HOW SHOULD RESPONSIBILITY BE SHARED FOR THE BANKING CRISIS?

DO EU INSTIUTIONS SHARE RESPONSIBILITY?

WHAT IS A SENSIBLE STRESS TEST OF A BANK?

WHAT SHOULD IRELAND AND EUROPE DO NOW?

People in Ireland are awaiting with acute interest the results of stress tests on their banks to be made public on Thursday. Stress tests are estimates, estimates of what assets might be worth at some time in the future .

Estimates can be made on either very pessimistic, or very optimistic, assumptions about economic developments in the future.

The hope in some quarters is that the EU exercise of stress testing banks will generate confidence in banks based on certainty, but we should be careful here. Certainty about the future is a logical and philosophical impossibility. All banking, everywhere and always, is a matter of confidence, not of certainty. If one makes exceptionally pessimistic assumptions these can become avoidably self fulfilling. One must avoid accentuating the economic cycle in the downturn phase, just as much as one should lean against the wind in the up phase!

In Ireland’s case, the credit of the state itself has unfortunately become entangled with that of the banks. It would be no solution to anything to enhance the credit of the banks, by diminishing the credit of the state. This is the issue with which the newly elected Irish Government is working with its EU partners.

I am sure EU decision makers are by now fully aware that the Irish banking problem has been influenced by the requirement of free movement of capital within Europe since 1990, and the deep interdependence that that has created, with all its good and bad aspects.

In a sense, the Irish banking problem is a manifestation of a wider European banking problem that grew in the context of monetary union. We have had, as President Barroso has said, a monetary union without an adequate economic union.

But I would add that we have also had monetary union without adequate monitoring of risks to European financial stability through lax banking practice across borders within the EU . Systemic interdependence between banks was allowed to develop, indeed encouraged, but without systemic supervision of the cross border risks that that created .

I will show that, back in 1992, the framers of the Maastricht Treaty foresaw these risks, and created the necessary powers to monitor them, but that EU institutions failed to follow up on key provisions. of that Treaty. If these provisions had been fully followed up, it would have helped us avoid what happened to European banking in 2008.

As a result of the failure to follow up on some of the Maastricht provisions, there was not adequate Europe wide monitoring of the risks arising from flows of money across borders from countries, with surplus saving, to other countries where banking bubbles developed. Ireland is a country in the latter category, unfortunately.

To make that point is not to argue that Irish institutions should avoid their financial responsibilities, to bondholders or others. A bond is a promise, and promises should not be broken, especially if ones economy is based, as Ireland’s is, on the provision of international services, in which trust is vital. Let me reiterate, of course, that the main responsibility for Ireland's plight rests with Irish institutions.

In Ireland, private sector institutions were first and foremost responsible for the bubble, especially the property development industry for it's reckless borrowing, and estate agency community .

The boards and managements of banks for the reckless lending share responsibility, as do the media, with their reliance on property advertising ,for encouraging people to climb the so called property ladder, as if one place on this ladder was a measure of one’s place in society.

The Irish economics profession has a responsibility for, generally speaking, not calling attention to the obvious unsustainability of the borrowing , and of the level of construction activity, which could not possibly have been maintained. The methods of the accounting and auditing professions have also to be called into question.

It is obvious that the Irish Central Bank, the Financial regulator, and Government made major errors.

But , if we are to overcome the crisis and avoid a new one, everybody must be self critical, including the ECB and other European institutions. A single currency for 16 or more separate nations was always a challenging project, intellectually, politically and economically. If there were design flaws in the project, these must be remedied but , even more so, if powers to act existed, and these were not used, that must be acknowledged.

Risks inherently flowed from the decision to allow free movement of capital within the EU. Exchange controls at national level were no longer available as a means of preventing bubbles developing. That gap had to be filled at a higher, EU wide, level.

The ECB has, under its statute, which was appended to the Maastricht Treaty in 1992, a responsibility to oversee supervision of banks. Some in the ECB may feel that that responsibility rests solely with national central banks but a close reading of the statue of the European System of Central Banks shows that that is not so.

A single currency for 16 or more separate nations was always a challenging project, intellectually, politically and economically. If there were design flaws in the project, these must be remedied. If powers to act existed, but were not used, that too must be acknowledged.

To assess what the ECB could ,or should , have done, about the credit bubble in Ireland one should look at the statues under which it was established, which were appended to the Maastricht Treaty in 1992.

Article 3.3 of the statute of the ESCB says that the ECB

"shall contribute to the smooth conduct of policies pursued by the competent authorities relating to prudential supervision of credit institutions , and the stability of the financial system".

Note two phrases here... “the prudential supervision of credit institutions” and the “stability of the financial system” .

The ECB would claim that this does not give them a frontline or direct responsibility for prudentially supervising individual banks. But it does give them a contributory responsibility, a role that I would construe as including drawing attention to banking practices that threaten the overall stability of the financial system in the euro zone. Forinstance if in one country, credit was growing at 30% a year and lending had reached 300% of GDP, that was something that the ECB would have been aware of, and which would certainly have come within its mandate under Article 3.3.

Furthermore, Article 25.2 of the ESCB statute says that the ECB

"may perform specific tasks relating to prudential supervision of credit institutions"

and Article 34.1 goes on to say that the ECB may make regulations to implement Article 25.2 that is concerning prudential supervision.

Under Article 14, the ECB had power to issue instructions to national central banks.

A normal reading of this would suggest that it was the intention of the framers of the Maastricht Treaty that prudential supervision would be a responsibility of the ECB, in conjunction of course with the central banks of the member states.

