Europe ignores credit dynamics

Europe's rule-based approach to fiscal reform will fall short because it effectively ignores the dynamics of credit markets, which laid the tracks along which this train wreck traveled.

Europe moved last week to impose some discipline on its member states' fiscal houses, choosing a rule-based fudge rather than the fiscal union that a common currency probably ultimately needs. It will thus take discretion away from member states, pre-committing them to austerity measures during tough times, while doing very little to address the malfunctions in the banking system which create destructive credit bubbles in the first place.

Reforming Europe's fiscal framework without addressing the financial system which created all of the credit is like having alcoholics take ever more severe pledges of sobriety and penalties but still allowing them to own cocktail lounges.

To be sure, some sort of reform is welcome. The past decade has provided ample evidence that the previous framework was easy to game for states without sufficient discipline.

That said, while the shambolic arrangements of the euro zone have hamstrung attempts to react to the crisis, the means by which euro zone states got themselves into trouble are varied.

There is, however, one common denominator - a credit bubble was a necessary precondition to the borrowing which now leaves various European sovereign borrowers suspect.

This is as true of Ireland as it is of Greece. It is also true of France and may someday be true of Germany, if the current stream of policy thought is brought to its logical conclusion.

Ireland suffered a collapse in sovereign credit-worthiness because its banks engaged in a Ponzi-fest of lending, both to their domestic clients and to borrowers abroad. Ireland was brought low by assuming, effectively, the credit risk for Irish banks, while a policy of austerity has combined with the natural fallout of a credit bust to crater tax receipts, further undermining the state's ability to service its debts.

Something not too dissimilar happened in Spain with housing-related credit but not on the same scale and, so far, without an outright banking crisis. There too a credit bubble floated the economy, flattered tax receipts and put off the reckoning Spain is now undergoing.

Greece too fattened at the trough of the credit bubble, using easy global credit to allow it to finance profligate government spending, despite endemic tax fraud and corruption. You have to note here too that if a state fabricates its economic statistics no number of new rules or treaty revisions will work. Greece's problem wasn't simply that it could borrow at German-like rates while being an old-fashioned emerging market, it was that it was doing so in the midst of probably the biggest global credit bubble ever.


And then we come to France, and its banks. Investors are now demanding more than a percent extra in interest to hold French bonds compared to German ones, in large part because France is the obvious bag-holder should its horrifically over-leveraged banks come undone. And yes, those banks have created credit and bestowed some of it on France itself, and much of it on doubtful borrowers further south, thus piling leverage upon leverage.

This seems to be a real blind spot in European - really in global - policy making. It is instructive to note that the European Central Bank has focused most of its ire on sovereign borrowers, which it refuses to coddle with direct purchases of government debt, while at the same time taking ever more extreme steps to keep banks alive with generous financing.

Last week the ECB came out with a host of liquidity provisions aimed at banks, including new long-term funding options, a relaxing of collateral rules and allowing national central banks to finance certain bank loans. Of course some of this liquidity will simply find its way back into sovereign debt, or at least many European states must hope so.

As far as Europe's reform of its banks goes, most of the effort is expended on making banks solvent, without effective measures to short-circuit the next credit bubble. That bubble will only happen after an almighty credit bust, which is now on its way as banks pull back from lending and seek to dispose of assets.

Looking through the coming recession and credit crunch, the excessive co-dependence of states and their banking systems looks likely to continue. There are no convincing measures under discussion in either Europe or the U.S. to break the too-big-to-fail guarantees, and so long as financial institutions are run for private profit while benefiting from a public guarantee the risk is the formation of another credit bubble.

Maybe next time it won't be excessive government borrowing. It doesn't need to be. The financial system will create the money, and governments will foot the bill for the instability that ultimately follows.

States must break the state/bank co-dependency or ultimately the banks will, perhaps literally, break the states.

[Source: By James Saft, Reuters columnist, London, 13Dec11]

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