Colm McCarthy: Little hope for state of the union
We need a fully fledged monetary union like in the US or risk further financial crises
When central banks cut their policy interest rate, this is meant to cut the cost of funds to banks and work through the financial system, resulting in greater, and cheaper, availability of credit. Central banks around the world have cut rates sharply, almost to zero, since the onset of the Great Recession and some have gone further, resorting to direct interventions to stimulate private sector credit.
At its meeting in Bratislava on Thursday the European Central Bank decided to cut its principal policy interest rate from 0.75 per cent to 0.5 per cent, the lowest it has ever been. ECB president Mario Draghi explained the move as a response to the continuing signs of recession and the weakening threat of price inflation.
The rate reduction is small and there would be limited impact if it worked through in the normal way. But the eurozone has become so dysfunctional that the move is unlikely to improve credit conditions in those countries that need more (and cheaper) bank lending. In Ireland, the move could actually result in increased lending rates for many borrowers.
In addition to cutting the main policy rate, the ECB announced several other measures which indicate that it sees a continuing need for an easier monetary stance. The ECB interest rate has been low for quite some time and the message is that Frankfurt expects to keep things that way into 2014.
In the particular case of Ireland, the move will immediately benefit those fortunate enough to have tracker mortgages, linked directly to the ECB interest rate. Banks are losing prodigious amounts of money on trackers, since they are lending at well below the cost of funds. These losses will now rise and the banks will seek to compensate by raising variable interest rates and other charges. AIB managed to get their retaliation in first and raised variable interest rates the week before the ECB move, which had been well signalled.
The principal problem in eurozone credit markets is not the general level of official interest rates. It is the fragmentation that sees retail lending rates vary enormously across the zone. Smaller companies in Germany can borrow at rates far lower than their competitors in Spain or Italy. This is not meant to happen in a well-functioning monetary union. The problem is not so serious for large companies, which have multiple banking relationships. They are not captive customers of any single damaged bank. The reason this fragmentation has happened in Europe is that the common currency has not been accompanied, as in the United States, by an integrated approach to financial supervision and a common approach to resolving bust banks. Each individual state must carry their own banking system on the shoulders of the national treasury, several of which are no longer credit-worthy. Hence, the banks are seen as lacking credibility too and cannot fund themselves at reasonable cost.
The housing bust in the USA was not uniform across the country's 50 states. The worst excesses were in the so-called 'sand' states – California, Nevada, Arizona and Florida – whose local banks took heavy losses. But since the United States is a proper and well-functioning monetary union, the governments of these four states were not responsible for supervising banks or for resolving banks that fail. These functions are carried out at federal level and there is a federal system of deposit insurance. If Nevada had the misfortune to be part of the eurozone, it would now be bust, its banks would be zombies and any small manufacturer in Nevada would face the tight and expensive credit now afflicting southern Europe (and Ireland).
A monetary union is meant to have, in addition to a common currency and free capital flows, similar credit conditions throughout. For borrowers of equal credit standing, both the availability and cost of bank credit should be the same. A euro deposited in any bank in the zone should enjoy the same depositor protection. What happened in Cyprus simply could not happen in any of the US states.
The source of eurozone financial fragmentation is the doom loop between shaky banks and over-borrowed governments, which cannot be addressed permanently without turning the eurozone into a proper monetary union. The ECB, to be fair to Mario Draghi and his colleagues, cannot do this off their own bat and Draghi has acknowledged the problem on numerous occasions. This week, he again stressed the urgency of moving quickly to retrofit a banking union, consisting of centralised supervision, resolution of failed banks and depositor protection. There is now widespread acceptance that the monetary union agreed for Europe during the 1990s contains serious design flaws, although no sign of any apology from the designers. The eurozone is just a currency union, not a fully-articulated monetary union like the USA, and it cannot avoid periodic crises, including the risk of a break-up, unless the crucial decisions on banking union are taken. In a large monetary union, regional banking busts are common and have been a frequent feature in the USA in recent decades.
Only in the matter of centralising bank supervision has there been any real progress in turning the eurozone into a proper monetary union. Agreement has been reached to bring bank supervision under the ECB umbrella from 2014 onwards. Without the agreement of Germany, there cannot be centralised bank resolution (a pre-arranged system for allocating losses when supervision fails and banks go bust) and it looks increasingly unlikely that German support will be forthcoming.
As for a centralised European system of deposit insurance modelled on the US Federal Deposit Insurance Corporation, German politicians appear to regard centralised depositor protection as an optional extra, and many have expressed opposition to the very concept.
It is not an optional extra – the value of a euro cannot depend on the national identity of the bank in which it was deposited. If it does, you end up with the Cyprus shambles. The eurozone ceased to function even as a mere currency union, at least for Cypriots, the day deposits in Cypriot banks (including some that were solvent) were declared to be inconvertible, with the consent of the ECB.
The ECB's decision to cut its main lending rate was not unanimous. Since the ECB, unlike many other central banks, does not publish the minutes of its meetings, nobody knows who voted against, but there is speculation that Jens Weidmann, the representative of the German Bundesbank, was likely a dissenter. Chancellor Angela Merkel had earlier argued that an interest rate reduction was not appropriate for Germany.
With Weidmann in a minority on the ECB board, his views are not decisive. But both the German government and the potential alternatives due to contest September's election have been indicating for months that they are not prepared to push ahead with a banking union. They are afraid of frightening voters already convinced that Germany is subsidising southern Europe and that banking union would expose them to further transfers. Both the ECB and the International Monetary Fund have been making urgent calls for centralised bank resolution in particular. If German politicians are unwilling to complete the process, the built-in fragility of Europe's common currency will persist. This not only runs the risk of further financial crises down the road, it fuels broader political forces driving the European Union apart.
When the post-meeting press conference ended on Thursday in Bratislava, ECB president Draghi introduced the new series of euro banknotes, to be released across the zone in the coming months.
Presenting autographed €5 notes to assembled schoolchildren from member states (€5 – a bit miserable?) he waxed eloquent, describing the notes as ". . . the most visible and tangible symbol of European integration, used from one end of the continent to the other".
Warming to the theme, he expanded: "The children who are here today are growing up in a continent of peace. They belong to the 'euro generation' – they have only known one currency."
They have known two currencies actually, if any Cypriot children were present. It is no longer permitted, in Europe's common currency area, to move funds freely across national boundaries, since the Cypriot euro is no longer convertible.
Cyprus, like Ireland, was at the receiving end of a major banking bust. It is not likely to be the last eurozone member to discover that Europe introduced its common currency without building the necessary foundation of a monetary union.