My views on the Euro Crisis
Remember Groundhog Day? It was a great comedy from 1993 where Bill Murray was a weatherman who woke up to “I got you babe” at 6am every morning and relived the same day over and over again.
The euro crisis feels a bit like that. Alarm bells go off in the financial markets and we all wake up to banks wobbling, bond yields rising and some unfortunate country in the spotlight. We´ve lived through it with Greece, Ireland, Portugal and Italy. All we´re missing is Andie MacDowell.
The Pain in Spain
Spain is getting all the unwanted attention now. As things currently stand, its banks are cut off from foreign funding and its government is paying extortionate rates to borrow on the open markets.
Markets are sceptical of Mariano Rajoy, the Spanish Prime Minister, when he insists that Spain can take care of its own banks. In the past three weeks both his cabinet and the Spanish Central Bank have been heavily criticized for their handling of the recapitalization of Bankia, the countries third largest bank. The Spanish authorities seemed to think that seven toxic banks could be magically combined to create one big stable bank. Unsurprisingly enough, they were wrong.
Ireland has a much more flexible labor market than Spain, but they also had to deal with the aftermath of a big property boom and the banks who lent recklessly during it. Portugal & Italy didn´t have property booms but their economies had been uncompetitive and stagnant for years. Greece didn´t really have a banking problem but their economy was extremely inefficient and its government took advantage of low bond yields during the boom years to borrow way beyond its means.
What strikes me as strange is that despite having completely different economic problems, the suggested remedy for each of these countries was essentially the same. They were all told to cut spending, cut wages, raise taxes and lower debt – i.e. austerity.
Misdiagnosing the patient
For years, the authorities have been misdiagnosing the problems in Europe. Greece was put through the wringer to try and pay back loans it couldn´t possibly afford and their economy is on its knees as a result. Ireland´s government thought that guaranteeing all the reckless loans its banks made would prevent a financial crisis (it didn´t, but there are now plenty of bargains available as a result).
And now Spain is being asked to move mountains to cut a budget deficit and a public debt that are not even that high to begin with (its public debt is lower than Germanys, its budget deficit is lower than the UK & USA).
Instead of austerity, what Spain really needed last year was a huge injection of capital into its banks. The reason the government didn´t do it was because injecting public funds into their banking system would have added a few points to their (low) public debt. Crazy isn´t it?The fact that they´ve recapitalized their banks in dribs and drabs is a big reason their public borrowing costs are now so high.
Patient: Doctor, I have a terrible pain in my leg.
Doctor: No problem sir, let me put your arm in a sling and you´ll be right as rain.
Patient: But it´s my leg that hurts?
Doctor: Don´t argue son, I was educated in Berlin´s finest medical school.
Like Ireland, the root of Spain´s problems is private debt, not public debt. In other words, the government didn´t borrow too much - its banks, property developers and citizens did. Wasting two precious years concentrating efforts on cutting the government deficit and ignoring the mounting bad debts in the banking system strikes me as nonsensical (like our doctor above).
One side affect of this crisis is that the general public is now expected to understand a huge range of financial terms that most economic students would have struggled to remember during their college exams (I certainly did). I´ll just clarify two of them here:
Recapitalisation is when fresh equity (money) is injected into a bank. This reduces the risk of insolvency and helps repay debts. In normal times, banks can raise this finance on the open market, but when they are under significant pressure, they need to turn to their government. When a government recapitalises a bank, they usually end up owning a stake in the bank itself (and sometimes all of it).
A government/sovereign bond is simply an IOU. A bond is issued when the government borrows money on the open market and promises to pay it back at a fixed rate and term (e.g.€3 billion for 10 years at 5% interest per year). Like shares, these bonds can be traded on the open market. A large proportion of government bonds are purchased by banks.
The EU merry-go-round
Now that we´ve clarified the jargon, let me explain why the banks and governments on the periphery of the EU are in so much trouble.
Despite everybody using the same currency, each individual European government is responsible for its own banking system and each bank generally buys sovereign bonds from its local government.
In other words, if a bank is in trouble, the government helps it out, and if a government is struggling to issue bonds, their banks will step in and buy them. A time goes on, both the banks and the governments will get weaker and weaker from this mutual dependency. In fact, if it goes on for long enough they will end up looking like a couple of drunks holding each other up on a Friday night. Then Angela Merkel comes along with a bucket of cold water to douse them with.
Suffice to say, this game doesn´t fool investors for very long and the governments of countries with the weakest banks end up issuing bonds at the highest rates. The cost of borrowing is therefore very high in Spain and ridiculously low in Germany.
Investors are essentially giving money to Germany for safekeeping and expect nothing in return. You do not need to be Paul Krugman to understand that investors don´t normally behave like this. To put it bluntly, a situation where Berlin insists on austerity and then benefits from all the money that flows north across the Rhine as a result is patently unfair. It is also a highly dangerous cycle needs to be broken.
So what is the answer?
The solution to this mess is very easy in theory and fiendishly difficult to implement.
1. European bank supervision
A centralized European authority should be supervising and recapitalizing struggling European banks, not individual governments. European wide deposit guarantee schemes should also be in place to prevent nervous investors and savers from transferring money out of their country every time there is a mini crisis.
As the Federal Reserve in the US guarantees deposits across the country, savers in California don´t transfer money to Illinois just because their local government is up to its neck in debt. Using this same logic, if both Spanish and German bank deposits are guaranteed by the same body, there is no incentive to move money from one country to the other.
2. European Debt Integration
Instead of each European country borrowing the same currency at wildly different rates, common euro bonds should be issued which are guaranteed by the EU as a whole. In other words, government debt should be pooled, or at least some of it should be. Some economists have suggested mutualizing public debt above 60% of GDP, which strikes me as a very elegant solution.
These aren´t off the wall suggestions by think tanks or left wing economists. They are both being discussed right now at the very highest levels in Europe. In the past two weeks the heads of the British, French, Spanish and Italian governments have all come out in favor of these steps. The governor of the European Central Bank has also argued strongly in favor of centralized support and supervision of national banks.
What will the Germans do?
Most articles you read on this saga will involve a paragraph or two exhorting the Germans to open up their checkbooks and stand behind the debts of their fellow EU members. And they do need to do that. German bond yields need to rise and capital must start flowing south.
The price Angela Merkel demands will be closer fiscal integration and while Europe might take a while to acknowledge this reality, there can be no middle ground. Either Europe moves very fast towards debt integration and transfers its powers to common institutions or the weak countries will fall into a deep recession and they will drag everyone else, including Germany, down with them.
While the solution to the crisis might be relatively straightforward on paper, implementing it involves taking unprecedented political decisions. Deficit countries will not want to give up fiscal independence and surplus countries will not want to weaken their balance sheets by guaranteeing the debts of other nations.
I strongly believe something resembling the steps outlined above will happen in Europe within 3-4 months and perhaps much sooner. In fact, a new European wide bank recapitalisation system could be created within days or weeks.
Let us not forget that the last two years has already brought sweeping changes to the economic and political structure of Europe that previous generations of politicians could scarcely have imagined, never mind implemented.
A Happy Ending
In Groundhog Day, Bill Murray finally breaks the cycle by casting aside his grumpy, selfish persona and becoming a better person. He learned French, saved lives, helped townspeople and crafted a news report so eloquent all the other stations turned their microphones on him.
Alas, no such fairytale ending awaits the countries of Europe. Nonetheless, if we want those alarm bells to stop ringing, Europe needs to change its character and its wayward habits just like our protagonist did (no need to learn French though).
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