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Financial market fragmentation: A bad thing or to some degree natural?
Probably most observers would agree that financial markets in today’s European Monetary Union are still segmented or fragmented – especially when compared with the situation before the crisis. But diagnosing financial fragmentation is by no means a purely technical exercise with a clear result. In the end, it requires a normative judgement, offering answers to questions such as: Which differences are well-founded and therefore justified? Which differences are not well-founded and, hence, potentially a sign of a dysfunctional market?
Segmented markets are primarily the symptoms of underlying structural causes, which usually explain most of the differences. This applies, for example, to government bond markets, to the corporate credit market as well as to the interbank money market. Even if prices on these markets differ markedly among market participants or countries, it would be premature to interpret such differences as a definite sign of market exuberance or market malfunction, as a sign of irrationality or as a sign of inefficiencies.
How can the Eurosystem contribute to reducing fragmentation?
The single monetary policy cannot make a distinction between differing economic and financial conditions among EMU member countries. Instead, what matters for the single monetary policy is the aggregate situation of our monetary union. Does this, in turn, mean that economic conditions as well as economic outcomes need to be the same in every single member state of a monetary union? No – in fact, on the contrary: If national economic policies and national public preferences are different from one country to another, national economic outcomes will differ as well. These differences will then be mirrored in different financial market conditions.
So what is the role of the Eurosystem in the context of financial fragmentation? My central point is that the Eurosystem cannot overcome the structural causes of the market segmentation, because these causes are beyond its control. As the Eurosystem cannot solve the sovereign debt crisis, it cannot solve the ensuing market fragmentation, either.
Banking Union and the treatment of sovereign exposures
The European Banking Union will be a very important step – actually the most important European integration effort in the financial market since the introduction of our single currency. But even a sound Banking Union will not be sufficient to reach our goal of making the financial system more stable. Apart from supervision and resolution, we have to look at bank regulation. The current regulatory framework, too, promotes this nexus between bank and sovereigns because it encourages banks to invest in sovereign debt. This reinforces the "doom loop" between the sovereign sector and the banking system. Should doubts about the sustainability of government debt arise, the national banking sector will also be negatively affected. This is particularly relevant in the European Monetary Union as European banks often only invest in the sovereign bonds of their home countries. Reassessing the regulatory treatment of financial institutions’ sovereign exposures is crucial. More effective financial market regulation is necessary to ensure that a "doom loop" between sovereigns and banks cannot emerge.
Fragmentation also exists in the Real Economy
Germany has been criticised for its relatively high current account surpluses. The current account balance in Germany is, however, not the result of distinct government policies or even central economic planning. It is, first and foremost, the result of market-driven processes reflecting the investment and saving decisions of millions of market participants. And they simply reflect structural causes. For countries like Germany, a current account surplus helps to absorb future burdens induced by its demographic development. In this sense, current account surpluses are not an economic harm but an economic asset.
Neither fellow European Monetary Union countries nor the European Monetary Union as a whole would be better off if Germany were to be weakened artificially. Especially, since the relatively strong balance sheets of German households, businesses, and of the public sector provide a certain degree of stability not only for Germany, but for the euro area as a whole. We have to accept the structural differences between economies.