[Michael Boskin] Time running out for Europe to choose on recovery

PALO ALTO ― Europe is suffering from simultaneous sovereign-debt, banking, and currency crises. Severe economic distress and political pressure are buffeting relationships among citizens, sovereign states, and supranational institutions such as the European Central Bank. Calls are rampant for surrendering fiscal sovereignty; for dramatic recapitalization of the financially vulnerable banking system; and/or for Greece and possibly other distressed eurozone members to quit the euro (or for establishing an interim two-tier monetary union).

In this combustible environment, policymakers are desperately using various vehicles ― including the ECB, the International Monetary Fund, and the European Financial Stability Facility ― in an attempt to stem the financial panic, contagion, and risk of recession. But are officials going about it in the right way?

The sovereign debt, banking, and euro crises are closely connected. Given their large, battered holdings of peripheral eurozone countries’ sovereign debt, many of Europe’s thinly capitalized banks would be insolvent if their assets were marked to market. Their deleveraging inhibits economic recovery. And the large fiscal adjustment necessary for Greece, Ireland, and Portugal, if not Italy and Spain, will be economically and socially disruptive. Default likely would be accompanied by severe economic contraction ― Argentina’s GDP fell 15 percent after it defaulted in 2002.

Despite stress tests, bailout funds, and continual meetings, a permanent workable fix has so far eluded European policymakers. Failure will erect a huge obstacle to European economic growth for years to come, and could threaten the survival of the euro itself. Disagreement among and between heads of state and the ECB over the Bank’s purchases of distressed sovereign debt have only added to the uncertainty.

A decent pan-European economic recovery, and successful gradual fiscal consolidation, would allow the distressed sovereign bonds to rise in value over time. Until then, the jockeying will continue over who will bear the losses, when, and how. Will it be Greek citizens? German, French, and Dutch taxpayers? Bondholders? Financial institutions’ shareholders? And the fundamental problem is that how the battle is resolved will affect the amount of the losses.

Prices of bank shares and the Euribor-OIS spread (a measure of financial stress) signal a profound lack of confidence in the sovereign debt of distressed countries, with yields on 10-year Greek bonds recently hitting 25 percent. The crisis affects non-Europeans too; for example, concern over the exposure of American banks and money-market funds to troubled European banks is harming U.S. financial markets.

There are three basic approaches to resolving the banking crisis (which means resolving the fiscal adjustment, sovereign debt, and euro issues simultaneously). The first approach relies on time, profitability, and eventual workout. One estimate suggests that a 50 percent reduction in the value of peripheral countries’ sovereign debt (reasonable for Greece, but high for the others) would cause about $3 trillion in losses, overwhelming the capital of European banks. But the banks are profitable ongoing enterprises in the current low-interest-rate environment, because they typically engage in short-term borrowing and longer-term lending at higher rates, with leverage. Playing for time thus might enable them gradually to recapitalize themselves by retaining profits or attracting outside capital.

A strong, durable economic recovery would make such an approach workable. Most European officials hope that, when combined with substantial public money to support troubled sovereign debt, it will.

The Obama administration adopted this option, following the unpopular Troubled Asset Relief Program, which injected hundreds of billions of public dollars into the banking system (most of which has been repaid). But some U.S. banks, including Bank of America and Citi, are still vulnerable, with considerable toxic assets (mainly related to home mortgages) on their balance sheets.

The second approach is rapid resolution. But letting questionable banks gradually recapitalize themselves and resolving the bad debt later ― perhaps with European Brady Bonds (zero-coupon bonds which in the 1990s enabled U.S. banks and Latin American countries to agree to partial write-downs) ― won’t work if the losses are too large or the recovery is too fragile. More rapid resolution may be necessary to prevent zombie banks from infecting the financial system.

The U.S. Resolution Trust Corporation rapidly shut down 1,000 insolvent banks and Savings and Loans from 1989 to 1995 so that they would not damage healthy institutions. Scaled to today’s economy, assets worth $1.25 trillion were sold off, with 80 percent of the value recovered. The financial system rapidly returned to health. This approach requires judgment and resolve in separating insolvent institutions from solvent ones.

Finally, there is the path of public capital. If market-driven recapitalization is too slow, and closing failing institutions is impossible, a more extreme alternative is to inject public capital directly into the banks (rather than indirectly, as now, by propping up the value of the sovereign debt that they hold). This approach prevents bank runs, because banks with more capital are safer. But how much public capital should be used, and on what terms? Private capital, of course, is preferable, but, given the risk that it will be wiped out by future public intervention, investors will be wary. In the meantime, regulators are increasing banks’ capital ratios.

Europeans, both debtors and creditors, must address the banking problem forthrightly, and simultaneously with the euro, sovereign-debt, and fiscal-adjustment issues. Pretending that banks that passed modest stress tests can be kept open indefinitely with little collateral damage is wishful ― and dangerous ― thinking.

By Michael Boskin

Michael Boskin, currently professor of economics at Stanford University and a senior fellow at the Hoover Institution, was chairman of President George H. W. Bush’s Council of Economic Advisers, 1989-1993. ― Ed.

(Project Syndicate)