Friday's announcement that the European leaders of the Eurozone agreed to use the European Stability Mechanism (ESM) to recapitalise Spanish, Italian and other banks was met with euphoria.
Under the preliminary agreement, the ESM will be able to use part of its EUR 500 billion credit reserves to participate in bank recapitalization, subject to certain conditions which include the development of a pan-European banking regulator under the European Central Bank (ECB) as well as a wider national commitment to an austerity / balanced budget programme.
Several commentators have already remarked that the agreement lacks detail. I will go a step further and argue that the dual mechanism of European banking regulation plus bank recapitalization will fail, if not entirely, then at least partially.
The reasons for this are based in two salient facts: recent history, and regulatory operations. If we look at the emerging market debt crisis of 1982; the US savings and loan crisis of 1987; the east Asian currency crisis of 1997-1998; the dot.com boom and bust of 1999-2000; the mortgage/property crash of 2007-2008; and the sovereign debt crash of 2009 and onwards, we readily see that these crises were caused by an excess of capital chasing outsized returns from a relatively few real investment opportunities.
This search for outsized returns is possible either at the early stage of the boom, or by taking on massive leverage, or by finding gullible investors, or by illegal activity. Or a combination. But the longer a boom continues, the more difficult it becomes to regularly earn high returns. Market saturation results; the good opportunities are taken; competition lowers margins for everyone. As a result, bubbles burst.
In each of the cases mentioned, the initial investments and subsequent credit or investment booms were entirely legal. There was nothing inherently illegal, for instance, about dot.com stocks being valued at 200 times earnings. Similarly, there was nothing illegal about adjustable rate mortgages, or sovereign loans to Greece.
The problems occurred when too many institutions starting throwing too much money at too few opportunities. This is a common factor in most boom-bust cycles, but it has usually has little to do with regulation.
This is not to say there were regulatory failings: there were many, and these have been widely documented after each crash. But during the boom, a common factor is that the power to regulate loses its political acceptability in inverse proportion to the outsized profits being made.
Let's look at the Spanish bank recapitalization as a case study. Spanish banks are currently in dire need of recapitalization primarily because the Spanish property market boomed in the 1990s through to about 2005. This investment boom was very well known and widely reported. See The Economist's survey of Spain in June 2004 as an example:
The first problems for the new government are the demand for housing, which is such a large component of general economic growth, and the supply of labour, which also drives growth, though by boosting jobs, not productivity. Spain made a start on 700,000 houses last year, four times as many as Britain. Even so, prices for new Spanish houses rose 18.5% and for existing ones 16.7%. The boom continues, fuelled partly by foreigners drawn to Spain by the thought of a house in a sunny part of the euro area, partly by share-shy Spaniards looking for an investment. The upshot is that though 3m-4m houses stand empty and a similar number are used as secondary residences, many young Spaniards cannot afford even the smallest flat, and thousands of workers turn down job offers that involve moving house because they cannot find a house to move to. At the same time household indebtedness has risen sharply (nearly half of the average family's disposable income goes on servicing housing debt), while some 40% of Spanish capital stock is in nothing more productive than property.
This single paragraph summarizes everything wrong with the Spanish economy at the time.
Remember that in the mid-1990s, the whole objective of economic development in Spain under standard EU procedures was to attract domestic and foreign investment and promote economic growth. One of the main beneficiaries of the Spanish property boom was British and German vacationers, and speculators. Some of the main sources of capital for property development in Spain came from British and German banks.
The problem was-and remains-that nothing about the Spanish real estate boom was illegal, or even unsustainable, unless financiers, customers and regulators were to have taken a much longer-term, conservative view.
So let's assume the impossible: that a long-term, "economically rational" or conservative view prevailed among public policy makers, bankers, developers and customers. What could have regulators done to stem the property rush? There are several classic policies, ranging from requiring a greater deposit ratio for mortgages, to increasing a transaction tax on frequent sales of homes in order to avoid "flipping" or other speculation.
All these tools exist. But experience shows us that applying them is nearly impossible.
Now let's fast-forward to the ESM and the ECB. Thus far, the European Central Bank has been placed in a nearly-impossible task of maintaining a Euro-wide inflation target while providing liquidity to European banks. Along the way, it has purchased over EUR 200 billionin sovereign debt, which it is not supposed to do, and also lent over EUR 1 trillion to European banks under LTRO, not counting additional loans previous to LTRO.
What exactly is this ECB bank regulator supposed to do in the next boom? Order Spanish banks to stop lending for property development? Insist via the Eurozone economic planning committee that Spanish property taxes should rise by 10% to discourage speculation? Force Spanish banks to increase the deposit ratios to 40% of mortgage loans?
Does anyone realistically see this happening?
Most Eurozone countries, including Germany, have been in breach of the Maastricht criteria since their inception. These criteria underpin the European convergence criteria, and therefore the basis of European monetary policy. Let's remember what these criteria are:
1. Inflation no higher than 1.5% of the average three best performing member states in the EU
2. Annual government deficit not more than 3% of GDP
3. Government debt not more than 60% of GDP
4. Long-term interest rates not more than 2% higher than the rates of the three lowest-inflation member states.
These criteria are the real problem in the Eurozone crisis. They impose an inflexible, rigid set of macroeconomic and fiscal standards which are almost impossible to apply in a monetary community of 17 member states, which pack small, service centers such as Ireland, Cyprus and Malta alongside larger economic powers such as Germany or France. They are also impossible to enforce given the lack of a single, elected budgetary and decision-making authority (which is ironically what Germany is trying to develop).
These criteria themselves have fed the economic boom-bust cycle. As countries with weaker government economic planning and weaker enterprises such as Spain, Italy or Greece entered the Eurozone, they saw interest rates fall, leading to a massive credit expansion in both the public and private sectors. This credit expansion was fuelled by lower interest rates, and by the fact that credit was secured not only by normal economic conditions, but by the very convergence policies and infrastructure spending channeled through the European Union (Common Agricultural Policy, Structural Funds, etc.).
The results today are clear: there has been a massive transfer of credit and investment from better-developed capital markets in northern Europe (and Asia and North America) into the southern European countries. This was used for everything from capital investments (hospitals, highways, ports, schools) to private homes to luxury consumption (imports of Porsche Cayennes and Hugo Boss suits).
Eventually, the boom turned into a bust, either in terms of the state-led development model (Greece) or the property / tourism boom (Spain). Now creditors and lenders are left with non-performing loans and deteriorating public and private assets that are rapidly losing their value.
The classic solution in this case is a debt restructuring and work-out. It is not a EUR 100 billion recapitalization in exchange for "better regulation", which will be politically impossible to implement.
The sooner Greece, Spain and other countries (including the UK and Germany) come to terms with re-pricing asset values and their associated debt service assumption, and restructure these loans contracts, the sooner the crisis will end and "normal" growth will resume. Until the next bubble, of course.
© Philip Ammerman, 2012
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.