Europe's Growing Subprime Quagmire

larger | smaller

comments: 0

Europe's Subprime Quagmire

BRUSSELS "“ Back in 2007-2008, when the financial crisis was still called the "subprime" crisis, Europeans felt superior to the United States. European bankers surely knew better than to hand out so-called "NINJA" (no income, no job, no assets) loans. These days, however, Europeans have little reason to feel smug. Their leaders seem unable to come to grips with the eurozone's debt crisis.

Banks in Ireland and Spain are discovering that their customers are losing their jobs and income as the construction bust hits the national economies. And one could argue that a loan to the government of Greece or Portugal affords little more security than a NINJA loan. Indeed, lending to governments and banks in the European periphery represents the European equivalent of subprime lending in the US (which was also concentrated in a few sunshine states).

Given the many similarities between the two crises' basic features, European leaders could learn a lot from the US experience.

The first lesson is that, despite the limited overall volume of subprime loans, the subprime crisis could blow up into the biggest financial crisis in living memory, because an overstretched financial system was unable to cope with even limited losses. Similarly, the combined debt of Greece, Ireland, and Portugal is small relative to the eurozone economy, but the European banking system is still so weak that these countries' debt problems can create a systemic crisis.

A second lesson is that dealing successfully with a financial crisis requires, most immediately, a strong dose of liquidity. Then, once the financial system has been stabilized, a combination of debt restructuring and recapitalization is required. Has the European Union followed this recipe?

After some hesitation, Europe showed that it could manage the first phase "“ a liquidity injection to prevent systemic collapse. Greece and Ireland received funding when they were shut out of the capital market. And the last EU summit announced the creation of a permanent European Stability Mechanism (ESM) "“ a sort of European Monetary Fund with an effective lending capacity of â?¬500 billion.

This is equivalent to $700 billion, the same magnitude as the Troubled Asset Relief Program (TARP) instituted in late 2008 to keep US financial markets from collapsing. The ESM should be sufficient to deal with the refinancing needs of Greece, Ireland, and Portugal. It might even be sufficient to address Spanish government debt, though this would be a stretch.

But, just as the $700 billion TARP did not assuage nervousness financial markets in 2008, so the ESM's â?¬500 billion seems to have left investors unimpressed. The risk premia on the sovereign debt of Greece, Ireland, and others have not diminished. The premia paid by Portugal have actually soared since major ratings agencies, explicitly citing the agreement reached at the EU summit in late March, lowered the country's sovereign-debt rating.

In the US, the turning point came with the authorities' stress tests of banks in early 2009. The tests were seen as credible; indeed, their results prompted US officials to force several major banks to increase their capital.

This did not happen in last year's European version of the US stress tests, and this year's stress tests in Europe are unlikely to be tougher. The reason is simple: the US authorities checked whether their banks could survive the sort of downturn that the market feared most at the time. By contrast, European authorities refuse to test the scenario that the market currently fears most: losses on loans to banks and governments on Europe's periphery.

A third lesson derives from a little-noticed but vital aspect of the US experience: debt reduction is comparatively easy in the US, because the no-recourse feature of most mortgages there limits repayment obligations to the value of the house. Moreover, the US bankruptcy code can free consumers of their debt within months.

Of course, the millions of personal bankruptcies and home foreclosures in the US are not popular, but they provide debt relief each time, thereby enabling households to make a fresh start. This steady flow of debt relief is allowing US consumer spending to recover slowly.

By contrast, debt restructuring for either banks or governments is politically unacceptable in Europe. This implies that the crisis is likely to persist much longer than in the US, because households in Spain and Ireland will labor for decades to service mortgages on houses that they can no longer afford. And the Greek government faces an endless succession of budget cuts, with each step being more difficult than the last as the economy spirals down a black hole.

Debt relief created fewer problems for banks in the US because a significant proportion of the subprime loans packaged into AAA-rated securities had been sold to gullible foreigners. A good proportion of the losses on subprime lending was thus borne by banks from Northern Europe, leaving these banks in no position to sustain further losses on their European peripheral lending. But this should compel a strong recapitalization program "“ not weak stress tests.

Europe is making a fundamental mistake by allowing the two key elements of any resolution of the crisis "“ namely, debt restructuring and real stress tests for banks "“ to remain taboo. As long as successive EU summits persist in this mistake, the crisis will fester and spread, eventually threatening the stability of the eurozone's entire financial system.

Daniel Gros is Director of the Centre for European Policy Studies.

Copyright: Project Syndicate, 2011. www.project-syndicate.org For a podcast of this commentary in English, please use this link:http://media.blubrry.com/ps/media.libsyn.com/media/ps/gros21.mp3

You might also like to read more from Daniel Gros or return to our home page.

