Stefano Micossi – Economy Watch

The Eurozone Exposed – How Europe Can Avoid A Prolonged Depression: Stefano Micossi

Stefano Micossi — Fri, 20 Jul 2012 08:43:32 +0000

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At their meeting at the end of June, European leaders acknowledged for the first time the multiple dimensions of the crisis, accepting that austerity – putting everyone’s house in order – will not suffice. What is still missing, however, is recognition of the need for greater flexibility on fiscal-consolidation efforts.

MILAN – A rapid and large increase of government debt has been a general phenomenon in the advanced countries since the 2007-09 crisis: for the first time, the average debt/GDP ratio for OECD countries has surpassed 100 percent. Fiscal consolidation will weigh on growth prospects for two generations to come, and the welfare state as we have known it in Europe since World War II will have to be transformed, especially given a rapidly aging population.

But the eurozone debt crisis has distinctive features. Most importantly, while the average debt/GDP ratio is no higher than it is in other advanced countries, and consolidation efforts started earlier, the eurozone has been mired in a severe crisis of confidence for the past two years. This points to a systemic dimension of the crisis that cannot be reduced to profligate behaviour by fiscal sinners.

Indeed, the Greek crisis exposed three main flaws in the monetary union itself. First, the system lacked effective arrangements to align fiscal and other economic policies. As long as enforcement of fiscal discipline is entrusted to an intergovernmental body, the problem is bound to reappear, limiting the credibility of common budgetary rules.

Moreover, financial markets underpriced private and sovereign credit risks, in the implicit belief that no one would fail, and that all debts would somehow be made whole, implying weak market discipline on borrowers.

Finally, once the crisis hit, leading to a re-pricing of risks in financial markets, the need to avoid an economic and financial meltdown compelled governments to support aggregate demand and make private liabilities whole. But the disconnection between centralized monetary and decentralized fiscal powers de facto impeded the full use of monetary instruments to meet monetary and financial shocks.

[quote]That left individual eurozone members exposed to brutal pressure by financial markets at a time when excessive private debt was turned into unsustainable public debt. Suddenly, the eurozone had become a straightjacket.[/quote]

And so it has remained: budgets are cut, growth falters, and periphery countries must engineer substantial real exchange-rate devaluations to regain competitiveness and close their external deficits. Core countries, meanwhile, argue that they can do little to strengthen aggregate demand and relieve pressure on their partners, even as the periphery’s agony is dragging the core into recession, owing to its dependence on peripheral export markets. And, indeed, recent data point to a rapidly worsening economic environment in Germany, where the trade surplus has shrunk dramatically in recent months.

Over the past two years, fundamental changes in the eurozone’s economic governance have aimed at rectifying the monetary union’s founding flaws. And, along the way, an intergovernmental process has become communitarian. Key powers over the implementation of common policy guidelines have been entrusted to the European Commission, and the European Council has limited its own ability to reject Commission recommendations by requiring a qualified majority to change them.

Strong economic-governance rules, however, will not suffice. A fully functioning monetary union also requires a central bank that is free to act as required to confront liquidity and confidence shocks, some mutualization of government debts, and centralized control over fiscal policy. Moreover, it must have centralized banking supervisory policies, with strong powers to manage bank crises and to liquidate banks that cannot be rescued.

[quote]All of this can be achieved only gradually, as Europe moves to a fully-fledged federal union. Whether the eurozone will survive in the meantime will be determined by the European Council’s capacity to establish intermediate arrangements that can halt the crisis and restore trust among its members.[/quote]

At their meeting at the end of June, European leaders acknowledged for the first time the multiple dimensions of the crisis, accepting that austerity – putting everyone’s house in order – will not suffice. Accordingly, new joint policy initiatives will address economic growth, banking union, and liquidity. Moreover, European leaders have placed these new policies within a coherent longer-term framework that may also include “the issuance of common debt.”

Likewise, the European Council has agreed on a new “Compact for growth and jobs” that identifies a specific European dimension of growth policies, mainly integration of energy, transport, communications, and services, together with higher infrastructure investment.

What is notably missing is recognition of the need for greater flexibility on fiscal-consolidation efforts. As the Commission has requested, countries with stronger fiscal positions should consider slowing their consolidation efforts in order to avoid aggravating the recession. But, in order to preserve investors’ confidence, some eurozone countries must strike a difficult balance between austerity and overkill, which would have been facilitated had the European Council issued a clear statement that letting automatic stabilizers work, while remaining on track with structural budget targets, fully complies with European Union obligations.

Moreover, a greater share of the adjustment burden must fall on Germany. Recent fairly generous wage agreements in Germany will help, but are not enough; there is also a need to boost domestic demand. More aggressive liberalization of the bloated banking system, network services (especially in energy and transport), and public procurement may contribute significantly over time to raising domestic investment and incomes. The sizeable investments required to make up for the loss of nuclear energy may contribute more immediate stimulus.

