The Eurozone is teetering in the edge of a collapse. The massive economic costs caused by the coronavirus outbreak and the draconian measures needed to contain it are pillaging the world economy. However, they will deliver their worst hit on the Eurozone.
This is for the simple reason that the Eurozone has become extremely fragile. The monetary union and banking sector have been mishandled for years. This, not the Covid-19 outbreak, is the true reason, why we are on the edge of a collapse.
But, how did we get here?
The failed clean-up
During the Great Financial Crisis (GFC), only a few European banks were allowed to fail, which were mostly concentrated to one country: Iceland. In total, 114 European banks received government support during the crisis.
The banks were also allowed to carry non-performing loans and assets on their balance sheet. This meant that:
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1) Banks held defaulted loans on their balance sheets, instead of writing them off and recapitalising.
2) Assets (like mortgage-backed CDOs) that had lost most or all of their value could be held on the balance sheet based on their “nominal value”, that is, their purchase price.
In practice, the balance sheet of the European banking sector was divided into three layers. The first included the good assets, held “mark-to-market”, meaning that their value was based on actual daily market quotes. The second layer included assets that had lost value, but which the banks could pretend had not. The third layer, “the dark pit”, included assets that were nearly or totally worthless, but are nonetheless held on bank books as if they still had some value.
Using traditional accounting, a large part of the European banking sector has probably been insolvent for the past 10 years.
Bailing out the banks, through Greece
The fate of the Eurozone was most-likely sealed in the summer of 2011, when the second Greek rescue package was accepted by European leaders. The first package, issued in 2010, had been used, in essence, to recapitalise German and France banks through “loans” to Greece. Banks had lent heavily to Greece and its looming default threatened to topple some of them.
Threatened by this unpleasant scenario, and a possible partial collapse of the Eurozone, European leaders superseded Article 125 of the Treaty of the Functioning of the European Union (TFEU) forbidding mutual fiscal responsibility. They issued bilateral loans and established the European Stability Facility, which later turned into the European Stability Mechanism (ESM). Eurozone governments guaranteed the bonds these facilities issued, which were used to finance the ailing governments of the Eurozone.
In the summer of 2011, Greece was again on the edge of a collapse. The majority of banks had reduced or eliminated their exposure to Greek debt, however. A possible Greek default now only threatened the stability of the euro, which would have, in turn, likely precipitated a banking crisis. Yet, this would have fixed most of the problems of the Eurozone.
In 2011, the balance sheet of the ECB was nearly empty, political cohesion supporting the euro was strong, and the world economy was growing relatively fast. The ECB could have used programmes such as the Outright Monetary Transactions (OMT) programme to stop the spread of the panic to sovereign bond markets of other weak member countries.
If European leaders had let Greece fail and the banking crisis had run its course in 2011/2012, weak banks would have been wound down or recapitalised. We would have had a crisis and recession, but the Eurozone would have emerged stronger. The no-bailout rule would have been enforced and our banking sector would have been cleaned up.
None of this happened, and then things got really bad.
The ECB policy of “zombification” and banking sector decimation
When the ECB launched its OMT programme, two things happened. While the OMT programme helped banks by increasing the market values of Eurozone government bonds they were holding, it helped to sustain ailing banks.
Weak banks, in an effort to guard against further losses, engaged in lending to weak or even insolvent, or “zombie” corporations. Moreover, corporations that received these loans did not use them to invest or to employ, but to build cash reserves.
This meant that, while banks were cutting back on lending, the share of lending to zombie corporations increased. Creditworthy firms suffered greatly from this misallocation of credit further hurting the Eurozone economy.
Banks make the majority of their profits from the interest rate differential between lending and borrowing (deposit taking). However, when a central bank drops rates to negative, which occurred in the Eurozone in June 2014, banks need to pay interest on their central bank reserves. But, they are usually not relieved of the obligation to pay interest on customer deposits, who tend to be reluctant to pay interest on money they place at a bank.
This seriously hurts their profit margins, and when the profit margins of banks are squeezed, they start to cut back on lending, which further damages the profitability of banks. Moreover, because low and negative interest rate policies hurt the profitability of banks, they tend to target non-profitable firms, or “zombies”, in their lending practices to avert any further losses.
The European banking sector = monetary union is done
The fact is that the European banking sector is ready to “catch fire”, at any time. There’s just no way that our weak banking sector can handle the massive losses that the coronavirus will inflict to our “zombified” corporate sector.
This naturally should concern the whole world, as Europe holds the largest concentration of global systemically important banks. The exit and default of Italy would be very likely to set in motion a process leading to both collapse of the European currency bloc and the global banking sector.
We are playing with fire.
Tuomas Malinen is Chief Economist of GnS Economics.