Text for eurozone cover story

In: Uncategorized

18 Jan 2012

This is the main text for my recent Fund Strategy cover story included links to the articles cited (see 16 January post). I will paste the text for the boxes over the next couple of days.

The eurozone financial crisis is usually seen as one of sovereign debt as opposed to the banking crisis that exploded on Wall Street in 2008. Whereas the turmoil in Greece, a nation state, is seen as the trigger for the eurozone’s predicament, the earlier crash is associated with the collapse of Lehman Brothers, an investment bank. The discussion of Europe’s plight focuses much more on the dangers of the weaker eurozone nations collapsing than on its troubled banks.

This perspective is misleading on both counts. The instability of the banking system is central to the eurozone crisis, whereas the Lehman crash was also related to broader weaknesses in national economies. Chronically sluggish national economies and bloated banking systems were central to both stories (see box on the Lehman example).

In reality the financial and economic aspects of the crisis are intertwined like a mass of twisted vines. But to properly understand what is going on it is necessary to discern the specific role of the banks in the whole mess. It may not be possible to separate them in the real world but it is possible to logically untangle their part in the turmoil.

Having said that, the economic plight of the eurozone is more convoluted than that of America or Britain. Both Anglo-American economies have severe economic problems but they exist within individual nation states. The peculiarity of the eurozone is that it locks together 17 diverse economies into an unwieldy monetary bloc.

It is neither a single, sovereign nation nor a United States of Europe. Eurozone member states all share a single currency while lacking the flexibility to set their own interest rates.

n a sense it is like the multi-headed Hydra of Greek mythology. Although it has one body it has many heads; each of which often wants to move in a different direction.

To understand the role of the banks in this arrangement this article will first revisit the fundamental structural tensions embodied in the eurozone. In common with many others it will argue that the combination of diverse nation states into a monetary bloc undermines its durability.

It will then be possible to examine the banks’ role in the set-up. Although cross-border lending increased substantially in the run-up to 2009 the banks themselves remained national in many respects. This combination of mobile liabilities and relatively immobile assets only added to the region’s problems.

Finally, it will examine the implications of the eurozone’s ambiguous status for its central bank. Since the European Central Bank (ECB) does not represent a sovereign entity it lacks the lender of last resort powers that are a key feature of most central banks.

Structurally uneven

Back in 2010 I argued in a cover story that the eurozone could be seen as operating on three different levels: national, regional and global. Each country, as with other nations in the world, has its own distinct national characteristics.

Unlike, say, with America or Japan, the regional level plays a particularly important role in its economic life (Britain’s position is more hazy as it is not a member of the eurozone but it is in the European Union). Its ambiguous status, as neither a nation state nor a fully unified economic region, makes the eurozone more unstable than it would be otherwise.

Many commentators have recognised the inherent tensions within the eurozone. For example, Martin Feldstein, an economics professor at Harvard, wrote in the current issue of one of America’s most prestigious international relations publications of: “the inevitable consequence of imposing a single currency on a very heterogeneous group of countries.” (“The failure of the euro”, Foreign Affairs, January/February 2012). But despite this being a fairly widespread view among a small group of specialists it is not widely understood.

The fundamental problem is that combining countries with different levels of competitiveness into a single bloc inevitably creates tensions. Typically such imbalances are expressed as widening current account deficits for the weaker economies and widening surpluses for the stronger ones.

Examining the experience of the eurozone over the past decade illustrates how such arrangements can go wrong. Take Germany and Greece as two countries at opposite ends of the spectrum to see how problems can emerge. For Greece the advent of the eurozone meant that it could obtain credit more cheaply than if it had retained its own currency. Until the emergence of this crisis in 2009 the yield on Greek bonds was little different from German Bunds. In effect Germany was helping to underwrite Greek credit.

The financial bubble that emerged in Greece and other countries should therefore be understood as at least partly the result of the structural characteristics of the eurozone. It should not simply be dismissed, as some commentators have done, as a result of “klepto-socialism”.

Although eurozone membership helped to boost Greece for several years it also had short-term benefits for Germany. The advent of the euro meant that, in effect, German exports were much cheaper than they would otherwise have been. If they were still denominated in Deutschmarks importers both inside and outside Europe would have had to pay substantially more to buy German goods.

Therefore Germany’s support for the eurozone should be seen as at least partly driven by a mercantilist policy of providing national support for its exports. At the same time it provided German policymakers with a way of avoiding the need for restructuring its chronically sluggish domestic economy.

Unfortunately for both sides this arrangement could not last over the long term. As is clear with the benefit of hindsight it had the paradoxical effect of widening the divisions with the eurozone. The productivity gap between Germany and Greece became even more stretched. Eventually something had to give and in the event it was Greece’s ability to repay its debt.

To make matters worse the existence of the eurozone meant that Greece could not devalue its currency to help adjust its economy. It had to struggle to repay its debts in what, from its perspective, was a substantially overvalued currency.

Nor was Greece the only country in trouble. It has only become a focus because it is the most extreme example of the eurozone’s structural weaknesses. Many eurozone countries, most notably Italy and Spain, face similar problems. Meanwhile, core countries such as Germany and the Netherlands face the problem of picking up the tab for the mess they helped to create.

No doubt the temptation for most politicians will be to attempt to somehow muddle through. That is what they have done until now.

But ultimately the problem can only be resolved in one of two ways. Either the leaders of the eurozone will have to impose full economic integration from above. That would make it easier to transfer resources between different parts of the region. For example, capital could be moved from Germany to Greece in effect without crossing any boundaries. However, it would also come at the expense of democracy as unelected technocrats would rule over elected politicians. This trend towards technocratic rule is already most clear in Greece and Italy where unelected governments of experts have taken control.

