March 2012

Paper Series
Rebuilding Together: The Renewal of Transatlantic Leadership in the Global Economy
by John Schellhase and Thomas Gietzen
Introduction Each of the transatlantic partners is mired in a unique state of crisis. In Europe, the euro remains a currency without a country in an asymmetric system. Necessary steps toward political reform and deeper integration conflict with national interests. In the United States, an unprecedented budget deficit weighs down an economy that is slow to recover, and political brinkmanship and rigidity preclude innovative problem-solving. These immediate, separate problems take place against the backdrop of a larger, shared crisis. The global recession has raised difficult questions about the primacy of market-based democracies and their ability to lead the global economy. The transatlantic partnership must undertake an aggressive, coordinated effort to reaffirm its leadership of the world economic order on two main fronts. First, the dramatic collapse of the financial sector demonstrates the need for strategic regulatory reform. Policymakers must address key weaknesses in regulatory agencies, banking structure, ratings agencies, and the role of lenders of last resort. Second, monetary policy needs to return to the forefront of the transatlantic conversation. The United States and the European Union should act now to preserve and enhance the advantages of having the worlds most powerful currencies. The reforms resulting from this far-sighted, cooperative effort would help each side of the Atlantic escape their own unique crises, as they solve their shared crisis together. Strategic Regulatory Reform Policymakers must pursue coordinated financial regulatory reforms to minimize the possibility of another global collapse. The political economies of the United States and European nations demonstrate important differences in how they view the purpose of economic behavior and the role of the state. Nonetheless, the transnational nature of modern finance, as shown recently by the contagion of bad debt, demands more than mere consultation between governments. The United States and EU must each independently, but cooperatively reform their regulatory regimes. This process would create a more unified, transatlantic economic space. In particular, both sides of the Atlantic must consolidate regulatory agencies, demarcate commercial and investment banking, address

Summary: The global recession has raised difficult questions about the primacy of marketbased democracies and their ability to lead the global economy. The transatlantic partnership must undertake an aggressive, coordinated effort to reaffirm its leadership of the world economic order on two main fronts. First, the dramatic collapse of the financial sector demonstrates the need for strategic regulatory reform. Policymakers must address key weaknesses in regulatory agencies, banking structure, ratings agencies, and the role of lenders of last resort. Second, monetary policy needs to return to the forefront of the transatlantic conversation. The United States and the European Union should act now to preserve and enhance the advantages of having the worlds most powerful currencies. The reforms resulting from this farsighted, cooperative effort would help each side of the Atlantic escape their own unique crises, as they solve their shared crisis together.

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flaws in the ratings agencies, and establish clear standards for access to lenders of last resort. Consolidating regulatory agencies will help both the United States and EU anticipate and prevent future crises. The bewildering mesh of agencies currently charged with oversight failed to forestall the global crash. In 2009, the Organisation for Economic Co-operation and Development (OECD) recommended that the United States pursue [s]implification of regulatory structures and that the EU should adopt a single bank regulator to, in both cases, strengthen regulation through streamlining it.1 As both the United States and EU independently reduce the number of agencies involved, they will clarify roles, concentrate authority, and reduce myopia in favor of a more system-wide perspective. These steps will be the groundwork for further coordination. A more streamlined regulatory regime on each side of the Atlantic will enable governments to oversee bank behavior more effectively and will offer firms a more efficient transatlantic marketplace.

