The Eurozone’s Triple Crisis: Part 2 (Evolution 2010-2012)
The following is a continuation of the three part series on the Eurozone’s continuing triple crisis (sovereign debt, banking system, and recession). Part 1 previously addressed some origins and background of the crisis. Part 3 to follow will consider developments from the Brussels economic summit this past June 2012 through the September 6 meeting of the region’s central bankers and their attempt to create a monetary-banking solution to the continuing crisis.
Austerity in the Eurozone—the Causes and Consequences
In the spring of 2010 the sovereign debt crisis in Greece erupted and intensified further. Prior to that event, sovereign debt problems in Greece and the periphery had been addressed by a relatively greater emphasis on imposing austerity measures on the periphery governments as a precondition for northern core governments and banks lending more to enable them to make sovereign debt payments coming due. Remember, those debt payments were to be made to northern ‘core’ banks and their bond investors, as well as to northern core governments. So austerity measures such raising taxes and cutting social spending in the periphery economies, like Greece, meant the general populace would in effect be paying the banks and bondholders. That’s a naked class-based income transfer, in other words.
Austerity measures had another contradictory effect: they reduced income in the periphery economies and therefore reduced tax receipts needed to make the debt payments to northern governments and banks even after debt was renegotiated. Austerity made debt repayments actually worse, requiring the need to lend periphery governments still more in order to make debt payments—which resulted in requiring still more spending cuts, tax hikes, less tax revenue…and so on in a downward spiral.
So why was austerity the central policy focus in the first place if it just made things worse? Focusing on austerity as the primary solution meant northern banks and bondholders did not have to take any losses in the short run on their loans to the sovereign governments. Austerity solutions are a ‘bet’ by bank and bondholder capitalists that the crisis will be short, that the populace will be able to cover the burden of debt payment for a period, that the crisis will pass eventually on its own, and that they (banks, bondholders, and their core governments) will get off free from having to pay anything. But this ‘bet’ failed.
By 2011 the crisis that initially erupted in Greece in 2010—and appeared to be stabilized by year end 2010 by means of periphery government bailouts by northern core government and rescue fund further lending—began to deteriorate once again. Austerity measures associated with the 2010 bailouts only made debt matters worse. It became increasingly clear that sovereign debt restructuring would require not only more loans and austerity measures, but also some reduction of principal by banks and bondholders. Simply rolling over debt by issuing more debt (even with austerity measures) was no longer sufficient. More aggressive debt restructuring was necessary. Some bondholders-banks would therefore have to take ‘a haircut’ and lose money as part of a restructuring of debt as a condition of more debt issuance to periphery governments. At the same time, still more austerity was also imposed, including now demands for more aggressive sales of public assets and properties.
2011: Debt Crisis Intensifies and Spreads
By late 2011 the banking system was also becoming increasingly fragile. Losses on government and other loans, combined with the deepening recessions in the periphery economies, were taking their toll on the private banking system throughout the EZ. Hardest hit were the banks in the periphery, but the tight connections between lending by the northern ‘core’ banks to the periphery banks meant the losses and declining bank revenues were penetrating the northern banks as well. In addition to the major banks in Greece, Spain, Portugal and Italy, the northern banks most heavily impacted were Credit Agricole and Societe General in France, Commerzbank and Deutsche bank in Germany, Unicredit and and Intesa in Italy, and, although formally outside the EZ but closely integrated with the EZ banks, in the United Kingdom, Lloyds and Barclays.
As the sovereign debt problem continued to grow, EZ governments collectively raised the amount in their rescue funds. Thus the EFSF was raised and supplemented by the ESM. But growing bank debt and spreading bank crisis from the periphery was another problem. The two rescue funds (EFSF and ESM) were earmarked for bailing out sovereign government debt and not banks’ debt. That left the critical question: what is to be done in the case of growing—and spreading—losses in the private banking system?
