Bill Emmott - International Author & Adviser

Article

Europe and the financial crisis
Exame - October 2008

This was supposed to be an American crisis, based on American subprime mortgages and American-style capitalism. So why do European banks seem now to be suffering more than their American counterparts? No one’s nerves were steadied by the vote in the US Congress on October 3rd to approve, at a second attempt, the $700 billion rescue package for American banks, but they also haven’t been steadied in Europe either by a rather panicky series of government announcements of extra protection for depositors. Worse may well be to come, not just in the financial system but the “real” economy.

            The only good thing about the turmoil in Europe is that it should kill off the frequent claims by politicians and some commentators that the European model of capitalism, and especially of finance, is somehow superior to the supposedly wild Anglo-American sort. That this is wrong—or at least misleading—should already have been shown by the fact that European banks have written off larger total losses thanks to bad debts during this crisis than have their American counterparts: $181 billion against $150 billion, according to the Financial Times, which cited a study by Creditflux, a research firm. If European banks were more stable, more cautious, better regulated, less wild, then this would not have happened.

            The reason for all these European losses is that European banks bought huge amounts of derivative securities from American markets. They also produced some of those derivatives themselves, but most came from America. So, you may say, we can still blame the US? Well, the European banks did not have to buy the derivatives, and their regulators did not have to allow them to build up such big holdings. But they did, because they thought it would be profitable. Just like American banks, they want to make a profit and yet had been finding it harder to be so, as interest rates in developed economies have been low and the spreads between funding rates and lending rates had narrowed during this decade.

 

A transAtlantic weather system

            Now, Europe is facing three separate storms, which in combination could well be very damaging. Already, the European economies have entered recession sooner than has the American economy. America may well now have quite a sharp downturn, as consumer spending drops and lending is withdrawn. But so will Europe.

One of European banking’s storms comes from the American derivative securities. Another, however, comes from rising default rates on borrowings in European housing markets where prices are now sliding, in particular Ireland, Britain, Spain and France. The third, which is only just starting, looks like coming from a deepening economic recession worsened by banks’ cutbacks in lending, and during which many companies and households will go bankrupt, adding to the banks’ bad debts and losses. Uncertainty about how bad these storms are going to be and about what weaknesses are hidden on banks’ balance sheets is what is now driving share prices downwards.

            As always, though, the most important and immediate uncertainty concerns what governments can or will do about the problem. Markets may be better than governments at allocating capital, inventing technologies and interpreting people’s preferences, but when there is a crisis only governments have large enough resources to organise a solution, for they represent the whole nation and all of its taxpayers.

            Nation: that, however, is proving to be a crucially important word. The American government has caused controversy among its taxpayers by its use of public money first to nationalise two giant mortgage-guarantee companies, then the AIG insurance company and now to buy up to $700 billion-worth of bad debts. But at least it has acted—and it has done so a lot more rapidly and decisively than did Japan’s government during that country’s financial crisis during the 1990s. Almost certainly, it will have to act again, with another huge package designed to inject new capital into the banks. But so will Europe—and we can now see that the problem in Europe is that we have many nations, which are refusing to co-operate with one another.

            This is inevitable but also disappointing and disturbing. It is inevitable because separate national governments will always be loyal to their separate electorates and their separate taxpayers. That is why Ireland rushed in early October to guarantee its banks’ deposits despite the risk that this would destabilise other European countries’ financial systems by luring away deposits; and it is why the Netherlands rushed to nationalise the Dutch parts of Fortis, the troubled Belgian bank that had only recently bought them from the former Dutch bank, ABN-Amro. But what is disappointing is that these governments ought at least to be able to co-ordinate with one another: after all, they meet regularly in summits of European finance ministers and most of them are together as users of the euro currency and as members of the European Central Bank.

            The lesson both of America’s actions and of the Japanese financial crisis in the 1990s is that in the end the banking system is likely to be stabilised only by a government effort to recapitalise banks. This can and should be done by taking special “preference shares” in return for capital, in just the way that the great investor Warren Buffett has done at Goldman Sachs in New York: he will get a 10% annual dividend in return for his capital, which is just what governments can also demand. As things stand in Europe right now, however, this recapitalisation is going to be done country by country, probably with each government’s package different from the others. This could be destabilising rather than stabilising.

            For that reason, it is a big pity that the idea promoted by France and the Netherlands of a collective recapitalisation fund for the European Union has been so strongly rejected by Germany, among others. Eventually, this fund is going to be necessary. The longer Europe waits, the bigger the fund will have to be. And if it is not done collectively, then the angry arguments and competitiveness between the separate national attempts to set up their own recapitalisation funds could cause deep fractures in the European Union as a whole. If it raises doubts about whether countries want to remain members of the euro, it might even destroy—or at least damage—one of the EU’s great achievements, the single currency itself.


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