As Europe struggles to contain its government debt crisis, the greatest fear is that one of the Continent’s major banks may fail, setting off a financial panic like the one sparked by Lehman’s bankruptcy in September 2008.
European policy makers, determined to avoid such a catastrophe, are prepared to use hundreds of billions of euros of bailout money to prevent any major bank from failing.
But questions continue to mount about the ability of Europe’s banks to ride out the crisis, as some are having a harder time securing loans needed for daily operations.
The problem, unfortunately, is there is a negative interaction between sovereign debt and bank rescues. Bailing out banks is enormously expensive - just ask the Irish. It runs from 5% of GDP up to 40% or more in some cases.
That makes the sovereign debt burden worse, which raises fears about whether a particular country's debt will be downgraded, or even in extreme cases like Greece, default.
And here's the problem. Most banks hold their own government's debt in amounts far in excess of their own capital. Under Basel II capital rules these holdings are treated as riskless. You don't need to hold capital against them.
So when there IS obviously risk in holding government debt in such huge amounts, that adds to market fears about the viability of the bank.
It also raises fears that the contingent liabilities of the government are much larger, which makes debt/GDP ratios look much worse, which makes government bonds look a worse bet, which makes the bank balance sheets worse... which makes markets more nervous about the banks. And that raises fears about the contingent liabilities of the government.
Not to mention that blanket assurances that the authorities will not let a major bank go down is the essence of a moral hazard problem.
Italy in particular is profoundly frightening as the government debt is so large already. Many European governments do not have the resources to bail out banks without undermining their own fiscal position (again, ask the Irish). And that means people ask whether stronger governments, like the Germans, will bear some of the burden. And that raises doubts about the political viability of such burden sharing and the democratic legitimacy of European decisions. Bailing out any bankers is politically toxic in most countries, let alone assuming huge generation-crushing burdens to bail out foreign bankers. There is no good way to solve this.
Incidentally, this is why Paul Krugman is wrong to keep arguing in his NYT column that deficits should not be a concern, and record low yields (the US 10=year Treasury hit 1.94% yesterday) show that all those who worry about government debt are wrong.
Markets didn't distinguish at all between Greek and German sovereign debt yields for years. Until they did. And now the sovereign debt problem is on such an epic scale in Europe it is hard to see a way out.
By the time markets get worried about your debt, it is already too late. Krugman is right to say there should be less concentration on short-term deficits, even if the US deficit is still over 10% of GDP. You don't necessarily want to cut spending drastically when you are teetering on the brink of a double-dip recession.
But that only means you have to do more to control long-term spending, to make it clear that responsible choices are being made about the path of spending in the future. So when the day comes that markets do panic about current deficits, you have a sustainable position.
And that is just what has not been done in the US. The problem is entitlement spending, especially on healthcare. Far from taking long-term decisions to improve the path of debt, we've added two whole new healthcare entitlements in the last ten years - Bush's Medicare Part D, i.e. the prescription drug benefit, and Obamacare. The CBO score Obamacare as technically saving money - but no one believes that. The similar state plan in Massachusetts has been much more expensive than projected.
You have to fix problems BEFORE they become almost insoluble. Because then none of your options are good.