Power Politics, Banking Union and EMU

Adjusting Europe to Germany

Shawn Donnelly

• Publisher: Routledge
• Year: 2018
• Print ISBN: 9780367591717
• eBook ISBN: 9781351332576
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: Politics
• Index: Politics & International Relations

This book examines the politics of Banking Union and EMU reform in the EU, and draws lessons for what it means for international politics, both in Europe, and for international relations more broadly. It demonstrates that most of the reforms in Europe to break free of the Eurozone and banking crises in which Europe continues to find itself focus on building up the capacities of national authorities rather than European ones. The result is that national authorities remain largely in control of the decisions and funds that are to be deployed to prevent economic disaster if a single EU bank fails. The likely outcome is an accelerated balkanization of the European market for the foreseeable future.

The book also contends that power politics, and realism in particular, is a defining feature of European politics with coercion and enforced national responsibility at the demand of Germany; the dominant form of institution-building that established the responsible sovereignty model, and shut down the possibility of alternatives. In making this case, the book demonstrates that the dominant view in international relations, that power politics best explains the behaviour of states, also apply to the EU.

This text will be of key interest to scholars and students of the Eurozone crisis, EU politics, economic policy, and more broadly to political economy, public policy and international relations.

The Open Access version of this book, available at http://www.taylorfrancis.com, has been made available under a Creative Commons Attribution-Non Commercial-No Derivatives (CC-BY-NC-ND) 4.0 license.

1 Introduction

Do international institutions shape the behaviour of powerful states or do those institutions adjust to their wishes? Can great powers step outside established institutions to alter the existing status quo? The European Union (EU) was shaped to tie Germany’s hands after reunification, but changed after 2008 to reflect Germany’s priorities. New EU institutions of macroeconomic governance were introduced to change state behaviour of states, but German-led institutions were also established outside the EU that bypass its legal and institutional order and force the EU to adjust. This strategy magnified German capacity to secure its goals over the objections of other countries within and without the EU. The result is a German Europe (Beck 2013) more than a European Germany. This took place in a contentious environment in which EU and international institutions, France and Southern Europe pushed for the EU to develop supranational institutions and a federal government to combat the Eurozone Crisis (EZC), and in which Germany and Northern Europe sought to impose national responsibility for financial stability and public finances.

The Great Financial Crisis (GFC) and the EZC that followed shifted power resources and vulnerabilities in Europe in ways that enhanced Germany’s power, allowing this strategy to succeed. Germany remained economically strong and resilient, a fact that financial markets amplified by treating German securities as a safe haven in turbulent times. Southern European countries, in contrast, were dragged down by declining demand and scarcer credit, which financial markets amplified by withdrawing and withholding investment to the point where neither banks nor sovereigns could borrow – imposing a full stop on economic prospects. France, meanwhile, with the strongest EU investments in Southern Europe of any country, came out weakened and nearly as vulnerable to a Southern European collapse as those countries themselves.

As a result of these changes in relative power, German capacity to determine outcomes in Europe’s adjustment process rose dramatically. The relative power of Southern Europe should have been minimal. That of France, which traditionally lobbies to soften German demands for austerity on the rest of the Eurozone, should have been weakened as well, resulting in a modified Eurozone architecture reflecting German interests. Although this happened to some degree, EU institutional rules blocked German proposals or watered them down sufficiently that Germany remained dissatisfied. In response, Germany pushed the establishment of a new institutional architecture outside the EU to overcome resistance to its demands over the terms of financial stability within the European Economic and Monetary Union (EMU). Germany still found itself confronted with resistance from national governments and parliaments, but could better impose its preferences.

In this context, the range of tools that Germany used to achieve its goals grew after 2008 from hard bargaining, a staple of intergovernmental politics in the EU, to include coercion and imposition of its own terms on other states through non-EU institutions, practices that are decidedly not and that strain European legitimacy (Piattoni 2015; Fabbrini 2017). Germany’s dominance is limited to the realm of financial policy, where its interest in its neighbours and how they govern themselves (lest they hurt Germany’s own financial interests) is direct and intense, and its capacity to bring pressure to bear on others is greatest.

