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As economic and financial pressures rise in the euro area, the commentary often suggests that an economic collapse and an outgrowth of extremist political forces reminiscent of the 1930s are upon us. These alarmist analogies come from two groups of people. Some are global hedge fund specialists whose "tail-end event risk franchises" require predictions of new economic calamities every quarter to be relevant to their clients—even though their funds suffered abysmal returns in recent years.1 Others are professional historians who have written scholarly works on the 1930s and are extending that franchise as well. History may repeat itself, but historians tend to repeat their own mistakes even more so. There is just no incentive for either of these groups to see light at the end of the tunnel for Europe.
But there is another way to approach the euro area crisis and envision a less dire outcome, based on seeing it as a political crisis over completion of the European economic and monetary union. The design flaws in the euro area were no accident. The euro area's founding members did not have the political will in the early 1990s to surrender their national control over vital areas of "deep sovereignty" like domestic banking sectors and fiscal policy. At its core, the euro area crisis is about national sovereignty and about the process in which European governments can transfer sovereignty to new regional institutions governing the banking sectors and fiscal policies.
No matter what financial markets want, national sovereignty is not surrendered lightly. Indeed, the degrees of sovereignty that must be surrendered today are the kinds traditionally associated with direct military threats. Accordingly, periods of elevated sovereign bond yields and banking sector funding stress are now politically required to facilitate this peacetime process. As discussed previously on RealTime, political brinkmanship and purely reactive responses are to be expected. Bold or radical solutions to crises are politically impossible. The decades-old political project of European integration requires crisis to move forward—but it cannot be completed suddenly.
Europe's gradualist process faces another milestone at the next EU Council on June 28–29. Some may disparage the seemingly endless number of euro summits required in this crisis, but they entirely miss the point. Discussion about "subsidiarity"—which policies to implement at the center, and which at the member state level—involves an open-ended debate. No single summit can settle the matter. A long sequence of regular EU Council summits is required. That is what euro area economic governance looks like.
Perhaps it will not always do so, but "old Europe" should remember that the United States took well over 120 years to create a central bank and institute a national income tax. So while future European economic and political integration will take its own path and create its own unique institutions, this author is convinced that quite a few European economic governance institutions will end up looking like some of those in the United States. Europe has begun the process of enacting national constitutional balanced budget amendments, for example—the equivalent of which have existed in most US states since the early 19th century.
What should be expected from EU leaders on June 28–29? Four main issues can be identified.
1. For Greece, a Political Deal
Some sort of political deal easing the austerity measures imposed on Greece must be reached. The recent Greek elections produced the best outcome possible given the circumstances—a three-party governing coalition with a strong incentive to hold together for the full parliamentary term. After several months of further accelerated economic decline, the Greek economy will probably hit bottom in the next couple of years after a cumulative 25 percent decline in GDP, provided that the banking system remains solvent and the government can maintain access to outside funding from the European Union, European Central Bank (ECB), and the International Monetary Fund (IMF), known as the Troika. All three coalition members in Athens will thus have perhaps a few years of economic rebound to run on in the next elections, due in four years. For the coalition parties, that would be a better prospect than breaking up their partnership and facing Alexis Tsipras, leader of the defeated left-wing alliance known as Syriza, in a few months.
Meanwhile, the euro area has its own reasons to avoid hardball with the Greek voters and threaten them with ouster from the euro (which, as discussed on RealTime, remains extremely improbable). Euro leaders are therefore likely to hold their noses and give the Athens government something to take home to Greek voters, despite the fact that the new Prime Minister Antonis Samaras is among those most responsible for the deterioration in Greece in the last six to nine months.
Don't expect any details about a new deal for Greece until after the next Troika mission to Athens, though an extension of some deficit targets and some high-profile measures to ease the most acute social effects of the current program seem likely. Despite the maximalist demands from the Samaras government itself, no serious changes in the structural reform components of the current Memorandum of Understanding with Athens are likely. One can debate whether the previously agreed 150,000 reductions in the bloated public sector workforce are "an austerity measure" or a "structural economic reform." There is plenty to negotiate. But given the alternatives, the political will seems to exist on all sides—including the IMF and its non-European supporters like the United States (keen to avoid more turmoil ahead of the elections in November)—to reach an accommodation.
2. For Europe, a Growth Compact
An agreement will likely be reached at the EU Council to forge a new European Growth Compact to complement the earlier Fiscal Compact and to provide a boost to economic growth in the short run. Politically, this is critically important to French president Francois Hollande, who won his election promising to shift priorities in the face of the crisis. Look for a headline number of perhaps 1 percent of EU GDP, around €130 billion, the amount being reported in the news media. But reflecting the political and economic realities of Germany's dominance in the euro area, there will be relatively little new money involved. Accordingly, a new Growth Compact should not be seen as Keynesian stimulus called for by some in the United States. In the same way that Hollande's promise of stimulus policies in his campaign will produce less than his campaign rhetoric implied, the Growth Compact will likely redirect existing EU funds towards job creation, expand lending by the European Investment Bank to co-finance new EU projects, and introduce new EU project bonds to pay for infrastructure.
