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Growth in Mature EconomiesThe First CEPR-Modena Conference

Centre for Economic Policy Research

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© November 2013 Centre for Economic Policy Research

Edited by Lucrezia Reichlin and Ferdinando Giugliano

Growth in Mature EconomiesThe First CEPR-Modena Conference

Centre for Economic Policy Research (CEPR)

The Centre for Economic Policy Research is a network of over 800 Research Fellows and Affiliates, based primarily in European universities. The Centre coordinates the research of its Fellow and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a European economics research organization with uniquely wide-raning scope and activities.

The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-term policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions expressed in this report are those of the authors not those of the Centre for Economic Policy Research.

CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026).

Chair of the Board Guillermo de la DehesaPresident Richard PortesChief Executive Officer Stephen YeoResearch Director Lucrezia ReichlinPolicy Director Richard Baldwin

The CEPR-Modena Conference

The conference is the first of a series of conferences on growth in mature economies to be held in Modena, Italy and co-organized by CEPR with the Center for Economic Research (RECent) of the University of Modena and Reggio Emilia, with the financial support of Fondazione Cassa di Risparmio di Modena.

The Organising Committee for the first edition included:

Viral Acharya (New York University and CEPR)Graziella Bertocchi (RECent - University of Modena and Reggio Emilia and CEPR)Antonio Ciccone (UPF, Barcelona GSE and CEPR)Nicholas Crafts (Warwick University and CEPR)Marc Ivaldi (Toulouse School of Economics and CEPR)Lucrezia Reichlin (London Business School and CEPR)

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About the Editors

Lucrezia Reichlin is Professor of Economics at the London Business School, non-executive director of UniCredit Banking Group and AGEAS Insurance Group. She is Chair of the Scientific Council at the Brussels based think-thank Bruegel. Between March 2005 and September 2008 she served as Director General of Research at the European Central Bank. She is a co-founder and director of Now-Casting Economics ltd. She is a columnist for the Italian daily paper Il Corriere della Sera.

Lucrezia has been an active contributor of the life of the Centre for Economic Policy Research (CEPR) over the years. She has been research director in 2011-2013, first Chairman of the CEPR Euro Area Business Cycle Dating Committee, co-founder and scientist in charge of the Euro Area Business Cycle Network.

Lucrezia received a Ph.D. in economics from New York University. She has held a number of academic positions, including Professor of Economics at the Université Libre de Bruxelles. She has also been a consultant for several Central Banks around the world, including the Board of Governors of the Federal Reserve.. She is a Fellow of the British Academy, a Fellow of the European Economic Association and member of the council of the Royal Economic Society. She is in the advisory board of several research and policy institutions around the world.

Ferdinando Giugliano is a leader writer for the Financial Times, where he covers economic and financial issues. He holds a M.Phil and a D.Phil in economics, both from the University of Oxford and has worked as a consultant for the Banca d’Italia.

Contents

Foreword ix

Introduction 1

1 Lessons from History 9Nicholas Crafts

Discussant 1: Daniel Cohen 16Discussant 2: Gianni Toniolo 17General discussion 19

2 Industrial policy 23John Van Reenen

Discussant 1: Marc Ivaldi 27Discussant 2: Otto Toivanen 28General discussion 28

3 The Political Economy of Structural Reforms 313.1 The political economy of credit cycles 31 Luis Garicano

3. 2 Reforming the Spanish labour market 36 Samuel Bentolila

Discussant: Graziella Bertocchi 41General discussion 42

4 Trade and Growth 45Richard Baldwin 45

Discussant: Philippe Martin 48General discussion 49

5 Capital Flows and Growth 51Jaume Ventura

Discussant: Kevin O’Rourke 52Discussant: Richard Portes 54General discussion 55

6 Social Costs and Benefits of the Financial Sector 57Marco Pagano

Discussant: David Thesmar 63General discussion 65

7 Private Equity 677.1 Venture and growth capital investors 67

Francesca Cornelli

Discussant: Ulf Axelson 71Discussant: Laura Bottazzi 74General discussion 75

7.2 Technology 76 Joshua Lerner

Discussant: Francesco Caselli 82General Discussion 84

8 Demography, Finance and Growth 87Carlo Favero

Discussant 1: Tullio Jappelli 92Discussant 2: Michael Reiter 93General Discussion 95

References 97

ix

The 9-10 November 2012 conference in Modena was the first in a series of events focusing on growth in mature economies. The inspiration for the conference came from Lucrezia Reichlin, who thought it important to bring together researchers from across the CEPR network to share different ideas and perspectives on a key policy issue – what can stimulate sustained growth in economies that cannot simply add more capital or import technologies developed abroad? This is an important question not only in the short run, as Europe struggles to emerge from recession, but also over the longer term as population ageing begins to affect these mature economies.

The Fondazione Cassa di Risparmio di Modena provided very generous support, without which neither the conference nor this volume would have been possible. We are grateful to them. In addition, the support of the Center for Economic Research (RECent) at the University of Modena Reggio Emilia was essential to the success of the conference. We are also immensely grateful to Graziella Bertocchi, one of our Research Fellows based at RECent, for her tireless efforts to ensure that all arrangements for the conference were put in place in a timely fashion.

We are also grateful to Lucrezia, of course, for inspiring the conference and then working with energy and determination to ensure that her vision was realised. We are also grateful both to her and to Ferdinando Giugliano for their hard work in summarising and synthesising the conference presentations. As ever, we also gratefully acknowledge the vital contributions of Anil Shamdasani and Charlie Anderson, CEPR’s Publications Officer, for their characteristic speed and professionalism in producing the book.

Stephen YeoChief Executive Officer, CEPR23 October 2013

Foreword

1

Introduction

This book summarises presentations and discussions from the first CEPR-Modena Conference on Growth in Mature Economies held in Modena in November 2012. The conference is the first of an annual series and aims at discussing research, from a variety of fields within economics, of potential relevance for growth in countries which have reached maturity and cannot therefore only grow by accumulation of capital or technology transfer alone. The idea is to establish a forum for the CEPR community involving scholars from different research programmes and therefore establish connections across different specialisations, possibly helping to develop innovative ideas. Presentations are policy oriented, but are all based on original research.

At the 2012 conference, we had presentations based on work in economic history, political economy, labour, trade, open macro and finance. Each chapter of this report summarises the content of a presentation and the discussion which followed. At the 2012 conference, several talks focused on Europe and its dismal growth performance.

In Chapter 1, Nicholas Crafts offers a long-term perspective on Europe’s growth experience since World War Two. Between 1950 and 1973, Europe experienced remarkable convergence in terms of labour productivity vis-à-vis the US. Between 1973 and 1995, Europe continued to catch up with the technological leader, but this time only in terms of output per hour worked. However, the process of convergence in terms of output per person halted. In the decade between 1995 and 2007, Europe began to fall behind under any productivity indicator. This widening productivity gap is the root of today’s crisis.

Crafts’ conjecture is that this divergence is the result of the ICT revolution. With the exception of Britain, ICT-using services have been Europe’s Achilles’ heel, scoring poorly in terms of productivity growth vis-à-vis the US. To Crafts, the ICT revolution would have required an overhaul of Europe’s institutions. Labour and product markets had to be reformed to allow European countries to reap its benefits.

Crafts believes Europe suffers from a form of institutional sclerosis. Successive European governments have failed to reform their institutions in a way which was compatible with the ICT revolution and today, according to Crafts, deregulation is needed just as badly. However, he is sceptical that the eurozone crisis will push European governments to remove barriers from competition. To prove his point, he quotes the experience of the 1930s. After the Great Depression, European governments reacted to the demands of the public by introducing capital controls, raising tariffs and restricting competition. In the British case, this led to a productivity slowdown. Crafts fears the same may happen in the eurozone today.

2 Growth in Mature Economies

There are, however, limits to Crafts’ analysis. First, measurements of productivity are always shaky. If one only looks at more reliable variables, such as GDP, it is not at all clear that Europe had slower growth than the US. Second, deregulation is no panacea. In his discussion of Crafts’ paper, Daniel Cohen argues that over the last 60 years, the US has experienced a dramatic widening of income inequality, from which Europe has been largely spared. Other discussants also argued that the institutions of the 1930s may have had a delayed effect on growth, paving the way for the economic boom of the post-World War Two Golden Age.

In Chapter 2, John Van Reenen also questions the view that European governments should adopt a more laissez-faire approach in order to promote economic growth. He argues that industrial policy has a role to play in creating employment in the least developed areas of rich countries.

The conventional view among economists is that industrial policy rarely works. It is often argued that the state has a poor record at picking winners. Bureaucrats tend to award funds with little knowledge of what really happens in the private sector. In many cases, it is the companies with the best political connections – rather than the most productive – that are able to secure government funds.

Van Reenen analyses the impact of the Regional Selective Assistance (RSA) programme in Britain. RSA is the UK’s main subsidy scheme for companies operating in the manufacturing sector. His main finding is that a 10 percentage point investment subsidy in a given area generated a 6.6 per cent fall in unemployment – an effect which can be explained both in terms of existing firms investing more and of new entry.

Van Reenen’s study, however, also shows that there are no positive effects from industrial policy on productivity. This is an important limitation. For industrial policy to be more than just a type of welfare policy, it must be shown it has a permanent effect on productivity.

In two different papers included in Chapter 3, Luis Garicano and Samuel Bentolila agree with the intellectual premise of Nicholas Crafts’ work that the disappointing performance in parts of the eurozone is linked to the failure of governments to pass market-friendly structural reforms.

Luis Garicano argues that the euro crisis was largely the result of institutional failure. Some of the crisis-hit countries in the eurozone – Spain and Ireland in particular – were not ready for the large capital inflows which they received after the convergence in interest rates which followed the introduction of the single currency.

Garicano’s paper is focused on Spain. During the boom, it was hard to evaluate how well managers were performing and whether or not they were taking on too many risks. In fact, the least prudent managers were typically the star performers. Bank shareholders had an incentive to pick them. Since their results were artificially strong, the regulators found it hard to punish their excessive risk-taking.

Garicano argues that the same problem applied to elected officials too. Those politicians who took the riskiest decisions from the point of view of the public finances found it easiest to gain the support of the public and win elections. He

Introduction 3

concludes that there is a strong case for bolstering the economic expertise of governments, perhaps via a greater role for technocrats.

It is beyond doubt that democracy has its limits. Yet, Garicano’s lesson is controversial. First, technocrats are not flawless. The ‘textbook’ solutions which they tend to apply may not suit the complexities and nuances of an economy. Second, it is essential that the public owns the reforms which a government takes. Without democratic ownership, it is much harder to ensure that a reform is successfully implemented. Here, elected governments have an advantage over technocracies, in that the economic reforms they want to implement have typically been subject to public scrutiny during the electoral campaign.

In the same chapter, Samuel Bentolila looks at the political economy of reform in the eurozone. His focus is on the Spanish labour market which, along with others in the currency union, is blighted by a persistent dualism. Some workers, typically the elderly, enjoy generous contracts with strong protection against dismissal. Other, usually younger workers have to settle for temporary contracts. Not only are these employees less well paid, but they are also the first to be fired during a downturn. The diffusion of temporary contracts in Spain explains the large swings which characterised its labour market before and after the crisis.

Bentolila notes that throughout the 2000s the Spanish government was well aware of the need to reform the labour market. Not only are dual labour markets manifestly unfair, they are also inefficient, since whether a worker is dismissed or not during a crisis does not depend on his productivity but on the type of contract he is on. Finally, companies also have little incentive to invest in training for temporary workers, which lowers productivity.

Spain needed to reform its labour market, reducing the generous protection associated with permanent contracts. Companies would have then had an incentive to hire more workers under these terms. Yet Bentolila shows that politicians had little incentive to change the rules significantly, since workers on temporary contracts were always a minority. A significant reform effort only came in 2012, when markets turned against Spain and the government had to introduce more meaningful changes to its labour market legislation in order to appease international creditors.

A central lesson from Bentolila’s paper is that crises make it easier to overcome the political constraints which block structural reforms. Bentolila also argues that, in the case of labour market reform, right-wing governments tend to be more radical than left-wing governments.

However, both conclusions are questionable. In the 2000s, Germany overhauled its labour market, paving the way for the country’s later competitiveness miracle. This radical reform agenda was spearheaded by the then chancellor Gerard Schroder, a social democrat.

Furthermore, while crises tend to strengthen the incentive to pass structural reforms, there is no guarantee that these changes will be properly implemented. The economic literature has shown that stable governments have a better record at implementation. This creates a dilemma, in that those politicians who are better-suited to implement structural reforms are also those who are less likely to pass them.


Finally, it is not just the countries experiencing a bubble that tend to duck reforms. In the eurozone, Italy did not suffer from overvalued assets in the same way as Spain or Ireland but it still failed to overhaul its labour and product market. Its growth record during the boom of the 2000s was among the worst in the developed world. The depth and persistence of its recession today is also worse than any country in the G7. Avoiding a bubble is no guarantee of sustainable economic growth.

It is possible, however, that governments cannot do all that much to influence a country’s growth trajectory. The decisions taken in the headquarters of large multinational corporations may be ultimately more important. This is the focus of Chapter 4, in which Richard Baldwin explores the links between technological change and the existing patterns of trade and globalisation.

In the last 20 years, the nature of trade has changed profoundly. Before the 1990s, vertical integration between companies of different countries typically occured within the rich world. Now, ever more stages of the production process take place in emerging markets. This is particularly evident in the manufacturing sector, where G7 countries have seen their share of global production shrink substantially. Emerging economies such as Poland, Thailand and South Korea have made large gains.

Prima facie, this process of outsourcing looks particularly gloomy for mature economies. It would seem that the only way the rich world can recoup some of the market share it has lost is by forcing steep wage cuts on its workers. However, Baldwin believes the answer lies in moving away from fabrication, which is not where most of value added lies. Mature economies have a comparative advantage in the more valuable pre-fabrication (for example, design) and post-fabrication (for example, marketing and distribution) stages of production. This is what they should concentrate on.

This means that governments still have a role to play in fostering development. Baldwin argues that they should shift their focus away from protecting whole sectors towards financing active labour market policies. These should aim at moving workers away from the low-value fabrication stage of production and towards stages which can allow workers to command higher wages.

In Chapter 5, Jaume Ventura looks at the effects of the internationalisation of global finance. One of the darker sides of financial globalisation is the creation of large and persistent current account imbalances between countries. China and the oil-producing nations have accumulated large current account surpluses, while the US and other western economies have seen their deficits explode.

Some in the economic literature have argued that these large imbalances are the consequence of asymmetric financial development in the world economy. Given the lack of a sufficiently deep domestic financial market, countries such as China have had to invest in the US, helping to fund its large current account deficit. According to this view, financial liberalisation in emerging markets would lead to a repatriation of capital, narrowing existing imbalances.

Ventura presents a fairly specific paper in which he takes a different view. By introducing a degree of heterogeneity among companies in the developing world, he shows that financial liberalisation can worsen existing imbalances. Were

Introduction 5

companies in China to enjoy greater access to credit, this money would largely flow to the most productive businesses. Wages would rise across the economy, which would increase costs for all firms, leading to a wave of bankruptcy. The end-result would be a reduction in the domestic demand for credit and an increase in net capital outflows.

In the discussion, Richard Portes asks whether Ventura’s model applies to mature economies. Financial innovation is not always the main driver of capital inflows. This was the case in the US, but not in the eurozone, where financial integration played a more significant role.

Portes is also sceptical that the mechanism described in the model can explain what happened in the eurozone. In particular, he looks at the case of Spain. After the country entered the single currency, it experienced a relaxation of financial constraints. Yet, capital inflows went in the opposite direction to what Ventura predicts. New capital mainly went into construction, a non-traded sector characterised by low productivity. Higher-productivity sectors were crowded out, which led to a fall in overall total factor productivity.

Chapter 6 addresses the more general question of the social costs and benefits of the financial sector. Traditionally, economists have considered finance as an efficient allocation machine, which ensures that capital is put to the best use and that risks are shared efficiently. Yet, the financial crisis has shown how there is a darker side to financial development. The banking sector was responsible for large-scale misallocation of capital. Enormous sums of money were wasted on real estate developments which remained empty. Several other more productive enterprises were starved of credit.

Marco Pagano provides a comprehensive review of the literature on the costs and benefits of a deep and developed financial sector and argues that whether finance is a force of good or evil may depend on a country’s stage of economic development. In the early stage of economic growth, a country typically lacks a strong banking sector and sufficiently deep financial markets. The removal of financial constraints will help credit-constrained firms that want to expand, fostering economic growth.

After a certain level of financial development, however, firms no longer face significant credit constraints. Money becomes easily available, leading to a deterioration in lending standards and a misallocation of capital. Furthermore, banks become too big to fail. When a crisis hits the banking system, the only option may be to save them using taxpayers’ money – another enormous misallocation of capital.

The view presented by Pagano clashes, however, with much of the existing literature on financial development. When banks are not sufficiently strong and financial markets not adequately deep, sudden reverses of ‘hot money’ can quickly escalate into full-blown financial crises. Hence, it may be preferrable to have stricter regulation and greater financial repression at early stages of development.

One way to reconcile Pagano’s view with that which is prevalent in the literature is by noting that Pagano’s work focuses on the size of the banking sector, while other authors have mainly looked at the volatility of finance. Countries at early stages of development may have an interest in promoting financial development


in order to relax the credit constraints facing their firms. However, they should also monitor carefully the volatility of these flows, since there are severe risks coming from having capital which is overly mobile.

Furthermore, Kevin O’Rourke underlined how financial development is no precondition for economic growth, even when income levels are low. The industrial revolution – which spurred one of the most sustained economic accelerations in world history – was not preceded by financial liberalisation. In fact, in the decades before the industrial revolution Britain had tightened financial regulation. Furthermore, many of the technological innovations traditionally associated with the industrial revolution came from private partnerships and hence had nothing to do with the availability of public capital. It was economic growth that led to financial development, not the other way round.

In Chapter 7, Josh Lerner and Francesca Cornelli look at two specific ways in which finance can help economic growth: private equity and venture capital. These are alternatives to the traditional form of innovation financing, namely corporate R&D.

Josh Lerner presents a summary of his recent book The Architecture of Innovation. He shows how venture-backed entrepreneurial activity in the rich world is still a less widespread form of innovation financing than corporate R&D. Between 60 per cent and 70 per cent of the funds going to innovation go through the corporate lab. China is also largely following this model.

Companies, however, are becoming increasingly dissatisfied with the traditional corporate R&D model, which is deemed to produce only second-tier innovation rather than radical change. This has to do, in part, with the soft incentive schemes which are normally used in corporate labs.

For this reason, companies are changing the incentive schemes they use in their corporate labs. Bonuses and long-term incentives now make up a larger share of the salaries of the heads of corporate R&D departments than they did in the past. Yet, there are still questions over whether high-powered incentive schemes are well suited to the corporate R&D model. The risk is that these compensation structures encourage short-termism and dissuade employees from cooperation.

Venture capitalism is the natural alternative to the corporate R&D lab. Lerner presents evidence showing that between the late 1970s and the mid-1990s, funding for venture capital was only 3 per cent of the amount of money going into corporate R&D. Still, venture capital was responsible for around a tenth of privately funded innovation.

There are, however, some important caveats. Firstly, venture capitalism is largely a US phenomenon. In the same chapter, Cornelli shows how the returns generated by investment in venture capital in Europe have been abysmally low. This explains why investment in venture capital in Europe is falling. There are several hypotheses of why venture capital does not seem to suit European markets, ranging from the inappropriate background of investors to their size. Pension funds, for example, are excluded because of exceedingly conservative regulation.

Do alternative models exist? Cornelli looks at forms of government-backed venture capital. However, most schemes launched in Europe have been

Introduction 7

unsuccessful. One of the main problems was that the state was shielding private investors from possible losses. This reduced their incentive to screen properly the possible targets and possibly led to excessive risk-taking.

Lerner concentrates on corporate venture capital. This form of innovation financing was popular before the ‘dot-com’ bubble and is now making a comeback. Lerner shows how established companies have made some horrible mistakes via their corporate venturing vehicles. However, these poor choices often occurred when a corporation invested in a sector unrelated to its core products. When large corporations invest in a sector they have direct knowledge of, they seem to do a much better job.

Should we worry about the lack of venture capital in Europe? In the discussion, Francesco Caselli argued that it may simply be the consequence of the fact that Europe tends to innovate less than the US. Since technological growth in Europe typically happens through imitation rather than innovation, the absence of venture capital may be perfectly normal. Furthermore, the rate of entry of new companies in the European market is very similar to the US. The real problem in Europe is that companies are typically too small. This suggests that what Europe really lacks is growth capital and not venture capital.

In Chapter 8, Carlo Favero looks at the sustainability of the European welfare model and, in particular, of its pension system. Favero takes a look at the case of Italy, which he believes to be representative of what is occurring in several other OECD countries. In Italy, between 1965 and 2008, the mortality rate at 65 fell from 2.4 per cent to less than 1 per cent. The number of years an Italian man could expect to live once he reached the age of 65 rose from 13 in 1965 to 20 in 2008.

The effect of the continuous increase in life expectancy on the pension system is what economists refer to as ‘longevity risk’. Governments are trying to eliminate indexing the retirement age to the expected residual life at retirement. This is exactly what successive Italian governments have done in a pension reform which began to be implemented in 2010 and was completed in 2012. While this reform reduces the longevity risk, it does not cancel it altogether. Favero argues that governments should look carefully into longevity bonds – instruments that are designed to hedge the longevity risk.

However, the model presented by Favero may be exceedingly pessimistic. In particular, Tullio Jappelli underlined how Favero did not take into account the effects of immigration. Immigrants are younger than the average population and have lower life expectancy. As a result, their total contribution to the pension system is greater than the benefits they receive. Provided that net immigration continues to increase, the welfare system is under less pressure than Favero assumes. Furthermore, individuals may respond to the longevity risk, either by increasing their savings or by working longer.

It is also unclear whether there is a market for longevity bonds. In the discussion, Michael Reiter doubts that these instruments can be easily priced. This uncertainty on the pricing would increase their risk premia and reduce how widely they are traded. Reiter argues there are better ways to deal with the longevity risk than raising the statutory retirement age. A better alternative for


the government would be to let individuals choose when they want to retire, but to provide incentives to encourage people to work longer.

In conclusion, not much certainty but lots of food for research.

9

1 Lessons from History1

Nicholas CraftsUniversity of Warwick and CEPR

Nicholas Crafts argued that Europe’s growth experience since World War Two can be divided in three phases. The years between 1950 and 1973 were marked by rapid catch-up growth vis-à-vis the US. The productivity gap with the world’s technological leader fell quickly, both in terms of output per person and in terms of output per hour worked. In the years between 1973 and 1995, output per person stopped converging, while the catching-up process in terms of output per hour worked continued. Europeans worked less compared with the Americans and there were more unemployed. Finally, between 1995 and 2007 the catching-up process halted altogether. Europe is falling behind, both in terms of output per head and of output per hour worked.

The standard explanation for this divergence is that Europe has paid the price for too much regulation and taxation and too little competition. Yet, Europe’s ‘corporatist legacy’ model was also present in the post-war era, when Europe grew faster than the US. Blaming the European model per se would not explain why the 1950s and 1960s were a period of such high growth.

