Whither Europe

The Never Ending Story of Europe’s Crisis, the Great Recession in the States and, before that, the Great Depression, all remind us of a basic fact: Capitalism is dependent first and foremost on the availability of Capital.

In 1933, with massive bank runs across the country, FDR declared a national bank holiday and the Federal Reserve committed to supply unlimited amounts of currency to banks. There was what amounted to a 100% backing of banks. When the banks, reopened, people stood in line redeposit their money and the bank runs were over. 2

During our most recent crisis, the coverage was of CDO’s, MBS’s, massive bubbles and greed, corruption and foolishness by lenders, borrowers and politicians. But, the moment that we came closest to turning a massive recession into a Depression to rival that in the ’30s was when overnight lending markets froze up. A long list of businesses are dependent on overnight lending markets. It’s the mechanism that many capital-intensive businesses use to finance operations. As an example, when a car dealer needs to buy inventory, they often use overnight lending to purchase inventory and then role those loans over for short periods as they sell that inventory. You can round up examples throughout the economy.

As the crisis deepened in late ’07, the key index on this type of lending (the Libor-OIS spread) went from single digits to 90 basis points. Borrowing costs went up ten fold. But, in the Fall of ’08, the situation went from bad to worse and credit markets freaked out and the Libor-OIS spread past 350 basis points.1

Lenders had no faith they’d be repaid. If you could borrow money, it cost you 35 times as much as before. It was so expensive that, by the time a car dealer sold the cars they’d financed, they didn’t make enough to cover what they paid for that car and the money they borrowed.

If you missed it, the basic common element is a kind of faith. If the people with money don’t think they’re going to get their money back, why should they let someone else use it? Those people want to know their money isn’t going to disappear. They lend their money to make money. Greed may or may not be good but it’s what motivates Investors to let other people use their money.

Available Capital for businesses doesn’t magically create economic growth or jobs. It’s just a necessary prerequisite. Joe’s New and Used Cars isn’t going to have cars to sell if he isn’t either already very very rich or can use someone else’s money, and do so cheaply enough that he can still make money on those cars after he pays for the money, his employees, building and so on.

Which brings us around to Europe. A big part of the problem in Europe is in their banking system. Countries in Europe, experienced a housing bubble that popped. High unemployment in certain Euro-zone countries, like Spain, added even more bad private sector debt to the books of European banks, cutting the amount of capital banks have available to loan.

Many of these banks have also been financing the debt of Europe countries. It’s become clear that Greece won’t collect the taxes that are owed, provides services completely out of line with its resources and keeps cooking the books to hide the mess. Other countries in Southern Europe had debt loads that were sustainable before the crash caused large drops in their tax revenues.

So now, the same European banking system is loaded with both bad private sector debt and bad public sector debt and the public knows it. The countries with the biggest banking problem are precisely those countries that are having problems borrowing the money. They are in no position to help their own banks. Europe as a whole has already funneled more funds to the banks. But, the banks have sat on the funds. Instead of being available, it sits.

Combine a banking system that’s broke with a Greek government that many people believe will pull out of the Euro and the public in Greece has lost all confidence in their banks. Money is pouring out of Greek banks.

But, whether Greece pulls out of the Euro in the short term or not, there’s a fundamental disconnect in Europe. Europe’s banks and markets are tied together by one currency but there’s no comparable structure in place to guarantee those banks. Next to that is a related issue: why should Germany in particular get on board with guaranteeing banks that are caught in the mess of structural problems that are Greece, Spain and Italy? Thus the demand for outside oversight of the Greek budget.

More and more, there only seem to be two scenarios on the table. The first is the collapse in part or in full of the common currency. That way lies decades of cleanup and (at least) a massive recession that will spread world-wide. The other path being discussed is a form of European Federalism. This would (at least short term) be a step or two short of the so-called United State of Europe but it would still centralize much of the authority on taxing, budgets and managing the European capital system in Brussels. European voters have repeatedly rejected the so called United States of Europe. They fear loosing their individual identities. Do they fear the dissolution of the common currency enough to develop the political will to move to Federalism?

And, if Europe does move that way, it does so by accepting joining the Americans in what we’ve been doing since 1970: socializing risk. You can’t have a single economic entity with hundreds of millions of people under free market capitalism and not socialize the risks in the financial systems, because the alternative is to watch that system and your economy collapse every recession or so.

Socializing risk has a cost. Some have calculated that the average systemic banking crisis cost 13% of GDP to clean up and resulted in a loss of 20% of GDP.3 But, there’s a little more to this puzzle. As one participant in a discussion on CBC’s ideas program a few days ago noted, European economic growth has steadily dropped over the course of the European Project. The current world economic model that marries capitalism to free markets has been working better in most people’s eyes than the long-gone Soviet-style command and control economic system. But issues like socialized risk, the requirement for indefinite growth and the problems we are seeing –the crisis in Europe, the systemic the stagnation in the U.S. and the developing strains in China– beg two questions: can the current model be fixed and is a better model possible?

1 Emergency Banking Act
2 Interbank Lending. Many people blame the spike directly on the US Government refusal to bail out Lehman brothers. There are other arguments. Why the credit markets blew up doesn’t matter for the basic point.
3 Bank runs

Note: all of the linked sources are Wikipedia. While I drew on many additional sources putting together this piece, Wikipedia’s articles in this are solid pieces that provide further links back to various sources. The fact that any group of three economists will have four opinions on a subject pretty much guarantees that, if you want to get a reasonably complete range of opinions that deeply covers the problems in Europe, you’re going to need to read more than a few pages.

Update: The story in Europe is changing so fast that this piece was drafted Saturday, went through a major rewrite (instead of a simple edit) before I posted it Sunday and the, this morning, news hit of the 100B Euro Rescue of Spanish Banks. Stock markets around the world spent the day going south. A few hours ago, the Wall Street Journal published an editorial by Chris Noyer (Governor of the Banque de France) advocating a milder version of the Fiscal Federalism I describe above.