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Emerging Europe and
the Great Recession
Emerging Europe and
the Great Recession
By

Daniel Dăianu
Emerging Europe and the Great Recession

By Daniel Dăianu

This book first published 2018

Cambridge Scholars Publishing

Lady Stephenson Library, Newcastle upon Tyne, NE6 2PA, UK

British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library

Copyright © 2018 by Daniel Dăianu

All rights for this book reserved. No part of this book may be reproduced,
stored in a retrieval system, or transmitted, in any form or by any means,
electronic, mechanical, photocopying, recording or otherwise, without
the prior permission of the copyright owner.

ISBN (10): 1-5275-0881-1

ISBN (13): 978-1-5275-0881-1
 CONTENTS

List of Illustrations ..................................................................................... ix

List of Tables ............................................................................................... x

Acknowledgements .................................................................................... xi

Preface: Why This Volume?..................................................................... xiv

Introduction ................................................................................................. 1

Part I. Society and the Great Recession

Chapter One ............................................................................................... 12

Limits of Openness
1. What went wrong? ........................................................................... 12
2. Reinterpreting globalisation ............................................................. 14

Chapter Two .............................................................................................. 20

When Models Crumble
1. Reform of the regulation and supervision of financial markets ....... 20
2. Revision of financial organisations’ business models...................... 21
3. Risk modelling needs to change....................................................... 21
4. More suitable cognitive models are needed ..................................... 22
5. Downsizing the financial sector makes sense .................................. 22
6. Economies need to be more balanced to enhance their robustness
and resilience .................................................................................. 23
7. Globalisation may have gone too far, so corrections are needed ..... 23
8. Models of economic integration need re-thinking ........................... 24
9. The relationship between governments and society needs to be
repaired........................................................................................... 24
10. Revisiting the rules and institutions of the international regime
is a must ......................................................................................... 25

Chapter Three ............................................................................................ 26

When Finance Corrodes Economy and Undermines Democracy
vi Contents

Chapter Four .............................................................................................. 33

Who Creates Money and What This Is Used For?
1. Commercial banks precede central banks ........................................ 35
2. The money vs. credit debate ............................................................ 36
3. Money creation and financial stability ............................................. 38
4. Crypto (parallel)-currencies and the money supply ......................... 39
5. Financial system overhaul proposals ............................................... 41
6. What would happen to credit? ......................................................... 42
7. Unconventional policies................................................................... 44
8. What does the future hold for finance? ............................................ 45

Chapter Five .............................................................................................. 47

Resilience and Robustness: When Systems are Under Siege
1. Shocks: Conventional and unconventional ...................................... 48
2. Why has robustness (resilience) been falling? ................................. 50
3. What to do now? .............................................................................. 55
4. Instead of conclusion: Is a new industrial revolution the solution? .... 61

Chapter Six ................................................................................................ 63

The Inward Looking Syndrome (The New Protectionism):
Where Does It Come From and Where Could It Go?
1. A few historical benchmarks............................................................ 64
2. Why is protectionism returning in the developed world? ................ 66
3. Simple analytics of a trade-off ......................................................... 68
4. A resurrection of national interests .................................................. 70
5 The New Protectionism: Whither? .................................................... 72

Part II. The European Union and the Great Recession

Chapter Seven............................................................................................ 76
Domestic Cycles, Financial Cycles, and Policies: What Has Gone Wrong?
1. Introduction ...................................................................................... 76
2. Domestic cycles and the financial cycle: The story of a big bubble ... 79
3. When the financial cycle meets “secular stagnation” ...................... 84
4. An Age of ultra-low interest rates? .................................................. 92
5. The Financial Cycle and macroprudential policies........................ 103
6. Elements of a policy agenda .......................................................... 106
7. Final remarks ................................................................................. 112
 Emerging Europe and the Great Recession vii

Chapter Eight ........................................................................................... 119

Regaining Financial Stability: Taming Financial Markets is a Must
1. Introduction .................................................................................... 119
2. Financial stability: Rediscovering structure ................................... 120
3. A focus on NMSs: The role of structure ........................................ 125
4. Regaining financial stability .......................................................... 137
5. Issues to ponder on......................................................................... 150

Chapter Nine............................................................................................ 153

The Euroarea Crisis
1. Introduction .................................................................................... 153
2. Roots of strain in the EMU ............................................................ 154
3. Deceptive aggregate deficits in the EMU: Why there is a need
for a fundamental repair? ............................................................. 159
4. The EU policy response: Crisis management and reforming
the EU (EMU) governance ........................................................... 161
5. The policy space challenge ............................................................ 170

Chapter Ten ............................................................................................. 173

External Imbalances and the Governance of the Euroarea
1. A global perspective ...................................................................... 175
2. A European perspective ................................................................. 179
3. Conclusion ..................................................................................... 183

Chapter Eleven ........................................................................................ 186

The European Union and the International Policy Regime
1. Why the Bretton Woods logic needs to be rediscovered................ 186
2. The Euroarea needs its own Bretton Woods .................................. 189
3. Democratic order demands taming financial markets .................... 191
4. Rediscovering the logic and spirit of Bretton Woods .................... 192

Part III. Romania and the Great Recession

Chapter Twelve ....................................................................................... 196

A Central Bank’s Dilemmas during Highly Uncertain Times
1. Introduction .................................................................................... 196
2. Romania: Huge correction of imbalances in a highly
unfavourable environment ............................................................ 197
3. Older vintage policy issues/dilemmas ............................................ 200
4. Recent vintage dilemmas: A new age? .......................................... 206
5. Final remarks ................................................................................. 218
viii Contents

Chapter Thirteen ...................................................................................... 219

Whither Romanian Capitalism?
1. Introduction: Romania in a crisis-ridden environment................... 219
2. Where has Romania come from? ................................................... 220
3. Post-communist transition in Romania .......................................... 225
4. Romanian capitalism in its post-communist phase ........................ 232
5. Romania, the EU, and catching up ................................................. 240

Chapter Fourteen ..................................................................................... 254

Euroarea Accession: The Question Is Under What Terms?
1. Introduction .................................................................................... 254
2. The Economic and Monetary Union between theory and practice ... 258
3. Euroarea vulnerabilities and reform limits. Further progress
is needed ....................................................................................... 261
4. Conditions for joining the Euroarea: From nominal convergence
to real and structural convergence ................................................ 266
5. Conclusions.................................................................................... 276

Afterthoughts on What Ails Europe and What To Do About It .............. 281

Bibliography ............................................................................................ 289

Index ........................................................................................................ 311

 LIST OF ILLUSTRATIONS

Fig. 6–1. The relation between protection (S) and economic openness (O) ............69
Fig. 7–1. Bank lending and GDP growth ................................................................82
Fig. 7–2. “The big impasse” in Europe ...................................................................83
Fig. 7–3. Evolution of real interest rates (William and Laubach, 2003) ..................85
Fig. 7–4. Real interest rate.......................................................................................85
Fig. 7–5. Value added shares of finance in GDP .....................................................87
Fig. 7–6. Growth of securities industry 1980–2007 ................................................87
Fig. 7–7. Public debt/GDP in advanced economies.................................................89
Fig. 7–8. Private domestic debt in advanced economies .........................................90
Fig. 7–9. Debt/GDP ratio in the United States ........................................................90
Fig. 7–10. Government gross debt (% GDP), 2013 .................................................91
Fig. 7–11. Nonfinancial corporate gross debt (% GDP), 2013 ................................91
Fig. 7–12. Investment (I) and Saving (S), equilibrium rate ................................97
Fig. 7–13. IS curve and potential output Qn ............................................................97
Fig. 7–14. The fall of real rates in the world (1980–2015) ......................................98
Fig. 7–15. Shifts in saving and investment schedules
in the world economy (1989–2015) ..................................................................98
Fig. 7–16. Fiscal expansion at the zero lower bound
with a constant real interest rate ........................................................................99
Fig. A-1. Potential and actual growth; budget and current account imbalances ....116
Fig. A-2. GDP gap, the growth rate deviation, and macroeconomic imbalances ..117
Fig. 8–1. Foreign bank ownership, 1998–2005 .....................................................128
Fig. 8–2. Credit to the private sector (measured in domestic currency unit,
September 2008=100), January 2008 to February 2010..................................129
Fig. 8–3. Gross private and public debt (% of GDP), 2008 ...................................130
Fig. 8–4. External debt (% of GDP), 2008 ............................................................131
Fig. 8–5. Share of non-performing loans, 2000–2009 ...........................................137
Fig. 10–1. Germany’s current account surplus according to EU data ...................174
Fig. 12–1. Fiscal consolidation in Romania (percent of GDP, 2008–2015) ..........198
Fig. 12–2. Real GDP growth rates (percent yoy, 2006–2015) ...............................198
Fig. 12–3. Romania’s public debt..........................................................................199
Fig. 12–4. Bank lending and GDP growth (2002–2012) .......................................202
Fig. 12–5. Disinflation in Romania (yoy, percent) ................................................204
Fig. 12–6. REER, GDP growth, policy rate, fiscal impulse ..................................205
Fig. 14–1. Nominal convergence of CEE Member States .....................................267
 LIST OF TABLES

Table 12–1. Current account balance (percent of GDP, 2007–2015) ....................197

Table 12–2. Gross external debt (percent of GDP) ...............................................199
Table 13–1. Per capita GDP of various European countries (1900–2010) ............227
Table 13–2. Catching-up of EU NMSs (per capita GDP at PPP, EU-27=100) .....230
Table 13–3. Main economic sectors according to their contribution
to the Romanian GDP (%) ..............................................................................237
Table 14–1. GDP per capita, EU28=100 ...............................................................269
Table 14–2. Potential GDP growth (reference year = 2010) .................................270
Table 14–3. Trend TFP .........................................................................................271
Table 14–4. Scenarios on the number of years needed to achieve real
convergence with the EA ................................................................................273
Table 14–5. Correlation of business cycles with that in the EA ............................275
Table 14–6. Estimation of synchronisation via additional measures .....................275
 ACKNOWLEDGEMENTS

I wish to thank first the publications and media vehicles which hosted
the pieces that are brought together in this volume; I mention them below:

• “Limits of Openness”, Europäische Rundschau, no. 4, 2009, pp. 93–

101 (which is an expanded version of a text published by Politico
(European Voice) in August 2008);
• “When models crumble”, Hotnews and Stratfor, 25 May 2013;
• “When high finance cripples economy and corrodes democracy”,
Eurozine and Dilema veche, 27 July 2011;
• “Who creates Money?”, Opinii BNR (blog) and World Commerce
Review, June 2017;
• “The New Protectionism”, World Commerce Review, Spring 2017;
• “Robustness and Resilience of Social Systems”, presentation made at
the World Policy Conference, 14 December 2013;
• “Financial cycles, domestic cycles and policies: what has gone
wrong?”, CASE Working Paper, 5(129), 2017; an earlier version
appeared as NBR Occasional Paper, no. 26, 2016; and a shorter
version, “An Age of Ultralow Interest Rates?”, appeared in World
Commerce Review, September 2016;
• “Regaining financial stability’: taming financial markets is a must”,
Romanian Journal of Economic Forecasting, no. 2, 2011;
• “Euroarea crisis and EU governance: tackling a flawed design and
inadequate policy arrangements”, Acta Oeconomica, 62(3), 2012; an
updated version in D. Dăianu, C. D’Adda, G. Basevi, and R. Kumar,
The Euroarea Crisis and the Future of Europe (Palgrave Macmillan,
2014);
• “The Governance of the Euroarea: Do external imbalances matter?”,
World Commerce Review, December 2014, and Central Bank Journal
of Law and Finance, no. 2, 2015;
• “Rediscovering the Logic of Bretton Woods”, Europe’s World,
Autumn 2013;
• “A Central Bank’s dilemmas in highly uncertain times”, NBR
Occasional Paper, no. 13, 2015 and in Ewald Nowotny et al., The
Challenge of Economic Rebalancing in Europe: Perspectives for
CESEE Countries (Cheltenham: Edward Elgar, 2015);
xii Acknowledgements

• “Whither Romanian Capitalism” (with Bogdan Murgescu), FES

International Policy Analysis, June 2013;
• “Euroarea accession: The question is under what terms” (with Ella
Kallai, Gabriela Mihailovici, and Aura Socol), Romanian Journal of
European Affairs, December 2017;
• “What ails Europe and what to do about it”, Europe’s World, 20
October 2015.

