Can the European Union avoid a financial market meltdown?

Last week, after much angst and inde­ci­sion, the 17 nations mak­ing up the core of the Euro­pean Union (which fully uti­lize the euro as their com­mon cur­rency) agreed to a frame­work to resolve their finan­cial cri­sis. In a nut­shell, the coun­tries involved needed to address three core issues. First among these — and the one which tends to get the most atten­tion — is to bailout the Greek econ­omy, which is heav­ily in debt and unable to ser­vice debt oblig­a­tions with­out finan­cial assis­tance from other EU mem­bers. Some bailout funds have already been pro­vided to Greece, but the size of the finan­cial assis­tance seems to increase con­stantly, par­tic­u­larly under the influ­ence of fis­cal restraint by the Greek gov­ern­ment and a rapidly fal­ter­ing econ­omy. So severe is the prob­lem that one of the enti­ties charged with the bailout, the Euro­pean Finan­cial Sta­bil­ity Facil­ity (EFSF) is chew­ing through its 440 bil­lion euros much more rapidly than antic­i­pated. And with other EU gov­ern­ments also in trou­ble (includ­ing Por­tu­gal, Italy, Ire­land and Spain), the EFSF needs to expand its abil­ity to meet its obligations.

A sec­ond and intri­cately related issue is the sta­bil­ity of EU banks. With the value of Greek bonds under down­ward pres­sure, banks through­out the EU which have a sig­nif­i­cant expo­sure to such assets may find them­selves at increased risk.

How would this work? Much like here in the U.S. where banks pur­chase U.S. Trea­sury secu­ri­ties, Euro­pean Union banks poten­tially hold huge amounts of sov­er­eign debt (that is, bonds sold and backed by the capa­bil­ity of gov­ern­ments to repay) as part of their asset struc­ture. Accord­ing to a basic account­ing iden­tity, assets must equal lia­bil­i­ties plus net worth. As such, if the asset val­ues (in this case, the Greek bonds) fall due to the government’s per­ceived or actual inabil­ity to repay its oblig­a­tions, a por­tion of the bank’s asset base looses value. With lia­bil­i­ties unaf­fected (with a bank’s prin­ci­pal lia­bil­i­ties being the accounts held by depos­i­tors), the full weight of the reduced asset value would fall onto the “net worth” posi­tion of the finan­cial insti­tu­tion. If the loss in net worth is large, the cap­i­tal­iza­tion ratio of the insti­tu­tion falls below accept­able lev­els, or — worse yet — should it become neg­a­tive (due to a huge drop in the value of the sov­er­eign debt hold­ings), the finan­cial insti­tu­tion goes “bank­rupt.” Need­less to say, the EU must avoid such a pos­si­bil­ity for its sake as a func­tion­ing econ­omy with a viable cur­rency (the euro). Fur­ther, should such a cat­a­strophic sce­nario unfold, the entire world’s finan­cial sta­bil­ity could be placed at risk, as was wit­nessed in 2008 under the weight of falling mort­gage backed secu­rity val­ues here in the U.S. and the inter­ven­tion needed by the U.S. Trea­sury via TARP.

The final piece of the bailout puz­zle is the recap­i­tal­iza­tion of the EFSF (or other sim­i­larly entrusted enti­ties), which would be able to with­stand a much wider and deeper finan­cial cri­sis than that imposed by a Greek default. At present, the coun­try get­ting the most atten­tion as the next poten­tial hotspot of finan­cial and eco­nomic insta­bil­ity is Italy. As a far larger nation, any pos­si­bil­ity of default could send finan­cial shock waves through­out Europe and beyond. So much a mat­ter of con­cern is this issue that the Euro­pean Cen­tral Bank (ECB) has been buy­ing Ital­ian (and Span­ish) bonds to try to main­tain an accept­able level of demand and hold down the inter­est rates that Italy (and Spain) must pay to ser­vice their debt. With­out this ECB inter­ven­tion, yields required to attract pri­vate sec­tor bid­ders for these debt instru­ments would likely soar, and both Italy and Spain might be unable to meet their oblig­a­tions. With the EFSF already heav­ily com­mit­ted to bail­ing out Greece, the mod­est 440 billion-euro fund would quickly be depleted.

One fur­ther com­pli­cat­ing fac­tor is that the EU econ­omy is slow­ing down, poten­tially to the point of enter­ing a reces­sion. Not all 17 coun­tries that are full mem­bers of the EU are in such dire straits (for exam­ple, Ger­many con­tin­ues to per­form well), but with EU nations so eco­nom­i­cally inte­grated, the prob­lems of one set of coun­tries inevitably become prob­lems for oth­ers if the EU and the euro are to survive.

Last week, it would seem that a solu­tion was found and tri­umphantly announced. Stock mar­kets around the world advanced broadly, at least on Thurs­day. So, what is this solu­tion and how might it fare? Next week will exam­ine these questions.

Dr. James New­ton serves as chief eco­nomic advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion/Newark.

Posted by Jim Newton on Nov 2 2011. You can follow any responses to this entry through the RSS Feed. Comments can be made below.