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.