I should say that some of the texts for this volume have been very
slightly revised as against the versions contained in the publications and
media venues mentioned above.
I am grateful to the Center for Transylvanian Studies, Romanian
Academy, Cluj-Napoca, to Rector Ioan Aurel Pop and Vice-rector Ioan
Bolovan in particular, who accepted that an earlier version of this volume
be revised, restructured, and published by Cambridge Scholars Publishing.
The National Bank of Romania (NBR) hosted events at which I
presented my views on the roots of the financial crisis, the Euroarea crisis,
and finance reform; for this I am indebted to Governor Mugur Isărescu and
other current and former members of the board of the NBR: Florin
Georgescu, Liviu Voinea, Eugen Nicolaescu, Cristian Popa, Nicolae
Dănilă, Marin Dinu, Gheorghe Gherghina, Ágnes Nagy, Napoleon Pop,
and Virgil Stoenescu.
I feel bound also to mention current and former top officials from
central banks in Central and East Europe with whom I have exchanged
views on monetary and financial policy issues over the years; I refer
especially to Leszek Balcerowicz, Marek Belka, Mojmír Hampl, Kalin
Hristov, Marek Mora, Ryszard KokoszczyĔski, Jerzy OsiatyĔski, Paweá
Samecki, Miroslav Singer, György Surányi, György Szapáry, and Boris
Vujþiü.
I thank also fellow economists with whom I have debated topics
tackled in this volume; I refer in particular to Carlo D’Adda, Adrian Alter,
Dan Armeanu, Claudio Borio, Mihai Copaciu, Lucian Croitoru, László
Csaba, Marek Dabrowski, Bruno Dallago, Zsolt Darvas, Božidar Ðjeliü,
Emilian Dobrescu, Aurelian Dochia, Sebastian Dullien, Vladimir
Gligorov, Daniel Gros, Doris Ritzberger-Grünwald, Anton Hemerijck,
Bodo Herzog, Julius Horvath, Aurel Iancu, Ella Kallai, Michael Keren,
Wolf Klinz, Grzegorz Kolodko, János Kornai, Michael Landesmann,
Valentin Lazea, Laurian Lungu, Klaus Masuch, Gabriela Dragan, Gabriela
Mihailovici, Dániel Palotai, Jean Pisani-Ferry, Helene Schubert, Aura
Socol, Jerome L. Stein (late), Jonathan Story, Martin Suster, Jan Svejnar,
ElĘd Takáts, Milica Uvaliü, Nicolas Veron, Radu Vrânceanu, Benjamin
 Emerging Europe and the Great Recession xiii

Weigert, Guntram Wolff, Brigitte Young, Gheorghe Zaman, and Fabian

Zuleeg.
The Romanian Academy, Bruegel, Bertelsmann Foundation, CASE
(Warsaw), Friends of Europe, The World Policy Conference, The
Romanian Economic Society, The Romanian European Institute, The
Academy of Economic Studies (Bucharest), The Central European
University (Budapest), Babeú-Bolyai University (Cluj-Napoca), A. I. Cuza
University (Iaúi), University College (London), George Washington
University (Washington, DC), West University (Timiúoara), and SNSPA
(Bucharest) are among the venues which helped me voice my opinions; I
thank them all.
Certainly, I bear sole responsibility for the views expressed in this
volume.
Last but not least, I thank my son, Matei, whose candour, joy
alternating with disappointments, and vibrancy constantly remind me that,
however much I am fond of books, life around me is richer and is “alive”.
 PREFACE

WHY THIS VOLUME?

My experience as a member of the European Parliament (EP) is vivid

in my mind. Together with a colleague of mine, the German MEP Wolf
Klinz, we organised what was probably the first seminar on the financial
crisis in the EP, in March 2008. At that time, quite a few members of the
European Commission and many top European policy-makers were in a
state of denial as to the magnitude of the financial crisis; for them, the
latter was, simply put, “an American affair”. The Lehman Brothers’
collapse and its reverberations across the Atlantic came as a shock that
forced a reality check. Since then, disbelief and policy disarray have been
highly on display.
An economic recovery has been underway in Europe during recent
years. But much of it has, arguably, cyclical roots and has also been driven
by unconventional policies of the ECB. We continue to live in a period
dogged by “tail events” and high uncertainty. The meltdown of the
financial system was averted, but at enormous costs to public budgets.
Private debts are still at staggering levels. Claudio Borio, Ken Rogoff, and
others are right to highlight the implications of over-debt. The ECB’s
unconventional interventions since late 2011 and the Banking Union
project seem to have silenced existential worries, but there is still a long
way to go in order to end the Euroarea troubles. There is talk about
“secular stagnation” in industrialised economies, a notion that we owe to
Alvin Hansen and that was resuscitated by Lawrence Summers in Jackson
Hole in 2013. Social systems are under siege because of proliferating
shocks and rising economic inequality; robustness and resilience remain a
huge policy challenge in spite of efforts to create buffers of all sorts. There
is also a spreading sentiment that the international financial system is not
working well.
The EU and the Euroarea troubles severely impact the New Member
States (NMSs), countries that joined the European Union (EU) in 2004 and
2007, or, as this volume uses as a term, Emerging Europe. Apart from the
impact of the financial crisis, NMSs also have to cope with the flip side of
a growth model that relied on massive capital imports, external
 Emerging Europe and the Great Recession xv

indebtedness, and a relative neglect of tradable sectors (see also Becker et

al. 2010). This growth model is rooted in the logic of the single market
(ex.: the complete opening of the capital account) and major economic
discrepancies; and it contrasts with the evolving model in Asian emerging
economies after the crisis of 1997–1998. It is true that economic
convergence has been a hallmark of NMSs’ evolution in the EU, in spite
of the fracas also produced by the financial crisis in these countries. In this
respect, it is worth pointing out that NMSs have resumed their
convergence towards EU benchmarks in recent years, which is in contrast
to divergence and cleavages inside the Euroarea. Nonetheless, the “middle
income trap” is looming on the horizon. Therefore, prospects of economic
catching up in the EU, in the Euroarea, have to be re-examined under the
new circumstances, in the wider frame of what ails Europe and longer
term trends in the global economy.
During the past decade, I have been involved in efforts to tackle the
current crisis, as a legislator (in the EP) and as a member of the Romanian
authorities for the regulation and supervision of financial markets.
Together with the late Ieke van den Burg, I co-authored the EP report “The
Lamfalussy Follow Up”, that deals with the reform of the regulation and
supervision of financial markets and that can be seen as in line with other
key pieces of reform legislation. I have also attended international policy
meetings (as a member of ESMA, IOSCO, ESRB boards, etc.) and
academic meetings, and I have written on issues pertaining to the Great
Recession, Europe’s major problems.
The volume Emerging Europe and the Great Recession tries to sum up
my thinking on where the Union’s and Euroarea’s pains come from and
what lies ahead; it blends my experience as a policy-maker, legislator, and
academic. In a way, this volume is a sequel to my Which way goes
capitalism? (CEU Press, 2009). This new volume aims also at providing
an analysis of policy issues that concern the EU’s less developed/emerging
economies (NMSs), and it is made up of three parts which comprise 15
chapters (including afterthoughts).
The first part of the volume, “Society and the Great Recession”,
illustrates my thinking on the roots of the financial crisis and its impact on
society; the six chapters refer to limits of openness, a crisis of cognitive
and operational models, the relationship between finance and economy,
money creation, trends that cripple the robustness and resilience of
systems, and an “inward-looking syndrome” (a new protectionism) in
advanced economies.
The second part is “The European Union and the Great Recession”; its
five chapters refer to the linkages between domestic economic cycles and
xvi Preface

the European financial cycle, the reform of the regulation and supervision
of financial markets as a means to regain financial stability, the Euroarea
crisis, external imbalances and the governance of the Euroarea, and the
international policy regime.
The third part focuses on European Emerging Economies (NMSs) and
Romania in particular. Its three chapters refer to policy dilemmas and
trade-offs during highly uncertain times, the dynamics of Romanian
capitalism, and Euroarea accession.
A final chapter contains afterthoughts on what ails Europe and what
should be done about it.
The paradigm I espouse is that markets are a must for entrepreneurship
and economic dynamism. But market failures are part and parcel of reality,
and these can cause a lot of misery in society unless they are reined in. The
approach in this volume is multi-perspective since it embeds NMSs’
experience into a wider European context; it also looks at the wider
financial picture in order to get a grasp of how derailed finance and rules
of the game in the EU have favoured a boom and bust cycle in European
economies.
The volume brings together texts that were published in various
publications; some of them have been updated or slightly revised for this
volume.
In a sense, one could wonder what this volume adds to the current
literature on the Great Recession, on the Euroarea troubles, and what lies
ahead for NMSs, which is enormous. The IFIs, central banks, European
organisations, major international and European think tanks (Bruegel,
CEPS, Friends of Europe, Bertelsmann, Notre Europe, CEPR, etc.),
universities, individual scholars, etc. are all engaged in a frantic effort to
answer the “Big Questions” (Die Grossen Fragen). Edward Elgar
publishes proceedings of conferences hosted by the Central Bank of
Austria, which are dedicated to challenges facing NMSs. It does likewise
with volumes issued under the aegis of the European Association for
Comparative Economic Studies. Other publishing houses have been
involved in similar efforts. But there are reasons to believe that the value
added by this volume will not be nil. First, it provides the views of
someone who has been (and still is) in the trenches. Second, it tries to
blend policy and academic experience. Not least, it voices concerns and
dilemmas from the perspective of New Member States, of Romania in
particular, in a period of rising uncertainty and policy trade-offs. The
volume relies on a relevant literature and the author’s own experience.
I thank my colleagues Ella Kallai, Gabriela Mihailovici, Bogdan
Murgescu, and Aura Socol, who were kind enough to accept the inclusion
 Emerging Europe and the Great Recession xvii

in this volume of papers we co-authored. I am also grateful to all

publications which accepted that texts of mine be brought together in this
volume.
I express my gratitude to the Center for Transylvanian Studies of the
Romanian Academy for accepting that a restructured and revised version
of a previous work of mine (New Europe and the Great Recession, 2017)
be published by Cambridge Scholars Publishing.
This volume would be of interest to all those who wish to get
additional insights on the challenges the Union, the Euroarea, and the
European emerging economies have faced since the eruption of the
financial crisis and will face in the years to come. Its target audience is
academia, research outfits, policy-making circles, business circles, and
NGOs.

