The origins of the Eurozone Crisis and Banking Union
by George Hatjoullis
The origins of the eurozone crisis lie within the Maastricht Treaty. It connected a subset of EU states through a common monetary policy (EMU) and made no treaty provision for fiscal coordination. This lack was papered over by the Stability and Growth pact (http://bit.ly/199QLRy), which took its legal authority from the Treaty on the Functioning of the European Union (TFEU).
The markets were at first sceptical of the EMU project but later warmed to it and priced eurozone sovereign debt as if it was guaranteed by some overarching EU body. It took the debt crisis in Greece to explain to the markets that it was not so guaranteed. Worse still, it became apparent that the Maastricht treaty precluded the possibility of a collective EU institution providing assistance to debt-ridden sovereign states within the eurozone. The crisis management mechanisms have so far been constructed as bilateral commitments from member states. No single eurozone member is liable for all other eurozone member state liabilities. Individual commitments to crisis management mechanisms such as the EFSF and ESM are limited by design.
The only institution that is genuinely a collective eurozone entity is the ECB. This is why ECB action under the crisis has been so closely scrutinised by the German Constitutional Court. The Court has been at pains to make sure that the ECB did not act in a way that implied a collective bail-out of the debt-ridden states. The ECB has been quite creative in this respect and has provided considerable collective assistance under the guise of monetary policy and of repairing the monetary transmission mechanism. The Outright Monetary Transactions (OMT) programme has been a particularly effective innovation.
The objective of Berlin has been to avoid the crisis becoming an excuse to move from bilateral action to official collective action by EU institutions. Collective actions would make, implicitly or otherwise, each member state jointly and severally liable for other member states. If a collective framework emerged then eurozone sovereign debt would become mutual and the liability of all eurozone states. This is what the markets originally thought was happening which is why they allowed countries such as Greece to borrow excessive amounts at very low-interest rates. Such mutualisation carries with it the risk of moral hazard and the behaviour of many member states in the early years of EMU suggests that moral hazard is a very real issue for the eurozone.
Germany, as the wealthiest member state, took control of the crisis (excluding France) and made avoiding moral hazard its main target. Hence all responses have been structured as bilateral arrangements. This is not to say that Berlin will not ever countenance a collective structure. However, it will not do so until it believes it has put into place safeguards against moral hazard.
The main innovation from Berlin is the Treaty on Stability, Coordination and Governance in the Economic and Monetary Union or the Fiscal compact for short. This is an international intergovernmental Treaty and outside of the EU legal framework. It nevertheless binds those ratifying to a Berlin-approved fiscal framework and ratification is a pre-condition for access to some bilateral eurozone arrangements (like the ESM). The intention is to incorporate this treaty into the EU legal framework but of course that will require the unanimous agreement of all EU states.
The existence of the fiscal pact reveals a fundamental problem in the EU. There is a subset of member states, the eurozone, with different needs. The EU legal framework is set up for all member states, including non-eurozone. To resolve this requires some significant treaty change and treaty change must be unanimous. This is a politically complex situation and lies behind the clumsy and cumbersome manner in which the crisis has been handled.
The same problem is now evident in the debate on banking union. The union requires a single supervisory mechanism (SSM) for banks. All banks in the union should be bound by the same rules and be supervised by the same entity. Troubled banks must be resolved in exactly the same manner by this authority so there is a need for a single resolution mechanism (SRM). Finally, there needs to be a central fund to finance these actions, namely a single resolution fund (SRF). All three must operate above sovereign states and the single supervisory authority must be able to intervene in member states independently of the views of the government of that state.
Such an arrangement effectively mutualises banking risk across member states. It raises a lot of questions. Will individual member states be willing to give up supervisory control of their own banking systems? Indeed in this framework there are no national banking systems, only EU-wide. The second question is the source of the SRF. The plan is for a levy on banks in the same manner as say the FSCS. Such a levy is sufficient for individual bank problems but what happens if a systemic crisis arises? Will an EU-wide body act to avoid systemic failure in the way the UK government used tax payers money to save the UK system? If so is this not a form of sovereign debt mutualisation? Finally, there is the nature of bank resolution. The Cyprus crisis revealed that the prospective banking union will place senior bond holders and uninsured depositors explicitly at risk in the SRM. They have always been implicitly at risk (that is why the deposits are called uninsured) but it has been rare to bail-in uninsured depositors in the manner we have seen in Cyprus. It will no longer be rare. This may have important implications for financial centres such as the City of London.
The important point however is that this total framework cannot reasonably be expected to operate on an intergovernmental basis. The SSM has been advanced within the Treaty of Lisbon. However, the SRM and SRF may prove more problematic.These steps may require changes to the Treaty of Lisbon. Good luck with that. The likely result will be that banking union may be less smooth in its manifestation than many seem to assume. It essentially mirrors the fiscal union issue and it is unlikely that one can be resolved without the other.
My own personal view, for what it is worth, is that the EU project has reached its day of reckoning. An EU consisting of euro zone and non-eurozone is no longer possible. The direction is now for EU institutions to evolve to serve the eurozone and for non-eurozone states to be marginalised. The eurozone structure will also become ever more integrated and reflect a fiscal framework that is a direct copy of that of Germany. Mutualisation may eventually occur but not before all members have legally enforceable budget constraints built into their constitutions. Talk of repatriation of powers by the UK is so much subterfuge. The UK faces a straight in or out choice. Moreover, ‘in’ now means joining the euro.