December 12, 2012 6:29 pm

Cure for Europe lies at the state level

Avoiding faulty domestic policies is crucial, says Leszek Balcerowicz

Europe’s leaders are gathering in Brussels once again for a crisis summit. The talk is of Europe-wide initiatives to strengthen the single currency, with a banking union top of the agenda.

This is misguided. Averting future crises depends far more on avoiding faulty domestic policies than on Europe-wide governance. Sound domestic policy is crucial in the eurozone’s largest countries. By virtue of their size these countries are subject to less market discipline than smaller peers. Their economies also have a large impact on the eurozone as a whole.

If Greece were the only problem country in the eurozone there would be no talk of a crisis. But issues have also accumulated in large countries such as Italy and Spain. Fortunately those two, along with Ireland and Portugal, have much improved their policies. The focus is therefore now on France. And it is France’s turn to undertake domestic reforms – both for its own benefit and that of the eurozone as a whole.

To be sure Europe-wide initiatives, such as fiscal rules and enhanced macroeconomic supervision, are important. But a top-down approach alone is insufficient to prevent future crises. There was no shortage of European rules before the financial crisis. But they were all broken – witness the sad story of the stability and growth pact. There are also limits to the effectiveness of official monitoring – supervisors do not always have the incentive, or the ability, to spot dangerous trends; the International Monetary Fund did not raise the alarm on Greece before 2008, for example.

Europe-wide approaches cannot substitute for improved domestic political culture. This should stress the positive role of fiscal discipline and of market forces. Creating such a culture is the challenge for opinion leaders in eurozone countries, which display a strong statist bias. At the minimum opinion leaders should stop equating “the European social model” with a large (and often badly structured) welfare state, and stop blaming markets for the problems produced by faulty policies.

Even in the US, the federal government cannot prevent bad policies in individual states and it is up to state-level politics to correct these distortions. US federal policies themselves, especially fiscal ones, are also far from ideal. This fact seems to be largely overlooked by those in the EU who see a “federal Europe” as the ultimate solution to the economic ills of the eurozone.

The most recent example of this centralising faith is the idea of a eurozone banking union, potentially involving a single supervisor, joint deposit insurance and a shared mechanism for winding up failed banks. Banking union has been proposed as a solution to the problem of dangerous financial links between governments and domestic banks, which in turn has been attributed to failures in domestic banking supervision.

Such a diagnosis may contain a grain of truth but it is incomplete, and potentially misleading.

To see that, let us distinguish two kinds of crises. The first one, in which fiscal problems lead to a financial catastrophe, is exemplified by Greece. It starts with the excessive accumulation of public debt, which is largely owned by domestic banks. When the fiscal bubble bursts domestic lenders are imperilled. Such crises are encouraged by global regulations that encourage banks to lend to their sovereigns regardless of the risks they incur. Before any new institutional overhaul at the European level, these perverse global regulations should be removed. Moreover, a solution to this problem must include strengthened fiscal discipline, which requires a change in the national political culture.

Examples of the second type of crisis, in which a financial crisis leads to a fiscal one, include Ireland, Spain, the UK and US. It starts with a private credit boom. When that boom turns to bust it produces a serious recession, and related strains on government finances. Contrary to widespread belief, private credit booms are not purely a market phenomenon. Banks may be encouraged to lend into bubbles by bad policies, such as excessively low official interest rates, or politicised credit allocation (which may explain actions by Fannie Mae and Freddie Mac in the US, the cajas in Spain and Landesbanken in Germany before 2008). As long as such policies remain, plans for banking union omit important causes of the problem they are supposed to solve.

There are also important questions about implementation of banking union. Big ideas are a poor substitute for detailed plans. New European supervision may be created while fiscal responsibility remains at the national level. The European Central Bank may or may not be the regulator. Non-eurozone nations that are dependent on eurozone banks may be vulnerable to regulatory decisions they cannot influence.

Banking union, and other Europe-wide initiatives, may be useful reforms. But they cannot substitute for regulatory reform and improved policies in the eurozone’s problem countries, especially the largest.

The writer is a former president of the Polish central bank and former Polish finance minister

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