‘Act on banks’ or risk 25-year deflation

Billionaire investor George Soros has warned that the eurozone faces a 25-year deflationary slump if the banking problem is not sorted.

The worst phase of the financial crisis is over but the region now faces a political crisis that pits creditor countries against debtor nations, Mr Soros said in an interview with Bloomberg TV. He also warned that there would have to be much further integration, including deeper banking union. “You have to go further with the integration. You have to solve the banking problem, because Europe is lagging behind the rest of the world in sorting out its banks.”

Eurozone finance ministers are currently locked in negotiations over the architecture of banking union.

The Irish Government was forced to pump €64bn into the Irish banking system from 2009 onwards. The stress on sovereign debt yields forced the country into an EU/IMF bailout in November 2010.

In future, the senior and junior bondholders will be burned as well as depositors over €100k before any funds will be committed to a struggling bank.

However, there are deep divisions over who pays to rescue a bank. Germany wants each national government to be responsible for recapitalising banks in their jurisdiction. The ECB, EU Commission and most other member states want a common resolution fund as well as a common deposit insurance scheme.

If banking union falls short of what is needed then the region’s banks will not be able to generate the liquidity required to fund an economic recovery, said Mr Soros.

He was also critical of the sharp budgetary adjustment foisted upon the periphery countries.

Also warning about the threat of a deflationary spiral gripping the eurozone was the Financial Times’ columnist, Martin Wolf.

The inflation rate is running at 0.8%, which is well below the ECB’s target of 2%. It would take just one economic shock to tip the region into deflation, which could have potentially very damaging economic consequences.

The solution would be to try and reach a 3% inflation rate among core countries and 1% in the periphery, which would go a great deal towards restoring the competitiveness of the weaker member states. The ECB would have to embark on an ambitious bond buying programme.

However, this would be politically unacceptable for Germany as well as other creditor nations. But without such a policy, the eurozone’s future looks bleak, said Mr Wolf.