Today, we’re fortunate to have a guest contribution by Jeffry Frieden, Stanfield Professor of International Peace at Harvard University, and coauthor of Lost Decades: The Making of America’s Debt Crisis and the Long Recovery. This article first appeared on Reuter’s Opinion.
Europe’s Lehman Moment
By Jeffry Frieden
Europe is in the midst of its variant of the great debt crisis that hit the United States in 2008. Fears abound that if things go wrong, the continent will face its own “Lehman moment” — a recurrence of the sheer panic that hit American and world markets after the collapse of Lehman Brothers in October 2008. How did Europe arrive at this dire strait? What are its options? What is likely to happen?
Europe is retracing steps Americans took a couple of years ago. Between 2001 and 2007 the United States went on a consumption spree, and financed it by borrowing trillions of dollars from abroad. Some of the money went to cover a Federal fiscal deficit that developed after the Bush tax cuts of 2001 and 2003; much of it went to fund a boom in the country’s housing market. Eventually the boom became a bubble and the bubble burst; when it did, it brought down the nation’s major financial institutions – and very nearly the rest of the world economy. The United States is now left to pick up the pieces in the aftermath of its own debt crisis.
Europe’s debtors went through much the same kind of borrowing cycle. For a decade, a group of countries on the edge of the Euro zone borrowed massively from Northern European banks and investors. In Spain, Portugal, and Ireland, most of the borrowed money flooded into the overheated housing market. “At the height of the building boom,” Menzie Chinn and I write in our new book, Lost Decades: The Making of America’s Debt Crisis and the Long Recovery (W.W. Norton):
One Spanish worker of every seven was employed in housing construction. Half a million new homes were being built every year—roughly equal to all the new homes in Italy, France, and Germany combined—in a country with about 16 million households. The amount of housing loans outstanding skyrocketed from $180 billion in 2000 to $860 billion in 2007. Over the ten years to 2007, housing prices tripled,second only to Ireland among developed countries; by then, the average house in Madrid cost an unheard-of $400,000. (pp. 49-50)
Greece was a different story. It borrowed, as we write, “mostly to finance a continual budget deficit and an American-style consumption boom.”
Greek borrowing went beyond the sensible: at its peak, in one year Greece borrowed an amount equal to nearly 15 percent of GDP, so that more than one euro in seven spent locally was borrowed from abroad. By 2009, the country’s eleven million people owed more than $500 billion to foreigners, more than the foreign debts of Argentina, Brazil, and Mexico combined (with thirty times the number of people and ten times the economic output of Greece). (pp. 186-187)
Europe’s experience differs from that of America’s because of the existence of the euro, a common currency for both the lenders and the borrowers. The monetary policy of the European Central Bank (ECB) kept interest rates very low, even for rapidly growing countries in Southern Europe that had previously had high interest rates. And the expectation that other members of the Euro zone would step in if a debtor member state got into trouble led lenders to believe that lending within the Euro zone was close to riskless.
But as in the United States, the boom was not sustainable. When the global financial crisis began in October 2008, the European debtors were largely frozen out of financial markets. As their economies spiralled downward, they faced grave difficulties in servicing their debts.
The problems of Europe’s debtors were not just worrisome for the debtors themselves. Most of their debts were owed to Northern European banks and investors, and the crisis threatened the very solvency of major European financial systems. This – not some abstract desire to extend a hand to the Greek and Portuguese people, or to save the euro – has been the principal reason for Europe’s ongoing debt bailout:
The rationale here was like that of bailing out a bank: a collapse of Greek or Portuguese finances could harm the rest of the euro-zone financial systems. If Bank of America was too big to fail, then so was Greece. And since a deepening of the financial crisis that drew in the entire euro zone would affect the entire global financial system, the International Monetary Fund was also drawn into the rescue….And because the Greek emergency triggered a crisis of confidence in other euro-zone countries whose failure could harm the region as a whole, the European Union was driven into a massive trillion-dollar package for other troubled European debtors. (page 188)
But the first bailout was not enough. It seems clear that the Greek and Portuguese austerity measures will not be sufficient to allow the countries to continue to service their debts; Spain seems on the verge of a similar slide into default; and even Italy is now at risk of going the way of the other debtors. Some or all of these debts will have to be restructured, the interest rates reduced and maturities extended. If not, there will be a wave of defaults whose reverberations will rival those of the Lehman failure.
