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Finance and Knowledge: The Need for Effective Governance. ...... Accessed: 28.02.2012, http://www.bankofgreece.gr/BogEkdoseis/Paper2009102.pdf. Euro Area ...... Czy można odnosić korzyści z integracji walutowej?, in: S. Owsiak (ed.),.
EDITORIAL BOARD: Prof. Andrzej Stępniak (University of Gdańsk, Poland) Prof. Zofia Wysokińska (University of Łódź, Poland) Prof. Serguey V. Ryazantsev (Russian Academy of Science, Russia) Prof. Rogério Sobreira Bezerra (Fundação Getúlio Vargas, Brazil) LANGUAGE EDITOR: Renata Siuda-Ambroziak COVER: Łukasz Kamiński, Renata Siuda-Ambroziak PROOFREADERS: Neil Armstrong, Matthew Davies, Renata Siuda-Ambroziak TECHNICAL AND LAYOUT EDITOR: Beata Bereza © University of Warsaw, Rio de Janeiro State University © Alojzy Z. Nowak, Renata Siuda-Ambroziak, Alexis Toríbio Dantas © Cover design: Łukasz Kamiński, Renata Siuda-Ambroziak ISBN (PL): 978-83-235-1471-8 ISBN (BR): 978-85-99958-23-0 Druk i oprawa: Zakład Graficzny UW, zam. 843/2014

ADDRESSES OF THE PUBLISHERS: University of Warsaw (UW) 26/28 Krakowskie Przedmieście St. 00-927 Warsaw POLAND http://www.uw.edu.pl/

Rio de Janeiro State University (UERJ) 524 São Francisco Xavier St. 20550-900 – Maracanã, Rio de Janeiro BRAZIL http://www.uerj.br/

CATALOGAÇÃO NA FONTE UERJ/REDE SIRIUS/CCS/A B827

Brazil – Poland. Focus on Economy/ Alexis Toríbio Dantas, Alojzy Z. Nowak, Renata Siuda-Ambroziak, editores. - 1.ed.- Rio de Janeiro: UERJ/Nucleas; Warsaw: University of Warsaw, 2014. 210 p. ISBN 978-83-235-1471-8 1. Política econômica. 2. Relações econômicas internacionais. I. Dantas, Alexis Toríbio. II. Nowak, Alojzy Z. III. Siuda-Ambroziak, Renata. CDU 338.98

Acknowledgements The deepest debts are always private. However, here there is no need to cross the border between our private and professional lives, as He was simultaneously a Teacher and a Friend. Through the years we have learnt from many, but He was the one who in particular helped form our thinking on Polish-Brazilian cooperation and its possible positive outcomes in the future, and showed us how to approach and study each other effectively, but also affectively – ‘with a heart and reason’. He taught us that critical thinking is the only way of pushing the boundaries of Academia and both the pursuit and dissemination of well-grounded, genuine knowledge. He showed us that intellectual development is the product of hard work, experience and precious interdisciplinary perspectives, but also of lifelong, inspiring academic friendships involving sometimes difficult conversations on controversial topics (and, perhaps, too forthright argumentation), but always - mutual trust, respect and reliability. We owe him a great deal: ideas, support, critical skills, courage, knowledge and so much more… He helped us spread our wings, fly across the Atlantic and not be afraid to ‘think big’. Professor, it’s so good to have met You. Thank You.

On the 5th Anniversary of Prof. Andrzej Dembicz’s Death (1939-2009) Renata Siuda-Ambroziak & Alexis Toríbio Dantas

CONTENTS

Alojzy Z. Nowak Preface

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Alexis Toríbio Dantas, Renata Siuda-Ambroziak (Brazil, Poland) The Interdependence of Brazil’s Foreign Policy and Foreign Trade

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Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove (Poland) The Euro Reconsidered

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Alexis Toríbio Dantas (Brazil) Social Policy in Brazil – Economic Implications and Challenges

55

Alojzy Z. Nowak (Poland) How to Enhance Competitiveness of Polish Economy? SMEs as Innovativeness Stimulator

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Leonardo Burlamaqui (Brazil) Finance and Knowledge: The Need for Effective Governance. An Evolutionary Perspective

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Grzegorz Tchorek (Poland) How to Fix the Euro Area? Poison and Remedy: The Roots of the Crisis and New Institutional Solutions

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Contents

Frederico Rocha (Brazil) Brazil’s Specialization in Natural Resources: The Role Played by China

143

Teresa Czerwińska (Poland) The Development of the Commercial Insurance Sector in Central and Eastern European Countries: Comparative Analysis

163

Carlos Eduardo Frickmann Young, Érico Rial Pinto Rocha, Leonardo Barcellos de Bakker, André Falkenbach Santoro (Brazil) How Green Is My Budget? Public Environmental Expenditures in Brazil

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PREFACE

This book is a direct result of the current rapprochement in PolishBrazilian academic contacts established for the first time almost 20 years ago between the University of Warsaw (UW) and the Rio de Janeiro State University (UERJ), represented respectively by: the late Prof. Andrzej Dembicz, the founder and the director of CESLA (Center for Latin American Studies of the University of Warsaw) and Prof. Maria Teresa Toríbio Brittes Lemos, who, for the last 10 years, has coordinated NUCLEAS (Nucleus for the Studies on the Americas of the Rio de Janeiro State University). It is also the fruit of numerous academic and organizational meetings and discussions that took place in May 2013 during my formal visit to the UERJ, coordinated by my co-editors: Alexis Toríbio Dantas (UERJ) and Renata Siuda-Ambroziak (UW). During the last two decades, a lot has already been done in terms of common projects, conferences and publications – it does not, however, satiate either our mutual academic interests or our willingness to cooperate in various areas and fields of study. Therefore, while Polish-Brazilian academic relations, nourished and managed so successfully for many years, have always been strictly oriented only towards Latin American regional studies (though understood interdisciplinarily), not involving, at least in the case of Poland, scholars without such a specific academic background, here the editors purposefully decided to change the usual content scheme. Our intention is to successfully extend this cooperation, understood in a much broader, more inclusive sense, into other fields and areas of study, thus broadening both perspectives and the potential number of people who might be able to get involved, actively participate, take advantage, and, finally, become prepared to take over and lead others in the future. I do believe that it is precisely such an efficient and smooth continuation that should be carefully maintained and always wisely prepared for in advance, in order not to let good things perish or already initiated processes stumble.

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Alojzy Z. Nowak

This book is meant by the editors to be the first of a whole series of “Brazil-Poland. Focus on….” that will boost both Polish-Brazilian interinstitutional relations and personal contacts by means of facilitating dialogue, getting to know each other better, establishing common spheres of interests, and laying strong foundations for new, international research projects, grants and joint publications. It focuses on economy, comprising articles by the representatives of both institutions (UW and UERJ), as well as invited guests from the Federal University of Rio de Janeiro. Some of the authors have already made themselves nationally recognizable in their field (and respective specializations), though they might not be necessarily known by their potential partners or counterparts in the other country’s academic world. This should definitely be helped by means of this joint publication, prepared in English, providing all the necessary data for each of the authors (including their academic background, current position and valid e-mail address) and directed to all those, who are interested, in this particular case, in: economy, Brazil, Poland, Latin America, Europe, and international relations with regards to economic policy. Thus, the scope of the included topics and the spectrum and number of our prospective readers is very wide. The articles have been carefully reviewed and selected from a wide thematic range of numerous obtained proposals. In order to reach a desirable international academic balance, there are, in total, nine articles included in the book – four by the representatives of the two countries involved and one written in close Polish-Brazilian cooperation. There are specific interests shown by the authors in their given specializations: social policy and its economic implications, insurance market, monetary and economic unions, international relations and foreign trade, economic innovations and competitiveness, green economy, effective governance problems, economic crises and their management, etc. Taking all these editorial assumptions into consideration, I hope this book meets its most important objectives: it will become an academic “directory” for all those interested in establishing new contacts in the above mentioned areas of economic interest; it will show prospective fields for further international team research, networking and grant development in both countries (and on both continents); and it will become one more solid fundament to build on in our current and future academic cooperation. On behalf of the editors, I wish to all a fruitful reading. Alojzy Z. Nowak 8

THE INTERDEPENDENCE OF BRAZIL’S FOREIGN POLICY AND FOREIGN TRADE

Alexis Toríbio Dantas1 Renata Siuda-Ambroziak2

Abstract: Both the range and dimension of political and economic changes (not to mention social reforms) implemented in Brazil in the 21st century are unprecedented in the history of the country. In terms of foreign policy, it is becoming clear that Brazil is strongly committed to consolidating the trend towards cooperation and integration within South America, but also, in a broader sense, within the global South-South alliances. Here, Brazil does not only aim at exerting a leadership role in order to deepen its trade relations and establish greater integration via development projects, but also for the sake of leadership itself, showing its growing regional and global superpower aspirations. It is precisely in the area of international relations and foreign trade that such changes have been noticeable and significantly intertwined. Therefore, this article will present some reflections on recent changes in Brazilian foreign policy which are visibly oriented towards the country’s growing political ambitions that decisively mark its foreign trade characteristics. It will also emphasize the more and more prominent role of some regions (and countries) as the focus of Brazil’s both political interests and exports. Keywords: contemporary Brazil, foreign trade, international relations, economy, foreign policy.

1

Alexis Toríbio Dantas – PhD in Economics, Associate Professor, Faculty of Economic Sciences, Rio de Janeiro State University, Coordinator of the NUCLEAS, e-mail: [email protected]. 2 Renata Siuda-Ambroziak – PhD in Social Philosophy, Assistant Professor, Centre for Latin American Studies, Institute of the Americas and Europe, University of Warsaw, Institutional Ranking Coordinator of the University of Warsaw, e-mail: [email protected]. 9

Alexis Toríbio Dantas, Renata Siuda-Ambroziak

1. Introduction Until the beginning of the 21st century, Brazil functioned on the periphery of the global politics – at least such is the interpretation of Samuel Pinheiro Guimarães (2001), Secretary General of the Palace of Itamaraty (Ministry of Foreign Affairs) during the presidential term of Inácio Lula da Silva, presented in his book, a manual for Brazilian diplomats. According to him, only internal factors influenced the shape and perception of Brazilian foreign policy, defining its national interests locally and regionally. At the moment, however, it seems that the importance of Brazil in the world is beginning to grow rapidly – not only is Brazil becoming a representative (and the leader) of the South, but also an increasingly interesting (though difficult at times) partner for the North, calling for a new division of regional spheres of interests and expecting to get its ‘fair share’ not only in terms of the range of global political influence but also in the volume, destination and terms of its foreign trade. Undoubtedly, Brazil is becoming more and more noticeable and audible in the international arena. This is due in part to the two landmark presidential terms of Inácio Lula da Silva, his undeniably strong personality and political charisma3. However, Brazil’s international reputation has also been transformed by beneficial economic circumstances and the implementation of wide-ranging social reforms, which are changing both the reality and the image of the country, up till now often perceived through the prism of its shocking social inequalities. Here it is worth noting that Brazilian social programs, being an important part of the country’s economic and political “third way”, have become widely known and adopted not only in the region, but also by some African countries engaged in intensive cooperation with Brazil in the South-South alliance. Therefore, both the position and international perception of Brazil is changing. It is happening due to several factors, mainly: the country’s political 3

It is interesting that the popularity of President Lula was not hurt substantially even after the “mensalão affair”, i.e. buying the votes of the parliamentary opposition by the ruling party (PT) through regular payment of “extra” salaries. After all, Lula was leaving office with a very high approval rating (over 80%), passing it on to one of his ministers and closest colleagues – Dilma Rousseff. Surprisingly, it was during her term, however, that the guilty of mensalão were not only tried, but also convicted in 2012. 10

The Interdependence of Brazil’s Foreign Policy…

and economic stability, together with its economic potential; the size of its territory and its population, which constitutes an important internal market for consumption; stimulation of policies aimed at alleviating social inequalities; and, last, but not least, Brazil’s conscious efforts to promote its image as “the rising superpower”, which bears quite a strong impact on international relations, the country’s foreign policy and foreign trade. Foreign policy decisions implemented already by the Lula governments have become in many ways a negation of those pursued by his predecessor – Fernando Henrique Cardoso. While Cardoso’s strong pro-American and neoliberal approach was aimed primarily at integrating Brazil into the global economic and political system, from the beginning of his term of office, Lula da Silva stressed the need to create a strong counterweight to the American influence in the region. He promoted new relations with the United States, based on the principle of partnership, prioritized continental cooperation within Latin America, and undertook efforts to build a new order in global politics (with the support of the countries of the South) in order to reduce the large development gap between the Southern nations and the wealthier North. This meant questioning the current model of globalization established in accordance with the provisions of the Washington Consensus, criticizing widening social inequalities and voicing the need for reorganization and reform of the existing international organizations and bodies (e.g. the UN and the WTO) in order to adapt them to changing economic and political conditions. Such action included the need for Brazil to be recognized in a new role as representative/leader of the countries of the South and the mediator between the North and the South. During the presidential office terms of Lula da Silva, Brazil’s foreign policy seems to have been essentially based on three main pillars: strengthening national (including energy) security; boosting foreign trade; and building a strong international position for Brazil while promoting its regional (and global) superpower aspirations. National security matters have been recently focused on securing total independence in the Brazilian part of the Amazon threatened by claims for its “internationalization” as a World Heritage site, as well as being one of the frontline territories for the United States’ war on drugs. This is manifested in a selfreinforced Brazilian military presence in the Amazon, especially on the border with Colombia, and also in the implementation of national advanced monitoring 11

Alexis Toríbio Dantas, Renata Siuda-Ambroziak

systems through a network of radars, patrolling flights and satellites. Another important element is the active policy of Brazil on international forums related to issues of ecology, environmental protection and the fight against bio-piracy – Brazil’s position is unrivaled here due to the country’s strategic share in the surface of the equatorial forests located within its territory, its global share in the provision of fresh water, the level of biodiversity, and its potential for generating clean and renewable energy (Feldman, 2002; Figueiredo, 2005; Becker, 2005; Becker, 2001). The second major component of Brazilian national security relates to the issues of energy security and energy independence, which, thanks to the sugar cane bio-ethanol production and extracting crude oil from the Atlantic shelf, has already been achieved to a large extent. Still, Brazil’s foreign policy is focused on strengthening it by means of carefully run “energy diplomacy”, for example, by supporting pipelines supplying gas from regional exporters (especially Bolivia, Peru and Venezuela) in order to avoid by all possible means another energy crisis, like the famous apagão, which took place at the end of the presidency of Fernando Henrique Cardoso and forced Brazil to endure regular power outages in different regions of the country. Energy security is also cleverly used as a strong point of Brazilian foreign policy in the region – intensive use of the Brazilian bio-fuel sector in the form of so-called “ethanol diplomacy”, significantly strengthens the position of Brazil in Central America and the Caribbean (Oberda-Monkiewicz, 2013), which highlights the central hypothesis of the article, based on the strong interdependence of Brazil’s foreign policy and its foreign trade. While it is acknowledged that all of these pillars of Brazil’s foreign policy are still valid under the presidency of Lula’s successor, Dilma Rousseff, special emphasis is placed on foreign trade and Brazil’s superpower ambitions, which are discussed in more detail.

2. Foreign trade: recent evolution The first and most pragmatic pillar of new Brazilian foreign policy has been to build a strong position in international trade, especially with regards to the support given by Brazilian diplomacy to the sectors of competitive advantage (for example, agriculture). The effects of this have been manifested in 12

The Interdependence of Brazil’s Foreign Policy…

the: strong opposition of Brazil at the WTO against state subsidies of the United States and the European Union (including Brazilian protests at the Summit of the Americas in Mar del Plata in 2005 against North American agricultural subsidies which badly hit Brazilian food exports); Brazilian anti-dumping protests; attempts to create coalitions within the WTO; and a bid to strengthen and expand the direct economic influence of Brazil in the Mercosul, the Caribbean, and Asia (especially economic relations with China), at the expense of the ALCA proposal, advocated by the United States. In terms of numbers, the Brazilian economy has registered a trade surplus since the end of the fixed exchange rate regime established in the Real Plan of July 1994. After the reversal of trade balance between 1995 and 2000, as a result of the policy of exchange rate bands and its initial appreciation of the new currency, the real, the external crisis of January 1999 and the consequent end of the “exchange rate anchor”, the adjustment of the rate permitted the resumption of an upturn in the generation of surpluses. Table 1: Exports, imports and trade balance – Brazil – 2011/2012 (USD current billions) 2001=100

Imports

2001=100

Trade Balance

Years

Exports

2001

58,29

100,00

55,60

100,00

2,68

2002

60,44

103,69

47,24

84,97

13,20

2003

73,20

125,59

48,33

86,91

24,88

2004

96,68

165,87

62,84

113,01

33,84

2005

118,53

203,36

73,60

132,37

44,93

2006

137,81

236,43

91,35

164,29

46,46

2007

160,65

275,62

120,62

216,93

40,03

2008

197,94

339,60

172,98

311,11

24,96

2009

152,99

262,49

127,72

229,71

25,27

2010

201,92

346,42

181,77

326,91

20,15

2011

256,04

439,28

226,25

406,90

29,79

2012

242,58

416,18

223,15

401,33

19,43

Source: MDIC/Brazil.

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Alexis Toríbio Dantas, Renata Siuda-Ambroziak

As shown in Table 1 and Figure 1, this trend is largely due to the rapid increase in exports, which ensured a growing surplus even with the simultaneous increase in the volume of imports. It is important to point out that the trade surplus was still possible in another context characterized by the resumption of economic growth at higher levels than in previous years to the third quartile of the first decade of this century. Figure 1 – Exports, imports and trade balance – Brazil – 2011/2012 (USD current billions) 300 250 200 150

Exports Imports

100

Trade Balance

50 0

Source: MDIC/Brazil.

In 2011, the amount of both exports and imports was already more than four times larger than the volume recorded in 2001, with a slight advantage for the export performance (4.39 times higher against a 4.01 times greater volume of imports in the same period) – see table 1. It should be noted, however, that the picture starts to show a relative change from 2007 on. In that year, the growth rate of exports was significantly lower than that recorded in imports (nearly half – 16.6% growth in foreign sales against 32.0% increase of international purchases). This situation has already demonstrated the effect of the onset of the international financial crisis, especially in developed countries, initially in the United States, and its impact on the level of global economic activity – at 14

The Interdependence of Brazil’s Foreign Policy…

a time when the Brazilian economy maintained its growth trajectory in motion, at least by 2009, which supported the demand for imports. Moreover, the beginning of the last quartile of the decade registered a fundamental change in the composition of Brazilian exports: the absolute and relative decline in exports of manufactured products. Part of this change was due to the cyclical higher international prices of major commodities exported by Brazil, which occurred in the decade. At the same time, the export of industrial products encountered two different problems, especially from 2006/7 – see Figure 2. Figure 2: Brazil – Composition of exports(1) – 2001/2011 60,0

50,0

40,0 Basics 30,0

Semimanuf. Manufactured

20,0

10,0

0,0 200120022003 20042005200620072008200920102011 (1)

Exclusive Special Operations. Source: MDIC/Brazil.

First, as noted earlier, the decline in economic activity that followed the financial crisis in the United States and later in the European Union, which caused significant decrease in demand for imports (the maintenance of Chinese

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Alexis Toríbio Dantas, Renata Siuda-Ambroziak

demand explains the inverse behavior of commodity exports). On the other hand, the combination of high interest rates in Brazil (in part also exacerbated by the external crisis) and a continued appreciation of the domestic currency caused the increase of imports and, at the same time, led to the substantial drop in the competitiveness of industrial production. Similarly, the change in the behavior and structure of Brazilian exports determined a significant turn in the relative composition of the destinations of Brazilian exports – Table 2. As one can see, the traditional destination of Brazilian sales in the United States and the European Union, saw their portions decline substantially over the first decade of this century. This was especially the case of U.S. sales, which fell from being a final destination for almost a quarter of Brazilian products marketed abroad to approximately 10% in 2011. In the case of the sales to the European Union, the respective percentages declined from 26.6% to 20.1%. Imports followed the same trend, and here we can note the continuous decline in the relative share of the United States and the European Union in the amount of purchases by Brazil abroad – see Table 2. On the other hand, China’s performance was exactly the opposite. Between 2001 and 2012, China increased its share in Brazilian exports from 3.3% to 17%, surpassing the United States in the ranking in 2010 and steadily approaching the position of the European Union. Another group of countries that maintains a significant share of external transactions with Brazil is Latin America and the Caribbean – the relative share of exports is between approximately 20% and 25% over the decade, while import percentages remain at around 17 % in the period – see table 2. It is important to note, however, that the performance of trade relations between Brazil, China, Latin America and the Caribbean is the result of different situations. In China’s case, despite the undeniable progress of exports and imports of this country relating to Brazil, the trade balance, although positive, is relatively low compared to the overall performance of the Brazilian external transactions. Besides, it shows a small positive inflection at the end the past decade, just as the level of economic activity in Brazil enters a period of decline in growth rates, particularly with respect to industry – see Figure 3.

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The Interdependence of Brazil’s Foreign Policy…

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Alexis Toríbio Dantas, Renata Siuda-Ambroziak Figure 3: Exports, imports and trade balance – Brazil/China – 2011/2012 (USD current millions) 50 000

40 000

30 000 Exports Imports

20 000

Trade Balance 10 000

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

0

-10 000 Source: MDIC/Brazil.

Moreover, what clearly dominates export of Brazil to China are the commodities, characterized by low technological content, with increasing relative share, which has remained as a trend – see figure 4. Despite the slight decline in 2012, the relative share of primary products in total exports from Brazil to China soared from 60.7% to 85% between 2001 and 2011 (82.8% in 2012). Meanwhile, the share of manufactured goods in the exports from Brazil to China declined from 24.4% to 4.6% between 2001 and 2011 (5.8% in 2012).

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The Interdependence of Brazil’s Foreign Policy… Figure 4: Composition of exports(1) – Brazil/China – 2011/2012 (USD current millions) 40 000

35 000 30 000 25 000 Basics

20 000

Semimanuf.

15 000

Manufactured 10 000 5 000 2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

0

(1)

Exclusive Special Operations. Source: MDIC/Brazil.

On the other hand, Brazil’s economic relations with Latin America and the Caribbean have a different performance and economic policy from those observed in the case of China. These issues are highlighted in the official statements of the Brazilian authorities (Brazil, 2008: 19, 20, 24, 83, 84): When President Luiz Inácio Lula da Silva took office, Brazil changed the tone of its foreign policy; a policy that is concerned with the country’s sovereign insertion, at once universal and humanistic, firmly anchored in the interests of the Brazilian Nation and in the integration of South America (…). The South-South relationship is not only possible; it is also necessary. The South is not an amorphous complex of underdeveloped and dependent countries that have nothing to offer other than raw materials to wealthy countries. (…) Together we can become stronger, not only through the growth of our trade, but also by participating more actively in economic and political forums, such as the World Trade Organization and the United Nations, where questions of great interest to humanity are discussed. (…) Now, a more intense, more creative and a stronger relationship between countries of the South, does not mean that we will abandon our rela-

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Alexis Toríbio Dantas, Renata Siuda-Ambroziak tions with developed countries, which are also important to all of us. Let’s do what developed countries do: take advantage of all opportunities and make our union our strength. Brazil is very similar to the Caribbean: a land of many cultures. We have the second largest population of African descendants in the world, only second to Nigeria. Like the Caribbean, we are proud to have provided a refuge for a great many European and Asian immigrants. Miscegenation and the harmonious co-existence (of our peoples) are a hallmark of our identities. (…) Brazil is prepared to move boldly forward, with flexibility and generosity to further this association. We will stimulate business and cooperation projects that go beyond our trade relations. We will encourage the circulation of goods and services and we will seek greater inter-regional agreements on all levels (…) In Davos, at the beginning of this year, I said that Brazil had made an option for South America. An option that also extends to the whole of Latin America and the Caribbean. I am convinced that our region is more and more prepared to deal with the challenges of globalization. We are conscious of the fact that the destiny of our countries is becoming more and more intertwined.

This foreign policy stance reflects clearly the definition of a zone of preferential relations and a clear choice of development model. From a commercial standpoint, the choice is well-founded and it has influenced the evolution of trade and economic relations in recent years. First, there is a growing expansion of both exports and imports with countries in the region (see Figure 5), following the trajectory of Brazil’s trade relations in general. Figure 5: Exports, imports and trade balance – Brazil/Latin America and the Caribbean – 2011/2012 (USD current millions) 70 000 60 000 50 000 40 000

Exports

30 000

Imports

20 000

Trade Balance

10 000 0 1

2

Source: MDIC/Brazil.

20

3

4

5

6

7

8

9 10 11 12

The Interdependence of Brazil’s Foreign Policy…

Secondly, and more importantly, unlike the global trend of business transactions of Brazil, where commodities grow considerably in the relative composition of total exports, Brazilian sales for Latin America and the Caribbean are increasingly concentrated in manufactured goods, with a stable performance throughout the first decade of this century – see Figure 6. Thus, the region remains the prime destination of Brazilian industrial production, especially after 2006/7. Figure 6: Composition of exports(1) – Relative Share – Brazil/Latin America and the Caribbean – 2011/2012 100,0% 80,0% 60,0%

Basics

40,0%

Semimanuf

20,0%

Manufactured

(1)

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

0,0%

Exclusive Special Operations.

Source: MDIC/Brasil.

Thus, as can be easily observed, Brazilian’s trade relations have experienced important changes in recent years. In this sense, firstly, one can highlight that the volume of international trade increased significantly – in 2011, it was more than four times higher than in 2001. Until 2007 this performance was explained especially by the exports trajectory and after that one can observe an inflexion of the import curve due to a slowdown in international economic activity (particularly in relation to the United States and European Union) and the maintenance of the rate of growth of the Brazilian economy, which supports domestic demand. In this case, the combination of high interest rates and appreciation of the domestic currency imposed a fall in the competitiveness in industrial production.

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Alexis Toríbio Dantas, Renata Siuda-Ambroziak

Regarding trade with China, it is clear that as China’s performance kept growing, the structure of Brazilian exports changed – China increased its share in Brazilian exports from 3.3% to 17% between 2001 and 2012. However, although it was important to maintain the growth of Brazilian exports, those sales are based on commodities characterized by low technological content. On the other hand, Brazilian trade relations with Latin America and the Caribbean have a special impact in this scenario. Firstly, this can be seen in the expansion of exports and imports with countries in the region, which display similarities with Brazilian’s general trade relations performance; secondly, it is important to note that Latin American and Caribbean countries are a more and more important destination for Brazilian manufactured products; last, but not least, Brazil’s trade performance in the region is closely intertwined with its regional superpower political aspirations.

3. Brazil’s superpower aspirations One of the three main pillars of Brazilian foreign policy is the desire to strengthen the position of the country and support superpower aspirations of Brazil in the international arena (especially in the context of its ambitions to obtain a permanent membership in the UN Security Council)4. This translates directly into: creating strategic alliances (within BRIC or UNASUR); Brazilian leadership, alongside China, India and South Africa, of the G20 (where developing countries fight together against protectionist policies pursued by the EU and the United States); adopting a leadership role in North-South conflicts (Ricupero, 2011); and undertaking UN stabilization missions in the region (the case of Haiti). In the 21st century, Brazil’s foreign policy seems to be, as previously indicated, both strongly focused on consolidating its own autonomy and on building a regional superpower image while searching for ever more visible and 4

Certain authors (Ricardo, 2006) argue that Brazilian membership in the UN Security Council should have been granted as a result of it being an ally during WWII – Brazil was the only Latin American country which broke diplomatic relations with the Axis countries and participated actively in the war, sending to Europe an Expedition Corps in 1944. However, as a result of US support, the USSR strongly opposed this candidacy.

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The Interdependence of Brazil’s Foreign Policy…

responsible role in international relations – hence the already mentioned desire to build Brazilian leadership among the countries of the South (but we can also detect attempts to engage with the Arab states, including President Lula da Silva’s visits to the Arab League countries and the South American-Arab states summit organized in Brazil, as well as to cooperate with BRICS countries, especially China and Russia). In the context of traditional Brazilian foreign policy based largely on the principle of non-intervention, the Lula government’s controversial decision to make a strong commitment to the UN peacekeeping mission in Haiti (MINUSTAH) in 2004 came as quite a surprise. The official government version argued that Brazil undertook the mission, upon the request of the UN, in order to maintain peace, stability, law and order in a country at risk of violence and recovering after deep political conflicts (the so-called “diplomacy of solidarity”). Thus, Brazil had demonstrated obvious willingness to preside any mediation as regional leader in the democratization processes in South America (da Silva, 2004). But the case of Haiti is, at least for some, a bit more complicated – after all, Aristide was a legally elected president, and his escape to South Africa following the diplomatic pressure from the United States and France plunged the country into a bloody civil war. Whilst it is true that all the formalities had been met (even with the adoption of a UN Security Council resolution in order to authorize the American and French presence in Haiti and constitute a new government), the situation has been treated by many Latin American countries (e.g. members of CARICOM) as a coup. Therefore, when Brazil pledged to take over the mission, thus providing a more neutral image for UN military corps stationed in Haiti, political adversaries of the government called the decision illconceived and taken under pressure from the United States, and noted the unexpected change in the policy of Lula towards Washington. His overwhelming criticism of the invasion of Iraq and the U.S. embargo against Cuba seemed inconsistent with the sudden confirmation of Brazil as a mediator between the U.S. and Latin America (especially in the context of Haiti crisis and verbal skirmishes between Hugo Chávez and the Americans). These criticisms emphasized the fact that the desire for Brazil’s membership of the Security Council is too costly, and that it was mainly a personal ambition of the president, who, it was argued, did not know “what Brazil is supposed to be when it grows up” (Suano, de Aragão, 2006). 23

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On the other hand, UN peacekeeping forces under the command of Brazilians have actually been well-received by the Haitians themselves and, despite initial organizational delays and language barriers, seem to cope well in the field. This is especially visible in the context of the amelioration of the disastrous effects of the hurricane, and the support of third sector organizations from Brazil in the implementation of social policies, which have had a distinctly Brazilian inflection, in Haiti. This is why the mission in Haiti, despite the presence of the army (1200 Brazilian soldiers), seems to be a good example of building Brazil’s regional “soft” superpower influence. Additionally, taking into account the importance (and even a priority for the government of Lula) of membership of the UN Security Council, such a step was, perhaps, necessary in order to obtain a favor in this case from the United States, especially against strong opposition of Brazil’s own Latin American competitors, namely Argentina (who, with the help of China, Pakistan and Italy, even led a policy to boycott Brazil’s candidacy in the so-called anti-G4) and Mexico. This serves to confirm the impression that Lula was committed to achieving these political goals by all possible means, and reaffirms the enormous significance of the membership issue for Brazilian diplomacy during Lula’s office terms, where the matter was treated as an absolute priority. Brazil’s traditional foreign policy with regards to the implementation of the principle of multilateralism in international relations also evolved under Lula’s government. Here, Brazil’s arbitrary and selective application often depended on the situation and whether the necessary action required a global, continental or regional approach. It is worth noticing, for example, that Lula gradually distanced himself internationally from Latin American leaders perceived as “too radically leftist”, such as Chávez, Morales and Correa, whilst at the same time emphasizing his own traditional leftist roots and beliefs. However, in the context of Brazil’s new ambitions, the reasons for this selectivity are understandable: for Brazil, the principle of multilateralism in creating diverse coalitions is a way of aspiring to be a premier league player, as well as a means of balancing the influence of other superpowers. Further light on this matter is shed when considering the role of the United States. Latin American countries adopted an ambiguous approach to the American ALCA proposal and deve-

24

The Interdependence of Brazil’s Foreign Policy…

loped alternative plans, such as the Venezuelan ALBA5. In response, the United States clearly decided to circumvent what is perceived as the “limping” Latin American integration processes, opting for separate negotiations with particular countries and concluding bilateral agreements, which significantly reduce both Brazilian aspirations and factual influence in the region. Conversely, although the superiority of the United States in the Americas fails to be balanced by any local alliances as to date, Brazil is more and more often seen as both an important, though not always easy partner of the North, and, regardless of the current regional conflicts and alliances, an increasingly dominant state in the region. Evidence of this can be seen in the field of Brazilian diplomacy, where clever “tactical maneuvers” were used to oppose the plans of the United States and Canada relating to the formalization of continental cooperation in the fight against terrorism and the inclusion of the Pan-American military forces in the fight against organized crime6. Other examples include the withdrawal from the satellite launch base in Alcântara (2003) lease agreement with the United States or repeatedly expressed dissatisfaction with the signing (under President FH Cardoso in 1998) of the Treaty on the Non-Proliferation of Nuclear Weapons and subsequent misunderstandings in the inspection of Brazilian laboratories in Resende7. It seems that Lula’s government might have aimed at the possession of nuclear weapons by Brazil as an important element to ensure national security and independence from the influence of the United States (Silvestre de Albuquerque, 2005), often using an anti-imperial tone in the context of American policy towards Latin America. This translated directly into bitter criticism of the United States for imposing sanctions on Cuba, and into Brazilian support, against the United States, for the Honduran president who was ousted in the 5

It is worth mentioning, in the context of the growing importance of Brazilian trade exchange with Venezuela, that Brazil played an important role proposing membership of Venezuela in Mercosul and as the initiator of international negotiations that led to the settlement of the internal conflict in the country in 2003. 6 „Nono ministro da Defesa vai a Quito para tratar da cooperação hemisférica” and “Discurso de Alencar contraria sugestões norte-americanas” in: Informe Brasil, No. 166, 13.11.-19.11.2004: 11-13. São Paulo: Observatório Cone Sul de Defesa e Forças Armadas (OCSD), Centro de Estudos Latino-Americanos (CELA), Universidade Estadual Paulista (UNESP). Accessed: 25.12.2013, http://www.cee-chile.org/resumen/brasi/bra151-200/sembra166.htm. 7 Arms Control Association. Accessed: 25.12.2013, http://www.armscontrol.org/act/2005_10/Oct-Brazil. 25

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2008 coup. It was also noticeable in the use of the “reciprocity rule” in relation to the visa problems concerning the entry of Brazilians to the United States and, consequently, the introduction of the same restrictions for U.S. citizens wishing to cross the Brazilian border. This showed in definitive terms that not only was Brazil willing to make pragmatic decisions in the international context without external pressures while paying close attention to the political and economic interests of the state, but also wishing to challenge the global U.S.A. superpower position. However, it does not change the fact that, at least in terms of obtaining formal confirmation of the rising status of Brazil in international relations by means of the permanent membership in the UN Security Council, President Lula had to begin to temper his previously strong anti-American sentiments, as well as to start building alliances and coalitions with partners that considered the quest for such permanent membership of Brazil natural and consistent with its role, aspirations and image (though the simultaneous introduction of several new members: Germany, Japan, India and Brazil, or the so-called G-4, is still quite unlikely).

4. Conclusion In spite of all the above mentioned problems and doubts, it seems that Lula’s two terms were a success: visibility, prestige and influence for Brazil in regional and global decision-making processes have never before been so significant. Of course, the current position of Brazil is also determined by the country’s favorable economic situation, high demand for its natural resources, increasing energy self-sufficiency and, last but not least, a demographic situation capable of absorbing internal market production. In Brazil, over the last decade, all of these factors certainly influenced the perception of the country (both external and internal) as a rising power both in regional and global scale. Although both the leading position and aspirations of Brazil were loudly commented on (and bitterly criticized) from the beginning till the end of the term of office of President Lula, especially by Brazil’s own Latin American neighbors, who quickly sensed the “imperial” regional ambitions of the giant (Magnoli, 2007), the travel agenda itself of the former 26

The Interdependence of Brazil’s Foreign Policy…

president is significant – for the first time in the history of Brazil, the president managed to keep perfect balance in the number and destination of official visits between North and South, the South American continent and all the regions beyond it (Seitenfus, 2006). The importance of Brazilian hegemony in the region was also shown clearly by Lula da Silva in his selection of the first official foreign visit destination, Argentina – a partner of Brazil in the Mercosul, but at the same time, the biggest rival to the Brazilian South American hegemony, and in the changing, strongly region-oriented, foreign trade destination. On the other hand, although it is not reflected directly by its current foreign trade patterns, Brazil is also certainly becoming an interesting and desirable partner for the North, both in international organizations and specificpurpose alliances, and a necessary participant (as well as initiator and organizer) of international meetings, summits (and events, including sport ones). It is clear that the country is treated more and more seriously by the North, including the United States – as a stable, though sometimes difficult partner, who approaches any alliance tactically and opportunistically, knows its own value and treats foreign policy primarily as a means of obtaining both tangible economic benefits and the strengthening of its superpower image. Such behaviour is, however, characteristic of those who can afford to do so – is the hallmark of powers (even if still only regional, “virtual” or “rising”). It is, therefore, interesting that despite a great effort to improve regional relations and create a new quality in the form of the South-South alliance, Brazil is perceived as an indisputably major partner by the North and such relationships cost Brazil less political effort while producing more tangible results than those laboriously worked out with the poor and internally shattered South. This is particularly the case with Brazil’s own Latin American neighbors, whose acceptance of Brazil’s regional (and global) superpower ambitions can be regarded as reluctant at best. It can be noted that, despite Latin America (and the Caribbean) constituting a more and more important market for Brazilian processed products in the context of difficult problems of reprimarização (a growing share of raw materials in the Brazilian exports globally, especially to China), Brazil is not always able to deal well with both Latin American protectionism (Argentina) and nationalism (Bolivia), which is particularly harmful to Brazilian translatinas. This also needs to be understood in relation to 27

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Brazilian-led integration projects, which have tended recently rather to purely physical in nature, including the construction of road infrastructure linking Brazilian industrial centers with the Pacific Ocean through the territories of Bolivia and Peru, and completing a gas pipeline linking Peru with importers in the region. Whilst these are obviously important endeavors, they do not compensate for the lack of further, noticeable progress in the economic integration of Mercosul. Rather paradoxically, therefore, it might be expected that the regional superpower position of Brazil will receive the strongest support from the United States, which is itself occupied with the global war on terrorism and drug trafficking, and relies on Brazil to meet the challenge of being a regional “policeman”, just as happened in the case of Haiti. Since Brazil does not have a competitor capable of rivaling its regional hegemony, the largest country in Latin America will probably accept this role of leader, along with the enmity of its neighbours (and, perhaps, even against the real “feeling of power” among a large part of its own population, not necessarily reflecting the imperial ambitions of Itamaraty). On the other hand, so much of today contested “political expenditure” may also become soon regarded as just one more necessary investment in the foretold Brazilian “dawn” and – the country’s increasing regional trade figures. Hence, although it might not be easy for Brazilians themselves (not mentioning their closest Latin American competitors) to recognize the emergence of the mythical “Fifth Empire”, they will probably have to accept their new regional glory together with its burden.

