- The problem is that the current approach – centred on dealing with liquidity problems now and solvency issues later – is not working.
-
A liquidity approach that delays the day of reckoning may be good regional politics, but it’s bad economics. It does not restore sustainable growth to the periphery, and it exposes the core to contamination.
-
Rather than simply doubling up on a faltering liquidity approach, the time has come for Germany to lead a more holistic solution focused on addressing the periphery’s debt overhang and competitiveness problems.
–Germany in a Lose-Lose Situation, Mohamed El-Erian, Pimco
But isn’t this how politicians always react in crisis? It is certainly what the US and Japan have done in their respective crises. Forget about Greece for a second; it is an outlier. At heart, this is about the European banking system. The politicians are making bets that their banking systems can weather these crises if they bail them out. That is what the Germans did with Commerzbank and Hypo Real Estate, what the Irish have done with their banks and they are not the only ones. I have a whole banking crisis timeline from 2008-2009 dedicated to politician’s premise that bailouts are good long-term solutions. So, the fact that the Germans are "centred on dealing with liquidity problems" is to be expected. The question is: what’s next and what does it mean for us all?
Right now it means austerity and depression in the European periphery. El-Erian explains:
Less investment in peripheral Europe means fewer jobs and deeper economic contractions, making it even harder to deliver austerity plans that are already contributing to social unrest, including Wednesday’s disturbances in Athens. So the pressures on Germany to do more are rising. In the last week, Germany has been called upon to back even more ambitious bailout initiatives, with proposals to create a unified European bond and double the size of the emergency funding facility for peripheral countries. In the process, the country also finds itself in a growing standoff with an ECB that now wants to limit the weakening of its own balance sheet.
Sensing the risk that Germany’s balance sheet (and that of the ECB) may continue to be contaminated by someone else’s problems, the markets have started to signal some initial concerns about the country’s fiscal robustness. In addition to some jitters at a recent government bond auction, German interest rates have followed American ones sharply higher even though the two countries’ fiscal paths diverge dramatically.
All this highlights the dilemma facing a Germany that feels politically compelled to support a liquidity approach for peripheral Europe’s solvency problem, but knows the economics of the situation are wrong and, ultimately, harmful. A liquidity approach that delays the day of reckoning may be good regional politics, but it’s bad economics. It does not restore sustainable growth to the periphery, and it exposes the core to contamination – be it through peripheral liabilities being transferred to the German tax payer or the ECB’s balance sheet coping with by purchases and repos of peripheral bonds.
I think this is exactly right. The periphery will be harmed by this particular ‘liquidity approach’ because it enforces austerity which makes solvency harder to maintain. Now, getting back to the banks for a moment, the real problem for the Germans is the recklessness of their banking sector. The Irish debacle is about bankers gone wild in Ireland AND Germany. And just to reinforce how wild German banks went, we have to remember that even Deutsche Bank, the biggest and most well-respected German bank, was getting hand outs from the U.S Federal Reserve to prevent its insolvency during the liquidity crisis in 2008-2009. I should also point out how reckless German banks like Hypo Real Estate have been implicated in misadventures in Spain.
Now, I know I am picking on the Germans here; every European country has its list of problem banks from Fortis to RBS to Anglo Irish. But this article is about Germany and the German government’s posture on the origins of the crisis seeks to diminish Germany’s role in the crisis. The Germans are saying, in effect: "The periphery governments were reckless and now we have to bail them out." The truth is that European banks were reckless and now you need their creditors to take haircuts. Bank restructuring is what is desperately needed in Europe, particularly in Spain as it is the country which represents the largest threat to European-wide contagion. But we know that none of this is going to happen; the proposed Irish bailout tells you that.
Let’s assume we get over this hump in 2011. Then, eventually at some point down the line, the next crisis will occur – probably when the EFSF, the temporary bailout mechanism, ends in 2013. And then the choice for the euro zone will be clear: monetisation, default, or break-up.