Why Europe Can’t Afford a Greek Haircut

If a picture is worth a thousand words, the following chart from the IMF encapsulates all the analysis one needs to understand why Mr. Trichet and the rest of the Eurozone bureaucracy are so adamant about not letting Greece restructure its debt.  The leverage ratios of some of Europe’s country banking systems are nothing less than stunning.   At the end of the day,  it was Lehman’s leverage coupled with its overexposure to a declining asset class that brought it down.  Once the markets sniffed this Lehman’s liquidity was cut off and rest is history.

A Greek sovereign restructuring followed by, say Ireland and Portugal, and market speculation that Spain and Italy may be next, could bring down many of Europe’s  thinly capitalized country banking systems.    Fed Chairman, Ben Bernanke,  believes the Great Depression was not caused by 1929 stock market crash, but by the the 1931 failure of Austria’s Creditanstalt.  In a 2009 conversation with the Council of the Foreign Relations,  the Chairman reflects,

I learned basically two lessons from my studies of the depression.  The first is that monetary policy needs to be supportive, not contractionary…The second lesson is that — to reiterate what I said before, is that when the financial system breaks down, becomes highly unstable, then that has very severe adverse effects on the economy… The Federal Reserve did not intervene to stop the failure of about a third of all the banks in the United States.  Globally, there were massive bank failures.  I think perhaps the most critical, in May of 1931, the Creditanstalt, which was one of the largest banks in Europe, failed, which generated a wave of financial crisis around the world.  Up till early 1931, arguably the 1929 downturn was just a ordinary — severe but ordinary downturn.  It was the financial crises and the collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression great.

Does anyone hear the rhyme of history?   These European banks can either raise new capital or shrink their balance sheets by reducing loans, for example, which, if done in mass, creates a credit crunch and an adverse impact on economic growth   Hopefully,   European policymakers are twisting the arms of these banks to reserve every single Euro of bailout money against loan losses as their Greek, Irish, and Portuguese sovereign bonds mature.  This will require taking a hit to profits and pushback from the banks.  Then,  let the haircuts begin.   That is, if the European political structure can endure for that long.

(click here if chart is not observable)

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