Europe's inverted socialism

And most Northern Europeans also seem to believe that the bailouts have gone to lazy Southern Europeans. In fact, their purpose has been to shore up the fragile Northern European financial systems. German banks are among the weakest in Europe; some of them (especially the state-owned landesbanks) are effectively bankrupt. If they were forced to mark down their Southern European debt, they might well collapse in a heap, and the European financial system could grind to a halt. Just as in the United States, the real impact of the European bailout has been to shore up the continent’s banks – not to help the continent’s debtors. The recent downgrading of two of France’s most important banks, due to their holdings of Greek debt, reminds us of how exposed Northern Europe’s financial systems remain. And rumors of a recent IMF report that European banks are over $270 billion short of the capital they need to confront their current problems served to drive the point home.

- Jeffry Frieden, "Europe's Lehman moment"

Europe's financial problems have escalated to the point where a world-wide contagion has become again possible.  Economists and international leaders are sounding alarms that have rarely been spoken in unison, since the inception of the 2008 financial crisis.  Christine Lagarde, the managing director of the International Monetary Fund, said "We have entered into a dangerous phase of the crisis." Her words come at a point where the Greek debt crisis appears to be reaching its climax.  Moody's Investors Service downgraded two of France's top banks, Societe Generale and Credit Agricole, stating that it had concerns about the two banks funding and liquidity profiles, due to their exposure to Greek debt.  A recent analysis indicates that 43 large European banks hold debt in the PIIGS equivalent to 65% of the book value of those institutions. Gretchen Morgenson of the NY Times explains the current situation:

Some of these [European] banks are growing desperate for dollars. Fearing the worst, investors are pulling back, refusing to roll over the banks’ commercial paper, those short-term i.o.u.’s that are the lifeblood of commerce. Others are refusing to renew certificates of deposit. European banks need this money, in dollars, to extend loans to American companies and to pay their own debts.  

As a result several central banks have mounted a coordinated effort to inject US dollars into the financial system to stimulate market confidence.  The Guardian newspaper elaborates:

The Bank of England joined the US Federal Reserve, the European Central Bank, the Swiss National Bank and the Bank of Japan on Thursday to announce that they would flood money markets with dollars over the coming months.

Gus Faucher, director of macroeconomics at Moody's Analytics, states "The big question is: is this enough in the short term to get us to a longer term solution? There is a potential for a really huge financial crisis in Europe. Things are bad now, but they could get a lot worse."

Many observers are looking at the current European situation and seeing similarities between Lehman Brothers demise and the 2008 crisis.

Adding to the peril is that these banks are funded primarily by short-term investors, like buyers of commercial paper, rather than by depositors, as is more often the case with American banks. This was the same problem faced by Bear Stearns and Lehman Brothers, which collapsed after short-term lenders fled in panic.

Economist Barry Eichengreen says that, "The euro’s survival and, indeed, that of the European Union hang in the balance."  He says long term proposals on restructuring Europe's sovereign debts are not of immediate concern, rather the continent needs to act decisively in stabilizing its banks.  The European Financial Stabilty Facility (EFSF) and even the IMF should be used to re-capitalize Europe's weak banks.  The second move should be to give Greece sufficient room to maneuver by asking its creditors to relax its fiscal targets.  Third, governments need to end this futile dalliance with austerity and proceed with stimulus projects that would create real growth.  He states, "Without growth, tax revenues will remain stagnant, and the capacity to service debts will continue to erode. Social stability, similarly, depends on it."

Economist Paul Krugman at the beginning of this week had some serious words for European governments.  He states, "We’re not talking about a crisis that will unfold over a year or two; this thing could come apart in a matter of days. And if it does, the whole world will suffer"  Likewise, he is telling Europe to use the ECB to continue buying up Spanish and Italian debt to contain the risk of default. The moral argument for inaction or worst punishing Europe's peripheral nations and the Mediterranean nations of Spain and Italy, will drive the continent -if not the world- into another economic abyss.

The reality is Greece's debt problems have been growing and not diminishing over the past two years.  The country is not in any position today or in any foreseeable future to repay the totality of its debt.  Under the current regime imposed on the country, Simon Johnson a former IMF chief economist concludes that "The tax revenue needed to service [the Greek] debt would burden businesses and households for decades – enterprising and productive people will move their fortunes and their futures elsewhere in the euro area or to the United States." Throwing billions of dollars at the nation, only to prop up banks in the northern economies of Europe and hoping that the situation will be resolved at a later date, has now been shown to be an unfeasible and irresponsible position.  Europe needs to first stabilize its banking sector immediately and then proceed in an orderly default of Greece's debt. An unorderly default will plunge the entire Eurozone into chaos.  Spain and Italy will face unprecedented pressure, whereas the remaining nations of Portugal, Ireland, and Greece may well face economic collapse.