Unfortunately these provisions were never activated. This is because the Council of Ministers never adopted the necessary enabling regulations. One really ought to know why.

The Treaty provided that the Council of Ministers, acting by means of regulations in accordance with a special legislative procedure, may unanimously , and after consulting the European Parliament and the ECB, confer specific tasks on the ECB concerning policies relating to the prudential supervision of credit institutions. A proposal from the Commission would have been required. This was never done. We now have a European Systemic Risk Board, but that is 18 years late

It would appear that the ECB found itself with a clear responsibility ,under one article of its statute, to contribute to supervising credit institutions like those in Ireland which have come to pose a systemic risk, but was never given the powers under another article to exercise those powers, as the framers of the Maastricht Treaty expected it would.

An explanation ought to be forthcoming from the European Commission, from each of the member states, and from the ECB itself, as to why these provisions were never activated.

A failure to activate specific Treaty powers, that could have been used to prevent EU wide systemic risks in the banking system, is no minor omission. The omission suggests that responsibility for failing to prevent a banking crisis in a number of EU member states is shared in part by EU institutions.

Clearly, as we now know all too well, the expansion of credit in some countries like Ireland and Spain has affected the "stability of the financial system", in the words of Article 3.3 of the ESCB statute.

I repeat that this does not mean that the ECB was ever to have, or ever had, the primary responsibility for failures of supervision of individual institutions ,like Anglo Irish Bank. But it does mean that the ECB, the Commission and Council could, could have seen the risk that overall imbalances in banking would upset the stability of the overall financial system, and could have activated the ECB’s Treaty powers to enable it to deal with that. They could have activated the ECBs powers to issue binding instructions to national central banks.

Even if the ECB could not use these powers I have mentioned above, it also had power under Article 4(b) of the statute to submit opinions to national central banks where it saw bubbles developing. It appears that the ECB took a rather narrow interpretation of this power and did not use it ,unless it was specifically consulted by a member state. This is a pity.

The ECB may have been inhibited here by the principle of subsidiarity, but I think it was mistaken in this judgement. We now know these banking risks were in fact not confined within one country, but spread across borders. With the benefit of hindsight, one can thus see that the principle of subsidiarity did not apply.

If the ECB felt it was not getting enough information from national central banks to form a judgement, it also could have used Article 5.3 to obtain better information. But unfortunately the Council regulations to give effect to this power excluded ,until 2009, information about prudential supervision of credit institutions. The Council and the Commission share responsibility for that critical omission.

EU institutions, including the ECB, are now helping to resolve the situation in Ireland and Greece, but this help is in the form of loans which will have to be repaid..

Of course, it would not have been politically easy for the ECB to have used its powers to warn the Irish authorities in 2003 or 2004 to rein in credit. There would have been an outcry from many in Ireland decrying "interference from Frankfurt", and all that sort of atavistic nonsense. But the ECB can ignore that sort of thing, because it is politically independent under its statute, more politically independent even than the European Commission.

I repeat that I do not make these points to out of any wish to shift blame away from where it belongs. The main blame must be borne in Ireland. But if the EU is to learn from the crisis, it has to look at the whole picture. Part of that picture is the role of the ECB and other EU institutions.

Having said all that, it is important that Ireland approach its European partners in a realistic frame of mind.

Other European countries have problems too.

For example, almost all of them have budget deficits of their own. Many of them have more severe immediate problems with the fiscal cost of the ageing of their societies and workforces than Ireland has. They are also aware that the original justification for the cohesion and regional funds of the EU, to which many were net contributors and we were net recipients, was precisely to prepare countries like Ireland to be able to face the rigours of a single currency. If Ireland now discovers it was ill prepared, the first responsibility is its own.

Other EU countries have domestic political constraints too.

For example, Germans have a justified horror of inflation after their unique experience in the 1920s when inflation peaked at level higher than were seen in Zimbabwe recently, and destroyed the saving of all thrifty families.

Reactionary and nihilistic anti EU sentiment, of the kind we seen in Ireland during the first Nice and Lisbon referenda, is rising in many other countries, and transferring money to countries that can be presented as not having managed their affairs well, feeds those sentiments. This is especially so if the country lending the money has a lower income per head than the recipient.

Irish people must understand these political realities, just as others must be realistic about what Ireland can do on its own about what is part of a systemic European banking problem.

It would make no sense for other EU countries, in their own interests, to make counterproductive demands of Ireland. Demanding that it change our corporation tax system is counterproductive. Corporation tax is one of the ways whereby Ireland will be able to repay the loans it has received. The 12 and a half percent corporation tax raises an amount equivalent to almost 3% of Irelands GDP, more than France collects in corporation tax, and a lot more than Germany collects, which comes to just over 1% of German GDP.

More importantly, low corporation tax rates to attract foreign investment, mainly from outside the EU, has been the core of Ireland economic model since 1956, before the EU had even come into being, and before many of the leaders sitting at the European Council were born! This foreign investment contributes hugely to Irish tax revenues, not only through corporation tax ,but even more so through all the other taxes paid by those working for and supplying these foreign firms. It also has made Ireland, a peripheral island by any standard, one of the most internationalised economies in the world, and that gives it a unique capacity to trade its way out of its current difficulties.

Lending Ireland money, but simultaneously asking it to dismantle the economic model that enables it to repay the money, would not be good banking practice, to put it mildly!

