LONDON – Europe’s great success in 2012 was to avoid becoming another of history’s failed monetary unions. European Central Bank President Mario Draghi’s actions prevented a market meltdown and bought European leaders time to deliver on political and institutional reform. But have political leaders again chosen to muddle through, rather than meld a resilient strategy?
To be sure, few envisioned the degree of compromise and integration that was achieved during the acute phase of Europe’s financial crisis. Control mechanisms that theoretically infringe on sovereignty are now in place for national budgets and, soon, for the 150 or so largest European banks. Creation of the European Financial Stability Facility and its successor, the European Stability Mechanism (ESM), provide an important financial backstop for smaller countries that are destabilized by external shocks.
But the real game changer has been the ECB’s creativity in designing ways to prevent the sudden insolvency of banks and governments. While it might take military expertise to learn all of the acronyms created in the last three years, the LTRO (long-term refinancing operation) and OMT (outright monetary transactions) will be remembered as the ECB’s twin bazookas.
Nonetheless, while bazookas may win battles, they do not win wars. This is particularly true in finance, because markets, politicians, and citizens adapt to changing circumstances. The success of 2012 was to end the acute phase of the crisis; but its chronic features persist.
Of course, capital markets have reopened to large corporations and many European banks. Europe “feels” better. But it is rarely wise to judge financial health by one’s borrowing costs, which can change abruptly. Together with other major central banks, the ECB has ensured that any doubts about solvency have been temporarily put to rest with a tsunami of liquidity.
The European Council’s decisions in December defined the vision outlined by Draghi last July. But European leaders rejected even limited fiscal risk-sharing in the form of temporary unemployment contracts. Banking union was left looking like a stool with one sturdy leg (common supervision), a toothpick (common resolution), and no third leg (common deposit insurance) whatsoever. The creditor countries, seeking to define legacy assets narrowly in order to minimize their losses, are emasculating the most important vehicle for breaking a vicious feedback loop between sovereigns and banks – direct bank recapitalizations with ESM funding.
The most creditworthy European countries still believe that a monetary union can work only if every member is committed to responsible macroeconomic policies that avoid the accumulation of imbalances. There is a powerful logic to this argument, given that a union in which some states’ conservative taxpayers always pay for others’ profligate spending cannot endure politically.
Nonetheless, in a world of fast and free capital flows, Europe’s leaders have failed to grasp that control mechanisms cannot prevent the build-up of imbalances. After all, one of Europe’s great strengths has been to bind together large and small, rich and poor, and labor-intensive and services-intensive countries. Despite their differences, all are subject to the same monetary policy and, at least according to the current vision, to very similar (and rigid) fiscal policies.
That vision involves miniscule fiscal transfers to help buffer the asymmetric effects of common shocks. Instead, a group of regulators in Frankfurt and bureaucrats in Brussels will catch imbalances before they become severe.
For Europe’s periphery, this minimalist vision of fiscal integration means one thing: government and private debt will need to fall to levels associated with the AAA-rated economies, because external financing for persistent imbalances cannot be assured. Even if monetary policy remains extremely accommodative (despite being inappropriately loose for some of the healthy economies), this implies decades of stagnation for the periphery and the transformation of high long-term unemployment into a lost generation of chronically jobless youth.
Acute crises rarely produce political movements demanding change. On the contrary, fear prevails and the status quo – in this case, European integration – wins, as it has since 2010 in Greece, Spain, Portugal, Ireland, and the Netherlands. Rather, it is the chronic phase of the crisis that will breed change, as fear gives way to anger and politics moves to extremes.
Japan might seem to provide a counter-example. After all, the country has been in a chronic state for nearly a quarter-century, yet it took almost two decades to kick the Liberal Democratic Party out of power (and now it is back). But the decline in Japan’s per capita GDP has been gradual and, importantly, unemployment has remained below 5.5%, compared to just under 20% in Europe’s five worst-hit periphery economies.
Much of the blame for Japan’s malaise lies with its politicians’ unwillingness in the early 1990’s to address a banking sector laden with bad real-estate debt. The lesson of that and other banking crises is that speedy diagnosis and treatment go a long way toward determining whether a country’s exit from the acute phase of crisis leads to a protracted chronic phase or a rapid return to healthy growth. Japan could rely on its large stock of domestic household savings to cushion the corporate sector’s adjustment and to finance massive fiscal spending, with government debt now around 230% of GDP.
This strategy cannot be replicated in Europe. Chronic adjustment is not sustainable, given localized pockets of unemployment above 20%, minimal recourse to fiscal policy to smooth adjustments, and a lender of last resort that is constrained by its members’ preferences. Moreover, Europe does not have the social strength to cope with such a strategy, owing to its lack of cultural homogeneity and large, often marginalized immigrant populations.
The prescription is clear: fix the banks, share the burden of past mistakes between countries, and replace the OMT with an equivalent bazooka by turning the ESM into a rescue fund that can cope with problems large and small. The planned shift to a bail-in regime for private creditors and political acceptance of default for errant sovereigns will probably end fiscal profligacy.
But Europe’s saga will not end there. Having escaped markets’ wrath, politicians will now face that of their voters.