One of the interesting and perhaps sad lessons of last weekend’s mini-summit of European leaders in Paris is that Europe’s predicament has been made worse by allowing financial integration to run ahead of fiscal integration.
Financial integration got ahead of Europe’s governance capacity
The logic at the time was that financial integration would reinforce the single market and facilitate economic integration. The consequence is that Europe now has financial institutions that are large relative to individual member states. European financial institutions funded the acquisition of cross-border assets through the money markets (since regulators make it expensive to acquire deposits). Now the money markets have frozen and these institutions are too large for taxpayers in their home country to rescue.
Europe’s national leaders don’t have the tax base for a US-style bailout
Individual European states could not agree to a US-style bail out over the weekend because they do not have the tax bases to do so. The liabilities of Bank of America, the largest US bank by balance sheet, are approximately half of the annual tax revenues of the United States. That is a big ratio, but it is dwarfed by the ratio of liabilities to home tax revenues of Deutsche Bank at one-and-a-half times, and of Barclays at two times.
The currency markets have followed the scent of this fiscal issue ever since the US began considering Treasury Secretary Paulson’s Plan. The Euro lost 5% in a little over a week against the US dollar. But the problem may not be as bad as the currency markets think. Big government can make big mistakes. Far from enviable, the US approach may prove to be expensive folly. It is far from clear that Paulson’s Plan will trigger private investment into banks, and if there is none, US Treasury purchases of troubled assets above market prices is an expensive way to inject new capital into the banks. I suspect Europe will eventually stumble towards solutions to the credit crunch that are better for being constrained by Europe’s national budgets, but can nevertheless operate effectively at the European level.
Better than Paulson’s Plan: Capital injections and debt-equity swaps
One idea that is emerging from the weekend discussions is for European governments to offer an injection of equity capital into institutions that seek assistance. I would add that as a condition of doing so, they should negotiate a partial debt-for-equity swap of the bank’s creditors.
Getting sufficient capital is the problem that banks have today – we have moved on from the liquidity problem of the last eighteen months – and injecting capital is far less expensive than buying assets. The US is taking advantage of its tax base more than it should. Using the promise of an equity injection as a lever to negotiate a restructuring of bank debt will also help European taxpayers share this lower burden of bank rescues with bondholders. Recall that bondholders were paid to take the risk of bank failures.
Addressing government control issues with European-level institutions
Many thorny issues arise when governments start taking equity stakes in local banks. This is one of the reasons why the US authorities decided to be indirect and buy bank assets instead. But Europe has the potential to do this one step removed from national governments in a way that the US may not have been able. European governments can increase the capital subscription of the Luxembourg-based European Investment Bank to fund capital injections into banks. The weekend meeting already sanctioned a €30bn EIB fund to help small businesses hit by the credit crunch. While the process could not be de-politicised, the EIB or a new cousin can act more independently of national governments and more consistently across them.
Limits to global finance: The tax base
But the most interesting lesson of this phase of the crisis is that there is a greater limit to the globalisation of finance than we thought. The constraint is in a different direction than previously imagined – the taxpayers' guarantee.
This will cause a reappraisal of a few global banking brands. It also casts a new light on the viability of offshore financial centres. In Europe’s case, it either leaves financial integration plans in tatters, or it quickens the development of a European fiscal capacity. For good or for ill, I would bet on the latter. The history of European integration has been that the process routinely stumbles upon crises that threaten to destroy it, only to find that it has been deepened by the crisis. The euro’s arrival probably required the near collapse of the European Monetary System in 1992-1995.