MY PROFESSIONAL ACTIVITIES

Since last December , I have been in correspondence  with the European Commission in  regard to my private professional activities since  ceasing to be a temporary Commission  official, which  was my status during the five  years up to 31 October 2009  while I was  the European Commission’s Ambassador in Washington.

The initiative to appoint me to that position in 2004 came from the Commission, rather than from me, although I was delighted to accept the post.

Last December  it  was brought to my attention by the Commission that , under their rules, I ought to have sought  their consent for any professional activities I  undertook in the two  years  after  I ceased to be in their employment. I was unaware of this requirement, as it had not been brought to my attention by the Commission either in the discussions that took place before I accepted the post in 2004, or at any time thereafter until December 2010.  While I was aware that such requirements applied to former Commissioners, I was not aware that it applied to persons in my position.

On becoming aware of the requirement, I immediately made an application under the rules.

 I am glad to say  that in the past week I received a positive response from the  Commission in respect of all the  professional  activities I have undertaken. These are President IFSC Ireland, Member Board of Directors of Ingersoll Rand PLC ,and of Montpelier re PLC, Senior Advisor American Oriental Bioengineering, Senior Advisor Cabinet DN, and Council member  Gerson Lehrman Group .  I also informed the Commission of some 2 to 3 days consultancy work I did for the law firm, McDermott Will and Emery on the internet numbers issue in 2010.

 All these activities were approved subject to a restriction on contacts with former Commission colleagues or other activities in respect of specific files I dealt with while acting as an Ambassador.  This an entirely reasonable restriction to avoid conflicts of interest, with which I will fully comply even after the expiry of the two years.

This is a critical week for Ireland and for Europe.

The publication of the bank stress tests will require careful decision making. Stress tests are estimates, estimates of what assets might be worth at some time in the future .

Estimates can be made on either very pessimistic, or very optimistic, assumptions about economic developments in the future.

The hope in some quarters is that the EU exercise of stress testing banks will generate confidence in banks based on certainty, but we should be careful here. Certainty about the future is a logical and philosophical impossibility. All banking, everywhere and always, is a matter of confidence, not of certainty.

In Ireland’s case, the credit of the state itself has unfortunately become entangled with that of the banks. It would be no solution to anything to enhance the credit of the banks, by diminishing the credit of the state.

I hope EU decision makers will also see that the Irish banking problem has been influenced by the requirement of free movement of capital within Europe since 1990, and the deep interdependence that that has created, with all its good and bad aspects.

I would like to return now to a topic I have developed elsewhere, the lessons that need to be learned from our banking crisis, and to show that there is a European, as well as an Irish dimension, to Irelands current problems.

Let me reiterate at the outset that the main responsibility for Ireland's plight rests with Irish institutions.

Private sector institutions were first and foremost responsible, especially the property development industry for it's reckless borrowing, and estate agency community for encouraging the bubble.

The boards and managements of banks for the reckless lending share responsibility, as do the media, with their reliance on property advertising ,for encouraging people to climb the so called property ladder, as if one place on this ladder was a measure of one’s place in society.

The Irish economics profession has a responsibility for, generally speaking, not calling attention to the obvious unsustainability of the borrowing , and of the level of construction activity, which could not possibly have been maintained.

It is obvious that the Irish Central Bank, the Financial regulator, and Government made major errors.

But , if we are to overcome the crisis and avoid a new one, everybody must be self critical, including the ECB and other European institutions.

To make that point is not to argue for Irish institutions trying to avoid their financial responsibilities.

A bond is a promise, and promises should not be broken, especially if ones economy is based on the provision of international services, in which trust is vital.

A single currency for 16 or more separate nations was always a challenging project, intellectually, politically and economically. If there were design flaws in the project, these must be remedied. If powers to act existed, but were not used, that too must be acknowledged.

Risks inherently flowed from the decision to allow free movement of capital within the EU. Exchange controls at national level were no longer available as a means of preventing bubbles developing. That gap had to be filled at a higher, EU wide , level.

Some of these topics were addressed in an interesting speech in Lucca on the 11th March by one of the Executive Directors of the ECB, Lorenzo Bini Smaghi.

He noted that the financial crisis had caught Europe unprepared in some respects. The institutional design of the single currency did not take into account a crisis like the present one. But he defended the euro, using the analogy that the first ever cars in the road over 100 years ago did not have reinforced bumpers or airbags. Like the early motor cars, the euro, as a single currency for many nations, is a pioneering venture, and all pioneers must learn from experience. I agree with this.

He also criticised both the content and the timing of the Franco /German proposal for states to be allowed to declare themselves insolvent. Again I agree. He suggests a different approach, requiring all future debt issuance by member states in the euro should have approval at EU level, a radical proposal, but we need radical thinking.

He says that the errors and negligence of the Irish regulation and supervision of its financial markets have

“been paid for by the taxpayers of that country, but they expose others to enormous risks”.

Again I agree with him.

But he then seems to disclaim all responsibility of the ECB. He says that, in the euro area, banking supervision is not

“subject to supranational control”

(ie. The control of the ECB) , and then he goes on to talk of a “former Irish Prime Minister” having the “honour of front page headlines”

“when he reproached the ECB for not having sufficiently monitored the Irish banking system, when it is well known that in Europe the powers of prudential supervision are the responsibility of national authorities, a power they do not want to give up”

This is a reference to my speech in the LSE recently in which I drew attention to the power the ECB had, under Article 14 of the statute of the ESCB, to issue instructions to the Irish Central Bank, and to other euro area central banks.

