I have been travelling today a lot and so haven’t had much time to write. I have been reading early (1970s and 1980s) documents in recent days relating to the debate that preceded the establishment of the Eurozone. I have read them before, at the time they were released in many cases, but they provide a salutary reminder of how the political and economic reality in Europe diverged with catastrophic consequences for millions of people that live there. There was ample analysis and supporting evidence in the late 1970s to tell us that the creation of a common monetary union in the form that was eventually agreed in the 1990s would fail. But even now, with that failure for all to see, the same dynamics that predicate against any reforms that might create a strong federal fiscal capacity, are present in the discussions surrounding the creation of a Single Supervisory Mechanism to regulate banks and protect their depositors. The Germans, exhibiting all their irrational paranoia about inflation, are using their political weight to influence the design of the banking policy and the likely outcomes are looking decidedly deficient. They are doomed to fail if subjected to a stern test.



In 1977, the European Commission released the – MacDougall Report – named after the chair of the study group.

The Study involved:

… a detailed and quantitative study of public finance in five existing federations U.S.A., Canada, Australia, Switzerland) and three unitary states of Germany, (France, Italy and the U.K.) … and in particular the financial relationships between different levels of government and the economic effects of public finance on geographical regions within the countries.

In other words, they sought to work out how a common currency system might operate where there are decentralised government structures (such as, state governments in Australia or the US) with fiscal capacities and a currency-issuing central government and central bank.

If you read the Report in detail you will wonder why the Eurozone was ever created. The issues the MacDougall report identified certainly were still relevant at the time the Lisbon Treaty was bulldozed through to form the monetary union.

The Study concluded that:

It is most unlikely that the Community will be anything like so fully integrated in the field of public finance for many years to come as the existing economic unions we have studied.

They found that:

1. Per capita income inequality was “at least as unequal” between the EC states (9 at the time) and the 72 regions that comprise these states “as they are on average between the various regions of the countries we have studied.”

2. Once the “equalising effects” of national government spending and taxation was taken into account, “regional inequalities in per capita income” in the nations studies were reduced “on average” by “about 40%” (“by more in Australia and France, by less in the U.S.A. and Germany).

But the “redistributive power between member states of the Community’s finances, by comparison, is …. very small indeed (1%); partly because the Community budget is relatively so small …”

3. The “redistribution through public finance between regions in the countries studied tends to be reflected to a large extent … in corresponding deficits in the balances of payments on current account of tbe poorer regions, with corresponding surpluses in the richer regions. These deficits and surpluses are of a continuing nature.”

4. “As well as redistributing income regionally on a continuing basis, public finance in existing economic unions plays a major role in cushioning short-term and oyclical fluctuations. For example, one- half to two-thirds of a short-term loss of primary income in a region due to a fall in its external sales may be automatically offset through lower payments of taxes and insurance contributions to the centre, and higher receipts of unemployment and other benefits.”

They noted there was no such mechanism for addressing asymmetric negative demand shocks within the European Community and concluded:

… this is an important reason why in present circumstances monetary union is impracticable.

5. They noted that in federations, “as much as one-half to two-thirds of civil expenditures is left in the hands of the lower levels of government” (excluding defence and external relations), that “social security is normally predominantly a federal responsibility” and that “the financing of the expenditure is much more a federal responsibility”.

They gap between spending and funding responsibilities so identified is closed through systems of grants from federal to lower levels which are common in federal systems.

They then outlined what they thought would be required for an effective monetary union in Europe. Among the concerns they note are:

1. “There is a case for Community involvement when developments in one part … ‘spill over’ into other parts, or indeed all of it”. They argue that when structural or cyclical events occur (they mention unemployment as an example) the aim of central action should be “to ensure as far as possible that the benefits of closer integration are seen to accrue to all, that there is growing convergence – or at least not widening divergence – in the economic performance and fortunes of member states”.

2. The Community must look for “transfers of expenditures from national to Community levels”.

They also suggested that if the Community budget was to be used “as an instrument for helping to stabilise short-term and cyclical fluctuations in economic activity” the resources at the Community level would have to be significantly increased.

They considered that the way forward for an effective monetary union would be some form of public sector federation (small or large depending on the political considerations) which would perform “important equalisation and stabilisation functions”.

They said that:

Existing national federations enjoy such union internally, and its maintenance is powerfully assisted by the largely automatic equalising and stabilising inter-regional flows through the channels of federal finance.

The Report concluded that a federal spending of at least 10 per cent of GNP would be required (including defence expenditure)to achieve a “small public sector federation” where the “supply of social and welfare services … remain at the national level” and “the required equalisation of public service provision between members would be achieved by financial transfers between them which would be smaller than those in existing federations”.

So the minimum size federation would see federal spending of at least 10 per cent of GNP while the federations they studied had ratios in the range of 20 to 36 per cent of GDP.

At the time, the European level spending was around 1 per cent of GDP.

Unfortunately, the political aspirations of the elites in Europe dominated the next 15 years or so and culminated in the – Delors Commission Report – which was commissioned in 1988 and released in 1989.

