(This post was written for Citywire and adapted for this site)
Many readers of this site think the best answer to resolve the Euro crisis would be to announce the intention to re-establish independent currencies across Europe. They could each find their own level and economies would start to improve. This is not about to happen because the Euro is a political project. The fact that it does economic damage does not matter very much to its creators. That is why they will instead make more moves to create an economic government of Euroland, and have to do so.
Every successful currency has a sovereign to take care of it. The Euro is an orphan currency. It is a currency in search of a country to love it. Given the rolling sovereign debt crisis in Euroland, and a smouldering banking crisis, it is time to ask will someone be a good parent to this struggling adolescent money?
Traditionally sovereigns placed their stamp on the money and placed their force, their Treasury and economic policy behind it. The sovereign decided how much to issue and whether to debase it.
Modern democracies behave in a similar way, though they often use a so called independent Central Bank to make some of the important decisions for them. In practice the Central Bank only maintains its independent action whilst it continues to please the sovereign. Parliaments and Congress can change the rules governing the Central Banks, change the targets, change the personnel when need arises. They can even change the money, as the German government instructed the German Central Bank to do when they surrendered the DM.
The Euro lacks some of the usual arrangements. There is a so called independent Bank, but it changes policy quite frequently and clearly listens to the ebb and flow of political debate about whether to buy in bonds, whether to monetise any debt and whether to change interest rates. Like other Central Banks, in the middle of the Credit Crunch it joined in a co-ordinated lowering of rates and related actions which arose out of Finance Minister discussions. Unlike sovereign countries, the Euro lacks a single authority drawing up a single state budget, single political control over the levels of sovereign borrowing, and a single issuer of sovereign debt.
The architects of the Euro recognised the potential weakness. They said Euro area governments had to keep their stock of debt below 60% of National Income, and keep annual deficits below 3%. Unfortunately they did not enforce the governance to ensure this happened. Some states borrowed far more. They were free riders at the lower average rate for a bit. Now they face spiralling debt costs, as markets have come to realise there is no EU sovereign guarantee on states’ debt.
A single currency area also needs strong banking regulation, capable of keeping all the main banks in the system solvent and liquid. The Central Bank either has to do the regulating itself, or be confident in the banking regulator. The Central Bank has a duty to supply liquidity to all banks should need arise. The ECB has done this for much of the time, but recently announced it wished to reduce the amounts lent under special facilities. In particular it wanted a refinancing of Irish banks which led to the week-end crisis of the Irish state financing.
The ECB has to be comfortable with the solvency regulation of main Euro area banks. If it has any doubts it needs the ability to sort these out in private with the bank concerned and or the bank regulator. All banks in the system must be deemed to be solvent and seen to be solvent. They should then be offered whatever liquidity it takes if there is a run on their deposits or wholesale funding. To reassure investors it is likely the Euro authorities have to conduct new tests and hold private discussions with each bank, and make sure every bank has a plan to strengthen its position where this is needed.
This week has seen major advances in the task of finding a parent for the Euro. We have the first issue of EU bonds with an EU sovereign backer, as they raise money for the Euro bail out fund. We have more support for Euro area banks announced by the ECB. They now need to use the time they have bought to create a true sovereign. That is an economic government of the Euro area that controls debt and deficits and ensures strongly regulated banks.