The following is a guest post by Clemens Fuest, a Professor at the Saïd Business School and Research Director of the Centre for Business Taxation, both at the University of Oxford. Fuest serves as chairman of the German finance ministry’s technical advisory committee and is an expert on issues relating to the Eurozone.
Many observers of the Eurozone debt crisis argue that the Euro can only survive if the common currency is complemented by a fiscal union. But there’s a problem with that: Fiscal union, mostly understood as a combination of centralized control over public finances with joint guarantees for government debt, is a fundamentally flawed concept.
The political integration required to achieve it is not in sight. In order for a fiscal union to work, national governments including parliaments would have to give up the right to set taxes and determine public expenditure independently and accept a restriction of national sovereignty in other areas of economic and social policy. The debate about the fiscal compact has shown that most member countries, in particular France, are not willing to conform. This is an understandable position considering the absence of democratic control at the EU level with decisions made in Brussels about key issues like national taxes and expenditures, which directly affect most citizens, simply lacking legitimacy.
A much more promising approach than fiscal union would be to focus on a Europeanization of the banking sector. This would require a complete shift of banking regulation and supervision to the European level and the creation of a European bank resolution mechanism. A key aspect of this Europeanization would be that banks would no longer be allowed to hold as many domestic government bonds as they do today. Politically, a Europeanization of the banking sector would also require countries to give up sovereignty, but in the area of banking regulation and supervision, which is rather technocratic and more remote from day-to-day concerns of ordinary citizens. It would be politically much more acceptable to delegate this task to an independent European body like the European Central Bank than to relinquish the right to set fiscal policy.
One of the key difficulties in overcoming the Euro debt crisis is that the current financial system is characterized by a close symbiosis between national governments and national banking systems. The situation in Spain offers a good example. The Spanish banking system is plagued by huge and unrealized losses from the financing of the real estate bubble. At the same time, Spanish banks are massively invested in government bonds and the Spanish government puts pressure on Spanish banks to buy more bonds if funds are available. This undermines the ability of the banking system to provide credit to sectors which might contribute to an economic recovery. Financial difficulties of the Spanish government threaten the stability of the Spanish banking system and vice versa.
A recapitalization of Spanish banks with money from other Eurozone countries will be accepted by those countries only if they have a say over how these funds are used. As long as the Spanish government controls its banking system through national banking supervision, recapitalizing Spanish banks is like giving money to the Spanish government.
A Europeanization of the banking sector would improve the Eurozone situation. Since banks would be less exposed to their national governments, financial sector stability would be less endangered if a national government has financial problems. In addition, the finances of national governments would not be endangered by problems of national banks, because collapsing banks would be restructured or recapitalized at the European level, rather than threatening to draw their national governments into bankruptcy. Providing funds at the European level is possible because control over, and supervision of, the banking system also takes place at the European level. In the US, for instance, financial problems of the state of California are less dramatic for Californian banks because their activities and asset holdings are more diversified across the US. If a bank faces financial difficulties, funds required to restructure or recapitalize the bank would not have to come from the California government, but rather from a federal institution.
Of course, while giving up national control over the banking system will be more acceptable for voters than giving up the right to set fiscal policy, national governments will still find this hard to swallow. Control over national banks offers many advantages to politicians and access to bank credit for the government is just one of them. But holding on to national sovereignty in both fiscal policy and the control of the banking sector may indeed be incompatible with the survival of the Euro.