Normally that would be a task for the central bank, the ECB. But the ECB is not a normal central bank, like the US Federal Reserve Bank. Each EZ economy has its own ‘mini-Fed’ central bank. For the ECB to pump money directly into the private banks on its own meant it would in effect bypass the other national central banks. Agreement for it to do so therefore had to come first from the national central banks themselves. Unlike the U.S. Fed as well, the ECB also cannot function as a lender of last resort to bail out a failing Euro bank directly. For that it must also coordinate and get approval of the 17 Eurozone national central banks. Nor does the ECB have Fed-like authority to even supervise the private banks to ensure they do not engage in ‘Lehman-like’ excessive risk taking that leads to a bank’s collapse. The ECB thus does not have the deeper authority that the Fed has to rescue banks in trouble.
But the rapidly developing Euro banking system crisis in late 2011 would not wait for the EZ to work out these institutional contradictions. With Greece having erupted a second time in 2011, requiring still further debt restructuring, with the sovereign contagion clearly haven spread to Portugal, Spain and threatening Italy as well, and with the growing realization that the banking systems in those countries might spread their contagion ‘north’ as well—EZ governments added a further government bailout fund, the ESM. EZ governments also reached consensus that the ECB to preemptively bail out the private banks with massive money injections to prevent their possible collapse as well.
The ECB response in November 2011 and February 2012 was to inject more than $1.2 trillion into the EZ banking system in what was called the LTRO, or Long Term Refinancing Operations. That massive injection stabilized the banks—albeit only temporarily. Soon after, in the spring of 2012, the Greek sovereign debt crisis erupted for yet a third time in as many years. The crisis quickly spread to Spain and Italy in turn. This time it was not just the periphery governments but the banks in Greece, Spain, Italy—as well as banks in France, U.K., and elsewhere in the northern ‘core’.
Spanish and Italian banks in particular were major financial players in the EZ banking system. And they had borrowed heavily from French, Netherlands, German and UK banks, both before and after 2009. In non-banking terms, the Greek economy accounted for less than 3% of total Eurozone Gross Domestic Product (GDP). But Spain represented a significant 12% of the Euro GDP. Italy an even greater 17%. A banking crisis in either Spain or Italy clearly threatens the rest of the EZ banking system. By the summer 2012 the LTRO had clearly shown that it may have temporarily stabilized the banks, but it had virtually no impact on the EZ real (non-bank) economy or its drift toward region-wide recession.
Euro Banks Growing More Unstable
Since the spring 2012 a number of signs and indicators suggest the European banking system is becoming more unstable. One of the obvious has been the need to bail out most of the Spanish banks, at the forefront of which was the Spanish bank, Bankia. Like Bankia, most of the remaining major Spanish banks are in deep trouble. At mid-year 2012, more than $123 billion has been committed thus far to prop up the Spanish banking system. Perhaps three times that will be eventually necessary. And that does not count additional bail out costs for the Spanish federal government as well as untold amount to bail out the Spanish regional governments like Valencia, Catalonia and others—all also deeply in debt. The total bail out costs for Spain alone could exceed the total available in the EFSF fund’s $500 billion or so.
Another sure sign of growing Euro bank instability in recent months is banks’ inability to obtain short term loans from other financial institutions. For some time Spanish, Italian and other periphery banks have been unable to obtain such loans, and have had to turn to the ECB for most short term lending. Spanish banks’ borrowing from the ECB escalated to $440 billion in June alone, double the $220 for January six months earlier. The growing unavailability of bank short term lending is now spreading throughout the European banking system. A major source for short term bank funding in the past was US money market funds. However, for the past six months US money market funds have been withdrawing hundreds of billions of dollars from Europe, as concern about the EZ banking system has risen following several steep downgrades of the EZ and UK banks by rating agencies, Standard & Poor’s and Moody’s Inc.
Banks not in as serious trouble as those in the periphery have begun hoarding cash, another sign of impending instability. Capital flight from the periphery to the ‘core’ has been accelerating, with investors pulling money out from the periphery and re-depositing it in Germany, Finland, and elsewhere at zero and even below zero rates (i.e. paying the German banks to take their money without even paying interest). Instead of lending to periphery bank partners and customers, northern core banks have been depositing excess, hoarded cash with the ECB. In 2007 the total such ‘parked cash’ was only $15 billion. Today in 2012 it is more than $400 billion. Such cross border capital flight, whether back to the US or from south to north in Europe, is typically ‘the canary in the coal mine’, signaling expectations of further bank problems. Meanwhile, bank to bank lending in general throughout Europe has been drying up, prompting ECB president, Mario Draghi, this past July to remark that “inter-bank lending is very dysfunctional” and essentially “not working”.
