Tuesday, June 12, 2012

“A False Dawn in Madrid?”

Sydney M. Williams

Thought of the Day
“A False Dawn in Madrid?”
June 12, 2012

Will a €100 billion injection into its banks solve Spain’s bank’s problems? Perhaps. It’s a large amount of money, representing almost 10% of Spain’s annual GDP, and would cover about 60% of bank real estate loans that are considered at risk. It may lower the fever, but the patient will still be very sick. Structural problems remain.

The issues are two-fold. First, Europe faces a credit crisis, potentially hastened with what could be an uncontrollable run on bank deposits. It is not unlike the one we faced in September 2008, when the Federal Reserve had to step in to guarantee all deposits on amounts of $250,000 or less and money market funds. Second, the socialist nature of Europe’s economy makes reform, which definitionally will involve austerity, painful. It will only be entered into under duress. Europe, no matter what politicians claim, cannot solve its problems painlessly. The best answer would be some form of regulatory and tax reform that would lead to faster economic growth, dismayingly an unlikely prospect in my opinion.

A sobering op-ed on the subject was written by the odd combination of Nouriel Roubini and Niall Ferguson, and appeared in last weekend’s edition of the Financial Times. Their point was that, absent an FDIC-like guaranty, there could be a run on the banks; the risk to Europe would be a recession (depression) with devastating consequences. As they point out, the European Union was initially created to avoid the nationalism that led to the Second World War. The risk Europe faces today is one of repeating those disastrous mistakes of 80 years ago. They conclude their piece: “It is time Europe’s leaders – and especially Germany’s – understood how perilously close they are to doing just that.”

Keeping in mind that Greeks have withdrawn more than €700 million in bank deposits in the past month, the intractable nature of the problem suggests, on the one hand, an immediate risk of the withdrawal of smaller, insured deposits from “Club Med” banks, and, on the other hand, the need for meaningful and necessary reforms among most of the Euro zone countries. Germans fear that if they endorse the concept of debt mutualisation, necessary structural reforms will only be delayed, and perhaps never implemented. The wags have it that on Angela Merkel’s last visit to Greece, when the customs people asked, “Occupation?” she responded, “No. I’m just here for a meeting.”

Both options – austerity or more loans to the profligate – are repulsive to the opposing side. Loans without restrictions are unacceptable to the Germans, while austerity alone will almost certainly create economic chaos. There are no attractive options, only ones that may be less bad.

Fear serves only to make the problem worse. Martin Wolf, writing last week in the Financial Times, and bringing to mind FDR’s famous admonition that “we have nothing to fear, but fear itself,” noted, “In a panic, fear has its own power.” The 1930s have recently been referenced by observers of the European scene. In 1931, the Viennese bank Credit-Anstalt failed, leading Europe into a financial panic that infested other parts of the world. Two years later, Adolph Hitler was elected Chancellor of Germany.

I am certainly no expert when it comes to the European credit and debt crisis, but what I find mind-numbing has been the lack of anticipation. This is not a run-away train that crashed suddenly into a railroad crossing. This has been an accident happening in slow motion, as though a 45rpm record were playing on a 33rpm turntable. Four years ago Iceland’s economy crashed, as did Ireland’s. Greece’s economy, as measured by GDP, first fell in 2008 and its rate of decline has been accelerating since. There has been plenty of time for banks to have begun writing down loans. It would appear that none did; they were governed by the philosophy of “hear no evil, see no evil, speak no evil” – a case of foolish, Panglossian optimism. Similarly, there was time for governments to take action. Again, most did not. Attempts at reform in Greece led to street riots. Entitlements, apparently, are not up for debate. And now France has decided to lower the age of retirement from a too-young 62 to an even younger 60! How bad do things have to get before the people accept the facts on the ground?

The funds to save Spanish banks are expected to come from the European Stability Mechanism (ESM,) the expected successor to the European Financial Stability Facility (EFSF), a fund to which all eurozone members (and the IMF, which means the U.S.) will contribute. Ironically, as Vince Farrell pointed out yesterday, that means, for example, Italy must borrow money at 6.15% and lend it to the ESM at 3% – not a formula that makes a lot of sense for a cash-strapped nation.

It is likely foolish on my part, but I hope that Europe’s leaders are preparing for the exodus of Greece from the eurozone, if not the dissolution of the entire enterprise. It may not be their desire, but to not prepare for the worst would be a dereliction of their duty. I fear, though, they are blinded by hope and unwilling to admit they were wrong in creating a currency before they built an infrastructure to support it. The biggest risk facing Europe is a rise of nationalism that could lead to a leadership vacuum into which might fall a new charismatic dictator that could arrive from either the Right or the Left. Prejudice and racial hatred lurk near the surface in many parts of Europe – the targets generally being Jews and Muslims. It is tinder that could easily be lit, because when hard times get worse, as they likely will, blame will fall somewhere and it usually descends on those that are considered the most alien.

Victor Davis Hanson wrote yesterday that the current meltdown in Europe is “a morality tale of those nations and regions that sought to stay fiscally responsible …and those that did not…The truth is that one workable paradigm reflects human nature, of spending what you make and the other does not.” Perhaps Europe will extricate from the mess they have made without undue imbalance, but that bet is a long shot. The acceptance of responsibility for what has been wrought is a mark of maturity and common sense. Thus far, leaders whether in Brussels, Athens, Madrid or Washington have not yet reached that conclusion. It is we, not them, who stand to suffer. As much as I would like to believe that €100 billion loan at 3% will do the trick, count me as being from Missouri.

While in the U.S. there seems to be a growing realization at the grass roots level that the entitlement state no longer works (the Wisconsin recall election being the latest example,) most of Europe, from my limited knowledge, does not seem to have reached that point. That does not portend well.

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