It's the (German) banks, stupid!

Or what’s behind Germany’s hesitant statements on Greek debt restructuring, Ireland’s move against subordinated bondholders and the ECB’s stance on interest rates

Europe is at it again, trying to pretend that it has stemmed the tides of insolvency through its program of lending huge amounts of money (at high interest rates) to… insolvent member-states. The official line, currently, is that the rot has stopped with Lisbon. Just like (almost a year ago) the EU-IMF €110 billion loan to Greece (in conjunction with a nominal €750 billion fund, the EFSF, standing by for other fiscally stricken countries) was meant to ring-fence the rest of the eurozone, inhibiting contagion from Athens, so now we are being asked to hope (against hope) that Spain has ‘decoupled’. It has done no such thing. As long as the banking crisis is left alone to fester, the crisis will continue its triumphant march.

For a year now many of us have been arguing that, to paraphrase good old Bill Clinton, It is the banks, stupid! Having started in their guts in 2008, the Crisis spread to the sovereign debt realm and then returned more viciously to where it had started: the banks. The result is that Europe’s zombiefied banks are now great black holes that absorb much of Europe’s economic energy (from the surpluses produced in countries like Germany to the loans taken out by struggling minnows, like Greece and Portugal). Quite remarkably, while the insolvent states are visited upon by stern IMF and EU officials, are constantly reviled by the ‘serious’ press for their ‘profligacy’ and ‘wayward’ fiscal stance, the banks go on receiving ECB liquidity and state funding (plus guarantees) with no strings attached. No memoranda, no conditionalities, nothing.

This is not to say, of course, that the powers-that-be do not discuss the banking catastrophe. I am sure that they are talking about little else. Only they do so in secret, behind closed doors, struggling to find a solution to the Great Banking Conundrum behind the European people’s backs and away from the spotlight of publicity. Their deliberations are now in a new phase, taking their cue from the Greek debt crisis. Lest I be misunderstood, the Greek crisis, however monstrous by Greek standards, is in itself no more than an annoyance for Europe’s surplus countries. A gross sum of €200 to €300 billion could be restructured quite easily or at least dealt with somehow. Its significance lies in the opportunity it offers Germany for revisiting the European banking disaster in its entirety. The Greek debt restructure, with its repercussions on Europe’s banks, is a useful case study; a dress rehearsal; an excuse to begin the process of taking the broader Great Banking Conundrum  more seriously.

So, what is the Great Banking Conundrum that Europe is now facing? Put bluntly, Germany’s banks have not been cleansed of much of the worthless toxic paper of the pre-2008 era and, on top of that, are replete with bonds issued by the now insolvent peripheral member-states. French banks  are in a similar state, with even more of an exposure to Spanish debt. Spanish banks are fibbing about the extent of their potential losses from falling real estate prices (which need to be added to their exposure to Portuguese and Spanish sovereign debt). Meanwhile, the ECB-system is massively exposed to the totality of this combination of stressed sovereign debt and unrelenting bank losses (actual and potential).

Question: What happens when a currency area (such as the dollar zone, the sterling area or, indeed, the eurozone) is lumbered with a mountain of debt plus banking losses at a time of sluggish growth both internally and externally?

Answer: It makes this mountain shrink through macroeconomic means. These means fall mainly under two categories. First, there are the blessings of mild inflation. By allowing average prices to rise, the mountain’s real value shrinks. Secondly, by effecting haircuts on debts and write-offs in the case of banking losses.

In the USA as in the UK, after re-capitalising the banks at the taxpayers’ great cost, the authorities opted for both strategies at once: Bank write-offs, large scale haircuts (e.g. a 90% cut into the debts of General Motors) plus quantitative easing for the purposes of pushing inflation to a modest level that will, in the long run, cut into the national debt. In sharp contrast, Europe has not moved in either direction. The lack of a common fiscal policy and the coordination failures that come with an ill-conceived monetary union played a central role in this dithering but are, I wish to argue, not the whole story.

