Will the eurozone break up?
"The short-term banking crisis is the biggest concern Europe is facing," said the International Monetary Fund's (IMF) Deputy Managing Director, Min Zhu, yesterday.
"There is no room for politicians to muddle through. They have to take decisive action today."
Well, did they? They had a teleconference at which they assured Greece it would stay in the euro, and urged Greece to meet the conditions of the 21 July 2011 re-bailout agreement.
Min was only repeating what his boss, Christine Lagarde has been saying for some time, that there is an urgent need to recapitalise Europe's banks - and the only shouting is about by how much.
One trillion dollars said Goldman's oft quoted but not yet leaked investor note. Five hundred million dollars said Lagarde at Jackson Hole, revising it down to 200m euros lately.
Let me just pause for an explainer on how the euro crisis and the banking crisis are linked.
- Ireland needed a sovereign debt bailout because its banks were bust;
- Greece needed a sovereign bailout because it had an uncontrollable deficit, but if it defaults, then 50% of its debt is held by Greek banks and pension funds which will go bust. But they cannot be bailed out by Greece because it has no money;
- Two French banks (SocGen and Credit Agricole) and one German bank (Commerzbank) have big direct exposure to a Greek default. Also Dexia of Belgium;
- Because many other bank prop trading desks and hedge funds have taken bets on Greek debt, a default would shoot through - a mini Lehman - into the global finance system.
This is the souce of the IMF's worry and it is reflected in the stock markets. As banks shares have been dumped by scared investors, six major EU banks are valued at below half their tangible book value.
That is, below half what shareholders would get if the bank went bust tomorrow and sold all its assets at their notional value. Even the perennially solid and diversified banks - HSBC, Santander, Nordea - are trading at just above book value. Analysts believe investors are pricing in the exit of all five PIIGS countries from the eurozone.
So what does this mean? As I have been banging on about for several weeks - institutional investors are starting to plan for the breakup of the eurozone. If you believe the eurozone will break up, leaving Portugal, Italy, Ireland, Greece and Spain outside it, then you start to look at major bank exposure - not just to the sovereign debt of this sector but to the whole economy.
If you think the peripheral Europe will drop out of the euro, you must expect a devaluation of assets in those countries or imminent defaults on loans you have made there. That will bust certain banks.
Here is how David Zervos, an analyst at Jefferies, put it earlier this week, in a note that caused a certain amount of shock and awe:
"The bottom line is that it looks like a Lehman like event is about to be unleashed on Europe WITHOUT an effective TARP like structure fully in place. Now maybe, just maybe, they can do what the US did and build one on the fly - wiping out a few institutions and then using an expanded EFSF/Eurobond structure to prevent systemic collapse. But politically that is increasingly feeling like a long shot. Rather it looks like we will get 17 TARPs - one for each country. That is going to require a US style socialization of each banking system - with many WAMUs, Wachovias, AIGs and IndyMacs along the way. The road map for Europe is still 2008 in the US, with the end game a country by country socialization of their commercial banks. The fact is that the Germans are NOT going to pay for pan European structure to recap French and Italian banks - even though it is probably a more cost effective solution for both the German banks and taxpayers." (Note courtesy of Zerohedge).
Now you do not have to go with the whole of that to see what is scaring the EU authorities, and IMF etc.
But it is vital to understand the scale of the potential catastrophe to understand the response. And the response yesterday - albeit delivered in meaningless hyperbole akin to Chamberlain after Munich - was clear.
Having looked over the abyss of a Greek default, because the "Troika" of lenders were hearing from their experts that Greece was not going to do the austerity properly, they pulled back.
This must leave the Troika experts in Athens wondering what their job is. If, whatever they find, they cannot trigger a non-payment of the Greek bailout tranches, what is the point of being there amid all the tear gas and close protection?
Here we come to the question, what can anybody do? The answers revolve around timescales and psychology.
The European political elite is coming around, at various speeds, to the idea of a full fiscal union. Eurobonds, as proposed by European Commission President Jose Manuel Barroso yesterday, are just one aspect of this; there is also the idea, gaining ground within the German CDU I understand, of a fiscal transfer system that might resemble a euro-only structural fund, to address the long-term competitiveness issues of the periphery.
The Greens and SPD in Germany already back eurobonds; it remains to be seen how hard they will push this if an electoral backlash builds against fiscal union. In France there is mild support for the proposal. The British Conservatives are, to the annoyance of some backbenchers, positive.
To stop the "Jefferies Scenario" coming true, Europe's politicians would have to go on a co-ordinated political offensive with their electorates for a short-term, co-ordinated fiscal rescue plan, together with a short-to-medium term adoption of fiscal union.
This latter would need a Treaty change and I cannot see it happening without autocratic measures - i.e. some kind of soft diplomatic coup that saw 17 governments agree overnight and then refuse to put it to referendums or constitutional courts. And of course that is not going to happen.
There is, of course, a short-term co-ordinated fiscal transfer plan in process: the expanded European Financial Stability Facility (EFSF). It should manage to get voted through various parliaments over the next few weeks, and has been declared legal by the German court.
However, the 440bn euros agreed on 21 July 2011 is inadequate. When Italy and Spain got dragged into the danger zone (their bond yields breaching 5%) the European Central Bank (ECB) had to step in and is currently supporting their ability to borrow by, er, buying their bonds.
Some analysts have estimated that, to credibly act as the kind of "overwhelming force" Tim Geithner called for yesterday, the EFSF would need to be expanded to E1.5 trillion or even E3.5 trillion. Even the lower figure would leave Germany pledging 39% of its GDP to bailing out Europe's banks and stricken countries.
Right now the EFSF is operating out of a small office in Luxembourg and nobody has ever heard of the man who runs it. But to recapitalise Europe's banks, and to properly bail out GR, P and IE, it will have to become very powerful indeed.
Here are the stakes, as spelled out in the Jefferies note:
"Expect a massive policy response in Europe and a move towards financial market nationalization that will make the US experience look like a walk in the park."
It feels strange to be writing this though, with the clear skies and Indian summer and a bunch of non-lethal protests swirling around Rome and Athens.
There is a mismatch between the screaming abdabs of the doom-economists and the atmosphere in politics, where in Britain Labour MPs stand up during a leisurely PMQs to read onto the record items about their local football team.
For two nights now Newsnight has had to lead its economic coverage with stories that say nothing has happened yet and we don't know what the EU leaders have discussed.
And nothing will happen until the authorities either reprieve Greece and Ireland of their depression-inducing austerity programmes, or conversely pull the plug - inducing default. The implicit plan is they will do the latter, but not until the full EFSF is in place, together with the various pledges from the IMF, China etc.
Ending on a lighter note, there is soon to be a new euro coin to commemorate 10 years of euro banknotes and coins. According to the website:
"The winning design symbolises the way in which the euro has become a true global player in the last ten years and its importance in ordinary people's lives (represented by the people in the design), trade (the ship), industry (the factory) and energy (wind power stations)."
The winning designer works at the Austrian mint. The winning voter - (you get winning voters in the Eurozone) - is a Monseiur Cretinon.