By Stefano Micossi, Director General, ASSONIME; Professor, College of Europe. Cross-posted from Naked Capitalism
Some economists are approaching a consensus that the Eurozone’s financial architecture is now resilient enough to withstand another shock similar to that of 2010-11. This column argues that such a view may be overly optimistic. Economic and financial instability persists in member states and the banking sector, and institutions to tackle a shock remain incomplete. While the Eurozone remains vulnerable to a bad shock, the blanket application of burden sharing without consideration of current economic and financial conditions is unwise.
On 25 June, Vox published a column – “Making the Eurozone more resilient: What is needed now and what can wait”, signed by an impressive list of ‘Resiliency Authors’ – arguing that the Eurozone now has an adequate financial architecture for coping with another ‘bad shock’, and that what needs to be done “mostly [is] to make sure that the rules in place can be enforced” (Resiliency Authors 2016).1 I would like to explain why I feel that this view may prove optimistic and, more importantly, that the careless implementation of existing rules may become the very source of a new bad shock.
Is the Glass Half-Full or is it Half Empty?
The Resiliency Authors share the view that the Eurozone has not resolved the problem of risk sharing that lay at the root of the sovereign debt crisis of 2010-12. They recognise that the ESM is too small to provide sufficient resources in case of a shock hitting the sovereign debt of a large country such as Italy, while its decision-making procedures would not ensure the prompt action needed to stop a financial market rout. They also see that the Single Resolution Fund may prove too small to meet a major shock hitting a large cross-border bank or an important segment of a national banking system, but hold that in case of need the ESM would be allowed to step in. And they see the lack of cross-border deposit insurance (EDIS) as something to be fixed over time, but not urgent. In sum, the glass in their view is half-full, and they maintain that what we have is sufficient to rule out a new bad shock.
I rather see the glass as half-empty. I fear that the combination of extensive economic and financial fragility in some member states and large segments of the banking system on one hand, and an incomplete institutional set up on the other, create sufficient opportunities and incentives for financial investors to test the system’s resiliency – they may only waiting for some trigger to coordinate expectations, and then launch the attack (and the after-shocks of Brexit could well provide that trigger). Should that happen, a new bad shock could well arrive, similar to that of 2010-11.
Why Financial Stability in the Eurozone Cannot Be Taken for Granted
I see three main reasons why the Eurozone remains exposed to a new shock bad enough to endanger its survival. First of all, the re-emergence of severe stress in the Eurozone financial markets is likely to lead to the same acrimonious and publicly voiced disagreements on the source of the shock and its remedies as when the Greek public sector woes first came to full light in 2010. In this regard, failure to agree on working risk-sharing arrangements for sovereign and banking risks reflects fundamentally different, and indeed incompatible, views on the way to bring about lasting financial stability to the Eurozone. The latest manifestation of this is the recent decision by the ECOFIN Council to freeze ‘political’ negotiations on EDIS until “sufficient progress has been made on measures for risk reduction” and, furthermore, that any such negotiation will resume in the framework of an inter-governmental agreement, requiring unanimity, and no longer under the normal Community decision making under Article 114 (the legal basis for the internal market legislation). I view this decision as an official declaration that the sovereign-bank doom loop may restart at any time…