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As the European Central Bank (ECB) begins to tighten monetary policy, Ireland, as the famous band U2 once wrote, really is “stuck in a moment it can’t get out off”. With inflation at multi-decade highs (9.6% and rising), a worsening housing crisis, escalating public spending and full employment, the Irish economy is remarkably unbalanced.

However, unlike in the 2007 crisis, these characteristics are not unique to the Emerald Isle and the Mediterranean fringe. Rather, they are now shared by an increasing number of other EU member states. In Estonia, prices are rising at an annual rate of 22%. Eight other Eurozone states are now experiencing double-digit inflation. All the while, unemployment across the EU remains at historic lows.

A common narrative is that COVID, followed by war in Ukraine, has turbo-charged price levels. Spikes in energy and food prices are exacerbating the mix of excess savings and supply-side shortages deriving from pandemic shutdowns. The contribution of these events to current economic conditions is undoubtedly true. However, such an overwhelming focus on these risks ignores the longer-term underpinnings of Europe’s destabilising economies.

Namely, the Eurozone’s addiction to cheap money as the principal driver of its growth and investment.

Even before the February 24th invasion of Ukraine, inflation was becoming embedded across the Eurozone. In January 2022 – much to the increasing consternation of the “transitionary” inflationary brigade – price rises were already above 5% in the Eurozone. And these are inflation readings which continue to take no account of most households’ biggest cost of living expense – housing!

Even in that pre-Ukraine context, the politicisation of the ECB was clearly evident. President Lagarde’s view at the time that raising interest rates too soon risked “putting the brakes on growth” highlighted how political concerns have superseded the ECB’s core objective of maintaining price stability.

The scale of global monetary imbalances cannot be understated. The ECB and the Bank of England now account for nearly 40% of their own government bonds. In this world of puny yields “fund managers were effectively pushed into taking ever greater risks to deliver the returns that their end investors expected”.  The ongoing shake-out in the broader crypto-assets markets highlights just how skewed the risk-return trade-off has become.

And this rebalancing dance has only just begun.

Worse still has been the invocation of central banks – most notably the ECB – as agents of social change. The development of Frankfurt as a key facilitator in the battle against climate change has further diluted its focus on controlling inflation and further increased uncertainties in the financial markets. The argument is not that central banks should be detached from helping to tackle climate change, but that they are not the most effective, or appropriate, mechanism for doing so.

The cumulative result of these trends – greater politicisation and a widening scope – is the erosion of the ECB’s credibility in controlling inflation. As noted by Jürgen Stark and others, the ECB has “jeopardised its political independence and compromised its primary objective. Actions that are clearly intended to anticipate political pressure leave no doubt that it has exceeded its mandate”.

For the Eurozone, the implications will be profound.

Because, just like Ireland, the ECB now finds itself facing an intractable policy bind. In allowing inflation far above its 2% mandate, Frankfurt is seeking to soothe the political implications by deliberately lagging on raising interest rates in the hope of maintaining economic growth. But, just as Ireland discovered in 2007, the belief in a “soft landing” for the economy is more wishful thinking than sound economics.

There simply is no easy way out.

The result is an ECB that is now a prisoner of fiscal policy. A captive of its own member states with high debt, low growth and a tradition of unfinished reform programmes. And while this reality is the implicit rationale for the ECB’s current strategy, it belies a much wider structural problem. Namely, that the Eurozone continues to be characterised by weak potential growth, a Germany over-reliant on exports to China (and energy imports from Russia) and an unresolved “doom loop” between indebted governments and banks holding that debt.

Ultimately, the most far-reaching results of the ECB’s policy failures will be political. As evidenced in recent French elections, a prolonged cost of living crisis will sap strength from centrist parties, feed the political extremes on both the left and right and destabilise wider society. National elections in Italy in 2023 may well mark the beginning of the political fragmentation amplified by over a decade of easy money and limited reforms.

Back in 2012 former ECB President Mario Draghi calmed markets when he proclaimed he would do “whatever it takes” to protect the Euro. Unfortunately, the ECB seems to have lost any such commitment to controlling inflation.

Eoin Drea Banking Crisis Economy

The architecture of the original euro was flawed, and so was the commitment of the EU member states to abide by fiscal orthodoxy. However, both did convey sound monetary principles, these being (1) to preserve the purchasing power of the euro and (2) to isolate it as much as possible from political pressures.

As evidenced in the euro crisis, both EU member states and European institutions have committed to maintaining the euro via further integration and the growing centralisation of monetary and fiscal powers in EU institutions. The European Banking Union is one example of this commitment.

This article argues that these changes have paved the way for the creation of another modern-state currency: a currency that belongs to a supranational state and that is ultimately linked to an ever-growing supranational treasury that works hand in hand with the central bank. This article offers a more market-friendly monetary alternative to such an arrangement.

Read the full article in the June 2017 issue of the European View, the Martens Centre policy journal.

Juan E. Castañeda Banking Crisis Eurozone

The economic and financial crises evident since 2007 have refocused the debate as to the future structure of the European Economic and Monetary Union (EMU). This article looks at the issue from the perspective of economic history and identifies that current proposals for fiscal union are based on an over-reliance on Optimum Currency Area theory and are not realistic in the current political environment.

