The Bloated Financial Sector

How to Save the Banks and This Time Maybe Even Get Rid of Some

By Lucas Zeise

(article originally published in German in the October 18th, 2011 issue of the daily newspaper junge Welt)

In the last few weeks there were a number of cute scenes; for example, the thundering applause for Giorgios Papandreou during his speech before the BDI (Federation of German Industries). In excellent English with an American accent, the Greek Prime Minister promised the assembled German business leaders: “I can guarantee that Greece will live up to all its commitments.” The business bosses were as pleased as punch. Everything will be fine, promised the Social Democratic Greek Prime Minister with an American past. Formulated a bit differently, Papandreou’s message was: the EU market area will be preserved in its entirety, including Greece; the money invested by the German state for this purpose will be repaid.

As boss of the construction company Hochtief, BDI President Hans-Peter Keitel has had some good experiences in Greece. The construction of Athens International Airport was conducted by the German corporation as a general contractor. And the license to operate the airport also yielded some extra income within the framework of a classic “Private Public Partnership”. One could say that Keitel experienced up close and personal how enriching a Euro partnership can be, even with the Greeks, economically weak and denounced as lazy and untrustworthy by the tabloid Bild. Keitel and the other capitalists and head managers organized in the BDI know the advantages they have from the currency union. The event with Papandreou occurred at the same time as the Chancellor and her parliamentary ankle biter Roland Pofalla made an effort to organize a majority vote by the coalition parties for an extension of the rescue package for Greece. They succeeded – among other reasons, because the industry federation made it clear to the representatives of the FDP, CDU, and CSU how they were supposed to vote in this situation. In case of emergency, according to the clear message, the German state would have to pony up even more money, even if that would contradict its long practiced iron principles of political conservatism. The important thing in any case was that the euro, the precious currency union would be maintained.

Just Like Three Years Ago

At the BDI event, the Greek Prime Minister also positioned himself firmly on the side of the German bosses. He promised to represent their interests, while putting the interests of his Greek fellow citizens on the backburner. This is not because Papandreou is afflicted by a lack of courage. He openly advocates this position in Athens and Thessaloniki. His government dutifully fulfils the requirements dictated to it by the Troika (a wonderfully old-fashioned expression from monarchist Russia) consisting of the International Monetary Fund, the European Central Bank, and the European Commission. This trinity checked the conditions, prescribed firing public sector employees, reducing the sovereignty of collective bargaining agreements, the sale of all state property not yet privatized, and made judgments and varied its message concerning the ability of the Greek state to service its increasingly growing debt. Sometimes it looked good, sometimes not so good. In the first case, the next tranche of credit from lenders beckoned. In case of the latter, the bankruptcy of the state was imminent. In any case, Papandreou and his enormous and for purposes of PR unsuitably fat financial minister Evangelos Venizelos stood firmly on the side of the Troika, creditor banks, and the BDI.

The “cost-cutting measures” and “reforms” dictated within the framework of the first bailout fund for Greece in May 2010 have plunged the country deeper into recession, as could have been expected. And it’s not the only one. Confidence in other European countries has also vanished. In the middle of a universally acclaimed upturn, the second quarter of 2011 only brought stagnation to Germany, while the third quarter is expected to bring light contraction. The world economy has ended its interim high and is returning to a state of affairs characterized by general weak consumption and demand. A further straining factor in Europe is that some countries like Great Britain and Spain are rigorously and brutally cutting state expenditures by their own free will. Others such as Greece, Portugal, Ireland, and Italy are doing so under pressure from Berlin and Brussels. The general result is fatal.

Thanks to the impending return of recession and thanks to the crisis of state debt which has not even been solved in the slightest, we’re back to where we were three years ago. Banks once again have to be rescued from downfall with a lot of state money. Our chancellor, otherwise bent on “saving”, casually said as much after a visit with European Commission President José Manuel Barroso. At the same time, the European heads of state prepared for debtors having to take a bigger haircut in the case of the main problem country Greece (or risk a state bankruptcy). Both things have quite a bit to do with each other. Some European banks might not be able to deal with a greater devaluation of Greek state bonds – certainly not the Greek ones. Incidentally, we learn from this that the big bailout funds were only constructed with great effort in order to bailout domestic banks.

It’s still unclear how exactly the bank bailout will look. But the basic idea is as follows: first of all, the German bank bailout program “SoFFin” – hastily thrown together in autumn 2008 at the modest amount of 480 billion euro and which expired at the end of 2010 – will probably be switched on again through a resolution of the Bundestag. All other euro countries will proceed in a similar manner. In order to support those countries that can’t come up with the necessary sums to bail out “their” banks, the authority and scope of the European Financial Stability Facility (EFSF) will be extended by further resolutions of parliament. When all that is arranged, Greece will be allowed to go bankrupt. Then – such is the political calculation of our leaders – such a bankruptcy will no longer devastate any banks.

