by Philipp Hildebrand and Lee Sachs
September 24, 2012
Mario Draghi, European Central Bank president, has reduced the risk of a eurozone break-up by undertaking to buy unlimited amounts of sovereign bonds in the secondary market. ECB purchases will require deep budgetary and economic reforms by participating nations. Angela Merkel, German chancellor, is right to insist on these reforms over time. But a genuine solution to the crisis also requires shoring up Europe’s banking system to restore the flow of credit to businesses and households.
Europe must ultimately grow its way out of its crisis. Economies cannot grow unless banks have sufficient capital to lend and businesses have the confidence to borrow to expand their operations. As was the case in the US in 2008 and 2009, central bank intervention cannot succeed on its own. Then, actions by the US Federal Reserve were bold, creative and necessary to help put a floor beneath a crumbling credit system. However, the Fed was limited in what it could achieve on its own. In the US, the end of the banking crisis required private capital investment, encouraged by incentives and financial commitments from the government. The same must happen in Europe.
Now is the time to rebuild confidence in Europe’s weakened banks through an accelerated introduction of robust, credible capital standards and the injection of new private capital. Banks will begin to lend only when they have sufficient capital and liquidity. The conventional wisdom that more robust capital standards constrain lending is borne out by neither economic theory nor the facts. In the US, where the largest banks were compelled to raise capital in 2009, business loans at commercial banks have increased significantly since.