This capacity to direct outcomes can nevertheless be seen in Banking Union (BU) and the reform of European economic governance as well, particularly the rules surrounding EMU membership. The present book focusses on the last two issues.

Germany’s power resources are important in explaining outcomes, as are the distributional interests, but its ideas about what is right and wrong in public policy matter as well for the nature of Europe and of European states (Hall 2012; Dullien & Guerot 2012). In Banking Union and EMU, German conviction is high that others must emulate their ideas of financial prudence and self-sufficiency in macroeconomic policy and institutions, but also bank and financial market regulation – the institutional sinews of modern economies.

What is remarkable about German initiatives inside and outside the EU is that they move Europe further away from the organized chaos and compromises that are the traditional hallmark of European public policy making and impose direction, and above all order more compatible with its conceptions of its own interests. Also remarkable is that the voluntarism and national prerogatives that persisted well into the 21st-century EU were significantly displaced by new ordering principles for the EU stressing obligation and punishment. Those principles start out with the notion of responsible sovereignty (Piattoni 2017) – national responsibility for carrying out policy within pre-defined parameters (rather than in a fully discretionary manner), and then increasingly escalate to country-specific recommendations, then demands made under coercion and finally direct imposition on governments that resist.

The core mechanisms of German policy that break with the past are coercion – intrusion into the domestic internal policy of EU member states – and the willingness to abandon EU institutions and use other mechanisms that increase German leverage over other states. The principal mechanisms are not only international treaties like the Treaty on Stability, Coordination and Governance (TSCG), which requires the signatory states to balance their budgets, but also the establishment of institutionalized instruments of power outside the EU like the European Stability Mechanism (ESM) and the Single Resolution Fund (SRF), which provide emergency funds for states and banks in financial distress. The ESM, with a German veto, imposes conditions for loans over the opposition of states requiring assistance, without violating the EU’s principles that member states are still ultimately in control of their own policy and commitments. The threshold to demand important constitutional (Wiener 2008) and policy changes from others is lower, as in the TSCG, but in the case of the ESM, conditionality, coercion and imposition become the primary means of interacting with target states. These powers exceed anything the EU has ever used against member states, even though the legal framework to do so was introduced after the EZC (on Germany’s insistence).

What happened instead since the onset of the GFC has been the construction of a different Europe. It has been built on principles and using methods that European area study specialists failed to foresee and continue to have difficulty squaring with their understanding of how Europe ‘should’ work, based on their observations of past behaviour. But things have changed. Although Germany seeks voluntary agreement from its fellow states, and engages in traditional intergovernmental bargaining and decision-making to achieve its ends within coalitions within the EU, it is no longer willing to accept deadlock if its concerns are not met. It resorts to more coercive and intrusive methods to get what it wants.

The fate of Europe is instructive for our understanding of international relations more broadly. Without going so far to conclude that Europe’s transformation proves realist assumptions about great powers, institutions and international order, we can contend that it worked out that way. This is neither classical nor structural realism, however. Classical and structural realists expected the EU to fall apart at the end of the Cold War without the external security pressure to stick together – but institutionalized Europe is very much alive. European area study specialists explained this as evidence of sticky institutions exerting influence over states. Liberal institutionalists see a Europe dominated by national governments who maintain it for commercial interest, while neofunctionalists, akin to complex interdependence theorists, see a highly supranationalized and transnationally interdependent Europe from which no country can extract itself or exert any meaningful control. This did not happen. Instead of EU institutions, it got German ones. How do we account for this?

This outcome naturally has consequences for the practical nature of Europe in the international system, but even more importantly, gives us food for thought regarding the role of states, power and international institutions like the EU. The EU is the exception in international relations in the establishment of supranational institutions, but primarily a body of rules and regimes that commit the member states to particular policies, limiting their sovereignty in ways that international organizations generally do not. Until recently EU law and institutions were still widely based on voluntary agreement. That which failed to attract consensus support or a strong supermajority did not proceed. Recent developments have changed that and again covered new territory found nowhere else in the world. Where other regional institutions exist – NAFTA, ASEAN etc. – they have assiduously protected the principle of national sovereignty, with the result that the regional international organizations are associations of sovereign member states.

