Epic hopes for a devalued euro

The Greek bailout is merely an exercise in wishful thinking – that, first, 95 per cent of bondholders will accept it and second that Greece's economy will return to growth sometime next year.

But it should get everyone past the March 20 bond rollover and perhaps even slow down the capital flight from Greece, and buy the authorities some time to deal with Portugal, and then Ireland and then…

But it needs to be remembered that this is, and always has been, primarily a banking problem and that the world remains in the grip of sustained bank deleveraging, similar to what kept Japan in depression for more than 10 years in the 90s and beyond.

The crisis has its roots in two events in 1995: Bill Clinton's drive to increase home ownership and the creation of the euro, which was eventually introduced in 1999.

Clinton's 1995 document, "The National Homeownership Strategy: Partners in the American Dream”, combined with the repeal of the Glass-Steagall Act of in 1999 which unleashed the banks, and led directly to the explosion of subprime mortgage lending that brought American banks undone in 2007.

The creation of a single European currency, also between 1995 and 1999, led to that continent's own subprime bubble and bust – that is the explosion in lending to Greece, Portugal, Spain and Italy by French and German banks.

In 2008 the US government stepped in and recapitalised the American banks. It had the borrowing power to do it and despite a massive increase in its own sovereign debt and a subsequent credit rating downgrade, the US is still able to borrow readily from the bond markets. (It did muck up the rescue operation, however, by drawing the line at Lehman Brothers, thinking the investment bank didn't matter.)

European banks took the single currency to mean uniform credit-worthiness and happily lent to sovereigns that they otherwise wouldn't have touched with a shillelagh.

Then in 2009-10, when US banks were deleveraging furiously, European banks stepped in and took up the slack because the true value of their euro sovereign loans had not, at that point, become clear. According to UBS' bank analysts, French banks in particular borrowed US dollars heavily in the interbank market to build up US dollar assets.

By 2010 they had become the world's biggest trade financiers, commodity trade financiers, and very big in shipping, aviation and commercial property.

As a result European banks entered 2012 in a precarious state: $US26 trillion assets were backed by just $US12 trillion in deposits and $US2 trillion in equity.

And now European governments, including Germany's, are in no position to recapitalise them, so they must try to prevent the default of their customers where possible and provide funding to keep them liquid while waiting for the markets to recover sufficiently to give them capital.

The European Central Bank's LTRO (long term repurchase operation) in December, and then again this month, is designed to remove the immediate risk of a Lehman-style European bank liquidity crisis but it provides no solution to the government debt issue.

The problem with LTRO is that the banks have to post collateral with the ECB to get the money, and when they do that two things happen: existing lenders are subordinated and the collateral gets a haircut (is reduced in value) by up to 65 per cent.

That means a troubled bank that needs LTRO money can quickly go through its entire balance sheet posting assets as collateral and still not get enough cash.

As for the latest Greek bailout, nobody seriously believes it will hold. The forecasts on which it is based assume GDP contraction of 1 per cent in 2013 and growth of 1.4 per cent in 2014, which means a return to growth sometime late next year.

This, to say the least, is a heroic assumption considering its GDP shrank at a horrible annual rate of 7 per cent in the December quarter and the government must now impose further budget cuts of €325 billion.

But even with these assumptions, Greece's debt only gets as low as 157 per cent of GDP before starting to rise again, and certainly not down to the required level of 120 per cent. And since private bondholders have been subordinated to government lenders (because the ECB has refused to take a haircut) they won't be back lending to Greece for a long time, if ever.

Greek GDP is now about €220 billion and falling. It has a persistent current account deficit, increasingly impoverished citizenry, massive capital flight and a bankrupt government. It is going nowhere fast.

The question for the world economy is whether European banks can be propped up long enough for the devaluing euro to work its magic on France, Germany, Netherlands, Austria and Belgium and allow the banks to recapitalise themselves.

And the problem is that to do it they need to deleverage, by $US3 trillion according to UBS' analysts. That will offset the effect of the euro and act to depress the economy.

Increasing bank leverage produced the boom of 2002-2007; decreasing bank leverage is doing the opposite, and still has years to run.

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