Share Tweet

Click here for reuse options! Copyright 2011 Project Syndicate Reprinting material from this website without written consent from Project Syndicate is a violation of international copyright law. To secure permission, please contact distribution@project-syndicate.org. var OB_langJS = 'http://widgets.outbrain.com/lang_en.js'; var OBITm = '1292502431965';var OB_raterMode = 'none';var OB_recMode = 'rec'; var OutbrainPermaLink='http://www.project-syndicate.org/commentary/gros21/English'; if ( typeof(OB_Script)!='undefined' )OutbrainStart(); else { var OB_Script = true; var str = unescape("%3Cscript src=\'http://widgets.outbrain.com/OutbrainRater.js\' type=\'text/javascript\'%3E%3C/script%3E"); document.write(str); } print recommend Send link clip secure rights COMMENTS

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

COMMENTS

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

Username Password New registration     Forgotten password AUTHOR INFO    Daniel Gros Daniel Gros is Director of the Centre for European Policy Studies. MOST READ MOST RECOMMENDED MOST COMMENTED The Mauritius Miracle Joseph E. Stiglitz Bubble Spotting Robert J. Shiller Aftershocks from Japan Stephen S. Roach Europe Re-Divided? George Soros The Economic Consequences of the Arab Revolt Nouriel Roubini A New World Architecture George Soros Did the Poor Cause the Crisis? Simon Johnson No Time for a Trade War Joseph E. Stiglitz Avatar and Empire Naomi Wolf America's Political Class Struggle Jeffrey D. Sachs Grameen vs. Bangladesh Jagdish Bhagwati The California Syndrome Michael Boskin Imperialism Reclaimed Robert Skidelsky Bubble Spotting Robert J. Shiller A Cure for Fiscal Failure? Kenneth Rogoff ADVERTISEMENT PROJECT SYNDICATE

Project Syndicate: the world's pre-eminent source of original op-ed commentaries. A unique collaboration of distinguished opinion makers from every corner of the globe, Project Syndicate provides incisive perspectives on our changing world by those who are shaping its politics, economics, science, and culture. Exclusive, trenchant, unparalleled in scope and depth: Project Syndicate is truly A World of Ideas.

 

Project Syndicate provides the world's foremost newspapers with exclusive commentaries by prominent leaders and opinion makers. It currently offers 52 monthly series and one weekly series of columns on topics ranging from economics to international affairs to science and philosophy.

PROJECT SYNDICATE Anatomy of the Global Economy J. Bradford DeLong Is a new global reserve currency needed? Do central banks need to be reigned in? Will health-care reform help or hinder efforts to control government budgets? ...read more Against the Current Robert Skidelsky Are markets moral? What does the East expect from the West? Has globalization killed the idea of equality? ...read more The Next Financial Order Barry Eichengreen Will the euro or the SDR become the world's major reserve currency, ending the decades-long reign of the dollar? ...read more © Project Syndicate 1995 - 2011    How to become a member   |   Member papers   |   Support us   |   About us   |   Contact us var gaJsHost = (("https:" == document.location.protocol) ? "https://ssl." : "http://www."); document.write(unescape("%3Cscript src='" + gaJsHost + "google-analytics.com/ga.js' type='text/javascript'%3E%3C/script%3E")); try { var pageTracker = _gat._getTracker("UA-10108778-1"); pageTracker._trackPageview(); } catch(err) {} _bizo_data_partner_id = 790 var OBCTm='1292510578203'; var _comscore = _comscore || []; _comscore.push({ c1: "2", c2: "8756795" }); (function() { var s = document.createElement("script"), el = document.getElementsByTagName("script")[0]; s.async = true; s.src = (document.location.protocol == "https:" ? "https://sb" : "http://b") + ".scorecardresearch.com/beacon.js"; el.parentNode.insertBefore(s, el); })(); _qoptions={ qacct:"p-f8E80KYHdFRZg" }; var _sf_async_config={uid:19954,domain:"project-syndicate.org"}; (function(){ function loadChartbeat() { window._sf_endpt=(new Date()).getTime(); var e = document.createElement('script'); e.setAttribute('language', 'javascript'); e.setAttribute('type', 'text/javascript'); e.setAttribute('src', (("https:" == document.location.protocol) ? "https://a248.e.akamai.net/chartbeat.download.akamai.com/102508/" : "http://static.chartbeat.com/") + "js/chartbeat.js"); document.body.appendChild(e); } var oldonload = window.onload; window.onload = (typeof window.onload != 'function') ? loadChartbeat : function() { oldonload(); loadChartbeat(); }; })();

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

You must be logged in to post or reply to a comment. Please log in or sign up for a free account.

Project Syndicate: the world's pre-eminent source of original op-ed commentaries. A unique collaboration of distinguished opinion makers from every corner of the globe, Project Syndicate provides incisive perspectives on our changing world by those who are shaping its politics, economics, science, and culture. Exclusive, trenchant, unparalleled in scope and depth: Project Syndicate is truly A World of Ideas.

 

Project Syndicate provides the world's foremost newspapers with exclusive commentaries by prominent leaders and opinion makers. It currently offers 52 monthly series and one weekly series of columns on topics ranging from economics to international affairs to science and philosophy.

Read Full Article »