Since the summer, the continuing installments of the Greek crisis have concealed a worrying process of fragmentation in the eurozone. Indeed, there are several grim indicators of this development.
First, the spread between banks’ borrowing rate and the zero-risk rate has been climbing since July. Financial institutions with liquidity increasingly prefer to deposit their cash with the European Central Bank, which has had to resume its lending to banks. The same thing occurred in the 2007-2008 crisis, though the shift is less acute this time, and is confined to the eurozone. In London and New York, the interbank market is still working; nevertheless, there is reason for concern.
Second, cross-border banks are charging higher interest rates to firms in southern Europe than they are to comparable firms in northern Europe, which is worsening the situation for crisis-hit economies. This fragments Europe’s supposedly unified market. And, instead of combating this trend, northern European regulators are amplifying it by limiting financial institutions’ exposure to southern European banks.
Third, international investors no longer view southern European government bonds as in the same asset class as northern European ones. This is not simply about the price of risk, which is easily reversible. It marks a deep change in attitude. If this lending approach to southern countries continues, their solvency and economic recovery will suffer.
Eurozone officials’ decision to reform the surveillance of governments and banks, and to boost the European Financial Stability Facility, is a welcome response, but, unfortunately, a partial one. Beyond firefighting, the key issue is the need to construct a more robust monetary union.
The eurozone’s creeping fragmentation is primarily the result of the mutual dependence of banks and governments. In the eurozone, banks are vulnerable to sovereign-debt crises because they hold a lot of government bonds – frequently issued by their country of origin. Governments, for their part, are vulnerable to bank crises because they are individually responsible for rescuing national financial institutions. Each episode in the current crisis illustrates the fragility caused by this interdependence.
There are three possible responses to this state of affairs. The first relies on intervention by the central bank in the event of a threat to the sovereign-debt market. The United Kingdom’s budget situation is worse than Spain’s, but the certainty that the Bank of England would prevent speculation on the UK’s debt is sufficient to reassure investors.
The ECB, however, has not been equipped with this mandate. It has played this role with Italy and Spain, but it has met stiff opposition internally and may capitulate soon. The newly-created European Financial Stability Facility may play a similar role, but its war chest is limited. As for changing the ECB’s mandate, Germany would protest, if only for constitutional reasons.
The second response consists in strengthening the banks through recapitalization, and removing the regulatory walls that separate national banking systems in order to limit overexposure to the risk of their own sovereign’s default. The eurozone would be healthier with a properly capitalized banking system that holds diversified assets and is subject to a common supervisory framework and deposit insurance. But European leaders may not be bold enough to embrace such a plan in full. This is likely to become clear when the details of the recapitalization program are revealed.
The third response is to reduce sovereign risk by establishing a system of surveillance and mutual guarantees between the eurozone countries. This would be tantamount to a fiscal union, which could be empowered to issue Eurobonds, coupled with ex ante control of the issue of public debt. Politically, this is a very tough choice, both for guarantor and guaranteed countries, but it is probably the most practical way forward of the three alternatives.
These responses are, of course, partly complementary. Even espousing one of them would be a positive sign. But ultimately, the challenge for Europe is to decide what to tell markets to give them a good reason to regain trust in the eurozone’s credibility.
By Jean Pisani-Ferry, Director of Bruegel, an international economics think tank.