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An apparent first step was taken last week to create a banking union for the eurozone. Although a lot of details were left out of the agreement and a lot of questions were not answered about such a union, hopes were raised that such an initiative would lead to more details and more answers.

One of the big hopes that attached itself to the possible creation of a European banking union is that it would help to produce a working-relationship amongst the 17 European nations included in the effort to then move on toward the creation of a European fiscal union.

Making it work is critical. In the short term, a signal of tighter regulation in the future—along with bailouts for troubled banks—is needed to stem the flight of capital from countries with banking problems, which threatened to spread to financial institutions throughout Europe,” writes James Kanter in the New York Times.

“In the longer term, by agreeing to cede power over banks, European countries hope Germany will trust them more and eventually stand ready to share eurozone debt, which could help them ease austerity measures and adopt pro-growth plans to revive their struggling economies.”

To “share eurozone debt” will require that the eurozone countries agree to some kind of fiscal union. Nothing, however, was accomplished last week concerning this “sharing” of eurozone debt.

“Countries led by Germany agreed to allow a new, permanent European bailout fund to recapitalize banks directly…In exchange, Germany and its allies won more rigorous centralized authority over lenders.”

In essence, Germany gave up nothing and yet accumulated greater relative authority in Europe over bankers should such a central banking union actually be formed.

The early interpretations of last week’s summit agreement were that Italian prime minister Mario Monti trumped German chancellor Angela Merkel. Further readings are tending to go the other way. Not only did Germany achieve more say in any European banking union that is formed, it also gave away nothing in terms of promising more money for any kind of European fiscal union that is formed.

Wolfgang Münchau writes in the Financial Times that the most important event that took place last week was the statement by Ms. Merkel that there would be no eurozone bonds “for as long as I live.” To Münchau, this statement reveals, that Ms. Merkel “is not serious about political union.”

This leads back to a point I made in a previous post.Germany, the creditor nation, “is acting as creditors always do. It wants to be paid back or put debtors through default proceeding to extract maximum benefits.”

Germany, it is argued, can ultimately achieve its goals by one of three paths: deflation, inflation, and writing checks.

“Deflation in the periphery would eventually make it competitive, and is Germany’s favored option. But, as we are seeing, it naturally leads to default by weaker banks and governments.”

With inflation, Germany loses because it gets paid back in cheaper euros. By writing checks, Germany would pay off the periphery for leading an undisciplined life: Another case of moral hazard.

To others, Germany has made a decision. They have opted for the first of the three: European deflation. The idea here is that the deflation would become so painful to the periphery nations that they would finally move to correct their situation.

Europe is in the midst of a big experiment in Game Theory. But one has to decide what form of game theory is being played. Some analysts argue that the game being played is that of “Chicken.” In the game of chicken, the goal is to make someone else get out of the game first. The game is only played once and there is potentially only one winner.

Another game is called “The Prisoner’s Dilemma.” If the Prisoner’s Dilemma is played only once, everyone comes out with a bad result. However, if the Prisoner’s Dilemma is perceived as a long-term game that is played over and over again, the players in the game can “cooperate” and all can reach a better solution over time.

If the European situation has evolved into a “Game”, the question then becomes, “What game is Germany playing? Chicken or The Prisoner’s Dilemma?” If it is “Chicken”, then the eurozone certainly will fail. If it is “The Prisoner’s Dilemma” then there is hope that a “cooperative” solution will be achieved.

But that means that for a banking union and a fiscal union to be formed, nations must give up some of their sovereignty and really cooperate in the solution.

However, this last solution is a very difficult one for proud, sovereign nations with histories of “non-cooperative” solutions going back centuries to do. In this sense, using the formation of the United States as a proxy example for the European nations to form a federal fiscal union does not exactly fit.

Still, a first step has been taken. I hope that further steps follow. I believe that we all will benefit from Europe having a single currency, a banking union where all European banks have a single regulatory authority and deposit insurance is available to all institutions, and a fiscal union where the countries of the eurozone cooperate on budgetary matters.

Such an result is, obviously, not a foregone conclusion.

Source: For Europe, Fiscal Union? Banking Union?