Daniel Dăianu
December 2017
 INTRODUCTION

The Great Recession engulfed Europe, as it did with most of the

industrialised world, about a decade ago. All of a sudden, a simplistic
paradigm which equates price stability with financial stability fell into
disrepute, and major flaws of finance, as it has evolved during the last few
decades, came glaringly into the limelight. Oversized finance, a growing
shadow banking sector, and destabilising capital flows, against the
backdrop of over-indebted and stagnant economies, test the ability of
policy-makers to manage disequilibria and deliver essential public goods.
Policy choices are complicated by rising inequality, the erosion of the
middle class, and a spreading sentiment of declining fairness in society at
large. This set of circumstances strains economies and societies, and
foments political extremism.
The financial crisis shed light on basic weaknesses of the Euroarea
design and of its policy arrangements. The Euroarea is in a prolonged
phase of crisis management; the QE (quantitative easing) programmes of
the ECB, in general, are symptomatic of policies having sailed into
uncharted territory. The ongoing Greek drama is only the tip of the
iceberg; non-existing solid fiscal underpinnings and improper policies
have favoured a growing fracture between North and South in the
Euroarea. Deep reforms of the Euroarea’s institutional setup and structural
reforms in its Member States are badly needed in order to make it viable.
The refugee crisis adds to a sense of policy stalemate and inadequate ad
hoc measures.
“The Five Presidents’ Report” of June 2015 is bold when it talks about
a joint treasury, a Fiscal Capacity, but it still bets on incrementalism in
proceeding with institutional and policy change. The same can be said
about the reflection paper of the European Commission of May 2017.
Thence, the ambivalence of several New Member States (except those
which have or had currency boards) regarding a quick Euroarea accession,
apart from the need to achieve a critical mass of real convergence.
For the emerging economies of Europe, the New Member States, the
Great Recession came as a formidable blow that was felt via several
channels. One is a growth model that relied extensively on debt and
external borrowing. The crisis entailed quasi sudden stops, which hit the
Baltic countries, Romania, and Hungary in Central and Eastern Europe.
2 Introduction

These countries had to get financial assistance from the IFIs and the EU in
order to avert a liquidity crisis turning into a solvency crisis. Another
channel of transmission is made up of the trade and financial linkages with
the Euroarea, during a period when the latter is being afflicted by intensive
deleveraging and is threatened by secular stagnation—a notion resuscitated
by Larry Summers in order to emphasise the impact of declining
productivity gains, demographics, and prolonged hysteresis phenomena in
the industrialised world. This situation is illustrated by very feeble new
credit flows and dim prospects of growth in the years to come (as OECD
and IMF studies indicate). An economic recovery has been underway in
Europe in recent years, but high uncertainties regarding longer term
prospects and unintended consequences of unconventional policies (as
these are implemented by major central banks) heighten concerns about
the future.
The abovementioned context provides the background for the volume
Emerging Europe and the Great Recession, which deals with the impact of
the financial crisis and the Euroarea crisis on the European Union and on
the New Member States (viewed as emerging economies) in particular.
Part 1, “Society and the Great Recession”, takes a look at the broad
picture, at how finance serves, or not, the economy, and is made up of six
chapters.
Chapter 1, “Limits of openness”, stresses that globalisation (and
liberalisation) can be understood in a different vein, which looks at the
actual functioning of markets—with their pluses and minuses—and which
takes into account insights of economic theory such as information
asymmetries, increasing returns (while technological progress is intense—
endogenous growth), agglomeration effects (clusters), multiple (bad)
equilibria, coordination failures, the role of economic geography, and so
on. As these theoretical constructs and, a fortiori, the effects of the current
financial crisis suggest, there are lessons to be learned: the need for
effective regulation of markets; the role of the state in providing public
goods; the role of institutions (structures of governance); the need of
public goods and effective governance in the world economy; the
importance of variety and policy ownership in policy-making.
A combination of two dynamics will arguably develop as a means to
preserve an open global economic system, albeit in a restrained form. One
dynamic refers to a partial domestication of market forces in national
governments’ quest to cope with systemic risks and social strain. This
would involve more state presence in the economy and broader
regulations; elements of “war economy” conduct in public policy will also
be quite visible, in liberal democracies too. Ideological propensities are
 Emerging Europe and the Great Recession 3

less involved here, for governments act, basically, out of sheer necessity.
The other dynamic refers to blocs of countries that decide to use a
common currency and trade more intensively among themselves; such
arrangements would be a means to avoid brutal disruptions to their internal
activities were a global crisis to occur. This is like saying that the global
system needs several sub-global clusters in order to mitigate the
potentially devastating effects of a completely open world system that
would be prone to recurring major crises.
Chapter 2, “When models crumble”, observes that the current crisis
questions cognitive and operational models that organisations, big and
small, private and public, have used in the pursuit of their goals. Much of
the rethinking of models is induced by the role played by finance in this
crisis. The rethinking of models/paradigms is either deliberate, or it will be
forced upon organisations by forces and pressures from outside; it will
take place at micro, macro, and international level, be it in a forceful or a
protracted and confusing manner. The light touch regulation model has
brought havoc in the financial industry and in economy/society at large.
Business models have proved inadequate on a massive scale, with their
overemphasis on trading and speculation, the use of fancy (toxic)
derivatives, and the neglect of risks and of complexity as a trait of
contemporary systems. Likewise, regulators and supervisors succumbed to
the reasoning that a low inflation rate is equivalent to financial stability
and that the spread of derivatives is a means to diminish risks throughout
the economic body. Systemic risks have skyrocketed and have compelled
central banks and governments to come to the rescue of banks as a means
to avert a financial meltdown. What has brought organisational patterns
into disrepute, in the end, is a blatant misunderstanding of risks—as the
latter were entailed by expanding financial markets. The problem,
therefore, is to deal with the very object of regulation and supervision and,
consequently, to tame financial markets.
Chapter 3, “When finance corrodes economy and undermines democracy”,
observes that the “too big to fail” syndrome would maintain a captivity
status towards these financial groups on the part of governments. The very
logic of a fair market economy is seriously perverted. This is because it is
totally unacceptable that losses of the financial industry be recurrently
socialised, at the expense of taxpayers, while gains of employees and
capital providers of the financial industry be protected in view of
“systemic risks”. The financial and economic crisis is reinforcing a
worrying tendency in Europe and the US: the erosion of the middle class.
This erosion can be linked with technological change (which has favoured
highly skilled labour in advanced economies), Asia’s phenomenal economic
4 Introduction

growth (which has dented the Western countries’ market shares), public
policies that have underestimated the role of industrial policies, and, not
least, an overexpansion of the financial industry in several economies, at
the expense of other sectors. The excessive growth of finance has entailed
a marked change in profit distribution in the corporate world and in
income distribution in society at large. There is also a huge ethical
problem which is exposed by this crisis as well. Big companies are fond of
speaking of corporate social responsibility. But where is it when
investment banks sell financial products to investors which they short at
the same time? Where is corporate social responsibility when companies
that make billions of dollars (or euros) in net income pay almost nothing to
national fiscal authorities? The way financial markets have functioned in
recent decades is not God-given. Public policy can and should change it,
as it did after the Great Depression and after the Second World War.
Chapter 4, “Who creates Money?”, argues that what matters most for
individuals and for society as a whole is what money is used for. There is
an older debate, on “who creates money”, on the relationship between base
money/outside money supplied by central banks and the inside money
created by commercial banks. This dispute should be linked with the
equally old observation that the financial system is prone to crises, to
instances of panic—to “runs”. Is money creation given an additional life
by crypto-currencies? It is not clear that crypto-currencies are as trustworthy
as some claim them to be. And, in the end, what matters for money to be
accepted and used on a big scale is the trust one puts in the issuer and its
capacity to deliver what it claims to do. As we can see, central banks have
been—as Mohamed El Erian put it—“the only game in town”, and the
rescuer of last resort—as they are supposed to be. And this is likely to stay
so for a long time. This said, however, finance has to change its behaviour,
and central banks and governments have a long way to go in order to
redeem their reputation when it comes to the regulation and supervision of
banks and non-banks alike.
Chapter 5, “Resilience and robustness: when systems are under siege”,
argues that the world seems to be caught in a vortex of bifurcations, which
may land us in a very different environment with much more uncertainty
and perils. What may be striking is that a very deep financial and
economic crisis has hit most of the industrialised countries, which are
presumed to have solid institutional arrangements (though one could argue
that no system is immune to the accumulation of tensions over time and
that cyclicality is part and parcel of economic dynamics). Economic
decline in many economies has caused enormous strain, which shows up
in social life and in the political process, too (e.g. stalled institutions of
 Emerging Europe and the Great Recession 5

dialogue/negotiation/decision, and extremist manifestations in the politics

of mature democracies including augmented chauvinism and xenophobia).
The current financial/economic crisis deepens social dislocations that were
already at work in quite a few industrialised countries. The crisis of the
welfare state, in conjunction with rising income inequality, has weakened
a social milieu that was dealt further blows by the financial crisis. Social
strain, which shows no sign of abating, is spreading around. There is also
the dramatic climate change of the last couple of decades, which indicates
basic disorders in the human–nature relationship. Some of these disorders
are rooted in societies’ disregard for or misunderstanding of ecological
needs. The proliferation of extreme events questions the very perception of
them being rare. Even though we have ever more information, scientific
and technological advance never stops, and societies do not automatically
have superior cognitive capacities and capabilities to respond to shocks
and challenges. This hypothesis is examined and some avenues for
strengthening robustness and resilience are outlined.
Chapter 6 deals with “The inward-looking syndrome” (the new
protectionism), which is manifest in more than a few advanced economies
(societies). The New Protectionism (NP) can be interpreted in a narrow
sense, along the lines of trade/economic relations and in a broader sense,
when it covers a vast array of measures targeting national security (which
has other dimensions than the pure economic one). In both senses, the
liberal order, as it was set following WWII, is questioned. It should be
emphasised, however, that a liberal order is not synonymous with market
fundamentalism. The world that we seem to be bumping into shows signs
of fragmentation, with societies more polarised. More than a few
developed states feel threatened and seek self-protection via various
measures; protectionist measures are part of a return of the state in the
economy. There is a competition between the developed world and the one
that is arising, and this contest needs to be managed through clear rules.
And rules imply a world order. What would be the result of NP as an
economic defence response? It may probably open the door to a prolonged
interregnum, with a corrosion of international, global institutional
arrangements. Such an evolution is likely to lead to a precarious balance—
an unstable equilibrium in international relations.
Part 2 makes an assessment of the main causes of the Great Recession
and how it has hit the European Union; it includes five chapters.
Chapter 7, “Domestic cycles, the financial cycle, and policies: what has
gone wrong?”, takes a longer term, historical perspective on economic
dynamics—under the impact of structural trends, globalisation, and
policies. This chapter focuses on economic cycles and policies in an
6 Introduction

international (European) context. The financial cycle is a key concept in

the logic of this chapter. The experience of NMSs is amply taken into
account. Attention is paid to the linkage between domestic cycles and the
European financial cycle, drivers of financial cycles in the global
economy, finance deregulation and systemic risks, the international policy
regime, and global stability. The Great Recession is examined through the
lenses of financial cycles, and likely causes of this very deep crisis are
pointed out. The syndrome of ultra-low interest rates is also examined.
Chapter 8, “Regaining financial stability”, highlights the need for a
radical overhaul of the regulation and supervision of financial markets.
Something pretty wrong has occurred with financial intermediation in
recent decades. This is like saying that structure has been no less important
in derailing economies than misconceived policies and unavoidable cyclical
dynamics. By structure is meant the configuration of rules and practices in
the realm of regulation and supervision, on the one hand, and the evolution
and practices of financial institutions, including securitisation and the
growth of the so-called shadow banking sector (which has escaped
regulations), on the other hand. Structure has, arguably, influenced policies
in view of the relative neglect of systemic risks and the almost blind belief,
by some, in the self-regulatory virtues and clairvoyance of financial
markets. For a long time, financial stability was relegated, de facto, to a
second tier policy priority—especially in advanced economies. The
economies of new EU Member States in Central and Eastern Europe have
been strongly hit by this financial crisis, although these economies’
exposure to toxic products was quite minimal and their budget behaviours,
with some exceptions, were not profligate. What this chapter argues is that
this dynamic can be explained by considering the implications of deep
financial integration. The latter can bring benefits and rapid growth, which
did take place in the region until 2008, but is can also do harm unless
proper institutions and policies operate. Moreover, the impact of the
current crisis on NMSs illustrates the role of structure, of the rules of the
game in the EU (complete capital account liberalisation), the nature of
regulation and supervision, and not least, massive cross border operations.
The case of NMSs is all the more significant since these economies
imported capital on a large scale as a means to foster growth—while in
Asia and Latin America, the episodes of crisis of the past two decades
induced countries to attach a high premium to the accumulation of foreign
exchange reserves and the reduction of current account deficits. NMSs
look like they have tried to defy the lessons of previous crises by betting
on the virtues of deep financial integration.
Chapter 9, “The Euroarea crisis”, focuses on the roots of the huge
 Emerging Europe and the Great Recession 7

