European leaders need to face facts: their strategy for tackling the crisis sweeping through the eurozone is failing dismally. Far from preventing contagion, it is spreading it. It is aggravating, not alleviating, Europe’s debt problems. It is provoking political conflict both within countries and between them. And it is failing to address the underlying Europe-wide banking mess. Isn’t it time for a different approach?
The problem is partly that the causes of the crisis are misdiagnosed. This is primarily a crisis not of the euro, but of the global financial system. Not long ago, market fears focused on the dollar and the US Federal Reserve’s quantitative easing. And the key issue in Europe now is not the merits of the single currency but the parlous state of its banking system.
During the bubble years, the global financial system underpriced risk and misallocated capital. Too much was lent too cheaply to American subprime borrowers and Spanish property developers, Icelandic and Irish banks, Dubai and Greece.
Among the biggest lenders were European banks. They now hold mountains of debt – government, bank and property – that they wish they didn’t. Many are illiquid, and depend on cheap ECB finance to stay afloat. Many have also incurred huge losses that they have only partly recognised; as a result, some are, in effect, insolvent. The stress tests of EU banks were not stringent enough to shed light on this – after all, they gave both Bank of Ireland and Allied Irish Bank a clean bill of health.
At heart, the “euro crisis” is a wrestling match over who will ultimately bear these bank losses. So far, EU governments have decided that banks’ bondholders must be protected at all costs, preferring to impose losses on taxpayers instead – even if this stretches governments’ solvency to breaking point. This is explicit in Ireland, much less so elsewhere. Because voters’ tolerance for bank bailouts has worn thin, governments are acting covertly: lending huge sums to Greece and now Ireland so that they can repay German, French and UK banks in full – all under the pretence of “defending the euro”.
This strategy is not just unfair, costly and dangerous; it is ineffective. Governments are burdening taxpayers with huge bills that will impede future growth; Ireland’s “bailout” is actually a high-interest loan of €20,000 per Irish person. They are inviting a populist and extremist backlash; witness Sinn Fein’s recent success. They are corroding support for both the euro and the EU: prudent Germans rage against bailing out profligate Greeks and reckless Irish, the Irish against EU-imposed “reparations”, when their anger ought to be directed at the banks that ultimately benefit. They are encouraging financial speculation, not least by distressed banks: heads they win, tails taxpayers lose. And by guaranteeing banks’ debts, all EU governments are risking their credibility and ultimately their solvency.
Bond markets are now testing governments’ promises: you bailed out holders of Greek government bonds and Irish bank bonds, what about Portuguese, Spanish and other debt? This is a self-fulfilling prophecy: even a sound credit is in trouble if markets refuse to lend. And whereas Greece’s bailout cost €110 billion and Ireland’s €85 billion, Spain’s could top €400 billion – and then, who knows? The crisis could sweep on to Italy, Belgium, France and eventually Germany too. At some point the cost of bailing out banks would prove unbearable – there is a limit to Germany’s ability and willingness to borrow –and the euro could needlessly fall victim to the resulting political and financial turmoil.
Even if EU governments’ ability and willingness to bail out banks is not tested to destruction, the strategy remains misguided. Instead of sacrificing taxpayers to protect bondholders, watching the sovereign dominos fall and failing to tackle the underlying banking problem, what is needed is an EU-wide solution that forces banks to recognise their losses and bondholders to recapitalise them if necessary.
This would involve a much more rigorous stress test to find the holes in banks’ balance sheets. Banks would then be forced to raise additional capital, first from the market and then by converting bondholders’ bonds into shares. The weakest would be sold or closed down. Until then, the ECB would continue to provide liquidity to banks as necessary.
Freed from worries about bank debt, most governments’ debts would be manageable; only Greece would need to restructure its debts. There would less need for self-defeating austerity; the EU could instead launch infrastructure bonds to boost growth. All this would arrest the financial crisis, boost economic growth, reduce political and social tensions, and safeguard the euro.
This is a decisive moment for the EU. Will the narrow interests of financiers prevail or those of society as a whole?