Luxembourg could have missed the economic restructuration train in the 60's, like some neighbouring "Länder" and "départements", who still struggle, it seems, to find a new take-off. How could a small-sized country like Luxembourg develop its banking strengths, overcome a non-existent domestic market and finally take advantage of centrifugal forces in the field of banking and finance?

Within four decades the country has become the second most important centre worldwide in the investment funds industry; by creating a more attractive regulatory framework for investors and therefore inducing the development of centripetal forces in the finance industry, which effect externalities with other transverse sectors.

Being small was not a handicap, according to Patrice Pieretti and Arnaud Bourgain of the University of Luxembourg. In a recent book the two economists analyse the sources of Luxembourg's competitive advantages and describe its dynamic. "The relatively fast evolution of the financial sector proves the existence of a capacity of innovation," they say.

1. Sirs, what were your main objectives when writing this book?

2. Patrice Pieretti: "We tried to make an academic work, which consists in applying a scientific methodology to the current events, by proceeding from the general to the particular.

   Arnaud Bourgain: "We tried to find out what the main features of a financial marketplace like Luxembourg are. Actually, Luxembourg does not dispose of a client potential as captive as other financial centres like Zurich, Frankfurt, Paris or New York may have. We tried to discover the strengths and weaknesses of such a financial place, which is anyway exposed to international competition.

3. What is exactly the methodology you developed?

4. P. P.: "We built an economic model by extracting a set of relationships from a classical protocol, which consists in a reflection on a deductive approach. We started from the individual behaviours as well as from all these
   relationships between these behaviours. We extracted a state and analysed the results.

   A. B.: "These are depicted in the three chapters of our book. The first chapter highlights the main competitive advantages of institutional and regulatory frameworks. For this, we built a table in order to identify the network of relations between the key actors and their capacity to exploit and generate competitive advantages.

   The second chapter develops a mathematical model that tries to capture the fundamental features of jurisdictional competition. This implies two jurisdictions (sovereign regions or countries), which compete with each other, not only at the public level (via the fiscal and non-fiscal rules), but also on the financial issue (via interest rates on deposits).

   The third chapter features an econometric study, which measures the external effects between the financial services industries and the other services on the Luxembourg economy. We tried to identify and measure the triggering forces (exogenous and endogenous) of the system that might contribute to a self-development dynamic.

5. What is the aim of this mathematical model?

6. P. P.: "A mathematical model is practical, because it gives an insight of the financial centre and its features. It also helps to better understand the chain of causation. We built a theoretical representation, which helps to structure the reflection in order to solve a problem and to give a sense to figures.

7. What are these forces you develop in the third chapter?

8. P. P.: "We tried to identify two kinds of forces or externalities: technological externalities and pecuniary externalities.

   Technological externalities are information externalities; they consist in all the information, which circulates and profits all, due to the closeness of all the actors. Here, the word 'technology' must be understood in the sense of productivity and efficiency.

   A. B.: "Pecuniary externalities are channelled by upstream and downstream relations. Upstream, you have the financial industry, which induces economies of scale: the more it produces, the less expensive its services will be. As some diversification potentialities also exist, the financial sector has strong chances to create a broadening of its activities. Thus, the cheaper we buy, the cheaper its product development and supply will be. We therefore have a virtuous circle. In the case of Luxembourg, we have specific branches, as the computer services for financial products that profit from these economies of scale of the financial institutions.

   P. P.: "We see that Luxembourg integrates significant agglomeration forces, which interact between business services and computer industry (upstream industries) on the one hand, and financial intermediaries (downstream industry) on the other. These forces are reciprocal and induce mutual self-reinforcing effects between these industries that finally constitute an endogenous cluster centred on a banking place. But still a competition shall necessarily exist on the upstream level, the prices would otherwise remain high. Both these externalities confer benefits to a self-sustained development.

   Geographically speaking, if technological externalities rely on proximity, the pecuniary ones can develop on greater distances. More specifically, downstream activities are mostly transverse, financial and technical (consultancy, IT, telecommunications, human resources...). This certainly explains the great information circulation.

9. This means that financial institutions develop new needs that generate new services...

10. P. P.: "...which relate back to these institutions. These services are more efficient, as diversity exists. This service diversity gives a higher added value to the production.

11. To whom is this book dedicated?

12. A. B.: "To those who are interested in the financial centre of Luxembourg and who want to have an understanding of its actors and functioning.

13. What are the main conclusions you draw?

14. A. B.: "The financial centre is neither homogenous, nor monolithic. It is a system with its own complexity. These characteristics are important. The system can thus develop, react and generate innovation.

    P. P.: "It has the ability to develop competitive advantages by a product differentiation and through regulatory advantages. These latest permitted the expansion and the development of diverse new products. We showed how the system was able to create a legal and regulatory framework and make it adapt in order to develop such products. This system integrates the complementary action of both the public action and the private initiative from the main actors of the financial centre. This development capacity is strength and a competitive advantage.

    There are more incentives - in a small place subject to high competitiveness - to initiate such complementarities between public authorities and private actors.

15. On which economic references is your analysis based?

16. A. B.: "The recent economic literature shows the importance of regulation in terms of improvement of the provided regulatory framework (lowest responsible bidder) and regarding the role of the institutions to create original forms of jurisdiction differentiation.

    Also, a new paradigm develops the importance of investor protection as an incentive to innovation. It is a new way of considering the regulatory context as an extra investor protection that valorises financial products.

    It is also a major cultural shift among the main actors who now see regulation as a positive approach.

17. How does Luxembourg position among the other financial places?

18. A. B.: "Luxembourg is an off-shore centre, in terms of clientele, as most of the customers are non-domestic. The Grand Duchy has a good position: according to The Economist, one of its advantages - as a small jurisdiction mainly depending on the financial industry - is to adapt rules and legislation very rapidly and to promptly react to new opportunities. It can quickly seize the opportunities and adapt fast, as the financial industry dominates. It is easier to concentrate on its core activities, when the internal competition does not exist.

    The regulation, which emerges from this situation, creates a new space or a niche and therefore an institutional competitive advantage: costs are reduced in time, money and in political lobbying.

19. What could be the limits of the Luxembourg model?

20. P. P.: "This could certainly be its constricted situation. Some congestion effects exist, such as the real estate prices, the manpower rarity, which is a major problem.

    This could also be a new competing supplier of financial services, which offers lower prices to lower costs, by delocalising their activities. But we do not have the impression that such a situation exists".

*Patrice Pieretti, Arnaud Bourgain, Philippe Courtin (2007). Place financière de Luxembourg, analyse des sources de ses avantages compétitifs et de sa dynamique, Fondation Alphonse Weicker, de boek Edition.