Forget a banking union, only fiscal discipline can save the euro zone
The European think tank Breugel recently produced a report suggesting there was a fundamental 'trilemma' between the European monetary union, national banking systems and the lack of fiscal union. This added a twist to the old argument that, for a single currency, you need a single fiscal policy.
The argument for a banking union arose because European governments were able to finance their deficits largely through their national banks. This created an interlocking crisis. If national banks hold lots of national debt, when debt prices fall the banks become insolvent, but illiquid governments cannot bail out insolvent banks without further borrowing at higher real rates.
The illiquidity trap was relieved when the European Central Bank undertook longer-term refinancing operations, effectively giving the national banks three-year money at 1per cent to buy their government paper. Liquidity and capital shortage were simultaneously relieved, because the more the national banks buy national bonds, and bond prices rise, the less capital is required. But these refinancing operations only relieved the symptoms without sorting out the structural issues of excessive debt.
Unitary states like China, India and the US do not have this problem, because their provincial governments do not have large local banks to fund their deficits and, anyway, these local governments cannot run large deficits without approval from the centre. So should Europe have a banking union as well as fiscal union?
My answer is that this debate is a distraction from the real argument over fiscal discipline. If all European national banks were instantly merged to become a single transnational European bank, would it solve the problem of a lack of fiscal union? That transnational bank would still have the problem of whether to buy national debt paper and whether to mark them to market. A banking union may solve the euro-zone funding problem, but not the problem of write-offs between surplus and deficit members, which only a fiscal union can solve.
The fundamental issue is the exercise of fiscal and financial discipline. Should this be exercised at the national level (this is clearly not working) or at the central level (who decides - the surplus 'winners' or the deficit 'losers')?
The European tragedy is that member governments ran large deficits for years because there was no central mechanism to discipline them, and nor did the market. I am amazed financial institutions that helped governments disguise the size of their debt have not been sanctioned for violating the most basic market discipline - truth in transparency. Having overspent and overborrowed, deficit countries face two unenviable choices - deflation through austerity or a combination of debt forgiveness and funding to grow out of the crisis.
Market discipline exercised through rising interest rates seems to doom the deficit countries to impossible situations. Deflation is extremely painful and perhaps politically unacceptable. Unemployment among youth is already unacceptably high, and if there are riots in the streets or the polls reject further austerity, then the euro zone could fragment. It is too expensive for it all to break up, but for those undergoing deflation, it may feel like it is too expensive to stay in.
To me, the European crisis brings a sense of dej?vu - the lesson of the 1997/98 Asian crisis is that a fixed exchange rate is incompatible with independent monetary policy and open capital accounts.
Hence, the big debate is essentially political. Who pays and why? To keep the euro, the deficit countries must deflate through austerity, or the surplus countries must be willing to lend or spend.
In my view, the present solution of very loose monetary policy is still the wrong medicine - central banks cannot solve structural problems through monetary creation. A structural solution must be targeted and implemented at the national level - spend to stimulate growth where necessary and cut waste where necessary.
The surplus countries like Germany know they have to pay, but are worried about moral hazard - they pay, but don't get the desired reforms. The deficit countries worry that the surplus countries would become too powerful and exact too much pain for too little money, too late. Europe is rich enough to solve its own problems, but it cannot agree on who should bear the losses of its 'trilemma'.
The global dilemma is that Europe is too important to sink, but too big for the rest to help. Japan and the US have enough of their own problems and do not want to be seen to interfere in Europe's woes. Individually, none of the emerging markets can justify to their own poorer citizens why they should help a rich and powerful Europe.
The solution is in Europe's own hands. Family members cannot enforce discipline within their own family. The International Monetary Fund can act as an independent enforcer of discipline and reflation by recycling global surpluses for deficit countries. But this requires Europe and the US to significantly recapitalise the fund by enabling surplus emerging markets to have better representation, and they're unwilling to do so.
Hence, the real global dilemma is that advanced countries are reluctant to improve democracy and legitimacy in the IMF to help solve their own problems.
Andrew Sheng is president of the Fung Global Institute