It's the (German) Banks, Stupid!
by Yanis Varoufakis
Or what's behind Germany's hesitant statements on Greek debt
restructuring, Ireland's move against subordinated bondholders, and the
ECB's stance on interest rates. . . .
Europe is at it again, trying to pretend that it has stemmed the tide of
insolvency through its program of lending huge amounts of money (at high
interest rates) to . . . insolvent member-states. The official line, currently, is
that the rot has stopped with Lisbon. As at the advent of the EU-IMF €110
billion loan to Greece (almost a year ago, in conjunction with a nominal
€750 billion fund, the European Financial Stability Facility, standing by for
other fiscally stricken countries), which was meant to ring-fence the rest of
the eurozone, inhibiting contagion from Athens, now we are being asked to
hope (against hope) that Spain has "decoupled." It has done no such thing.
As long as the banking crisis is left alone to fester, contagion will be
unstoppable.
For a year now many of us have been arguing that, to paraphrase good old
Bill Clinton, It is the banks, stupid! Having started in their guts in 2008, the
crisis spread to the sovereign debt realm and then returned more viciously to
where it had started: the banks. The result is that Europe's zombified banks
are now great black holes that absorb much of Europe's economic energy
(from the surpluses produced in giants like Germany to the loans taken out
by struggling minnows, like Greece and Portugal). Quite remarkably, while
the insolvent states are visited upon by stern IMF and EU officials,
constantly reviled by the "serious" press for their "profligacy" and
"wayward" fiscal stance, the banks go on receiving ECB liquidity and state
funding (plus guarantees) with no strings attached. No memoranda, no
conditionalities, nothing.
This is not to say, of course, that the powers that be do not discuss the
banking catastrophe. I am sure that they are talking about little else. Only
they do so in secret, behind closed doors, struggling to find a solution to the
Great Banking Conundrum behind the European people's backs and away
from the spotlight of publicity. Their deliberations are now in a new phase,
taking their cue from the Greek debt crisis. Lest I be misunderstood, the
Greek crisis, however monstrous by Greek standards, is in itself no more
than an annoyance for Europe's surplus countries. A gross sum of €200 to
€300 billion could be restructured quite easily or at least dealt with
somehow. Its significance lies in the opportunity it offers Germany to revisit
the European banking disaster in its entirety. The Greek debt restructure,
with its repercussions on Europe's banks, is a useful case study; a dress
rehearsal; an excuse to begin the process of taking the broader Great
Banking Conundrummore seriously.
So, what is the Great Banking Conundrum that Europe is now facing? Put
bluntly, Germany's banks have not been cleansed of much of the worthless
toxic paper of the pre-2008 era and, on top of that, are replete with bonds
issued by the now insolvent peripheral member-states. French banks are in a
similar state, with even more of an exposure to Spanish debt. Spanish banks
are fibbing about the extent of their potential losses from falling real estate
prices (which need to be added to their exposure to Spanish and Portuguese
sovereign debt). Meanwhile, the ECB system is massively exposed to the
totality of this combination of stressed sovereign debt and unrelenting bank
losses (actual and potential).
Question: What is to be done when a currency area (such as the dollar zone,
the sterling area, or, indeed, the eurozone) is saddled with a mountain of
debt plus banking losses at a time of sluggish growth both internally and
externally?
Answer: Make this mountain shrink through macroeconomic means. These
means fall mainly under two categories. First, there are the blessings of mild
inflation. Allow average prices to rise, and the mountain's real value will
shrink. Secondly, effect haircuts on debts and write-offs in the case of
banking losses.
In the USA as in the UK, after re-capitalizing the banks at a great cost to
taxpayers, the authorities opted for both strategies at once: bank write-offs,
large scale haircuts (e.g. a 90% cut into the debts of General Motors), plus
quantitative easing for the purposes of pushing inflation to a modest level
that will, in the long run, cut into the national debt. In sharp contrast, Europe
has not moved in either direction. The lack of a common fiscal policy and
the coordination failures that come with an ill-conceived monetary union
played a central role in this dithering, but that is, I wish to argue, not the
whole story.
So, what else is there, lurking in the shadows and prolonging Europe's
reluctance to act decisively? The answer, I submit, is: Germany's twin angst
regarding (a) its competitive edge in Asia and (b) the state of its banks.
Germany's relative success at weathering the crisis, after its own precipitous
fall in 2008, has been due to the healthy demand for its capital goods from
Asia: i.e. Japan and China. With Japan out of the picture (for reasons that
were manifesting themselves even before the tsunami), China is Germany's
sole source of optimism. But China's own growth is based on the policies
that Germany refused to countenance: i.e. massive infrastructural
investments, which have, interestingly, suppressed the country's
consumption share from 45% to 38% of GDP at a time of 10% GDP growth.
With the USA entering a period of renewed contraction, following the
budget cuts agreed between President Obama and the Republican Congress,
China's export growth (at least to the US) will dip. Given the inability of its
domestic sector to replace the lost aggregate demand, and in the context of
an inflation rate racing ahead at 5.4% (March 2011 datum), with house
prices continuing to soar at a breathtaking rate of 24%, China is heading for
a recession -- one that will either be induced by the authorities or, more
worryingly, simply happen spontaneously and rather brutally. Against this
backdrop, it would be unwise, and particularly anti-Lutheran, of Mr.
