Why Europe's Feeding of the PIIGS Continues to Be a Problem

tWSJ's Alen Matich does an excellent job of explaining the continuing crises in the EU.

There’s a widespread view the 2008 banking crisis is over. It’s not. At least not in Europe. And the eventual fallout could result in a significant shrinkage of the financial services industry.

To see the scale of the problem, it’s important to start with Europe’s rolling sovereign-debt crisis. Core European countries, led by Germany, are hammering out an expanded bailout facility for a “periphery” sinking under the weight of unmanageable debt.

So far, the bailouts have been structured as loans, albeit with ever longer maturities on ever better terms. But loans nonetheless. That’s because core European governments are terrified their voters will rebel at a deal that would entail massive transfers to pay off peripheral Europe’s debts. But peripheral European countries already can’t pay back what they owe. New debt, even on better terms, doesn’t solve the problem.

The scale of austerity demanded of peripheral Europe’s populations and scale of debt service needed to pay back loans is already beyond what these countries will be able to tolerate for long. And they need new loans.

The latest estimates are that Irish banks will need as much as another €23 billion to meet tightening capital requirements. Although Spain is not yet in the same boat as Ireland, Portugal and Greece, it runs the risk. By some estimates, its banks will need as much as another €70 billion of capital, although it’s not clear what the scale of real-estate losses they have on their books really is.

Spanish real-estate prices have been marked down by an improbably small amount given the vast amount of overcapacity.

This is why the likes of Ireland have been talking about imposing losses on bondholders. These losses are not acceptable to core Europe because they would fall on their own banks, which are heavily exposed to peripheral Europe. But when push comes to shove, it’s likely to be more politically defensible for these countries to refinance their own banking sectors than to bail out foreigners. This, though, is likely to come at a price.

The endgame here, thus, becomes one of whether the PIIGS default outright and the lending nations then step in to bailout their local elitist banks, or whether the eurozone cracks up, the PIIGS resort to their pre-euro currencies and print themselves out of the mess. The printing would be highly inflationary, but a bailout of elitist banks is also likely to also be inflationary---just using a different money printing shop, with impact on a slightly different sector of the eurozone.

It's going to be painful. The only question will be whether the pain will fall on the PIIGS or creditor countries such as Germany. It make come down to which citizenry screams the loudest and breaks the most windows.