Too leisurely a stroll towards any banking union

From Dr Desmond Lachman.

Sir, Gene Frieda is certainly correct in warning that Europe’s move towards a weak banking confederation, rather than towards a true banking union, heightens the risk that deflation will take hold in Europe (Insight, December 9). However, he seems to downplay the more immediate deflation risk posed by the leisurely pace at which Europe is moving towards any form of banking union and by the sequencing of the policy steps towards that goal.

In the context of indications that countries such as Greece, Ireland and Spain are already experiencing wage and price deflation, it has to be regretted that the European Central Bank will only complete its asset quality review exercise and begin supervising European banks by the end of 2014. Since that is just the first step towards banking union, it would imply that the earliest time that Europe might move towards any form of banking union would be by 2015. In the meantime, one must anticipate that the very large gaps expected to persist in Europe’s labour and product markets will continue to exert substantial downward pressure on European wages and prices, as they have done over the past year. And they will do so at a time when the overall European inflation rate is already disturbingly low.

Of equal concern is the fact that the ECB’s asset quality review exercise is being conducted ahead of the recapitalisation of Europe’s undercapitalised banking system. This poses the risk that Europe’s banks will continue to deleverage and to cut back on lending to households and companies as a precaution against being found short of capital by the ECB. At a time when European bank credit is already contracting at a 2 per cent annual rate, the fastest pace of contraction in the euro’s 15-year history, this would seem to be a risk that a struggling European economy can ill afford.

Desmond Lachman, American Enterprise Institute, Washington, DC, US

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