Well, now it’s back on the table; the good old basic idea of creating a real European union – both economic and political. I guess some local politicians will blow their top off just trying to think about it, but professor of International and Development Finance, Adalbert Winkler, presents the following case for a political union in the Euro Zone.
When it comes to bringing stability and trust bact to the financial markets, it would certainly be easier if the EU could speak with one single voice and market particiants only had one government to deal with. The problem is; that’s the theory. In practice, however, I’m not sure it is possible. Anyway, it’s absolutly time to pick up this fundamental debate once again.
Adalbert Winkler is professor of international and development Finance at the Frankfurt School of Finance & Management.
Why the eurozone requires a political union : Lessons from 19th century America for today’s crisis
Economic history offers some conter-intertuitive lessons for the eurozone’s financial crisis. Among others, it debunks the notion, popular especially in Germany, that EU governments should have focused on mechanisms for the orderly restructuring of debt rather than designing rescue operations.
This view is based on the hypothesis that the crisis countries not only face a liquidity problem, but a solvency problem.
The comparison suggests that the crises analysis, focusing on liquidity, was correct. But the effectiveness of the rescue mechanisms in producing confidence has been severely hampered by bad timing, insufficient quantities and an incoherent communication policy.
The experience of 19th century US banks is relevant for the analysis of the crisis in euro area government bond markets because US banks – like euro area governments today – had been operating without a lender of last resort.
When facing a crisis, they used clearing houses as a co-insurance mechanism employing instruments that are similar to the ones EU governments have designed.
Most importantly, clearing houses issued loan certificates jointly guaranteed by all member banks to refinance weak member banks, thereby replacing the open capital market with an internal one.
They did so to contain the risk of contagion from weak to strong institutions. This is why in a crises situation no member bank was allowed to fail even if it was insolvent.
The support by fellow member banks was not for free.
Receiving institutions had to place collateral and were put under a special regulatory regime.
Replacing “certificates” with “EFSF or ESM loans” and substituting “conditionality” for “special monitoring regime” transforms the historical US experience almost 1:1 into current EU crises policies.
There is a broad consensus that clearing houses were an excellent device to contain financial panics.
This suggests that in principle the euro area crisis response has followed best private sector practices of crisis management.
But if this is the case why did it fail to calm markets?
Again, US financial history provides an explanation.
The evidence shows that clearing houses failed in reducing market tensions when the crisis response was too late, too timid and incoherent.
Indeed, the potential for failure was an inherent characteristic of the clearing house approach to financial crises as the decision to provide assistance was taken by a committee of major commercial banks with diverse interests.
In particular strong member banks faced a conflict of interest: on the one hand they wanted to contain contagion effects, on the other hand crises were also perceived as opportunities to reduce the number of competitors by refusing to issue certificates.
By founding the Federal Reserve in 1913 policy makers addressed these inherent weaknesses of clearing houses.
Again this sounds familiar.
The EU crisis response has been slow and involved insufficient quantities.
Moreover, financial markets have continuously received conflicting signals by strong Member States.
While stressing the importance of maintaining stability, they also announced policies geared at limiting their taxpayers’ exposure to weak countries’ government debt and involving investors in restructuring mechanisms.
Since latter policies reinforced the very doubts about weak countries’ solvency that triggered the crisis, it is not too surprising that the stability benefits of the mechanisms designed were quickly eroded.
Without full backing by strong Member States they lack credibility. Would the Federal Reserve or the ECB have succeeded in calming markets after 15 September 2008 if they had insisted on a preferred creditor status when lending to illiquid and in some cases insolvent financial institutions?
Finally, the comparison with 19th century US banks provides arguments suggesting that it might be almost impossible to set up a credible EU crisis mechanism based on current governance structures.
These arguments refer to, first the long-term nature of the liabilities to be co-insured, second the elusive character of the “asset” backing these liabilities, namely the willingness of the taxpayers in the crises countries to honor their commitments, and third the moral hazard risks arising from both characteristics as well the political environment the co-insurance mechanism is placed in.
Thus, a substantially more comprehensive economic union might be needed to stabilize the euro area.
This is not a new idea.
Already in 1990 the Bundesbank argued that a political union might be a prerequisite for the smooth functioning of European monetary union.
The comparison with 19th century US banks provides a new backing for this claim.
By Adalbert Winkler
Syndicated by www.eurointelligence.com
(Download a copy of professor Winkler’s forthcoming working paper, Winkler, A. (2011), HERE).
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