An entirely valid reason for the ECB/Eurosystem to refuse to engage in either outright purchases of private securities or in unsecured lending to the banking sector (or to the non-financial enterprise sector directly), is that there is no ‘fiscal Eurozone’ – just as there is no fiscal EU. The absence of a fiscal Europe that matters here is a narrow one. I am not talking about the absence of a significant supranational fiscal authority in the EU (or in the Eurozone), with significant tax, spending, and borrowing powers – one capable of material system-wide fiscal stabilisation and cross-border redistribution. I am talking instead about two related fiscal vacuums.
The first vacuum is that there is no single fiscal authority, facility, or arrangement that can recapitalise the ECB/Eurosystem when the Eurosystem makes capital losses that threaten its capacity to implement its price stability and financial stability mandates.
The second related vacuum is that there is no single fiscal authority, facility, or arrangement that can recapitalise systemically important border-crossing financial institutions in the EU or provide them with other forms of financial support.
When the Bank of England develops an unsustainable hole in its balance sheet, Mervyn King knows he only needs to call one person: Alistair Darling, the UK Chancellor of the Exchequer. If the Fed were to become dangerously decapitalised, Ben Bernanke also needs to call just one person, Timothy Geithner, the US Secretary of the Treasury.1
Whom does Jean-Claude Trichet call if the Eurosystem experiences a mission-threatening and mandate-threatening capital loss? Does he have to make 16 phone calls, one to each of the ministers of finance of the 16 Eurozone member states? Or 27 phone calls, one to each of the ministers of finance of the 27 EU member states whose national central banks are the shareholders of the ECB? I don’t know the answer, and I doubt whether Mr. Trichet does.
This situation is intolerable. We need a fiscal Europe, at least at the level of the Eurozone, to fill the first vacuum. If we are to fill the second vacuum, we need a fiscal Europe at the EU level also.
Three ways to fill the vacuum
I see three alternatives. In decreasing order of desirability but increasing order of likelihood they are:
(a) A supranational Eurozone-wide tax and borrowing authority, specifically dedicated to fiscal backing for the ECB/Eurosystem.
This could be extended to include the provision of financial support to systemically important border-crossing financial institutions. In that case, the supranational fiscal authority would have to encompass all of the EU, not just the Eurozone. This might require a two-tier authority, with a Eurozone-only tier to back up fiscally the ECB/Eurosystem, and a EU tier to financially back systemically important border-crossing financial institutions.
(b) A Eurozone-wide fund, funded by the 16 Eurozone governments (in proportion, say, to their relative shares in the ECB’s capital), that the ECB/Eurosystem could draw on (subject to qualified majority support in the Eurogroup) if it were to suffer losses as a result of Eurozone-wide monetary policy, liquidity, and credit-easing operations. This fund could be capitalised by the 16 Eurozone national Treasuries, say in proportion to their shares in the ECB’s capital. Around €2.5 trillion to €3.0 trillion would be enough initially to cover the likely losses of the Eurosystem if the downturn is prolonged and deep and requires large-scale credit easing.
As an interesting extra, the fund (let’s call it the Eurosystem Fund) could be allowed to borrow with its debt guaranteed joint-and-severally by the 16 Eurozone member states. This is permitted under Article 103.1 of the Treaty:
“The Community shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of any Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project. A Member State shall not be liable for or assume the commitments of central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of another Member State, without prejudice to mutual financial guarantees for the joint execution of a specific project.”
What gets the camel’s nose of a joint-and-several guarantee in the tent is the reference to “…mutual financial guarantees for the joint execution of a specific project.” What, after all, is a “specific project”? Anything can be a project. Certainly the creation of a special fund dedicated to the specific purpose of providing the ECB/Eurosystem with additional capital, should the need arise, would qualify as a specific project.
You could even create the Eurosystem Fund as an activity of the European Investment Bank. According to the Treaty’s Article 267:
“The task of the European Investment Bank shall be to contribute, by having recourse to the capital market and utilising its own resources, to the balanced and steady development of the common market in the interest of the Community. For this purpose the Bank shall, operating on a non profit making basis, grant loans and give guarantees which facilitate the financing of the following projects in all sectors of the economy:
(a) projects for developing less-developed regions;
(b) projects for modernising or converting undertakings or for developing fresh activities called for by the progressive establishment of the common market, where these projects are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States;
(c) projects of common interest to several Member States which are of such a size or nature that they cannot be entirely financed by the various means available in the individual Member States.”
The Eurosystem Fund would fit quite snugly into category (c) above. The European Investment Bank borrows on international capital markets under something practically equivalent to a joint-and-several guarantee of the 27 EU member states. If joint-and-several borrowing by the Fund is considered a bridge too far, each of the 16 Eurozone member states could guarantee just a share of the losses of the Fund equal to its share in the ECB’s capital.
A larger fund, separate from the Eurosystem Fund, could also be set up to provide financial support for border-crossing systemically important financial institutions for the EU as a whole. Let’s call it the Crippled Bank Fund. We certainly will need something like that to retain meaningful border-crossing banking activity in the EU. This crisis has reminded us that there is no such thing as a safe bank, even if the bank is sound in the sense that its assets, if held to maturity, could cover its liabilities. This crisis has also reminded us that there may no such thing as a sound bank any longer, but that is a separate story.
To be viable, a bank needs to be scrutinised by a supervisor/regulator, have access to the short-term deep pockets of a central bank as lender of last resort and market maker of last resort, and have access to the long-term non-inflationary deep pockets of a Treasury. If we are to continue to have meaningful cross-border banking, we will need a European supervisor/regulator for border-crossing banks and a European fiscal authority or at least a European fiscal facility like the Crippled Bank Fund.
(c) An ad hoc, hastily cobbled together fiscal burden sharing rule for the 16 Eurozone national governments to restore the capital adequacy of the ECB/Eurosystem. This may well be the best we can hope for in practice. The experience of the Fortis debacle makes me doubt whether it will work. When the three-country banking and insurance group Fortis (Belgium, the Netherlands and Luxembourg) was about to go under, the authorities of the three countries agreed a joint plan to save the institution as a border-crossing bank, with Belgium putting in 50% of the agreed funds, the Netherlands 40% and Luxembourg 10%. The agreement lasted less than a week. Fortis was broken up according to the national location of its activities, with the Dutch state buying 100% of Fortis Nederland and Belgium and Luxembourg doing the same for their local subsidiaries. This repatriation of cross-border banking will become a flood wave if more cross-border banks go under and country A’s tax payers refuse to stand behind the balance sheets of subsidiaries of their banks in countries B and C.
Editors’ Note: This first appeared on Willem Buiter’s blog Maverecon. Copyedited and reposted with permission.
1 It is possible that no one in the US Treasury will pick up the phone, as none of the senior political appointments below Geithner are in place yet, but Geithner clearly would be the man to call.