This Time Europe Really is on the Brink

Niall Ferguson is professor at Harvard University and author most recently of Civilization: The West and the Rest; Nouriel Roubini is professor at New York University and chairman of Roubini Global Economics.

ROME—Is it one minute to midnight in Europe?

We fear that the German government’s policy of doing “too little too late” risks a repeat of precisely the crisis of the mid-20th century that European integration was designed to avoid.

We find it extraordinary that it should be Germany, of all countries, that is failing to learn from history. Fixated on the non-threat of inflation, today’s Germans appear to attach more importance to the year 1923 (the year of hyperinflation) than to the year 1933 (the year democracy died). They would do well to remember how a European banking crisis two years before 1933 contributed directly to the breakdown of democracy not just in their own country but right across the European continent.

We have warned for more than three years that continental Europe needed to clean up its banks’ woeful balance sheets. Next to nothing was done. In the meanwhile, a silent run on the banks of the Eurozone periphery has been underway for two years now: cross-border, interbank and wholesale funding has rolled off and been substituted with ECB financing; and “smart money”—large uninsured deposits of high net worth individuals – has quietly exited Greek and other “Club Med” banks.

But now the public is finally losing faith and the silent run may spread to smaller insured deposits. Indeed, if Greece were to exit a deposit freeze would occur and euro deposits would be converted into new drachmas: so a euro in a Greek bank really is not equivalent to a euro in a German bank. Greeks have withdrawn more than 700 million euros from their banks in the past month.

More worryingly, there was also a surge of withdrawals from some Spanish banks last month. The government’s bungled bailout of Bankia has only heightened public anxiety. On a recent visit to Barcelona, one of us was repeatedly asked if it was safe to leave money in a Spanish bank. This kind of process is potentially explosive. What today is a leisurely “bank jog” could easily become a sprint for the exits. In the event of a Greek exit, rational people would ask: Who is next?

As discussed at a recent meeting of the Nicolas Berggruen Institute in Rome, the way out of this crisis seems clear.

First, there needs to be a program of direct recapitalization—via preferred non-voting shares—of EZ banks both in the periphery and the core by the European Financial Stability Facility (EFSF) and its successor the European Stability Mechanism (ESM).

The current approach of recapping the banks by the sovereigns borrowing from domestic bond markets—and/or the EFSF—has been a disaster in Ireland and Greece: it has led to a surge of public debt and made the sovereign even more insolvent while making banks more risky as an increasing amount of the debt is in their hands.

Second, to avoid a run on EZ banks—a certainty in the case of Grexit and likely in any case—an EU-wide system of deposit insurance needs to be created.

To reduce moral hazard (and the equity and credit risk taken by EZ taxpayers), several additional measures should also be implemented:

The deposit insurance scheme has to be funded by appropriate bank levies: this could be a financial transaction tax or, better, a charge on all bank liabilities.

There needs to be a bank resolution scheme in which unsecured creditors of banks—both junior and senior—would take a hit before taxpayer money is used.

Measures to limit the size of banks to avoid the too-big-to-fail (TBTF) problem need to be taken.

We also favor an EU-wide system of supervision and regulation.

True, European-wide deposit insurance will not work if there is a continued risk of a country leaving the Eurozone. Guaranteeing deposits in euros would be very expensive as the exiting country would need to convert all euro claims into a new national currency, which would swiftly depreciate against the euro. On the other hand, if the deposit insurance holds only if a country doesn’t exit, it will be incapable of stopping a bank run. So more needs to be done to reduce the probability of Eurozone exits.

Structural reforms that improve productivity growth should be accelerated. And economic growth needs to be jump-started. The policies to achieve this include further monetary easing by the ECB, a weaker euro, some fiscal stimulus in the core, more bottleneck-reducing and supply-stimulating infrastructure spending in the periphery (preferably with some kind a “golden rule” for public investment), and wage increases above productivity in the core to boost income and consumption.

Finally, given the unsustainably high public debts and borrowing costs of certain member states, we see no alternative to some kind of debt mutualization.

There are currently a number of different proposals for Eurobonds. Among them, the German Council of Economic Advisers’ proposal for a European Redemption Fund (ERF) is to be preferred—not because it is the optimal one but rather because it is the only one that can assuage the German concerns about taking on too much credit risk.

The ERF is a temporary program that does not lead to permanent E-bonds. It is supported by appropriate collateral and seniority for the fund and has strong conditionality. The main risk is that any proposal that is acceptable to Germany would imply such a loss of national fiscal policy sovereignty that it would be unacceptable to the EZ periphery, particularly Italy and Spain.

Giving up some sovereignty is inevitable. However, there is a difference between federalism and “neo-colonialism”—as a senior figure put it to us at a meeting of the Nicolas Berggruen Institute in Rome.

Until recently, the German position has been relentlessly negative on all such proposals. We understand German concerns about moral hazard. Putting German taxpayers’ money on the line will be hard to justify if meaningful reforms do not materialize on the periphery. But such reforms are bound to take time. Structural reform of the German labor market was hardly an overnight success. By contrast, the European banking crisis is a financial hazard that could escalate in a matter of days.

Germans must understand that bank recapitalization, European deposit insurance and debt mutualization are not optional. They are essential steps to avoid an irreversible disintegration of Europe’s monetary union. If they are still not convinced, they must understand that the costs of a breakup of the Eurozone would be astronomically high—for themselves as much as for anyone.

After all, Germany’s current prosperity is in large measure a consequence of monetary union. The euro has given German exporters a far more competitive exchange rate than the old deutschmark would have. And the rest of the Eurozone remains the destination for 42 percent of German exports. Plunging half of that market into a new Depression can hardly be good for Germany.

Ultimately, as Chancellor Merkel herself has acknowledged, monetary union always implied further integration into a fiscal and political union.

But before Europe gets anywhere near taking this historical step, it must first of all show that it has learned the lessons of the past. The EU was created to avoid repeating the disasters of the 1930s. It is time Europe’s leaders—and especially Germany’s—understood how perilously close they are to doing just that.