Nervous markets

Erik Jones is director of European Studies at the School of Advanced International Studies of The Johns Hopkins University and Head of Europe at Oxford Analytica. He is based in Bologna, Italy.

The recent European Council summit offered reassurance for European financial markets. The agreement reached by the group of countries that participates in the euro - the 'Eurogroup' - makes it clear that there should be less reason for investors in banks and government debt markets to be concerned about potential future losses.

The European Central Bank will play a leading role in the prudential oversight of the European banking system. The European Financial Stability Facility (EFSF) and its successor, the European Stability Mechanism (ESM), will help to put a floor under sovereign debt prices.

Sensible decisions

The loans given to the Spanish banking system by the EFSF will not gain seniority over other creditors when they are handed off to the ESM. And, once new arrangements for banking supervision are in place, the ESM will be able to inject funds directly into troubled banks without adding to the public debts of the countries where they are domiciled. These are all sensible changes that add up to a single message: don't be afraid.

The fear in the market before the summit was palpable. The International Fund (IMF) and the World Bank issued warnings; bond spreads with Germany for Italy and Spain increased; the euro lost value against the dollar; and business confidence declined. The threats by Italian Prime Minister Mario Monti to veto the European growth initiative only heightened the tension.

It was a good time for reassurance and the European Council delivered. Once the message came out, the markets offered a positive response.

Just a few days later, however, and the reassurance is fading. Pundits complain that the agreement is too vague; analysts worry that it may take a long time to implement; and economists argue that the effects could be counter-intuitive. These are all rational concerns but they are generating an irrational response. Fear is coming back into the markets.

Emergency guidance

The return of fear was always to be expected. Market participants are driven by irrational emotions - like fear and greed - that Keynes referred to famously as ‘animal spirits.' The question is what Europe's political leaders are going to do about that fact. It is not enough simply to try and calm the fear. Europe's leaders need to learn how to channel it.

The problem that is driving the crisis at the moment is 'what to do in case of emergency.' As investors become afraid and so revise their estimates of risk and return, they are moving their money across countries. They are selling bonds and liquidating deposits on the eurozone periphery, and transferring the proceeds into countries that they view as ‘safe,' like Germany and the Netherlands, but also Denmark, Switzerland and Norway.

The European Council summit did nothing to address this dynamic. The message of reassurance it had to offer could only hope to slow the flow of capital from the periphery to the core and not eliminate it entirely.

Of course at some point in the future investors might see real opportunities to be had from moving money out of the safer countries and back into the periphery. But that will take place only once the crisis is over; it is not the mechanism that will bring the crisis to an end.

This flight to safety across countries is creating problems on both sides of the flow and creating enormous strains in the architecture of the European financial system. The countries that are losing money have no credit for industry and so must watch their economies wither.

Neglected growth agenda

The European growth agenda is far too small to reverse that effect and economic development on the eurozone periphery will be permanently damaged as otherwise competitive firms are undermined by lack of credit or lack of demand.

The core countries are damaged as well by the unnaturally low interest rates that prevail as money seeks a safe haven. How many years of contributions must be added to pension savings when retirement accounts do not benefit from the miracle of compound interest? Then there is the fact that the flow of capital no longer accommodates current account positions in the balance of payments.

The inevitable result is that financial accounts between central banks and the pan-European Target2 system (which makes it possible for Europeans to settle electronic transactions in euro within the eurozone - the ed.) move well out of alignment. These are symptoms that the European Council summit agreement does not address except through the more general message of reassurance.

Threat from imbalances

Countries in a fixed exchange rate system cannot long survive the forces unleashed by a geographic flight to safety. Even the receiving countries can swiftly buckle under the strain. That is the German experience under the Bretton Woods system; it is the plight of Switzerland and Denmark today.

The Swiss example shows that a floating exchange rate is not a superior alternative. That is why the Bank of Switzerland put a cap on the appreciation of the franc against the euro. Germany's experience in the 1970s offers the same lesson; that is why Germany led in the creation of the European Monetary System.

The United States does not suffer from the same problem of a geographic flight to safety. Although there are some district imbalances in the US monetary union, these are not viewed as cause for alarm in the same way that Target2 imbalances create fear in Europe.

The European Council should pay more attention to this example. The goal should not be to replicate US fiscal arrangements but rather to create the same mechanisms for channeling the flight of capital to safety across asset classes and not national boundaries. Only that way can it eliminate the worst symptoms of the crisis while accepting that the potential for fear in the markets will remain in place.

Considering Eurobonds

The safe haven for capital in the United States is the vast pool of US government securities - which are assets that trade equally in all US states. Europe needs to construct a similar ‘risk-free' asset to secure capital across the eurozone so that money does not have to cross national boundaries in order to be safe.

This safe-haven feature is an important aspect of the Eurobond proposal that has not been much appreciated in public debate. Unfortunately, the European Council summit appears to have retreated from considering Eurobonds as a possible part of the solution to the crisis. In doing so they seem to have overlooked the fact that if you do not tell investors what to do in case of emergency, they won't believe you when you tell them don't be afraid.

Editor: Michael Knigge/ Rob Mudge