European Conundrum: Increasing Regulation without Stifling GrowthPublished: January 06, 2010 in Knowledge@Wharton
Wall Street may have been the epicenter of the financial crash that shook the world, but Europe -- along with other global markets -- experienced the aftershock in the form of a deep recession in 2009. As a result, European countries can expect to experience only weak growth in the coming year, according to Wharton faculty and other experts.
"The immediate concern in 2010 is still the crisis, which hit some countries more than others, but [almost] every country has been affected," says Wharton management professor Mauro Guillen. "I think everybody is hoping things are going to turn around. The problem is, it's not obvious how [that will happen]."
In addition to an anemic recovery, Europe will face a number of key challenges that will shape the business and economic environment in 2010 -- including concerns about economic integration, sovereign debt default, regulatory change and the European Union's place in the global economy.
The European Commission forecasts overall growth of just 0.75% in 2010 and 1.5% in 2011, compared to 2.6% in 2007 before the crisis took hold. At the end of 2009, the European economy was rebounding, but the Commission warns that this was due in large part to unprecedented fiscal and monetary policy stimulating consumer confidence. In 2010, the Commission predicts, growth will be weaker than usual due to continued deterioration in labor markets, massive financial deleveraging, low demand, weak profits and modest credit growth.
Guillen notes that unemployment is a serious drag on European economies. The EU estimates employers will have shed 7.5 million workers through 2009 to the end of 2010, leveling off at a rate of about 10% in 2011, when employment growth is expected to again become positive.
Despite such obstacles, he adds, Europe has the potential to increase its already strong position in the global economy as unification measures take hold and expand the EU's economic importance. But for now, Europe continues to act like a "fragmented player," according to Guillen, who notes that European countries "don't throw their weight around" as a unified force. "Europe has to find its own voice in global affairs. It's been trying hard for the last 20 to 30 years." For example, given the rising competition among Western countries to court China's favor, it will be "interesting ... to see how Europe relates to China and the United States [given that it] has many trade and commercial agreements with the U.S. and major dialogue with China."
Default among the PIGS
John Kimberly, a Wharton professor of management and executive director of the Wharton/INSEAD Alliance in France, says that Germany and France -- where more conservative pre-crisis lending patterns made the impact of the downturn less painful -- are the European nations best positioned for growth in 2010, with Germany the stronger of the two.
In Portugal, Spain and Greece, where the possibility of sovereign debt default has emerged as a major issue, economic problems were fueled, in part, by speculative real estate investment. Italy, with high unemployment and some political instability, could become volatile, he adds. "What will be interesting to watch is the way in which the EU responds to the situation in Greece. Will Greece take the steps necessary to cut its deficit -- and, if it doesn't, what will the EU do? This is a high-stakes game and it will be precedent setting."
Under EU rules, member states in default on government debt must seek support from the International Monetary Fund. Meanwhile, according to a report in The Wall Street Journal, Greece committed this week to cutting its budget deficit from 12.7% of GDP in 2009 to 3% by 2012, one year earlier than it had originally promised. This follows a decision two weeks ago by Moody's Investors Service to cut Greece's sovereign-debt rating, an action already taken earlier by Standard & Poor's and Fitch Ratings, according to the Journal, which also noted the upcoming arrival in Athens of EU and European Central Bank officials in preparation for a review of Greece's budget.
According to Greg Salvaggio, senior vice president for capital markets at Tempus Consulting in Washington, D.C., the possibility of a sovereign debt crisis in nations that are now being called the PIGS -- Portugal, Ireland, Greece and Spain -- is a growing concern. "Some analysts in Europe are saying there is a possibility that one or more of these countries might be forced to temporarily exit the EU to get their financial house in order." He notes, however, that nearly every European country is in violation of some element of EU stipulations that govern a range of fiscal requirements, including deficit levels and collateral requirements, as a result of the global recession.
Philip Nichols, Wharton professor of legal studies and business ethics, notes that the crisis also has helped to heat up political debate about how much support richer countries owe poorer nations coping with high levels of unemployment. In some countries, nationalist backlash to deepening integration could gain momentum. "Euroskeptics are pleased as punch with what they see as a stalling out of growth of the European Union. But other people [citing] European pragmatism foresee slower, continued steady growth in the European Union."
According to Salvaggio, some are increasingly worried that if Greece goes into default, other countries may become "dominos" vulnerable to attack by speculators who will likely turn first to Spanish debt, then perhaps move on to Ireland and even the United Kingdom. Default, or even the potential for sovereign debt collapse, will prevent the European Central Bank (ECB) from raising interest rates and will most likely encourage lower rates, he argues. "The downside is that lower interest rates in the Eurozone could end up increasing inflation."
The ECB's president, Jean-Claude Trichet, is "hawkish" when it comes to inflation, according to Salvaggio. "He is from an old Bundesbank [the German Central Bank] mindset that inflation must be controlled at all costs. We believe inflation will surface as consumption levels increase. The ECB should react with hikes -- but with the possibility of sovereign debt default in the Eurozone, this will be a tough decision. That's going to be the interesting story [over] the next couple of months."