Dr Bini Smaghi claims that the ECB’s powers are confined to monetary policy, and do not extend to prudential supervision of risks in the banking system.

On the basis of this speech, the ECB seem thus to believe that, in the period from 2000 on, it could not have given instructions under Article 14 to the Irish Central Bank in respect of the obvious credit bubble that was developing in Ireland, and the unjustified, speculation driven, increase in house prices here.

I respectfully suggest that Dr Bini Smaghi is wrong, and that a reading of the statute of the ESCB shows that he is.

Article 3.3 of the statute of the ESCB says that the ECB

"shall contribute to the smooth conduct of policies pursued by the competent authorities relating to prudential supervision of credit institutions , and the stability of the financial system".

Note two phrases here... “the prudential supervision of credit institutions” and the “stability of the financial system”

Furthermore, Article 25.2 of the ESCB statute says that the ECB

"may perform specific tasks relating to prudential supervision of credit institutions"

and Article 34.1 goes on to say that the ECB may make regulations to implement Article 25.2 ie concerning prudential supervision.

I would read all that as meaning that prudential supervision was, and is , in fact , a core responsibility of the ECB.

I, therefore, believe that

1.) The ECB could have issued instructions to the Irish Central Bank in respect of its supervision of Irish banks, when it saw the explosion of credit in Ireland, and the imprudent concentration of that credit in one volatile sector, construction.

2.) It could also have issued instructions to the Central banks of the other euro area countries, whose banks were availing of the free movement of capital to lend imprudently to the Irish banks in a way that fed the Irish property bubble, to rein in that lending.

I would argue that, under any reading of Article 3.3, these things were the ECB's business, as well as of course being the business of the Irish authorities and the authorities of the countries whose banks lent irresponsibly into the Irish property bubble.

Clearly, as we now know all too well, the expansion of credit in question did affect the "stability of the financial system", in the words of Article 3.3 of the ESCB statute. So I would argue that my reference to Article 14 and the responsibility of the ECB was in fact correct.

I repeat that this does not mean that the ECB had the primary responsibility for failures of supervision of individual institutions ,like Anglo Irish Bank, but it does mean that it could, and should , have seen the overall imbalances in the lending patterns to and within Ireland, and their potential to upset the stability of the financial system, which is clearly the ECB's responsibility.

Even if the ECB did not use Article 14 or Article 25.2, it also had power under Article 4(b) to submit opinions to the Irish authorities, and if it felt it was not getting enough information from the Irish authorities to form to form a judgement, it could have used Article 5.3 to obtain better statistical information.

I do not think it is to be either nationalistic or populist to say that, between 2000 and 2006, the ECB was in a better position to know what was going wrong in Irish credit markets, and to do something about it, than was the average Irish taxpayer , who now has to deal with the consequences. Some Irish taxpayers may have benefitted from the boom, many did not. All have to pay.

I accept that the EU institutions, including the ECB, are helping to resolve the situation, but this help is in the form of loans which will have to be repaid, and is also being accompanied by self serving demands from some other countries.

I fully accept that it would not have been politically easy for the ECB to have used its Article 14 powers in 2003 or 2004 . I have no doubt there would have been an outcry from many in Ireland decrying "interference from Frankfurt", and all that sort of atavistic nonsense. But one should not forget that it precisely so that the ECB can ignore that sort of thing, that it was made politically independent under its statute, more politically independent even than is the European Commission.

The ECB's power to give "instructions" to the member state central banks also seems, on the face of it, also to be greater than any power the Commission or Council had under the existing Treaties.

A suggestion has appeared in the Irish media that, when Anglo Irish Bank was on the brink of collapse, the ECB told the Irish authorities that it did not want any bank to be allowed to fail.

I wonder if this could be true, and if it is true, if it influenced the then Government to give such a wide guarantee to the banks as it gave. In light of the powers of the ECB, which I have cited above, the Irish authorities could not easily have ignored such a view from the ECB. But with power comes responsibility, and if the ECB did say this to the Irish authorities, it can hardly argue now that the sole responsibility for what followed rests with the Irish taxpayer .

I repeat that I do not make these points to out of any wish to shift blame away from where it belongs. There is a great deal of blame due to the Irish authorities and people, the majority of the blame by a long distance. The recent election result shows that the Irish people know that. So also does the fact that substantial austerity has been accepted.

But if the EU is to learn from the crisis, it has to look at the whole picture. Part of that picture is the role of the ECB and other EU institutions.

These institutions should be willing to consider reasoned criticisms, from any quarter, even from Ireland!

Having said all that, it is important that Ireland approach this week’s meetings in a realistic frame of mind.

Other European countries have problems too. For example, almost all of them have budget deficits of their own. Many of them have more severe immediate problems with the fiscal cost of the ageing of their societies and workforces than Ireland has. They are also aware that the original justification for the cohesion and regional funds of the EU, to which many were net contributors and we were net recipients, was precisely to prepare countries like Ireland to be able to face the rigours of a single currency. If we now discover we were ill prepared, the first responsibility is our own.

We also have to understand that other EU countries have domestic political constraints too. For example, Germans have a justified horror of inflation after their unique experience in the 1920s when inflation peaked at level higher than were seen in Zimbabwe recently, and destroyed the saving of all thrifty families. Reactionary anti EU sentiment, of the kind we saw here during the Nice and Lisbon referenda, is rising in many countries, and transferring money to countries that are perceived as not having managed their affairs well, feeds those sentiments. Irish people must understand these political realities, just as others must be realistic about what we can do.

