The world’s biggest central banks came together yesterday in a financial choir to sing a hymn called “There Will Never Be Another Lehman.”
It was music to the ears of financial markets. European and U.S. stocks moved sharply higher on the announcement that the U.S. Federal Reserve, the European Central Bank and their counterparts in Japan, Switzerland and the United Kingdom are ready to lend unlimited amounts of dollars to European banks that are having trouble funding their operations.
The news came on the third anniversary of the date on which Lehman Brothers, then America’s fourth-largest investment bank, filed for bankruptcy when it could not raise the money it needed to keep going. Lehman’s bankruptcy sent the global financial system into a nosedive that was stopped only when governments around the world stepped in to say, in essence, that there would be no further uncontrolled failures of key financial institutions.
Yesterday’s announcement is proof that, despite years of rhetoric against bank “bailouts” and “too big to fail” institutions, this no-failure rule is still the policy – because the alternatives are simply unacceptable.
There is still a gap between political rhetoric and economic reality. In a separate statement yesterday, German Chancellor Angela Merkel vowed to resist “collectivizing debts” among countries of the eurozone. Merkel’s thrifty countrymen are outraged at the thought of having to pick up the tab for Greece and other heavily indebted nations on the eurozone’s periphery. They also dislike the idea of allowing the euro nations to borrow money jointly, which would permit high-risk nations to take advantage of the better credit ratings held by Germany and other financially solid states, while those stronger states would see their own borrowing costs rise.
Merkel is in a political box. After repeated electoral setbacks in the past year, she has to validate her country’s reaction, but she also has to face facts – principally, the fact that major banks all over Europe, notably in France, are deeply exposed to Greek and other shaky sovereign debt.
In practice, then, the eurozone’s sovereign debt has already been collectivized, via the banking system. A Greek default would not merely mean bankruptcy for Greece and its banks; it would mean bankruptcy or bailout for banks all over the continent. A larger sovereign default, by a country such as Italy, could take everybody down.
Europe has been in denial about this collectivized-debt reality for a long time now. Two rounds of stress tests on the continent’s banks failed to reassure anybody of the banking system’s soundness because, as I wrote here in July, those tests did not even consider the possibility that any government might default. Yet apart from European politicians and bank regulators, nearly everyone who is paying attention to this issue considers Greece, at least, likely if not certain to default.
If Greece cannot pay back everything it owes in full and on time, then the parties to whom it owes money are not as financially solid as they claim. Among those parties are, to a considerable extent, the major banks in France. Moody’s cut its credit rating on two of France’s largest banks earlier this week. Bloomberg reported on Monday that investors are now valuing European banks at the lowest levels since the crisis that followed Lehman’s collapse.
American money market funds are a key source of dollars for foreign banks. Fund managers have become increasingly reluctant to lend to the big European institutions, however, because they fear that the institutions may not be able to meet their obligations if Greece or another sovereign borrower defaults.
Things were starting to deteriorate rapidly before the central banks stepped in yesterday. Two unidentified banks turned to the ECB for dollar loans just hours before the central bankers’ announcement. On Wednesday, Reuters reported that French banks were looking to raise their prices for lending dollars in order to offset the rising costs of their funds. A price increase might only have made matters worse, however, by sending the French banks’ customers elsewhere.
As Europe’s lender of last resort, Germany wants to make sure that Greece and other shaky borrowers do everything possible to repay their debts. The Germans can demand that Greeks pay higher taxes and live with much less government spending. They can squeeze as much as possible out of Athens. But chances are that, even after all that squeezing, there just is not enough juice in the Greek economy to satisfy the country’s creditors. Someone else is going to have to take a hit.
That someone else will be a combination of bondholders and taxpayers, mainly but not solely in Europe. Banks are fighting any suggestion that they are short of capital, because they don’t want to have to sell stock at today’s depressed prices to bolster their reserves. Taxpayers, in Germany and elsewhere, are fighting suggestions that they might have to help make up for debtor nations’ shortfalls. But both parties will ultimately have to do the things they don’t want to do.
The one option that is not on the table, for which we all can be grateful, is to let a Lehman-like institution collapse and set off a chain reaction throughout the financial system. We saw the consequences of that approach three years ago. So I’m not listening to the fire-and-brimstone sermons from European politicians. I’m listening to the hymns they choose to sing.