The ratings agency system also requires serious reforms. Over the last century, both in the United States and Europe, agencies such as Moodys and Standard and Poors have acquired a semi-governmental mantle that leads to perverse outcomes for the financial markets and global public policy, worsening pro-cyclical market tendencies and weakening accountability.2 To correct this problem, policymakers have two choices: either to disentangle the ratings agencies from official policy; or, given the complexity of the first option, to open the current system to new firms to promote greater competition. More competition would need to be combined with stiff legal consequences for ratings malpractice so that firms would not run to the agency offering the highest rating based on the lowest standard. Instead of being bestowed with official privilege regardless of outcomes, rating agencies would have to earn their reputations based on the accuracy of their predictions in a competitive marketplace.3 Finally, the transatlantic partnership should coordinate the conditions it will require that firms meet in order to receive taxpayer bailouts from lenders of last resort. The unprecedented rescue packages doled out to scores of banks on both sides of the Atlantic have created an environment of extreme moral hazard. Naturally, firms are likely to expect similar taxpayer assistance in the next crisis. The Federal Reserve, the Bank of England, national banks throughout the European continent, and, as it evolves further into this role, the European Central Bank need to define clear, strict procedures for what happens when a near-insolvent bank wants to access their liquidity. First, firms should be required to make living wills that have clearly-defined and credible plans for how to maintain capital and liquidity adequacy in the event of distress.4 Second, governments should be clear in advance about what decision-making authority they will assume upon bailing out a firm. For example, will firms exchange corporate governance control for access to taxpayer funding? One consequence, though, should be nonnegotiable. Governments should have the ability to take toxic assets off of a firms balance sheet and deal with them as quickly and profitably as possible. In Europe, officials should consider similar prerequisite standards for access to European capital during national
2 Matthew R. King and Timothy J. Sinclair, Private Actors and Public Policy: A Requiem for the New Basel Capital Accord, International Political Science Review. Vol 24, No. 3 (2003). 3 See Nouriel Roubini and Stephen Minh, Crisis Economics, p. 197. Penguin Press (May 2011). 4 David T. Llewellyn, The Global Banking Crisis and the Post-crisis Banking and Regulatory Scenario, p. 89, Research Papers in Corporate Finance (June 2010).

The bewildering mesh of agencies currently charged with oversight failed to forestall the global crash.
Regulatory reform should also involve returning to a more traditional understanding of what a bank is. Commercial banks and investment banks should be separated and should have different regulatory standards. This division actually simplifies the tasks of regulators by quarantining dramatically different risk pools. The United States had such regulation under the GlassSteagall Act from 1933 until its repeal in 1999. Since the crisis, various manifestations of this concept have re-emerged, including the Volcker Rule in the DoddFrank Act in the United States and the Vickers proposal in the United Kingdom. These promising reforms, if seen to completion, offer one way to manage the size of banks without taking draconian, and unfeasible, measures to break them apart. Ensuring these provisions are enforced and expanding them throughout the EU ought to be urgent priorities.
1

See The Financial Crisis: Reform and Exit Strategies, ps. 29-32, OECD (2009).

debt crises. For banks, transatlantic coordination of standards for access to lenders of last resort will reduce moral hazard, regulatory arbitrage, and the likelihood of the uneven, ad hoc responses that have characterized the aftermath of the current crisis. These strategic responses diminish both the likelihood of future financial catastrophes and their potential fallout. While the United States and Europe should pursue such reforms for their own separate benefit, coordinating this strategic, far-sighted response can only strengthen the results. As Daniel W. Drezner has written, Regulatory coordination reduces the transaction costs of cross-border exchange, leading to an increase in static efficiency, which increases economic benefits for all participating states.5 While multinational firms may resist strong, coordinated standards, Drezner agues that such standards benefit firms in the long-term by clarifying regulatory restrictions, creating a level playing field across borders, and illuminating the political process by which transnational regulatory standards can be changed. A coordinated, transatlantic financial regulatory policy built on the lessons of the global crisis is an essential step toward restoring healthy, growing economies on both sides of the Atlantic. Currency Exchange in the 21st Century Facing new currency competition from China and others, the United States and the European Union must make monetary relations a priority. Historically, monetary management has been a key feature of the transatlantic partnership. The following represent only a partial list of transatlantic monetary agreements over the last half century: the Bonn Summit in 1978, the Plaza Communiqu among the G5 finance ministers and central bankers in 1985, the Louvre meeting of the G7 in 1987, the first Basel Capital Accords of 1988, and even the enigmatic meeting of Presidents Nixon and Pompidou in the Azores in 1971. For the last 20 years, however, monetary relations have been dramatically underrepresented, especially compared with trade relations. This approach made sense during the Great Moderation,6 when, starting in the mid-1980s, low overall economic volatility allowed central banks to focus almost exclusively on inflation targeting. The economic growth following the collapse of the Soviet Union also
5 6

