Europe's sovereign funk denies solutions

It's hard to know whether to laugh or cry. Every week, seemingly, brings some new miracle cure, some further quack remedy, produced as if from the back of a lorry, which promises finally to fix the eurozone debt crisis once and for all.

A little while back, it was eurobonds, then it was European Central Bank intervention in sovereign bond markets, followed by project bonds, use of European bail-out funds for direct recapitalisation of struggling periphery banks, and so on. It's desperate stuff.

The favoured fix du jour is that of rapid progression to a fully-fledged banking union, or federal banking system a plan which the European Commission seems to think it could have up and running by the beginning of next year. This one lasted even less time than the others before being shot down in flames by the big wigs of Berlin and Frankfurt.

No sooner had José Manuel Barroso, president of the European Commission, published his blueprint for a banking union than it was ripped to bits by a combination of the Bundesbank and the German political hierarchy. Angela Merkel and her finance minister, Wolfgang Schäeuble, were particularly scathing in their analysis.

You almost feel sorry for Mr Barroso. The crisis has sidelined Brussels and made it apparently irrelevant. However ineptly, national governments have taken control of the fire brigade. Like the distraction of a financial transactions tax, the banking union proposal is an attempt by the commission to get back into the action.

Admittedly, on paper it's actually not such a bad idea. Indeed, it's textbook stuff. You cannot have a successful monetary union without a federal banking system, for unless the entire edifice is underwritten collectively by the whole, you are bound to get, when banks become stressed, the sort of cross-border flight of capital we see in the eurozone today.

It makes perfect sense for the Spanish depositor to take his money out of an insolvent Spain and stick it into a German bank account instead, especially if he sees some risk of a euro exit. Centralised supervision, deposit insurance and resolution, ought to help prevent these panics.

If you think of the single currency as like a body which lacks the skeletal structure to make it function properly, a federal banking system is the rib cage, which Mr Barroso proposes surgically to implant, after the birth as it were, into the enfeebled flab. Logical enough, then.

Unfortunately, like much textbook economics, the plan takes no account of the real world, and as things stand, is essentially impossible to implement. Nor would it address the crisis in hand. The horse has not just bolted; it's over the hill and far away. It's far too late to install the barn doors now.

The thing that makes all these ideas be they eurobonds, ECB intervention, or a banking union so unacceptable to Germany is that they all involve a degree of debt mutualisation, or burden sharing. Germany has no particular objection to these ideas as an end game, but as a starting point, with no disciplines in place to control use by the profligate periphery of the German credit card, they are a definite no-no.

To German policymakers, a banking union looks like pooling of individual sovereign liabilities through the back door.

If that's what eurozone members want, then they have to be prepared to give up sovereignty, by agreeing fiscal and political union. Politically, Europe is far from ready for such an endeavour, and even if it was, it would take decades to implement. To these fundamental objections must be added some very practical ones. Take universal deposit insurance a fine idea in principle, but who is going to underwrite it, will it be pre-funded or paid for on a case-by-case basis, and which type of deposits will qualify? These are hard enough issues to settle at a national level. On an international basis, with 17 different states and banking systems all sticking their oar in, it would be virtually impossible.

Centralised supervision would be similarly problematic. If all that is proposed is some kind of brass plate in Brussels or London, with the donkey work essentially left to national supervisors, then its hard to see the point of it.

To be credible, it's going to have to be done by the ECB on a fully independent basis. Again, Europeans are not ready for the consequent loss of sovereignty, or indeed for the sort of transparency it would impose on banking systems shot through with cronyism and underperforming loans. Much of Europe continues to regard banking as essentially an arm of government, or a conduit for politically determined industrial and economic policy.

It would be overwhelmingly positive to make banking fully independent of such political direction, but for Europe it's radical stuff and won't be easily ceded.

Then finally, there is the idea of a common resolution regime for dealing with banks that get themselves into trouble. This is once more a great idea in theory, but any suggestion that senior bank creditors will be "bailed-in" to banking insolvencies would, in present circumstances, with confidence so fragile, only accentuate the flight of capital away from the more distressed eurozone countries.

"If you owe your bank a hundred pounds, you have a problem", wrote John Maynard Keynes. "But if you owe a million, it has." Bizarrely, German policymakers have failed to recognise this ancient truism as they struggle with Europe's intractable debt crisis, or rather, they obstinately refuse to recognise it. Their position is entirely understandable. They are like all aggrieved creditors. They want their money back and they certainly don't see why they should be made to throw good money after bad by agreeing to underwrite the debt of their 16, fiscally sovereign fellow travellers.

Yet they are also making the classic creditor's mistake. When the debtor borrows too much, it's the creditor that always ends up paying. Policy that punishes the debtor, as the austerity of the fiscal compact seems to, may be quite satisfying but it doesn't help the creditor get his money back. To the contrary, by depriving the debtor of his means of income, it will only increase the size of the final loss.

One way or another, Germany will eventually have to accept some form of burden sharing. Regrettably, it's looking ever more likely that this is going to happen in a chaotic manner that will set Europe back for a generation or more.

There are solutions to this crisis, but none which is remotely acceptable. What George Osborne has called "the remorseless logic of fiscal union" constantly clashes with unyielding defence of fiscal sovereignty.

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