"There is no means of avoiding a final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system involved."
- Ludwig von Mises

Monday, January 24, 2011

Are Euro Bailouts Really German Bank Bailouts?

One thing I have noticed in the debate on Euro bailouts is the single focus on the irresponsibility of periphery countries. But there is also something else that is lacking in this debate.  It is the state of the European banks - particularly, German banks.

Before I proceed, I want to describe once again the concept of double entry book keeping in a debt based monetary system.  We have to understand that banks do not wait for you and I to make a deposit in order for them to make a loan.  If banks only lent money that was deposited, they would not be the financially successful and powerful businesses they are today.  Their lending would be constrained by their deposits.  Banks create money by lending that which does not exist today; they look for reserves after the loan is made. Credit is created, it is not something that is re-lent, say, like me lending you $10 from my wallet.  Which assumes I have the ten dollars in my wallet in the first place.  Banks don't look in their "wallet" when they make a loan.  That's why they're banks!

I covered this in my post on Australian Economist Steve Keen:  How is Money Created? A Look Back at Economist Steve Keen's "The Roving Cavaliers of Credit." 

But back to double entry book keeping.  Think of it this way: when a bank lends money to a borrower, the transaction affects the balance sheets of two parties.  One entry is the loan - a liability - which exists for the borrower.  The other entry, on the part of the lender, is an asset - a promissory note, a loan due to them.  This asset also has a rate of return; the interest rate paid to the owner of the debt.  So loans created and held by banks are assets, loans owed by borrowers, whether they be individuals or countries, are liabilities.

The two need to co-exist.  If the borrower can no longer pay off the loan, the asset that sits on the bank's balance sheet loses value - or becomes worthless.

Thus, any bailout given to any country, whether it is Greece or Ireland, is not only "maintaining" the borrower's ability to pay the loan, but it is "maintaining" the value of the loan, as an asset, on a bank's balance sheet.  So whenever you read about a bailout, I think it's important to understand that there are two parties to a loan - a lender, and a borrower, and BOTH parties are being supported by a third party - the IMF, the ECB, the Fed, etc...

And this concept has been indirectly brought to attention recently by Italy's Economy Minister Giulio Tremonti.  From the Wall Street Journal's blog, "The Source":
But Economy Minister Giulio Tremonti ramped up the decibels after yesterday’s meeting of European finance ministers, taking a shot at Germany by noting that banks in the bloc’s largest economy stood to gain seven times more than Italian lenders from an enlarged European Financial Stability Fund. 
Tremonti said: 
“Everyone is saying how good and generous and euro-patriotic they are. Well, we can reply to countries with triple-A ratings complaining of the [bailout] burden by pointing out that our banks are exposed to Ireland for 22 billion, yours for 180 billion.” 
Those figures, in dollars, represent the exposure to Irish debt of Italian and German banks respectively, according to the latest data from the Bank for International Settlements.  
The article continues:
Italian Foreign Minister Franco Frattini has lamented that informal meetings aimed to plot out EU strategy, especially between French and German officials, are unfair. Tremonti called last week’s huddle of the euro-zone’s six triple-A-rated nations a “merely technical meeting.”  
That meeting took place as part of an ongoing debate about how to expand the EU’s firepower in responding to the sovereign-debt crisis. Many of the higher-rated nations are worried they will be forced to pony up more funds or guarantees to various bailout facilities.  
“It can’t be that six countries bear the burden and that the others profit from that,” German daily Handelsblatt cited German Finance Minister Wolfgang Schäuble as saying.  
With such views increasingly passing as established wisdom, Italy’s Tremonti pointed out that the bailout schemes offer generous benefits to creditor countries whose banks made loans that now appear to have been unsound.  
Italy’s contribution to the European Central Bank’s capital base, one measure of EU members’ commitments to the bloc, is 12.5%, compared with 19% for Germany.  
But German banks account for around 37% of the impaired assets in Ireland, compared with less than 5% for Italian lenders. Insofar as the Irish rescue package boosts the value of Irish debt — which is its point — German banks benefit disproportionately.
But here's the number that surprised me:
The latest BIS data, released in December and reporting claims as of June 30 last year, show that the combined exposure of French and German financial institutions to Portuguese, Irish, Greek and Spanish debt was $923 billion, while that of Italian lenders was $76 billion.
But there is one caveat to the numbers given above:
Still, the BIS data focus on gross numbers and have been contested. Germany’s Bundesbank said last November that German bank exposure to Ireland is in fact only €25 billion, six times less than reported by the BIS, implying that many loans are located there only for legal or tax reasons but aren’t subject to Irish default risks.