It makes no sense for them, in their own interests, to make counterproductive demands of Ireland. Demanding that we change our corporation tax system is counterproductive. Corporation tax is one of the ways whereby we will be able to repay the loans we have received. Our 12 and a half percent corporation tax raises an amount equivalent to almost 3% of Irelands GDP, more than France collects in corporation tax, and a lot more than Germany collects, which comes to just over 1% of German GDP.

More importantly, low corporation tax rates to attract foreign investment , mainly from outside the EU, has been the core of Ireland economic model since 1956, before the EU had even come into being, and before many of the leaders sitting at the European Council were born! Lending us money, and simultaneously asking us to dismantle the economic model that enables us to repay the money, would not be good banking practice, to put it mildly.

At home, we must avoid the errors we see in the US, where so many areas of spending and revenue have been ruled out of consideration for closing the deficit, that all that is left is so called discretionary spending, that only comes to about 20% of all spending.

Speech by John Bruton, former Taoiseach, to the Irish Institute of Chartered Accountants at 8am on Tuesday 22 March

St Patrick

I am  deeply honoured to be invited to  address  this  dinner, an honour that has also been  given to three other  former Taoisigh of Ireland, Garret FitzGerald, Albert Reynolds and  Bertie Ahern.

Others  who have spoken at this dinner include President Harry Truman, Senator Robert Kennedy, Senator Hubert Humphrey , Senator Eugene McCarthy, Senator Bob Casey, and Governors Bill Scranton and Martin O Malley.

The life of St Patrick has very important lessons for us in the  21^st century

St Patrick was above all a Christian man of faith.  His faith was so deep that he was prepared to go back among a people who had previously enslaved him to share that faith, that good news, with them.  He did not do it for material wealth. He did it because of belief in a cause, a reality, greater than himself, greater  than all  humankind.  I believe that faith, and  a consequential willingness to work  for a cause greater  than ourselves is something we need to  rediscover, and foster, in this  generation.

St Patrick was born Welsh or British, and a  citizen of  a Roman  Empire, a Roman Empire that  encompassed  most of western Europe and the Near East.  But by the time he died, the Roman Empire had fallen, Rome itself had been taken, and Europe did not rediscover  its unity until modern times.

Two reflections on that.

Irish people should remember where St Patrick came from. If, as is likely he had brothers and sisters,  their distant descendants are  probably living today in Wales, the South west or the  North west of England. This reminds us of how much our two islands, Ireland and Britain,  in the North Atlantic have in common, of the good things we have given to one  another, and continue to do to this day.

Perhaps even more topically, in these  anxious economic times, we  should reflect of what  happened to the economy of Northern  Europe during St Patricks life time.

  When he was  born there was considerable prosperity, a common currency system  for all of Europe based on silver coinage minted in the name of the Roman Empire.  This  currency, this means of  exchange, enabled citizens of Rome, including  St Patrick’s family to trade  across long distances,  to buy and sell good, and to   enjoy a  good standard of living.

By the time St Patrick died, this system had collapsed. 

 Because it was cut off from  Rome, silver was no longer  available in  Britain to provide  currency. Anyway, there was no political authority strong enough to stand behind an alternative currency, and ,as a result, scholars now  believe that living standards fell dramatically, to perhaps a  quarter of their previous level, and stayed at that level for centuries.  All that happened during the life time of one person. 

This shows the fragility of all economic systems, how dependent they are on political conditions,  and how change can be sudden and destructive, as  well as slow and benign.

 While St Patrick  had his mind on  other, arguably much more important things, we  can learn a lot for today from what happened  to the economy during his life.

We need to  be careful to value and maintain  a  political system that  encourages trade,  sustains credit,  and  keeps all of us open to  the needs and aspirations of people far away from us, and very different from us, as different  as the Irish who captured and  enslaved  St Patrick as a boy must have seemed to him.

 In a word, economics and finance are important, but they are dependent on a robust, believable and  strong political system, something that existed when St Patrick  was born, but had disappeared by the  time he had died.

 Extract from remarks of John Bruton, former Taoiseach, at the  dinner of the Friendly Sons of St Patrick in Scranton Pennsylvania on 17  March  2011 at  8.30pm EST

The Future OF THE EUROPEAN UNION............an Irish perspective, the podcast

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THE FUTURE OF THE EUROPEAN UNION............an Irish perspective

In this lecture I hope to deal with the process of European economic integration, with particular reference to the establishment of the euro. The views I express are my own and are not representative of any body of which I am a member.

 I hope to show that this project has deep roots in post war European history. It is part of a process to build a structure of peace and stability in Europe based on deep integration of European economies with one another.  

The euro has helped keep inflation low. Inflation in Germany has been, for example, lower in the 12 years since it joined the euro, than it was in the  12  preceding years. It has created a zone of exchange rate stability, very helpful for exporting nations. The usage of the euro in a large number of countries has saved travellers cost and inconvenience, and brought seignorage revenues  to  the euro area’s  central banks. It has increased the availability of credit and households and businesses and it has facilitated trade within the euro zone.

 It was at all times a pragmatic project, where one learned by trial and error how best to achieve the ultimate goal.  Some problems were not foreseen, others were not addressed as soon as they might have been, but  European  Union leaders have, sometimes late in the day, been able to find solutions.

