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Another Critical Week for the Euro

Here we go again, folks—Monday supposedly began another“critical week for the euro.” But this time, it seems there’s a twist: Some claim the full month of October are "Decisive Days for the Euro."

Among upcoming European events are the next chapter in Greece’s efforts to negotiate with its international creditors. Prime Minister Antonis Samaras seeks to extend the timetable for various delayed austerity targets the troika is requiring to disburse the next aid tranche. It’s rumored the Greek government wants to have a troika-approved deal to present to eurozone finance ministers at their October 8 meeting. Although both sides continue negotiating the hard line, in our view, it’s likely they eventually reach a compromise and Greece gets its next aid tranche—even if it’s not by their “deadline” in the sand.

Also set for October 8—the ESM bailout fund is scheduled to be “fully operational.” This has led to speculation Spain will submit its formal bailout request and put the ESM to work before the staff even has a chance to set up their desks. But to us, it’s an open question whether Spain follows through. The country continues to issue debt at reasonable yields while making ongoing austerity commitments. And recall, Spain’s already drafted a bank bailout—should that come to pass, it would seem to address the vast majority of the nation’s needs. Many are seeing recent developments like the additional austerity announced last week as essentially pre-negotiating the terms of a bailout. And that’s possible, but also widely anticipated.

The real story in Europe, in our view, is not so much handwringing over the day-by-day developments which are nearly always labeled urgent by the media. Rather, the key is what’s prevented any single week in the last three years from being catastrophic: European officials’ commitment to finding ways to compromise and maintain the euro.

Don’t Fence Me In

The EU’s taskforce on banking regulation, led by Bank of Finland Governor Erkki Liikanen, has released its recommendations for financial sector reform. Among its many proposals: Ring-fencing proprietary and other “significant” trading activities of the largest European banks.

Under the proposed scheme, any bank whose trading portfolio is at least €100 billion or represents 15-25% of total bank assets must assign these trading activities to a separate legal entity—essentially, a wholly owned investment bank. Structured investment vehicles, private equity investments, hedge fund-related transactions (including prime brokerage and market making), most derivative positions and the like all would fall inside the ring-fenced “trading entity.”

In theory, the aims are making failed banks easier to unwind, preventing taxpayers from bailing out banks’ (allegedly) risky behavior and protecting retail depositors from investment banking gone-wrong—or, in simpler terms, it aims to prevent a repeat of 2008. However, as we’ve written, there’s no evidence a firewall between retail and investment banking would have made much difference then. None of the failed US financial institutions were retail and investment banking monoliths—Washington Mutual was essentially a thrift, Lehman Brothers and Bear Stearns were pure investment banks and AIG was an insurance firm. The UK’s Northern Rock was a building society. But the four Nordic banks potentially caught by the new rule were deemed success stories in 2008! And while other big European banks did receive government support in 2008, this was tied more to the frozen interbank funding market than bank-specific balance sheet issues. Overall, ring-fencing trading seems a solution in search of a problem.

Whether and how soon these proposed changes will take effect isn’t clear. EU Banking Commissioner Michel Barnier said he’s not in any hurry to adopt the recommended reforms, and he’s ordered an assessment of the proposals’ potential impacts on economic growth and “the safety and integrity of financial services.” And the UK, which is pursuing plans to ring-fence banks’ retail operations, may request some fine-tuning. How the recommendations evolve over the months ahead will bear watching.

Putting the Cart Before the Horse

According to the World Bank, the world faces a hefty challenge over the next eight years: “creating” a whopping 600 million jobs—the number required to “absorb young people entering the work force, spur development, empower women and prevent unrest.” So not only a hefty challenge, but also one whose resolution of which is supposedly something of a cure-all for the world’s ills.

Set aside the fact it’s near-impossible to make terribly reliable or accurate long-term forecasts (which an employment estimate covering a 15-year span certainly is). Our bigger quibble is with the primary focus on jobs, which in our view is largely putting the cart before the horse. We’d suggest instead what’s likely needed is increased focus on freeing capital markets and increasing economic freedom globally, particularly in the areas emphasized by the World Bank—namely, Asia and sub-Saharan Africa. If the areas of the world still maintaining relatively tight government control over their economies were to liberalize, we have relatively little doubt jobs would follow rather promptly. But focusing so intently on job creation as a primary goal is rather like replacing all the windows in a tornado-stricken home, neglecting the fact the roof’s been blown off, and expecting to keep the rain out.