Big Trouble for U.S.? Europe's Banking Crisis Moves Closer to a Lehman Brothers Moment
The recent euro summit in Brussels was supposed to make things better for the European economy. And if you listen to the mainstream press spin, you hear that a growing Mediterranean alliance, led by France's new president, Francois Hollande, Spain's Mariano Rajoy and Italy's Mario Monti, forced Germany to cave. We are led to believe that Germany has capitulated on things like less fiscal austerity, the sharing of debt, and direct recapitalization for ailing banks through the European Stability Mechanism (ESM). We are also supposed to accept at face value the claim that the European Union as a whole will work toward some form of common deposit insurance to arrest the prevailing bank run.
This is all bunk. But why does that matter to you? Well, recall for an instance what happened to the global economy when Lehman Brothers went bust in 2008. The world’s entire credit system froze up. Now consider the implications for the U.S. if the currency union in the world’s largest economic bloc was to blow apart. Do you think the fallout might wind up in your backyard? Economist Simon Johnson recently gave a warning on the impact on U.S. banks in the event of a dissolution of the euro:
[I]n recently released highlights from its so-called living will, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. .. The Fed is convinced that its recent stress tests show U.S. banks have enough capital even though these tests didn’t model serious euro dissolution risk and the effect on global derivatives markets. The striking thing about JPMorgan’s recent London-based proprietary trading losses is not the amount per se. If the world’s largest bank can lose $2 billion to $3 billion in a relatively calm quarter through incompetence and neglect on the fringes of its operations, how much does it stand to lose when markets really turn nasty across a much broader range of its activities? And how might that harm the U.S. economic recovery?
So, measures designed to save the euro are something we should pay attention to here in the U.S. They also help to explain why President Obama remains in persistent contact with Europe’s key political players, notably German Chancellor Angela Merkel.
In contrast to previous summits to "save the euro," expectations for this one were set very low by the time this meeting started, leading you to assume that any bit of good news would be sufficient to induce a market rally. At the same time, if you ignore the spin and actually read the text of the statement released after the summit, it does not appear that the package announced does anything to alleviate the problems that created the crisis conditions in the first place, especially the bank run.
So what was actually agreed? Let's concede one positive point at the start: It seems to be that any monies used to recapitalize Spanish banks (which are now at the heart of Europe’s systemic instability) won't rank higher than other forms of bonds, which removes one disincentive to buy more Spanish bonds, which in turn could mitigate Spain's own funding strains.
However, the decision to award private creditors the same status as the Eurozone bailout fund in the Spanish rescue means that German taxpayers will have to join the queue to get their money back, which in turn threatens Germany's own credit rating. Accordingly, the German media were quick to howl that Merkel was putting the German taxpayer on the line for the success or failure of banks in Madrid. The concession might also be unconstitutional, given recent rulings by Germany’s Constitutional Court.
It is also important to note that what was conceded here by Berlin is tightly circumscribed. Funds may be given directly to Spanish banks, but the same provision does not apply to other nations in the Economic and Monetary Union (EMU) such as Italy. Furthermore, money being given to Spain’s banks will only come in the form of loans, not additional equity, which means that Madrid’s overleveraged banks are being forced to take on yet more debt to sort out an existing debt problem.
Hardly a satisfactory conclusion to the summit! Spain's banks need equity -- and lots of it -- so that they can withstand the impact of writing off an increasingly large number of worthless real estate loans. Yes, the loans to Spain’s banks might eventually be converted into capital, but this conversion will be highly conditional, as the final communique makes clear:
Following a regular decision, (the ESM could) have the possibility to recapitalise banks directly. This would rely on appropriate conditionality, including compliance with state aid rules, which would be institution specific, sector specific or economy wide.
For at least the next several months, the Spanish banks will receive debt funds, not equity, until sometime in 2013. Even then, conversion into capital will be iffy and perhaps very selective, and again, subject to a German veto. And given the flak that Mrs. Merkel is taking at home in the aftermath of the summit, she is unlikely to feel particularly philanthropic for a while. So the "concession," such that it is, is unlikely to change the current adverse behavior by banks and their depositors over the balance of this year.
In contrast to what the international press has been saying, the actual statement released in the aftermath of the summit shows that nothing has been introduced that would credibly backstop Spain and Italy, and thereby prevent rising bond yields which are threatening the solvency of both countries.
Another key point: There was no progress toward German acceptance of debt sharing (whereby the stronger countries in effect use their balance sheet to help the weaker countries, much as the US Treasury uses federal funds to help backstop economically weaker American states). There was no mention whatsoever of American-style FDIC deposit insurance. It will be at least a year, possibly several, before the "banking union" is operating properly, but the financial crisis is occurring now.
The bank run, therefore, will almost certainly continue. Remember, in the U.S. we have 50 states and one central bank. Likewise in other federal systems such as Canada and Australia. In all these cases, there are fund transfers across states (or provinces). And these are permanent institutional arrangements. It is highly likely that West Virginia or Mississippi will remain long-term recipients of federal transfer payments, even if they remain “uncompetitive” compared to states with stronger economies, like Texas or New York.
In a country like the U.S., which has this system of shared economic fate, there's no chance that a state will opt out and bring with it its own devalued currency. So there is no incentive for people to take their deposit from banks in one state or region to another. That means that the private markets, with a little help from the Fed, will close the financial circuit to the extent there are such fund transfers.
The European Monetary System was supposed to work that way. And as long as no one worried about any country leaving the euro, it did. But once the risk of euro exit on Europe’s periphery raised its ugly head, the euro system became completely different. Peter Garber, a strategist at Deutsche Bank, has argued that given such a perceived prospect, the euro system was a perfect mechanism for a deposit run. And once doubts arose in 2009 about a possible euro exit by Greece and Ireland, a deposit run began – and in earnest.
It has been troubling to hear the triumphalism that has characterized some of the post-summit talk, with marked anti-German overtones. This is very unhelpful to Angela Merkel, who still faces significant constitutional hurdles and was greeted home by the sight of German papers castigating her surrender. One can only imagine that this will strengthen the hands of the anti-euro faction in Germany, which is prepared to countenance a substantial hit to Germany's GDP in order to prevent much worse in their eyes from occurring later. Even those sympathetic to the European Project in Germany might find it more difficult to rally public support to take on the likely huge burdens needed to keep the euro project afloat, given the graceless reactions in Madrid, Paris and Rome.
In the end, much depends upon whether there is an ongoing and escalating bank run. If there is, the outcome of the euro summit has done nothing to solve the most threatening immediate problem. One can actually sympathize with Germany's concerns about being enveloped in a series of institutional structures that might have the effect of tainting the country's credit rating and possibly raising its own cost of borrowing from the markets. It would be akin to asking several states to help bail out Illinois without any help from the US Treasury (which is the issuer of the dollar). All the more reason why the ECB, as the issuer of the euro, must remain at the center of a solution. Funding and deposit insurance guarantees and the like must come directly from the central bank in the Eurozone because it is the issue of the currency.
Absent a role for the ECB, we have a sort of logic whereby we are robbing Peter to pay Paul. To reiterate: The ECB is the currency-issuer of the euro. It can never run out of euros. At an intrinsic level, it has no need for capital. It could operate forever with a balance sheet that if held by a private bank would signal insolvency.
Judging from last week's euphoric reaction in the aftermath of the meeting, the financial markets might see it differently for a while. But this summit genuinely appears to be a case of much ado about nothing. The only difference is that Shakespearean comedy has a happy ending. By contrast, if the last few years have shown us anything, Europe is heading inexorably toward tragedy.