Transatlantic coordination of standards for access to lenders of last resort will reduce moral hazard, regulatory arbitrage, and the likelihood of the uneven, ad hoc responses that have characterized the aftermath of the current crisis.
contributed to complacency among central bankers and policymakers. Since the advent of the euro in 1999, the Federal Reserve and ECB have shown a benign neglect for their mutual exchange rate. In the wake of the financial crisis, however, the dollar-to-euro exchange rate has become highly volatile. In a world of vigorous crossborder trade, the costs of this volatility, if ongoing, could exceed the costs of managing the exchange rate more actively. It is time for monetary management to return to the transatlantic agenda. The extensive literature of ideas for a more active relationship between the Federal Reserve and the ECB dates back to the introduction of the euro. In 1999, Peter Bofinger argued for an active exchange rate management in which the ECB defends the upper band and the Federal Reserve defends the lower band at a certain dollar-per-euro value via interventions on the foreign exchange market.7 All foreign exchange market interventions impact the monetary base. Therefore, central banks will sometimes inevitably have to carry out inflation- or deflation-spurring strategies to defend exchange rate bands. Bofingers strategy, however, could be accomplished using sterilized interventions that is, interventions that counteract first round forex-market interventions. When threatened by inflation, which calls for the defense of the upper band, the central bank could issue bonds domestically to mop up the excessive money supply. Exchange market inter7 See Bofinger, Options for the Exchange Rate Management of the ECB Economic Affairs Series, ECON 115 EN, European Parliament Working Papers (1999).

See Drezner, All Politics are Global, pp. 43-45. Princeton University Press (2007).

Though often attributed to Ben Bernanke, this phrase first appeared in James H. Stock and Mark W. Watson, Has the Business Cycle Changed and Why?,NBER Working Papers, #9127, National Bureau of Economic Research. (2002).

ventions, therefore, would not interfere with the ultimate goal of price stability. This sort of agreement would be especially fruitful between bilateral partners, rendering the difficult measures against depreciation redundant. Bilateral, sterilized interventions, in which one partner defends an upper band, are less costly and easier to implement than other arrangements, such as creating Special Drawing Rights through the International Monetary Fund (IMF). Earlier attempts to establish this sort of surrogate money have failed. Future efforts are just as likely to fall apart. Critics might argue that unless the United States and EU further commit to a global system of floating or of hard-pegged currencies they leave themselves vulnerable to speculative attacks. Given the size of the United States and the eurozones economies, however, this argument loses much of its validity. Resiliency in the face of speculative attacks depends on the soundness of the transatlantic economies and the depth and liquidity of their internal markets. Therefore, an operative exchange rate management is contingent on deeper European integration, including the creation of a European common bond market. Euro bonds would be a major positive step, both for the EU and the transatlantic partnership, creating the conditions for more active management of the exchange rate. The United States, which has been tepid when it comes to deeper European integration, should actively encourage this process. The benefits to both partners are significant. An operative exchange rate strategy, such as the one described above, would lower risk, enhance trade, discipline monetary policy, and consolidate the dollar and euros role in international monetary markets. Leaders must begin making these decisions now, while rival currencies remain relatively weak. The first major shift in the modern monetary system occurred after World War I as monetary dominance shifted across the Atlantic, from the pound sterling to the dollar. While the possibility may seem remote at first glance, the global financial crisis and its unique impacts in the United States and Europe could create the conditions for another major reordering. A shift of the worlds monetary center could occur again this time across the Pacific, to China. A number of economists, Barry Eichengreen and Arvind Subramanian among them, believe China is heading towards a leading role on the world monetary stage. While at present, due to its large trade imbalances, China has a significant interest in the financial stability of the

United States and Europe, it is seeking a way out of the dollar trap. As Subramanian has argued, Internationalizing the renminbi offers one such exit.8 Just as in the 1920s U.S. officials at the newly established Federal Reserve sought to make New York the worlds financial capital, China hopes to make Shanghai the financial capital of the 21st century.

