The Perils of a Free Trade Pact With Europe

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Simon Johnson, former chief economist of the International Monetary Fund, is the Ronald A. Kurtz Professor of Entrepreneurship at the M.I.T. Sloan School of Management and co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.”

Currently slightly beneath most people’s radar, but coming soon to the fore is a potential free trade agreement with Europe. Negotiations started in October and, after a delay because of the government shutdown, may now pick up speed. Some parts of this potential agreement make sense, but there is also an important trap to be avoided: European requests on financial services.

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In a recent paper, “Financial Services in the Transatlantic Trade and Investment Partnership,” my Peterson Institute colleague Jeffrey J. Schott and I review the history of finance in free trade agreements and examine the reasonable options for any potential deal between the United States and the European Union.

In this instance, the United States Treasury has the right general idea: don’t let discussions over this free-trade agreement divert attention from completing the Dodd-Frank financial reforms and then figuring out what else is needed to make the American financial system safer. The big banks, naturally, would like American regulators to become enmeshed in constraints set by the negotiations with Europe. This is a trap that must be avoided.

The overall rationale for a free trade agreement with the European Union is that while many traditional trade barriers are low — such as tariffs (a form of tax on imports) and quotas — there are still regulatory impediments that limit some forms of trade. Removing such restrictions can make sense in some sectors — for example, the United States and the European Union have reached agreement on standards for organic food, telecommunications and aviation.

Whatever you think of this argument in general, it does not work well for finance – either at this moment or, I would suggest, in general.

The European banking system currently has numerous significant problems, including large holdings of sovereign debt, which remains under intermittent pressure. While a wave of “stress tests” is under way to examine actual and potential losses of these banks, progress in cleaning up balance sheets – including recognizing losses – has been slow over the last four years.

And there is a definite temptation for European politicians and regulators to go easy on banks, including by allowing them to operate with less bank capital (meaning relatively less equity and relatively more debt) and with easier rules than would otherwise be the case. The Europeans also continue to cling to the idea of very large banks as a form of national champions, despite all the indications that they have become instead a form of national millstone around the neck of the real (i.e., nonfinancial) economy.

None of this should make the United States feel confident about the strength of the European financial system today or going forward. This is the Europeans’ own business, of course – although the spillover effects on the rest of the world are not good. But the European Commission is also proposing that as part of any free trade agreement, national rules on finance should be mutually recognized, implying that American regulators should regard European financial companies as well regulated.

The European officials making this case also previously asserted, for example, that European government debt should be regarded as being just as safe as United States government debt (this was in discussions about the technical parameters of the so-called Volcker rule, which is designed to limit proprietary trading). The recent Greek debt restructuring indicates that this argument was completely wrong.

To be fair, the Europeans are trying to improve the regulation and supervision of their banks, including through the creation of elements of a banking union. But this will be an uphill battle, in large part because national governments do not want to cede sovereignty on this issue.

The global megabanks like the idea of committing the United States to treat Europe’s rules as equal to its own. This would allow high-risk activities to be placed in places with lighter regulation – just as A.I.G.’s highly risky financial products activities were centered on London before their spectacular blow-up in September 2008.

Finance should be regulated on a national basis. Some defenders of big banks say this will give an unfair competitive advantage to European banks, because they already have fewer restrictions.

Nothing could be further from the truth. How have the Europeans used their supposed “advantages” to date, including the lower capital requirements they had under the previous Basel II framework? They built bigger banks that funneled credit in irresponsible fashion and made huge mistakes in assessing risks.

Europe offers only cautionary tales in terms of how executives at big banks can lose control of their businesses. Governments step in to provide backstops, but this only worsens the problem of moral hazard – no one has an incentive to be careful.

Financial reforms in the United States are already on a precarious track. Disappointingly little has been achieved in the last five years; perhaps the Treasury secretary, Jacob Lew, will move the process forward more decisively.

The United States should not derail the reform process entirely by binding it to the failed European banking approach.