Editorial Board

How to Break Europe's Financial 'Doom Loop'

The connection between banks and public borrowing still threatens financial stability.

Better luck next time.

Photographer: Yorgos Karahalis/Bloomberg

The euro-zone economy is looking a lot healthier. After years of stagnation, growth has finally picked up and unemployment is falling. Fears of a paralyzing bout of deflation have receded as well. Yet there’s a risk of relapse -- and Europe’s banking “doom loop” is the reason.

Close links between government finances and the banking system were a main cause of the collapse of Spain, Ireland and Greece, and policy-makers have done too little to break the connection. In a report published this week, the International Monetary Fund rightly draws attention to the danger: So long as this linkage persists, Europe will continue to pose a threat to financial stability worldwide.

There are two sides to the linkage between governments and lenders. When investors believe that a government will bail out a weak bank, troubles in the financial system can cause sovereign bond yields to spike. Conversely, when lenders hold too much government debt, doubts over a country’s fiscal health can spill over to the banks.

To be fair, the euro zone has taken some steps to cut this link. The European Commission has put in place new rules forcing bond investors to take losses before governments can bail out a bank. Regulators have also forced lenders to raise more capital, reducing the risk of new rescues.

Yet these efforts have not gone far enough. Italy is exploiting a technicality in the rules to save three banks while sparing senior bondholders, showing that the era of bailouts isn’t over. Meanwhile, lenders in fiscally weak countries continue to pile into government debt.

The euro zone should be more forceful in breaking this connection. What’s needed is a grand bargain between more vulnerable countries such as Italy and stronger economies such as Germany.

The former should accept that there must be limits on how much sovereign debt European banks can hold, even though this process must be gradual to minimize instability. In addition, the existing rules on bank bailouts need to be more strictly enforced, so that it’s harder to rescue banks that don’t pose a systemic threat. At the same time, Germany’s government should understand that weaker member states can’t resolve their banking troubles without help. The European Stability Mechanism, the euro zone’s rescue fund, intervenes mainly by lending to governments -- burdening them with more debt. The ESM should be able to intervene directly instead.

These measures will be politically difficult for all parties, but they’re necessary to strengthen the euro zone ahead of the next crisis.