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.
A strong, durable economic recovery would make such an approach workable. Most European officials hope that, when combined with substantial public money to support troubled sovereign debt, it would.
The administration of US President Barack Obama adopted this option, following the unpopular Troubled Asset Relief Program, which injected hundreds of billions of public dollars into the banking system (most of which has been repaid), but some US banks, including Bank of America and CitiGroup, are still vulnerable, with considerable toxic assets (mainly related to home mortgages) on their balance sheets.
The second approach is rapid resolution. However, letting questionable banks gradually recapitalize themselves and resolving the bad debt later — perhaps with European Brady Bonds (zero-coupon bonds which in the 1990s enabled US banks and Latin American countries to agree to partial write-downs) — won’t work if the losses are too large or the recovery is too fragile. More rapid resolution may be necessary to prevent zombie banks from infecting the financial system.
The US Resolution Trust Corp rapidly shut down 1,000 insolvent banks and savings and loans institutions from 1989 to 1995 so that they would not damage healthy institutions. Scaled to today’s economy, US$1.25 trillion in assets were sold off, with 80 percent of the value recovered. The financial system rapidly returned to health. This approach requires judgment and resolve in separating insolvent institutions from solvent ones.
Finally, there is the path of public capital. If market-driven recapitalization is too slow and closing failing institutions is impossible, a more extreme alternative is to inject public capital directly into the banks (rather than indirectly, as now, by propping up the value of the sovereign debt that they hold). This approach prevents bank runs, because banks with more capital are safer, but how much public capital should be used and on what terms? Private capital, of course, is preferable, but given the risk that it would be wiped out by future public intervention, investors would be wary. In the meantime, regulators are increasing banks’ capital ratios.
Europeans, both debtors and creditors, must address the banking problem forthrightly and simultaneously with the euro, sovereign debt and fiscal adjustment issues. Pretending that banks that passed modest stress tests can be kept open indefinitely with little collateral damage is wishful — and dangerous — thinking.
Michael Boskin is professor of economics at Stanford University and senior fellow at the Hoover Institution. He served as chairman of former US president George H.W. Bush’s Council of Economic Advisers from 1989 to 1993.
Copyright: Project Syndicate
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