Why Europe’s extend and pretend strategy will fail
Michael Pettis had a great write-up on the situation in Spain and Europe’s depressing prospects. While his conclusion that Spain will be forced to exit the euro zone is something I have yet to endorse, the logic he uses surrounding many of the economic and policy constraints bears remembering. In particular, his comments on Europe’s inability to extend the crisis and pretend their banks are solvent are important because the undercapitalisation of Europe’s banks lies at the heart of this crisis.
This is a brief post, so I’ll get right to the part that Pettis draws on which i believe is significant. He writes:
I think Berlin is betting that if they can prolong the crisis long enough, while pretending that the problem is one of liquidity, not solvency, they can recapitalize the German (and other European) banks to the point where they eventually are able to recognize the obvious and take the losses. This was, after all, the strategy followed by the US during the LDC Crisis of the 1980s, when it waited until 1989, seven or eight years after the crisis began, to arrange the first formal debt forgiveness (the Mexican Brady Bond). During that time a steep yield curve engineered by the Fed allowed the US banks to earn sufficient profits to recapitalize themselves to the point where they could finally formally recognize what had long been obvious.
There are at least two reasons however why this strategy won’t work for the European banks. First, the hole in the European banks’ balance sheets dwarves the equivalent hole in the balance sheets of the American banks during the LDC crisis. It would take them much longer then seven or eight years to fix the problem.
Second, postponing resolution of the debt crisis is extremely painful for the debtor countries, who have to bear the full brunt of the adjustment that both debtor and creditor countries really need to make together. This reduces maneuvering space for Europe because the political system in Europe is less able than that of Latin America during the 1980s to accommodate this very painful process. Well-functioning democracies, after all, make it harder for bankers and elites to force the cost of the adjustment onto the middle and working classes.
The goal then is to socialise as many losses onto savers and taxpayers via financial repression and bailouts as the democratic process can muster. This is how all debt crises are finessed. Michael believes the hole in European banks’ balance sheets is too large to fill in in the period of time they will have before the democratic process moves against creditor-centric policy. And so, his conclusion is that the whole scheme will rip the euro zone apart.
I disagree that the euro zone destruction is inevitable. The key here is where he writes later that "as time horizons shorten and politics becomes increasingly radicalized, policymakers shift their behavior in ways that reduce credibility further, increase business uncertainty, and raise national antagonisms." I agree with that sentence but i think policy movement toward recapping banks in Europe is far enough along that it will allow European policy makers the political space to close the gap toward fiscal integration before the whole thing falls apart. The way I see it, EU leaders are already talking about recapping Spanish banks and I believe they will do. Recent reports suggest Spain’s bank losses could hit €260bn. This is a sum that is completely manageable for the ESM/EFSF funds if those funds are extended to be tapped by banks.
So, the question for Europe is how much political space EU leaders give themselves before fiscal integration is reached as the crisis evolves. My last post on Germany’s movement on the eurobond and fiscal austerity issues suggests that EU leaders have ample political space to meet the problems in Spain without a Spanish exit from the euro zone. At this time, it is only in Greece where I think an eventual exit is likely.
Yes, Europe’s extend and pretend strategy will fail. Crisis will undoubtedly flare again. However, Europe’s politicians are not yet boxed into a rhetorical corner that prevents legitimate sustainable solutions down the line.