So, what else is there, lurking in the shadows and prolonging Europe’s reluctance to act decisively? The answer, I submit, is: Germany’s twin angst regarding (a) its competitive edge in Asia and (b) the state of its banks. Germany’s relative success at weathering the crisis, after its own precipitous fall in 2008, has been due to the healthy demand for its capital goods from Asia; i.e. Japan and China. With Japan out of the picture (for reasons that were manifesting themselves even before the Tsunami), China is Germany’s source of optimism. But China’s own growth is based on the policies that Germany refused to countenance; i.e. massive infrastructural investments that have, interestingly, suppressed the country’s consumption share from 45% to 38% of GDP at a time of 10% GDP growth.

To sum up, with the USA entering a period of renewed contraction, following the budget cuts agreed between President Obama and the Republican Congress, China’s export growth (at least to the US) will dip. In conjunction with the incapacity of its domestic sector to replace the lost aggregate demand, and in the context of  an inflation rate inflation racing ahead at 5.4% (March 2011 datum) [while house prices are continuing to rise at a breathtaking rate of 24%], China is heading for a recession; one that will either be induced by the authorities or, more worryingly, one that will simply happen spontaneously and rather brutally. Against this backdrop, it would be unwise, and particularly anti-Lutheran, of Mr Schauble (Germany’s finance minister) to imagine that Germany’s smooth 2010 run can continue during the next few years. The rise in the interest rates of Germany’s own bonds, from 2.8% to 3.45% surely weighs heavily in his mind.

So, back to the debt crisis and Europe’s Great Banking Conundrum. If Europe were to allow inflation gently to eat at the sovereign debt (especially of the periphery), it would make some sense to keep lending Greece et al until the problem fades sufficiently. Indeed, it would be, other things being equal, equivalent to a haircut: For there is, at least on paper, no difference between (a) imposing a 30% haircut in nominal values to Greece’s €300 billion debt when inflation is around 1.5% to 2% and (b) imposing no haircut but allowing inflation to edge up to 2,8% to 3% for seven to eight years. From a political viewpoint, and from the perspective of the banking sector that hates haircuts as much as Dracula hates a rising sun, option (b) would be vastly preferable to option (a). But then again, others things are not equal!

To see what is not equal, just look at the fresh downgrade of Irish bonds. What was the rationale? That the austerity imposed in order to compensate for the state’s support of Ireland’s banks weakens the state’s finances making it necessary to bring on more austerity. (See here  and also here for my prognostication of a similar fate for Greece ) The implication is clear: The vicious circle is unbroken. The EFSF lending to the Irish state is making no inroads into the crisis. In effect, the debt mountain is rising and so are the  banking losses not just of the Irish banks but of the whole eurozone.

This realisation, though never acknowledged openly by the German Finance Ministry, is what lies behind the not so subtle change in Germany’s position vis-à-vis debt restructuring. That they only talked about Greece was merely a case of hinting at the general by focusing on the particular. In short, the temptation to allow the mountain of debt to fade in the hands of mild inflation was purged by the belated realisation that the crisis’ dynamic is stronger than any mild inflationary process. And in view of developments in China and the USA, Germany is now eager to consider Plan B: Debt restructuring, beginning with Greece.

In the last few days, the first official mention of restructuring came from Ireland where the new government, with a fresh mandate to do all it can to shift the burdens off the weakened shoulders of the taxpayer, announced (through Michael Noonan, Ireland’s Finance Minister) a haircut of around €6 billion that would hit the banks’ subordinated bonds. Ideally, the government wanted to hit the banks’ senior creditors. In view, however, of staunch ECB resistance (in defence of these great sharks), Ireland is making a start with the medium sized fish that have, in the past, lent money to the private banks. As they say, the culling has to start somewhere. First, the weakest of all (the taxpayers), secondly the second weakest (the ‘subordinated’ bondholders).

Another sign that the combination of inflation and EFSF bail-outs is no longer seen as a viable ‘solution’ to the Crisis is the ECB’s determination to push official eurozone interest rates to about 2% by the end of the third quarter. Do they not know that this would push the insolvent peripheral states over the edge? Are they not aware that, for example, the interest rate reduction (over the bail out loans) that Greek PM George Papandreou so boisterously celebrated on 25th March has withered away as a result of the  ECB rate hikes? Of course they do. But that is the point: Whether the hapless Mr Trichet, the ECB Governor, knows it or not, Germany’s motivation to push for an ECB rate hike is crystal clear: To start the process of debt restructuring instead of relying on mild inflation to do the job that austerity in the peripheral countries could never do.