strain in the Union and on policy issues ensuing from the current crisis. It
remarks that the sovereign debt crisis has created enormous anguish in the
European Monetary Union (EMU), and emergency measures are being
used in order to prevent its breakdown. The European Council summit of
October 2010 considered a report with a telling name: “Strengthening
economic governance in the EU”. This document should be examined in
conjunction with the governance reform proposals issued by the European
Commission and related documents. In March 2011, the Council adopted
the Euro Pact and the European Parliament approved the “Six pack”
measures later in the year. A Treaty on Stability, Coordination, and
Governance was signed by 25 governments in March 2012. At the end of
2011, the European Central Bank (ECB) embarked on extending ultra-
cheap credit lines aimed at keeping banking groups afloat. And in 2012,
the ECB announced its determination to help Euroarea governments via
purchases of sovereign bonds in secondary markets. Several meetings of
the European Council focused on the setting up of a banking union.
However, this démarche to reform governance is not an attempt to deal
with a terra incognita. From the very beginning of the Euroarea, there was
some discomfort with its institutional underpinnings, and there were
misgivings regarding its optimality as a currency area. This explains why a
train of thought also underlines a political rationale for its creation.
Likewise, criticism over the way regulation and supervision were
established in the Union is not of recent vintage. Moreover, insufficiencies
of the Stability and Growth Pact (SGP), with almost all Member States
flouting its rules at various points in time, were repeatedly pointed out.
This said, however, the flaws of financial intermediation have been less
considered by policy-makers and central bankers for reasons which,
partially, are to be found in a paradigm which has dominated economic
thinking in recent decades.
Chapter 10 deals with “External imbalances and the governance of the
Euroarea”. Recent years have brought to the fore a salient feature of the
Euroarea and of the global economy: Germany’s current account surplus,
with an ensuing debate on its impact on neighbouring economies. This
surplus was above 8% of Germany’s GDP in recent years; at about 200
billion euros, it was the largest in the world. Is this surplus a problem,
especially when there is such a diminished ability to grow in the
economies of the Euroarea, and when there is a need for burden sharing
when it comes to the costs of adjustment in a single currency area? The
way the Euroarea functions now resembles the gold standard regime of the
interwar period, and this should be quite alarming, for we know what that
international policy regime contributed to. The talk about a looming
8 Introduction

economic stagnation in Europe is motivated by a very serious situation.

Unconventional monetary policies aimed at breaking the deadlock of the
transmission mechanism need to be combined with bold public investment
policies which should prop up aggregate demand at the Euroarea level and
structural reforms in national economies. What may look optimal at a
national level may not be optimal for the Euroarea as a whole. And this is
arguably the crux of the matter right now. Structural reforms fully fit the
logic of individual responsibility. But however responsible national
policies may be, a union still asks for a lender of last resort and tools for
dealing with asymmetric shocks.
Chapter 11, “The European Union and the international policy regime”,
focuses on the international policy regime. The Bretton Woods arrangements
could be seen as the epitome of a hegemonic shaping of the international
economic regime after the end of the Second World War. But such a view
would be questionable for two reasons, at least. First, because there is
always a need for an effective international regime, which should foster
peaceful interactions among sovereign states. Second, the Bretton Woods
arrangements were rooted in the lessons of a huge financial and economic
crisis, the Great Depression, and tried to combine regulations applied to
domestic affairs with rules covering international relations. The logic of
the Glass–Steagall Act (which separated investment banking from
commercial operations) and Keynesian macroeconomics applied to domestic
finance, whereas pegged but adjustable exchange rates and capital controls
were used for the sake of enhancing economic recovery and world trade.
What is called the “impossible trinity” (concomitant stable exchange rates,
free flow of capital, and independent monetary policy) was taken care of
through those arrangements. However, once the USD was delinked from
gold in the 1970s, a dynamic was put in motion that gathered tremendous
speed via waves of financial deregulation. The Big Bang in the City of
London in 1986, the rescinding of Glass–Steagall in 1999, the Commodity
Futures Modernization Act of 2000 in the US, etc. have brought in a new
era, a rapid growth of finance in the industrialised world, and fuelled deep
financial integration in the EU. But darker sides of the new financial
system were poorly understood and largely dismissed due to a blind belief
in the virtues of market self-regulation and of derivatives. And we have,
gradually, got into another huge financial and economic mess, which
harms the social fabric of society, and even democratic politics. Add to
this the profound Euroarea crisis. As was the case almost 60 years ago, in
order to create adequate policies, one has to come to grips with the
profound roots of the financial and the Euroarea crises and, arguably,
rediscover the Bretton Woods spirit and logic.
 Emerging Europe and the Great Recession 9

Part 3 focuses on emerging economies in general and Romania in

particular; it comprises three chapters.
Chapter 12, “A Central Bank’s dilemmas during highly uncertain
times”, frames its analysis in a European and historical context. Some of
the policy dilemmas are of an older vintage, such as how to deal with
massive capital inflows and outflows, or how to combat high inflation
when resource misallocation is a burdensome legacy and expectations of
high inflation are well entrenched. Other dilemmas are pretty new, or have
acquired more salience during the Great Recession. Romania has had to
undertake a painful correction of its large macroeconomic imbalances,
under very unfavourable international circumstances. Its macroeconomic
situation is much better now than when the financial crisis hit during
2008–2009, but a highly uncertain European environment is a major
source of concern. The NBR’s monetary policy arrangements (“light”
inflation targeting) have provided leeway for mitigating the fallout from
the financial crisis, although high euroisation has dented their efficacy.
When easing monetary policy, central bankers cannot afford to
underestimate the wealth effect and the balance sheet impact which a
significant exchange rate depreciation entails. The spectre of stagnation in
the Euroarea, financial deleveraging, and unconventional monetary policies
pursued by key central banks, combined with the ongoing reform of
banking regulation and supervision, a growing shadow banking sector, and
the uncertainties regarding the evolution of the Banking Union make up a
very complex European context and pose a range of big challenges for the
central banks of New Member States (NMSs).
Chapter 13, “Whither Romanian capitalism?”, intends to explore post-
communist Romania—its market based economy—from a long term
perspective and in a wider context. The focus is on the catch up prospects
against the backdrop of the Great Recession’s impact and internal
weaknesses. The emphasis is on economic issues, which are blended with
social and political insights; the analysis is cast in a comparative
framework. Romania joined the EU in 2007 as one of its least developed
economies. A catch up process is indisputable as its GDP/capita went up
from approximately 23–24% (in PPP terms) of the EU average at the start
of this century to about 57% currently. But the country still has to achieve
a critical mass of real convergence in order to enter the Euroarea, which is
an obligation according to the Accession Treaty. Its basic infrastructure is
pretty poor, and a significant portion of the population lives in rural areas.
The domestic output is, to a large extent, made up of lower end value
added products, although its range is amazingly large. For a long period of
time, Romania was an outlier when it comes to inflation—pretty high
10 Introduction

according to EU standards. In recent years, inflation has come down

dramatically owing to trends in the global economy and disinflationary
(deflationary) pressures. After the crisis hit in 2009, a major fiscal
consolidation took place. However, and as in the case of other EU
emerging economies, huge uncertainties and challenges lie ahead; these
relate to conceptual frameworks of economic policies in view of the
lessons of the Great Recession, rethinking the economic growth model,
preconditions for joining the Euroarea, taking stock of developments in the
global economy, dealing with effects of the geopolitical strains in Europe
(the war in Ukraine, rising disorder in other vicinities of the Union, the
refugee exodus), etc. As a matter of fact, these are challenges that face all
EU emerging economies to a greater or lesser extent.
Chapter 14, “Euroarea accession: The question is under what terms?”,
argues that Euroarea accession should mainly depend on the achievement
of a critical mass of real and structural convergence, which should
diminish the risks of operating in an incomplete monetary union.
Accession would also be enhanced by reforms in the functioning of the
Euroarea institutions and policies which should deal with asymmetric
shocks. The true issue of euro adoption in Romania should be neither “if”
nor “when”, but “under what terms” and “how it will be done”. The
essential prerequisite for real convergence is raising competitiveness. The
analysis shows common problems regarding competitiveness in NMSs in
terms of infrastructure, institutional development, business sophistication,
and innovation; it points out the scale of risks attached to a premature
Euroarea accession. This accession does not require the achievement of
the Euroarea average level of GDP/capita (in PPP terms). One can imagine
Romania’s accession after having achieved a minimum of 75% of the
Euroarea GDP/capita average and the fulfilment of a series of structural
conditions against the backdrop of Euroarea reforms. Solid public budget
consolidation, which implies low structural deficits, is a must to this end.
Geopolitical considerations can speed up accession nonetheless.
The epilogue contains a few afterthoughts on what ails Europe and
what should be done about it.
 PART I

SOCIETY AND THE GREAT RECESSION

 CHAPTER ONE

LIMITS OF OPENNESS

The current world financial crisis compels deep soul-searching and

scrutiny of where top politicians and their advisers were wrong. Never
mind that stern warnings on the incoming crisis were made by astute
economists and financiers years ago. Unfortunately, vested interests
prevailed over the cautionary words of Warren Buffett, Edward Gramlich,
Alexander Lamfalussy, Paul Volcker, and others. This crisis underlines the
pitfalls and dangers of financial deregulation (lack of regulation) in global
markets and raises fundamental issues for public governance; it should be
seen in conjunction with the resounding fracas of the Doha trade round,
with the resurrection of economic nationalism in industrialised economies,
which is not of recent vintage, and not least with the geopolitical
consequences of the economic rise of China and other emerging global
powers. This crisis should be judged against the backdrop of the effects of
climate change and of the mounting fear about nearing the limits of
exhaustible resources—which raises huge security concerns.
Arguably, coming to grips with the effects of this financial and economic
crisis, together with food, environment, drinking water, and energy-related
concerns, forces national governments to reassess the advantages of
unrestrained economic openness; systemic risks, not only of a financial
nature, will increasingly be a focus of the public agenda in the years to
come. This reassessment involves more government presence in the
economy as well as broader regulatory frameworks; some of it is prompted
by the exceptional circumstances of the crisis, but the whole context is
undergoing a change of Zeitgeist and policy paradigm.

1. What went wrong?

During the last decades, rapid technological change has reduced
transportation and transaction (information) costs enormously and has
speeded up the transfer of know-how, albeit in a highly skewed manner,
among regions of the world; the internet connects hundreds of millions of
people instantaneously nowadays. World trade has expanded at a very
 Limits of Openness 13

rapid pace and has broadened the scope of choice for individuals
throughout the world. The collapse of communism has expanded the work
of market forces and democracy in a large area of the world. And the very
dynamic of the EU can be seen as an alter ego of globalisation on a
regional scale.
However, we are now in the midst of the deepest financial crisis after
the Great Depression, which erupted after a sequence of other episodes of
crisis in the US and Europe during the last couple of decades; this
indicates the increasing instability of the world financial system—as it has
evolved during recent decades. Likewise, financial and currency crises
have been recurrent in emerging markets in the same period of time and
have caused economic and social havoc in quite a few countries, while
world trade liberalisation has left many poor countries in the dust. The
distribution of wealth in the world seems to be more unequal nowadays
than 20 years ago; the myth of the “new economy” has dissipated and
corporate scandals in the affluent world show that cronyism and bad
governance are a more complex phenomenon than is usually assumed and
ascribed geographically; social fragmentation and exclusion have been
rising both in rich and poor countries; there is a sense of disorder and a
rising tide of discontent and frustration in many parts of the world. Can we
make some sense of all this in relation to policy dynamics?
The past two decades have been suffused with claims that economic
policy, in the advanced countries, is being driven by an emerging new
consensus on principles and practice. One origin of this “consensus” could
be ascribed to the ever longing desire to control the environment and be
more efficient. Max Weber’s “rationalisation of life” referred to rational
accounting, rational law, and rational technology, which by extrapolation
can be extended to “rational economics”. Daniel Bell upheld the primacy
of knowledge and theory-related activities in ordering our life— man’s
technological and economic ascendancy—which would imply that economic
wizards can secure a fool-proof policy. Even the clash between Keynesism
and monetarism, as the two main competing macro-economic paradigms,
could be seen in the vein of searching for the ultimate piece of wisdom.
Another origin of policy amalgamation came out of the death of
communism. Francis Fukuyama’s End of History was seen by many as an
embodiment of a, presumably, single cosmology which was meant to rule
the world. At that time, Reagan’s and Thatcher’s revolutions were in full
swing in the US and the UK, respectively. The fall of communism
immensely favoured the advance of neo-liberal ideas. Internationally, this
dynamic was reflected by the expansion of global markets—globalisation.
“The world is flat”, to use Thomas Friedman’s phrase, became synonymous
14 Chapter One