Crafts believes that any analysis of this divergence should look at how the European social model interacted with the requirements of different technological epochs. Institutions and policies must always be judged against the technology they interact with. It is possible that Europe’s model was suitable for an era in which the production process was dominated by Fordist manufacturing, but proved inadequate for the ICT revolution.

Generally, European countries have not matched the US in terms of ICT contribution to economic growth. In particular, ICT-using services, such as distribution, have been Europe’s Achilles’ heel. A working hypothesis is that Europe’s institutions and policies proved particularly damaging for this sector of the economy. If this were correct, Europe did not fall behind the US because it had too much regulation or inadequate human capital. Rather, existing regulations and the skills of European workers proved inadequate for an ICT dominated world.

1 Talk based on Crafts (2013).


Table 1 Sources of labour productivity growth in market sector, 1995-2005 (% per year)

Labour Quality ICT K/ HW Non-ICT K/ HW TFP Y/HW

France 0.4 0.4 0.4 0.9 2.1

Germany 0.1 0.5 0.6 0.4 1.6

Italy 0.2 0.3 0.5 -0.7 0.3

Spain 0.4 0.3 0.5 -0.8 0.4

Sweden 0.3 0.6 1.1 1.6 3.6

UK 0.5 0.9 0.4 0.8 2.6

USA 0.3 1.0 0.3 1.3 2.9

Table 1 looks at the proximate sources of productivity growth in the market sector for a range of European countries and the US between 1995 and 2005. It shows how the weak productivity performance across Europe can be accounted for by the less widespread diffusion and use of new technology. The process of capital deepening in the non-ICT sector in continental Europe was similar to that of the UK and the US. But the process of capital deepening in the ICT sector was substantially slower in continental Europe. In particular, ICT-capital deepening in countries like Italy or Spain was only a third of that of the UK. The weaknesses of the ICT sector were reflected in low rates of total factor productivity growth. This was relatively slow across the eurozone and negative in Italy and Spain.

However, it would be wrong to conclude that Europe should seek to become a net producer of ICT. The experience of the last two decades shows that the gains of ICT accrue mainly to its users, not to its producers. Therefore, the eurozone needs to ensure it uses the output of ICT quickly and effectively, even without producing it.

For this to happen, the eurozone needs to equip itself with institutions which are suitable for stimulating growth in the ICT era. This means passing supply-side reforms which, inter alia, would raise ICT use. The list includes many policy changes that have been long advocated by the OECD: strengthening competition, improving the educational system, cutting distortionary taxes and reducing unemployment benefits. These reforms would have, at the very least, a level effect, i.e. raising the level of productivity. It is also possible that these reforms would have more than a one-off level effect, raising the growth rate of productivity.

In “Project for Europe”, the OECD argues that the financial crisis had a permanent effect on potential output in the eurozone. Potential output will be around 4 per cent lower than before the Great Recession. However, the trend rate of growth will not be affected. By 2018, the OECD expects catch-up growth to resume as usual. The southern periphery will converge towards the rest of the eurozone. Countries such as Italy, Spain, Greece and Portugal will slowly adopt the best-practice supply-side policies present in the rest of the currency bloc.

Lessons from History 11

Table 2 OECD long-term real GDP growth projections (% per year)

1995-2007 2008-122012-17

(potential)2018-30

(potential)

Eurozone 2.3 -0.1 1.8 1.8

France 2.2 0.1 2.2 2.1

Germany 1.6 0.6 1.7 1.1

UK 2.9 -0.5 1.9 2.1

Sweden 3.2 0.9 2.6 2.3

Greece 3.8 -2.8 1.7 2.4

Ireland 2.4 -1.7 2.6 2.6

Italy 1.5 -1.0 0.9 1.6

Portugal 3.2 -1.2 1.0 1.8

Spain 3.7 -0.4 2.3 2.3

Table 3 OECD long-term growth of real GDP/worker projectons (% per year)

1995-2007 2008-122012-17

(potential)2018-2030(potential)

Eurozone 1.0 0.3 1.5 1.8

France 1.1 0.1 1.4 1.9

Germany 1.2 0.0 1.4 1.7

UK 1.9 -0.4 0.8 1.5

Sweden 2.4 0.4 1.8 1.9

Greece 2.5 -0.8 0.3 2.2

Ireland 2.3 1.2 0.9 1.3

Italy 0.3 -0.5 0.1 1.5

Portugal 1.4 0.2 0.5 1.7

Spain 0.1 1.7 0.8 1.6

Sources: 1995-2012: The Conference Board Total Economy database; 2012-30: OECD (2012, ch. 4)

As Table 2 shows, real growth of GDP will be lower than before the crisis. Between 2018 and 2030, the eurozone will grow at 1.8 per cent per year, which is 0.5 percentage points slower than between 1995 and 2007. Yet, this is largely explained by a reduction in the working population. Table 3 shows the OECD long-term growth projections for real GDP per worker. Labour productivity in the eurozone had grown at 1 per cent between 1995 and 2007, but is expected to grow at 1.8 per cent between 2018 and 2030. Countries such as the UK or Sweden will see the growth of labour productivity slow down compared to the 1990s and 2000s. The OECD believes they have already accrued the gains from the ICT revolution. Conversely, countries like Italy and Spain will be able to enjoy rates of growth of labour productivity which are over 1 per cent higher than before the Great Recession, since they can still reap these benefits.


Are the OECD predictions realistic? History offers several useful comparative benchmarks. One is what happened to the US in the 1930s. The Great Depression caused large falls in output, massive bank failures and a severe credit crunch. In 1933, investments fell to virtually zero. What were the consequences of this dramatic downturn? The problems of the banking system were not really resolved. The re-regulation of the financial sector constrained the recovery. While bank lending eventually picked up, it took a very long time before it recovered to its pre-crisis level.

Yet, the banking crisis did not undermine productivity growth. As Field (2003) has argued, the 1930s were the most technologically progressive decade of the 20th century. Between 1929 and 1941, total factor productivity grew extremely quickly – by around 3 per cent per year. What is more, the technological advances were well distributed among the different sectors of the economy. Distribution, transport and public utilities contributed to this spurt as much as manufacturing.

Table 4 Contributions to labour productivity growth, US private non-farm economy (% per year)

Capital DeepeningHuman-Capital

DeepeningTFP Y/HW Growth

1906-19 0.51 0.26 1.12 1.89

1919-29 0.31 -0.06 2.02 2.27

1929-41 -0.19 0.14 2.97 2.92

1941-48 0.24 0.22 2.08 2.54

1948-73 0.76 0.11 1.88 2.75

Source: adapted from Field (2011)

The US experience of the 1930s would therefore suggest that the right way to look at the Great Depression is that it had a sizeable effect on the levels of output, due to the lack of investment at the bottom of the crisis. As Table 4 shows, capital deepening between 1929 and 1941 was negative. However, the strong rate of TFP growth in the 1930s shows that there were no effects on the trend rate of growth of productivity.

This result is confirmed by the work of Ben-David et al (2003). They found that a naïve extrapolation of the assumed trend-growth of labour productivity before 1929 forecasts extremely well what actually happened after World War Two. The Great Depression produced an immediate reduction in the levels of labour productivity, which fell by around 20 per cent. However, after the crisis labour productivity growth was slightly faster than it would have been otherwise. Ben David et al (2003) find that even without even the Great Depression, the US economy would be roughly where it is now in terms of labour productivity.

This is a cheerful comparison for the eurozone, which, as the US during the Great Depression, is in the middle of a financial crisis. The massive disruption of credit which occurred in the US did not lead to an impairment of TFP growth. In theory, investment in ICT in the eurozone today could produce the same results


as investment in physical infrastructure did in the US in the 1930s. This would suggest that the steady-state growth rate of the eurozone can slowly return to the pre-crisis rate.

However, there are limits to how far one can stretch this comparison. First, throughout the Great Depression, US public debt remained relatively low, never exceeding 55 per cent of national income. Today, in much of the OECD, the debt-to-GDP ratio is approaching 100 per cent. Recent work by Checherita and Rother (2010) and by Kumar and Woo (2010) has argued that high debt can reduce trend growth appreciably, probably by more than 0.5 percentage points per year. Dealing with high debt requires a long period of substantial fiscal consolidation, which will negatively affect public investment and education spending (Bacchiocchi et al., 2011).

Table 5 Dates of changes in gold standard policies and economic recovery

Return to 1929 income level Devaluation

Austria 1939 09/1931

Belgium 1939 03/1935

France 1939 10/1936

Germany 1935 *

Italy 1935 10/1936

Netherlands 1949 09/1936

Norway 1932 09/1931

Sweden 1933 09/1931

Switzerland 1938 09/1936

United Kingdom 1934 09/1931

United States 1940 04/1933

Source: (Bernanke and James, 1991; Maddison, 2003)

Second, how well an economy performs after a crisis is a function of the government’s policy response. In the 1930s, governments progressively chose to leave the gold standard. Of course, this led to a wave of defaults. However, in the absence of a coordinated monetary expansion, those countries which left gold first could benefit from an earlier and faster recovery (see Table 5). Early leavers did not have to wait for money wages to fall to increase their international competitiveness. They also regained control of their interest rates. This ‘devalue and default’ strategy was good for individual countries’ growth, but undermined the integration of the financial and goods markets.

As discussed by Eichengreen and Irwin (2010), the 1930s were also marked by a slide towards protectionism. Protectionism, industrial policy and a retreat from competition became popular responses, particularly among those countries which did not leave gold and devalue. With hindsight, the protectionist turn of the 1930s should be seen as second-best macroeconomic policy management, which


governments used when their fiscal and monetary policies were constrained. The decision to restrict competition also produced lower trend rates of growth.

Finally, governments introduced capital controls and pursued financial repression. Governments forced domestic investors to purchase public debt at below-equilibrium market prices, in order to improve fiscal sustainability. These resources capital could have been employed to finance capital deepening and investment in infrastructure and technology instead. Financial repression therefore contributed to reduce the trend rate of growth.

So did capital controls. Voth (2003) has found that capital controls enforced in the interwar years and maintained during the ‘golden age’ reduced economic growth in Europe in the 1950s and 1960s by at least 0.7 percentage points per year.

Were the eurozone to repeat the policy mistakes made in the 1930s, the optimistic picture painted by the OECD would be unrealistic. Trend rates of growth would be permanently affected by the crisis. It is therefore important to understand whether these errors can be avoided.

Optimists would argue that the institutions of the eurozone are better equipped to resist the types of pressures to which the US and Europe succumbed in the 1930s. But one wonders for how long. Countries may choose to leave the euro and devalue. After all, the experience of the 1930s shows that countries which left the gold standard first enjoyed a more rapid recovery than those which came off it later. The backlash against bankers and finance could lead politicians to introduce capital controls and opt for financial repression. Finally, protectionism has been avoided so far, but eurozone members may well see it as the only policy they can pursue. After all, they have lost control of both their exchange and interest rates. Because of the high debt-to-GDP ratios, fiscal policy is often not an option. As a result, it is not impossible to imagine that the eurozone periphery may one day stop implementing the single market, which would be a modern form of protectionism.

It could be argued that even if the eurozone decided to adopt protectionist policies, their long-run impact would not necessarily be disastrous. The policies adopted in the 1930s might have knocked a few percentage points off trend growth, but they ultimately led to the post-World War Two ‘golden age’. The experience of the 1950s also shows that European integration can (in the long-run) be an engine of income growth. Badinger (2013) has shown that income levels in 2000 were 26 per cent higher than if European integration had stayed at the same level as 1950.

However, the policy cocktail at the base of the 1950s miracle is not easy to replicate. First, the policy environment of the ‘golden age’ was particularly favourable. As Crafts and Toniolo (2008) have shown, in the 1950s Europe’s “social capability” and its “technological congruence” both improved. Trade unions also acted cooperatively. Workers were willing to accept wage restraint in exchange for high investment. Cameron and Wallace (2002) have shown that this cooperative attitude would not be easy to replicate today. Finally, the Bretton Woods agreement and the Marshall Plan promoted a return to openness, but neither is likely to be repeated today.


Table 6 Pre-crisis productivity performance

GDP/HW, 2007 ($1990GK)

Y/HW growth, 1995-2007 (% per year)

TFP growth, 1995-2007 (% per year)

Greece 17.29 3.36 0.61

Italy 25.63 0.46 0.20

Portugal 15.62 1.16 0.63

Spain 23.50 0.48 0.58

EU-15 median 30.44 1.67 0.64

Czech Republic 14.51 3.87 0.79

Estonia 22.69 7.18 4.71

Hungary 10.66 3.08 0.21

Latvia 14.20 5.84 2.86

Lithuania 15.30 6.30 4.31

Poland 11.83 3.20 2.01

Slovakia 17.32 5.18 2.96

Slovenia 22.40 4.32 1.70

One feasible escape route for the eurozone is to take steps to increase productivity growth in southern Europe. Faster productivity growth would increase competitiveness and improve the fiscal arithmetic. Table 6 shows how the pre-crisis productivity performance of southern Europe has been dismal. Total factor productivity growth in Italy, Portugal and Spain has been negative. They performed worse than the EU-15 median and worse than several accession countries.

The abysmal productivity performance of southern Europe over the last decade means there are large catch-up opportunities which can be unlocked via suitable supply-side reforms. However, structural reforms are generally politically costly. In the absence a reform-minded governments, they can only happen if the rest of the eurozone can impose them via some form of conditionality.

A successful programme of supply-side reforms enforced via conditionality would not be unprecedented. Eichengreen and Uzan (1992) argued that the main contribution of the Marshall Plan to European growth was forcing it to pass some important structural reforms. They find that the aid flows were actually quite small – equal to 2 per cent of European GDP over four years. Hence the direct effect of the Marshall plan on European growth was limited. The success of the Marshall Plan lay in its ability to work as a ‘structural adjustment programme’, promoting pro-market reform via strict conditionality.

However, there are doubts over whether the success of the Marshall Plan can be replicated. At the moment, the eurozone lacks two important characteristics of 1950s Europe. First, the punishment for non-compliant countries is not as credible as in the 1950s. After all, the fiscal transfers which are currently under discussion in the eurozone are less significant than the Marshall Plan. Second,


today’s southern Europe is a worse candidate than Europe in the 1950s. With its lower level of social capability, the eurozone periphery today is unlikely to experience a rapid growth spurt as Europe did in the post-World War Two era.

In conclusion, conventional wisdom suggests that the crisis will not affect trend growth in Europe, but this seems optimistic. History shows that policy responses which cause a retrenchment from competition have the potential to limit the scope for economic growth. As a result, it is quite possible that the average real rate of GDP growth between 2012 and 2030 will be closer to 1 per cent than the pre-crisis rate of 2.3 per cent.

Discussant 1: Daniel Cohen, Paris School of Economics and CEPR

Daniel Cohen did not share the same view as Nick Crafts as he does not think that the eurozone should press ahead with more deregulation to solve its crisis.

Cohen first compared the performance of the EU and the US after World War Two. During the ‘golden age’, the EU performed better than the US. True, there was a Catholic ring, formed by countries such as Spain, Portugal and Ireland, which did not perform as well. Other economies, such as Italy and France, performed spectacularly well. The growth rates enjoyed by these two countries can be explained via a simple catch-up story: capital went to Europe to seek attractive returns.

It is possible that the Marshall Plan may have played a role. However, one should not underestimate the role played by institutions; a crucial role was played by the market-unfriendly institutions built in the 1930s. It is therefore possible that the problems facing Europe today may be linked to the institutions built in the 1950s. These institutions were tailored for an environment characterised by rapid catch-up and growth, but they may not be suitable for the current crisis.

Between 1975 and the 1990s, the process of catch-up in terms of productivity per hour continued. However, it halted in terms of income per head. In Europe, labour inputs were not fully used and unemployment increased. The third phase, which includes the past two decades, shows the EU falling behind the US in terms of both output per worker and output per hour worked. Crafts’ explanation is that Europe failed to grasp the benefits of the ICT revolution. European institutions would then be to blame for failing to develop a knowledge-based economy.

However, Cohen claims that the point made by Crafts is different. What Crafts really argues is that Europe had neither an ICT revolution nor a proper market environment which could provide the right incentive to attract and adapt ICT technology.

Yet, Crafts’ explanation is not entirely convincing. While it is true that the US has enjoyed faster productivity growth than the EU, work by Thomas Piketty and Emmanuel Saez has shown that the US experience in terms of income distribution has been disastrous (Piketty and Saez, 2003). The discussion over the relative performance of the US and the EU over the last two decades must be framed within the equity-efficiency trade-off.


It is also possible that institutions have an effect on the rates of growth that is different from the one they have on levels. Take, for example, the minimum wage. A high minimum wage, which is more common in Europe than in the US, has a negative effect on productivity levels. Firms are obliged to pay too much for their workers. But having an abundant supply of low-paid, unskilled workers may reduce the incentive for technological change and therefore contain productivity growth. Hence, a high minimum wage may have a negative effect on productivity levels but a positive effect on productivity growth rates.

Crafts’ thesis is also hard to reconcile with the productivity figures he presents. True, the ICT sector did much better in the US than it did in Europe. But when one looks at the productivity performance of the ICT sector vis-à-vis the non ICT-sector, the former does not look as impressive. In fact, productivity growth in both sectors is rather sluggish. One can conclude that the ICT revolution did not affect productivity growth in the same way as the steam engine in Britain during the industrial revolution or electricity in the US during the interwar era.

Looking back at the experience of the 1930s, Cohen is less concerned than Crafts about a possible return of protectionism. European institutions are much stronger today than they were back then. However, there are striking analogies between the gold standard and the euro. Just like the 1930s, countries are trying to devalue internally by imposing austerity on their citizens. This is largely due to the accumulation of large current account imbalances between most of the eurozone and Germany, a country with the second largest trade surplus in the world.

How did Germany engineer this success? First, in Germany productivity growth in the industrial sector has outpaced that of services. The secondary sector is attracting ever more workers. This creates an excess supply of industrial goods, which are exported to the rest of the eurozone.

Second, German industry is very competitive. But contrary to what many assume, this is not simply the result of faster productivity growth. Productivity has grown in Germany at roughly the same rate as in France. However, Germany has been more successful at imposing wage moderation on its industrial workers. Had Germany kept the Deutsche mark, the currency would have appreciated and the benefits from wage moderation would have largely been lost. However, because Germany is in the euro, its competitiveness vis-à-vis other countries has remained high. There are encouraging signs that this trend is reverting. Wages in Germany have started to rise, which should contribute to the rebalancing of the bloc.

Discussant 2: Gianni Toniolo, Duke Universoty, LUISS and CEPR

Gianni Toniolo provided an additional perspective on what happened in Europe in the 1930s. True, the countries which left the gold standard and devalued first enjoyed a faster recovery. Competitive devaluations, however, were only a second-best policy. The first-best policy would have been for countries in the gold standard – both creditors and debtors – to opt for coordinated reflation.


Between 1927 and 1932, France accumulated large gold reserves whose size grew from 7 per cent to 27 per cent of total world reserves. US gold reserves also increased, though less dramatically. Conversely, Germany’s reserves shrunk dramatically. This was a consequence of Berlin’s reparation bill.

The first-best policy would have been for France to suspend the payment of reparations from Berlin. France should have also provided emergency loans to Germany and expanded domestic demand. Had this occurred, Germany might have been able to stay in the gold standard.

Why did France not expand fiscal policy? First, its population was full of anti-German sentiment. Second, the public was obsessed with gold. These events strike a very familiar chord for observers of today’s crisis in the eurozone, except that Germany is playing the role of France. As Jean Bouvier put it: “as one looks at the thirties, in retrospect one cannot but note the striking contrast between the general awareness of the reforms that were conceived as necessary and the incapacity to bring them to maturity “.

Toniolo also discussed the long-run story presented by Crafts. There should be no doubt that continental Europe has fallen behind the productivity leader – the US. Of course, it may be too early to talk about the economic decline of Europe. But it is important to spot early signs of decline so that one can make the necessary policy corrections.

Toniolo argued that there have been two great global shocks in world history. The first one occurred at the end of the 16th century. After the geographical discoveries of the 15th and 16th centuries, the Great Divergence set in. China retreated into its own borders and so did Japan. As Islamic law spread across north Africa and the Middle East, the Arab world ceased to be a constant stream of innovation. The big winners of this process were the countries with the newest technology, including the Netherlands and Britain. The Great Divergence then widened as a result of the Industrial Revolution.

The second shock occurred after the 1980s and coincided with the fall of the Berlin Wall, the introduction of ICT as a general purpose technology, and the creation of the euro and the deepening of the European single market. Initially, this breakpoint went largely unnoticed. Yet, it is possible that it may have marked the end of the Great Divergence between Asia and Europe.

Is Europe destined to decline? Not necessarily. One helpful comparison is what occurred to Venice around the 16th century. The conventional explanation is that the decline of Venice was inevitable. Its domination in the Mediterranean became much less significant when world trade patterns moved westwards as a result of the opening of new sea routes in the Atlantic and around the Cape of Good Hope.

However, work by Carlo Maria Cipolla has shown that the decline of Venice was not unavoidable (Cipolla, 1959). The Venetians could have turned the 16th century revolution in world trade into an opportunity had they been less conservative about their ship-building techniques. The Venetians could have copied the Spanish and the Portuguese and built ships with a V-shaped keel and sails. These would have been more suitable for navigation in the Atlantic Ocean. Instead, the Venetians persisted in building boats with an U-shaped keel, oars


and sails, which were best suited to navigating shorter distances and in the lower waves of the Mediterranean Sea. According to Cipolla, the explanation behind the decline of Venice had more to do with the failure to adapt institutions than with geography.

The decline of Venice reflects the pattern of decline outlined by Kindleberger in his 1995 book, World Economic Primacy (Kindleberger, 1995). According to Kindleberger, the way in which technological and economic leaders have declined in history has followed a common pattern. Success always breeds complacency which, in turn, allows sclerotic institutions to survive, leading to the slow adoption of new technology. This has occurred time and again in history: northern and central Italy lost their primacy after the 16th century; so did the Netherlands after the 17th century and Britain at the end of the 19th century. The US, too, will eventually lose its own economic supremacy.

Kindleberger’s theory suggests that decline is inevitable. Yet, it need not be sudden. Indeed, economic decline can be slow. A good example is what has occurred to Italy in the last two decades. Despite obvious economic decline, life expectancy has increased, human capital accumulation has been fast and there have been some technological innovations, including the introduction of fast trains across the peninsula. However, a slow decline can be a blessing in disguise, since the population feels no urgency to shake off outdated institutions.

Economic decline can be resisted and even reversed. For example, in the 17th century, Venice managed to delay its own decline by around a century. It did so by rebalancing its economic structure away from trade towards manufacturing. The Netherlands managed to resume growing at a sustained pace as of the 1950s, after a period of relative decline. British convergence vis-à-vis other European countries resumed in the 1980s.

It will not be easy for Europe, Japan and the US to avoid decline. As Gordon (2012) has put it, they face a number of strong headwinds: the demographic dividend is in reverse; educational attainment has reached a plateau; inequality is rising; there are substantial environmental risks; public and private debt is extremely high.

Unfortunately, history has few lessons to teach us on many of these risks. There have been some environmental shocks, though these were of smaller magnitude and more localised than today’s. Large-scale inequality and the reversal of the demographic dividend are totally new phenomena. The past is, therefore, a totally different place. Yet, knowing that the past is different is still very useful.

