The Other Euro Flaw
We have not been shy to point out the potential (and now proven) flaws in the Euro experiment (here, here, and here for example) over the past year or so but UBS reminds us that while most people remain fixated on the absence of a fiscal transfer union in so large a monetary union (to offset incidents of inappropriate monetary policy) as Eurobonds and Federalism come back to the fore; it is the second flaw - the absence of an integrated banking system (backed implicitly by a credible lender of last resort) - that should be getting front-page headlines. As Niall Ferguson noted at Zeitgeist this morning, "Structural reforms will work but will not work this week" and in the meantime, TARGET2 balances grow out of control and the longer the 'problem' remains, the worse it becomes leaving an implicit infinitely supported firewall as the only interim solution. While most who foresaw the Euro as implicitly leading to federalism were right, it seems the link to a German dominance (of ECB rulings and general fiscal and monetary decisions) has been the ultimate outcome. While an integrated banking system would do nothing to change the relative competitiveness or growth issues that plague Europe, the 'essential' internal capital flows would be sustained. Is this sort of integration a realistic prospect? The politics is not especially propitious.
UBS - The other flaw with the Euro
Before the ink had dried on the Treaty of Maastricht, economists gathered to point out the two fundamental problems that existed. The first was the absence of a fiscal transfer union in so large a monetary union to offset incidents of inappropriate monetary policy. Fiscal policy transfers cannot create equality of economic performance, of course, but they can smooth the rough edges of a monetary union.
Much of the current crisis of the Euro has focused on the fiscal failings of the union. This is, perhaps, an inevitable consequence the current circumstances. A partial transfer mechanism is in place which is fuelling national resentments. Governments have focused, occasionally with a certain amount of hypocrisy, on the need for fiscal rules to be rigidly enforced on others (few governments have followed the rules to date). Fiscal transfers are a visible cost to taxpayers in parts of the union, and so inevitably this is a topic that encourages emotional headlines in the populist media.
The need for a Euro banking system
The second flaw or the Euro as a monetary union, which has received less media attention, is the absence of an integrated banking system backed by a credible lender of last resort (with the power of seignorage). This plays a critical role in a monetary union by ensuring that internal imbalances in trade are readily offset by capital flows.
If we consider a monetary union like the United Kingdom, the regional imbalances in trade that exist between the component parts of the monetary union are not something that is economically important. Partly this is because of the existence of a functioning fiscal union, of course. Those regions with a “trade deficit” towards the rest of the country may be net recipients of fiscal transfers, and that is a capital flow finances the current account imbalance. Partly, however, it is the result of an integrated banking system.
In the case of the United Kingdom, capital flows are hidden within individual financial institutions. If Yorkshire (for instance) runs a trade deficit with the rest of the United Kingdom, that can be financed by bank lending into Yorkshire from UK banks. The bank lending itself is financed by deposits (collected from Kent, perhaps). The bank is internally transferring capital between geographies, from south to north.
The Euro area’s lack of a pan-monetary union banking system (internalising the capital transfers that are necessary to offset the imbalances) has seen an evolution of capital transfer mechanisms. Initially this was through bank lending from banks in one economy to customers in another economy; a German bank lends to clients in Spain, or a French bank lends to clients in Greece. This creates a country risk to the bank, to be sure, but in reality it is not that different from a UK bank using deposits in Kent to lend to Yorkshire.
With the advent of the global financial crisis, this mechanism has shifted. Banks are retrenching in the Euro area, and the capital flow of cross border lending that balanced the internal balance of payments has been lost. Instead, as is well known, an imbalance has occurred in the Target II transfer system with central bank money. Simplistically this is two stage process (a Greek importer is effectively creating a securitised liability with the Greek central bank, and the Greek central bank incurs a liability with the Bundesbank and receives money from the Bundesbank to pay for the import). As long as the Euro is intact, this is not a problem. Any loses incurred (because of collateral default, for instance) are incurred in common by the European System of Central Banks. It could be considered akin to foreign exchange intervention in a fixed exchange rate system.
The risk is if Target II ceases to function. This, it should be noted, would have to be a deliberate action by central banks. However, there is a (distant) precedent in the United States. The implosion of the US monetary union in 1932/33 had many facets. Banks refused to lend across state boundaries, inter-state transfer payments were limited or prevented, and so forth. One of the key markers in the fragmentation of that monetary union was the refusal of the Federal Reserve Bank of Chicago to discount the bills of the Federal Reserve Banks of New York (i.e. a refusal to lend dollar cash to the New York Fed), in January 1933. The consequences are pretty much the same as if central banks in the European system of central banks refused to participate in Target II, or discriminated against specific economies in some way. In all probability, such discrimination would lead to a general fragmentation of the Euro area – as of course it did in the United States.
So what would help?
Creating an integrated Euro area banking system would further internalise the imbalances that persist in the Euro area. Moving to a single bank regulator, a single source of capital for bank bail outs, and a single lender of last resort for the banking system would create a more integrated banking system across the Euro area. To be sure this would do nothing to change the relative competitiveness or growth issues that plague the Euro area monetary union. However, the risks that surround the essential capital flows would be lessened. Moreover, individual governments would be lifted of the burden of contingent liabilities associated with their banking systems, which would help to clarify their fiscal positions.
Is this sort of integration a realistic prospect? The politics is not especially propitious. One can imagine the populist media asking “Why should German taxpayers pay for Spanish banks?”, even though this is not what is happening (at least not in the long term). On the other hand, the benefits of a more integrated financial system are clear, and the ECB has been a strong proponent of such a move.
Politically, presenting integration as being a means of strengthening regulatory control of the banking system may be acceptable. The current crisis may help to propel the idea of integration up the political agenda as being a necessary condition for a functioning monetary union – or at least, a monetary union that functions more effectively than does the Euro.