Bibliography Almeida de, P. R. (2004). “Uma política externa engajada: a diplomacia do governo Lula”, Revista Brasileira de Política Internacional, No. 47 (1): 162-184. Amorim, C. (2005). A política externa do governo Lula: os dois primeiros anos, Rio de Janeiro: Observatório de Política Sul-Americana/Iuperj. (Análise de conjuntura No. 4). Accessed: 01.09.2013, http://obsevatorio.iuperj.br/analises.php. Becker, B. (2005). “Por que não perderemos a soberania sobre a Amazônia?”, in: E. Silvestre de Alburquerque (ed.), Que país é esse? Pensando o Brasil contemporâneo, São Paulo: Editora Globo: 245-282.

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The Interdependence of Brazil’s Foreign Policy… Becker, B. (2001). “Construindo a política brasileira de meio ambiente para a Amazônia: atores, estratégias e práticas”, in: G. Kohlepp (ed.), Brasil: modernização e globalização. Madrid, Frankfurt am Main: Iberoamericana/Vervuert: 197-208. Brasil (2008). Ministério das Relações Exteriores. Secretaria de Planejamento Diplomático. Brazilian Foreign Policy Handbook/Brazilian Ministry of External Relations, Bureau of Diplomatic Planning, Brasília: Alexandre de Gusmão Foundation. Burges, S. (2005). “Auto-Estima in Brazil: The Rhetorical Logic of Lula’s South-South Foreign Policy”, International Journal, No. 60 (3): 1133-1151. Dantas, A. T., Koval, A. (2010). “Evolução econômica do Mercosul: relações com a Organização Mundial do Comércio (OMC)”, in: Maria Teresa T. B. Lemos, Alexis Toríbio Dantas (org.). América: visões e versões – identidades em confronto, 1 ed., Rio de Janeiro: 7Letras. Daudelin, J. (2008). “Lula and the End of Periphery for Brazil”, in: P. Birle, S. Costa, H. Nitschak (eds.), Brazil and the Americas. Convergences and Perspectives, Madrid, Frankfurt am Main: Iberoamericana/Vervuert: 51-78. Iglesias, E., Conde, R., Pertierra, G. S. (eds.) (2011). El momento político de América Latina. Madrid: Fundación Carolina. Feldmann, F. (ed.) (2002). Rio+10 Brazil. A Decade of Change. Rio de Janeiro: MMA, ISER, FBMC. Figueiredo Ribeiro de, N. (2005). A questão geopolítica da Amazônia. Da soberania difusa à soberania restrita. Brasília: Senado Federal. Gawrycki, M. F. (ed.) (2009). Dzieje kultury latynoamerykańskiej, Warszawa: PWN. Gawrycki, M. F. (ed.) (2013). Brazylia jako mocarstwo wschodzące, Warszawa: Biblioteka Iberyjska. Guimarães, S. P. (2001). Quinhentos anos de peryferia: uma contribuição ao estudo de política international. Porto Alegre: Universidade Federal do Rio Grande do Sul, Contraponto Editora. Lula da Silva, L. I. (2004). Discurso do Presidente da República, Luiz Inácio Lula da Silva, na cerimônia de embarque das tropas militares para missão de paz no Haiti. Brasília (Base Aérea de Brasília), May 31, 2004. Accessed: 24.06.2013, http://www.radiobras.gov.br/integras/04/integra_310504_1.htm. Magnoli, D. (2007). “Política externa”, in: J. Pinsky (ed.). O Brasil no contexto1987-2007. São Paulo: Ed. Contexto: 47-62. Menezes, R. G. (2012). “Integração, imaginação e política externa: as bases do paradigma sulamericano?”, Brazilian Journal of International Relations, Marília, Set/Dez. 2012, Vol. 1, No. 3: 482-497. 29

Alexis Toríbio Dantas, Renata Siuda-Ambroziak Oberda-Monkiewicz, A. (2013). “Brazylia-USA od «niepisanego sojuszu» do partnerstwa”, in: M. Gawrycki (ed.). Brazylia jako mocarstwo wschodzące. Warszawa: Biblioteka Iberyjska: 99-114. Pereira, M. (2013). Mensalão. O Dia do mais importante julgamento da história política do Brasil. São Paulo, Rio de Janeiro: Editora Record. Ricupero, R. (2011). “Brasil: ejemplo de éxito económico y social de una democracia de masas”, in: E. Iglesias, R. Conde, G. S. Pertierra (eds.), El momento político de América Latina. Madrid: Fundación Carolina: 183-206. Sader, E. “What is Brazil Doing in Haiti?”, ZNet. Accessed: 24.06.2013, http://www.zmag.org/content/showarticle.cgm?ItemID=5838. Schüler, F., Axt, G. (eds.) (2006). Brasil contemporâneo, Porto Alegre: Artes e Oficios. Seitenfus, R. (2006). “O Brasil e suas relações internacionais”, in: F. Schüler, G. Axt (eds.), Brasil contemporâneo, Porto Alegre: Artes e Oficios: 129-150. Silvestre de Albuquerque, E. (2005). “O Brasil lidera a América Latina? Estratégias subimperiais na periferia: as pretenses hegemônicas brasileiras”, in: E. Silvestre de Albuquerque (ed.). Que país é esse? Pensando o Brasil contemporâneo. São Paulo: Editora Globo: 209-244. Suano, M., Aragão de, Th. (2006). “Política externa brasileira: um exercício de liderança virtual”, in: F. Schüler, G. Axt (eds.). Brasil contemporâneo. Porto Alegre: Artes e Oficios: 151164.

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THE EURO RECONSIDERED

Alojzy Z. Nowak1 Kazimierz Ryć2 Yochanan Shachmurove3

Abstract: This paper describes and analyzes the impacts of the euro in the European Union. It analyzes the impacts of countries joining the European Union and its trade performance on the world economy. In order to depict and explain Europe’s role in the world economy, this study provides a detailed analysis of the Eurozone trade with the world. The study offers potential solutions to the financial crisis of the European Union and details their advantages and disadvantages. Keywords: European Union, Eurozone, GDP, interest rates, Harmonized Index of Consumer Prices, PIGS countries, fiscal union, financial crisis, Maastricht criteria, Maastricht Treaty, exchange rate.

1

Alojzy Z. Nowak – PhD in Economics, Professor of Economics, Faculty of Management, University of Warsaw, Vice-Rector for Research and Liaison of the University of Warsaw, e-mail: [email protected]. 2 Kazimierz Ryć – PhD in Economics, Professor of Economics, Faculty of Management, University of Warsaw, e-mail: [email protected]. 3 Yochanan Shachmurove – PhD in Economics, Department of Economics and Business, City University of New York, e-mail: [email protected]. 31

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

1. Introduction The current fiscal problems confronting the European Union4 are compromising the future of the Eurozone5. Key players in the global economy are questioning whether European politicians are able to successfully cope with the challenges to the Eurozone. The breadth and continuity of the crisis highlight the urgency of this issue. This paper describes and analyzes the impacts of the Euro crisis on the countries that are members of the European Union. Specifically, the paper investigates the effects on the countries that join the European Union and their exports, imports and capital account performances vis-à-vis their European partners as well as the world economy. The study details the Eurozone trade with the world and describes the consequences of the financial crisis on the European Union.

2. Literature review The theory of an economic monetary union was advanced as early as 1961 by Mundell with his classic paper “The Theory of Optimum Currency Areas”, and subsequently by McKinnon (1963) and Kenen (1969). Mundell defined optimum currency area as a geographical unit closely integrated through international trade and factor movements such as labor and capital, and his theory states that fixed exchange rate systems are most appropriate for these areas. Mundell recognized the costs of adopting a single currency and made the case for the establishment of a common fiscal authority to facilitate the transfer of resources between members hit by asymmetric economic shocks when mechanisms such as the wage and price flexibility and labor mobility did not function. These authors demonstrated that the choice of exchange-rate regime should de4

European Union = economic and political union: Austria, Belgium, Bulgaria, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom. 5 Eurozone = Euro Area = Euroland = Monetary Union under the euro: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. 32

The Euro Reconsidered

pend on a country’s structural characteristics, such as size, openness, and product diversification. In other words, the respective cases for either floating or fixed-exchange rates (or an intermediate regime) are not equally applicable to all economies, so that the exchange-rate regime that a particular country chooses may matter a great deal for macroeconomic performance. Historical comparison of past fiscal unions reveals telling similarities about their formation that can currently also be applied to the Eurozone. In the case of the United States, Argentina, and Germany, the fiscal unions were preceded by political ones, and the institutional development associated with fiscal union was preceded by exceptional events (Bordo, James, 2010: 58). Friedman set-forth the basic core of what subsequently emerged as optimum-currencyarea analysis. Friedman clearly understood that, in an imperfect world, separate currencies and flexible exchange rates among different areas would facilitate adjustment among the areas (Friedman, 1952b). Examining the various criteria, including the presence of asymmetric shocks, labor mobility, wage and price flexibility, and current risk sharing mechanisms, as they pertain to the European Union, there is empirical evidence to support the establishment of a supplementary fiscal union (Bordo, James, 2010: 55). Authors, Lerner (1947), Friedman (1953b), Meade (1951), and Scitovsky (1958) anticipated the basic tenets of optimum-currency-area analysis. In analyzing the effectiveness of inter-regional adjustment within countries, those authors drew attention to the crucial role played by single, central monetary and fiscal authorities and the free movement of goods and factors of production among regions in economic adjustment. Cesarano (2006: 726) argued that the above-mentioned authors believed that the classical adjustment mechanism would be effective in the absence of exchange-rate variations among separate, national currencies. In other words, the free movement of labor, capital and goods, and a single monetary policy would negate the need of exchange-rate variations; the logical extension of this line of reasoning is that a single currency would be optimal for the global economy.

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Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

3. Disadvantages of joining the Eurozone: focus on Poland Being outside of the Eurozone, Poland has not experienced the most serious fiscal crisis. While Poland does not play the most prominent role in the European Union (EU), representatives of Polish financial institutions and business circles actively participated in drafting proposals to improve the economic condition of the European Union and offer solutions for prevention of future crises. The task, however, is not an easy one. First, the EU itself is not uniform; its member states feature diverse stages of economic, financial, social and political development, which is reflected in the goals each pursues. Individual member states offer different visions concerning the direction that the European Union should follow. Some of them emphasize the need for more independence for its individual member states, while others are keen on further integrating the EU. Poland, making it clear that it does not act in only its national self-interest, acknowledged the need to consider the interests of the entire EU. Poland recognizes that the proposals of the largest member states of the EU to overcome the crisis are realistic. Currently there is an agreement among Polish economists that although economic sovereignty is costly, Poland benefited from remaining outside the Eurozone. The country applied the fundamental tools of monetary policy (money supply, interest rates, cash reserve, exchange rate) with relative freedom throughout the global financial crisis. Mundell (2011) claims that the loss of control over such tools is the main cost of joining the Eurozone. By participating in a monetary union, a country is essentially forfeiting its right to determine how much its currency is worth. Unfortunately for that country, it also means that without the ability to exercise its own monetary policy, it loses the power to impose inflation to its advantage, namely to decrease public debt. Such practices were used by France in the 1920s to wipe away 70% of its public debt. Professor Adam Szyszka of the Warsaw School of Economics believes that the loss of this freedom over currency leads to a much higher risk of default in the euro countries over non-euro countries (Szyszka, 2012). He states that a country can always increase its money supply in order to repay its debt as long as this debt is in its own national currency. This practice can lead to 34

The Euro Reconsidered

currency depreciation and inflation, although the problem of debt would be solved. On the other hand, a united common currency may also be seen as an advantage. A stable exchange rate means less uncertainty about how much the currency will be worth, making it a more appealing investment. Currency control, however, is not the only thing a nation needs to give up upon joining the Eurozone. European countries must also comply with other conditions, such as keeping up with their national debt and expenditures while creating a competitive job market, as well as increasing overall productivity (conditions which several countries, such as Greece, failed to comply with and are now on a verge of defaulting). The cost of joining the euro is actually very high. Great Britain for example, experienced “The Black Wednesday” losing £3.3 billion as a result of its efforts to join ERM. Despite the fact that it was later announced that Great Britain decided to abandon its efforts to join the ERM, the losses could not be recovered. On the other hand, looking at the current events, member states were placed under too much pressure to join the Eurozone. Many countries considered their Eurozone membership as a sign of prestige and were more likely to spend more than they could afford. They assumed that default was less likely since the effect would be too serious for other European countries. Greece for example, did not show enough effort to reform its economy. Unlike its European counterparts, Greece could not create more jobs. Government expenditure which is not balanced with investment and economic growth became a huge problem. It took its toll in 2010 and now the same scenario was happening once again only this time with economic reform, which Greece failed to make in the past, despite its promises. Greece must now cut its expenditures to balance its budget and cover its debt. But this time, many creditor countries must also pay to salvage what is left in order to avoid default in Greece. Eurozone members have to take the fall and save other Eurozone members so they can all survive, otherwise they will all fail. They must work in-sync and increase their growth rate or it will be impossible for the euro to maintain its stability. Szyszka believes that crises such as the one occurring in Greece could have been avoided, had they strictly adhered to the criteria of the Maastricht Treaty. One criterion states that the ratio of annual government debt to GDP must not exceed 3%. Another criterion states that the ratio of gross government debt to GDP must not exceed 60%. Had Greece been forced to comply with 35

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

such requirements, it may not have even joined the euro in the first place. However, a clause in the Treaty permits a country to join as long as its violation of the criteria is only temporary, and the country is showing signs of improvement. This exception to the rule became the norm as time went on. By 2010, the average debt to GDP ratio in the Eurozone was 85.5%, and the average deficit was 6.3%.

4. Advantages of joining the Eurozone Nevertheless, being a member of the Eurozone increases a country’s reliability, enhancing a country’s investment grade and improving its prospects for foreign capital inflow. Other benefits stem from the fact that being a part of a monetary union lends itself to greater efficiency. For example, the Eurozone experiences lower interest rates with less fluctuation in times of distress relative to other regions, because it is in less danger of inflation. Figures 1 and 2 display the Euro Area interest rate and Harmonized Index of Consumer Prices (HICP), inflation rate. Figure 1: Euro Area Interest Rate, Official Deposit Rate 1999-2009

Source: Central Bank Interest Rates-Annual Data. (2012, January). ECB Statistical Data Warehouse. Accessed: 26.02.2012, http://sdw.ecb.europa.eu/home.do.

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Within the EU, there are reduced transaction costs on trade because they are under a common currency (Mundell, 2011). These factors enable faster convergence of the Polish economy to that of the leading Western countries within the Eurozone. It is quite obvious that it will take reliable and extensive economic and financial analysis to evaluate the pros and cons of Poland’s current standing outside the Eurozone. However, in the long run, the necessity of Poland’s Eurozone membership is indisputable, with the only question being when. Belonging to the group of countries using the common European currency is the best anchor for a national economy. Figure 2: Euro Area Inflation Rates 1997-2011. Harmonized Index of Consumer Prices

Source: “Euro Area HICP Statistics” (2012, January). ECB Statistical Data Warehouse. Accessed: 26.02.2012, http://sdw.ecb.europa.eu/home.do.

5. The EU today Currently, ten out of 27 European Union member states remain outside the Eurozone. Then, among seventeen Eurozone countries, there are the core countries that are net payers proposing changes in the principles regulating the way the Eurozone operates. These core countries have implemented rescue packages for the indebted countries. Germany and France are those mentioned 37

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

most often as core states, although some analysts include more countries in the group. Another group of Eurozone members consists of the peripheral countries, referred to as “PIGS” – an acronym for Portugal, Ireland, Greece and Spain, with Italy sometimes added. Their present problem is mainly that they are all in substantial sovereign debt, posing threat to the survivability of the banking system worldwide. Figures 3-5 presents the data for the indebtedness of selected Eurozone countries from 2003-2010 in comparison to the United States and the United Kingdom, in billions of U.S. dollars. Figure 3: Debt as Percent of GDP in Year 2003

Source: OECD (2011), “Total Central Government Debt”, Finance and Investment: Key Tables from OECD, No. 1. Accessed on Feb, 15, 2012.

Figure 4: Debt as Percent of GDP in Year 2006

Source: OECD (2011), “Total Central Government Debt”, Finance and Investment: Key Tables from OECD, No. 1. Accessed: 15.02. 2012. 38

The Euro Reconsidered Figure 5: Debt as Percent of GDP in Year 2010

Source: OECD (2011), “Total Central Government Debt”, Finance and Investment: Key Tables from OECD, No. 1. Accessed: 15.02.2012.

6. The Eurozone debt Figure 6 demonstrates that debt continues to constitute a serious problem in the Eurozone. Such indebtedness is worrisome since these countries were obliged, on their accession to the Eurozone, to satisfy the Maastricht criteria, also known as the convergence criteria. These requirements, as previously stated, include a low inflation and interest rate, a stable exchange rate, and the satisfaction of fiscal criteria based on low budget deficits and public indebtedness. Discussion of the negotiations behind the Maastricht Treaty and the associated convergence criteria can be found in Kenen’s 1995 book, Economic and Monetary Union in Europe. These criteria were met, with much effort, by most countries before their accession to the European Union. This was challenging because many of the countries were rooted in a tradition of high inflation and interest rates, large budget deficit, and public debt. Certain balance sheet and budget-related items were “fine-tuned” during the period of adaptation by using some “innovative” accounting procedures. For example, current expenditures were accounted as future ones while future incomes were recorded as current outlays. 39

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove Figure 6: Euro Area Debt as Percentage of GDP

Source: Central Bank Debt. (n.d.). European Central Bank Statistical Warehouse. Accessed: 26.02.2012, http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=121.GST.A.I6.N.B0X13.MDO.B1300.SA.G.

However, exceptions were made for countries such as Italy, who could not satisfy the Maastricht criteria related to its debt to GDP ratio, but was allowed in because of the importance of its economy. The debt to GDP ratio criteria was not an obstacle for Poland who already had a law similar to the Maastricht criteria prohibiting debt to GDP to exceed 60% prior to joining the European Union (Mundell, 2011). The push to fulfill the criteria is further examined in Obstfeld’s 1997 paper, “Europe’s Gamble”. The accession was followed by a “Euro-banquet.” There was a marked increase in consumption and investment. The period of adaptation required sacrifice, and these peripheral countries believed they earned the right to indulge. They increased both consumption and investment. Szyszka points out that the peripheral “PIIGS” countries in particular significantly increased their consumption and decreased savings after joining the Eurozone. Such behavior can be justified if productivity is also experiencing a comparable growth rate. From 1990-2007, private sector savings in the peripheral countries dropped from 24% to 14%. However, unit labor costs saw an increase of 32%. Szyszka concludes that this led to a large gap between savings and consumption that contributed to the development of the sovereign debt crisis in the Eurozone. 40

The Euro Reconsidered

7. Admission to the Eurozone Figures 7-9 mark the consistent growth in Gross Domestic Product for the various countries after their admission to the Eurozone. Figure 7: GDP Growth from 1960-2010 for Selected Countries

Figure 8: GDP Growth from 1960-2010 for Selected Countries

41

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove Figure 9: GDP Growth from 1960-2010 for Selected Countries

Source: Gross Domestic Product: Various Countries, The World Bank, World Development Indicators. Last cited: 24 Jan. 2012. Web. 2 Feb. 2012.

The relatively low interest rates in the European Union gave these countries many opportunities for growth. This mindset was largely shared by banks, which were simultaneously giving credits to private sector customers and acquiring government-issued securities from countries, such as Greece, Ireland, Portugal and Spain. In both cases, recent satisfaction of the Maastricht criterion bestowed a certification of reliability upon these countries, creating an impression that they had made fiscally solid choices. This belief included the public institutions and private sectors. Banks, fundamentally concerned with maximizing profit for a given risk, were interested in giving credits and in acquiring more profitable (i.e., bearing higher interest) government securities from peripheral countries. In effect, there was both a credit and investment boom throughout the entire European Union. The level of credits in the PIGS countries increased, over the years 2003-2009, to between 170% in Portugal and as much as 350% in Ireland. Growth of GDP followed, in some cases even exceeding the so-called potential growth resulting from the level of productive factors. This was accompanied by a rising inflation rate and by appreciation of the euro exchange rate6. 6 Euro/ECU Exchange Rates- Monthly Data (Rep.). (2012, February 22). Accessed: 27.02.2012, Eurostat website: http://epp.eurostat.ec.europa.eu/portal/page/portal/exchange_rates/data/database.

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The Euro Reconsidered

8. The financial crisis and the EU In the financial sphere, prices of financial assets, housing, and land increased. Payment gridlocks resulted, and many businesses lost their financial liquidity. Problems arose as a result of the insolvency of business entities and even of governments. Despite these issues, the EU member states and even the group of peripheral countries are not to be blamed for the problems they experienced. The United States was the principal source of the financial crisis. The crisis stemmed from the financialization of the American economy and the creation of toxic financial assets, which ended up losing much of their value and creating a lack of trust in the financial markets. Many of these toxic assets were held by European commercial banks which had trusted American financial institutions. Therefore, many of the problems experienced by the EU, including difficulty with liability repayment, are the result of American actions. Early solutions to the crisis, proposing that European banks should be allowed to fail if they could not repay their debts, also came from America. The American point of view regarding the crisis in the Eurozone is biased because it is rooted in the opinion that, from its conception, the monetary union in Europe had a very poor chance of success. The Nobel Prize economist Joseph Stiglitz (2010) observes that “it is going to be extremely difficult now to return from scrambled eggs back to intact ones”. According to Stiglitz (2010), the Eurozone is never going to return to its previous state, and he questions whether the cost of rescuing the Eurozone will be greater than just ending the whole experiment. However, it seems reasonable to maintain a more reserved attitude than Stiglitz (2010) towards the potential disintegration of the Eurozone. More than once, the Eurozone has managed to overcome crises and emerge as a stronger entity. This may be the result of the present crisis. Nevertheless, a number of questions emerge. The creditors of indebted companies and countries are mainly banks and financial institutions based in France, Germany, the Netherlands and other countries (see Table 1). As a result, the collapse of institutions in the PIGS countries would also bankrupt a substantial part of the German, French, Dutch, Austrian and Benelux economies.

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The countries thus have a common interest, a factor that necessitates implementation of a mutually beneficial rescue or emergency plan. Resources need to be found to bailout the PIGS countries. The task is difficult and, in most core countries, controversial. Balcerowicz (2012) believes that massive purchases of government bonds by the European Central Bank would be an even worse kind of bailout. It would exacerbate the problem of moral hazard as such purchases are potentially unlimited, and would also increase the risk of inflation along with other negative economic consequences. More generally, trust in the European Central Bank as guardian of the euro’s stability could be undermined, and the European Central Bank would be granted a powerful new political position with politicians attempting to influence its purchase decisions. It would also further undermine the rule of law in the EU at a time when confidence in the way the treaties are respected is so crucial. Balcerowicz (2012) believes that the main solution to the Eurozone crisis lies in properly structured reforms in the affected countries, and believes that experience clearly shows us that such reforms offer both a short-term and long-term solutions. Statistics suggest that such an aid-intervention would require a contribution of at least one trillion euro. This is an enormous sum, extremely difficult to bear for the budget of even the entire European Union. The burden of the operation has mainly been borne by France, Germany, and the Benelux countries, while those standing in line to benefit from financial support include Spain and, probably, Italy. However, there is a limit of taxpayer tolerance in the countries in charge of bailing out the failing euro economies. Table 1: Exposition of financial assets of PIGS countries in balance sheets of banks from selected countries (US$ billions) Entities German banks

512.7

French banks

410.2

Spanish banks

117.3

Italian banks Total Eurozone Source: BIS, 2010.

44

US$ billions

73.3 1397.6

The Euro Reconsidered

Data presented in Table 1 indicate that it is appropriate for countries shouldered with the bailout burden to demand the balance of the debt alongside explanations for its emergence. The core governments are also at least partially to blame. After all, once the Eurozone was established and demand for credits and capital skyrocketed in the PIGS countries, the core countries failed to implement the necessary supervision or coordination of the economic policies of the PIGS countries. In fact, the core countries seemed to overlook the high economic and financial risk of Portugal, Ireland, Greece, and Spain. Worse yet, Berlin, Paris and Brussels turned a blind eye toward the authorities of Greece, Ireland and Portugal as they “tuned up” their balances and official statistics, even at the stage of their accession to the European Union. At the same time, one has to remember that the EU was mainly a political project. Otherwise, Greece and the other countries would have had to wait longer before becoming a part of the common European currency. Mundell (2011), like many others, holds that the prestige of being in the Eurozone can provide additional motivation for countries such as Greece to overlook problems in their spending. For example, they hiked pension plan expenditures to the level of Germany, regardless that their per capita income was only ⅓ of Germany’s. Joining the Eurozone exponentially increased the moral hazard of Greece because it rationalized that the Eurozone community would never let Greece fail. In essence, countries can fall into the trap of going on a “fiscal binge”, as Mundell puts it, because they assume that their expenses can never exceed the massive budget of the Eurozone. Currently, the EU contains many different economic traditions and policies. There are many who live by the mantra: “first we work, then we save, and then we invest”. Conversely, there are those who say “first we’ll consume, then we’ll invest what is left, if any, and in case something still remains, we’ll save it”. Two very different worlds are trying to exist alongside each other. Consequences of aggressive real estate investments made by investors from the PIGS countries are also felt in Poland. Some of them purchased land, factories and buildings under the assumption that prices would go up because Poland, along with other Central and Eastern European countries, became a European Union member state. They hoped to capitalize on the principle of price equalization, according to which assets would increase about twenty percent. 45

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

The idea was to take credit in the Eurozone-based banks which bore interest rates of a few percent and invest in assets whose rates of return seemed substantially higher. The idea was sound in theory, but reality deviated from the hypothesized course. The financial crisis born in the real estate markets in the United States had repercussions in the EU. The crisis caused prices in real estate markets to fall, severely limiting chances to achieve expected rates of return on investments. In consequence, a large number of businesses in PIGS countries experienced problems with their liquidity and solvency. What is the remedy to this situation? Does the Eurozone have any real chances of survival and further growth? Does the euro have any chance to continue as an international currency? These questions cannot easily be answered. Proposed solutions are numerous and often contradictory. In an attempt to find a solution to the crisis, it must be recalled that the foundation of the Eurozone was based on political as well as economic motives. These political motives included, among others, the will to deepen integration within the European Union, a goal considered achievable only with the adoption of a single common currency. The second political motive was Europe’s intent to improve the stabilization of the global financial system, hitherto based upon only the dollar. The Asian crisis of late 1990s revealed a number of weaknesses in the dollar based global financial system. In order to prevent a calamitous collapse, it seemed appropriate to propose a financial system based upon another international currency in addition to the US Dollar. A third political motive for the creation of the Eurozone was the wish to weaken West German currency, the Deutsche Mark, and to control the strong, united German state. Paradoxically, Germany favored the idea of the common currency in the expectation that it would be weaker than the Deutsche Mark. Germany hoped that the adoption of the euro would improve the state’s competitiveness following the burden of the unification process, aggravated by the introduction of a strong national currency. The Eurozone deepened the processes of integration in the European Union and stabilized the global financial system. For the first dozen years, the euro was a solid and stable currency, with the most stable prices in fifty years. The average inflation in Euroland amounted, over the last 12 years, to c. 1.97% and the average level of inflation in Germany to c. 1.5%. Budgetary deficit (on average) at the end of 2011 was at around 4.5%, while budgetary deficit ex46

The Euro Reconsidered

ceeded 10% in both the United States and Japan. Sure enough, not all of the Eurozone countries fared equally well, but it cannot be said that the Eurozone as a whole fared poorly. We can conclude from the data presented that the Eurozone is not homogeneous concerning financial and, in particular, fiscal, policy. This diversification gives rise to policy divergence regarding proposals to remedy the present situation and prevent a similar situation in the future.

9. The Eurozone’s scenarios According to P. Krugman (2011), there are four scenarios for overcoming the present state of affairs in the Eurozone. While theoretically possible, they are practically difficult to implement in their pure form. Scenario one recommends applying a restrictive financial and, in particular, fiscal policy to the Eurozone, especially fiscal policy. This would consist of strict control of budgetary expenditure, cuts in budgetary outlays, and, where practicable, an increase in budget income. Considering that the troubles in Europe are not part of a currency or monetary crisis (the euro exchange rate has been appreciating against US Dollar since about third quarter of 2001, and businesses keep more and more euro as foreign currency reserves – at present close to 30%), but a crisis of economic policy, such ideas are hardly surprising. Budgetary restrictions or discipline in the field of public debt seem obvious remedies. However, stern fiscal policy means that something has to be taken away from somebody. From whom, then, and where? Budgetary cuts would mainly target three areas: education, health care and pension funds. In addition, it would be necessary to increase taxes and cut wage rates in the public sector. The experience in Greece shows how practically difficult this is. The Greek riots were only a little shy of letting the monuments of Athens go up in flames. On the other hand, historical perspective provides examples of successful implementation of restrictive fiscal policy. Several years ago restrictive financial policy was applied in Baltic countries with considerable success. Budgetary and public debts were reduced, exchange rates of local currencies were

47

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stabilized, and inflation was decreased. Economies of the region stabilized enough to allow Estonia to meet the Maastricht criteria and become a part of the Eurozone. This example demonstrates that a policy of compulsory savings is not necessarily doomed to failure. Scenario two involves the restructuring of the debt. Debt restructuring would reduce all of the debts of the PIGS countries and their indebted entities. This program is already underway in Greece. The restructuring program is implemented basing on the assumption that the debt weighs down upon both debtors and creditors, since both were initially over-optimistic in borrowing money and giving credits. Problematically, this prompts other countries and businesses to demand debt restructuring. While, formally, they might not belong in the Eurozone, their trade exchange with the Eurozone accounts for such a significant share that they hope to be regarded as part of it. Of course, it is impossible to satisfy the demands of all interested. Consequently, this second scenario also has little chance of success, even though it cannot be totally ruled out. Scenario three is referred to as the “Argentinization of Europe”, initiating changes similar to the policies in Argentina just over a dozen years ago. The Argentinian peso was devalued with respect to the US Dollar in order to improve the competitiveness of Argentina’s economy, stimulating business activity and increasing income to the state budget. Is this scenario relevant to the European Union? In our opinion, it is not practicable. Recalling the political motive for the establishment of the Eurozone, one must realize the importance of the euro and the Eurozone as stabilizing forces in the global economy, due to the possibilities of investing financial assets either in the US Dollar or in the euro. As a result, devaluating the euro would not only mean destabilization of the Eurozone, but also destabilization of global finance and global politics. Devaluation of the euro is even more incomprehensible given that, as mentioned before, the problems in the Eurozone are not a currency crisis. Additionally, there are still stable countries in the Eurozone despite the strong currency. The German economy was the best example, up until the recent news that it failed to sell its ten-years bonds out (just 40 per cent of the issue was sold). The economy of Germany is not totally immune to the unstable financial markets, and the same goes for the Benelux countries and France. Still, the risk inherent in devaluation scenario is excessive, and the costs of launching the policy could be extreme. 48

The Euro Reconsidered

Scenario four, known as “Europe’s Resurrection”, is based on the assumption that the states of Europe must return to a community-wise manner of thinking, a viewpoint of solidarity. The individual states succumb to nationalist and individualistic tendencies. Sooner or later, Europe is going to have to face the vital question of whether to evolve as a confederation or a federation. This will take profound political changes. Adequate institutions will have to be instated to take responsibility for the supervision and coordination of the economic and fiscal policy of the European Union member states. It is quite unlikely, however, that all countries will behave with equal decency and truly care for stabilization of the European Union through responsible fiscal and social policy. Therefore, it might be advisable to consider a common governance institution, such as an Agency of European Finance. The operations of such an agency or ministry are debatable. Should an agreement be reached between all countries interested in a coordination of budgetary policy at the level of their national parliaments? Can an agreement be made about a new regulative institution at this level? Present dilemmas, such as apprehension over the restriction of state sovereignty, would be multiplied. This confronts us with the pivotal question: which Europe do we want? Do we want to have a single strong European government or separate national governments? The essence of the problem is in the implementation of a German-French concept concerning fiscal union. Such a fiscal union would effectively mean that a certain part of budgetary policy would be transferred from the national onto the community level. Put another way, this would entail giving up narrowly perceived national interests. It seems worthwhile to adduce the example of America in this context. The United States are engineered so that, should Alabama, California, or Mississippi face serious hardship while Washington, New Jersey or another state fare fine, federal taxes are sent to Washington D.C. and subsequently sent to the states most badly in need. America thus reveals a strong tradition of solidarity. However, in Europe there is no consensus about the need to build the Union based upon solidarity transfers. On the contrary, net payers view this proposal out of the question. In addition, it is unclear how the hypothetical Fiscal Agency would operate. The Agency could not completely overshadow national parliaments on areas such as the state budget, but then its strength would be largely diluted. These are the doubts and dilemmas that will plague this at49

Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

tempted solution unless a concept with appropriate legal and administrative formula is adopted. This leaves us with scenario five, that Krugman (2011) did not address, which is perhaps even more illusory but should nonetheless be taken into account. Many countries have substantial reserves in foreign currencies, including China and some Islamic countries. The Chinese have proposed opening European borders so that they can buy out European debt and help manage it. Such a solution would drastically alter the global economic landscape and the distribution of relative economic power. With the West in its weakened state, new power would be distributed among China, India, perhaps also Brazil and South Africa, resulting in far reaching repercussions. In response to the question about the future of the euro, it is not the time to plan its demise. First, in spite of the present problems in Euroland, the condition of the euro is quite good. The euro is going to survive even if Greece or Portugal decides to leave the Eurozone, a highly implausible prospect. As long as there are core countries interested in strengthening, consolidating and developing the euro, it will exist. The current situation demonstrates that the core countries are still concerned about it: 1. the Eurozone ensures states’ access to large and wealthy sales markets; 2.

the Eurozone ensures economic, financial and political stabilization, both in Europe and worldwide;

3.

membership in the Eurozone, all things said and done, conveys an indisputable prestige upon members;

4.

quitting the Eurozone would cause a great deal of economic, financial, and social turbulence in the deserting country as well as the Eurozone. For example, should Greece leave, its new currency would greatly be devaluated. This would further deteriorate the living standard in Greece, decrease the import of goods and services from other Eurozone countries, and worsen economic condition of exporting countries. No party to the game is thus interested in the Eurozone disintegration.

Aside from Krugman, many other economists also agree that the austerity measure applied today in the Eurozone is actually the best solution. As the dominant economic power in Europe, Germany also had its history of heavy inflation and stagnation.

50

The Euro Reconsidered Figure 10: Germany: Annual GDP Growth (%)

Source: German Growth Will Remain Sub-optimal, Forbes.com, May 2006. Oxford Analytic.

The austerity measure proposed by Germany today is not that different from what they have applied in the past. Germany tightened its budget, and tried to pass local laws to improve business competitiveness. Germany also changed their unemployment benefit system to promote productivity. The new system discouraged workers from retiring early, and encouraged some of the workers in the labor force to take low paying jobs. This effort cut the expense of unemployment benefits and reduced the unemployment rate at the same time. It is not a win-win solution, but in the end, more people are able to get jobs, pay taxes and contribute to GDP. The belt tightening measure also helped Germany avoid the housing bubble problem. Their government required a 40% down payment for every house mortgage. The German government also saved money from the taxes collected while improving the efficiency of government offices and passing regulations to increase productivity. Germany invested more in education from the money they saved. The bottom line is: Germany did it from both sides, demand and supply. Today, Germany can enjoy the fruits of their labor by showing economic growth despite the crisis all over the world. Learning from their own history, Germany is now pushing Greece to do the same.

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Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove

From this point of view, saving the Eurozone is not going to be an instant measure. What is happening in Greece is a result of long-term excessive expenditure and decline in growth. Paul Krugman (2011) suggested killing the euro, but despite this, Germany and other euro economy owners are trying to save it by applying a long-term solution. Greece will default if they don’t get a bailout, but the effect is bigger than just Greece. If Greece isn’t saved, and Spain and Italy end up defaulting as well, Germany itself will be hit with a bigger recession (or even fail). At this point, no remedy is good for everybody. Whether it’s the shortterm solutions proposed by Krugman or long-term solutions proposed by Germany and France, the euro will surely suffer for the next few years. Until innovation and productivity in the Eurozone are restored, the European countries will remain non-competitive and stagnant.

10. Conclusion The European Commission and the European Parliament are also interested in the survival of the Eurozone. The establishment and operation of the Eurozone has strengthened these institutions by lending additional legitimacy to their existence and development. Finally, the United States is interested in maintenance of the Eurozone as well. Why? The euro has become a stabilizing force in contemporary world finance. It enables the coexistence between the Eurozone and the US Dollar zone and opens prospects for further economic growth. Of course, one might be tempted to ask whether these two pillars of global economy, one based upon the US Dollar, another one upon the euro, shall suffice. Is a third one going to appear, Asian perhaps? This remains to be seen in the coming ten or fifteen years. However, the idea of replacing Adam Smith as the father of the free market economy in academic textbooks with a communist party secretary is still incomprehensible to Europeans.

