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Three layers of the European debt crisis

This post is for Americans who know nothing about the debt crisis in Europe.  I am going to try to provide a big picture framework and draw attention to what I think should matter most to Americans.  If you have expertise in this topic I hope you’ll help me improve my analysis.  This topic is somewhat new for me.

I think of the European debt crisis in three layers:

  1. national debt crises in several European countries;
  2. a structural crisis of the Eurozone; and
  3. potential banking crises in Europe and the U.S.

Most current press coverage is about the middle layer: can European leaders prevent the Eurozone from dissolving? The top and bottom layers deserve more attention than they are receiving. American policymakers need to think hard about and plan for the possibility that a really bad outcome in Europe leads to another American banking crisis.

On the top layer we have national budget crises in several countries. For weeks and in some case months, Portugal, Ireland, Italy, Greece, and Spain (the so-called PIIGS) have each had trouble issuing government bonds at a sustainably affordable interest rate. Each of the PIIGS has some combination of unsustainably high budget deficits, high government debt, and weak economic growth. As a result investors worry that if they loan money to these governments they won’t get it back in full and on time.  They therefore insist on a high interest rate to compensate for this risk. In the case of Greece those fears were well-founded, as private investors “voluntarily” (yeah right) took about a 50% haircut on the value of their Greek bonds.

On this top layer of national debt crises there are a few important things to remember:

  • Each of the PIIGS’ fiscal situations is different. Spain had a housing bubble like we did in the United States. Ireland incurred a lot of debt because they bailed out their banks in 2008 and 2009. The Italians have a lot of debt while the Greeks have huge deficits. Each of these countries is having trouble issuing government (“sovereign”) debt at an affordable interest rate, but for different reasons.
  • A growing economy can cover up a lot of problems.  An economic slowdown in Europe has revealed problems in the PIIGS that have been building, in some cases for years.
  • At this fiscal solvency layer the idea of “contagion” from one of the PIIGS to another is overblown. The underlying fiscal solvency crises in these governments are basically independent. While the reactions of policymakers to Greece is affecting investors’ expectations about the value of debt issued by Italy, Spain, or Portugal, the underlying fiscal solvency problems in these countries were not caused by the problems in Greece. Contagion pops up in other parts of this story, but the term is often misused in this layer.  See this Lazear op-ed for more on this point.
  • From a broad American perspective we care about each of these countries because we want our friends and allies to succeed economically. From a narrow American economic self-interest viewpoint, we care about each because they are our trading partners. But on the raw numbers the economic fate of each of them (separately) will have only a small effect on the U.S. economy. If we in the U.S. did not have to worry about the other two layers, then this would probably not be the most important current issue for most American economic policymakers.  The worrisome quantitative hit to the U.S. economy comes if Europe as a whole goes into a deep recession, or if European debt problems cause a banking crisis that spreads to the U.S.

In the middle layer we see the Europeans trying to solve the structural flaw of having a centralized monetary policy in a Eurozone economy that is still heavily balkanized, especially on fiscal policy. Because my point today is to emphasize the relative importance of the other two layers relative to this one which is getting all the public attention, today I’ll mention only a few important points about this layer.

  • Outside of a monetary union, a government that borrows in its own currency and develops debt problems has the option of inflating away its liabilities. This generally also occurs in the context of a currency devaluation. The PIIGS don’t have this option as long as they are members of the Eurozone, since they don’t control their own monetary policy, inflation, or currency. This means they must either make dramatic changes to solve their underlying fiscal problems (which, presumably is quite difficult given that they haven’t done it so far) or they have to get someone else to help them pay their bills. (translation: “someone else” = Germany)
  • In theory Greece or Portugal could leave the Eurozone, reinstitute their own currency, and then devalue. In practice ut the treaties that formed the Eurozone don’t describe how to do this, and you have to worry about capital flight, how to get anyone to use your new currency, and how to deal with old contracts and debts denominated in Euros when you’re now using drachmas or lira.  I have yet to find someone who can describe how a country could successfully do this, legally or financially.
  • Given this huge uncertainty about whether and how a country could actually leave the Eurozone, there appear to be a few possible outcomes:
    • Everyone now in the Eurozone stays in it;
    • Some of the smaller periphery countries (Greece, Portugal? Ireland?) leave it (but how?), while the rest in the core stays intact; or
    • The whole Eurozone falls apart.
  • If the whole Eurozone falls apart, then Europe as a whole probably falls into a deep recession. That would seriously hurt the rest of the world’s economies, including ours. This is a bad scenario for a U.S. economy that is already growing way too slowly. It’s also a scenario that American policymakers can do little to prevent.  Chancellor Merkel and President Sarkozy are doing everything in their power to avoid this outcome.

The bottom layer, the interaction between European sovereign governments and banks in Europe and the U.S., is not getting nearly enough policy or press attention, and it worries me a lot. From an American self-interest perspective, the direct economic effects of a Eurozone collapse on U.S. exports would be very bad and could easily tip the U.S. into recession. But the effects of a collapsed Eurozone or an Italian default on European banks, and the indirect effects that are passed through to American banks, could be far, far, worse. Think 2008 financial crisis worse.  The worst case scenarios for Europe appear to pose a low probability, high consequence threat of another horrific U.S. banking crisis.  This is why American policymakers should care deeply about Europe — because if the Europeans screw it up badly, it could do serious damage to the American economy, transmitted through still flawed and vulnerable banking systems.

