Europe's Economic Crisis Is Not A Euro Crisis


October 24, 2011

(This originally appeared in Forbes Magazine dated October 24, 2011.)

http://www.forbes.com/forbes/2011/1024/opinions-nathan-lewis-capital-flows-europe-crisis-economic.html



The funny thing about the "euro crisis" is that it is not a euro crisis. The currency itself is meandering along, the way it is supposed to, without any particular issues, serving as a unit of account and means of payment.

Instead, we have a crisis of insolvency, first among certain profligate governments and second among banks. In other words, someone might not be able to make the payments on their debt. This has nothing to do with the euro itself.

Greece has about the same population as Los Angeles. If the government of Los Angeles defaulted on its debt--which is possible, you know--does that mean that Los Angeles must leave the "dollar zone" and issue a new Los Angeles peso? The issues facing the Greek government are not really any different from those facing millions of U.S. homeowners who borrowed more than they should have. Hard decisions must be made. But nobody suggests that those foreclosed homeowners need their own personal currency.

The other strange idea out there is that these various insolvency problems require some sort of aggressive federalization, the creation of a European superstate. The rationale behind this argument seems to be that the superstatists want some kind of central body of such immense stature that it can bail out the entire Continent. The reasoning behind that, in turn, appears to be that lenders--even those reckless enough to lend to the Greek government--should never take an honest loss when the losses can be foisted on the innocent taxpayer instead.

The other insolvents in our drama are the banks themselves. They are busy promoting the line that any bank losses need to be made up via a tax-payer-funded recapitalization, usually on terrible terms that amount to little more than theft.

A more sensible and fair approach would be a debt-for-equity swap, which provides much more equity capital and doesn't cost the taxpayer anything. In the simplest terms, a typical bank will have 1,000 euros of assets in the form of loans, 900 euros of liabilities in the form of borrowed money and 100 euros of equity. After a series of losses the bank's assets are worth 800 euros, but the 900 euros of liabilities remain.

At this point 300 euros of bonds could be converted to equity. This would leave the bank with 800 euros of assets, 600 euros of borrowings and 200 euros of equity, thus returning the bank to a state of health without the need for taxpayer funds. A huge equity cushion remains for any future losses.

Do banks know this? Of course. They employ hundreds of sophisticated securities analysts. JPMorgan Chase ( JPM - news - people )'s takeover of Washington Mutual in 2008 was done under similar conditions. The unsecured debt was eliminated, thus recapitalizing the bank. WaMu's bank operations continued, quickly rebranded as Chase. We can only wonder why this option is not being more fully discussed across the pond.

The basic problem with the euro project is that it is in the hands of incompetents who seem to have no idea what to do when a borrower can't make the payments--one of the most elemental and rudimentary features of the free market. The rules of capitalism on that score are clear: If the borrower is no longer able to borrow, the lender takes a loss. Both can learn from their errors and avoid them in the future.

Unfortunately, what should be a simple debt-workout matter is in danger of spinning into a genuine catastrophe. The euro itself, which in principle ought to be immune from these contractual disputes, might soon enter a real currency crisis, either from the sovereign debt the European Central Bank is buying with freshly printed money or from general negligence.

A currency can get into serious trouble really in only one of two kinds of ways: a crisis of rising too much or a crisis of falling too much. The first can be solved by expanding the monetary base, thus depressing the value; the second can be dealt with by reducing the monetary base, thus supporting the value. It has nothing to do with whether this or that borrower makes its payments.

The idea, repeated so often, that the euro zone needs to either break up into multiple currencies or form some sort of superstate has no basis in reality. Europe's problems are eminently solvable. However, given the very poor quality of leadership on the Continent today, lots of unpleasant things that don't have to happen might indeed happen anyway. Europe has no one to blame but itself.