The Eurozone's Triple Crisis

The Eurozone (EZ) is a collection of 17 European economies sharing a common currency, the euro. The meaning of the term, crisis, does not refer to a condition that is simply serious or even severe. It means a problem has reached a fundamental turning point—i.e., a bona fide crisis

The major dimensions of the EZ crisis are threefold: starting out as a sovereign debt crisis, it has progressively evolved to a EZ-wide banking crisis. The sovereign debt-banking crisis in turn has a region-wide deep recession throughout the non-banking and non-government sectors of the Eurozone economy. The Eurozone crisis is thus a simultaneous triple crisis.

Current policies addressing the deepening recession have all largely failed to date. A fundamental change is necessary. Without such change, the EZ will eventually experience a classical banking crash. Britain is already experiencing a double dip recession—as have, or will, other economies within the broader 27-country European Union.  It has affected the already slowing economies in the U.S., as well as China, India, Brazil, and elsewhere. It is the main force in the global contraction of manufacturing underway since late 2011.

Background to the Eurozone Crisis

With the eruption of economic problems in the Euro periphery economies (e.g., Greece, Portugal, Spain, Ireland, etc.) circa 2009-10, the EZ crisis was initially represented in the press largely as a sovereign debt crisis—i.e., where governments in the Euro periphery had taken on too much debt and were thus experiencing a Sovereign debt crisis due to their inability to repay principal and interest on prior incurred debt that grew too large and/or too expensive to repay in full and/or on time out of normal government income flows—i.e., from government tax revenue receipts.

In order to avoid default on their debt, Euro periphery governments since 2009 have chosen to respond with the following policy alternatives: (1) borrow more debt to meet payments on the old debt; (2) restructure the old debt (reduce principal levels, change terms of payment, etc.) to enable existing tax revenues to cover debt payments in the future; or (3) introduce austerity measures to supplement inadequate tax revenues. Austerity measures include raising taxes, reducing government spending, and selling off government (national) assets and properties. Austerity measures are designed, in theory, to raise governments’ income in order to help make interest debt payments coming due. In practice, all three alternatives tend to occur simultaneously for a government facing default on debt payments.

Lenders who would issue additional loans to a sovereign government unable to make its debt payments insist the sovereign periphery, in order to make debt payments in the future, raise sufficient cash flow by reducing government spending, raising taxes, or by selling off public assets (i.e. austerity). Similarly those lenders would, instead of issuing new additional loans, restructure existing debt that hasn’t been paid.

What the foregoing scenarios show is that debt is always a two-way street—i.e., a borrower (sovereign government) and a lender. The lenders who issue the credit and loans to sovereign borrowers are first and foremost Eurozone banks, specifically northern European core banks that loan to periphery governments.

But government debt is not just composed of direct bank to government loans. When the sovereign debt crisis worsens, other Eurozone governments also loan to periphery governments accumulating debt. This government to government lending occurs to ensure their northern core banks continue to get paid on their prior loans to the periphery governments. So debt may be government to government in origin, as well as bank to government.

As government debt repayment difficulties deteriorate still further, core government lenders may decide it is better to amortize the need for further loans to indebted periphery governments. At that point, pan-Eurozone rescue funds are created to provide loans for sovereign debt refinancing. In the case of the EZ, there are two supranational bailout funds: the European Financial Stability Fund (EFSF) and the (still not yet fully approved) European Stability Mechanism (ESM) designed to supplement the EFSF. The EFSF and ESM together have mustered about $1 trillion for sovereign debt rescues—an amount that is totally inadequate.

The IMF is a third possible government debt bailout fund. However, its loans to periphery sovereign governments require the agreement of its other international participants. Unable to obtain that agreement, the IMF has been reluctant to provide lending to the Euro periphery.

There is a potential fourth source of government bailout funding—the European Central Bank (ECB). Its rescue funding is potentially limitless and could be applied both to sovereigns and private banks. But the broader European Union Treaty prohibits the ECB from providing financing to periphery or other Euro governments with debt problems. Nevertheless, the ECB found a way around the prohibition in 2010 and again in 2011 when the Euro government debt crisis rapidly deteriorated. But it bought only a couple hundred billion euros of the estimated trillions of outstanding government debt. Furthermore it did so in the face of stiff German resistance to such direct government bond buying.

