My post yesterday on how the German banking sector can likely withstand a restructuring of Greek debt touched on, but did not dwell on, another important aspect of the Euro crisis: it's not just the banks in the Eurocore that own debt in the periphery, but also the governments. I wrote "The taxpayers have already loaned Greece a lot of money, either directly or via the ECB" and quoted a Der Spiegel report that said:
Taxpayers might need to step in, as might the savings banks that are owned by municipalities.
In addition, the European Central Bank (ECB) has bought up tens of billions of euros of Greek sovereign bonds. Because the Bundesbank, Germany's central bank, holds more than a quarter of the ECB's capital, it would have to take its share of losses accordingly.
This latter point is the subject of this Martin Wolf column that has made the rounds of the blogosphere (Salmon, McArdle, Krugman) and yielded the above graphs. Wolf's column is provocative -- he begins with "The eurozone, as designed, has failed." -- but makes a very important point about the centrality of the European banking system to the broader regional economy:
The role of banks is central. Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. In the eurozone, for example, currency in circulation is just 9 per cent of broad money (M3). If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But what happens if the banks in a given country are on the verge of collapse? The answer is that this presumption of equal value no longer holds. A euro in a Greek bank is today no longer the same as a euro in a German bank. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system. This is, of course, what the federal government has prevented in the US.
The ECB doesn't technically have legal authority as a lender of last resort (although it's taken on part of that function since 2007), so domestic central banks as well as the US Federal Reserve have had to fill that role. The upshot? Central banks in the Eurocore, such as the German Bundesbank, are now heavily exposed to debt from the periphery. At current rates of lending they're likely to run out of cash by 2013, and unlike the US Fed, they can't just print more. This is becoming a slow-moving liquidity crisis, in other words, and as London Banker wrote a few days ago, liquidity crises (such as occurred in the Fall of 2008) are really nasty. As Wolf notes, this is serious business:
Government insolvencies would now also threaten the solvency of debtor country central banks. This would then impose large losses on creditor country central banks, which national taxpayers would have to make good. This would be a fiscal transfer by the back door.
In a sense this is already a fiscal transfer, since debtor countries are spending the funds on financing the state, and the creditor central banks don't have a printing press. So why, given that a fiscal transfer was needed, was it done in a way that risks the solvency and credibility of Eurocore central banks? Because they are unelected. Such a large transfer plan on top of the EFSF is unlikely to have been approved by voters in the Eurocore, as my post from yesterday indicates. And as Hans-Warner Sinn notes (via Henry Farrell's Twitter), the size of these hidden transfers "dwarfs the parliament-approved bailouts extended to Greece, Ireland and Portugal." It's easy to see why European leaders would opt for a bailout mechanism that was less transparent, and that involved non-elected actors pulling the strings: it allows bailout financing to continue, but with plausible deniability.
Sinn draws an analogy between the situation in the Europeriphery and Britain in 1992, when Soros sank the pound by selling it off. Eventually, the British Treasury ran out of marks and francs to exchange for pounds, and was forced to devalue. Soon, writes Sinn, there won't be enough funds in Bundesbank to cover the borrowing in the periphery. At that point, the Euro will collapse like the pound. If Sinn is right, then the Euro has two years. I've been saying for awhile now that 2013 was key to the Euro's future. 2013 is officially when haircuts begin, and when new bailout lending ends. It's also when the "stealth bailout", through the central banking system in the EU, can no longer sustain itself. At that point, either the peripheral economies have righted the ship by balancing the budget and/or regaining access to private credit markets, or they exit the Euro.
So right now it's a waiting game. The Eurocore doesn't want a restructuring, which would cost taxpayers (and banks) billions, if it can avoid it. The Europeriphery doesn't want the economic collapse that would accompany a Euro-exit. But both of them want the other to pick up more of the tab. But there's not much more the periphery can pick up, with unemployment above 11% in Portugal, 14% in each of Greece and Ireland, and 20% in Spain. And there's not much more the core can pick up without risky the solvency of their domestic central banks. More direct fiscal funding mechanisms look to be politically impossible. Maybe one of those things changes by 2013, but I wouldn't bet on it.