Europe’s debt problems date from late-2009. Upon winning the Greek parliamentary elections in October that year, new Prime Minister George Papandreou found that fiscal figures had been falsified by the outgoing government to appear low enough to be in line with European Union guidelines. Tiny Greece – accounting for a mere 2% of Eurozone GDP – continues to be in crisis for a third year, and investors have tested the ability of other member nations to borrow at reasonable rates in capital markets. In addition to Greece itself, Ireland and Portugal have been forced to receive bailouts arranged by the “troika” (the EU, the European Central Bank and the International Monetary Fund), and none of these countries has been able to return to global credit markets as the troika had hoped. And the curse of bailouts —that they put nations in perpetual recession even as they do little to stabilize the debt situation – has made a far larger country, Spain, struggle to avoid an official bailout as it addresses lower real estate prices, a plunging stock market, and a flight of bank deposits.

The persistence and virulence of the debt crisis is explained largely by two factors: (1) treating what is basically a lack of solvency in some countries as if the problem was one of temporary liquidity shortage; and (2) the tendency of debt crises to jump from the banking sector to the sovereign sector, and back again, adding to the overall risk level. And why would skilled EU officials misdiagnose the problem as one of liquidity? Because it is politically easier to provide liquidity through “bailouts” rather than to recognize the situation as one involving excessive debt. The latter would call for a debt reduction exercise for the crisis countries, resulting in massive losses to the creditor institutions. And as for the second factor, viz., the mutually reinforcing influence of banking and sovereign risks, history provides several examples of how this relationship has deepened and extended debt crises.

Adding Liquidity Will not Correct for Excessive Debt
A homeowner unable to make payments on his $300,000 mortgage due to reduced economic circumstances such as a job loss will not be better off if, in trying to improve the situation, the bank simply extends fresh credit of $100,000. While the debtor would be able to make payments temporarily using the new funds provided by the bank, the enhanced debt load of $400,000 will be even less serviceable than the previous $300,000, and the bank will likely suffer larger losses in the future.

While this may seem easy enough to understand, Greece, Ireland and Portugal find themselves in a similar situation in dealing with the troika. In the case of Ireland and Portugal, the bailouts involved the provision of new funds by the official creditor agencies, accompanied by official assurances that these two countries would soon be able to access private credit markets. This has yet to happen. And even though Greece’s most recent debt restructuring completed in March involved private creditors accepting “voluntary” haircuts of over 70% of face value, capitalization of interest over coming years will keep the debt-GDP ratio at an unsustainably high 120% even in 2020, according to EU calculations.

All these countries were major borrowers in the international credit markets until just before the global financial crisis. Some lenders had erroneously considered the countries’ membership in the common currency area as also reflecting a similar level of sovereign risk, and had willingly extended loans to the sovereigns and to the banking sector. With the buildup in debt resulting in increased consumer spending and, probably, some amount of capital flight by local investors over the years, the debt is currently too large to be serviced by the countries’ public sector entities. The EU’s approach of dealing with a solvency problem as though it was a short-term liquidity issue can only lead to the solvency situation getting worse as in the case of the homeowner dealing with his bank.

Switches in Risk Between Banking and Sovereign Sectors Raises Overall Risk Level
The persistence of the debt crisis is also explained by the fact that risk has, over time, mutated from the banking sector to the sovereign or, in some cases, moved in the opposite direction. An example of the former is the Irish government’s assumption of the banks’ obligations after they incurred substantial loan losses in 2008 and 2009. While the guarantee on bank debt forestalled a run on its banks, the same act caused Irish sovereign risk to rise sharply, resulting eventually in the country requiring a bailout.

In the case of Spain, on the other hand, the banking system was weakened by the magnitude of real estate loans whose quality has continued to deteriorate since the boom ended in 2006. Until recently, despite concerns about a few banks, Spanish debt yields declined as its banks used funds from the ECB’s LTRO programs to purchase sovereign paper. Spain’s country risk was not believed to be in serious question. The latest bout of concerns about Spain were triggered by an announcement in March by Mariano Rajoy, Spain’s Conservative Prime Minister, that the fiscal deficit in 2011 had been higher than expected at 8.5% of GDP. Furthermore, Mr. Rajoy unilaterally announced that he would seek a deficit target of 5.8% of GDP this year, higher than the 4.4% he had agreed to with the EU.



Concerns about Spanish fiscal policy were accompanied by signs that the recession was deepening and, with it, that the quality of real estate loans on the banks’ books would deteriorate further. Rumors of a deposit flight from Bankia, a large Spanish financial institution formed by last year’s merger of seven savings banks, and since nationalized by the Spanish government, called into question the safety of bank deposits in the country. Figures released by the ECB yesterday indicate that corporate and retail deposits in Spanish banks declined by 1.9% in April alone as capital fled Spanish institutions. Fears about the banking system have also led to a growing perception that Spain itself may require a bailout engineered by the troika, resulting in the yield on ten-year Spanish debt rising yesterday to 6.61%, 534 basis points over the German bunds whose yields fell to a record low 1.27%.

If fears of Spain needing a bailout come to pass due to the mutual reinforcement of rising banking and sovereign risks, the next stage in the prolonged European debt crisis will likely be contagion from Spain to Italy —the third largest debtor in the world after the United States and Japan, and a country with €1.9 trillion in total public debt. If it was not apparent so far, right now is the time for Europe’s leaders to recognize the urgency of arresting the crisis on its tracks through economic growth-enhancing measures.