Hugo Dixon

Does Europe need a “banking union” to shore up its struggling monetary union? And is it going to get one?

These questions are raised by the increasingly lively debate over how to break the link between troubled states in the euro zone periphery and their equally troubled banks. In some countries, such as Ireland, the lenders have made so many bad loans that they have had to be bailed out – in turn, dragging down their governments. In Greece and Italy, the banks have gorged on so many government bonds that they have been damaged by their state’s deteriorating creditworthiness. And, in Spain, the current focus of the euro crisis, a bit of both has been happening: banks made too many bad loans – and then bought too many government bonds.

One proposed solution to this incestuous relationship, advocated among others by the International Monetary Fund, involves creating a centralised Europe-wide system for regulating banks and, if necessary, closing them down and paying off their depositors. The idea is that the region’s lenders would be viewed as European banks rather than Spanish, Greek or Italian ones. If they got into trouble, they wouldn’t infect their governments; and vice versa. That would make the whole euro crisis easier to manage.

While the idea carries much theoretical appeal, such a fully-fledged banking union isn’t realistic. The incestuous embrace between governments and banks may be unhealthy, but that doesn’t mean politicians entirely dislike it. National oversight of lenders gives politicians all sorts of ways of meddling in their economies. And this is not just in the troubled countries. Relatively healthy states such as Germany and France would be loath to surrender the power to boss around banks to some supra-national authority.

Citizens in rich states wouldn’t like the idea of having to bail out banks that had gone on a binge in a completely different part of Europe either. What’s more, even if a centralised banking body was created, would it really have the clout to tell the big boys what to do?

We’re going to be really tough on the euro zone. If they want more bailouts from the International Monetary Fund, they are going to have to submit to strict conditionality. That was the message delivered by the rest of the world when it agreed at the weekend to participate in a fundraising exercise that will boost the IMF’s resources by at least $430 billion.

But the meaning of the message isn’t quite what it seems. The IMF is actually in some ways calling for less rather than more short-term austerity in the euro zone. So if the Europeans submit to IMF discipline, it will ironically mean less of a hair shirt.

It is easy to see why the rest of the world is unhappy with the special treatment the euro zone receives from the IMF. The managing director, currently Christine Lagarde, has always been a European. Vast resources, way beyond what are normally available in IMF programmes, have been channelled to Greece, Ireland and Portugal.

Can the euro omelette be unscrambled without provoking the mother of all financial collapses? With the crisis heating up again as Spanish 10-year bond yields hit 6 percent last week, the question has renewed urgency. The conventional wisdom is that such unscrambling is impossible. The economic, political and legal complications of bringing back national currencies are so immense that the euro zone’s 17 nations are effectively locked in a prison with no exit.

A 250,000 pound prize offered by Simon Wolfson, a UK businessman, has aimed to turn this conventional wisdom on its head. In offering what is the second-largest economics prize after the Nobel, Wolfson hoped to stimulate creative juices. In one case, he has – although even it is no silver bullet.

Of the myriad problems with returning to the drachma, peseta and lira, the most intractable is how to prevent it triggering bank runs and ultimately financial chaos. Depositors would flee if they thought their euros were set to be converted into a national currency certain to suffer dramatic and immediate devaluation. This has already been happening to some extent in Greece. If the Greeks knew for sure that their old currency was coming back, the current fast walk would turn into a stampede. Even worse, the damage wouldn’t be confined to Greece.

Beware the “F” word. The European Central Bank and, to a lesser extent, the zone’s political leaders have bought the time needed to resolve the euro crisis. But there are signs of fatigue. A renewed sense of danger may be needed to spur politicians to address underlying problems. It would be far better if they got ahead of the curve.

The big time-buying exercise was the ECB’s injection of 1 trillion euros of super-cheap three-year money into the region’s banks. A smaller breathing space was won last week when governments agreed to expand the ceiling on the region’s bailout funds from 500 to 700 billion euros.

These moves have taken the heat out of the crisis – both by easing fears that banks could go bust and by making it easier for troubled governments, especially Italy’s and Spain’s, to fund themselves. Data from the ECB last week shows how much of the easy money has been recycled from banks into government bonds. In February, Italian lenders increased their purchases of euro zone government bonds by a record 23 billion euros. Spanish banks, meanwhile, increased their purchases by 15.7 billion euros following a record 23 billion euro spending spree in January.