Jose Manuel Barroso, President of the European Commission, thinks Europe needs a unified banking system.. That idea may be the fastest way to a Euro break-up that I can imagine. What lesson did we learn for the formation of the EMU? Or maybe I should ask what lesson did we fail to learn from the formation of the EMU? The answer is that a system was erected with a clear systemic fault. That fault was having one currency and one monetary policy but no coordination or constraint on fiscal policy. And while it was recognized it was ignored. Ignored problems do not go away. The situation for the banking system is similar in that the euro-banking system has a huge flaw. And if the system is united and backstopped it will allow the Zone’s credit problems to run wild and to become magnified. This problem stems from a mispricing of assets. Under the Basel rules government bonds are tier-one capital. Spanish banks will always buy Spanish debt. Greek banks will always buy Greek debt. German banks will buy German debt. But German banks will not buy Spanish and Greek debt if the securities look unstable. So what we have is banking system that is on a valuation standard that differs from the market standard or true value. Whenever this happens there is a potential for arbitrage and market participants will find a way to exploit the valuation differences and create havoc. Spain already has. Spain decided to recapitalize Bankia with government debt, exchanging one set of questionable paper for another (Banking shares for Spanish government debt). Spain did not have cash to pump into Bankia but by having Bankia give it shares Bankia could acquire tier one capital, government debt, and ‘arbitrage’ the system allowing Spain to bypass the capital markets and to issue bonds directly and for Bankia to use the bonds at the ECB for real money. It’s as though you were playing Monoploy and could use the fake money in the real world. The Achilles heel to the euro banking system is the Basle rule that make all things equal when they are not. All government debt is definitely not equal just look at your screen or a quote. Compare coupons. But Europe now has a full blown banking sector problem and it wants so solve it. Banks have their own special problems, with bad loans of various sorts, but since the ECB launched LTRO the banking sector and country debt problems became thoroughly intermixed. The more that ECB LTRO funds were used to buy local government bonds the more the country debt rating issue became a banking sector issue. LTRO has allowed some withdrawal of credit from the government securities markets by banks domiciled outside the issuing nation. This has tended to concentrate the problem on the balance sheets of local country banks in debt-troubled countries. But since LTRO lies at the bottom of this lending what it has really done is to take local debt problems and concentrate them at the ECB through official channels more than though private banking channels. An EMU banking system that does not close those loopholes will only make the troubles in the Zone worse. For now the e-zone troubles have magnified because the perceived instability in large borrower nations is leading investors to remove funds from the troubled nations where funds might be expropriated and redenominated in local currency should a break up occur. So financing the banks with a hair-brained scheme that is not viable and that does not make the zone more viable will not solve the problem of capital flight and banking system strain. Even a ’proper’ backstopping of the banking system would leave deposits vulnerable to confiscation and redenomination in the event of a break up. So how does fixing the banking system really help? The e-Zone continues to chase ambulances. It does not deal with the fundamental issue which is the loss of competiveness across countries. The quickest way to solve the competitiveness problem is to let countries devalue (i.e. leave the Zone). But since they are trying to stay in the Zone, this solution is not taken, but is feared as an option and it is the cause for capital flight. The root cause of the instability in the Zone is that the Zone itself does not have a credible plan to convince investors that the Zone can stay the course configured as it is. The stay-in and work-out solution is a long hard road that will take a generation of austerity from some nations. Germany is trying to foist that path on other countries but with no concept of the pain involved and seemingly by being oblivious to the needed time-line. Some will dispute this saying East and West Germany united and it was painful, Germany has that experience. But that was done with a strong healthy West Germany backing East Germany all the way and with a set of common if somewhat eroded values. And it took a long time. Trying to unite an uncompetitive Europe without such support seems an impossible task. Bundesbank board member Andreas Dombret said the European Central Bank has done its job to buy time for governments to fix their weaknesses. This statement is so unrelated to the truth one can only wonder what propaganda it represents. Fitch has just said that Spain will not hit its fiscal targets in either of the next two years. Much of Europe is in a recession or a severe slump. It is not a conducive atmosphere to making these changes; certainly not in short-order. If Germany is not part of the solution this experiment will not work. AND the signs are that Germany is getting closer to having had its fill while the problems are not getting closer to being fixed. Germany should know from its very much more controlled experience with East Germany that this is a process than will take much more than a decade. How could the ECB’s job be done when it has only just begun –and has yet to be rationalized? Of course this is not to say that the debt ridden and credit ratings challenged countries are not at fault too. But that is the issue. Germany, to fund them, must trust them. There must be real reform. In the case of East and West Germany the shared values were not an issue. For the rest of the Zone it is very much more of an issue. What will be the values that they will choose to share? More fiscal responsibility is number one. But it does not stop there. That is the main conversation that Europeans need to have: what are their shared values? What is their shared vision? Once they establish that, the other things can fall into line, like backstopping banking systems and fiscal fixes and the like. Spain’s un-bail-out that has been unsuccessful in getting market sentiment patched up may prove to be a catalyst. If this much money has no effect it should be clear that Europe will not able to raise enough of it when the real dam bursts and that is close to happening. Either Germans have to change their mind or their time horizon or the euro-Zone will break apart. The evidence clearly suggests that progress cannot go much faster largely because the reality of the economic cycle makes staying in one place a hard enough job as it is let along making progress. Europe is swimming against the current of economic conditions and its lack of focus to deal with – or have a plan to deal with- THE NUMBER ONE PROBLEM in the zone (varied competitiveness) condemns it to deal with the black swan factory it has become. Every several months it’s a new problem, a new bank, a new banking system, a new issue that goes bad and for which the e-Zone creates a new partial fix. Why not a real fix? Why not for the real problem? Why not now? Or, end the madness and just break up.