with economic development reaching out to all corners of the earth,

provided adequate policies are put in place. By adequate policies one
understood, mostly, the Washington Consensus, which encapsulated
policies and practices advocated by international financial institutions
(IFIs).
Needless to say, the overwhelming superiority of the US on all fronts
(economic, military, technological) offered a sui generis Pax Americana
and created prerequisites for an international regime. The latter was
supposed to order the world by providing international public goods and a
widely embraced vision, and by resolving/preventing possibly major
conflicts.
But economics as a hard science is only a dream, while market
fundamentalism has revealed its serious weaknesses over time, and its
coup de grace is, arguably, the current financial and economic crisis. It is
true that liberalisation and extensive privatisation did transform post-
communist societies in Central and Eastern Europe and allowed most of
them to join the EU. But their case is quite unique owing to geography,
cultural and political consciousness, and considerable support from the US
and Western Europe. It is also true that market-oriented reforms have
unfettered entrepreneurship and have stimulated economic growth in
China after 1978 and in India during the last decade, but those reforms
have been implemented in a pragmatic way, with close attention paid to
social issues and rural development problems, while financial and trade
markets have not been liberalised recklessly.
The interpretation of liberalisation/globalisation, which I mention
above, puts emphasis on unbridled markets, privatisation (also of public
utilities), and downsizing of the public sector to the utmost. This
philosophy has widened to international markets—finance and trade—and
the IFIs have often championed it. Let me give an example. The IMF and
the World Bank advocated capital account liberalisation worldwide, and
South Korea’s entry in the OECD was preconditioned by its capital
account opening. As many accept nowadays, the Asian crisis of a decade
ago was caused, primarily, by a premature opening of the capital account
in the economies of that region.

2. Reinterpreting globalisation
However, globalisation (and liberalisation) can be understood in a different
vein, which looks at the actual functioning of global markets— with their
pluses and minuses—and which takes into account insights of economic
theory such as informational asymmetries, increasing returns (while
 Limits of Openness 15

technological progress is intense—endogenous growth), agglomeration effects

(clusters), multiple (bad) equilibria, coordination failures, the role of
economic geography, and so on. As these theoretical constructs and, a
fortiori, the effects of the current financial crisis suggest, there are lessons
to be learned: the need for effective regulation of markets; the role of the
state in providing public goods; the role of institutions (structures of
governance); the need for public goods and effective governance in the
world economy; the importance of variety and policy ownership in policy-
making.
To some, this interpretation of globalisation may sow seeds of
confusion. But, in this way, one can dispel a biased interpretation of it. By
the way, I have always been baffled by the language used by some media
when describing market-friendly reforms. Is a rescue package, like the
ones destined currently to help banking sectors get out of trouble, against
the logic of a market economy? For a market fundamentalist it may be, but
for those who, while acknowledging governments’ failures, see market
failures as well, the need for intervention—in order to prevent a meltdown,
a terrible crisis—gets another connotation, which is not inimical to market
economics. Similarly, is a Keynesian approach in policy-making not
market-friendly? I could continue along this line of reasoning. Moreover,
globalisation would no longer be assigned an ideological mantra and one-
sided policy implications. Instead, it becomes an open-ended concept,
which purports to define the mutual “opening” of societies, under the
impetus of technological change and the manifold quest for economic
progress. Such an opening should be pragmatic and flexible. By flexibility
one can imply policy reversals as a function of changing circumstances—
be they in the realm of trade, finance, industrial policy, etc. Moreover,
such an interpretation rids itself of a perceived West-centred origin. Such
an unconstrained interpretation of globalisation would have major
repercussions for national public policies and international politics.
Thus, national public policies could be fairly pragmatic, varied, and
geared towards the traditional goals of economic growth, price stability,
and social justice. There is no modern economy that does not blend the
public and the private spheres. Some could say that too much variety in
institutional and policy design would damage a level playing field and
impede markets from functioning effectively. And there is truth in this
argument, but it is one-sided: for it underplays the importance of working
out policies that keep in mind the extreme diversity of conditions in the
world economy and the fact that market forces do not automatically bring
convergence. As a matter of fact, they may even increase discrepancies, as
they often do, because of cumulative causation processes. And if we add
16 Chapter One

here the inexistence of a world government, which should try to do what

the EU tries to achieve via its cohesion policy, inescapable conclusions
come to the fore (just keep in mind the abysmal results of the Millennium
Agenda). Let me focus now on finance and trade as fields which relate
national economies to each other and where policy reassessments seem to
be in the making.
As the current crisis amply shows, one of Keynes’s intellectual
legacies, which is enshrined in the Bretton Woods arrangements—namely,
that highly volatile capital flows are inimical to trade and prosperity—has
not lost relevance. For decades now, a mantra has been heard worldwide:
that not much can be done in national policy-making because global
markets would punish a government. But is the complexion of global
markets God-given? Aren’t global markets, aside from their technological
drivers, also the product of human beings’ decisions to set rules for
finance, trade, and investment? The argument that we should not turn the
clock back may be right in the sense that open systems bring benefits and
should be protected as much as possible. And here Pascal Lamy’s and
other top international public servants’ worries are well founded. But to
claim that nothing can be done about financial flows, when they bring
about misery, is unconvincing. Can the parallel banking sector (including
hedge funds and private equity funds) be regulated? Definitely it can! Can
we restrain leverage in finance? Sure we can. Can we forbid short-selling
if the need arises? Certainly we can. Can we regulate rating agencies? Of
course. Can we impose capital account restrictions in case of need, though
one has to think about regulatory arbitrage? Absolutely. Those who say
that it is hard to fetter capital movements in our times have a point, but not
a peremptory one. Likewise, the argument that financial innovation should
be unchecked sounds hollow in view of the toxicity of many of its
products. For not all financial innovation is sound.
Free trade as a headline will continue to be paid lip service to
worldwide, but in the years to come, trade patterns will likely be re-
examined owing to growing security concerns of national states. One type
of concern originates in the costs of adjustment to competitive pressures.
In a global economy where win-lose situations are not uncommon and in
which currently leading economies can be on the losing side, trade and
investment restrictions, more or less subtle, would be resorted to. There
are seminal studies (of Paul Krugman, Elhanan Helpman, Herschel
Grossman, etc.) which show that industrial, investment, and trade policies
can make a difference, for the better, for those that practise them. And
Western countries may try to use them in order to protect their competitive
edges in the world economy. The doyen of world economists, Paul
 Limits of Openness 17

Samuelson, also contributed to this debate (2004). Other types of concerns

relate to “hard security”. “Trading with the rival” worries may lead to the
imposition of restrictions—very much in the vein of the old COCOM
norms (which operated during the Cold War). Likewise, would the US, or
major EU Member States, accept big chunks of their most sensitive
manufacturing and IT sectors being acquired by Chinese or Russian
companies (or sovereign wealth funds (SWFs) belonging to these
countries)? Trade restrictions may pop up also due to the thinking that it
pays not to rely too much on overseas suppliers regarding basic food.
Climate change could also force governments to see indigenous farming as
a way to protect the local habitat, which may dramatically filter down a
narrowly defined rationalisation of trade flows. The security and the cost
of managing networks would also come increasingly into the picture—
terrorism being a factor here, too. We may think globally, but be forced,
owing to various risk-related considerations, to limit ourselves to what are
perceived as safer patterns of trade and production. In this way one can
think of an optimal trade openness. Ironically, managed openness may be
better for competition to the extent that unrestrained liberalisation leads to
the formation of a few giant global companies in various fields (the current
financial crisis favours big groups which can swallow weaker competitors).
This myriad of concerns could also stimulate the formation of alliances
(trade and other) among groups of countries that share common interests.
The EU is already such a bloc. A transatlantic trade area could also
emerge. We could see a replica of it in Asia, though the rivalry between
China, India, and Japan will be a big handicap in this respect. But keep in
mind that there was talk about setting up a monetary union in the wake of
the Asian crisis, and such a proposal may come into being in the end. And
if the yuan turns into a reserve currency, the rationale for creating an Asian
monetary area would grow.
How would the EU evolve in this world context? The logic of single
markets would continue to dominate, but policy-making will be quite
nuanced at national level. There will be more regulation of financial
markets, both at national and EU level. National governments will be more
active in the economy. By activism, I think of efforts to support sectors
and companies that are deemed essential for national security. As long as
the EU does not develop a common foreign and security policy, which
should be supported by a larger collective budget as well, national
governments will not give up what they see as vital for their security.
Therefore, the EU will continue to have a pretty complicated policy-
making structure, while variable geometry will likely be on the rise.
18 Chapter One

Barriers to unrestrained free world trade, investment, and finance

would also stem from the global system getting multi-polar. The effects of
the current financial crisis have hit the Western world at a time when
tectonic shifts in the global economy had been taking place for more than
a decade. The rise of China, India, and Brazil, and the resuscitation of a
capitalist Russia (which benefits from huge natural resources) are ushering
in an increasingly multi-polar world, with growing reverberations
economically and geopolitically. The rise of sovereign wealth funds,
which are heavily concentrated in Asia and the Gulf region, illustrates the
shifting balance of power in the world. The struggle for the control of
exhaustible resources (oil and gas in particular) epitomises this phenomenon.
Who would formulate and enforce a suitable international regime for
the 21st century? On its own, the US does not have this capacity any
longer. And I hardly see the EU taking over such a role. If EU Member
States have such a hard time in seeing eye to eye when dealing with the
causes of the financial crisis, think about problems at the international
level—where Realpolitik considerations play a critical role. Besides, in a
multi-polar world, the establishment of an international regime is a very
complicated affair. The IFIs—the international architecture—need to be
reformed. But their reform hinges on what the main international actors
wish to do in this respect and on how they relate to each other. That the
G20 seems to have taken the place of the G8 is not sufficient grounds for
optimism in this regard. Nevertheless, I dare to believe that if the US, the
EU, and the emerging global powers (China, India, Russia, etc.) can strike
a deal to this end, other significant players would come along eventually.
To conclude: I submit that a combination of two dynamics will
develop as a means to preserve an open global economic system, albeit in
a looser form. One dynamic refers to a partial domestication of market
forces in the national governments’ quest to cope with systemic risks and
social strain. This would involve more state presence in the economy (state
capitalism) and broader regulations; elements of “war economy” conduct
in public policy will also be quite visible—in liberal democracies too
(a thesis I have argued about in a previous article of mine in Europe’s
World, and which is illustrated glaringly by how governments in the
Western world have reacted to the effects of this financial crisis). I should
say that ideological propensities are less involved here, for governments
act, basically, out of sheer necessity. The other dynamic refers to blocs of
countries that decide to use a common currency and trade more intensively
among themselves; such arrangements would be a means to avoid brutal
disruptions to their internal activities were a global crisis to occur. This is
like saying that the global system needs several sub-global clusters in
 Limits of Openness 19

order to mitigate the potentially devastating effects of a completely open

world system that would be prone to recurring major crises, the latter state
of a global system being, in reality, unsustainable because of its unavoidable
motion towards an eventual breakdown and proliferating fragmentation
effects. About a decade ago, Dani Rodrik (1998), who is one of the most
insightful development economists, remarked that no globalisation is good
for poor countries. I would paraphrase him and say that openness has to be
made to work for the world as a whole, which implies shedding the blind
belief in the self-healing and self-regulatory virtues of markets.
 CHAPTER TWO

WHEN MODELS CRUMBLE

The financial and economic crisis has brought enormous strain to

Europe and the whole world. Healing will take quite a while, for much is
damaged and adjustments and repairs at both macro and micro levels are
time consuming. The crisis also challenges the models that so many
organisations, big and small, private and public, have relied on. Much of
the rethinking of models is induced by the role played by finance in this
crisis. A rethinking of these models will be forced on them by outside
pressures, and this chapter sets out ten of them that are ripe for change.

