Eurozone quick-fix will create political monster - FT.com http://www.ft.com/intl/cms/s/0/9216efea-f02c-11e0-977b-00144feab49...

October 9, 2011 7:19 pm

Eurozone quick-fix will create political

monster
By Wolfgang Münchau

If the optimum is not attainable, we are tempted to settle for the second best. The optimal
response for the eurozone would be to turn it into a fiscal union. But it might not happen –
or not in time. In that case, the question naturally arises: what would constitute a
minimally sufficient solution to the crisis?

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. We already saw that in the stress caused by the

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Eurozone quick-fix will create political monster - FT.com http://www.ft.com/intl/cms/s/0/9216efea-f02c-11e0-977b-00144feab49...

relatively modest private sector involvement agreed at the July European summit. 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. Judging from their comments, Europe’s
leaders have learnt nothing. The reluctance to shift power over banking to the eurozone
level is, of course, deeply rooted in national politics. Political parties and non-commercial
banks are closely interlinked in Spain and Germany. In Germany, the savings banks and
Landesbanken play an important role in the financing of industry. 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. It is in the economic
nature of insurance that it requires rules to contain moral hazard. The eurozone’s
experience of rules-based governance has been a disaster. The first attempt at a stability
pact collapsed because Germany and France breached it. The second did not survive the
2009 downturn. They did not fail because of technical deficiencies, but because it is in the
nature of national sovereignty that governments breach rules if their electorate so wish.

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.

munchau@eurointelligence.com

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