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Bibliography Balcerowicz, L. (2012). “Eurozone I: Bail-outs Are no Substitute for Reforms”, Europe’s World, Spring 2012: 75-77. Bordo, M., & James, H. (2010). “A Long-Term Perspective on the Euro”, in: The Euro. The First Decade. Cambridge: Cambridge University Press. Central Bank Debt. (n.d.). European Central Bank Statistical Warehouse. Accessed: 26.02.2012, http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=121.GST.A.I6.N.B0X1. Central Bank Interest Rates-Annual Data. (2012, January). ECB Statistical Data Warehouse. Accessed: 26.02.2012, http://sdw.ecb.europa.eu/home.do. De Grauwe, P., & Mongelli, F. P. (2005). Endogeneities of Optimum Currency Areas: What Brings, Countries Sharing a Common Currency Closer Together?, (ECB Research Paper Series – Working Papers) (Germany, European Central Bank). Frankfurt. Accessed: 29.01.2012, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=691864. De Grauwe, P. (2009). Economics of Monetary Union. Oxford: Oxford University Press. Dellas H., Tavlas G. S. (2009, September). An Optimum-Currency-Area Odyssey. Accessed: 28.02.2012, http://www.bankofgreece.gr/BogEkdoseis/Paper2009102.pdf. Euro Area HICP Statistics. (2012, January). ECB Statistical Data Warehouse. Accessed: 26.02.2012, http://sdw.ecb.europa.eu/home.do. Euro/ECU Exchange Rates – Monthly Data (Rep.). (2012, February 22). Accessed: 27.02.2012, Eurostat website: http://epp.eurostat.ec.europa.eu/portal/page/portal/exchange_rates/data/database. Eurostat: Your Key to European Statistics. (n.d.). Accessed: 29.01.2012, http://epp.eurostat.ec.europa.eu/portal/page/portal/eurostat/home/. Gross Domestic Product: Various Countries (2012). The World Bank, World Development, Indicators. Last cited: 24 Jan. 2012. Web. 2 Feb. Kenen, P. B. (1969). “The Theory of Optimum Currency Areas: An Eclectic View”, in: R. Mundell and A. Swoboda (eds.), Monetary Problems of the International Economy, University of Chicago Press: 41-61; reprinted in: Exchange Rates and the Monetary System: Selected Essays of Peter B. Kenen, Aldershot: Edward Elgar (1994): 3-22. Kenen, P. B. (1995). Economic and Monetary Union in Europe: Moving beyond Maastricht. Cambridge England: Cambridge University Press. Krugman, P. (2011, January 12). “Can Europe Be Saved?”, New York Times Magazine. Accessed: 26.02.2012, http://www.nytimes.com/2011/01/16/magazine/16Europe-t.html?pagewanted=all. McKinnon, R. (1963). “Optimum Currency Areas”, American Economic Review, 53: 717-24. Mundell, R. (2011). “The European Fiscal Reform and the Plight of the Euro”, Poznan University of Economics Review, 1st ed. Vol. 11: 7-22.

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Alojzy Z. Nowak, Kazimierz Ryć, Yochanan Shachmurove Mundell, R. A. (1961). “A Theory of Optimum Currency Areas”. American Economic Review, 51(4), 657-65. Accessed: 29.01.2012, http://links.jstor.org/sici?sici=0002-8282%28196109%2951%3A4%3C657%3AATOOCA%3E2.0.CO%3B2-V. Nowak, A. Z., Stępniak, A. (2003). Strefa euro – wyzwanie dla Polski. Warszawa: Wydawnictwo Naukowe Wydziału Zarządzania Uniwersytetu Warszawskiego. Nowak, A. Z., Tchorek, G. (2007). European Economic Integration: Chances and Challenges. Warszawa: Wydawnictwo Naukowe Wydziału Zarządzania Uniwersytetu Warszawskiego. Obstfeld, M. (1997). Europe’s Gamble, Brookings Papers on Economic Activity, 2: 241-317. Ryć, K. (2006). “Jak szybko do euro?”, in: Zrównoważony wzrost gospodarczy: Rola polityki finansowej: Polska droga do euro. Warszawa: Wydawnictwo Naukowe Wydziału Zarządzania Uniwersytetu Warszawskiego. Stiglitz, J. E. (2010, May 5). Can the Euro be Saved? Project Syndicate. Accessed: 29.01.2012, http://www.project-syndicate.org/commentary/stiglitz125/English. Szyszka, A. (2012, March). Economic and Behavioral Aspects of the Euro Crisis. Accessed: 2.04.2012, http://www.case-research.eu/sites/default/files/Economic%20and%20Behavioral%20Aspects%20of%20the%20Euro%20Crisis.pdf.

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SOCIAL POLICY IN BRAZIL – ECONOMIC IMPLICATION AND CHALLENGES

Alexis Toríbio Dantas1

Abstract: Brazil’s economic policy is still being conducted, broadly speaking, on an orthodox basis. Nevertheless, one can see many important changes in social fields. Programs of income transfer like Bolsa Família, the continuous increase of the real minimum wage, and the recent growth of GDP, especially based on the increase of internal demand at least until 2011, resulted in a much better income distribution and the rapid decline in extreme poverty in Brazil. As a challenge, however, there is currently an important debate about the level and expected path of the overvalued exchange rate and its implications for the growth of imports and the evolution of exports, which could cause deindustrialization in Brazil. Keywords: social policy, income distribution, Brazil.

1

Alexis Toríbio Dantas – PhD in Economics, Associate Professor, Faculty of Economic Sciences, Rio de Janeiro State University, Coordinator of the NUCLEAS, e-mail: [email protected]. 55

Alexis Toríbio Dantas

1. Introduction The basis of Brazilian economic policy has experienced few changes since the external crisis of January 1999, and it is still supported on three pillars. The first one, directly resulting from the balance of payments crisis, the adoption of a floating exchange-rate regime, due to the impossibility of continuing the exchange rate regime, which became a nominal anchor to support the Real Plan since 1994. Second, the monetary policy to stabilize prices as substitute for that nominal anchor was based on the inflation targeting mechanism system: characterized by the official announcement of a target for any price index chosen a priori for a given period, and the recognition that price control is the primary goal of monetary policy. Thus, these goals would coordinate the formation of inflationary expectations of economic agents and the fixing mechanism of prices and wages (Ferreira, Jayme Junior, 2005: 2).

Third, and closely related to this monetary policy choice, an austere fiscal policy defining what levels of primary surplus to cushion the potential explosive effect of government debt in a context of high interest rates, much higher than the growth rate of GDP. In this case, the goal was to offset the financial costs of government debt with a positive balance in spending and revenue streams, avoiding an uncontrolled growth of the operating budget deficit. Fiscal policy therefore operates as an adjustment variable, given the role of the interest rate as a stabilizing mechanism. Regarding the question of economic growth, the combination of inflation targeting and austere fiscal policy would, according to the basis of the model adopted and the economic stability required, provide economic agents with a favorable scenario through investment decisions. The ability to raise growth rates would increase factor productivity under conditions of free market mechanisms, leaving relative prices to act as a stable mechanism in order to create a favorable environment to stimulate competition in the economy (and, in particular, foreign competition). However, the end of the first term of President Luis Inácio Lula da Silva’s office was characterized by important changes, especially in the direction of economic policy. In this case, it was based on three aspects:

56

Social Policy in Brazil…

(a)

expansion at an accelerated pace of social policies already in progress, particularly the income transfer programs (and especially the family allowance program – “Programa Bolsa Família”);

(b)

a systematic increase in real minimum wage, especially after 2003;

(c)

expansion of public investment programs in infrastructure, expecting favorable effects on the level of economic activity, implementing the Program to Accelerate the Growth (Programa de Aceleração do Crescimento – PAC).

In the next two sections, we discuss the main impacts of these changes in the course of economic and social policy in Brazil in its recent evolution. In the last section we analyze the key lessons and conclusions about the new scenario and a possible future agenda of concerns in this direction.

2. Evolution of income transfer programs and the real minimum wage in Brazil: main effects (a)

(b)

With regard to the family allowance program, one can highlight that: Between 2004 and 2012 the program expanded the number of beneficiaries of about 7 million to about 14 million (with approximately 50 million Brazilians effectively included directly or indirectly) – Figure 1; The volume of income transfers increased from around US$ 3 billion to approximately US$ 20 billion in the same period without significant rising of the government expenditures as a share of GDP, still around 0.5% – Figure 1.

The minimum wage curve followed the same direction. Between January 1995 and December 2002 (the two terms of President Fernando Henrique Cardoso’s office), the growth of the real minimum wage was 42.1 % – Figure 2. On the other hand, between January 2003 and July 2010 (the period of the government of President Luiz Inácio Lula da Silva), the growth of the real minimum wage was 71.5 % – Figure 2 (this value was valid until the end of his term in January 2011) and the trend has been maintained in the early years of the Dilma Rousseff’s government. 57

Alexis Toríbio Dantas Figure 1: Evolution of Programa Bolsa Família in Brazil – 2004-2012

Source: Ministério da Fazenda/Brasil – http://www.fazenda.gov.br/divulgacao/publicacoes/economia-brasileira-em-perspectiva/brazilian_economy_outlook_eng_ed17_dec2012.pdf.

Figure 2: Real Minimum Wage – Brazil – 1994-2013

Real Minimum Wage 800 700 600 500 400 Real Minimum Wage

300 200 100 1994.01 1995.08 1997.03 1998.10 2000.05 2001.12 2003.07 2005.02 2006.09 2008.04 2009.11 2011.06 2013.01

0

Source: IPEADATA.

According to the International Labour Organization (OIT: 1): The minimum wage (MW) is a key indicator for earnings trends in Brazil. It determines the earnings of formal workers who receive the MW and of those whose earnings are expressed in multiples of the MW (called the nu-

58

Social Policy in Brazil… meracies effect) as well as for informal workers whose wages equal the MW (lighthouse effect). There is ample evidence to suggest that the MW acts as a reference indicator for job earnings. Workers and employers negotiate wages often using the MW as a reference.

Regarding the Program to Accelerate the Growth (PAC), a DIEESE technical note highlights that: The PAC reveals a government action planned in order to assume the guiding ability of the state on the issue of economic growth, by increasing the rate of public and private investment in strategic areas. Thus, the government seeks to have a prominent role in the growth process, through induction and targeting of investment at the economy. Such measures may represent a qualitative change in the role to be played by the State in Brazilian society by distancing itself from the liberal discourse of the "benefits of the free market" in the allocation of resources for investment (3).

In this sense, we can see a clear change of the government’s position as to the relative importance of fiscal policy. As a summary of the objectives of the PAC, the following aspects can be highlighted: (a)

The main point of the program is the expansion of investments – it is assumed that as a consequence of higher public investment, there will be also a strong acceleration of private investment, stimulated by the performance of state enterprises, state banks (mainly BNDES – Banco Nacional de Desenvolvimento Econômico e Social, the most important Brazilian development bank, state-owned);

(b)

The main target is infrastructure, especially roads, waterways, railways, ports, airports, sanitation, and water. Electricity (particularly hydropower), gas, and oil are also essential in the basis of the program. In the case of the latter, there is an important incentive program to increase local content in the provision of goods and services for new investments, especially for the pre-salt oil and gas exploration and production process;

(c)

It is expected that economic performance will be able to achieve a sustainable growth average rate of 5% per year in the coming years, more than double the average of the last 20 years.

In addition to a possible reduction in the primary surplus target in the fiscal policy, the expectation of lower expenditure on interest payments on do59

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mestic debt and the performance of official banks constitutes the main source of funds for implementing the program.

3. Main results Figures 3 to 6 clearly show the improvement in terms of GDP growth and income distribution in Brazil in recent years, especially from 2003-4. On the one hand, the GDP registered an important increase in the average rate of growth, contributing greatly to the reduction in the unemployment rate – which has dropped drastically from the double digits to stabilize at around 5,5% per month on average in recent years. On the other hand, the proportion of Brazilians living below the poverty line (that is, people who earn less than 1 US $ a day) fell sharply once again with strong inflection after 2003. After the fall immediately after the Real Plan in 1994, it remained stable over Fernando Henrique Cardoso’s two periods of government and then fell rapidly in the two terms of Luiz Inácio Lula da Silva. With the increase in the minimum wage, income distribution began to show a clear improvement over the period. Figure 3: GDP evolution in Brazil – 1994-2013

GDP - Brazil 800 700 600 500 400 300 200 100 0 1994.01 1995.03 1996.05 1997.07 1998.09 1999.11 2001.01 2002.03 2003.05 2004.07 2005.09 2006.11 2008.01 2009.03 2010.05 2011.07 2012.09

GDP - Brazil

Source: IPEADATA. 60

Social Policy in Brazil… Figure 4: Unemployment rate – Brazil – 2002-2013

Unemployment Rate 14 12 10 8 6

Unemployment Rate

4 2 2002.03 2003.01 2003.11 2004.09 2005.07 2006.05 2007.03 2008.01 2008.11 2009.09 2010.07 2011.05 2012.03 2013.01

0

Source: IPEADATA.

Figure 5: Extreme poverty in Brazil – 1993-2009

Source: http://muitopelocontrario.wordpress.com/2010/07/21/evolucao-da-miseria-durante-oreal/.

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Alexis Toríbio Dantas Figure 6: Expectations on extreme poverty in Brazil: 2011/13

Source: MDS/Brazil.

Figure 7: Change in the real minimum wage and income distribution (%) – Brazil – 1995-2007

Source: OIT (2008).

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Social Policy in Brazil…

4. Conclusion (a)

The Brazilian economy effectively began a trajectory of higher growth than previously observed over the last 25 years, in a situation of stability, and maintained a relatively comfortable external situation;

(b)

Socioeconomic conditions were significantly improved due to the implemented social policies that allowed at the same time reducing the number of citizens living below the poverty line and, after much time, advancing in terms of income distribution;

(c)

The basic programs that effectively alter the initial situation are clearly turning into state policies and not only a government option, losing the character of the short run policies that have dominated the scene over the past three decades;

(d)

However, there is now an important debate, since this model shows signs of exhaustion due to two main aspects. First, maintaining an exchange rate overvalued for a long time, which significantly affects the competitiveness of domestic industry, not only by higher import penetration but also by the greater difficulty of external insertion of Brazilian products. Fixing this is also a great dilemma, as it can have negative impact on the evolution of the inflationary process. Second, the significant increase of the average real wage in an overvalued exchange rate environment determines a noncompetitive ratio (wages are, on average, very high in US dollars for instance), which is unfavorable for domestic producers, once again interfering negatively with their competitiveness. These are currently the most important challenges of the adopted model.

But more than only focusing on the over-valued exchange rate, the problem of productivity includes long term issues, among them necessary changes in terms of industrial policy. According to Rhys and Barbosa (2012: 81): Measures are required to make Brazilian manufacturers more competitive both at home and abroad. One focus of attention here must be the real exchange rate which has appreciated strongly vis-à-vis both the US dollar and the Chinese RMB since 2003. While this partly reflects the high level of commodity prices for goods that Brazil exports, steps need to be taken to moderate the appreciation of the Real if Brazilian manufacturers are to compete. Brazilian industry also needs to become more competitive through in-

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Alexis Toríbio Dantas creases in productivity, which has grown slowly in recent years. This requires an active industrial policy focused on promoting technological change and improving skill levels. It needs to seek more access to other Latin American markets, where it is losing ground relative to China. In order to do that, traditional free trade mechanisms are not sufficient. Brazil may take the lead in promoting new regional integration schemes, showing that real advantages can come about for its Latin American partners, enabling them to develop some sectors of their manufacturing industry.

Bibliography Belluzo, L. G. M., Almeida, J. G. (2002). Depois da queda, Rio de Janeiro, RJ: Civilização Brasileira. Bresser-Pereira, L. C. (2008). “The Dutch Disease and Its Neutralization: a Ricardian Approach”, Revista de Economia Política, São Paulo, Marzo, Vol. 28, No. 1. Dantas, A. T. (1998). “Neoliberalismo e globalização”, Revista Archè, # 20, Out.: 183-194. DIEESE (2007). “Principais Aspectos do Programa de Aceleração do Crescimento”, Nota Técnica, No. 41, Janeiro, http://www.adur-rj.org.br/4poli/documentos/dieese_nota_tec_pac.pdf. Ferreira, A., Jayme Junior, F. (2005). “Metas de inflação e vulnerabilidade externa no Brasil”, Anais da ANPEC, http://www.anpec.org.br/encontro2005/artigos/A05A035.pdf. Jenkins, R., Barbosa, A. F. (2012). “Fear for Manufacturing? China and the Future of Industry in Brazil and Latin America”. The China Quarterly. March, No. 209: 59-81. Kupfer, D. (2003). “Política industrial”, Econômica, Vol. 5, No. 2, Dez.: 91-108. Marconi, N., Barbi, F. (2010). Taxa de câmbio e composição setorial da produção: sintomas de desindustrialização da economia brasileira. Texto para discussão, No. 255, Setembro, Fundação Getúlio Vargas (FGV-EESP). Ministério da Fazenda – Brasil (2013). “Economia brasileira em perspectiva”. 18a edição. Março. Ministry of Finance – Brazil (2012). “Brazilian economic outlook”. 17a edition. December. Nassif, A. (2008). “Há evidências de desindustrialização no Brasil?”. Revista de Economia Política, Vol. 28, No. 1. OIT. 2008 “Good policy practices on minimum wage and social security: the cases of Brazil and Chile”, http://white.oit.org.pe/estad/laclispub/english/ndestacados/MWSS.pdf. Muito pelo Contrário. Política, Economia e Cotidiano, http://muitopelocontrario.wordpress.com/2010/07/21/evolucao-da-miseria-durante-o-real/. SERPRO, https://www2.gestao.presidencia.serpro.gov.br/em-foco/pasta.2008-11-28.3964764734/folderimagem.2008-12-02.7506485675/evolucao-da-bolsa-familia/view.

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HOW TO ENHANCE COMPETITIVENESS OF POLISH ECONOMY? SMES AS INNOVATIVENESS STIMULATOR

Alojzy Z. Nowak1

Abstract: The article describes the role and growing importance of microbusinesses and small and medium-sized enterprises (SMEs) in Polish and European policy. Small and medium-sized enterprises are the leading sector in the European Union’s economy. They have particular importance in the European Union’s regional policy. Due to their strong ties with local environment and the influence they have upon it, they came to be perceived as the important link in regions’ development. The key to understanding the role of small businesses in stable economic development seem to be systematic efforts to improve the competitiveness and productivity of the economy. The article stresses that governments seek to expand the area of the economy and services based on knowledge. In these conditions, innovations become as well an important modernization-fostering factor which improves the economic efficiency, the fundament for permanent economic growth, the factor promoting economic potential, and, finally, a factor that crucially determines not only the growth of enterprises, but also improves living standards of consumers. Keywords: micro-businesses, small and medium-sized enterprises (SMEs), SMEs sector, innovativeness stimulator, competitiveness of companies, regional policy, European policy, EU funds.

1

Alojzy Z. Nowak – PhD in Economics, Professor of Economics, Faculty of Management, University of Warsaw, Vice-Rector for Research and Liaison of the University of Warsaw, e-mail: [email protected]. 65

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1. Introduction The current micro-businesses and small and medium-sized enterprises (SMEs) have increasingly become quite a strong driving force in European economy. Research about the way they operate confirms the following facts about them: ˗ they have higher average productivity compared to large corporations; ˗

they are usually better and more effectively managed;

˗

they operate more flexibly in the EU Single Market;

˗

they generate an extra synergy through various forms of cooperation with other businesses, e.g. through clustering.

Additionally, it also results from the experience so far, regarding the operation of such businesses, that they are distinguished in their local environments by: ˗ being highly active in new job creation; ˗

contributing to the development of regions;

˗

being more resistant to political changes;

˗

revealing greater social responsibility.

This latter aspect of ethical business has been emphasized especially in light of the recent financial crisis. When large companies considered too big to fail faced imminent bankruptcy, governmental intervention placed a serious burden on a number of state budgets. It was regular taxpayers that ultimately had to pay the cost.

2. The role and importance of SMEs in European economy Small and medium-sized enterprises are the leading sector in the European Union’s economy. They account for nearly 99% of all business entities in the EU and they employ over 74 million people, generating around 60% of the EU’s GDP and providing almost 70% of jobs throughout the EU territory. They are vital source of innovation, true entrepreneurship and economic growth (Buzek, 2011). Dynamic growth of that sector in the European Union should be 66

How to Enhance the Competitiveness of Polish Economy?...

attributed to the fact of adoption of the European Charter for Small Enterprises, approved by the European Union leaders at the Feira European Council, in June 2000. This was a document presenting the key assumptions of policy concerning the SMEs, in which emphasis was put upon acknowledging the needs of small businesses in the process of creating EU legislation. At the same time, as new technologies are developed and IT revolutions proceeds, the need emerged of having more precise definitions of both micro-businesses and small and medium-sized enterprises. One of the principal objectives for such new definitions was to ensure that measures given in support of businesses were only provided to the types of entities which actually need them. That’s why the definition included methods of calculation of employment and financial level thresholds in order to obtain a true picture of an enterprise’s economic condition. To this end, the following categories of businesses are introduced: an autonomous, a partner and a linked enterprise. It was specified in detail how to regard particular types of links between SMEs and other businesses or investors while calculating financial indices and employment levels. The new definition also clarifies the issue of SME’s ability to acquire external financing sources. For example, enterprises linked with other entities, the latter ones having significant financial resources, may exceed some specified limits whereupon they are denied the SMEs status. The actual purpose of all those measures undertaken in the European Union is to foster the SME’s sector competitiveness. Small and medium-sized enterprises have particular importance in the European Union’s regional policy. Due to their strong ties with local environment and the influence they have upon it, they came to be perceived as the key link in regions’ development. Accordingly, promotion of entrepreneurial culture as well as the creation and development of innovative, competitive small and medium-sized enterprises increasingly becomes one of the most important domains of public intervention policy in local categories. In the process of SME sector growth, the role played by regional and local-level governments in individual EU member states is undeniably increasing, if diversified. Very significant in this respect is a network of Euro-Info centers which act as local information providers to small and medium-sized enterprises. The European Commission, through its policy, supports the creation and operation of Euro-Info centers, in particular in such areas as: 67

Alojzy Z. Nowak

˗

counseling in acquiring financial resources from structural funds, the provision of information concerning particular sales markets and combining business partners;

˗

aid provided to businesses, especially over initial stages of their development;

˗

holding of and active participation in all sorts of seminars and conferences concerning business innovativeness and competitiveness; publication of documents and brochures for small and medium-sized enterprises.

˗

A special role in the strategy for modernization and reform of the European economy was attributed by the European Union to the sector in question in the so-called Lisbon Strategy adopted in 2000. The EU leaders had little doubt that initiatives and actions aiming at the generation of a modern, competitive economy could only be successful when the development of entrepreneurship was real rather than just declared. Indeed, the SMEs sector grew up to become, over time, the principal driving force in the growth of innovativeness, employment and social integration in Europe. From today’s perspective, measures undertaken by the European Commission and the EU Council, with 14 years of operation of the Lisbon Strategy taken into account, seem just partial and not entirely satisfying. However, it would be an oversimplification to say that no success has been achieved altogether during the strategy implementation by member states, with respect to SMEs-related policy. Actually, progress was largely attained in ten principal directions of action planned, namely the following: ˗ development of education and training in the field of entrepreneurship; ˗

cheaper and faster process of businesses’ registering;

˗ ˗ ˗

simplification of legal regulations; development of occupational and sustained education; improvement of access to electronic services;

˗

improvement of conditions for SMEs sector operation in the EU Single Market;

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simplification of tax system and improvement of access to financing sources; improvement of access to new technologies;

˗ 68

How to Enhance the Competitiveness of Polish Economy?...

˗

promotion of effective cases of application of e-business and advanced companies’ support systems;

˗

better representation of SMEs sector interests, both in individual member states and at the EU level.

3. SMEs in Polish economy development As far as problems of SMEs in Poland are concerned, this issue should largely be considered from the point of view of the need to improve the competitiveness of Polish companies on global markets (PARP, 2013). It is beyond argument that decisive progress is needed in the following areas: ˗ improvement of economic competitiveness; ˗ stimulation of a knowledge-based economic model; ˗

introduction of a new system of education based on creativity and the creation of new skills and competence, including language and cultural skills, in order to provide a solid foundation for releasing intellectual capital;

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consolidation of fundaments for friendly and efficient state with respect to individuals and entities undertaking business activity;

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equality of opportunities and social and economic potential throughout Poland, in recognition that more sustainable growth also contributes to SMEs sector development;

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promotion of attitudes aimed at mutual trust and ability to cooperate rather than confrontation, which is especially important for small and medium-sized enterprises for which reliability, legitimacy and positive image rank among crucial strengths.

In the area of practical solutions available to authorities at all levels, but especially central government, this translates, among other things, into the following being necessary: ˗ achieving a real breakthrough in levels of R&D activities financing – at present the state only allocates around 0.65% of Poland’s GDP to that end. Companies from the SME’s sector should become crucial benefi-

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ciaries of this form of financial support to much higher extent than at present; ˗

modernization of the system and provisions concerning intellectual property, with the aim of gradually abandoning the present model of imitation-based development and introducing one based to a higher degree on original solutions. The role of SMEs in this context is highly underrated;

˗

incorporating these changes within regulations, including legal frameworks that promote better linking of EU funds with Poland’s development priorities, including those related to the specificity of SME’s nature and activities. It is also necessary, in this context, to achieve better linking of local government and the business environment, as well as its more pronounced involvement in creation of new legal solutions;

˗

activating the policies of many state institutions, among other things to enable the implementation of the document entitled “Small Business Act for Europe”, adopted by the European Parliament in 2008. Its key elements include 10 common guide principles applicable in the EU member states, such as the provision, on a permanent basis, of more business-friendly conditions which frame active measures, to be taken by state, to ensure the SMEs sector better access to financing, both from the EU funds and from member states’ resources.

4. SMEs and the innovative economy As we witness the present efforts aimed at alleviating the consequences of financial crisis or of turbulence occurring in the Eurozone, it becomes clear how individual governments actively undertake a variety of measures to overcome economic stagnation and its negative results, and to give a fresh impulse for growth in the sphere of real economy (Orłowski, et al., 2010). Traditional methods, including, on the one hand, budgetary and fiscal discipline restriction of public spending, and tax rises and, on the other hand, stimulation of the economy, fiscal loosening, and efforts to increase consumption and reduce unemployment, become more and more popular. 70

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However, what we are witnessing as well is that some governments go further than standard procedures and either raise or do not restrict public expenditure on servicing the needs of elderly population in such areas as: biomedicine, health restoring, or social care, because it is in the development of these specialties that they also see a potential source of creating new, prospective products or innovative technologies. Indeed, it seems that systematic endeavors to stimulate competitiveness and productivity of any given economy is the key to achieving more stable economic growth. In these conditions, innovations become the following: ˗ the driving force of contemporary economy; ˗

an important modernization-fostering factor which improves the economic efficiency;

˗

the basis for permanent economic growth and an important factor in developing economic potential, and, finally;

˗

a factor that crucially determines not only the growth of enterprises, but also improves the living standards of consumers.

That’s why governments, as they opt for this development model, aim for the following: ˗ extending the area of a knowledge-based economy and services; ˗

implementation of an educational system in which the priority is given to creative attitudes and the creation of new competence;

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reforms in academic education in order to link the universities to a higher extent with needs and challenges of the local and global economy and with provision of a stable fundament for releasing the intellectual capital;

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support for public education where electronic media, Internet and elearning are capable of playing a significant role in promotion of innovative attitudes;

˗

the creation of legal and institutional framework for an efficient state, which is friendly to innovation-fostering policies.

In this development model much importance is attributed to the SMEs sector. This is because this type of businesses fit very well within the abovementioned governmental priorities. And, furthermore, it is exactly small and 71

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medium-sized enterprises that most readily and aptly grasp the new 21st century trends in the area of desirable economic policy and development strategy (Buko, 2012). The trends in question, which are more and more pronounced, are as follows: 1. Giving up the hitherto-prevailing model of creation of innovation-fostering policy based on a single company in favor of a model relying upon collaboration between many companies, operating in a number of complementary areas of entrepreneurship. It has become more and more popular to create clusters of new technologies or consortia whose cooperation is not only confined to similar levels of research or technology, but also relies on better recognition of the specific nature of a given local market, as well as including a cultural dimension. 2.

It is a region that increasingly becomes a place of interactions necessary for the emergence of modernization processes, while the characteristics and specific potential of such a region make it easier to reduce the risk inherent in innovation, in order to absorb various types of knowledge and enable interactive learning and the exchange of experience.

3.

Small and medium-sized enterprises increasingly gain a role – not decisive perhaps, but significant nonetheless – in innovation, since their principal driving force is not only the level of spending on research, but also their creativeness and an ability to apply a high degree of development of exact sciences which may be used by individuals or relatively small groups. Hence the increasing importance of innovative family businesses in the market.

4.

The increasing complexity as well as the costs and risk related with innovation highlight the value of links and ties among entities beyond the scope of regular market relations. Here academic establishments, research laboratories, and providers of counseling or technological services can forge valuable links with businesses. The proportion of SMEs cooperating with such entities is increasing.

5.

The concept of demand-based approach to innovation, oriented at creating new ideas and solutions, becomes quite a significant method of implementing innovation. This is based on better reconnaissance into and understanding of demands, both hidden and manifested, of consumers’

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How to Enhance the Competitiveness of Polish Economy?...

needs. Its implementation happens through the creation of effective mechanisms of acquiring and using of information originating from consumers as well as – quite often – through taking advantage of their ideas or even ready solutions. Flexibility of SMEs sector in this respect is more and more appreciated. 6.

Innovative activities of companies in the 21st century are not going to be exclusively oriented at profit maximization. Instead, they will also take into account human needs, variable over time. Small and medium- sized enterprises are best fitted to meet this kind of expectations. Therefore, one should expect new dynamics in the development of areas in which the following factors will play important roles: ˗

green technologies;

˗

medical technologies;

˗

information technologies;

˗

biotechnologies and nanotechnology.

It seems that awareness of such trends, if still insufficient, is becoming more and more universal also in Poland. Innovations become a real driving force of the contemporary economy, a modernization-fostering factor which stimulates economy efficiency, consolidates economic potential and, through exports, lays foundations for sustainable growth. Considering the issue from the perspective of the Polish experience, there is a problem of knowledge transfer from science to the economy that warrants closer inquiry. This also includes the elements making up a so-called knowledge triangle (research & technology, education & innovation, links with business, including in the SMEs sector). There are reasons to argue that as technological progress becomes more and more dynamic, the requirements asked of scientific centers concerning forms, types, ways and means of knowledge transfer from the world of science and technology and its implementation in the field of business would increase accordingly. Obviously, academic institutions have significantly contributed to economic progress, but today expectations from them are greater than ever. Companies, who are most interested in the transfer, have a genuine wish for innovative solutions and ideas to emerge from research circles. However, so far, this “aspiration” of knowledge and new technologies by companies in Poland has been insufficient. On the other hand, it would be a 73

Alojzy Z. Nowak

severe simplification and mistake to underrate positive changes taking place in this respect. In many cases such positive changes occur thanks to European Union schemes and programs promoting innovative projects, which also – or perhaps quite largely – benefit the SMEs sector.

5. EU funds – opportunities and threats. A Polish perspective European funds, therefore, have provided an important growth stimulus for companies from the SMEs sector, in particular for start-ups and young initiatives seeking proper market entry. As a preferential financing source for enterprises, they have significantly contributed to the improvement of Polish business competitiveness, including the SMEs sector. However, according to conclusions from research carried out in the Faculty of Management in the University of Warsaw in cooperation with the Office of the Marshall of Mazovia Province and the State School of Higher Professional Education in Płock and Płock Society on relevant factors and barriers to business development in Mazovia, institutional, legal and procedural obstacles in Poland are still seriously hampering the process of acquiring funds provided by the European Union. In Poland there are almost 150 offices and institutions involved in the management of financial resources and in many cases beneficiaries of such funds from the sector of small and medium-sized companies complain about the following: ˗ low quality of service for applicants and beneficiaries, including poor customer orientation; ˗ bureaucracy of the process of application for subsidies, resulting from excessive complexity and the level of detail in competition regulations; ˗ bureaucratic rigors in offices – lengthy periods for verifying the applications for disbursement; ˗ poor level of preparation of some personnel working in public institutions, which impedes their ability to implement the objectives of Operational Programs effectively; ˗ the imposition upon beneficiaries of obligations, which contradict the provision of generally applicable law, for example vague guidelines concerning expenditure eligibility or financing principles; 74

How to Enhance the Competitiveness of Polish Economy?...

˗ ˗

inadequate operation of the mechanisms of investment-project coordination at both local and central levels; the lack of consistent information policy covering the entire area of issues regarding the implementation of projects co-financed from European funds.

The above are just some of the barriers most frequently signaled in the research. While the pressure of public opinion has recently led to the simplification of procedures relating to applying for EU aid funds and a shortening of waiting time for payments to be made (Poland generally experienced no problems with absorption of resources from the EU budget for the years 2007-2013), further improvement in the system of EU funding management is certainly needed. It would also be quite desirable to develop a public ranking of work quality of managing institutions, including those acting as agencies and involved in the implementation of funding, arranged according to specific criteria, mainly with respect to time-limits for activities performed.

6. Importance of financial and tax policy to SMEs Although it has to cope with a great deal of problems – as shown above – the absorption of funds by the SMEs sector from the EU is still an important factor alleviating another serious economic barrier to that sector’s efficient operation. Depending on the development of business cycles, a number of sources from which capital is acquired increases or decreases and – from companies’ point of view – the role played by less or (desirably!) more stable fiscal policy run by state institutions becomes more important. Research, ordered by the European Commission and carried out by the Gallup Organization among 15 thousand small and medium-sized enterprises operating in the European Union territory, indicates that their most serious concerns are related to limited demand, but also uncertain conditions in financial markets (The Gallup Organisation, 2007). This situation then tends to largely translate into the policies applied by banks which, facing uncertain prospects and the troubled condition of European economies, restrict access to credits of which businesses are beneficiaries. One of the key barriers hindering the growth 75

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of either a small or a growing entrepreneur is the lack of capital for a start-up and then for necessary investments. This phenomenon becomes further aggravated over periods of turbulence in the financial markets. We are yet to see whether we will have to deal with this aggravating phenomenon in Poland over the next couple of years. The present economic slowdown makes such a scenario seem quite likely. The acquisition of capital is probably going to become more difficult and expensive. We also have to reckon with access to microloans, so important to entities from the SMEs sector, becoming more restricted. As shown by the outcomes of studies carried out by TNS Pentor, one of the principal research agencies in the Polish market, specializing in corporate research, the economic slowdown which affected Poland in the years 2008-2009 as an echo of the global financial crisis, had a negative impact upon relations between banks and corporate customers, especially small and medium-sized enterprises. Pentor argues that banks caused a great damage in this respect, by losing – sometimes just overnight – the trust and companies’ confidence in being able to regulate their liabilities toward banks. In the effect of abrupt depreciation of Polish zloty some banks, especially those with prevailing foreign capital, started verification of credit contracts made, demanding additional collateral from their contractors and, in certain cases, rendering them immediately due and payable. At the same time, due to the lack of liquidity in the inter-banking market, credit activity all but stagnated. Credit became a good in deficit and companies seeking credit experienced tremendous difficulties. Banks’ credit committees extended the procedures, increasing the means of security required, raising the prices of credit and so on. Credit availability was abruptly reduced with a corresponding increase of a number of businesses refused credit by banks. The breakdown of trust in relations between banks and enterprises was seriously aggravated by the problem of the so-called foreign currencies options i.e. losses suffered by companies on derivatives securing foreign currencies exchange rates-related risk. Two thirds of businesses perceived that the financial crisis reduced their access to banking products and services while eight out of ten declared that they faced increased prices for banking services and sharpened criteria in applying for credit. According to 60% of entrepreneurs the principal reason behind the tightened credit policy toward business circles was in banks’ apprehension about solvency of their clients. These are TNS Pentor’s findings. 76

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While the year 2013 was slightly better for the SMEs sector and the problem of its access to credit was, accordingly, less serious than during the recent slowdown of the years 2008-2009, any further deterioration in business outlook may change the attitude of the banks in this respect. However, according to at least some part of the small business environment, at present banks seem to show some effort to better understand the specificity of small and medium-sized enterprises and their needs, and, even more importantly, they also seem to better understand the increasing potential of the sector than they did until quite recently. Another aspect, just as important for the sector in question and crucial for some entities within it, is that of tax policy, in particular during periods of worsening economic conditions (Matejun, Kaczmarek, 2010). When narrowly treated, it is only of a fiscal nature reduced to collection of taxes to maintain the stability of public finance. However, when considered broadly and in the long run, it may actively support the state social and economic policy and favor the pursuit of its goals. This latter approach is vastly more advantageous to the SMEs sector. The Polish tax system is perceived by small and medium-sized entrepreneurs as complicated, awash with vague and incomprehensive provisions as well as being rather unstable. Additionally, they are irritated by an excessive number of legal acts applied therein – worse still, such regulations tend to become more and more extensive and, unnecessarily, increasingly detailed. Their ever-present weakness is far too many references to other provisions, as is the lack of statutory definitions and the use of terms and notions having unequivocal or inconsistent meaning.

7. Conclusion Some problems that make life difficult for the SMEs sector stem from poor company management. Research undertaken to date and a number of analyses indicate one of crucial factors hindering the innovativeness and competitiveness of Polish businesses from that sector which is their lack of properly skilled and competent staff. This problem is serious, considering how the research, carried out by Polish Agency for Enterprise Development, among oth-

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ers, concludes that in the processes of economic globalization we are witnessing, competent and properly skilled personnel have the potential to become a new and most effective source of competitive advantage. Therefore, it seems very important and urgent to recognize actual demand for human resources, in particular in sectors featuring the largest potential for innovation. Another development barrier lies in the mixed and rather reserved attitude of small businesses to external sources of finance. However, as underlined in the research conclusions, banks and financial institutions recently are more aware of the increasing potential in the SME sector. Looking from SMEs perspective, this environment tends to emphasize that the process of delivering Polish economy from the excess of legal regulation and bureaucracy should be accelerated and accompanied with the introduction of simple and transparent principles concerning business activity. From the point of view of the interests of the Polish economy it is also necessary to foresee trends that are likely to happen in the global economy and its individual sectors and to prepare, on that basis, potential development scenarios with small business adequately taken into account (Orłowska, 2010). Despite some weaknesses, the SMEs sector remains a significant opportunity for the Polish economy to raise its efficiency and to improve its competitiveness in Europe’s Single Market.

