What is the situation today? Europe's periphery is in depression. According to the IMF, gross domestic product will contract this year by 4.7 percent in Greece and 3.3 percent in Portugal. Unemployment is 24 percent in Spain, 22 percent in Greece and 15 percent in Portugal. Public debt already exceeds 100 percent of GDP in Greece, Ireland, Italy and Portugal. These countries, along with Spain, are now effectively shut out of the bond market.
Now comes the banking crisis. We have warned for more than three years that continental Europe needed to clean up its banks' woeful balance sheets. Next to nothing was done. In the meanwhile, a silent run on the banks of the euro zone periphery has been underway for two years now: cross-border, interbank and wholesale funding has rolled off and been substituted with ECB financing; and "smart money" -- large uninsured deposits of high net worth individuals -- has quietly exited Greek and other "Club Med" banks.
Now, the public is finally losing faith and the silent run may spread to smaller insured deposits. Indeed, if Greece were to exit, a deposit freeze would occur and euro deposits would be converted into new drachmas: so a euro in a Greek bank really is not equivalent to a euro in a German bank. Greeks have withdrawn more than €700 million ($875 million) from their banks in the past month.
More worryingly, there was also a surge of withdrawals from some Spanish banks last month. On a recent visit to Barcelona, one of us was repeatedly asked if it was safe to leave money in a Spanish bank. This kind of process is potentially explosive. What today is a leisurely "bank jog" could easily become a sprint for the exits. Indeed, a full run on other PIIGS banks would be impossible to avoid in the event of a Greek exit. Rational people would ask: Who is next?
In the meantime, the credit crunch in the euro-zone banks on the periphery remains severe as banks -- unable to achieve the new 9 percent capital targets by raising private capital -- are selling assets and contracting credit, thus making the euro-zone recession more severe. Fragmentation and balkanization of banking in the euro zone, together with domestication of public debt, is now well underway.
The process of political fragmentation is also speeding up. In the last Greek elections, seven in 10 voters cast their ballots for smaller parties opposed to the austerity program imposed on Greece in return for two E.U.-led bailouts. Established parties are also losing out to splinter parties in Italy, where the comedian Beppe Grillo's Five Star Movement has just won control of the city of Parma, and in Germany, where a maverick party called the Pirates is all the rage. Less frivolous populists now have substantial support in France, the Netherlands and Norway. This trend is ominous.
Reducing Moral Hazard
The way out of this crisis seems clear.
First, there needs to be a program of direct recapitalization -- via preferred non-voting shares -- of euro-zone banks both in the periphery and the core by the European Financial Stability Facility (EFSF) and its successor the European Stability Mechanism (ESM). The model should be the U.S.'s successful Troubled Asset Relief Program (TARP).
The current approach of recapping the banks by the sovereigns borrowing from domestic bond markets -- and/or the EFSF -- has been a disaster in Ireland and Greece. It has led to a surge of public debt and made the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands.
Direct capital injections would bypass the sovereign and avoid the surge in public debt. In practice, the euro-zone taxpayer would become a shareholder in euro-zone banks and the current balkanization of banking would be partially reversed. This might also help overcome the political resistance to cross-border mergers and acquisitions in coddled domestic banking systems.
Of course, over time, sound banks that restore capital through earnings would be able to buy back the public preferred shares. So this partial nationalization would be temporary.
Second, to avoid a run on euro-zone banks -- a certainty in the case of a "Grexit" and likely in any case -- a E.U.-wide system of deposit insurance needs to be created.
To reduce moral hazard (and the equity and credit risk undertaken by euro-zone taxpayers through the recap and the deposit insurance scheme), several additional measures should also be implemented:
-- The deposit insurance scheme has to be funded by appropriate bank levies: This could be a financial transaction tax or, better, a levy on all bank liabilities -- both deposits and other debt claims.
-- To limit the potential losses for euro-zone taxpayers, there needs to be a bank resolution scheme in which unsecured creditors of banks -- both junior and senior -- would take a hit before taxpayer money is used to cover bank losses.
-- Measures to limit the size of banks to avoid the too-big-to-fail problem need to be undertaken. In the case of Bankia, the merger of seven smaller caixas merely created a bank that was too big to fail.