1. Reform of the regulation and supervision

of financial markets
The light touch regulation model has brought havoc to the financial
industry. Business models have proved massively inadequate with their
overemphasis on trading and speculation, the use of fancy (and often
toxic) derivatives, and their neglect of risks. Regulators and supervisors
succumbed to the reasoning that a low inflation rate is equivalent to
financial stability and that the spread of derivatives was a means of
diminishing risks. Instead, we ended up with a rising inter-connectedness
that, along with the consequences of light touch regulation, has crippled
robustness and resilience. Systemic risks have skyrocketed, compelling
central banks and their governments to rescue banks to avert financial
meltdown.
The overhauls of the regulation and supervision of financial markets
now underway show that an integrated model (like in the UK) was not
superior to sectoral or “twin peaks” models that distinguish between
macro-prudential oversight and the supervision of business conduct.
Contagion was favoured by the break-up of Chinese walls between
investment and retail operations and by increasing cross-border
transactions, but what in the end brought all these organisational patterns
into disrepute was the blatant misunderstanding of risk—as the latter was
entailed by expanding financial markets. The problem, therefore, is to deal
 When Models Crumble 21

with the very object of regulation and supervision and, consequently, tame
financial markets.

2. Revision of financial organisations’ business models

Not long ago, many extolled the virtues of large and integrated entities
able to provide a wide range of services and engage in all kinds of
operations. The mood changed once the present crisis erupted. Not only is
“too big to fail” (and “too big to save”) a formidable challenge to governments
and central banks, but complexity and size itself are a challenge to
management. Complexity and size are not a given, and they should be
dealt with in order to enhance the robustness of organisations, of economies.
Simpler and smaller organisations (by using anti-trust legislation and by
splitting large organisations through ring fencing retail from trading
operations) would be a step in the right direction, arguably. More own
capital and less reliance on debt (contrary to the Modigliani–Miller
theorem that where capital comes from does not matter), lower leverage,
and rules that prohibit the use of depositors’ money for the own trading of
banks (the Volcker rule) would contribute to making systems more robust.
The démarche to align incentives and to limit pay, to link it with
performance and the interests of shareholders is part of these reforms.
Bailing in creditors in moments of difficulty does make sense, but not at
the cost of weakening governments’ promise to make good on insured
deposits. To relinquish this promise would send banking and economies
into the wild.

3. Risk modelling needs to change

Risk modelling by banks and other financial entities needs to be made
more trustworthy and transparent. The current VAR (value at risk) enables
banks to fudge numbers and assume risks that are too high. The way large
banks have been fiddling with their risk positions and evaluations, with
reporting to regulators, even years after the eruption of the crisis, is quite
telling (J.P. Morgan’s treatment of its big trading loss in London comes to
mind). This would suggest that Basel III, too, has been overtaken by
events, and that the very logic of VAR is weak. At the same time, it shows
that misreporting to regulators, shareholders, and investors is a serious
challenge. This challenge goes beyond banking, for there are hedge funds,
brokerage houses, etc. that were in breach of trust, that provided incorrect
information and used their clients’ resources unlawfully. Compliance rules
and supervision need to be strengthened in the financial industry.
22 Chapter Two

4. More suitable cognitive models are needed

The present crisis is likely to be the great watershed and wake-up call
telling us that quantitative models which underestimate tail events and rely
on linearity are flawed. It appears that the golden boys, the “quants”, in
building increasingly high octane models, had brought about unintended
bad effects. They made their bosses turn a blind eye to the need to never
put qualitative analysis (“nose-metrics”) on the shelf. But this was clear
since the LTCM (a hedge fund) episode, when the models concocted by
two Nobel Prize laureates were made irrelevant by unexpected events. One
can argue that what hedge and private equity funds use in their modelling
is their exclusive business; that banks and insurance companies are in a
different league, which would and should make them objects of public
scrutiny and regulation when it comes to risk modelling. But hedge funds
and other asset management funds, and the shadow banking sector in
general, create systemic risks through operations that can be huge and can
destabilise markets. Therefore, they too should be regulated and supervised.
When it comes to the economy as a whole and to systemic risks, financial
stability comes prominently to the fore. Monetary policy is bound to
pursue price stability, but this goal cannot be divorced from the stability of
financial institutions. And even if overall financial stability were to be
under the oversight of a special body, central banks’ modelling would
have to internalise it.

5. Downsizing the financial sector makes sense

Events in Cyprus have captured much attention, notably the attempts to
work out and implement a bailout plan. Cyprus, like Ireland, Iceland, and
the UK, epitomises a fragile economic model. This model has favoured the
expansion of finance, of the banking sector, at the expense of other
sectors, which has resulted in an over-dependency on it. Once the crisis
hit, the fragility of this model came vividly into the open. A downsizing of
the financial sector makes sense in quite a few economies, though it will
not be at all easy to achieve it. One reason is that this kind of adjustment is
very difficult and painful. Also because there are vested interests which
would oppose it. The Cyprus episode of crisis fuels the discussion on
whether tax havens (and off-shore banking) should be accepted in the
Euroarea (in the EU), or worldwide, regardless of money laundering and
tax evasion considerations.
 When Models Crumble 23

6. Economies need to be more balanced to enhance their

robustness and resilience
Another model under question is linked with the insufficient attention
paid to tradable sectors, to external imbalances. This model relies on the
tenet that markets know best and their failures are negligible. The boom
and bust dynamics in the Euroarea, some new Member States, and in other
emerging economies, indicate that public policy has a role to play in
mitigating destabilising capital flows and in enhancing better resource
allocation. Whether that is possible under the rules of the single market is
something yet to be seen because the free flow of capital has a key role in
the European Union, and EU level policies are quite weak in this respect
(structural and cohesion funds are useful, but not a sufficiently powerful
instrument). Some say that the downhill capital flows model has been
validated in Europe in terms of economic convergence. This is the gist of a
recent World Bank study (“Regaining the Lustre of the European Model”).
And it is correct to notice that Spain, Ireland, and Portugal have achieved
substantial catching up after they joined the EU. Some catching up has
happened in the case of New Member States too. But this conclusion has,
nevertheless, to be nuanced considerably. For threatening divergence in
economic performance has taken place in the Euroarea after the introduction
of the euro. And boom and bust dynamics did happen in several NMSs,
which has caused a major setback in their convergence trajectory. This
remark is not meant to favour the uphill flow model, which has been
practised by Asian economies following their 1997–1998 crisis as a means
to accumulate hard currency reserves and forestall shocks from outside.
Instead, it is an invitation to see things in the wider picture of pluses and
minuses of international finance, in terms of the organisational and policy
rules in the Euroarea, and as an indication of the need to improve
governance structures in the EU as a whole.

7. Globalisation may have gone too far,

so corrections are needed
A study by McKinsey consultants notes a substantial reduction in
cross-border financial flows during the crisis years. Some decry it as a sign
of the reversal of globalisation, with a malevolent foreboding. But it would
arguably be better to see it as a healthy phenomenon to the extent that we
acknowledge that: a dangerous overexpansion of financial flows took
place in many regions; there are limits to openness (which is not the same
as limiting an “open society”, in Karl Popper’s terms), and there may be
24 Chapter Two

an optimal degree of openness and of reliance on external supplies of goods

and services (as a means to control vulnerabilities); that rediscovering home
and closer-to-home markets is a way to regain robustness in view of the
risks entailed by proliferating tail events and chain links disruptions, etc. If
globalisation is unmanaged, it puts reversal forces into motion; it may
backtrack as open international regimes did at the end of the 19th century
and in the interwar period of the 20th century, with spreading
protectionism and the formation of rival commercial alliances.

8. Models of economic integration need re-thinking

This is particularly true in Europe. The Euroarea crisis provides plenty
of evidence that its design and policy arrangements were and still are
inadequate, that a one-size-fits-all monetary policy should have been
accompanied by a fiscal union from the start. The Euroarea is, currently,
more a single currency area than a monetary union, and the way it operates
is more rigid than the gold standard regime of the interwar period, in spite
of the existence of automatic stabilisers. We know where that international
policy regime has led to. Therefore, we should be quite worried about the
Euroarea crisis. It is fair to remember that more than a few economists
warned, before its inception, that its sub-optimality as a currency area was
a major weakness of the Euroarea. But more to blame are its design and
policies. The banking union may be a way out of the current troubles to
the extent that fiscal arrangements are mended and a fiscal capacity (as
Herman van Rompuy put it) will come into being. But there is too much
procrastination and lack of resolve to move on all fronts in order to
achieve this union. Without it, it is likely that the European project will be
crippled further, and exits from the Euroarea will happen.

9. The relationship between governments

and society needs to be repaired
The current crisis in many countries has entailed a rejection of
traditional policies, the rise of extremism, and an erosion of the social
contract. All this is demanding an overhaul of public policies, a redesign
of the relations between the public and the private sector, and the fostering
of more individual self-reliance simultaneously with measures to preserve
social solidarity and a sense of fairness. Democracy can be undermined as
a societal model by the disconnection between politics and citizens and by
the distortions caused by the over-expansion of finance, and thus a
simplistic economic paradigm that sees public policy and the public sector
 When Models Crumble 25

as a nuisance. Whenever income inequalities become excessive, social

strain takes its toll; and this can happen both in democracies and in more
authoritarian forms of capitalism.

10. Revisiting the rules and institutions

of the international regime is a must
The rules of the international regime should also be overhauled. When
the IMF, which years ago was a staunch promoter of unimpeded capital
flows, makes a turnaround and says that capital controls may be useful,
one needs to pause. Students of finance and international relations know
that to simultaneously achieve exchange rate stability, free capital flows,
and monetary policy independence is an impossibility—the so called
“impossible trinity”. The experience of the Euroarea shows that the
relinquishing of monetary policy by Member States needs to be
accompanied by fiscal integration.
In world finance, it may be necessary to revisit the Bretton Woods
arrangements for the sake of preserving a relatively open trading system.
And this can happen provided financial markets are tamed. The Financial
Stability Board (FSB), the Bank for International Settlements (BIS),
specialised public institutions in the US and the EU, and the BRICS as
major voices in the G20 can all play an essential role in this respect. The
governance of the IFIs should heed the concerns of the emerging
economies more, and this should be reflected by their governance
structures. Big players in the global space must be made aware of the
externalities that their actions produce.
 CHAPTER THREE

WHEN FINANCE CORRODES ECONOMY

AND UNDERMINES DEMOCRACY

On 22 May 2008, the French daily Le Monde published an open letter

signed by three former presidents of the European Commission, nine
former prime ministers, and five former finance/economy ministers
(including myself) from EU Member States.1 The text “Financial markets
must not govern us” sketched the contours of a devastating financial crisis,
which would weaken Western societies tremendously. At the time this
letter was made public, top officials of the Commission and the ECB used
to boast about the “robustness” of European economies and claimed that
banks in the EU were not involved in the origination and distribution of
toxic products; they also conveyed the message that the financial crisis
would likely not cross the ocean. We have all seen what happened after
Lehman Brothers’ collapse. That is the moment when the financial turmoil
engulfed Europe too. The Euroarea crisis came soon afterwards.
Two thoughts had been working my mind during this terrible financial
crisis. And I would not have put them in writing now unless I had watched
a banker’s remark made on a public TV channel a short while ago. With
much nonchalance, he told his audience that the main mission of a bank is
to take care of its depositors’ money, that is, to be trustworthy. I was
stunned by his remark for it was publicly known that the bank he
represented had been bailed out with public money during this crisis, and
that it was involved in the origination and distribution of highly
questionable financial products. The stark reality is that quite a few in the
financial industry do not acknowledge, even now, the role it has played in
bringing about a crisis that in living memory is matched only by the Great
Depression. The gross abuse of securitisation, the promotion of a wide
range of exotic (this is a euphemism) financial products that were hardly