General discussion

According to Richard Portes, the productivity performance of individual countries in the last two decades has depended on ICT-using services. There are, of course exceptions. Some success stories in the business world would suggest that deregulation is not always needed. A good example is Zara, a Spanish company which has thrived in spite of restrictive regulations.


Yet, as a general rule Europe’s future growth will depend on the deregulation of the service sector. Unfortunately, European governments have not yet moved in this direction. Competitiveness shocks, such as the Galois report endorsed by President Francois Hollande in France, are still targeted at manufacturing. In the service sector, we are observing a retreat from competition, a willingness to pick a winner and a return of industrial policy. While trade barriers have remained low, a different type of protectionism in the shape of non-trade barriers is emerging. Portes believes that flirting with protectionism can be extremely dangerous.

He also underlined how exchange rate independence should not be considered a panacea. Britain has had both monetary policy independence and its own currency and yet it has taken many years to rebound with a sustained pace from the crisis.

Kevin O’Rourke underlined how the very successful growth performance of European countries in the 1950s may have depended on the very policies implemented in the 1930s. Unfortunately, it will not be easy for Europe to replicate the miracle of the Golden Age. Back in the 1950s, capital inflows from the US helped innovation via capital-embodied technology transfers. These are very likely to happen again.

He also dismissed the idea that there was a Catholic ring which underperformed during the Golden Age. Between 1950 and 1973 there were only six countries in Europe which managed to treble national income. These include Portugal, Spain, Italy and Austria. Ireland did slightly worse, but this can be traced back to its strong links with the British economy, which grew more slowly than continental Europe.

Francesco Caselli argued that it is foolish for people to claim that Germany should re-regulate its labour market to solve the problem of intra-European current account imbalances. Instead, other countries should copy what Germany did in the 2000s, when it reformed its labour market and pressed ahead with wage moderation. He also disagreed with Richard Portes on the importance of exchange rate adjustments. The weak economic performance of the manufacturing sector in the UK is the consequence of the government’s brutal austerity policy, not proof that exchange rate adjustments do not matter.

Jeromin Zettelmeyer argued that the crisis could actually accelerate structural reforms across EMU rather than slowing them down. Throughout the 2000s, peripheral countries saw no reason to implement structural reforms. Now, as a result of the crisis, internal resistances are weaker.

Luis Garicano emphasised how there are political limits to austerity. Voters in the European periphery are bound to lose patience with spending cuts and tax hikes and either protest on a large scale or leave their countries. He asked whether history can offer some guidance on how long patience will last for.

Marco Pagano referred to a paper by Charles Wyplosz which looks at the evolution of competitiveness across EMU (Wyplosz, 2013). According to Wyplosz, there was a large misalignment in competitiveness, but in the last couple of years this has been reversed. With the exception of Italy, we are almost back to normal.

Giuseppe Nicoletti pointed out that structural reforms have accelerated over the last couple of years and the productivity improvements that crisis-hit


countries have experienced are real. The real question for the governments of the Eurozone periphery is whether the reforms, which they have passed in haste under pressure from the market, are good or counter-productive.

Lucrezia Reichlin pointed out that data on GDP per capita are more reliable than data on productivity. Looking at GDP per capita, the process of convergence of Europe towards the US ended in the early 1970s and the gap (about 30 per cent) has not changed since. Productivity, on the other hand, converged until the early 1990s and then diverged again. This turning point coincided with labour market reforms that favoured an increase in unskilled labour participation. She also observed that the persistence of the gap in GDP per capita is puzzling, also because causal observation does not suggest such a large disparity in standards of living. Is it the reliability of data, or the limitation of GDP as a summary statistics of living standards?

Nicholas Crafts concluded by saying that the comments on his paper made him slightly more optimistic. The structural reforms occurring throughout Europe are not yet deep enough, but one should not overlook the fact they are taking place. Still, there are two reasons for pessimism. The first is economic. Since the 1990s, Europe has seen a large increase in labour force participation. The new entrants have lower productivity than those already in the labour market. As a result, productivity is not rising as much as it was in the past. The presence of a large share of unproductive workers should, in theory, trigger investment, but this has not happened. The second reason for pessimism is political. Work by Alan de Bromhead, Kevin O’Rouke and Barry Eichengreen (de Bromhead, 2013) has shown that prolonged depressions help the rise of extreme right-wing parties. Of course, the strength of a country’s democratic tradition and its electoral laws can limit their rise, but there are still some risks. In particular, the length of a depression – rather than its depth – is a good predictor of the probability of an extreme right-wing party emerging.

23

2 Industrial policy1

John Van ReenenLondon School of Economics and CEPR

Industrial policy is among the most pervasive forms of government intervention in both developed and developing economies. It involves large sums of taxpayers’ money. Data from the OECD show that in 2002, direct grants to producers amounted to around $44bn in the US, $43bn in Japan, $17bn in France, $13bn in Italy, $11bn in Canada and $8bn in the UK. Since the beginning of the financial crisis, the amounts involved have increased substantially. The banking sector has been a prime beneficiary, but other sectors, such as the car industry, have also benefited. In 2010, the EU spent €1.18trn on state aid – about 9.6 per cent of GDP.

Industrial policy can take different forms. It ranges from direct subsidies, to loan guarantees, to forms of export and FDI support, to special enterprise zones. Economic theory has not given a clear answer on whether industrial policy is beneficial or not. The arguments made in its favour include the need to shelter infant industries and the importance of generating economies of agglomeration.

However, free-market economists are typically sceptical of industrial policy. They believe that the government does not have sufficient information to pick winners. They also think that applicants for a grant can capture those in charge of handing it out. This can lead to a severe misallocation of government resources. The same economists quote an array of cases in which industrial policy has failed, leading to substantial losses for the taxpayer. These include the cases of several European national champions, such as British Leyland in the UK. However, historical examples from other parts of the world show that industrial policy can be successful: the Asian Tigers (Taiwan, South Korea and Singapore), as well as China, achieved fast economic growth through extremely interventionist policies, often involving large-scale subsidies.

The pessimistic view of industrial policy held by a large majority of economists has been criticised by Rodrik (2007). He argued that this negative view does not have a firm empirical basis. Since governments typically target ‘losers’, naïve empirical techniques may underestimate any ‘true’ positive effect industrial policy has. So-called causal links between industrial policy and growth may in fact only be picking up the fact that governmental help typically goes to weaker companies. Serious identification problems and the difficulty of accessing the administrative data of the companies that receive subsidies make it extremely hard for researchers to evaluate correctly the causal impact industrial policy has on economic activity.

1 Presentation based on Criscuolo et al. (2012).


Criscuolo et al. (2012) estimated the causal effects of one such scheme – the UK’s Regional Selective Assistance (RSA) programme – on jobs, investment, productivity, firms’ entry and exit, and unemployment. RSA is the main subsidy scheme in the UK for companies, under which selected firms, mainly from the manufacturing sector, are given investment subsidies to operate in disadvantaged geographical areas. One of the advantages of this scheme is data availability; the authors have administrative data on all RSA recipients, which is matched to the population of plants. This gives 2.2m observations over 350,000 plants.

The authors use a quasi-experimental approach. This means using an exogenous policy change in order to distinguish any causal effect from simple correlation. They therefore use the change in the EU-wide definition of a “disadvantaged area”, which is determined by EU State Aid rules. These are revised, exogenously, every six to nine years. In the sample period, spanning between 1986 and 2004, there were two changes, one to the eligibility rules and the other to the maximum subsidy a firm can receive. The first occurred in 1993 and the second in 2000.

Criscuolo et al. (2012) found that the programme had surprisingly large effects on both investment and employment. This effect can be explained both in terms of existing firms investing more and of new entry. The study also found that there was little displacement from other areas. This suggests that the gains in employment were ‘real’. These employment gains mostly accrued to medium-sized and small companies. This may suggest that large firms are better at playing the system. There were, however, no effects on total factor productivity. On balance, the companies which applied for subsidies followed an imitative, rather than an innovative, strategy. The cost per job created (about $6,500) was relatively cheap. This does not mean that industrial policy is good for the economy. However, industrial policy has to be relatively low cost for governments to pursue it.

RSA provides investment grants to firms in selected areas. The grants cover between 10 per cent and 35 per cent of capital expenditure of a given project. Firms that apply for a grant have to present a business plan and their accounts, as well as outline why they are applying for a grant. A government agency (currently the Department for Business, Innovation and Skills) decides on whether or not it will fund an individual project. This choice depends on a wide range of criteria, the key one being that the investment has to occur in an ‘assisted area’. The applicant also needs to show that the investment would have not occurred without the subsidy. Finally, the investment is meant to create or safeguard employment, not to offset job losses elsewhere. These last two criteria are particularly hard to enforce by government agencies, since they require speculating about possible counterfactuals.

The size of the grant hinges on the location of the investment. In the so-called Tier 1 areas, a grant can cover up to 20-35 percent of the net grant equivalent (NGE) of investment project costs. In Tier 2 areas, the limit is lower, at 10-30 per cent.

RSA is a form of state aid to industry and as such, it could, in theory, distort competition between EU member states. It is therefore governed by the Treaty of Rome and the Treaty of Amsterdam. These treaties say that state aid is illegal except under restrictive conditions, for example that it must be destined for

Industrial Policy 25

“deprived areas”. These areas are defined by rules which are common for the whole of the EU and are decided upon every seven years. There is also a maximum threshold of support.

The eligibility criteria for an area vary over time and depend on changes in EU-wide conditions. For example, eligible areas need to have their GDP per capita well below the EU average. The eligibility of an area is therefore subject to exogenous shocks. When Poland and several other countries, mostly from central and eastern Europe, joined the EU, average EU GDP per capita fell and, as a result, some EU areas lost their eligibility.

Table 1 Examples of criteria for area eligibility

The 1993 rules The 2000 rules

PeripheralityPopulation densityGDP per capita relative to EU averageRelative unemployment (level and long-term)Activity ratesOccupational structureNew business growth

PeripheralityPopulation densityGDP per capita relative to EU averageRelative unemployment (level and long-term)Activity ratesManufacturing share of employment

Table 1 shows some examples of the criteria on area eligibility according to 1993 and 2000 rules. Some, including peripherality, population density, GDP per capita relative to EU average and relative unemployment, have stayed the same, even though the benchmarks used to assess them may have shifted. Other indicators have changed altogether – occupational structure and new business growth have been replaced by manufacturing’s share of employment.

These criteria are used to differentiate between Britain’s regions. The most disadvantaged areas, called Tier 1 areas, are eligible for a maximum ceiling of 35 per cent NGE. The less disadvantaged areas, Tier 2 areas, are divided into four sub-tiers, with maximum upper limits of 30, 20, 15 and 10 per cent of NGE, depending on local economic conditions.

As Table 2 shows, the number of plants and firms observed by the authors increases between the 1993 and 2000 samples. The number of units that have changed their eligibility status for RSA is significant. For example, almost a third of the plants observed in 2000 had changed their eligibility status.


Table 2 Identification

Unit of observation YearTotal number of

units

Units which changed their eligibility for

RSA

Increase in eligibility

Decrease in eligibility

Areas (wards) 1993 10,737 1,893 1,034 859

2000 10,737 4,048 1,424 2,624

Plants 1993 146,420 23,225 14,369 8,856

2000 163,796 50,920 14,967 35,953

Firms 1993 125,444 19,866 12,505 7,361

2000 148,598 45,692 13,520 32,172

The theoretical reason why industrial policy should work is relatively straightforward. An industrial subsidy lowers the cost of capital, which, in turn, makes a company more willing to invest. However, this is only one part of the story. Spraying subsidies across Britain would result in some companies paying a lower price for investments that they would have made anyway. This is why industrial policy must be well-targeted: there has to be adequate monitoring, so that money only goes to those projects which would have not occurred with a higher cost of capital. However, monitoring is hard, particularly in the case of large firms. Capital misallocation will dampen the effectiveness of subsidies. Conversely, industrial policy is very powerful when firms are credit constrained.

What are, in theory, the employment effects of industrial policy? A firm which invests in new capital does not necessarily create jobs. Of course, since this company is now in the position to produce more goods, the scale effect means that employment should increase. But since new capital may be used to substitute for existing labour, investments may actually have a negative effect on employment. In theory, RSA should have a larger impact on employment in capital-intensive firms than in labour-intensive ones. The former will experience less substitution between capital and labour than the latter.

The key result of the work by Crisculo et al. (2012) is that companies that receive a subsidy tend to hire more. This affect is statistically significant. On average, firms that receive an industrial grant tend to create more jobs than companies that do not. This is particularly true in the case of small firms. Conversely, large firms do not appear to increase that many jobs after receiving RSA. There may be different explanations behind this result. First, larger firms may be better at playing the system, receiving subsidies for investments they would have made anyway. Second, smaller firms may benefit more since they are more likely to be credit constrained. Third, the government may be better at selecting smaller firms than larger firms. Fourth, this result may be due to the interaction between RSA and other parts of the industrial policy system.

The same result also holds for investment. Subsidies appear to spur investment and this effect is stronger among small firms. Meanwhile, subsidies have no effect on productivity levels, whether among small or large firms.


Crisculo et al. (2012) also analyse the broader effect of a subsidy on the area around the company which has received the money. This part of the study checks whether subsidies only result in workers moving from non-participant companies to participant companies. However, the authors do not find evidence of significant displacement effects. In fact, there are some signs of possible agglomeration effects, with the subsidy having positive spill-overs to other firms in the area, even when these do not participate in the scheme.

When one looks at the magnitude of these effects, the authors conclude that a net grant equivalent of 10 per cent creates 2.9 per cent more jobs. Overall, the scheme creates 111,000 extra jobs per year, at a cost of about £4,000 ($6,300) per job in 2010 prices, which is only slightly higher than the cost of welfare-to-work programmes. Furthermore, these jobs do not seem to be the result of displacement activity within the UK. Most of the increase in jobs comes from lower unemployment rather than higher immigration.

Discussant 1: Marc Ivaldi, Toulouse School of Economics and CEPR

In his response, Marc Ivaldi said that, over the years, industrial policy has developed a bad reputation. However, industrial policy is just another type of public policy and should be evaluated as such. Researchers should not ask themselves whether a government has a duty to fund industrial development, but what is the best way to do it.

According to Ivaldi, the work by Criscuolo et al. (2012) shows that the employment effect of specific subsidy programmes depends on the size of the recipient firm. Small firms enjoy larger effects than big companies.

Yet, it would be wrong to conclude that giving employment subsidies to small firms in disadvantaged areas is always an effective strategy. First, we do not know whether large firms give accurate information on the impact of subsidies on their levels of employment. Second, employment is probably not the right criterion to judge the effectiveness of industrial policy. Any analysis of the effect of subsidies should take into account redistribution effects as well as the cost of the policy to the public purse.

Rodrik (2007) proposes three principles for sound industrial policy. First, it has to be “embedded” – it must be built on close collaboration between government and the private sector. Second, there have to be both sticks and carrots. Sticks are needed to cancel inefficient programmes and avoid capture. Third, it is paramount to have accountability, in order to control decision-makers.


Discussant 2: Otto Toivanen, Catholic University of Leuven and CEPR

Otto Toivanen said that it is essential to quantify the effects of industrial policy. Government subsidies to companies involve a large amount of taxpayers’ money, so their effectiveness must be reviewed.

He argued that the dataset underlying the paper by Criscuolo et al. (2012) is extremely rich and could have been explored more. The authors could have investigated whether the effects of industrial policy are different across sectors. Also, the results of the paper seem to be driven mainly by a small proportion of firms, so it would be helpful to know whether they all belong to the same sector.

The main conclusion reached in the paper is that a 10 percent increase in the net grant equivalent leads to a 2.9 per cent increase in employment and a 7 per cent reduction in unemployment. An area that receives the maximum subsidy will see its net grant equivalent increase from 0 per cent to 35 per cent. As a result, employment should increase by 9 per cent and unemployment fall by 20 per cent. These are very large effects. Researchers should investigate whether there may be possible biases in the results.

It would also be useful to understand more about which companies apply for industrial subsidies and how the government chooses to allocate its money. There are several questions: Which companies apply? How does the application process work? How do bureaucrats decide? What are their preferences? Finally, it may be necessary to develop a more complex model. This would allow researchers to perform a more direct calculation of the welfare effects of industrial policy.

General discussion

Francesco Caselli argued that the results of the paper are devastating for industrial policy. The intellectual argument underpinning the decision to give government subsidies to companies in deprived areas is based on the hope that they may benefit from learning-by-doing and enjoy increasing returns. This is what drove governments in Asia, Latin America and Europe to invest vast amounts of taxpayers’ money in industrial policy. Were the recipients of a government subsidy to enjoy learning-by-doing effects or increasing returns, one would observe a rise in total factor productivity. The absence of any effect on total factor productivity is devastating.

Caselli does not deny that there are positive effects on employment. Yet, without tangible effects on productivity, what Criscuolo et al. (2012) define as industrial policy is just another type of welfare policy. In other words, industrial policy pays for the unemployed to do useless tasks at work rather than just sitting at home.

Nicholas Crafts agreed with Caselli that the impact of RSA as described by Criscuolo et al. (2012) makes it a type of employment policy, rather than industrial policy. In order to assess its effectiveness, however, it is important to have access to a broader dataset. For example, we should know how long the


newly employed stayed in work for. Were they to lose their jobs quickly, it would be clear that industrial policy is not so effective. Data on the effect of RSA on the different sectors would provide further useful information. Yet, Crafts is inclined to think that, from what we know, the scheme was not designed optimally.

Ulf Axelson asked whether the conclusion of the paper is that the government should target small firms with high Tobin’s q.

Philippe Martin wanted to know whether the employment effects found by Criscuolo et al. (2012) were temporary or permanent and whether there was evidence of spill-overs from recipient firms to other companies in the same region.

Giuseppe Nicoletti also agreed that RSA should be defined as employment policy. He argued that RSA has the additional feature of teaching skills for the newly employed. However, he wondered whether the money would have been better spent on active labour market policies.

Marco Pagano warned that these subsidies may have had a negative effect on the process of re-structuring the economy. Industrial policy slows down the necessary process of creative destruction, as it keeps alive firms which should go bankrupt. This can have large dampening effects on productivity growth.

John Van Reenen responded that one should be less dismissive of his results. A necessary condition for industrial policy to work is that companies which receive the subsidy invest the money. His work on RSA shows that firms do make these investments and that these investments create jobs. This may make RSA an employment policy but, as such, it is still a useful policy.

The scheme could clearly be re-designed in a more effective way. For example, it could be focused more on smaller firms. Of course, it is important to look at what are the exact distributional and welfare effects of the RSA, as well as whether there are different effects on different sectors. These questions will be the subject of later work. Finally, it is impossible to use data on Tobin’s q, as many of the recipient companies are not listed and therefore have no market valuation.

31

3 The Political Economy of Structural Reforms

3.1 The political economy of credit cycles1

Luis GaricanoLondon School of Economics and CEPR

“You never know who is swimming naked until the tide goes out”. When Warren Buffet, one of the world’s most respected financiers, pronounced one of his most famous quotes, he was referring to investors and asset managers. But his words apply equally to the experience of the crisis-hit countries in the eurozone periphery throughout the 2000s. For most of the decade, cheap money allowed countries like Greece, Ireland, Italy, Portugal and Spain to hide their institutional failings. But when the credit binge ended, these weaknesses become impossible to hide.

Luis Garicano argues that institutional failure is the key to understanding the troubles of the eurozone periphery. He argues that there are four possible explanations for the currency bloc’s crisis. The first sees it as the consequence of a competitiveness problem. Diverging unit labour costs among eurozone countries led to an unsustainable currency. Adjustments via the exchange rate were impossible and this led to the accumulation of excessive current account deficits. The second explanation says that governments of crisis-hit countries managed their budgets imprudently. The third sees it as the consequence of excessive accumulation of public debt. The fourth looks at it as a classic banking crisis. Garicano, however, argues that one should not stop at these four explanations. All of them can be traced back to a single root: crisis-hit countries had weak institutions and these institutions were not ready to face large capital inflows such as those that occurred throughout the 2000s.

The current crisis should not be blamed on the euro. The competitiveness problems of the periphery of the currency bloc pre-date the introduction of the common currency.

1 The basis of this talk is Fernadez-Villaverde et al. (2013).


Figure 1 Real GDP per capita

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1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009

Spain Italy France Germany

Spain

Italy

France

Germany

Figure 1 shows how the divergence in real GDP per capita between Spain and Italy, on the one hand, and Germany and France on the other began in 1995. This is also when countries in the eurozone periphery started to accumulate large current account deficits. Their net international investment position also began to deteriorate around then. True, there were big institutional flaws in the design of the currency area. But the problem for the weak macroeconomic performance of the periphery has to do with their weak institutions and pre-dates the introduction of the common currency.

There are deep historical reasons why the eurozone periphery is characterised by weak institutions. For example, Portugal and Spain only became democracies in the 1970s. When this happened, there were large political divisions among the population. Institution building was the result of compromise. The system of institutions that was put in place was riddled with patronage.

Throughout the 1990s, there were hopes that the creation of a monetary union in Europe would help institutional change in the periphery. Optimists thought that the best practices, typically located in the northern countries, would spread across the eurozone. However, this did not happen. Instead, during the first ten years of existence of the eurozone, institutions in what are now known as deficit countries became weaker. This was largely the fault of the credit bubble of the 2000s.

Garicano analyses the Spanish case. He argues that early on in the decade, several well-qualified observers – including, crucially, some among Spain’s banking supervisors – knew of the risks of a bubble. In an article written for El Pais on 11th August 2003, Miguel Angel Fernandez Ordonez, who would become governor of the Bank of Spain between 2006 and 2012, wrote:

The Political Economy of Structural Reforms 33

Whoever wins will find the first part of a legislature in which the expansion of

domestic demand will continue and will be even encouraged by the international

recovery. When we see mortgage lending growing at 22 per cent and we know that

the injection of EU funds will continue through 2006, we see the growth differential

due to domestic demand and concentrated in construction can be maintained for

some time. The problem is what will happen when the drug of domestic demand is exhausted. (…) We will see negative effects appear on the demand arising from the accumulation of household debt and the debt of public enterprises that the Government hides today. (...) The current excess of domestic demand are not new in

Spanish economic history. We have seen it emerge periodically during the past fifty

years, (…) The problem is that this time the output will be very different, because [the

government] may not resort to devaluation to restore competitiveness (…). It would

have been necessary to focus on the productivity and competitiveness policies”2

While commentators were aware of the frailty of the Spanish situation, little was done to address these weaknesses. Plans for a labour market reform were abandoned in 2001. While private debt grew throughout the decade, almost nothing was done to address this problem. Most importantly, no steps were taken to improve the deteriorating governance of the cajas. A good example is what happened to Caja Madrid. Since 1996, people had talked about its flawed governance and the excessive amount of political pressure it was subject to. But politics was allowed to continue to run the show. Caja Madrid eventually went bankrupt.

In theory, the euro should have helped countries to reform. Many political leaders and intellectuals thought that, since peripheral countries could no longer use devaluation to regain competitiveness and make up for an overly expansive fiscal policy, they would have to pass structural reforms. The introduction of the common currency, however, ended up reducing the incentive to pass these reforms. As interest rates fell, it become harder for governments and supervisors to control lending by the banks, which became excessive. Moreover, some credit institutions probably thought there was an implicit sovereign guarantee on their debt – both from their own government and from the other eurozone countries.

