With the crisis in the Eurozone set to resolve itself in 2012, what will the single currency’s disastrous fate actually mean in practice? Tim Congdon, who has called the matter correctly from the start, offers his take in a series of articles devoted solely to this central, dominating political issue.
The cure being worse than the sickness?
Revelations that the French government has considered an elite Eurozone (i.e., an inner core of Eurozone member states, excluding some of the existing members) have made it essential to analyse the possible results of the Eurozone’s break-up. Drastic contractual revisions would be inevitable. Government securities and inter-bank deposits – usually regarded as nominal-value-certain and hence very safe by banks – would see substantial changes in value. The resulting losses would destroy banks’ capital. As we’ll see during the course of this series of articles, state-owned banks can “achieve” an apparently painless recapitalization, a “bogus recapitalization”, by a well-known accountancy trick. This may be part of the eventual “solution”.
If policy-makers were foolish enough in a Eurozone break-up to demand that banks “strengthen their balance sheets” (by shedding risk assets and/or assets that had lost much of their value) and “make themselves safer” (by operating with the minimum regulatory capital at all times), the Eurozone could suffer another appalling recession. I contend that instead policy-makers should ensure that the quantity of money continues to grow, and that banks are given time (by means of long-term, low-cost finance from the state) to rebuild capital. If a very severe slump threatens, the likelihood has to be that highly expansionary open market operations (similar to the “quantitative easing” adopted in the USA and UK) would be chosen by the European Central Bank and key Eurozone governments. But it’s alarming that until now the emphasis in official rhetoric has been on bank recapitalization. There is another safety-valve provided by ECB loans to banks, with the tacit understanding that such loans enable banks to keep Eurozone government bonds on their books or even to start purchasing such bonds at present very high yields, and in examining this we’ll see just where a decade of the Delorsian dream of a European currency has brought both them and us.
Banks’ vulnerability in severe financial crisis
Banks are undoubtedly very odd organizations compared with most companies and financial institutions in capitalist economies. The next few years in the Eurozone are likely to be a period of traumatic institutional upheaval, with the redefinition of the Eurozone’s membership and the possible re-introduction of national currencies in some countries. Contrary to reports based on the misleading examples of the UK/Ireland and Czech Republic/Slovak Republic split, the re-introduction of national currencies by existing Eurozone members could be a nightmare. Three core points should be borne in mind in relation to this crisis.
i. The restoration of national currencies will be accompanied by extensive rewriting of contracts, which will have material redistributive consequences for creditors and debtors. Some banks could be heavy losers, with write-downs on both sovereign debt and loans to the private sector. As a result, the return of the drachma, lira and so on may well be associated with the wiping-out of banks’ capital in some countries. Gradual recapitalization (from profit retentions and loan write-backs) would be far more sensible than “Big Bang” recapitalizations of the kind seen, for example, in the UK in late 2008 and in Japan just before the Asian crisis of 1997/8.
ii. State-owned institutions – including probably the European Central Bank (or at any rate the Eurosystem of central banks) – will need more capital, as they also are “bust”. Watch out for a bogus method of recapitalization, often found in developing countries (including China).
iii. The combination of banks’ high gearing and the extraordinarily high level of yields now available on some Eurozone government bonds gives banks scope to make very high returns on capital from buying high-yield government bonds if the governments do not default. And – as in 2008 and 2009 – the ECB is again making available to banks easy-going and generous loan facilities. This enables the better-placed organizations to become buyers of sovereign debt and eases the strains in the sovereign debt markets. This is a form of safety-valve which can legitimately be used in emergencies, although it should not become a habit and has many drawbacks if it becomes a permanent feature of the single currency area.
The following articles in this series should remind us that this crisis is nowhere near its peak and that all political reactions to it are as yet entirely provisional.
Tim Congdon is the founder of International Monetary Research Ltd.