The sovereign debt crisis picture is one in which the cumulative government debt amounts to several trillions of dollars, but the funds in the periphery (and increasingly elsewhere in the Eurozone) amount to only somewhere between $500 billion to $1 trillion at most. The IMF as a bailout source remains on the sidelines by choice. A political battle continues to rage over to what extent, national governments in the core north and their national central banks will allow the ECB to usurp their roles as lenders to governments. Were the latter to occur, investors in national government bonds would experience significant losses on their issue bonds.

Origins of the Eurozone Crisis

The EZ crisis has its roots in the creation of the euro as a common currency in 1999 at a time of concurrent, expanding global financial speculation. The euro made possible a massive increase in trade and money flows between the EZ northern core and periphery economies. More purchases by the Euro periphery of goods and services produced in the northern core economies (France, Germany, Netherlands, etc.) meant more profits for businesses and banks. So northern banks were more than eager to lend to the periphery economies. Sometimes the lending went directly to businesses in the periphery. Sometimes to periphery banks and/or branches of northern banks and sometimes to northern core non-bank businesses—much like U.S. businesses in the northern industrial states relocating to the south and southwest in the 1970s-1980s.

The lending to the periphery thus came back to the core in the form of purchases of internal imports from the north. Germany was a particular beneficiary of this arrangement,  resulting in a major expansion of intra-Eurozone purchases of German goods and services.

Even more money flowed from banks in the north to the periphery. Heavily involved in this lending flow were French banks such as Credit Agricole and Societe General, UK banks, German Commerzbank, and others. Combined with a global shift toward financial speculation, the real estate boom created a housing-construction bubble not unlike that which was occurring simultaneously in the U.S. Still more money flowed into investments, especially real estate and financial speculation based on it. Meanwhile, with GDP and income rising, peripheral governments appeared able to afford to borrow more as well. Booming real estate required infrastructure development in the periphery. Governments would borrow to finance that infrastructure and to expand social services and transfer payments to those segments of its population not directly benefiting from the investment, real estate, and financial speculation booms. 

Banks in the peripheral economies, like Spain, may have done much of the direct lending to finance the local Spanish real estate bubble and to pump ever larger amounts of loans to local governments for infrastructure and real estate expansion, but the money originated in loans by northern core banks to the Spanish banks or else from the national Spanish government’s budget, the latter of which became increasingly dependent itself on loans from the north.

This scenario raises the question: was the build up of excess debt in the periphery a result of excessive borrowing  or the result of excessive lending by the core north? Despite the fact that the northern European core banks and government lenders were just as responsible as the peripheral southern tier economies governments and borrowers, the Eurozone crisis was framed initially in terms of a peripheral (and especially southern tier) sovereign debt crisis The role of core northern banks was barely mentioned. It was all due to bad government practices and not bad banking practices—i.e., a line of argument that absolves the banking system from its responsibility in creating the debt crisis.

When the global housing bust occurred in 2008-09, it had the effect in the EZ of collapsing housing and commercial property assets there as well as in the U.S. The real estate bust meant losses by banks—both local banks and those in the northern core banks—that had loaned to the periphery banks. 

More loans were subsequently needed to cover losses, both to local banks, businesses, and governments. National governments borrowed more, growing national debt as GDP declined. By 2010, EZ-wide government borrowing rescue funds—like the EFSF—were created to accommodate the greater volume of loan refinancing needed. Austerity programs were introduced as conditions of further lending. Austerity reduced government revenues, requiring still more emergency loans and more government debt. A vicious cycle set in: recession causing less tax revenues requiring more loans from core governments and funds, accompanied by more austerity that deepened and prolong recession, resulting in still less tax revenues, and so on. This scenario is what in fact happened in Greece over the course of 2009-10.

Austerity—the Causes and Consequences

Greece’s sovereign debt problems had been addressed by a relatively greater emphasis on austerity measures 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 as 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. In other words, a class-based income transfer.

Austerity measures had a 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 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.