 I will deal with some of these problems as I go along, such as

1.) The narrow focus, and ineffectiveness, of the Stability and Growth Pact

2.) The strange failure of the European Central Bank to use its very explicit article 14 powers to rein in  member state  Central Banks  in countries where credit  fuelled bubbles were developing, and

3.) The failure, so far at least, to come up with a credible overall plan to recapitalize Europe’s banks   

 But, overall, the process toward Economic and Monetary Union has brought great benefits to Europe. To understand that, one has only to contemplate what Europe would have been like in the last thirty years, if we had had a series of competitive devaluations of national currencies. If that had happened, the common market itself might not have survived.

The goal of Economic and Monetary Union has been part of the European agenda from the immediate post war period. When the European Federalists met in Montreux in 1947, they spoke of the need to regulate currencies and capital movements at European level. They recognised that devaluations and protectionism in the inter war period had aggravated the Depression and contributed to the tensions that led to World War Two.

When the OEEC, the forerunner of the OECD, was founded in 1948 to help ensure that Marshall Aid was spent effectively, its mandate spoke of the need to avoid financial disequilibria in Europe and of studying the possibility of setting up a European Customs Union.

Nine years later, the Treaty of Rome was agreed between six countries, and established the European Common Market. It set the goals of

“ever closer union among the peoples of Europe”,

 of “strengthening the unity of the economies “of member countries, and of

 “progressively approximating” their economic policies.

The goal of the Treaty of Rome  was never a simple free trade area. It was always more than that. It was an economic union.

The first serious outline  of a plan for a  single  currency for Europe was considered at a Summit of the  leaders of the six Common Market  countries in the Hague in 1969.They commissioned a study on Economic  and Monetary Union and a single  European currency, from a group chaired by the then Luxembourg Prime Minister, Pierre Werner.

 Pierre Werner’s report was  presented in 1971  before  either Britain or Ireland joined  the  Common Market, but   both intending members  were put on notice , by this report , of the direction in which the  body they  were joining  was heading,  and  were free not to join at all,  if they did not  accept what it entailed. Neither Britain nor Ireland made that choice.

The Werner report envisaged proceeding towards the issuance of a European currency in three stages.  The first step would involve free movement of capital between intending members. The second would involve a system of coordination between the Central banks of the intending members, and the final stage involved fixing exchange rates and issuing a single currency.

The Werner Report was quite specific on the point that that being part of Economic and Monetary Union would mean   EU involvement in domestic economic policy making.  Here is an extract from the Report, issued in 1971

“To facilitate the harmonization of budget policies, searching comparisons will be made of the budgets of the Member States from both quantitative and qualitative points of view. From the quantitative point of view the comparison will embrace the total of the public budgets, including local authorities and social security.  “

It was thus clear that EU scrutiny would extend beyond narrow public finance, to include impacts on the broader economy.

 It also said

“It will be necessary to evaluate the whole of the fiscal pressure and the weight of public expenditure in the different countries of the Community and the effects that public receipts and expenditure have on global internal demand and on monetary stability. It will also be necessary to devise a method of calculation enabling an assessment to be made of the impulses that the whole of the public budgets impart to the economy”

The next big step was the Single European Act of 1986. It sought to introduce majority voting on a range of matters so as remove barriers to intra EU trade in goods and services. It also made Economic and Monetary Union an explicit goal in the EU Treaties. To help countries prepare for the extra competition they would face in an economic union, regional funds were introduced. Both Ireland and Britain accepted these funds.

 In 1989, a second report was prepared with the goal of reviving the project for Economic and Monetary Union..  This time the report was prepared by a group chaired by Commission President, Jacques Delors, and on which Ireland was represented by Maurice Doyle , Governor of the Irish Central Bank,  and the United Kingdom by Robin Leigh Pemberton of the Bank of England.

This Delors report was even more specific than the Werner report was, in envisaging the dangers that inconsistent economic policies within the single currency area could give rise to.

It  warned

“Monetary union without a sufficient degree of convergence of economic policies is unlikely to be durable and could be damaging to the Community. Parallel advancement in economic and monetary integration would be indispensable in order to avoid imbalances.”

It went on to predict exactly what went wrong in Ireland’s case.  Recalling that financial markets are very bad at predicting crises, and go on lending long after they should have stopped, it said

 “Experience suggests that market perceptions do not necessarily provide strong and compelling signals and that access to a large capital market may for some time even facilitate the financing of economic imbalances. Market forces might either be too slow and weak or too sudden and disruptive. Hence countries would have to accept that sharing a common market and a single currency area imposed policy constraints. “

Unfortunately the Delors report was all too prescient. Markets, and  their handmaidens the rating agencies, were initially “too weak and slow” in  penalising the build  up of excessive  borrowing and lending  in parts of the  eurozone in the period from 2000 on, and when they did  eventually recognise the problem, they were,  exactly as Delors predicted,  “sudden and  disruptive” in their response.

The next important step in the process of economic integration was the negotiation of the Maastricht Treaty in 1992, which set a precise timetable for the actual achievement of Economic and Monetary Union.  It followed the three stage model recommended by Werner. 

Free Capital movements came first, in 1990, and restrictions on capital movements were explicitly forbidden in the Maastricht Treaty. The full implications of this  seem not to have been envisaged at the time.

 It created the conditions in which banks in EU countries could borrow freely from one another.

  At retail level, Europe still had national banking systems, supervised by national regulators.

 But, at wholesale level, free movement of capital meant that the European Union gradually developed a single European banking reality, with banks all over the EU, seeking the highest  returns wherever they could find it, increasingly lending to one another,  dependent on one another, and vulnerable to one another.

 The logic of that development should have been a common European Banking policy, with tight supervision from the centre, especially in those parts of the Union where the common interest rate was inappropriately low for local conditions.

