Chronic Europe

LONDON – Europe’s great success in 2012 was to avoid becoming another of history’s failed monetary unions. European Central Bank President Mario Draghi’s actions prevented a market meltdown and bought European leaders time to deliver on political and institutional reform. But have political leaders again chosen to muddle through, rather than meld a resilient strategy?

To be sure, few envisioned the degree of compromise and integration that was achieved during the acute phase of Europe’s financial crisis. Control mechanisms that theoretically infringe on sovereignty are now in place for national budgets and, soon, for the 150 or so largest European banks. Creation of the and its successor, the , provide an important financial backstop for smaller countries that are destabilized by external shocks.

But the real game changer has been the ECB’s creativity in designing ways to prevent the sudden insolvency of banks and governments. While it might take military expertise to learn all of the acronyms created in the last three years, the LTRO (long-term refinancing operation) and OMT (outright monetary transactions) will be remembered as the ECB’s twin bazookas.

Nonetheless, while bazookas may win battles, they do not win wars. This is particularly true in finance, because markets, politicians, and citizens adapt to changing circumstances. The success of 2012 was to end the acute phase of the crisis; but its chronic features persist.

Of course, capital markets have reopened to large corporations and many European banks. Europe feels better. But it is rarely wise to judge financial health by one’s borrowing costs, which can change abruptly. Together with other major central banks, the ECB has ensured that any doubts about solvency have been temporarily put to rest with a tsunami of liquidity.

The European Council’s decisions in December defined the vision outlined by Draghi last July. But European leaders rejected even limited fiscal risk-sharing in the form of temporary unemployment contracts. Banking union was left looking like a stool with one sturdy leg (common supervision), a toothpick (common resolution), and no third leg (common deposit insurance) whatsoever. The creditor countries, seeking to define legacy assets narrowly in order to minimize their losses, are emasculating the most important vehicle for breaking a vicious feedback loop between sovereigns and banks – direct bank recapitalizations with ESM funding.

The most creditworthy European countries still believe that a monetary union can work only if every member is committed to responsible macroeconomic policies that avoid the accumulation of imbalances. There is a powerful logic to this argument, given that a union in which some states’ conservative taxpayers always pay for others’ profligate spending cannot endure politically.

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