...and Rome, Madrid, Lisbon, Athens...
Willem Buiter has an excellent article in the Financial Times making the case for timely debt restructuring in Europe. Willem was one of speakers on the debt restructuring panel organized jointly by CIGI and the UN Financing for Development Office (see discussion) held on the margins of the IMF/World Bank annual meetings in Tokyo last fall. He argues that zombie banks, and the excessive debt burdens of households and sovereigns throughout Europe are holding back recovery. His prescription is "Easy, really" as he puts it: "early, coordinated and simultaneous debt restructuring of banks, households and sovereigns, of sufficient size to convince markets that there will not be an early repeat of the exercise."
It is hard to disagree with him. Everyone is well aware of the debt burdens of distressed euro zone sovereigns. Over the past week or so, however, attention has focused on the high rates charged by banks and on the plight of small- and medium-sized enterprises (SMEs) that need access to capital. The experience between Europe and the U.S. is striking. In the U.S., demand for commercial loans and lending spreads have fallen significantly. Not so in euroland. The charts below from The Economist illustrate the problem.
This divergence goes a long way to explaining the “two-track” growth prospects on the two sides of the Atlantic. Notwithstanding disappointing growth late last year and early this year, the U.S. is widely viewed to be on the verge of stronger growth — were it not for sequestration-induced fiscal restraint, growth would be higher. Europe, meanwhile, languishes in stagnation with no immediate improvement in sight. The contrast between the situation in Europe and the U.S. also begs the question—why?
The answer may lie in the difference between the European and U.S. approaches to banking sector restructuring in the wake of the global financial crisis. One explanation is that U.S. stress tests were designed to move from a pooled equilibrium in which, given problems of information asymmetry, all bank assets were viewed as “toxic,” to a separated equilibrium that, as the name suggests, separates the good assets from the bad. At the time, the European-led exercise struck me as an attempt to convince markets that things really weren't as bad as people feared. Moreover, the U.S. exercise led to the cleansing of bad loans from balance sheets and recapitalization; in Europe, not so much. The result is that European banks continue to struggle with an overhang of bad assets. Absent injections of new outside equity — the likelihood of which is remote given continuing dysfunction in the euro area and the prognosis of protracted stagnation — banks must recapitalize through retained earnings. And that means widening out the spread on those assets that are performing.
A second problem that European banks face is a potential adverse selection problem.[1] The overhang of bad loans means that they have to charge higher rates; yet given the rates that they are charging in the current Depression-era conjuncture, the probably that any given borrower seeking funding is high risk is increased. Of course, this creates a potentially de-stabilizing dynamic of more bad loans, requiring higher lending rates, which exacerbates the adverse selection problem.
So, Buiter is spot on in pointing out the need for debt restructuring to deal with the euro zone’s dysfunctional banking system. The problem is that this would entail haircuts to depositors (á la Cyprus), with the potential disruption and dislocation that could result. Alternatively, governments could remove bad assets from bank balance sheets through the socialization of those assets. The potential costs are large, however, and most governments in the euro zone are fiscally constrained by their monetary commitments. Moreover, governments that need to restructure sovereign debt typically wait too long, and do so only when, to channel Churchill, they have exhausted all possible alternatives. As a result, the prospects for timely action are remote.
In this respect, it can be asked: Was Buiter behaving mischievously when he judged it “easy, really” to get an early, coordinated and simultaneous debt restructuring in the euro zone? Yes, partly so. Agreeing on what must be done is the easy part, implementing a comprehensive approach is considerably harder to do.
[1] See: Stiglitz, Joseph and Weiss, Andrew, Credit Rationing in Markets with Imperfect Information, The American Economic Review, Vol 71, No. 3 (June 1981), pp. 393-410.