The deepening European financial crisis is the direct result of the failure of Western leaders to fix the banking system during the first crisis that began in 2007. Barring a miracle of statesmanship, we are in for Financial Crisis II, and it will look more like a depression than a recession.
The Greek crisis, and the inadequate official response to it, is only a symptom. The flight of banks and other private creditors from Greek government bonds has left European leaders and the IMF to fashion a series of piecemeal rescue plans lest a Greek default trigger a broader global financial collapse.
But each rescue has been behind the curve. Over the weekend, European leaders fashioned yet another patch, in the hope of buying more time. The details are still to be worked out at a follow-up meeting later this week. But the problem with the tactic of "kicking the can down the road," as the dean of financial writers, Martin Wolf, noted at a recent Financial Times conference, is that "the can is filled with gasoline."
Beginning in 2008, the collapse of Bear Stearns revealed the extent of pyramid schemes and interlocking risks that had come to characterize the global banking system. But Western leaders have stuck to the same pro-Wall-Street strategy: throw money at the problem, disguise the true extent of the vulnerability, provide flimsy reassurances to money markets, and don't require any fundamental changes in the business models of the world's banks to bring greater simplicity, transparency or insulation from contagion.
As a consequence, we face a repeat of 2008. Precisely the same kinds of off-balance sheet pyramids of debts and interlocking risks that caused Bear Stearns, then AIG, Lehman Brothers and Merrill Lynch to blow up are still in place.
Following Tim Geithner's playbook, the European authorities conducted "stress tests" and reported in June that the shortfall in the capital of Europe's banks was only about $100 billion. But nobody believes that rosy scenario. At the weekend summit, that was raised to about $160 billion, still too little -- yet a sum that the banks themselves will have difficulty raising, especially in the most stressed countries like Italy.
The Greek situation reveals the deeper potential for contagion, and the Ponzi scheme that now characterizes the banking system. Europe's banks hold some in $121 billion Greek government bonds that are trading at about 40 cents on the dollar. Europe's leaders, meeting in a summit conference over the weekend, admitted that Greece needs a reduction in its debt load of 50 to 60 percent, and not the 21 percent that was agreed to by the banks back in July.
So Europe's banks will need to take much a bigger hit, and it's not clear that they have the capital to sustain it. But Europe's governments and the European Central Bank are balking at providing this money directly. Instead, they hope to double down with a bailout fund, the $606 billion European Financial Stability Facility that, in effect, borrows against the credit of Europe's soundest economies.
But that is a shrinking club. If France, home of increasingly shaky banks, were to lose its triple-A credit rating as Moody's has threatened, then the scheme fails because French collateral would not be accepted as backing for the EFSF's new borrowings. (Where Moody's, which failed to accurately assess the risks of sub-prime, gets off passing judgment on an entire country, but that's a question for another day.)
If Greek bonds are written down to half their face value -- a "haircut" in the misleading and cutesy jargon of finance -- banks stand to bear hundreds of billions of dollars of losses. The banks' own shaky condition makes them risk-averse about holding not just Greek sovereign debt, but also the bonds of Portugal, Ireland, Italy and Spain.
The financial industry has coined the acronym PIGS to denote these nations, implying that the crisis is their own fault for living beyond their means. But the true pigs of the story are the banks. The same banks that hold the debt of at-risk countries have also written hundreds of billion dollars in insurance against default for other banks, in the form of credit default swaps. The total cost of the "haircuts" required to get several nations out of their unsustainable debt burden is estimated by outside experts in the range of $1 to $2 trillion dollars.
This was the scale of the financial near-meltdown in the U.S., which was averted by a $700-billion bailout plan plus zero-interest lending by the Federal Reserve well into the trillions. But because of the fragmentation of the EC and its governmental institutions, the Europeans are unlikely to come up with money on this scale.
The one European nation with the political and economic resources to mount an adequate rescue is Germany. But spending German money to bail out the rest of Europe is monumentally unpopular in Germany. Barring a true act of statesmanship by Chancellor Angela Merkel, putting the rescue of Greece, the Euro, the European Union and the European economy ahead of her own reelection prospects, the latest summit actions will be behind the curve once again.
Euro-skeptics are saying, "We told you so" -- the Euro was always a doomed idea. It's true that creating a monetary unit to be used by 17 separate nations with diverse economic strengths and budgetary conditions was a risky proposition. The Euro was a vessel designed for calm seas, not for once-in-a-century storms.
But to solely blame Europe and its institutions is to excuse the source of the storms. That is the political power of the banks to block fundamental reform.
The financial system has mutated into a doomsday machine where banks make their money by originating securities and sticking someone else with the risk. None of the reforms, beginning with Dodd-Frank and its European counterparts, has changed that fundamental business model.
The banks have created layers of impenetrable debt obligations. As long as nobody asks what these securities are really worth in the marketplace, the Ponzi scheme holds. But once creditors begin doubting whether the debts will be paid, an ostensibly well-capitalized firm like Lehman Brothers or Bear Stearns can become insolvent overnight. Now entire countries are prisoners of a dysfunctional system of private finance.
Until our political leaders on both sides of the Atlantic muster the will to radically simplify the financial system and put an end to the game of pass the risk and reap the reward, we will be in chronic peril of financial collapse, in which governments and taxpayers are held hostage by banks.
Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is A Presidency in Peril.
Gordon Brown: Why Europe Slept
Compound all that by the fact that the euro was predicated on the fact that european governments would act responsibly with their finance instead of letting the deficits grow (political reasoning is short terms, consequences are long term: this is a mismatch that is a recipe for disaster : no incentive for politicians to be responsible) while they just kept deficits, even before the financial crisis. Thus you had banks (commercial banks mind you) thinking they were very safe investing in government bonds, while in effect they were taking the unthinkable risk of being exposed to the bankruptcy of a country... You can change whatever you want to the passing of risk, it would not have changed the exposition of Unicredit or BNP to sovereign risk, Robert.
By letting the banks have their way, Ireland has ended up economically back where it used to be before the boom of the 1990s. The Irish are once again the blacks of Europe.
Ireland is in its precarious position because like Greece and the USA it spent more money that it does NOT have.... Where do you think the government money comes from? It does not grow on tree or in the printing press plant..... Government cannot create wealth it just spends yours and my money, the more it takes the less we have for our livelihood….
We're in the situation now where the banks potentially owe the US a huge amount of money through government loan guarantees and derivative exposure, and now essentially the banks own us.
And republicans want to continue on with their quest for deregulation.........
The repeal of Glass-Steagall passed in the Senate by a vote of 90-8 and in the house by a vote of 362-57. It was signed into law by President Bill Clinton on November 12, 1999.
I'd like to pin this economic mess on the Republicans, but the Democrats' fingerprints are all over it -- including the repeal of Glass-Steagall.
The United States government could wait until there is a debt induced economic crash...wait until the market for treasuries freezes....and then they will have to make massive middle of the night spending cuts in a panic.
I beleive we are doomed to follow the latter route. Why is it our government just can't cut spending now ??
you want to blindly slash spending when other nations (such as China, Germany, etc.) are investing heavily into their infrastructure and energy research, ensuring that they will economically dominate in the future.....
and US citizens wonder why their country continues to fall further....
America gave birth to this financial fraud... we own it.
It's our legacy.
Address TBTF, and you will go a long way toward addressing the bank problem.