The European University Institute hosted a symposium on Europe’s banking union last Friday, 22 May. The organizing theme was the interaction between ‘banking union’ as a form of integration and ‘democratic legitimacy’. My contribution was to try and frame that question within the larger context of European financial market integration. What follows is the formal presentation.

Many thanks for letting me participate in this discussion. Since we are the second panel on banking union and democratic legitimacy, I have just three themes I want to introduce into the discussion.

The first point I want to make is that Europeans have already created a financial system within which institutions and expectations exceed the scope of democratic accountability – both in terms of quantity and in terms of quality. That happened more than twenty-five years ago. European financial integration was a democratic choice made by the heads of state and government within the context of the completion of the internal market. As part of that choice, they hoped to make banks bigger and more competitive. They also hoped to escape from the tight correlation between national savings and national investment – in order to escape the Feldstein-Horioka puzzle and use European savings more efficiently to promote growth and convergence.

The bigger banks were the quantitative side of the puzzle. As a result, many countries in Europe saw the ratio of banking assets to gross domestic product grow dramatically. Given the bank-centred nature of the European financial economy, this growth created unprecedented contingent liabilities for national deposit insurance schemes and for domestic financial regulators. That story is well known and yet worth reiterating because Europe’s political leaders chose to run these risks on the back of a democratic mandate and yet they are risks that no democracy can easily bear – just witness the cases of Iceland, Ireland, Spain, and Cyprus.

The qualitative part of the story has more to do with the efficient allocation of savings and the ease of gaining access to capital for investment. The bottom line is that rich, developed, ageing populations in the North looked for higher rates of return than they could gain in domestic markets; poor, backward, and yet also ageing populations in the South looked for ways to develop their economies more quickly than they could on the back of domestic savings. Financial market integration offered to solve both problems at once – that is clear in the Padoa-Schioppa paper and it is a recurrent theme up through the Financial Services Action Plan and the Lamfalussy report. In pursuing financial market integration, Europe’s political leaders reset the baseline for expectations about rates of return on savings and the pace of growth and development. Northern Europeans expected to retire with dignity and southern Europeans expected to hand a better future to their children. Financial market disintegration forces politicians to reframe and diminish those expectations. Northerners have to learn to accept lower rates of return; Southerners have to accept slower rates of growth and development. I don’t have to go into the details to suggest that the implications of these changes are stark.

This changeover to diminished expectations is not something that democratic institutions handle well. So to summarize this first point we have a problem that democracies have put themselves into a situation that they cannot manage effectively and that they cannot retreat from easily. It is small wonder, therefore, that we are seeing so much tumult in European politics both in the North and in the South. You can see it expressed in welfare chauvinism as easily as in anti-austerity movements. Fortunately, banking union provides a convenient escape from this dilemma. By pooling resources, banking union makes the challenges of financial integration more manageable. And by stabilizing financial integration, banking union makes it unnecessary for politicians to confront the task of lowering expectations about savings and investment. Of course, that is only true in theory.

In practice, the politics of banking union does not come across as a win-win situation or even as a positive-sum game. This is the second point I want to make and the reason behind it is simple. Democratic politics requires effective communication between politicians and voters, and voters base their preferences on perceptions rather than ‘reality’. Within this world of communication and perceptions we have two obvious problems – one distributive and the other normative. The distributive problem is that people do not like losing; the normative problem is that people believe they deserve to ‘win’ or at least to have their losses mitigated.

I can provide a long and complicated version of this argument, replete with unappreciated heroes and lionized or lionizing villains. But the bottom line is simple and Occam’s razor suggests that the summary version is all we need to push the argument ahead: there will be winners and losers from financial market integration and these two groups will never buy into a political narrative where they share equal responsibility for their fate. Hence any framework for risk sharing through banking union is going to be perceived as too generous by some and not generous enough by others. And since risk sharing is a positive act that has to overcome the inertia of the status quo, we should expect any institutional framework that is developed to under-provide for the system as a whole. This is true particularly if we layer the process of institution-building across a multilevel game where there are winners and losers at each level who will reinforce inertia across the political system as a whole. This explains why European progress toward a banking union has been so limited in comparison with initial expectations.

All the while, as negotiations over banking union unfold, we should expect political rhetoric to circle around memes attached to individual responsibility and moral hazard. Democracy and solidarity are not close bedfellows in that respect. Moreover, the debate we are witnessing in Europe is hardly unique. We can find similar episodes in US, UK, German, and Canadian history as well (just to name a few obvious examples). Just look at the current state of German deposit insurance provision and you will know what I mean. So to summarize this second point, democracies tend to buy too little insurance and to engage in too little risk sharing either across groups within society or from one country to the next. A supranational banking union like the one Europeans are currently building will suffer from this tendency.