So why was austerity the central policy focus if it just made things worse? 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 appeared to be stabilized by means of bailouts by northern core government and rescue fund lending. But austerity measures associated with bailouts only made debt matters worse. It became increasingly clear that sovereign debt restructuring would require not only more loans and austerity measures, but some reduction of principal by banks and bondholders. Simply rolling over debt by issuing more debt  was no longer sufficient. More aggressive debt restructuring was necessary. Some bondholders-banks would have to lose money as part of a restructuring of debt and as a condition of more debt issuance to periphery governments. At the same time, still more austerity was imposed, including demands for more aggressive sales of public assets and properties.

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 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. EFSF and ESM were earmarked for bailing out sovereign government debt, not bank debt. That left the critical question of what is to be done in the case of growing 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 U.S. 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 had to come first from the national central banks. Unlike the U.S. Fed, the ECB also cannot function as a lender of last resort to bail out a failing Euro bank directly. For that it must coordinate and get approval of the 17 Eurozone national central banks. Nor does the ECB have Fed-like authority to supervise the private banks to ensure they do not engage in Lehman-like excessive risk taking that leads to a bank’s collapse. 

But the rapidly developing Euro banking system crisis in late 2011 could not wait for the EZ to work out these institutional contradictions as Greece erupted a second time in 2011, requiring still further debt restructuring, and the sovereign contagion also spreading to Portugal, and Spain, and threatening Italy as well. With the growing realization that the banking systems in those countries might spread their contagion north, EZ governments added a further bailout fund, the ESM. EZ governments also reached consensus that the ECB should preemptively bail out the private banks with massive money injections to prevent their possible collapse.

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 a third time in as many years and quickly spread to Spain and Italy. This time it was not just the periphery governments, but the banks in Greece, Spain, Italy, France, UK, and elsewhere in the northern core

Spanish and Italian banks, in particular, were major financial players in the EZ banking system. 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 percent of total Eurozone Gross Domestic Product (GDP). But Spain represented a significant 12 percent of the Euro GDP; Italy an even greater 17 percent. A banking crisis in either Spain or Italy clearly threatened the rest of the EZ banking system. By the summer 2012, the LTRO had 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 Spring 2012, a number of signs and indicators suggest the European banking system was becoming more unstable. One of the obvious signs has been the need to bail out most of the Spanish banks, at the forefront of which was Bankia. At mid-year 2012, more than $123 billion has been committed thus far to prop up the Spanish banking system. And that does not count additional bailout costs for the Spanish federal government, as well as untold amounts to bail out the Spanish regional governments like Valencia, Catalonia, and others—all also deeply in debt. The total bailout costs for Spain could exceed the total available in the EFSF fund’s of $500 billion or so.

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 billion for January. The growing unavailability of bank short term lending is now spreading throughout the European banking system. A major source for short-term bank funding had been U.S. money market funds. However, for the past six months those funds have been withdrawing hundreds of billions of dollars from Europe, 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 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—more than $400 billion. Such cross border capital flight 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-U.S. capital flight 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 U.S. 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 U.S. and UK will continue for months. Meanwhile, the immediate effect is a further decline in confidence in banks and their lending practices.

From Crises to 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 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 is falling rapidly, and investment is slowing. Latest EZ unemployment figures show a EZ jobless rate just short of 12 percent and rising. In Spain, Greece, and Portugal it is more than 20 percent. Soon the escalating unemployment will add a third major source to the EZ recession—a contraction of household income and therefore consumption.

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, continuing the vicious cycle of debt crises, bank losses, instability, and more austerity.

The dilemma faced by policymakers in government and business in the EZ is how 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.

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.

The June 2012 Brussels Summit

On June 28 in Brussels, it was finally recognized that the banking crisis was more critical than the sovereign debt crisis in Greece and even Spain. The decisions reached at that summit called for creating a Eurozone banking union as well as more centralized supervision of the Euro banking system by the ECB or some new central bank-like entity. More centralized supervision of the Euro banks is a prerequisite for the ECB or any central bank, acting as a lender of last resort—i.e., directly bailing out failing banks. Establishing a bona fide banking union in the Eurozone was also decided by the Brussels summit.

A third important decision was to decouple bailing out banks from bailing out sovereign governments in the future. It was declared that in the future the EFSF would be used to directly bail out banks in trouble. That meant the EFSF bailout funds in the future would be distributed directly to banks in trouble and not disbursed to the governments in those countries to distribute to the banks in trouble. Prior to June 2012, bailout funds for governments and for banks were distributed to the governments first. That had the effect of raising the debt of those federal governments even more and resulted in the diversion of the funds by those governments in some cases, thus preventing the funding from getting to the banks that were to be bailed out. The banking crisis was growing too serious to work bank bailouts in such an indirect, inefficient manner.

