The Periphery Holds all the Cards

Europe Is Messing Up Merkel’s Union – Council on Foreign Relations.

Pundits enjoy writing articles detailing how a few simple reforms could fix the eurozone.

In this piece, the fix is a weighted voting system for ECB supervision. The idea is that the new system’s superiority to the one country, one vote standard currently employed will create tougher supervision of the periphery and its banks. This thinking is flawed, because the periphery holds all the cards.

The eurozone has deployed two methods to maintain its status quo, bailouts and money printing.

While the countries are the ones being nominally bailed out, the actual beneficiaries of eurozone largesse are the banks. Eurozone banks are the most leveraged in the world sporting an average debt to capital ratio of greater than 25 to 1. What this figure means is that if a mere 4% of a bank’s assets become worthless, as in the case of a sovereign default, the bank’s capital is completely exhausted.

The bailouts of Greece, Portugal and Ireland have actually been bailouts of the banks holding their debts. The citizens of these countries do not benefit from the bailouts but are certainly suffering from them in the form of austerity.

The other method of keeping the eurozone together is through money printing. Once again, the main beneficiary of this money printing is the banks. Due to a declining economy, the private loans the banks made are underperforming and steadily losing value. This is causing them to bleed capital.

In response, the ECB has deployed Long Term Refinancing Operations (LTRO) in order to place over €1tr into the banking system. The banks pledge whatever assets they have lying around in exchange for virtually free money from the ECB. While the taxpayers, particularly the Germans, are on the hook for these loans, they do not benefit from them.

In the meantime, the crisis fighting efforts have led to several unintended consequences that are making it worse.

By not allowing poorly run banks to fail, all of the banks are turning into zombies just like in Japan’s financial system. Japan’s economy has been stagnant for years, and ultimately what Europe needs to end this crisis in economic growth.

Cheap money has also lowered interest rates in the Northern tier countries. Germany is benefiting from a lower priced euro and lower interest rates, so it is not feeling the pain in the periphery. This is making Germany more arrogant than usual and harder to negotiate with.

The author believes that what is needed is stricter, by which he means more German, supervision of the banks and sovereigns, but this idea does not hold water.

Giving Germany more votes under a weighted system would give the proposed banking union and budget tzar more of a German flavor. You could even argue that Germany could use the promise of more money to coerce the periphery to agree to such a system, but in the end the periphery has the trump card.

If the PIIGS do not believe that they are being treated fairly, they can always default and exit leaving Germany and the rich countries with the bill.

 

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