Rabu, 09 Mei 2012

Eurozone banks: the sum of all fears

As these charts show, Eurozone financial conditions are still under a lot of stress; Euro swap spreads reflect a significant degree of systemic risk. The U.S. has largely avoided Eurozone contagion, but the threat of a banking collapses in Europe still weighs heavily on investor sentiment around the world.

This chart compares the S&P 500 Banks Index (white line) with the Euro Stoxx Banks Index (orange line). Here we see that the capitalization of Eurozone banks has been in sharp decline since October 2009, while U.S. banks have been roughly unchanged since then. Eurozone banks are now just inches from their crisis lows of March 2009, while U.S. banks have recovered significantly over the same period.

This chart shows the ratio of U.S. bank stocks to Eurozone bank stocks to put the divergence in performance into perspective. Since the panic lows of March 2009, U.S. stocks have outperformed their Eurozone counterparts by 235%. (The Euro/$ exchange rate is about the same today as it was then, so this is a valid comparison.) The relative performance differential is simply astonishing—U.S. banks are still 63% below their 2007 highs—and it highlights just how much the Eurozone banking system has suffered as the risk of sovereign defaults has surged.

Eurozone banks are bearing the brunt of the deterioration of sovereign debt prices because they have been the most significant holders of this debt. This illustrates how debt defaults are zero-sum games: Greece benefits from its debt restructuring because it is relieved of the need to make burdensome debt payments, while Eurozone banks (and their shareholders) are punished because their future cash flows are now much less than originally expected. Meanwhile, life goes on for most of the rest of the world. Debt defaults don't destroy the productive capacity of the world, they simply are the consequence of imprudent and unproductive investment decisions. The funds that were lent to Greece and other PIIGS were misspent (e.g., on lavish pensions for public sector workers) and there is nothing to show for it. The Eurozone's scarce resources were wasted and frittered away for years, and that has already been reflected in weak growth and high unemployment. The economic damage of lending to unproductive nations has already been done.

The main threat posed by Eurozone sovereign defaults is that the Eurozone banking system implodes, and the severe underperformance of Eurozone bank stocks and the still-high level of Eurozone swap spreads shows that investors are very much aware of this threat. But painful and frightening though this may be, it is not a reason to expect the end of the world as we know it. Eurozone banks can be nationalized and/or recapitalized, and the ECB can lend massively—which they've been doing. The vast majority of the people working in the Eurozone will continue to work even if more sovereign debt is written off. Debt defaults and restructurings are like an economic version of neutron bombs: they destroy the net worth of lenders, but they leave productive resources intact. Eurozone economies need not collapse, and the U.S. economy needn't suffer very much.

Meanwhile, the solution to Europe's problems is not all that difficult. As Mark Perry noted in a recent post, Sweden has made significant progress in recent years by eschewing the Keynesian solutions that have failed elsewhere in Europe. Cutting back on public sector spending while reducing tax burdens on the private sector is the perfect way to solve the problems facing Europe, and the U.S. for that matter. Most of Europe is still refusing to acknowledge this, but sooner or later more people will understand that growth-oriented policies such as are being pursued in Sweden and Ireland are the not only the least painful solution, but also the best solution for countries that are burdened by too much government spending and too much debt.

There is a way out of this mess, so there is no reason to despair.

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