The weakening of institutions in the eurozone periphery cannot simply be blamed on the euro. The main problem was the formation of a credit bubble. Booms make it harder for citizens to monitor and hold to account those at the helm of an institution.

Banks are a very good example. In banking, it is generally very hard to evaluate how well managers are performing and whether or not they are taking on too much risk. During a bubble, this evaluation process becomes even harder. Since profits rise artificially high, the performance of the management of a bank will look good even if it is actually bad. What is more, since the situation across the sector looks generally fine and it is hard to discriminate between managers, there will be fewer incentives for shareholders and the government to seek to understand whether managers are acting sensibly. In fact, were the government

2 Miguel Angel Fernández Ordonñez, in El Pais, 11th September 2003.


or shareholders to attempt to differentiate between banks, they would probably reward those managers who are taking on excessive risks. This is because in a credit bubble, risk-loving bankers tend to generate higher profits than their more prudent colleagues.

Hence, during the bubble it became harder to select the best bank managers. But the same was true for politicians. Those politicians who were taking the most risky decisions from the point of view of public finances were often those who gained the most support from the public.

Luis Garicano offers two examples to back up his theory. The first is what happened to the Spanish cajas, the regional banks that bear the main responsibility for Spain’s economic problems. Madrid’s stock of public debt is, in fact, sustainable and Spain is a solvent country. But the bankruptcy of three cajas has forced the government to apply for help from the European Stability Mechanism, the eurozone’s rescue fund.

Traditionally, the cajas were generally small, regional institutions. The selection of their managers occurred in Madrid and these appointments were almost always political. However, the process of banking deregulation which occurred in Europe in the early 1990s allowed these small lenders to expand beyond their own home region. Their governance, however, did not change. As a result, the managers of the cajas became hopelessly inadequate for the activities their banks were involved in.

Initially, as the bubble inflated, the irresponsible lending behaviour by most of the cajas was rewarded. They posted excellent returns, and were floated in the stock market. They chose to expand their balance sheets, racking up debt from the wholesale market. Deposits fell, while capital and reserves hardly increased. The extra leverage was used by the cajas to expand their loan books. They competed fiercely with larger banks, gaining market share in some of the latter’s core business activities, such as lending to businesses and individuals.

Yet, the managers of the cajas remained inexperienced; in many cases, they had no banking background at all and this contributed to the downfall of their banks. Research by Cunat and Garicano (2010) shows that the professional background of a bank’s chairman – whether or not he had any previous banking experience – had a significant effect on measures such as the proportion of non-performing loans taken up by his bank.

However, the negative impact of poor governance on performance was not immediately visible. In the early days of the credit boom, the performance of inexperienced managers was actually very good. For this reason, they tended to climb the ranks of a bank, taking on roles of ever-greater responsibility. The promotion of less experienced and more risk-loving managers led the cajas to take up more dubious loans, worsening their position.

A second example is what happened to Spain’s fiscal position throughout the 2000s. True, with a relatively low debt to GDP ratio, Spain is in better shape than the other peripheral countries. But for much of the 2000s, Spain’s fiscal position was not as sustainable as outsiders believed. The cyclically adjusted position was weak, with Spain regularly posting structural deficits of around 2-3 per cent of GDP.


However, politicians repeatedly failed to understand what was happening. The construction boom led to large tax windfalls, which relaxed the government’s budget constraint. The government led by Luis Zapatero passed a number of overly generous laws, including the now infamous ‘dependency law’. This allowed anyone who was taking care of an old person at home to claim a wage from the state. When the government awarded money to the regional administrations, no region was ever penalised. Too many high-speed trains were introduced around the country, even on routes that would later prove rarely used. As the credit bubble continued to grow, voters had no incentives to ditch populist politicians for more competent ones.

What happened in Spain was, therefore, a form of collective failure. The credit boom distorted incentives for the population and induced citizens to take wrong decisions. But there were individual failures too. One example is what happened to the accumulation of human capital. The bubble caused wages in the construction sector to increase. This meant that, for part of the 2000s, the returns to acquiring skills in Spain were negative. Conversely, in the rest of the world, they remained unmistakably large and positive.

Many young people decided to opt for a job on a building site rather than going to school or university. Spain is one of the very few European countries where the number of high school drop-outs did not decrease throughout the 2000s. By 2009, Spain had the third highest proportion of high-school drop-outs in Europe, behind only Turkey and Malta.

What happened when the bubble burst? It took Spain a long time to pass the reforms needed to put the economy back on track. Garicano blames this on weak institutions and bad elites.

Yet, Spain’s recalcitrance to reform is also explained by moral hazard. The government, the unions and citizens more generally knew that Spain was too big to fail. Therefore, they expected eurozone partners and, in particular, Germany, to come to the rescue.

But moral hazard was only one part of the story. The second and arguably more important problem has to do, once again, with the economic environment, which prevented citizens from understanding what course of action would be best for them and for their country. During the credit boom, the economy enjoyed large positive shocks, which made it impossible for individuals to understand correctly the risks associated with their decisions. Similarly, during the recession, the large negative shocks made it hard for them to realise that reforms will have a beneficial effect.

This holds a discouraging lesson for the supporters of democratic systems. Democracies can find it hard to adopt good economic policies during a boom and in a bust. The solution may lie in giving a greater role to experts. Technocratic governments may be more capable of educating the public on what is needed and taking policy steps which are less short-termist.


3. 2 Reforming the Spanish labour market3

Samuel Bentolila CEMFI and CEPR

The eurozone debt crisis has forced some countries to take unprecedented reform steps. But since many of these policy changes were rushed through under market pressure, their outcome was far from perfect.

Samuel Bentolila examined the labour market reforms undertaken by the Spanish government between 2010 and 2012. Even before the crisis, the need for reform was self-evident.

Figure 2 OECD-harmonised unemployment rate (%)

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France Spain

France

Spain

Figure 2 shows the evolution of the unemployment rate in Spain between 1978 and 2011 and compares it with what happened in France, a country that is deemed representative of the rest of continental Europe. The two countries experience similar cycles. The average unemployment rate in Spain throughout the period, however, is around 60 per cent higher than in France. Furthermore, volatility is much higher in Spain than in France. During the Great Recession, unemployment has risen much faster in Spain, reaching 25 per cent. It is also interesting to look at the relation between unemployment and output. Unemployment is typically less variable than output, as firms tend to retain workers during a crisis so as not to be understaffed during the recovery. But several studies have shown that unemployment in Spain is more variable than output.

The Spanish crisis came after a long boom, which lasted between 1996 and 2007. Low interest rates and easy access to credit led to a credit binge which, in turn, fuelled a housing bubble. The increased availability of jobs in the

3 The basis of this talk is Bentolila et al. (2012).


construction sector led to a large immigration inflow, with the Spanish labour force increasing by 14 per cent between 1996 and 2007.

While construction boomed, the rest of the economy did not grow. Total factor productivity shrunk; unit labour costs increased by 14 per cent between 1999 and 2008, leading to a large current account deficit equal to 10 per cent of GDP in 2007.

When the housing bubble burst in 2008, unemployment in the construction sector rose quickly. But unemployment shot up in the other sectors too. Bentolila argues that such widespread labour shedding was the consequence of the two-tiered structure of Spain’s labour market. Younger workers are typically hired on flexible contracts, while their older colleagues benefit from much greater protection. Two-tier labour markets give very little hope to younger workers as they are continuously moving from one job to another, so it becomes very hard for them to accumulate skills and start a proper professional career.

Table 1 Main reforms

1975Franco’s legacy: High severance pay (SP) and judicial protection, no collective bargaining (CB), low unemployment insurance (UI)

1980 Workers’ Statute: New institutions (SP, CB, UI)

1984 Temporary labour contracts regulation relaxed

1992 Reduction in generosity of unemployment benefits

1994 Restrictions on temporary contracts, more scope for collective bargaining

1997 New permanent contract with lower severance pay

2002Firms allowed to dismiss at penalty severance pay without advance notice and without going to court

2006 Attempt to discourage temporary employment

Table 1 offers a brief summary of the main reforms of the Spanish labour market since 1975. In 1975, the settlement which came after the end of the Franco dictatorship meant that workers on permanent contracts were able to enjoy high severance pay and judicial protection. Conversely, there was no move towards collective bargaining. Unemployment insurance was kept low.

Five years later, in 1980, Spain passed its Workers’ Statute. This retained the existing high severance pay, but introduced collective bargaining and a more generous unemployment insurance scheme. In 1984, the relaxation of regulation on temporary labour markets laid the basis for the creation of a two-tiered labour market. In the 1990s, there were attempts to reform this structure, but they were largely unsuccessful. In particular, in 1997 there were discussions over the introduction of a new permanent contract with lower severance pay. However, this prompted a judicial controversy, with judges arguing over it for almost a decade. As a result, not many firms adopted the new contract.


Table 2 EPL and collective bargaining

Employment protection legislation Collective bargaining

• Dismissal for economic reasons blocked by labour courts

• High severance pay for permanent (45 days, unfair), very low for temporary (8 days)

• Collective dismissals subject to authorisation (so: unions)

• Lowaffiliation(15%)andhighcoverage(80%), 10% enough

• Bargaining is industry-level with regional compenent

• Automatic extension to all workers and firmsinindustry

• High indexation to CPI (65%)• Frequent social pacts

Table 2 presents the main characteristics of Spain’s labour market during the crisis. It shows that there were significant differences between the status of temporary and permanent workers. For example, severance pay was much higher for workers on permanent contracts than for those on temporary ones. Workers on permanent contracts could also enjoy the benefits of collective bargaining, as well as protection from collective dismissals, which had to be subject to authorisation from the unions. Workers on temporary contracts could not enjoy the same luxuries.

It is often argued that Spain did not reform its labour market as it suffered from reform fatigue. Bentolila disagrees.

Table 3 Employmentprotectionlegislationreformsofspecificaspects(%oftotal)

PeriodYears with

reformFlexibility-increasing

Structural Complete Discrete

France 1982-2007 56 68 32 18 44

Germany 1985-2007 50 72 39 22 36

Italy 1982-2007 56 68 32 18 44

Average 54 69 35 19 41

Spain 1980-2007 48 61 24 21 29

Table 3 shows the frequency and intensity of changes in labour law in Spain and compares it with France, Germany and Italy. Over the last three decades, Spain had fewer and less-encompassing reforms than other major European countries. Reform fatigue could not be a factor.

Instead, the problem was that the constituency backing a labour market reform was not large enough. Data collected by Dolado et al. (2010) show that unemployed and unskilled workers tend to be more favourable to the idea of injecting some flexibility into the labour market than skilled workers. But unemployed and unskilled workers do not matter very much for politicians. Since the late 1990s, the number of employees on permanent contracts was always larger than the sum of unemployed and of workers on temporary contracts. As a result, the median voter – the voter politicians care about – was always a worker with a permanent contract.


Bentolila argues that the labour reforms passed in 2010 and in 2012 were both prompted by the financial crisis.

Figure 3 Differential yield between Spanish and German 10-year bonds (pp.)

First labourreformproposal

Start of Greek crisis

Labour reform decree

EU rescuefunds/Spanishbudget cuts

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2Irish crisis deepens

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1/11/10

Figure 3 looks at the 2010 labour market reform. This was passed under severe market pressure: both the proposal and the actual decree were drafted after a spike in the yields on 10-year government bonds. Markets, however, did not just influence the timing of the reform; they also affected the substance of the policies. Since this reform was passed in haste, however, the changes introduced were not as innovative and comprehensive as they should have been.

The 2010 labour market reform affected both employment protection and collective bargaining. In terms of employment protection, there were some improvements. The reform made it easier to dismiss workers for economic reasons. It reduced the advance notice an employer has to give to a dismissed worker from 30 to 15 days. The government also introduced a new type of permanent contract, under which severance pay was reduced to 33 days of wage per year of service, compared with 45 days under the old contract. Employers would also be able not to go to court (although they would still have to for disciplinary dismissals). Finally, temporary contracts were made less flexible: severance pay would gradually increase from 8 to 12 days of wage per year of service.

The reform of collective bargaining was more timid. Companies in financial trouble were allowed to opt out of industry-wide collective bargaining, but this had to happen in agreement with workers. Moreover, firms had to go back to collective bargaining within three years of opting out. The reform also introduced several measures which protected insiders. For example, it was decided that the counterpart to employers in negotiations over working conditions would be the unions’ committee, not the workers’ committee.

Overall, the reform included some measures with which trade unions disagreed. However, the government made the policy changes more palatable for organised labour by reducing their scope. Much of the two-tiered system was kept in place. For example, the government backtracked on a proposal which would have


imposed severe limitations on the possibility for employers to create “chains” of temporary contracts. Furthermore, the government did not dismantle industry-level bargaining, which remained the most prominent level of negotiations.

A further reform adopted by the Spanish government in 2012 went deeper than the 2010 one. The 2012 laws made it easier to dismiss workers for economic reasons. Severance pay for unfair dismissal was reduced from 45 to 33 days per year of service on all contracts. The upper limit on how much severance pay a worker can receive pay was reduced from 42 to 24 months.

The new labour laws also introduced a new type of contract. Workers dismissed during their first year in a job would not receive any severance pay. Collective dismissals also became easier: politicians no longer had to approve them, as was necessary under the old regime.

The most important change introduced under the 2012 reform concerned collective bargaining. Firm-level bargaining replaced industry-level agreements as the main negotiating framework. It is now much easier for firms to opt out of industry-level agreements; firms can do so after posting losses or declining revenues for two consecutive quarters. The government also cut unemployment benefits for those who are out of work for longer than six months.

While the 2012 reform was more radical than the one passed in 2010, Bentolila argued that this too was insufficient. In particular, the government should have ended the two-tiered nature of the labour market by severely constraining the use of temporary contract. The cabinet should have introduced a single open-ended contract, with severance pay increasing with seniority. Spain should have done more to decentralise collective bargaining and should have broken the link between wages and inflation by getting rid of wage indexation. Unemployment benefits should be more generous to begin with, but decline more rapidly to ensure that the unemployed search for a new job. Finally (to help those without work and those who have dropped out of the labour force altogether), the government should have invested more in active labour market policies. These should have been targeted at unskilled workers and their results subject to a rigorous assessment.

The extremely high rate of structural unemployment experienced by Spain during the crisis was a direct consequence of its labour market. Yet, even the large rise in unemployment at the beginning of the Great Recession was insufficient to trigger a labour market reform. The main driver of reform was market pressure. The government decided to act when the risk premium on Spanish debt increased sharply. Rising pressure from Spain’s eurozone partners was another important factor. However, even in 2010 and 2012, internal political constraints still mattered. The labour market reforms passed by the government were limited in scope and the two-tiered structure of the labour market has remained largely in place.

While still imperfect, the labour market reform approved in 2012 was more effective than that of 2010. There were two reasons for this. First, the 2012 reform was passed by a right-wing government, whereas the 2010 reform was passed by the left-wing Socialists. Saint Paul (2002) and Hoj et al. (2006) have shown that right-wing governments tend to pass more radical labour market reforms than


left-wing cabinets. Second, labour market reforms are politically more viable when the economy is doing badly. Higher unemployment reduces the political weight of labour market insiders. When the number of labour market outsiders grows, there is more urgency for politicians to listen to them.

Discussant: Graziella Bertocchi, University of Modena and Reggio Emilia and CEPR

Graziella Bertocchi emphasised how European governments need to introduce structural reforms to kick-start economic growth. However, they face a dilemma. Hoj et al. (2006) have shown how higher reform activity is typically associated with periods of economic turmoil. The same study also shows that only stable governments can implement reforms effectively. Unfortunately, there is a large body of evidence (e.g. Alesina et al., 1996) showing that slow growth increases political instability. Hence, the ingredient which is most needed for effective reform implementation – stability – is typically lacking when there is the greatest urgency to reform.

The main obstacle to a successful reform of the Spanish labour market is its segmentation. The introduction of a single open-ended contract, as proposed by Bentolila, would affect workers on temporary contracts and those on permanent contracts in opposite ways. The presence of multiple stakeholders makes it possible for one group to block the reform. What matters are the relative size of the groups as well as the presence of external triggers.

Conversely, the key explanation for the lack of decisive action shown by the Spanish government in dealing with its banking and fiscal crises is uncertainty. The government was well aware of Spain’s growing lack of competitiveness, fiscal imbalances, as well as the inflating credit bubble. But no action was taken, because during a boom it is difficult to extract meaningful information from the existing signals. Just as importantly, learning did not become any easier when the party ended and the bubble burst.

Bertocchi thinks that what happened to Russia after the collapse of the USSR holds some useful lessons for Europe. The early 1990s were a period of severe economic crisis for Russia. GDP fell by 50 per cent in the first seven years of the transition, and in 1998 there was a financial crisis and Russia had to default on its debt. One of the reforms Russia needed at the time was to launch an ambitious programme of privatisations. Just like Spain in the 2000s, the Russian government of the time faced multiple stakeholders. Bertocchi argues that it is optimal for the government to employ a divide-and-rule strategy. Had workers formed a united front, the government would have had to find measures which would have benefited everyone, rather than just one group. The Russian case shows that, at a time of crisis, a government has an incentive to give large benefits to a powerful elite. Conversely, a stable government prefers to give smaller benefits to larger groups.

The Spanish government seems to have done what other crisis-hit administrations have done in the past, namely adopt a divide-and-rule strategy.


The People’s Party-led government has preferred to keep many of the existing privileges for those in permanent employment, rather than adopting a single open-ended contract which would have given smaller benefits to a larger number of workers.

The experience of transitional economies such as Russia also shows that in theory, economic turmoil should lead politicians to take more decisive reform action. The economic environment policymakers face is so uncertain that they are forced to push hard in order to learn whether their policies are successful or not. Whether or not politicians do this depends on how long they expect to be in government for. If they do not expect to be in government for very long, then they have no incentive to learn the impact of their reforms.

This could explain why the reforms pursued by the Spanish government are still not sufficiently aggressive. Politicians may not be looking at a longer-term horizon, whether because of their myopia or because of the uncertainty of the political environment. Here, Bertocchi agrees with Garicano’s viewpoint that political instability can lead to bad policies.

General discussion

During the discussion, Richard Portes outlined that the problems spelled out by Luis Garicano did not apply just to the eurozone periphery, but extended to the UK, the US and Germany. In all these countries, financial institutions proved ill suited to deal with cheap credit. In particular, banking supervision in Germany was completely incompetent; Portes argues that the German landesbanken did not behave differently from the Spanish cajas. In both cases, high-profile jobs were given to unqualified people who had strong political connections but no previous banking experience. Garicano agreed with Portes on this point.

Portes disagreed with Garicano that moral hazard was one of the reasons why Spain and Ireland did not control their credit bubbles. He argued that Irish banks did not think there would be a bailout from Germany; they just rode the bubble. In fact, they would have looked stupid had they not done so.

Finally, Portes challenged the view put forward by Samuel Bentolila that right-wing governments tend to pass more effective labour market reforms. He pointed at the reform of the labour market passed by the Labour government in the UK just after the Second World War, or what was achieved by Gerard Schroeder in Germany in the early 2000s. Samuel Bentolila disagreed with Portes. Of course there can be exceptions, but studies looking at a wide number of labour market reforms show that right-wing governments are typically more effective.

Jeromin Zettelmayer outlined how the quality of institutions before the credit boom matters more than what was suggested by Garicano. He pointed to the literature on the relation between institutional quality and economic performance in countries experiencing a commodities boom and argued this holds important lessons for Spain. Commodity-rich countries with stronger institutions tend to suffer less when a commodity bubble bursts. This may explain why countries in the eurozone had different experiences during the era of cheap credit.


Kevin O’Rourke argued that what happened in Ireland was worse than what occurred in Spain. Spain had some high-quality politicians and central bankers in the 1990s, while in Ireland politicians and central bankers have traditionally been very mediocre. He agreed with Richard Portes that there was no moral hazard; the deregulation of the banking sector occurred because politicians and bankers simply thought a crash would never happen. When – between 1999 and 2001 – policymakers realised that there was a real risk of a bubble, their response only focused on fiscal policy and completely ignored banking regulation (for example, leverage ratios).

Lucrezia Reichlin and Gianni Toniolo thought Luis Garicano’s signal extraction story was plausible, but was not sufficient to explain what happened to the eurozone as a whole. In particular, they outlined how his model cannot explain what occurred in Italy.

Lucrezia Reichlin pointed out that Italy did not experience a credit bubble, and yet still failed to reform its economy. In fact, the Italian experience was, in some respects, worse than that of Spain. National income is now shrinking fast in both countries but, in contrast to Spain, Italy did not benefit from the boom of the early 2000s. While Spanish citizens are richer than before the bubble started to inflate, Italians are poorer. Spain’s labour productivity is rising, while Italy’s is falling. A comprehensive explanation of the eurozone crisis must address these points.

Luis Garicano agreed that the Italian case did not fit his narrative and more research should be done to explain this.

Samuel Bentolila argued that the improvements in labour productivity that one can see in Spain are cyclical and depend on labour-shedding. He suggested one should look at total factor productivity instead, and that recent data show a very poor trend for Spain.

Giuseppe Nicoletti argued that it was not true that the credit bubble made policymakers blind to the need for structural reforms. Throughout the late 1990s and 2000s, policymakers discussed extensively the need for the eurozone periphery to implement significant reforms in their labour and product markets.

Luis Garicano responded that this was exactly his point. The Spanish government knew reform was needed and in 2001, the cabinet was going to pass a labour market reform, but then decided not to. The choice to back down was, once again, a consequence of the bubble. Given that Spain was creating so much employment, it was deemed unnecessary to pass a reform.

45

4 Trade and Growth1

Richard BaldwinGraduate Institute, Geneva and CEPR

Globalisation – the shift from a world of no trade to one of free trade – has traditionally been seen as a single, long-term process which started around the 1870s and has continued, with some interruptions, until today.

There are good reasons, however, to believe that the process of globalisation we see today is different from the that which occurred in the past. Richard Baldwin argues that the nature of globalisation changed around 1985 and that this change has already had and will continue to have profound implications for both mature and developing economies.

The conventional view has seen trade costs as the main driver of globalisation. This was generally true, at least between 1870 and 1980. Between 1870 and the First World War, global trade costs plummeted and global trade flows increased. The opposite occurred in the interwar era, when global trade costs rose and trade flows fell. The pre-First World War trends occurred again between 1945 and the early 1980s, when trade flows rose as trade costs fell.

However, from the mid-1980s onwards, this relation ended. Trade flows continued to rise in spite of the absence of any secular decline in global trade costs. Economists have called this the ‘distance paradox’.

Understanding the reasons behind the distance paradox is important. Since this paradox first emerged, the impact of globalisation on mature and developing economies has changed substantially.

Figure 1 Globalisation impact changed

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1 This talk is based on Baldwin (2012).


Figure 1 shows what has happened to the exports of G7 countries since the Second World War. Until the 1990s, as trade grew, the share of world exports belonging to the world’s seven most industrialised nations rose with it, reaching a peak equal to 52 per cent of total world exports in 1991. Since then, the G7’s share of world exports has declined and is now as low as 30 per cent.

The share of world GDP produced by G7 nations followed a similar trend. Between 1950 and 1988, it rose from 55 per cent to 67 per cent. In the last 25 years, it has declined steadily, and its level is now below where it was 60 years ago. The big winners were the so-called Asian Tigers and China.

