Why European Banking Union May Fail (Varoufakis)

Greek political economist and writer Yanis Varoufakis wrote an interesting article entitled “From Contagion to Incoherence Towards a Model of the Unfolding Eurozone Crisis”. Varoufakis is the most critical economist regarding the institutional failures of the monetary union. Here I reproduce his main conclusions, which are quite clear.

The euro zone was built on two principles not heavily advertised: firstly, that the European Central Bank (ECB) would not be lender of last resort; and secondly, that the fiscal debts would be national –i.e. responsibility of the Member States.

With the crisis and its destabilizing repercussions, and also to avoid the implosion of the euro, the ECB had to persuade the Northern governments to enable it to be lender of last resort. Thus, the central bank would be obliged to condition its loans to a maximum exigency of fiscal austerity.

The curious thing is that the OMT (the established aid operation that is also dependent on a formal appeal for a bailout) was never used: no country wanted to be rescued at that price. At the same time, just announcing the OMT was enough to reassure Europe’s markets because they understood that the euro would be saved in any case, no matter what.

However, the process only maximized macroeconomic imbalances in the euro zone. For instance, lenders don’t care that Spain grows less than 1%, with possible relapses into recession, high unemployment rates and weak domestic demand, and exports as the only element growing, as long as the necessary resources to buy credits are diverted.

The Eurozone was founded on two principles. The first principle was that its central bank would explicitly be banned from acting as a lender of last resort (for states and/or banks facing insolvency). A second principle imposed upon the fledgling currency union was the notion of, what I term, Perfectly Separable Sovereign Debts. With these two principles in place, the scene was set for contagion following a financial crisis serious enough to cause pairs of national banking systems and states sequentially to titter on the verge of bankruptcy.

Europe’s reaction to the crisis was to establish a new institution, the EFSF-ESM that would borrow on behalf of its (still) solvent member states in order to prevent sovereign defaults in their weaker partners. Alas, the funds of this new ‘special purpose vehicle’ were to be drawn from markets courtesy of bonds redolent with the whiff of toxic derivatives. Their toxic structure was, therefore, bound to foment deeper and faster contagion.

As the contagion gathered pace, at some point, the ECB was left with no alternative to intervening in a bid to prevent the European Monetary Union’s disintegration. But to be allowed to step in (with its LTRO and OMT programs), the ECB first had to enter into a Faustian Bargain with the surplus countries: in exchange of being unshackled from the prohibition from acting as a lender of last resort, the ECB had to commit to using its coercive powers in order to impose a third, new principle: that of the greatest austerity upon the weakest member states. In so doing, these ECB-based ‘solutions’ exacerbated the Eurozone’s underlying macroeconomic conundrum while, on the surface, bringing temporary stability to the inter-bank and bond markets.

Euro zone’s macroeconomic imbalances can be summarised in the contraction of the total demand in the area, which means a worsening of the recession in those countries most in need of growing. Domestic demand contracted due to the fiscal adjustment and, whereas Southern countries were barely able to balance payments, Germany increased its surplus to 7% GDP.

The crisis we are –still- suffering entails nominal debt balances (accrued during the market bubble) that require a monetary policy to sustain demand, and a fiscal policy as a bank rescue package.

To sum up, from the very start, euro’s institutions were poorly designed to slow down the banking crisis – unavoidable after the bubble, and were also unable to contain the bubble. Moreover, subsequent reforms were intended to create a “health cordon” that cut the tax burdens for Northern countries, which only came to the rescue ad hoc when they found their payment was threatened. But this measure does not really mend macroeconomic imbalances of EU Southern countries -quite the opposite.

There is a gap between the established policy and the macroeconomic imbalance, which may bring a long period of anaemic growth and high unemployment rates. Do they really think that it is enough the action of markets to overcome those problems when the interest rates among European countries are so different and the banking credit is decreasing?

European institutions are not European at all because they don’t have the assigned power necessary to operate as national institutions would.