European Central Bank president Mario Draghi surprised markets last Thursday by cutting the Bank’s benchmark interest rate to a record low 0.25 percent (as low as the federal funds target rate in the U.S.). Explaining his decision, Draghi—the person who deserves most of the credit for the lull in the euro crisis over the past 15 months—noted that “monetary and, in particular, credit dynamics remain subdued” and that monetary policy must remain accommodative in order to “assist the gradual economic recovery” taking hold in the Eurozone. In other words, monetary policy must remain extremely loose to prevent Europe from sliding into a Japan-style period of protracted stagnation.
The Eurozone recovery, which materialized in the second quarter of 2013 after a year-and-a-half of double-dip recession, is weak and, more importantly, uneven— as the head of the ECB is well aware. While Germany and Finland grew 0.7 percent quarter-on-quarter and France followed closely behind with 0.5 percent, Spain contracted by 0.1 percent (1.7 percent year-on-year), Greece by 3.8 percent (4.6 percent year-on-year), and Cyprus by 1.4 percent (5.2 percent year-on-year). This is mostly due to austerity policies forced on bailed-out and other over-indebted states. What has received less attention is the role of the “credit dynamics” Draghi mentions, more specifically the extreme credit crunch afflicting the economies of the European periphery.
According to the most recent survey by the ECB (October 2012 to March 2013), 38 percent of small and medium-size businesses in Greece, 25 percent in Spain, 24 percent in Ireland, and 21 percent in Portugal consider access to finance their most pressing problem. In Germany and Austria, only 8 percent of small and medium enterprises (SMEs) shared the same view. During the same period, availability of bank loans to SMEs fell by 40 percent in Greece, 32 percent in Portugal, 22 percent in Ireland, and 17 percent in Spain, while growing 7 percent in Germany. The percentage of small businesses reporting a fully successful loan application was highest in Germany (85 percent) and Finland (79 percent) and lowest in Greece (25 percent) and Ireland (32 percent).
It’s not just access to credit that divides the core from the periphery, the North from the South—it's the terms as well: The interest rate on business loans is about 7 percent in Greece, Cyprus, and Portugal. For the Netherlands and Germany, the interest rate hovers around 3 percent. In France, Belgium, and Austria, it is even lower (data from April, compiled in a paper for the Bruegel institute by Zsolt Darvas).
The significance of this cannot be overstated. The economies of the European South in particular are far more dependent on SMEs than the rest of the Eurozone. It suffices to note that the share of employment of small and medium-size firms in Greece exceeds 85 percent of total jobs in the country. SMEs exceed 75 percent of total employment in Spain, and Portugal. The EU average is far lower, at 67 percent. Not suprisingly, unemployment in these countries is far above the Eurozone average of 12.2 percent (27.3 percent in Greece, 26.6 percent in Spain, and 16.3 percent in Portugal).
The European Commission and the European Investment Bank, a development bank whose shareholders are the member-states of the EU, have sought to rectify this imbalance through a number of policies aimed at enhancing credit access for companies in the Eurozone’s most troubled countries. But the tiny size of the European Union budget—about 1 percent of the collective GDP of the countries that make up the union, compared to the individual member-states' governments spending around 50 percent of GDP on average—and the conservative approach of the EIB have meant that their influence has only been marginal.
The key to solving the credit crunch lies instead in fixing Europe’s ailing banking sector. In the aftermath of investment bank Lehman Brothers’ collapse in 2008, the United States moved swiftly to test the resiliency of its financial institutions. It injected funds where necessary and confidence in the banking system soon returned. European officials, terrified by the heart attack the global financial system suffered, have been reluctant to poke around too meticulously.
“Kicking the can forward is the typical European response because Europeans need to reach a consensus on most decisions”, explains Gikas Hardouvelis, professor of economics and finance at the University of Piraeus, chief economist of Greece’s Eurobank and a former prime ministerial adviser. As a result, stress tests were too weak, market confidence has remained elusive and Europe’s small firms in the recession-battered South have seen liquidity dry up.
While acknowledging all this, optimists saw hope in the ambitious plans for a European banking union. Southern leaders had dragged Germany into accepting such a program in the euro summit of June 2012. The core idea of the banking union was that it would Europeanize supervision and resolution of financial institutions, including deposit guarantees, and thus break the “doom loop” tying bankrupt governments with insolvent banks. For example, if a bank got into trouble because its government was in dire fiscal straits and it owned large amounts of government debt, it could be recapitalized with European money (from the ESM, the EU rescue fund), without further encumbering the already over-indebted state where it was based. A truly European banking sector would emerge, and cross-border discrepancies in lending rates, though not vanishing altogether, would narrow considerably.
Things haven't quite worked out in accordance with the initial high expectations. Angela Merkel and her allies in the North started backtracking from the original agreement almost as soon as it was signed. The finance ministers of Germany, the Netherlands, and Finland then insisted that the ESM would deal only with problems occurring under the new, ECB-centered supervisory regime, and that so-called “legacy assets” from past recklessness would be left to national authorities to tackle. In practice, that meant that banking union could no longer be used as a weapon to deal with the “doom loop” that is at the core of the current crisis—it could only be used for crises to come. Meanwhile, any talk of a pan-European deposit-guarantee scheme has been pushed far into the mists of the future.
Then came Cyprus and the bail-in of depositors, as part of that country’s disastrous “bailout.” Touted by Jeroen Dijsselbloem, the new head of the Eurogroup (group of Eurozone finance ministers) and protégé of his German counterpart Wolfgang Schaüble, as the new model for dealing with European banking crises, it further clarified the Northern approach to banking union: it is the “limited liability” way, whose ultimate aim is to avoid using European funds to bail out any bank. (Dijsselbloem said after Cyprus: “We should aim at a situation where we will never need to even consider direct recap.”)
The new stress tests about to be carried out by the ECB, which takes over next year as supervisor of the Eurozone’s systemically important financial institutions, are likely to be far more rigorous than their predecessors. If they are, Europe’s banks will emerge from them with healthier balance sheets and better able to finance productive investment. But that is in the long run, where, according to Keynes, we are all dead. In the meantime, as Hardouvelis puts it: “This new bail-in feature discourages cross-border banking and works against a true banking union.” This ensures that credit in the South will remain scarce, that the recovery will be further delayed.