In addition, European fiscal rules have become over-complicated, inefficient and open to widespread manipulation. In the medium term, rather than risk the lessening of political commitment to the EMU through divisive fiscal union proposals, the EU should focus on developing unique governance mechanisms that better reflect the current characteristics of the EMU.

In this context, this article proposes four actions to complement existing initiatives such as the Banking Union: (1) simplified EU budgetary rules, (2) the creation of an independent European Fiscal Board to assess and enforce national compliance, (3) a commitment to retaining core national fiscal autonomy with a strict ‘no bailout’ rule, and (4) increased levels of investment through an expanded European Fund for Strategic Investments. Only following the successful completion of these measures should fiscal deepening be discussed at a political level.

Read the full article in the December 2016 issue of the European View, the Martens Centre policy journal.

Eoin Drea Banking Eurozone Macroeconomics

Joris Luyendijk was invited by The Guardian in 2011 to write a blog about the City of London and learn about the financial world. He did so for two years. Known in The Netherlands as a journalist and writer on the Middle East, he wrote a book entitled Het zijn net mensen (Hello everybody) in which he separated fiction from reality in journalism. Luyendijk himself knows little more about the financial world than we do and he had to find his way into the City to meet bankers, traders, analysts, brokers, lawyers, etc.

As an anthropologist he tried to go native in the world of finance. His book, translated from its Dutch title This can’t be true, is a summary from his blog for The Guardian, in which the mist of the credit crunch slowly evaporates. The reader gets a feeling of these faceless humans in their bespoke suits, its unwritten rules, taboos and hierarchies in this city that functions like a village or tribe. The book exposes the secrecy of the financial world and how it developed its own rules and (inter)national laws. The bankers’ personal opinions give the reader a human feeling of a world that is often considered in the popular media to be made up of little more than incalculable economic theories.

The problem described in the book is the onset of the financial crisis in 2008, which according to his interviewees had, at it’s a core, a small group of projects and people. Even the people that were most involved did not expect this crisis to happen. Over lunches and glasses of wine, Luyendijk learns about the reasons for the 2008 crash in the financial world. A lot of profit making by traders and brokers was, and still is, based on short-term thinking. Job insecurity makes the bankers less involved with their bank and therefore they are not concerned with long-term consequences. The CEO’s of the big banks only seem to be interested in profits and have little care about the impact or consequences of their products. And all of these pawns play with other people’s money for banks that are listed and have grown so big that they have become too big to fail.

Everybody was shocked when the credit crunch happened, nations, consumers and banks all agreed that something had to be done to alter financial practices. But, years later it looks like it is business as usual notwithstanding the increased financial regulation imposed by both the EU and British authorities. The banks are still too big. The so-called Chinese walls that separate divisions within banks, and the many extra rules are still breeched.  And the same outrageous bonuses are back in the city. Bankers explained to Luyendijk that the caveat emptor, the contract law principle, of which the buyer should beware is still in a place. Hence, the buyer is responsible for any loss concerning the purchase, not the broker.

Joris Luyendijk ends his book the way he starts, with a story of him being on a plane when he sees a big flame coming out of the engine. He turns to his neighbous, but everybody tells him that all is well. He makes his way to the front of the plane and finds out that the cockpit is empty. The system with its perverse incentives is the problem and if we do not tackle the problem, 2008 will happen all over again. The increased financial regulation imposed in the EU since 2008 is only the first step in making the financial system safer for us all.

Pieter Habets Banking Crisis Development

Joris Luyendijk was invited by The Guardian in 2011 to write a blog about the City of London and learn about the financial world. He did so for two years. Known in The Netherlands as a journalist and writer on the Middle East, he wrote a book entitled Het zijn net mensen (Hello everybody) in which he separated fiction from reality in journalism. Luyendijk himself knows little more about the financial world than we do and he had to find his way into the City to meet bankers, traders, analysts, brokers, lawyers, etc.

As an anthropologist he tried to go native in the world of finance. His book, translated from its Dutch title This can’t be true, is a summary from his blog for The Guardian, in which the mist of the credit crunch slowly evaporates. The reader gets a feeling of these faceless humans in their bespoke suits, its unwritten rules, taboos and hierarchies in this city that functions like a village or tribe. The book exposes the secrecy of the financial world and how it developed its own rules and (inter)national laws. The bankers’ personal opinions give the reader a human feeling of a world that is often considered in the popular media to be made up of little more than incalculable economic theories.

The problem described in the book is the onset of the financial crisis in 2008, which according to his interviewees had, at it’s a core, a small group of projects and people. Even the people that were most involved did not expect this crisis to happen. Over lunches and glasses of wine, Luyendijk learns about the reasons for the 2008 crash in the financial world. A lot of profit making by traders and brokers was, and still is, based on short-term thinking. Job insecurity makes the bankers less involved with their bank and therefore they are not concerned with long-term consequences. The CEO’s of the big banks only seem to be interested in profits and have little care about the impact or consequences of their products. And all of these pawns play with other people’s money for banks that are listed and have grown so big that they have become too big to fail.