The Delors Report recommended a three-stage approach to the creation of the European Monetary Union.

The Treaty of Maastricht was signed in 1992, which paved the way for the creation of the common monetary system (that is, implementation of Stages 2 and 3 of the Delors Report recommendations).

This blog is not intended as a history of the creation of the Eurozone. That is well documented. But an examination of the MacDougall Report is part of a book project I am working on at present and it is clear that its message was lost in the rush by the politicians to create the Euro.

The debate was further compromised by the Maastricht process where the Stability and Growth Pact (SGP) emerged as a reflection of the paranoia Germany and other advanced states about a union with the “southern states” particularly Itay.

There was a lot of talk about moral hazard, which in this context related to the worry that Italy and other states would run large government deficits at all times and take advantage of the easy credit (lower ECB rates than they could achieve without union) and ultimately force Germany etc to pay.

You may have wondered, given that level of distrust within Germany etc, as to why the hell they wanted to have the union in the first place. The answer is that Germany knew all along that if they suppressed real wages for their own workers they could gain growth by selling products (export surpluses) to these partner states. This would be easier if there was no exchange rate risk to deal with.

But it was a train wreck waiting to happen because there was no federal capacity created – which the MacDougall Report had gone to some lengths to recommend and articulate as being essential.

The SGP proved to be a ridiculous constraint given the automatic stablisers in many cases pushed deficits beyond the 3 per cent ceiling at the height of the crash.

English is a funny language – height of the crash – doesn’t make much sense literally given height is up and crash is down. But in usage I hope you all know what I mean.

This brings us to the recent discussions about the creation of a single banking union and Germany’s continuing inability to understand the problem.

On Monday (December 16, 2013), the President of the ECB, Mario Draghi appeared before the Committee on Economic and Monetary Affairs of the European Parliament. Here is his – Introductory statement.

In this statement, Mario Draghi discussed the “latest developments establishing the Single Supervisory Mechanism (SSM)” from the perspective of the ECB likely “supervisory responsibilities”, which will take effect in November 2014.

He addressed the EP’s recent agreement with the European Council on the “Bank Recovery and Resolution Directive” and said:

However, for the credibility of the Banking Union, another step must be taken too: The SSM needs a strong and credible Single Resolution Mechanism as its counterpart. Responsibilities for supervision and resolution need to be aligned at the European level. Thus, I urge you and the Council to swiftly set-up a robust Single Resolution Mechanism, for which three elements are essential in practice: a single system, a single authority, and a single fund. We should not create a Single Resolution Mechanism that is single in name only. In this respect, I am concerned that decision-making may become overly complex and financing arrangements may not be adequate. I trust that the European Parliament, together with the Council, will succeed in creating a true Banking Union.

What he was referring to when he said “single in name only” relates to the German insistence that the responsibilities for bank solvency in the new system remain at the member-state level, which means that effectively there is no effective reform.

The most recent – draft agreement – was released by the the Council of the European Union on November 28, 2013.

The proposals outlined in the 167-page document still resemble the plan that German finance mininster, Wolfgang Schäuble set out in his Financial Times article (May 12, 2013) – Banking union must be built on firm foundations.

In that article, he said “We should not make promises we cannot keep” which referred to the likelihood of a single system being introduced quickly.

He might have used the same warning when reflecting on the limitations that the Germans have demanded, in particular, their insistence that there be no single European-level fund to lend to banks in trouble.

In the FT article he wrote that:

Instead of a single European resolution fund – which the industry would take many years to fill – such a model would lean on national funds, which already exist in several member states.

This is code for the German fear that if there was a pooled fund under the direction of a European-wide authority (the proposed European Banking Authority), which would intervene when there was a bank failure to ensure deposits were safe, then Germany would have to stump up funds for failed banks elsewhere.

While the Germans have seemingly compromised on some non-essential elements relating to the singe banking concept (such as, its objection to the EC becoming the authority that winds-up failed banks) they will not relent on there being a sufficiently-funded federal fund to protect depositors.

The draft proposal sets out the creation of bank-funded national resolution funds which would allegedly be used to cover a bank failure.

These separate funds are in contrast to a single resolution fund at the federal level. German opposes the latter because it thinks it will get lumbered with disproportionate funding requests.

The point is that with member-states using a foreign currency (the Euro) they are not in a position to ensure that the depositors in the banks within their borders can be protected. They cannot guarantee their own debt much less any other liabilities.

The only way that the bank depositors can be fully protected and the banking system rendered stable is if the ECB is given a true “lender of last resort capacity” and a federal insurance fund be set up to cope with bank failure.

Conclusion

On another tack, Mr Draghi’s wanrings about not wanting to create a single system – “single in name only” – could well apply to the whole Eurozone – that is, the currency rather than just the common banking system.

The discussions to date about the latter tell me that the political masters in Europe heavily controlled by Germany are making the same type of errors that they made back in 1992 and after in relation to the currency.

They just cannot get it sorted that a federation can only work if there are certain characteristics present. The very characteristics that the Germans will never allow to exist.

That tells you why the Eurozone is a recipe for stagnation and periodic crisis among at least several of its member-states.

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.