Sovereign debt crisis going from bad to worse

The eurozone continues to keep us in suspense in the wake of the French elections, and pending the second Greek election in as many months, the underlying financial deterioration is accelerating. Funds are being withdrawn from banks in troubled countries, rapidly depleting their capital. At the same time collateral held against loans is often over-valued, so write-offs that should have been taken have not. The predictable result is a developing run on both individual banks and whole national banking systems.

It should be noted that there are two reasons depositors are fleeing banks: fear that the bank itself is insolvent, and fear that the relevant government might impose restrictions on the movement of money. Fear of bank insolvency is driving funds out of Spanish banks, while fear of government restrictions is driving funds out of Greek banks. To deal with these problems they must be recognised as distinct and different.

A potential banking crisis, as that faced by Spain, requires two further considerations. The first, of providing liquidity, has been addressed by the European Central Bank through its long-term refinancing operation (LTRO); but this is a stop-gap measure and requires the second consideration to be addressed: the reorganisation and recapitalisation of the banks. And here, the cost for Spain is impossible to meet at a time when she faces a combination of deteriorating government finances and escalating borrowing costs.

Greece’s difficulties are even greater, given that depositors are trying to discount the possibility she may leave the euro entirely and introduce exchange controls to manage a new drachma. The virtually unanimous consensus among Keynesians and monetarists is that such a move is both inevitable and desirable, but public opinion in Greece is increasingly in favour of sticking with the euro. Call it the difference between macro-economic theorising and on-the-ground micro-economic reality. For the fact of the matter is that neoclassical solutions that rely on devaluation as an economic remedy provide only temporary relief at best at greater eventual cost, and exiting the euro is neither a legal nor a practical option.

That is the monetary reality behind the eurozone’s crisis. The solution is not to ease the pressures on governments to address their excessive spending: if anything this pressure needs to be intensified, a point well made in a recent Cobden Centre article by Jesús Huerta de Soto. And the idea that more money should be made available for profligate governments through multi-government sponsored bond issues should be firmly rebutted. The banks, which should be allowed to fold, should be removed from the system in a controlled manner, that is to say that the ECB and the national central banks must devise a solution, perhaps a good bank/bad bank division, to give depositors sufficient confidence to keep their funds in the system.

Unfortunately, the political tide is running strongly against this two-pronged approach, with the developing rebellion against “austerity” from all European politicians, and the Keynesian and monetarist pressures from everyone else to reflate increasing. The chances of the ECB properly ring-fencing funds to deal with the banks and stopping them being used to prop up eurozone governments are becoming more remote by the day.

This article was previously published at