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October 26, 2011
Europe is facing a banking crisis as well as a sovereign debt crisis. This has been developing for two years. The euro is a shared currency outside a fiscal union – and as a currency shared by fiscally independent member-states it has generated vicious negative feed-back loops between sovereigns and banks.
The legacy of the global financial crisis in 2008 was a sovereign debt crisis in parts of the eurozone, and a banking crisis across the region as a whole. The two crises have fed on each other ever since, with weak sovereigns undermining confidence in banks and vice versa. The greatest threat to the eurozone is that this vicious feedback loop spins out of control.
Three crises have intermingled and reinforced each other: Greece, Ireland, Italy, Portugal and Spain face crises of excessive debt (public and private); those same countries suffer from low economic growth; and much of the European Union is afflicted with a banking crisis.
Much of the debt owed by Greece, Portugal and perhaps others will have to be written off, and that in turn will require a massive recapitalization of European banks (by €200-300 billion, IMF figures suggest). Then the markets will have to be calmed with a big bazooka aimed on them. Behind Europe's sovereign debt crisis sits Europe's declining economic growth. Without growth, the debt crisis will continue to re-emerge.
Governments will need to recapitalise their European banks (around €100 billion is minimally required); the banks will need to take a haircut (40-50%) on their bad debts in Greece; the firepower of the eurozone bailout fund (European Financial Stability Facility [EFSF]) will need to be increased (to €2tn?); the European Central Bank will need to become a lender of last resort to stabilize the various economies; and Italy and Greece will need to live up to their promises to get their debt and budgets in order.
Italy is the key. It has the third largest debt market in the world, well over €1trn of outstanding debt. Investors, fearing a possible default, are demanding high interest rates on Italian debt. And these high interest rates, by raising the burden of debt service, make default more likely. They'll do just enough to buy themselves more time. Italy is unwilling to engage in reform, preferring the no growth option.
So far it doesn't look as if the European political class is getting on top of the problem. Paul Krugman says
It’s a vicious circle, with fears of default threatening to become a self-fulfilling prophecy. To save the euro, this threat must be contained. But how? The answer has to involve creating a fund that can, if necessary, lend Italy (and Spain, which is also under threat) enough money that it doesn’t need to borrow at those high rates. Such a fund probably wouldn’t have to be used, since its mere existence should put an end to the cycle of fear.
Krugman adds that the problem is that:
All the various proposals for creating such a fund ultimately require backing from major European governments, whose promises to investors must be credible for the plan to work. Yet Italy is one of those major governments; it can’t achieve a rescue by lending money to itself. And France, the euro area’s second-biggest economy, has been looking shaky lately, raising fears that creation of a large rescue fund, by in effect adding to French debt, could simply have the effect of adding France to the list of crisis countries.
Yet, if the European Central Bank were to stand behind European debts, the crisis would ease dramatically. Much of the debt owed by Greece, Portugal and perhaps others will have to be written off, and that in turn will require a massive recapitalization of European banks (by €200-300 billion, IMF figures suggest).
Euroskeptical Britain — it is currently in the EU but not the euro-- is talking about its national interest and protecting the special position of the City of London and its get-rich-quick culture. Many Europhobic Conservatives-- have signed a parliamentary motion calling for a referendum on whether Britain should leave the EU or renegotiate the terms of its membership. These Eurosceptics----Little Englanders-- want splendid isolation and a neo-liberal economy.
Update
The measures are:
(1) the banks would take a 50 per cent haircut on their holdings of Greek sovereign debt. This will wipe about €100 billion off Greece’s near-€350 billion of sovereign debt. In addition there is €100bn of new loans.
(2) the European Banking Authority announced that the EU banks would raise €106 billion of new capital between now and June next year to cover the holes in their balance sheets created by the losses they face.
(3) an increase in the size of the European Financial Stability Facility, which has been trying to put a floor under the bonds issued by the more parlous economies, from €440 billion to one €1 trillion. That’s an attempt to head off any assault by the markets on the next most vulnerable economy, Italy.
What was excluded was the European Central Bank promising to purchase bonds without any arbitrary limit from every solvent but distressed sovereign state. So we fall back to the European Financial Stability Facility with its non existent €1 trillion. This is supposed to be raised by luring in private investors and the likes of Beijing through special vehicles and sophisticated insurance deals, a state-sponsored variety of the antics which occupied the markets before the crash.
The measures will not stimulate economic growth, which is what is needed to help the angry, unemployed citizens. If Europe cannot grow an economy big enough to shoulder its debts, then the crisis will not go away. For instance, Greece is bust, and the harsh austerity plans means that it will have a sickly economy, still mired in debt in nine years' time. That means more social and political unrest to follow in the months and years to come, particularly as the economic recovery will be a long time coming.
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Another long-term problem is peoples’ growing hostility to the EU in general and to the euro in particular. Even if EU leaders can, belatedly, agree on the right policies to save the euro, public opinion may prevent them from carrying out those policies.
At the moment little is being done to boost growth across Europe.