The alternative approach would be a wind-up of the eurozone as it is presently constituted. This might be a traumatic process but it is arguably far better it happens in an orderly way than letting the monetary bloc collapse of its own accord. It would also provide the basis to build a genuinely democratic united Europe based on a popular mandate in the future.

Commercial banks

Once the structural flaws of the eurozone are understood it is possible to divine exactly how banks fit into the process. However, it should be said that even if the euro had never been invented the region, in common with the rest of the western world, would likely have had a bloated banking system. Instead the likelihood is that the advent of the eurozone has intensified trends that would have already existed.

In broad terms the banks became channels for the increased movement of capital between eurozone states. In the simplified example above, which just focused on Germany and Greece, it means German banks would have played a key role in lending to Greeks. Once the Greek bubble burst the German banks would have been left holding large amounts of bad debt. A Greek economic crisis could easily be translated into a German banking crisis.

This model outlines the essence of the problem although in reality the situation is more complicated. The eurozone consists of 17 countries rather than just two. Non-eurozone banks, such as institutions from Britain and Switzerland, have also played a role in the process. In addition, the linkages between the banks have become complicated in these days of complex financial instruments.

In the years running up to the emergence of the Greek crisis there was a huge increase in regional lending in Europe. Cross-border, euro-denominated liabilities of eurozone banks surged from about €2 trillion with the advent of the eurozone in 1999 to about €10 trillion in 2008, according to the Bank for International Settlements.

It should also be remembered that once the crisis started to emerge in Greece in 2009 there was concern about the liquidity and even solvency of many European banks. Nor did it take long for it to be seen as a broader systemic problem. According to an IMF study:

“Spillovers from high-spread euro area sovereigns have affected local banking systems but have also spread to institutions in other countries with operations in the high-spread euro area and with cross-border asset holdings. In addition to these direct exposures, banks have taken on sovereign risk indirectly by lending to banks that hold risky sovereigns. Banks are also affected by sovereign risks on the liabilities side of their balance sheet as implicit government guarantees have been eroded, the value of government bonds used as collateral has fallen, margin calls have risen, and bank ratings downgrades have followed cuts to sovereign ratings.” (Global Financial Stability Report, September 2011).

The uncertain character of the eurozone – neither nation nor integrated region – also has a direct impact on the operation of the banking system. Hyun Song Shin, an economics professor at Princeton, has made the point that although bank liabilities are relatively free flowing the assets are less mobile:

“Compared to other dimensions of economic integration within the Eurozone, cross-border mergers in the European banking sector remained the exception rather than the rule. Herein lies one of the paradoxes of Eurozone integration. The introduction of the euro meant that “money” (that is, bank liabilities) was free-flowing across borders, but the asset side remained stubbornly local and immobile. As bubbles were local but money was fluid, the European banking system was vulnerable to massive runs once banks started deleveraging.” (“Global savings glut or global banking glut?”, Voxeu, December 20, 2011).

In other words banks lent across borders but they still remained largely national in character. It was still, for example, French and German banks lending to Greece rather than genuinely pan-European banks emerging.

Central banking

The ambiguous status of the eurozone also applies to its central banking. Unlike the Federal Reserve or the Bank of England the ECB is not a lender of last resort. Its mandate does not allow it to step into the market to buy sovereign debt direct from governments when no one else is willing to do so. As a result its power to deal with financial crises is more limited than those of its international peers.

As Mark Blyth, a professor of International Political Economy at Brown University in Providence, Rhode Island, observed:

“When the periphery was hit by the crisis in 2009 and investors figured out the ECB wasn’t a real central bank since it had no lender of last resort function, periphery bond yields exploded as prices fell. Core banks that had loaded themselves with periphery debt a decade earlier found themselves horribly exposed.” (“Greece, Lehman, and the politics of Too Big To Fail”, Deutsche Welle, October 17, 2010)

This institutional failing of the ECB is a direct result of the eurozone’s structural predicament: it is neither a nation state nor a completely unified regional economy. Germany, in particular, is hostile to giving the ECB full central banking status as it would lose its ultimate control over the region’s purse strings.

Of course in practice the ECB, along with many European officials, have desperately struggled to find ways round these limitations. In December, for example, the ECB implemented a huge refunding operation where it indirectly borrowed sovereign debt from banks rather than directly from governments. The hope was that the operation would both help avert a credit crunch and bolster the banks. In effect it was an indirect form of quantitative easing. Whether such tactics will work in the medium or long term remains to be seen.

Ambiguous status

The eurozone financial crisis can therefore be seen as having two intertwined components. There is the crisis of sovereign debt on which most of the attention is focused, which in turn is inextricably bound up with a banking crisis.

Both of these are tied to the ambiguous status of the eurozone. It’s uncertain position as neither a nation state nor a unified regional economy generates inherent tensions. This ambiguity explains why the eurozone’s recent crisis has become so intense.

Most politicians and technocrats will no doubt be tempted to muddle through in the hope that the crisis will eventually disappear. Indeed, that is exactly what they have done for more than two years. But such a course of action is likely to mean years of turmoil with no resolution of the underlying problems.

There are two possible courses of action to resolve the crisis: technocratic and democratic. The technocrats, along with many European political leaders, favour a top-down process of economic integration. This would involve creating genuinely pan-European institutions that have supremacy over national governments. It would amount to a transfer union where public resources can be freely moved across borders without the consent of Europe’s citizens.

The alternative is to have an orderly dismantling of a system that has proved itself inherently flawed. This would mean handing back power to popular control rather than leaving it in the hands of unelected bureaucrats. Such a move would be a precondition for campaigning for a genuinely democratic Europe rather than one imposed by diktat.

In the meantime there is no end in sight for the crises of sovereign debt and of the eurozone banking system.