EU leaders are aiming to hammer out a legal framework for the nascent eurozone banking union at the final European Council summit of the year on December 13-14 in Brussels. The meeting comes amid political uncertainty in Italy, which has rattled markets and threatened to trigger renewed economic unrest in other peripheral eurozone states like Spain. At the summit, EU leaders are likely to agree on plans to situate a banking supervisor within the European Central Bank, but it is doubtful they will decide on a bank resolution mechanism or a deposit insurance scheme, says CFR’s Robert Kahn. "A full banking union does seem many years away. Beyond that, we expect to see a general setting of goals and objectives, but not much progress toward a fiscal union or other elements of better governance in Europe," Kahn argues.
Can you start by discussing the EU summit agenda for this week, specifically plans for finalizing a legal framework for the so-called banking union?
This week’s summit has a relatively modest agenda. The key achievement, if in fact it happens, will be on a banking supervision structure that puts the ECB at the center of a system that involves the national central banks and is comprehensive. That’s the first of three pieces that need to be in place to have a true banking union, and the one that is the furthest along. Beyond that, the critical need for a bank resolution mechanism seems very far off, as well as agreement on a deposit insurance scheme. So a full banking union does seem many years away. Beyond that, we expect to see a general setting of goals and objectives, but not much progress toward a fiscal union or other elements of better governance in Europe.
What are the issues of contention between Germany and other eurozone states regarding the banking union?
Pan-European responsibility without a true capacity for oversight or intervention creates an environment where you have to write checks but really can’t effectively control behavior.
It reflects, ultimately, a debate over how many banks the ECB has effective oversight over. Pan-European responsibility without a true capacity for oversight or intervention creates an environment where you have to write checks but really can’t effectively control behavior. So [Germany has] continually pushed for a stronger ECB role in supervision, but limited to major banks. This preserves their authority over German state-supported banks while at the same time retaining a say in the questions of how banks in other countries are supervised and how they’re intervened, and how then they’re resolved. What we don’t want is a system where notionally the ECB is at the head but can’t effectively supervise the banks that are likely to get into trouble.
Are EU states likely to agree on a banking union legal framework at the summit?
On that one piece—banking supervision—they’re pretty close to a deal. Last week, the Germans did publicly air their objections to the proposals as they now stand, so there is uncertainty about whether we’ll get agreement at the summit. But given that it’s the main deliverable, there will be tremendous pressure on all sides to get this done.
Other issues on the agenda include the development of a eurozone budget, or so-called fiscal capacity. How likely is it that EU leaders will agree to this, and what would be the role of such a budget?
Agreement on a eurozone budget is unlikely, given disputes both within the eurozone and between eurozone and non-eurozone members. That will likely be pushed off into 2013. But over the longer term, Europe will require a stronger federal budget that provides an automatic stabilizer within the union. We’re very far off from that, and it is likely the last stage once we’re much further down the road.
Would a eurozone fiscal capacity be a step along the path towards debt mutualization, or euro bonds, and would Germany support such a move?
There is a sense that the Germans are very much focused on their September 2013 elections, and as you get closer to that date, their interest in making new commitments to Europe will be very limited.
I haven’t seen evidence that the Germans, at this point, would be terribly interested in even making forward-leaning statements in this area. They see debt mutualization as a last step once effective fiscal control is in place. Furthermore, there is a sense that Germans are very much focused on their September 2013 elections, and as you get closer to that date, their interest in making new commitments to Europe will be very limited.
What are the implications of Italian Prime Minister Mario’s Monti’s recent resignation announcement on Italian borrowing costs, and what are the broader consequences for the structural reforms that have been implemented in Italy thus far under Monti?
The markets have broadly been cheered by the reforms undertaken by the Monti government and see it as the best hope for sustained structural reform and a return to growth. So anything that undermines that government obviously has been negative. And we saw a significant selloff in bonds after Monti announced his decision to resign on December 9. Markets will continue to be very sensitive to Italy—whether Monti will run and stand in the new elections, and what his odds are returning in a government. But what it underscores is a great deal of concern about the durability of the reforms that have been undertaken and what policies a successor government will follow. The fact that we are going to have to live with a fair amount of uncertainty for a while is going to be one of the issues that affect markets.
What are the potential implications of the Italian situation for other peripheral eurozone states like Spain?
Generally speaking, anything that creates concerns about Italy will affect the other peripheral countries to some extent. Right now, it is seen mostly as an Italy-focused event, but naturally, if there is pressure on Italy, Spain will feel the effects of that. For Spain and Italy, ultimately, if spreads widen, the focus will shift to whether these countries are willing and able to adopt programs with the EU that would be sufficient for the ECB to enact their program of bond buying. Up until now, Spain has not been willing to ask formally for the program. There is an expectation that eventually they will. But if turmoil continues to push up Italian spreads, the pressure on Spain to ask for support would intensify.
What is the situation in Greece? Can you give an overview of the revised agreement with the EU and IMF over bailout and austerity conditions?
The agreement that was reached at the end of last month provides financing for the next several years on paper, and includes budgetary financing, funds to recapitalize the banking system, and financing for a buyback of debt, which is now under way. In principle, this program aims to ensure that Greece, if it meets its targets, can stay in the eurozone for the indefinite future. A more realistic interpretation is that it’s a stopgap measure. Greece has had terrible trouble meeting these targets. It reflects both the economic and political difficulties facing the government. Those pressures continue to exist: the recession is deepening, and it’s likely that this package really only holds for a short period of time before Greece requires more money. Markets up till now have felt that Greece will get the money it needs to get it through the German elections. I am a little more doubtful. It is quite possible, in fact, that Greece will find that the requirements of this program are just too onerous and that it would be in its interest, as well as Europe’s, for it to consider leaving the eurozone, and that could occur during 2013.
In terms of 2012, would you say this has been a year of progress for the eurozone?
The solution to the crisis rests with governments reforming their economies and providing adequate financing for governments that are doing the right thing, and moving firmly toward completing the union.
It has been a year of stabilization. What we have seen, on one hand, is a continuation of a very slow process of reform in which measures taken by governments to resolve the crisis are seen as inadequate by markets. This leads to pressures on bonds and on governments, which leads to some additional measures sufficient for the ECB essentially to come in with a wall of money. It is ultimately a disappointing process from the policy perspective. It creates a lot of problems for markets and undermines a country’s creditworthiness. But the positive side of this story is that the ECB has taken a number of very strong measures this year, including, most recently, its program for bond purchases that have provided a good deal of stability for markets; in that sense, there has been progress. Ultimately, though, the solution to the crisis rests with governments reforming their economies and providing adequate financing for governments that are doing the right thing, and moving firmly toward completing the union. From that perspective, we’re not a whole lot closer to that than we were a year ago.
What are the main challenges for the eurozone in 2013?
It’s going to be essentially [about] supporting reform in an environment of very low growth. Looking at this year, growth has faltered. Exports have done well, while domestic demand in the eurozone has done pretty poorly. Looking ahead, the outlook for exports may not be as good. The global environment looks quite fragile, and, of course, issues like the U.S. fiscal cliff or China’s slowing growth rate are out there. But even in the eurozone, there are questions about credit availability and the role of financial markets in supporting growth, and it looks like financing will be a real constraint on activity next year. So in the first instance, growth is the main challenge that they face, and if there isn’t growth, it certainly will put more pressure on the adjustment process.