How will Europe’s economic crisis be resolved? Answers tend to one of two poles. The EU will finally emerge stronger: battle-hardened, with mistakes in its first design put right, the world-class economy it was always meant to be. Or the euro system, if not the EU itself, will simply fall apart, even if governments can’t yet face it.
The likeliest future for the EU isn’t either of these. The euro system can be patched up—and most likely will be, because the costs of letting it fail are enormous. But it won’t be definitively rebuilt and made fit for purpose, and the consequence will be years if not decades of economic underperformance.
The reason is the same reason its design was flawed in the first place: national politics. You can see the pattern right now. This year the euro system came close to outright collapse, thanks to a combination of weak banks, overborrowed governments, and plummeting confidence in the integrity of the European currency. The point of maximum stress was the cost of borrowing for supposedly non-core countries. Notice this list began with Greece, Ireland and Portugal, but has grown to include Spain and even Italy. (One of the founding European partners is now regarded as non-core.) With its cost of borrowing at more than 7%, Spain was headed for insolvency—and, if the worst happened, the cost of bailing it out would be politically insupportable.
The way Europe faced this crisis was predictably indecisive. After months of dithering, the European Central Bank announced a two-pronged approach. One prong was the large-scale purchases of distressed governments’ bonds (paywall)—a plan, in effect, for the ECB to act as lender of last resort to euro area governments. Financial markets were relieved and the crisis abated. But the scheme was strung with so many qualifications and conditions that its efficacy under renewed stress remains in doubt, and the burden of adjustment it imposes on Spain and others is crippling.
Europe’s plans mean that the ECB can’t act as lender of last resort quickly or at its own initiative. Spain will have to ask other governments, via the European Stability Mechanism, for a lending program first and accede to its terms—akin to the conditionality the International Monetary Fund applies to its borrowers.
The principle of conditionality isn’t wrong. In fact, it’s essential. Without it, a lender of last resort would be a license for governments to spend without limit at other countries’ expense. But the form of the conditionality, by involving another agency and another layer of national political control, introduces extra delay and uncertainty at the worst possible time. A country prequalified as being in good fiscal order should have instant access to the ECB’s support. Instead Spain’s government is wrestling with the domestic political challenge of piling yet more fiscal austerity on a deeply depressed economy. It’s wondering whether it can survive volunteering for more—as it will have to, should it apply for the ESM program that has to precede ECB support.
The other prong of the ECB’s new role is the proposal to create a euro-area “banking union”. Again, in principle, that’s a good idea. Actually the failure to do this at the start was one of the biggest defects in the euro system’s original design. Though the single currency had created a deeply integrated European financial system—partly because no-one thought any country that had joined the euro would ever leave it—financial regulation, including support for distressed financial institutions, stayed mainly a national responsibility. This made the crisis, when it came, much harder to contain—the more so, of course, now that the commitment to the single currency is wavering.
However, the proposed European banking union is partial at best. A banking union is usually thought to include three elements: a common supervisor, a common deposit guarantee scheme, and a common resolution authority for failing institutions. That’s what the European Commission first had in mind for the euro area. But when it released an official proposal recently, the idea had been stripped back to the first component—supervision, and a seriously compromised version even of that.
The ECB, according to this plan, would become a financial supervisor, but wouldn’t replace national regulators. Worse, Europe still can’t agree on what bank “capital” means for regulatory purposes, or on what ratios of capital adequacy to set. What’s taking shape is far from a common system of supervision. As for deposit insurance and resolution authority—both of which involve fiscal transfers, possibly on a huge scale (should the crisis cause a system-wide run on a particular country’s banks)—the plan has almost nothing to say. Germany and other core countries are deeply suspicious of anything that smacks of fiscal union.
So Europe has agreed that the ECB should act as lender of last resort—except that it hasn’t, quite. And Europe has agreed to build a banking union—except that it hasn’t done that, either.
None of this is new. It’s business as usual. Europe does enough to keep the show on the road, and no more. It’s gotten away with it so far and chances are this will continue. With the union as a whole still stuck in recession, and Spain and Italy facing worse to come, avoiding outright collapse isn’t good enough. For now and for the foreseeable future, it’s the limit of Europe’s ambition.