Wednesday, 14 September 2011

Eurozone Debt Crisis Part One: What is it all about?


Sometimes, when talking about the eurozone debt crisis, headlines announce the “struggle to save the euro.”

The reality however is that it is not the euro that is directly at risk. Rather abstract fears of different coloured bank notes and longer queues at the Bureau de Change, regrettably, underplay the risks which markets are trying to discount.

To be clear, there is no prescribed mechanism for any country to leave or be ejected from the European Monetary Union - whether or not they default on their debt.

The ill-effects of default would instead be felt by European banks making this, what we would term, a banking crisis. Perhaps disappointingly too, the much heralded concept of ring fencing would not have saved the banks from making the mistakes that have left them teetering on the edge of panic.

It is part of the “traditional” banking function to advance loans to governments – rather than the “rock and roll” investment banking functions which Lord Vickers is concerned about. Making too many loans to governments who cannot repay is the same as making too many loans to businesses or households who cannot repay. It means losses, which reduce capital, and will ultimately curtail lending to the economy until the capital has been replenished (for more of the delights of how banks should work please read our previous post).

Bank lending is crucial to the economy. Some might say that the economy should learn to live without its addiction to credit. However even if you think that households don’t need credit cards, most would concede that mortgages (by and large) are economically useful loans. Perhaps more important still, small and medium-sized businesses need loans to invest, expand and create jobs. Companies also need access to credit in order to build an inventory of goods for sale.

Credit default swap insurance costs for the a selection of banks

The cost of insuring the senior (safest) bonds of many banks using credit default swaps (CDS) continues to rise beyond the levels seen in 2008. CDS are complex instruments, however, if the cost of insuring against default is rising, it implies that the likelihood of default is rising too.

On these measures markets are extremely pessimistic, a view which is echoed by the volatile state of equity markets and their lowly valuations.

As Warren Buffett says “We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.” And he cheerfully backs such rhetoric with his $5 billion investment in Bank of America.

The fall out from the last time a bank went bust (Lehman Brothers) has sharpened the authorities’ awareness of banking crises. Their policymaking efforts will now be directed squarely at preventing another.

Eurozone Debt Crisis Part Two will look in more detail at the possible prescriptions.

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