Everybody was shocked when the credit crunch happened, nations, consumers and banks all agreed that something had to be done to alter financial practices. But, years later it looks like it is business as usual notwithstanding the increased financial regulation imposed by both the EU and British authorities. The banks are still too big. The so-called Chinese walls that separate divisions within banks, and the many extra rules are still breeched.  And the same outrageous bonuses are back in the city. Bankers explained to Luyendijk that the caveat emptor, the contract law principle, of which the buyer should beware is still in a place. Hence, the buyer is responsible for any loss concerning the purchase, not the broker.

Joris Luyendijk ends his book the way he starts, with a story of him being on a plane when he sees a big flame coming out of the engine. He turns to his neighbous, but everybody tells him that all is well. He makes his way to the front of the plane and finds out that the cockpit is empty. The system with its perverse incentives is the problem and if we do not tackle the problem, 2008 will happen all over again. The increased financial regulation imposed in the EU since 2008 is only the first step in making the financial system safer for us all.

Pieter Habets Banking Crisis Development

There already have been two or three enquiries by outside experts into the things that went wrong in Ireland between 2000 and 2008, that led to the banking crisis.

Now that ground is being traversed again by a Committee of elected politicians.

What extra value can this Oireachtas Enquiry add to what has been found by the expert enquiries?

The crucial job to be done by the Oireachtas Enquiry is to discover whether, since 2008 and since the completion of the earlier expert enquiries, the Irish state and the EU, have done enough to prevent this sort of banking crisis happening here again. It is hard to see how the latter part of that task can be dealt without some input from the ECB.

Some may think a similar property led banking crisis is most unlikely. They assume everyone has learned the lesson, and that the memory of 2008 will stay fresh for decades to come .I am not so sure.

The present artificially low interest rates, and the lack of sufficient investment opportunities outside property could easily lead to another property bubble.

A recent paper by Larry Summers for the US National Institute of Business Economics suggests that we may be in for a very long period of low interest rates on a global basis,  combined with few opportunities for productive investment.

If that proves to be the case, the temptation for that cheap money again to seek returns by speculatively lending to buy property, in the hope of a capital gain, will be very strong.

We must not forget that it is really hard to apply the brakes during a boom, so we need to work on the road signals well ahead of time.

The reason it is hard to put on the brakes in mid boom is because so many people would lose if the boom stopped. If people have borrowed money on the assumption that property prices will continually rise, they will go bust if property prices stop rising. These borrowers will punish the politician or institution who stops the boom. In such circumstances, everyone (including regulators) will prefer to leave the blowing of the whistle, and the blame taking for the resultant property price decline, to someone else.

A similar problem would arise if a government decided to take the heat out of the market, by running an exceptionally large surplus of taxation over spending, instead of giving in to spending demands.

In politics, it is difficult to run a large budget surplus, as one will tend to have during boom, if there is one family without a house, one patient untreated by the health services, or one pay demand unmet. Anyone who urged the government to do that would be shouted down, by the very people who would subsequently condemn that government for letting the bubble develop.

The crucial task for the Banking Enquiry is to help Ireland develop institutions that will have the popular respect, and the legitimacy, to lean strongly against the wind of popular opinion during a boom, without doing so when the economy is not in a boom. This is an art, not a science. But if that is not done, we will have another banking crisis.

I do not believe we have such institutions in place yet. Even the new European Single Supervisory Mechanism for banks will be subject to political pressures from member states. The recommendations of the European Commission in favour of fiscal prudence are being undermined by some governments, and by much economic commentary.

Those who give bad news during a boom, put their careers at risk. In the pre crisis years in Ireland, an intolerance of dissent existed within the banks themselves, and within the in the institutions supervising the banks, including government.

Dr. Nyberg found that, in Ireland in pre crash period,

“A minority of people indicated that contrarian views were both difficult to maintain during the long boom, and unhealthy to present to boards or superiors. A number of people stated that had they implemented or consistently supported contrarian policies, they may ultimately have lost their jobs, positions, or reputations.”

Will that be any different the next time?

The Oireachtas Banking Enquiry needs to ask itself honestly, if enough has changed since 2008, to ensure that this sort of conformist response to a new bubble, would not recur in political parties, in the media, in the economics profession, in the Department of Finance, and in the banks in Ireland.

In other words, has Irish human nature, or Irish culture, changed sufficiently as a result of the experience of 2008, to avoid a repetition?  If it has not, new institutional structures are needed to safeguard against these weaknesses of human nature and culture.

Blaming individuals is all too easy, but devising new institutions that counter natural human instincts is very difficult indeed. But these are the questions that matter.

It is also important to look at the macroeconomic forces that led to the Irish property bubble.

We must remember that an infinite amount of credit, trying to buy into a finite commodity, developable land, is a recipe for disaster.

In the years before the crash, there was an almost infinite amount of credit on offer to buy into something that was in inherently limited supply, land on which property could be built.

A situation like this will always be volatile.

If the unlimited credit was, instead, able to find a home producing new products or new services, of which (unlike land) the supply was not inherently limited, there would be a much less volatile situation. But sufficient such opportunities may not be available.

As Larry Summers points out“it used to require tens of millions of dollars to start a significant new venture, but significant venture can be seeded(nowadays) with tens of thousands of dollars”.

This is because the big new ventures today are in software, which does not require big capital spending. In the past, the big breakthroughs were in the motor industry, steel, or aviation, which required huge amounts of capital.

