Note: This essay, originally posted in 2012, grew out of a correspondence with a dear friend, Willem van Hasselt of the Dutch Ministry of Foreign Affairs, who sadly died in June 2014. It is now dedicated to his memory.
John Nugée, July 2014
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the message was lost.
For want of a message the battle was lost.
For want of a battle the kingdom was lost.
This traditional proverb, which was certainly known in the 14th century if not earlier, shows the major consequences that can arise from seemingly unconnected events, and how things that are on the surface safe and secure can be brought down by something remote and insignificant, through a chain of cause and effects. In this essay, we will apply this form of analysis to the European Crisis, with the intention of illuminating some of the connections which are in play and what the possible end game of the Crisis might be.
The Currency Union
We start with the most basic and visible form of Europe’s Economic and Monetary Union (EMU), the Currency Union. The Currency Union is the common banknotes and coins used throughout the 17 states of the Eurozone, and, as even EMU’s harshest critics will admit, it has been very successful. There really is no perceived difference between coins issued by the various states – there is no national preference in the use of the coinage by the general public in any country, no singling out of Greek euro coins as less acceptable – and there is no difference between the banknotes at all. Even the different serial letters on the notes, which indicate which national central bank has physically issued each note, are in fact of no greater significance than this minor administrative point: a note issued by the Bank of Greece, say, is not an obligation of the Bank of Greece alone but a joint and several liability of the whole Eurosystem.
This is not a negligible achievement, and is a more complete currency union than the United Kingdom, for example, has created even today, with the everyday notes in two parts of the UK (Northern Ireland and Scotland) neither legal tender nor readily accepted across the whole of the sterling monetary area.
The Monetary Union
The Currency Union, therefore, works. But it only works because of this joint and several liability for the notes and coins, and it relies on the Eurosystem and the links between the national central banks (NCBs) to effect this. In short, it relies on the Monetary Union – the single central bank, the unified monetary policy, the single money market, and the inter-NCB payment system TARGET2 which facilitates the transfer of payments around the Eurozone.
Like the Currency Union, the Monetary Union works. The ECB is a very effective central bank, the Eurosystem operates one undivided monetary policy and money market, and the payment system is entirely successful in ensuring smooth payments across the Eurozone. It is as efficient, quick and cheap for a bank in Portugal to transfer assets to a bank in Cyprus as it is for it to make a transfer to another Portuguese bank. This degree of success and unification proved beyond the Latin Monetary Union[1], for example, and beyond the US monetary union until after the creation of the Federal Reserve.
The success of the Monetary Union as an administrative operation is undoubted, and a considerable achievement which should not be understated. Again, the comparison with the United States is illustrative: the Eurozone has a more complete monetary union than the US achieved for over 100 years: the US had one currency (the dollar) from the outset, but for many years it had multiple banking and monetary systems, and even after the Federal Reserve was created in 1913 it took time for the various reserve banks to come together and create a truly unified single monetary area.
The Economic Union
But, as the founding fathers of EMU knew well, technical administrative competence is not enough to preserve a monetary union. There is an extensive literature on optimum currency areas and the requirements for a durable monetary union, but in essence there is agreement that a monetary union without some form of economic union supporting it will not prove resilient to external shocks. The reason for this is that without the economic union to bind the economies of the constituent parts together, an external shock is likely to affect the component states of the monetary union in different ways and make a uniformly effective response from the monetary authorities impossible to devise.
The form the economic union to support a monetary union should take has several possible components, but most experts are agreed that it should at the least entail the free movement of goods and services, of labour (people) and of capital (money). Again, the EU has been fairly successful here in creating the support required for the Eurozone to function as a single currency area. There is free movement of goods and services across the Eurozone – in fact across the whole EU – through the Single Market, and it works very well. There is also free movement of labour, at least in theory, and if people are perhaps more reluctant to move across national boundaries in Europe than they are to move across state boundaries in the USA, this is only a matter of degree and for many commentators, the amount of labour movement between countries in the EU is surprisingly high rather than the opposite.
But it is the third freedom of movement, the movement of capital, which is currently the weak link in the Eurozone. The lack of confidence in banks and banking systems generally in the Eurozone is stifling the free movement of money between banks, and increasingly is driving financial actors to seek to match their assets and liabilities not on a Eurozone-wide basis but on a country by country basis. This is unpicking the unity of the Eurozone’s banking system, which is increasingly coming to resemble not one common unified system but a network of linked national banking systems.
This is what lies behind the current talk of a banking union, a term which has moved from non‑existence to prominence in an extremely short space of time, and to which we must now turn.
The Banking Union
The term Banking Union is so new that it does not exist in the standard reference books, or even in the online dictionaries. But its meaning is clear: in a banking union, the banking system is unified. This implies that banks have a common regulator, common financial social insurance (for example a deposit insurance scheme and, in times of stress, state underpinning), and in the last resort, a single resolution mechanism for failing or failed banks. In short, in a banking union, the interaction between the banks and the authorities, whether as regulator, insurer or liquidator, is the same for all banks in the union.
