America Won’t Escape Fallout
A fracture has grown in the European Union (EU) since the global financial crisis of nearly a decade ago. Anemic economic recovery has revealed its flaws and critics are increasingly skeptical of EU survival. The Italian banking crisis, now in initial stages and anticipated to be more distressing than the Greek crisis, may just be the straw that breaks the EU’s back.
The fate of Banca Monte dei Paschi – the world’s oldest bank (since the Renaissance in 1400s) and Italy’s third largest – went for government bailout last month. Bad loans, failing profits, and inability to raise capital made the Italian government its only hope. And similar to the opening of the U.S. banking crisis with Bear Stearns and Lehman Brothers, Monte dei Paschi may just be the tip of a very large iceberg. Contagion to the rest of the EU, and beyond, is a very real possibility.
To date, little attention has been given to the events in Italy. But America should take heed. Its economy is very much entwined with Europe’s. The level of the cross-border activity in finance, product distribution, technology, and security, warrants greater concern. Europe’s problems are America’s. Inter-dependencies have intensified over the last three decades, making escape from contagion unlikely.
The European Confederacy
Since World War II, a unified Europe has been a work-in-process. Certainly, its original purpose was necessary – to rid the centuries-old, xenophobic conflict that had regularly devastated Europe and spilt over its borders with increasing consequence.
But as the Cold War escalated, the importance of a unified Europe shifted. America needed Europe to be its front line against Soviet expansion. The Marshall Plan, NATO, and the early precursors to the EU provided the continent to be once again economically and militarily strong. Centuries of transgressions, even the latest horrific ones, were washed away and to be forgotten.
When the Iron Curtain finally fell, European confederacy would again transform. The existential threat faded and now the EU would pull together for relevance in the new global economy. Its combined economies would come to rival those of China and the U.S. Reunited Germany along with France, Italy, and the U.K. – each of comparable size – would make up two-thirds. While smaller nations such as Portugal, Ireland, Greece, and Spain, along with former Soviet satellites, would add the rest.
A single currency and monetary authority were adopted. Borders and trade restrictions were dropped. Laws and a separate legal system were implemented. Immigration policies were relaxed and standardized. Surprisingly, even a common foreign policy was moderately successful. When times were good, it was almost the United States of Europe. Almost.
But important differences could not be overcome. A unified fiscal structure (tax, debt, and spending) was never agreed. Common language was impossible. Replacing NATO with an integrated military force was rebuffed. And most importantly, the human factor – the mistrust shaped from centuries of conflict combined with numerous cultural differences – would simply not allow for a sovereign European Union similar to the U.S.
Italian Banks and Economy
Symptomatic of the global monetary excesses pursued over the last few decades, non-performing loans (NPLs) are once again the problem. Some estimate Italy’s NPLs at close to twenty percent of its gross domestic product (GDP). For comparison, the American debt crisis during the Great Recession was approximately five percent of its GDP.
Making matters more difficult are the amounts expected to be recovered from the bad loans. Recovery values are likely close to zero and far below the U.S experience. Thus, Italy’s difficulties may be five to six times worse than the U.S. crisis.
Also worse is the Italian government’s ability to cope with the problem. Entering the banking crisis, U.S. government debt relative to its GDP was still within reason at seventy-five percent. But Italian government debt as a percentage of its GDP ranks only behind Greece’s and currently stands over one hundred and thirty percent.
The Italian economy is ten times larger than Greece’s and is comparable with those of France, Germany, and the U.K. Meaning that the Italian problem is large, making any effective bailout from the already reluctant International Monetary Fund and other EU states uncertain, at best.
Much of Italy’s financial problems stem from its decade-long flat line growth, its large government deficits, its unemployment and worker participation rates (particularly youth unemployment greater than forty percent), its age demographics (retirement and health care burdens), and the government’s long standing state of disarray.
Which now leads to the dilemma facing Italian and EU leaders. The Italian banks received a considerable amount of funding from smaller domestic investors who purchased the banks’ bonds for their savings and retirement accounts. Unlike deposits, those bonds aren’t covered by deposit insurance. Also, EU law forces bank bailouts to come only after creditors and bondholders absorb losses first. Thus, those bonds are now virtually worthless. So any system-wide bailout will only come by first forcing significant losses on a wide swath of the Italian populace.
That, and EU limitations on size of government debt and deficits, tighten the shackles already around Italy’s wrists. The Italian government is unable to make the bondholders whole without further crossing the line of its already large debt load and deficits. Fixing the Italian banks may come only at the cost of a substantial austerity program, one which would be forced upon the Italian people as a result of EU membership.
Much of the Italian government debt is financed beyond Italy’s borders. Many of its bonds are held by banks throughout the EU – banks like Deutsche Bank, Societe Generale, and the Royal Bank of Scotland, all with enough problems ex-the Italian effect. The Italian bonds present a significant risk to the EU banking system which has been struggling with inadequate capital from the global financial crisis of 2008 and the European debt crisis in 2011.
An Italian debt default would be a serious setback to the global economy and most economists do not expect it to happen. But obviously, the risk of Italian government bonds are increasing and are closely monitored by ratings agencies for additional downgrades. If those bonds do weaken further, even without default, a Europe-wide liquidity event could still result, forcing central banks to play their rescue cards once again with a flood of new money.
Shift in Sentiment
Europe’s situation now is significantly different from when Greece’s debt crisis began unfolding in 2011. The EU is far more divisive and compromise has cracked. The weights of uneven economic recovery, terrorism, immigration, inequality, and regional differences caused by the common currency have dramatically shifted Europe’s sentiment.
For example, last year in Germany, stemming from the Syrian refugee crisis and the rise in ISIS-related terrorists attacks, polls disclosed for the first time that a majority want a rebirth of national sovereignty. As rebuke to longtime Chancellor Angela Merkel, Germany is now moving away from being the EU’s staunchest stronghold.
And Italy is not alone in its financial troubles. Spain has a very similar situation brewing. The problems of Greece, Italy and Spain aren’t going away any time soon, especially not with further globalization and not under the current EU regime.
The patience of more well-off EU members – Germany and France – is wearing thin. A bailout without forced austerity is improbable and any push for austerity is bound to be volatile. It is conceivable that some EU members could again move to the left with a new variant of socialism, as seen recently in Portugal.
It is also conceivable that longtime resentments could resurface. Many now believe that Europe’s southern nations – Greece, Italy, and Spain – have been living beyond their productive means for quite some time. Many also believe this situation was fueled by the economic interests of Germany and France, and was only made possible through the monetary policy controlled by those same interests.
Furthermore, it is expected that all these pressures will persist or worsen. Brexit, the Italian referendum, and the controversies surrounding the upcoming French and German elections are reflections of Europe’s overall splintering. Admittedly, the EU’s structure is stressed and the call for greater national sovereignty is growing louder. How will the center continue to hold?
The world’s geopolitical and economic uncertainties, combined with the EU’s difficulties, make a case for further unraveling. Unfortunately, Europe does not have a shared legacy to fall back on during these troubled times. Rather, it may be that Europe’s long history of conflict is actually working against its uncertain unified future.
Christopher Petitt – financial executive, board advisor, and business consultant – is the author of the book, The Crucible of Global War: And the Sequence that is Leading Back to It. It is available at Amazon.com, Barnesandnoble.com and at bookstores everywhere.