The sector of the economy which has changed the most as a result of this new process of globalisation is manufacturing. In spite of a continuing rise in the absolute size of world manufacturing, the share produced in G7 countries has steadily decreased since 1990, falling from 65 per cent then to below 50 per cent now. Meanwhile, only seven countries in the world have seen their share of global manufacturing increase: China, Korea, India, Turkey, Indonesia, Thailand and Poland. All the other countries in the world only kept their share or lost some.

The most recent wave of globalisation has therefore created seven winning manufacturing nations (which are mostly located in the developing world), and seven losers (the members of the G7). The seven most industrialised economies in the world suffered from relative, rather than absolute, decline. Their manufacturing output kept rising, but much less rapidly than that of emerging economies.

Baldwin argues that, since the 1990s, the nature of trade has changed. Before the 1990s, vertical integration between companies of different countries typically took place in rich economies. In particular, intra-industry trade normally occurred in blocs of wealthy countries, such as the EU or the US and Canada. However, starting in the 1990s, Asia’s share of vertical specialisation took off and now exceeds that of the richest western countries. Conversely, nothing happened in Africa or Latin America.

Over the last two decades, the world has witnessed a change in the organisation of three so-called ‘old global factories’ – North America, Europe and Asia – rather than the creation of new ‘factories’ in Africa or Latin America. Production has moved from Italy and Germany to Turkey, and from Japan to China, rather than going to South Africa or Brazil.

The North American case is a good example. In 1995, the US exported intermediate goods to Canada and then re-imported them. Now, the same process largely occurs with Mexico. Mexico’s industrialisation is largely driven by a process of offshoring by US companies.

Baldwin argues that this is the result of what he calls the “second unbundling”. The “first unbundling” took place during the Industrial Revolution. In the pre-industrialised world, production and consumption were geographically bundled. People only consumed goods produced nearby. The steam revolution and the resulting decrease in transport costs led to the “first unbundling”. Production became globally dispersed but still based around local clusters of factories. The presence of these clusters of factories was due to coordination costs, not trade

Trade and Growth 47

costs. Factories needed to share information and to coordinate their activities. This forced them to be geographically close.

The “second unbundling” is a direct consequence of the ICT revolution. Following the arrival of the internet and the spread of email, factories no longer need to be geographically close to each other. As a consequence, production can be more easily dislocated from the developed world, allowing entrepreneurs to chase lower wages. This process has some positive effects for emerging economies: they can import intermediate goods from the developed world and enjoy the benefits of technological transfers. This combination of state-of-the-art imported technology and low local wages has allowed many emerging economies to take off.

Baldwin argues that globalisation should be seen as the progressive peeling off of layers of economic constraints. The steam revolution relaxed the transportation constraint. However, the location of firms was still dictated by coordination constraints, which were only relaxed after the ICT revolution.

Since then, face-to-face constraints have begun to emerge and these are today’s real constraints on production. They oblige people to locate factories at no more than one day’s travel from a headquarter. If something goes wrong within the supply chain, the only way to solve this issue is to travel to the company where the problem has been identified. This has to occur within a day, hence the constraint. In the future, the expansion and improvement of video-conferencing and of virtual presences will push the frontier of manufacturing further and relax face-to-face constraints. This may finally allow countries such as those in Africa to join the global supply-chains.

The second unbundling has had important consequences for both developing and developed economies. For emerging markets, it has meant that governments no longer have to worry about building an entire domestic supply chain. Developing countries can join a global supply chain and rely on technological transfers. Relying on global supply chains may, in fact, be a superior strategy. Korea was the last Asian country to successfully build its own supply chain. In contrast, Thailand has industrialised largely by joining the Japanese supply chain.

The second unbundling raises some important policy questions for developing countries. For example, it is not clear whether a country which decides to join the global supply chain should concentrate on one particular industrial sector, or pick many. There are also questions over which role – if any – should be played by multinational corporations. Finally, an emerging country should ask itself how it can move up the value chain it is not building its own supply chain from scratch.

The second unbundling also holds some important implications for mature economies. Prima facie, this process appears to be extremely gloomy for industrialised economies with a competitiveness problem (for example, those from the eurozone periphery). In recent years, these countries have passed labour market reforms in order to attract foreign capital and be part of the global supply chain. However, even if their governments were capable of attracting foreign investments, there is a risk that these investments will be limited to the low-value segment of a given supply chain and since it is unclear how exactly one


country can move up the value chain, there is a real risk of being stuck in an equilibrium in which investors only demand low skills in return for low wages. Were this scenario to become a reality, then the benefits accruing to workers from these labour market reforms would not be very high. This explains the resistance offered by unions and organised labour to the reforms that the governments of the eurozone periphery are trying to pass.

However, the prospects for mature economies need not be so gloomy. The main lesson to draw from the history of the second unbundling is that the rich world needs to move away from fabrication. This is the segment of manufacturing in which wealthier countries have the greatest competitive disadvantage vis-a-vis emerging economies and where technological developments, such as the creation of robots, is likely to lead to even greater displacement of existing workers.

However, abandoning fabrication does not mean abandoning manufacturing altogether. Most of the value-added of manufacturing is locked in the stages of production that happen before or after fabrication. These stages include all the intermediate services from developing and designing a product to marketing it. Mature economies should use their high level of human capital to compete in these areas of manufacturing, leaving fabrication to the emerging world.

To compete effectively in these pre-fabrication and post-fabrication stages, Europe, the US and Japan need to leave behind them their fascination with industrial districts. Cities are the factories of the 21st century and governments should therefore encourage the creation of large urban centres.

Finally, governments should be careful about what sectors and stages of production they choose to protect. The second unbundling does not entice entire sectors, rather only some segments of production. As a result, seeking to protect an entire sector is the wrong response and risks driving out both jobs that would be lost anyway, and jobs – for example, those in product development – which could be kept at home. The adequate public policy response is to have less extensive employment protection but to use more public money to fund active labour market policies. These should be aimed at re-training workers so that they can find jobs away from the fabrication stage.

In conclusion, the second unbundling has transformed the nature of both trade and industrialisation. Globalisation – which is now both about moving goods and about transferring technology – has different implications from the past. Both academics and governments should take a close look at how this process has changed.

Discussant: Philippe Martin, Sciences Po and CEPR

In his discussion, Philippe Martin focused on the impact that the second unbundling has had on productivity growth of in-sourcing countries.

According to Baldwin, developing countries that choose to join a global supply chain should industrialise more easily. Yet, Baldwin does not explain where exactly productivity growth comes from. If productivity growth comes from external economies of scale and technological spillovers, then he needs

Trade and Growth 49

to be clearer about how and why the process taking place as a consequence of the second unbundling is different from that which occurred after the first unbundling.

Martin argues that the process of global vertical integration which occurred as a result of the second unbundling may have led to fewer – not more – instances of technological transfer. In the second unbundling, technology transfers are limited to a specific production stage, rather than to the entire production process. Labour pools in in-sourcing countries tend to be more specialised, which in turn limits the scope for positive spillover effects.

There are significant differences in the speed at which in-shoring countries have industrialised as a result of the first and second unbundling. Following the first unbundling, in-sourcing countries found it difficult to industrialise. However, as the Korean story shows, once these countries managed to get on the ladder of industrialisation, they climbed it quickly. Conversely, the second unbundling has made it easier for developing countries to industrialise, but only in part. Since they only join one part of the global supply chain, typically industrialisation does not spread to other segments of production.

An equally plausible scenario to the one described by Baldwin is that the second unbundling has led to more episodes of positive growth, but fewer take-offs. Hence, it is important to try to measure what exactly has happened. One solution would be to measure the total factor productivity growth rate in countries that joined the global supply chain and compare it with countries that did not join. It is equally important to look closely at which countries have captured the gains from offshoring. One possibility is that the winners were, indeed, the developing countries. However, it is equally plausible that offshoring countries took the lion’s share of the gains.

Finally, Martin argues there should be a greater discussion of the role of institutions. Global production networks require very complicated contractual arrangements. However, these international contracts are often incomplete and can lead to severe disruptions to production, such as lower quality and time lags. Multinational corporations may therefore have an incentive to avoid contracting with foreign firms and prefer to open their own plants abroad. This would limit the positive effect of technological spillovers, since productivity-enhancing innovations are kept within the boundaries of a single firm.

General discussion

Giuseppe Nicoletti argued that there should be a greater discussion of the role of international institutions. He also emphasised how economic development within these new global supply chains is more fragile than in the past. Global supply chains generally make it harder to generate a comparative advantage. Finally, there are important distributional issues: in-shoring only benefits a restricted number of workers, who earn much higher wages than the rest of the country. This is a matter of great importance for governments.


Richard Baldwin agreed that one should factor in the role of international institutions. He underlined how most of the supply chain arrangements he described are underpinned by regional trade agreements which go beyond what is decided at the level of the World Trade Organisation.

Marco Pagano wondered whether another problem with global supply chains is that they produce fewer spillovers in terms of education. Since production is segmented and the different labour pools are kept very distinct, there may be less sharing of technological know-how among workers.

Luis Garicano found the implications for inequality of Richard Baldwin’s story quite frightening. In the in-sourcing countries, workers are divided between those who work in a global supply chain and therefore have access to good management and new technology, and those who do not. Workers who are part of these global teams can also benefit from better learning. The wedge created between these two pools of workers can have significant long-term consequences. Those who have acquired skills in the global supply chain may be able to command higher wages throughout their career than those who have not.

Marco Pagano countered that it is equally important to think in terms of global inequality. While domestic inequality may increase as a result of the formation of these global supply chains, worldwide inequality should decrease.

Richard Baldwin agreed that the role of institutions deserves greater scrutiny. In particular, future studies need to focus on multinational corporations. Around 80 per cent of all trade in goods is carried out by about 2,000 firms. The same 2,000 companies are responsible for the majority of foreign direct investment. As a result, the development of the global supply chain is not driven by governments or by the existing nexus of complex international agreements on capital, trade movements and intellectual property rights. What matters are the decisions taken by these 2,000 companies in order to maximise their profits.

51

5 Capital Flows and Growth1

Jaume VenturaCREI and CEPR

The integration of the world economy has been highly beneficial for the rich world. The production of cheap goods in low-cost emerging markets has been good for consumers. Meanwhile, savers who decided to invest abroad could chase higher returns than they would have enjoyed at home.

Yet, there was a darker side to globalisation. The integration of the world economy has led to the accumulation of large and persistent current account imbalances between countries. Significant current account deficits in the US and in several other rich countries are the mirror image of equally sizeable current account surpluses in China and in oil-producing nations. Such is the size of these imbalances, that they are widely perceived to be a threat for the stability of the global economy.

How did these large current account imbalances emerge? Scholars such as Caballero et al. (2008) and Song et al. (2011) have argued that they are the consequence of asymmetric financial development in the world economy. Emerging countries such as China typically have an array of capital controls in place. They are also have underdeveloped financial markets. This combination of excessive regulation and insufficiently deep financial markets acts as a constraint for capital inflows, which in turn leads to the accumulation of large current account surpluses. Bernanke (2005) and Rajan (2005) have therefore argued that the financial development of emerging economies and the relaxation of capital controls would help to solve the problem of global imbalances.

Martin and Ventura (2012) argue that firms in the developing world are significantly more heterogeneous than is conventionally assumed. If one takes into account this heterogeneity, financial development in emerging markets can worsen global imbalances, rather than improving them.

The mechanism identified by Martin and Ventura is the following. Financial liberalisation leads high-productivity firms to demand more credit. However, this extra demand for credit can crowd out investment by less productive companies. Since more productive firms invest more, their demand for intermediate inputs also increases. In turn, this raises the price they have to pay for these inputs. To give just one example, companies will have to pay higher wages to their workers.

As intermediate inputs become more expensive for everyone, low-productivity firms will see their profit margins fall. Some of these companies will be driven out of the market. More generally, the reduction in investment by low-productivity firms can prove greater than the increase in investment by high-productivity

1 Presentation based on Martin and Ventura (2012).


companies. Hence, removing capital controls does not necessarily lead to more demand for investment. If there are more low-productivity than high-productivity firms, financial liberalisation will cut demand for investment.

The study by Martin and Ventura also has implications for another empirical question economists have looked at closely, the ‘allocation puzzle’. Economists expect capital to flow to countries which enjoy faster income and productivity growth. These economies are characterised by a scarce capital stock and high returns to capital, which should attract investments. Yet, this relationship between productivity growth and capital inflows only holds in the rich world. Among emerging markets, capital flows fastest to countries experiencing the lowest economic and productivity growth.

According to Martin and Ventura, their work can solve this puzzle. Studies have shown that countries which open up their capital markets experience faster productivity and output growth. Yet, as Martin and Ventura have shown, the removal of capital controls may lead to significant capital outflows. As a result, countries with faster productivity and output growth may be those which experience the least capital inflows.

Discussant: Kevin O’Rourke, University of Oxford and CEPR

Kevin O’Rourke argued that the paper should allow for countries having specific productivities. Most importantly, the central result of the paper hinges on whether or not the wage rate (or the price of other non-tradable goods) in emerging markets is sufficiently responsive to financial reform. This may not be the case; several economists, starting from Lewis (1954), have noted that the emerging world has a very elastic supply of labour. Large numbers of workers from the countryside are willing to migrate to cities, exerting downward pressure on wages. If this is true, then even if high-productivity firms were to invest more after the removal of capital controls, their increased economic activity will not push up wages. As a result, financial reforms would not crowd out low-productivity firms and the effects hypothesised by Martin and Ventura would not occur.

O’Rourke then asks how one should interpret the emergence of large-scale current account imbalances. One possibility is that these are a transitory phenomenon. If this interpretation is correct, then current account imbalances are simply due to the desire of emerging markets to accumulate reserves. The second interpretation is that current account imbalances are an equilibrium phenomenon and, therefore, cannot be easily eliminated.

The debate between these two points of view is not new; it already cropped up in the late 19th and early 20th centuries. Both periods were characterised by current account imbalances that were much larger and more persistent than those we observe today. The key drivers of global imbalances then were the long investment cycles first identified by Simon Kuznets (Kuznets, 1930).

Trade and Growth 53

Figure 1 UK current account, 1850-2010

An interesting historical example of the emergence of large-scale global imbalances is what occurred to the UK in the first half of the 20th century. Between 1925 and 1950, Britain ran large and persistent current account deficits. The traditional view, expressed in the 1931 Macmillan report, was that these current account imbalances were the result of capital market imperfections. More precisely, these imbalances were said to be the consequence of irrationality and myopia on the side of investors. However, work by Edelstein (1982) disproved this thesis. His research showed that the long swings in domestic investments were driven by relative returns. For much of the interwar era, foreign assets offered generally higher returns than domestic assets. As a result, investors chose to invest abroad.

What about 19th century flows? The literature has found entirely rational explanations behind these imbalances too. Hobson (1902) argued that these current account imbalances were the result of a savings glut in the source countries. Backus et al. (2009) explained them on the basis of scarce investment opportunities in the source countries. Cooper (2004) and Clemens and Williamson (2004) saw them as the necessary consequence of the incorporation of the American frontier into the world economy. Emerging economies could offer higher returns to investment because of the relative scarcity of capital. A fourth explanation, by Summers (2004) and Taylor and Williamson (1994), links the creation of large-scale current account imbalances to the scarcity of savings in the host countries.

The main point to note, however, is that at least in the late 19th century, capital market outflows tended to be sustainable over the long run. Of course, there were several current account reversals. But as Meissner and Taylor (2006) have shown, the adjustment process was typically rather smooth. The real exchange rate and migration flows were two of the reasons behind these smooth adjustments. In particular, reversals were typically associated with currency depreciation (in real terms) of between 2 and 8 per cent. Current account reversals were rarely associated with banking or currency crises. Only in three out of 33 reversals


(Argentina in 1885, Chile in 1898 and Greece in 1885) was there also a currency crisis.

It is hard to say whether this system could have continued had the First World War not broken out; it is obviously impossible to perform a counter-factual analysis. However, one can say that in the early 1900s there were no warning signs that would have led us to believe that the system would have crashed down in the absence of war.

The main lesson to draw is that even large-scale current account imbalances are sustainable over the long run. Canada and Australia have run very large current account deficits for the majority of years since the 1850s. Rather than just looking at how large current account deficits are, analysts should ask themselves three questions: What is the host country is borrowing for? Which country it is borrowing money from? Is it investing the money it receives sensibly? If the answers to all these questions are reassuring, then a current account deficit can be sustained for a very long time.

Discussant: Richard Portes, London Business School and CEPR

Richard Portes analysed the implications of Martin and Ventura’s (2012) model for mature economies. Most empirical work seeking to understand the effects of capital flows on growth has dealt with emerging markets. For mature economies, the literature has concluded that financial integration has no clear, direct effect on growth. There are, however, some indirect effects. As Papaioannou and Portes (2008) have argued, financial integration acts as a stimulus to domestic financial development, which, in turn, can raise growth rates.

It is therefore essential to differentiate between financial ‘integration’ and financial ‘reform’. The former is defined as the relaxation of constraints on cross-border financial flows, while the latter is the reduction of frictions to domestic financial transactions and contracting. Martin and Ventura’s paper focuses on financial reform, but claims to be relevant to cross-border flows. However, such flows are affected by financial integration more than by financial reform.

Portes believes that Spain is a good case study for Martin and Ventura’s model. After the country entered the single currency, it experienced a relaxation of financial constraints. Yet, contrary to what Martin and Ventura predict, capital inflows went mainly into construction, a non-traded sector characterised by relatively low productivity. High-productivity sectors were crowded out. As a result, total factor productivity fell.

Spain’s experience can be generalised. The relaxation of cross-border financial constraints with the European Monetary Union led to huge capital flows from countries with abundant savings, such as Germany, the Netherlands and France, to peripheral countries. These flows went mainly into the non-traded sectors, such as construction. The price of goods produced in non-tradable sectors relative to those produced in the tradable sector increased, attracting ever more resources. Since non-traded sectors typically have lower productivity, this allocation of capital drove down total factor productivity.

Trade and Growth 55

Martin and Ventura concentrate on firms’ exit as the mechanism driving their model. Yet, Portes does not think exit is particularly relevant for mature economies. For example, Britain has for many years had a long tail of low-productivity manufacturing companies. Yet, even though the UK has a relatively open and competitive economy, these firms do not leave the market. There have been roughly 15,000 bankruptcies per year over the past 20 years. With roughly five million firms, the UK bankruptcy rate is around 0.3 per cent per year, which is almost irrelevant. Such a low bankruptcy rate is not unique to the UK. The US, which is among the most fiercely competitive economies in the rich world, has a bankruptcy rate of only about 1 per cent.

Over the last two decades, the US has experienced a phase of significant financial reform, in the shape of financial innovation. The same, however, cannot be said of Europe. Here, it was financial integration – the elimination of capital controls and currency restriction, as well as the diffusion of cross-border banking – that drove the large-scale capital movements which occurred from the core of the eurozone to its periphery.

This distinction between financial integration and financial development raises questions over whether the mechanism identified by Martin and Ventura is the most relevant for emerging markets. It is very difficult to argue that in countries such as China or South Korea, financial intermediation constraints have restricted investment. Most likely, the decision by some governments to accumulate large foreign reserves was the key driver behind global imbalances.

General discussion

Marco Pagano agreed with Richard Portes’ account of what happened in Spain. Following financial integration, capital flowed to construction, a sector characterised by low total factor productivity. Construction was characterised by a fixed stock of land and as a result, capital inflows pushed up the prices of land, creating a bubble. Foreign investors were compensated for the risks taken via higher returns to land. Yet, excessively high land prices were also one of the reasons behind the financial crisis. Financial integration has the potential to end in tears.

Pietro Reichlin asked whether the model is robust to the introduction of extensions such the inclusion of debt limits, uncertainty or precautionary savings. In the case of China, one important problem was the misallocation of savings. Many investors lent via the central bank, which then chose to invest in foreign reserves.

Francesco Caselli disputed the claim that there is an allocation puzzle. Studies have shown that private capital goes to high productivity countries everywhere, not just in the case of mature economies.

Daniel Cohen argued that the model should be extended to include housing and banking. When capital constraints are removed, capital flows to the housing sector, resulting in higher prices and, potentially, a bubble. This is what occurred


in Spain. Martin and Ventura argue that financial reform can lead to firm bankruptcies, but bank failures are just as relevant.

Giancarlo Corsetti argued that financial reform has made it extremely cheap for both households and firms of the developed world to accumulate debt. Advanced economies are now paying the price for borrowing too much. When the price of debt flipped and interest rates went up, what had initially looked like a manageable pile of debt became an enormous burden. With hindsight, it was wrong to think that financial liberalisation would be unequivocally good for the economy.

Jaume Ventura responded by saying that his paper was only discussing one type of reform: the relaxation of credit constraints in the developing world. As for the possible extensions of the model, debt limits can be included but are unlikely to alter the results. Conversely, introducing greater uncertainty may alter the response of savings. Bubbles can also be incorporated in the model, though it would be wrong to assume that they are formed exclusively in countries that liberalise their financial system. A construction bubble can crowd out other sectors and can worsen the allocation puzzle. The reason is that foreign capital is driven to countries with large construction sectors because of the high returns there. The construction sector, however, typically has low productivity growth. As a result, capital tends to go to countries with low productivity growth, worsening the allocation puzzle.

57

6 Social Costs and Benefits of the Financial Sector1

Marco PaganoUniversità Federico II, Napoli and CEPR

Economists have traditionally looked at finance as an efficient allocation machine, which ensures that capital is put to best use and that risks are shared efficiently. However, since the financial crisis and the recent array of banking scandals, many commentators have accused the world of finance of being responsible for a large-scale misallocation of resources. The media is full of reports on empty real estate developments in the US, Spain and Ireland, massive losses on the banks’ loans portfolios that were often funded by taxpayers, and the cost of foregone output and employment in the current recession, which is ultimately blamed on the excesses of the banks. The bubbles and crashes to which finance is prone are seen as a source of risk for the real economy, rather than an efficient way to share risk.

Both the benign and the malign views of finance have been with us for a long time. The Nobel Prize winner, Sir John Hicks (1969), saw finance as an engine for economic growth. To Hicks, it was not technology that sparked the Industrial Revolution. Rather, the Industrial Revolution took place in England in the 18th and 19th century because England had large and liquid financial markets that could sustain growth.

Hicks’ claim has been generalised in later work by other scholars and is also backed by a large amount of evidence. As stated by Levine (2005), “the preponderance of evidence suggests that both financial intermediaries and markets matter for growth and that reverse causality alone is not driving this relationship. Furthermore, theory and evidence imply that better developed financial systems ease external financing constraints facing firms”. In other words, developed financial systems relax the constraints facing firms and can trigger economic growth.

John Maynard Keynes (1936) held a different view. In his General Theory of Employment, Interest and Money, he talked of finance as a casino:

As the organisation of investment markets improves, the risk of the predominance

of speculation does however increase […] These tendencies are a scarcely avoidable

outcome of our having successfully organised ‘liquid’ investment markets. It is usually

agreed that casinos should, in the public interest, be inaccessible and expensive. And

perhaps the same is true of stock exchanges.

1 Presentation based on Pagano (2012).


Over the years, many other prominent economists have shared Keynes’ views. Minsky (1986, 1993) argued that the irrational behaviour which is typical of bankers and investors makes financial markets inherently prone to boom and bust cycles. Shiller (2000) argued that the housing and securities markets are prone to bubbles because of the irrational exuberance of investors. Later, scholars in behavioural finance – a relatively new branch of economics – have built an extensive body of research based on the assumption that individuals and companies are not fully rational, which is the traditional assumption made by economists.

