For nearly two years Eurozone governments have been fighting a crisis in the sovereign debt markets. New instruments and institutions have been designed but have failed to bring about an end to the panic. At first glance this is not surprising as the governance of the Eurozone, as enshrined in the Maastricht Treaty, is something of an oddity. When it comes to financial stability, its peculiarity can be summarised by noting that Eurozone governments issue bonds in domestic currency without having access to a lender of last resort (De Grauwe 2011).
Financial history suggests that this governance structure is fragile. As evidence, we can look at the series of financial crises in the nineteenth century when banks, performing maturity-transformation services, operated without a central bank. Most prominently, this was the case in the US, a latecomer among today’s mature economies in establishing a central bank. As a result, when facing financial turmoil US banks made use of clearinghouses as a co-insurance mechanism. To fight financial panic, clearinghouses issued loan certificates jointly guaranteed by all member banks to refinance weak member banks. Thus, they co-insured debt and replaced the open capital market with an internal one. The main motivation for transforming the clearinghouse into a co-insurance mechanism was to fight the risk of contagion from weak to strong institutions. This is also why in a crisis no member bank was allowed to fail even if it was insolvent. It was feared that any incident of insolvency would confirm the very concerns of depositors and other bank investors that had triggered the turmoil in the first place and would deepen the crisis. At the same time, the support by fellow member banks to weak institutions was not free. Banks receiving loan certificates had to place collateral and were put under a special regulatory and monitoring regime.
On several occasions clearinghouses proved quite successful in containing financial panics by jointly producing confidence. However, there were also incidences of failure when the crisis response was too late, too timid, and incoherent. This was because strong member banks faced a conflict of interests: on the one hand they wanted to contain contagion effects, on the other hand crises were also perceived as opportunities to reduce the number of competitors by refusing to issue certificates. Policymakers addressed this inherent weakness by founding the Federal Reserve as a proper lender of last resort and by putting it in charge of safeguarding systemic financial stability.
Given the Maastricht Treaty design and the no–ECB credit clause, Eurozone governments were the modern equivalents of US banks in the 19th century. However, at the beginning of the crisis strong member governments refused to set up a co-insurance mechanism as it would run counter to the no-bailout clause of the Treaty and would ‘socialise’ debt (Sinn 2011) thereby undermining the disciplinary forces of the market. With many economists explicitly dismissing arguments related to liquidity and contagion (Bindseil and Modery 2011), governments decided to manage the Greek debt problem through the lenses of a pure solvency issue.
Investors responded to this course of inaction in a way US banks were well aware of when operating under similar conditions 150 years ago – they took their money and ran. In other words, they sold Greek bonds and decided not to renew credit. Moreover, with contagion kicking in, this not only involved Greek bonds, but also the bonds of other Eurozone member states. Thus, Eurozone governments were forced to choose between financial collapse and moving towards a co-insurance mechanism. Finally, in May 2010 governments opted for the second alternative and established the European Financial Stability Facility (EFSF) and at a later stage the European Stability Mechanism (ESM). Replacing ‘clearinghouse loan certificates’ with ‘EFSF or ESM loans’ and substituting ‘conditionality’ for ‘a special monitoring regime’ transforms the historical US experience almost 1:1 into current EU crisis policies. The adoption of euro bonds would be the exact equivalent of what US banks did to fight a crisis of confidence.
However, the move towards co-insurance was not only slow, but also timid and incoherent. It was timid because the support was limited in volume and time; it was incoherent because governments insisted on the involvement of private creditors in any possible future debt restructuring. By doing this, policymakers reconfirmed the concerns of investors which had sparked the crisis and which the EFSF and ESM were aimed at mitigating.
Indeed, strong member states have tried on various occasions to limit the exposure of their taxpayers and to backtrack from the move towards co-insurance. This was the case when
Germany and France agreed on a framework for the involvement of the private sector in autumn 2010,
European leaders decided in March 2011 that the ESM should operate with a preferred creditor status (which was later revoked),
Governments neither agreed on the issuance of euro bonds nor on a significant expansion of the EFSF in July 2011.
In all cases these attempts have been self-destructive and destabilising: yields soared and the need for government intervention rose further.
The timid and incoherent move towards a co-insurance mechanism has steadily put pressure on the ECB to make use of its lender-of-last-resort capabilities and to intervene in government bond markets. Thus, the fragile and decentralised fiscal foundation of the Eurozone, along with the lack of political will by European leaders to evolve in this respect, have been major triggers of the very “politicisation” of the euro many deplore (Issing 2011). Of course, the examples of the US and the UK, where central banks intervened in government bond markets under different conditions, suggest that in the aftermath of a severe financial crisis it may actually be impossible to avoid joint and overlapping action by monetary and fiscal policy. However, the lack of a robust co-insurance mechanism in the Eurozone implies that the interventions by the ECB come in the worst of all possible forms. This is because by intervening the ECB exposes itself to the specific credit risk of weak Eurozone member states only and not to the much stronger credit risk of the Eurozone as a whole. This explains why on the one hand the ECB has been hesitant in applying the Bagehot principle of “lending freely” in government bond markets and on the other hand has been a strong supporter of enhancing the co-insurance mechanisms established, for example by calling for an ESM that can operate as flexibly and as strongly as possible.
At the same time, it has to be acknowledged that the co-insurance mechanisms established today, ie the EFSF and ESM, are more fragile than in the case of US banks 150 years ago. This is due to the (1) the long-term nature of the liabilities to be co-insured, (2) the elusive character of the ‘asset’ backing these liabilities, namely the willingness of the taxpayers in the crisis countries to honour their commitments, and (3) the substantial moral hazard risks arising from both characteristics as well as the political environment in which the co-insurance mechanism is placed. Thus, a substantially more comprehensive fiscal and economic union is needed to address these fragilities and stabilise the Eurozone (Trichet 2011). This is not a new idea. Already in 1990 the Bundesbank argued that a political union might be a prerequisite for the smooth functioning of European monetary union. The crisis and the comparison with the crisis response by 19th century US banks provide a new backing for this claim.
Bindseil, U, and W. Modery (2011), Ansteckungsgefahren im Eurogebiet und die Rettungsmaßnahmen des Frühlings 2010 (Risks of contagion in the Eurozone and the rescue packages of spring 2010), Perspektiven der Wirtschaftspolitik, 13(3): 215-41.
De Grauwe, P (2011), “Managing a fragile Eurozone”, VoxEU.org, 10 May.
Issing, O (2011), “Slithering to the wrong kind of union”, Financial Times, 8 August.
Sinn, HW (2011), Interview in Het Financieele Dagblad, 4 February.
Trichet, JC (2011), “Building Europe, building institutions”, Speech on receiving the Karlspreis 2011 in Aachen, 2 June.
Winkler, A (2011), “The joint production of confidence: lessons from nineteenth-century US commercial banks for twenty-first-century Eurozone governments”, Financial History Review, 18(3): 249-76.