Addressing Europe’s risks

By Felix Salmon
May 30, 2012
says today that the EU should move towards "a full economic union"?

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What exactly does the EU’s José Manuel Barroso mean, when he says today that the EU should move towards “a full economic union”, which would include “a banking union with integrated financial supervision and single deposit guarantee scheme”? In a simultaneous EC report, there was also talk of “direct recapitalization by the ESM (European Stability Mechanism)” when banks run into solvency issues.

The big idea here is simple, and relatively easy to understand. Banks in Europe’s peripheral countries, most importantly Spain, are understandably seeing their deposits move to countries like Germany, where there’s no risk of devaluation. But that kind of a slow bank run — Mohamed El-Erian calls it a “bank jog” — inevitably weakens those banks’ balance sheets, and the straitened PIIGS governments are in no position to shore up their banking systems with billions of euros in bailout money.

Here’s Mohamed’s suggestion, which seems to be extremely close to what the EC is now signing on to:

An incredibly disruptive situation could be avoided if Greek depositors were given quick access to a region-wide (as opposed to just national) deposit insurance scheme that is unambiguously supported by the fiscal authorities in the strongest eurozone countries. This would need to be coupled with even larger liquidity support from the European Central Bank, along with direct capital injection into the Greek banks from regional funds (e.g., the European Stability Mechanism, or ESM) and multilateral institutions (namely the International Monetary Fund).

I have a funny feeling that this is exactly what’s going to happen, but that implementation is going to be carefully timed so that it happens after Grexit, and not before. First you wait for Lehman Brothers to go bankrupt, then you give investment banks full access to the Fed discount window.

The problem is that deposit-guarantee schemes need to be tested before they’re trusted. Even with an EU-wide guarantee in place, at the margin German banks are always going to be safer places to put your money than Irish banks — and of course a guarantee would only cover relatively small six-figure retail deposits, it wouldn’t cover the huge corporate cash balances which only the most foolish of corporate treasurers would still consider leaving on deposit at, say, Bankia.

All of which is to say that although the degree of risk and uncertainty in Europe is high and can come down, there’s also a limit to how far it can come down. As Walter Russell Mead masterfully explains, Europe’s politics — much of which are playing out at the national level within multi-nation states — will inevitably and fatally trump whatever theoretical economic union the Eurocrats attempt to put in place. And because that risk is now so clear, the one thing that no one has to worry about is the kind of complacency where enormous systemic risks build up quietly without anybody noticing or worrying about them.

That’s the point that Nassim Taleb was trying to make in his Montreal speech yesterday — a speech which got reported by Bloomberg as simple investment advice. I know Nassim reasonably well, and I can promise you that he would never say that he “favors investing in Europe over the US” — he has nothing but disdain for anybody who makes such grand and stupid pronouncements. He would be happy, however, to reprise the theme of of his Foreign Affairs article last year, on the subject of “How Suppressing Volatility Makes the World Less Predictable and More Dangerous”. Clearly, the US is much better at suppressing volatility than Europe is, right now.

That essay has disappeared behind a paywall now, but I excerpted a bit of it here:

A robust economic system is one that encourages early failures (the concepts of “fail small” and “fail fast”)…

Consider that Italy, with its much-maligned “cabinet instability,” is economically and politically stable despite having had more than 60 governments since World War II (indeed, one may say Italy’s stability is because of these switches of government).

During the global economic crisis, the US was happy to see many more domestic bank failures than Europe was — and on top of that was happy to put its big automakers into bankruptcy. Those decisions served America well. Now, Taleb’s saying, the tables are turned: the volatility in Europe has become unavoidable, while the US appears to be a beacon and a safe haven. And whenever you achieve safe-haven status, the short-term benefits (the 10-year Treasury bond now yields just 1.65%, which more or less amounts to the markets begging the US government to borrow more) are always offset by hidden tail risks which tend to bite very hard indeed when they finally materialize.

None of which, of course, is or should be taken as investment advice. A long-Europe, short-US trade would be highly risky right now, with a greater-than-even probability of losing money. Now back in his trading days, Taleb specialized in putting on trades with a greater-than-even probability of losing money: he reckoned those trades were generally underpriced, and that the amount you made in the minority of cases where the bet paid off could more than cover the amount you lost in the majority of cases where it didn’t. But Taleb’s not a trader any more, and in any case none of that kind of sophistication made it into the Bloomberg article.

If you want a safe place to put your money, the conventional wisdom remains correct: Germany and the US are definitely safer than Spain and Greece. Nassim’s new book isn’t going to help you find a new, undiscovered safe haven. But it might serve to remind you that the stronger you think a political economy is, the more violently it tends to break.

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