If there is too much capital, and too few productive opportunities,the risk is that  all the cheap money, now being pumped into the system by the Central Banks all over the world to revive the economy, will find its way into another property bubble, simply because it will have nowhere else to go.

If this is so, a higher risk rating should be placed by the Central Bank and by the European Supervisor of banks on that portion of a loan that covers the value of the site on which a property is built. This is because, in an era of cheap money, site values are more volatile, and more subject to speculative pressures up and down, than any other subject of bank lending.

John Bruton Banking European Union

To many observers outside of Brussels the recent ratification of Banking Union by the European Parliament represents the final step in the EUs fractured response to the economic crisis. To some, the Banking Union, as is now being implemented, represents nothing more than a superfluous project which will make no practicable difference to weaker member states faced with collapsing banks in the future.

However, as noted by Geeroms and Karbownik (2014), the economic consequences of a euro zone without a Banking Union are significant. They illustrate that a Banking Union will help ensure the long term sustainability of the euro through a mechanism for dealing with asymmetric shocks. Citing the US experience they note that a Banking Union is a more important absorber of economic shocks than a fiscal union.

In this context, the development of the ECB as a single banking supervisor will play a key role in shaping the euro zones long term financial architecture. Although arguments continue as to the actual robustness of the forthcoming stress tests, the very existence of such a supervisory framework has already had an impact on banking operations. The raising of additional capital by many banks has been complemented by the raising of statutory capital requirements by national authorities. The ‘coco’ bond market (i.e bonds that either convert to equity or simply write down investors’ principal when a certain threshold is reached) has expanded dramatically as banks seek to absorb losses while simultaneously increasing their capital reserves.

Banking Union, specifically the creation of a meaningful European banking supervisor, has shown that financial regulation can have a direct impact on how major financial institutions operate. In this context, at least, it is clear that financial regulation can have a role in ensuring that the weak regulatory practices followed by Ireland and other member states in the past will not reoccur in the future.

However, an overlooked aspect of the European Parliament’s recent legislative package concerns the imposition of strict rules on high frequency traders (i.e. financial traders that use sophisticated technology to execute orders in fractions of a second). This practice has been the subject of recent controversy in the US where characterisations of these traders as ‘flash boys’ has been accompanied by serious accusations that such trading allows better access to information, thereby prejudicing traditional investors. These accusations are currently under investigation by relevant US authorities and follows the so called ‘flash crash’ in 2010 when a sudden drop in the value of the Dow Jones was at least partially attributable to high frequency trades.

The recently passed EU legislation also aims to prevent a repeat of these problems in Europe. Commissioner Barnier has noted that the recent regulations are among the strictest set of rules for high frequency trading anywhere in the world. Such rules will serve to protect the integrity of the European financial markets while maintaining the effective use of technology in financial market innovation. Combined with the coming into operation of the resolution mechanism of the Banking Union and the ‘bail-in’ concept regarding failing banks, the EU has significantly strengthened consumer (and national government) protections against collapsing financial institutions.

Financial regulation may be an overused term in the post-2008 political landscape, but the EU – through its recent regulatory package – has ensured that the mistakes of the past will stay consigned to history as Europe continues to build a stronger and more efficient regulatory environment.

Eoin Drea Banking Economy EU Institutions Eurozone

In 2001 the well-known American economist Rudi Dornbusch summed up the attitudes of U.S. economists to the euro with the phrase “It can’t happen, it’s a bad idea, it won’t last”. For Dornbusch, as for many economists at that time, the euro represented a misplaced political project without the required economic rationale. The outbreak of the global financial crisis in 2008 at first seemed to corroborate Dornbusch’s negative assessment of the euro’s prospects. It has added to populist arguments that the euro is reducing the competitiveness of national economies and is somehow contributing to the difficult economic conditions facing member states.

However, these arguments fail to recognise the real achievements of the euro since its introduction into public circulation in 2002. In 2014 the euro remains an enlarging global currency with an important role across the financial markets. In the period since the outbreak of the financial crisis in 2008, the euro and European Monetary Union (EMU) have provided a framework for supporting struggling economies while putting in place an institutional framework designed to strengthen the economic co-ordination of member states. Political parties advocating a euro breakup remain in a minority across euro zone members.

Overall, populist rhetoric against the euro are fuelled by frustration at the slow pace of institutional reform within the European Union (EU) rather than entrenched public opposition to a common currency. The debate on the euro in 2014 needs to be moved from a static, ahistorical analysis of the weaknesses of EMU to a forward looking debate on banking and currency structures in a post-crisis environment.

The actions of the European Central Bank since 2011 have been vital in convincing the financial markets that the EU will act to establish an institutional architecture capable of strengthening EMU. Although significant achievements have already been made in this context, particularly with regard to budgetary and economic surveillance processes, much more work remains to be completed.

In the short term it is vital that the first two pillars of a robust banking union – a single European banking supervisor and a single mechanism for dealing with failing banks – are both brought into operation as dual supports to the euro. Any delays beyond the end of 2014 in implementing a mechanism for dealing with failing banks will increase market uncertainty, reduce private sector investment and act as further drag on employment growth. Internal EU disagreements as to the exact structure of a bank resolution mechanism should not be allowed to distract from the imperative of acting speedily to introduce such a mechanism.

