Who is to bear the losses?


Philipp Bagus is an associate professor at Universidad Rey Juan Carlos in Madrid. He is the author of The Tragedy of the Euro. Visit his personal website here

Police and rioters are clashing in the streets of Athens as the Greek government approves further austerity measures. Indeed there are conflicts over austerity measures all over Europe. At the root of these conflicts lies an interventionist banking system, credit expansion and the perverse setup of the European Monetary System as described in my book The Tragedy of the Euro.

During the 2000s artificially low interest rates lead to an impressive boom, asset price bubbles and malinvestments. Real resources were wasted in building houses that no one wants at bubble prices, in the overexpansion of certain industries and in countries such as Greece in maintaining and expanding an immense public sector.

When Lehman Brothers collapsed governments came to the rescue of industries such as the automotive sectors and, of course, of the banking industry. The losses of these sectors were, thus, partially transferred to the governments. Government deficits and debts soared. The result is the sovereign debt crisis.

Now, European governments like the Greek one are on the border of default. If Greece would be allowed to default, its banks holding Greek government debts and experiencing a run would go bust. In a European banking crisis, French, German and British banks could go insolvent.

While society in general is already poorer due to the malinvestment of the artificial boom, the burden of the losses has not been finally assigned. And losses have not disappeared. They were partially shifted from banks and companies to governments.

Who will be the final bearer of these past losses? Will banks, that bought government bonds, finally be the bearer of losses because governments default on their bonds? Will governments suffer the losses as they lose in power when they are forced to auction off public resources and reduce their spending? Or will taxpayers bear the losses? And finally, which countries’ taxpayers will bear the losses? A huge struggle has started in the Eurozone on how to split the losses between governments, banks and tax payers in the periphery and the core.

The fastest and cleanest solution would be that the responsible actors bear the losses themselves: governments and banks. They would have to default. Banks have lent to irresponsible governments or granted loans flowing into asset price bubbles. Their shareholders would lose everything. Unsurprisingly, politicians and bankers suggest that this would lead to chaos and trigger a long depression. They want taxpayers to pay their bill, at least partially.

Yet, in the case of non-intervention, the world would not come to an end. More realistically, there would be a short and sharp crisis and a fast adjustment. Economically unsustainable business models in the financial sector would disappear. Sounder banks could raise new capital and creditors could agree to a debt to equity swap if a bank´s business model was judged sound.

The alternative is that the past losses are not realized at once but stretched through a long crisis and put on the shoulders of innocent parties. Banks could be sustained with unrealized losses similar to Japanese zombie banks. Taxpayers and users of the single currency could be made reliable for losses. The Eurozone would then stagnate for years.

Through the bailout of irresponsible banks and governments, irresponsible behavior is encouraged. Past malinvestments are not dismantled and new ones are added. A taxpayer bailout reduces the pressure on the Greek government to sell its assets and cut its spending – i.e. malinvestments are not liquidated and continue. Similarly, banks can maintain their support for irresponsible government and prevent the fast liquidation of malinvestments such as unsold housing units. Ordinary people in the Eurozone then suffer through price inflation and a greater tax burden, as well as a long, drawn out crisis.

By contrast, ordinary Europeans would strongly benefit from a liquidation of malinvestments following a Greek default and a European banking crisis. This would not be the end of the world, but the beginning of a short, efficient adjustment process and the just distribution of the burden of losses.