Monday, January 26, 2009

Eurzone's growing pain

Willem Buiter's post makes a timely and an obvious point that the new stage of the global financial crisis is beginning to pull Eurozone monetary structures apart. Buiter starts the argument by describing a rising tide of financial protectionism:

“Consequently, we have seen two forms of re-nationalisation of banking and finance. The first form of nationalisation has been the taking into partial or complete public ownership of banks and other financial institutions deemed too systemically important (too big, to interconnected or too politically connected) to fail. This has happened virtually everywhere... More examples will follow. The second form of re-nationalisation of banking and finance is the restriction of access to the fiscal and financial resources of the nation state just to those banks and other financial entities that have a significant presence in that nation state.”

Buiter points to the lack of coherent single fiscal policy platform for the EU as the underlying cause for these developments. In particular, he stresses that the Eurozone has common monetary policy, but national regulatory environments and fiscal polices, all pulling in different directions at the time of the crisis.

“The Eurozone is in a bit of a pickle here, because although it has a central bank with supposed uniform access to its resources for all Eurozone banks, regulation and supervision remain national and fiscal bail-outs (recapitalisation by the state, guarantees, insurance, loans or whatever provided by the sovereign) definitely remain national. When the central bank acts as market maker of last resort, as the Banca d’Italia is now doing in the Italian interbank market, it takes on significant credit risk which requires a fiscal back-up - the Italian Treasury. But that undermines the principle of equal treatment of banking institutions across the Eurozone...”

• either a “supranational fiscal authority with its own tax and borrowing powers, accountable to the European Parliament …and the Council...” or
• “…a pan-Eurozone fund, fully pre-funded and containing, say, 2 or 3 trillion euro to begin with. This Eurofund could be managed by the European Commission, subject to parliamentary oversight and control by the European Parliament and the Council. The fund could be drawn upon to provide financial assistance to systemically important troubled banks in the Eurozone, according to guidelines agreed by the EC, the EP, the Council and the ECB. …the fund [is] to raise its resources through the issuance of bonds that would be guaranteed jointly and severally by all Eurozone member states.

Of course, there are other solutions, which Buiter omits for obvious political reasons. These include:
1. Doing nothing, threatening a disorderly collapse of the Euro, should the current crisis continue to deepen; or
2. Partially re-introducing parallel national currencies to run alongside the Euro.

The last option is a milder version of a ‘nuclear’ first option, but desperate times do call for desperate measures.

The two solutions Buiter proposes are about as realistic as Salvador Dali’s landscapes:

• A common fiscal policy is a complete non-starter at this time.
• While a joint EU15-wide fund would be welcomed by the EU officials – ever hungry to get more power – underwriting such a fund (in excess of 32% of the Eurozone 2008 GDP) will be crippling for national governments, especially at the time when their own finances are under immense pressure from banks bailouts and fiscal stimuli.

In addition, the ages old concern of Germany and other states that the fund will be abused by the less fiscally prudent states, e.g Italy, Spain and France, constrains its feasibility, while strained sovereign debt markets are constraining the feasibility of raising such amount of money to capitalize the fund.

In this framework, unless the current downturn is reversed in the next 3-6 months, it is clear that an evolutionary process of fiscal policy responses and monetary policy constraints across the Eurozone will be creating more incentives for Balkanization of the Euro. Short of lapsing into oblivious denial of the reality, it is only a matter of managing this process that the ECB can be concerned with at this moment in time.

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