Challenging the 'Anglo-Saxon View'
According to Wharton legal studies and business ethics professor Janice Bellace, the economic crisis caught leaders in some countries by surprise because they did not fully appreciate the level of interconnectedness of financial markets around the world. Free-market ideals caught on throughout Europe -- and the UK in particular -- in the 1990s and the early 2000s. Now known as the "Anglo-Saxon view," many countries embraced the ideology and took steps to deregulate or introduce more flexible economic regulatory regimes.
For example, she points to Spain, which benefited greatly from relaxed financial regulations that encouraged foreigners to invest in second homes, fueling a boom in real estate development and other services. Now, the boom has become a bust. Spanish unemployment is among the highest in Europe and concerns are rising about the quality of Spanish debt. In Iceland, major banks made bad investments and the nation's entire economy collapsed at the beginning of the global financial crisis, leaving citizens questioning the free-market model endorsed by the UK and the United States.
"There is great uncertainty about what is the right course to pursue. The more cautious course is being put forward by [Germany and France], which [are] less free market" and more heavily regulated than other European countries, Bellace notes. "Everyone believes the Marxist/Socialist model is completely dead -- but there's a difference between belief in markets and how lightly or how heavily they should be regulated."
According to Bellace, the global crisis should heighten European nations' desire to integrate even more deeply to counterbalance the economic power of the United States, which created much of the current mess. "Individual countries can't do it. To some extent, that might explain why France and Germany are growing closer together."
Bellace also cites the November appointment of former French agriculture minister Michel Barnier to head the EU's internal markets commission -- a position similar to the U.S. treasury secretary -- as another indicator of what may come to pass in 2010. The appointment was viewed by some as a sign that the more heavily regulation-oriented economic policies of France had won over the Ango-Saxon model. "The British papers were full of comments that this is a terrible blow to the City of London, because Barnier will support more regulation of markets, which will cause firms that can locate in other places to leave."
Regulatory reform will be an important issue particularly for London, where financial services have become a major engine of economic activity, according to Wharton management professor Felipe Monteiro. "London has always been on the vanguard of what's happening in financial services, and I have no doubt all the things that are being discussed now in terms of restructuring financial markets and financial services will have a great impact on London, and will have cascading effects in financial markets worldwide, for good or for bad," he says.
In a report titled Regulatory Roundup 2009 and Outlook for 2010, the International Centre for Financial Regulation (ICFR) notes that regulatory initiatives will fall into three broad categories:
- addressing early identification of systemic risks, often called "macro-prudential regulation";
- improving regulation and supervision so that individual institutions are less likely to need public funds in the future; and
- structural reforms of the regulatory architecture.
The last element -- structural reforms -- would involve determining responsibility for systemic risk and deciding whether change is needed to unify or separate regulation and supervision of banks, insurers and markets. According to the report, the UK is "grappling" with whether the Bank of England or the Financial Services Authority should handle regulation. In Europe, the report continues, plans for a new European Systemic Risk Board should be final sometime in 2010.
THE ICFR adds that many other topics have yet to appear on the regulatory agenda, including "two particularly tricky conundrums." The first would be how to manage concerns over the size and systemic instability of large, complex financial institutions, especially since the financial crisis has reduced the total number of institutions and made those that have survived the consolidation all the more important. The second issue mirrors the first in the regulatory arena. "On the one hand, we seek regulatory convergence and harmonization so as to prevent regulatory arbitrage," the report states. "But there is a risk that without diversity, when all supervisors use the same methods and tools, they are all wrong at once. So how do we encourage diversity in bank business models and regulatory models?"
The Downside to Regulation
Guillen notes that in addition to spurring new regulation, the crisis should prompt a simultaneous reexamination of regulations and practices that inhibit competitiveness. "It is widely recognized that Europe still has a problem with too many regulations, and the incentives are not in place for entrepreneurs to succeed." For example, he notes that the venture capital industry has never developed substantially in Europe because of weak intellectual protection and patent laws, even as state regulations continue to stifle businesses with excessive red tape. "The crisis has heightened the need for European countries to do something about this. Their future prosperity hinges on it. This will be a big topic in 2010."
Some of the same ideological dynamics are playing out in Russia, according to Nichols. He says that in the coming year it will be important to see whether Russia allows people and businesses to work together freely, or whether the government increasingly inserts itself into business and individual relationships. Indeed, Russia appeared to be allowing more of these relationships to exist, although in the last year and a half, it has seemed "to be plateauing, or even moving in the other direction." If Russia continues along this path, the nation's economy will be heavily influenced by special interests -- a direction which Nichols says historically has resulted in poor economic performance.
Despite the amount of attention focused on China and emerging economies in other parts of the world, Monteiro states that many of the top 100 multinational corporations are still based in Europe. While growth may be slower across the continent in the immediate future, Europe will continue to be a major global economic force for years to come. "Whatever these companies do, there will be global impact resulting from their actions."
The key to continued European business expansion, he adds, lies in multinationals structuring their global operations to capture the benefits of global innovation. Most large European companies have assets worldwide, not only for production but for the generation of knowledge and innovation, he notes. "I expect them to be increasingly global -- not just in selling, but in product integration and changing technology.... To create new products today, we rely on different parts of the world. European multinationals, because of their [geographically distributed] assets, are well-positioned" to do that.