If I am right, why is Germany still not coming out with a clear statement that reflects its new mindframe? The sad answer is: They have not worked out yet the form that the restructure will take, unsure of its costs in the German banks!

Before turning to the German banks as Germany’s main concern, what of the other prospective victims of a debt restructure? Is the German Finance Ministry not worried about Europe’s pension funds, about the hedge funds, about the ECB (which is holding about €100 billion of dud peripheral bonds, the result of its bond purchase program that started in May 2010, following the Greek IMF-EU loan)?  My answer is no, no and no. But let me take these three no’s in turn:

Pension funds: It is true that here in Greece, as elsewhere, many people worry about the costs of a restructure on pension funds. Allow me to speculate that Mr Schauble and Mrs Merkel do not share these worries. If need be, they concluded long ago, pensioners will have to do with less. What alterative do they have? Perhaps (from Berlin’s perspective) this is a good thing, as southerners will now have an incentive to retire later and to save more during their working lives.

Hedge funds: Similarly with hedge funds. German politicians have always taken a dim view of these outfits (except when their failure brought down German banks, like IKB – but that is another story). In any case, Mr Schauble (I have it on good authority) thinks that hedge funds are not likely to lose much from a debt restructure at this juncture because over the past year (after the Greek crisis erupted) they managed to de-leverage considerably.

ECB: It is clear that Europe’s Central Bank is vehemently opposing a debt restructure for a number of reasons. One is that since last May it has purchased close to €100 billion of peripheral sovereign bonds and, thus, worried about its own balance books in case of a haircut. Another is that bankers do not like haircuts; it is in their nature to resist it. A third reason, the most powerful of the three, is that the ECB is already cross with European politicians because it feels the strain of dripfeeding the banks with huge amounts of liquidity. A haircut, the ECB feels, will increase this reliance. Does Germany not share these fears? It does but, according to my understanding of the consensus in the German Finance Ministry, Germany’s economic strategists are beginning to fear the effects of the crisis more. In the final analysis (they seem to think), the ECB’s position can be bolstered fairly easily if push comes to shove.

So, the only thing that stops Germany from announcing here and now a wholesale debt restructure is the banks. Thus my term the Great Banking Conundrum. The reason why banks are such a large problem is that they have their tentacles everywhere. Their profit is theirs to enjoy but their bankruptcy is everyone’s loss. Unable to cash in their ‘assets’ at a time of crisis, i.e. to retrieve their loans from their creditors (homeowners, businesses, governments), if they are forced to come clean regarding the true value of these assets bank insolvency beckons. And so Europe is not forcing serious stress tests upon them.

Germany’s concern, therefore, and the reason its government remains undecided on the Greek debt, is that it is struggling to compute the losses to Germany’s banks from a restructure of Greek, Irish and Portuguese sovereign debt. There are two issues here: First, it is impossible simply to calculate the knock on effects. For instance, while we know almost to the last euro the exposure of European banks to peripheral debt (see here for a great interactive guide), it is virtually impossible to predict how a, say, 50% haircut of that debt will reverberate throughout a financial system whose opacity and inter-connectivity is notorious. A recent figure that was given to me confidentially, by a well known German banker, is that a 50% haircut on EU peripheral debt would translate into an extra €850 billion of fresh capital that would need to be put into French and German banks alone to compensate them for the losses they will end up incurring.

Secondly, there is an international dimension that an export-oriented country like Germany cannot afford to ignore. E.g. many of these bonds are owned by non-European banks. If they lose a lot of money, these losses can trigger another round of government infusions (in places like Japan, China, Korea etc.) which may affect local investment in projects that would otherwise require German capital goods… What is the likely magnitude of this problem? The Bank for International Settlements tells us that the total exposure of non-EU banks to Greek, Portuguese and Irish debt is a mere $363 billion. This is peanuts, by the standards of the 2008-11 crisis. But then again it does not take into consideration (a) the amounts owed to UK banks and (b) the more than likely Spanish sovereign troubles.