The prospect that the governments of the euro territory are contemplating once again using taxpayer money to prop up the banks has stimulated the financial markets. That was good news for investors, since over the course of the summer it became increasingly clear that some banks would not be able to deal with taking a haircut on the debt of even a small country. The banks started distrusting each other. The “money market between banks”, where credit institutes usually procure without much fanfare the necessary liquidity for each other in order to meet payment obligations and get rid of spare money, stopped functioning. Just as in the summer of 2007, when the great financial crisis had just begun, the European Central Bank (ECB) sprang to the rescue. It once again provided the banks with all the money they needed. Without this aid, some banks would have had to close due to a shortage of liquidity.

A “Watering Down Effect”

The joy on the financial markets over the rescue operation for the banks contemplated by Merkel, Barroso, and French President Nicolas Sarkozy was strangely enough not shared by some of the boards of those very banks. There arose the suspicion that the banks were to be force-fed capital. But for once, the bank rescuing politicians were actually right. What’s the use of the most beautiful bailout fund if the institutes won’t take the money, while at the same time a state bankruptcy occurs that topples one or two banks and thus knocks out the entire financial system? The bankers for their part don’t want the additional capital, since it reduces their returns. Lots of capital in relation to transaction volume, a high capital ratio, reduces profitability for two reasons. First, the leverage by means of which banks make a lot of money out of a little borrowed money becomes smaller. Second, accumulated profit then has to be distributed amongst a greater volume of capital – or as funds managers say, the “watering down effect” pushes down the return on equity. In times of crisis, it becomes more apparent than ever how the interests of bankers contradict the general interest, including the general interest of capital, in the most frictionless possible flow of economic activity. It will be interesting to see how and to what extent the European heads of state will be able to impose this forced capitalization.

As is often the case, presumably a fake solution will be conceived. Since the last highpoint of the still current financial crisis, the EU countries have achieved enormously important regulatory progress. They have created numerous coordinating bodies for the previously nationally circumscribed financial regulatory agencies. The committee for the European Banking Authority (EBA) was established in London, where the density of banks is extremely high, and thus the bankers don’t have to travel very far in order to advise their regulators as to how they’d like to be monitored. That’s how the comprehensive bank testing action came about a half a year ago which was propagated as a comprehensive stress test – a PR action thought up by the banking associations. This PR action was not aimed at the public, but rather at the banking profession itself. The banks had begun to mutually distrust one another and not lend each other any more money. Only a few unimportant small institutes did not pass the test. The rest were evaluated as primed for the coming crisis. It’s at least pleasing to know that the bankers themselves did not believe in this bogus event.

Now the EU governments have resolved to approach things more seriously. The London-based EBA is supposed to once again test the same banks and determine if they have enough capital to withstand the stress of a Greek bankruptcy. Whoever does not possess enough capital will have a few weeks’ time in order to procure it on the financial markets. Whoever is unable to do that will receive state money by force. In order to prevent that, a few power breakfasts with the gentlemen and handful of ladies of the national and European supervisory agencies will be necessary. You can bet a good package of derivatives that the support program for the banks will be arbitrary and ineffective. That means furthermore that the planned bankruptcy of Greece will be postponed until all of Greece’s bonds are in the hands of the rescue fund or the ECB.

The second phase of the bank bailout thus presents itself as a truly complex rescue apparatus. It can’t and won’t work, for the simple reason that in a Europe with a common currency, it’s absurd to leave the rescue of the banks to the respective national governments. Furthermore, the bank rescue plan won’t change anything about the fact that a haircut for a country’s debt will set a precedent for other countries. Behind that is not just the danger of infection or the herd instinct of the markets, but the rational calculation of investors. At the moment, the ECB’s diligent purchase of state bonds is maintaining the illusion that Italian and Spanish bonds can still be brought to market.

First as Tragedy, then as Farce

In fact, both Spain and Italy – already since the last Council of the European Summit declarations of July 21 – can no longer borrow money on the open market at acceptable conditions without the support of the ECB. That has less to do with the policies of the Zapatero and Berlusconi governments, which are on their last legs, than with the fact that the euro governments have openly shown that they are no longer willing and capable of avoiding a haircut for a member country. Ever since, the markets have been awaiting decisions from the euro countries and their unofficial leader, Chancellor Merkel, concerning how the big operation will proceed. Since then, the crisis of the European banks has entered a new, acute stage. In any case, it is clear that even in the case of a haircut limited to the Greek state, the debt crisis will expand to other Southern euro countries and possibly even France.

Nicolas Sarkozy and Angela Merkel frequently and eagerly emphasize that they are completely united concerning the bank bailout. The opposite is the case. The French President wants a concerted European bank rescue, while Mrs. Merkel desires – as was the case in 2008 – a competition between the euro countries as to which one can most amply supports its banks. Mrs. Merkel presumably believes what the German banking associations are whispering in her ear, that this time around German banks will be less affected than last time. Disregarding the fact that both Germany and France are driven by their own respective interests, the German attitude is somewhat crazier than the French.