For two years, Europe’s governments have been grappling with how to address this continuing debt crisis. But most of the public discussions have been highly misleading. In Northern Europe, and especially Germany, the tone has been one of outraged indignation. This high moral tone is misplaced. Certainly many Southern European banks and households, and the Greek government, borrowed irresponsibly; but German and other Northern European banks and investors lent just as irresponsibly. It’s not clear that there’s any real ethical distance between irresponsible borrowers and irresponsible lenders.
And most Northern Europeans also seem to believe that the bailouts have gone to lazy Southern Europeans. In fact, their purpose has been to shore up the fragile Northern European financial systems. German banks are among the weakest in Europe; some of them (especially the state-owned landesbanks) are effectively bankrupt. If they were forced to mark down their Southern European debt, they might well collapse in a heap, and the European financial system could grind to a halt. Just as in the United States, the real impact of the European bailout has been to shore up the continent’s banks – not to help the continent’s debtors. The recent downgrading of two of France’s most important banks, due to their holdings of Greek debt, reminds us of how exposed Northern Europe’s financial systems remain. And rumors of a recent IMF report that European banks are over $270 billion short of the capital they need to confront their current problems served to drive the point home.
Some of the European debates end up considering whether the euro has been good for its members. Most Germans seem to think that the European Union has become what in Eurospeak is often called “Transfer Europe,” a mechanism to channel honest Northern European money to lazy Southern Europeans. This makes it hard to understand why any German government would put up with such a thing. But it ignores the gains that Germany has realized by being the leading economy in the eurozone. For a decade, Germany’s growth has come almost exclusively from its exports; and the eurozone and its periphery have been central to this export growth. German industrialists, at least, seem to believe that the euro has been crucial to their business. Just as bailing out Nevada and Florida may be the price people in Massachusetts and New York pay for sharing a continental economic and monetary union, so too does this calculation apply to Germany. Certainly many Germans would prefer not to have to contribute to resolving the European crisis; but these skeptics seem not to understand that the alternative might be, in the short run, a gut-wrenching collapse of the German banking system, economic distress in the rest of the eurozone, and in the long run, a loss of a major source of German economic growth.
There is also an air of unreality about European discussions of how to deal with the debts themselves. In just about every debt crisis, the eventual workout requires both debtors and creditors to pay some of the price for crisis resolution. Delay in recognizing this only makes matters worse. In the aftermath of the Latin American debt crisis that began in 1982, the U.S. government tried to maintain the fiction that the debts would eventually be paid – forcing a decade of austerity on Latin America that led to the region’s lost decade. Ultimately, in 1989 the George H. W. Bush Administration recognized reality and engineered a regional write-down that allowed the banks to get the bad debts off their books, and allowed the countries to resume growth.
Eventually Europe’s creditors and its debtors will have to admit that these debts will not be serviced as contracted, and the debts will be restructured. Pretending otherwise will only prolong the agony – not just for the debtor countries imposing austerity, but also for the financial systems that are now crippled by debts that nobody believes will be repaid. When major central banks, earlier this week, threw a lifeline to the European financial markets, they undoubtedly helped avoid what appeared to be an imminent panic. However, this initiative will only postpone the final reckoning with the region’s underlying financial weaknesses.
