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Europe’s banks need to be recapitalised – now

Europe’s growth performance was disappointing before the financial crisis. It has been dismal since. Five years into the “great recession”, the r

Publishing date
15 April 2013

Europe’s growth performance was disappointing before the financial crisis. It has been dismal since. Five years into the “great recession”, the risk for Europe is to remain trapped in stagnation. Vicious circles are apparent across the continent: weak growth undermines deleveraging and fuels banking fragility. Persistently high unemployment erodes skills and undermines Europe’s growth potential. Low overall growth makes it much harder for the hard-hit economies in southern Europe to recover competitiveness and regain control of their public finances. Stagnation reduces the attractiveness of Europe for investment. Under these conditions, Europe’s social models are bound to prove unsustainable.

Why is this so?

Structural weaknesses are part of the explanation. But Europe also made two mistakes in responding to the crisis. First, it failed to recognise the true extent of its banking problem. It believed – or pretended to believe – that the guarantees and recapitalisations of 2008-2009 had addressed the issue whereas weaknesses were in fact much more widespread. Second, it failed to appreciate that excessive private-sector debt was not just an American problem. In Europe too many households and companies needed to deleverage.

The European mantra – structural reform and fiscal consolidation – was and remains correct. But a still-dysfunctional financial system and an overleveraged private sector made the eurozone unable to reallocate resources, engender productivity and sustain demand. Add relative price rigidity in the euro area and the picture is complete: the medicine may be the right one, but the patient is not yet fit to really benefit from it.

How does Europe get out of this predicament?

Comprehensive action is needed to break the mutually reinforcing links between limited productivity, slow deleveraging, weak banking sectors and distorted relative prices.

The first priority is financial repair. Banks with weak balance sheets lend on too expensive terms or lend to insolvent borrowers to keep them afloat and do not grant credit to new firms. This prevents profitable investment and the growth of new, more efficient firms. A comprehensive bank balance sheet assessment is needed. For those that would take part in this assessment, the introduction of the Single Supervisory Mechanism, the first element of the European banking union, offers a opportunity. The ECB should not and will not accept undercapitalised – let alone insolvent – banks to fall under the common supervision. National authorities therefore have to initiate a recapitalisation of undercapitalised banks and a resolution of the insolvent ones. The moment is now. When public money is needed, the European Commission should exclude it when making decision on excessive deficits.

Even before the repair is completed, action is needed because the monetary policy transmission mechanism in the eurozone is impaired in some countries, further limiting credit supply. Significant haircuts on collateral in the repo operations that underpin the provision of central bank liquidity limit the willingness to provide credit to small firms. This limitation has a particular importance in the current low-growth environment and needs temporary but forceful action. The ECB alone cannot solve the problem because it has a fiscal dimension. The EU should explore temporary collateral enhancement schemes, for example, in liaison with the European Investment Bank.

The second priority is to balance private and public deleveraging. This requires an appropriate speed of fiscal adjustment, one that is adapted to the context of stagnating economies. Where consolidation is needed – that is, in most countries – there is a case for spreading it out over a longer period, provided governments can credibly commit to future action. One way is to legislate now for the years to come, for example on far-reaching pension reforms. Another is to use the EU fiscal framework as a credible commitment device. More needs to be done to prevent fiscal retrenchment in the south of Europe from further dampening economic activity and increasing social hardship, ultimately undermining economic and political stability. Up-front payments from existing EU convergence funds and increased EU-supported investments would be a good way to help address demand weaknesses.

The third set of measures should aim at addressing the differences of competitiveness acorss eurozone countries; a problem that was in place before the crisis. Structural reforms are of central importance to increasing long-term productivity and need to be continued vigorously. The EU should provide incentives to addressing weaknesses in product, labour and capital markets as well in skills. It should explore new approaches, including, contractual budgetary support in specific policy areas. Nevertheless, within the eurozone, wage rebalancing should involve northern Europe as well as southern Europe. Consistent with the ECB mandate, average inflation in the eurozone should be close to the 2 per cent target yet inflation expectations have fallen to well below that. Northern Europe should refrain from domestic policy action that would prevent domestic inflation from rising above 2 per cent, as long as eurozone price stability remains ensured.