Bibliography Buko, J. (ed.) (2012). “Uwarunkowania rynkowe rozwoju mikro, małych i średnich przedsiębiorstw. Mikrofirma 2012” (Market-related Determinants for Growth of Micro-, Small and Medium-sized Enterprises. Micro-business), Zeszyty Naukowe, No. 695, Szczecin: Uniwersytet Szczeciński. Buzek, J. (2011). Wystąpienie inauguracyjne, I Europejski Kongres Małych i Średnich Przedsiębiorstw (Opening Address, Small and Medium-sized Enterprises First European Congress), Katowice. Krugman, P. (2012). End This Depression Now!, New York: W. W. Norton &Company. Matejun, M., Kaczmarek, E. (2010). “Wpływ form opodatkowania podatkiem dochodowym na funkcjonowanie małych i średnich przedsiębiorstw” (Impact of Forms of Income Taxation on the Operation of Small and Medium-sized Enterprises), in: M. Matejun (ed.), Wyzwania i perspektywy zarządzania w małych i średnich przedsiębiorstwach (Chal78

How to Enhance the Competitiveness of Polish Economy?... lenges and Prospects for Small and Medium-sized Enterprises), Warszawa: C.H. Beck: 208-224. Orłowska, J. (2010). Kompetencje kadr i zawody przyszłości w świetle badań foresight, Raport o stanie sektora małych i średnich przedsiębiorstw, w Polsce, w latach 2008-2009 (Personnel Competence and Professions of the Future in the Light of Foresight Research. Report of the Condition of the Small and Medium-Sized Enterprises Sector in Poland in 2008-2009), Warszawa: PARP (Polish Agency for Enterprise Development). Orłowski, W., Pasternak, R., Flaut, K., Szubert, D. (2010). Procesy inwestycyjne i strategie przedsiębiorstw w czasach kryzysu (Investment Processes and Corporate Strategies at the Time of Crisis), Warszawa: PARP. Skowronek-Mielczarek, A., (2007). Małe i średnie przedsiębiorstwa. Źródła finansowania (Small and Medium-sized Enterprises. Financing Sources), Warszawa: C.H. Beck. Sosnowska, A., Łobejko, S. (2006). Małe i średnie polskie przedsiębiorstwa w Polsce w warunkach konkurencji: Pozytywy i trudności w rozwoju (Small and Medium-sized Enterprises in Poland under Conditions of Competition. Strengths and Weaknesses in Their Development), Warszawa: PARP. “Start-upy («pierwszaki») klucz do walki z bezrobociem” (Start-ups as an Instrument to Fight Unemployment), Obserwator finansowy, 29.08.2010, Accessed: 12.10.2013, http://m.obserwatorfinansowy.pl/bez-kategorii/start-up-y-klucz-do-walki-z-bezrobociem/. Tarnawa, A., Zadura-Lichota, P. (ed.) (2013). Raport o stanie sektora małych i średnich przedsiębiorstw w Polsce w latach 2011-2012 (15th Report on the Condition of Small and Medium-sized Enterprises Sector in Poland), Warszawa: PARP. The Commission of the European Communities (2005). Cohesion Policy for Growth and Employment: Community Strategic Guidelines 2007-2013, Brussels, Accessed: 12.10.2013, http://ec.europa.eu/regional_policy/sources/docoffic/2007/osc/050706osc_en.pdf. The Gallup Organisation (2007). Entrepreneurship Survey of the EU-25, Secondary analysis, Poland, Flash Eurobarometer, 192, Accessed: 12.10.2013, http://ec.europa.eu/enterprise/policies/sme/files/survey/static2008/poland_static_en.pdf.

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FINANCE AND KNOWLEDGE: THE NEED FOR EFFECTIVE GOVERNANCE. AN EVOLUTIONARY PERSPECTIVE1

Leonardo Burlamaqui2

Abstract: This paper’s aim is to apply the evolutionary perspective to the emerging field of Economic Governance. It does so by showing that the core areas behind the spread of globalization are exactly the same ones as behind Schumpeter’s model of economic evolution: finance (credit expansion and financial innovations) and knowledge (innovations in knowledge creation, protection, and diffusion). The paper argues that those are two key areas that governance-oriented institutional change agendas should address in order to provide a more effective and democratic frame to globalization itself. It concludes by sketching out, in a compressed way, the core issues for reforming agendas in governing finance and knowledge. Keywords: globalization; financial regulation, competition; intellectual property; antitrust.

1

I would like to thank Michael Edwards, Peter Evans, Lisa Jordan, Jan Kregel, Jan Aart Scholte and Neil Netanel for helpful comments and suggestions that inspired this paper. 2 Leonardo Burlamaqui – PhD in Economics, Associate Professor, Faculty of Economic Sciences, Rio de Janeiro State University, e-mail: [email protected]. 81

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1. Introduction This paper’s aim is to apply the evolutionary perspective to the emerging field of Economic Governance. It will be done by showing that the core areas behind the spread of globalization are exactly the same ones as behind Schumpeter’s model of economic evolution: finance (credit expansion and financial innovations) and knowledge (innovations in knowledge creation, protection, and diffusion). It will also be argued that those are two key areas that governance-oriented institutional change agendas should address in order to provide a more effective and democratic frame to globalization itself. The paper provides a compressed analysis of globalization’s main problems springing from finance and knowledge and a preliminary agenda for institutional reform in both areas. It will be done by means of utilizing the broader evolutionary perspective developed by Schumpeter (the multiple sources of innovation and the interplay of knowledge and finance as core levers for development), Minsky (capitalism should be understood essentially as a financial system and markets should be analyzed first and foremost as webs of credit and debt contracts that tend to self‐destabilize), Karl Polanyi (markets need to be embedded in non‐market institutions in order to work efficiently) and the contemporary neo‐Schumpeterian thinking on the co‐evolution of technology, institutions and economic performance3. The paper’s main conclusion is that, from an evolutionary perspective, a global Economic Governance agenda reform is an urgent task and it should seek to restore both “Schumpeterian finance” relegated to a stealth position in the current ungoverned financial regime and “Schumpeterian entrepreneurship”, substantially deterred by the IP based rent seeking knowledge governance regime. Those would be necessary (although not sufficient) conditions for a more effective and democratic frame to manage globalization both in finance and in knowledge. Finally, the paper’s concerns are primarily directed towards policy and institutional/regulatory design. However, its main proposition on the necessity for governing finance and knowledge can also be stated from a more theoretical perspective: the case for governance springs from the theory of change which 3

A useful plea for broadening the evolutionary agenda towards the realm of finance can be found in Hanusch and Pyka, 2006. 82

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can be labeled an Evolutionary Theory of Social Change. It has Darwinian roots but takes heavily into account the ‘Lamarckian’ dimension of adaptive mutation, as well as culture-based elements like the presence of purpose, intelligence and intellectual interaction (cf. Nelson and Winter, 1982; Minsky, 1990; Laurent and Nightingale (eds.), 2001; Nelson, 2006). Its core elements are variation, selection and retention, which can be narrowed down to innovations (the sources of variation), competition (the selection mechanism) and institutionalization/diffusion (the retention process). The process of change, propelled by the interaction of those three features, is irreversible and characterized by continuous gales of creative destruction. It always produces winners and losers and is embedded in instabilities with uncertain (not predicable) outcomes. The governance implications of this process, for our concerns, are straightforward: they suggest that economic and social change are evolutionary processes but they are not necessarily progressive. To become progressive, change has to be governed. In other words, it implies that “creative destruction management” is at the heart of both effective economic change as well as of social justice – or progressive social change (cf. Burlamaqui, 2000, 2009).

2. Globalization and Economic Governance From the economic point of view, globalization can be defined as a process associated with increasing economic openness, growing economic interdependence and deepening economic integration among countries in the world economy. Globalization itself is not a new phenomenon, but it entered a new phase in the mid-eighties (Nayyar, 2002; Scholte, 2005; Weinstein, 2005; Frieden, 2006). This new phase, just as the previous one, is deeply rooted in a technological revolution (Bell, 2001; Freeman and Louçã, 2005; Reinert, 2007). It exhibits as its main elements: a huge expansion of markets (and especially of financial markets); challenges to state sovereignty, to established institutions and to social values; the rise of new social actors and political movements; and an increased level of “global instability” (Underhill, Zhang, 2003; Underhill, 1997; Michie, Smith, 1999; Gilpin, 2000). It also provides the poten-

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tial for a diverse cluster of learning and economic opportunities for countries, corporations (and individuals) that are capable of positioning themselves strategically towards those changes. This “new” global landscape includes actors empowered by globalization, like global corporations, global private financial institutions and civil society associations. It’s also shaped by the proliferation of semi-official and nonofficial rule-setting bodies (like: IOSCO, the World Federation of Exchanges, the International Swaps and Derivatives Association [ISDA], and the, now (in)famous, Credit Rating Agencies) and international treaties and regional agreements (such as: The Trans-Pacific Partnership, the Chiang-Mai Initiative, International Arbitration Tribunals and Bi-Lateral Trade Treaties). The main challenge of the state is thus to increase, or even maintain, domestic policy in face of these new global “entities”, but also new global issues, such as vastly increased cross-border financial flows (and growing financial instability), a deepening knowledge divide, cross-border tax evasion, spurts of mass migration, environmental degradation, terrorism and religious fundamentalism (Woods, 2000; Kaletsky, 2010). From the economic policy perspective, the Keynesian approach that “the whole is greater than the sum of its parts” was largely replaced by the neoliberal view that only individual incentives can produce efficient results; a doctrine dubbed as the “Washington Consensus” which had as its central assumption the superiority of market-based over governance-based solutions and a strong bias against state intervention. From a global governance perspective, both the United Nations and the Bretton Woods institutions, which are now seventy years old, have largely been sidelined by the aforementioned “semi-official” bodies and the post-financial crisis institutions, such as the Financial Stability Board and the G20. On the other hand, both the world economy and global geo-politics have changed almost beyond recognition since 1945, compelling researchers, policy-makers and regulators to break new ground both in analysis and strategies (Kaletsky, 2010; Rodrik, 2011; Krugman, 2012; Turner, 2012). The relationship between globalization and global governance is, therefore, an unbalanced one. It seems adequate to say that it has become clear since the Asian and Russian crises, in 1997-99, and very much confirmed by the current situation we are facing, that what we have in place right now is, to quote 84

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Rodrik, “global markets without global governance”, a statement that was certainly reinforced by the collapse of the Doha round in July of 2006 and made crystal clear by the 2008 global financial crisis. In the realm of global Economic Governance institutions, the vacuum is especially vexatious in the area of finance.

3. Globalization and finance As Schumpeter, Keynes and Minsky showed us, economic development relies on credit (finance) and innovation. However, financial issues are perceived as both complex and far removed from our daily lives. Indeed, they are often intricate but belong to the core of our daily affairs. To reassert the centrality of finance in capitalist economies and of financial governance, I will briefly turn to Minsky’s “Wall Street Paradigm” in macrofinance, whose core assumption is that capitalism should be understood essentially as a financial system and markets analyzed first and foremost as webs of credit and debit contracts (Minsky, 1978; 1982; 1986). The way to flesh out that vision is to look at every economic unit – firms, households, governments and even countries – as though it were a bank daily balancing cash inflow against cash outflow (Mehrling, 1998). From that point of view, categories such as production, consumption, trade and investment are first of all flows of money, assets and liabilities, exchanged between different economic agents. To put it as Keynes did, money and finance are the most real aspects of capitalism, the ones from which everything else springs. Credit permits these units to acquire assets whose expected cash flows will exceed their cash commitments. But that may not happen and then liquidity crunches result. Insolvencies and bankruptcies are the possible “worst case outcomes” of that failure to achieve. Financial fragility is the route towards those possible outcomes. “Fragile finance” refers to profiles of economic units (or of the whole economy) where cash commitments are relatively heavy compared to cash flows so that there is a danger of widespread failure to meet commitments and, consequentially, of breakdowns. Financial fragility surfaces as an endogenous feature of capitalist economies, springing from the connections between indebtedness and uncertainty. 85

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The central implication of this perspective for global – as well as for domestic – finance is that left to its own devices, the inherent herd behavior built in systems based on expectations about an unknown future produces a financial system that operates to amplify rather than to reduce its propensity towards both financial fragility and financial instability. Here, financial governance and financial regulation enter the scene. In order to “stabilize an unstable economy” (Minsky,1986), domestic governments and global governance institutions would be the prime candidates to act as global prudential supervisors and systemic regulators, overseeing global capital flows, structuring pools of global liquidity and as rule enforcers for both creditors and debtors, besides their function of setting standards. When credit markets froze after the Lehman Brother’s collapse on September 15, 2008, this perspective appeared to qualify for a “comeback” (Skidelsky, 2009). However, the issue is far from settled. The post-crisis policy responses and subsequent evolution of western capitalism are taking an almost reverse course from the one springing from that Keynes-Minsky paradigm, and do not confirm what, at the beginning of the crisis, seemed to be the demise of the Washington Consensus: light financial re-regulation, anti-government campaigns, a strong faith in “corporate responsibility” and an obsession with balanced budgets and “austerity” are still largely in place (Krugman, 2012; Stiglitz, 2012; see Blinder, 1913 for a less pessimistic analysis). The focal point here is the resilience of that “free markets work better” approach. The “emergent markets” financial crisis that shook the world during 1997-2002 (Asia, Russia, Latin America and Turkey) opened a window for thinking about a “new financial architecture” (cf. Eichengreen, 1999; Eatwell and Taylor, 2000; Blustein, 2001). As soon as the debate moved to consider instruments like reintroducing capital controls or building a “world financial authority”, it ended in the relevant fora and was kept almost only inside a few academic departments (mostly outside Economics) and just a few engaged NGOs. Unfortunately, this seems to be happening again: representatives of the G20 financial market regulatory and supervisory agencies have been drawing up a set of best practice standards and austerity packages whose adoption is being encouraged through peer pressure or through conditions attached to IMF lend-

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ing programs4. Indeed, the credit worthiness of individual countries’ liabilities is increasingly judged by the quality of individual countries’ regulatory and supervisory systems as measured by their adherence to these international standards. It has become crucially important for developing countries to be seen adhering to these standards as a minimum condition for attracting and retaining international capital flows. The Bank of International Settlements and the Basel Committee gained much more preeminence with the new Basel III accord, but its adequacy in terms of regulating liquidity or leverage is far from established (Cornford, 2011). Additionally, various “global standards” are being proposed by a whole gamut of unofficial bodies that include the International Accounting Standards Board, the International Federation of Accountants, the International Organization of Securities Commissions, the International Association of Insurance Supervisors and the World Federation of Exchanges (Helleiner, Pagilary and Zimmermann, 2010). There are several problems with this emerging financial patchwork. The Bretton Woods twins have lost power and influence and, in fact, have never been “global” institutions but rather creditors’ watchdogs. They were not meant to ensure stability of the financial system, only of the exchange rate system in support of “free” trade. Their move into financial stability is just mandate creep. As for the expanding unofficial bodies (for example: the International Association of Insurance Supervisors and International Federation of Stock Exchanges), they exacerbate the democratic deficit in global financial governance: by and large “standards setting” bodies, these organizations are opaque and accountable only to themselves. Their ultimate goal is to impose a one-size-fits-all set of rules which most likely will have deleterious effects in developing countries (Burlamaqui, 2007). In that “new” financial landscape, business was reshaped by reckless massive borrowing, which is still largely unseen, unregulated and little understood5. Because of the lack of transparency, policy makers cannot see whether 4

This time, Europe is – somewhat ironically - the major victim. “Be Afraid. That’s the takeaway for both investors and taxpayers in the 307-page Senate report detailing last year’s $6.2 billion trading fiasco at JPMorgan Chase. The financial system, thanks to dissembling traders and bumbling regulators, is at greater risk than you know” (G. Morgenson, New York Times, 16.3.2013). 5

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these volatile new debt and private equity instruments are in safe hands or how they will behave in a crisis when everyone is heading for the exits (Partnoy, Eisinger, 2013; Blinder, 2013). On the international taxation front, it is estimated that for every $1 poor nations receive in foreign aid, an estimated $10 in illicit money flows abroad, usually to the West (Baker, Alii, 2011). With such large amounts of capital draining from weak economies, there is little hope of success, even for a well-crafted development strategy. To sum up: despite the global financial crisis the evidence suggests we are still facing a global financial governance vacuum. Worse: it seems to be growing, not shrinking. However, if we turn to Asia, although the vacuum is also visible there, some promising initiatives are taking place. The damage caused by the Asian financial crisis of 1997-98 made the countries in that region acutely aware of the need to promote regional financial cooperation to prevent resurgence of a crisis and to attain stable economic growth. Since then, Japan has been vigorously promoting regional financial cooperation together with the other ASEAN+3 countries. More recently, with the rapid increase in economic interdependency in East Asia, regional financial cooperation is becoming all the more important. Initiatives under the ASEAN+3 Framework include the Chiang Mai Initiative (CMI), the Economic Review and Policy Dialogue (ERPD), the Asian Bond Markets Initiative (ABMI), and the ASEAN+3 Research Group. Those initiatives are evolving at a fast pace and have yet to be properly understood, discussed and developed, but they could well become the seeds of a more effective, transparent, and badly needed global financial architecture (Cf. Underhill and Zhao, 2003; Ramo, 2004). Summing up: what we now have in place is a financial system where the whole institutional structure for setting margins of safety was made “Ponzi by design”6. In that regard, the “new financial system” is one in which, follow6

“This system has produced a new form of bank operations now known as “originate and distribute,” in which the bank seeks to maximize its fee and commission income from originating assets, managing those assets in off balance-sheet affiliate structures, underwriting the primary distribution of securities collateralized with those assets, and servicing them. Under this system, the banker has no interest in credit evaluation, since the interest and principal on the loans originated will be repaid to the final buyers of the collateralized assets. The deterioration in cushions of safety caused by the evolution of the bank’s evaluation of the borrower’s credit risk through periods of stability plays no role here” (Kregel, 2008: 11).

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ing Minsky’s approach, there was no evolution from Hedge to Speculative to Ponzi. Instead, it was Ponzi finance at the staring point7. Minsky himself was, once more, ahead of the curve. In a paper written in 1990 and presented at the 12th Congress of the International Joseph Schumpeter Society, he argued that “Schumpeter’s banker financed the creative part of creative destruction… the Schumpeterian [banker] is not our own day’s master of the corporate raid and the leveraged buyout” (cf. Minsky, 1990: 56). What he was foreseeing has now become evident: the financial system lost, almost completely, its connections with the goals of productivity enhancement, employment creation and development. From an evolutionary perspective, recasting “Schumpeterian finance” and the Schumpeterian (investment) banker has to be at the center of any meaningful financial governance reform agenda. I will revisit the theme in the conclusion of the paper.

4. Knowledge and knowledge governance Knowledge – especially technology and innovation – is the second main driver behind globalization and the main lever for the achievement of economic development (cf. Schumpeter, 1934; 1942), but also of social justice, cultural enhancement and true democracy (cf. Benkler, 2003; 2006). As we dive into an increasingly knowledge-intensive economy and society, where knowledge and information become the strategic and transforming resources of society (cf. Bell, 2001), it also becomes clear that knowledge governance should be at the center of a global Economic Governance agenda. 7

A more blunt assessment along the same lines is given by Faux (2008): “Giant Ponzi scheme? Not to worry, responded the Wall Street geniuses. By spreading risks among more people, the miracle of «diversity» was actually turning bad loans into good ones. Anyway, banks were buying insurance policies against default, which in turn were transformed into a set of even murkier securities called «credit default swaps» and marketed to hedge funds, pension managers and in some cases back to the banks that were being insured in the first place. At the end of 2007 the market for these swaps was estimated at $45.5 trillion-roughly twice as large as all US stock markets combined. This huge pyramid of debt was made possible by thirty years of relentless deregulation of financial markets, culminating in the 1999 repeal of the Glass-Steagall Act, which had prohibited banks from dealing in high-risk securities. In effect, Washington regulators became passive enablers to Wall Street's financial binge drinkers”. 89

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Knowledge is embodied in books, journals, equipment, technological and social innovations and, especially, in the human mind. It diffuses through society via investments and the result is development and structural change. As Schumpeter pioneered in showing, modern capitalism has proved a remarkably powerful engine of technological progress (cf. Schumpeter, 1942: part 2). Until very recently, most of the attention to its workings had focused on the business firms and entrepreneurs operating in a market setting who are the central actors in developing and introducing new products and processes. Now, it is widely recognized that the power and speed of invention and innovation is increasingly dependent on the strength of the science base from which they draw. This science base is largely the product of publicly funded research, and the knowledge produced by that research used to be largely open and available for potential innovators. That is, market dynamics used to rest on a publicly supported scientific commons: ideas could never be owned. (cf. Nelson, 2003; Boyle, 2004; Ruttan, 2006; Weiss, 2014). However, as markets and corporations went global, a paradox has developed. In total contradiction of the globalizer’s ideology of “free movement of goods, capital and ideas”, intellectual property rules and agreements have become much more restrictive, just like their enforcement mechanisms such as the Trade-related Aspects of Intellectual Property agreement included in the WTO (TRIPS) and TRIPS-plus. More precisely, intellectual property rules and regulations became the center of knowledge governance. They are the legal sinews of the information age; they affect everything from the availability and price of AIDS drugs, to the patterns of international development and to the communications architecture of the Internet (Boyle, 2004). From an evolutionary perspective, or in the context of Schumpeterian competition, intellectual property rights (IPRs) – patents, trade secrets, confidentiality contracts, copyrights, trademarks, and registered brand names – are powerful, strategic weapons for generating sustained competitive advantages and Schumpeterian and Ricardian rents (cf. Jolly and Philpott, 2004)8. In the evolutionary economics framework, it is quite clear that in the absence of legal 8

Having said that, it is striking how little has been written about the crucial connection between Schumpeterian competition and IPR. And, of course, I include myself in that loophole. In that regard, legal theorists like Landes and Posner or Benkler are clearly ahead, in the sense that they are already doing the reverse track – using Schumpeterian concepts and insights to deal with IPR (cf. Landes and Posner, 2003; Benkler, 2006). 90

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protection for an invention, the inventor either will have less incentive to innovate or will try to keep his invention secret, thus reducing, in both cases, the stock of knowledge for society as a whole (Landes, Posner, 2003: 294). From an entrepreneurial perspective, patents and other IPRs are extremely effective means to reduce uncertainties – and therefore, to ignite the animal spirits and long-term expectations – through building temporary monopolies around products, processes, market niches, and, eventually, whole markets (Burlamaqui and Proença, 2003; Nelson, 1996). However, the word “temporary” is crucial here because of creative destruction: as Schumpeter stated long ago, “A monopoly position is in general no cushion to sleep on” (1942: 102). But the picture can get much more complicated as we examine the details. Dynamic inefficiencies can easily arise from a too strictly – and privately – regulated IPR regime. Let’s consider three possibilities where the case for knowledge governance reform emerges quite strongly. Firstly, as Arnold Plant, an almost forgotten analyst in the field, observed in the early 1930s: In the case of physical property, the institution of private property makes for the preservation of scarce goods (…). In contrast, property rights in patents and copyrights make the creation of scarcity of the products appropriated possible (…). T h e b e n e f i c i a r y i s m a d e t h e o w n e r o f t h e e n t i re supply of a product for which there may be no easil y o b t a i n a b l e s u b s t i t u t e (Plant, 1974 [1934]: 65-67, emphasis added).

In sum, an overprotective intellectual property rights regime can easily give rise to dynamic inefficiencies9, and that alone leaves ground for a different set of knowledge governance policies to enter the scene, as we will see shortly. Secondly, the broader the patent protection (and IPRs, generally), the less the patentee’s competitors are able to benefit from the patent by “inventing around,” or innovating on the shoulders of the patent- (or copyright-) holder. Broad IPRs are, thus, bound to exacerbate the dynamic efficiencies that Plant and others have observed. Accordingly, especially given the complexity and diversity of patents and other IPRs, a one-size-fits-all prescription seems ill9

Meaning the expected (negative) impact on future incentives for competitors to compete (innovate) and future consumer welfare. (See Anthony, 2003: section IV). 91

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advised. Here, again, knowledge governance reform surely has a place in limiting IPR scope as well. Thirdly, from a global outlook an even more worrisome scenario can be outlined. If we think of knowledge production and innovation as cumulative processes where cutting edge knowledge and know-how rests on previous ones and of stronger patents and IPRs in general as “fences” erected to privatize and protect them, it’s not difficult to figure out the inevitable tension and potential trade-off between the private and public dimensions of IPR rules. The tradition of intellectual property as a thin layer of rights around a carefully preserved public domain was replaced by a practice where the public domain should be eliminated whenever possible (cf. Boyle, 2003). There are two halves to this “second enclosure” movement. The defensive side focuses on government-backed corporate strategies for intensifying the enforcement of protected monopoly rights to exclude others from using information that has been defined as private property. The offensive side involves strategies for taking information that has been considered part of “nature” or the common cultural and informational heritage of humankind and transforming it into “private property” (cf. Evans, 2005). The success of both halves of this movement is leading to a global re-distribution of property as well as to deepening of the knowledge divide. If we take this arguments seriously, what we see emerging is a mix of global “knowledge monopolies”, preclusion of access to new knowledge and privatisation of traditional common knowledge. However, ever increasing privatisation of knowledge at the expense of the public domain is not the only way forward. In the past decade, however, there has been growing recognition on the part of many civil society organizations, academics, developing countries, and, most surprisingly, large numbers of commercial organizations that the drive to ratchet up intellectual property, to harmonize the law everywhere (irrespective of state of development, and to do so through the trade system), has worked to the detriment of human development, as well as innovation in all but a narrow range of fields, most prominently, pharmaceuticals. What started out as disparate ideas, concerns, and movements - access to medicines; information commons; Internet freedom; open spectrum; ICTs for development – has increasingly moved to an international and development focused political drive, be it the shift from Creative Commons and its internatio92

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nal version, iCommons, or the emerging global A2K movement (cf. Benkler, 2008). Alternative modes of knowledge governance like these deserve more attention and development. Notwithstanding, a knowledge governance system committed to the development needs of emergent and poor countries, to closing the knowledge gap and to restoring the balance of public domain and private interests has yet to develop.

5. Financial governance reform: a draft agenda In the 12th chapter of the General Theory, Keynes argued that “when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done” (cf. Keynes, 1936: 116). Securitizationbased hedge-fund capitalism took Keynes’s statement to a whole new level, where financial governance is almost non-existent and markets are not selfcorrecting, but highly self-destabilizing devices which, by contagion, spread instability and volatility to the rest of the system. What is to be done? The debate on financial governance and re-regulation sparked by the current crisis is still heated and will be around for a while, but there are already some lessons to which parliamentarians, policy makers, regulators and central bankers should be paying attention. Alan Blinder’s, Martin Wolf’s, George Soros’, Jan Kregel’s, and Elizabeth Warren’s proposals are among those who have captured some of the key lessons. I will quote them extensively in order to sum up the proposals. Firstly, perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net (cf. Blinder, 2008; Wolf, 2008). Secondly, leverage. High leverage means owning a lot of assets with only a little capital. This is where something changed fundamentally on March 16, 2008, when the Federal Reserve became the lender of last resort to selected securities dealers. Before that day, only banks had access to the Fed’s discount

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window; broker-dealers took large risks without a safety net. Because securities firms are now under the Fed’s protective umbrella, they must start operating as safely and soundly as banks. That means both closer supervision and less leverage (cf. Kregel, 2007; Blinder, 2008). Third, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity. Poor liquidity risk management and the risk of bank-like runs on nonbank financial institutions have been shown as severe problems in the shadow financial system (cf. Wolf, 2008; Soros, 2008). Thus, an essential element of the common regulation of all non-bank financial institutions should be a greater emphasis given to the management of liquidity risk. Such firms should be asked to significantly lengthen the maturity and duration of their liabilities in order to reduce their liquidity risk. A firm that makes money only because it borrows very short, has little capital, leverages a lot and lends long and in illiquid ways is reckless in its risk management. It should certainly disclose fully to supervisors and to investors the liquidity and other risks that it is undertaking. But it should also be required to reduce its liquidity risk with a variety of tools and provide it with a greater liquidity buffer (cf. Roubini, 2008). Fourth, commitment. The originate-and-distribute model has, as is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload onto others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitized loans (cf. Blinder, 2008; Wolf, 2008). Fifth, the BIS and Basel II. Even before being fully implemented, the Basel II agreement has already shown its flaws: capital adequacy ratios that are pro-cyclical and thus inductive of credit booms in good times and credit busts in bad times; low emphasis on liquidity risk management; excessively low capital ratios, given the risks faced by banks; excessive reliance on internal risk management models; and excessive importance given to the rating agencies. In implementing Basel III, special importance should be given to measures that would reduce the pro-cyclicality of capital standards and to measures to in94

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crease – rather than decrease – the overall amount of capital held by financial institutions. As recent history suggests, most financial institutions were vastly under-capitalized given the kind of market, liquidity, credit and operational risks that they were facing in an increasingly globalized financial system (cf. Blinder, 2008; 2013). Sixth, rating agencies. By now, the conflicts of interest and informational problems that led the rating agencies to wrongly rate (many MBS and CDO and other poorly understood financial innovations products as highly rated) are well known and recognized. With a large fraction of their revenues and profits coming from the rating of complex structured finance products and the consulting and modeling services provided to the issuers of such complex and exotic instruments, it is clear that rating agencies are ripe with conflicts of interests. Dilip Abreu suggests paying ratings agencies with some of the securities they rate, which they would then have to hold for a while. Blinder’s idea is to have a public body, like the S.E.C., hire the agencies, paying the bills with fees levied on issuers (cf. Roubini, 2008; Blinder, 2013)10. Seventh, the creation of a financial product safety commission. “Financial products should be subject to the same routine safety screening that now governs the sale of every toaster, washing machine, and child’s car seat sold on the American market” (cf. Warren, 2007). Like its counterpart for ordinary consumer products, this agency would be charged with responsibility to establish guidelines for consumer disclosure, collect and report data about the uses of different financial products, review new financial products for safety, and require modification of dangerous products before they can be marketed to the public. The agency could review mortgages, credit cards, car loans, and a number of other financial products, such as life insurance and annuity contracts. In effect, the FPSC would evaluate these products to eliminate the hidden tricks and traps that make some of them far more dangerous than others (cf. Warren, 2007: 16). Warren’s proposal won its day and is now – despite the intense lobbying against it – part of the Dodd-Frank regulatory reform approved by the US in 201011. 10

To that respect, Germany’s Prime Minister Angela Merkel’s call for a Eurozone ratings agency and her remarks that “Continental Europe should take the lead in devising new rules for financial markets, because the Anglo-Saxon model of regulation has failed” should be given attention as well (cf. Merkel, Interview to the Financial Times, 11.06.2008). 11 The Dodd–Frank Wall Street Reform and Consumer Protection Act. 95

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However, there is actually a bigger challenge for regulators: it became clear that they need to get a much better understanding of financial innovations, and they ought not to allow practices that they do not fully understand (cf. Soros, 2008: chapter 8).There is an emerging consensus – do including many market makers, such as Soros himself – that the idea that risk management can be left to market participants is an aberration. Ninth, much closer international cooperation and coordination among the world’s major financial regulators is needed. Today’s level of international cooperation is wholly inadequate to the need. Perhaps the current worldwide financial crisis will finally persuade the world’s financial regulators that lip service is not enough (cf. Blinder, 2013; Tarullo, 2014). It will take time, but once in place, those reforms would pave the way for the return of “Schumpeterian finance”, where banks and other financial institutions with proper monitoring and plenty of skin in the game, will certainly have more incentives to go back to the business of financing “the creative part of creative destruction”.

6. Knowledge governance reform: a draft agenda Knowledge governance reform should seek to build institutions and shape markets in order to build a more effective, democratic and equitable knowledge ecology. From an evolutionary perspective, such knowledge ecology should be based on a more cooperative set of institutional arrangements where commons-based, peer production and open source architectures would lead the way for a more effective way to generate and diffuse knowledge and innovation (cf. Benkler, 2008; Burlamaqui, 2009). Competition policies and creative-destruction management are the major tools available here. From an evolutionary perspective, competition policies should not be about interfering with consolidation or preventing “market power” but should be about preventing “too secure monopolies” – and especially those not based and thriving on higher productivity and superior technological performance. Firstly, competition policies should shape markets and drive firms toward establishing research coordination, pushing common standards, preserving multiple sources of experimentation, monitoring patent pools, establishing va96

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riable patent and copyrights terms, and severely punishing both “unproductive patenting” behaviour and attempts by firms to close markets through creating their own proprietary, closed systems (cf. Carlton, Gertner, 2002; Burlamaqui, 2009; Mazzucato, 2013). Secondly, competition policies should be crafted to deal, first and foremost, with dynamic market inefficiencies. Plant argued that patents can make the beneficiary “the owner of the entire supply of a product for which there may be no easily obtainable substitute”, which is a troubling claim. A clever, but not radical innovation (for instance, Post It® notes from 3M) should not raise major concerns among policy-makers dealing with competition issues. But what about a nascent general-purpose technology (for instance, the new genetic engineering research tools or a particular DNA sequence)? Then Plant’s point would hold completely, and the granting of the patent would create substantial monopoly for the owner, potentially preventing others from exploiting it, thus slowing the diffusion of a new innovation. In cases like those involving general-purpose technologies, the IPR policy should be much more rigorously examined and carefully constructed. A possible “tool” for dealing with that would be for the government to claim a “golden share” in the IPR system (especially patents and copyrights, but also trade secrets) by which it would be able to convert a property right previously granted12 into a general public license, should the owner refuse, after establishing his first-mover advantage13, to behave cooperatively, and license broadly and fairly14. In sum, radical innovations and, especially, general-purpose tech12

That is, a “legally enforced” temporary monopoly. Meaning: being able to recover his costs, establish a robust competitive advantage, and enjoy a sizable profit stream, but not be able to exclude others from using and inventing around his innovation, or protect its diffusion. Taking as an example the Microsoft case, the battle shouldn’t be about “breaking” the company. The golden share would allow the government to force Microsoft to publish its source code. An open code would quickly get cleaned up and improved, consumers would benefit, and new entrants would probably arise helping ignite the innovation race and dislodging Microsoft from its monopoly position while preserving the company’s market power and ability to innovate. 14 In fact, this is already in the EU Competition Commission’s radar. Neelie Kroes argued in a speech that “industry standards for technology could be based on either proprietary or nonproprietary technologies, but when a market developed so that a proprietary technology became a de facto standard and the owner of that technology exploited that market power, competition authorities might have to intervene. One remedy would be to require to disclose of information at “fair rates” so that other companies could design compatible products and systems” (cf. Financial Times, 11.06.2008). 13

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nologies, should be subjected to a special IPR regime in which the government’s administrative guidance should be able, if needed, to “shape” the market toward a more competitive institutional design – away from too secure monopolies (Burlamaqui, 2013). A legitimate and fair reason to do so is that, according to some recent studies, the U.S. government played a decisive part in the development of virtually all general-purpose technology, from interchangeable parts and mass production to Darpa15 and biotech (cf. Ruttan, 2006; Weiss, 2007; Block, 2008). Having financed the bulk of the basic R&D that enabled the emergence of champions such as Colt, Boeing, General Electric, IBM, and a whole host of high-tech giants in hardware, software, and biotech, it would not be unreasonable for the U.S government to have a stronger role in granting that technological achievements don’t remain overly protected and scarcely diffused (cf. Roland, 2002; Ruttan, 2006; Mazzucato, 2013; Weiss, 2014). Although in other countries the privatization of publicly generated knowledge is not as acute as in the contemporary U.S., the U.S. PTO is certainly setting standards for everyone else. The way we have it now, its “public virtues, private vices”, an inversion of Mandeville’s dictum. Thirdly, given both the complexity and diversity of patents and IPRs, in general, a one-size-fits-all prescription is certainly not the best way to handle the matter. The 20-year length of a patent (or the terms of copyrights and registrations) is certainly not a “scientifically established outcome” (cf. Landes and Posner, 2003). It is, rather, a convention: that is, an institutional-legal construct that, as such, can very well be questioned and changed16. Conversely, as Jaffe and Lerner adduce (very much in line with the market features approach17): 15

DARPA is the Defense Advanced Research Projects Agency, the central research organization of the United States Department of Defense. It’s most radical innovation was the Internet (known first as “DARPA-Net”). 16 As a matter of fact, a century ago, copyrights lasted for 14 years — and could be extended for another 14, if the copyright holder petitioned for an extension. Today, corporate copyrights last for 95 years, while individuals retain copyrights for 70 years after their deaths. There was nothing “scientific” to back these changes, but rather the powerful lobby of the entertainment industry. As for patents, mind the reader that both in Switzerland (between 1850-1907) and in the Netherlands (between 1868 and 1912), industrialization occurred without enforcement of patent laws (cf. Schiff, 1971). 17 For a further elaboration of the “Market Features Approach” and its relation to competition policies, see Burlamaqui, 2008 (sections 3 and 4). 98

Finance and Knowledge: The Need for Effective Governance... [i]n the world of theoretical patent analysis, it is easy to show that the attributes of patent protection should vary depending on the characteristics of the technology (cf. ibid.: 203).

