The financial education of the euro zone
In 2017, Europe’s leaders will confront an array of severe tests, including tumultuous elections featuring populist insurgencies, complex negotiations over Britain’s departure from the EU, and a new US president who thinks the transatlantic alliance is “obsolete.”
But despite these challenges, EU leaders will have an opportunity to strengthen their battered union and reinforce its institutions. In particular, they should focus on restoring the banking sector’s credibility by providing it with more capital and better oversight. Even if they make progress on nothing else, achieving this goal could turn 2017 into a very good year after all.
Europe’s banks have long been central to the continent’s economy. In France and Germany, bank assets amount to 350-400 percent of gross domestic product (GDP), whereas in the US they are equal to just over 100 percent of GDP.
After the 2008 financial crisis, the euro zone’s weakest banks quickly buckled under the weight of their bad loans, and then threatened to drag their respective governments down with them. With many countries’ creditworthiness in doubt, even strong banks were caught in a “doom loop” as they suffered losses from the collapsing sovereign debt on their books.
Ironically, euro zone banks’ interdependence is what eventually saved the day. Because Irish, Portuguese and Greek banks owed money largely to German, French and Dutch banks, the external shocks to the weakest banks and economies were immediately shared with the strongest.
This forced all stakeholders to cooperate on a joint response despite the political costs. Had all European banks and economies not been imperiled, it is hard to imagine that European leaders would have ever agreed to a $1 trillion backstop for financial markets.
Meanwhile, the European Central Bank’s (ECB) integrated payment system enabled regular transfers to continue between peripheral and core banks, which sustained commercial activity and financing through the worst parts of the crisis.
The ECB also maintained its liquidity support — if not always generously or reliably — and ultimately committed to intervening to resolve threatened institutions, thus alleviating market turmoil. While political leaders were caviling over the legality of interstate loans, European institutions were softening the blow from a global shock.
Economists tend to agree that an “optimum currency union” requires such features as high labor mobility, shared fiscal oversight and synchronized business cycles, none of which the euro zone has. But as the financial crisis revealed, integrated banks and financial markets can also be an essential source of resilience.
Today’s political climate limits the possibilities for structural reforms, fiscal pooling and improved labor mobility. But if European leaders can strengthen the banking union, there is still hope for the euro zone’s future.
Christopher Smart
Contrary to many predictions, the euro zone did not inevitably collapse; rather, it was undeniably bolstered by a response that improved oversight, strengthened institutions and pooled resources. It is particularly remarkable that euro zone regulators can now oversee and, if necessary, intervene on behalf of the monetary union’s largest banks.
Of course, the crisis, together with European institutions’ perceived clumsiness, has also provoked a significant backlash among voters, some of whom doubt the common currency can deliver prosperity. Indeed, just because the euro survived the last crisis does not mean it will survive the next one.
Yet even in today’s fraught political climate, European leaders can make progress if they set aside grand, unrealistic proposals for a European finance minister or more intrusive inquiries into countries’ economic policies. Instead, they must concentrate on reinforcing the common currency’s inherent strengths, not least by formulating a credible plan to clean up the bad loans on Italian and Portuguese banks’ balance sheets.
Ideally, such a plan would include European resources as well as local reforms, and would address insolvency-regime inefficiencies so banks are not burdened with non-performing loans while they await a court’s approval to convert collateral.
To improve confidence in the overall system, policymakers also need to set limits on banks’ sovereign-debt exposure, which will end the doom loop and allow for more contributions to flow into the EU’s Single Resolution Fund. And for good measure, the ECB should consider intervening to restructure a couple of medium-size banks, just to show it can.
Finally, policymakers should encourage further capital-market integration, which would reinforce the euro, improve cross-border risk-taking, diversify funding sources and expand access to finance. This will become all the more important after the UK has left the single market.
Today’s political climate limits the possibilities for structural reforms, fiscal pooling and improved labor mobility. But if European leaders can strengthen the banking union, there is still hope for the euro zone’s future.
The euro zone has gone through a period of financial education. Political leaders were forced by global markets to take unpalatable steps to reinforce the monetary union, only to realize that one feature of the problem — bank and market interdependence — also pointed to a solution, and will likely drive more reforms.
Taking steps to integrate the banking union and European capital markets further may not be sufficient to ensure the euro’s long-term survival, but doing so is necessary. In these politically tumultuous times, it is the only realistic option.
• Christopher Smart, a senior fellow at the Mossavar-Rahmani Center for Business at Harvard University’s Kennedy School of Government, was special assistant to former US President Barack Obama for international economics, trade and investment, and deputy assistant secretary of the US Treasury for Europe and Eurasia.
©Project Syndicate