It is clear that under this definition, the Eurozone does not have a banking union. Although there is a single central bank money market for monetary operations, and although (as we have observed) there is a true Eurozone-wide payments system, the banking system is not yet unified across the euro area. The banking systems of Europe – the plural is intentional – are linked but not yet unified; they have not yet fully escaped from their national roots and constraints. The EU’s passporting system may allow authorised EU banks to operate anywhere in the Union[2], and the new European supervisory agencies ensure that they are regulated on a Union-wide basis, but in a crisis, the support and underpinning for the banking system remains a national one. And there is no unified resolution mechanism at all: when a bank fails it is entirely for that bank’s national government and national judicial system to resolve the ensuing claims.
The result is that when doubts are expressed about a country’s banking system, the degree to which those doubts can be met and confidence rebuilt is intricately linked to confidence in the national finances of the country concerned. And in the weaker states of the Eurozone, that confidence is currently in very short supply. Hence the toxic combination of weak banks weakening the state and the weak state in turn undermining confidence in its banks.
To resolve this – to build the banking union that the economic union needs to prosper – requires both financial and legislative action. On the legislative front, there is a need for a common regulatory regime for European banks while they are alive, and also a common resolution regime for failed banks. The first is “work in progress” – actually, the progress has been very good and the new EU-wide banking regulator, the European Banking Authority, is making its mark commendably fast – but the second is much more complex and progress has not been as complete as many would hope.
A Fiscal Union
But it is the financial side of a banking union which poses the challenge. Any common deposit insurance scheme will require common Eurozone-wide funding to support it, and any official underpinning of banks under stress (for example injection of new share capital) carries with it a fiscal dimension for which there is as yet neither the administrative mechanism to deliver it nor the political will to support it.
In effect, for the financial side of a banking union to be effective and solid, it requires the banking union to be part of a wider and deeper fiscal union. But any move towards creating such a structure (for example through common eurobonds, fiscal transfers between states, or even a common treasury), will raise major issues of sovereignty, taxation powers and democratic oversight and it is far from clear that the various states of the Eurozone are close to agreement on how this is to be achieved or even whether they want to.
Indeed it is not too much to say that many in Europe’s political class are not so much “undecided as to whether they want a fiscal union” as “decided that they do not”. And without doubt the electorates of Europe have never expressed any desire for one. And this is for a very good reason: a full fiscal union implies a full political union.
Towards a Political Union?
This may seem a somewhat absolute statement. But taxation is the heart of the contract between a people and their government, and the right to tax is the very essence of sovereignty. Furthermore, on the issue of monetary unions, history is quite clear: the successful monetary unions of the past are either made up of small countries borrowing the currency and so credibility of a large country, or of similar sized entities bound together by political union. In considering the case of the EU and EMU, the first is not relevant (Germany is not big enough relative to the rest of the Eurozone to play the part of “the large country”), and we are left with possibility that the Crisis may require some form of political union, of pooling of sovereignty, before a stable solution is found.
This is the truth that the EU’s political class has been fighting for the last two years. Ever since the Crisis started, it has been clear that there are and always have been two corner solutions to the crisis: full political union in a federal state or full collapse of EMU and a return to national currencies. Both are stable endpoints (in the sense that the Eurozone crisis would be resolved one way or another), but for the political class, neither are remotely attractive. And for over two years now, they have therefore been searching for an intermediate solution which shored up EMU without requiring an unacceptable amount of pooling of sovereignty.
But that search has still not yielded success. And the thought is beginning to dawn that it may never do so, and that while political union between the states of the Eurozone would undoubtedly be sufficient to preserve EMU, it may in fact also be necessary.
For want of a nail …
If we take it that no country in the EU wants to or is ready to move towards full federal union (and there is no evidence that any country does want to), then a political union cannot be brought about. There is insufficient political will to build it, and insufficient electoral support for it to survive and prosper even if they did.
But without a Political Union the Fiscal Union cannot be created
… And without the underpinning of a Fiscal Union the Banking Union will be incomplete
… And without a Banking Union the Economic Union will be weak
… And without a strong Economic Union the Monetary Union will be compromised
… And in due course the Currency Union will collapse
… And, in the words of the proverb, the Kingdom will be lost.
We have indeed returned to the old proverb we started with, with its stark conclusion. But time is running out for Europe to find a different path to a happier ending.
[1] A 19th century attempt to provide a zone of currency stability in Europe and in some ways a precursor to EMU. It flourished in the last quarter of the 1800s, and included an agreement to issue coinage to agreed specifications which was in theory usable in any member state. But it failed to graduate from a currency union to a full monetary union, and in particular had no single central bank or common money market. It was fatally weakened by the First World War, and although it staggered on until 1927 it was in practice non-operative well before its formal demise.
[2] More correctly, the passporting system operates across the whole European Economic Area or EEA, which consists of the 27 nations of the EU plus Iceland, Norway and Liechtenstein. Switzerland (not a member of the EEA) has its own separate access treaty with the EU for its financial institutions.
A version of this essay was also published by State Street Global Advisors as part of their Insight programme