 The Maastricht Treaty gave the independent  European Central Bank   a responsibility to “keep under review” the monetary policies of member states, a right to “deliver opinions” and to keep capital movements under review.

Furthermore, Article 14 of the statute of the European System of Central Banks says clearly that

“the national  central  banks are  an integral part of the European System of Central Banks and shall act in accordance with the guidelines and instructions of the ECB”

One must ask then what use the ECB made of Article 14 when it saw the disproportionate increase in the size of the banking sector in countries like Ireland and Spain from 2000 on.

 For example, The European Commission has recently claimed that it “repeatedly signalled downside fiscal and macroeconomic risks related to the property boom in Ireland” from “as early as 2000.” If that is so, and given that the ECB had the  power under article 14 of  its statute to issue instructions the Irish Central Bank  , one has to ask whether and how  it  used those powers  and if not why.

  If the Central Bank of a country  was allowing its banking sector to grow to 300% of its GDP, surely the ECB would have seen the dangers in that and used its powers?

 As a member of the Executive Board of the ECG, Lorenzo Bini Smagi himself said in Paris last week

“ It is no surprise  that most of the  countries  with  the largest deficits and the largest increases in debt after the  crisis,   have  been those in which the financial sector played an increasing role”

“ No surprise” he said.  The financial sector in Ireland and Spain grew disproportionately.  Given its overall responsibility for financial stability, should  then the ECB have been surprised by what followed, as they clearly were?

 So it is fair to ask if the ECB considered using Article 14 when it saw the domestic financial sectors in Ireland  and Spain  grow disproportionately, and if not, why it did not do so.

From 2000 on, British, German, Belgian, French banks, and banks of other EU countries   lent irresponsibly to the Irish banks in the hope that they too could profit from the then obtaining Irish construction bubble.  They did this notwithstanding the fact that they  had lots of information available to them  about spiralling house prices in Ireland. They were supervised by their home Central banks, and  by the ECB,  who  had the same information available to them too,  and who seemingly raised no objection to this lending.

Of course, primary responsibility for this does rest with the Irish authorities who did not supervise the Irish banks properly.  There were, I suggest, major  failures of prudential supervision, at  wider European level  too, in other  central banks, and in the ECB.

Irish taxpayers, in taking on in 2008 the private liabilities of the Irish banks to other European banks, are now helping to stabilize the situation of European banks , and of the European banking system.  There is a tendency in some quarters to glide over that fact, and to present it as a purely Irish problem with purely Irish responsibility. While that story may be comforting to some audiences, it is not the whole story, and blinds us to lessons that need to be learned at a wider  European level too.

Moving back to the narrative, one has to admit that when we came, at the Dublin EU Summit  in 1996, to set up the Stability and Growth Pact to give effect to Maastricht, we again made the mistake of focussing exclusively on Government finances, and neglecting the possibility that trouble would be caused by private sector excesses, and that to avoid that, we needed tougher transnational European banking supervision.

As I have said, this omission subsequently facilitated pro cyclical monetary expansion in some countries, like Ireland and Spain. Interest rates, that were suitable to Germany, as it went through the difficult post reunification phase, were too low for Ireland and Spain. When local inflation was taken into account, they were actually negative.  When interest rates are negative, you create an incentive to the creation of pro cyclical bubbles in the economy.

  In putting that right now, we must not over react in the opposite direction.

 Insisting, at the bottom of a market, in marking all bank assets to the price they could realise if sold immediately into a market in which nobody can raise the money to buy them, would aggravate an already difficult situation. It would destroy value and  make no economic sense. I hope European and national regulators do not compound the problem by doing that.  Fire sales do not clear the road towards prosperity.

On the 25^th March, EU leaders will come together to agree a new Treaty based fund to  help countries that get into difficulty.

 This will be underpinned by a competitiveness pact. The latest draft of this has been prepared by President Van Rompuy of the European Council and President Barroso of the European Commission. It focuses on measures to be taken by member states in their own field of competence. In this respect it is an elaboration of the so called Lisbon Strategy, but it contains somewhat more rigorous invigilation of what states do, and do not do, in respect of the commitments they make under the pact.

The focus is, I believe, on

• Reducing labour costs in countries with competitiveness problems
• Decentralizing wage bargaining
• Opening up professions and energy networks to competition
• Less expensive legal systems
•  Raising the retirement age
• Introducing a constitutional or other legal limit on government borrowing and
•  having a single consolidated base for corporation tax

 Most of these proposals are good and sensible.  I believe strongly that it is right that the European Commission will have an important role in monitoring all this, and in proposing changes in policy when  member states depart from the pact. 

 On the suggestion of a common consolidated tax base, Ernst and Young have , however, estimated that a common consolidated tax  base would add a net 13% to the tax compliance costs of  Irish firms. Another study suggests that big countries with big markets would collect more tax under it, while smaller peripheral countries would collect less, thereby worsening their relative debt repayment position

 I am also not sure that it is sufficient to rely on heads of Government policing one another to ensure that commitments are delivered. While small countries may submit to peer pressure from big countries, I am not sure the process will work in reverse, when bigger countries are the ones needing to respond. The experience of trying to apply the Stability and Growth pact to Germany and France in 2004 is a case in point. That part of the  Van Rompuy/Barroso proposal  must be  strengthened ,if it is to be credible.