Those seeing an urgent need for coordinated fiscal stimulus will be disappointed, no doubt, and they may deliver a negative media (and markets) verdict on the EU Council deliverables. That conclusion would be a mistake. Fiscal spending in Europe remains overwhelmingly at the member state level. By far the most important fiscal policy issue in the euro area is the national budget targets, which are not on the agenda this week. As discussed previously on RealTime, the new Fiscal Compact actually gives plenty of room for structurally reforming countries—like Spain or Italy—to take extra time to achieve fiscal consolidation. There is no chance that the European Commission will force Spain, for example, to reach its 2012 deficit target of 5.3 percent of GDP. Discussion of such latitude is part of a bureaucratic process, which the EU Council will not join.
3. For European Banks, Steps Toward Union
By far the most important step to be taken by the EU Council will deliver progress on a European banking union. As I will elaborate in a new PIIE Policy Brief with C. Fred Bergsten—to be published later this week—integrating euro area banking is vital to achieving the longer-term integration of euro area fiscal policies.
Euro area states must hand over more of their national sovereignty to new euro area institutions to complete their economic and monetary union, accompanied by a synchronized and proportional mutualization of euro area government debt liabilities and contingent liabilities. This political-financial linkage will, in turn, determine the progress toward integration at the next EU Summit on two key subject areas: banking union and fiscal union.
Immediate progress on the integration of the banking sectors is urgently required. First, EU leaders should appoint the ECB as the single euro area banking regulator, with the authority to overrule national banking regulators—a step that seems likely to be approved. No government is eager to lose control over its national banking system, but present circumstances dictate such a move. It seems probable that the ECB will become the sole regulator for only the largest and cross-border euro area banking institutions. Limiting the action in that way would mitigate the loss of national sovereignty and set up something similar to the regulatory framework for the US banking system. In the United States, most smaller banks are state chartered, whereas the larger banks are nationally chartered with different regulators, but based on the same single supervision rulebook.
Prospects of progress in this area are encouraging because of supportive statements by the ECB itself and by German Chancellor Angela Merkel.2 The euro area crisis has so far shown that when both the ECB and Germany want something, they get it.
Simultaneously, the European Union as a whole has already been negotiating a new common resolution authority,3 with explicit provisions for write-downs, or "bail-ins," of shareholding capital and uncollateralized/asset-backed liabilities—including both subordinated and senior unsecured debt holders. In addition, guaranteed deposits, short-term interbank lending, client assets, salaries, pensions, and taxes would be excluded from such restructuring.4 These changes to shield European taxpayers from the fallout caused by future bank failures are critically important to the general shift towards pan-euro area banking resolution. Bondholder concessions are also a powerful tool to limit potential future implicit cross-border fiscal transfers related to large bank bailouts in a fully implemented euro area banking union.
The vast majority of the costs of cleaning up the peripheral euro area banking systems will have been incurred and transferred to the national government balance sheets ahead of the next EU Council meeting. This fact is clear from the recent Spanish bank bailout, and the fact that the national banking systems of Greece, Ireland, and Portugal are being recapitalized as part of the IMF programs. As with the introduction of EU bank bondholder haircuts, these incurred costs will limit the amount of future cross-border fiscal transfers resulting from bank bailouts in a fully implemented euro area banking union. After all, it is easier to integrate solvent, rather than insolvent banking systems.
Bail-ins and previously implemented peripheral bank restructurings will facilitate German agreement on the last and most critical part of a euro area banking union—mutualization of contingent banking sector liabilities in the form of a joint deposit insurance scheme modeled on the US Federal Deposit Insurance Corporation (FDIC), and a joint euro area bank resolution fund. Provided that agreement can be reached on the transfer of supervisory banking authority to the ECB, Germany must fulfill its side of the bargain and agree to this reciprocal mutualization of related contingent liabilities.
In a possible transition period, a dual level resolution and deposit insurance fund scheme can exist at the national and euro area level. Under this arrangement, national level funds would take the first loss (eliminating most moral hazard concerns) and the euro area level fund would be called upon subsequently. But such a setup would clearly only exist until banking supervision could actively be carried out at the euro area level. After that, full euro area contingent liability mutualization must occur. Initial financing issues may have to be overcome through the deployment of European Stability Mechanism (ESM) funds until a regular insurance based model financed by the banking industry is self-sustaining.
