low yields. The interest payments that are due to emissions of bonds and bills made between 2009 and 2012 are approximated and compared to several benchmark scenarios. Compared to the mean yields of the years 1999-2008 profits of the federal government are quite high (68 billion euros). Application of yield curve models show that most of these profits are due to the macroeconomic conditions in the euro area and to low central bank rates. To a much smaller extend these profits are due to flight into safety, which, however, has become more relevant recently.

The Basel III Framework introduces a countercyclical capital buffer to reduce the procyclicality of the minimum capital requirements. The reference point for the decision to impose the buffer is based on the credit-to-GDP ratio. However, this guidance will exacerbate the problem of procyclicality in a rule based application, because in periods with a low GDP growth it sends a signal to increase the capital requirements and in periods with a high GDP growth it sends a signal to reduce the capital requirements. Instead of the credit-to-GDP ratio the credit growth and the credit impulse should be used as reference point, because these variables are high correlated with the real GDP growth.

Since 2011 the trans-European payment system TARGET2 has been heavily criticised. TARGET2 is argued to create automatic financial risks for the economically stronger core countries of the European Monetary Union. TARGET2 risks only materialise in case of a country leaving the Monetary Union. We show that a sound analysis of these risks has to explicitely consider the Community’s bank note traffic. So far, four substantial suggestions have been made to reform TARGET2. These suggestios aim at limiting the core countries’ risks relating to the payment system. We discuss the consequences of these reforms and conclude that they are no meaningful options in the present crisis.