Stock markets have staged huge rallies since late last week on hopes that France and Germany were close to working out a deal that would finally put the euro crisis behind us. But this morning European stocks are once again down as the euphoria wears off.
Some of last week’s optimism was justified, since at least both Germany and France are now talking openly about the need to recapitalize European banks. Until last week the French were still lying through their teeth, pretending that their banks were just fine, thank you. More than any other factor, the spectacle of the second most important EU country living in denial and delivering unconvincing lies to investors who know that French banks are in deep, deep trouble undermined the world’s confidence in Europe’s ability and desire to do something about the fire in its kitchen before the whole house burns down.
The announcement by Angela Merkel and Nicolas Sarkozy that the Germans and the French would present a joint plan to recapitalize European banks by the end of October came as an enormous relief. The most powerful leaders in Europe had recognized that they had a problem, and were committed to doing something about it.
Unfortunately, the situation is still complex. The gap between the German and French positions on how to rescue the banks remains wide. We are by no means out of the woods, and it is not unlikely that fresh waves of giddy horror will sweep through the world’s markets in the coming weeks as the Europeans struggle with a crisis that, according to remarks by outgoing ECB head Jean-Claude Trichet, has worsened. As Trichet puts it, the crisis is now “systemic” and involves the credibility of key governments. It isn’t a banking crisis or a debt crisis anymore, and it is not about a handful of weak economies. It is a crisis of the eurozone and there is no telling how it will end.
The depth of the chasm between the French and German positions on the bank bailout suggests that yet again the Europeans will struggle to come up with a common program — and that the new program, like every other agreement they have reached in more than a year of gradual meltdown, will fall well short of solving the underlying problems. Germany and France appear to agree that the banks are the problem — but they have almost totally opposite views on what to do about it.
Chancellor Merkel has, I think, turned an important corner — or realized that German public opinion has now turned one. Public concern about the German banking sector is now acute enough that it is politically easier for her to arrange to bail out German banks than to drum up support for new funding for the PIIGS. Flinty German taxpayers hate to throw money away, but if throw they must, better to save the German banks in which the taxpayers keep their savings.
Rather than pushing hugely unpopular bailouts of lazy Latin and Mediterranean foreigners through a restive Bundestag, Merkel thinks it is better to dedicate any new bailout spending to rescues of innocent German banks. Instead of using taxpayer money to prevent defaults in Greece and elsewhere, use taxpayer money to insulate German banks (and their depositors) from the consequences of the defaults and “haircuts” when they come.
This is the good news underlying last week’s market rallies: the German political establishment seems to have figured out a way to pry much more money out of German taxpayers to prevent a total European meltdown. Germany can and, it now looks like, will, put any amount that is necessary into the banks to make sure the German banking system doesn’t do a Titanic impression.
Let defaults happen, make the banks take large haircuts when they do, and then bailout the banks. From a German point of view, this is a workable and sensible plan. Defaulting will allow Greeks and perhaps others to shorten the painful austerity and begin to escape recession while staying in the euro; the”haircuts” satisfy the German urge to punish the wicked and discipline the private sector; the bank bailouts will prevent the consequences of Club Med defaults from destroying the European financial system. At the same time, this approach limits the need to rely on politically toxic country bailouts; Germans do not want to send their hard earned money to bail out “thieving, lazy” Greeks. The EFSF does not have to be increased, but Europe can still be saved. Merkel and her colleagues have found a creative way to match the preferences of German voters with the needs of the European financial system. Well done, but now comes the hard part.
The French approach is very different. It appears that one of the principal reasons (if not the only reason) for France’s new willingness to discuss the parlous state of its banks is French hunger to get its hands on some of the €440 million of EFSF money that was slated to help weak European countries through the crisis. If France is going to have to pump tens of billions of euros (if not more) into its banks, the French reasoning goes, why not use other peoples’ money? Why should the French government pour French resources into French banks when it can dip into a common European fund? Unfortunately this may not just be greed and reflexive French cleverness at work; it may also reflect the weakness of French government finance.
The logic of the German approach is that the debts of troubled governments should be aggressively restructured, with the banks in the lending countries taking the resulting hit. If Greek debt is written down by 50 percent or more, the value of the Greek bonds held by banks falls as well; those losses undercut the amount of capital the bank has to back up its other loans. The German plan would be that every country would then recapitalize its own banks.
The Germans think the best way forward is to reduce the value that the bondholders get from Greek and perhaps some other debt; already we have gone from the 21 percent “haircut” envisioned last summer to a 50 percent haircut today. The bigger the haircut, the bigger the problem for the banks who have to write down the value of their bond portfolios to reflect the diminished, post haircut value of the PIIGS’ government bonds. But the bigger the haircut, the faster the peripheral countries can emerge from savage austerity programs, and the more likely it is that they can return to financial markets in the near to medium term.
The French banks are more dangerously exposed to the PIIGS than the Germans are, it appears. Worse, the French government may not have enough money to rescue its banks without losing its Triple A credit rating — and perhaps facing a debt and credit crisis of its own. The logic of the French position is that “haircuts” must be small, and the EFSF bailout fund should be large. This goes against the German view that haircuts should be large and the EFSF fund should not be increased.
Underneath all this is the ugly reality that the French are not sure that they can get through this crisis without money from Germany — and that the Germans think they have their hands full already. The Germans have come up with a plan that substitutes domestic bailouts of troubled banks for international bailouts of troubled governments; the French are looking for a plan that substitutes international bank bailouts for domestic ones.
This is not a good match and the very different priorities of the two plans suggest that the French and the Germans will have a hard time coming up with a common approach. But that isn’t the biggest problem Europe is facing. The biggest problem is the possibility that the crisis is moving north to France. The need to fling tens of billions of euros into the banking system could cut France’s credit rating, increasing the size of the interest payments it must make on its large national debt. That in turn would cut France’s creditworthiness even farther, driving the interest rates up yet again. This is the same disabling spiral that has thrown one euro country after another into crisis; if France goes, there is nothing left to defend.
Is the European financial crisis so severe that France can’t ride out the storm without help from Germany? The French are behaving in ways that suggest that they are worried; if this is true, then politically and economically this crisis is just getting started. Germany can protect itself from meltdowns in Greece, Portugal, Spain and even Italy; France is something else again.