The G-20 Communique's statement from Los Cabos on this subject was encouraging. It said that "Euro Area members of the G-20 will [our emphasis—rather than should or intend to] take all necessary measures to safeguard the integrity and stability of the area, improve the functioning of financial markets, and break the feedback loop between sovereigns and banks."This wording makes it less likely that euro area leaders can wiggle out of the commitment.
The critical factor is the so-called doom-loop between national banks and their sovereign government. But several feedback loops exist with varying degrees of importance. One doom-loop is the negative spiral prompted by banks becoming too big for their national government to guarantee. This is what happened in Ireland and is the principal reason why supervision and resolution responsibilities must be elevated for at least the largest banks up to the euro area level.
With the largest banks instead supervised and guaranteed by euro area institutions, the potential for simultaneous increases in the funding costs for sovereigns and their banks in individual member states should be reduced. A sufficient threshold for the share of each national banking system lifted up to the euro area level must be established. Many smaller banks will retain their national regulator and (at least initially) be nationally guaranteed. But enough of each member state's banking system must be transferred to the euro area level to ensure that the remaining contingent liabilities for each member state do not threaten the credit worthiness of the sovereign. Where this threshold will be for each country is of course affected by also the capitalization of banks (as well-capitalized banks will represent a less risky contingent liability for a government) and other issues. The threshold will ultimately be at least partially market-driven.5 Establishing the right cut-off point for national vs. euro area regulated banks may change over time.
Breaking the doom-loop now is critically important, because it is the pass-through from higher sovereign borrowing costs to higher funding costs for all banks (or vice versa in the case Ireland and Spain). These costs—which exist irrespective of the individual capitalization and financing costs for the non-financial sector—pose the biggest threat to economic growth in Spain, Italy, and the rest of the periphery. Introducing a banking union will therefore contribute urgently needed monetary stimulus for the euro area periphery.
A banking union would also help ease concerns over high bank holdings of domestic government bonds. It is not clear that these are legitimate concerns in the euro area. After all it is often said that high domestic government bond ownership is one of beneficial stabilizing factors in Japan. If it is a good thing in Japan, why is it terrible in Italy? The reason is obviously excessive concerns over the solvency of the Italian and Spanish governments, for example. These concerns are made worse by potential liabilities from Italian and Spanish banks. But because a banking union will remove many of these contingent liabilities from national balance sheets, it should also serve to quell these concerns about domestic banks no longer holding sovereign debt.
4. For the European Union, a Fiscal Union Agenda
The fourth main issue on the agenda of the European Council is fiscal union. Immense political obstacles must be overcome to complete it. Fewer concrete immediate steps are possible on this action than on the issue of the banking union. As discussed above, Europe should further transfer national sovereignty over fiscal policies and seek the proportional mutualization of euro area existing and future national sovereign debts. This can be accomplished in several ways: eurobills (only part of the yield curve), the European Debt Redemption Fund (ERF) for everything above 60 percent of GDP, Red Bond/Blue Bonds (everything below 60 percent of GDP), or other similar proposals.
Compared to implementing the euro area banking union, the key political difference is the new euro area institution into which political sovereignty is transferred. In the case of banking union, because of the complex technical nature of the subject matter, the ECB as a competent technocratic and unelected institution is an adequate institution for these responsibilities. But in fiscal policy matters, technocratic and bureaucratic institutions (like the European Commission in its current form) will not suffice because fundamental political and distributional choices in society are at stake. Genuine fiscal policy competencies can only be transferred to a new euro area institution imbued with direct democratic legitimacy. How to design such an institution and instill the European Union/euro area with additional democratic legitimacy from the European population is a profoundly complex task. It will take years to complete. As illustrated by the Future of Europe Group, consisting of interested foreign ministers first convened by Germany in March 2012, European leaders have however begun to debate it.
At their summit, EU leaders need to articulate the longer term direction of the euro area. They have to spell out the 10-year plan for the common currency, as Mario Draghi, president of the ECB, has proposed. They have to assure markets and voters of the path forward. With banking union becoming a more imminently achievable goal, longer-term visions must flow from the design of the fiscal and political union. But the politically feasible down payment on that vision will be the crucial forward step to a banking union at the upcoming EU Council.
Notes
1. Look no further than the Dow Jones Credit Suisse Hedge Fund indices found here or here.
2. See http://online.wsj.com/article/BT-CO-20120622-703222.html
3. See COM(2012) 280/3.
4. Member States can also choose to exclude other liabilities on a case-by-case basis if necessary to ensure the continuity of critical services.
5. Since in the longer run the resolution and deposit insurance funds will be financed by the banks themselves through a fee-based insurance model, it is for long-term redistributional and "implicit fiscal transfers" reasons less relevant that some countries might have more large banks regulated at the euro area than others.