An intermediate view is that finance is not dysfunctional per se. Still, badly designed policies and regulation can provide perverse incentives to market participants or fail to correct their mistakes. As a result, individuals take on too much risk or invest in the wrong projects. If this happens, then policy and regulation have failed and need reforming.

These contrasting views of finance may both be right. Whether finance is a force for good or is dangerous may depend on the stage of economic development a country is in.

In the early stages of economic growth, financial development (for example, the liberalisation of the banking industry) may ease credit constraints for firms that want to expand. In this case, finance should be seen as lifeblood for the economic system.

However, financial development gradually reduces the number of credit-constrained firms. As the financial system expands, increasing credit availability produces an even smaller effect on output. Lending standards begin to deteriorate. The banking system grows and eventually becomes hypertrophic, leading to financial instability. From lifeblood, finance becomes a toxin.

How does the ‘lifeblood’ side of finance work? This is linked to ‘financial development’, which can occur through at least three different channels.

First, a government can choose to liberalise the banking sector. This increases competition among existing banks. It also triggers the entry of new lenders. Savers and borrowers both benefit since they face more competitive interest rates.

Second, a country can open up its stock market. As foreigners begin to invest in it, domestic companies find it easier to raise capital. The government can also take steps to let domestic savers invest in foreign stocks. This allows them to diversify risks.

Third, reforms can strengthen investor protection. This makes savers more willing to take risks.

These three channels produce the same result: firms face less severe credit constraints. As a result they invest more, enter new markets and expand output. Funding is allocated across firms more efficiently, improving the stability of the economic system.

Several empirical studies have found a strong correlation between financial development and economic growth. However, it was typically hard to determine the direction of causality between the two variables. The result that greater financial development is correlated with faster economic growth may just depend

Social Costs and Benefits of the Financial Sector 59

on the fact that faster economic growth leads to greater financial development rather than the other way round.

More recent studies – including work by Jayaratne and Strahan (1996) on bank liberalisation in the US, by Bertrand et al. (2007) on the 1985 French Banking Act, and by Henry (2000), Bekaert, Harvey and Lundblad (2005) and Gupta and Yuan (2009) on stock market liberalisations – have overcome the problem of reverse causality and showed that financial development does indeed cause faster economic growth.

What about the ‘darker side’ of finance? It is useful to look again at what happened in several western countries in the late 2000s. Until 2007, finance expanded at a rapid pace in Europe and the US. Private credit, the leverage of financial institutions, the issuance of securitised assets and the compensation of those working in the financial sector all grew abnormally.

There were at least three reasons behind this hypertrophy of finance. First, there was an unusually fast development of ‘shadow banks’ in the US. Shadow banks include finance companies, structured investment vehicles, investment banks and government-sponsored agencies, including, for example, Fannie Mae. These institutions were outside the view of regulators such as the Federal Deposit Insurance Corporation. They were funded by the issuance of securities rather than via deposits. Their reliance on securitisation created a dangerous mutual feedback loop between asset price bubbles and their own leverage.

Figure 1 OutputofUSfinanceindustryas%ofGDP

0.0%

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1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006

Out

put a

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Originations Other fees on residential loans

Credit Card fees Securitizations on bank balance sheets

All other securitization

Traditionalbank-basedcredit intermediation

Mortgage origination and `other'- mostlyconsumer-related fees

Uncounted outputfromsecuritization

Source: Greenwood and Scharfstein (2012)


Figure 1 shows the growth over time of the output of the US finance industry as a proportion of GDP. It also shows how its composition changed over time. The data make it clear that the boom of the US finance industry did not originate from the expansion of the traditional banking sector. Between 1980 and 2008, old-fashioned bank-based credit intermediation became an ever-smaller proportion of GDP. The driving forces behind the expansion of finance were, instead, mortgage origination, other types of household lending and securitisation. The expansion of finances benefitted those who decided to work in this sector.

Figure 2 WageofUSfinanceworkersrelativetonon-farmprivatesector

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34

1930 1940 1950 1960 1970 1980 1990 2000 2010

Credit Intermediation Insurance Other Finance

Source: Philippon and Resheff (2008).

Figure 2 shows how the wages of finance workers in the US grew relative to other wages in the private sector (excluding agriculture). Between 1930 and 2010, wages in the credit and insurance sector did not rise much faster than those in the rest of the private sector. However, as of the early 1980s, the levels of compensation in asset management and investment banks began to outpace those of other sectors of the economy.

The second mechanism behind the massive expansion of finance was a period of unusually low interest rates. Cheap borrowing led to higher asset prices, greater credit creation and a deterioration in credit standards. The abundance of liquidity in the system made banks less careful about whom they were lending money to. In countries such as Ireland, Spain, Iceland and the US, when the bubble burst the consequences were dramatic.

Work by Dell’Arriccia et al. (2012) has shown how lending standards in the US dropped more in areas which experienced a dramatic credit boom and a greater increase in house prices. As for the eurozone, Maddaloni and Peydrò (2011) analysed the determinants of bank lending standards, showing how these were softened by the sharp reduction in short-term rates. Finally, research by Jimenez et al. (2011) has shown that low short-term rates induced less-capitalised banks


to lend more to riskier firms. Many companies were kept on life-support as banks engaged in greater forbearance.

Third, the anticipation of future monetary accommodation and of bailouts by governments further contributed to the deterioration in credit standards. Banks probably knew that they were engaging in excessively risky lending, but they also assumed (correctly) that they were too big to fail and that the politicians would come to the rescue if they got into trouble.

To make things worse, financial institutions took excessive risks simultaneously, as many bankers believed there was safety in numbers. Even when banks were not individually too big to fail, collectively there were too many to fail. This forced the monetary authorities to help them even though it was clear that they had taken too much risk. Once many banks began to have financial problems, the only option for the central banks was to loosen monetary policy.

However, monetary accommodation holds dangerous consequences for the future, as it plants the seeds of the next crisis. The authorities essentially tell banks they will be ready to intervene in the future if their bets go wrong again. The decision by the US government to let Lehman Brothers fail in 2008 was an attempt to adopt a tougher stance vis-à-vis their banking sector and to escape the moral hazard trap. Yet since this decision resulted in a financial meltdown, governments can no longer credibly announce that they will not come to the rescue of banks in the future.

Finance is, therefore, both useful and harmful for an economy. These two roles, however, are predominant at different levels of financial development. In other words, beyond a certain threshold of financial development, finance turns from lifeblood to toxin.

To test this hypothesis empirically, Pagano searches for a non-linearity in the relationship between financial development and three indicators: the growth rate of value added (a measure of economic development), an indicator for bank solvency, and one for systemic stability.

Rajan and Zingales (1998) analysed the effect of financial development on economic growth, using data from 63 countries. Financial development is measured either via the ratio of private credit to GDP, or via the ratio of stock market capitalisation to GDP. Their study finds that while financial development is positively correlated with economic growth in non-OECD countries, the relation becomes negative in the case of OECD countries. This supports the view that, after a certain income threshold, financial development does not lead to economic growth.

Unfortunately, the data on bank solvency do not stretch very far back; it is only possible to analyse the period between 1997 and 2010. The impact of financial development on bank solvency across all countries is negative. However, the data show that the relation is much stronger for countries with a high proportion of credit to GDP and, in particular, for those countries that have experienced a credit boom. Therefore, financial development after a certain threshold has a negative impact on banking stability. Below that threshold, these effects are much smaller or even non-existent.


Finding data on systemic instability is also difficult; they only exist for the period between 2000 and 2011. Over this timeframe, financial development has a negative effect on stability. Yet, this effect is significantly stronger for countries with a high proportion of credit to GDP, while it is absent for those with a smaller financial system. Overall, the findings on systemic stability agree with the findings on bank solvency. Financial development makes a system more unstable after a certain threshold. These pernicious effects do not exist at relatively low levels of financial development.

Since the ‘toxic’ side of finance emerges when the banking sector expands beyond a certain level, it is important to ask why regulation has failed to prevent this abnormal growth. There have been both ‘sins of omissions’ and ‘sins of commission’. ‘Sins of omission’ are cases in which a regulator did not take any action as the financial sector expanded, or simply extended the old rules by analogy. There are two good examples. One was the extensive regulatory delegation to credit ratings agencies. These agencies had been effective in the simpler corporate bond market, but were not well suited to monitoring more complex asset-backed securities. Yet regulators extended their remits, without paying attention to these limitations. A second example is the choice not to regulate the setting of the LIBOR rate even once this had become the benchmark rate for trillions of financial contracts. The size of this market created huge conflicts of interest for the banks making individual submissions. Traders attempted to manipulate the rate in order to make profits on derivatives benchmarked on LIBOR. Governments should have placed the setting process under regulation, as indeed, they are doing today. Instead, they allowed self-regulation to remain the norm.

There were also ‘sins of commission’, which can be defined as inappropriate changes to the rulebook. In the US, politicians let government-backed agencies guarantee high-risk loans. They also allowed the FDIC to lower banks’ capital requirement for investments in mortgage-backed securities and collateralised debt obligations to a fifth of the original level (from 8 per cent to 1.6 per cent). Both mistakes were due to the same political reason. Politicians were keen to support widespread homeownership across the country.

In Europe, the European Commission allowed banks to apply a zero risk-weight on all their eurozone sovereign debt holdings when calculating capital ratios. This meant that banks lent too much money to sovereigns, tying their own destiny to one government. Once again, this had a precise political intent: to ensure that the demand for sovereign debt was high in order to keep interest rates low.

Other good examples of a ‘sin of commission’ are what happened in Iceland and Spain. In Iceland, as documented in the work by Benediktsdottir et al. (2011), politicians were instrumental in allowing a tiny fishing and aluminium-producing economy to turn itself into a platform for international banking. Politicians chose to sell state-owned banks to crony capitalists. They also allowed these lenders to borrow vast amounts from the international capital markets, with an implicit government guarantee. Finally, politicians failed to equip the


country with the adequate supervisory authorities for the scale of the banks. When the bubble burst, the country paid a heavy price for these mistakes.

In Spain, regional politicians were extremely close to the managers of the cajas and to real estate developers. Together, they formed a powerful social coalition, which chose to channel vast amounts of credit towards the construction sector. Work by Cuñat and Garicano (2009) has shown how the cajas headed by politically appointed managers tended to lend more to real estate developers and, as a result, performed worse during the crisis. In separate work, Garicano (2012) has underlined how the same political connections can explain the failing of the Banco de España to properly supervise the cajas.

In conclusion, when economists assess the merits and faults of finance, they have a tendency to be excessively influenced by current events. In recent years, the crisis has painted an overly bleak picture of finance. Yet, finance has an important role to play in supporting growth helping the efficient allocation of capital. The key issue for policymakers in the developed world is to understand when finance becomes too large for the good of the economy, and what should be done to prevent this from happening.

Discussant: David Thesmar, HEC and CEPR

In his discussion, David Thesmar looked at why financial instability is not always a problem and why exactly financial development can make an economy less stable.

For Thesmar, instability is not always a problem. Of course, a chain of bank insolvencies can produce a financial meltdown. However, having some instability in an economic system is a prerequisite for the Schumpeterian process of creative destruction. Without instability, it is impossible to reallocate resources and funds from incumbents to entrants, which is essential for economic growth.

Thesmar also contends that while financial development does make growth more volatile, higher volatility does not mean lower growth. This claim is supported by evidence from Ranciere, Tornell and Velasco (2006).


Figure 3 Thailand vs. India: Credit and growth, 1980-2002

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As Figure 3 shows, between 1980 and 2002, Thailand enjoyed much faster credit growth than India. Output volatility was greater in Thailand, but economic growth was faster. While in 1980 the two countries had roughly the same level of GDP per capita, by the 2000s Thailand was substantially richer.

Financial development has several other advantages. Financial integration can lead to a greater synchronisation of asset prices. As Landier et al. (2013) have shown, since banks were allowed to operate in multiple states in the US, asset prices became more correlated across the union.

Rather than opposing financial development, policymakers should focus on apt ex ante and ex post regulation. Unfortunately, ex ante regulation is hard. It is impossible to say whether a certain level of capitalisation is adequate before a crisis. Some steps can nonetheless be taken. At the micro-prudential level, policymakers should ask themselves whether credit ratings are a reliable way to measure risk. They should also ensure that banks are not overly dependent on short-term funding, which can be reversed quickly, causing dangerous liquidity shortages. From a macro-prudential point of view, regulators need to monitor carefully deleveraging externalities. When all banks stop lending, this leads to lower asset prices. This reduces a bank’s capital, which, in turn, forces it to lend even less. The same process occurs when all banks decide simultaneously to sell their assets. Asset prices go down, forcing banks to sell even more. Regulators must find ways to break these vicious circles.

Capital adequacy ratios and liquidity ratios are two further key aspects of ex ante regulation. Yet, it is hard to establish how high they should be. Setting them at a too high a level can choke off lending and damage the economy.

Since ex ante regulation is difficult, it is essential that governments put in place an adequate system of ex post regulation. In particular, one cannot underestimate the importance of mechanisms to facilitate debt restructuring. These should cover all sovereign, household and bank debt. Having an effective debt restructuring mechanism is essential in the so-called Minsky moments, when over-indebted investors are forced to sell off their assets to pay back their loans. In the case of systemic “too-big-to-fail” banks, the absence of restructuring mechanisms during


a Minsky moment forces governments to step in and use taxpayers’ money to fund a bail-out.

One risk of putting in place universal debt-restructuring mechanisms is that markets will conclude that there are no more ‘safe assets’, i.e. assets on which investors know they will never lose the principal invested. It is still unclear whether markets can still work efficiently without safe assets.

The other important question for regulators concerns the shadow banking system. The US shadow banking system has assets worth $2trn more than the ordinary banking system. In the eurozone, the conventional banking system holds assets worth €30trn, while shadow banks ‘only’ about €10trn. However, even in Europe the size of non-banking financial institutions is destined to grow. Policymakers would be wrong to neglect its supervision.

When regulating the shadow banking system, governments should ask themselves whether or not it is systemic. One way to understand this is by exploring what would happen if securitised loans defaulted.

If these loans have been guaranteed by traditional banks, then the shadow banking system has the potential to cause a full-scale financial crisis. If this is not the case, then the maturity transformation is achieved through the secondary market. This is less of a problem for policymakers, who may be tempted to follow a less heavy-handed regulatory approach. Yet, an additional problem is that liquidity can still freeze in these markets. In 2008, the ABCP market froze. Since then, the repo market has shrunk substantially.

In conclusion, having a hypertrophic financial system can lead to greater instability. The welfare impact of greater instability, however, is ambiguous. For example, more volatility in output can be accompanied by faster economic growth.

Policymakers should concentrate on establishing an effective regulatory regime. Ex ante regulation, however, is hard to implement. This is why ex post regulation is paramount. In particular, debt should be treated more like equity. Policymakers should ensure that effective debt-restructuring mechanisms are put in place. Finally, regulators should ask themselves whether shadow banks are systemic. If the answer is yes, then there is a strong case for stricter regulation.

General discussion

Pietro Reichlin asked whether the most important trade-off policymakers should concentrate on is that between insurance and moral hazard. Governments must decide whether they feel comfortable insuring the banking system, even though this can lead bankers to take excessive risks. It is possible that western governments are changing their position vis-à-vis this trade-off, since they have realised that they have offered too much insurance to the banks.

Francesco Caselli thought that the idea presented by Marco Pagano is quite plausible. In fact, it is also relevant to savings decisions taken by individuals. The initial stages of financial development allow individuals to save for their retirement or to tackle negative health shocks. This is socially useful. So, at low


levels of financial development, the expansion of banking services is socially useful. However, at higher levels of financial development, people start taking excessive risks, which can be damaging for society.

Lucrezia Reichlin pointed out that much of the development literature has said the opposite of what Pagano is claiming in his paper. It is traditionally deemed preferable to have more financial repression and regulation at early stages of financial development. This is a way to protect financial markets from flows of ‘hot’ money, which can easily be reversed, potentially causing a financial crisis. One possible way to reconcile the literature with Pagano’s paper is that his work concentrates on the size of the financial sector, while the development literature stating the opposite has focussed on the volatility of finance.

Graziella Bertocchi emphasised how in developed countries, finance can have some positive redistributionary effects. For example, subsidised loans to students and to immigrants can have large welfare effects.

Carlo Favero underlined how the paper should have looked more closely at the effects of fiscal policy and its interaction with monetary policy.

Kevin O’Rourke stated that the Industrial Revolution was not helped by financial liberalisation. Earlier on in the 18th century, Britain had experienced a huge bubble, which was quickly followed by a regulatory clampdown. So the 18th century was not an era of financial development. Moreover, many of the technological innovations which we traditionally associate with the Industrial Revolution occurred via private partnership, so had nothing to do with the availability of capital on the public market or with banks. In 18th and 19th century Britain, it was economic growth that led to financial deregulation, not the other way round.

Gianni Toniolo pointed out how the American experience at the end of the 19th century might be more relevant for Pagano’s work than the Industrial Revolution. In the US, financial markets were an important engine of economic development, in spite of their volatility.

Marco Pagano replied by saying that the western world has not yet picked an optimal point between the beneficial and the damaging effect of finance. This is a problem of political economy: as the financial sector grows, so does its ability to capture regulators and politicians. When politicians are captured, they pass laws that allow banks to expand further, strengthening this vicious circle. Volatility is not always damaging. As we know from Schumpeter, creative destruction can lead to economic growth. But volatility can be a source of instability too, which is damaging for economic development.

67

7 Private Equity

7.1 Venture and growth capital investors

Francesca Cornelli1

London Business School and CEPR

Over the last decade, the media from around the world has not been particularly kind to the world of private equity. Many commentators have claimed that the only contribution private equity firms make to the companies they take over is in the shape of financial and tax engineering. Critics are all the more vocal in the case of leveraged buyouts. In this case, purchases are financed through a combination of equity and debt. The cash flow and the assets of the target company are used to secure and repay the debt raised to finance the deal.

Despite this negative press, there are several reasons why private equity can perform a useful function, both for the target firms and for society as a whole. A leveraged buyout means that the incentives of the buyer and those of the target firm are often well aligned. It can also lead to more effective monitoring and to qualified advisory support. The changes in corporate governance instrumented by a private equity deal can help tremendously in turning a company around. Venture capital firms – a specific form of private equity – can foster innovation and the creation of new companies. Venture and growth capital can provide an alternative source of financing for small and medium enterprises. There is a discussion to be had on whether venture capital firms really improve performance by enforcing better monitoring, or if they only have a screening function – distinguishing success stories from failures, without adding much value. Yet, in the present climate where firms face difficult access to capital, even if venture capital funds were just performing a screening role, this would still be useful.

Around two-thirds of private equity investors operate in the field of leveraged buyouts. The remaining third is made up of venture and growth capital investors.

Cornelli chose to concentrate on the latter segment of the industry. Measuring the impact venture and growth capital investors have on target

firms is difficult. The industry is extremely secretive and, therefore, there is not much data to look at. Yet, there is some evidence that venture capital in particular can perform a useful role. Hellmann and Puri (2000, 2002) provide evidence that venture capital is positively related to a variety of measures of professionalism. Companies backed by venture capitalists tend to hire better managers and are more likely and faster to replace their founder with an outside CEO. Bottazzi et al. (2008) show that venture capitalists improve the performance of their portfolio companies by helping to recruit qualified managers or board members. They are also useful in arranging follow-on funding. Kortum and Lerner (2000)

1 Presentation prepared for this conference.


have evidence showing there is a positive effect of venture capital on patented inventions.

Using Ernst and Young data on the exit of private equity investors between 2007 and 2010, Cornelli offers an overview of what venture and growth capital firms can add to a target. This goes beyond financial capital. In many cases, venture and growth capital firms can help targets to cut costs, which improves margins. But they also change the product offering (13 per cent of cases in the study), help to create new products (22 per cent) and promote geographical expansion (17 per cent). Additional advantages include fostering brand promotion and helping to improve a company’s value proposition.

Furthermore, a 2002 survey by the European Private Equity and Venture Capital Association shows that investment by venture capital firms is used to fund value-added developments. The survey shows that, on average, between the time of the initial investment and the time of the survey, venture capital firms increased the investment in training and marketing expenditure by around 1,200 per cent, investment in capital expenditure by 800 per cent, and investment in R&D by 1,400 per cent. A different survey shows that the three single most important contributions by the venture capitalist to targets are strategic advice, networking opportunities and connections, and focus and support. Of course, this last piece of evidence comes from the industry itself, but this result is corroborated by other, more impartial, evidence.

If these claims are true – and there is some evidence that they are – then mature economies should have an interest in attracting venture capital firms to support their entrepreneurs. A survey by Deloitte (2010) has asked which policy changes would create a more favourable climate for venture capitalists. Top of the list is “an improving entrepreneurial environment”, which is listed as important by 59 per cent of the firms surveyed. In second and third place are “a strong R&D climate supported by the government” and “a growing market”, which are deemed relevant by 49 per cent and 43 per cent, respectively.

The survey also presents evidence of what factors venture capitalists believe create an unfavourable climate. Top of the list is “difficulty in achieving successful exits”, which is named by 72 per cent of respondents. Hence, making both IPOs and trade sales easy is bound to attract more private equity firms. “Unfavourable tax policies” and “unstable regulatory environment” are second and third, deemed important by 56 per cent and 48 per cent of the surveyed venture capital investors, respectively.

What do private equity limited partnerships think of Europe as an investment destination for venture capital? The Global Private Equity Barometer for 2011-12 shows that private equity firms do not want to act in the field of venture capital. Instead, they are more interested in financing mid- and small-market buyout funds and growth capital.

How can we explain this? First, there are some industry-wide trends. Venture and growth capital funds have become less appealing than buyouts. This is, in part, driven by returns. According to Prequin, private equity growth funds raised in 2005 and 2006 generated a net median internal rate of return of 25 per cent

Private Equity 69

and 7.8 per cent globally, versus 10.2 per cent and 6.1 per cent for buyouts. Prima facie, this would suggest that growth funds perform better than buyouts.

However, venture and growth capitalists experienced a reduction in realisation activity in the second half of 2011, which was mainly due to the slowdown of IPO markets. In the third quarter of 2011, private equity-backed IPOs fell by 84 per cent. In the first three quarters of 2011, 41 private equity-backed companies withdrew their IPOs. Still, venture and growth funds experienced a modest increase in investment activity over the same period. Buyout activity, however, increased much more.

Survey evidence of limited partnerships confirms this negative outlook for venture and growth capital. The Global Private Equity Barometer for 2011-12 shows that 64 per cent of LPs believe that only a small number of venture capital firms worldwide will generate consistently strong returns over the next decade. One fifth of the LPs believed that no venture capital firms will be able to deliver consistently strong returns.

This data suggests that venture and growth capital funds face difficulties everywhere in the world. However, other research shows that there may also be a peculiarly European problem. The same study from the Global Private Equity Barometer shows that 57 per cent of European LPs believes there will be an early-stage venture capital funding shortfall in the region. This contrasts sharply with the opinion of North American LPs, only 33 per cent of which believe there will be a shortfall.

