Today’s emergency summit of EU leaders at the Elysee Palace in Paris is more important than the normal photocalls might suggest. Ireland’s decision – now largely followed by Greece – to put a State guarantee under not only retail depositors, but also more significantly international investors’ debt as well as wholesale deposits and inter-bank loans poses a huge challenge not only to other EU countries, but also to regulators worldwide.
In today’s market conditions international funds will rapidly migrate to wherever their money will be secure. If then other EU countries follow the Irish lead because otherwise their own banks would be disadvantaged, the costs to national treasuries (and their taxpayers) could be astronomical. Britain’s GDP amounts to £1.5 trillion, but the cost of underwriting every bank in Britain could be up to £9 trillions. That could put even Paulson’s $700bn US bail-out in the shade.
If on the other hand EU countries do not go down the Irish route, their financial institutions suffer a competitive disadvantage compared to the Irish (and Greeks) which could be seriously damaging. Moreover, it drives a coach and horses through the whole idea of the EU internal market as a level playing field, as the EU Commissioner Nellie Kroes plaintively acknowledged yesterday.
The situation is worryingly reminiscent of the self-defeating competitive devaluations of the 1930s. Faced with a desperate need to escape the depression dragging everyone down, countries opted to lower their currencies to seize a larger share of whatever international economic activity remained. But when other countries followed suit to protect themselves, any unilateral benefit was quickly eroded and all finished at relatively much the same position, but at one or two notches lower as the economy contracted.
How to avert a similar disaster this time round – not of depression, but rather of even sovereign countries facing potential bankruptcy as the guarantees underwritten escalate? Doubts have already arisen whether the Irish Government can in fact meet all the guarantees it has now offered.
Maybe the solution is not to try to underpin all banks irrespective of their capitalisation, but only banks whose funding composition makes them good risks. ‘Bad’ banks, i.e. those over-dependent on toxic securitised derivatives, should perhaps then be bundled together and, whilst protecting their despositors’ funds, their toxic assets would be sold off at the best prices that could be secured in the market. The Swedish Government pioneered a similar scheme in the early 1990s, and with considerable success. It would preserve a measure of moral hazard as a future warning for the banks, whilst at the same time avoiding the risks and cost of an indiscriminate all-or-nothing bail-out.
Any hope the EU might today arrive at such an ingenious resolution of the current crisis? I wouldn’t hold your breath.

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