Seeking a cure for Europe's banking plague

Last night we were again reminded that the core of the global problem is that European politicians and central bankers have failed to recapitalise their broken banks.

The FT index, after being buoyed by the possibility of Greece sticking with austerity, fell one per cent from its peak as a result of another Spanish banking crisis.

The European banking system is a key element in the finance of world trade and in the global wholesale lending market, which Australian banks rely on for a large slice of their funding.

The simple truth is that when a country undertakes an austerity program involving cutting government spending and raising taxes it slows down the economy and drives down asset values while boosting unemployment, which in turn raises bad debts for banks.

Naturally this makes everyone nervous about lending to European banks, which in turn worsens the problem.

Into that dangerous cocktail we throw the possibility of a breakup of the euro, which is forcing the banks to try and make sure their deposits and assets in individual countries are matched. In effect the euro is gradually breaking down via the banking system.

And finally the European central bank lends the troubled banks vast sums at low interest rates and encourages them to use the money to gamble on bonds in countries that are under great pressure and may not be able to repay the debt. Italian and Spanish bonds have been the biggest beneficiaries and last night's crisis in Spain involved the already hard-pressed Spanish government being pressured into more banking rescue packages.

All this should have been conducted via equity markets as soon as the core problems emerged. Instead in the early days the problems were concealed by stress tests that were very selective about what stress they tested.

The European banking mess casts a pall over better signs around the world. China clearly knows it took the slowdown measures too far and is again stimulating – the latest plan is to subsidise car purchases in rural areas. That plan will not change the China outlook but it is a clear signal as to what is ahead. In the US consumer confidence is rising.

Because the attempts to rescue European banks have never addressed the core banking problem, the size of the mess keeps rising and makes it harder to solve. And a vast amount of the world's banking capital has been lost.

In my view there are two broad possible outcomes – we keep trying to muddle through for a decade, or there is a dramatic event. That dramatic event will either be a major breakdown, a flood of money to push down the euro and lift asset values (what France wants), or the wealth of Germany will underwrite Spain and Italy and probably Greece and Portugal as well, assuming they stay with austerity.

Many Germans fear that's where Angela Merkel is taking them. And then finally the banks must raise real capital, not government money.