“Nothing is safe that does not show it can bear discussion and publicity”. These words, among the many pearls uttered by the celebrated 19th century historian Lord Acton, have often come to me in recent years, as the sub-prime crisis has unfolded. They’ve been particularly on my mind over the last week or so, as I’ve watched events in the eurozone.
Investor sentiment in Western Europe appears to have improved over the last few days. In the aftermath of last weekend’s French sovereign downgrade, financial markets have staged a counter-intuitive rally, with European equities reaching a five-month high on Thursday. At the same time, and perhaps even more surprisingly, France and Spain between them off-loaded no less than €14.6bn of government paper last week, at relatively favourable borrowing costs.
Downgrade or not, Paris sold close to €8bn of medium-term state bonds, with yields falling across the board. Spain then flogged €6.6bn of government IOUs, exceeding its €4.5bn target, with investor demand driving yields well below expectations.
In the wake of these successes, the euro rose sharply, putting the dollar under pressure as investors ventured away from the traditional “safe haven”. Those of us who worry aloud about the monetary union’s inherent structural flaws, laughed at for years and only taken seriously in recent months, are now being laughed at anew. “Crisis, what crisis?” the eurocrats are crowing last week. “When will these bickering economists shut up and accept that the euro is forever”.
The relevant observation, though, isn’t that France and Spain just managed to auction more debt at lower yields. The relevant observation is “why?” For the reality is that the European Central Bank – whisper it – is now engaged in full-on “stealth monetization” of the eurozone’s hideous, inter-locking edifice of bank and sovereign liabilities. This isn’t openly admitted, of course, given the German public’s acute opposition to “money printing”. But it’s happening nonetheless.
The ECB has, for several months now, been aggressively lending to European banks, those banks in turn using such funds to buy eurozone sovereign debt. And in response to S&P’s French-bound downgrade exocet, such “special operations” have just been cranked-up.
The ECB’s cheap 3-year LTRO (long-term refinancing operations) finance has created a juicy “carry trade” for the continental banking sector. Banks can borrow at 1pc from the ECB, posting near-meaningless collateral, then buy sovereign bonds with higher yields, the resulting profit helping them recapitalize, covertly, at the taxpayers’ expense. Why wouldn’t European banks pile-in to newly-issued bonds as fast as eurozone governments can issue them, when they’re effectively being bribed to do so?
While there’s barely any technical difference between this now widespread practice, and out-and-out circular financing, politically the difference is huge. For now, ECB lending to eurozone banks is just about acceptable to the German public, not least because most barely understand it, but outright debt monetization is not. Chancellor Merkel’s mind has also lately been focused by fears of systemic risk in Germany’s own banking sector. That’s why the ECB “special ops” have Berlin’s tacit approval.
Most Eurozone governments haven’t agreed this radical, unprecedented currency debasement. National Parliaments have barely discussed it. But it’s now in full-swing and is the principal reason why eurozone debt markets have lately shown signs of “improvement”. This tawdry practice, for sure, is providing eurozone politicians, and their banking sector friends, relief for now. Yet, it cannot go on – which is why, to reprise Lord Acton, it is happening “below the radar”.
Beyond the sly moves, though, the eurozone still faces an imminent, chronic funding problem. Member states need to repay €770bn of debt this year, the bulk of it over the first six months. European banks, themselves heavily dependent on state largesse, have another €520bn of debt coming due by this June, much of it during the first quarter. Berlin appears to decided that raising the alarm about eurozone QE – for that is what it is – would seriously undermine not only recent stock market gains (which are helping bank balance sheets look less ghastly) but also upcoming government debt auctions themselves.
The fundamental issue is that Europe’s banks remain locked-out of traditional funding markets, leaving them reliant on the ECB – which, in turn, is now increasingly reliant on conjuring-up credits ex nihilo, while begging the Chinese to provide a bail-out. Behind last week’s triumphant headlines, this is the reality. Faced with a funding freeze, banks are shrinking their balance sheets, of course, strangling growth by refusing to lend, a problem the ECB’s black arts will do nothing to address.
Unable to raise genuine commercial cash, Eurozone banks are barely lending even to each other, due to crippling fears of counter-party risk, given that many continue to hide massive liabilities in so-called “special purpose vehicles”. European lawmakers, after all, like their UK counterparts, lack the guts to force them to publish their balance sheets in full.
This remains the nub of the sub-prime problem. The so-called “stress tests” – bank balance-sheet inspections by regulators, who then tell the markets what they think – just won’t do. Investors themselves need to judge who is solvent and who isn’t. Only then can realistic, enduring judgments be made about which banks should and shouldn’t survive. Capitalism only works when, as Lord Acton might have put it, there is “full disclosure” of all relevant information and creditors can take a meaningful view. So eurozone governments need to stand-behind retail depositors, make the financial institutions “fess-up” and let the cards fall, forcing the bombed-out European banking sector to consolidate.
This really is the only solution – in the eurozone, as well as the UK and US. Europe’s failure to grasp it is more immediately explosive, though, given the political pressures created by being locked into the single currency strait-jacket.
The Basel Committee on Banking supervision has lately been making noises about requiring banks, when they announce their crucial “tier-one” capital ratios, to reveal how such ratios have been calculated. Outrageously, across the Western world, banks are still permitted to cover this up. In what other industry would such accounting secrecy be tolerated, particularly an industry of such huge systemic importance to the rest of the economy?
Already, banks are messing with internal “risk-weight” assumptions, in a bid to dodge new rules requiring them to hold more capital. Now they’re pushing back against efforts to introduce further, much-needed transparency. Are the politicians reining-in the banks, putting them in their place and protecting public interests? Are they heck.
Some play down the possibility of a “euroquake” and the likely fall-out if one happens. While Eurozone nations contributed 20pc of global GDP growth during the 1970s, that share is now way below 10pc, given the new importance of the emerging giants of the East. Having said that, a systemic eurozone banking crisis would rock the world. The financial contagion on asset markets elsewhere would be huge.
In the end, this eurozone crisis is less about Greek pensions or Italian welfare payments than it is about the region’s Gordian know of entwined bank and sovereign debt. The banks are destroying the governments. And once the governments go down, social unrest will ensue. Eurozone banks need to be forced to fess-up, write-down their losses and consolidate, yet lawmakers hesitate. That’s because our political classes have been “captured” by the financial services sector, a sector allowed to run riot, in recent years, to an ever greater degree. “Power tends to corrupt,” as Lord Acton once said. “And absolute power corrupts absolutely”.