Two events from the summer of 2012 most likely set the path for establishing a credible and stable financial architecture in the euro area.
The first major event consisted of key decisions made at the European Union (EU) summit in late June 2012: That a single-bank supervisory mechanism (SSM) would be established; and that once the SSM were to become operational, European stability mechanism (ESM) funds could ultimately be used to recapitalize euro area banks directly—eliminating the need to channel the funds through governments. These EU decisions were quite important. Establishing the SSM showed that common standards for bank supervision would be applied, which should help prevent diverging future developments within the EU's banking and financial industry – a root cause of the current crisis. In addition, directly recapitalizing banks using ESM funds should help break the link between banks and sovereign risks.
The second major event of last year was a game-changer for financial markets: European Central Bank (ECB) President Mario Draghi announced that he would do "whatever it takes" to preserve the euro, which resulted in the ECB becoming a lender of last resort for sovereigns via its outright monetary transaction (OMT) programme. Because the ECB is acting "within its mandate", OMT sovereign bond purchases require ongoing structural reforms and fiscal austerity measures—a necessary albeit not sufficient precondition for the ECB to purchase sovereign bonds. By making the OMT dependent on sovereigns signing a memorandum of understanding, the ECB is effectively addressing the "moral hazard" problem.
However, while we view these two developments as critical for providing a more stable architecture for the euro area, we believe they are not yet sufficient. More efforts and additional political agreements are needed. Because the SSM appears to be a precondition for the direct recapitalization of banks via the ESM, it actually needs to be implemented quickly – yet recent reports suggest it will only become operational in summer or autumn 2014. In addition, recent discussions among euro-area policymakers show that there may be limits to the overall amount of ESM funding that can be used to stabilize the banking system; indeed, the German Minister of Finance, Mr Schäuble, suggested introducing a cap of EUR 80bn. If more funds are needed, bank and sovereign risks would be linked again - clearly an undesirable outcome in our view. Furthermore, a full banking union needs to see that the SSM will be accompanied by a bank resolution mechanism and a functioning deposit insurance scheme – yet we have not seen many proposals on either count.
We believe it is absolutely crucial to move to a full banking union and implement what has been already decided upon in principle. Otherwise, decision makers will have to resort to ad hoc measures, as was the case with the very badly handled restructuring of the Cyprus banking sector. It is essential to avoid private-sector uncertainty, which could hurt economic growth.
Even though we see some loss in political momentum with respect to building this full banking union, we appreciate that the Troika has become more pragmatic when it sees programme countries miss deficit targets for purely cyclical reasons. Our research comes to the same conclusion as the International Monetary Fund: Fiscal multipliers in the euro area at this juncture are well above¹. As a result, we believe euro-area countries should focus on growth-enhancing structural reforms and certain well-targeted fiscal austerity measures. For major fiscal austerity adjustments, however, John Maynard Keynes said it best in 1937: the right time is the boom, not the slump.