Wolfgang Schauble, Germany's finance minister, to imagine that his
country's smooth 2010 run can continue during the next few years. The rise
in the interest rates of Germany's own bonds, from 2.8% to 3.45%, surely
weighs heavily on his mind.
So, back to the debt crisis and Europe's Great Banking Conundrum. If
Europe were to allow inflation gently to eat at the sovereign debt (especially
of the periphery), it would make some sense to keep lending Greece, et al.
until the problem fades sufficiently. Indeed, it would be, other things being
equal, equivalent to a haircut: there is, at least on paper, no difference
between (a) imposing a 30% haircut in nominal values to Greece's €300
billion debt when inflation is around 1.5% to 2% and (b) imposing no
haircut but allowing inflation to edge up to 2.8% to 3% for seven to eight
years. From a political viewpoint, and from the perspective of the banking
sector that hates haircuts as much as Dracula hates a rising sun, option (b)
would be vastly preferable to option (a). But then again, others things are
not equal!
To see what is not equal, just look at the fresh downgrade of Irish bonds.
What was the rationale? That the austerity imposed in order to compensate
for the state's support of Ireland's banks weakens the state's finances,
making it necessary to bring on more austerity. (See here for my
prognostication of a similar fate for Greece.) The implication is clear: the
vicious circle is unbroken. The EFSF lending to the Irish state is making no
inroads into the crisis. In effect, the debt mountain is rising and so are the
banking losses not just of the Irish banks but of the whole eurozone.
This realization, though never acknowledged openly by the German Finance
Ministry, is what lies behind the not-so-subtle change in Germany's position
vis-à-vis debt restructuring. That they only talked about Greece was merely
a case of hinting at the general by focusing on the particular. In short, the
temptation to hope that the mountain of debt will shrink through mild
inflation was purged by the belated realization that the crisis's dynamic is
stronger than any mild inflationary process. And in view of developments in
China and the USA, Germany is now eager to consider Plan B: debt
restructuring, beginning with Greece.
In the last few days, the first official mention of restructuring came from
Ireland where the new government, with a fresh mandate to do all it can to
shift the burdens off the weakened shoulders of the taxpayer, announced
(via Ireland's finance minister Michael Noonan) a haircut of around €6
billion that would hit the banks' subordinated bonds. Ideally, the
government wanted to hit the banks' senior creditors. In view, however, of
staunch ECB resistance (in defense of those great sharks), Ireland is making
a start with the medium-sized fish that have, in the past, lent money to the
private banks. As they say, the culling has to start somewhere. First, the
weakest of all (the taxpayers), secondly the second weakest (the
subordinated bondholders).
Another sign that the combination of inflation and EFSF bailouts is no
longer seen as a viable "solution" to the crisis is the ECB's determination to
push official eurozone interest rates to about 2% by the end of the third
quarter. Do they not know that this would push the insolvent peripheral
states over the edge? Are they not aware that, for example, the interest rate
reduction (on the bailout loans) that Greek PM George Papandreou so
boisterously celebrated on 25th March has withered away as a result of the
ECB rate hikes? Of course they do. But that is the point. Whether the
hapless ECB Governor, Mr. Jean-Claude Trichet, knows it or not,
Germany's motivation to push for an ECB rate hike is crystal clear: to start
the process of debt restructuring instead of relying on mild inflation to do
the job that austerity in the peripheral countries could never do.
If I am right, though, why is Germany still not coming out with a clear
statement that reflects its new mind frame? The sad answer is: They have
not yet worked out the form that the restructure will take, unsure of its costs
to the German banks!
Before turning to the German banks as Germany's main concern, what of the
other prospective victims of a debt restructure? Is the German Finance
Ministry not worried about Europe's pension funds, about the hedge funds,
about the ECB (which is holding about €100 billion of dud peripheral
bonds, the result of its bond purchase program that started in May 2010,
following the Greek IMF-EU loan)? My answer is no, no, and no. But let
me take these three no's in turn:
Pension funds: It is true that here in Greece, as elsewhere, many people
worry about the costs of a restructure on pension funds. Allow me to
speculate that Mr. Schauble and Mrs. Angela Merkel do not share these
worries. If need be, they concluded long ago, pensioners will have to do
with less. What alterative do they have? Perhaps (from Berlin's perspective)
this is a good thing, as southerners will now have an incentive to retire later
and to save more during their working lives.
Hedge funds: Similarly with hedge funds. German politicians have always
taken a dim view of these outfits (except when their failure brought down
German banks, like IKB -- but that is another story). In any case, Mr.
Schauble (I have it on good authority) thinks that hedge funds are not likely
to lose much from a debt restructure at this juncture because over the past
year (after the Greek crisis erupted) they managed to de-leverage
considerably.