In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed. Who will pay – creditors or debtors? Taxpayers or government employees? Germans or Greeks? More realistically, what combination of sacrifices will be politically tenable, both across countries and within countries. The aftermath of every debt crisis sinks into conflict over who will bear the burden of adjustment to the new reality. The sooner Europeans recognize the true nature of the debates they’re having, and the inevitability of working out some mutually acceptable conclusion, the better off they will be.
The post written by Jeffry Frieden.
I have followed this crisis and the related opinions of it relatively closely. I thought this piece was realistic for the most part. However, it assigned equal blame to the north and south, stating that those making bad loans are equally as responsible as those taking on debts they cannot service. In general, I agree with this theory. However, it is also my understanding that at the beginning of the crisis, the Greeks were found to have hidden large sums of reportable debt from the Euro authorities using swaps and other innovative financial instruments with the assistance of Goldman Sachs. This fact must be recognized in order to have a more complete understanding of the problem we now all face.
Goldman and other American banks fooled European and Asian investors about the debt of both the Greek government and American households. In effect, their business model was “Take the money and run!”
So now the business model of their former counterparties–from Kuwaiti sheiks to German banks to Pennsylvania school districts to Asian governments to midwestern exporters–has become “Don’t ever come back!” And this is why Europe’s transparent crisis should not distract Americans from their own hidden one, to wit, the incredible shrinking American financial sector. Perhaps the federal government will keep the big banks on life support until it, too, expires.
Liquidity,solvency duplicity the trinity of the financial world,amnesia its support.
Feb 9 2010 (Reuters) -” U.S. banks have $176 billion in exposure to Greece, Ireland, Portugal and Spain, with risks concentrated among the 10 largest U.S. banks, Barclays Capital said on Tuesday.”
One may search either through BIS the cross countries exposure or FDIC cross borders lending survey of US banks in Europe.From memory US banks loans exposure to Europe in large was 330 billions usd and more than a trillion euros derivatives. http://www.fdic.gov/bank/.The so called pair trades may offset some exposure or derive super profits provided the counterparties are solvent,and a Lehman moment buried in the Lethe river.
Europe is a provider of several meal plans the full board Euro zone and the half board European members.This buffet is quiet large when compared to the size of the guest.
BIS Detailed tables on preliminary locational and consolidated banking statistics at end-March 2011
Table 2A: External positions of banks in all currencies vis-à-vis all sectors In individual reporting countries (in billions of usd)
Reporting countries Dec 2010 Mar 2011
United Kingdom 5,510.3 5,771.4
Reading Bloomberg may supplement information on the intertwined existence of loans assets and derivatives.
Bloomberg
“Regulators said they might not have enough information to assess the threat over-the-counter derivatives pose to the financial system.
Shortfalls in available data may undermine attempts to use so-called trade repositories as a tool to improve market oversight, the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions said in a report published today.
The lack of details on the value of trades “presents a potential gap in the data that authorities may require to fulfill” their mandates, the organizations said. More data on collateral would allow regulators to “better assess exposures, counterparty risk and ultimately systemic risk,” they said.
All above information do not offset the too extreme passivity of Europe when it comes to Public governance and its members undertakings.
We can count on one thing in any forensic analysis, which is the analyst totally ignoring the issue of central banks across the globe letting their member banks be thinly capitalized.
If you misread the cause your prescription will not be effective.
Everyone points to Canada as the example of virtuosity but no one notes that its central bank did not buy into the idea that risk management could replace capital. So it did not allow its banks to play in the securitized loan racket. They had to keep their loans and have capital and reserves to back them.
The Basel rules allow banks to lend to to sovereigns without any capital at all. The outcome was inevitable.
http://www.realclearpolitics.com/articles/2011/09/16/europes_banking_crisis_111352.html
“Under Basel I, banks were required to hold 8 percent capital against most assets. Ordinary loans to companies required 8 percent: That’s $80,000 on a $1 million loan. By contrast, home mortgages required only 4 percent; they were considered safer. Later, “securitizations” of “prudentially” made mortgages required only 1.6 percent; they were judged even safer. And most government bonds required no capital; that’s how safe they were rated.” (Basel II was even worse.)