The history of monetary unions, particularly in the United States, highlights that institutional reform (and policy innovation) is a required element of responding to a banking crisis. In this context it is up to the EU itself to meet the challenges of monetary and banking reform. If this is successfully progressed in 2014 Dornbusch’s negative assessment of the euro’s prospects will be long forgotten.

Eoin Drea Banking Economy Eurozone Macroeconomics

The EU Summit last week discussed the digital economy, a youth guarantee, apprenticeships, and the European Semester. During the Semester, each EU state will have an input to the policies of each of the other states. Hopefully, they will learn from each other.

But it would be a mistake to think that the main ingredients of a solution to the economic problems of the countries of the eurozone will be found at European level, because the problems did not, in the main, arise at European level. Although they had the same currency, some countries did much better than others did. Between 2008 and 2013, the growth in the euro zone ranged from plus 6% growth in Slovakia, to minus 6% in Greece. Some countries (Bulgaria, Sweden and Germany) grew faster than the United States between 2008 and 2013, while most of the other EU countries saw their economies contract.

It is good that, at EU level, we will now, through the European Semester, have detailed peer review of one another’s growth policies, including market liberalisation, taxation and public spending. But it would be a great pity if this encouraged national governments to delegate strategic thinking, about how to maximise the growth of their own economies, to the European Union.

Growth promoting reforms, whether these reforms be

+ of professional restrictions,
+ of slow and costly courts systems
+ of welfare systems that penalise work,
+ of educational systems that leave too many 15 year olds unable to read properly,
+ or of public sector wage and pension policies that are unaffordable,

will all differ from country to country, and can only be made on a country by country basis. The EU cannot do that job for national governments. They must do it themselves.

EUROPE MUST TAKE RESPONSIBILITY FOR THE EUROZONE BANKING SYSTEM

The EU has some things it must do. It must set up a single banking system for the euro zone. Given that most money takes the form of bank credit of some kind, it makes no sense to have a single currency without a single banking system. It makes no sense either that, at the moment, a badly run, and possibly insolvent bank in a well run country can borrow much more cheaply than can a well run and solvent bank in a country whose public finances are in a mess. These things can only be put right by EU action. Nor is it right that European arrangements to deal with banking and currency problems should be held hostage to the decision of the constitutional court of one country (Germany).

THE NEXT GENERATION WILL BE LESS ABLE TO REPAY THIS GENERATION’S DEBTS THAN THIS GENERATION IS TO MAKE SAVINGS

I find the arguments against “austerity”, in countries whose governments are spending more than they are collecting, to be lacking in rigorous thought. If a state is spending more than it is taking in by taxes, to borrow more today is simply to decide to pass the “austerity” on to a later generation, and to do so with interest! As a result of compound interest, a future generation will have to repay a lot MORE that the present generation will have borrowed. But the next generation will be far LESS able than we are to meet our bills that this one is.

This is because, 35 years from now, there will be two Europeans at work for every European who is retired, whereas today there are four Europeans of working age for every European who is retired. Thus the future burden of debts taken on today will have to borne out of the earnings of a smaller number of working people than are at work today. And those working people will also have to provide for a larger number of retired people than this generation has to cater for.

I wonder what the anti austerity protesters think of that!

John Bruton Banking Crisis Economy Sustainability

I have just spent three days in Cyprus talking to political and economic figures in the island. I encountered a very strong sense of determination to overcome their present severe economic difficulties.

These difficulties arise from mistakes made in the banking sector, whereby very large overseas deposits (mainly from Russia) were invested by the banks in lending to the Greek private sector and in Greek Government bonds. Banks exposure to Greece totalled 28 billion euro, or 170% of the entire Cypriot GDP. This concentration of risks in one place was bad banking practice, in the same way that excessive concentration of risks in the construction sector, was bad banking practice in Ireland and Spain.

As in Ireland and Spain, Cypriot banks also lend unwisely in the domestic economy, fuelling a real estate bubble. Meanwhile, and partly as a result, the Cypriot economy also lost competitiveness.

The Cypriot Central Bank must accept a major share of the blame for this excessive concentration of risk. It did not use its power to stop it.

At European level, once Cyprus joined the euro, the European Central Bank also had a responsibility. Under article 14.3 of the ECB statute, national central banks are obliged to “act in accordance with the guidelines and instructions of the ECB”. And under Article 25.1, the ECB may also offer advice on the scope of national legislation for the prudential supervision of credit institutions”. It is open to question whether the ECB used these powers in sufficient time. ECB policy of saying that banks did not have to set aside reserves against holdings of government bonds artificially incentivised Cypriot banks to invest in Greek and other government bonds, and that distortion continues.

At the end of 2011, the EU/IMF/ECB found that the situation of the public finances of Greece was so severe that senior bondholders (whose position had been famously protected from haircuts by the ECB in the Irish case) would have suffer a 75% haircut. This created an immediately critical situation for the Cypriot banks. They lost 33% of their capital.

This crisis for the Cypriot banking system was known to the EU/IMF and to the Cypriot Government of the time of the Greek haircut. Apart from a temporary loan from Russia, little was done. The Cypriot Government of the time did not respond to suggestions that it apply for assistance in a timely way. Given the powers cited above, more could perhaps have been done to require the then Cypriot Government to act.