All of this should not be seen as a concession, but as part of the obligations undertaken by eurozone governments to address excessive imbalances.

[quote]Now more than ever, Germany must be persuaded that without its contribution in reviving growth and correcting external imbalances, the eurozone faces prolonged depression and certain collapse.[/quote]

By Stefano Micossi

Copyright: Project-Syndicate, 2012

Stefano Micossi is Director-General of Assonime, a business association and private think tank in Rome, Chairman of the board of CIR Group, and a member of the board of the Centre for European Policy Studies in Brussels.

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Banking Breakdown – Why The Basel Accords Failed: Stefano Micossi

Stefano Micossi — Fri, 04 May 2012 02:48:01 +0000

Please note that we are not authorised to provide any investment advice. The content on this page is for information purposes only.

The Basel Accords were introduced to protect consumers from bad banking practices; yet somehow they managed to exacerbate the 2008 financial crisis even further – causing a sharp drop in drop in GDP and employment, while the sharp sell-off in assets ensured further declines. Why did the Basel accords fail so miserably and what can be done to ensure better regulation of the banking industry?

ROME – The Basel Accords – meant to protect depositors and the public in general from bad banking practices – exacerbated the downward economic spiral triggered by the financial crisis of 2008. Throughout the crisis, as business confidence evaporated, banks were forced to sell assets and cut lending in order to maintain capital requirements stipulated by the Accords. This lending squeeze resulted in a sharp drop in GDP and employment, while the sharp sell-off in assets ensured further declines.

My recent study with Jacopo Carmassi, Time to Set Banking Regulation Right, shows that by permitting excessive leverage and risk-taking by large international banks – in some cases allowing banks to accumulate total liabilities up to 40, or even 50, times their equity capital – the Basel banking rules not only enabled, but, ironically, intensified the crisis.

After the crisis, world leaders and central bankers overhauled banking regulations, first and foremost by rectifying the Basel prudential rules. Unfortunately, the new Basel III Accord and the ensuing EU Capital Requirements Directive have failed to correct the two main shortcomings of international prudential rules – namely, their reliance on banks’ risk-management models for the calculation of capital requirements, and the lack of supervisory accountability.

The latest example highlighting this flaw is Dexia, the Belgian-French banking group that failed in 2011 – just after passing the European Banking Authority’s stress test with flying colors. The stunning opacity of solvency ratios encouraged regulators to turn a blind eye to banks’ excessive risk-taking.

[quote]The problem is that the Basel capital rules – whether Basel I, II, or III – are of no help in separating the weak banks from the sound ones. Indeed, more often than not, the banks that failed or had to be rescued in the wake of the 2008 financial crisis had solvency ratios higher than those of banks that remained standing without assistance.[/quote]

Compounding the problem, the diversity in banks’ capital ratios also indicates a dramatic distortion of the international playing field, as increasingly competitive conditions in financial markets have led to national discretion in applying the rules. Meanwhile, the opacity of capital indicators has made market discipline impossible to impose.

Thus, large banks are likely to continue to hold too little capital and to take excessive risks, raising the prospect of renewed bouts of financial instability. In order to overcome these shortcomings in international banking regulations, three remedies are needed.

First, capital requirements should be set as a straightforward ratio of common equity to total assets, thereby abandoning all reference to banks’ own risk-management models. The new capital ratio should be raised to 7-10 percent of total assets in order to dampen risk-taking by bankers and minimize the real economic impact of large-scale deleveraging following a loss of confidence in the banking system.

Second, new capital ratios with multiple and decreasing capital thresholds, which trigger increasingly intrusive corrective action, should serve as the basis for a new system of mandated supervisory action. Supervisors should be bound by a presumption that they will act. They could argue that action is not necessary in a specific case, but they would have to do so publicly, thus becoming accountable for their inaction. In order to eradicate moral hazard, the system must have a resolution procedure to close banks when their capital falls below a minimum threshold.

Finally, solvency rules should be complemented by an obligation that banks issue a substantial amount of non-collateralized debt – on the order of 100 percent of their capital – that is convertible into equity. These debentures should be designed to create a strong incentive for bank managers and shareholders to issue equity rather than suffer conversion.

These three measures, if applied to all banks, would eliminate the need for special rules governing liquidity or funding (which would remain open to supervisory review, but not to binding constraints). There would also be no need for special restrictions on banking activities and operations.

The most remarkable feature of the policy deliberations on prudential banking rules so far has been their delegation to the Basel Committee of Banking Supervisors and the banks themselves, both of which have a vested interest in preserving the existing system. Governments and parliaments have an obligation to launch a thorough review of the Basel rules, and to demand revisions that align them with the public interest.

By Stefano Micossi

Stefano Micossi is Director General of Assonime, Visiting Professor at the College of Europe in Bruges, Member of the Board of Directors of Center for European Policy Studies (CEPS), and Chairman of the Board of the CIR Group.

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