European Financial Reform: Bluster or Substance?

Germany's unilateral imposition of a ban on naked short sales of European bonds, CDS and shares of the top 10 financial firms has stolen the headlines for sure, but it is part of a larger development that needs to be understood. The poor reception to the German moves seemed so obvious it begs the question of why did it do it and why then.

Germany's announcement followed a two-day European finance ministers meeting that reached important decisions on a tax on financial transactions and regulation of hedge funds. In order to reach an agreement required a political compromise within the German ruling coalition. Moreover, the German parliament may vote on the Stabilization Mechanism as early as the end of the week and the compromise enhances the chances of smooth passage.

There are two hedge fund regulations that stand out. The first seems minor: hedge funds will have to register their activity in Europe. There is some reporting requirements for foreign-based hedge funds.

The second will be more objectionable: hedge funds have to reveal strategies. Perhaps it is not Germany's blunder that is the key driver over the past 24 hours, but rather Europe's blunder. It is difficult to envisage the US or the UK accepting this and therefore it may simply serve to undermine the euro zone as a financial center.

Turning to the financial transaction tax, there seems to be a couple basic approaches. Financial institutions, like banks, can be taxed on the basis of size. Larger banks pose greater bail out costs and therefore their contribution to an insurance fund should be larger. An alternative would be to tax financial transactions themselves.

When James Tobin first proposed such a tax it was intended to slow the circulation of capital not raise revenue. Now too there seems to be some disagreement whether the tax should be simply to fund a type of insurance or down payment of the next crisis, or whether it should go into a general revenue fund.

Politicians will generally want the latter while business and investors may prefer the former. Merkel tried to have it both ways in terms of the financial transaction tax, but now appears to have endorsed it more wholeheartedly.

This does not end the process, but really starts a new stage. The European Parliament is like to take up the agreement of the finance ministers. Here the UK (and others) objections will be more evident. But even that is not the end. There is a G20 meeting in June.

Merkel says she will champion the European agenda on hedge funds and financial transactions. The effectiveness of Europe's plans require acceptance by others, especially the US. As it will be an uphill fight, the compromises she had to make in her domestic politics, including the ban on naked short sales of European bonds, CDS and some equity, likely protects her flank.