To be less abstract on the matter, let me propose this broad guideline for competition policies on IPRs: the length and breadth of patent protection, as well as innovations protected by copyrights, like software, should be linked to the expenditures in R&D, made or to be made18, by applicants. Thus, big research budgets (in terms relative to the firm’s size) would, in principle, qualify better than “historical accidents” to earn legitimate protection. This would enable them to cover their costs but not to expand their market power indefinitely. Instead of one size fitting all, we would have something like – paraphrasing Rodrik – “Many recipes under the same rule”19. Fourth, the “information feudalism” or “second enclosure movement”. This movement is seen by the so-called “progressive IP lawyers”, software programmers, and a sizable number of social and natural scientists of various extractions as a recipe for global monopoly, one that is likely to stifle innovation at the same time it concentrates wealth (cf. Drahos, P., and J. Braithwaite, 2002; Moglen, 2003; Benkler, 2003; Evans, 2005). A number of commentators have called for an alternative to this second enclosure, an alternative they term “the new commons”20, as Evans has aptly put it, this alternative is “attractive both because of its distributional implications and because of its potential for raising the rate of innovation and value creation” (2005: 3). The basis of the new com18

R&D expenses as a percentage of the applicant’s sales or assets, assuming that those R&Dintensive industries are also the ones bearing more fixed and sunk costs, plus, near-future planned expenses tied to the “birth” of an innovation or technology should be in the contract granting the rights and their actual production of the enabling mechanism to conclude the exam. Otherwise, patent pending would be a sort of “reasonable doubt” proviso. 19 A very difficult, emerging theme here is the protection to be given to traditional knowledge: DOC (Denominacione de Origine Controllata certifications that grant monopolies based on regional know-how and capabilities, like Champagne versus sparkling wines) issues and related others. We acknowledge its importance but will not deal with that in this paper. 20 A “commons” is a piece of land over which people can exercise certain traditional rights in common, such as allowing their livestock to graze upon it. Older texts use the word “common” to denote any such right, but more modern usage is to refer to particular rights of common, and to reserve the name “common” for the land over which the rights are exercised. By extension, the term “commons” has come to be applied to other resources which a community has rights or access to.

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mons comes from a redefinition of “ownership”: from the focus on the right to exclude to the focus on the commitment to distribute (disseminate). The key idea here is that once property rights are redefined along the lines pioneered by the open source software movement, a much more egalitarian redistribution of intangible assets and a more powerful rationale to foster innovations will be able to emerge. This rationale is one that unfolds from the characteristics of the networked information economy - an economy of information, knowledge, and culture that flows over a ubiquitous, decentralized network. In that environment, as Benkler remarks, productivity and growth can be sustained in a pattern that differs fundamentally from the industrial information economy of the 20th century in two crucial characteristics. First, non-market production can play a much more important role than it could in the physical economy. Individuals working alongside firms can make a real difference in the creation of innovative solutions and productivity gains (Benkler, 2003: 1; 2006)21. Second, radically decentralized production and distribution, whether market-based or not, can similarly play a much more important role by increasing the diversity of ways of organizing production and consumption and, therefore, by increasing the sources and possibilities for multiple forms of experimentation. This is clearly a global issue and – because of its global scope, and also due to the under-theorized relationship between competition policies and intellectual property rights – a very difficult one to handle. It will certainly require the active involvement of governments, as well as much more international cooperation, in encouraging and assisting the development of open-source systems to move society toward more general-public-licenses-oriented IPR regimes. It will also require comprehensive reforms of both WIPO and the WTO – a very turbulent matter from a power-politics perspective. Nevertheless, the recent deliberations of the EU Competition Commission (See note 19 above), and the decisions by IBM and Nokia, for example, to put part of their patents into the public domain suggests that there is perhaps more room to maneuver than the skeptical analyst might expect. 21

And, he adds, one can clearly observe this behaviour by noticing that most of what we do on the Internet runs on software produced by tens of thousands of volunteers, working together in a way that is fundamentally more closely related to a community than to a hierarchical big corporation standing alone.

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Lastly, patents and intellectual property in general are too important to be left to lawyers, juries, and a single PTO. They should be institutionally restructured, in the form of a cross-cutting knowledge governance agency working in coordination with the other regulatory bodies, where field experts from specific agencies would get training in IP issues in order to become examiners. Dedicated judges and courts (but not juries) should be the “last resort” in those matters, not the first. Additionally, this agency should be structured along “Weberian lines” - a set of offices, in which appointed civil servants operate under the principles of merit selection, expertise, a flat hierarchy, exclusive employment, career advancement, and legality. This type of rationality – Weber’s key term - would increase speed, scope, predictability, and cost-effectiveness (cf. Weber, 1922: 124-130). From an evolutionary-policy perspective, the key issue to deal with is how to separate innovation-rooted profits, which should be rewarded but understood as windfalls (dependent on continuous innovation), from legal monopolygranted rents, which should be eliminated or, at least, closely monitored and curtailed. Working along those lines, a successful knowledge governance reform will most likely restore the role of true Schumpeterian entrepreneurship at the expense of IP “rentiers”.

7. Conclusion To conclude, let me underline that, from an evolutionary perspective, Economic Governance reform agendas should: firstly, seek to restore both “Schumpeterian finance” and “Schumpeterian entrepreneurship”; secondly, “creative-destruction management policies” should become a key tool to accomplish those goals; lastly, the draft agendas proposed above (sections 5 and 6) would be a necessary and important step, “but not a sufficient one” for building a more effective and democratic frame in order to manage globalization both in finance and in knowledge.

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Bibliography Albrow, M. (1996). The Global Age, London: Polity Press. Anthony, S. (2000). “Antitrust and Intellectual Property Law: From Adversaries to Partners”, AIPLA Quarterly Review, Vol. 28, No. 1: 1. Bartokas, A., Mani S. (eds.) (2004). Financial Systems, Corporate Investment in Innovation and Venture Capital, London: Elgar. Benkler, Y. (2003). “Freedom in the Commons, Towards a Political Economy of Information”, Duke Law Journal. No. 52: 1245-1276. Bell, D. (2001). The Future of Technology, Kuala Lumpur: Pelanduk Press. Benkler, Y. (2006). The Wealth of Networks, London: Yale University Press. Benkler, Y. (2008). Commons-Based, Cooperative and Peer Production as Strategies for Development. Research Project for the Ford Foundation. Blinder, A. (2006) “Offshoring: The Next Industrial Revolution?” in: Foreign Affairs, Vol. 85, No. 2: 113-128. Blinder, A. (2008). “The Case for a Newer Deal”, in: The New York Times, 4.05.2008. Blinder A. (2013). When the Music Stopped. The Financial Crisis, the Response, and the Work Ahead, London: Penguin Press. Kindle edition. Blustein, P. (2001). The Chastening. Public Affairs. Blustein, P. (2005). And the Money Kept Rolling in (and Out), Boston: Public Affairs. Block F. (2001). “Introduction” to the new edition of The Great Transformation, Beacon Press: XVIII-XXXVIII. Block, F. (2008). Where do Innovations Come From? Transformations in the U.S National Innovation System 1970-2006. Research Paper for The Ford Foundation, Grant #: 10751307. Boyle, J. (2004). Manifesto on the Future of WIPO. Accessed: 21.08.2012, http://www.law.duke.edu/boylesite/. Boyle, J. (2003). The Second Enclosure Movement and the Construction of the Public Domain. Accessed: 21.08.2012, http://www.law.duke.edu/boylesite/. Burlamaqui L. (2000). “Evolutionary Economics and the Role of State” in: L. Burlamaqui, A. C. Castro, H. J. Chang (eds.) Institutions and the Role of the State, Cheltenham: Edward Elgar: 27-52.

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Leonardo Burlamaqui Jolly, A., Philpott J. (eds.) (2004). A Handbook of Intellectual Property Management, London: Kogan Page. Kaletsky, A. (2010). Capitalism 4.0. – The Birth of a New Economy in the Aftermath of Crisis, Public Affairs. Keynes, J. M. (1936). The General Theory of Employment, Interest and Money, New York: MacMillan. Khor, M. (2006). The WTO’s Doha Negotiations and Impasse: A Development Perspective,. Third World Network. Accessed: 22.08.2012, http://www.twnside.org.sg/title2/twninfo488.htm. Kregel, J. (1997). Yes, “It” Did Happen Again – the Minsky Crisis in Asia, Jerome Levy Institute Working Paper. Kregel, J. (2008). Minsky’s Cushions of Safety – Systemic Risk in the U.S. Subprime Mortgage Crisis, New York: Jerome Levy Institute Public Policy Brief No. 93. Landes, W. Posner, R. (2003). The Economic Structure of Intellectual Property Law, Harvard: Belknap Press. Laurent, J., Nightingale J. (eds.) (2001). Darwinism and Evolutionary Economics, London: E. Elgar. Mazzucato, M. (2013). The Entrepreneurial State, London: Anthem Press. Michie, J., Smith J. G. (eds) (1999). Global Instability – The Political Economy of World Economic Governance, London: Routledge. Mehrling, P. (1998). The Vision of Hyman P. Minsky, Working Paper, Columbia University. Minsky, H. (1977). “The Financial Instability Hypothesis: An Interpretation of Keynes and an Alternative to «Standard» Theory”, in: Challenge, Vol. 20, No. 1 (March/April): 20-27. Minsky, H. (1982). Can “IT” Happen Again: Essays on Instability and Finance, Armonk: M. E. Sharpe. Minsky, H. (1986). Stabilizing an Unstable Economy, New Haven and London: Yale Univ. Press. Minsky, H. (1990). “Schumpeter: Finance and Evolution”, in: A. Heertje, M. Perlman (eds.) Evolving Technology and Market Structures, Ann Arbor: Michigan University Press: 51-74. Moglen, E. (2003). Freeing the Mind: Free Software and the Death of Proprietary Culture, Fourth Annual Technology and Law Conference, June 29, Portland: University of Maine Law School. Nelson, R. (1987). “Roles of Government in a Mixed Economy” in: Journal of Policy Analysis and Management, Vol. 6, No. 4: 514-541.

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Finance and Knowledge: The Need for Effective Governance... Nelson, R. (2003.). The Market Economy and The Scientific Commons, LEM Working Paper Series, Pisa: Sant’Anna School of Advanced Studies. Nelson, R. (2006). “Evolutionary Social Change and Universal Darwinism”, in: Journal of Evolutionary Economics, Vol. 16, No. 5: 491-510. Nelson, R., Winter, S. (1982). An Evolutionary Theory of Economic Change, Cambridge (MA), Harvard/Belknap. Nayyar, D. (ed.) (2002). Governing Globalization, Oxford: Oxford University Press-New Delhi. Plant, A. (1974). Selected Economic Essays and Addresses, Photocopy. Polanyi, K. (1944) [2001]. The Great Transformation, Boston: Beacon Press. Reinert, E. (2007). How Rich Nations Got Rich... and Why Poor Countries Stay Poor, London: Constable Press. Roland, A. (1983-1993). Strategic Computing: DARPA and the Quest for Machine Intelligence, Cambridge, Mass.: MIT Press. Ruttan, V. (2006). Is War Necessary for Economic Growth?, Oxford: Oxford University Press. Rodrik, D. (1999). The New Global Economy and Developing Countries: Making Openness Work, Washington D.C.: ODC Press. Rodrik, D. (ed.) (2003). In Search of Prosperity, Princeton: Princeton University Press. Rodrik, D. (2005). “Feasible Globalizations” in: M. Weinstein (ed.), Globalization – What’s New?, New York: Columbia University Press. Rodrik, D. (2007). One Economics, Many Recipes, Princeton: Princeton University Press. Roubini, N. (2008). Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization. Accessed: 22.08.2012, http://www.rgemonitor.com/blog/roubini/252272/. Ruttan, V. (2006). Is War Necessary for Economic Growth? Oxford: Oxford University Press. Schiff, E. (1971). Industrialization without National Patents, Princeton: Princeton University Press. Schiller, R. (2000). Irrational Exuberance, Princeton: Doubleday. Scholte, J. A. (2005). Globalization – a Critical Introduction, New York: Palgrave Macmillan. Schumpeter, J. A. (1934). The Theory of Economic Development, New Jersey: Transaction Books. Schumpeter, J. (1942). Capitalism, Socialism and Democracy, London: Routledge.

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Leonardo Burlamaqui Soros, G. (2008). The New Paradigm for Financial Markets – the Credit Crisis of 2008 and what it means, New York: Public Affairs. Stiglitz, J. (2001). Foreword to the New Edition of the Great Transformation. Stiglitz J., Charlton (2005). Fair Trade for All – How Trade can Promote Development, Oxford: Oxford University Press. Turner, A. (2012). Economics After the Crisis, Cambridge (MA): MIT Press. Underhill, G. (ed.) (1997). The New World Order in International Finance, New York: McMillan. Underhill G., Zhao, (eds.) (2003). International Financial Governance under Stress – Global Structures versus National Imperatives, Cambridge: Cambridge University Press. Wade, R. (2007). The Aftermath of the Asian Crisis: From “Liberalize the Market to “Standardize the Market (and Make a Level Playing Field). Paper given at the Tenth Anniversary of the Asian Crisis Conference, May 2007, Washington D.C. Warren, E. (2007). “Unsafe at Any Rate – Why do we need a Financial Products Safety Commission” in: Democracy Journal, Summer. Accessed: 22.08.2012, http://www.democracyjournal.org/5/6528.php?page=all. Weber, M. (1922) [1976]. Economy and Society, Berkeley: Berkeley University Press. Weinstein, M. (ed.) (2005). Globalization – What’s new?, New York: Columbia University Press. Weiss, L. (ed.) (2003). States in the Global Economy, Cambridge: Cambridge University Press. Weiss, L. (2014). America Inc.?, Cornell: Cornell University Press. Wolf, M. (2008). “Seven Habits Finance Regulators Must Acquire”, in: The Financial Times, 6.05.2008. Woods, N. (ed.) (2000). The Political Economy of Globalization, New York: St. Martins Press. Woods, N. (2006). The Globalizers – the IMF, the World Bank and Their Borrowers, Cornell: Cornell University Press.

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HOW TO FIX THE EURO AREA? POISON AND REMEDY: THE ROOTS OF THE CRISIS AND NEW INSTITUTIONAL SOLUTIONS

Grzegorz Tchorek1

Abstract: The objectives of the article are as follows: firstly, to consider the main economic and institutional weaknesses of the Euro Area before the crisis; secondly, to assess the introduced and proposed reforms as a response to the crisis; and thirdly, to contribute to the optimum model of the Euro Area functioning in the future. The main findings after the crisis indicate that the euro introduction was based on incorrect assumptions, which led to a real and nominal divergence between countries despite expected convergence. The new institutional regulations, introduced in the EU after the crisis, strengthened the current and established new mechanisms forming the fiscal, economic and financial pillars of the monetary union. A “hub and spoke” model of the European cooperation, as suggested by the author, confirms that the single currency is based on the power of institutions rather than on that of sovereignty. Keywords: Euro Area, crisis, institutional reforms.

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Grzegorz Tchorek – PhD in Economics, Associate Professor in Economics, Faculty of Management, University of Warsaw, National Bank of Poland, e-mail: [email protected] . 107

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1. Introduction The objectives of the article relate to three main issues: firstly, identification of the main weaknesses of the Euro Area mechanisms, which led to the crisis; secondly, an assessment of the introduced and proposed reforms; and thirdly, a proposal for the optimum institutional model of the Euro Area functioning in the future. The main findings from the literature review indicate that the euro introduction was based on incorrect assumptions, which led to real and nominal divergence between countries despite expected convergence. Moreover, the economic and financial crisis stressed that the Euro Area was an incomplete monetary union because of insufficient stabilization instruments and low level of solidarity between countries. The new institutional arrangements introduced in the EU are a big step towards strengthening the current and establishing new mechanisms forming the fiscal, economic and financial pillars of the monetary union. However, the progress and quality of their implementation is conditioned by a lot of factors. The main risks which can undermine the effectiveness of the reforms are connected with the fact that they are related to a broad set of economic and political aspects and demand giving up of national competences which should be delegated to the EU level. The proposed model of European cooperation of a “hub and spoke” type means that the single currency is based on the power of institutions rather than on the power of sovereignty. It can constitute an alternative or transitional form of integration contrasting with decentralized monetary union before the crisis, and a highly centralized model of full political union, indicated as a target for the UE, and especially the Euro Area.

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2. Theoretical foundations of the Euro Area structure and sources of the crisis The main arguments in favor of the Euro Area establishment included the elimination of exchange rate risk and transaction costs resulting from dealing with a number of various currencies. Monetary integration was expected to entail significant transformations in both financial dimension and real economies of the Euro Area. Firstly, the common currency was intended to stabilize inflation expectations which, in the 1970s and 1980s, constituted the principal source of macroeconomic instability, also caused by serious exchange rate volatility, frequent devaluations and inadequate fiscal discipline. Secondly, lessons learnt from the debt crisis of the 1980s and the currency crisis of the 1990s suggested that the elimination of exchange rate risk might reduce the macroeconomic instability and country risk resulting from currency speculation and the threat of bankruptcy related with the so-called “original sin” (Eichengreen et al., 2003)2. Thirdly, a large and integrated financial market, connected through the common currency and monetary policy, was meant to facilitate access to a deep and diversified financial system and to stimulate processes of real convergence. Fourthly, it was assumed that integrated financial markets would act as mechanisms absorbing asymmetric shocks – “risk sharing channel” (KalemliOzkan et al., 2001) – see Table 1. In the real economy, adoption of the euro was meant to increase the efficiency of the monetary union economic system through better price transparency, stimulated competition and increased trade and investments (Mongelli, De Grauwe, 2005) as well as more incentives for structural reforms (Duval, Emelskov, 2006). Therefore, there appeared expectations that even if a country was not ready to participate in the Euro Area, it would be easier for it to fulfill the conditions of the Optimum Currency Area (OCA) as a member of the monetary union – endogeneity of the OCA (Rose, 1998). As a result of increased 2 The so-called “original sin” may affect developing countries that borrow money in foreign currencies, thus exposing themselves to the risk of losing their ability to service their debt as a result of a profound devaluation/depreciation of national currency.

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trade, convergence of income levels as well as a correlation of business cycles were also expected. Table 1: Macroeconomic assumptions and experiences of the Euro Area Prior to the crisis it was assumed that:

elimination of exchange rate risk – would reduce the macroeconomic risk by stabilizing the inflation expectations and increase the efficiency of marketbased mechanisms through integration of national markets into a Single Market and elimination of “home bias”, – would reduce the risk of currency crisis and bankruptcy due to the absence of exchange rate risk and elimination of the so-called original sin; structural convergence – would proceed as a result of intensified trade and synchronization of business cycles – endogeneity of the OCA criteria, – would be stimulated by structural reforms through market discipline and inability to use currency devaluation as a competitiveness tool (known as the TINA argument, i.e. There Is No Alternative); financial markets integration – would stimulate economic growth, – would facilitate financing of balance of payment deficits, – would alleviate shocks through the so-called risk – sharing mechanism, – would uniform the mechanisms of monetary policy transmission. Source: Tchorek, 2014.

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In the wake of the crisis it occurred that: – might lead to other types of risks and market dysfunctions, for example excessive debt and credit booms, – might lead to susceptibility to contagion and speculation in financial market segments other than the foreign exchange market, as well as market fragmentation – might increase the risk of bankruptcy due to inability to monetize debt;

– had not really happened. Instead, divergence had appeared, due to: – significant disparities in term of GDP per capita and economic structures among economies when the Euro Area was established, – pro-cyclical macroeconomic policy and boom and bust phenomena, – lack of flexibility of economic structures and of capability of meeting the Maastricht criteria in a sustainable way, – lack of structural policy to boost competitiveness; – had contributed to the boom and bust phenomenon, thus abruptly increasing divergence, – had acted as both generator and accelerator of shock due to the inadequate and fragmented financial supervision and the ”sudden stop and reversal” phenomenon as well as reemergence of the “home bias”, – might, in the absence of institutional integration, lead to financial fragmentation and dysfunctions in the mechanism of monetary policy transmission.

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Assessments made until 2008 indicated that many of the abovementioned benefits of the monetary integration had become a reality. Nonetheless, the crisis over the years 2008-2012 revealed many weaknesses of the Euro Area mechanisms. The crisis also contributed to the deepening of many dysfunctions of the common currency system. In evaluating a period of almost fifteen years of the Euro Area functioning, it may be argued that the monetary integration failed to fulfill many expectations. In a number of fields, mechanisms of the Euro Area have to be reformed or even new institutions should be established. Firstly, experiences of the Euro Area countries (as well as other EU member states maintaining fixed exchange rates, such as Baltic countries or Bulgaria) suggest that elimination of exchange rate risk may indeed improve microeconomic efficiency of the economy (lower interest rates and costs of capital as well as capital flows from wealthy to poorer countries). However, from macroeconomic point of view, greater availability of cheap money may cause the risk of excessive debt in the private sector because of boom and bust cycle phenomena. The integration of financial markets, spurred by elimination of exchange rate risk and common monetary policy in place of national policies, contributed to an abrupt reduction of interest rates, improved access to financing and soaring cross-border capital flows. Increasing differentials in national inflation rates made common monetary policy pro-cyclical because of negative real interest rates and led to excessive debt in the private sector and to accumulation of macroeconomic imbalances. Secondly, in the absence of crisis management mechanisms, an abrupt outflow of private capital from the Southern countries of the Euro Area resulted in contagion effect because of speculation in financial markets. In consequence of the private sector debt, dependence on wholesale and short-term financing sources and exposure to American toxic assets, the Euro Area was affected by the banking crisis. Due to the enormous size of national banking sectors (several times bigger than GDP), the banking crisis was so severe for financial systems as well as national sovereignties. National budgets suffered because of nationalization of collapsing financial institutions or guarantees for them. Liquidity problems experienced by the governments of member states contributed to the insolvency crisis. A growing risk of the Euro Area break-up, on the other hand, spurred sudden stops and reversals in capital inflows and a balance of payment crisis (Bijlsma, Vallee, 2011). 111

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The lack of institutional stabilizing mechanisms, including the lender of last resort function for the governments, revealed that the risk of the individual Euro Area countries collapse might be more serious than in the case of a country with its own currency. The elimination of exchange rate risk failed to eliminate the risk of the original sin, so it did not protect the Euro Area member states from the risk of speculation against any given economy or from the contagion effects. Despite the absence of national currencies, speculation still became a problem in the government bond and derivative markets (De Santis, 2012; Arghyrou, Kontonikas, 2011). Accordingly, financial markets which – as originally assumed – were meant to absorb asymmetric shocks, became their source themselves. Because of downgrading credit ratings, serious turbulence in government securities’ markets, banking crisis and freezing of wholesale money markets, the mechanism of monetary policy transmission was seriously disturbed. Financial markets underwent a fragmentation process, which led to increasing differentiation of long-term interest rates and cost of credit for the private sector in the situation of historically lowest ECB’s nominal interest rate (IMF, 2012). The data presented in Figure 1 suggest that integration of financial markets did not really support the process of structural transformation in the Southern Euro Area economies and that, at the same time, it played the role of an important source of macroeconomic imbalances – see Figure 2. In the cases of Greece, Portugal and Italy, the credit was directed towards private consumption. In Ireland and Spain, the credit was also targeted at companies but it was largely allocated to the non-tradable goods sector. Moreover, the currency integration contributed to the worsening of the structure of foreign capital inflow, shifting it towards debt financing (bank and market debts), with a diminished role played by FDI and equity financing. It exposed the peripheral countries to the financial shock after Lehman collapse in 2008 to a greater extent than the countries financed more by equity flows.

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How to Fix the Euro Area?... Figure 1: Financing structure of the chosen Euro Area economies Spain: non - financial corporations Gross fixed capital formation

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1995

1999

2007

1995

2011

Intangible fixed assets Cultivated assets Other machinery and equipment Transport equipment Other buildings and structures Dwellings

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

2007

2009

2007

2011

Italy structure of domestic credit

100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

2011

Households; non-profit institutions serving households General government Financial corporations

1999

Intangible fixed assets Cultivated assets Other machinery and equipment Transport equipment Other buildings and structures Dwellings

Greece structure of domestic credit

1995

Ireland: non-financial corporations Gross fixed capital formation

1995

2007

2009

2011

Households; non-profit institutions serving households General government Financial corporations Non-financial corporations

Source: Own calculation, based on the Eurostat data.

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Thirdly, mechanisms designed to eliminate structural differences between countries were missing, as were instruments preventing and correcting the macroeconomic imbalances. Divergences largely manifested themselves as a result of the price competitiveness loss by some member states’ economies, accompanied by inflexible labor and goods markets. This led to real appreciation of exchange rates, which was caused by increasing inflationary differentials, stemming from, among other things, consumption and investment booms. Simultaneous wage pressure in the services sector triggered the shift of production structure towards non-tradable sectors, lowering export market shares. Fourthly, the impact of the euro on trade appeared to be lower than expected. The original outlook was based on the assumption of a strong influence of exchange rate risk elimination over trade and business cycles correlation. This phenomenon was usually called the “endogeneity of the optimum currency area criteria”. Experiences of initial years of the monetary union indicate that the “euro effect”, i.e. additional trade volume thanks to the adoption of the common currency, amounted to around 2-5%. This means that the impact of the euro was weaker than expected and weaker than the influence of other determinants, such as ongoing globalization and inclusion of emerging economies with low labor costs (like China, Central and Eastern European Countries) in international trade, changes in raw material prices, appreciation of the euro from 2001 to 2008, and reallocation of foreign investment outside the Euro Area because of higher GDP growth of the global economy than in the Euro Area (Mroczek, 2009). Fifthly, in terms of the influence of the euro adoption over FDI flows, the early expectations were also greater than investment actually made. According to initial evaluations, the common currency had a positive impact on the FDI flows both within and beyond the Euro Area (Sousa, Lohchard, 2006). Petroulas (2007) argues that the introduction of the euro could have contributed to an increased flow of FDI between the Euro Area countries as well as to increased outflows of FDI from the Euro Area to third countries. On the other hand, Taylor (2008) comes up with less encouraging conclusions. He observes that, excluding the flows to Luxembourg from the group of the analyzed countries, changes in the FDI flows between the Euro Area countries were below average for all the countries worldwide. As regards significance of the euro introduction for FDI, studies by Flam and Nordstrom (2008) indicate that com114

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mon currency cannot be considered as a decisive factor. They suggest that the single market effect may be more important for FDI flows. Dinga and Dingova (2011) also seem quite far from confirming the influence of the euro on FDI. What they notice, instead, is the significance of the EU membership as a factor stimulating the FDI flows. In the context of these observations, it seems worthwhile to consider the examples of Greece and Italy, i.e. countries in which no major growth of direct investment inflow was recorded in the wake of the euro adoption – see Figure 2. Investment attractiveness of these countries was largely limited by poor institutional quality (unfriendly legislation, malfunctioning administration, etc.) and low international competitiveness. One peripheral country which, unlike the other two, absorbed much investment in relative terms is Portugal. Nonetheless, the sectoral structure of FDI inflows shows bias toward non-tradable sector, mainly services targeted at market penetration rather than export activities. Figure 2: Foreign Direct Investment in the Euro Area Inward FDI, stocks as a % of GDP

200 150 100

1995

Belgium

Ireland

Netherlands

Slovakia

Portugal

Spain

France

Austria

Finland

2007 Germany

0

Italy

1999 Greece

50

2012

Source: UNCTAD.

As we see from the example of Portugal, in addition to the scale of FDI inflows, their structure should also be taken into account (Christodoulakis, Sarantides, 2011). Empirical studies suggest that the composition of FDI inflow in the Euro Area countries, as well the EU non-Euro Area countries, could deter115

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mine divergent levels of labor productivity and economic competitiveness, and magnitude of external imbalances (Mitra, 2011; Kinoshita, 2011). In the case of the monetary union, Northern countries mainly attracted FDI in more productive industries while Southern ones absorbed more investment in non-tradable sectors. The above experiences indicate that instead of an expected convergence, following an initial period of positive tendencies, serious divergences appeared among the Euro Area countries. A number of studies emphasize a growing divergence, especially over the last couple of years preceding the crisis. Lewhad (2012), who examined changes in production, investment and consumption in both sub-periods, i.e. over the years 1991-1998 and 1999-2010, distinguished a group of “central” countries including Belgium, France, Germany, Italy, Finland and the Netherlands and “peripheral” countries of the Euro Area (Greece, Ireland, Portugal and Spain). He points to greater synchronization of cycles in the earlier period in both groups of countries. Following the introduction of the common currency, the synchronization increased only in the central countries while the peripheral countries recorded decline. The author explains closer economic and financial ties within the former group in relation to the increasing significance of global factors (trade and financial flows) which are more important in the central than peripheral countries. Sinn et al. (2011) confirm that capital inflow to the peripheral countries accelerated economic growth; however, in northern countries, which exported capital, investment rates shrank as a result of economic stagnation. Breuss (2011) indicates that the introduction of the euro emphasized the differences between economies in terms of competitiveness and entailed differences in business cycles. Miles et al. (2011), in examining cycle correlation between four peripheral economies (Greece, Spain, Portugal and Ireland) and the central ones, i.e. Germany and France, do not observe more intensive synchronization in the case of the two former ones and confirm a decrease in the case of Ireland and Greece. As they evaluate changes in synchronization between the Euro Area center and three economies of the European Economic Area not belonging to the Euro Area (namely Denmark, Switzerland and Sweden), the authors do not note lower synchronization in the two former cases and observe higher synchronization in the case of Sweden. These observations indicate that growing importance of the “central” countries actually confirms Krugman’s hypothesis concerning production concentration 116

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as a result of monetary integration and undermines Rose’s hypothesis of endogeneity (Pisani-Ferry, 2012)3.

3. Weaknesses of the Maastricht Treaty There is no doubt that the crisis in the Euro Area is a part of the global crisis. However, the above-mentioned deficiencies of the Euro Area functioning also had their roots in a flawed institutional structure established under the Maastricht Treaty. Most of all, the rules of the Treaty focused on fiscal stability limited to such issues as the level of budget deficit, loose coordination of member states’ macroeconomic policies and price stability as the fundamental objective for the central bank. It was assumed that there would be no need to have crisis mechanisms in place because the Treaty rules were meant to prevent any crisis – see Table 2. Table 2: Assumptions of the Maastricht Treaty and experiences of the Euro Area Prior to the crisis it was assumed that: fiscal policy – would be stable and credible thanks to market discipline and to the Treaty rules containing the budget deficit limit of 3% and the “no-bailout VE”; economic and structural policy – would be coordinated at the European level through non-binding coordination instruments (Open Method of Coordination), – would be “a matter of common interest”;

In the wake of the crisis it occurred that: – had been ineffective in building anti-cyclical buffer and preventing excessive public debt; – had not been accompanied by financial market discipline (interest-free ride), which was aggravated by the problem of “zero risk free weight”; – requires more advanced and stricter instruments of coordination and alignment of common goals in order to prevent negative spillover effects, – requires elimination of incentives for the “beggar thy neighbor policy”;

3

Contrary to Rose’s assumptions, Krugman indicated, giving the example of the USA, that a common currency may lead to agglomeration of production and to increased differences among business cycles in individual areas (see: Mongelli, 2002 for more details). 117

Grzegorz Tchorek monetary policy – should be focused on narrowly understood price stability;

– should be extended to include the function of ensuring the financial stability, including the macro-prudential policy, – should ensure the lender of last resort function;

crisis management mechanisms – would not be necessary because the Treaty rules prevented fiscal and balance of payment crises;

– should constitute an indispensable element of the financial safety nets in the Euro Area, since the lack of them undermined the trust in the stability and future of the monetary union project, – should have been established ex ante, because the process of their establishment during the crisis inevitably entailed a great deal of political dispute; division of the EU into the Euro Area countries and non-Euro Area countries – would not be a real problem since the Maastricht Treaty assumed that all the EU member states would eventually become the Euro Area members too.

– constituted a serious barrier to the process of agreeing upon new institutional solutions, and led to the risk of a two-speed Europe.

Source: Tchorek 2014.

3.1. Fiscal Policy According to the assumptions of the OCA theory, the monetary union should be accompanied by an integrated fiscal policy in the form of a common budget ready to initiate transfers between individual countries in reaction to asymmetric shocks. The importance of such an instrument had already been signaled by, among others, Ingram as early as in 1959 or McDoughall in 1977. As a result of the lack of either social or political consensus on the establishment of a common budget, fiscal rules defined under the Maastricht Treaty emerged as a substitute of the common budget. On the one hand, their aim was to facilitate the implementation of an anti-cyclical fiscal policy, the role of which is indeed increasing once national monetary policies have been given up. On the other hand, the introduction of fiscal rules in member states’ policies was to reduce the risk of excessive debt of individual countries at the cost of the other ones (moral hazard). Protective measures against these threats were included the Excessive Deficit Procedure (EDP), specifying the threshold of 3% 118

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budget deficit in relation to GDP as well as the “no-bailout clause” prohibiting provision of “financial rescue”. According to the latter one, neither European institutions nor member states should have to bear responsibility for other member states’ debt. However, these instruments bringing discipline into fiscal policy failed to prove effective, for the reasons discussed below. Firstly, this was caused by fragility of the European institutions in enforcing the provisions of the Stability and Growth Pact (SGP). The first serious weakness of the SGP appeared in 2003 when the EU Council did not adopt the European Commission recommendations concerning the sanctions against two largest countries exceeding the 3% limit, i.e. France and Germany. Indeed, throughout the history of the SGP, not a single fine has ever been imposed on any EU member state, despite the rules being violated many times. Secondly, this was a consequence of the lack of member states’ ownership of fiscal rules defined at the European level (Filipek, Schreiber, 2010). The problem of violating the rules not only concerned the above-mentioned largest countries (in 1999-2008, Germany and France infringed the 3% deficit criterion five and four times, respectively), but, most of all, Greece (which actually never met the criterion since its accession to the Euro Area until 2008), Portugal and Italy (the limit of 3% of GDP for budgetary deficit being exceeded six times), as well as some EU member states not belonging to the Euro Area. Thirdly, financial markets’ discipline weakened in the Euro Area and in the whole global financial system. The elimination of exchange rate risk premium in the Euro Area, which was perceived as a factor eliminating the risk for a given country, removed differences between the levels of long-term interest rates. Relationships between the quality of fiscal policy and long-term interest rates were weakened as well. Moreover, financial markets did not attach much importance to the “no-bailout clause”. This resulted from the assumption that should any member state face bankruptcy threat, its debt would be bailed out by other member states because of their close economic and financial ties (Gianviti et al., 2012). Finally, financial market failure also stemmed from global factors, in particular – after 2003 – from low interest rates in the main global financial centers, increasing global capital supply as a result of saving glut, low risk aversion and search for yield.

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3.2. Economic policy The Euro Area’s official name is the Economic and Monetary Union. However, the EMU lacked a common economic policy and, as evidenced by the crisis, it has not even become a complete monetary union so far. Instead, one centralized monetary policy run by the ECB was accompanied by national fiscal and macroeconomic policies. In the area of national macroeconomic and structural policies, the Broad Economic Policy Guidelines were meant to play the role of a coordination tool. Unfortunately, this instrument was not legally binding upon member states and non-compliance was not regarded as a violation of law (Oręziak, 2004). What the Treaty actually required was only that countries, while running their economic policies, regard them as a matter of common interest by taking the goals and priorities defined at the EU level into account. Therefore, the Open Method of Coordination failed to provide a sufficiently effective instrument to ensure that the Euro Area’s (and, in fact, the entire EU’s) competitiveness and stability is treated as a common good (Tchorek, 2013). In consequence, the conducted economic policies led to instability of the Euro Area economies (booms in real estate markets in both Ireland and Spain) as well as those of the other EU member states (such as expansion of Scandinavian banking over Baltic countries, which also contributed to the emergence of bubbles). The literature also points out that the institutional model of the EU functioning left a relatively vast room for running a “beggar thy neighbor” policy (Łaski, Podkaminer, 2012; Vernengo, Pérez-Caldentey, 2012). 3.3. Monetary policy Based on the experiences of the 1970s and early 1980s, inflation was considered the crucial risk for a stable macroeconomic environment. In the face of general increase of central banks’ independence since the early 1990s, a measure that became more and more popular was the inflation targeting strategy with an evident focus on price stability as the only objective for the central bank. Thus, stabilization of inflation was expected to guarantee macroeconomic stability. Unfortunately, this approach failed to take into account the problem of counteracting speculative bubbles and financial systems’ instability (IMF, 2009).

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Capital outflow from the Euro Area peripheral countries as well as the lack of crisis management mechanisms exposed another weakness, namely no lender of last resort (LOLR) for national governments. As the contagion effect was spreading, in the face of missing crisis management mechanisms and speculations about the Euro Area break-up, expectations appeared with respect to the ECB assuming such a role. This was especially important as, with no LOLR role played by the ECB, countries issued debt in foreign currency, which remained beyond their control. A further consequence was that liquidity crisis led to the insolvency crisis. The EFSF (European Financial Stability Facility) and then the ESM (European Stability Mechanism), which were meant to perform the role of a substitute for the LOLR function, proved ineffective due to financial restrictions that, as such, are not relevant for the central bank in its role of the lender of last resort. 3.4. The problem of the balance of payment crisis and lack of stabilization mechanisms Before the crisis, the balance of payment problem in the Euro Area member states was not regarded as serious (Merler, Pissani-Ferry, 2012). This was manifested in the Treaty regulations stating that the Euro Area member states could not use the balance of payments assistance mechanism (Article 143 TFEU). This approach resulted from the assumption that capital flows from central to peripheral countries were justified by tightening trade, capital and investment relations (Blanchard, Giavazzi, 2002). Catching up countries were borrowing capital which was intended to stimulate income convergence and enable the borrowers to pay it back in the future. Integrated financial markets were expected to fund the imbalances in the monetary union, as mentioned by Ingram as early as in 1972. Moreover, the balance of payments of the Euro Area as a whole was close to zero or even slightly positive so any imbalances in individual member states were seen as no reason for concern. However, the balance of payment crisis appeared as a result of banking and fiscal crises. The lack of assistance mechanisms or their provisional nature caused an outflow of capital from peripheral countries. Instead of contributing to depreciation of respective currencies, this phenomenon resulted in the fleeing private capital being replaced with public resources provided by the IMF-EU 121

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assistance programs as well as capital transfers within the Euro system through TARGET2. In terms of liquidity, the sudden stop is effectively mitigated by the internal payment system of the ECB and national central banks of the Euro Area countries (Bijlsma, Vallee, 2011). However, still there are no systemic mechanisms for alleviating the balance of payment crisis in terms of solvency – see Table 3. Table 3: Typology of crises and remedies undertaken in the Euro Area Liquidity mechanisms

Solvency

banking

government guarantees, unconventional monetary policy actions – SMP, LTRO

recapitalization by governments

fiscal

EFSF, ESM, IMF

ESM, private sector restructuring

balance of payments

extraordinary support for liquidity

no proposals

Crisis/actions

Source: Bijlsma and Vallee, 2011.

