Much has been done to overcome the eurozone crisis, observes Pisani-Ferry in this Project Syndicate article. But it is still too early to declare the job done and claim victory.
One problem is architectural: any banking union is only as strong as its weakest component. What matters for markets is not what happens in normal times, or even what happens when uncertainty and volatility rise; what markets care about are possible scenarios in truly adverse conditions.
Breaking the negative feedback loop between distressed sovereigns and distressed banks – whereby bank rescues exhaust fiscal resources and make it likely that the next financial institution in trouble will not be able to count on government support – requires ensuring that it will not recur even in extreme circumstances. Merely “weakening” this loop, as European officials recently advocated, could prove deeply insufficient.
There are two ways to eliminate the feedback loop. One is to exclude bank rescues altogether: only creditors would have to pay for bankers’ mistakes. This type of rule could insulate governments from banking risk only if applied systematically, even at the expense of financial stability. Simply put, governments should be ready to let banks fail.
The other solution is to mutualise the cost of rescue at the margin. States could be involved and accept losses, but catastrophic risks would have to be shared among all eurozone members.
Europe these days is vacillating between these two approaches. France does not want to rule out state-financed bailouts; Germany is reluctant to mutualise budgetary costs. A compromise is being worked out, but it must pass the test of reality. Unfortunately, the middle way between two logically consistent solutions may itself not be a logically consistent one.
Meanwhile, the credibility of Draghi’s atomic weapon is being undermined. The miracle of the OMT scheme is that, since it was announced a year ago, it has had its intended effect without ever being used. Strong opposition on the part of the Bundesbank and many German academics, however, has raised questions about whether and how it could ever be used.
To defend its legality in hearings before Germany’s Constitutional Court, the ECB itself has argued that the OMT programme is a less potent instrument than many believe. Although the German government has been adamant that it is not a German court’s role to rule on the legality of ECB instruments, markets have taken note.
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© Project Syndicate
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