Now we have some kind of banking union that is supposed to take care of capitalizations. It is only half-baked. Each country has systemic banks that are under ECB supervision. If they fail, ECB takes 20% of the risk and national governments the other 80%. But most governments don’t have enough reserves to take on 80% risk. So ECB’s attitude is to supervise so strictly that no need for recapitalizations will ever arise. There is no lender of last resort, one of the key functions of central banks. Instead, that the need for one might arise is one of the unthinkable scenarios in Eurozone central banking. In addition, there is supposed to be a ranking of assets according to risk, which are then used to provide capital for the banks, but no such ranking is made explicit. On top is equity – surely it can go in the event of bank failure – and at the bottom deposits, which are safe – no Cyprus style bail-in again. But where do we draw the line? The ECB supervisors are making sure no bank fails out of the blue.
What is the new policy doing to banks? European banks have lost their business model. QE has flattened the yield curve. Borrowing short and lending long, the traditional way that banks make money, is no longer an option. Taking risks to enjoy the return is also not an option, because the ECB supervisors do not allow them to take risks. Compliance with the supervisors is increasing costs, and negative interest rates with squeezed margins are adding to them. So what can they do to make money? The only business left is commission business. We are beginning to see commissions introduced and much reduced banking profit margins. Some say that now banking margins are down to margins in utilities and manufacturing; profit-making is back but under a different business model than the one that existed before the Great Recession.
Governance in the eurozone and the European Union
The eurozone seems to have reached a point where decision-making has reached the lowest denominator: if it’s acceptable to Germany it passes, if not it doesn’t. The Eurogroup meeting of finance ministers is completely ineffective. The chairman is strongly supportive of German policies and rumour has it that decisions are reached before the meetings between the German finance minister, the chair and a few key political allies. The Eurozone clearly needs closer political and economic cooperation. But do they have the political will to cooperate further? It is doubtful. The risk is that sooner or later countries will rebel – Italy and France GDP per head relative to Germany is the lowest that it has ever been. For how long will they be willing to go along with German policy-making? All credit to Mario Draghi and the ECB for breaking away from it with their QE programmes
A feature of the debt crisis was that countries acted in their self-interest. Whereas at the start (2010-12) European officials emphasized “solidarity” in dealing with the problem, country leaders are now emphasizing their voters’ wishes. “I would love to help but my voters won’t let me” is being heard frequently. The final outcome is always a compromise but with more emphasis being put on the country interest. This is leaving a legacy: “it’s your problem, not Europe’s problem” is being heard more and more often. This is not a good basis for future cooperation and it is already showing elsewhere. Most tellingly in the asylum and immigration crisis, which is threatening EU integration even more than the debt crisis did.
What will the future bring? It is still not clear that European leaders have the will to move towards more integration. Common monetary policy requires more fiscal coordination than we now have. Any coordination that we now have is enforced by German wishes, not reached amicably and cooperatively. Yet the fiscal austerity combined with the low interest and inflation regime and the high unemployment is destroying societies. “Kicking the can down the road” and hoping for a good outcome is a good description of what has been happening and looks like continuing. But Europe needs more collective decisions and it needs to reduce Germany’s influence. Brexit will hurt Europe in this dimension. At least Cameron got a promise that European Union decisions will not be driven by the needs of the eurozone.
Brexit: impact on Europe and Britain
There are too many uncertainties about the impact of Brexit on the economies of Britain and Europe. Most economists will agree that if Britain negotiates a free trade agreement with the EU any long term impact of Brexit on its economy will have to come from growth effects. This is the channel emphasized by the LSE research and the Treasury research published earlier this month. The argument is that foreign direct investment brings in new technology and Brexit will affect it negatively. With less FDI there will be less technological evolution and less growth. There is strong statistical support for the links between FDI and new technology and also between FDI and the certainty with which foreign investors view a country’s future economic relations.
Renegotiation with the EU will be tough. This will be mainly for political and reputational reasons. If the EU makes it easy for Britain to exit and renegotiate a new favourable deal more will want to follow. But if they are tough and don’t give enough away they will show their intentions to anyone else contemplating exit. Britain will be the first to leave and it will have to pay the cost that will pass the message that disengaging will not be easy.