Furthermore, data from Thomson Reuters shows that venture capital fundraising in Europe fell from £12.23bn to £4.99bn between 2006 and 2011. The lack of enthusiasm for investing in Europe is in stark contrast with the situation in the rest of the world. Globally, venture capital fundraising has almost doubled between 2009 and 2011, rising from $31.98bn to $58.33bn. Over the same period, the amount raised in Asia has quintupled, going from £6.09bn to a record £32.11bn. Data from Deloitte (2010) shows that venture capital is moving from Europe to the emerging markets and, in particular, to Asian countries such as China and India.

The main reason behind this trend is that returns to venture capital in Europe have, quite simply, not been there. There are several explanations for such a poor performance. The first is insufficient investment. Venture capital investment as a share of GDP in Europe between 1993 and 2008 was only 0.03 per cent, which is only a quarter of the US level. The fact that there were so few investments explains the low returns. However, one cannot rule out the possibility that causality may have been the other way around, with low returns attracting little investment. A second explanation for the poor returns of venture capital in Europe is that it is excessively organised across country lines. This limits the size of the market for start-ups compared to, say, the US. Third, the available funding is spread too thinly. Fourth, Europe suffers from insufficient portfolio diversification, but, once again, it is not clear whether this is a cause or a consequence of low returns. Fifth, studies such as Bottazzi et al. (2004) have argued that European venture capital managers have an inappropriate background. Sixth, there may be poor exit options. However, the data seem to dismiss this last hypothesis.


A seventh hypothesis, which Cornelli focuses on, is the difficulty for venture capital funds to obtain financing from pension funds because of conservative regulation. As a result, only Sweden, the Netherlands and the UK have pension funds that invest heavily in private equity. In Europe, venture capital is more often backed by government agencies. In 2009 and 2010, these provided more than 30 per cent of funding, compared to around 10 per cent in the US.

Because of the lack of funds from pension funds, venture capital firm often had to rely on public funds. Unfortunately, government-backed venture capital has often proved unsuccessful. In part, this is due to how the government chose to provide funding. In some cases, governments have tried to insure venture capital investors against their losses. However, this defeats the raison-d’etre of private equity: investors should face the risks involved.

Two final explanations for the poor performance of venture capital investments in Europe have to do with the lack of investment opportunities and the lack of a venture capital-friendly ecosystem. The first explanation would suggest that Europe does not have enough profitable projects for venture capitalists to invest in. As a result, governments should focus on encouraging entrepreneurship and creating managerial skills. The second explanation would mean that governments should seek to create an environment that can help the financing and growth of start-ups. One example is the recent attempt to create a Tech City in London.

Since venture capital has failed to take off in Europe, European governments are looking at possible alternatives. These include corporate angels, corporate venture capital, government funding of venture capital, and the creation of ‘pools of money’ through regulation of pension funds. In particular, government support programmes have proven popular. Among them is the Equity Enhancement Program. This caps the profit entitlement of the public investor and guarantees compensation to private capital. Yet, there is a risk that the state may just be offering a subsidy to private money.

One such example is the UK’s Enterprise Capital Funds scheme. Its key objective was to increase the availability of growth capital for small and medium-sized enterprises. It should have encouraged an increased flow of private capital into these enterprises by adjusting the risk-reward profile of private investors who choose to make these investments. It should have also lowered the barriers to entry for entrepreneurial risk capital by reducing the amount of private capital needed to establish a viable venture fund.

The ECF scheme was aimed at plugging the so-called ‘equity gap’ facing companies with equity needs of up to £2 million. The government would leverage the private sector investment either directly, i.e. using its own funds, or indirectly, i.e. providing a guarantee for debt raised in the market. The maximum leverage ratio was fixed at 2:1 and it was decided that the maximum leverage would amount to £25 million. In return, there would be a fixed return to government on the leverage, equal to roughly 4.5 per cent, which would be prioritised over all other investors. This would then be followed by pari passu repayment of capital to both the government and all other private investors. Thereafter, the government would receive a fixed share of profits, which was

Private Equity 71

negotiated at the outset. So would private investors, who would pay any carried interest to the manager as negotiated and agreed at the outset.

In order to limit the risk that the private sector will free-ride on public sector capital, the UK scheme was characterised by an asymmetric profit share and, crucially, by private sector first loss. Yet, the risk of moral hazard remains.

Rather than subsidising venture capital through government money, policymakers in Europe should focus on allowing pension funds to invest venture capital funds. A key move is to encourage the creation of large pools of money over a plurality of small funds. Small pension funds do not have resources to screen companies and initiatives. Conversely, large pools are typically able to pick winners. Once a government has created a large pool of money, it should force it to invest a fixed proportion of its resources in infrastructure funds, venture capital and growth capital funds. This is what happened in Peru and Chile, with some success. Europe can learn from the experience of South America and help venture capital thrive.

Discussant: Ulf Axelson, London School of Economics

Ulf Axelson also thinks there is a dissonance between the public perception of private equity and the role it can play in society. The public imagines private equity deals as overleveraged financial operations, whose main aim to shed jobs. However, economic research shows that, especially in the realm of venture capital, social returns are typically higher than private returns. In fact, the main failure of venture capital is its inability to generate sufficiently high private returns.

There is a strong economic case for private equity. Dispersed shareholders have little incentive or means to monitor the management of a company. The opposite model, that of family firms, does not work either. Here, individual families bear too much risk and may not be best suited to running a firm. While family firms successfully align the incentives of the management and the owners, risks are too concentrated. Furthermore, evidence shows that the second and third generation of a family is not as creative as the first. Private equity is a good intermediate solution, since it provides firms with strong, expert and informed owners.

As Axelson et al. (2009) have shown, profit-sharing gives private equity firms the incentives to choose the best investment opportunities and to continue monitoring them. When profit-sharing is based on money pools, instead of single deals, private equity firms avoid gambling. Finally, the need to raise debt for each deal operates as a market check, with banks acting as gatekeepers. The limits on the ownership terms give focus and urgency. Since a private equity investor’s track record affects future fundraising, there is a strong incentive to perform.

There is also evidence that private equity investors add value to the companies they finance. Accounting studies are generally quite positive. Kaplan (1989) has looked at a range of public-to-private deals in the 1980s in the US, showing how target firms enjoyed big improvements in terms of efficiency. Studies based on European data, as well as on private-to-private deals, have confirmed this finding.


A later study on private-to-private deals for the US by Cohn et al. (2013) also found improvements, albeit quantitatively smaller.

It could be argued that these improvements in profitability mean that private equity deals always reduce employment in the target firm. European data, however, do not back this hypothesis. Boucly et al. (2009) have found that private equity deals in France had a positive effect on employment. In the US, they led to greater churning, accelerating both job creation and job destruction. Finally, Stromberg (2007), Lerner et al. (2010) and Cao and Lerner (2009) rule out the hypothesis that private equity deals are short-termist.

As for the broader impact of private equity on the economy, there is evidence of positive spillovers. Studies of leveraged buyouts in the 1980s show that these deals led to better governance in public firms. Bernstein et al. (2010) analyse data from a broad pool of countries and industries. They find that private equity is responsible for 2 percentage points of economic growth per year, mainly due to higher exports. However, Axelson believes that this figure is probably too high.

Looking at venture capital instead of private equity as a whole, Griffith (2000) has found that in the case of venture capital funds, social returns to investment in R&D are significantly higher than the private returns. Brown et al. (2009) have argued that the venture capital-driven IT boom of the 2000s has increased R&D and led to long-term productivity gains for the economy.

These studies suggest that the social returns of venture capital are high. Does this mean that the private returns are also high? Not necessarily. Social returns can be higher than investor returns for several reasons. First, funds receive high fees. Selling shareholders also benefit from high premia. Second, private equity deal may produce wider externalities on the economy, such as innovation.

The best available indicator to assess the private returns of private equity funds is the public market equivalent (PME). The PME compares the performance of a private equity investor to that of the stock market. A PME of 1 means that private equity fund has done just as well as the stock market. A PME above 1 means that a private equity fund has outperformed the public market.

Figure 1 PME, buyouts

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Figure 1 shows data relative to the PME for 629 funds of leveraged buyouts between 1979 and 2010. Looking at the median PME, private equity funds outperformed the stock market in most of the period. The relative performance of private equity was particularly strong in the early 2000s, when even the worst performing funds managed to beat the stock market.

Figure 2 PME, venture

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Figure 2 shows the PME for 535 funds of venture capital between 1979 and 2010. Overall, the performance of venture capital funds was more disappointing than that of leveraged buyouts. Their median PME is often below 1 and, for much of the past decade, even the best-performing quartile has barely beaten the stock market. Meanwhile, the worst performing quartile of the funds analysed had a PME below 1 for almost all the years under consideration (1979-2010).

One should also compare the returns of private equity with the investment risk. Axelson et al. (2013) find the betas of leveraged buyouts to be 1.9. This means that investing in leveraged buyouts is roughly twice as risky as investing in the stock market. Since the returns of buyouts are often less than twice as high as the stock market, leveraged buyouts are not a particularly attractive investment proposition.

The risk/reward profile of venture capital is even worse. Here, risk – as expressed by the betas – is close to three times as high as in the public market. Conversely, the returns are only marginally better. Furthermore, investors in both leveraged buyouts and venture capital should be compensated for the lack of liquidity but are not. For these reasons, the private returns to investment in private equity – and in venture capital in particular – are low.

Why do buyout and venture capital deals offer private rates of return that are so low? One possibility is that private equity relies too much on debt and venture capital too much on ‘bubbly’ IPO markets. In the case of buyouts, leverage is almost entirely driven by how easy it is to borrow. But since buyout firms typically want to borrow when credit is in high demand, they risk paying too much for it, lowering the returns of their deals. In case of venture capital, returns are generally driven by the success rate of IPOs. However, as Axelson


and Martinovic (2013) have shown, the success rate of IPOs in both the US and Europe has fallen sharply since the highs of the early 1990s. This has had an inevitable negative effect on the returns of venture capital.

The recent poor performance of IPOs is the best available explanation for why private equity has done so much better Europe than in the US. As shown by Axelson and Martinovic (2013), all the other factors which are normally mentioned are marginal. True, Europe has a small pool of serial entrepreneurs, but it is rising. The stigma of failure is no higher in Europe than it is in the US. While Europe has fewer experienced venture capital funds than the US, it is catching up and its markets are consolidating.

Overall, the social returns to both private equity and venture capital appear adequate. However, the private returns in venture capital markets are far from impressive. Both buyouts and venture capitals are too cyclical, since their success is driven by boom and busts in debt and equity markets. Governments can help irrational investors, but it would be wrong to deny the difficulty of the challenge, particularly for venture capital funds.

Discussant: Laura Bottazzi, Bologna University

Laura Bottazzi emphasised that it is very important to distinguish between private equity and venture capital, since they have different effects on innovation, employment and economic growth.

There is abundant evidence that venture capital promotes innovation. Kortum and Lerner (2000) and Hirukawa and Ueda (2008) found this link using industry-level data. Hellmann and Puri (2000), Chemmanur et al. (2011) and Engel and Keilbach (2007) used a firm-level dataset to show that venture capital is associated with more innovative companies. Overall, the empirical evidence is consistent with the notion that venture capitalists select more innovative companies and then help them with the commercialisation process. However, while there is plenty of evidence of correlation between venture capital activity and innovation, it is much harder to establish a causal link.

While both venture capital and private equity seem to have a positive effect on innovation, it is important to distinguish between the two when one wants to assess their impact on employment and growth. Work by Samila and Sorenson (2011) and Mollica and Zingales (2010) has shown that there is a positive correlation between venture capital, entry and employment at the aggregate level. Puri and Zarutskie (2011), Chemmanur et al. (2011) and Engel and Kelibach (2007) find the same positive relationship at the company level.

The effect private equity has on growth and employment is a matter of great debate and concern. Regrettably, there are significant problems of measurability. Younger firms, which are the typical target of leveraged buyouts, are bound to grow more. It is hard to say whether their growth should be attributed to the beneficial effect of private equity. Davis et al. (2008) used a longitudinal business database to follow and track employment before and after private equity transactions at the level of both firms and plants. They find that the target firms

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typically decrease their level of employment, while creating more new jobs in their new plants. They also find that these companies tend to acquire and divest plants more rapidly.

Bottazzi and Da Rin (2002) analysed a sample of 540 companies that went public on three of Europe’s then new markets for technology. Their findings show that the post-IPO operating performance of venture capital-backed firms is not significantly different from that of other public technology companies. This would deny the existence of a venture capital ‘added value’.

Bottazzi and Da Rin employ the Survey of European venture capital funds (SEVeCa). Their dataset includes information on 108 venture capital funds from the EU15 countries; 12,16 companies from the EU15, US, Norway and Switzerland; and 1,277 realised deals in the period between 1998 and 2001. They also make a special effort to construct the average human capital profile of the venture capital funds, by measuring the partner’s years of experience as a venture capitalist, the partner’s prior business experience and the partner’s scientific education. The authors aim to understand what kind of human capital is conducive to an active investment style.

Their main finding is that venture capital firms with partners that have prior business experience are generally more active. This means that they are more likely to recruit managers and directors directly, help with fundraising, and interact more frequently with their portfolio companies. They also found that independent venture capital investors are more active than enterprises which are owned by a bank, a corporation or the government. Finally, investor activism is shown to be positively related to the success of portfolio companies, even after accounting for the fact that weaker companies are more likely to seek value-adding venture capital.

Bottazzi and Da Rin also found that differences in the institutions matter for the success of venture capital. Investing in supporting activities is only worthwhile if the legal system provides investors with sufficient guarantees that these efforts will not be wasted. Generally, intermediaries from countries with a better legal system will provide more value added services, even when investing abroad.

One question left unanswered is why the demand for venture capital activities is low in some parts of Europe, such as Italy. Among the possible explanations, Bottazzi suggested legislation and difficulties in developing entrepreneurial activity, labour market rigidities, lack of knowledge on markets, shortage of skilled labour and poor access to finance. Generally, the analysis of these barriers shows that there are differences across firm types and across country groups.

General discussion

During the discussion, Andrea Landi asked whether the government could take steps to promote private equity in Europe, for example by providing tax incentives. The EU should also be involved.

Francesca Cornelli responded that, on the whole, tax incentives are typically distortive. Also, the government needs to be clear about why it chooses to


intervene in venture capital funds. For example, its aim may be to promote some sectors of the economy, or to foster technological spillovers.

7.2 Technology2

Joshua Lerner Harvard Business School

It only takes a quick glance at the chart mapping the evolution of public debt to realise how important it is for mature economies to resume sustained economic growth. The US is an excellent case in point.

Figure 1 Federal debt held by the public under CBO’s long-term budget scenario

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Figure 1, from the Congressional Budget Office, shows how, under current baseline budget projections, public debt is predicted to rise to close to 200 per cent of gross domestic product by 2035. This is unsustainable. Without sustained economic growth, only large-scale spending cuts and tax hikes can ensure that public debt does not explode.

There are two avenues to growth. The first is to use more inputs, increasing the capital stock, the number of people in work and the amount of time spent working. The second is to get more output from existing inputs. This can occur either by combining existing inputs in a more efficient way, or through technological progress.

Economists have long understood the importance of the link between innovation and growth. Starting with the pioneering work by Solow (1956) and Abramovitz (1986), several studies have repeatedly shown that, in the long run, innovation is the only avenue to growth. In fact, 85 per cent of growth is explained through innovation.

There are two primary avenues to innovation. The most common one is corporate R&D. In the industrialised world, 60-70 per cent of the funds going to innovation are channelled through this model. China is also following this

2 Presentation of Lerner (2012).

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route, while Russia was the first large economy in which corporate R&D spending was below 50 per cent of total R&D spending. The second avenue, which has emerged since the Second World War, is made of venture-backed entrepreneurial activity.

Figure 2 Company and non-federal R&D spending by company employee size

As Figure 2 shows, corporate R&D has traditionally been associated with larger firms. Back in 1984, around 60 per cent of company R&D spending occurred in companies with more than 25,000 employees. Since then, the proportion of innovative activity in smaller businesses has been constantly on the rise. Yet, in 2007, larger firms were still responsible for only a third of corporate R&D spending.

There are some good reasons why the bulk of R&D spending takes place in larger firms. The first has to do with efficient risk-management. R&D projects are conceptually similar to financial options: they can deliver innovation or fail. Large firms can spread the risk by running many parallel projects. This is equivalent to building a portfolio of options.

Second, large firms can exploit synergies between seemingly unrelated projects. Throughout corporate history, many successful research projects have been the product of joint work by researchers working in different areas. This is why businesses prefer to have flat – rather than high-powered – incentive schemes. They do not want to dissuade different research teams from collaborating.

Third, large firms are in a much better position to adopt a long-term perspective, which is essential for R&D activity to be successful. Many R&D projects can deliver high net present value for companies, but these gains are often reaped only after many years and can require sizeable up-front investment.

Businesses, however, have become increasingly dissatisfied with the traditional corporate R&D model. This is seen as capable of producing only second-tier innovation, instead of radical change. Furthermore, the soft incentive schemes


normally adopted by corporate R&D departments are ill-suited to promoting more revolutionary innovations.

A good example is what happened to Motorola, a world leader in the production of mobile phones with a long history of successful product innovation. Motorola’s researchers concentrated on very incremental research. In the late 1990s, Motorola filed over 50 patents for battery latches. However, they missed the boat on smartphones. This mistake lost the company its technological and commercial leadership.

Widespread disappointment with the traditional corporate R&D model has led to the decline of centralised research. Data from the Industrial Research Institute show that the share of internal R&D funding from corporate sources declined throughout the 1990s and then accelerated in the 2000s. Corporations have also moved away from soft incentives for the heads of their R&D departments. Lerner and Wulf (2007) have shown how, between 1987 and 1998, the combination of bonuses and long-term incentives moved from being around 60 per cent of the compensation of heads of R&D departments to around 70 per cent.

However, it is becoming increasingly clear that the centralised research model is not working. What is much less clear, however, is whether alternative approaches can deliver better results. Abandoning the traditional R&D model may simply mean that firms have stopped seeking long-run opportunities and have become victims of short-termism. Also, there are questions over high-powered incentives. It is unclear how payments can be linked to performance while retaining cooperation.

The most prominent alternative model to internal corporate R&D is venture capitalism. The first venture capitalist was George Doriot, an academic at Harvard Business School. In the 1940s, Doriot was worried that the US economy would stagnate after the boom caused by the war effort. He also thought there were substantial limits with the then-prevalent system of R&D. Since both banks and public markets were ill-designed to promote innovation, Doriot thought there was both the space and the need for a new type of financial institution. This should play three different roles: sorting the best business opportunities from the less profitable ones, governing the process of innovation, and certifying its results. This marked the birth of venture capitalism.

Has the new model fulfilled the high aspirations of its creator? To some extent it has. Kortum and Lerner (2000) looked at evidence spanning 20 industries. They used data on patenting and other proxies to establish the relationship between venture capital, corporate spending and innovation. The main result of their study is that, even controlling for endogeneity, venture capitalism is 3-4 times more powerful than corporate R&D in promoting innovation. From the late 1970s to the mid-1990s, funding for venture capitalism was only 3 per cent of funding or corporate R&D. However, venture capitalism was responsible for between 10 and 12 per cent of privately funded innovations.

Nevertheless, one should be cautious before concluding that venture capitalism is a superior model to promote innovation. Firstly, venture capitalism is largely a US phenomenon. In 2010, almost three quarters of venture investment was performed in the US.

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Figure 3 Venture investments as a share of GDP, 2010

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Figure 3 shows venture investments as a share of GDP across the world in 2010. Hong Kong had the highest level for any country in the world, but this is a statistical artefact. Many Chinese venture capital firms have chosen to domicile in Hong Kong for tax reasons. Venture investment as a share of GDP in the US was 0.2 per cent, the highest of any advanced economy, and more than double that of all European countries.

It would be wrong, however, to assume that European entrepreneurs are irrational not to adopt the venture capital model. Venture capital firms tend not to perform worse in Europe than they do in the US. Data from Thomson Reuters (2011) on mature venture capital funds show that, between 1990 and 1998, returns to investment in the US were as high as 37 per cent, while in Europe they were only 8 per cent. It could be argued that this data is skewed because of the Dotcom bubble, which disproportionately benefited US start-ups. However, US venture capitalists performed better even after the end of the boom. Between 1999 and 2005, investment from venture capital companies in the US has delivered, on average, zero returns. In Europe, the average return to investment has been -5 per cent, an impressive accomplishment in terms of destroying value.

Second, venture capitalism is much better suited to some sectors of the economy than it is to others. Figure 4 shows an index of venture capital returns by sector. Even after the Dotcom bubble, venture capital investments in hardware and software companies have delivered the best returns. Conversely, venture capital investments in pharmaceuticals have underperformed the stock market.

Third, investors in venture capital have a dangerous tendency to invest at the wrong time. Lerner shows how there is a strong correlation between the amount of funds raised by investors in venture capital and investment returns, a symptom of myopia. Furthermore, the prizes of venture capital are shared among few winners. Lerner et al. (2007) look at the returns by investor type for venture funds between 1992 and 2001. Endowments gained the lion’s share, while banks,


insurers, funds-of-funds, and public and private pension funds enjoyed marginal or even negative returns.

Figure 4 Index of venture capital returns by sector

Source: Sand Hill Econometrics (2011)

This overview of the corporate R&D and the venture capital models shows that both systems of doing R&D are under severe pressure. This is dangerous, as the need for innovation has rarely been more pressing than it is today. Lerner asks whether there is room for a third way, which combines the strengths of corporate R&D with those of the venture model. Such an intermediate model could juxtapose the rapid response and high-powered incentives of venture capital to the long-run aims of corporate R&D.

Figure 5 Return of corporate venturing

Source: National Venture Capital Association (2011)

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As shown in Figure 5, ‘corporate venturing’ had become very popular in the late 1990s, just before the Dotcom bubble. In 2000, the proportion of venture capital investments funded by corporations had peaked at 15 per cent, to then fall immediately after the crash. Following a long period of stagnation, corporate venturing is making a comeback, having reached 10 per cent of venture capital investment in the first three months of 2011.

The ‘corporate venture’ option is not without problems. As shown in Figure 5, corporate venture capitalists also invested at the wrong time, for example just before the Dotcom bubble burst. The history of corporate venture capital is full of terrible investment decisions by well-established corporations. One example is the decision by the motorbike giant Harley-Davidson to produce its own wine cooler.

Yet, Lerner argues that this hybrid model is not necessarily sub-optimal. Crucially, corporate venture capital works best when large businesses invest in sectors in which they have experience.

Figure 6 Probability of going public

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Figure 6 shows the probability of going public for companies backed by independent venture capital, corporate venture capital without strategic ties with the target company, and corporate venture capital with strategic ties with the target company. This last model is the most successful. The corporate venture capital model is also best in terms of innovations produced. Corporate venture capital-backed initiatives have 47 per cent more patents than independent venture-backed firms. And since the stream of innovation produced by corporate venture capital continues even after a buyout, this model tends to have a better long-run performance than traditional venture capital.

A good example of the mixed record of corporate venture capital is what happened to Xerox. The company’s management decided to spin off those areas of R&D which it felt had been neglected within the corporation. Following the spin-off, several of these labs were extremely successful and developed a stream of profitable innovations. However, the incentive structure was ill-designed. The


people administering these projects were promised 20 per cent of the returns. Given the remarkable success of some of these programmes, the managers of these spin-offs made more money than the chief executive of Xerox.