A sudden dip in the value of Italian debt could create solvency problems and/or liquidity problems for banks and other large financial institutions.  Here is the solvency scenario that really scares me:

  • Italy defaults on its sovereign debt or the Eurozone collapses. Italian debt is suddenly worth much less.
  • Everyone holding Italian bonds, or derivative securities based on Italian bonds, suddenly must realize a big loss.
  • Large European banks that were holding massive quantities of Italian debt must realize huge losses. The biggest concern here is probably the big French banks, but there could be others throughout Europe that face similar risks.
  • These European banks fail. European governments begin rescuing their banking systems (again).
  • While large American banks appear to face little direct exposure to the risk of losses on Italian bonds, they could face much larger counterparty exposure to failing large European banks that hold those Italian bonds.
  • Failures of European banks trigger large losses in large American banks.
  • Some of the biggest American banks fail. Again.

To put it even more simply, I worry about this:

(Eurozone collapses or Italian government defaults) –> European banks fail –> U.S. banks fail

A second and closely related scenario derives from European banks using PIIGS government bonds as collateral for short-term interbank loans.  If a European bank needs an overnight loan from another bank, and that second bank won’t take Italian government bonds as collateral, then the first bank may need to sell other assets to raise cash. If a whole class of collateral for liquidity is no longer available, it can have broader effects in liquidity markets, including for U.S. banks that don’t use European sovereign debt as collateral but rely on these wholesale markets for short-term liquidity.  This could force the U.S. Fed to once again provide emergency liquidity to American banks.

From a narrow American economic self-interest standpoint, our second biggest concern should be whether our trading partners go into a deep recession and what that would mean for U.S. exports and U.S. GDP growth.  Our biggest concern should be the value of Italian bonds. Why? Because there are a whole lot of them, and because they are concentrated in large European banks that (as best I can tell) are counterparties to large American banks.

You may notice parallels to 2008. Then, big American banks failed in part because they concentrated huge amounts of highly correlated mortgage risk on their balance sheets. When those housing-related financial assets declined sharply in value, those banks failed. The same could happen in Europe, where government debt has previously been (mistakenly and stupidly) treated as a risk-free financial asset. We Americans should care specifically about Italian debt because there is so much of it, because it is concentrated on the balance sheets of some large European financial institutions, and because these institutions are now realizing it’s risky and worth less than they had previously thought.

An even better 2008-era analogy would be debt issued by Fannie Mae and Freddie Mac. U.S. rules allowed banks and other financial institutions to treat this Agency debt as risk free and as functionally equivalent to U.S. Government bonds. As a result, financial institutions around the world concentrated huge amounts of apparently risk free Agency debt on their balance sheets. When in 2008 Fannie and Freddie were deemed to be insolvent, we in the Bush Administration worked with the regulator to in effect guarantee that Agency debt would be worth 100 cents on the dollar. We did this because the alternative would have triggered failures in financial institutions around the world. The U.S. financial system mistakenly treated Agency debt as risk free. When that was no longer true because the underlying institutions were recognized to be insolvent, we had to step in to make it risk free or else, we thought, face the collapse of much of the global financial system. European sovereign debt, and especially Italian bonds, appear to be the 2011 equivalent, at least in Europe, of 2008 era Agency debt.

Over the past week there have been significant policy actions on all three layers of the crisis:

  • New Italian Prime Minister Mario Monti has proposed and is trying to enact new laws to address his government’s underlying solvency problems;
  • European leaders and finance ministers are working furiously to figure out how to hold the Eurozone together; and
  • The U.S. Federal Reserve started a new stress test of big American banks to figure out whether they could withstand an economic shockwave from a European implosion.

While the press focuses almost entirely on the Eurozone negotiations, American policymakers should be focusing even more on whether PM Monti is successful in Italy and especially on the results of the U.S. Fed’s stress tests.

Unlike with U.S. mortgages in 2008 and thereafter, the Italian government can solve its underlying solvency problems.  Through some combination of cutting government spending, raising taxes, and economic reforms that will allow more economic flexibility and competition and faster productivity growth, the Italian government can reduce the risk of insolvency and increase the value of Italian debt.  This would help Italy, it would make it easier to keep Europe intact, and it would reduce the risk to the European and banking systems. Win-win-win.

At the same time the U.S. Fed is requiring the biggest banks to test a scenario in which U.S. GDP declines eight percent and the unemployment rate jumps to 13%. I hope they are also requiring the American banks to prove they can survive if their European counterparts fail or if liquidity suddenly dries up.  These stress tests, and corrective actions demanded of any American banks that fail the tests, are the most important thing American policymakers can do now to protect the American economy from the worst case scenarios in Europe.

From an American economic self-interest perspective, this bottom layer of the European debt crisis is by far the most important. If events in Europe could cause American banks to fail, American policymakers need to know this and deal with it before disaster strikes.

(Hat tip to the students in my Stanford Business School class who have been helping me learn and think about the European crisis and how to explain it.)

(photo credit: FurLined)

By | 2015-05-30T06:57:46+00:00 Wednesday, 7 December 2011|