Bursting the Bubble

Is the Banking Union strong enough to avert the next economic crisis?

14 December 2015 | by

At the heart of the Economic and Monetary Union lies a fundamental contradiction. On the one hand, the EMU requires considerable integration of policies at euro zone level, and a high degree of economic discipline at the national level. On the other hand, most people of the euro zone do not want to be ruled by some kind of euro zone government: they prefer national democracies.

This lies at the core of the political trilemma developed by Harvard professor Dani Rodrik. The reason for the trilemma is that globalization requires countries to adopt common policies. Therefore, the democratic nation state cannot simply tailor policies to domestic needs and preferences. The EU is an example of how globalization works. To tackle this trilemma governments have three choices. First, policy-makers could move one level up, to a democratic EU, with countries ceding national self-determination but preserving democracy and globalization. Second, nation- sates can act in ways that violate electorates’ preferences in order to make their policies compatible with a globalised world. Third, governments can limit the flow of goods, capital and people across their borders (globalization), and so preserve democracy at the level of the nation state.The challenge of the euro zone is to find a middle ground between the three choices of the trilemma to make the euro work.

The middle ground

To find a middle ground is to define areas where common policies are economically essential. The euro zone’s economic problems are its reliance on cross-border bank lending, banks’ close links to national governments, self-fulfilling runs on government bonds and weak aggregate demand. The Banking Union is such a set of common policies. The Banking Union’s birth was in 2012 and two pillars already have been implemented: the Single Supervisory Mechanism (SSM) and the Single Resolution Mechanism (SRM). The groundwork has been laid but the Banking Union is far from complete. For a European banking system, powers have to be given at a European level to control that system that is independent from national governments.

Furthermore, the euro zone has to tackle how banks tie themselves to their nation-states. Regulators should move ahead to decoupling banks from their governments, by restricting the assets that banks are allowed or encouraged to hold. This has been planned by the authorities, i.e. to move the centralization and supervision of the European banking system to the ECB. A common deposit scheme is also necessary to combat a euro-zone wide crisis. This is in order to ensure that the safety of the bank deposits in a country does not depend on the solvency of its government.

Aggregate Demand

The final problem that needs euro zone level policy making is the fluctuation of aggregate demand. Excessively low levels of demand and inflation condemn the weakest regions to severe recessions, lead to soaring debt burdens and destabilize the whole monetary union. Excessive demand on the other hand opens the way for destabilizing booms in strong regions. The ECB has as mandate price stability which is another way of saying that it has to keep demand flowing at a sustainable way. After the crisis the ECB has had some problems maintaining price stability.

To combat such shortfalls in demand the ECB must have new tools to help prevent risks from emerging and to counter regional booms. And, the ECB has to get a new mandate: more activist and robust to manage demand, more like the duo-mandate of the Federal Reserve, which also must deliver on growth but the German Bundesbank and central banks of other strong European states will avoid such centralization of the ECB.

The lender-of-last-resort of the ECB mandate has to be maintained too. This mandate has worked fine during the crises but is now offset due to a case made by Germany that it was illegal. The Court of Justice has made clear that actions of the ECB were necessary and in the mandate of the ECB, but many Germans are not convinced that such a function is needed. For them it tends to enforce free-rider behavior of weaker states which don’t want to comply to the rules of the EMU because the ECB will rescue them at any time. However, financial markets are not convinced by the stance of Germany, seeing their reaction on European bonds when the euro was in peril in 2012. The ECB reacted that it would do whatever it takes and did so with Outright Monetary Transactions (OMT). Spreads between the strong and the weak countries lowered because of that speech of Draghi.

Conclusion

With these extra powers to the ECB and the SSM and SRM with deposit insurance in place, it is doubtful that national central banks and national financial regulators would still be needed.  National regulators tend to favour narrow national interests over the stability of the euro zone. Moreover, supervisory practices and standards differ across member countries, and institutional inertia makes harmonization difficult. The SSM is designed to ensure that such national considerations play a limited role.

What do you think?