New solution to European debt crisis: refinancing Europe's banks?

The past few days have seen Europe’s leaders hectically playing firefighter to save the union’s financial system and prevent the crisis from reaching the real economy.

The global economy is going through the most severe crisis since World War II, Jean-Claude Trichet, the outgoing president of the European Central Bank, said in an interview on German television last night, calling on political leaders to take coordinated action. But while analysts may share Mr. Trichet’s gloomy assessment of the ongoing financial crisis in the eurozone and its vicinity, they are unconvinced by his call for unity.

European leaders have to confront not one, but several wildfires. The sovereign debt crisis engulfing Greece and several other countries – mainly in southern Europe – is now aggravated by concerns about the health of Europe’s banks, which only a few months ago were deemed safe and sound. There is disagreement within the eurozone about the design of mechanisms devised to prevent future debt crises. And there is an increasingly skeptical European population, wondering if saving the project of a common currency is worth paying the price.

Concerns about Europe's banks

A Greek default is now more likely than ever, and there is growing consensus that it might be the only way forward for the country. “Greece needs a restructuring of its debts,” says Jörg Hinze, senior economist at the Hamburg Institute of International Economics (HWWI). “In conjunction with structural reforms of its public sector – so far Athens has not shown it is serious about such reforms – and with further international aid, such a haircut [a partial write-off of debt] could help Greece get back onto its feet within five or 10 years. Without it, the country faces political, social, and economic chaos.”

A Greek default – and the example it sets for other struggling eurozone economies – would have serious consequences for Europe’s banks, though. Even though a stress test conducted earlier this year seemed to show that the majority of banks were in good health, it now appears that the capital resources they are holding may not be enough to absorb losses caused by sovereign defaults. The newly elected director of the International Monetary Fund, Christine Lagarde, was the first to warn – five weeks ago already – that European banks were up to 200 billion euros short. In the course of this week alone, firms in Italy, Portugal, and the United Kingdom were downgraded by the rating agency Moody’s.

“A stress test simulates certain scenarios,” says Hans-Peter Burghof, chairman of the Banking and Finance Department at the University of Hohenheim. “But fearing a self-fulfilling prophecy, Europe’s financial watchdogs avoided to test the worst-case scenario. The EU’s political leadership must be blamed for the current banking crisis.”

A shift against bailouts?

Still, refinancing Europe’s lenders might be cheaper in the end than repeatedly bailing out whole economies. German Chancellor Angela Merkel and the president of the EU Commission, Manuel Barroso, both declared earlier this week that a recapitalization of banks should be considered, and on Thursday, Trichet announced that the ECB would later this year give out loans with a 12-month maturity.

This could also be seen as an acknowledgement to the growing opposition towards bailouts. Yesterday, the Dutch parliament approved the expansion of the eurozone bailout fund EFSF, as did the German Bundestag last week, in spite of growing public opposition. Next week, the last two eurozone countries, Malta and Slovakia, are expected to vote, and in Slovakia the outcome is open.

“Expanding the EFSF means trying to solve the debt crisis with new debt. This won’t work, and we won’t pay for it,” Slovak politician Richard Sulik said in an interview with the German Spiegel magazine. Mr. Sulik is president of the Slovak parliament, and his party, a member of the governing coalition, will vote against the expansion, which has to be ratified by all eurozone members.

“I understand the Slovaks,” says Professor Burghof. “Their per-capita income is half that of Greece, their public debt rate is high, and they are trying to bring it down through painful austerity measures. So why should they feel inclined to help the Greeks?”

Meanwhile in Athens, the government of George Papandreou is facing persistent opposition to reforms of the public sector and spending cuts. On Wednesday, a general strike brought life in the capital and several other cities to a halt: planes remained on the tarmac, trains in stations, and ferries in ports. Tens of thousands protested against the government, and according to the Greek daily Kathimerini, Prime Minister Papandreou told members of his socialist party he was afraid of a “big bang” among the population.

“If the Greeks don’t make an effort themselves, we won’t be able to help them,” says economist Mr. Hinze. “Calling for more European integration to solve the crisis is nonsense, national interests in the EU are too diverse. What we need for the euro is a set of rules, which are followed. And those who don’t follow the rules must get kicked out until they change and join again.”