Nonetheless, German, and other banks, were party to this debt game. But I pick on German banks because of this:

SOURCE (Note: the data above was compiled June 2010)

So where am I going with this?  I am not going to absolve the Greek government of massive irresponsible mismanagement and corruption.  I just believe that the debt debate should cover all parties.  I do actually feel bad for Ireland.  Their citizens, already over-leveraged, are paying for the sins of their banks.  I wonder if Germans, one day, may be forced to pay for the sins of their banks?


Anonymous said...

We already do, Misthos.
8m unemployed - inofficial number.
It's the taxpayers that bear the burden. The living standard is sinking. Germany is Aldi-land.
Working on Hartz 4 for 1 (one) euro/hour. And if you have a partner you receive zilch unemployment aid. Your parner has to feed you one year later after expiration. Nice, isn't it?

Misthos said...


Good to hear from you, and I hope all's well.

I was not aware of how difficult it is for many people in Germany. The media gives us this image of Germany that is very different from what you describe.

But come to think of it, much of the media does the same thing with the US. Unofficial unemployment in the US is 16-17%, and one in seven Americans gets money from the government each month to buy food - the SNAP, or food stamp program.

fauvi, how do you see things for Germany in the future? Better, worse, same?


Jim Slip said...

Why not let Greece default and recapitalize their (German) banks?

The most convincing argument I read recently mentioned the role of credit default swaps which are to the tune of 80 billion euros in the case of Greece alone.

Misthos said...


There are no easy solutions. And all "solutions" either involve political obstacles, or contagion spread risk.

The political solution is Fiscal Union - like that in the US. That's a difficult thing to sell as it is a European-wide socialization of losses.

As for a default:

Keep in mind that a Greek default, in my view, would energize the bond vigilantes, and like a swarm of locusts, they would then attack Portugal and Spain, and even Belgium...

(This happened with Lehman Brothers and Bear Stearns... the hedge funds moved on and piled on and started shorting all the other banks in 2008)

with Spain, the system would be extremely fragile, as the current European Stability fund isn't large enough for a Spanish default.

And what of the German, and other over leveraged banks? They too, would need recapitalization.

Thus, in my opinion, a Greek default could trigger BOTH a sovereign bond crisis and a bank solvency crisis. Those are two giant headaches you don't want at the same time.

I think we are in the eye of the storm right now. It's a false sense of security. Things could get out of control in the Eurozone sometime this year.

Jim Slip said...

Misthos I was approaching the issue from the perspective of what would be easier to "sell" to German voters. Bailing out Greece is obviously unpopular, so bailing out the German banks directly would be more popular.

The role of CDS and what would happen with them in the case of a default is something I had not previously thought about.

The architecture of the Eurozone brings us back to the major issue: account deficit economies worldwide. You are right in saying that fiat currencies allow imbalances to go on for a long time. The reasoning behind this is that deficit spending in fiat currencies is easier than under a gold-standard. Perhaps that wouldn't be the case if exchange rates were not manipulated (or fixed), but whatever. The role of private credit is something which hasn't been examined thoroughly. After all, like you've said, "the Eurozone makes paper behave like gold".

Furthermore, the world has to decide what it wants. If it wants less crises, then it has to tame trade and capital movement through some sort of central planning at the global stage. If it wants to allow full-blown economical competition between nations, then at least it should allow crises to complete their circle, so that at least we can move on at some point. What is happening right now is a little bit of everything.

Misthos said...

Jim - I agree that politically, Germany would rather sort out its banks than continue to fund them indirectly thru increasing sovereign bailouts.

Contagion is always an issue. And I wouldn't put it past Germany or France if they have something planned discreetly. After all, they can't publicly announce all their full intentions, or the market will get in front of them - very quickly.

But you're right about as you say:

"Furthermore, the world has to decide what it wants. If it wants less crises, then it has to tame trade and capital movement through some sort of central planning at the global stage. If it wants to allow full-blown economical competition between nations, then at least it should allow crises to complete their circle, so that at least we can move on at some point. What is happening right now is a little bit of everything."

My view is that the world is mostly in disarray. And that sovereign self interest will always trump global cooperation. And so my ultimate view is an eventual breakdown... not sure how it happens, but I don't see a successful cooperative effort on managing the crisis or a smooth long term evolution of the current global monetary system into something else.