Europe’s debt crisis is getting worse

Allister Heath
EMPIRES seem to be going out of fashion. It is not just News Corp, Rupert Murdoch’s media colossus, which is in trouble; the Eurozone, a very different political conglomerate, is unravelling in front of our eyes. The next step in its demise will come when the results of the stress tests for Europe’s 91 largest banks are announced this evening at 5pm. They will show that several continental institutions would be incapable of surviving a crisis – even though, absurdly, the tests don’t even acknowledge the possibility of any country defaulting. There is a decent chance that the Eurozone could be plunged into turmoil on Monday. If so, London will be affected, even though UK institutions are much more robust. It won’t entirely be a case of déjà vu, however.

The crisis of 2008-09 erupted when vast amounts of loans lost much of their value; the financial system suddenly faced massive losses. The weaker banks lost too much capital, forcing them into insolvency (and bailouts); others faced a liquidity crisis as financial markets stopped working.

Institutions have since been increasing their capital reserves and focusing on more liquid assets. The idea is to make sure they are more resilient to what jargon-loving economists call the next “credit event” – in other words, the next time a large amount of debt goes bad in one go. Many people still don’t realise that such a catastrophe could well already be upon us: this time, it is not mortgages and covenant-light corporate debt that is the problem but loans to several Eurozone governments. Toxic governments and their junk debt are the new systemic threat. But even though financial institutions and regulators are better prepared this time around, the crisis of 2011-13, as it may end up being called, could still inflict massive devastation.

This is not just about banks: insurance companies, pension funds and all other kinds of institutions own government debt. In many cases, they have no choice: laws stipulate that they must. Greek banks are forced to own Greek government debt; the usual assumption is that the debt of strong governments is risk-free, and because Greece became a member of the euro it was preposterously assumed that it had taken on all the prudent characteristics of Germany.

When financial institutions lent money to countries such as Greece, Portugal and the other weaker EU nations, they were actually entrusting their money to sub-prime borrowers masquerading as high-quality sovereigns. Too many people believed the propaganda spewed by supporters of ever-closer European political integration. It is always thus: the majority of folk invariably convince themselves that the world has changed when in fact the basic rules of life, economics and human nature never do.

The numbers are big. As of this May, Eurozone banks had made loans to Eurozone governments of €1.156 trillion and held securities issued by them of €1.442.7 trillion, while their capital and reserves totalled €2.118.8 trillion, says International Monetary Research. The problem is that the system as a whole would be in deep trouble if the losses on Eurozone government bonds end up higher than €500bn. And of course such losses would hit different institutions in very different ways: many would not be able to survive even a much smaller overall loss. This is going to be a long weekend. Let’s hope it is a false alarm.
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