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(Updated with magazine version.)
Europe’s banks and national governments are locked in a vicious cycle. Weak banks are dragging down governments, while weak governments are dragging down their nations’ banks. Picture drowning swimmers trying to climb up on each other’s shoulders. Investors are reacting by driving up rates on both public and private borrowings, making the problem worse. Economists say Europe is in a “doom loop.” The consequence “has been to transform isolated sovereign debt crises into systemic bank crises, and to transform isolated national bank crises into systemic sovereign debt crises,” Perry Mehrling, an economist at Columbia University’s Barnard College, wrote in a June 19 blog post.
Something has to be done, and urgently. But there are few ideas for saving Europe that don’t run into a wall when they reach the Bundeskanzleramt, the Berlin offices of German Chancellor Angela Merkel. While Merkel is committed to saving the euro currency and the European Union, she says Germany won’t open its wallet more to ease the crisis until European nations submit to centralized control of their national budgets—that is, surrender a big part of their sovereignty.
Is there an easy way to break the stalemate and stop the doom loop before it dooms Europe? No. Whatever emerges in the days after the leaders’ summit set for June 28-29 is likely to be insufficient. Still, sheer necessity may ultimately force creditor and debtor nations to step outside their comfort zones and take unprecedented action. That’s the way European unification has proceeded since the early days of the European Coal and Steel Community after World War II. “Europe will be forged in crises, and will be the sum of the solutions adopted for those crises,” said Jean Monnet, the French diplomat who worked on European unity from World War I through the 1950s.
The ideas in official circulation are attempts to split the difference between debtor nations such as Spain and Italy and creditors such as Germany, Netherlands, and Finland. On June 26, in preparation for the Brussels summit, European Council President Herman Van Rompuy released a proposal called Towards a Genuine Economic and Monetary Union whose very title signaled that the Economic and Monetary Union that has existed since 1999 hasn’t been the real deal. The proposal was prepared with the heads of the European Central Bank, the European Commission, and euro zone finance ministers and calls for tighter financial, budgetary, and policy integration, without sacrificing “democratic legitimacy and accountability.”
Financial integration, in the form of some kind of banking union, would go a long way toward easing the crisis. It would include a Europe-wide deposit insurance plan and a fund to cover the costs of shutting or arranging a buyer for insolvent banks. The Van Rompuy report recommends such a system, along with a single financial supervisor to oversee and preempt national bank regulators. (The logical candidate for that job would be the ECB.)
But if weakly supported, a banking union could get dragged into the doom loop, too. Even the backing of the new European Stability Mechanism, which is to have €500 billion of pledged contributions from member countries, could fall short, says Jacob Funk Kirkegaard, a research fellow at the Peter G. Peterson Institute for International Economics in Washington, D.C. In the U.S., it was the open-ended commitment of the government and central bank to back all the liabilities of American banks and money funds that calmed the panic of the 2008-09 crisis. Europe needs the same capability, says Kirkegaard—backed by the full taxing power of its governments. “You cannot disentangle this from the very tricky issue of having outright fiscal union.”
Angela Merkel has figured that linkage out already, which is why she insists on enforceable budget controls over national governments before she’ll even consider a banking union or common debt issuance. She told a private meeting of German lawmakers in Berlin on June 26 that she doesn’t expect joint euro-area bonds in her lifetime. She’s a healthy 57, so that’s saying something.
Merkel has even shot down a compromise plan from her country’s own Council of Economic Experts, known as “the wise men.” It would make the 17 euro-zone nations jointly liable for that part of each member’s previously incurred national debt that exceeds 60 percent of its gross domestic product. The joint liability would kick in only if the individual countries failed to pay off their debt on their own.
Barnard’s Mehrling has devised a way to reassure Germany that it won’t have to fund Southern European profligacy. He would break the government debt crisis and the bank debt crisis into separate problems. He says the idea “has definitely been inserted into the conversation at the highest level. What they’re doing with it, I don’t know.”
Mehrling’s notion is for Europe to separate the banks’ fates completely from their governments. The first step would be to set up a special investment vehicle, funded with private money, that would buy up all government debt from Europe’s banks at market value. Next, banks would stop relying on governments for deposit insurance. Since deposit insurance is a valuable if unrecognized asset, the governments would make the banks whole by replacing it with bonds having an equal value. The banks would then immediately sell this second batch of bonds to the SIV, leaving them as purely private institutions, ending the co-dependence between banks and governments.
The American’s idea has some loose ends, like how to get investors in banks to switch en masse to investing in the SIV; how banks will fill holes in their balance sheets that have been abruptly exposed; and how they’ll replace their lost deposit insurance. But the status quo has some big question marks, too. What’s undeniable is that something major has to be done to break the doom loop soon.
The bottom line: Fresh thinking is needed to break Europe's vicious cycle of interdependence between weak banks and weak national governments.