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Johnson: Euro’s Appeal Masks the Gathering Storm
Is the economic and financial situation in Western Europe largely under control, as many prominent Europeans contend? Or is it poised to move into a new and more difficult phase?
The crisis feels unreal to some people in the same way that war felt phony to some Britons from September 1939 through spring 1940. In contrast to previous crises in emerging markets, Europe hasn’t moved precipitously toward collapse. But the main element that lets the European crisis unfold in slow motion -- the existence and appeal of the euro -- also explains why a great deal of volatility lies ahead. The storm is gathering.
In a classic emerging markets crisis -- Asia in 1997-98 or Latin America many times in the past -- there is a loss of confidence in the ability of local borrowers to repay their foreign creditors. Many debts are denominated in foreign currencies and, as confidence declines, the exchange rate drops, making debt payments that much harder. If interest rates are raised in an attempt to stabilize the currency, the borrower’s burden increases. If companies default, the solvency of local banks and governments becomes a concern. The resulting rush for the financial exits tramples on a great deal of wealth, and many ordinary citizens suffer disproportionately.
The big difference with the European situation today is the euro. As the world’s No. 2 reserve currency after the dollar, euro assets are in demand by investors around the world. This means that almost all euro-zone corporate, household and government borrowing is in euros, making the classic downward emerging market spiral unlikely.
If the euro depreciates, debt burdens don’t increase. In fact, euro depreciation mostly helps the real economy by increasing exports and making it easier to compete against imports.
But a run is still possible within the euro area. If you have a euro deposit in a Greek, Spanish or Italian bank, you can transfer the funds to a German or other bank. A euro is a euro; with some small transaction costs, you can move money to whichever part of the euro zone is more convenient or seems safe on any given day.
This doesn’t happen in the U.S. Even if you were convinced that a state was about to suffer a severe financial disruption, deposits would still be backed at the federal level. Runs in the U.S. can occur, of course: In the fall of 2008, there was a run out of money market mutual funds and away from the likes of Goldman Sachs Group Inc. and Morgan Stanley. But these were moves out of broad asset classes or away from specific institutions.
In Europe, any run would be within the euro zone and across banks, not out of the euro or away from a pan-European asset class. It would be running uphill to escape whatever flood one imagines is coming to a particular country or bank.
The shift now taking place in euro balances toward more Germanic areas -- besides Germany, this includes the Netherlands and Luxembourg, among others -- wouldn’t be a problem if the banks receiving funds were willing to hold the same portfolio of assets in peripheral countries as the banks that are losing deposits. But they aren’t.
In addition to the lack of full financial integration -- meaning that German banks are, almost by definition, not as present in Italy as are Italian banks -- the unfortunate system of risk weights under Basel II plays a compounding role by encouraging European banks to lend excessively to local governments, making conditions ripe for this specific kind of run.
The most important fallacy within the Basel framework is that AAA-rated securities and sovereign debt (when less than AAA) are regarded as zero-risk. In most instances, banks have the lowest risk weight on debt issued by their own government -- Greek bank lending to the Greek government, Italian bank lending to the Italian government, and so on. (For more background on capital regulation and Basel in general, see this excellent paper by Martin Hellwig.)
An example, and one that deliberately avoids some of the more precarious financial institutions, is the balance sheet of the Belgian group Dexia SA. (Here is the news release of second- quarter results; start on page 11.) On June 30, Dexia had total assets of just over 517 billion euros. But its total weighted risks -- assets that regulators say must have a cushion of capital underpinning them -- amounted to only 127 billion euros. Does Dexia have a lot of debt relative to equity? If we evaluate the balance sheet as we would for any nonfinancial company, the answer is an unambiguous yes: Assets are 74.5 times total shareholders’ equity.
Yet according to the Basel II agreement -- and reinforced by the new Basel III deal that bank regulators negotiated last year -- Dexia is a well-capitalized bank because so many of its assets are regarded as essentially riskless. This logic assumes that the weights correctly assess government debt as having precisely no risk of default or loss of value. Even a 1 percent fall in the value of its zero-risk assets would almost wipe out Dexia’s shareholder equity.
Under the risk-weighting system, we can safely presume Dexia holds a great deal of Belgian government debt. To be clear: Belgium does not have an immediate government solvency issue, although some flags have been raised. Dexia is just an example of how a flawed view of risk has created both macroeconomic vulnerability -- encouraging lending by local banks to weak economies like Greece and Portugal -- and the potential for disruptive bank runs within the euro zone.
Such runs will tighten the credit available to troubled sovereigns and tend to push up the interest rates at which they have to borrow.
As deposits flow from the troubled periphery to the Germanic core, there will naturally be a contraction in credit - - and growing concerns about liquidity of peripheral banks. Stress across the bank funding market can be counterbalanced only by European Central Bank loans. The ECB will increasingly be called upon to lend to governments that can no longer place debt easily with their own banks.
The loss of liquidity for both banks and governments is just a symptom of an underlying malaise. Too much moral hazard crept into the European financial system and the run-up in debts was unsustainable. As I argued in a recent Peterson Institute for International Economics policy paper, written with Peter Boone, a visiting fellow at the London School of Economics, Europe must choose between restructuring debts in a systematic fashion or issuing a great deal of money, increasing the moral hazard and possibly creating significant inflation.
So far this summer, European policy makers have headed further down the road to easing monetary conditions, while refusing to discuss the real causes of their situation with any degree of frankness. An anchor of global stability is beginning to slip.
(Simon Johnson is a Bloomberg View columnist. The opinions expressed are his own.)
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