THE MYTH ABOUT RUSSIAN HOT MONEY

Meanwhile a press campaign was mounted to suggest that the Russian depositors in the Cypriot banks were tax evaders, money launderers, oligarchs or worse.

This campaign seemed to be designed to persuade public opinion that depositors in Cypriot banks were less deserving of protection than depositors in banks in Athens, London, or Frankfurt. In fact, little evidence has subsequently emerged to justify any of these stories.
And, indeed, there is a perfectly good, and legitimate reason for these Russian deposits in Cypriot banks.

Many Russian businesses did not trust their OWN legal system, and felt that their assets would be better protected in a country like Cyprus, with a common law legal system, and which was in the euro. But in March of this year, they were to be brutally disabused of the notion that euro zone banks were a safe haven. Eventually the problem was tackled, in March 2013, in an agreement by IMF, the EU, and the ECB with a newly elected Government in Cyprus, who had had little or no time to assess the options for themselves.

TROUBLING ASPECTS OF EU DEAL

The March 2013 agreement contained a number of elements that are troubling.

For the first time this century, depositors have had to take a haircut. This was a radical departure from previous policy.

The fact that this procedure was followed creates a new and permanent uncertainty for depositors who hold more than 100000 euros on deposit in any bank in the euro zone.

They now must, to protect their assets above 100000 euros, scrutinise the situation of their bank on an ongoing basis, and move money regularly out of banks that seem to them to be pursuing risky strategies. Some would see this as a market solution to bank supervision, but markets only work if there is full and timely information available to all marker participants. But most depositors will not have the requisite information.

For a retail bank depositor, who may have little financial expertise, getting the relevant information of the safety of banks, in which he may need to keep a deposit account, will be difficult and time consuming. The accounts of banks are often opaque and do not always tell the full story.
There will be a tendency to move money towards bigger banks, which will aggravate the “too big to fail” problem.

In the Cypriot agreement of last March, no haircut was, however, imposed on the depositors in the Greek branches of the Cypriot banks, and those branches were transferred to Greek banks. This inflicted additional losses on Cyprus, and is hard to justify, within a monetary union that comprises both Greece and Cyprus as equal partners.

CREDIT FROZEN FOR CYPRIOT BUSINESS

The Cypriot banking model of attracting overseas deposits has been destroyed, although Russians continue to invest and holiday in the island, which disproves the suggestion that they were all fly by night tax evaders and hot money merchants. . It would be interesting to know which country’s banks are now benefitting from these Russian deposits that were formerly in the Cypriot banks.

Meanwhile, viable Cypriot businesses, that were well capitalised and equipped with working capital before March, are struggling to access funds to keep going.

Deposits they could have used have been reduced by haircuts, and capital controls mean that what remains in their accounts cannot be used freely. Bank credit is frozen.

A Cypriot export model, to replace the old bank deposit led model, cannot be put in place without access to day to day funding.

I left Cyprus feeling that, if Cyprus did not constitute a mere 0.2% of the euro zone GDP, and was physically closer to the centre of Europe, it would not have been the subject of these radical experiments in European banking policy.

It would, instead, have been the subject of much timelier, and less harsh, actions by its partners. That said, none of the options were palatable. Asking Cypriot or European taxpayers to recapitalise the Cypriot banks would have not have been easy and might have set a dangerous precedent in place. But burning depositors is a bad precedent too, when restoring confidence is so important.

Of course, Cyprus must now abide fully by the terms of the March agreement, and, like Ireland, establish a good track record.

But if it does so, it should, like Ireland, see progressive easements in the terms of its bailout, so that its economy can be allowed to breathe again.

Meanwhile, the Cypriot horror story should remind us of the urgency of completing European Banking Union, including some form of mutual deposit insurance.

Europe also needs to develop automatic stabilisers to deal with the problem of asymmetric shocks to individual states, as suggested in a recent IMF paper on the euro.

Otherwise the European economy will continue to run at below capacity, at the very time when it should be running at full capacity, so it can build up surpluses to deal with the looming cost of ageing.

John Bruton Banking Crisis

Today, no one disputes that credit is vital for small and medium enterprises. Despite the momentum that big businesses give to our economies, SMEs are still the basis of the Spanish productive sector and the ones employing the majority of citizens in Spain and in Europe.

With the crisis, the challenges facing SMEs have become more pronounced. Not only because of the drop in sales as it is the case for other companies, but because of major difficulties in accessing credit. A few years ago, almost any solvent SMEs in Europe could take out a loan. However, the situation has changed and today, the financial market is “fragmented”. What do we actually mean with this? Simply that the criteria for accessing credit varies greatly across Europe. For example, an SME in Spain must satisfy vastly different criteria than an SME in Germany in order to take out a loan.. The result of this is that banks are failing to grant loans to companies in Spain, while similar companies in Germany are being provided with the credit they need. Moreover, even in cases where they can access loans, Spanish companies end up paying a hefty premium, estimated by Deutsche Bank to be in the region of three and four percent.

This fact is drowning many small and medium Spanish enterprises and therefore affecting the recovery of the country and of Europe as a whole. If SMEs do not have access to credit, their ability to run a business is severely impeded and this in turn has serious consequences on the employment situation and economic growth. We need to consider the different possibilities available to solve this problem. The ECB is expected to cut the interest rate by 0.5% in a few months. However, we have observed how a decrease in interest rates will not solve the fragmentation in the financial markets. We should therefore consider measures such as the ECB changing its collateral policy and authorising banks to use SMEs debt to access credit from the ECB. There is also possibility that the ECB could buy SMEs debt directly from banks in the periphery countries.

