THERE has been a remarkably weak policy response to the Eurozone crisis relative to non-euro countries equally affected by the financial crash. Others have responded more effectively, notably the United States where a sustainable recovery seems finally to have commenced. The manner in which the Eurozone was constructed in the 1990s is the main problem. It is just a common currency area without the necessary institutions that would make it into a proper monetary union. Add in the absence of the Franco-German political leadership that traditionally fixes problems in Europe and the nightmare for distressed Eurozone members could have several more years to run. "If it's not broken, don't fix it" may be a sensible motto for business and political leaders, but it has a corollary: if it really is broken, you had better quit pretending. After five years of sticking plaster non-solutions, it is now abundantly clear that the European common currency system is broken and needs to be fixed.
European leaders need to clean up the mess that has emerged in the European banking system and in the sovereign debt market since the crisis erupted in 2008. They also need to prevent the next crisis through re-designing the common currency area as a full monetary union. Instead, they have persistently avoided measures that would address the sovereign debt crisis at its core (for slow learners, several Eurozone members cannot sustain actual and prospective debt levels), and remain in denial about the fragility of the European banking system. There cannot be an integrated Eurozone financial system – the principal benefit promised on adoption of the Euro – without a banking union. This means centralised bank supervision, centralised rules for resolution (including closure where needed) of failing banks and system-wide deposit insurance.
All 50 states of the USA are members not only of a common currency area but of a banking union. The three critical functions of supervision, resolution and deposit insurance are conducted at federal level. Had they not been, some states that experienced the largest bubble capital inflows and consequently the worst financial excess would now be in serious trouble. The US financial system would have fragmented geographically, with the highest interest rates charged in the most distressed states. But the dollar zone system, which certainly failed to the degree that there was a serious banking bust, has succeeded far better than Europe in distributing the losses (including to bank creditors) and moving on. The distribution of losses in the Eurozone was left to national governments and to fitful and hesitant collective action cobbled together reluctantly and far too slowly. The result has been an arbitrary distribution of losses, as well as losses magnified by the consequent deep recessions in several member states. Under its then president Jean Claude Trichet, the European Central Bank reacted initially in a manner that denied the extent of the banking crisis and added to the costs of the debacle.
There has finally been agreement in the Eurozone on a limited centralisation of bank supervision, the least important component of banking union. The European Central Bank will recruit up to 1,000 personnel who will supervise Europe's largest banks directly, leaving the smaller institutions to local supervisors. This can only be an improvement on what went before and should have been a feature of the euro design from the beginning. It is also excellent news for Lufthansa, whose Frankfurt hub should enjoy a useful boost to business traffic. But there has been no political agreement on new rules for bank resolution, a far more important issue than better supervision.
One of the lessons of history is that banks are fragile institutions and there will always be management failures. Supervisors will never spot and prevent every emerging bank crash, although they can certainly do better. The key question is what to do when the next banking disaster comes along, as inevitably it will. The answer is a pre-agreed system of bank resolution at European level, assigning losses in advance to bank shareholders, bank bondholders and finally to uninsured depositors. The continued absence of a proper system of bank resolution ensures that the next European banking crisis is more likely to happen and will be more damaging when it comes.
Bank resolution does not avoid the losses from bank failure. By the time the banks begin to fail the losses have already occurred, in the form of the foolish real-world investments they have financed. A good resolution regime will discourage poor bank management in the first place, through warning bank creditors to be vigilant, and will distribute those losses in the least damaging fashion. A lamentable feature of the mishandled Eurozone banking bust has been the failure to impose sufficient losses (until Cyprus) on careless investors in bank liabilities. A resolution regime needs to begin with bank regulation, the rules about how much equity capital a bank should have and about the adequacy of cash resources. The supervisors are there to ensure that the regulatory rules are observed. In the Eurozone, bank lobbyists have been resisting tougher bank capital rules, deploying specious arguments about potential damage to bank customers, and they appear to have been succeeding.
Bank lobbyists have been less successful in both Britain and the USA, where a tougher bank capital regime is in prospect. Tough bank capital rules make bank busts less likely, as do better rules requiring banks to hold adequate liquid assets.
The European bank lobbyists have also been seeking a continued role for taxpayers in helping to bail out creditors of bust banks. Remarkably, they appear to have been succeeding here too. The bank resolution plans announced by the European Commission in Brussels during the week continue to envisage that both national and European-level funds would be available for resolving failed banks. Several European governments, including our own, have zero capacity to inject further funds into failing banks, and the European political leadership are well aware of this. But Germany appears unwilling to countenance the essential severing of the doom-loop between insolvent banks and insolvent governments, and has been resisting the Commission's proposals. These proposals, while an improvement on the vacuum that went before, are in any event less decisive than bank resolution measures taken and contemplated in Britain and the USA.
On the third component of banking union, a centralised system of deposit insurance, there appears to have been no progress at all. There is no monetary union unless depositors regard funds in all banks in the Eurozone as equally safe up to whatever limit is agreed, and there will be retail bank runs whenever people get worried about banks in a country whose treasury is already bare, which means rather a lot of countries right now. The consequences of not centralising deposit insurance have been seen most vividly in Cyprus, where deposit accounts (including deposits in solvent banks) were frozen.
In addition to its lack of enthusiasm for centralised supervision and opposition to the European Commission's proposals for bank resolution, Germany also appears to be the principal opponent of centralised deposit insurance. If there is to be no meaningful banking union, there will be no proper monetary union in Europe. Since the distressed countries cannot easily leave the Eurozone, they become trapped in a system that has already been shown to be unstable and that, moreover, is refusing to take the steps essential to ensure long-term stability.
Ultimately, the crisis is not just about economic recovery and the best path to monetary stability. The bigger issue is the project of European integration itself. It is becoming easier to view Ireland's decision to join the Euro as a mistake, not least because it is impossible to depart. There are doubtless many who hold similar views in some of the southern European countries. But there are fewer people who would view membership of the union itself in the same light. Has a successful project (the union) been damaged by a premature and ill-designed rush to an unstable common currency with little evidence of intent to reform?
The German elections are in September, and perhaps the next Eurozone crisis will be kept at bay until the new government has emerged. At that point, either the common currency area is transformed into a durable monetary union, with all legacy issues squarely addressed, or the European leaders further damage the union in the cause of the misbegotten currency.