Democracies want financial market integration but they cannot manage the consequences and they don’t want to build the institutions necessary to provide for an adequate pooling of risks. As a result, they tend to overreach and then express outrage when they face the inevitable consequences. This is where I get to my third point, which is that undemocratic (or, perhaps better, non-democratic) institutions have to fill in the gap between what democracies want and what they are willing to do to accomplish their explicitly stated goals. The non-democratic institution I am thinking about here is the so-called ‘politically independent’ central bank.

I put the quotation marks around ‘political independent’ because that modifier tends to obscure more important aspects of what central banks do. Political independence is important, particularly when we are talking about democratic legitimacy. But political independence is not why central banks exist. Hence, I think we need to look at central banks from three different perspectives – as lenders of last resort, as managers of macroeconomic performance, and as guardians of financial stability. I am running out of time at this point and so I will tackle these issues quickly. I think most people overlooked or ignored the extent to which the ECB propped up the European banking system by lending directly to a wide range of institutions against a collateral framework that could best be described as ‘ecumenical’. Other central banks were probably quicker to recognise the advantages of the ECB’s uniqueness than the ECB has been to celebrate is own capacity to keep European banks afloat. As a consequence, other central banks not only borrowed but also improved upon what the ECB had to offer in terms of lender of last resort facilities. I think this is worth noting because it is one of the odd exceptions where the least-common-denominator kind of institution building that multi-level democracy necessitates actually turns out to be an advantage. In other words, it is the exception that proves the rule about what I say in my second point above.

Unfortunately, propping up banks is not the same as getting them to drive the economy. That is where the improvements wrought by other central banks turned out to be important. They were able to deploy ‘unconventional’ monetary policy more easily than the ECB. I have a complicated theory about why that is so, that I am developing with a colleague named Huw Macartney at Birmingham and that I could elaborate if you are interested. The basic premise is that unconventional monetary policy is inherently and overtly distributive. As such, it requires some kind of outlet to vent the inevitable controversy. Where politics and monetary policy operate at the same level of aggregation, you can see that venting take place in the normal arenas for democratic politics. Where they do not – and worse, where monetary policy is heavily insulated from political ‘interference’ – the only way to vent the controversy is through the politicisation of the committee responsible for making monetary policy decisions.

I don’t want to diminish the role of the European Parliament here, but I would suggest that its role has been less prominent than the role played by national parliaments in countries with their own currencies. Meanwhile, the Governing Council of the ECB has been somewhat more politicized than the monetary policy committee of the Bank of England or the open market committee of the the US Fed. Hence, for example, we get Axel Weber refusing to stand for ECB President, Juergen Stark announcing his resignation while the markets are still open, and Jens Weidmann being publicly isolated in the discussion of outright monetary transactions or OMT. The room for maneuver of the ECB has been less evident as well. While it is clear that the ECB has done a lot over the years of this crisis, it has really struggled to repair the monetary transmission mechanism in order to stabilise European macroeconomic performance; neither the Fed nor the Bank of England has experienced as much difficulty.

Moreover, the ECB’s task is further complicated by its responsibility as guardian of financial stability. We could see that during the ‘comprehensive assessment’ as the Governing Council watched in bewilderment (or, perhaps better, resignation) while the banks deleveraged to strengthen their balance sheets. And we can see it today as the turmoil that surrounds Greece spirals ever more tightly around the connection between Greek government solvency and the provision of emergency liquidity assistance. At each step in its efforts to navigate this new responsibility, the Governing Council has found itself politically exposed. It is filling the gap but it is consuming its own democratic legitimacy along the way.

To put not too fine a point on this, I could only stand back in amazement when the ECB lifted the waiver for the use of Greek government backed assets as collateral for routine liquidity operations. Given the timing of the decision, that was obviously a political act – which is strange for an institution that vaunts its own independence from politics. As a result of that decision, the ECB now has a host of other political decisions to make – about the size of ELA that should be offered, about the haircuts imposed on Greek-government-backed collateral, about the cap on bank use of Greek t-bills in exchange for central bank liquidity, and about the eligibility of specific Greek financial institutions to continue to receive support. Each of these decisions has obvious and direct distributive consequences; each is prone to democratic scrutiny and debate; and none is covered by the traditional arguments for central bank independence (i.e. the time-inconsistency dilemma or the grounding of expectations).

Sure, we can swallow this interference in distributive politics in exchange for the benefits of central bank independence in normal times, but that is not the same as saying that the doctrine of central bank independence somehow renders these decisions democratically legitimate. I cannot think of any version of history where the framers of the Maastricht Treaty imagined the scenario we face today; it fits nowhere in an imaginable doctrine of original ‘intent’ and so the delegation of authority is hard to accept. If it works, and this crisis dissipates, then the ECB will nevertheless have to defend itself against accusations of overreach like those we see in Germany already. If things go terribly wrong, I suspect the ECB will find itself with few allies among the member states. And if the ECB fails or the euro splinters, there will be no banking union to talk about.

Many thanks for your attention.