1
The letter was signed by Helmut Schmidt, Otto Graf Lambsdorff, Lionel Jospin,
Jacques Delors, Michel Rocard, Romano Prodi, Jacques Santer, Goran Persson,
Par Nuder, Massimo d’Alema, Hans Eichel, Poul Nyrup Rasmussen, Daniel
Dăianu, Paavo Lipponen, Ruairi Quinn, Laurent Fabius, and Anneli Jaatteenmaki.
 When Finance Corrodes Economy and Undermines Democracy 27

tradable and frequently of lousy value, the reckless short-termism in

maximising profits, and a blatant neglect of risks, have turned major
components of high finance into an in-built destabiliser. I would mention
here the role played by a paradigm which extols the virtues of self-
equilibrating financial markets (the efficient markets hypothesis) and
which was embraced by major central banks. This paradigm has proved to
be quite wrong. The way financial intermediation has evolved during the
past two decades has increased systemic risks enormously. As the research
director at the Bank of England, Andrew Haldane, pointed out, the very
robustness of economies has suffered dramatically. And it pays to recall a
brilliant analysis by Alexander Lamfalussy, who is an éminence grise in
the world of finance. Years ago, he noted that the proliferation of
securitisation and the growth of the shadow banking sector, which escapes
regulation and supervision, made economies increasingly fragile and
vulnerable (Financial Crises in Emerging Economies, 2000). This
financial crisis has compelled governments and central banks to rediscover
financial stability as a basic, if not an overriding, policy concern, but at a
terrible economic and social cost.
It is not my aim to focus again on the flaws of financial intermediation
as it has evolved in recent decades. Since the crisis has erupted, I have
done it both in writing and as a member of the European Parliament,
where I co-authored a report demanding a radical overhaul of the
regulation and supervision of financial markets. On various occasions, I
decried the wave of deregulations that took place in the US, including the
rescinding of the Glass–Steagall legislation in 1999 and the passing of the
Commodity Futures Modernization Act of 2000. But there are two
processes under way that deeply worry me, since both seem to be
accentuated by this financial crisis. One process concerns what is
happening in the financial industry itself. The fear of a financial meltdown
forced governments to intervene and, consequently, “too big to fail”
financial groups were rescued. It is true that this large scale operation was
followed by efforts to reform the regulation and supervision of financial
markets. Limits on leverage, increases in capital and liquidity adequacy,
regulations concerning derivatives, changes in remuneration schemes, and
constraints on proprietary trading were put into place, more or less, around
the world. It is an irony that Adair Turner (the head of the Financial
Services Authority) and Mervyn King (the governor of the Bank of
England) are bolder than their European counterparts in this regard. An
explanation is, probably, the over-expansion of the City during the past
decades, which has made the British economy quite lopsided and highly
vulnerable during this crisis (Ireland and Iceland are two other examples
Another random document with
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asked him, Why he went to bed without shoes.
A scholar being told the river had carried off a great part of his
ground, answered, What shall I say?

A scholar sealed a wine vessel he had, but his man bored the
bottom and stole the liquor. He was astonished at the liquor’s
diminishing, though the seal was entire; and another saying,
“Perhaps it is taken out at the bottom.” The scholar answered, Most
foolish of men, it is not the under part, but the upper that is deficient.

A scholar meeting a person, said to him, “I heard you were dead.”

To which the other answered, “You see I am alive.” The scholar
replied, Perhaps so, but he who told me the contrary was a man of
much more credit than you.

A scholar hearing that crows lived two hundred years, bought one,
saying, I wish to make the experiment.

A scholar being on board a ship in a tempest, when the rest

seized upon different articles to swim ashore on, he laid hold of the
anchor.
 A scholar hearing one of two twins was dead, when he met the
other, asked, Which of you was it that died? You or your brother?

A scholar coming to a ferry, went into the boat on horseback.

Being asked the reason, he said, I am in great haste.

A scholar wanting money sold his books, and wrote to his father,
Rejoice with me, for now my books maintain me.

A scholar sending his son to war, the youth said, “I shall bring you
back an enemy’s head.” To which the scholar replied, If you even
lose your own head, I shall be happy to see you return in good
health.

A scholar in Greece receiving a letter from a friend, desiring him

to buy some books there, neglected the business. But the friend
arriving some time after, the scholar said, I am sorry I did not receive
your letter about the books.

A scholar, a bald man, and a barber, travelling together, agreed

each to watch four hours at night, in turn, for the sake of security.
The barber’s lot came first, who shaved the scholar’s head when
asleep, then waked him when his turn came. The scholar scratching
his head, and feeling it bald, exclaimed, You wretch of a barber, you
have waked the bald man instead of me.

Pope Alexander VII. asking the celebrated Greek, Leo Allatius,

why he did not enter into orders? he answered, Because I desire to
have it in my power to marry if I chuse. The pope adding, And why
do you not marry? Leo replied, Because I desire to have it in my
power to enter into orders if I chuse.

Erasmus, himself a Satirist, collected thousands of the jests of the

Greeks and Romans. These more often noted the wit than the
witlessness of the speakers and include all degrees of wit from mere
whimsicality to sharpest satire.
Some of the best ones follow.

GREEK
A friend asking him how great glory was procured, Agesilaus
answered, By contempt of death.

Being asked the boundaries of the Spartan state, he answered,

The points of our spears.

One asking him why Sparta had no walls, he shewed him armed
citizens, saying, These are the walls of Sparta.
 Being very fond of his children, he would sometimes ride about on
a cane among them. A friend catching him at this sport, Agesilaus
said, Tell nobody till you are yourself a father.
King Demaratus being asked in company whether he was silent
through folly, or wisdom, answered, A fool cannot be silent.

Cleomenes the son of Cleombrotus, when presented with some

game-cocks, by a person who, enhancing the gift, said they were of
a breed who would die before they yielded; answered, Give me
rather some of the breed that kill them.

Pausanias, when a physician told him “You look well,” answered,

Yes, you are not my physician.

When the same was blamed by a friend, for speaking ill of a

physician, whom he had never tried, he replied, If I had tried him, I
should not have lived to speak ill of him.

Charillus, being angry with his slave, said to him, Were I not in a
passion, I would kill thee.
 A dancer saying to a Spartan, “You cannot stand so long on one
leg as I can.” True, answered the Spartan, but any goose can.

Another Spartan mother giving her son his shield, when going to
battle, said Son, either this, or upon this.

Another to her son who complained that his sword was short, said
Do you add a step to it.

One objecting to him his luxurious feeding, he showed him some

dear-bought dish, and said, “Would not you buy this, if it were sold
for a penny?” “Surely,” said the other. Then, said Aristippus, I only
give to luxury what you give to avarice.

Diogenes the Cynic, being in the house of Plato, strode over the
carpets with his dirty feet, saying I trample the pride of Plato. True,
said Plato, but with a greater pride.
Seeing a very unskilful archer shoot, he seated himself by the
mark. The reason was That he may not hit me.
Going to the town of Myndus, and seeing the gates very large,
and the town small, he called out Men of Myndus! shut your gates
least the town should escape.
Being asked of what beast the bite is most dangerous, he
answered Of wild beasts, that of a slanderer: of tame, that of a
flatterer.
 Entering a dirty bath he said Where are those washed who wash
here?
Being asked what wine he liked best, he said Another’s.
Crates the Cynic of Thebes, being asked a remedy for love, said
Hunger is one remedy. Time is a better. The best is a rope.
Theophrastus to one who was silent in company said If you are a
fool you do wisely! if you are wise you do foolishly.
Empedocles saying to Xenophanes the philosopher “That a wise
man could not be found.” True, answered Xenophanes, for it must be
a wise man who knows him.
Archelaus, to a prating barber, who asked how he would please to
be shaved? answered, In silence.
One asking Demosthenes what is the first point in eloquence, he
answered, Acting. And the second? Acting. And the third? Acting
still.
An Athenian who wanted eloquence, but was very brave, when
another had, in a long and brilliant speech, promised great affairs,
got up and said, Men of Athens, all that he has said, I will do.
Zeuxis entered into a contest of art with Parrhasius. The former
painted grapes so truly that birds came and pecked at them. The
latter delineated a cloth so exactly, that Zeuxis coming in, said, “Take
away the cloth that we may see this piece.” And finding his error,
said, Parrhasius, thou hast conquered. I deceived but birds, thou an
artist.
Zeuxis painted a boy carrying grapes: the birds came again and
pecked. Some applauding, Zeuxis flew to the picture in a passion,
saying, My boy must be very ill painted.
Gnathena the courtesan, when a very small bottle of wine was
brought in, with the praise that it was very old, answered, It is very
little for its age.
Philip of Macedon, sitting in judgment after dinner, an old woman
receiving an unjust sentence, exclaimed, “I appeal.” “To whom!” said
Philip. To Philip, when sober, answered the matron. The king took
the lesson.

ROMAN
A soldier boasting of a scar in his face, from a wound in battle,
Augustus said, Yes, you will look back when you run away.
Fabia Dollabella saying, she was thirty years of age; Cicero
answered, It must be true, for I have heard it these twenty years.
Seeing Lentulus, his son-in-law, a man of very small stature,
walking up, with a long sword at his side, he called out, Who has tied
my son-in-law to that sword?
One finding his shoes eaten with mice, in the morning when he
rose, asked Cato, in great agitation, the meaning of the portent; who
answered, It is no prodigy that mice should eat shoes! had the shoes
eaten the mice, it would have been indeed a prodigy.
When Brutus was dissuaded from his last battle, as the jeopardy
was great, he only said, To-day all will be well, or I shall not care.

A large bull being produced in the amphitheatre, the hunter struck

ten times, and missed. Gallienus, the emperor, who was present,
sent the hunter a wreath: and all wondering, he said, It is extremely
difficult to miss such a mark so often.

One saying, that in Sicily he had bought a lamprey five feet long,
for a trifle; Galba, the orator, to reprove the lye, said, No wonder.
They are found there so long, that the fishers constantly use them for
cables.
 Scipio Nasica going to visit Ennius the poet, was told by his maid-
servant, that he was not at home, though he knew he was. A few
days after Ennius came to see Nasica, who hearing his voice, called
out, that he was not within. Then said Ennius, “What! Do not I hear
your voice?” To which Nasica replied, You are an impudent fellow. I
believed your maid! and you will not believe myself.

Sulpitius Galba the orator, pretended to sleep once, while

Mecenas made love to his wife, but seeing, at the same time, a slave
stealing wine from the side-board, he cried, Friend, I do not sleep for
all.

From the collection of Poggio we get other Italian stories.

Some clowns going to Arezzo, to buy a crucifix for their church,

the carver seeing them very stupid, said, Do you want a living or a
dead crucifix? They requiring time to consider: after much
deliberation, returned, saying, Make us a living one! for if our
neighbours be not pleased with that, we can easily kill it.

An inhabitant of a maritime town, looking out at a window, and

seeing the ocean in a violent storm, and many vessels tossing about,
said to a friend who was with him, “I wonder so many people go to
sea, when so many die there.” Do not you wonder, answered the
friend, why so many people go to bed, when so many die there?
 Bardella da Mantoua, being led to execution, a priest, who was
with him, said, “Be of good cheer, for to-night you will sup with the
Virgin Mary, and with the apostles.” Bardella answered, It will be a
favour if you will go for me, for this is a fast-day with me.

Marcello da Scopeto, consulting Coccheto da Trievi, the

physician, he wrote a receipt, and said, “Here, take this at three
times; one every morning.” Marcello cut the paper in three; and
made a shift to swallow it in three mornings.

Tosetto one day putting the physician Zerboico in a violent

passion; he said, “Peace, rogue. Do not I know that your father was
a bricklayer?” Tosetto answered, Nobody knew this, save your father,
who used to carry him lime.

The following are from Il Cortegiano, by Castiglione.

An Italian Doctor of Law, seeing a criminal, who was whipped,

walking very slowly during the operation, asked him why he did not
hasten, that he might have fewer stripes; adding many arguments to
shew that the slower he went, the more he must suffer. To which, the
criminal, standing still, and looking him full in the face, replied with
great gravity, When you are whipped through the streets, walk as
you please, and pray allow me to enjoy the same liberty.
 Duke Frederic of Modena, having built a palace, was at a loss
what to do with the rubbish. An abbot, standing by, told him to cause
a pit to be digged large enough to contain it. “And what,” said
Frederic, laughing, “shall I do with the earth which is dug out of the
pit?” To which the abbot, with great wisdom, replied, Make the pit so
large as to hold all.
Ponzio of Sila seeing a rustic who had two capons to sell, and
agreeing on the price, begged him also to carry them to his lodging,
where he was going, and he would pay him for his pains. Ponzio led
him to a round bell-tower, separate from the church, near which was
an alley: when standing still, Ponzio said, “I have wagered a couple
of capons with a friend, that this bell-tower is not forty feet round,
and have got a packthread here that we may try it.” So drawing the
thread from his pocket, he gave one end to the rustic; bidding him
hold it, while he went round. But when Ponzio came to the other side
of the bell-tower, where the alley was, he fixed the thread with a nail,
and ran down the alley with the capons. The peasant after long
standing and bawling, went round, and had the nail and packthread
for his capons and labour.

