The Tragedy Of The Euro

Eurozone banks simply cannot afford to ride out the effect of falling prices on their core capital bases. The European Banking Commission and other regulators have introduced rules that make it impossible. Assuming a developing funding crisis begins to drive up bond yields, we can be sure that Eurozone banks will find it increasingly difficult to maintain their margins over minimum Tier 1 and Tier 2 capital requirements, as well as capital conservation buffers, countercyclical capital buffers and global systemically important institutions buffers.

There is therefore a growing probability that the withdrawal of the ECB as a buyer of government debt will bring forward the next Eurozone banking crisis, and it has the potential to escalate rapidly. Not only has the money-bubble through the ECB’s asset purchases gone, but there is a growing risk of contraction in the quantity of bank credit available for government bonds at a time when Italy, Spain, France and other smaller states will most need to issue new debt.

The removal of national currencies in 1999 reduced the status of Eurozone states to entities that can become bankrupt in every practical sense, even if not legally. And without the ECB financing them, they will rapidly become insolvent. Taking the Eurozone as a whole, government deficits last year needed a relatively modest €70bn or so increase in bond issuance. Assuming no deterioration in government finances, a similar level of funding could perhaps be achieved by the ECB keeping its deposit rate at minus 0.4% and relying on interest rate arbitrage plus coupon flows to create buyers willing to subscribe for very short-term government debt.

It allows no room for slippage. The signs are that the global economy is slowing, and the widening spreads on commercial loans confirms the process of central bank base money contraction is beginning to undermine business activity world-wide. At this time of the credit cycle the process of continuing debt expansion always falls entirely on the shoulders of governments and their central banks.

The emerging signs of a credit shock that will engulf public finances are everywhere. The Eurozone appears to be at the greatest systemic risk. The only way these dangers can be averted in the Eurozone is for the ECB to reinstate its asset purchase programmes to rig bond markets again. But having just stopped them, the ECB will need very good reasons to start them again. As usual, the order is crisis first QE second.

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