-- We also favor an E.U.-wide system of supervision and regulation. If the euro-zone taxpayer backstops the capital and deposits of euro-zone banks, then supervision and regulation cannot remain at the national level, where political distortions lead to less than optimal oversight of banks.
True, European-wide deposit insurance will not work if there is a continued risk of a country leaving the euro zone. Guaranteeing deposits in euros would be very expensive as the exiting country would need to convert all euro claims into a new national currency, which would swiftly depreciate against the euro. On the other side, if the deposit insurance holds only if a country doesn't exit, it will be incapable of stopping a bank run. So more needs to be done to reduce the probability of euro zone exits.
No Alternative To Debt Mutualization
Specifically, three actions are needed:
-- Fiscal austerity policies should not be excessively front-loaded while structural reforms that accelerate productivity growth should be sped up.
-- Economic growth needs to be jump-started in the euro zone. Without growth, the social and political backlash against austerity will be overwhelming. Repaying debt cannot be sustainable without growth.
-- The policies to achieve this include further monetary easing by the ECB, a weaker euro, some fiscal stimulus in the core, more bottleneck-reducing and supply-stimulating infrastructure spending in the periphery (preferably with some kind of "golden rule" for public investment), and wage increases above productivity in the core to boost income and consumption.
Finally, given the unsustainably high public debts and borrowing costs of certain member states, we see no alternative to some kind of debt mutualization.
There are currently a number of different proposals for euro bonds. Among them, the German Council of Economic Experts' proposal for a European Redemption Fund (ERF) is to be preferred -- not because it is the optimal one but rather because it is the only one that can assuage German concerns about taking on too much credit risk.
The ERF is a temporary program that does not lead to permanent euro bonds. It is supported by appropriate collateral and seniority for the fund and has strong conditionality. The main risk is that any proposal that is acceptable to Germany would imply such a loss of national fiscal policy sovereignty that it would be unacceptable to the euro-zone periphery, particularly Italy and Spain.
Giving up some sovereignty is inevitable. However, becoming subject to a "neo-colonial" submission of one's fiscal policy to Germany -- as a senior periphery leader put it to us at a recent meeting of the Nicolas Berggruen Institute (NBI) in Rome -- is not acceptable.
Until recently, the German position has been relentlessly negative on all such proposals. German officials have repeatedly opposed the direct recapitalization of troubled banks. Chancellor Merkel has consistently ruled out euro bonds. Some German spokesmen have made it sound as if they actually want a Greek exit from the euro zone. Others have been over-eager to impose the same fiscal regime on Spain as has already been imposed on Portugal.
We understand German concerns about moral hazard. Putting German taxpayers' money on the line will be hard to justify if meaningful reforms do not materialize on the periphery. Such reforms are bound to take time. Structural reform of the German labor market was hardly an overnight success. By contrast, the European banking crisis is a financial hazard that could escalate in a matter of days.
We have tried to come up with proposals that address German anxieties; but we want to emphasize that action is urgently needed. Germans must understand that bank recapitalization, European deposit insurance and debt mutualization are not optional. They are essential steps to avoid an irreversible disintegration of Europe's monetary union. If Germans are still not convinced, they must understand that the costs of a breakup of the euro zone would be astronomically high -- for themselves as much as for anyone.
After all, Germany's current prosperity is in large measure a consequence of monetary union. The euro has given German exporters a far more competitive exchange rate than the old deutsche mark would have. And the rest of the euro zone remains the destination for 42 percent of German exports. Plunging half of that market into a new Depression can hardly be good for Germany.
Ultimately, as Chancellor Merkel herself acknowledged last week, monetary union always implied further integration into a fiscal and political union.
Before Europe gets anywhere near taking this historical step, it must first of all show that it has learned the lessons of the past. The E.U. was created to avoid repeating the disasters of the 1930s. It is time Europe's leaders -- and especially Germany's -- understood how perilously close they are to doing just that.
Intellpuke: You can read this commentary by Spiegel journalists Niall Ferguson and Nourial Roubini in context here: http://www.spiegel.de/international/europe/the-germans-have-learned-nothing-from-history-a-838429.html