But that policy is very short-sighted, with severe economic consequences, which brings us to the second question. The fiscal compact and its predecessors brought austerity, which had a devastating and lasting impact on gross domestic product. This banking union will produce the financial sector equivalent of austerity – a secular credit crunch.
To see this, one needs to understand how banking union is going to work. The European Central Bank, in its role as supervisor, has started a comprehensive assessment of the banking sector. As part of this exercise, it assesses financial risks, takes an in-depth look at balance sheets, and subjects banks to stress tests. This exercise is going to end with a demand that some banks raise their capital.
But without a common fiscal backstop, it lacks credibility. The ECB will be in no position to demand that banks raise capital if there is no backstop. It would risk financial instability if it exposed a bank as undercapitalised that has no access to outside capital. The resolution fund will not be able to help because it will not be fully mutualised for a decade. At the start all risks will remain within the member states.
Unlike the Federal Deposit and Insurance Corporation of the US, the eurozone’s resolution fund will have no credit line.
The ECB thus has every incentive to fudge the exercise. This is possible because reviewing a bank balance sheet or a stress test is no exact science. The key variable is the assumption made about the future.
Unfortunately, a fudge does not change the dire economic reality. An exercise in ending the credit crunch in the banking sector will actually prolong it because the recapitalising banks in the periphery will be put on ice due to a lack of funds.
Economically, this is 1990s Japan all over again, probably worse given the periphery’s dire economic state. The banking system in the eurozone will not be able to supply the economy with sufficient credit, except in creditor countries. The economic consequences of what finance ministers hailed as a “historic” decision will be substantially negative.
The periphery finance ministers who accepted this deal know all this. They are not stupid. And still they are not acting in their best interest. If your policy consists of keeping your head down, then perhaps this is the banking union you deserve.-- Richard O'Connell +34 666 24 1104