So, Europe’s leadership, under German pressure, decided to postpone any decision on how to tackle the euro crisis until the end of February, or even March. Hiding behind the ECB’s agonising and costly attempts temporarily to contain the periphery’s spreads, the eurozone has decided to do what it is best at: To dither a little longer. When one buys time, unless a complete fool, there must be a reason; there must be an issue that needs to be resolved prior to making an important decision. I think that this issue, which is holding up the EU’s debate, is becoming increasingly easier to discern. What is the issue? Eurozone’s surplus countries must decide between two equally unappealing options: One resolves the crisis forthwith at the cost of making impossible for the surplus countries to exit the eurozone. The second option is much riskier, in that it maintains the crisis, and is much costlier in the medium run, but allows them to retain the ‘exit option’. Until they decide on which of the two options to adop, the euro crisis will continue and the eurozone will be losing ground in the international scheme of things.
Our first thought, on the path that will lead us to uncovering the real cause of Europe’s dithering, must be a simple judgment call: This crisis is not a crisis of public debt. It is a crisis of Europe’s banking system which was occasioned by the Crash of 2008. The sovereign debt crisis is a mere symptom of the global financial sector’s meltdown (the Death of the Minotaur, as I call it), even in the case of Greece. A terrible symptom but a symptom nonetheless. Not a cause.
The ‘good old times’, prior to 2008, saw our European banks lend as if there were no tomorrow. The result is that their books are weighed down by an assortment of debts the size of the Alps (if not the Himalayas). It is a diverse lot, comprising the debt of other banks, mortgages, synthetic debt and, of course, sovereign debt. When the Crash of 2008 happened, you may recall, and before the real economy was affected, it was branded the Credit Crunch – the cessation of all lending between financial institutions, courtesy of mutual mistrust.
Since then, the wheels of the global financial sector were oiled up, mainly by the Fed, and they are turning again. Everywhere, that is, except in Europe. Europe’s banks remain in their very own credit crunch, locked out of the inter-bank market and unable to secure liquidity, even overnight, from anyone else except the reliably kind ECB. Why is that? Why have Europe’s banks not been able to overcome the credit crunch, like their American counterparts did?
The answer is brutally simple: Because they have not been forced by Europe’s regulators to come clean; to own up to their likely losses; to write down bad debt and to re-capitalise on the basis of an honest account of the true assets on their books. The stress tests of last summer, unlike the US stress tests on which they were supposedly modelled, were a cynical exercise in hiding under the carpet the massive losses already made. (If you are in doubt, ask yourself two questions: Did the Irish Banks pass those tests? Would Lehman Brothers have passed such tests in August 2008?)
Time for the next question: If I am right, and Europe’s banks are replete with bad debts, why is no one doing anything to force them to come clean? Are our politicians and regulators corrupt? It would be easy to stigmatise what is, after all, an unattractive lot with accusations of graft, corruption, capture or mere idiocy. But I do not believe that the explanation we would get would be a reliable one. So, I seek another answer to the question of why have Europe’s banks been allowed to hide their sorry state from the public eye for so long.
The explanation I am converging on, and which also explain why Europe is dithering today, is simple: Our politicians have not resolved yet:
- Who should play for cleaning up the banks mess
- How much should be set aside for the task
- Whether the ‘payments’ should be up-front (or come later, once some banks default on their own commitments)
- How the resolution of the banking crisis can be utilised, politically, in order to re-shape the eurozone
These are big issues and, given the heterogeneity of views and interests within the eurozone, it is understandable that a final decision is being delayed. Having acknowledged that, the current procrastination is not only inflating the size of the problem but is also threatening the very existence of the euro area. But this is another discussion. Back to the dithering and, more precisely, to the real dilemmas facing Europe’s powerful elites.
As I see it, the euro’s survival is predicated upon a thorough clean up of the banking sector. This can take, roughly, two different forms: A front loaded, preemptive write down, backed up by direct ECB financing (and not just liquidity injections). Or an ex-post clean up after an explosion that will, possibly, begin with the default of some sovereign debtors (Greece and Ireland being the prime candidates) before bringing Europe’s banking system crashing down, at which point the EU and the ECB step in with massive support to reflate their banks. My simple point here is that our political and economic elites have not decided yet which type of outcome they prefer. They dislike both and, like Buridan’s Ass, do not know, yet, which way they want to go.
