Stress in Europe

NOTHING seems to be going right for the Europeans. Whether it is the relatively dismal and uneven performance of most of their star football teams (barring the Netherlands and Portugal) at the FIFA World Cup in South Africa, or the battering the eurozone continues to receive at the hands of the financial markets, their cup of sorrows continues to fill.

What is more surprising is how much of the pain is self-inflicted, and how the governments concerned keep adding to the masochistic turn in economic policy that promises growing material hardship to most of their populations. In the midst of a fragile and easily reversible recovery after a very severe recession, governments across Europe in both deficit and surplus countries are announcing fiscal austerity packages that are all but guaranteed to prolong recession or at the very least, damage the prospects of recovery especially in employment.

Now, as if the proclivity of financial markets to pressure European governments into deflationary policies were not sufficiently severe, they have decided to provide more grist to the mill of bond market bears, by performing stress tests on their own banks, even in the currently better performing economies.

To some extent, this is driven by the markets themselves or at least by the international financial media that so often appear as their voice. They have been clamouring for more information on the degree of involvement of banks belonging to the leading European countries such as Germany, France and the United Kingdom, in lending to what are now seen as the weaker economies.

Severe pressure

But this was also driven at first by the leaders of these weaker economies, whose governments and banks have been under severe pressure from the financial markets in the past few months. In May, the government of Spain announced that it would conduct stress tests on Spanish banks, and in effect dared other European governments, including Germany, to follow suit. This follows a period in which it has been next to impossible for private corporate borrowers (and banks) in Greece and more recently Spain, to access international credit.

Probably the point then was to argue that in fact Spanish and Greek banks were no worse than banks in the stronger eurozone countries, especially Germany, whose government has taken a pious and puritanical attitude to the sovereign debt problems of Greece and Spain. It was presumably hoped that this would make credit access for such borrowers easier, by dispelling rumours and encouraging investors to be more optimistic about lending to these countries. But it seems to have had the opposite and inadvertent effect of spreading the concern about possible default to other parts of the European economy, which had seemed invulnerable. The point about stress tests on banks was taken up with alacrity by the financial press, which started building up on this demand and emphasising the possibility of contagion in the entire eurozone.

This has been made more intense with the publication of the Bank for International Settlement's (BIS) Quarterly Report in mid-June , which showed that banks based in France and Germany are very deeply implicated in the mess that is unfolding in the weaker countries of the eurozone. The countries that are currently under pressure and those that are seen as potentially under pressure very soon Portugal, Ireland, Italy, Greece and Spain have been given the unfortunate acronym PIIGS. The BIS data show that European banks had as much as $2.95 trillion in loans outstanding to these five countries at the end of December 2009.

Of this, banks headquartered in certain countries were the most heavily involved both in terms of absolute amounts and in terms of their own international claims. Chart 1 shows that banks based in France, Germany, the U.K. and the Netherlands have invested a significant part of their lending in these five countries. Of course, it is not the case that all these countries are currently in crisis only Ireland and Greece have faced the real possibility of sovereign default (or at least substantial debt restructuring). But all of these countries have macroeconomic variables that suggest that their fiscal and external deficits will be increasingly hard to finance, especially without the possibility of exchange rate changes that have been ruled out by membership of the eurozone. They are already facing a hard time from financial markets that have forced up bond yields and created a drought of credit to borrowers in these countries. And so those holding such debt are inevitably at some risk of a fall in the value of their assets.

The countries most deeply in the hole at the moment are, of course, Greece and Spain. Chart 2 shows that French and German banks together account for more than half of Greek debt (including both public and private debt).

In Spain, the proportion is less but the amounts involved are significantly more. While the government bond market is the focus of the current crisis, and the talk is all about the possibility of sovereign default, in fact the lending of banks to these countries is dominated by private debt. Lending to governments accounts for less than one-fifth of the total exposure of banks to these countries.

But the problem is this: the more the financial markets hammer the government bond markets, the more this governments of Greece and Spain are forced to announce and try to implement severe austerity packages that entail large cuts in public expenditure with adverse effects on employment and output. The multiplier effects of these moves are obviously negative, and so the economy tanks. This makes it much harder for all the private borrowers large and small firms, household enterprises, individuals who have taken credit to buy homes or purchase consumer durables, credit card holders, and so on to repay their debt, because their incomes also collapse. So the economy gets into a vicious downward spiral, in which even previously solvent and liquid borrowers become progressively less liquid and end in insolvency.

This is part of the bust phase of a classic credit cycle. The difference here is that it is being helped along by governments who seem to be powerless to confront the workings of private bond markets.

The European Union is 53 years old now (dating from the Treaty of Rome in 1957). This is about the right time, some commentators have suggested, to have a mid-life crisis. There are many expressions of such a crisis, which are likely to become more and more evident in the near future. The earlier aims of the European project, such as peace and unity, may well be forgotten when the Union does not appear to be able to deliver the promised prosperity to all its citizens.

Social model undermined

It is startling that this voluntary subservience to international finance, which could so easily be put in its place if the governments concerned really wanted it, is instead being used to undermine and possibly even destroy the much-vaunted social model that was such a cornerstone of European economic and social policy for several generations.

It is possible that what is being presented as a crisis of currency and bond markets is really class struggle by other means, part of the vicious drive by large capital in both finance and industry to secure an ever-larger share of the distribution of national incomes. Of course, it is yet to be seen how all this will unfold.

If the acceptance of interdependence does not lead to a greater drive for fiscal integration and transfers from stronger to weaker segments, as well as a focus on wage-led growth in the entire region, the eurozone may well disintegrate because the conflicting pressures simply become impossible to contain.