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.