You've heard of Greco-Roman wrestling. Now there's a Greco-Roman financial crisis. The headlines coming out of Europe are filled with talk of a banking and sovereign debt crisis in Europe. The problems, which had their origins in Athens, have now spread to Rome — and have become much larger in the process.
Why we should Americans care? It's simplistic to say, but we're all connected. U.S. banks -- and probably the one where you have an account -- have billions of dollars of Greek, French, and German government and private sector bonds on their books; many are active direct lenders in those countries. The Euro zone, taken together, is one of the largest economic forces in the world. Behind Canada, the European Union is the largest destination for U.S. exports, accounting for about 18 percent of the total. If you work in an industry that exports — agriculture, airplanes, tourism — a demand shock from the world's largest markets would be very bad news. In addition, European companies are big employers in the U.S. On Monday, BMW announced it would invest $350 million in a plant in Tuscaloosa, Alabama, to enable it to build a new crossover. If the home markets of the big European employer collapse, they'll have to retract. Like it or not, we're all in this together.
As Henry Blodget and I discuss in the accompanying video, the European financial crisis is going through a predictable series of stages.
First, there's the continuing tragedy of Greece. The government, unable to stay current on its debt and shut out of bond markets, sought an international bailout and enacted austerity programs -- only to find that the economy shrank, which caused deficits to rise and the nation's debt as a percentage of GDP to soar. And that triggers a need for fresh bailouts. It's long been obvious that Greece has little hope — and not that much interest — in paying the debts the government incurred to private investors. It can't hope to repay the bailout funds it has used to remain current on the debt. In July, banks accepted a 21 percent haircut on Greek government bonds. Now there's talk that investors will have to accept a 50 or 60 percent reduction in the value of their Greek debt.
This prospect is transforming the Greek crisis into a European banking crisis. Ordinarily, banks rely on their colleagues, competitors, and customers for loans and deposits. But when fears arise that banks may not be solvent — due in part to large reductions in the value of assets like Greek debt — banks have to turn to their shareholders. They have to raise new capital in order to make up for the holes that Greek debt will open in their balance sheet. Which is why European bank stocks took a big hit on Monday. In order to withstand this stress — and other stresses — European authorities have determined that European banks need to collectively raise about $150 billion in new capital.
In theory, that's not so awful. But the European banking crisis, caused by a Greek sovereign debt crisis, now threatens to create sovereign debt crises elsewhere. Banks that have exhausted their shareholders' assets and patience will have to call upon their governments. Dexia, the French-Belgian bank, last week sold itself to state-controlled companies in Belgium and France. Of course, there's likely to be more where this came from. If large banks all need to raise capital at the same time, they'll have to turn to their government.
That's what happened in the U.S. with the TARP in the fall of 2008. But this likely next step leads to a new problem, which markets are already anticipating. Governments will have to borrow lots of money to backstop their own banks — even if, as with the TARP, the taxpayers end up getting the money back. But given their high levels of existing debt and low levels of growth, there's no guarantee that, say, France will be able to increase its borrowings without harming its own credit rating.
The next step, after banks have exhausted the patience of their fellow banks, their shareholders, and their governments, is for banks to call on their central bank or some other authority. In the case of the U.S., the Federal Reserve in the fall of 2008 effectively guaranteed large asset classes, bought up chunks of other assets and provided unlimited short-term funding, all in an effort to bolster confidence, stop banking panics and provide some breathing space.
But here's where the analogy to the U.S. breaks down: The European Central Bank simply isn't capable of acting in the same way that the U.S. Federal Reserve did. It doesn't have the authority, the license or the independence to inject itself into markets the way the Fed does. The ECB won't print money in huge quantities in order to help ward off a financial crisis. Knowing this, in May 2010, the European Union created the European Financial Stabilization Fund, funded by governments, which would perform some of those bank-of-last-resort functions. But its funds are limited at about $600 billion, and it has to act with consensus.
That would be enough to stabilize Greece. The problem is that Greece has caused investors to cast a jaundiced eye on countries with high levels of debt and problematic political systems. And that has caused them to look across the Adriatic to Rome. Italy has about $1 trillion in debt that will need to be refinanced in the next three years. Bond markets have signaled their concern about Italy's dysfunctional political system by driving interest rates up. The European Central Bank in August began buying small quantities of Spanish and Italian bonds in an effort to instill confidence. But these purchases are like bringing a pea shooter to a bazooka fight. Controversial on a small scale, the efforts aren't likely to be expanded.
The ECB, which can print money, isn't willing to bail out or guarantee Italy, and the EFSF, which has to ask European taxpayers for money, isn't big enough. Meanwhile, Italy's politics, dominated by Silvio Berlusconi, are something of a farce. The markets are continuing to fret that Italy, like Greece, simply may not be able to or interested in staying current on its debt at some point in the not-too-distant future. As the Financial Times reported, at the EU's big debt summit last weekend in Brussels, Berlusconi, "according to diplomats, pretended to doze off." At a press conference after the summit, French Prime Minister Nicolas Sarkozy and German Chancellor Angela Merkel practically rolled their eyes when they were asked if they thought Italy was capable of stepping up.
The European Union was designed to avoid the sort of sudden, traumatic political moves that made life in the continent so miserable for much of the 20th century. The policy architecture means that, in the 21st century, there can't be quick fixes to big problems.
Daniel Gross is economics editor at Yahoo! Finance.
Follow him on Twitter @grossdm; email him at firstname.lastname@example.org.
His most recent book is Dumb Money: How Our Greatest Financial Minds Bankrupted the Nation.