The European Union at a Critical Juncture: In Defense of a Capital Markets Union

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In 1844, the American poet Ralph Waldo Emerson commented: “Railroad iron is the magician’s wand, capable of arousing the dormant energies of land and water. He believed that railroads could greatly increase the economic potential of the United States, and he was proven right in many ways.

Railroads not only connected remote areas of the United States, they connected all corners of the country. They also connected capital markets. The need to finance projects of unprecedented scale fundamentally altered the American financial system and changed America’s destiny forever.

Today, Europe is at a similar moment. We have emerged strongly from a series of profound economic shocks: real GDP today is only 2% below our expectations for the end of 2019. But we are facing a new set of challenges that will take generations.

The European Union at a Critical Juncture: In Defense of a Capital Markets Union

In this context, the Capital Markets Union (CMU) is an indispensable program that we have so far been unable to move forward for two reasons.

First, it is clear from historical examples that the conditions for the development of capital markets in Europe are not yet in place. Most importantly, we lacked a unified program around CMU. But this is now changing.

Secondly, perhaps it is because of the lack of such a project that we have relied too much on a “bottom-up” approach to integration. In my opinion, the solution at Carnegie Mellon is a “Kantian shift.”

Immanuel Kant turned philosophy on its head when he asserted that it is not the world that creates our perceptions, but rather our perceptions – products of the human mind – that determine how we experience the world. In the same way, we can revolutionize CMU’s approach and make it an essential tool for funding the transformation underway.

Lessons from CMU’s History

What does history tell us about how capital markets evolve?

The most important lesson is that CMUs emerge when the financing needs of transitioning economies exceed the capacity of fragmented financial markets.

In the 19th century, U.S. financial markets were extremely fragmented, with states restricting bank licenses. This created a fundamental mismatch in the economy.

The U.S. has a “single market” for goods and services (reinforced by the Commerce Clause), which means that businesses can grow across the country. However, the banking system does not operate on the same scale and therefore cannot meet the resulting financing needs.

This problem was particularly acute in the railroad sector, where loans for railroad projects were risky and defaults were frequent. U.S.-based banks could not diversify these risks across their loan portfolios, and transaction costs made syndicated loans too expensive.

As a result, entrepreneurs and investors filled the gap. Railroads were considered vital to the nation’s future, so capital markets were developed to attract more domestic and foreign investors.

In 1909 dollars, railroad investment increased from about $90 million in the 1830s to nearly $5 billion in the early 1900s. Most of the financing was in the form of bonds, with as much as one-third coming from foreign investors.

From this perspective, one reason for CMU’s failure to date is obvious.

Since CMU became a target of EU policy nearly a decade ago, its stated goals have tended to prioritize the stabilization benefits of integrated capital markets. The focus has been on increasing risk sharing in the private sector, making monetary union more resilient, or making the financial sector more resilient by providing “spare tires” during banking crises.

These worthy goals owe much to the environment in which the Carnegie Mellon agenda arose, namely the aftermath of the financial crisis and the eurozone sovereign debt crisis. But these are just some of the welcome side effects of integrated capital markets. They are not the main effects.

If we take the United States as an example – and I should point out that the United Kingdom has followed a similar path – there needs to be a larger common goal. Over the last decade, not only has Europe lacked this larger common goal, but governments and businesses everywhere have actually cut back on investment.

The EU is at a critical juncture

But the situation today is very different. In many ways, the problems we face now are similar to those faced by the United States in the 19th century.

Europe faces a common set of challenges, with “de-globalization,” “demographics,” “decarbonization,” and the “three Ds” standing out. These “three Ds” are becoming increasingly prominent.

There are growing signs that the global economy is fragmenting into competing blocs. We are approaching a long-awaited demographic tipping point: in the eurozone

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