How to stop fragmentation of the Eurozone

The continual rebounding of the Greek crisis is making the headlines. But a less visible yet even more worrying development has appeared in the Eurozone since the summer: the beginnings of a creeping process of fragmentation.

The first sign is that banks are once again reluctant to lend to each other. Since July the spread between the rate at which they borrow from each other and the zero risk rate has been climbing. Rather than to lend it on the interbank market, financial institutions with liquidity increasingly prefer to deposit their cash with the ECB, which has had to reactivate its direct lending procedures to banks. This is the same situation – though at this stage less acute – than in the 2007-08 crisis. The tension is obvious, and this time it is internal in origin. In London and New York the interbank market is still working.

The second sign is that one and the same cross-border bank is charging higher interest rates for firms in southern Europe than to similar firms in northern Europe. This cuts to the core of the single market, and it is making the situation for crisis-hit economies worse. Instead of combating this trend, northern European bank supervisors are magnifying it by setting limits to the exposure of their banks to southern Europe.

The third sign is that, in the eyes of international investors, southern European government bonds no longer belong to the same asset class as northern European ones. It is not simply a case of the price of risk, by definition easily reversible. It marks a deeper change in attitude. If it continues to affect lending behaviour to southern countries, it will harm their solvency and economic recovery.

It is in this light that we must consider the proposed crisis responses which are being discussed in the run-up to a decisive European summit on 23 October and the G20 summit in early November. The heads of state are expected to agree on a higher debt relief for Greece, a boosting of the European financial facility, and the recapitalisation of banks. These would be welcome moves, but the heart of the problem is to determine which set of principles will underpin the construction of a more robust monetary union.

The main cause of the creeping fragmentation which is observable is the mutual dependence of banks and governments. In the Eurozone banks are vulnerable to sovereign debt because they hold a lot of public paper, frequently issued by their country of origin, and the governments are vulnerable to bank crises because they are individually responsible for rescuing national financial institutions. Every episode in the crisis illustrates how much this interdependence is a source of fragility.

There are three possible responses to this state of affairs. The first relies on intervention by the central bank in case of a threat to the sovereign debt market. The mutual exposure of banks and the sovereign exists in the UK and the UK’s budget situation is worse than that of Spain, but the certainty that the Bank of England would prevent speculation on the UK’s debt is sufficient to reassure investors. In the Eurozone the ECB has not been equipped with this mandate. It is not meant to be a lender of last resort. It has played this role with Italy and Spain but is up against stiff opposition from within its own ranks, and it may well not continue for much longer. In fact, it does not have the right decision-making structure to take decisions that may end up implying a transfer from one set of countries to another one. The recently created European financial facility is better equipped to take such decisions and may play a similar role but its war-chest is limited. As for changing the mandate and structure of the ECB, this would not be acceptable for Germany, if only for constitutional reasons.

The second response consists of strengthening the banks through recapitalisation and removing the dividing walls between national banking systems in order to staunch their overexposure to sovereign default. The Eurozone would be healthier with a properly capitalised banking system, holding diversified assets and endowed with common surveillance and deposit insurance. This would sever banks from over exposure to their own sovereigns and sovereigns from exposure to their own banks. However, it is to be feared that European leaders may not be bold enough to fully embrace such a plan as they are reluctant to renounce their national banking champions and access to captive investors. We will soon see how the land lies here when the recapitalisation details become known.

The third response consists of reducing sovereign risk by means of a system of surveillance and mutual guarantees between the Eurozone countries. This is budgetary union, and the fuller form of this is the issue of bonds jointly guaranteed by all participating states, which are known in Europe as Eurobonds. The principle of them is best summarised if one imagines that each states borrows from a common debt agency that in turn issues debt on behalf of all states and with their joint and several guarantee. Introducing Eurobonds would in fact imply for each state giving its neighbours access to its own taxpayers and this cannot be imagined without ex ante control of the same neighbour’s budgetary decisions. Moving to such a system is a politically very tough choice both for those countries who would perceive themselves as guarantors and those who would benefit from the guarantee. But it probably remains the most practical way forward of the three.

These three responses are in fact in part complementary, though any durable regime is likely to give priority to one. Even espousing one of them would be a positive sign. It would show that Europe goes beyond mere patches to revisit the fundamental principles upon which monetary union is based. This would be the surest way to regain investors’ confidence.

A version of this column was published in Le Monde and Century Weekly