ECB: It is clear that Europe's Central Bank is vehemently opposing a debt
restructure for a number of reasons. One is that since last May it has
purchased close to €100 billion of peripheral sovereign bonds and, thus,
worried about its own books in case of a haircut. Another is that bankers do
not like haircuts; it is in their nature to resist it. A third reason, the most
powerful of the three, is that the ECB is already cross with European
politicians because it feels the strain of drip-feeding the banks with huge
amounts of liquidity. A haircut, the ECB feels, will increase this
dependency. Does Germany not share these fears? It does, but, according to
my understanding of the consensus in the German Finance Ministry,
Germany's economic strategists are beginning to fear the effects of the crisis
more. In the final analysis, (they seem to think), the ECB's position can be
bolstered fairly easily if push comes to shove.
So, the only thing stopping Germany from announcing here and now a
wholesale debt restructure is the banks. Thus my term the Great Banking
Conundrum. The reason why banks are such a large problem is that they
have their tentacles everywhere. Their profit is theirs to enjoy but their
bankruptcy is everyone's loss. Unable to cash in their "assets" at a time of
crisis, i.e. to retrieve their loans from their debtors (homeowners,
businesses, governments), if they are forced to come clean regarding the
true value of these assets, bank insolvency looms. So, Europe is not forcing
serious stress tests upon them.
In other words, the reason the German government remains undecided on
the Greek debt is that it is still struggling to compute the losses to German
banks from a restructure of Greek, Irish, and Portuguese sovereign debt.
There are two issues here: First, it is simply impossible to calculate the
knock-on effects. For instance, while we know almost to the last euro the
exposure of European banks to peripheral debt (here is a great interactive
guide), it is impossible to predict precisely how, say, a 50% haircut of that
debt will reverberate throughout a financial system whose opacity and inter-
connectivity is notorious. A recent figure that was given to me
confidentially, by a well-known German banker, is that a 50% haircut on
EU peripheral debt would translate into an extra €850 billion of fresh capital
that would need to be put into French and German banks alone to
compensate them for the losses they will end up incurring.
Secondly, there is an international dimension that an export-oriented
country like Germany cannot afford to ignore. For example, many of these
bonds are owned by non-European banks. If they lose a lot of money, these
losses can trigger another round of government infusions (in places like
Japan, China, Korea, etc.), which may affect local investment in projects
that would otherwise require German capital goods. What is the likely
magnitude of this problem? The Bank for International Settlements tells us
that the total exposure of non-EU banks to Greek, Irish, and Portuguese debt
is a mere $363 billion. This is peanuts, by the standards of the 2008-11
crisis. But then again it does not take into consideration (a) the amounts
owed to UK banks and (b) the more-than-likely Spanish sovereign troubles.
In view of the serious problems that a horizontal debt restructure would
cause to Germany' banks and to its external trade relations, the German
Ministry of Finance is therefore reluctant to come out, once and for all, in
favor of a debt restructure. On the one hand, they have concluded that it is
inevitable. On the other, they know it will bring huge costs to bear upon
primarily Germany's own banks but also, and this is equally daunting, its
export sector. The result is a new round of . . . dithering.
Epilogue
Germany is experiencing a surge in self-confidence which, paradoxically,
comes hand-in-hand with a realization that its current good fortunes may be
on borrowed time. For a year now, Berlin kept hoping that the euro crisis
would, given sufficient time, go away of its own accord. Mild inflation
played a major role in that dream of gradual recovery. However, the
complete and utter failure to end the debt crisis by means of austerity-plus-
loans in the European periphery has caused the German Finance Ministry to
conclude that there is no way of avoiding Plan B: a debt re-structure. Alas,
the Great Banking Conundrum is causing much consternation, the result
being more procrastination and a series of conflicting statements from the
German government that, understandably, push spreads up and intensify
both the debt crisis and the banking conundrum.
This is the bad news. Is there a silver lining? I believe so. In our Modest
Proposal Stuart Holland and I suggest a simple way out: A tranche transfer
of part of the sovereign debt (which effectively restructures the Maastricht-
compliant part of the debt without imposing a haircut), a selective haircut on
zombie banks that rely on the ECB for liquidity (which does not affect the
pension funds), plus (and this is important) the recapitalization of banks by
the EFSF in a manner that allows Europe, once and for all, to cleanse its
banks of worthless titles and, soon, to return them to the private sector
squeaky clean and ready to do business (as opposed to their current function
as the EU's black financial holes). Ignoring the Modest Proposal or some
such policy intervention, and continuing with the current, punitive bailouts
instead, will lead to the worst of all possible worlds: a deterioration of the
debt crisis, a further escalation of the banking crisis, and, in the end, a
weakened Germany at a time when its good fortunes in Asia will be waning
fast.
Yanis Varoufakis is Professor of Economic Theory and Director of the
Department of Political Economy in the Faculty of Economic Sciences of
the University of Athens. Varoufakis' books include: The Global Minotaur:
The True Origins of the Financial Crisis and the Future of the World
Economy (Zed Books, 2011); (with S. Hargreaves-Heap) Game Theory: A
Critical Text (Routledge, 2004); Foundations of Economics: A Beginner's
Companion (Routledge, 1998); and Rational Conflict (Blackwell Publishers,
1991).
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From online source at URL:
http://mrzine.monthlyreview.org/2011/varoufakis170411.html