Europe trilemma is global dilemma


By Andrew Sheng

The European think tank, Breugel, recently produced a report suggesting that there was a fundamental trilemma between the European monetary union, national banking systems and the lack of fiscal union (Pisani-Ferry, 2012). This added a twist to the old argument that for a single currency, you need a single fiscal policy. The argument for a banking union arose because European national governments were able to finance their deficits largely through their national banks, which could buy their long-term paper. This created an interlocking crisis. If national banks hold lots of national debt, when debt prices fell, the banks became insolvent, but illiquid governments cannot bail out insolvent banks without further borrowing at higher real rates. The illiquidity trap was relieved when the European Central Bank undertook long-term refinancing operations (LTRO), effectively giving the national banks three-year money at 1 percent to buy their government paper. Liquidity and capital shortage are simultaneously relieved, because the more the national banks buy national bonds, and bond prices rose, the less capital is required. But LTRO (just like quantitative easing in the U.S.) only relieved the symptoms without sorting out the structural issues of excessive debt.

Unitary states like the U.S., China and India do not have this peculiar problem, because their provincial governments do not have large local banks to fund their deficits and anyway, these local governments cannot constitutionally run large deficits without approval from the center.

Should Europe have a banking union as well as fiscal union?

My answer is that the banking union debate is a distraction from the real argument over fiscal discipline. If all European national banks were today instantly merged to become a single transnational European bank, would it solve the European problem of lack of fiscal union? That transnational bank would still have the problem to buy or not buy national debt paper and whether to mark them to market. A banking union may solve the problem of eurozone funding, but it does not solve the problem of write-offs between surplus and deficit members, which only a fiscal union can solve.

The fundamental issue is the exercise of fiscal and financial discipline. Should this be exercised at the national level (this is clearly not working) or at the central level (who decides — the surplus “winners” or the deficit “losers”?) The European tragedy is that member governments ran large deficits for years, because there was neither a central mechanism to discipline them nor did the market, which priced deficit state credit risks like Greece wrongly. I am amazed that financial institutions that helped governments to disguise the size of their debt have not been sanctioned for violating the most basic of market discipline — truth in transparency. Having overspent and overborrowed, deficit countries face two unenviable choices — deflation through austerity or a combination of debt forgiveness and funding to grow out of the crisis.

Market discipline exercised through rising interest rates seems to doom the deficit countries to impossible situations. Deflation is extremely painful and perhaps politically unacceptable. Unemployment among youth is already unacceptably high, and if there are riots in the streets or the polls reject further austerity, then the eurozone can fragment.