The legal structure of the common currency did not foresee a necessity to counteract any liquidity or solvency problems. Accordingly, the Euro Area system was not equipped with any formal crisis management mechanisms. The lack of clear crisis management rules raised country risk and contributed to a significant increase in bond yields. Thereby, through growing financing costs, it increased the risk of individual countries going bankrupt. In effect, the Euro Area actually appeared to be a group of countries bound by fixed exchange rates, rather than a complete monetary union. What we experienced in the face of the crisis was the return of “home bias” and the actual recurrence of the exchange rate risk, which could have potentially materialized in case of the Euro Area break-up (“redenomination risk”). 3.5. The EU fragmentation: deepening of the division into Euro Area and non-Euro Area countries The designers of the Maastricht Treaty assumed that the EU member states would automatically become Euro Area members. Thus, they failed to foresee legal problems stemming from the formation of three groups of the EU 122

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countries: those belonging to the Euro Area, countries with a permanent derogation (Denmark and the United Kingdom) and those with a transitional derogation (the remaining EU member states). Prior to the crisis, the problem was not particularly onerous. Relatively fast economic growth, increasing trade and financial integration of the EU member states as well as the absence of any deeper economic shocks helped to hide these problems even further. The need to develop risk-sharing mechanisms and implement reforms revealed serious differences between the EU countries. This resulted from the necessity to adopt new rights, obligations and a system of sanctions. Moreover, another problem for the integration stemmed from a tendency to solve the current issues at the intergovernmental level, i.e. beyond the EU institutions such as the European Commission or the European Parliament. Indeed, such solutions as the ESM or the Fiscal Compact are rather similar to intergovernmental agreements in their nature and may function with no connection to the EU (Barcz, 2012). Together with the Euro Plus Pact and the proposed banking union, these instruments clearly emphasized a division of countries into a twospeed Europe.

4. Evaluation of proposed reforms 4.1. Fiscal policy and fiscal union According to theoretical assumptions, the best solution for the Euro Area is to establish a common budget. In this case, the fiscal union should provide ex-ante stabilization instruments (fiscal risk-sharing) by means of transfers between countries, financial stability mechanisms and provision of public goods (IMF, 2012). It would also be necessary to set up a system of common taxes and give up much of national autonomy. The latter seems to be very unlikely in the short run, in light of all social and political considerations. This means that the future of the Euro Area’s fiscal policy is going to be based upon the reformed SGP under the six-pack, Fiscal Compact and two-pack4. 4

The Fiscal Compact (Treaty on Stability, Coordination and Governance in the Economic and Monetary Union) is an instrument intended to increase the efficacy of fiscal discipline among 123

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In terms of fiscal policy, the proposed solutions seem to largely address the problems faced by the old SGP (Tchorek, 2013). Firstly, in reaction to the SGP’s weakness as regards inefficiency of the EU institutions in enforcing fiscal rules, a new mechanism was introduced providing for more automatic fine impositions (Reversed Qualified Majority Voting (RQMV) in the EU Council. RQMV means that a recommendation or a proposal by the Commission is considered adopted in the Council unless a qualified majority of Member States votes against it. Whilst the RQMV is seen as the most important reform of the SGP, it fails to completely eliminate the risk of political actions and still allows countries to evade sanctions. Secondly, significantly more attention was paid to ensuring the anticyclical nature of fiscal policy and its greater discipline in good times by the introduction of an expenditure rule, as proposed, among others, by Hauptmeier et al. (2011). This may prevent such situations as those experienced in Ireland and Spain, which, despite meeting the SGP rules, were affected by a serious breakdown of their public finance when the bubble burst on the real estate market. Unfortunately, before the crisis, both countries increased their structural spending, assuming that it was accompanied by structural revenues, which indeed appeared to be only cyclical. Thirdly, public debt was considered as a more important measure of fiscal policy quality because, as made evident by the crisis, it was the total debt rather than just deficit that might really determine a country’s solvency (both the reformed SGP and the Fiscal Compact indicate the need to reduce the debt which exceeds 60% of GDP, or else sanctions must be imposed). Fourthly, a possibility was introduced to initiate the procedure of imposing sanctions upon countries for non-compliance with the SGP requirements already within its preventive arm. Fifthly, SGP is supplemented by the Council Directive specifying the so-called budgetary framework for member states, which, among other things, the Euro Area member states. It reiterates the fundamental SGP requirements to maintain fiscal stability and the maximum 3% deficit level or the 60% level of public debt in relation to GDP, and it also sets forth several additional elements. Most of all, it states that member states must introduce the so-called fiscal golden rule to their national legislation. This prohibits them to maintain structural deficit at a level above 0.5% of GDP. At the same time, sanctions for noncompliance can be imposed more automatically. Fines of up to 0.1% of GDP will be ordered by the EU Court of Justice, thus additionally depoliticizing decisions. 124

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provides for the establishment of fiscal councils by the end of 2013, the adoption of multi-annual financial planning and the independence of national statistical offices. Sixthly and perhaps most importantly, the reformed SGP, the two-pack and the Fiscal Compact constitute a two-stage mechanism of supervision over member states’ fiscal policy at both Union and national levels. Through effective implementation of these measures, the problem of the lack of ownership will be eliminated and national authorities will be more involved in coordination of fiscal and economic policies. This means that a number of obligations must be transferred to the national level. At the same time, the new instruments will enable the European institutions to monitor compliance in a more comprehensive way. They also comprise the European Semester, which is included in the six-pack and is also meant to form this kind of measure5. The main threats to effectiveness of the new instruments include an increasing complexity of fiscal rules and the prevailing broad discretion of the EU institutions, which may further hamper their enforcement (Schuknecht et al., 2011; Marchewka-Bartkowiak, 2012). Moreover, due to insufficient integration, the adopted solutions have not led to the development of a fiscal transfer mechanism initiated by the common budget in reaction to shocks (both symmetric and asymmetric). Even if the new solutions ensure fiscal discipline together with the so-called automatic stabilizers (within 3% budgetary deficit), episodes of serious turbulence (such as the recent crisis or declines caused by other, for example climate-related, events) will require the initiation of substantial transfers exceeding the capacities of individual countries (Tchorek, 2013). Accordingly, the necessity to accumulate a capital buffer against potential shocks will be a future challenge. Moreover, fiscal policy should constitute an instrument of anti-cyclical policy in the case of imbalances resulting from excessive allocation of resources in a specific segment of economic activity. While this is not a fundamental function of fiscal policy, it may complement the macro-prudential po5

The aim of the European Semester is to coordinate three following aspects of EU member states’ economic policies: structural reforms defined under the Europe 2020 Strategy, budgetary policy according to the revised SGP and macroeconomic policy as overseen under Macroeconomic Imbalance Procedure. The primary aim of this new coordination method is to introduce ex-ante procedures to replace the outgoing ex-post evaluation, which should allow for earlier detection of macroeconomic problems and implementation of appropriate solutions even before final budget-related decisions are made (Delors et al., 2012). 125

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licy with adequate instruments for selective actions. Studies show that booms in real estate markets may be neutralized by, inter alia, tax impulses and the level of regulation in the real estate rental market (but also by instruments regulating access to financing – loan to value, debt to income (EC, 2011). A further action should aim at establishing institutional legitimacy of fiscal councils in individual countries, as required under the six-pack and Fiscal Compact. This means that the quality of solutions proposed will really depend on their implementation at the national level. What might become important in this context is coordination of work and exchange of experience among these institutions at the EU level, e.g. in the form of a European Fiscal Institute (Dunin-Wąsowicz et al., 2012). This corresponds to a cooperation model presented below, based upon relatively strong national institutions and European institutions equipped with mechanisms aimed at improved discipline. 4.2. Structural policy and competitiveness policy The lack of structural and competitiveness policies has been one of the most serious weaknesses not only in the Euro Area but, in fact, the entire European Union. The problems concerned both the EU (inefficiency of the Lisbon Strategy and the Open Method of Coordination) and the lack of policy stimulating national competitiveness. According to the laissez-faire doctrine of the economic policy that prevailed in the 1990s, it was assumed that market-based mechanisms were going to replace structural and sectoral policies and that the changes triggered by the euro adoption would contribute to higher competitiveness. A procedure that is meant to provide an antidote to the abovementioned problems is known as the Macroeconomic Imbalance Procedure (MIP). It involves an assessment of macroeconomic indices, which might potentially signal accumulation of imbalances. The preventive dimension of the new procedure, which involves monitoring of the different economic areas, is evaluated relatively well (Goodhart, 2011). Furthermore, the procedure establishes an economic pillar of the EMU, which used to be seriously neglected because of the focus on fiscal policy. The instruments proposed under the procedure will probably make it possible to identify many problems that led to the crisis. Nonetheless, a weakness of the en126

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tire six-pack is the anti-crisis bias of the instruments, which do not provide solutions conducive to growth and increasing competitiveness. The procedure should better reflect a competition-stimulating environment and Europe 2020 priorities (Bastian et al., 2011). Another significant weakness of the adopted solutions it that they lack mechanisms for diminishing structural differences among countries, which would require the establishment of a common budget. Finally, the role of the macro-prudential policy and of the ESRB recommendations which should be followed by individual countries under the procedure seems to be insufficiently emphasized under MIP. The experience of the crisis indicates that an uncontrolled integration of the Euro Area financial markets, in particular fast growth of credit, acted as a significant source of imbalances (Giavazzi, Spaventa, 2010).

5. What kind of integration model for the EU and the Euro Area? Barcz (2012) claims that the consequences of the implemented institutional solutions are that the EU member states will either belong to the monetary union or not. At the same time, he underlines that the new instruments also open up a possibility to differentiate between particular Euro Area countries. In case of breaking the rules, the European institutions will be able to punish individual Euro Area countries, which are covered by a more restrictive system of sanctions than the rest of the EU member states. As monetary integration proceeds, it will also be necessary to identify institutions responsible only for the Euro Area member states and accessible to non-Euro Area countries. From the point of view of institutional efficiency, they should act as an effective instrument to mobilize members of the monetary union to conduct necessary structural reforms. Accordingly, deeper integration and broader competences of institutions responsible only for the Euro Area6 seem inevitable.

6

If this fails to happen, the Euro Area and the EU will probably be exposed to further financial crises. 127

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It might mean that the Euro Area membership may not be a crucial factor for countries’ creditworthiness and political position. Indeed, if we expect positive outcomes of the new reforms and solutions, factors beyond monetary integration should be taken into account. An important criterion for differentiating between particular EU countries should stem mainly from the quality of application of economic governance rules, and, to a lesser degree, from the stage of integration (these should certainly be interrelated). What is more, as established in six pack and two pack, the Euro Area member states can be punished with more severe sanctions than non-Euro Area countries. The main difference between countries should be based not only on new economic governance but also on implementation of the Single Market rules. It is in line with the identified causes of the present crisis, one of them being the countries’ failure to ensure adequate conditions for integration of services sectors, which account for up to 70% of the Euro Area GDP. Considering the limitations under which European institutions are reformed, in particular the lack of prospects for deeper political integration, they should be structured upon the pattern of cooperation between the strong decision-making center and relatively strong national institutions supported by welldesigned and respected rules (i.e. according to the so-called “hub and spoke” delegation7 model). See Figure 3. Each European institution (responsible for monetary, fiscal, structural policies) should have a national counterpart, the latter one having the right, in cooperation with the decision-making center, to adapt such common rules to local circumstances. This really holds true for almost all important areas of the economic policy. One of the serious weaknesses of the European integration has been weak transmission of rules between the central level and the local environment in which they are to be implemented. The above “hub and spoke” model requires consolidation of three following elements of the cooperation mechanism: 1. decision-making center – the Euro Area central institutions (with social and political legitimacy); 7

In economic literature related to economic geography, the “hub and spoke” model was used, among other things, to describe cooperation of firms and institutions in clusters. Goyal et al. (2013) proposed such a model as the optimum one from the point of view of the banking union in the Euro Area. 128

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2.

broad and comprehensive legal and communication infrastructure (rules of cooperation);

3.

national institutions (corresponding in their functions with the central level, having local social and political legitimacy). Figure 3: Models of cooperation among the Euro Area institutions

Source: Own summary.

This kind of structure may be seen as unrealistic due to the fact that a simple model presented in Figure 3 does not reflect the reality. Various levels of political (a number of votes within institutions) and economic (GDP level) power of individual countries make it more probable for countries to form a kind of economic and political club. Factors favoring such a tendency may stem from common challenges or threats from a group of countries, which will not always be the same as the European interest. Moreover, the efficiency of the new institutional solutions will largely depend on the will to implement the relevant regulations at the national level (which often requires the establishment of new institutions) and the quality of this process. In order for such a model to operate properly, it is important that the reformed and reinforced institutions do not allow as much political and economic room for maneuver to member states as was the case prior to the crisis. This 129

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practice led to asymmetric maximization of national interests and also created room for the “beggar thy neighbor policy”. The existing institutional system allowed for the “asymmetry of power” (more political power enjoyed by larger than smaller countries) which led to the “asymmetry of rationality”, enabling to prioritize national interests over the rationality (and indeed the efficiency) of the entire system (Grosse, 2012). The “strong central institutions – strong national institutions” model may be a better solution than the previous one (under which countries were really stronger than the European institutions) and is frequently proposed as a model in which the European institutions clearly prevail over national ones. But full centralization of governance with rigorous rules may constitute an element which makes the operation of the Euro Area ineffective in some areas. It seems that local authorities are sometimes better equipped to prevent pro-cyclicality of the centrally designed macro-economic policy. In the case of common monetary policy, it seems necessary to ensure decentralized (i.e. at national level) use of the remaining instruments, namely macroprudential and fiscal policies. Such an institutional model is also in line with the EU’s key principle, which is subsidiarity. National regulations can to some extent mitigate negative effects of “one size (does not) fit(s) all policy” and help avoid “boom and bust effects”, which were one of the main reasons for the Euro Area crisis. No matter which model of cooperation is finally adopted, better efficiency of the Euro Area institutions will require some competence transfer to the central level. If the “hub and spoke” model is chosen, some serious risks may arise, including those stemming from potential conflicts between national and European institutions as well as from regulatory arbitrage, which may occur due to differences in the way rules are shaped at the local level. The European Commission’s role in safeguarding the rules of the Single Market should also increase. As a result, it seems necessary to transfer the pool of many economic competences to the European level, mainly by leading member states. In view of extended powers of the decision-making center as well as new local competences provided in order to avoid disputes and solve regulatory inconsistencies, it is important to give a mediatory role to one of the institutions in question (in a similar way as powers conferred to the EBA). Another important success factor will be the possibility of the central authorities relying on the knowledge and competence of national bodies. 130

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6. Joint issuance of bonds In a short run, some EU and the Euro Area member states face a number of serious interrelated problems resulting from the increase in public debt, which has jumped abruptly since the crisis began, the banking crisis and poor economic growth. To meet all of the above challenges, the EU needs financial resources that would be available thanks to joint bond issuance. On the one hand, this would help stimulate structural reforms and economic growth, and, on the other hand, cope with excessive debt, including the restructuring of some member states’ debt. Moreover, debt “mutualization” could also make it possible to use the opportunities of having the world’s second international currency and well-developed financial markets. Joint bond issuance and deeper fiscal risk-sharing process would require a deeper political union because jointly guaranteed debt securities would encourage countries involved to coordinate their fiscal policies in a better way (De la Dehesa, 2010). Furthermore, the issuance of bonds would reduce the bankruptcy risk for the peripheral countries resulting from significant growth of their government bond yields. The most important argument against joint issuance of bonds is a threat of weakening the incentives for fiscal discipline. The lack of market discipline ensuring the stability of public finance may be the main obstacle to joint issuance. In order to increase the credibility of joint bonds and eliminate moral hazard, it is necessary to have strong and reliable mechanisms ensuring fiscal, economic and financial discipline in the Euro Area countries. Another problem is the magnitude of debt accumulated during the crisis and its mutualization. Irrespective of the form of joint bonds, at an initial stage, they should only be issued on a minor scale by a central European institution and the ESM appears to be a natural candidate for this role. The benefits of the common Euro Area credibility should depend on satisfaction of the criteria of financial and macro-economic stability under preventive and repressive parts of the EDP and MIP as well as on a country’s commitment to comply with the macro-prudential policy rules.

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7. Pillars of monetary integration The foundation of the single currency on the power of institutions rather than of individual states should reduce the need for full political integration, including the need to establish a common budget8. This, however, requires efficient operation of several unions: economic, fiscal and banking one, supported by the ESM and the EBC as the lender of last resort. As a condition of the efficient operation of the model in question, an appropriate symmetry should be ensured between rights and obligations defined at both national and European levels. The following actions and elements seem necessary for the proper functioning of the Euro Area: Firstly, high efficiency of the economic governance rules concerning excessive macroeconomic imbalances and stability of public finance thanks to new solutions (six-pack, two-pack, European Semester, Fiscal Compact). On the one hand, an increased economic policy coordination, imposed by the MIP and supported by a macro-prudential policy used to monitor relations between the real and financial spheres, will reduce the systemic risk and a threat of crises. On the other hand, solutions in the field of fiscal policy should impose automatic economic stabilizers through accumulation of savings during good times and allowing for up to 3% of nominal deficit in “rainy day” periods. Secondly, the establishment of a separate transfer budget for the Euro Area or an extension of financial potential of the existing EU budget. Wolff (2012) indicates that the Euro Area’s budget should account for circa 2% of GDP of the entire monetary union and be available to the Euro Area countries and potentially also to the countries which intend to adopt the common currency and already are members of the ERM II system9. Instead of a separate Euro Area’s budget, an increase in the EU budget with newly defined priorities for the competitiveness policy and a dedicated pool of funds earmarked for the Euro Area member states should be considered. As the common budget evolves towards greater strength and extended scope of structural activities, the social legitimacy of the EU actions will be enhanced. 8

According to historical plans, the common budget should account for up to 25% of the monetary union GDP (McDoughal Report). 9 Dullien and Torreblanca (2013) point out that a real influence on economic processes may be achieved with a budget of around 4-5% GDP. This, however, would entail the need to delegate the right to impose taxes to the European institutions. 132

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Thirdly, increasing financial capacity of the “European Monetary Fund”, i.e. in fact the ESM, with financial power equal to around 10% of the Euro Area’s GDP. The ESM could eventually constitute a financial backup for its role of LOLR vis-à-vis governments as well as two important pillars of the banking union: resolution mechanism and deposit guarantee system. Fourthly, full banking union. The establishment of the banking union should make it possible to reduce risks in the banking sector through their early detection by means of the single supervisory mechanism. Moreover, the banking union with an adequate financial power ensured by the ESM which should make it possible to eliminate the risk of contagion and fragmentation of financial markets. Fifthly, it also seems desirable to create or improve the existing national institutions whose competences correspond to those of the European institutions. In line with the subsidiarity principle, national authorities should, in justified cases and upon approval by the central institutions, have a possibility to correct, adjust and supplement the objectives and instruments created at the EU level. This requires better democratic legitimacy through consolidation of roles and competences of the central institutions (EC, EP) as well as national parliaments, and also by authorization of politically independent national institutions (fiscal councils, systemic risk boards). Sixthly, the possibility of creating additional impulses to increase financial markets’ discipline should be considered, e.g. through changing the weights of investment risk attributed to government bonds, diversifying securities accepted by the EBC in refinancing operations depending on a country’s rating or establishing exit rules from the Euro Area. Finally, the issuance of common bonds should be an important way to achieve sufficient financial capacity and increase credibility. The role of common bonds and debt mutualization should increase gradually and be accompanied by the enforcement of economic governance. The above solutions should make it possible to accumulate financial resources amounting to 10-15% of the Euro Area’s GDP. This capacity might stem from: ˗ automatic economic stabilizers (c. 3% of GDP as regards admissible deficit at the level of individual countries);

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fiscal transfer related to the common budget (at 2% of GDP); full banking union and the ESM (10% of GDP). This instrument should be accompanied by the possibility of taking advantage of the EBC unlimited liquidity. Most economists, politicians and societies seem to believe firmly in the deepening of integration but, at the same time, some resistance against the renouncement of more and more autonomy is clearly visible. That is why the “hub and spoke” model seems worth considering, with the following advantages taken into account: ˗ it may well be more effective than the present or highly centralized one; ˗ it is easier to implement because of evolutional progress regarding the deepening of integration and can potentially eliminate many weaknesses experienced so far; ˗ it is more acceptable, both socially and politically, since it does not entail the necessity to create a large budget, accumulating several per cent of the Euro Area’s GDP, which would probably require some political union to become reality. ˗ ˗

8. Between the EU and the Euro Area In many cases, solutions implemented in the EU increase the power of the decision-making center, improve the infrastructure of communication between the center and member states and also impose new obligations and sanctions on member states. One available way to be treated less rigorously under the existing procedures may be to remain outside the Euro Area because new regulations are more demanding for the monetary union member states. In this way, the EU’s new institutional model is going to deepen the present division into the Euro Area member states and other countries. Two (or even several) speed Europe may entail some negative consequences for the countries, which have not adopted the common currency. For example, the creation of a separate budget for the Euro Area may lower the importance and financial capacity of the EU budget, i.e. its largest beneficiaries, including Poland. In a broader sense, being outside the monetary union will probably lower the political status of the non-Euro Area countries. 134

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However, the political power of individual EU member states will not only result from the stage of institutional integration but will be based on their economic and financial strength as well as their ability to build relations beyond the EU in the global environment10. The emergent institutional solutions also give the possibility of imposing various sanctions on the Euro Area countries. Thus, the political status of a Euro Area country could also be diminished because of non-compliance with the common rules and obligations. New EU member states (periphery) benefit from the fact that they operate very close to the Euro Area, which uses the second largest international currency in the world (center). Such a neighborhood offers access to trade and investment ties as well as new technology, a deep and liquid financial market, and a reduced exchange rate risk thanks to a single exchange rate instead of nineteen different ones (one currency versus nineteen separate ones in the case of no monetary integration in Europe). Nonetheless, these countries may benefit from the Euro Area existence without official membership in the monetary union (like Denmark, Sweden, United Kingdom, Baltic States, as well as other EU member states). While it is a certain form of “free ride”, it seems in many respects the best solution until real convergence is achieved at the level, which minimizes the risk related to abandoning a country’s own monetary and exchange rate policy. Until such time, the Euro Area may play the role of economic, institutional and political anchor, while at the same time leaving the privilege of using national macro-economic policy instruments. Admittedly, what is going to prove crucial for sustainable growth of catching-up countries is their ability to run an anti-cyclical macroeconomic policy (fiscal, monetary, financial). The promotion of solutions ensuring compliance with the Single Market rules will be important for stability and integrity of the EU. This requires the development of a strategy for Poland’s presence in the EU as a country which heads toward the Euro Area at its own, rather than imposed, pace. 10

It should be noted in this context that potential benefits of participation in the customs union between the EU and the USA will not depend on whether a country belongs to the Euro Area or remains outside the monetary union. Even if the customs union were only established for relations between the USA and the Euro Area, this would never preclude other countries outside of the Euro Area from benefiting from the union. Considering the geographic structure of political and business relations as well as the trade between the USA and the EU, the trade volume would most likely be increased through the United Kingdom, Ireland, Germany, France, the Netherlands and Belgium. 135

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9. Conclusion The crisis in the Euro Area is a part of the global financial crisis. We have highlighted the fundamental economic and institutional assumptions of the Euro Area, which were made before the crisis, not only in the EU but, in fact, all over the global economic system. This means that the sources of the crisis in the Euro Area really extend beyond the mere inefficiency of the EU institutions. Nonetheless, there have been some evident mistakes made in the Euro Area establishment. Mainly due to political reasons and optimistic approach, institutional solutions did not foresee any crisis management mechanisms. The first part attempted to highlight wrong macroeconomic assumptions behind the broad consensus in economic literature concerning monetary integration in the EU. As revealed, the crucial dysfunction of the Euro Area was the lack of mechanisms for: ˗ avoiding structural divergences and stimulating real convergence; ˗ financial market regulation; ˗ enforcing fiscal policy discipline and crisis management, including the LOLR role. The latter part attempted to evaluate the adopted institutional measures aiming at increased efficiency in enforcing discipline in both fiscal and economic policy. These solutions may provide a significant step toward the reduction of systemic risk through the development of a two-stage control mechanism over fiscal and macroeconomic policy at both national and European level. However, they are characterized by anti-crisis bias, and thus fail to solve a serious problem of poor economic growth and the need to stimulate the EU member states’ international competitiveness. Another issue is the necessity to control and reduce rapidly growing public debt. Measures that may be helpful in this respect include the issue of common bonds as an instrument of debt reduction and debt mutualization as well as pro-growth measures. The establishment of the ESM as a permanent instrument, which may be used in case of crisis, is a very positive sign. However, its lending capacity has to be extended. Another positive proposal is a greater role of the EBC in financial market stabilization. Despite more restrictive rules, the efficacy of the solutions adopted will depend on member states’ will to implement and comply with them. It seems

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difficult, however, to make countries respect any common provisions unless they perceive the stability and competitiveness of the Euro Area and the EU to be a matter of common interest. An efficient institutional system may not leave so much room for prioritizing national interests over the EU interest. This suggests the need for a greater ownership of rules specified at the EU level, including an extension of the roles played by the European Commission, the European Parliament and national parliaments as well as independent national institutions as counterparts of the European institutions. This may be promoted by the suggested “hub and spoke” model, but it also requires giving up some of national autonomy, most of all by the EU’s leading economies. The new institutional system entails consequences for a further division into the Euro Area countries and countries unwilling to use the common currency. The reforms implemented will mostly regard countries bound by the common currency and only to a lesser extent other EU member states, not belonging to the Euro Area. Such a two-level arrangement, referred to as two-speed Europe, while having its weaknesses, ensures some flexibility of the system – something particularly desirable with respect to catching up countries. The membership in the EU alone makes it possible to benefit from integration and, largely, also from monetary integration, but staying outside the Euro Area gives more room for national policies until the countries complete real convergence process. However, a condition for such co-existence to be of any advantage is to have the entire European Union operation based upon some common fundaments, laid down in the Single Market rules and accompanied by new economic governance rules. Staying outside the Euro Area should not exclude a country from the mainstream of integration because it is the economic and financial potential, not only the institutional stage of integration that really determines the status of a country. As the crisis has shown, economic power does not necessarily depend on whether a country uses the common currency or not.

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BRAZIL’S SPECIALIZATION IN NATURAL RESOURCES: THE ROLE PLAYED BY CHINA

Frederico Rocha1

Abstract: This paper aims to investigate the role played by China-Brazil trade interaction in the view of Brazil's recent trade specialization. The paper shows that Brazil has again, in the last decade, caught up in rates of growth. This performance has been achieved through two main factors: (i) an improvement in the quantum of exports; (ii) favorable terms of trade. The trend in terms of trade was influenced by an increase in China’s demand for natural resources. In this sense, critics have stated that a unfavorable complementarity has arisen between China and Latin America, and more specifically, between China and Brazil. China has specialized in assembly products while Brazil has been left with export of natural resources. Some worries are then raised on the consequences of this specialization with regards to the future of Brazil’s industrial activity. Keywords: Brazil, China, international trade, productive specialization.

1

Frederico Rocha – PhD in Economics, Associate Professor, Director of the Institute of Economics, Federal University of Rio de Janeiro, e-mail: [email protected]. 143

Frederico Rocha

1. Introduction In the 1950s a group of authors characterized Latin American economies by two main features: (i) specialization in natural resource intensive industries, compared to a greater diversification in developed economies; and (ii) a structural difference in the levels of productivity amongst their productive sectors. The first characteristic was accompanied by a theory of deterioration of the terms of trade that stated that, due to the low income elasticity of agricultural goods or to the scarce capacity of agricultural goods to retain the benefits from technical progress, there was a tendency for the prices of these goods to deteriorate with respect to the manufactured goods produced by developed economies (Singer, 1950; Prebisch, 1957). Such a characteristic drove Latin America to repeatedly suffer balance of payment crises and gave rise to what may be called the “pessimism of the elasticities” thesis. According to it, Latin America would become hostage to the low income elasticities of its exports and to the high elasticities of its imports, violating the Prebisch/Thirlwall balance of payment identity, y=x/π, where y is the country’s rate of growth, π is the country’s imports’ elasticity with respect to income and x – the rate of growth of the country’s exports, being a function of the exports’ income elasticity and the rate of growth of the world’s economies. This pessimism finds some support in empirical evidence. Cimoli, Porcile and Rovira (2010) measured the income elasticity of Latin American exports over the 1961-2004 period at 0.19. In the same period, these authors found that the income elasticity of Latin American imports is 2.13. In contrast, world income elasticity of exports was found to be at 1.19 and of imports, 1.98. The second characteristic relates to what has been called structural heterogeneity (Pinto, 1970). In this case, a highly productive export sector with feeble linkages to the rest of domestic economy would cohabitate with a low productivity domestic sector. This is due to the lack of capacity to diffuse technical progress or diversify the economy towards sectors where technical progress is more dynamic. There are different phases and facets of structural heterogeneity (Lopez, 2013). In early phases of development, the level of structural heterogeneity would be affected by the general characteristics of the exporting sector and by the type of linkages it develops with the domestic economy 144

Brazil’s Specialization in Natural Resources...

(Hirschmann, 1958). Secondly, in subsequent phases, the generation of technical progress in the modern sector and the spillovers generated by this sector would be the main drivers for the deepening or reduction of structural heterogeneity. Thirdly, heterogeneity may be related to regional factors (Pinto, 1970). Fourthly, structural heterogeneity may be influenced by the demography of companies in the economies, for instance, when large multinational companies or large national capital firms act in their own value chain with few or no relation with small and medium firms (Kupfer, Rocha, 2007). Finally, structural heterogeneity may be related to the role domestic companies play in global value chains and mainly to the type of good being produced. Pérez (2013) argues that Latin American countries, specialized in natural resources, had a less laborintensive productive position in global value chains, while Asian countries, specialized in manufacture, had a more labor-intensive productive relation in global value chains. In the first case, the diffusion of technical progress or modern modes of production among labor positions is more difficult than in the second case. This may be the second potential problem of China's greater participation in Latin American exports. Once greater specialization in natural resource industries is achieved, greater productive heterogeneity may arise. The recent development of China and its increasingly important role in international trade has given some additional worries to economists in the more diversified economies of Latin America, such as Brazil and Argentina. The very high growth rates and the lack of natural resources of the Chinese economy have resulted in a burst in its imports of natural resource goods from Latin American countries. As a consequence, commodity prices have behaved in the opposite way to what is prescribed by Singer and Prebisch’s hypothesis. Latin American countries have seen their terms of trade increase in an unprecedented way during the last decade. This is due mainly to the low short run elasticity of the production of commodities. However, economists fear that, in the long run, after the expansion of production, terms of trade may return to their past trend, leaving Latin American countries in a worse position than before, with greater specialization in natural resource goods (Bekerman, Dulcich, Moncaut, 2014; Wilkinson, Wesz Junior, 2013). This paper aims to discuss the changes in the structure of Brazilian exports and imports in the last decade and the effect China may have had on it, deriving some consequences over the long-term positioning of Brazil in interna145

Frederico Rocha

tional trade and the effect this positioning may have on structural heterogeneity. In the next sections, the paper discusses recent developments in the Brazilian economy with particular emphasis on trade structure and bilateral trade with China and relates them to possible results and future trends.

2. Recent developments in Brazilian economy From 2000 to 2010, Brazil’s per capita GDP grew at a rate of 2.38% per year. Though not spectacular, and well beneath the historical rate from 1950 to 1980, this average rate of growth was celebrated after two decades of stagnation, when Brazil went through a major balance of payment crisis. One of the important features of this recent growth was the country’s ability to overcome balance of payment constraints that had haunted Brazil throughout its history. Brazil was able to achieve large trade surpluses (see Figure 1), due to a very steep growth in its exports (over 33% p.a. between 2000 and 2013 in current US$). This performance coincided with China having a stronger international presence. From 1996 to 2012, China increased its share as a world market from 2.5% to 10.4%2. The role of the Chinese market is, however, even more significant in the Brazilian case. In 1996, only 2.3% of Brazilian exports were directed to Chinese markets. These figures grew to 19% and 20.5%, in 2012 and 2013 respectively, with China becoming the most important Brazilian market3. This extraordinary growth was due to two important factors. On the one hand, China’s growth implied an increase in the country’s need for natural resources. Mattos and Carcanholo (2012) show that natural resource based imports represented over 35% of total Chinese imports in 2009, against 25% in 2000. On the other hand, the increase in demand for natural resource goods, coinciding with a rapid world economy growth up to 2008, resulted in a rise in commodities’ prices, benefiting terms of trade of Latin America in general, especially in the case of Brazil (Prates and Marçal, 2008). 2

Data obtained from UNCTADstat. Data obtained from Grupo de Indústria e Competitividade. Instituto de Economia – UFRJ. Trade Balance database. 3

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Brazil’s Specialization in Natural Resources... FIGURE 1: Trade Balance, Brazil, 1996-2013, in US$ 3E+11 2,5E+11 2E+11 1,5E+11 US$

Superavit 1E+11 Imports 5E+10 Exports 0 1996 1998 2000 2002 2004 2006 2008 2010 2012 -5E+10

Source: Grupo de Indústria e Competitividade, Foreign trade database.

However, critics suggest that the overwhelming performance of Brazilian exports was accompanied by two important structural transformations that may obstruct Brazilian growth in the long run: (i) the country’s return to its historical trade specialization in natural resource intensive goods; and (ii) the loss of opportunities for Brazilian industry through the import of goods from other countries, such as China, due to an overvalued domestic currency.

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Frederico Rocha FIGURE 2: Brazil: Terms of trade and purchasing power of exports indices, 1980-2012 300 250 200 150 100 50 0

Terms of trade indices

Purchasing power indices of exports

Source: UNCTAD statistics. http://unctadstat.unctad.org/ReportFolders/reportFolders.aspx?sCS_referer=&sCS_ChosenLang=en.

2.1. Export specialization A first glimpse of the changes in the product structure of Brazilian exports shows a shift towards more primary goods. This can be perceived by an analysis of Figure 3 and Figure 4 that decompose Brazilian exports according to product type, measured in current values. In Figure 3, all products are broken into three categories: basic, semi-manufactured and manufactured. The share of manufactured goods in total exports declined from almost 60% to 40%, representing a drop of 18 percentage points. Figure 4 uses a classification elaborated by Grupo de Indústria e Competitividade, from the Institute of Economics, UFRJ. It classifies exported goods according to production processes. On the one hand, there are those industries where assembly prevails; on the other hand, there are those industries where flow processes are more common. In the first case, industries are split in two classifications, according to the level of technology. Higher technology goods are grouped into the innovation inducers category, while low-technology ones 148

Brazil’s Specialization in Natural Resources...

are grouped into traditional industries. The flow industries are grouped according to the origin of their natural resources: agricultural, mineral (non-oil) and oil. Furthermore, agricultural goods are split into two categories: those that have undergone transformation in manufacturing industries and those that have not undergone any transformation. One first observation from Figure 4 is that commodities have always dominated Brazilian exports. Twenty years ago, commodities represented most of the Brazilian exports. This overall characteristic matches Pérez’s (2013) observations on the tendency for Latin America to be specialized in flow industries, opposed to assembly sectors. Pérez attributes this characteristic to the endowment of resources. More endowed with natural resources and less endowed with labor (population), Latin America specialized in flow industries and was engaged in global value chains (GVC) in flow industries, while Asia, endowed with labor, engaged GVC in labor-intensive (assembly) industries. Secondly, when one observes the evolution of the six groups, it seems clear that the assembly sectors have lost their share throughout the years. In 2000, innovation inducers represented almost 30% of total exports and, in 2013, their share was less than 20%, a loss of 10 percentage points. Traditional manufacturing reduced its share from almost 17% to less than 8%. On the other hand, commodities sectors have increased their share by 20 percentage points, attaining 71% in 2013. Inside commodities, there was also an increase in less elaborated goods. Both agricultural primary commodities and oil/gas have increased their share over the years. These changes have made some analysts argue for movement towards the reprimarization of the Brazilian exporting profile, returning to the immediate post-WWII situation.

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Frederico Rocha FIGURE 3: Structure of Brazilian Exports by Product Type, Basic, Semi-manufactured and Manufactured Goods, US$ current prices, 1996-2013

Source: FUNCEX in http://www.ipeadata.gov.br.

However, the observation of quantum tells a different story, suggesting that the primarization found by most authors is a relative prices phenomenon. Figure 5 shows that the quantum of manufactured goods increased more or less 20 percent points from 1996 to 2013. Figure 6 shows that the share of innovation inducers increased by more or less 5 percentage points from 1996 to 2013. However, traditional manufacturing has its share cut by half (a loss of 6 p.p.). Inside commodities, oil and gas and agricultural commodities again are the group of sectors with the greatest increase in share (9 p.p. in agricultural commodities and 6 p.p. in oil and gas, from 1996 to 2013). This may suggest that there is a primarization process going on inside the commodities sector, where more raw products gain their share and products with greater processing lose it. Nonetheless, it is clear that Brazil has gained competitiveness in natural resources in recent years. In 1980, Brazil held 6.4% of total world’s exports of natural resources, excluding oil; this share increased to 7% in 1990, 8.2% in 2000, and reached 13.4% in 2010. The country was able to produce technology 150

Brazil’s Specialization in Natural Resources...

in these areas and overcome obstacles related to crop control in different weather conditions. In this sense, dependence on natural resources is also related to the accumulation of production and technological capabilities. FIGURE 4. Structure of Brazilian Exports by Product Type, GIC Classification, US$ current prices, selected years, 1996-2013

Source: Grupo de Indústria e Competitividade (GIC), Foreign trade database.

