Christine Lagarde, the new IMF chief, is doing now what should have been done long ago: urging Europe’s governments to help its banks shore up their capital base to offset losses on their holdings of bad bonds from troubled European countries. European banks, partly because misguided (and politically influenced) bank regulations favored government bonds, hold some 45 percent of Europe’s government debt. The WSJ reports:
Christine Lagarde is getting pounded for pointing out what everyone knows but few in Europe care to admit—that bank lending to debtor nations is the primary source of Europe’s systemic-risk problem. In remarks at this weekend’s Jackson Hole confab for central bankers [she] said Europe’s banks “need urgent recapitalization,” adding that “they must be strong enough to withstand the risks of sovereigns and weak growth.”“The most efficient solution,” Ms. Lagarde argued Saturday, “would be mandatory substantial recapitalization—seeking private resources first, but using public funds if necessary.” She suggested that the EU’s existing sovereign bailout fund could be used for this purpose…The criticism merely shows that Ms. Lagarde understands the problem better than her former peers…The official position of insisting that Europe’s banks are sound hasn’t worked. Banks that don’t need the capital could repay it after the crisis has receded, while all of those subject to “mandatory” recapitalization would benefit from the strengthening of their balance sheets.
European politicians hate this idea and both Germany and France have systematically warped their response to the European financial crisis in attempts to cover the weaknesses in their domestic banking systems. “Bailouts” of countries like Ireland, Portugal and Greece are in large parts taxpayer funded bailouts of French and German banks and they have been set up to divert voter wrath from French and German politicians to Spain and Greece.Neither the French or the Germans want to admit this. If imprudent northern bank lending is seen as contributing to the southern crisis, it is harder to argue that the full cost of adjustment should be borne by the south.Why shouldn’t the northern banks take haircuts? That would mean that French and German politicians would have to go hat in hand to voters to ask for TARP style bailouts of their own insolvent banking systems. That would transfer voter resentment against free spending Greeks and Italians to poorly managed northern banks — and the political class that presided over twenty years of bad bank regulation that combined with a flawed monetary union has created an unholy mess?German and French politicians can think of many reasons why that is a bad idea. In any case, the nexus between big banks and politics is closer in Europe than it is in the US. This is partly because the individual countries in Europe have smaller economies and a smaller number of big banks that loom disproportionately large in policy making. But it is also because governments in those countries play much larger roles in the economy than in the US, and good relations with friendly banks are vital to the smooth operation of the European economic model.The otherwise inexplicably foolish and incompetent European response to the euro crisis makes a little more sense if you realize that German and French politicians want to manage this problem without letting the public in on the dirty little secret at the heart of the crisis. Christine Lagarde, now that she is working for the IMF rather than the French government, thinks it is time to come clean.She is right.