LETTERS TO THE EDITOR

Summer 2009

by Pavel Pelikan

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Sir,

Daniel Gros and Stefano Micossi are undoubtedly right to say that Europe’s banks need more money to provide “good” loans to support economic recovery. It is also true that non-European investors would readily provide the necessary finance if they were offered “good” government paper in return. But since European governments have earned very varied reputations concerning their ability to manage public finances soundly, not all countries can attract enough international investment to re-capitalise their banking sectors through the sale of national bonds and the like.

Unfortunately, Gros and Micossi’s proposal for dealing with this dilemma – a massive European Financial Stability Fund (EFSF) – is seriously flawed. As usual, the devil is in the detail. Put simply the basic problem is this: How do you allocate the new capital to individual banks? The U.S. has yet to solve this problem properly for the TARP, which the EFSF is intended to emulate. A European fund would face additional complexities over the role of national governments in the allocation process. For example, should EFSF managers be allowed to bypass member states altogether and select recipient banks directly? Or should there be some politically-determined rationing scheme, with each government choosing how to allocate its share of the capital to banks within its jurisdiction?

Since Gros and Micossi complain that European governments do too little to support their banks, I guess they would prefer EFSF managers to make the decisions. Yet this would exclude what I see as the main advantage of their proposal; the principle of distributing eventual losses according to the country where they arose. If fund managers allocated the capital unwisely, then governments might still be forced to pay for their mistakes. Such a system would be neither efficient economically nor acceptable politically. If on the other hand governments made the decisions, the principle of loss-distribution could operate but the EFSF would be superfluous. It would be cheaper to let each EU member state issue as much paper as it wanted, with the European Investment Bank guaranteeing an agreed amount per country.

The EFSF would also have to face a number of other questions that are now troubling the TARP. Two are particularly important and controversial. First, how easy should it be for a bank to obtain capital? Gros and Micossi favour easy capital, but here they face many opponents in both Europe and the U.S. Easy capital is only the right choice if we can be sure it will be transformed into good loans. Clearly there can be doubts on this score, since the entire financial crisis was caused by bankers who transformed too much easily-created capital into bad loans! This makes it reasonable to require bankers to meet more or less difficult conditions, and thus try to stop them making the same mistakes again – even if it is not entirely clear what these conditions should be.

Second, should most of the capital go to the worst banks with the largest losses, or to those which behaved more wisely? While Gros and Micossi leave this question aside, many policymakers now appear to favour the worst banks option. I see a strong “evolutionary” argument against this choice. Propping up the worst banks interferes with the invaluable working of markets as selection devices that demote insufficiently competent people from top economic positions. By contrast, channelling the capital to good banks would facilitate their taking over bad ones, which would allow their (probably) superior competence to benefit larger parts of the banking sector.

I don’t claim to know all the answers to the current crisis, but nor does anyone else. This point is important for proposals such as the EFSF because contrary to what many well-meaning EU politicians appear to believe, unity is not automatically better than diversity. Not only do some questions require different answers under different conditions, but diverse answers are also better in situations where the optimal common solution is not yet known. It is better to test a range of alternatives first, rather than reaching a premature consensus around a mediocre answer just because some powerful policymakers strongly, but wrongly, believe it to be right.