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Frederico Rocha FIGURE 5: Structure of Brazilian Exports by Product Type, Basic, Semi-manufactured and Manufactured Goods, constant prices, 2006 US$, 1996-2013

US$ constant, 2006

100% 80% 60% 40% 20% 0% 1995

2000

Basic products

2005

2010

2013

Semi-manufactured products

Manufactured products Source: FUNCEX in http://www.ipeadata.gov.br.

FIGURE 6: Structure of Brazilian Exports by Product Type, GIC Classification, US$ constant at 2007 prices, selected years, 1996-2013

Source: Grupo de Indústria e Competitividade, Foreign trade database. 152

Brazil’s Specialization in Natural Resources...

2.2. Imports The structure of the imports of the Brazilian economy did not suffer important changes when we observe the data in current prices. There has been a slight reduction in the imports of traditional manufacturing goods, agricultural commodities and agricultural industrial commodities and an increase in the share of expenditure in the oil and gas sector. On the other hand, innovation inducer goods remain important, answering for almost half of all Brazilian imports and industrial commodities remain the second most important category (see Figure 7). However, the evolution of the imports in constant prices shows more significant changes - the whole commodities share is reduced from almost 64% to 45% (with most of this reduction due to oil, gas, agricultural commodities and industrial agricultural commodities), while at the same time the share of innovation inducers increases from 30%, in 1996, to 47%, in 2013 (Figure 8). FIGURE 7: Structure of Brazilian Imports by Product Type, GIC Classification, US$ current prices, selected years, 1996-2013

Source: Grupo de Indústria e Competitividade, Foreign trade database.

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A better understanding of the changes in the Brazilian trade performance can be obtained by analyzing trade balance by product type. Brazil has been able to build larger trade surpluses of commodities, mostly based in agriculture, while suffering from large deficits in innovation inducers' products. This may be seen as an important indicator of the country’s growing specialization in natural resources. FIGURE 8: Structure of Brazilian Imports by Product Type, GIC Classification, US$ 2007 constant prices, selected years, 1996-2013 100

7

5

6

37

40

7

8

48

47

7

7

33

32

32

4 2 2010

4 2 2013

90 80

30

70 60 50

19

11 14

40 30

34

37

20 10 0

7 4

5 4

4 3

1996

2000

2005

Traditional industry Innovation Inducers Petroleum Mineral industrial commodities Agricultural industrial commodities Agricultural commodities Source: Grupo de Indústria e Competitividade, Foreign trade database. 154

Brazil’s Specialization in Natural Resources... FIGURE 9: Trade Balance per Product Type, GIC Classification, US$ current, selected years, 1996-2013 6E+10

4E+10

2E+10 1996 0 Agricultural Primary Commodities

Agricultural commodities

Industrial Commodities

Petroleum

Innovation Inducers

-2E+10

Tradutional Manufacturing

2000 2005 2010 2013

-4E+10

-6E+10

-8E+10

Source: Grupo de Indústria e Competitividade, Foreign trade database.

2.3. Brazil and China Commodities have always dominated Brazilian exports to China. In 1996, around 85% of these exports were commodities. In that period, China represented 2.3% of total Brazilian exports and around 12% of these exports were products of innovation inducer industries. Therefore, it is no surprise that commodities represent more than 95% of total Brazilian exports to China in 2013. Price effects and the boost of Chinese growth account for this transformation. However, what seems to be surprising is the change in the composition of commodities exports. In 1996, 62% of total exports were agricultural industrial commodities. In 2013, the share of these goods was reduced to only 10%. There was a strong growth in industrial mineral commodities and agricultural commodities. The overall increase of the share was concentrated on one product, 155

Frederico Rocha

iron ore that represented 87% of total mineral industrial commodities in 2013. In the case of agricultural commodities, almost total export (99.8%) is represented by soybeans. In both cases, there has been a visible substitution of unprocessed goods for manufactured goods. In 1996, the steel industry represented 1/3 of total mineral industrial commodities and iron ore a little less than 2/3. In 2013, the steel industry represented less than 5% of total mineral industrial commodities exports and iron ore over 83%. The same pattern appears in agriculture. In 1996, no soybeans were exported to China and soy oils were dominant in the agricultural value chain, representing over 90% of the exports of these products. In 2013, almost no soy oil was exported and soybeans dominated the agricultural value chain (Figure 10). FIGURE 10: Structure of Brazilian Exports to China by Product Type, Basic, Semi-manufactured and Manufactured Goods, US$ current prices, 1996-2013

Source: Grupo de Indústria e Competitividade, Foreign trade database.

This result goes in the opposite way to the trajectory proposed by Pérez (2013) that argued for the addition of downstream stages of production in the commodities’ value chain as a way for development, and coincides with data from Wilkinson and Wesz Junior (2013), according to whom, rather than in156

Brazil’s Specialization in Natural Resources...

creasing the potential for collaborative development, “China has in many cases provoked a reversion to raw material exporting status for many developing countries that were advancing towards growth based on export of greater valueadded products” (Wilkinson and Wesz Junior 2013:256). In this case, China has invested in establishing oil-crushing industry as part of a food security strategy aimed at gaining independence from traditional agro-industrial traders. Nonetheless, similar patterns have been followed in the steel industries for different reasons. In this case, Chinese cities have pursued strategies to construct their own steel plants. These cities have built steel excess capacity that has displaced exports from other countries. As a consequence, again, China’s trade strategies have pushed trade partners away from manufacturing. In fact, the structure of Brazilian exports to the world, without China, suffered no relevant changes (Figure 11), with the only difference being the strong reduction in the share of traditional manufacturing and the increase in the share of oil and gas exports. Most importantly, the structure of exports inside commodities has remained more or less the same. Therefore, without the influence of China, Brazilian exports do not show the same trend towards primarization. Brazilian imports from China are also different from the rest of the world and show the strong complementarity between these two countries. Since 1996, they have concentrated on assembly sectors, such as traditional manufacturing and innovation inducers (over 80% of total imports). The change from then on is a reduction in the share of traditional manufacturing and an increase in the share of innovation inducers. Furthermore, there has been a slight increase in the share of mineral industrial commodities. This increase has been dominated by steel products due to the process of expansion of steel plants in China, as explained above. Though the trade balance in the steel industry still favors Brazilian steel, Chinese steel is beginning to enter the Brazilian market and compete with Brazilian steel in secondary markets. Chinese competition in secondary markets is one of the main concerns for some Brazilian analysts. Chinese manufacturing products have displaced competitors from all over the world. In the case of Brazil, the increase in the share of Chinese products in Latin America is especially worrying. Mattos and Carcanholo (2012) show that while the share of Brazilian products in ALADI’s market decreased in the 2000-2010 period, Chinese products strongly increased theirs, with the trend even more noticeable in higher technology products. 157

Frederico Rocha FIGURE 11: Structure of Brazilian Exports to the world, except China, by Product Type, Basic, Semi-manufactured and Manufactured Goods, US$ current prices, 1996-2013

Source: Grupo de Indústria e Competitividade, Foreign trade database.

As Mattos and Carcanholo (2012:141) conclude: It is undeniable that the recent increase in international trade with China has had positive effects in Brazilian economic activity in the short run. However, there are strong signals that the expansion of Chinese exports has effected Brazilian exporting performance on secondary markets and, furthermore, these exports have hurt Brazilian manufacturing industry in the domestic market.

It is also evident that this process did not solely affect Brazil, but assumed global proportions. In fact, Brazilian manufacturing exports have experienced a much weaker negative influence of China than an average world market. 158

Brazil’s Specialization in Natural Resources... FIGURE 12: Structure of Brazilian Imports from China by Product Type, Basic, Semi-manufactured and Manufactured Goods, US$ current prices, 1996-2013

Source: Grupo de Indústria e Competitividade, Foreign trade database.

3. Conclusion In the first decade of this century, Brazil has again experienced increasing rates of growth. This performance has been strongly influenced by the way the country managed to overcome structural constraints related to its balance of payment. These limitations have been overcome by the country’s exports’ striking performance, growing at very fast rates and under favorable terms of trade. Terms of trade have been favorable mainly due to a very strong Chinese performance that has increased its overall demand, with specific concentration in the demand for natural resources. In this sense, critics have stated that an unfavorable complementarity has arisen between China and Latin America, and more specifically, between China and Brazil. China has specialized in assembly products, while Brazil has been left with the exporting of natural resources.

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Two main arguments have been drawn to state the traps to Brazil in this kind of specialization. On the one hand, critics have stated that favorable terms of trade are a result of a demand boom for natural resources and a low supply elasticity in the short run, but that they are likely to revert in the long run, returning Brazil to an uncomfortable position in terms of balance of payment. In this case, recent growth is seen as a short run premium that will revert in the future. On the other hand, some analysts argue that there are some long-term consequences of these bonuses – China, more specialized in assembly process goods, may enjoy dynamic economies of scale in their production, while Brazil – economies of scale in natural resources and flow process industries. Therefore, when the natural resources boom ends, the latter will have advantages in natural resources industries, while the former will have advantages in assembly industries. However, following ECLAC’s tradition, these analysts understand that assembly process goods have two important attributes that are absent in natural resources: higher income elasticity and greater capacity to capability accumulation. Thus, as Brazil is locked in natural resources industries, those critics argue that it will leave the demand boom in a worse situation. In fact, Brazil seems to face a strong challenge in this area. Its imports demand has very high income elasticity. Therefore, growth has been historically restrained by the balance of payment crises. Nonetheless, the events of the 1980s and 1990s showed a country that could not improve its international market share, no matter what situation it faced. Recent development has given some opportunities for growth in markets where, traditionally, the country enjoys absolute and relative comparative advantages and thus has managed to improve its market share. The challenge is therefore how to allow spillovers from these activities into the rest of the economy. Recent policy has followed two steps. On the one hand, policymakers have attempted to increase backward and forward links in the natural resources value chain. Some of the policy measures involve local content targets, especially in oil and gas sector, and the use of government purchase power to favor local producers. On the other hand, effort has been put in the establishment of R&D goals. Some sectors are subject to rules that force companies to direct resources to R&D expenditure and to the guidelines to national funds that direct these resources at science and technology institutions, mostly universities.

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To sum up, Brazilian economic interaction with China may bring about some opportunities for development. China’s growth has contributed to a great change in Brazilian international trade perspectives that, nonetheless, pose some important long-term challenges that Brazil will have to deal with. If assumptions of ECLAC’s economic thought are true and natural resources intensive products are subject to Engel’s law (Rocha 2012), the country may soon face some great problems and obstacles to its economic growth. The pursuit of a solution that guides Brazil towards higher income elasticity products through the economic specialization seems to be the greatest challenge of all.

Bibliography Bekerman, M., Dulcich, F., Moncaut, N. (2014). “La emergencia de China y sus impactos en las relaciones entre Brasil y Argentina”, Revista de Problema de Desarollo, No. 176 (45): 55-82. Cimoli, M., Porcile, G., Rovira, S. (2010). “Structural Change and the BOP-Constraint: Why Did Latin America Fail to Converge?”, Cambridge Journal of Economics, No. 34: 389-411. Hirschman, A. (1958). The Strategy of Economic Development, London: Yale University Press. Kupfer, D., Rocha, F. (2005). “Productividad y heterogeneidad estructural en la industria brasileña”, in: M. Cimoli (ed.), Heterogeneidad estructural, asimetrías tecnológicas y crecimiento en América Latina, Santiago de Chile: Economic Commission for Latin America and the Caribbean (ECLAC)/Inter-American Development Bank (IDB): 72-100. Lopez Vazquez, R. (2013). “Determinants of Structural Heterogeneity in Mexican Manufacturing Industry, 1994-2008”, CEPAL Review, No. 109: 115-130. Marçal, E., Prates, D. (2008). “O papel do ciclo de preços no desempenho recente da economia brasileira”, Revista Análise Econômica, No. 26 (49): 163-191. Mattos, F., Carcanholo, M. (2012). “Amenazas y oportunidades del comercio brasileño con China lecciones para Brasil”, Revista Problemas del Desarrollo, enero-marzo, No. 168 (43): 117-145. Pérez, C. (2012). “Una visión para América Latina: Dinamismo tecnológico e inclusión social mediante una estrategia basada en los recursos naturales”, Económica, No. 14 (2): 1150. Pinto, A. (1970). “Naturaleza e implicaciones de la «heterogeneidad estructural» de la América Latina”, El Trimestre Económico, No. 37 (145): 83-100.

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Frederico Rocha Prebisch, R. (1957). “El desarrollo económico de América Latina e sus principales problemas”, Revista de Economía Política, VIII: 296-314. Rocha, F. (2012). “Comentários a «Una visión para América Latina: dinamismo tecnológico e inclusión social mediante una estrategia basada en los recursos naturales», de Carlota Pérez: a Lei de Engel”, Econômica, No. 14 (2): 63-72. Singer, H. (1950) (1950). “The Distribution of Gains between Investing and Borrowing Countries”, The American Economic Review, No. 40 (2): 473-485. Wilkinson, J., Wesz Junior, V. (2013). “Underlying Issues in the Emergence of China and Brazil as Major Global Players in the New South-South Trade and Investment Axis”, International Journal of Technology Management & Sustainable Development, No. 12 (3): 245-260.

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THE DEVELOPMENT OF THE COMMERCIAL INSURANCE SECTOR IN CENTRAL AND EASTERN EUROPEAN COUNTRIES: COMPARATIVE ANALYSIS

Teresa Czerwińska1

Abstract: This study identifies key determinants of the development of the

commercial insurance sector and analyses and assesses the various insurance classes as well as the commercial insurance sector growth dynamics. The research covered the Central and Eastern European countries, i.e. Poland, the Czech Republic, Hungary, Slovakia, Bulgaria and Romania. The period analysed comprises the years 2003-2012. In order to conduct the research, measures of commercial insurance sector concentration that are classified as economic measures were used.

Keywords: insurance sector, insurance penetration, density, insurance sector efficiency, structural changes in insurance sector concentration.

1

Teresa Czerwińska – PhD in Economics, Professor of Economics, Faculty of Management, University of Warsaw, e-mail: [email protected]. 163

Teresa Czerwińska

1. Introduction Insurance as a socio-economic mechanism involves a transfer of financial consequences arising from risk materialisation to a separate legal and organisational entity, i.e. an insurance institution. Such transfers may be effected only for pure risks – that is the risks that, when materialised, entail a loss or health impairment (Mowbray, Blanchard, 1961; Vaughan, 1992). The insurance sector plays a unique function in the economy, which involves the accumulation and redistribution of financial consequences of risk concerning not only other business sectors, but also the risk inherent as such in lives and the functioning of individuals. The role of the insurance sector in the national economy is examined in two principal areas: (1) reduction of risk in business activity and personal risk in private and professional life; (2) shaping the situation on the capital market through the mechanism of technical provisions allocation. Undeniably, the primary role of the insurance sector is to reduce risk, hence insurance is most frequently considered in the context of risk management instruments – as a method of loss refinancing through paid transfer of risk that allows for replacing the uncertainty of incurring significant losses with a small, albeit certain, cost, that is the premium (Vaughan, 1992; Williams, Smith, Young, 1995; Harrington, Niehaus, 2003). The insurance sector has a special position in the economic system because, in line with the principle of certainty of the insurance cover, it is a safety buffer for the continued operation of many actors of the real economy as well as individuals, especially in the context of retirement security. The effective functioning of the commercial insurance sector contributes indirectly or directly to reducing capital costs in the economy by reducing business risk, stimulates investment and innovation and contributes to increased efficiency, business competitiveness through changes in behaviour of both individuals and market operators by stimulating prevention (Feyen, Lester, Rocha, 2011; Arena, 2008). The importance of the insurance sector for the stability of the financial system increases with the degree of insurers’ links with other segments of the financial system, in particular the banking sector and the capital market. The insurance sector acts as a mobiliser for transforming current consumer spending to investment cash flows, which contributes to economic growth (Banasiński, 1997). Insurers stimulating savings, particularly retirement savings, are – along 164

The Development of the Commercial Insurance...

with banks – the biggest investors that largely shape the situation on the capital market. In addition, acting as a financial intermediary, they contribute to the reduction of information asymmetries and stimulate a more efficient allocation of resources on the capital market (Arena, 2008). Studies show that insurance business as such does not directly generate systemic risk (Haefeli, Liedtke, 2012; Systemic Risk in Insurance, 2010; Baluch, Mutenga, Parsons, 2010; Fitzpatrick, 2013). The vast majority of insurers’ financial problems are caused by their quasi-banking activities, i.e. SDC issuance, provision of guarantees. Generally speaking, insurers’ conducting insurance business only do not contribute significantly to systemic risk generation both because of relatively (as compared with banks) low value of their assets (Fitzpatrick, 2013) and relatively slower impact of bankruptcy and insolvency effects, which allows for partial absorption and elimination of the effects, and because the specificity of insurers’ ties with other segments of the financial sector reduces the contagion risk (Systemic Risk in Insurance, 2010). Thus, so far, financial problems of insurers, unlike banks, have not made costly state interventions necessary. This study aims to: identify key determinants of the commercial insurance sector’s development; (2) analyse and assess the various insurance classes as well as the commercial insurance sector growth dynamics. The research covered the Central and Eastern European countries, i.e.: Poland, the Czech Republic, Hungary, Slovakia, Bulgaria and Romania. The period analysed comprises the years 2003-2012. In order to conduct the research, measures of commercial insurance sector’s development that are classified as economic measures were used. This study reviews the literature concerning the results of empirical studies on the links between economic growth and the development of the commercial insurance sector. Subsequently, key determinants of the sector are described. The third part of the study examines the dynamics and the degree of the sector in selected countries of Central and Eastern Europe, based on economic measures.

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2. Determinants of the development of the commercial insurance sector: literature review The determinants may be considered at three interrelated levels (cf. Feyen, Lester, Rocha, 2011; Arena, 2008): ˗ economic determinants – resulting from a country’s economic condition, defining the boundary conditions for the development of this sector; ˗

social determinants – including demographic, sociological and cultural factors, resulting from the perception of the welfare state role, insurance awareness in society and related insurance crime;

˗

institutional and legal determinants – related to regulations both at the level of the European Union directives and national regulations which define the scope of mandatory insurance, guarantee schemes for consumers of insurance services and tax system solutions, for example regarding the use of retirement savings products.

A significant part of the research conducted concerns economic determinants of development and interactions between the insurance sector and economic growth. Among economic factors, the research is mainly focused on the following variables having an impact on the commercial insurance sector: GDP growth rate, GDP per capita, inflation rate, interest rates, unemployment rate, wages and disposable income of the population. It also covers capital market parameters such as market capitalisation of listed companies and bond market development indicators. Some of these macroeconomic variables already form a standard in studies on insurance sector (cf. Feyen, Lester, Rocha, 2011; Arena, 2008). Such studies aim at specifying a group of stimulators and antistimulators on the demand and supply sides in each insurance class. The research conducted is mainly focused on three insurance classes: third party liability motor insurance, credit insurance to secure mortgage repayment, life (nonlinked and linked) assurance as well as individual and group pension assurance. Third party liability motor insurance is popular for obvious reasons: it is mandatory in the European Union countries, hence the need for guarantees for the system and transparency and efficiency of its operation (Retail Insurance Market, 2009; Gönülal, 2009; Insurance guarantee schemes, 2007). There is a renewed 166

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interest in credit insurance because of the search for risk management instruments in the banking sector in view of the recent crisis. A significant part of the research seeks to establish relationships between economic growth, usually measured by GDP, and development of the insurance sector, measured by the rate at which gross premiums written increase. In the light of the research undertaken, it is not clear how economic growth and the insurance sector development are interdependent (cf. Hung, Chiang, 2012), i.e. whether the insurance sector stimulates economic growth or a certain level of economic development is necessary to spur the development of the insurance sector. Some researchers are inclined to think that the insurance sector development depends on the level and rate of economic development, and does not itself lead to economic growth, unlike for instance banks (Adams, Andersson, Andersson, Lindmark, 2005; Webb, Grace, Skipper, 2002). Studies show that the penetration ratio is significantly higher in developed than in developing countries, and in both life and non-life sectors (Feyen, Lester, Rocha, 2011). Nonetheless, a big number of researchers indirectly confirm that an interdependence between the level of the insurance sector development and economic growth exists in the long and short term (Kugler, Ofoghi, 2005; Ward, Zurbruegg, 2000; Arena, 2008; Curak, Loncar, Poposki, 2009). A significant positive impact of the life sector expansion on economic growth occurs primarily in highly developed countries, whereas positive impact of the non-life sector can be observed in both highly developed and developing countries (Arena, 2008; Haiss, Sumegi, 2008). Among the macroeconomic variables, studies often concern such variables as: inflation, interest rate dynamics and income levels of the society measured by income per capita, which are assessed in terms of their impact on the insurance sector’s development. In the light of conducted research, the development of the life insurance sector (measured by gross written premiums) is positively affected by the level and growth rate of individual income (Dongshoi, Moshirian, Nguyen, Wee, 2007; Beck, Webb, 2003). Higher income levels are positively correlated with the demand for life insurance because life insurance types are often categorised as luxury goods characterized by a high-income elasticity of demand (Beck, Webb, 2003). On the other hand, inflation has a statistically significant negative effect on the level of gross premiums written in life insurance (Dongshoi, Moshirian, Nguyen, Wee, 2007; Beck, Webb, 2003; 167

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Feyen, Lester, Rocha, 2011). As regards the impact of interest rates dynamics on the insurance sector development, it is difficult to obtain conclusive research results (see Feyen, Lester, Rocha, 2011). Nevertheless, the term structure of interest rates, on the one hand, influences to a large extent insurers’ investment portfolio yield because portfolios are dominated by debt securities and, on the other hand, determines the value of portfolio of liabilities since they are valued on the basis of the expected interest rate. A major threat to the development of the insurance sector, particularly the life sector, are low interest rates which, although entailing an increase in the current value of liabilities, result simultaneously in low investment portfolio yield (decrease in current portfolio return and low reinvestment rate). The risk of low interest rates is higher for products with guaranteed payment, e.g. pensions. There is a large disparity between a guaranteed payment rate and achievable yield on a bond portfolio. According to a simulation being conducted by supervisors, should low interest rates prevail in the long run, in Germany, for example, more than one third of life insurance companies (market share of around 43%) will be unable to meet the capital requirements imposed by Solvency I (Insurance Companies: Bridging Low Interest Rates..., 2013) by 2023. Among social determinants of the insurance sector’s development, the following are mainly studied: demographic factors, i.e. population ageing, level of education (Ioncica, Petrescu, Ioncica, Constantinescu, 2012), membership of a religious group, cultural factors. In this group of determinants, several important correlations were observed; namely, studies reveal: ˗ a significant negative correlation between life expectancy and demand for life insurance, which is connected with a reduced likelihood of premature death, especially in highly developed countries (Feyen, Lester, Rocha, 2011); ˗

a significant positive correlation between the level of education and demand for life insurance (Dongshoi, Moshirian, Nguyen, Wee, 2007; Ioncica, Petrescu, Ioncica, Constantinescu, 2012);

˗

a significant negative correlation between the life insurance sector development and Muslim religion (Feyen, Lester, Rocha, 2011).

Among institutional and legal determinants of the insurance sector development, factors related to the implementation of the new capital require-

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ments under Solvency II feature prominently. Expected positive effects of the implementation of Solvency II for the insurance sector mainly include (Potential Impact of Solvency II on Financial Stability, 2007): ˗ increased transparency due to increased market discipline; ˗

increased efficiency and competitiveness of the sector due to consolidation, stimulation of mergers and acquisitions;

˗

greater certainty of insurance cover for beneficiaries of insurance services due to stricter capital requirements for insurers.

It should be borne in mind that the implementation of Solvency II by 2016 will not only strengthen the insurance sector in terms of capital, but will also contribute to adverse effects, i.e. bigger market concentration by stimulating consolidation processes. Given the specific nature of the insurance market and entry barriers, its bigger concentration will not implicitly lead to a growth in competitiveness. Implementation of the new capital requirements will lead to the elimination of undercapitalised entities, but also insurers operating on a membership basis, i.e. mutual insurance companies, which currently must meet significantly lower capital requirements compared with insurers operating as corporations. New solvency standards under Solvency II will have a considerable impact on insurers’ financial condition, which will contribute to structural changes in the insurance sector. Thus, a legitimate question arises: will the new capital requirements stimulate intensive or extensive development of the European insurance market? Given the high capital barriers to entry into the sector, increasing market discipline and high market saturation during the crisis as well as relatively stable demand for insurance services on highly developed markets, extensive growth or growth in terms of resources may be expected. Important institutional and legal determinants of the insurance sector’s development also include: regulations on mandatory insurance, especially third party liability motor insurance, and regulations to stimulate demand for savingsrelated pension insurance and health insurance (Gray, Bester, Hougaard, Thom, 2014). The development of the financial sector largely determines the insurance sector’s development, especially in the context of the development of the banking sector and its relationship with the insurance sector. Studies show that a more extensive system of social welfare and a greater role of the state in this 169

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respect have a negative impact on demand in the life insurance sector (Feyen, Lester, Rocha, 2011). At the same time, studies reveal that the life insurance sector develops more rapidly where supporting legal provisions exist (Feyen, Lester, Rocha, 2011; Beck, Webb, 2003).

3. Analysis of the commercial insurance sector development in selected countries of Central and Eastern Europe The analysis and assessment of the commercial insurance sector’s development and dynamics were based on a set of indicators: ˗ illustrating the importance of the commercial insurance sector in the national economy: (1) penetration ratio measured by gross insurance premiums written to GDP, (2) gross insurance premiums written per capita – insurance density; ˗

describing growth dynamics of the commercial insurance sector, namely: (1) dynamics of gross insurance premiums written, (2) insurance operators’ concentration ratios;

˗

describing the structure and financial stability of the commercial insurance sector: (1) the structure of gross premiums written by sector; (2) aggregate financial efficiency of business measured by profit or loss for the financial year to total balance sheet assets; (3) financial stability measured by available solvency margin to required solvency margin.

The research covered the Central and Eastern European countries, i.e.: the Czech Republic, Hungary, Poland, Romania, Slovakia and Bulgaria. The period analysed comprises the years 2003-2012. In view of the importance of the commercial insurance sector in the national economy, it should be noted, in particular, that a significant disparity exists between the analysed countries and highly developed countries of the European Union and the average indicator for the OECD countries (Graph 1). As the research demonstrates, the penetration ratio in the analysed countries stood at an average of 30-40% of the ratio for highly developed EU countries, with the highest ratio of almost 4% in the Czech Republic in 2003 and 2012. This in170

The Development of the Commercial Insurance...

dicates the relatively low importance of the commercial insurance sector in national economies of the analysed Central and Eastern European countries in 2003-2012. These results are confirmed by previous studies that show lower importance of the insurance sector in developing countries compared to highly developed countries (Feyen, Lester, Rocha, 2011). However, the penetration ratio was rising in most of the examined countries (except the Czech Republic and Hungary) in 2003-2012. In contrast, in highly developed EU countries, there was a downward trend from 2009 as a consequence of the crisis. The penetration ratio variations also reflect the relationship between the growth rate of gross written premiums in the commercial insurance sector and GDP growth rate. The penetration ratio was observed to have increased until 2008 and fallen markedly in the aftermath of the economic crisis in virtually all analysed countries (except the Czech Republic). This is discernible especially in Poland, where the penetration ratio decreased from 4.6% in 2008 to 3.8% in 2009 as aggregate gross premiums written in both sectors declined during this time by as much as 30% (Graph 1). What can also be observed is a shift of the insurance sector’s response to the crisis in the analysed Central and Eastern European countries (a fall in the penetration ratio in 2009) compared to highly developed EU countries (a significant fall in the penetration ratio in 2008). This shows that the dynamics of gross premiums written in the commercial insurance sector declined at a greater rate than GDP growth. This illustrates big income elasticity of insurance expenditure (especially as regards to voluntary insurance) and the significant vulnerability of the commercial insurance sector to general economic conditions. A much greater disparity between European countries with highly developed insurance markets and the analysed countries, in particular Romania and Bulgaria, is visible in insurance density. The difference in insurance density between countries of comparable populations, i.e. Bulgaria (approximately 7.5 million inhabitants) and Slovakia (approximately 5.4 million inhabitants) is very significant (as 1:4.5) in the analysed period (Graph 2). It should be pointed out, however, that insurance density is determined primarily by economic factors, hence the disparity in economic development translates into insurance density.

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Teresa Czerwińska Graph 1: Insurance penetration in selected European Union countries in comparison with OECD countries (premiums as % GDP)

Source: own work based on OECD, Swiss Re, CEA and EIOPA statistical database.

Graph 2: Insurance density in selected European Union countries in comparison with OECD countries* (premiums per capita in USD)

* right scale: EU 15, OECD total. Source: own work based on OECD, Swiss Re, CEA and EIOPA statistical database. 172

The Development of the Commercial Insurance...

Taking into account insurance density in the analysed countries, the period covered can be divided into two subperiods clearly coinciding with the onset of the economic crisis: (1) a period of dynamic growth in 2003-2008, (2) a period of marked slowdown and decline in 2009-2012. The gross premium per capita showed a dynamic upward trend in all analysed countries by 2008 (Graph 2). In 2004-2008, the average annual growth rate of gross premium per capita (average for the population concerned: 25%) was significantly higher in the examined countries than in highly developed countries of the EU (average annual growth rate of insurance density for the EU15 is 8.4% and 7.8% for the OECD countries) and reached up to 35% in Romania, 32% in Poland and 29% in Bulgaria (Table 1). On the other hand, 2009 saw the gross premium written per capita begin to decline in the countries concerned and, what is more, that decline was more dynamic than in highly developed EU countries. This confirms the well-known observation concerning greater volatility of emerging markets, more dynamic growth in good economic times and downward trend in periods of economic slowdown. The difference in gross premium written per capita in the life sector is clearly visible between the analysed countries (Graph 3). In the period concerned, premiums written per capita in the life sector were highest in Poland and the Czech Republic, while a very low, albeit gradually increasing level was observed in Romania and Bulgaria. This somehow proves the above-mentioned studies on the relationship between economic development, income of the population and the insurance sector. The research conducted on a sample of 31 European countries shows a significant income elasticity of life insurance expenditure, namely, according to the estimates, the rise in population income of 1% results in an increase in demand for insurance of 1.91% (Celik, Mesut Kayali, 2009). Low level of wealth in society, especially in Romania and Bulgaria, is a very important factor determining the life insurance sector development (Ioncica, Petrescu Ioncica, Constantinescu, 2012).

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174

The Development of the Commercial Insurance... Graph 3: Life insurance density in selected European Union countries 2005-2012 (in euro)

Source: own work based on OECD, CEA and EIOPA statistical database.

According to the studies, the Polish and Czech markets are the largest in terms of gross premiums written, while Bulgaria and Romania are the smallest ones. Bulgaria and Slovakia with comparable populations differ significantly in terms of gross premiums written, with the proportion being 1:2.5 in the analysed period. The analysis of the growth dynamics of the commercial insurance sector shows that in 2012/2005 the markets with the highest aggregate growth dynamics were: Poland (over 200%), Bulgaria (over 161%) and Slovakia (over 157%) (Table 2). Studies have revealed that the countries concerned differ significantly in the development of non-life and life insurance. In the same period, Poland, Bulgaria and Hungary saw much more dynamic growth in gross premiums written in life insurance in relation to the non-life sector. On the other hand, higher growth rate of non-life insurance was observed in the Czech Republic, Slovakia and Romania. Furthermore, it should be noted that these countries (except Hungary) also saw a dynamic growth in gross premiums written in insurance companies combining life and non-life insurance (composite enterprises), as permitted under national regulations. It is worth to note the specifics of the Hungarian market, where gross premiums written in non-life insurance declined systematically in 2005-2012, with an average low annual growth rate of approximately 6% in gross premiums written in the life sector.

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Teresa Czerwińska Graph 4: Annual dynamics gross insurance premiums written in selected EU countries in 2006-2012

Source: own work based on EIOPA statistical database.

The analysis of the structure of the various non-life insurance classes indicated that in 2005-2012 in the analysed countries motor insurance prevailed: motor vehicle third party liability and other motor vehicle insurance classes. On average, their total share was from 43% of gross premiums written in this sector in Hungary and 49% in the Czech Republic to 69% in Bulgaria and 71% in Slovakia (Table 3). Such a structure of non-life insurance classes is a common feature of emerging markets, where mandatory insurance prevails. Mandatory motor vehicle third party liability insurance accounts for a particularly high share in gross premiums written: up to 40%, as in Bulgaria in 2012 or Slovakia in 2005. On the other hand, in highly developed markets, namely Germany, Austria and the United Kingdom, motor insurance usually represents on average about 50% of gross premiums written in total in the non-life sector, while the share of motor vehicle third party liability insurance in gross premiums written is (certainly depending on the country) approximately 25-30%.

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It should also be stressed that the analysed markets were highly volatile, especially in Bulgaria and Poland, a factor specific to emerging markets. A gradual shift towards the structure of gross premiums written that is characteristic of highly developed European markets can also be observed. Statistical analysis of the gross premiums written dynamics distribution in the various classes of insurance in the analysed period showed that the structure of the nonlife insurance sector changed gradually, namely (Graph 5): ˗ the share of motor vehicle third party liability insurance and other motor vehicle insurance classes in the structure of gross premiums written decreased, except for Bulgaria and Romania, which are much less developed markets where the share of these insurance classes in gross premiums written increased; ˗ the share of general liability insurance and credit and suretyship insurance in gross premiums written structure increased, especially in Bulgaria, the Czech Republic and Poland, where the average annual growth rate of gross premiums written in 2005-2012 was the highest among all insurance classes and stood at 27%, 20% and 35%, respectively (Table 2). Changes in the gross premiums written structure in the non-life sector in the countries concerned may, on the one hand, indicate a gradual intensive market development towards optional products, corroborating increased insurance awareness. However, on the other hand, given the boom in the real estate market in Central and Eastern Europe in the same period (especially after joining the European Union), a conclusion might be drawn that the considerable growth in gross premiums written in credit insurance resulted from new residential real estate lending, where the bank requires mortgage insurance. A good example is Bulgaria, where gross premiums written in credit insurance in relation to the previous year increased by 273% in 2007 and 203% in 2008 (Table 3). This dynamics was reduced significantly after 2008 due to a strong downturn in the real estate market, especially in housing. The results obtained for the credit insurance dynamics may corroborate earlier studies that show important links between the development of the insurance sector and the banking sector as well as the dependence of the insurance sector development dynamics on the maturity of the financial system in a given country.

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The Development of the Commercial Insurance... Graph 5: Change in gross premiums written structure in non-life insurance sector in selected EU countries (2012 related to 2005)

Source: own work based on EIOPA statistical database.

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Studies have also proved the existence of some correlations between insurance classes in the analysed countries. Considerable similarities exist in Poland and Bulgaria. There is a significant correlation between premiums written for accident and health insurance and motor vehicle third party liability insurance both in Bulgaria and in Poland (positive correlation), while in Romania this correlation is negative. In addition, there is a major correlation between motor vehicle third party liability insurance and other motor vehicle insurance classes in both Poland and the Czech Republic, as well as between fire and other damage to property insurance and motor vehicle third party liability insurance and other motor vehicle insurance classes in both Bulgaria and Poland. Simultaneously, gross premiums written for fire and other damage to property insurance were observed to be largely positively correlated with credit and suretyship insurance in Bulgaria, Poland, Slovakia and Romania (negative correlation in the latter case), as were accident and health insurance and general liability insurance in Poland, the Czech Republic and Slovakia (Table 4). Given the practice of tying motor insurance and accident insurance, a positive correlation between motor and accident insurance classes may be associated with the dynamic growth of the number of vehicles, especially passenger cars, in the new member states of the EU. In Romania, there is a major negative correlation between insurance classes, especially between accident and health insurance and motor vehicle third party liability insurance (-0.84), accident and health insurance and fire and other damage to property insurance (-0.85), and also between credit and suretyship insurance and fire and other damage to property insurance (-0,8) (Table 4). This may indicate that the sector has low potential for development due to the relatively low level of economic development, which means that the various insurance classes can only develop at the expense of others. Taking into account the low level of wealth of the population as well as the importance of mandatory insurance, this means that the sector is focused on motor insurance: motor vehicle third party liability insurance and other motor vehicle insurance classes, which accounted for 66% of premiums written in 2012 in Romania.

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In the analysed period, a very dynamic growth in gross premiums written was observed in the life insurance sector in Poland and Bulgaria (Table 5). In turn, in the Czech Republic (a fivefold increase in 2012 relative to 2005) and Slovakia there was an extremely rapid growth in gross premiums written for linked life assurance (Table 5). The analysis of the various insurance classes in the life insurance sector showed a considerable similarity between the countries concerned. First of all, it should be noted that gross premiums written in virtually all analysed countries depended, in the period covered (except for the Czech Republic in 2011-2012 and Hungary in 2006-2012), on the development of two insurance classes: the dominant one – non-linked life assurance, and the second biggest – linked life assurance (except for Bulgaria, the Czech Republic and Hungary). At the same time, there is a clear difference between the life insurance sector in the Czech Republic and Hungary and the other countries in question. In both the Czech Republic and Hungary, linked life assurance represented a major (dominant in Hungary) proportion of life assurance. In the Czech Republic, its share in gross premiums written rose dynamically throughout the period covered. Furthermore, it is worth noting that in the Czech Republic and Slovakia (except 2009), this insurance class showed resilience to the effects of the crisis as the growth rate for linked life assurance declined, but was still positive, even when the effects of the crisis emerged in 2008-2009. Moreover, in the analysed countries some changes were noticed in the structure of gross premiums written in the life sector over the period. In the Czech Republic and Slovakia, the share of linked life assurance rose significantly at the expense of non-linked life assurance (Graph 6). At the same time, the linked life assurance shared decreased in Poland, Hungary and Romania, with gains in the linked life assurance class. Higher level of economic development can be supposed to determine linked life assurance expansion, which confirms the results of previous studies.

