At the heart of the Eurocrisis lies a vicious circle where once there was a virtuous one. Over the last week or two, the FT has been reflecting on the connection between the sovereign debt crisis and the bank crisis, conjoined twins (as George Soros has put it) of the current Eurocrisis. See here, here, here.
Historically, banks have stepped in to help sovereigns in their time of need, such as the stresses of war finance, by expanding their own balance sheets, offering bank liabilities (money) in exchange for sovereign debt that has no alternative ready market.
Contrariwise, sovereigns have stepped in to help banks in their time of need, offering central bank liabilities (reserve money) in exchange for bank debt to allay periodic liquidity crises, and sometimes going so far as to offer sovereign Treasury liabilities in exchange for bank equity issue that has no alternative ready market.
The problem Europe now faces is that monetary union, a fait accompli, left in place the historical symbiosis between national banking systems and national sovereignties, as well as the pattern of thinking formed by generations of experience with that symbiosis. As a consequence, when the crisis hit, national banking systems stepped in to help their national sovereigns, and national sovereigns stepped in to help their national banking systems.
Both thought they were doing the right thing, based on past experience. But the consequence has been to transform isolated sovereign debt crises into systemic bank crises, and to transform isolated national bank crises into systemic sovereign debt crises. What started as a problem of the periphery (the famous PIIGS) is now threatening the very core of Europe, both sovereigns and banks. The ongoing run on Greece et al. is now threatening to become a run on Europe, both European sovereigns and the European banking system.
The problem is that banking is no longer national, and neither is sovereignty.
Calls for “fiscal union” are calls for replacing lost national sovereignty with something new, supra-national sovereignty. The EFSF, and then the ESM, were supposed to be steps on the road toward a common European Treasury, and a common European sovereign debt (Eurobonds and Eurobills). Maybe it could work, from an economic point of view, but by now it looks like too big a step to be achieved in the time available, from a political point of view. Angela Merkel is not wrong when she says we are in a race between politics and the market, and we know which one of these is the hare and which one the tortoise.
That is the background needed to understand properly the shift, in recent weeks, toward focus on “banking union” instead. But old patterns of thinking still stand in the way. If you think of banks and sovereigns as inherently symbiotic, then it is hard to conceive of banking union without fiscal union, and vice versa. (See here the FT article today that finally inspired me to put my developing thoughts on the record.)
Here is the main point. History tells us that there is nothing inevitable about such a symbiosis. Banking, indeed even international banking, existed long before the modern nation state. The origin of the lender of last resort function of the modern national central bank is in the operation of private bankers’ banks. (In the US, before the Fed there was J. P. Morgan.) There is no logical, or economic, necessity for sovereign backstop of banking. It follows that there is no logical, or economic, necessity for fiscal or political union to precede, or even coincide with, banking union.
Of course today the balance sheets of European banks, including the ECB, are stuffed with sovereign debts of one kind or another, and that fact by itself makes it hard to think about banking union without fiscal union. But let’s try, as a little thought experiment.
Let us imagine a special purpose vehicle, a private vehicle without supra-national backstop, which issues its own private securities of various types and uses the proceeds to buy sovereign debts of various types. (For those who remember fall 2007, think of it as an analogue to the super-SIV idea, except that the assets are sovereign debts rather than tranches of securitized subprime mortgages.) In this way, sovereign debt could be removed from the banking system and replaced with cash, which (suppose) banks use to repay liabilities so shrinking their balance sheets by the size of their debt holdings. No doubt some banks would still be in trouble, but we can imagine banking union proceeding as the Europe-wide solution to that remaining trouble.
But wait, you say, what about deposit insurance, currently national and so currently a second channel of lethal embrace? But this is just another asset of the bank and another liability of the sovereign. Since we are just thinking, let’s imagine that we place a market value on this asset and have the SPV buy it as well. Note that, by making this implicit asset explicit, bank capital will be increased. Even so, no doubt some banks would still be in trouble.
The point of this thought experiment is to enable us to think separately about the sovereign debt crisis and the banking crisis, and to conceive of the possibility of addressing each separately. At the end of the day we will be left with a range of private banks, some insolvent, some merely illiquid, and perhaps a few that are okay. That is one side of the problem. And we will be left with our SPV; that is the second side of the problem.
But, most importantly, we will also have broken the lethal embrace. Investors who are thinking about lending to private banks, or perhaps taking up a new equity issue or taking over the existing equity ownership, can form estimates of value without having to consider the fortunes of the bank separately from the fortunes of the sovereignty where that bank has its headquarters. And investors thinking about lending to a sovereign, or perhaps taking up the securities issued by the SPV, can form estimates of value without having to consider the fortunes of the banking system that happens to be headquartered within the national boundaries of that sovereignty.
If we think the lethal embrace of banks and sovereigns is currently taking both down together, then breaking that lethal embrace should improve the fortunes of each separately. It’s a win-win.
Historically, the origin of the embrace between sovereigns and banks was pragmatic. They did it because it was a win-win. Today it looks like the win-win involves dissolving the embrace.