Another major financial event in recent months that is exacerbating bank loan contraction, cash hoarding, and south-to-north and Europe-to-US capital flight was what has been the ‘LIBOR Scandal’. Libor stands for ‘London Inter-bank Offer Rate’. It is the major market in Europe and globally in which banks lend to each other. When inter-bank lending shuts down, bank to non-bank business and bank to consumer lending quickly declines, further exacerbating recession. That is what happened in 2007-08 in the US when banks stopped lending to each other, since none knew which of them was technically insolvent (bankrupt). The Libor scandal was exposed this past summer, revealing that banks had been falsifying and manipulating the inter-bank rate for years in order to maximize their profits on derivatives trades. The Libor scandal may yet become the ‘subprime mortgage’ event of the next banking crisis. Most mortgage rates, consumer loan rates, and dozens of other interest rates in the U.S. and globally are ‘set’ according to the Libor. The fraudulent practices by the biggest banks globally manipulating Libor will no doubt produce legal suits worth tens and even hundreds of billions of dollars. The full scope and magnitude of the scandal is yet to be determined, as government investigations in the US and UK will continue for months to come. In the meantime, the immediate effect is a further decline in confidence in banks and their lending practices.
From Sovereign/Banking Crises to Deeper Recession
The key transmission mechanism between the banking crisis and the spreading European recession is bank lending contraction: banks to other banks, banks to governments, and banks to non-bank businesses and consumer households. As bank lending dries up, the economies—both peripheral and core—experience a decline in GDP and employment. Add to this lending contraction the various austerity programs and the dual impact on GDP and employment in the European economies is intensified. Ironically, both governments and banks have been the dual beneficiaries of bailouts for which trillions of dollars have been put aside, but both governments (austerity programs) and the banks (lending contraction) are the two major sources contributing to the deepening recession in the Eurozone through austerity (government) programs and lending (banks) contraction.
All the periphery economies are either in a double dip recession or even bona fide depression (Greece, Spain). The UK entered a double dip early in 2012, France has begun a decline, and output in Germany has flattened out. Throughout the EZ and UK, Manufacturing activity is contracting, business and consumer confidence falling rapidly, and investment slowing. Latest EZ unemployment figures show a EZ jobless rate just short of 12% and rising. In Spain, Greece, Portugal it is more than 20%. Soon the escalating unemployment will add a third major source to the EZ recession: a contraction of household income and therefore consumption in turn.
It is further ironic that the recession and declining GDPs throughout the EZ result in a still further collapse of tax revenues and consequent additional rise in government debt and bank losses. Governments and banks must then borrow even more, thus continuing the vicious cycle of government debt crises, bank losses and instability, and more austerity.
The dilemma faced by policy makers in government and business in the EZ is how do they confront the dual banking-government debt crisis and at the same time prevent the European recession from spreading and deepening? From 2009 through June 2012 the main policy thrust has been to protect the banks from losses and ensure the peripheral governments can continue making payments on their debt to the banks—i.e. ensure bank losses don’t grow further. A combination of austerity and loans to governments were the approach. By ensuring the banks don’t experience losses it was assumed the banks would then lend, investment would occur, and the economies would grow out of the crisis. But the banks contracted lending, for the various reasons stated above. Government austerity and bank lending contraction together have made the situation worse, not better. Austerity has not worked, and banking instability has grown.
By June 2012 a growing consensus among Europe’s bankers, capitalists and politicians has grown that the previous strategy of bailing out peripheral governments with special funds and imposing austerity on their populace to help pay for the bailouts needs to be replaced with something more effective. In a special Euro Summit gathering at the end of June 2012 in Brussels a different course of policy action was laid out in general terms.
Jack Rasmus is the author of the April 2012 book, “Obama’s Economy: Recovery for the Few”, published by Pluto Press and Palgrave-Macmillan, available at discount from Jack’s website, www.kyklosproductions.com, and his blog, jackrasmus.com, as well as Amazon and bookstores. For Jack’s latest analyses on the US, Euro and global economy, listen to his forthcoming radio show, TURNING POINTS, on the Progressive Radio Network from New York on Wednesdays at 2pm starting September 19, 2012.