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 tide 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. As at the advent of the EU-IMF €110 billion loan to Greece (almost a year ago, in conjunction with a nominal €750 billion fund, the European Financial Stability Facility, standing by for other fiscally stricken countries), which was meant to ring-fence the rest of the eurozone, inhibiting contagion from Athens, 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, contagion will be unstoppable.
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 zombified banks are now great black holes that absorb much of Europe's economic energy (from the surpluses produced in giants 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, 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 to revisit 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 Conundrummore 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 Spanish and Portuguese 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 is to be done when a currency area (such as the dollar zone, the sterling area, or, indeed, the eurozone) is saddled with a mountain of debt plus banking losses at a time of sluggish growth both internally and externally?
Answer: Make this mountain shrink through macroeconomic means. These means fall mainly under two categories. First, there are the blessings of mild inflation. Allow average prices to rise, and the mountain's real value will shrink. Secondly, effect haircuts on debts and write-offs in the case of banking losses.
In the USA as in the UK, after re-capitalizing the banks at a great cost to taxpayers, 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 that is, 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 sole source of optimism. But China's own growth is based on the policies that Germany refused to countenance: i.e. massive infrastructural investments, which have, interestingly, suppressed the country's consumption share from 45% to 38% of GDP at a time of 10% GDP growth.
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. Given the inability of its domestic sector to replace the lost aggregate demand, and in the context of an inflation rate racing ahead at 5.4% (March 2011 datum), with house prices continuing to soar at a breathtaking rate of 24%, China is heading for a recession -- one that will either be induced by the authorities or, more worryingly, simply happen spontaneously and rather brutally. Against this backdrop, it would be unwise, and particularly anti-Lutheran, of Mr. Wolfgang Schauble, Germany's finance minister, to imagine that his country'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 on 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: 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 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 realization, 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 hope that the mountain of debt will shrink through mild inflation was purged by the belated realization that the crisis's 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 (via Ireland's finance minister Michael Noonan) 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 defense of those 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 bailouts 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 (on the bailout 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 ECB Governor, Mr. Jean-Claude Trichet, 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, though, why is Germany still not coming out with a clear statement that reflects its new mind frame? The sad answer is: They have not yet worked out the form that the restructure will take, unsure of its costs to 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. Angela 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 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 drip-feeding the banks with huge amounts of liquidity. A haircut, the ECB feels, will increase this dependency. 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 stopping 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 debtors (homeowners, businesses, governments), if they are forced to come clean regarding the true value of these assets, bank insolvency looms. So, Europe is not forcing serious stress tests upon them.
In other words, the reason the German government remains undecided on the Greek debt is that it is still struggling to compute the losses to German banks from a restructure of Greek, Irish, and Portuguese sovereign debt. There are two issues here: First, it is simply impossible to calculate the knock-on effects. For instance, while we know almost to the last euro the exposure of European banks to peripheral debt (here is a great interactive guide), it is impossible to predict precisely how, say, a 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. For example, 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, Irish, and Portuguese 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 favor 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, its export sector. The result is a new round of . . . dithering.
Germany is experiencing a surge in self-confidence which, paradoxically, comes hand-in-hand with a realization 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 Stuart Holland and I 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 on the ECB for liquidity (which does not affect the pension funds), plus (and this is important) the recapitalization 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 bailouts 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.