European Solvency

This post significantly draws on George Soros, Michael Pettis, Martin Wolf.

Europe's banking crisis is a currency crisis, sovereign debt crisis, and a banking crisis.

At the heart of this crisis is the need to protect creditors.

As we look at the data, we see countries with contrasting fiscal narratives. Greece had its huge public deficit, Ireland a huge private deficit, Spain, with no deficits.

Following the formation of the Euro, perceived sovereign credit risk converged, such that Greece could borrow at very similar interest rates compared to Germany. The ECB treated all sovereign debt as riskless and accepted them at its discount window on equal terms.

Meanwhile, Germany sharply reduced relative unit labor costs following reunification. As such, a wide divergence in competition emerged in Europe between Germany and the peripherals. In Germany, low labor costs provided the edge to grow through trade surpluses. In the peripherals, the lower interest rates allowed them to finance growth through debt. The excess savings in Germany provided the credit channel.

Because extended credit was perceived as riskless in the case of sovereigns and banks, banks held too little capital against it. Thus, Europe has a solvency problem, not a liquidity problem.

Insolvency requires appropriating losses on liability holders (equity first, then debt). The largest creditors, or course, are German savers. A necessary restructuring will impose losses on the politically powerful Germans. This is why taxpayers are shouldering the cost of Irish and Greek debt.

In the meantime, the European Fiscal Stability Fund (EFSF) provides liquidity necessary to prevent contagion. The EFSF is in part a loss sharing mechanism, but more so it is a way to punish debtor nations. Paradoxically, Germany's economic competitiveness and savings are equally to blame.

This of course has happened before: Latam in 1980s. The model is to provide liquidity to problem debtors for long enough to recapitalize the financial sector (see appendix at the end), at which point bad debts will be restructured.

In the meantime, Europe is forced into slow growth and fast growth economies ("multi speed world says Pimco). The surplus/creditors build on their competitiveness and shift surpluses onto new trading partners. The deficit/debtor countries buckle under the weight of their debt, cannot devalue (Euro!), and cannot compete.

So to recap, Europe has a currency crisis: the single currency prevents adjustment and competition; a sovereign crisis: too much debt and not enough growth; and a banking crisis: under capitalized banks that cannot survive unless creditors are protected.

The current solution is to treat the problem as a liquidity crisis until the banking system is sufficiently rebuilt to restructure the debt. The result will be a two speed Europe and lower aggregate growth.

The alternative is to use EFSF to recapitalize the banks now, as Tarp did when it bought equity in banks, restructure debts now, force creditors to take losses as they should, and lay the seeds for future growth. In short, kick the can back up the road.

Appendix (this draws on John Hussman):
When the book value of equity of bank A falls below zero, the bank declares bankruptcy and the losses fall onto the creditors of the bank who also become the new equity holders. Repricing the liabilities as equity and/or raising new equity (recapitalization) forms a value creating institution.

The problem arises because the liabilities of bank A are also the ASSETS of bank B. The write off bank A's assets causes the book value of equity of Bank B to fall.

So if a large portion of German bank assets are the sovereign and bank debt of peripheral states, which should be restructured, that would imposes large losses on German financial system.

The sub optimal solution is to preserve the value of all the assets, temporarily, through excessive liquidity provisions for long enough for the banks retain earnings sufficient to absorb future losses. At that point, the bad debt can be sold at a loss without harming the capital position of the bank.

The optimal solution is to impose losses immediately while simultaneously recapitalizing the problem banks through "super equity" investments, ideally from the private sector.