Policy Research in Macroeconomics

The support given to EU banks is killing the recovery

By Michael Burke

Bailing out private-sector banks, and slashing public spending to pay for it, will aggravate the financial crisis, not diminish it:

The European Banking Association’s stress tests have been designed to provide reassurance to the financial markets that the European banks are sound. They are unlikely to be successful.

This is the EBA’s second attempt to provide reassurance. Last year’s exercise gave the all-clear to Europe’s banks. All the Irish banks collapsed just months later, with the credibility of the EBA’s tests among the collateral damage.

The latest tests are barely more onerous. It is true that, at least, this time the banks’ holdings of government debt are included, having previously been regarded as 100% safe. But the possibility of an actual default by one more European government was not part of the latest stress test, even though this is now widely held to be inevitable. As a result, these stress tests are wholly inadequate for identifying the true level of European banking fragility.

In addition, the sums suggested as necessary to restore strength to the banks are pitifully low. Previously, the European Central Bank’s own stress tests had suggested that the shortfall of capital was €440bn. Uncannily, this then became almost exactly the level of funds set aside by the European authorities for supposed bailouts of European governments . This was set at €450bn, underlining the fact that the beneficiaries of the bailouts are European (including British) banks, not the governments or people of the crisis-hit countries.

Amid all the smoke and mirrors, the process of stress-testing does, however, serve one important purpose. It highlights the real source of weakness for Europe’s banks. Without addressing the issue of sovereign defaults, the EBA’s review focuses on the risks to the banking sector arising from renewed economic slowdown, rising unemployment and falling prices of commercial and residential property. This begins to explain the key issue – the weakness of the recovery in most European countries.

Unlike US banks, EU bank weakness is not primarily driven by the souring of domestic property loans. Instead, it was their exposure to falling US markets that caused the first real stresses in the European banking system. For banks whose assets must be reported in euros, this was exacerbated by the US dollar losing a quarter of its value from 2006 to mid-2008. The coup de grace was the failure of a US bank, Lehman Brothers, which threatened to bring down the global financial system.

Crucially, it was not a sovereign debt crisis. Using a series of stress measures, the ECB pinpoints the emergence of a sovereign debt crisis in Europe beginning in April 2010, which was about three years after the international banking crisis.

It has become a sovereign debt crisis for two reasons. First, the national and international authorities have been unwilling to let the burden of bank failure fall where it truly belongs, on the shoulders of the banks’ shareholders and bondholders. Second, they have attempted to deal with an investment strike in the corporate sector by slashing the pay and indirect incomes of the household sector.

In the first instance, rather than the state protecting depositors and so ensuring the continued availability of credit, it is shareholders and bondholders who have been bailed out. The consequence is that the government’s and ECB’s finances have substituted for failed banks. This has reached scandalous lengths in Ireland, where the Dublin government’s bailout of mainly overseas creditors with taxpayers’ funds threatens to bankrupt the latter.

In the second instance, “austerity” measures purporting to reduce public-sector deficits have increased them. Reducing the incomes of households only increases the unwillingness of the corporate sector to invest. Public borrowing cannot fall if both the other sectors of the economy, businesses and households, are increasing their savings.

In this light, it is completely muddle-headed to welcome the latest Italian cuts in public spending. These will contribute to the crisis, not diminish it. It is the determination to bail out private-sector banks, and to slash public spending to pay for it, that leaves the European Union navigating towards the rocks. Only by reversing the course can disaster be avoided.

First published on the Guardian CiF pages >

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