By Wolfgang Münchau
Two years after the fall of Lehman Brothers, and a massive bank bail-out agreed by European governments, the eurozone’s financial sector is still fragile. As we have seen in recent weeks, the Irish banking sector is insolvent, and there are questions about the capacity of the Irish state to absorb those losses. Jürgen Stark, in charge of the monetary policy section of the European Central Bank, last week raised questions about the solvency of the German banking sector. Wherever you look, two years have passed and nothing has been resolved. There has been lots of activity – bail-outs, bad banks – but no resolution. It was always clear that this wait-and-see approach would eventually backfire. It may be happening already.
After Lehman’s collapse, Europe’s establishment adopted a dual strategy – if you want to call it that. In the short term, it threw money at the problem, through loan guarantees and generous liquidity provisions, culminating in a huge bail-out facility for sovereign states. The long-term strategy was a prayer for a strong V-shaped recovery.
As long as you make sufficiently optimistic assumptions about future income growth, you can pay off any amount of debt. If you assume a post-reform Greece will miraculously turn into a Aegean tiger, or that Ireland will generate another housing price bubble, the present rate of indebtedness will be no big deal. It all rests on your assumptions about growth. In the summer, it looked as though the strategy might work, as the economic data came in better than expected. That was then.
As we saw last week, this strategy came badly unstuck in Ireland. The Irish government massively underestimated the scale of the problem in its banking sector. On my own back-of-the-envelope calculations, the cost of a financial sector bail-out may exceed 30 per cent of Irish gross domestic product, if you make realistic assumptions about bad debt write-offs and apply a conservative trajectory for future economic growth.
We know from economic history that countries enter into longish phases of stagnation after a financial crisis. Ireland suffered an extreme crisis. In the light of what we know, the safe assumption to make for Ireland – and Greece – is that there will not be much nominal growth in the next five years. If you make that assumption, you realise Greece will almost certainly not be in a position to repay its debts. While Ireland’s situation is marginally better, there are justified doubts about the country’s long-term solvency.
Ireland and Greece are not the only eurozone countries in potential trouble. Portugal is in a predicament similar to that of Ireland. If Spain does not find a way to a sustained increase in productivity, the situation may blow up there as well. Belgium may not be on the radar screen of many investors but the country’s political crisis raises a number of disturbing questions about the country’s underlying solvency, hitherto taken for granted.
You need not make gloomy growth forecasts to reach a pessimistic assessment of underlying solvency. The eurozone will probably not have a double-dip recession. Even so, a sustained global economic slowdown, the start of which we may have just witnessed, is all it would take to derail the do-nothing strategy. In the absence of strong growth, the European banking sector will not be able to generate the excess profits needed to write off the bad assets.
Germany in particular is still under the illusion it can generate a strong and sustainable growth over a long period. Recent data were impressive but economic data tend to be volatile. I find it hard to believe the most recent performance is sustainable, although I do expect Germany to outperform the eurozone average because of the depressed real exchange rate.
The German state is in no danger in terms of solvency. But the health of the country’s banking sector is sensitive to various growth assumptions. I would consider the German banking system, taken as a whole, to be insolvent if you apply the strictest definition of capital – equity capital and retained earnings. The new Basel III capital adequacy rules are supposed to take care of the problem of dodgy categories of core capital. I wrote this before the conclusion of Sunday’s agreement in Basel, which irrespective of the details will take years to implement. In the meantime, there will be no crisis resolution.
In Ireland, the cure would consist of nationalisation and wiping out the bondholders of Irish banks through bond-to-equity conversions. In Germany, it would be a recapitalisation of the banking sector – a polite way of saying closing down, or merging, many public-sector Landesbanken and Sparkassen, local savings banks. Mr Stark was absolutely right. The system is no longer working.
Two years after Lehman’s collapse, the fragility of the European banking sector is still an issue. I would bet we are still talking about it in five years. That, in turn, means the financial crisis will go on and on and on, at least in the eurozone.
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