The long running crisis in the euro area is caused, at least in part, by the fact that the participants in the bond markets have little understanding of, and for a long time had little interest in, how the  eurozone makes its decisions at political level.

In the past, these bond market participants assumed, without much enquiry as to why, that Greek  government bonds were no more risky than German Government bonds, simply because Germany  and Greece had  the same currency.

At that time, they took no interest in the internal politics, or  relative  competitiveness, of Greece and Germany. This misunderstanding often also encompassed economic commentators, especially in the English language media, who, then and now, are unduly influential in the mind of  bond market participants.

Then, in the wake of the shock of the Lehman collapse, everything changed.
The slightest political ripple now sends  amplified shock waves through the  bond markets, and the interest rates charged to lend to different  countries  within the euro zone  vary greatly. Long ignored indices are now scrutinized obsessively.

Both bond buyers and economists, having blithely ignored the EU political system for years, now  crave complete and definitive answers from it, and they want those answers  yesterday!
Of course, the markets worry about the viability of the public finances of individual countries or of their banks, but an even greater concern is to know whether a particular country will stay in the euro in all circumstances.  A country leaving the euro could impose an immediate and shocking loss on lenders to that country, and to its banks.

So the first priority for the markets is convincing them that, no matter what happens, nobody is going to leave the euro. That is a matter of political conviction, not macroeconomic analysis. After that, everything else can be negotiated.

But the political leaders of the euro zone come at things from a very different angle to that of the  commentators and bond buyers. While the political leaders understand the bond buyers  craving for  certainty, they are  engaged in a complex multidimensional political negotiation, in which they have to balance the interests of  17 different sets of national taxpayers, some of whom want to shift liabilities to someone else, and others of whom  who want to  take on  as little  liability as possible, for the debts of others.

 The political negotiation is further complicated by the fact that the EU does not  yet have the  legal power to do some of the things it needs to do, and  some of its members  want to withhold  agreement to giving it those powers, in pursuit of national concessions . Britain is the most outstanding example of this, but more recently Italy played that game. In Ireland, one political party wanted to veto the ESM, which is beneficial to Ireland, simply to get concessions on something else. This sort of silly thing goes on often in EU negotiations, because EU negotiations are conducted by humans, not  by angels.

While there is a European Union, the people who make the final decisions for the Union are national politicians, elected by national electorates, and the national electorates frequently do not understand one another very well, or choose not to do so.

The cheap caricaturing of Germany in some other EU countries has been matched by equally  juvenile caricatures in parts of the German press of other countries, like Greece.  Sometimes the critics have a point, as when Germans complain about the possibility of  extending  their credit to countries ,like France, which  are reducing their  retirement  age to  60, while Germany  feels it has to raise its retirement  age to  70 to maintain German creditworthiness.

As well as making decisions, leaders have to bring their parliaments, which reflect these very diverse electorates, along. Sometimes they need a two thirds majority, as in Germany, or a referendum, as in Ireland.

To use a construction analogy, the markets want the EU to produce a fully constructed and furnished building in time for next week’s bond auction.  But the politicians are trying  to  build the  foundations without having  finalised the architectural drawings,  while  simultaneously arguing about the height of the building, investigating whether  they can buy some units prefabricated, and deciding  how much  bricklayers are paid  per hour by comparison with carpenters.

That’s politics, and this is a political negotiation. It is the way it has to be. No one is going to show their full hand until the moment they are satisfied that everyone else is going to show their hand too.

But commentators criticise the outcome of individual meetings as if it was not a political negotiation, but an academic exercise, and the 17 euro zone leaders were  “Platonic guardians” unconstrained by anything except the requirement to produce a theoretically symmetrical outcome.

For example, one notable commentator (Wolfgang Munchau in the Financial Times) announced recently that the crisis was going to last 20 years, just because Angela Merkel had not accepted that there would be joint euro zone insurance of deposits in euro zone banks, before she had seen the details of exactly what level of central scrutiny of their banks, the other countries would accept, so as to ensure that they would not take a free ride on the backs of German depositors.

What did he really expect? Mrs Merkel will not show her hand until she absolutely has to, any more than Enda Kenny or Francois Hollande will.

Likewise, it is unrealistic of people, like Nouriel Roubini, to  demand that the size of the  ESM fund be doubled  or trebled at this stage, before anyone knows for sure whether the  intended beneficiaries of an enlarged ESM will do all that is required of them, to deserve the money.  Uncertainty about the size of the fund, and doubt about whether it will be big enough in all circumstances, is essential as an incentive to get debtor Governments to do the things they need to do, to be sure they do qualify for the fund, if they need it. 

The Euro area Summit statement of 29 June said it was “ imperative to break the  vicious circle between banks and sovereigns.”.

But it also said that, for EU funds to be directly invested in banks,  an “effective (European) supervisory mechanism” would have first have  to be established, and that any injection of funds would have to be accompanied by conditions that would be  “institution specific, sector specific, and economy wide”.   So a deal will have to be negotiated in respect of each individual bank, each national banking sector, and each country.
According to a paper published recently by the highly regarded  Brussels based think tank, the Breugel Institute,  a  European Banking Union  would require decisions on at least 8 big questions

  1. whether to include countries not yet in the euro
  2. whether  to bring all banks under direct EU supervision, or just the big ones
  3. the scope of an EU wide deposit  guarantee, as to the  amount covered and whether there would have to a local contribution, without which the system might be abused
  4. an EU wide system for closing banks  down and distributing the losses between  shareholders, different classes of creditors, taxpayers and other banks in the  country in question and elsewhere. Associated with this is the question of requiring all banks to draw up “living wills” to say what would happen if they go out of business
  5. Some form of limited  euro zone wide taxing capacity to act as a back stop if  the deposit guarantee fund proves insufficient.
  6. how to  distinguish between past, and potential  future liabilities
  7. the proper focus of euro zone bank  supervision. Should it be on capital ratios, liquidity ratios, business models, diversification or other variables? Should different  types of banking be separated from  one another, or  does a  mixed system make it easier to get over  short term  difficulties?
  8. what to do about Britain, which wants nothing to do with the euro or a a European Banking Union, but still  wants unfettered access to euro zone financial markets  on the same terms as everyone else.

These are difficult political issues and they will need to be resolved in a way that is BOTH theoretically sound, AND politically balanced, between all the 27 countries in the EU. Patience  will be required.

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