Our European leaders’ starting position is the realisation of that which everyone knows but almost no one acknowledges (at least in public): That the current strategy, based on the EFSF funded ‘bail outs’, cannot work! (Click here for a reminder of the EFSF’s toxic architecture.) Lending €10,000, at high interest rates, to every Greek man, woman and child, and a further €20,000 to their Irish counterparts, does not steady the banks’ nerves. For the bankers understand well, on standard banking principles, that the stressed taxpayers will not be able to repay both these new senior loans (to the EU, the ECB and the IMF) and the mountains of money their states owe the banks. Especially so under the harsh austerity imposed upon their economies which reduce the taxpayers’ income as a pre-condition for getting the new loans. With all this common knowledge in place, Europe’s politicians must choose between the following two, equally unappealing, options:
Option 1: A preemptive move
If eventual sovereign defaults are to be prevented and the banks’ uncertainty reduced forthwith, both the public debt of fiscally stressed states and the private debt residing within our banks must be written down immediately.
- First, the banks must be convinced to write down part of the public debt they are holding by means of a straightforward swap of old sovereign bonds for new ones (of a lower face value and, perhaps, longer duration).
- Secondly, part of the existing public debt (the Maastricht-compliant part, as suggested in our Modest Proposal) must be homogenised in the form of eurobonds that are backed by the eurozone as a whole (as opposed to by CDO-type EFSF bonds). This will allow for serious reductions in interest rates for countries like Greece and Ireland, thus giving them a realistic prospect of repaying their remaining debt.
- Thirdly, the banks must be forced, perhaps through US-style (as opposed to Euro-type) stress tests to come clean on their other bad debts, aided in the process by ECB guarantees and assistance.
This option is, undoubtedly, reviled by North Europe’s political and economic elites. It is reviled for two reasons: First, because it will cost the ECB and possibly the surplus states up to €1.5 trillion to come to the banks’ assistance under 3 above). Secondly, because these three steps will stop the euro crisis in its tracks. Why is this a problem? Because, if the crisis is resolved quickly and painlessly, the surplus eurozone countries (Germany in particular) will lose two things of great importance to them: (a) The immense bargaining power they have vis-a-vis France and the periphery while the crisis is simmering, and (b) the hitherto complete independence (at least on a legal basis) of their public debt from the public debt of other eurozone nations.
To put this point (about the political costs of resolving the crisis by adoption this option) differently, at the moment, the surplus countries have one foot inside the eurozone while retaining the other foot outside it. They have, on the one hand, bound themselves up to their eurozone partners by means of a common currency, but they have ensured that every euro of debt in the eurozone belongs to a different country. This means that, if they so decide, Germany, Austria etc. can step out of the eurozone without being bound to the remaining rump by common debt. Opting for the Modest Proposal, or Option 1 here, means losing this right; the right to secede at will. It is, undoubtedly, a large political price to pay for saving the euro. For this reason, Germany, Holland, Austria etc. look at Option 1 and shiver. Yet again, Option 2, below, is equally unattractive!
Option 2: An ex post clean up
The second option is to continue with the pretense that the ‘bail outs’ plus greater fiscal discipline will work. Of course, for reasons already explained, no one in their right mind can possibly believe this. So, why say they do? Because Option 2 means a considered judgment that the crisis should be allowed to continue until it takes its toll; claims a few peripheral victims. The idea is simple: Allow Greece, Ireland and Portugal to default. Such an eventuality will cause all hell to break lose both within these countries (whose banks will meltdown) and without (since Germany’s and France’s banks will be equally hit). At that point the ECB and the surplus countries can step in, on the eleventh hour so to speak, to broker a deal between these countries and their creditor-banks; a deal that will, effectively, restructure the debts of only these countries (as opposed to an across the board write down of bad debts, as envisioned by Option 1). Meanwhile, to prevent a chain reaction of bank failures throughout the EU, the ECB, the EFSF (under new rules) and the surplus countries will come to the banks’ assistance and help them clean up their mess in the aftermath of a major banking crisis.
The risks and costs of Option 2 are huge. Starting a fire in order to effect a ‘clean up’ is a dangerous exercise. You may get seriously burnt. Even if no one cares much about the stressed Periphery, which will be plunged in a Latvia style socio-economic meltdown, Europe’s North will also be badly affected. The banks will have to be re-capitalised to the tune of at least €1 trillion. Who will pay for this? Both their shareholders and the taxpayers will be angry that they have to beat these costs. Politicians will be caught between a rock and a hard place. It is not a happy Option!
And so the dithering continues
If my analysis is correct, Europe’s politicians are caught in a classic Buridan Ass dilemma: Option 1 is, of course, the rational, cost-effective way of resolving the euro crisis, which as I have claimed is mostly a banking crisis. But it comes at a major political cost for the surplus countries, Germany in particular: The permanent loss of the option to withdraw from the eurozone. Option 2 is messier, riskier and costlier but, from a German perspective, is politically more attractive in the sense that not only does it retain the surplus countries’ ‘right to exit’ but, even more importantly, enhances Germany’s bargaining power within the Council of Europe. For as long as the crisis is simmering, and only the surplus countries retain their ‘exit option, it is they that rule the roost. Once the crisis ends, France and the rest will get a chance to speak their minds. Not a prospect that Mrs Merkel is keen on…