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186

The Development of the Commercial Insurance... Graph 6: Change in gross premiums written structure in life sector in selected European Union countries (2012 in relations to 2005)

Source: own work based on EIOPA statistical database.

The analysis of the insurance sector concentration in the countries examined showed that in 2005-2012 (Tables 6-7): ˗ the degree of concentration in all the countries decreased in both life and non-life sectors (except for Romania); ˗

market operators’ concentration in the non-life sector was significantly higher than in the life sector;

˗

the non-life sector was highly concentrated in the Czech Republic, Slovakia and Hungary, where the average C3 concentration ratio was over 67%, 74% and 63%, respectively;

˗

the degree of the non-life sector concentration was low in Bulgaria and Romania, where C3 ratio averaged around 40%;

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˗

the average C3 concentration ratio for the life sector in all analysed countries exceeded 50% (except for Hungary), which indicates a high degree of concentration in this sector; this ratio dropped below 50% in Bulgaria and the Czech Republic from 2009 and in Poland from 2011, whereas in Romania and Slovakia it still stands at over 64% and 54%, respectively.

Studies show that, paradoxically, higher concentration correlates positively with the level of the insurance sector development (Feyen, Lester, Rocha, 2011). The research conducted seem to corroborate this relationship because countries with a more developed commercial insurance sector have higher ratios of market operators’ concentration, for example the Czech Republic. Simultaneously, it is worth noting that in the analysed countries there are few strictly national operators (in the sense of the sources of initial capital). The companies operating there mostly form part of conglomerate structures of the major insurers from highly developed EU countries, such as Allianz, AXA, Aviva, Generali. Hence, it seems that this may be the reason why market operators are more concentrated in the analysed countries of Central and Eastern Europe than in countries with a mature insurance sector, such as Germany, Austria, and France.

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Slovakia

Romania

Poland

Hungary

Czech Republic

Bulgaria

Item

Country

Table 6: Concentration ratio* in non-life insurance sector in selected European Union countries in 2005-2012

CR 3 CR 5 CR 10 CR 3 CR 5 CR 10 CR 3 CR 5 CR 10 CR 3 CR 5 CR 10 CR 3 CR 5 CR 10 CR 3 CR 5 CR 10

Year 2011

2012

Change 20122005**

Average in 20052012

2005

2006

2007

2008

2009

2010

50,0

44,9

40,4

38,4

39,7

36,9

34,9

36,9

-13,1

40

68,4

63

60

58,8

59,6

57,1

55,8

58,1

-10,4

60

92,1

89,8

88,6

87,8

86,5

85

85,5

86,9

-5,2

88

75,2

73,2

70,4

68,5

65,5

62,1

60,8

60,9

-14,3

67

85,1

83,5

81,6

80,6

78,4

74,7

73,5

73,3

-11,8

79

95,3

94,6

93,4

93,1

91,9

89,7

89,3

89,7

-5,6

92

66,7

66,5

63,9

63,1

63

62,1

59

57,7

-8,96

63

81,4

81,7

80,1

80,7

81

81,5

78,2

78,1

-3,3

80

93,7

93,6

92,7

93,4

94,3

93,7

92,9

93,3

-0,4

93

66,8

64,2

61,9

59,1

56

53,3

52,1

55,9

-10,9

59

76,7

76

74,1

71,2

67,6

65,5

63,7

67,1

-9,6

70

87,3

87,2

86,7

85,9

83,9

83

82,4

84,4

-2,95

85

NA

45,2

81,4

43,9

43

44

42,2

42

-3,2

43

NA

62,6

89,8

60,9

58,6

62,7

61,9

62

-0,9

57

NA

89

97,7

89,1

86,5

90,1

87,1

89,7

0,7

79

61,5

72,9

73,3

76,6

78,5

75,7

75

74,5

13

74

100

83,7

85,1

89,1

91,5

89,2

88,2

88,5

-11,5

89

-

96,2

97

97,8

99,1

99

98,9

99,2

99,2

86

* gross written premiums of the largest 3, 5 and 10 companies as a % of total gross written premiums in the domestic sector. ** for Romania data from 2006.

Source: EIOPA statistical database.

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Average in 2005-2012

Change 2012-2005**

2012

2011

2010

2009

2008

2007

2006

Item

Hungary Poland Romania Slovakia

2005

Country

CR 3 CR 5 CR 10

Czech Republic

Bulgaria

Table 7: Concentration ratio* in life insurance sector in selected European Union countries in 2005-2012

65,0

63,5

54,1

51

48 44,2

45,6

47,2

-17,8

52

81,1

80,5

74,7

71,8

66,4 63,7

64,5

67,2

-13,9

71

99,5

99,2

97

94,7

93,6 93,7

94

94

-5,5

96

CR 3

59,3

53,8

51,2

51,6

46,8 45,8

44,2

43,9

-15,4

50

CR 5

73,5

72,5

73,1

72,7

66,2 66,2

64,8

64,7

-8,79

69

CR 10

93,8

93

92,6

92

91,3 91,5

90,5

90,7

-3,1

92

55,8

49,6

45,8

41,4

39,6 38,7

38,1

37,4

-18,4

43

73,5

67,5

64,7

59,7

57,8 57,7

56,2

55,7

-17,8

62

88,9

90

89

85,8

83,1 84,3

83,2

83,8

-5,1

86

60,2

56,3

51,7

53,7

50,3 50,1

46,7

44,8

-15,4

52

73,3

70,7

65,5

68,1

64,8 62,6

58,8

58,9

-14,5

65

86,4

87,3

85,6

86,9

86,6 83,6

79,9

82,1

-4,3

85

NA

58,3

84,2

59,6

59,8 63,4

63,6

64,8

6,5

57

NA

71,7

98,2

71,2

71,5 74,2

73,3

74,6

2,9

67

NA

95

100

93,7

92 93,4

89,9

91,9

-3,1

82

98,9

56,9

56,9

54,3

54,8 54,5

54,9

54,2

-44,7

61

100

73,5

74,8

73,6

72,5 71,8

72

70,9

-29,1

76

-

93,9

93,4

94,2

95 93,8

93,3

93,5

93,5

82

CR 3 CR 5 CR 10 CR 3 CR 5 CR 10 CR 3 CR 5 CR 10 CR 3 CR 5 CR 10

*

gross written premiums of the largest 3, 5 and 10 companies as a % of total gross written premiums in the domestic sector.

**

for Romania data from 2006.

Source: EIOPA statistical database.

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Taking into account the insurance sector efficiency measured by profit or loss for the financial year to total balance sheet assets in the countries concerned, the research found that (Table 8): ˗ efficiency was higher in Bulgaria and Poland, in both life and non-life sectors; ˗

in the life sector, efficiency ratios were positive in the countries concerned throughout the analysed period (except for Romania in 20072010 and Hungary in 2010-2011), while it should be noted that the measured efficiency is low, in particular in Romania, Slovakia and Hungary;

˗

efficiency ratios for the non-life sector were on average slightly higher than in the life sector; however, the average efficiency ratio in the analysed period was negative in Slovakia, Romania and the Czech Republic; the situation is particularly unfavourable in Slovakia, where negative efficiency ratios dropped further in 2008-2011, to -17.6% in 2011. This demonstrates extremely difficult conditions for the sector development, especially in the context of Solvency II implementation and the likely recapitalisation of some insurance companies, particularly as the solvency margin to required solvency margin is relatively lower in Slovakia than in the analysed group of countries.

˗

there was a clear positive correlation between the efficiency of life and non-life sectors in Hungary and Romania.

The research also covered the interdependence between the concentration of market operators (measured by the share of three largest operators in gross written premiums (C3)) in each sector and the sector’s aggregate financial efficiency measured by profit or loss for the financial year to total balance sheet assets (Graph 7). The results obtained are not conclusive because they indicate a positive correlation between concentration and efficiency of the insurance sector (both life and non-life) in Bulgaria and Poland. On the contrary, in the other cases, this correlation is negligible or even negative, as e.g. in the non-life sector in Slovakia. Therefore, it can be concluded that in the period covered, the sector concentration in the countries concerned did not significantly affect its financial efficiency measured by profit or loss for the financial year to total balance sheet assets. 191

Teresa Czerwińska Graph 7: Average concentration C3 and efficiency ratio in selected European countries in 2005-2012

Source: own work EIOPA statistical database.

The analysis of the insurance sector’s financial stability, measured by available solvency margin to the required solvency margin, showed that the latter was higher than prescribed in all countries assessed, which proves the sector’s high capacity to absorb any potential losses and market shocks (Table 8). The average required solvency margin coverage ratio was much higher in the life sector. It should be, however, noted that it was relatively lower in the life sector in Romania and in the non-life sector in Bulgaria. Additionally, the analyses found a major positive correlation between the sector concentration and the required solvency margin coverage in the non-life sector in Poland and Romania and in the life sector in Romania. This may mean that a greater polarisation of market operators leads to increased capital guarantees for the insurance sector’s financial stability. It is debatable because: firstly, the example of the banking sector provides a convincing argument that the actors which are too big to fail are a threat to financial stability, hence the greater dispersion of market operators would be desirable, and secondly – given that Solvency II implemen192

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tation requires the recapitalisation of small companies – this is an effect of mergers and acquisitions activity pursued by large companies that are able to increase their solvency capital margin significantly. Thus, greater concentration may, paradoxically, be associated with an increase in the insurance sector’s financial stability (Graph 8). However, this hypothesis requires a separate study. Graph 8: Average concentration C3 and solvency ratio in selected European countries in 2005-2012

Source: own work EIOPA statistical database.

At the same time, there was a significant negative correlation between the sector concentration and required solvency margin coverage in the life sector in Poland and in the non-life sector in Slovakia. These results are related to the specificity of these markets. In Poland, the decline in market share of one of the biggest companies, PZU Life, can entail a rise of the capital solvency margin since this national operator has relatively low capital compared to other companies that form part of foreign conglomerate structures. Therefore, lower concentration may result in an increase in required solvency margin coverage if the previously dominant operators have relatively small capital.

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Teresa Czerwińska Table 8: Insurance sector efficiency and solvency ratio in selected European Union countries in 2005-2012

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The Development of the Commercial Insurance...

4. Conclusion The analytical studies of the insurance sector’s development in the countries of Central and Eastern Europe in 2005-2012 showed that: ˗ after years of economic and political transformation, there is still a big disparity in the insurance sector’s development, not only between the analysed group of countries and highly developed EU countries, but also within this group, where more developed insurance sectors exist in the Czech Republic and Slovakia, but they are much less developed in Bulgaria and Romania; ˗

the insurance sector was marked by a high growth trend in all analysed countries, which clearly slowed down due to the effects of the crisis, especially in 2008-2009; the dynamics of the changes examined in the insurance sector are much greater than in the EU countries with mature insurance sectors;

˗

structural changes occurred in the non-life sector, namely motor vehicle third party liability insurance accounted for a dominant share in gross premiums written, but voluntary insurance, i.e. fire and other damage to property and general liability insurance, gained importance;

˗

structural changes in the life sector involved an increase in the linked life assurance share of the gross premiums written structure at the expense of non-linked life assurance, as in the Czech Republic and Slovakia;

˗

both life and non-life sectors are still highly concentrated, despite a downward trend in this respect (except Romania);

˗

in the period covered, the sector concentration in the countries concerned had no major links with its financial efficiency measured by profit or loss for the financial year to total balance sheet assets.

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Teresa Czerwińska

Bibliography Arena, M. (2008). “Does Insurance Market Activity Promote Economic Growth? A CrossCountry Study for Industrialized and Developing Countries”. The Journal of Risk and Insurance, December, Vol. 75, Issue 4: 921-946. Adams, M., Andersson J., Andersson, L. F., Lindmark, M. (2005). The Historical Relation between Banking, Insurance and Economic Growth in Sweden: 1839 to 1998, Norges Handelshoyskole, Department of Economics Discussion Paper SAM, 26. Baluch, F., Mutenga, S., Parsons C. (2010). “Insurance, Systemic Risk and the Financial Crisis”, in: Compensation for Industrial Injuries and Welfare Reform – an International Perspective. Accessed: 20.06.20014, http://www.cassknowledge.com/sites/default/files/article-attachments/369~~chrisparsons_insurance_and_the_financial_crisis.pdf. Banasiński, A. (1997). Ubezpieczenia gospodarcze, Warszawa: Poltext: 74. Beck, Y., Webb, I. (2003). “Economic, Demographic, and Institutional Determinants of Life Insurance Consumption across Countries”. The World Bank Economic Review, Vol. 17: 51-88. Celik, S., Mesut Kayali, M. (2009), “Determinants of Demand for Life Insurance in European Countries”, in: Problems and Perspectives in Management, Vol. 7, Issue 3: 32-37. Curak, M., Loncar, S., Poposki, K. (2009). “International Sector Development and Economic Growth in Transition Countries”, International Research Journal of Finance and Economics, Issue 34. Czerwińska, T. T. (2009). Polityka inwestycyjna instytucji ubezpieczeniowych – istota, uwarunkowania, instrumenty, Gdańsk: Wyd. Uniwersytetu Gdańskiego. Dongshoi, L., Moshirian, F., Nguyen, P., Wee, T. (2007). “The Demand for Life Insurance in OECD Countries”, The Journal of Risk and Insurance, September, Vol. 74, No. 3: 637652. Feyen, E., Lester, R., Rocha, R. (2001). What Drives the Development of the Insurance Sector? An Empirical Analysis Based on a Panel of Developed and Developing Countries, The World Bank Financial and Private Sector Development, Finance and Policy Units, February, Policy Research Working Paper 55721. Fitzpatrick, J. H. (2013). Cross Industry Analysis 28 G-SIBs vs. 28 Insurers – Comparison of Systemic Risk Indicators, February, Geneva: The Geneva Association. Gray, J., Bester, H., Hougaard, Ch., Thom, M. (2014). Regulatory Approaches to Inclusive Insurance Market Development. Cross-country Synthesis Paper 2, February. Accessed: 20.06.2014, http://www.a2ii.org/fileadmin/file_storage/Documents/Secretariat/final/-

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The Development of the Commercial Insurance... 07_Knowledge_and_Learning/Cross_Country_Synthesis/2014_03_10_Annex_9_A2ii_Cross-country_synthesis_doc_2_for_consultation.pdf. Gönülal, S. O. (2009). Motor Third-party Liability in Developing Countries, The World Bank. Accessed: 20.06.2014, http://siteresources.worldbank.org/EXTFINANCIALSECTOR/Resources/282884-1242281415644/Motor_3rd_party_liability_insurance.pdf. Haefeli, D., Liedtke, P. M. (2012). Insurance and Resolution in Light of the Systemic Risk Debate. A Contribution to the Financial Stability Discussion in Insurance, February, Geneva: The Geneva Association. Haiss, P., Sumegi, K. (2008). “The Relationship Between Insurance and Economic Growth in Europe: A Theoretical and Empirical Analysis”, Empirica, Vol. 35 (4): 405-31. Harrington, S. E., Niehaus, G. R. (2003). Risk Management& Insurance, New York: Mc GrawHill, International Edition. Hung, C.C., Chiang, C.L. (2012). “Non-Linearity Between Life Insurance and Economic Development: A Revisited Approach”, The Geneva Risk and Insurance Review, 37: 223-257. Insurance Guarantee Schemes in the EU. Comparative Analysis of Existing Schemes, Analysis of Problems and Evaluation of Options – Final Report Prepared for European Commission, Oxera, November 2007. Accessed: 20.06.2014, http://ec.europa.eu/internal_market/insurance/docs/guarantee_schemes_en.pdf. “Insurance Companies: Bridging Low Interest Rates and Higher Capital Requirements” (2013). in: Financial Stability Review 2013, Deutsche Bundesbank, Frankfurt am Main. Accessed: 20.06.2014, http://www.bundesbank.de, http://www.centerforfinancialstability.org/fsr/ger_fsr_201311.pdf Insurance and Financial Stability (2011). International Association of Insurance Supervisors (IAIS), November. Ioncica, M., Petrescu, E., Ioncica, D., Constantinescu, M. (2012). “The Role of Education on Consumer Behavior on the Insurance Market”, Procedia - Social and Behavioral Sciences, No. 46: 4154-4158 (WCES 2012). Kugler, M., Ofoghi, R., (2005). Does Insurance Promote Economic Growth? Evidence from the UK. Working Paper, Division of Economics, University of Southampton. Mowbray, A. H., Blanchard, R. H. (1961). Insurance, Its Theory and Practice in the United States, New York: Mc Graw-Hill Inc. Potential Impact of Solvency II on Financial Stability (2007). European Central Bank. Retail Insurance Market (2009). Study Final Report by Europe Economics, November (MARKT/2008/18/H), London, www.europe-economics.com.

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Teresa Czerwińska Systemic Risk in Insurance, an Analysis of Insurance and Financial Stability (2010). March, Geneva: The Geneva Association. Vaughan, E. J. (1992). Fundamentals of Risk and Insurance, New York: J. Wiley&Sons. Williams, C. A. Jr., Smith, M. L., Young, P. C. (1995). Risk Management and Insurance, New York: Mc Graw-Hill Inc. Ward, D., Zurbruegg, R. (2000). “Does Insurance Promote Economic Growth? Evidence from OECD Countries”, The Journal of Risk and Insurance, Vol. 67, No. 4: 489-506. Webb, I., Martin, F. G., Skipper, H. D. (2002). The Effect of Banking and Insurance on the Growth of Capital and Output, Center for Risk Management and Insurance, Working Paper 02.

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HOW GREEN IS MY BUDGET? PUBLIC ENVIRONMENTAL EXPENDITURES IN BRAZIL

Carlos Eduardo Frickmann Young1 Erico Rial Pinto Rocha 2 Leonardo Barcellos de Bakker 3 André Falkenbach Santoro4

Abstract: This paper analyses Brazilian spending on environmental protection, including at federal, state and municipal levels, in the 2003-2010 period. The results presented herein confirm previous studies that suggested a declining trend in public sharing in environmental expenditures at the federal level and an increasing trend at the state level. This demonstrates that (a) the federal government is pursuing an “anti-green” growth strategy, increasing activities that pressure the environment (especially infrastructure investment), while spending on environmental protection remains relatively stagnated, and (b) there is an important change in political distribution of environmental protection, with growing participation of state and municipal governments. It was also shown that increasing expenditures on environmental protection do not harm social and economic development, confirming the main “green economy” hypothesis. Keywords: public expenditures on environmental protection; development; Human Development Index; deforestation; Brazil.

1

Carlos Eduardo Frickmann Young – PhD in Economics, Associate Professor, Institute of Economics, Federal University of Rio de Janeiro, e-mail: [email protected]. 2 Erico Rial Pinto Rocha – MA student, Institute of Economics, Federal University of Rio de Janeiro. 3 Leonardo Barcellos de Bakker – MA in Public Policy, Environmental Working Group, Federal University of Rio de Janeiro. 4 André Falkenbach Santoro – BA student, Institute of Economics, Federal University of Rio de Janeiro. 199

Carlos E. Young, Erico R. P. Rocha, Leonardo B. de Bakker, André F. Santoro

1. Introduction One of the pillars of “greening” the economy is the increase in public expenditures on activities that are associated with sustainable development. Even though environmental protection is not the only concern for a “green” economy, it can only make sense if the public sector improves its efforts associated with environmental protection. The literature on empirical assessments of “public green budgets” is relatively poor, especially in developing countries. Previous studies suggested that in Brazil, in spite of the rhetorical concern with sustainability, there was a trend for decreased participation in environmental expenditure in the public budget (Young and Roncisvalle, 2002; Young, 2005). However, these studies are relatively outdated, and mostly restricted to the federal government’s participation. The objective of this paper is to expand the empirical analysis of the public expenditures on environmental protection in Brazil, extending the analysis to the state level and considering a longer period (2003-2010) in order to enable the development of more detailed analysis on the subject. The analysis of public expenditure is important in the Brazilian context, as the country experiences a cycle of expansion in economic activity, strengthened after 2006. The main characteristic of this cycle is the expansion of state intervention in the economy, with growth of public investment (especially in energy and infrastructure areas) and the return of long-term planning (Barbosa, 2010). Therefore, the analysis of the environmental budget is relevant to check if sustainability is a concern with the new development model which is being implemented. Another objective of this study is to analyse if the theories that economic development and environmental conservation are concurrent goals, and that deforestation is necessary to increase employment and income, as well as to improve social conditions, have had any empirical support. Statistical analysis was elaborated to estimate (i) the correlation between public expenditures and human development at the state and municipal (local) levels to check whether the increasing expenditures on environmental protection really do harm social and economic development and (ii) the correlation between deforestation and human development, at the state level, to check if high levels of deforestation are associated with increases in economic development. 200

How Green is My Budget?...

2. Methods Data on public spending was obtained from databases open to public access (Secretaria do Orçamento Federal – SOF/Ministério do Planejamento, and Secretaria do Tesouro Nacional – STN/Ministério da Fazenda), and spans the federal government, 26 States plus the Federal District, and 5.558 municipalities. In order to make the comparison of the public expenditure data in particular periods possible in real terms, the GDP deflator was used, calculated by the Brazilian Institute of Geography and Statistics (IBGE) and considering prices in 2010 Brazilian Real (R$). Development at the municipal level was estimated using the FIRJAN Municipal Development Index calculated by the Federation of Industries of Rio de Janeiro (FIRJAN). IFDM is a proxy of HDI and is based on indicators of employment and income, education and health, ascribing each municipality a grade from zero to one (the closer to one, the better the result). The most recent data provided by IFDM were published in 2010, but refer to the year 2007 – the time lag is due to dependence on external data for the consolidation of the index. The proxy used for measuring the threat/pressure on the environment was deforestation. This choice is justified not only by the lack of environmental indicators on the sub-national level, but also because it allows the analysis to test if deforestation is really a necessary condition for economic development. The deforestation data used referred to the period 2002-2008, and the source of the data varies according to the region’s biome. Deforestation data were obtained at the municipal level. For the Atlantic Forest, the source was the “Atlas dos Remanescentes Florestais da Mata Atlântica”, produced by the National Spatial Research Institute (INPE) in association with the NGO SOS Mata Atlântica. For the Amazon biome, deforestation data are provided by INPE. For the other biomes (“Pampa”, “Cerrado” and “Caatinga”), the data were obtained from the Ministry of the Environment (MMA). The year 2008 was chosen as the base year since it was the most recent year with data available for all biomes. The level of deforestation at the state level was obtained by adding data from the respective municipalities. Additionally, because of the huge disparity in state sizes in Brazil, the percentage of deforested area was taken into account instead of its absolute value.

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Carlos E. Young, Erico R. P. Rocha, Leonardo B. de Bakker, André F. Santoro

After the formulation of the database, the SPSS statistics software was used in order to check the proposed correlation tests. Pearson Correlation Coefficients were used to calculate the correlation between variables. However, it is important to note that the correlation analysis shows no distinction between the dependent and explanatory variables; in this sense, the correlation only measures the linear association between two variables, and does not allow any causal inference between them. The first test was aimed at finding the correlation between the public environmental expenditure and HDI levels, in order to try to prove that there is no conflict between spending on environmental issues and improving human development, at both state and municipal level. The variable used for public expenditure was the average of the percentage of the budget, which was spent on environmental programs during 2003-2010 – this amount appears in the budget allocation under the subscript “Environmental Management”. The average was used in order to try to mitigate the huge oscillation of budget data, which is quite common, especially in small municipalities. Secondly, we tested the correlation between HDI levels and deforestation, in order to clarify if deforestation actually leads to improvement in socioeconomic conditions – this test was carried out only at the state level. The variable used for deforestation was the average percentage of deforested area between 2002-2008, per state. After that, a two-tailed test was carried out to verify the statistical significance of the coefficients.

3. Results 3.1 Federal budget The recent expansion of economic activity in Brazil is strongly associated with the growth of public investment, especially in the energy and infrastructure areas. The cornerstone of this strategy was the promulgation of the Program for Growth Acceleration (PAC) in January 2007, at the beginning of President Lula’s second term. The program predicted more than five hundred billions of Brazilian Reais in public investment between 2007 and 2010, divided between three main areas: energy, logistic and social infrastructure. 202

How Green is My Budget?...

Besides that, at the end of Lula’s second term, the government launched PAC 2, which continues to be a very important program to Dilma Roussef’s current government, showing the maintenance of the state-driven strategy; the program predicts more than nine hundred billions of Brazilian Reais in public investment between 2011 and 2014, mainly in the infrastructure area. The analysis of SOF data confirms that, together with the objectives of the PAC, public expenditure on infrastructure projects sky-rocketed in the last few years. From 2003 to 2010, the federal governments’ discretionary5 expenditure on infrastructure rose from R$ 10.751 million in 2003 to R$ 42.416 million in 2010, an astonishing growth of 295% over the period; the bigger part of this growth occurred after 2007, due to the implementation of PAC projects. The practical result of this process was the increase in infrastructure investments, with the counterpart of higher pressure on the environmental authorities, both for the issuing of licences and for the supervision of the implementation of these projects. However, since expenditures on infrastructure projects were not being matched with an increase on the budget of public environmental agencies, the consequence was the poor environmental management of these new projects. The Ministry of the Environment (MMA) is the main institution regarding environmental management at the federal level. Thus, the MMA budget was used to analyse the evolution of the federal expenditure on environmental issues. The results demonstrate that the MMA budget remained almost stagnant between 2003 and 2010, while the budgets of the Ministries of Transport and Cities experienced a significant rise. The Ministry of Transport budget rose from R$ 3.467 million in 2003 to R$ 15.665 million in 2010 (growth of 351.8% over the period), while the Ministry of Cities budget grew 863.8% over the same period. On the other hand, the MMA’s budget grew only by 13.1% between 2003 and 2010, and never surpassed R$ 700 million over this period. Therefore, it is clear that despite being an important actor in the management of infrastructure projects, the Ministry of Environment has not been being properly treated in the redistribution and allocation of resources within 5

Discretionary expenses refer to expenditures directly related to the main purpose of the activity, not including public spending on wages, pensions and interests. 203

Carlos E. Young, Erico R. P. Rocha, Leonardo B. de Bakker, André F. Santoro

the federal budget. As a result, the Ministry of Environment’s share in federal government discretionary expenditure on infrastructure fell from 5.71% in 2003 to 1.64% in 2010. The other data source for the federal government’s expenditure (Brazilian National Treasury – STN) classifies the expenditures according to functions. The results, nevertheless, remained the same: environment related expenditures have been stagnant, while expenditure on infrastructure is growing at fast rates. For example, expenditures under the subscript “Transport” rose by 128.9% between 2003-2010, while expenditures under the subscript “Environmental Management” grew only by 20.8% over the same period. This discrepancy is even greater if the analysis is restricted to 20062010: while environmental related programs budget rose by only 0.7% (reduced to 0.19% of the federal budget in 2010), transport expenditures rose by 33.1%. 3.2 States budget The following functions were analysed on state level budgets: Transport, Environmental Management, Housing and Sanitation. Again, values were converted to 2010 prices using the GDP deflater and then aggregated over the 2003-2010 period. Differently from the federal government, spending on environmental management remained relatively stable at the state level, with a light rising trend in the 2003-2010 period. Due to the huge disparity between Brazilian states in terms of their absolute budgets, the average share of expenditure in the function Environmental Management over the period 2003-2010 was used for comparisons between states. As can be seen in Table 1, the average share of the function Environmental Management in total state public budgets is around 0.8% over the 2003-2010 period. However, there is a wide disparity between individual states, oscillating between 0.20% and 1.17%. 3.3 Comparison States x Federal Budget The analysis of the federal budget showed a stagnation of the budget of the Ministry of Environment, while the budget of both Ministries of Transport and Cities grew substantially over the period 2003-2010. On the other hand, at 204

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the state level, the analysis of aggregate state budget showed that, despite having different patterns of sharing in the total budget, none of the analyzed functions had experienced a huge increase over the same period, with their shares being relatively stable. One of the results of this process is that since 2007, the combined environmental spending by states has surpassed the federal government environmental expenditures. The analysis in terms of percentages also confirms that, when it comes to budget allocation, environmental issues had a more relevant role in the state policy in comparison to the federal policy. While expenditures in the Environmental Management function represented about 0.8% of the total state expenditure in 2003-2010, this share is reduced to about 0.2% for the federal budget – therefore, in percentage terms, environmental spending by the federal government is about the same as the Roraima State, the one with the smallest value in Table 1. 3.4. Correlation tests If expenditures on environmental conservation were an obstacle to economic development, thus states that allocate bigger shares of their budgets to environmental conservation should present lower levels of HDI. However, the statistical analysis carried out in this study shows that this theory has no empirical support – in fact, the correlation between these variables is positive. As explained above, the average share of expenditure in the Environmental Management function over the period 2003-2010, both for state and municipal levels, and FIRJAN Human Development Index served as a proxy for human development. At the state level (26 observations), the correlation coefficient was 0.423, statistically significant at 5%, and at the municipal level (5,558 observations), the correlation coefficient was 0.129, statistically significant at 1%. The lower statistical significance found for the states is due to the small sample, while the lower coefficient found for municipalities can be explained by the huge presence of outliers (municipalities with 0% of public spending over

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the analysed period) in the sample6. After the analysis of the dispersion between average environmental expenditure and HDI, it was clear that the relation between these variables is positive. As discussed before, since we only performed a correlation test, it is not possible to make any further comment about the causality between these variables – nevertheless, the trend line suggests that they are positively related. For instance, the existence of positive correlation between these variables is sufficient to refute the analysed theory. One interesting aspect of the municipal level data is that the average environmental expenditure also correlates positively with the Employment and Income components of the IFDM. The correlation coefficient between the variables was 0.167, statistically significant at 1%, suggesting that spending in the environmental area can stimulate job creation and income generation, instead of harming economic development. One possible counter-argument is that higher economic activity levels associated with higher HDI levels would represent higher pressure on natural resources, thus increasing the need for environmental protection efforts. To test this hypothesis, it was necessary to identify data for environmental stress that are comparable at state or municipal levels, which is a very difficult task considering the lack of information on environmental conditions at the sub-national level. The chosen variable was the average deforested area between 2002-2008 at the state level. If the argument cited above was right, the correlation between the average deforested area and the HDI should be positive – bigger development levels should come together with bigger losses of forested area. However, the results showed that states that presented higher forest losses presented lower HDI levels – the correlation coefficient was -0.418, statistically significant at 5%. Again, even without a linear regression, the trend line suggests that the relation between the analysed variables is negative and significant. In addition, the relation between the average deforested area and the Employment and Income component of the IFDM is also negative, with a stronger correlation coefficient (-0.461), also statistically significant at 5%. These 6

From the 5.558 municipalities analyzed, 2.388 (about 43% of the sample) had average expenditure in function Environmental Management for the period 2003-2010 lower than 0.05% of their budget, and 1.535 (about 27.5% of the sample) showed average environmental expenditure for the same period equal to zero. 206

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results confirmed previous studies (Young, 2006; Young, Neves, 2009) which argued that allowing more deforestation does not improve development conditions and higher human development does not represent a higher pressure on natural resources in comparison to a situation of worse economic or social conditions.

4. Conclusion This study provides several conclusions. First of all, the analysis of the federal budget confirmed the declining trend in public expenditures on environmental expenditures (in percentage terms). Despite the huge growth in budget for the infrastructure area, the budget for the environmental area remained stagnated over the period 2003-2010 – this situation became more explicit after 2007, with the implementation of PAC programme. This shows that the federal government is following an “anti-green” growth strategy, in the sense that activities that pressure the environment (especially infrastructure investment, such as dams and road building) are receiving more resources, while expenditure on environmental protection remains relatively stagnant. Another negative consequence of this strategy is the worsening of environmental management of infrastructure projects in Brazil, since the implementation of new projects amplifies the demand for licensing and supervision from the environmental authorities, but these authorities do not have any increase on their budgets to enable the realization of this extra demand. Besides, it is important to point out that environmental authorities in Brazil already suffer from a lack of material and human resources – for example, analyzing the National System of Conservation Units, Medeiros and Young (2011) showed that the proportion between area included in the environmental conservation system and the number of official employees on supervision of the area in Brazil is one of the worst in the world. While in South Africa and the United States this proportion is, respectively, of one employee per each 1.176 ha and 2.125 ha, in Brazil the proportion is of one employee per 18.600 ha – an area that, in practical terms, corresponds to approximately the area of 20.000 official football fields per one person. 207

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The comparison of the federal and the state budgets for environmental conservation showed that there is an important change in the political distribution of environmental policy: since 2007, state governments are spending more (in absolute terms) than the federal government in the area, thus playing a major role in the management of natural resources in Brazil. Additionally, the statistical test carried out in this study proved that the theory that environmental conservation is an obstacle to economic development is not empirically sustainable. If this theory was right, the correlation between public environmental spending and human development levels should be negative - however, the results showed that the correlation between these two variables is positive, both on state and municipal levels. It is also important to point out that the focus of the analysis was not the absolute value of the coefficient, but the direction of the correlation – since it is positive, the result is sufficient to refute the theory. Even though no causality tests were taken, these results suggest that increasing expenditures on environmental protection do not harm social and economic development, confirming the main hypothesis of the “green economy” strategy. One possible counter-argument is that higher economic activity levels, associated with higher HDI levels, would represent higher pressure on natural resources, thus increasing the need for environmental protection efforts. To test this hypothesis, it is necessary to identify data for environmental stress that are comparable on state or municipal levels, a very difficult task considering the lack of information on environmental conditions at the sub-national level. As discussed in section 2, the chosen variable was deforestation, and the results showed that states with higher forest losses presented lower HDI levels: the coefficient correlation was – 0.418, statistically significant at 5%. To sum up, this paper demonstrates that, despite the fact that the theories opposing environmental protection and development do not survive a statistical analysis, it seems that they are not totally ignored by public authorities in budget decisions, especially at the federal level where the conventional view increasing environmental, economic and developmental harm (instead of protection) seem to persist and be deeply rooted. As a result, unfortunately, the amount of public resources allocated to the environmental area is derisive if compared to the economic potential of activities that conjugate environmental conservation and economic growth. 208

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What policy makers should take into consideration is that these two objectives are not antagonists – in fact, environmental conservation can be a stimulus to economic growth, especially in poor areas. Public policies have a major role in the implementation of these activities and in assuring that the environmental aspect is effectively incorporated in the Brazilian development trajectory for the next years, as the conciliation of environmental conservation and economic development guarantees not only larger growth, but essentially, better growth.

Bibliography Barbosa, N., Souza, J. A. P. (2010). “A inflexão do governo Lula: política econômica, crescimento e distribuição de renda”, in: Sader, E.; Garcia, M. A. (orgs.), Brasil: entre o passado e o futuro, 1a. ed., São Paulo: Editora Boitempo. Medeiros, R., Young, C. E. F. (eds.) (2011). Contribuição das unidades de conservação brasileiras para a economia nacional: Relatório Final, Brasília: UNEP-WCMC. Ministério do Meio Ambiente. Projeto de Monitoramento do Desmatamento dos Biomas Brasileiros por Satélite (PMDBBS). Accessed from http://siscom.ibama.gov.br/monitorabiomas/. Secretaria do Tesouro Nacional (STN). Finanças do Brasil: Dados contábeis dos municípios. Accessed from: http://www.tesouro.fazenda.gov.br/estados_municipios/index.asp. Federação das Indústrias do Estado do Rio de Janeiro (Firjan) (2010). Índice Firjan de Desenvolvimento Municipal. Accessed from http://www.firjan.org.br/IFDM/. Fundação SOS Mata Atlântica. Atlas da evolução dos remanescentes florestais e ecossistemas associados no domínio da mata atlântica no período 2000-2005 e 2005-2008, São Paulo: SOS Mata Atlântica. Secretaria do Tesouro Nacional (STN). Finanças do Brasil: Dados contábeis dos municípios. Accessed from http://www.tesouro.fazenda.gov.br/estados_municipios/index.asp. Young, C. E. F. (2005). “Financial Mechanisms for Conservation in Brazil”, Conservation Biology, Vol. 19, No. 3 (June): 756-761. Young, C. E. F., Roncisvalle, C. A. (2002). Expenditures, Investment and Financing for Sustainable Development in Brazil. Santiago de Chile: U.N. Comisión Económica para América Latina y el Caribe (CEPAL).

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Carlos E. Young, Erico R. P. Rocha, Leonardo B. de Bakker, André F. Santoro Young, C. E. F., Roncisvalle, C. A., Neves, A. C. M. (2009). Destroying the Myth: Deforestation, Rural Employment and Human Development in the Brazilian Atlantic Forest, IV Congreso de la Asociación Latinoamericana y del Caribe de Economistas Ambientales y de Recursos Naturales, Costa Rica: Heredia: UNA – Universidad Nacional. Young, C. E. F., Roncisvalle, C. A. (2004). “Desenvolvimento e meio ambiente: uma falsa incompatibilidade”, Revista Ciência Hoje, Vol. 36, No. 211: 30-34.

Table 1: Average share of the total budget for function Environmental Management (2003-2010) Amapá

1.17%

São Paulo

0.80%

Piauí

0.47%

Paraná

1.17%

Sergipe

0.77%

Pernambuco

0.37%

Ceará

1.15%

Acre

0.74%

Roraima

0.33%

Espírito Santo

1.11%

Santa Catarina

0.72%

Alagoas

0.24%

Paraíba

1.11%

Goiás

0.67%

Mato Grosso

0.24%

Tocantins

1.02%

Mato Grosso do Sul

0.54%

Maranhão

0.23%

Rio Grande do Sul

0.97%

Pará

0.53%

Bahia

0.22%

Minas Gerais

0.94%

Rio Grande do Norte

0.52%

Roraima

0.20%

Rio de Janeiro

0.90%

Amazonas

0.47%

-

Source: Own elaboration based on STN data.

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