In view of the serious problems that a horizontal debt restructure would cause to Germany’ banks and to its external trade relations, the German Ministry of Finance is therefore reluctant to come out, once and for all, in favour of a debt restructure. On the one hand, they have concluded that it is inevitable. On the other, they know it will bring huge costs to bear upon primarily Germany’s own banks but also, and this is equally daunting, to its export sector. The result is a new spate of… dithering.


Germany is experiencing a surge in self-confidence which, paradoxically, comes hand-in-hand with a realisation that its current good fortunes may be on borrowed time. For a year now, Berlin kept hoping that the euro crisis would, given sufficient time, go away of its own accord. Mild inflation played a major role in that dream of gradual recovery. However, the complete and utter failure to end the debt crisis by means of austerity-plus-loans in the European periphery has caused the German Finance Ministry to conclude that there is no way of avoiding Plan B: a debt re-structure. Alas, the Great Banking Conundrum is causing much consternation, the result being more procrastination and a series of conflicting statements from the German government that, understandably, push spreads up and intensify both the debt crisis and the banking conundrum.

This is the bad news. Is there a silver lining? I believe so. In our Modest Proposal we suggest a simple way out: A tranche transfer of part of the sovereign debt (which effectively restructures the Maastricht-compliant part of the debt without imposing a haircut), a selective haircut on zombie banks that rely of ECB for liquidity (and which does not affect the pension funds) plus (and this is important) the recapitalisation of banks by the EFSF in a manner that  allows Europe, once and for all, to cleanse its banks of worthless titles and, soon, to return them to the private sector squeaky clean and ready to do business (as opposed to their current function as the EU’s black financial holes). Ignoring the Modest Proposal or some such policy intervention, and continuing with the current, punitive bail-outs instead, will lead to the worst of all possible worlds: A deterioration of the debt crisis, a further escalation of the banking crisis and, in the end, a weakened Germany at a time when its good fortunes in Asia will be waning fast.


  • Yanni…I agree with almost everything you have said here, albeit I find your statement that “the recapitalisation of banks by the EFSF in a manner that allows Europe, once and for all, to cleanse its banks of worthless titles and, soon, to return them to the private sector squeaky clean and ready to do business” is Panglossian to the extreme. But my main issue is that while the crisis may be a housing and banking crisis in Spain and Ireland, and a budget crisis in Portugal, in Greece we are witnessing something far more profound, in effect the final collapse of a dysfunctional and corrupt state. There is basically civil war in Keratea with the police (unfairly) called upon to perform military duties, ministers of state are physically attacked with impunity, tax evasion remains rampant, and the ruling party is in complete disarray and basically seems to be capable of nothing more than putting out press releases. With the economy crumbling, we will soon be witnessing the first cruise vessels in the decabotage program, being turned away by the unions. The issue in Greece is how to construct a functioning, quasi modern state with the consent of the electorate. Without that, rescheduling is like giving vitamins to a dying patient. That is the “political” side of “political economics” and what really needs discussing.

    • Dear Yanni and Jerry,

      I agree with Jerry that in Greece the discussion should start at the “political” side of the “political economics”.
      In my opinion there are three factors at play:

      1. The absence of trust of the electoral to the government and the current politicians in general
      2. The understanding that EU leaders have not clear plan to tackle the crisis in the eurozone and most important that eurozone is not a “union” and that euro is not a “common currency”
      3. The absence of alternative political leadership

      I think the above three factors are also at play at a large percentage of EU countries to a higher or lesser extent. The first factor is very intense in Greece as it has been proven that the political system the last 40 years or so has led the country to a perilous path. Moreover, it is very intense as the figures who led the country to this path, in many cases because they pursued their personal benefit, are not facing any kind of punishment and are still managing the country.

      In addition, about one year ago, and while Greeks were realizing that the country is in dire straits, (before that time, this fact was well concealed to the main street people), the political system signed on behalf of the country a debt contract following a procedure which is not supported by the constitution.

      I travel a lot and always people where interested to ask me about Greece. In past times they were talking about the islands, the seas, the food and history. Now the first thing they say is that Greeks are not paying taxes. But is that true?