I generally expect institutions to be built that incorporate formal respect for national sovereignty while focussing on rules of the game, as in ASEAN or NAFTA. The post-2008 European focus on intrusive institutionalism stems from the need to reshape existing institutions in the interest of a great power (possibly with a supporting coalition) over the objections of other actors while maintaining a high degree of interdependence. This outcome is the consequence of Germany having made compromises on the rule structure and membership of EMU that allowed more national budgetary leeway than it preferred (Dyson & Featherstone 1999; Donnelly 2005), and later helped to roll back (Heipertz & Verdun 2010). Dissatisfaction grew to the point where Germany pushed back to impose its own priorities and principles. Ironically, in the attempt to avoid taking financial responsibility for the entire Eurozone, a step that it equates with hegemonic status in the EU, Germany felt compelled to install that status by institutional means – by establishing principles of national economic self-sufficiency and institutionalized steps of command and control to achieve it within Europe. Given the uniqueness of this historical institutional legacy, the force required in other situations should also be less. It is therefore unlikely that what has happened in Europe could happen elsewhere. Although great powers seek to institutionalize relations with other states, the institutional demands on states need not be particularly thick.

I contend below that the contemporary trajectory of Europe can best be expressed as realist institutionalism (RI). RI rests on well-established realist assertions of how great powers seek to organize the international system, with particular attention to their neighbours. The European experience is characterized by the German desire to take an existing set of institutional commitments that impose semi-sovereignty on the member states, but in a chaotic and compromise-based way that does not reflect German preferences, and to move it forward to restrict sovereignty even further for other states as a means of correcting the chaos. In which ‘correcting’ means forcing other states in the EU to adjust to German preferences rather than accepting the status quo (lack of further agreement) or moving in another direction (more voluntary integration – which would result in a fiscal union with a different distributional outcome (Krasner 1991). This behaviour reflects the high degree of interdependence brought about by the single currency, the high potential cost of stabilizing it, and the highly ineffectual budget constraints on national governments. This makes it practically impossible for Germany to escape from a bad situation by emulating NAFTA or ASEAN or even UK preferences for the EU, which strip down interdependence into cooperation between fully sovereign states. The way forward is to coerce the others, particularly Eurozone members, if necessary to row the boat in the direction Germany lays out.

It is also important to outline the limits of what is being tested in the European case. The German transformation of Europe reflects the emergence of a financial and political great power, but not a military one. Germany lives in an environment in which military security is still provided by the United States and NATO, in which geopolitical order is structured primarily by the conflict between NATO and Russia, followed by a destabilized Middle East and North Africa. This means that Germany is not a regional hegemon. But it is nevertheless a resurgent financial great power that has translated its economic resources into political power over its neighbours at a turning point in the order of Europe (Dyson 2016).

The study of that transformation is nevertheless important because it demonstrates the drive of great powers to shape their environments to the extent of their capabilities. The capacity of great powers to shape international order and its institutions is therefore not dependent on the full spectrum of power resources and capabilities. It is layered. Realist institutionalism is reflected equally in the economic and financial realm: the restructuring of those other institutions and interdependencies that make Europe work.

This book is organized as follows. Chapter 2 outlines the case for realist institutionalism, outlines alternatives and sets out the research design. Chapters 3 through 6 test the hypotheses on the reform of economic governance in the EU, primarily rules regarding national government budgets and macroeconomic imbalances on the one hand, and the various components of Banking Union (BU) on the other. Chapter 7 concludes, outlines the implications for the EU and the world and makes suggestions for further research. The rest of this chapter outlines the case investigated in this book and the impact the outcome has on Europe and the rest of the world. It makes the introduction longer, but provides insight into the challenge facing Europe for those without a background in financial stability.