Good reminder about Bush #41 and the writing down of bad Latin American debts.
My only nit to pick is that the article ignores the European non-euro problem as well. German banks not only lent to southern Europe, they also lent heavily to the Baltic countres and those countries went through some wrenching recessions of their own in the wake of the 2008 financial crisis.
Good summary and some good comments. Other relevant points.
1. The soverign debt is not predominantly financed overseas – the largest holders of the debt are the banks, pension funds etc of the countries in question. So if Greece (or whoever else) defaults the banks in Greece (or whereever else) are so far bust that depositors money is at compomised. So it’s not as simple as a battle between foreign creditors and locals. The local banks also don’t want to see default and there’s a slow motion bank run as those that have signficant money in the banks move their funds offshore.
2. As the crisis has unfolded the ECB has stepped in to fund the soverigns in the crisis countries (buying in the secondary market to try and push down interest rates and stop a self fulfilling spiral of increasing rates and ever more likely default). They have also funded banks who can’t get funding (this is now also happening in France via the Fed/ECB deal). So now the ECB is on the hook for questionable loans. They’ve done this against their previous prouncments and under protest as the alternative is the crisis unravelling. So there’s a whole other dimension of conflict between the ECB and the Euro area governments. In theory the various Euro governments are on the hook to recapitalise the ECB when this is necessary. If/when the euro are unravels the paying up for these ECB losses is likely to be a huge area of conflict. i.e. if I leave the euro now then I’m saying I’m not responsible for losses only acknowledged at a later date. If I don’t leave I’m left holding the can. I believe this incentive situation will see the euro unravel fast once it starts to go and leave behind a lot of acrimony between the countries.
Um, trouble here is you barely mention the ECB.
Let’s get this straight — Germany, the leading economy in Europe, has grown a cumulative .8% over the past four years. Meanwhile, core inflation has been below 2 percent for the past few years, and below 1 percent for part of that time. At the same time, the ECB never lowered its key policy rate below one percent. In addition, the recent phase of the crisis was set off by the ECB raising rates. That’s what we call a mistake.
While there’s nothing in your blurb above I disagree with, necessarily, how can you write a long post about the ongoing Euro crisis without mentioning the craziness of the ECB? Doesn’t bode well for the book…
It would have been reasonable to have mentioned the role of Asian & petro-state central banks in depressing long-term interest rates globally in trying to keep their currencies cheap with regard to the Euro & $. Northern European banks were responding to these false signals in their loose lending. The inability of the Asians to buy more European debt because of their need to counter domestic inflation may well be the trigger for the day of reckoning.
Furthermore, it is important to note that the degree of credit bubble was enabled by fiat money. Tho’ there exist very little history of free-market produced money not interfered with by govt, it is hard to imagine a true market system producing a debacle of this magnitude.
“By 2009, the country’s eleven million people owed more than $500 billion to foreigners, more than the foreign debts of Argentina, Brazil, and Mexico combined (with thirty times the number of people and ten times the economic output of Greece). (pp. 186-187)”
Is this economics or popular press? Why not compare Greece with some countries with net foreign surpluses, like China or Japan? How many times the number of people and economic output would that give you?
And that’s quite a hodge-podge comparing external borrowing of the euro finge with with the internal borrowing of the U.S. mortgage boom, unless you buy the story (as do Krugman and I) that it was not the Fed or lax regulations at the heart of our mortgage boom, but net foreign borrowing (in our cases, the loans were stuffed down our throats by official currency purchases abroad, which may ruin the seeming symmetry between fault of lenders and borrowers pointed to in the post).
U.S. financial institutions have plenty of exposure to Greek debt as well – from insuring the debt held by European banks.
Some good points about the deny and delay tactics, of which our own Ben is as guilty as any. It also brings forth the question, why is financial sector compensation so high? Did those guys add any value?