Photo: Gordon Wrigley on Flickr
A storm is brewing behind the scenes in Europe and it’s not going away.The story goes like this: peripheral economies are contracting, workers are losing their jobs, the same workers and businesspeople are having a hard time paying off their debts because they’re not doing enough business, this hurts the financial sector which in turn is wary to lend, exacerbating the economic contraction. And so it goes in a vicious cycle.
For now, this has an only indirect effect on sovereign borrowing—banks re-invested much of the cheap cash they got from the European Central Bank in its two 3-year LTROs back into (primarily domestic) government debt, sharply bringing down the cost of financing for Spain, Italy, Ireland, and even Portugal.
Before the LTROs, these countries faced immediate liquidity problems, not insolvency problems (at least, not with current bailout funding. Thus access to cash has temporarily mitigated insecurity about sovereign funding.
But that doesn’t mean the crisis isn’t still relevant. If we look back to last fall, investors put a lot of emphasis on rising sovereign bond yields and illiquidity problems. In reality, however, the more immediate problems came from the financial sector—worries about French banks holdings of PIIGS sovereign bonds sent their share prices tumbling, and ultimately generated fears that contagion from peripheral Europe could spread to the core (see: a rise in French bond yields).
These fears are still very real. From a Fitch presentation published today, some concerns about Portugal:
The sovereign crisis poses significant risks to the banking system, which lends to one of the most indebted private sectors in Europe and is highly reliant on wholesale financing (access to which is now closed). Recapitalisation and increased emergency liquidity provision from the ECB to Portugal’s banks will, in Fitch’s view, be needed and provided.
The concern is less that the necessary funding to keep peripheral eurozone banking sectors afloat will be provided at all than that it will be provided in a timely fashion. As former ECB governing board member Lorenzo Bini-Smaghi argued a few weeks ago, only immediate talk of new funding for Portugal and Ireland will prevent the crisis from resurfacing, and convince the private sector that EU leaders will not tolerate a series of private sector debt restructurings across Europe.
It would appear that the OECD is just as worried. Today OECD Secretary Angel Gurria announced that EU leaders needed to approve “the mother of all firewalls,” according to Reuters—advocating an increase in the European bailout fund to €1 trillion ($1.3 trillion) rather than the €700 billion ($935 billion) that EU leaders are expected to approve this Friday. He named bank weakness as a primary concern and impetus for this measure.
But even this less-than-optimal increase in funding has taken forever to approve. For months, Germany repeatedly refused to expand bailout funding, before finally relenting yesterday.
There is an antidote to these concerns: rethinking some of the harsh austerity measures imposed by the European core in order to generate growth. Stimulus packages have helped the U.S. limp through a deep recession after the financial crisis, but without the government stepping in to prop up demand in the economy the effects of near financial collapse would probably have been much worse. This entails redistribution of wealth across the eurozone, and the political commitment to acting like a more cohesive monetary region.
If not, lack of economic growth will lead to a resurgence of banking problems, particularly in Portugal and Spain, which will ultimately spill over into bond yields. That will increase pressure on EU leaders to effect some more significant changes to eurozone governance. Problem is that, if last time is any indication, a banking crisis will go relatively unnoticed until it becomes severe. Translation? There’s a high likelihood of crisis measures being taken too late in the game, meaning that Europe’s problems will continue to drag on for years to come.