TWN Info Service on Finance and Development (July12/02)
2 July 2012
Third World Network

What now for European monetary union?
Published in SUNS #7397 dated 26 June 2012

Geneva, 25 Jun (Chakravarthi Raghavan*) - The Basel-based Bank for International Settlements (BIS) has joined a growing chorus of global institutions and leaders calling on the eurozone countries to quickly act to bring about more financial and fiscal integration, and strengthen the institutional foundations of the currency union itself.

"The conclusion is hard to escape that a Pan-European financial market and a Pan-European central bank require a Pan-European banking system," said the BIS, often somewhat loosely referred to as the central bank for the world's central banks, and functioning as a forum for the world's central banks.

Europe will overcome this crisis if it can address both the weaknesses in the economy seen elsewhere but also the incomplete nature of financial integration in the currency union. Euro-area countries need to attain "structural adjustment, fiscal consolidation and bank recapitalisation; and unify the framework for bank regulation, supervision, deposit insurance and resolution."

That approach will decisively break the damaging feedback between weak sovereigns and weak banks, delivering the financial normality that will allow time for further development of the euro area's institutional framework.

The report warned that bank deposits were already flowing out of countries perceived as vulnerable. By May, Greek banks had lost about one-third of their foreign deposits and one-quarter of domestic deposits, and the outflow seemed to be accelerating, the report said.

Money is also flowing out of Ireland, Italy, Portugal and Spain and into banks in Germany and the Netherlands that are perceived as safer, said the BIS, which regularly collects data on the flow of money between countries.

Underscoring the global ramifications of the euro crisis, the BIS said: "The world is watching the crisis gripping the euro area with trepidation for the spillovers it may have. But at its root the European crisis is a potential harbinger, a virulent and advanced convergence of the problems to be expected elsewhere if policy fails to break the vicious cycles generated by the global weaknesses ... sectoral imbalances, excess leverage, public over-indebtedness and overburdened central banks.

For now, the destructive feedback created by these problems is concentrated in the euro area, where the fiscal authorities in some countries, forced to consolidate, can no longer support either their banks or their economies. The rapid loss of investor confidence in these countries has caused an equally rapid fragmentation of euro area financial markets.

In this environment, asks the report, how can the common currency regain its credibility so that Europe can return to prosperity and continue on the road to further integration? In part, the euro area crisis involves underlying problems that were revealed by the financial crisis and are common to many advanced economies. Likewise, resolving it will require, in part, corrections that are also common: private sector balance sheet adjustment, sectoral rebalancing, fiscal consolidation and banking recapitalisation. Europe has made progress on this agenda: reforming labour markets and social insurance systems and, through adoption of the fiscal compact, requiring countries to have general government budgets in balance or in surplus.

But full resolution of the euro area crisis also requires strengthening the institutional foundations of the currency union itself, the BIS stressed.

"The European monetary union integrated financial markets and created a centralised monetary authority so that capital could flow freely and easily across the common currency area. Yet while the region's borders have become irrelevant for finance and for central banking, authorities in one country still have only limited responsibilities for actions that a financial intermediary takes in another country.

"Hence, the public in one country of the currency union cannot be expected to financially backstop actions taken elsewhere in the union. The conclusion is hard to escape that a pan-European financial market and a pan-European central bank require a pan-European banking system. Put slightly differently, a currency union that centralises the lender of last resort for banks must unify its banking system. Banks in Europe must become European banks."

Commending what it called "recent promising suggestions for movement on the banking front", BIS said these "offer quick progress because they would operate within the existing terms of the currency union. First, they would unify banking rules now fragmented along national boundaries. Second, common banking rules would centralise responsibility in a common regulator, supervisor, deposit insurer and resolution authority.

"If adopted, these measures will break the adverse feedback between the banks and the sovereign and other destructive links that are making the crisis so severe. They will revive interbank lending and sovereign access to funding markets. They will allow the Euro-system to withdraw from its unconventional and undesirable role as an intermediary. And they will restore confidence in the single currency so that both institutional and retail depositors return to the banks in their local markets. With day-to-day normality attained through a unified currency and banking system, leaders will have the time they need to finish building the broader institutional framework that the monetary union needs for its long-term viability."

As noted, the policy measures advocated in the BIS report, and in particular over the euro crisis, have been voiced elsewhere, and there is a growing chorus. Some of the problems now at the fore were identified as early as at the conception of the euro single currency itself.

What is holding up the urgent reforms, and the report stays away from it, are the political issues, including Germany's demand for a political union framework before fiscal and banking union and institutions. There is also the general disdain long prevalent in Brussels for any external institutions voicing their views.

As early as 1995, the UN's Economic Commission for Europe (UNECE), while supporting European integration, had voiced some caution over the Maastricht Treaty and its rigid criteria and the deadlines for the euro, the dangers of its ratios for government deficits and debt intensifying the pro-cyclical stance of fiscal policy, and simultaneously across Europe.

The UNECE argued for the target dates to be extended and fiscal consolidation pursued only when the recovery was well-established - more or less what the IMF and its chief economist Olivier Blanchard has been recommending in the last few years.

The UNECE came back to the issue in several Surveys up to the introduction of the euro, including a piece on "The euro ante portas" in the 1998 Survey. The then EC Commissioner for monetary and financial affairs, Thibault de Silguy, reacted violently, and in an interview to a Geneva newspaper, dismissed the UN regional body as some obscure little office, and questioned the right of UNECE to comment on EU matters.

Interestingly, after the euro-crisis, EU Commission President Jose Manuel Barroso came out more or less in the same language at the recent G-20 summit in Los Cabos, Mexico, where after blaming the US for the global financial crisis, he said: "Frankly, we are not here to receive lessons in terms of democracy or in terms of how to handle the economy" (Financial Times, 19 June 2012).

(* Chakravarthi Raghavan is Editor Emeritus of the SUNS.)