The Ball Will Fall Eventually

After explaining that the Fed’s risk in helping to provide liquidity for shaky European banks is quite low, financial advisor John Mauldin turns to the question I raised in my earlier post on the Fed’s action: why do it?

Why do it? It is not for solidarity among central bankers. The cold calculation is that a European banking crisis would leak into the US system. Further, it would throw Europe into a nasty recession, when growth is already projected (optimistically) to be less than 0.5%. That means the market that buys 20% of US exports would suffer and probably push us into recession, too (given our own low growth), making a far worse problem for monetary policy in the not-too-distant future.

Finally (and this is one I do not like), if the ECB was forced to go into the open market for dollars, the euro would plummet. As in fall off the cliff. Crash and burn. Which would make US products even less competitive worldwide against the euro. While I think we need a stronger dollar, that is not the thinking that prevails at higher levels. You and I don’t get consulted, so it pays us to contemplate the thought process of US monetary leadership and adjust accordingly.

Finally, I think that the end result of lending to the ECB will be to postpone the problem. The problem is not liquidity, it is insolvency and the use of too much leverage by banks and governments. This action only buys time. And maybe time is what they need to figure out how to go about orderly defaults, which banks and institutions to save and which to let go, which investors will lose, whether some countries must leave the euro, etc. Frankly, the world needs Europe to get its act together.

That is the critical issue and comes around to the point I was trying to make in my post. The problem of the European banks, like that of American banks, is solvency not liquidity. Providing additional liquidity merely serves to kick the can down the road and we and the Europeans are rapidly running out road. Nothing will come of nothing.

The challenge of dealing with a problem of the magnitude that faces us shouldn’t be allowed to dissuade us from dealing with it at all. You eat an elephant one bite at a time.

My problem with quietly allowing European bankers to continue to defer the necessary actions are that even small risks are not non-existent ones and that risks whose maximum effect is to allow the status quo to continue for a few days, weeks, or even months is a breach of fiduciary responsibility and a waste of the leverage that providing the support could bring. Use what leverage you’ve got.

Update

Another good commentary on Europe’s “Lehman moment” comes from international banking scholar Jeffrey Frieden:

For two years, Europe’s governments have been grappling with how to address this continuing debt crisis. But most of the public discussions have been highly misleading. In Northern Europe, and especially Germany, the tone has been one of outraged indignation. This high moral tone is misplaced. Certainly many Southern European banks and households, and the Greek government, borrowed irresponsibly; but German and other Northern European banks and investors lent just as irresponsibly. It’s not clear that there’s any real ethical distance between irresponsible borrowers and irresponsible lenders.

[…]

Eventually Europe’s creditors and its debtors will have to admit that these debts will not be serviced as contracted, and the debts will be restructured. Pretending otherwise will only prolong the agony – not just for the debtor countries imposing austerity, but also for the financial systems that are now crippled by debts that nobody believes will be repaid. When major central banks, earlier this week, threw a lifeline to the European financial markets, they undoubtedly helped avoid what appeared to be an imminent panic. However, this initiative will only postpone the final reckoning with the region’s underlying financial weaknesses.

In Europe as in America, the real question is how the costs of this devastating debt crisis will be distributed. Who will pay – creditors or debtors? Taxpayers or government employees? Germans or Greeks? More realistically, what combination of sacrifices will be politically tenable, both across countries and within countries. The aftermath of every debt crisis sinks into conflict over who will bear the burden of adjustment to the new reality. The sooner Europeans recognize the true nature of the debates they’re having, and the inevitability of working out some mutually acceptable conclusion, the better off they will be.

Read the whole thing.

The effective approach to dealing with insolvency is bankruptcy and liquidation, loss of shareholder equity, not bailout. Providing of temporary liquidity is acceptable to mitigate the risk of the crisis spreading or to provide time in which to deal with the problem. However, it is not an alternative to dealing with the problem.