Europe is suffering from simultaneous sovereign debt, banking and currency crises. Severe economic distress and political pressure are buffeting relationships among citizens, sovereign states and supranational institutions, such as the European Central Bank (ECB). Calls are rampant for surrendering fiscal sovereignty, for dramatic recapitalization of the financially vulnerable banking system, for Greece, and possibly other distressed eurozone members, to quit the euro or for the establishment of an interim two-tier monetary union.
In this combustible environment, policymakers are desperately using various vehicles — including the ECB, the IMF and the European Financial Stability Facility — in an attempt to stem the financial panic, contagion and risk of recession, but are officials going about it in the right way?
The sovereign debt, banking and euro crises are closely connected. Given their large, battered holdings of peripheral eurozone countries’ sovereign debt, many of Europe’s thinly capitalized banks would be insolvent if their assets were marked to market. Their deleveraging inhibits economic recovery and the large fiscal adjustment necessary for Greece, Ireland and Portugal, if not Italy and Spain, would be economically and socially disruptive. Default likely would be accompanied by severe economic contraction — Argentina’s GDP fell 15 percent after it defaulted in 2002.
Despite stress tests, bailout funds and continual meetings, a permanent workable fix has so far eluded European policymakers. Failure would erect a huge obstacle to European economic growth for years to come and it could threaten the survival of the euro itself. Disagreement among and between heads of state and the ECB over the bank’s purchases of distressed sovereign debt have only added to the uncertainty.
A decent pan-European economic recovery and a successful gradual fiscal consolidation would allow the distressed sovereign bonds to rise in value over time. Until then, the jockeying will continue over who should bear the losses, when and how. Will it be Greek citizens? German, French and Dutch taxpayers? Bondholders? Financial institutions’ shareholders?
The fundamental problem is that how the battle is resolved would affect the amount of the losses.
Prices of bank shares and the Euribor-OIS spread (a measure of financial stress) signal a profound lack of confidence in the sovereign debt of distressed countries, with yields on 10-year Greek bonds recently hitting 25 percent. The crisis affects non-Europeans too. For example, concern over the exposure of US banks and money-market funds to troubled European banks is harming US financial markets.
There are three basic approaches to resolving the banking crisis (which means resolving the fiscal adjustment, sovereign debt and euro issues simultaneously).
The first approach relies on time, profitability and eventual workout. One estimate suggests that a 50 percent reduction in the value of peripheral countries’ sovereign debt (reasonable for Greece, but high for the others) would cause about US$3 trillion in losses, overwhelming the capital of European banks, but the banks are profitable ongoing enterprises in the current low-interest-rate environment, because they typically engage in short-term borrowing and longer-term lending at higher rates, with leverage. Playing for time therefore might enable them gradually to recapitalize themselves by retaining profits or attracting outside capital.