Economic Papers

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The vicious loop between sovereign and bank debt threatens the integrity of the euro zone. This article examines why the banking union is a prerequisite to break this loop and concludes that the current design is clearly insuffi cient to achieve this goal. In particular, the transitional phase poses serious risks for the euro zone as fi nancial markets remain fragmented and the crisis is far from being resolved. The article discusses the components of a solid banking union, what I call a banking union made of concrete. Current plans by the euro area envisage a union that seeks to limit the use of taxpayer funds by extending the principle of "bail-in". It is a banking union that runs the risk of being insuffi cient to face a systemic crisis. This banking union, albeit limited, is diffi cult to implement in the short term given the current legal framework of the economic and monetary union. As a result, the union designed for the transitional period, which can be lengthy, will lack key elements such as a pan- European backstop that operates as a lender of last resort for sovereigns. Therefore, it is far from being a banking union made of concrete. This can be a fl imsy construction, not even made of wood but of straw. The risk is that it may be unable to withstand the challenges of the current crisis. Keywords: banking union, bank.

This paper argues that deep economic integration, which includes the single market plus monetary union, leads to economic divergences if the integration process does not comprise an appropriate set of mutually complementary policies. The Eurozone is an example of an almost fully integrated area, which faces an extreme case of unbalanced integration. The paper argues that unless domestic structural reforms are adopted by the less competitive Member States, this is a policy framework that is unworkable without more political union. The gradual move to such an institutional setup would allow either the financing of chronic current account imbalances or the enforcement of the needed institutional changes at a Member State level to reduce those imbalances. The paper concludes that the new EU legislation, regarding budget deficits, current account disequilibria and banking, could even be counterproductive if it is only based on sanctions and does not incorporate positive incentive schemes.

This paper reviews the theoretical and empirical arguments behind the increase in capital requirements proposed by the Basel III regulations. The detailed analysis of both theory and evidence casts doubts on the benefi cial effects of Basel III. It is shown that the new regulations are unlikely to diminish risk taking in the banking industry and that the increased capital requirements most likely will lead to increased costs of funding for the industry with adverse consequences for the real economy.

This paper investigates the behavior of inflation differentials between Spain and the rest of the euro area member countries. Cross country studies of inflation differentials, and in particular in the EMU, have focused on three explanations: (i) the role of tradable and nontradable sector productivity improvements, and the Balassa-Samuelson effect, (ii) the role of the demand-side effects, and (iii) heterogeneity of inflationary processes inside the EMU. First, the paper documents that, during the 2002-2006 period, inflation differentials in the tradable goods sector have been driving the inflation differentials in the headline HICP inflation. Second, the paper uses the estimates of a two country, two sector Dynamic Stochastic General Equilibrium (DSGE) model with nominal rigidities in a currency union using data for Spain and the euro area, to understand the role of each feature in shaping inflation differentials. The paper finds that fluctuations in productivity improvements in the tradable sector are the most important source of headline HICP inflation differentials. Demand shocks help explain a fraction of output growth, but not of inflation dispersion. In addition, the estimated model finds no evidence that inflation dynamics are different in Spain and in the rest of the euro area.

This paper assesses the integration strategy of the European Union in regulated network markets. The paper argues that in these markets integration should not be an end in itself. In regulated markets the conventional gains from trade or freedom of establishment may be outweighed by significant welfare losses if integration involves the choice of a misguided deregulation model. Moreover, the design of the integration process will affect the distribution of the gains from integration, and this may be unacceptable to some of the countries and/or social groups involved, leading to the failure of the process. The integration strategy should carefully balance several potentially conflicting interests, with priorities that may not be the same across industries. This paper assesses the integration strategy of the European Union in regulated network markets. The paper argues that in these markets integration should not be an end in itself. In regulated markets the conventional gains from trade or freedom of establishment may be outweighed by significant welfare losses if integration involves the choice of a misguided deregulation model. Moreover, the design of the integration process will affect the distribution of the gains from integration, and this may be unacceptable to some of the countries and/or social groups involved, leading to the failure of the process. The integration strategy should carefully balance several potentially conflicting interests, with priorities that may not be the same across industries.

This paper assesses the effectiveness of vertical industrial policies within the EU. Vertical industrial policy is defined as government support for specific firms or industries (picking winners or supporting losers) and measured by state aid granted by Member States to the manufacturing sectors. This aid is authorized by EU regulations under certain conditions and regularly monitored. This paper uses Member States data on state aid to manufacturing to analyze the extent to which this government intervention affects the growth of Multifactor Productivity (MFP) in manufacturing. The analysis is conducted using both sectoral aid data and horizontal aid, since in many cases vertical aid is disguised as aid pursuing horizontal objectives. We control for the potential endogeneity of state aids policy. The results indicate that vertical state aid contributes positively to MFP growth.

This paper provides a critical analysis of some of the key features of merger policy as understood and practiced in leading jurisdictions such as the European Community and the United States. It focuses first on a discussion of the gradual move of merger policy towards the examination of unilateral effects. The critical appraisal of this process is based on the practical and theoretical shortcomings of the economic models that underlie the growing prominence of unilateral effects as the key anticompetitive factor arising from a proposed merger. The paper stresses that even if unilateral effects were to lead to an increase in the conventional measures of anticompetitive performance (such as markups), it is not clear that this implies less competitive behavior for many of the most relevant industries in today's advanced economies. Finally, the paper also examines the relation between competition and welfare, and argues that even if competition does indeed diminish due to a merger, it is not a straightforward conclusion that this is not good in terms of economic welfare when we take fully into consideration the incentives to innovate and the dynamic welfare gains that arise from new products and production processes.

This paper analyzes the determinants of FDI. We use a new data set covering greenfield and expansion projects at a detailed value chain level to examine which factors influence the decision to invest abroad. Our empirical framework is an augmented gravity model that incorporates elements of factor proportions theory. At the aggregate level, we find that distance discourages FDI, size and sharing a language encourages it, and that FDI targets relatively capital-scarce countries. When we classify investment projects according to their stage in the chain of production, we observe a lot of variation across stages. Nevertheless, economic size, distance, and capital abundance are still determining factors for most value chain stages and preserve the sign of their effect. Moreover, even though the results confirm FDI targetting capital scarce countries, we find evidence of a minimum requirement on the host country's capital endowment in all the stages of production except extraction. Finally, ease of doing business is also important, especially so for the location of regional headquarters.

Several european politicians have complained that the ECB does not pay enough attention to job creation in the euro area. In this paper, we examine the behavior of the ECB during its first ten years of existence. We review the ECB's legal mandate, and study, using both informal evidence and regression methods, how the ECB reacts to economic conditions in the euro area. We find that despite its legal mandate, which assigns the ECB a primary objective of keeping inflation below 2 percent, the ECB has missed this target most of the time, and reacts to real activity indicators (the output gap and the unemployment rate) when setting the policy rate. Therefore, it is difficult to conclude that the ECB has been hawkish on inflation in its first ten years of existence. Finally, we study what is the optimal monetary policy rule in a model with labor and product market rigidities, and conclude that given these, the ECB should have a dual mandate of price stability and maximum sustainable employment.