A shift of the worlds monetary center could occur again this time across the Pacific, to China.
There are a number of reasons to doubt Chinas ability to realize this vision, including such internal pressures as ethnic tensions, environmental degradation, and widening income inequality. But these are not excuses for complacency among Western leaders. The dollar and euros dominance on the world stage gives both transatlantic partners significant advantages. The dollars status as the global reserve currency allows the United States to enjoy low interest payments on its foreign liabilities.9 U.S.-based companies and banks benefit from a more comfortable savings situation because they do not need to hedge against exchange rate risks. As a regional powerhouse, the euro is increasingly offering the same benefits to eurozone nations and firms. Currently, 23 countries and territories outside the EU peg their currency to the euro. The creation of European common market bonds would create an even greater depth and liquidity in the eurozone domestic market, and enhance the euros status as a global reserve currency. These advantages are central to the transatlantic partnerships global leadership. A deterioration of the dollar and euros status would certainly mean a forfeiture of transatlantic geopolitical power. As Robert J. Art has written, money is the most liquid asset of all.10 Strong economies
8 Arvind Subramanian, Coming Soon: When the Renminbi Rules the World. Financial Times. September 11, 2011. 9 A difference of 2-3 percentage points on interest between foreign liabilities and foreign investment allows the United States to import more than it exports without becoming indebted to the world. See Pierre-Olivier Gourinchas & Hlne Rey as just one example of the literature on this point: From World Banker to World Venture Capitalist: U.S. External Adjustment and the Exorbitant Privilege, in G7 Current Account Imbalances: Sustainability and Adjustment, National Bureau of Economic Research, Inc. (2007). 10 Robert J. Art, The Fungibility of Force, Security Studies, Vol. 5, No. 4 (Summer 1996).

and strong currencies give international actors enormous flexibility to achieve a variety of interests. Ensuring the continued dominance of the dollar and the euro must be a top priority for this generation of transatlantic leaders. Conclusion By coordinating financial regulation and more actively managing the dollar-to-euro exchange rate, the transatlantic partnership will gain significant leverage for shaping the global economy as a whole. The combined size of the United States and European economies, representing nearly half of global GDP, means reforms adopted on both sides of the Atlantic are likely to reverberate worldwide. Historically, transatlantic financial reforms have become de facto often de jure global standards. Actively managing currency policy will enable the United States and the EU to pursue a complimentary currency diplomacy, pressing China and other currency manipulators to move towards more responsible valuation. The transatlantic partners will also have more leverage to push the International Monetary Fund to strengthen its exchange rate oversight. These global, longterm goals must begin, though, with successful transatlantic reforms. The transatlantic partners must begin this work now, even as their own separate crises continue. The international system of rule-based institutions has rested on U.S. leadership and European stability and has been funded by the vibrancy of economic exchange between both partners. Its future, while bolstered by emerging markets around the world, requires this foundation to remain firm. A more efficient, more stable transatlantic economy

will help both partners rise out of their separate crises. As these reforms take hold and influence global policy, the renewal of transatlantic leadership will result in a more prosperous world.

About the Authors

John Schellhase, a masters student in global affairs at New York University, and Thomas Gietzen, a masters student in economics at Universitt St. Gallen, Switzerland, are the 2012 winners of the Brussels Forum Young Writers Award.

About Brussels Forum

Brussels Forum is an annual high-level meeting of the most influential North American and European political, corporate, and intellectual leaders to address pressing challenges currently facing both sides of the Atlantic. Participants include heads of state, senior officials from the European Union institutions and the member states, U.S. government officials, Congressional representatives, Parliamentarians, academics, and media. Leaders on both sides of the Atlantic continue to deepen transatlantic cooperation on a vast array of distinctly new and global challenges from the international financial crisis to climate change and energy security to the retention of high-skilled workers, yet there is no single transatlantic forum focused on this broad and increasingly complex global agenda. Brussels Forum provides a venue for the transatlantic community to address these pressing issues. By bringing together leading politicians, thinkers, journalists, and business representatives, Brussels Forum helps shape a new transatlantic agenda that can adapt to changing global realities and new threats.