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Why Crises Persist
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It has been two years since the flames were first spotted in Greece, yet the blaze still hasn't been put out. Now it has spread to Italy.
It's been five years since the U.S. housing bubble burst. Housing remains among the biggest reasons the U.S. economy is doing so poorly.
On both continents, there is no longer any doubt about the severity of the threat or the urgent need for better policies. Yet the players seem spectacularly unable to act.
What's taking so long?
Deciding who will get stuck with the tab.
'In every crisis, you have to allocate the losses between debtors, creditors and taxpayers,' says Anna Gelpern, an American University law professor and former Treasury official. 'It's a shockingly simple concept, and completely intractable.'
'By definition, it's a political problem,' she adds. 'Even if you came up with an optimal allocation, if it's not politically salable, it can't happen.'
This time, the scale is daunting. The International Monetary Fund estimates that holders of U.S. mortgage and other debt lost $2.7 trillion in the U.S. phase of the global financial crisis, some of that already shifted to taxpayers. American homes are worth nearly $7 trillion less than they were five year ago, a 25% decline. Nearly 23% of Americans with mortgages owe more than the value of their homes.
All sorts of attempts have been made to reduce monthly mortgage payments for some, to refinance high-interest mortgages, to be sure foreclosures are done correctly, to recapitalize banks so they can absorb losses, and so on. The big step untaken: reducing the principal on mortgages. The big hurdle: Who takes the hit? The banks? Mortgage investors? Taxpayers?
In Europe, delays in admitting that Greece borrowed too much turned what might have been a difficult but manageable problem into a calamity. One big reason for the delay: deciding who would take the hit. German taxpayers? French-bank shareholders? Foreign bondholders?
When a borrower─a bank, a company, a country─runs into trouble, the initial reaction is to say, well, they're good for the money, just short of cash. That's often true. So the lender cuts the borrower some slack, the company hocks its receivables, or the 'lender of last resort,' the central bank, makes emergency loans because it is certain it'll be paid back. The problem, it is said, is one of 'liquidity' (meaning no one will lose money in the end) rather than 'solvency' (meaning someone will lose money).
The temptation to extend that logic beyond reason is strong. Admitting that, say, some European governments won't pay 100 cents on the dollar, or that some mortgage loans aren't worth as much as bank books say, would force lenders to take losses. If the losses are large, then the solvency of the banks is in doubt. In France, markets aren't so much skeptical of the government's ability to pay bills and meet interest obligations as they are fretting about a potentially costly government bailout of the French banks that hold so much foreign-government debt.
Then, too, banks and investors lend, often at interest rates that reflect the risk they won't get paid back. If all goes well, they make a lot of money. If not, and there's a lot of money at stake, the taxpayers get the tab.
'Parties that have contractual losses try to shift those losses to counterparties, especially taxpayers,' says Edward Kane, a Boston College economist. 'These crises tend to drag on as long as there's a chance of sticking taxpayers with the losses.'
So first there is denial, then delay, then disguise. Fannie Mae, the now-nationalized U.S. mortgage giant, said this week it needed another $7.8 billion from the U.S. government to cover losses on loans it guaranteed, and it will get the money without further congressional action. That's less politically explosive than asking Congress for $7.8 billion to reduce some homeowners' loan balances. In Europe, everyone but the German taxpayer realizes the German taxpayer is on the hook if the euro is to survive.
There are costs to all this dilly-dallying. Bank lending is one. 'The banks aren't anxious to extend credit, because they don't know how much capital they have [after taking still-unacknowledged losses], and it's hard for them to raise money, because investors are uncertain about their financial condition,' says John Makin of the American Enterprise Institute and hedge fund Caxton Associates.
Italy is another. On the fundamentals, Italy should be good for the money, as long as it can borrow at rates paid by similarly situated governments. Unlike Greece, it's running a budget surplus, excluding interest payments. But it can't survive long if it has to keep paying 7%-plus. Italy has sinned, no doubt, but Europe's delays in managing Greece's insolvency have led markets to question the sovereign debts of half the euro zone.
Taxpayers are going to take a hit. How big a hit? Until that's decided, the crisis will go on, and the cost will grow.
DAVID WESSEL