Europe's Highway to Hell
European policymakers are still enjoying their famously long, languorous summer holiday. The vacations will end in the coming days, with Germany’s Chancellor Angela Merkel scheduled for a series of meetings with leaders from France, Greece and Italy this month. Meanwhile, at a more rapid pace, Europe is in the midst of a massive run on bank deposits in Greece, Portugal, Spain, Italy and Ireland. While the last out-of-office auto-responses zip across the continent in multiple languages, the bank runs continue to accelerate.
How did we get here? What can we expect next? And, most important, what is the way out?
Europe’s trip down the highway to hell began with an original sin. At the birth of the euro, nations that adopted it and formed the European Monetary Union (EMU) gave up their national currencies. They could no longer “print” money to pay for expenses (despite the longtime use of keystrokes for this purpose, the image of stacked, crisp bills somehow hangs on). The European Central Bank, comparable to the US Federal Reserve, could increase the supply of euros, but individual nations could not.
Like each of the US states, each nation in the EMU became a user, rather than an issuer, of money. But each country kept control of taxing and spending through its own treasury. The design flaw—think major miscalculation here—was the absence of a unifying body that could move resources from country to country in the event of local trouble, as the US government does between states.
The single currency was intended to insure that capital could flow easily across borders. For banks, this meant the ability to buy assets and make loans wherever the euro was used. And did they ever. The Basel Accords, initially set up in 1988 to establish international standards of capital adequacy, ended up allowing banks to self-determine the weight of risky assets on their balance sheets, leaving them without any supervision or regulation in their calculation and pricing. This added more opportunities to take on Wall Street–like risks.
Yet individual nations remained responsible for their own banks. Private “banks without borders” could, and did, run up fabulous debts that were easily several orders of magnitude greater than their host country’s total government spending or taxing. When the winning streak ended, the public had to pick up the tab. To visualize this debacle, picture a US state, any state, having to find the funds to settle a run on Bank of America because it happened to be headquartered there.
Covering the bank losses ballooned national deficits and debt to previously unheard of levels. This is what happened in Ireland, for example, and it is emerging now in Spain, where during the first five months of this year about 163 billion euros left the Spanish banks.
Finally, and key to the current cash exodus, depositors could shift their euros without cost from one bank to another throughout Euroland. Anyone with euros in, for example, a Spanish bank, can simply transfer them to a German bank.
The killer is that once the shift has been made, Spain, through its central bank, has to back up the money with reserve funds, which then accumulate in Germany’s Bundesbank. Where would Spain find those funds? Its central bank would need to borrow—deeply—from the European Central Bank.
This precise scenario is now playing out across Europe, as depositors in its poorer nations understandably move their money to relative safety in Germany. The cross-border mechanism is called TARGET2, for Trans-European Automated Real-time Gross settlement Express Transfer. The inelegant name is the least of its problems; it’s a system destined to crash and burn.
The flight of capital from the south had already begun in slo-mo by 2010. Then, this past May, as millions of euros a day were pulled from Greece and a major Spanish bank tottered, the world braced itself. Nationalization of the troubled Spanish bank and some largely insignificant measures on the part of European leadership followed, in what was widely reported as a definitive step back from the brink.
By this summer, optimism was replaced by increasingly frantic predictions of doom. When European Central Bank president Mario Draghi issued one in a string of we’ll-do-whatever-it-takes-to-save-the-euro statements in late July, the wheel turned again. Inaction followed, and the wheel lost traction.
The migration of money into Germany is quickening. And under TARGET 2, the trillions of euros that the ECB has loaned out to finance this race will be uncollectable.
How to counteract a disaster of these proportions? Unlimited deposit insurance for all euros in EMU banks, backed by the creation of a strong European federal treasury, would end the bank runs, just as deposit insurance in the United States has prevented them here ever since the Great Depression. The insurance liability would be on Europe’s central bank, which would become insolvent if Spain or Italy abandoned the euro. Since, unlike the United States, the ECB doesn’t have a unified European treasury to backstop it, Germany would presumably get the bill for a default.
As Randall Wray and I predict in a new Levy Institute policy paper, “That’s a bill Germany will not accept, hence, probably no deposit insurance.” And no future for the euro.
Auto-response message to Europe’s banks: See you in September?