Financial stability

Financial stability refers to the capacity of banks (and other financial institutions) to meet the demands of their creditors and depositors on a daily basis.¹ This capacity applies not only for retail customers with simple bank and investment accounts, but for commercial enterprises as well, including banks. Three meltdowns of the international financial system in Europe, in 2008, 2011 and 2012, took place when the interbank market in loans collapsed. One of the key functions of financial stability mechanisms is to ensure that threats to the integrity of the entire financial system, whether well-founded or imagined, emanating from within banks or from the broader economic environment, are not permitted to spread from one bank to another. Ideally they also minimize the likelihood of a single bank getting into trouble in the first place. They also help suppress contagion between banks and between national banking systems (Balogh 2012).

Stability requires not only sound economic fundamentals on bank balance sheets, but also confidence in the soundness of the bank’s procedural and institutional structures for managing that business, and on other outside factors that ensure it a sure source of income at any moment that access to capital becomes necessary to meet demand. It also depends, in a diffuse sense, on the general economic conditions that undermine the financial capacity of the bank or banks in question. The lower the confidence, the greater the need for guarantees that outside capital will assume the risk of shortfalls in income and asset value. Those outside factors may include the degree of reliable personal and corporate connections that can provide liquidity in times of crisis, but the most important are general public confidence in the banking institution, general public confidence in the banking sector as a whole, and in the willingness of public authorities, whether governments or central banks, to provide access to credit in time of banking crisis. In sum, financial stability relies on both the quality of individual bank management, and on its access to outside sources of capital. The greater the strain on the overall banking system, that is to say to the extent that economic problems or crises of confidence extend beyond individual institutions, the more generalized and massive the line of credit to the banking sector has to be to fulfil this function sufficiently. This is why public actors in a capacity as lenders or creditors of last resort are often seen as indispensable parts of a governance framework that provides for financial stability.

The symptoms of financial instability are illiquidity, insolvency, the collapse of interbank loans, zombie banks, which lead to a stagnant or declining economy, and very prevalent in the Eurozone crisis that started in 2010, a symbiosis of state-and private-sector debt, which leads to successive rounds of financial overextension between banks and sovereigns and possible collapse. Illiquidity refers to a bank being short of cash, but sufficiently rich in assets that ensure long-term ability to pay. Insolvency, a much more serious condition, refers to a bank’s long-term inability to fulfil its obligations. Zombie banks, which in the European case have gone hand in hand with the symbiosis of state and private-sector debt, are liquid and solvent in part by virtue of state intervention, and continued uncertainty about liabilities and the quality of assets. Whilst uncertainty about those figures would lead to the collapse of the bank without state aid, its provision allows the banks to continue functioning in the absence of general confidence regarding economic fundamentals or corporate governance and risk management measures.

Microeconomic measures taken to restore financial stability are recapitalization, reorganization, including the establishment of a bad bank to absorb the toxic assets of a bank, resolution, in which a bank is closed, and nationalization. In all of these cases in the early days of the Eurozone crisis, the only authorities capable of providing the monetary and regulatory resources to banks to continue doing business were national governments. The reasons for this are found in the institutional and political requirements for ensuring financial stability, coupled with the weakness of the EU in these areas. Beyond these microeconomic measures, macroeconomic intervention is important for providing improved access to capital in the form of general fiscal stimulus and monetary accommodation, both for the economy as a whole and for the banking sector in particular.

Macroeconomic institutional requirements for ensuring financial stability are of a financial and of a regulatory nature. The financial category, covering monetary and fiscal policy, is essential to crisis management, when emergency liquidity must be provided into the system by a central bank or central government. There are two kinds of institutions that are crucial to ensuring financial support for financial stability: a central bank that can make liquidity generally available to the economy, and specifically to the banking system (i.e. act as a lender or creditor of last resort); and a central public authority that can provide targeted financial injections (a public backstop for the banking system). In the EU, where the capacity of national governments to provide a public backstop varies widely, an additional requirement consists of f...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Acknowledgements
• 1 Introduction
• 2 Realist institutionalism: power, institutions and international order
• 3 The TSCG and EMU reform: establishing responsible sovereignty
• 4 The ESM: stabilizing the Eurozone without a fiscal union
• 5 The SSM: supervising Europe’s biggest banks
• 6 The SRM: resolving banks without deposit guarantees
• 7 Realist institutionalism and international order
• Index