Resolving to end European stagnation

Cleaning up Europe’s banking sector is an essential step on the road to economic recovery

The speed of recovery in the economy of the United States demonstrates that governments can combine economic and fiscal reform – so-called “austerity” – with growth. 

It also contradicts the arguments of fiscal stimulus junkies, such as American professors Larry Summers and Paul Krugman and, sotto voce, the chief economist of the International Monetary Fund, Olivier Blanchard, a Frenchman.

There are various reasons for the US upswing (European Voice, 29 November 2012), but a financial system that was quickly purged of its excesses after the 2007-08 crash is unquestionably one of them, a factor highlighted by the latest OECD Economic Outlook (29 May).

The contrast is stark between the parlous state of Europe’s financial system today and the financial clean-up that occurred in the US, which went beyond banks to include the effective nationalisation (in the US of all places) of the state-dependent home-loan facilitators Fannie Mae and Freddie Mac.

Now, in much of the European Union, ‘zombie’ banks are desperately shrinking their balance sheets, while lending to failing ‘zombie’ companies, in part because they cannot afford to take the losses that would come from cleaning up their loan books.

This is yet another European vicious circle, comparable to the ‘doom loop’ between banks and governments. In this case, as economists at Deutsche Bank point out (Focus Europe, 17 May), there is an added twist: lending by zombie banks to zombie companies is probably squeezing out lending to healthy companies that are vital to growth.

Further evidence of the severity of the funding crisis, particularly in the troubled, peripheral economies of Italy and Spain, which are dominated by small companies, came last week. Confindustria, Italy’s main employer organisation, warned that many small and medium-sized enterprises (SMEs) in the north of Italy, the country’s economic powerhouse, could run out of money before the end of the first quarter of 2014.

Almost four years ago, in a seminal paper for Bruegel, an economics think-tank in Brussels, Nicolas Veron and Adam Posen urged a swift, drastic clean-up of Europe’s banking system. Veron told me last week that he believed it was needed more than ever.

The opportunity is still there. The European Commission’s (almost enacted) Single Supervisory Mechanism (SSM), coupled with a proposal expected in June for a single resolution mechanism (SRM) for banks in the eurozone, could lay the foundations for a banking clean-up – provided that European leaders can cut a deal on resolution which is more than a tacit bail-out for reform-shy governments.

The SRM should not just be seen as yet another step towards stabilising the single currency, adding a vital component to the ECB-based supervisory mechanism, and addressing the threat from banks that are ‘too big to fail’.

It is all of these things, but most importantly it can also become the foundation for Europe’s much needed growth strategy.

Evidence of the importance of this next step towards banking union is provided by Japan. The failure there, early in the 1990s, to act swiftly to re-capitalise and restructure banks contributed to Japan’s economic stagnation, now nearly two decades-old.

Today, a similar failure in Europe could herald a further protracted but worse stagnation. Japan, note well, managed to avoid the mass unemployment which is already wracking Europe.

As Zsolt Darvas of Breugel writes: “Much of Europe suffers from a mutually reinforcing interaction between limited productivity gains, protracted deleveraging, weak banking sectors and distorted relative prices, [which] threaten to turn into self-perpetuating stagnation.”

The awaited SRM proposal is deeply contentious, since, if it is to be credible it must involve a further surrender of national sovereignty by participants. Unsurprisingly, therefore, Sweden and the UK will not participate.

There are deep divisions over the underlying principles. In September 2012, Germany, Finland and the Netherlands rejected the idea that bank “legacy assets” could be mutualised.

Why, they wondered, should the jointly funded European Stability Mechanism (to which Germany makes the biggest contribution) be a vehicle for helping to recapitalise weak banks whose parlous condition can be attributed to negligent decisions made several years ago by national governments and their bank supervisors? A good question.

And what about the coherence of the new banking union structures. With the ECB as a single supervisor, what Deutsche Bank economists describe as “a federal institution” will for the first time have the power on prudential grounds to order the closure of a member state’s bank.

But if this is the stick, where, they ask, is the carrot, the “federal backstop” (the equivalent of the Federal Deposit Insurance Corporation in the US), that would facilitate what has to be a swift recovery or resolution process in which shareholders, other creditors and large uninsured depositors should take the first hit?

Most immediately, how tough will be the planned ECB-led assessment of the health of eurozone banks, the asset quality review?

Yves Mersch, a member of the ECB executive board, said last month (5 April) “Supervisors cannot give objective verdicts on the viability of banks if banks can only be closed in a disorderly way.” Correctly, the ECB sees the SRM and a federal backstop for European-approved assets as vital elements of its new responsibilities to supervise banks.

It is easy to see why. Were the ECB to come under pressure to makes its asset review less than rigorous, that would compromise the independence of its monetary policy, undermine its hopes of becoming a credible bank supervisor, relax the pressure to sanitize a sick financial system, and so damage the prospects of economic recovery. The stakes are high in the next stage of the long march towards a genuine economic and monetary union.

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STEPS FORWARD

In their paper on banking union, Deutsche Bank economists argue that the eurozone must embrace what Nicolas Veron and Guntram Wolff of Bruegel have termed (February 2013) a “big bang” leap forward. “It is actually very difficult to ‘stop on route’ and deliver credible single supervision, a single rulebook for bank resolution and no federal backstop,” they write.

Graham Bishop, a London-based authority on EU financial markets, argues that if they are correct, then another big step towards deeper political as well as economic integration of the eurozone looms.

In a speech last week (20 May), Paul Tucker, deputy governor of the Bank of England, argued that effective, credible resolution regimes are essential. “The crucial next step is for an EU resolution directive,” he said.

It is the moment to press ahead, he argued, not least to prevent the world “slipping into a hard-to-reverse Balkanisation of the international financial system”.

He did not say so, but that Balkanisation would also throw the fortunes of the City of London into an irreversible downward spiral. British Eurosceptics may not like it but, as Mario Draghi pointed out in a speech in London last week, the City’s prospects are inextricably linked with those of the eurozone.

Stewart Fleming is a freelance journalist based in London.