The idea of a constitutional debt brake will bring lawyers into the centre of fiscal policy making. I am not convinced that this will improve matters. It would be useful to study the history of a similar effort in the United States, the Gramm-Rudman law. The debt brake could become a political  football . It needs to be very carefully designed, and leave room to deal with genuine emergencies. 

That said, it is absolutely right that we the focus be placed on getting public debt under control.   The US Congressional Budget Office predicts that, on present trends, US Federal debt service will rise from 10% of US revenues today, to 58% by 2040. Our present difficulties and the prospective cost of ageing societies puts most European Governments on a similar trajectory.

The real problem, in making sure these proposals are implemented,  is that of designing penalties for errant behaviour, that go beyond mere peer pressure.

Under the present rules, we say we will impose fines on countries that exceed the deficit limits (but interestingly not the debt limits). These rules have not worked.

 I have two concerns here.

First, in some countries like Ireland, government deficits were not the primary problem, the primary problem was the expansion of private sector credit, and there were and are no penalties for that. Nor are any proposed.

Second, imposing fines on countries, that already cannot pay their way because they have too big a deficit, is hard to enforce, because it involves trying to extract blood from a stone.

I believe we must design a new system which will ensure that the markets do their job properly and in good time,  and are not allowed to be “too slow and too weak” in reacting to problems in particular countries, as the Delors report feared they would be.  I believe the best way may be for the  supervisory authorities to rub the markets noses in problems they might otherwise ignore until it is too late.

I suggest that this could be achieved if   March 25^th meeting of the European Council decided that Commission and ECB should adopt a policy of formally and regularly briefing

1.)  the rating agencies, and

2.  ) all the political parties in all member states,

 with their candid assessment of emerging problems in competitiveness, credit growth, and public finance imbalances in each member state,  on a systematic basis.

Thus, rather than rely on cumbersome bureaucratic procedures in the European institutions to eventually bring peer pressure on countries to put problems right, more reliance would be placed on competitive markets,  on competitive financial markets, AND on  competitive political markets, to deliver the necessary policy changes.  I believe this would be much more effective than peer pressure at closed door meetings in Brussels!

Finally the Van Rompuy/Barroso proposals do not deal with the banking crisis.  They contain no proposals on that subject.  They seem to assume that the problem is solved ,and that a push on competitiveness is all that is needed.  I disagree.

The Summit on 25 March must tackle the problem of recapitalizing Europe’s banking system and show how that can be done over a reasonable time frame.    

I  accept that there will be no transfer union within the eurozone. The political conditions for it do not exist.  

 But a proposal to re launch Europe’s banking system would have much more support that a transfer union. George Soros recently wrote the EUs emergency funds should all be used to recapitalize Europe’s banks.  If that is not to be done, there must be an alternative. The  March 25^th Summit should come up with one.

 There has been much criticism of the stress tests carried out on Europe’s banks.

 Europe’s banking system is three and a half times Europe’s GDP, whereas the US banking system is only 80% of the US GDP. Loan to deposit ratios are considerably higher in Europe too.  Europe relies very heavily on banks because it has not developed alternative means of raising finance. The Van Rompuy/Barroso proposals should address that issue.

It  is arguable that Europe’s banks are now so interdependent on one another that the problem of recapitalising banks should be a European rather than a member state responsibility.  It is also arguable that central banking policy has added to problems, rather that mitigated them. The Basel  2 system that   central banks were using until recently was procyclical during the boom. The new rules may prove to be procyclical too, but in the opposite direction.

  Europe needs a banking policy. 

That means taking a European view about the size of banks, their interconnectedness of banks, the” too big to fail” problem, and a host of other difficult questions.

 But unless we restore our banking system,  confidence will not return,   small businesses will not thrive and we will lack the  necessary credit  to tackle our structural problems.

  For example, Europe has only 0.6% of the world’s oil reserves, but it consumes 17% of the world’s oil production.

A recent paper commissioned by the German Ministry of the Environment suggested that  achieving a  30% reduction  in Europe’s cO2 emissions by 2030 could add  0.6% to European GDP growth and  create 600000 jobs in renewables, smart grids, insulation , public transport etc.

Maybe this will not work, but necessity is the mother of invention.  The industrial revolution started in Britain in the 18^th century, rather than on the continent, because labour costs were higher in  Britain. This gave British eighteenth century industrialists the incentive to adopt labour saving machinery .  

 Perhaps the high cost of imported oil and gas will now give Europe the necessary incentive to adopt radical energy saving technologies.  But that cannot happen unless we have a properly functioning banking system all over Europe to lend to the entrepreneurs who make the breakthroughs.

To conclude, I would say that the problems the European Union faces today are challenging not only politically, but intellectually.  But they are problems that the rest of the world will have to face sooner or later. Europeans are the world’s pioneers of economic integration.

Those who founded the European Union had enormous intellectual self confidence.  That self confidence must be rediscovered.  There must be a coming together of minds in place of the institutional rivalry that sometimes characterises European Union politics. Lessons must be learned and problems confronted honestly, but once that is done, we must work together to find practical and imaginative solutions.

To sustain an economic and monetary union in the long run, we need to create a true European demos, and  a European patriotism.  That is needed to  make politically acceptable  the   occasional transfers of funds from one part of the  union to another, that help a single currency to work .  We have not created a European demos, nor have we created a common European patriotism, as has unfortunately become all too obvious.. But that is an argument for another day.

Lecture by John Bruton, Former Taoiseach of Ireland, in the APCO  ” World wide  Perspectives on Europe”  series of lectures , at the London School of Economics at  6.30pm on Monday  7^th March