09 October 2011

Wolfgang Münchau: Eurozone quick-fix will create political monster

There is an emerging consensus that bank recapitalisation lies at the heart of any solution short of a fiscal union. Few would claim it is sufficient. It would have to be somehow embedded into a system of cross-border financial insurance. Member States would remain sovereign, but the eurozone would make sure that all systemically important banks are properly capitalised, supervised and, if necessary, forced to close or merge. For this to work, all systemically relevant banks would have to come under the eurozone’s umbrella, not just those operating across borders.

In such a minimal system, cross-border transfers would still occur, but would be limited to supporting the financial sector. Member States would retain full sovereignty – subject to a common set of fiscal rules. If imbalances arose that destabilised the financial sector, the eurozone would provide effective insurance against cross-border spill-overs. Such a hypothetical set-up reminds me of a debate among central bankers during the credit bubble: should monetary policy prick bubbles, or mop up the debris afterwards? Our minimal solution mops up. The chaos in the eurozone would continue, but at least there would be some insurance at the end.

If the eurozone had adopted this approach in October 2008, right after the collapse of Lehman Brothers, it might just have worked. We would still have had the Greek and Portuguese crises, but Ireland, Spain and Italy might have been spared. Then again, it might not have worked. I can think of four reasons why it will not work today.

First, the sums involved have become too large. A recapitalisation fund of a few hundred billion euros might have done the job three years ago. Now you need much more, on top of the capital already invested.

I would also expect the dynamic effects to be more serious now. Governments have no doubt done the maths, but, as ever, their maths is static. It is not hard to add up German and French banks’ total exposure to Greece, and calculate the additional capital requirements. It is much harder to understand the dynamic effects of a Greek default on the wider financial and economic system. A default, even if anticipated, would spread further uncertainty through multiple channels. What we do know is that you will never be able to recapitalise the banking system enough to cope with contagious defaults. Should the first priority not be to prevent contagion, rather than to make the banking sector fit for it?

Second, even if European governments put up enough capital, they would not do it right. They would repeat the mistake they made in October 2008, when EU leaders agreed to recapitalise their banks, each for themselves. In political terms, this minimal solution is not minimal at all.

Third, a solution that relies on the financial sector hits a dilemma inherent to the structure of the European Union. A single market for finance is an EU-level competence that cannot easily be reduced to the eurozone. Non-eurozone members such as the UK would almost certainly not join such a system, and might block a single banking supervisor. If you rely on a financial insurance backstop as your main strategy, the non-eurozone members would ultimately be forced into the eurozone, or out of the EU. So you might end up saving the eurozone, by breaking the EU – or vice versa.

Fourth, a financial mopping-up strategy could prove economically more destabilising and financially crippling than its advocates admit. If you have no proper incentives in the system to reduce internal imbalances, financial instability could become the dominant factor, and the potential transfers could fast become very large.

The minimally sufficient regime is subject to an unalterable paradox: it is motivated by a search for a solution that is politically more acceptable than a fiscal union. Yet, in designing such a system you end up with a political monster.

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© Wolfgang Münchau