Yet, the relative success of hybrids should encourage governments across the world to promote their development. This can be achieved in a number of ways. First, governments should strengthen intellectual property rights. This will boost contracting between large and small companies and, more broadly, encourage entrepreneurial activity. Second, governments should make it easier for start-ups to go public. Third, they should facilitate labour flows across borders and across firms. Fourth, they should strengthen the ties between academia and industry. Fifth, they should adopt a more business-friendly tax and regulation policy.

In conclusion, the traditional venture capital model has been remarkably uninnovative. Its structure is old-fashioned and suffers from severe limitations. The life of funds – typically around ten years – is short. And since industries such as life sciences, clean technology, biotechnology and pharmaceuticals have much longer product cycles, it is not surprising that venture capital has been less successful in these sectors than it has, for example, in software development. Fund-raising is also problematic. Venture capital-backed companies are typically rushed to the marketplace, even though going public may damage the long-run perspectives of the company.

However, corporate R&D is not without problems. These include the absence of any binding commitments to a programme, the low-powered compensation of researchers, the inability to learn from past mistakes and the lack of investment in knowledge absorption. The solution may lie in what GlaxoSmithKlein experimented with in the 1970s and 1980s, when it sought to design internal R&D alongside venture capital lines. Retired researchers and venture capital academics were brought in to review ongoing projects every two or three years. Teams within the R&D department were downsized and there was an injection of competition, which helped to foster innovation.

Discussant: Francesco Caselli, London School of Economics and CEPR

Francesco Caselli looked at venture capital in Europe. Europe has much less R&D than the US and almost no venture capital. This absence, which is particularly acute in certain countries, does not mean that venture capital is irrelevant for Europe. In fact, the venture capital ‘tricks’ may be even more relevant for European corporations, which may want to look at the hybrid model as one worth pursuing.

The first question to ask is why there is so much less R&D in Europe than in the US. In part, this can be explained by measurement error. Many European firms are extremely innovative but have no formal R&D labs. This means that their R&D output is often impossible to measure. A second, related point is that much formal R&D occurs in sectors such as ICT, a sector in which Europe does not have a competitive edge. Europe is stronger in more mature sectors, which

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are traditionally characterised by less formal R&D. As a result, the presence of little recorded R&D in Europe may just be the consequence of doing better in sectors which are less suited to venture capital.

Furthermore, Europe is in a different position from the US. Europe is a technological follower, while the US is the technological leader. It is perfectly normal for followers to grow by imitation rather than by innovation. Nor is Europe at a disadvantage over the long run. Even by remaining a follower, Europe is expected to reach the same level of productivity as the US, though this will probably happen over a longer time horizon.

In spite of these structural differences between the US and Europe, policymakers should still ask themselves why there is little venture capital in Europe. Cornelli and Bottazzi have argued that Europe does not have many projects in which venture capitalists can invest. This hypothesis is consistent with the observation that Europe is lagging behind the US in terms of technological development. In Europe, most innovation happens through imitation. However, since venture capital is not suited for imitation, one should not be surprised that it plays a limited role in Europe.

A second hypothesis is that Europe’s education system may not provide potential venture capitalists with the right skills. In the UK context, this hypothesis was explored by the LSE Growth Commission, which was set up to identify the bottlenecks for growth. The work of the Growth Commission has shown that venture capitalists have too much training in finance. This means that they tend to be intellectually distant from the type of projects that they aim to fund.

European venture capitalists typically lack the technological skills needed to screen, evaluate and mentor projects. This is in contrast to what happens in the US, where venture capitalists can benefit from what Hal Varian has defined as a Palo Alto-Silicon Valley model. This is a virtuous circle whereby entrepreneurs who have successfully created, run and floated their own business are reincarnated as venture capitalists.

Distinguishing among these hypotheses is important to come up with the best policy recommendations. If one believes that the absence of venture capital in Europe is simply the consequence of European countries imitating more than innovating, then there is no real problem. Conversely, if the reason underpinning the lack of venture capital is that venture capitalists do not have the right skills, then policymakers can and should take steps to address this problem.

Finally, is the absence of venture capitalism really a problem? True, it may slow down the process of innovation. But the lack of venture capitalism is only one – and probably not the main – roadblock present in Europe on the way to fostering more innovation.

Furthermore, it is unclear whether the absence of venture capitalism matters for firms’ entry. Entry rates in Europe are no lower than in the US. Where Europe is different from the US is in the fact that firms tend to grow less, and more slowly. This may suggest that what Europe needs is growth capital, rather than venture capital.


General Discussion

John Van Reenen doubted that venture capitalism is crucial to promote innovation.

Giulio Nicoletti argued that it is essential to understand who is responsible for innovation, the incumbents or the entrants. Furthermore, innovation should not be seen as a process that occurs in the same way in each sector. For example, innovation in the software industry is unique; it requires fewer patents than the same process occurring in other industries. Conversely, innovation in the pharmaceutical industry requires large initial investment. Venture capitalism may be appropriate to promote one type of innovation – for example, in the software industry – but not to foster innovation in general.

Richard Portes suggests that securitisation may be a good way to ensure that venture capitalism spreads to other sectors, not just the software industry. For example, innovation in the medical industry is a hit-and-miss process: for each R&D project that results in significant innovation, there are many that fail. As a result, venture capitalists are unwilling to fund innovation in this sector, as it is too risky. A solution to attract venture capitalists to these industries is to bundle together a batch of R&D projects in a security and sell them to investors. Such projects need not be developed by the same company. Securitising projects from different companies would reduce the correlation of risks among them.

Josh Lerner is sceptical of those who argue there is a significant difference between European and US venture capitalists. When UK venture capitalists invest in the US, their results are very similar to those of US venture capitalists. Similarly, when US investors invest in Britain, their results are very similar to those obtained by UK venture capitals. Hence, the success of venture capitalism in Europe and the US seems to depend more on the broader environment than on the skill set of the entrepreneurs.

The different avenues through which innovation occurs in the various industrial sectors is critical when one compares the venture capital model with corporate R&D. The typical venture capital project has a lifecycle of between eight and ten years. In the software industry, projects can be monetised within that time frame. This means that venture capital is well suited to this industry. Conversely, it is much harder to convince existing companies operating in the field of green technology or in the pharmaceutical industry to buy a start up after less than ten years. Here, start-ups tend to remain in place for up to ten years before being dismantled, since no buyer can be found.

Therefore, one has to look at different models for the different industrial sectors. Portes’s idea of securitisation may an excellent way to attract investors in the life sciences. Another option is crowd-funding, but relying on the wisdom of crowds may not be the right strategy for industries such as biotechnology. Much better would be to rely on a small group of people who have important, and often hard-to-access, information. Finally, index-fund approaches will almost always generate miserable returns. This is because even for the best venture capital funds, the large majority of deals happen at below market rates. It is the

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top 5 per cent of deals that provide high returns to make up for the remaining 95 per cent which do not go so well.

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8 Demography, Finance and Growth1

Carlo FaveroUniversità Bocconi and CEPR

There can be too much of a good thing. The risk associated with an unpredicted rise in longevity is one of the largest and least-diversifiable perils facing western societies. Governments need to ensure their pension systems are strong enough to cope with this threat.

Carlo Favero looks at the Italian case, which, he argues, is representative of what is occurring in most OECD countries.

Figure 1 Longevity for over-65s in Italy

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As shown in Figure 1, between 1965 and 2008, the mortality rate at 65 in Italy fell from 2.4 per cent to less than 1 per cent. The probability of dying at 66 once one reached the age of 65 has also fallen. Once Italians turn 65, they live, on average, longer lives. The number of years an Italian man can expect to live once he has reached 65 rose from 13 in 1965 to 20 in 2008. This result applies equally to men

1 Presentation based on Bisetti and Favero (2012).


and women. Over the last 43 years, we have gained of 4 extra hours of life for every day we have lived.

Favero is unsatisfied with the way traditional economic models have evaluated the sustainability of pension systems. The traditional approach assumes that demographic trends are exogenous. Favero instead prefers to use a stochastic demographic model. He then combines the mortality rate emerging from this model with the projected pension payments for different cohorts of retirees. Uncertainty regarding the mortality rate allows Favero to evaluate the impact of the longevity risk on the financial stability of a pension system. He can also evaluate the effectiveness of different pension reforms.

Using a mortality model to assess the effects of pension reforms has two advantages. First, mortality models make it possible to analyse the effect of changes in the social security system on individual cohorts, rather than on the population as a whole. This is important. Most pension reforms are not retroactive; they affect differently different cohorts of the population.

There is a second, more technical reason. The parameters used in a mortality model are not affected by policy changes. Any simulations based on these models is robust to the Lucas’ critique (1976). It states that when a government changes its policy, individuals also change their behaviour. Econometric specifications aimed at measuring the effects of the original policy change must take this response into account.

Measuring the impact of pension reform in Italy is interesting from several angles. Italy is burdened by a large public debt (both as a ratio of GDP and in absolute terms) but has a traditionally generous pension system. Over the past two decades, there have been several pension reforms. The most recent one, which began to be implemented in 2010 and was completed in 2012, introduced the automatic indexation of the retirement age to expected residual life at retirement. The government saw this as a way to get rid of longevity risk. Were life expectancy to increase unexpectedly, people would automatically retire later, easing the stress on the public finances.

Favero assesses the impact of the longevity risk on the Italian pension system in three steps.

First, he derives the size of each cohort of retirees up to 2050. He uses a particular demographic model, the Lee-Carter model, to project future mortality rates. He then applies them to the current population pyramid. Each cohort is therefore attributed a given mortality rate predicted via the model. There is some uncertainty associated with future mortality rates. As a result, a confidence interval is associated with the number of people at each age of the population.

Second, he projects the pension payments due in the future to each cohort using institutional information on the Italian pension system.

Third, he projects the total old-age pension expenditure as a ratio of GDP over the horizon 2012-2050, with its associated confidence interval. The width of this confidence interval reflects the impact of longevity risk.

The model offers a good fit for the period until 2008. When it is used to predict what will happen by 2020, it shows some striking results.

Demography, Finance and Growth 89

Figure 2 Life expectancy at 65

10

15

20

25

30

35

40

65 70 75 80 85 90 95 00 05 10 15 20 25 30 35 40 45 50

EL_65EL_65 (Baseline Upper)EL_65 (Baseline Lower)EL_65 (Baseline Mean)

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EL_65 (Baseline Upper)

EL_65 (Baseline Mean)

EL_65 (Baseline Lower)

Figure 3 Retired population under different mortality scenarios

Figure 2 shows how life expectancy at 65 will change between today and 2050. In the most extreme scenario, it will rise by over 35 years. The central forecast is that it will rise by 30 years.

Figure 3 shows the effects of a rise in life expectancy on the size of the population of retirees. Were life expectancy to rise by 35 years – this is the most extreme case – the number of pensioners would increase from 12.5 million in 2012 to 30.3 million in 2050, a 140 per cent rise in just 40 years. Were life expectancy to rise by 30 years – the most likely outcome – the number of retirees would increase to ‘just’ 23 million, which is still a near doubling of the population.

Favero then calculates the expected total pension payments. He assumes there are three types of recipients. The first group, which he defines as the “old guard”, was not touched by any pension reform. It receives a pension still based on the defined benefit system. The second group was affected by the pre-2011 reforms.


These transformed the Italian pension system from one based on defined benefit to one based on defined contribution. As a result, they receive a pension on the basis of the defined contribution method. For them, the retirement age is fixed. Third, there are those who are affected by the reform of the pension system introduced by Elsa Fornero at the end of 2011. Their pension is based on the defined contribution scheme. Morevoer, their retirement age is not fixed; they will retire when they have reached 20 years of expected residual life. The government believed this was an appropriate way to eliminate the longevity risk.

Figure 4 Expected pension expenditure/GDP, 2012-50

Figure 4 shows the expected evolution of pension payments as a percentage of GDP between 2012 and 2050. These were 12 per cent of national income in 2012 and are expected to rise under all scenarios.

Figure 4 shows how the Fornero reform has ensured that pension payments do not rise indefinitely, but will plateau and eventually fall. There is, however, still substantial uncertainty over exactly when pension payments will peak and at what level. The average projection predicts that pension payments as a proportion of national income will be highest around 2040, when they will be just below 16 per cent of GDP. However, under the most pessimistic outcome they will continue to rise until closer to 2050, reaching 19 per cent of GDP. The difference between the two predicted peaks – the longevity risk – is therefore 4 per cent of GDP, hardly a trivial amount.

Figure 5 shows what happens to pension payments with the indexation of the retirement age. In this figure, the retirement age rises from 65 in 2012 to 74 in 2050, so as to deliver a constant expected retirement period of 20 years. The longevity risk in 2050 is just over 1 per cent. This is substantially lower than without indexation, but still far from zero.

The indexation of the retirement age reduces the longevity risk but does not get rid of it. Therefore, governments should ask themselves whether there are ways to hedge the outstanding longevity risk.


Figure 5 The effects of indexation of retirement age

In theory, there are financial instruments that allow to hedge the longevity risk; these include longevity bonds, which are linked to the survival of a given cohort, and longevity swaps.

In practice, however, these securities have not been very successful. There are several problems. First of all, it is unclear who would be willing to issue these longevity bonds. The issuer should certainly not be the government, since longevity risk is borne by the government. This question is strictly connected to the second problem: what would the effect be on existing securities of adding a longevity bond? Longevity might provide a source of diversification especially at the long end of the spectrum. If this is the case, the private sector might benefit from buying longevity risk. The presence of willing buyers should encourage privates to issue longevity bonds. The government would also be able to purchase them.

A final point which governments should keep in mind is that the longevity risk has non-negligible redistributive effects. First, it does not have the same affect on all cohorts. Cohorts retiring later will suffer the greatest brunt of an unexpected increase in life expectancy. The government will not have enough money to pay for their pensions.

Second, longevity is typically assumed to be correlated with income. Richer people tend, on average, to live longer. As a result, the longevity risk has a regressive effect on the pension system. Since richer people are more likely to live longer than expected, they will receive greater pensions than the average citizen.

Third, longevity risk can have an asymmetric effect on the population depending on other characteristics. For example, longevity is negatively correlated with tobacco consumption. As a result, the longevity risk imposes an implicit tax on smokers. Since smokers tend to live shorter lives, the longevity risk could increase the gap between their pension contributions and their pension payments.


Discussant 1: Tullio Jappelli, Universita Federico II, Napoli and CEPR

Tullio Jappelli defined the source of longevity risk as the discrepancy between one’s expected and one’s actual lifespan. So far, this risk has been large and one-sided – governments have always underestimated how long people live for. This systematic error has arisen from the assumption that longevity improvements will slow down in the future. However, this has not happened.

The longevity risk is important for governments since it threatens the solvency of private financial plans and of corporations, which are liable for the defined benefit plans they have offered to their employees. Above all, governments are exposed to large risks because of the ever-rising cost of the pension and healthcare systems.

There are three ways to deal with longevity risks. The first is to acknowledge its existence and implement measures aimed at limiting its effects. One of these policies is indexing the retirement age and retirement benefits to longevity. A second solution is to share risks between governments and the private sector in a different way. For example, the government could demand that institutions keep more savings to shield them from future turmoil in the financial markets. The third approach is to transfer the longevity risk to the capital market, for example through longevity bonds.

Jappelli believes that the model used by Favero to calculate what occurs to longevity has several limitations. First, the mortality projections assume zero net immigration flows, which is unlikely. The stock of immigrants in Italy increased from 0.2 to 4.5 million between 1970 and 2011. Immigrants are younger than the population average and have lower life expectancies. This means that their contributions to the pension system are greater than their benefits. Were net immigration to increase, the projections on the future trajectory of longevity based only on data from 1965-2008 would be too pessimistic.

Second, the model does not take into account the fact that the average age of childbearing may change. This variable is strongly affected by behavioural variables, such as the availability of child-care. Were women to have their children later, this would reduce the average number of children per household. In turn, this would reduce the size of future cohorts.

Third, the demographic model is only based on variables such as the proportion of women in society and the average age of the population. However, there are several other variables that affect life expectancy. For example, the empirical evidence shows there is a strong correlation between mortality on the one side and education, marital status and pollution on the other. In the Italian case, the model should pay more attention to regional variability. In Italy the quality of health care and hospital access vary hugely among regions.

Another limitation of the model is that it does not take into account the fact that individuals will respond to the longevity risk. For example, they will accumulate precautionary savings or retire later than they should. This behavioural response will limit the cost for the state of the longevity risk. Yet, one should not be too optimistic. Even if workers were to decide to retire later to


respond to the longevity risk, their productivity may decline because of age. This would limit the wages they will be able to command and, in turn, their pension payments. It is therefore important to understand whether productivity declines with age. Optimists would point to those studies showing that productivity at the age of 60 is not lower than at the age of 50. However, there is no evidence that shows this is also true at the age of 70-75.

Favero shows how indexing the retirement age to life expectancy – as was done in the latest pension reform in Italy – can substantially reduce the impact of longevity risk. However, alternative policies can have similar effects. In Sweden, the retirement age is flexible – workers can retire whenever they want. Pension benefits, however, are indexed to life expectancy. The pension one receives is therefore the ration of one’s account value at retirement and a common divisor, which is indexed to life expectancy and updated every year. The two systems – indexing the retirement age or the pension benefits to life expectancy – obtain similar results. Governments should look at their relative advantages and disadvantages before deciding which to adopt.

Finally, Jappelli looks at the delicate redistributive and ethical issues raised by policies linked to age, such as the indexation of the retirement age. The healthcare system is exposed to the same longevity risk as the pension system. Therefore, there may be a case for indexing the age at which the elderly can claim the healthcare benefits which they have paid for throughout their working life. There could be reasons to advocate a health test at the age of 65, and to make pension and health benefits depend on the outcome of this test. There may be a case for giving larger benefit payments to those individuals with the worst test results, since it is less likely they will live for as long as the average life expectancy. Similar policies, however, could prove ethically controversial.

Discussant 2: Michael Reiter,Institute for Advanced Studies, Vienna

Michael Reiter agreed that the increase in life expectancy is an issue economists should pay much attention to. It is a problem for the stability of pension systems: policymakers will have to increase the retirement age and find additional savings. It is also important in so far as it affects asset prices.

Any increase in longevity produces uncertainty about the aggregate mortality rate. This is known as the longevity risk. The longevity risk requires an automatic policy response, such as a pension formula. The risk may be diversified, either between governments and wealthy individuals or internationally.

In the demographic model used by Favero, the estimated uncertainty is large. Life expectancy at 65 in 2050 could be anything between 20 and 35. Policymakers would find it hard to design appropriate responses on the basis of such indeterminate results. It is important to reduce this uncertainty and there are ways to do this.

Rather than relying on Italian data alone, one can use data from other countries. Alternatively, one can reduce the noise present in the data by only using those


individuals who are genetically similar. For example, researchers could exclude immigrants from poorer countries from the sample and only look at the so-called ‘core population’.

Conversely, the work by Favero probably underestimates the problems that the longevity risk poses for the stability of the Italian social security system. First, Favero assumes that the increase in longevity goes hand-in-hand with an increase in the individuals’ productive lifetime. However, the fact that people live longer may not mean that they are able to work for longer with the same productivity. Second, Favero does not look at the impact of longevity risk on the healthcare system. Its costs are bound to increase with longevity.

A separate topic is the impact of demography on asset prices. Demography is an important factor in determining asset returns over the long run. A positive demographic shock would force older cohorts to dissave more than expected. As a result, the capital stock would shrink, which would lead to higher asset returns. Since demographic change can have profound implications for asset returns over the long run, investors need to find a way to hedge against these risks. This is why longevity bonds are a useful financial instrument.

Is there a market for longevity bonds? Whether a financial product is widely traded or not depends on if it can be priced using well-understood models. However, longevity is a tricky variable that is hard to predict, model and, therefore, price. This high uncertainty would impose high risk premia on longevity bonds. Companies would therefore be less willing to hold them. It is also unclear who exactly would want to hold these bonds. Pharmaceutical companies and hedge funds are two candidates.

Increasing longevity raises at least four important policy issues. First, governments tend to respond to any increase in life expectancy by

raising the statutory retirement age. However, this should not be the main focus of their policies. Raising the retirement age is only of limited efficacy; governments cannot impose the effective retirement age, that is the age at which people actually stop working. This depends on the statutory retirement age and on other variables, such as the proportion of disabled and unemployed people in the population, or the presence of loopholes hat let people retire before the statutory limit. Furthermore, raising the retirement age continuously may not be credible. It is much easier to state that, if necessary, the retirement age will raise to 75 than it is to actually do it. Facing a political backlash, future governments may be able to make a U-turn, claiming this was not their decision. For these two important reasons – lack of effectiveness and lack of credibility – governments should not dictate the retirement age, but instead provide the right incentives for those people who can to stay longer at work.

Second, there are issues of intergenerational redistribution. When longevity increases unexpectedly, a government has two options. The first is to increase the contributions from the working population. The second is to reduce benefits for the retirees. Clearly, these two options have very different effects on different age cohorts. The former policy would penalise the young, while the latter would be financially damaging for the old. Governments need to find a way to ensure they are fair to both groups. One solution is to tie benefits to the dependency


ratio. When many old people are supported by a few workers, pension benefits should fall. The opposite should happen in a population in which many working age individuals support a few retirees. Generally, policymakers must decide what is their objective. They may, for example, aim to maximise the ex ante efficiency of the system, or seek to equalise the lifetime utility across different age cohorts. The German pension rules tend to follow this latter aim and do it reasonably well.

Third, there may be a case for linking the pension benefit an individual receives to his life expectancy. It is unfair that a person with lower life expectancy should receive the same benefits as that of someone who has paid the same amount of money into his pot but who expects to live longer. Policymakers could use a range of variables to determine whether how long individuals will live for. For example, they can look at whether they are rich or poor or whether they smoke or not. They could then derive individual life expectancies and award pension benefits on the basis of these factors.

Fourth, it is important to reform the labour market so that the elderly can work more. This is particularly true in Europe, where the wage profile for the elderly is not in line with productivity and their unemployment rate is high. Making the labour market for the elderly more flexible will help to increase the retirement age. Governments would then find it easier to deal with rising longevity and the longevity risk.

General Discussion

Marco Pagano underlined how the role of official estimates of life expectancy is crucial to understand and measure the longevity risk. Since billions of euros depend on the mortality rate, the governance of the statistical offices that calculate demographic variables must be monitored carefully.

Otto Tovalanien suggested that it would be useful to perform an exercise which is conceptually opposite to the that in Favero’s paper. Researchers should first establish the maximum size of the pension system (as a proportion of GDP) a country can bear. Only then should they decide the maximum retirement age which allows that pension system to be sustainable.

Carlo Favero acknowledged that there are statistical problems with the demographic model he used. However, he did not think that pooling international data would help to reduce the variance in the model, as international data tend to be all very similar.

He agreed that a demographic model should include variables that affect mortality. The impact of immigration should also be included in the model.

He also agreed that, ideally, a good pension system is one in which pension payments are indexed to life expectancy and people are allowed to choose when they retire. The exact pension benefit each worker receives depends on when he has decided to stop working. This would allow addressing the longevity risk without imposing a common retirement age as done by the Fornero reform.


He acknowledged that longevity bonds currently have high premia. However, these need not be risk premia. They could also be liquidity premia, due to the small size of the market for these instruments.

He also said that the exercise suggested by Otto Tovalanien is helpful and can be easily done.

97

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