These measures, as opposed to low interest rates, would have a direct impact on SMEs, as they could access credit and thus bring us back to the path of growth. The two questions that will decide the future are: will Germany accept such measures? Will the ECB assume a role that it has until now refused? I have no doubt that something is moving in the ECB.

Pablo Zalba Banking Business Crisis Growth Jobs

All resolutions of banking crises involve imposing and sharing sacrifices. As far as possible, people should know in advance how sacrifices are to be shared. No way of saving is completely risk free, but the greater the risk, the greater should be the reward and vice versa. A high yield bond should be riskier than a low interest deposit.

It is on this basis that the terms of the proposed bailout of the Cypriot banking system should be scrutinised, because it illustrates how Euro Zone policy makers are thinking. The initially proposed bailout of Cypriot banks involved imposing haircuts of the depositors in Cypriot banks who have been covered by the deposit guarantee scheme, that is depositors with amounts less than 100000 euros. Whose idea was this? Setting aside the terms of a deposit guarantee like this would be a very serious step for Euro zone policy makers to have taken. It calls into question the integrity of deposit guarantees generally. That is hardly a good idea when we are trying to restore confidence in banks and rebuild their capital bases

SENIOR BONDHOLDERS TO BE PREFERRED TO DEPOSITORS?

According to today’s Wall Street Journal, an alternative to burning the guaranteed depositors was proposed by the IMF. This was “radically shrinking the two largest banks, including bailing in senior bondholders, and letting deposit insurance kick in. In that case, depositors in Laiki Bank and Bank of Cyprus would have faced losses of 30 to 40% above the insured 100000 euros.” It would appear therefore that an explicit legal guarantee of deposits is to be set aside so that senior bondholders and un-guaranteed deposits are to be reduced, or, in the case of senior bondholders, no haircuts. The net effect of this is that a deposit guaranteed euro in a Cypriot bank is not worth the same as a euro in a bank somewhere else in the eurozone.

This is contrary to the underlying principle of having a single currency. The philosophy behind the decision to afford protection to the position of the admittedly small number of senior bondholders of Cypriot banks at the expense of guaranteed depositors has yet to be explained. Senior bondholders are commercially well informed investors, depositors are not. Senior bondholders also earn a better interest rate than small depositors do.

SHOULD BONDHOLDERS OF BANKS BE PREFERRED TO BONDHOLDERS OF STATES?

It is also hard to understand why the EU policy imposed a haircut on the senior bondholders of the sovereign Greek state a few months ago, but it did not impose a haircut on the senior bondholders of private Cypriot banks, when that was suggested by the IMF. Indeed, part of the problem of Cypriot banks is that they were themselves senior bondholders of the Greek state, who suffered a haircut on those bonds as part of the terms of the Greek bailout. Who are the senior bondholders of Cypriot banks who are so deserving of 100% protection? Who are the big depositors whose haircuts were to be reduced by attacking the under 100,000 euro guaranteed depositors?

A credible and consistent banking system is essential to a modern economy. The EU is committed to establishing a banking union, including a single system for winding up banks and guaranteeing deposits. The precedents being set in the Cypriot case are important and, in my personal view, troubling. They do not indicate clarity or consistency of thought by either the eurozone, finance ministers, or the European Commission. The rejection of the deal by the Cypriot Parliament now gives eurozone policymakers a chance to think again about the underlying philosophy of their approach to the financial crisis.

John Bruton Banking Crisis European Union Eurozone

It has been five years since the banking crisis erupted in the United States. If, instead of boasting of having the most robust financial system in the world, the Spanish Government had immediately begun the process of restructuring its financial system, Spain would not have needed European aid to complete this arduous task. However, we should not cry over spilt milk. The important thing right now is to ensure that this type of crisis will never be repeated.

One year ago the Spanish savings banks finally acknowledged that they had serious problems after making excessive loans to the construction sector. Months later, problems with the saving banks turned into a government crisis: after injecting money into the financial system in order to save the banks, they continued to experience problems with financing because of the lack of trust of investors. This problem in countries like Spain and Ireland spread to the rest of the European Union. What started as a banking crisis ended up being a threat to the euro. It created a vicious circle between the banks, the trust in the Member States and the euro.

If we have learned anything from this crisis is that the architecture of the euro was flawed, since we created a monetary union with different economic policies and banking regulations. The result was that the citizens ended up paying for the banking disaster. Now we have the opportunity to change the structures supporting the euro which we were not able to be put in place at the time of its introduction..We are entirely committed to this task.

In order to do this, the European Parliament has been proposing to create a banking union for more than a year. The primary goal of this proposal is to protect taxpayers being forced to pay for the banking crises. Firstly, we need a single supervisor to ensure that all EU banks are supervised and they do not pose a risk to the rest of the banking system. This would guarantee that, for instance, a badly supervised saving banks in Spain or poorly supervised banks in Ireland would not pose a risk to the rest of the countries. This joint monitoring system, along with a Deposit Guarantee Fund and a common crisis resolution mechanism should be the three axes of a reform that will protect the citizens of all euro countries from another banking crisis.