The solution to Europe’s economic problem is neither stubborn persistence nor a U-turn. It is not to add a new policy procedure to the many existing ones. It is to recognise the true nature of the challenge it is facing and to adopt a more comprehensive approach.

This comment is based on the Bruegel paper ‘Europe’s growth problem (and what to do about it)‘.

About the authors

  • Jean Pisani-Ferry

    Jean Pisani-Ferry holds the Tommaso Padoa Schioppa chair of the European University Institute. He is a Senior Fellow at Bruegel, the European think tank, and a Non-Resident Senior Fellow at the Peterson Institute (Washington DC). He is also a professor of economics with Sciences Po (Paris).

    He sits on the supervisory board of the French Caisse des Dépôts and serves as non-executive chair of I4CE, the French institute for climate economics.

    Pisani-Ferry served from 2013 to 2016 as Commissioner-General of France Stratégie, the ideas lab of the French government. In 2017, he contributed to Emmanuel Macron’s presidential bid as the Director of programme and ideas of his campaign. He was from 2005 to 2013 the Founding Director of Bruegel, the Brussels-based economic think tank that he had contributed to create. Beforehand, he was Executive President of the French PM’s Council of Economic Analysis (2001-2002), Senior Economic Adviser to the French Minister of Finance (1997-2000), and Director of CEPII, the French institute for international economics (1992-1997).

    Pisani-Ferry has taught at University Paris-Dauphine, École Polytechnique, École Centrale and the Free University of Brussels. His publications include numerous books and articles on economic policy and European policy issues. He has also been an active contributor to public debates with regular columns in Le Monde and for Project Syndicate.

  • Zsolt Darvas

    Zsolt Darvas, a Hungarian citizen, joined Bruegel as a Visiting Fellow in September 2008 and continued his work at Bruegel as a Research Fellow from January 2009, before being appointed Senior Fellow from September 2013. He is also a Senior Research Fellow at the Corvinus University of Budapest.

    From 2005 to 2008, he was the Research Advisor of the Argenta Financial Research Group in Budapest. Before that, he worked at the research unit of the Central Bank of Hungary (1994-2005) where he served as Deputy Head.

    Zsolt holds a Ph.D. in Economics from Corvinus University of Budapest where he teaches courses in Econometrics but also at other institutions since 1994. His research interests include macroeconomics, international economics, central banking and time series analysis.

  • Guntram B. Wolff

    Guntram Wolff was the Director of Bruegel. Over his career, he has contributed to research on European political economy and governance, fiscal, monetary and financial policy, climate change and geoeconomics. Under his leadership, Bruegel has been regularly ranked among the top global think tanks and has grown in influence and impact with a team of now almost 40 recognized scholars and around 65 total staff. Bruegel is also recognized for its outstanding transparency.

    A recognized thought leader and academic, he regularly testifies at the European Finance Ministers' ECOFIN meeting, the European Parliament, the German Parliament (Bundestag) and the French Parliament (Assemblée Nationale). From 2012-16, he was a member of the French prime minister's Conseil d'Analyse Economique. In 2018, then IMF managing director Christine Lagarde appointed him to the external advisory group on surveillance to review the Fund’s priorities. In 2021, he was appointed to the G20 high level independent panel on pandemic prevention, preparedness and response. He is also a professor (part-time) at the Solvay Brussels School of Université Libre de Bruxelles, where he teaches economics of European integration.

    He joined Bruegel from the European Commission, where he worked on the macroeconomics of the euro area and the reform of euro area governance. Prior to joining the Commission, he was coordinating the research team on fiscal policy at Deutsche Bundesbank. He also worked as an external adviser to the International Monetary Fund.

    He holds a PhD in economics from the University of Bonn and studied in Bonn, Toulouse, Pittsburgh and Passau. He taught economics at the University of Pittsburgh and at Université libre de Bruxelles. He has published numerous papers in leading academic journals. His columns and policy work are published and cited in leading international media and policy outlets. Guntram is fluent in German, English, French and has good notions of Bulgarian and Spanish.

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