Not every tongue offers us collections to be translated, nor are all

those that are available yet translated, but we may give a few of
Spanish origin, taken from the collection of Melchior de Santa Cruz
which are the flowers of Spanish Apothegms and wise or witty
sayings.
Like jesters of all other nations the Spaniards saw fit to heap
sarcasms on the medical profession.
We can only assume that in those days doctors had not reached
the heights of sapience they have since attained.
And also, we must remember that it was the custom for the
unlearned to poke fun at the scholars, hence all professions felt the
satiric lash.

At the table of Pope Alexander the sixth, the company debated

one day, if it were advantageous to a state to have physicians in it?
The greater part held not; and alleged, as a reason, that Rome had
passed her first, and best, six hundred years without them. But the
pope said, he was not of that opinion, for were there no physicians,
the multitude of mankind would be so great, that the world could not
contain them.

A Biscayan clergyman, a follower of the cardinal Don Pedro

Gonzales de Mendoza, pulled one day a pistol out of his pocket. The
cardinal saw him, and reproved him, saying, “That it was indecent for
a clergyman to carry arms.” The Biscayan answered, “Most reverend
lord, I do not carry arms to hurt any man, but to defend myself
against the dogs of this country, which are remarkable for
fierceness.” The cardinal said, “I can tell you a charm against dogs.
You need only repeat any verse of the gospel of St. John.” The
Biscayan replied, Yes, my lord, but that does not apply in every case,
for many of our dogs do not understand Latin.

The same cardinal said of the monks, who, by shaving the top
and under part of the head, form a crown of hair around, that they
had crowns which the most ambitious would not envy.
 A bishop sent a present of six capons to brother Bernaldino
Palomo, but the servant who carried them stole one. Tell his lordship,
said Palomo, that I kiss his hands for the five capons.—Do you kiss
his hands for the other.

Juan de Ayala, lord of the town of Cabolla, slew a crane. His cook,
when he dressed it, gave a leg to his mistress. When it was served
up, Juan said, Where is the other leg? The cook answered, Cranes
have but one leg. The day following, Juan took his cook to the chace
with him, and perceiving a flock of cranes, which, as usual with that
bird, all stood upon one leg, the cook said, Your worship sees the
truth of what I said. Juan riding up to the birds called, Ox, Ox, Ox.
The cranes being startled, put down the other leg: and Juan said,
See, you knave, have they two legs or one? The cook answered,
Body of me, sir, had you called Ox, Ox, to the one you dined on
yesterday it would have produced its other leg too.

Perico de Ayala, the buffoon of the Marquis de Villena, came to

see Don Frances, the buffoon of Charles V. when he lay on his death
bed. Perico seeing him in so bad a way, said, Brother Don Frances, I
request you, by the great friendship which always was between us,
that when you go to heaven (which I believe must be very soon,
since you lived so pious a life), you will beseech God to have mercy
on my soul. Frances answered, Tie a thread on this finger, that I may
not forget it. These were his last words; and he instantly expired.

The servants of a Spanish lord said, in his presence, that Don

Diego Deza, archbishop of Seville, was very liberal to his domestics.
The lord answered, So he may, for he has his wealth but for his life.
A page replied, And for how many lives has your lordship yours?

Some thieves trying one night to break into a shop, in which two
servant men lay; one of them called to the robbers. Come back when
we are asleep.

A rich man sent to call a physician for a slight disorder he had

suffered the preceding night. The physician felt his pulse, and said,
Sir, do you eat well? Yes, said the patient. Do you sleep well? I do.
Then, said the physician, I shall give you something to take away all
that.

A labourer intending to bind his son apprentice to a butcher,

asked a gentleman of the village, his friend, to whom he should put
him. The answer was, You had best bind him to the physician, for he
is the best butcher I know.

A physician went to visit a young lady, daughter of a nobleman.

Desiring her arm, to feel her pulse, the damsel, from pride, covered
the place with the sleeve of her shift. The physician also drew down
his coat sleeve, and applying it, said, A linen pulse must have a
woollen physician.
 A bad painter, who had never produced any thing worth, went to
another place, and commenced physician. A person who knew him,
meeting him there, asked the reason of this change. Because said
he, if I now commit faults, the earth covers them.
To a student of a college was brought a large dish of soup, and
only one pea in it. He rose, and began to strip. His companion asking
what was the matter, he answered, I am going to swim after that pea.

The effects of a merchant, who was greatly in debt, being on sale,

one bought a pillow, saying, That it must be good to sleep on, since
he could sleep on it, who owed so much.

The same merchant being asked, how he could sleep with such
debts upon him? said, The wonder is, how my creditors could sleep.

A Gallician, being at the war of Granada, received a wound in the

head with an arrow. The surgeon arriving, said, upon examination,
You are a dead man, the arrow has pierced your brain. The Gallician
said, Look again, for that is impossible. The surgeon replied, It is so;
I see it plain. It cannot be, said the Gallician: for if I had any brain, I
should not have been here.

A man went to borrow an ass of a neighbour, who said the ass

was from home. Meanwhile the animal chanced to bray: upon which
the borrower exclaimed, How! did you not tell me the ass was
abroad? The other replied, in a passion, Will you prefer the ass’s
word to mine?

A passenger going to Peru, a great storm arose; and the master

of the vessel ordered, that the most burdensome articles that every
one had should be thrown into the sea, to lighten the vessel. Upon
which this passenger ran and brought up his wife, saying, That she
was the most burdensome article he had.

A squire being asked, why he had married a deaf wife? said, In

hopes she was also dumb.

The German nation made small pretence to wit or humor. What

we have of their early efforts is either gross or stupid.
A few specimens taken from their mediæval Jest collections will
quickly prove this.

A malicious woman often beat her husband; being reproved for it,
and told that her husband was her head, she answered, May not I
beat my own head as I please?

Some Dutchmen conversing in a bookseller’s shop at Leyden, an

unknown German came in, upon which one of them exclaimed, “Why
is Saul among the prophets?” The German retorted: He is seeking
his father’s asses.

A very ignorant priest saying mass, saw on the margin of his

book, Salta per tria (skip three); meaning that he should find the rest
of the office three leaves further on; upon which he leaped three
steps forwards from the altar. The clowns about him, thinking he had
suddenly gone mad, took and bound him, and carried him home.

One being asked, what made him bald? said, My hair.

A lady asking that celebrated general, prince Maurice, who was

the first captain of the age? he answered, The marquis of Spinola is
the second. He thereby gave to understand, that he knew himself to
be the first; but did not chuse either to say so, or tell a falsehood.

Two ladies of high rank, disputing the precedence in a procession,

the Emperor, Charles V. desired they would make him their arbiter.
Having heard the reasons on both sides, he found no other way to
end the difference, than by ordering that the most foolish should go
first. After which there were as many disputes who should go last; till
they agreed, that each should be foolish in her turn.
 Charles V. going to see the new cloister of the Dominicans at
Vienna, overtook a peasant, who was carrying a sucking pig, and
whose cries were so disagreeable to the emperor, that, after many
expressions of impatience, he said to the peasant, “My friend, do not
you know how to silence a sucking pig?” The poor man said
modestly, that he really did not, and should be happy to learn. “Take
it by the tail,” said the Emperor. The peasant finding this succeed
upon trial, turned to the Emperor, and said, Faith, friend, you must
have been longer at the trade than me, for you understand it better.
An answer which furnished repeated laughter to Charles and his
court.

EPIGRAMS
Collections of Mediæval Epigrams are both numerous and lengthy
and not infrequently their comparative value depends largely on the
translator’s learning or talent.
For instance a distich of Plato’s is thus translated by Coleridge,
 THE THIEF AND THE SUICIDE
Jack, finding gold, left a rope on the ground;
Bill, missing his gold, used the rope which he found.

and is thus rendered by Shelley,

A man was about to hang himself,
Finding a purse, then threw away his rope;
The owner, coming to reclaim his pelf,
The halter found and used it. So is Hope
Changed for Despair—one laid upon the shelf,
We take the other. Under heaven’s high cope
Fortune is God—all you endure and do
Depends on circumstance as much as you.

But the modernization is not just now our pursuit, so the epigrams
will be given in something approaching chronological order and the
translator’s name mentioned when known.
Plato
THE MISER AND THE MOUSE
“Thou little rogue, what brings thee to my house?”
Said a starv’d miser to a straggling mouse.
“Friend,” quoth the mouse, “thou hast no cause to fear;
I only lodge with thee, I eat elsewhere.”

Lucillius
A MISER’S DREAM
Flint dream’d he gave a feast, ’twas regal fare,
And hang’d himself in ’s sleep in sheer despair.

Nicarchus
THE GREAT CONTENTION
Three dwarfs contended by a state decree,
Which was the least and lightest of the three.
First, Hermon came, and his vast skill to try,
With thread in hand leap’d through a needle’s eye.
Forth from a crevice Demas then advanc’d
And on a spider’s web securely danc’d.
What feat show’d Sospiter in this high quarrel?—
No eyes could see him, and he won the laurel.

Unknown Author
ON LATE-ACQUIRED WEALTH
Poor in my youth, and in life’s later scenes
Rich to no end, I curse my natal hour,
Who nought enjoy’d while young, denied the means;
And nought when old enjoy’d, denied the power.

A VOICE FROM THE GRAVE

Phido nor hand nor touch to me applied;
Fever’d, I thought but of his name—and died.

ON THE INCONSTANCY OF WOMAN’S LOVE

My Fair says, she no spouse but me
Would wed, though Jove himself were he.
She says it: but I deem
That what the fair to lovers swear
Should be inscribed upon the air,
Or in the running stream.

Catullus
ON HIS OWN LOVE
That I love thee, and yet that I hate thee, I feel;
Impatient, thou bid’st me my reasons explain:
I tell thee, nor more for my life can reveal,
That I love thee, and hate thee—and tell it with pain.

Aly Ben Ahmed Ben Mansour

TO THE VIZIR CASSIM OBID ALLAH, ON THE DEATH OF ONE OF HIS SONS
Poor Cassim! thou art doom’d to mourn
By destiny’s decree;
Whatever happen it must turn
To misery for thee.
Two sons hadst thou, the one thy pride,
The other was thy pest;
Ah, why did cruel death decide
To snatch away the best?
No wonder thou should’st droop with woe,
Of such a child bereft;
But now thy tears must doubly flow,
 For ah!—the other’s left.

The Khaliph Radhi Billah

TO A LADY UPON SEEING HER BLUSH
Leila! whene’er I gaze on thee
My alter’d cheek turns pale,
While upon thine, sweet maid, I see
A deep’ning blush prevail.
Leila, shall I the cause impart
Why such a change takes place?
The crimson stream deserts my heart,
To mantle on thy face.

Janus Pannonius
ON AURISPA
Aurispa nothing writes though learn’d, for he
By a wise silence seems more learn’d to be.

Actius Sannazarius
ON AUFIDIUS
A hum’rous fellow in a tavern late,
Being drunk and valiant, gets a broken pate;
The surgeon with his instruments and skill,
Searches his skull, deeper and deeper still,
To feel his brains, and try if they were sound;
And, as he keeps ado about the wound,
The fellow cries—Good surgeon, spare your pains,
When I began this brawl I had no brains.

Euricius Cordus
TO PHILOMUSUS
If only when they’re dead, you poets praise,
I own I’d rather have your blame always.

THE DOCTOR’S APPEARANCE

Three faces wears the doctor; when first sought
An angel’s—and a god’s the cure half wrought:
But when, that cure complete, he seeks his fee,
The devil looks then less terrible than he.