Mark Blyth

The European sovereign debt crisis is little more than a huge ‘bait and switch’ perpetrated on the publics of Europe, by their governments, on behalf of their banks. We need to remember that what we refer to today as the ‘European Sovereign Debt Crisis’ began as a private sector financial crisis back in 2008, when ‘too big to fail banks,’ writing deep out of the money options on taxpayers, quite unexpectedly (to some) blew up. Fearing a financial Armageddon, governments transformed private bank debt into public debt via bailouts, lost revenues, lower growth, higher transfers, and yawning deficits. The unavoidable result across the European continent was a massive increase in government debt. While painting this as a story of fiscal irresponsibility has some plausibility in the Greek case, it simply isn’t true for anyone else. The Irish and the Spanish, I and S in the eponymous ‘PIGS’ were, for example, considered ‘best in neoliberal class’ in terms of debts and deficits until the crisis hit. Public debt is a consequence of the financial crisis, not its cause.

In explaining this to their voters states such as the UK insisted that the problem was runaway spending under the last government, so spending had to be cut now or else the UK would become Greece. Other states, notably Germany, insisted that ‘more rules’ and greater discipline for those impecunious budget-falsifying Southerners, would fix the problem.

Unfortunately, neither of these ‘fixes’ will work since these ‘objects of blame’ are not to blame for the crisis. Banks used to bail sovereigns, now sovereigns bail banks and citizens get to pay for it, through bailouts, lost output, higher unemployment, slashed services, tighter credit, and the costs of reinsurance to make sure that it doesn’t happen again, until it does. The problem began with the banks and continues to lie with the banks and blaming the state for a banking problem will not fix a banking problem. But what it has done, in a quite unexpected way, is to turn all of Europe into a continent-wide Collateralized Debt Obligation (CDO).

When the financial crisis hit Europe, the initial response was a smug schadenfraude over the plight of highly levered and hopelessly interconnected Anglo-Saxon finance-based capitalism. But quickly it became apparent that those inter-linkages were global, that many of the ‘primary-dealer’ banks that had been given truck-loads of cash by the Fed to stay afloat were in fact European, and that CDOs and CDS exposures wound up in the most European of places.

Rather than recognize this private-to-public debt-transfer as a structural inevitability that Europe as a whole had to deal with (after all, what is the EU for?) Germany painted the crisis as a struggle between the parsimonious North and the profligate South while the British cheered from the sidelines and the French organized the press conferences for the Germans.

The Anglo-German answer to this misdiagnosed crisis, now universally applied, was austerity: voluntary internal deflation in the profligate periphery to reduce wages and prices to levels commensurate with their external financial position. In other words, the Germans thought it was a good idea to run the functional equivalent of a gold standard in a democracy despite their own supposedly deep historical memory of what happened the last time we tried this.

The results were predictably disastrous for the periphery states. They have suffered year-on-year GDP declines since 2008, and as a result the debt to GDP ratios of the European periphery (Greece, Ireland, Portugal, Spain) have increased, not decreased, despite the cuts, as have their bond yields. This, in turn, makes their bondholders more nervous, and so to placate them they must make more cuts, which results in a further decline in GDP, more debt, and occasionally a loan from the Germans (kicking the can down the road). But in the end it’s still just piling debt on top of more debt. This has been going on for a year and a half and the problem is that it no longer stops at the European periphery.

Back in the early 2000s when the Euro brought all these countries together, the yields on periphery bonds narrowed relative to those of the core. The reason was the implicit guarantee of the debt by the new European Central Bank and the rules that everyone agreed to abide by regarding debts and deficits, at least until they found out how easy it was to either get Goldman to do a swap deal to camouflage debt in the case of Greece, or to simply ignore the rules that you have authored, in the case of Germany and France. So as yields narrowed, core banks loaded up on periphery debt, dumping their own nice safe German and Dutch and French debt for the sake of a few basis points more, multiplied by a few hundred billion exposures. Once the crisis hit however, it turned out that the ECB wasn’t actually the lender of last resort for the Eurozone. That role fell to the German taxpayer, and they didn’t want to take out the checkbook. With austerity as the only game in town, and with growth choked-off, the crisis transferred from the banks’ balance sheet to the state’s balance sheet, and a ‘sovereign’ debt crisis became an inevitability.

The initial cost of buying and holding Greek debt in order to stabilize the Eurozone in early 2010 was around $50 billion Euros. Today, after several failed grand bargains and the latest Merkel/Sarkozy press conference where once again nothing was actually done, stabilizing the situation may cost up to twenty times more.

If one tracks the potential bank-run/contagion mechanism around the periphery from bank to bank it ends up on the balance sheets of the major Italian, German and French banks. Bethany McLean has calculated that total periphery exposure for France alone is 408.4 billion Euros, which is over half a trillion US dollars. Add the cost of sovereign CDS exposures to this, and then allow for Italy and German to have proportionate bank exposures, and you get to $2 trillion dollars really quickly.

The European response to this problem, the ‘new and improved’ European Financial Stability Facility (EFSF) kicks in at around 25 percent of that figure. Unfortunately, it is actually a Special Purpose Vehicle (SPV) filled with promises to put money in from the very states that are on the hook for these enormous sums, which is a bit like running a blood bank in a castle of vampires. This is beyond too big to bail. The proposed Eurobond solution might have been possible a few months back but with exposures such as this, even that fails the sniff test.

Seen this way the ‘sovereign debt crisis’ is less a crisis of sovereigns than a crisis of the ability of sovereigns to bait and switch private debt for public debt on behalf of the biggest European banks. The consequence of which is not just the unfairness of the put on the taxpayer, or even the pointlessness of sustained austerity as a growth formula. Rather, it’s the fact that in enabling the bait and switch, European banks inadvertently turned their home into subprime CDO.

Remember how a CDO worked? You put a bit of Manhattan in with a bit of Baltimore and a bit of Detroit, cut the income streams from each into different tranches to isolate them, and pay out according to the risk profile of each tranche. In theory it made uncorrelated assets super-uncorrelated. But when all the liquidity in the world dried up, the correlation went to one, and the bonds blew up.

The Eurozone today resembles a 2008 vintage subprime CDO. The Greek, Irish and Portuguese periphery is the riskiest junior tranche, the Italians and the Spanish are, appropriately, the mezzanine tranche, with France and Germany forming the senior tranche. And just like 2007-8, all the liquidity is drying up, as seen in the need for the banks from these sates to keep going to the ECB’s discount window.

So all you need is a part of the junior tranche to default and the losses will rip through the junior into the mezzanine and will end up destroying the senior tranche as each bondholder dumps good to cover bad before the other guy does. Once again the CDO, despite its designer’s intent, stands or falls together, this time through contagion rather than correlation, but the principle is the same.

What will cause the CDO to implode? Exactly the austerity policies Germany demands of everyone else, which as we now see, has slowed growth in Germany’s main markets and Germany itself, to a standstill. Such sustained slow or negative growth will make bondholders still more nervous. And yet the German response will be the same – more austerity – more rules – more councils of the same people who have kicked the can down the road for a year and a half, and more declarations of ‘unshakable commitments’ to the Euro that no one believes anymore.

Europe has reached a point where its collective bank exposures are bigger than its collective bailout capacity. Like the CDO of legend, the income streams are running dry and correlation is rising to one. You can blame the state all you like, but its banking crisis at its core. The cover that the banks got from their bait and switch on the public is a one-time deal, and it is about to be rudely exposed.