Restoring confidence in the euro area

4th September 2012 by The Harried House Hunter

The title of this blog echoes the title of a speech given on 1 June by Benoît Coeuré, a member of the Executive Board of the European Central Bank. The first thing that comes to mind when one sees a title like this is a sense that this truly would seem to be mission impossible at the current time. The only magic wand that anyone could wave over the current mess would be a sudden pledge from the ECB to buy as much sovereign debt as was needed to calm markets. This wouldn’t cure anything, but it would “restore confidence”, at least for a while. If it was allied to a sudden urge by all members of the eurozone to meld together into a fiscal union, then the magic trick would be complete. However this latter point is right up there with “pigs might fly”.

Senior European politicians obviously hope that they can cajole and coax some willingness out of reluctant European heads of state that will allow the EU to head towards something approaching fiscal union. As one German politician famously put it, “A good crisis shouldn’t be wasted“. It has long been a maxim of those who have a United States of Europe in mind that progress down that road can only really be made when both politicians and the public feel that their backs are against the wall as Europe lurches from crisis to crisis. Something of this sort seems to be what Coeuré has in mind. He wants a genuine “fix”, something that restores confidence because it enables the world to see that what was broken in Europe is now fixed. In the shorter term, what is concerning market participants, he suggests, is their sense that there is some doubt about the political will to support the euro as a project.

So what is required to put these doubts to rest and to calm markets? Coeuré gives some pretty standard answers. Governments should pursue their efforts to bring down public debt. Austerity is the right road. It might well hurt short term economic activity, he concedes, but it opens the way for private investment and the restoration of long term growth. Interestingly, Coeuré is also concerned about what he terms “financial market fragmentation”. By this he means that as credit has dried up, the sense of a functioning, Europe wide reach to capital markets has faded and been replaced by a kind of “fits and starts” process, with companies having to trawl around to find a lender in this or that member country. Europe’s capital markets are bust and there is no easy way for European companies to finance their investment from a Europe wide pool of savings, he says.

“Bringing euro area capital markets together will require more than technical adjustments … it is trust that is the essence of the lending relationship. Restoring trust in banks and disentangling the fate of the banks from that of Governments are absolute prerequisites.

This last point is particularly interesting. The ECB’s long term refinancing operation (LTRO) has allowed banks to borrow very cheaply from the ECB and to invest in their own sovereign state’s debt at quite high rates of interest. This generates profit for the banks without them having to take on risky corporate debt (which would also require them to set aside large capital reserves while lending to sovereigns is zero weighted according to Basel III). This, of itself, is disincentivising bank lending to corporates, but it is also putting a great weight of dodgy sovereign debt on bank books and ensuring that the fate of a particular state’s banking sector is heavily entwined with the fate of the sovereign state itself. If the state defaults the banking system is absolutely bust.

Coeuré points out that lending banks money does not make them more solvent. (Actually this is wrong – assuming the banks get away with investing in their own sovereign debt, they are borrowing low and lending high, which recharges their balance sheets and over time would make them a good deal more solvent). However, what Coeuré wants is for banks to be recapitalized. The cash for this is unlikely to come from honest investors, who are more than a little concerned about all that dodgy sovereign debt on bank balance sheets, so he wants the banks that need recapitalization to be able to borrow freely from the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) once it comes into force.  This would make them a good deal less dependent on governments and would go some way towards making Europe’s banking sector a much more robust entity. He also wants a single resolution mechanism for Europe as a whole, to deal with bank failure, and a “resolution fund” that would deal with bank bail outs, plus a unified mechanism of deposit insurance.  As he puts it, “the only way out of this crisis is to map out a credible path towards a stronger Europe.” He may well be right, but for many, the price of that “way out” would be a massive dilution of democracy and a move towards a technocratic European super state. Great for those who want it, anathema to those who don’t. The impasse, it seems, is set to continue for a logn while yet, despite the best intentions of Coeuré and his colleagues at the BIS.

Further reading on the EU sovereign debt crisis:

This blog post was originally published on QFinance by Anthony Harrington.

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