Creating a more traditional form of central bank for the EZ thus became the new policy shift. Establishing a true banking union Euro-wide with a central bank (ECB or other) capable of printing money to quickly and directly rescue failing banks without the interference of 17 national governments and their national central banks, was the new line of thinking. Banking union creation meant establishing a U.S Federal Reserve-type central bank, with direct bank supervision authority like the Federal Reserve. This line of thinking recognized that direct bailouts of failing banks in the future was becoming increasingly likely. It is also a recognition that the Euro banking system was becoming dangerously unstable and existing funds and loans to peripheral governments were not addressing the banking system problem. The EFSF and ESM funds would still be used to bail out government debt and austerity programs would continue to be necessary to bail out those governments to ensure they could pay principal and interest on their debts to the banks and the two funds in the future. But creating a bona fide central bank with true central bank powers was the new element visited at the Brussels summit—an element recognizing that ensuring peripheral governments made the payments on their debts were necessary, but not sufficient, to ensure Euro-wide banking stability.

Some Predictions

The shift toward a banking union set forth in the Brussels summit will prove no more successful than the EZ’s prior focus on government debt restructuring and austerity as it does nothing to address the growing recession in Europe. It assumes that, if banks are rescued and the banking system stabilized with massive money injections by a central bank, that bank lending will grow and economic recovery will take place. But that is what the U.S. Federal Reserve has done since 2009 and no sustained economic recovery has occurred in the U.S.

Since 2009 the Federal Reserve has directly pumped liquidity into the U.S. banking system to the tune of $9 trillion or more. About $3 trillion had been injected as a result of the Fed printing money, called Quantitative Easing. It had stabilized the banks without adding to government debt, given that Fed/Central Bank debt is not recorded as government debt. But U.S. bank stabilization has nevertheless been accompanied by a steady decline of bank lending in the U.S., with banks hoarding cash and small-medium businesses and households being denied financing that might otherwise stimulate investing and job creation.

Post-Brussels European policymakers apparently believe that by creating a monetary and banking structure patterned on the U.S. could better contain the banking crisis in Europe. Also like the U.S., the ECB has been lowering interest rates to virtually zero. This is, in theory, supposed to stimulate bank lending and therefore investing, jobs, and recovery. But the U.S. Fed has kept rates at 0.25 percent or lower for almost four years and promises to continue those rates through 2014. Neither near zero rates nor bank bailouts in the U.S. have resulted in a sustained economic recovery. EZ near zero rates, bank supervision, quantitative easing money-printing, and direct bank bailouts will also fail to achieve economic recovery.

As Europe becomes economically more unstable, authorities and politicians in Europe, the UK, China, and elsewhere appear to be on a path toward closer coordination of monetary policies—especially direct bank bailouts, quantitative easing, and other measures of monetary policy. However, monetary policy may temporarily stabilize the banking system, but it cannot generate a sustained economic recovery from a spreading recession. Being essentially a bank bail out policy, however, the Brussels plan is preferred by the banking system to an alternative spending stimulus alternative program—showing that finance and banking are politically as powerful in Europe as in the U.S.

There will be more bank rescue-monetary policy coordination between the U.S., Europe, UK and even Asia in the near term as the triple crisis in Europe continues and as that crisis continues to slow the global economy in general. Watch for coordinated monetary action (Quantitative Easing perhaps and other measures) by the Fed and ECB as soon as September 2012 perhaps, with the UK’s Bank of England following quickly and probably Japan’s central bank as well.

Global quantitative easing and zero interest rates may keep the banks from descending into another banking crash. Banks may be rescued again. But the rest of the economy—in the U.S., Eurozone, and globally—will not benefit much. That means the Eurozone’s triple crisis is here to stay and will undoubtedly continue to erupt and get worse over time.

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Jack Rasmus is the author of Obama’s Economy: Recovery for the Few (Pluto Press and Palgrave-Macmillan). His blog is jackrasmus.com and his website: www.kyklosproductions.com.