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In 1844, the American poet Ralph Waldo Emerson observed that “railroad iron is a magician’s rod in its power to evoke the sleeping energies of land and water.”[1]
What he saw was that railroads could substantially increase the economic potential of the United States. And he was proven right in many ways.
The railroads not only linked up the far-flung corners of the United States; they also linked up its capital markets. The need to finance this project of unprecedented scale radically transformed the US financial system, changing its destiny forever.
Today, Europe is at a similar juncture.
We have emerged strongly from a series of profound economic shocks: real GDP is only 2% lower today than we expected at the end of 2019.[2] But we are facing a new set of challenges that will require a generational effort to finance.
So, this morning I will focus on how we can achieve this, and in particular on how to make Europe’s capital markets more supportive.
I will argue that a capital markets union (CMU) is an indispensable project in this context that we have so far failed to advance, for two reasons.
First, if we look at historical examples, it is clear that the conditions for capital markets to develop in Europe have not yet been satisfied. Most importantly, we have lacked a unifying project around which CMU can be anchored. But this is now changing.
And second, perhaps because we have lacked such a project, we have relied too much on a “bottom-up” approach to integration. The solution, in my view, is to make a “Kantian shift” in our approach to CMU.
Immanuel Kant turned philosophy on its head by asserting that, instead of the world creating our perception, it is our perception – the product of our human mind – that defines how we experience the world. In the same way, we can turn our approach to CMU on its head, so that it can become a vital tool in financing the ongoing transformations.
To start, what does history teach us about how capital markets develop?
The most important lesson is that a capital markets union emerges when there is a need to finance an economic transformation that exceeds the capacities of fragmented financial markets.
The US railroad example is a perfect illustration of this. In the 19th century, the US financial market was extremely fragmented, as individual states limited the chartering of banks. And this created a fundamental mismatch in the economy.
The United States had a “single market” in goods and services – fortified by the Commerce Clause – which meant that firms could grow to national scale. But the banking system was not operating on a similar scale, so it could not meet the financing needs this created.
This problem was particularly acute in the case of the railroads, because loans to railway projects were high risk and there were frequent defaults. No local US bank could diversify these risks in its loan portfolio, and transaction costs made loan syndication prohibitively expensive.
So, entrepreneurs and investors filled the gap. Railroads were seen as so critical for the future of the country that capital markets were developed to tap a deeper pool of domestic and foreign investors.
Measured in 1909 US dollars, investment in the railroads increased from around 90 million in the 1830s to almost 5 billion in the early 1900s. Most of the finance took the form of bonds, and up to one-third of it came from foreign investors.[3]
Seen from this perspective, one of the reasons why CMU has not yet succeeded is clear.
Since CMU became an EU policy goal nearly a decade ago, its stated objectives have tended to prioritise the stabilising benefits of integrated capital markets. We have focused on increasing private sector risk-sharing to make the monetary union more resilient, or having a “spare tyre” during banking crises to make the financial sector more resilient.