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24 March 2023

A cascade of falling zombies

You know you have a financial crisis of a rather different kind when the governor of the Greek central bank boasts that his country has no significant exposure to Switzerland. The comment by Yannis Stournaras adds a comic twist to Europe’s perma-financial crises.

His comment is rather unfair about the Swiss. I thought they did rather well. The Swiss government and the Swiss central bank managed to sort out of the mess of Credit Suisse in a single weekend. They got UBS, Switzerland’s largest bank, to gobble it up. Crisis over. Compare that to the eurozone debt crisis, which lasted for many years.

The eurozone is still vulnerable today. Its sovereign debt crisis of the last decade has never formally resolved. What happened was that the European Central Bank came to the rescue of national governments in 2015 when it bought government bonds through a policy of quantitative easing. That decision relieved pressure on bond yields. But it came at a cost: it also stopped governments addressing the underlying economic imbalances of the European economy: Italy’s low productivity growth, Germany’s and the Netherlands' excessive current account surpluses, failure to invest in the digital economy, and a chronically weak banking sector.

A eurozone crisis would this time almost certainly not start in Greece. Financial crises never repeat themselves in exactly the same way. One of several possible crisis scenarios is this: a debt crisis at the nexus of state-owned banks, industries that are past their prime and governments desperate to protect their economic model. The German car industry, for example, could trigger such a crisis in the next few years. It is struggling to make the transition to the world of electric cars and artificial intelligence. There is an awful lot of finance tied up in that sector. A critical node in such a crisis scenario could be the state-owned banks, like the German Sparkassen or the mutual banks.

Many of these financial institutions are too small to fall under the supervisory powers of the European Central Bank. There is a lot under the hood we don’t see. But even solid banks that are supervised by the ECB can be vulnerable during a contagion.

But no matter where a crisis starts, it always goes through the banks. One of the effects of the 2008 financial crisis was a de facto re-nationalisation of banking systems, because each government forced to bail out their own banks. In a monetary union, this is sheer madness, and a source of persistent vulnerability. Not every government has the capacity to bail out a large bank. Even Germany may struggle in some scenarios.

What about the EU’s banking union? It was a response to the financial crisis. Unfortunately, it was a banking union in name only. Only the largest banks are subject to EU-wide supervision. It lacks joint deposit insurance, but the biggest problem is the non-functioning bank resolution regime. The purpose of a resolution mechanism is to be able to do what the Swiss just did with UBS and Credit Suisse. The equivalent for the EU would be to get a French bank to buy a failing German or Italian bank. But this is not going to happen because you would have to get this past Giorgia Meloni and Olaf Scholz. Good luck with that!

Nor can the ECB come to the rescue this time. We have to remember that it was an unusually fortuitous circumstance that allowed the ECB to buy debt in the last decade. The debt purchases were intended to raise inflation when it was too low. It was a lucky side effect that they also helped governments find a willing buyer for their debt. Normally, central banks use one policy instrument for one target. The ECB’s decision to deploy QE was a rare example of the one-club golfer winning the competition. It is an expression coined by Ted Heath to describe one-instrument, multi-target economic policy - won the competition. Ted Heath, the former British prime minister, coined that expression for a one-instrument, multi-target policy.

We are now back in the sceanrio where this does not work. Inflation is high, and in my view at least, likely to remain above the 2% inflation target for a long time. In this environment, central banks have less room for manoeuvre. They need to keep interest rates high to fight inflation. In this environment, they are more likely to sell debt than to buy it.

Central banks have endless capacity to help banks in a liquidity sqeeze. The Federal Reserve provided some generous relief to the US banking system after the collapse of SVB. The US government guaranteed SVB customers, including those with deposits over the $250,000 for deposit insurance.

The US and Switzerland both moved fast. The eurozone is not like that. The scenario I fear for Europe is a slow-burning crisis, a chain of insolvent companies getting bankrolled by insolvent banks, which then get bailed out by governments whose solvency will then also weaken. A cascade of falling zombies. For a while, banks can play the old game of “pretend and extend”, pretend that their loans are still performing, and then extend them indefinitely. But in the process you end up creating a zombie economy and new zombie banks to add to the ones that you already have. Back in the days of the eurozone’s financial crisis, the most overused metaphor was “kicking the can down the road”. When the next crisis comes, the eurozone will revert to the only thing it ever knew. It will kick the can, once more.

The Greek governor has made an unwittingly good point. The eurozone is not Switzerland after all.

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