Apologies for the long absence. The past few weeks have been extraordinarily busy on several fronts. I think I'll be able to get this place back into fighting shape pretty quickly.
The decision of S&P to downgrade more or less the whole of Europe has made a lot of headlines, but I'm not sure how much it matters. The plan for Europe before that happened isn't much affected by the downgrade: the ECB prints money and gives it to the banks, accepting EMU sovereign debt as collateral. The banks use the funds to buy sovereign debt. The banks get financing for sure, and if all goes well so do the governments. As far as I can tell, for regulatory purposes all OECD sovereign debt still counts as "risk-less" -- meaning that banks are not forced to hold any capital against it -- under the Basel accords, so there is a regulatory incentive for banks to buy some of this stuff.
There's something absurd about all of this... every step in the chain is an attempt to hear no evil by sticking fingers in one's ear. But if the eurozone is going to survive the European banking system has to stand upright and be able to finance governments. That requires ECB support.
JP MorganChase CEO Jamie Dimon, who often says things in public that are more revealing than he perhaps realizes, recently claimed to believe that there is no banking problem in Europe:
“It eliminates bank liquidity or funding problems for at least the next year, that’s a pretty powerful statement,” Dimon said today after his company reported a drop in fourth-quarter net income. “That was the biggest single risk of an uncontrollable surprise right there, so if that’s taken off the table, that’s a good thing.” ...
“Europe is trying mightily to solve its problems. I still think the likely outcome is they will muddle through,” Dimon said. “The longer you wait, the higher you run the risk of something disorderly that you can’t really control. I think the ECB took off the worst outcome, i.e. a bank failure.”Dimon might be right about Europe being able to muddle through, although I still have my doubts. He might even be right that a bank failure is the "worst outcome" in Europe, although I can think of some worse outcomes. But what he doesn't say, indeed what no one has much talked about, are the negative effects this will likely have in the European banking sector if the plan works.
The problem that the new ECB policy is supposed to resolve is this: banks won't lend to needy European governments except at punitive rates. Why? Because those governments are highly likely to default. This is exactly what we want a responsible, healthy banking sector to do.* What we don't want is what we're now hoping to get, which is to say that we don't want a banking sector whose investment behavior is skewed by political institutions pursuing dubious policy goals. We don't want a banking sector that has an expectation of future support if their investments go bad, and we don't want a banking sector that cannot discipline either itself or those to whom it lends.**
We don't, in short, want a situation in which government interventions make Jamie Dimon smile. (Or interventions that make him rich.)
Is this road less bad than the one Europe was on previously? In short run, surely. In the medium-to-long run it's hard to say. Perhaps we think that once the crisis is resolved the ECB can make a credible future commitment to be more standoffish towards the European banking sector. Perhaps we think that we can rein in banks and national governments in other ways, via strict capital standards for the banks and "Hard Keynesianism" for the governments. But I have little confidence that those things are likely. They cut against almost every identifiable political current.
The only way it works is if this crisis really scares everybody so much that a significant (and durable) shift is made in the regulatory and fiscal infrastructure of Europe. While not impossible, I remain highly skeptical that that will happen. I believe it's more likely that policymakers will conclude that the institutions in place are pretty resilient already -- "How else could we have pulled through this crisis?" -- particularly when coupled with a more activist ECB that will support the banking sector when needed. I believe the banks will conclude that the ECB is their friend, and will therefore count on support when needed, particularly if the cause of the trouble are the member nations of the EMU. That is a recipe for a lot of future financial instability.
The ECB cannot, and should not, be in the business of resolving Europe's political problems. Forcing it into that role is likely to make things worse in the long run.
*The "we" here being an imagined societal consensus in possession of the general will, which reflects more-or-less center-left neoliberal technocratic principles. Yes, I know this "we" does not exist in nature.
**I have a paper, currently R&R, that argues that when banks expect preferential policies from governments they act less prudently. Simple argument, I know, but it's not in the literature yet. I find statistical support. I'll post it if/when it gets accepted somewhere; if someone wants it sooner e-mail me.