The truth is that progress in the last year has been substantial. However, there is some cause for concern in relation to the speed at which European institutions are responding to the problems posed by the banking crisis. Sometimes it seems that we fail to react until we are on the brink of another crisis. Progress was made last year because Europe felt the pressure of rising bond spreads. With lower spreads, we probably would have not reacted. Therefore, this year we risk failing to take decisive action and creating the banking union that is so urgently needed as bond markets appear more stable.

These days there is a heated debate on a bailout for Cyprus which seems to be breaking the taboo of the deposit insurance fund and its consequences for the fledgling banking Union. It is important to contextualize the measure. A high percentage of deposits in Cypriot banks are foreigners, mostly Russians. This is not the case in other euro zone states. Also, whether we like it or not, we must not forget that Germany faces an election in two months. I tend to be positive and believe that the Cyprus bailout may be the price we have to pay so that the Banking Union becomes a reality.

Pablo Zalba Banking Crisis Economy EU-Russia Eurozone

The financial transaction tax (FTT) has been in the limelight ever since the European Commission President, José Manuel Barroso, presented his proposal to the MEPs in Strasbourg in his ‘state of the Union’ speech (28/09/2011). In the current economic turmoil, this proposal revives an old debate and adds more food for thought to the general discussion on European economic governance.

The proposal will have to be approved unanimously by the 27 Member States at the Council of Ministers, following the opinion of the European Parliament. The FTT raison d’être is twofold: on the one hand, it is meant as a fair contribution from the financial sector to the cost of the economic crisis or, in other words, a way to make banks and similar institutions pay their share of the burden of adjustment; on the other hand, the proposal is expected to reinforce EU’s internal market by preventing financial speculative activities and competitive distortions from happening.

By introducing a FTT first at EU level, the measure is also projected to set up the appropriate grounds to eventually work on a similar tax at global level. The proposal has wide support from European citizens (65% according to the latest Eurobarometer) and has been fostered by the French-German axis. For this reason, critical voices speak about a ‘political’ proposal, while questioning its viability from an economic standpoint. Most of the criticism has come so far from Sweden and the UK. One of the main arguments put forward by the detractors of the proposal is its potential negative side-effects on the economy, namely the relocation of the financial institutions, the resulting loss of competitiveness and, eventually, the possibility of clients bearing the burden of the tax. Swedish economist Anders Aaslund has recently criticised the proposal recalling Sweden’s experience with the so-called Tobin Tax back in the 1980s. According to Aaslund, the revenue of the tax amounted at the time SEK80 million, while SEK1.5 billion was foreseen.

Furthermore, most of the securities market left the country as a reaction to the tax. A similar situation is foreseeable, in his opinion, with the security trade abandoning the EU. For that reason, the Swedish government is expected to reject the proposal and, always according to Aaslund, the Nordic and Baltic governments in general would reject it too. The UK’s opposition to the FTT is perhaps more difficult to explain, particularly if we take into account that there is already a sort of financial transaction tax in place in this country. However, according to some studies, the so-called Stamp Duty Reserve Tax actually exempts more than 70% of the total UK stock market volume from the tax. This situation would change with the introduction of a FTT at European level. Besides this economic argument, internal politics are likely to be an influential factor for the rejection of the proposal, mainly because the introduction of the FTT would mean a step towards more of the EU’s own resources. Other voices, such as the one from the European Central Bank President, Jean-Claude Trichet, do not criticize the idea of having a FTT per se, but emphasize the fact that it should be applied everywhere in the world. If not implemented at global level, the proposal would have disrupting effects on the economy, he asserts. In spite of the above mentioned criticism, the Commission proposal has the strong support of the European Parliament, as well as with the backing of French and German leaders.

When defending the FTT, there are many arguments to point out. Firstly, the proposal has the support of the majority of the European citizenry. Secondly, it is regarded by the Commission as a first step to a global transaction tax, this being the ultimate goal, which will probably be introduced in the next G20 meeting as a subject for discussion. Thirdly, the proposal addresses the financial services, which have benefited so far from preferential treatment when it comes to taxation compared to other sectors (financial services are, in general, exempted from paying VAT). Fourthly, it will only affect transactions on financial instruments between financial institutions, in other words, it will not be detrimental to private households or SMEs. Fifthly, the tax rates will vary from 0.1% and 0.001% depending on the product – this would be the minimum for Member States to implement – therefore not representing a threat for financial institutions and therefore an incentive to relocate. Sixthly, the tax is expected to raise revenue of approximately €57 billion per year, a part of which is meant to go directly to the EU Budget, thus reducing the Member State’s GNI-based contributions. What can be the expected outcome of the FTT proposal? As already mentioned, it is highly improbable that it will make its way through a Council deciding unanimously. It is more probable, however, that the FTT would begin its journey within the eurozone, as suggested already by some, like the Belgium Finance Minister Didier Reynders. Nevertheless, the approval of every country from the eurozone cannot be taken for granted either, since there is speculation that The Netherlands and Spain – two countries with powerful banking sectors – would be reluctant to approve the proposal. Another option would be a selected team of countries willing to participate under enhanced cooperation procedure but, in such a scenario, the ambition of having a universal FTT would be far from realized.

Banking Business Economy Social Policy