Today's European crisis trilemma is reminiscent of interwar Europe
Comment of the Day

October 23 2013

Commentary by Eoin Treacy

Today's European crisis trilemma is reminiscent of interwar Europe

Thanks to a subscriber for this interesting article by Michael Bordo and Harold James which may be of interest to subscribers. Here is a section
Banking expanded after the establishment of the euro (Shin 2012). No adequate provision on a European basis existed for banking supervision and regulation, which like fiscal policy, was left to rather diverse national authorities. An explosion of banking activity occurred simultaneously with the transition to monetary union and may well have been stimulated by the new single money. A “banking glut” led to a new challenge to monetary policymaking.

The bank expansion could go on longer because of implicit government backstop. It was reversed when government debt management no longer looked credible – in the Greek case after the elections of October 2009.

The implicit national government backstop was really only credible because of the international commitment to the European integration project. It was that commitment that led markets to believe that – in spite of the no bailout provisions of the Maastricht Treaty – there were almost no limits to the amount to which debt levels could accumulate both in the private and the public sector. When governments turned round, in particular after the Deauville meeting of Chancellor Merkel and President Sarkozy in October 2010 and demanded a haircut for Greek creditors (or Private Sector Involvement, PSI), the yields immediately diverged. Deauville undid the framework of solidarity that the EU treaties seemed to have created.

Eoin Treacy's view The confluence of factors that contributed to the Eurozone's banking and sovereign debt crises have been pored over in great detail for the last few years. From an investor's perspective, the measures which have been taken to deal with the problem are probably more important.

The size of the European banking sector ballooned with the creation of the single currency but measures have been underway for a number of years now to reduce the size of loan books and to rationalize the sector generally.

The Cypriot example highlights what we can expect from future bank failures especially once a Eurozone equivalent of the USA's deposit insurance corporation (FDIC) is created. Forcing sovereigns to absorb problem bank assets was a disastrous policy for the nations involved. A more varied range of options are likely to be examined in future crises.

The fact that the ECB is taking over scrutiny of pan-European banks also suggests that the regulatory laxity that allowed the crisis to form is less likely to be repeated in future. Regular commitments by the ECB to do whatever is necessary to ensure ample liquidity is available to the banking sector and to preserve the integrity of the currency are also supportive of the Eurozone generally.

The Euro Stoxx Banks Index traded at fresh lows for a few months in 2012 but this can be viewed in the context of a nearly two-year base formation. It broke out to new two-year highs at the beginning of October and rallied impressively. Today's downward dynamic suggests some consolidation of this month's powerful gain is underway. A sustained move back below the 200-day MA would be required to question medium-term recovery potential.

It is also noteworthy that a considerable number of Europe indices posted at least new two-year highs over the last few weeks but have developed short-term overbought conditions in the process. The Europe Stoxx 600 Index offers a reasonable template. It hit a new recovery peak yesterday but had developed an overbought condition following this month's rally to date. It is now susceptible to some consolidation of those gains. However, a sustained move below the 200-day MA, currently near 300, would be required to question medium-term recovery potential. Today's downward dynamics by the Italian and Spanish indices suggest consolidation of recent short-term gains is underway.

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