By Kevin M. Wilson
The ECB, the Fed and four other central banks announced at the end of November a new, coordinated effort to provided liquidity to the European banking system. Wall Street rumors suggest that a major European bank was about to implode due to illiquidity, and that may have driven the decision. Be that as it may, this action is strongly reminiscent of the fall of 2008, a time we would all like to forget, and certainly never repeat. There are differences this time, the most prominent one being that the central banks are more prepared. Another difference is that European governments are in general agreement that the Euro must survive, even if major changes are required. But a really scary difference this time is that the population (especially the middle class) is now fully aware that they will be stuck with the bill (again) to save those who caused the crisis, i.e. incompetent bankers and irresponsible governments. This may prove to be a wild card in the game of politics; certainly the approaches favored by the Germans (austerity and no money printing) have been strongly influenced by this aspect of the problem.
However, there are also a number of parallels with the financial crisis of 2008: 1) the problem again involves highly leveraged banks, but linked to sovereign rather than subprime debt this time; 2) off-balance-sheet assets (such as Greek, Spanish, Portuguese and Italian sovereign bonds) of Too-Big-To- Fail (TBTF) banks are again giving regulators and the public a false impression of bank solvency; 3) various governments again favor highly destructive bailouts over actually solving the underlying problems; 4) unregulated banking system credit derivatives (credit default swaps, or CDS) are again a real but indeterminate threat to the entire financial system; and 5) central bank policy errors (such as tightening earlier this year by the ECB) are exacerbating the problem. Failure of governments and central banks to reach at least an interim solution using a so-called monetary “bazooka” (now transformed into a “howitzer” in the media), will very soon cause a financial collapse, according to many observers. Signs of stress in the global banking system are manifest; indeed, we monitor these daily now ourselves. The overhanging threat from losses not yet taken is causing the entire banking system to freeze up, much like it did in 2008. However, much depends on market sentiment, and markets are completely agnostic as to the mechanisms used to “save” the system – they simply want something to happen that removes uncertainty and offers a chance at profitable new trades.
If we assume for starters that Greece, Portugal and Spain will soon default (in that order), regardless of any bailout attempts, we will merely be acknowledging what markets already believe. If we further assume that Italian debt is unsustainable at current high bond yields, and that failure to provide a means of rolling over maturing Italian and Spanish debt could take down the entire European financial system, we would again merely be reflecting what markets already think. Given the massive (40:1) average leverage within the European banking system, and the rising cost of financing European government spending, it is unrealistic to talk of “solving” these problems without write-offs and defaults. However, no one in government is even considering recognizing the actual losses; rather, naïve attempts are made to convince markets that much smaller “haircuts” are required than are already being priced. European banks are deleveraging rapidly in an attempt to beat the clock on new reserve requirements, with the ECB buying major portions of the bad debt that is sold each week. Banks are booking substantial losses on the rest.
The Eurozone bailout schemes now contemplated, involving debt purchases by the IMF or debt monetization (money printing) by the ECB, amount to little more than transfers of the private sector (bank) debt holdings back to the public sector where these instruments originated, with no net change in total debt. But only a major reduction in overall debt will solve the problem. This debt burden transfer is so huge it will probably take at least two generations to pay off, assuming that tax rates are sustained at very high levels. So the real problem is convincing the public that they should shoulder this burden for the greater good, rather than let the banks take their losses or fail. As Keynes pointed out in 1922, resolving this kind of crisis is always a political question – it’s about which group will end up paying the cost of rebalancing the system. Will it be the investors who gambled all and lost? Will it be the middle class who received little benefit but will pay the cost via taxes? Or will it be the working classes paying the major part of the cost through currency devaluation or hyperinflation?
In 2008, it was decided by the Fed and the US Treasury (on an ad hoc basis) that the public should underwrite essentially the full cost of all rescues and bailouts. This had the disturbing result that, almost without exception, no major group of bondholders ever paid the price for blowing up, or assuming cynically that they would be bailed out if anything went wrong. They were made whole by the public purse, violating one of the major tenets of capitalism. Thus “creative destruction” has not occurred and the weak and incompetent have been rewarded. The public in the US is permanently irritated by this action, and will be hard to deal with when the inevitable next crisis arrives. In the present European crisis, Germany has insisted on austerity budgets and no debt monetization by the ECB because of concerns about who will pay for the profligacy of Southern Europe. They are not wrong to think it is the German people who will pay the most, because in fact no one else has any money. The French people and those of several other fairly healthy countries will also pay a great deal over time.
The political question of the hour is how bad it would be for Germany if they don’t push for a bailout for the rest of Europe, versus the cost of actually doing so. There is room for serious disagreement here, but many Germans feel like they are being taken for a ride. Ultimately they must decide whether the European experiment is worth it, and whether changes in the EU charter will actually stop the outrageous spending habits of many European governments. They will also have to decide if TBTF banks should continue to get away with risking the whole system for private gain. Perhaps they will get something worthwhile out of this after all is said and done, but it will involve considerable pain in the short term.