The Other Default?

AP Images/Yves Herman

In Brussels they had a word for it: Shutdownfreude. As the standoff between the President and Congress reached its fever pitch last week, officials at the European Commission were relieved that, this time at least, it wasn’t their political system at the center of a potential global meltdown. Now that the United States won’t default on its debt due to a few dozen Tea Party radicals, things are returning to normal. Or should we say the new normal in Europe—serial crisis.

Amid Congress’s desultory lurch toward a government shutdown, Euro assets were looking good—growth continued to be anemic, but then again, no one in any European government was intentionally trying to force a debt default. However, that North American storm now seems to have passed. The usual fears about sovereign debt still haunt European markets, but what is driving concern today is the uncertainty surrounding the continent’s banking system.

In policy circles, everyone seems to agree that the weaknesses of European banks have to be addressed at a systemic level, hence plans for a unitary bank regulator under the authority of the European Central Bank (ECB) and future plans for a banking union to complement monetary union. But getting there will be tricky and is the main cause of concern right now. Just as there were “stress tests” in the United States in 2009 to determine which banks needed to be recapitalized, the ECB wants to apply systematic stress tests to all banks in the eurozone today, which could trigger another wave of crises.  

In no area of crisis management have the Europeans differed more from Americans than the way in which they dealt with the banks. Or didn’t deal with them. After the meltdown of 2008, the United States instituted a massive relief program, the controversial TARP, which, despite its flaws, helped shore up banks’ balance sheets and get them lending again. In Europe the reckoning never really came. Toxic assets like real estate weren’t the main problem, rather the general over-extension of the banking sector and the mounds of bonds that European banks had accumulated from the governments of Greece, Spain, Portugal, and Ireland.

Amid the overall global belt-tightening after 2008, countries like Greece attracted greater scrutiny. It turned out the entire country had been one great Ponzi scheme—officials had lied about everything: debt levels, tax revenues, growth rate, the whole shebang. Spain’s booming real estate economy went bust at roughly the same time, putting enormous strain on the country’s public finances. Suddenly all of the supposedly risk-free investments in government bonds (after all, these countries were all in the eurozone, what could go wrong?) seemed very risky indeed. Capital flight and fears of contagion ensued, bond buying stopped, and all of the assets in the balance sheets of European banks looked to be every bit as toxic as American mortgages did back in 2008-2009.

Yet instead of a TARP-like program and finding ways to recapitalize the banking system, European leaders blamed the southern European governments for “fiscal indiscipline”. Greece got a bailout, then Ireland and Portugal got one too, while Spain and Italy were told to save their way to prosperity and promised financial assistance if things got really bad. The bond-holding banks continued to get paid for their mistakes, while taxpayers in the wealthy North—Germany, the Netherlands, and Finland—were told they had to help insolvent governments in the South, not their own teetering banks, who had leant them the money in the first place and needed to get repaid to remain solvent

Thus you have had a strange spectacle in the generally leftish world of European social democracy over the last few years: bankers have shirked almost all responsibility for the crisis, while governments have gotten all the blame. Never mind that Spain’s public finances were in better shape than Germany’s before 2009, or that structural reform in times of global macroeconomic weakness is very painful and has led to unprecedented levels of youth unemployment and stagnation in southern Europe. It has strengthened nationalist resentments and led to muddled thinking about the underlying causes of the crisis. Even the International Monetary Fund (IMF) went along with this gambit, joining the European Commission and the ECB in the ominous-sounding Troika, which was designed to apply pressure on select countries to reform, rather than insisting on a systemic approach to fix the underlying problem: bad bank debt across the whole of Europe.

Now that process is finally beginning with the ECB stress tests. Expect bad news as huge holes in bank balance sheets are exposed and many financial institutions discover they are insolvent and need a “bail-in” from there stockholders, as happened in Cyprus earlier this year. Bank shareholders will protest and clamor for their governments come to the rescue, but one can only hope that the ECB will ride out the storm and remain firm, even if it means volatility in financial markets, as investors leap from one hot potato institution to another.

At last Europe would begin to deal with the underlying banking problem, but it’s bound to be a rough ride. Expect threats of default, only this time from European banks, not governments.

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