The Euro Zone Needs Better Shock Absorbers

The recent bank rescues in Spain and Italy underline the absence of a true banking union in the euro zone. In one, a Spanish bank took over another Spanish bank, while in the latter the Italian government had to step in. In neither case was the pain of the rescue shared across the euro zone. The fallout may be minimal in those cases, but the ability to share the pain of economic shocks through the credit and capital markets is critical if the single currency is to be sustainable.

A much-circulated 2004 paper measured shock-absorption capacity in the United States and found that just over a third of any asymmetric shock is absorbed by the affected U.S. state; the rest was dispersed through federal fiscal policy (15 percent), credit markets (14 percent) and capital markets (36 percent). When a state goes into recession, the federal government becomes a net contributor to the local economy. Out-of-state banks lose on their lending to in-state industries and consumers. Pension funds and insurance companies from all over the country take a hit on their equity and bond holdings from the affected state's corporations. The pain is shared across these actors.