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International

In just one Word, why Germany Refuses to End the Crisis in the Euro Area: “Leverage”

Leverage-1(Analysis) The drama in the euro area continues with no clear end in sight. Recession, unemployment, and worsening sovereign debt levels – all exacerbated by flawed policies of austerity pursued in weaker performing economies, continue to be reported and forecast into the future.

Because the crisis in the euro area directly resulted from the financial crisis of 2007-8 – without a crisis brought on by the US sub-prime debacle there would most likely be no crisis in the euro area, it is worthwhile to examine the euro zone’s financial sector in some detail.

Countries located in the north of the euro area are generally net lenders within the euro area, while those in the south are net debtors. This is important to understanding how the narratives are being written across the north-south divide. In the north it is portrayed as a morality play, with profligate spenders to the south filling the role of villains; in the south, the villains are heavy-handed bureaucrats from the north (especially Germans). As with most human conflict, there is some truth to each side’s narrative.

Because banks hold a large share of a country’s savings, no country is going to let its financial sector collapse without a fight, no matter how poorly its banks are managed. This is what economists and others call a moral-hazard problem, when incentives exist that make risky behavior more likely because the costs associated with those risks are not directly borne by those taking the risks. It lies at the heart of many explanations for the financial crisis: risky decisions were made by bank managers in order to reap large, short-term bonuses, with full knowledge that government(s) would intervene if their risky gambles did not pay out.

One way to look at the euro area’s exposure to this risk from bad banking decisions is to examine the financial sector’s leverage ratio: the ratio of total assets to the sum of a currency and shareholder equity. This ratio provides an indication of how deep a hole will exist after a bank fails, and both its currency on hand and shareholder equity are exhausted. It might be seen as a gauge for potential cost to bail out a financial sector.

The first chart (top left) shows the euro area’s (minus Estonia) leverage ratio from 1999 through 2007 (indicated by the series of white bars and the right scale). From the chart, it is evident that after exchange rates were fixed in preparation for the euro’s launch in 2002, leverage initially spiked to above 9, coming down thereafter to around 4 in 2006-7.

This measure of aggregate leverage in the euro area conceals large differences between countries, though. Most of the temporary initial spike in leverage comes from just two countries: Germany and Greece, with Germany’s spike more than three times as large as Greece’s (see the black and light blue lines and the left scale, indicating the cumulative change in leverage since 1999. Great Britain is included for comparison.) But by 2007 – the onset of the financial crisis, leverage was down from 1999 levels in all these countries except Ireland, where it was up by only 0.6. Through 2007, the euro was not adversely affecting any one country’s financial-sector leverage in an obvious way.

Again, more detail is needed to explain why there is such division over policy between countries in the north and the south of the euro area. The second chart (bottom right) shows financial-sector leverage ratios for individual countries in both 2007 and 2011. Great Britain and the US are added for comparison. Here we see large differences in leverage, with Germany’s financial sector exhibiting higher leverage ratios than financial sectors in other countries of the euro area.

Germany’s large leverage ratio of almost 16 in 2011 explains the near hysteria that Germans have to bailing out banks, because its taxpayers are potentially on the hook for a lot more than taxpayers in other countries are. It is in Germany’s clear national interest to see that all loans are repaid in full to its banks, and this explains the paramount position of morality to its crisis narrative.

The other option to mitigating bad bank assets – inflating them away, is a nonstarter with Germany because of its hyperinflationary episode during the early 1920s. So what they’ve got in the euro area is the most powerful country economically – the country to which many bad debts are owed, opposed from the get-go to either providing the sums necessary to sufficiently re-capitalize banks, or to implementing monetary policy that can effectively begin to end the crisis.

More painful rounds of negotiation and thinly disguised conflict between members of the euro area can be expected for years to come, unless Germany chooses to deal with its financial sector’s risk exposure once and for all. Failure to address lingering capitalization issues in the financial sector – especially in Germany, will cause the ongoing crisis to continue, spreading disease-like to other countries of the euro area. This is worrisome politically, as the ongoing crisis has the potential to fan the flames of radical conservatism in Europe, a feature of European politics once thought to be an anachronism. Addressing the financial sector’s problem of risk effectively, however, can return the euro area’s economy to growth, allowing for a slow, necessary re-balancing of price levels among countries in the euro area without crisis.

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