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.
Now compare that to the euro zone. A May European Central Bank report makes clear that over 80 percent of a euro-zone country's shock would be retained domestically, with less than 20 percent of the economic pain shared with the rest of the euro zone. The fiscal straitjacket imposed by the debt and deficit limits, together with the lack of ability to depreciate, means economic crises cannot be addressed by traditional macroeconomic policies, so diffusion through capital and credit channels is important.
In the chart below, from the ECB report, the light blue band is the proportion of country-specific shocks that remain "unsmoothed," or not shared out across the euro zone through cross-border ownership of assets (capital channel), cross-border borrowing and lending (credit channel) and cross-border transfers (fiscal channel).
The ECB indicators reveal that the level of financial integration in the euro zone is the same as it was 15 years ago. Not only that, but the concentration of credit means that a shock could unleash a banking crisis in a euro zone country. The irony is that the level of domestic government and corporate bonds held by financial institutions of the issuing country is now higher than at the euro's inception; in its bid to buy time, the ECB's quantitative easing operations had the impact of increasing financial disaggregation rather than the opposite.
Since much government debt is held by same-nation banks, rather than dispersed throughout the euro zone, a crisis in, say, Italy, would be most acutely felt by Italian banks, and so on. There is also not much room for dispersing the pain: European banking consolidation, as measured by cross-border merger and acquisition activity among financial institutions in the euro zone, has been steadily declining and compares unfavorably to the United States.
To compound the problem, highly skilled young graduates can migrate from the struggling country, leaving a higher proportion of benefits-supported, low-skilled labor behind. Countries no longer able to defend themselves through traditional economic tools are left with the liabilities while their human capital is hollowed out. This is exactly what happened in Italy, Spain and Portugal -- and to some extent, France -- since the euro's financial crisis in 2012, leaving high unemployment and a political backlash.
Perhaps a stronger political alliance between Germany and a rejuvenated France will lead to greater possibilities for fiscal transfers and help offset risk during a crisis. But credit and capital markets play a bigger role than government measures in the U.S. and must do so in the euro zone as well.
There are two vehicles necessary for improving these channels. One is the capital markets union, which harmonizes rules regarding bonds and securitization. The other is the banking union, which seeks to set up a single supervisory and resolution mechanism and, controversially, a common deposit insurance scheme. The capital markets union has been stalled by concerns over pooling sovereignty, foot-dragging and opposition from special-interest groups. The banking union has also been stuck; as the ECB report notes, the market seems to lack faith that it will be completed. Partly that's because there is such disparity across markets, from the non-performing-loan-challenged Italian banks to the profitability-challenged German banks to the tightly run Scandinavian banks.
It took more than 90 years between the creation of the dollar and the National Bank Act of 1863 in the U.S., which set up a national banking system through federally issued bank charters. The euro-zone region certainly has examples to emulate. But it has been slow to adopt the lessons from the U.S.'s shock-absorber system. The current period of robust recovery is the right time to push for that to happen.
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Therese Raphael at email@example.com