07 January 2018

Financial Times: Banking union is not enough to save the eurozone

Some leading economists, including Barry Eichengreen and Dani Rodrik, have been engaged in an important debate in recent months over the extent to which a fully operational banking union in Europe makes fiscal union redundant.

This is not the case, and the reasons why go to the heart of Europe’s woes, and the eurozone’s in particular. It is critical that the economic recovery in Europe, however anaemic, does not short circuit this debate and obscure the need to reform Europe’s economic and financial architecture.

All sides agree that the completion of banking union is an important pillar in this reform drive. Banking union will help diversify risk, attenuate the “doom loops” between banks and sovereigns, facilitate fairer resolution of banks and reduce the risk of deposit flight from stressed banking systems.

The differences begin over the question of whether it is feasible to have an adequate banking union in Europe and the extent to which such a union addresses other deficiencies in the European architecture. It is important to realise that there is only so much that private financial flows can do, and to recognise that such flows can be destabilising.

First, there are concerns about what is known in economic literature as the “time consistency” of some of the policies involved in banking union. Usually, economists propose rules to deal with time inconsistency — the situation in which policies were seen as optimal yesterday are considered inappropriate today.

The EU’s Bank Recovery and Resolution Directive is an attempt to offer such a solution. It may work in situations of isolated bank failure. But it will never be desirable in a systemic crisis to let banks fail — the state would inevitably intervene. Italy is a case in point. It is correct to point out, as some have done, that EU states have given up sovereignty in many areas, short of full political union. But Portugal will never be like Texas for the simple reason that a financial crisis is just too important to allow a hands-off approach.

Moreover, I am not sure that private financial flows, even after the completion of the capital markets union, can adequately compensate for public flows in the eurozone. Much of the real economy, especially in the south, is dominated by small and medium-sized enterprises, a situation very different from that of the US. Even unified and deeper capital markets will have difficulty lending to such small companies.

Financial flows can also be a source of instability by creating asset bubbles — for example, real estate in Ireland and Spain, and very high pricing of government bonds in Greece. And it is not the case that before the crisis there was not some diversification. Banks in other countries in the eurozone were holding considerable amounts of Greek government bonds.

Finally, financial markets work very pro-cyclically. It is not clear that both public and private sectors in a eurozone economy hit by a future crisis would have anything like adequate access to the international financial markets. There may be profitable projects, but tight financial conditions would prevent them getting access to finance. [...]

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