      The last 40 years Greeks have learned that each penny paid to taxes either goes down the drain by mismanagement or ends up in to politicians pockets. Indeed Greeks avoid to pay taxes. But are they really the notorious tax evaders that the international media portray?

      Well, the state collects taxes to provide infrastructure, healthcare, education, security and rule of law. The fact in Greece is that each family spends enormous amounts in additional education for their children in order to cover the absence of quality state education. Is it not this taxation? They save money in order to send their children abroad for higher education as the state universities are lumbering. Is it not this taxation? They pay very expensive private healthcare otherwise have to wait for months for their turn to see the doctor in state healthcare institutions. Pay with blood and damages the very expensive but badly built road network. Pay “extra” to public servants in order to “expedite” their applications to government institutions. Wait for years to receive back the VAT paid. Face enormous bureaucracy in any aspect of business and wait for years for their court case. Pay dearly for security systems in their homes and for medical support as they feel insecure since the state does not provide the necessary security. Is it not that taxation? Pay the most expensive defense budget just because EU does not recognize Greek borders as EU borders. Is that taxation?

      My answer is that Greeks pay far too much taxes and they get nothing in return. For the above and even more reasons Jerry, you see these phenomena which you describe. People just don’t trust and more important they do not see a “way out”.

      Yes ministers are attacked with impunity, a fact that I strongly condemn, however, ministers steal with impunity, which i also condemn. Indeed there is a minority which acts with force such as attacks, port closures etc. The mainstream sentiment is against such actions but at the same time wish to see a change in the political system.

      To your obvious question “well who voted these incompetent and corrupt politicians” , the obvious answer is the same people. However, in my opinion, when the kids end up in drugs, the parents are at fault. And with that, I mean that the fact that decision-makers of this or any country were voted by the people does not release them from their obligation to do their best for these people. “We do not own our country, we merely borrow it from our children” and we all have to act accordingly.

      To add to the above, more and more people understand that their current suffering is not a result of a plague, war, a comet, or gigantic tsunami. Their suffering comes from a mere technical issue: it happened because of a wrong and dysfunctional financial system

      A system that has gone out of control. A system that just increases moral hazard.

      Everyone understood that, but what we see is that moral hazard forces are gaining control again and governments succumb to these forces.

      What do you expect people to do?


      Kostis Antonopoulos – Rothschild

  • Despite my lack of background in economics, I will risk a judgement of this article. I believe the intention of “shifting excess savings into investments” as mentioned in your modest proposal (V2.2) is in the right direction. This, seams to me, is the source of the monetary system’s problem. Nevertheless, I believe, the expectation that eurobonds will “attract surpluses from the Central Banks of the emerging economies and from Sovereign Wealth Funds,” will not work without guaranties that it actually attracts surpluses and not borrowed funds. Reversely, providing such guaranties (is that possible?) will require some assurance that EU member states support this approach by taking part of the risk. Even then, I doubt there is perspective in this approach, because speculators will like this mechanism, but will not invest on eurobonds.
    In my view, without some form of pressure towards the restriction of the increase of debt, by forming a relation of debt increase with the investment of excess savings, will lead to another worse crisis. Naturally, this is because borrowing beyond a region’s GDP growth is not sustainable. Such a mechanism (if one can be designed), can support (i.e. finance) the ‘rescue’ of countries with unsustainable dept and exposed banks, by passing the cost to the countries and businesses it incorporates. The gain of these countries and businesses will be the increased trust to their financial stability.

  • While i am no economist, i wish to say that a governmental budget surplus necessarily constitutes either a private sector deficit, huge net exports or both. It’s simple accounting, really. So whatever nation is running a surplus is actually causing a demand drain, where their private sector is getting more and more indebted while losing demand to the nations “coffer”, unless they have huge net exports. The question for me becomes whether the government should really run surpluses at all. It should increase the risk for recession and cause unemployment, if i’m not wrong. Of course, i guess if the private sector was spending and investing like crazy and net exports were huge, there might be a need for a demand drain to avoid inflation, but no one in the EU is in full employment really, so that’s not very relevant at the moment, is it?

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