Eurocrisis Redux

Entangling alliances or entangling leagues are nothing to the entanglements of cash owing—Keynes

The recent BIS Quarterly Review article “European Bank Funding and Deleveraging” takes a stab at connecting all the dots in the Eurocrisis. It is only 12 pages, but with 8 (triple) graphs, there is a lot here to digest. Let’s take a stab.

In the FT gloss of the argument, the whole crisis was caused by the BIS itself, in the form of Basel III requirements to boost bank capital, or rather by the European Banking Authority which more or less endorsed the BIS requirements last October. Here is the origin of the stress.

There were only two ways for banks to meet the new requirements, raise their capital levels to meet the size of their balance sheets, or shrink their balance sheets to meet the size of their capital. The prospect of the latter is what unsettled markets and valuations, since necessitous sellers sell what they can sell, never mind fundamental value. Distortion of asset valuations (even mere prospective distortion) then undermined bank balance sheets, so undermining their ability to fund themselves, in euros but especially in dollars. Capital markets were effectively closed (at any reasonable price) but so were funding markets, and liquidity kills you quick.

From this perspective, the important thing about the LTRO operations of the ECB was that they stopped the downward liquidity spiral by providing the funding that banks needed. The hope now is that, having put aside immediate funding problems, banks can proceed in a more orderly way to raise capital, either in equity markets or more slowly by retained earnings. Maybe so, but maybe not.

Today, Paul de Grauwe connects the dots in a different way. The fundamental problem, according to him, is not bank capital requirements but rather sovereign debt, which threatened to become a bank crisis because banks held so much sovereign debt. ECB intervention does very little to settle the underlying debt markets, or to restore reasonable valuations, since there is no guarantee that banks will use the LTRO funds themselves to support sovereign debt markets. Indeed, nothing prevents a new round of selling, and what will the ECB do then? Even worse, austerity measures now worsen the fiscal prospects for Europe, and so further undermine bond values.

Myself, I am reminded of the words of John Maynard Keynes, in his Economic Consequences of the Peace, written in aftermath of World War I and the disastrous Treaty at Versailles:

The final consideration influencing the reader’s attitude to this proposal must, however, depend on his view as to the future place in the world’s progress of the vast paper entanglements which are our legacy from war finance both at home and abroad. The war has ended with every one owing every one else immense sums of money. Germany owes a large sum to the Allies, the Allies owe a large sum to Great Britain, and Great Britain owes a large sum to the United States. The holders of war loan in every country are owed a large sum by the State, and the State in its turn is owed a large sum by these and other taxpayers. The whole position is in the highest degree artificial, misleading, and vexatious. We shall never be able to move again, unless we can free our limbs from these paper shackles.

Read the BIS report with this quote in your head, and the graphs tell a different story. Financial globalization has ended with every one owing every one else immense sums of money. That is the big picture, and European bank deleveraging, as well as the European sovereign debt crisis, need to be understood as symptoms of this larger disease.

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