The Europe of Broken Dreams, Part 3: Baffling Borrowings4th February 2013

The news from Europe continues to escalate. Funny how things were so quiet just a few weeks ago, but such is the calm before the storm.

Over the last week we have more news from Spain. Their parliament is seeking to peel back regional business rules, under which the country’s 17 autonomous regions all have their own business regulations and permits. Want to start a business? You have to wait for all the permits! Want to become an interior designer? That’s a regulated profession![1]

Meanwhile, the news from Spain hits home in the Netherlands, which a few days ago nationalized SNS Reaal following heavy losses on its Spanish property lending. The state has committed €3.7bn, and is now the proud owner of two of the four large Dutch banks. And what do you think was their next move? To raise a special levy of €1bn on Dutch banks to “help” the financial sector! There is nothing like kicking them when they are down to play well with the electorate, but how this makes either the banks or the deposits of the electorate any safer is hard to fathom.

In France, the Labour Minister let the cat out of the bag. In a radio interview he reportedly said “There is a state but it is a totally bankrupt state”. The Finance Minister described the comment as “inappropriate”, but I wonder who is closer to the truth? A few commentators cruely quipped that at least the war in Mali will raise France’s GDP. But spending on bombs certainly won’t cut their borrowings, and FYI blog readers already know that GDP is a nonsensical measure for assessing the affordability of debt.[2]

So where does this leave us? From Part 1 of this Europe of Broken Dreams series (here) we know that banks create money. From Part 2 (here) we know that banks can grow, by creating this electronic money, and leveraging themselves to the hilt, with even the IMF suggesting that European bank leverage was 26:1, that’s €4 of capital to support over €100 of lending.

Back to leverage …

Back in 2011 I listened to James Ferguson, one of Moneyweek’s great commentators, share research that UK banks had already written off or provided for 6% of their risky assets, whereas 10% was the norm for a single country crisis, 15% for the Nordic crisis, and over 20% was experienced in Japan. I’m not sure how he defined “risky assets”, but clearly a bank’s capital is capable of being wiped out many times in an international crisis.

So when a bank is nationalized, lets not pretend that the state is now at risk for replacing the bank’s lost capital. The reality is that the capital will probably need replacing many times over, especially now that regulators are requiring the banks to hold more capital in the future. Which starts to make the idea of letting them go bust in the first place not so silly after all.

But our leaders decided to save them. Why?

The state entwined …

In Part 2 we started to explore the symbiotic relationship that the state has with its banks. For instance deposit guarantees have served to tie the banks and the state together, but actually made the banks less safe. The new regulatory demands for extra capital, when banks face no possibility of raising more from shareholders, has reduced their lending capacity to individuals and businesses. This is bad enough for starters.

If a state had wanted to calm growth in lending (which as we have seen is the creation of money by banks), all it had to do was to ask the central bank to tighten. A central bank would normally achieve this by adjusting the level of, or raising the price of bank reserves, reserves that are held at the central bank to provide the liquidity between banks in settling their affairs, and their imposed safety margins.

But surely we can’t pin that on the state? Well, over the past 15 years we have heard a lot of nonsense about the independence of the Bank of England. But if the Chancellor appoints the Governor, and the Chancellor is told that his job is to target a particular measure of inflation at a particular level, which the Chancellor can change at any time, and the Governor reports to the Chancellor if he fails, that really isn’t independence. It sounds more like a master/servant relationship to me.

The fact is that expansion of the banks suited the state very nicely, and this is the case in the US, the UK and Europe, in fact any state borrowing to balance its books, because through the banks the state issues its increasing debts to spend on an apparently grateful public.

State debt …

If a bank isn’t pushing against its leverage ceiling, or even if it is, it can buy a government bond. This government bond doesn’t count towards its risk calculations, because the regulators claim, encourage and permit that it is “risk free”. That’s quite tempting, because if a bank can create new electronic money by lending, and charge interest to the government, why not do it again, and again, and again, and whilst we’re about it lets do it for much larger sums of money, again, and again, and again. If that seems a bit like printing profits, it is.

Better not ask who ends up paying that interest, because it’ll only make you angry.

What is more, if a bank runs into a spot of bother and need some liquidity, it can take this government bond to the central bank, and lodge it as security. So if things get really bad, why not create some more electronic money to buy “risk free” government bonds, lodge them with the central bank, and hey presto, problem solved!

Because states create very little money, having handed that task over to the banks, they need the banks to buy government debt. In the US banks some banks are even compulsorily required to bid at government bond auctions, and one of those is Barclays.

States bailing out banks, who bail out the states, who bail out the banks, who …

In Europe the last few years have seen the farcical situation of banks being bailed out by governments, who then buy the government bonds that were issued to bail them out. Just as described above. As we all know from childhood, running around in circles like this much makes you dizzy, and eventually you are likely to fall over. I’ve referred to “carousel” or merry-go-round economics before. This is it.

The regulators still insist that it is OK, because Government debt is “risk free”. But the whole process serves to increase the banks’ leverage, which is where the problem started. So far from purging the system, the bailouts and state deficits are worsening the situation.

How it ends up going wrong …

So what happens when a state cannot repay its debt? States can and do go bust at an average rate of one a year. Both Brazil and Russia have defaulted quite recently, and their economies are much larger than many European states. Greece has already defaulted on large portions of its debts, not just on the interest but on the capital. But of course the “default” word isn’t used in polite political circles.In Europe we have seen a series of crisis meetings from politicians which appear to be mostly for show, and the next one will be no different.

The place to watch for real action is the European Central Bank. The ECB has launched numerous schemes, kicking off with LTRO 1 and LTRO 2, which provided liquidity to the banks, although when depositors found out they assumed the named banks were in peril and either withdrew their money or demanded higher rates, imperiling the banks even more, and turning a liquidity crisis into a major solvency crisis.

We now have numerous European solvency bailout funds, the largest of which are the EFSM, EFSF (comprising mostly borrowed money!) and the ESM, directing money to Greece, Ireland, Portugal and Spain. The latest, the ESM, has 19% of its funding coming from, yes, you’ve guessed it, Greece, Ireland, Portugal and Spain!

Thank heavens for Germany. But Germany alone cannot carry Europe, and its own debts and unfunded commitments are also very high, although for the moment it can service these. What Germany cannot afford, having helped out others so far, is more defaults.

So the ECB has promised “unlimited firepower” to buy-up government bonds. Why it should risk its own solvency by buying these bonds is alien to me. Remember these are the bonds that have been issued to bail out the insolvent banks, who have bailed out the insolvent governments. It aims to control its risk by imposing strict conditions on budgets and austerity criteria, although we have already seen in Greece that austerity begets more austerity which begets more austerity.

But this “unlimited firepower” comes with “conditions”. Will countries be willing to sign up to those conditions? Or will they prefer to default? The time is fast approaching when we will know the answer to this question.

We’ll explore the ramifications next week.

[1] I find this incredible. I had no idea that choosing wallpaper required exams. My own choice for my study is a nice Osborne & Little number (a wallpaper firm founded by the father of our very own George Osborne, Chancellor of the Exchequer – a position for which qualifications are not required).