Actually, the euro debt crisis should have made clear to all the German nationalists in the government and parliament that every competitive advantage enjoyed by German banks and the German state budget due to the flight of investors to Germany will soon be used up, since the “partner countries” from which capital is fleeing will have to be supported even more. That is not a zero sum game. No, the negative effects far outweigh the nice little advantages that Germany enjoys as an investment location. A little bit of “solidarity” between states bound together by a common currency would be useful even for the strong ones.

However, the actual perversion consists in even conducting a state bailout of banks. The first time it was a tragedy, and the second time, to borrow a phrase from Karl Marx, it will be a farce. A tragedy, because the states massively rewarded those who brought the global economy to crisis, thus putting them in the position to repeat their harmful behavior, while the states put themselves in the position of hopeless debtors. We will soon experience the rude farce, when the flabbergasted bankers and politicians notice that their words and declarations are misunderstood by both the public and financial markets, and the painstakingly constructed rescue apparatus collapses without a sound like in an early silent movie.

The Outlandish Lehman Thesis

One could ask whether the rescue operations for the financial system conducted worldwide in 2008 were a good idea. This question can be answered in the affirmative if for no other reason than that the bankruptcy of a bank and the consequent run on financial institutions would have led to a dramatic deepening of the crisis. In 2008, politicians from all the main capitalist countries explicitly referred to the experience of the Great Depression of the 1930s. The bankruptcy of the Austrian Creditanstalt and the German Danatbank in 1931 decisively contributed to a dramatic aggravation of the crisis.

Similar arguments are made today when the claim is made that the US government allowing Lehman Brothers to go bankrupt in autumn 2008 and the resulting shock on the financial markets was the cause of the global recession in the real economy.

However, this thesis is unfounded. The downfall of Lehman Brothers was a consequence, not the cause, of the raging global financial crisis. In September of 2008, the global economy had already entered a recession, and not because one bank or a group of banks were having a hard time, but because the crisis-ridden end of the financial boom in summer 2007 abruptly ended the debt-fuelled effective consumer demand of average Americans. The world economic crisis 80 years ago was also not caused by the collapse of the banks named above. What was terrible about these bankruptcies was not so much the collapse of the banks themselves, but the reaction by economic policy makers, who intensified their restrictive course, with particularly fatal consequences in Germany. The case of Lehman Brothers, on the other hand, was completely different. It led to hectic activity on the part of economic policy makers in all important states, who on balance went in the right direction.

All the money that was pumped into the financial sector stabilized the banks. All the money pumped into stimulus packages stabilized effective demand. And this was decisive. It helped to avoid the disastrous downward spiral (declining demand – declining profits – declining investment – unemployment – declining demand) which in the world economic crisis of the 1930s led to depression. As a provisional result, it should be noted that the point is not so much whether the collapse of a bank can be avoided, but rather how a bankruptcy takes place and what kind of economic policy is conducted around it.

As can be seen today, the bank rescue actions of 2008 have their drawbacks. For one thing, they led to a plundering of state budgets. That dramatically increased the already high indebtedness of the states and contributed to the current state debt crisis in the euro area. The burden of unsustainably high levels of debt of private capital was shifted onto state budgets. The bailout of the banks in 2008 prevented high asset claims that would have become unserviceable in the long term from being maintained. The financial and economic crisis has not consummated its purifying effect. The financial sector is still far too big in relation to the real economy, is a burden upon the real economy, and is an impediment to economic growth.

Relatively Painless Shrinkage

Without massive shrinkage of the financial sector, there is no way out of the crisis. The current aggravation of the crisis offers a chance to shrink the financial sector in a way relatively painless for the citizenry. The point of departure could be not just a rolling over of Greece’s debt, but that of all states in the euro area. All existing debt of these states would be converted to new securities with a markdown of maybe 30 to 50 percent. The level of the markdown is less important. What is essential is to trade in debt instruments that have the same conditions for all states, the conditions being set not by the market, but unilaterally by the governments, for example at one percentage point above the rate of inflation.

Such a haircut would allow the financial system to implode immediately. In the long term, it would lose one of its most important sources of financing. In the short term, the states would have to bolster the banks and insurance companies, and take responsibility for their debt. However, they would also actually have to take over control and ownership of the institutions, audit their business models, and if necessary wind them down or recapitalize them.

Analog to the neoliberal shibboleth of the lean state, citizens would be served by a “lean financial sector”. It could simply and modestly organize credit and savings like it did in the square 1950s and 1960s.

Lucas Zeise is a financial columnist for the Financial Times Deutschland. His most recent book is Geld – der vertrackte Kern des Kapitalismus. Versuch über die politische Ökonomie des Finanzsektors (Cologne, 2010), published by PapyRossa Verlag.