When a nation has more debt than it can manage, it has two options (1) inflate its way out by printing more money or (2) restructure the debt.
Typically the most politically feasible solution is to inflate. Generally wages tend to keep up to some degree with inflation, so the employed feel as if they are getting a raise and don’t gripe too much. Those in the population who have debts prefer inflation as the relative “cost” of their debt decreases over time, e.g. with 5% inflation, debt declines in real terms by 5% every year. It is the savers who suffer most as they watch inflation eating away at what they’ve built – in a converse to inflation reducing debt, savings declines in value by 5% every year. This is why inflation is often referred to as a hidden tax.
The Europeans cannot inflate their way out of too much debt for the PIIGS as the U.S. is way ahead of them in the race to the bottom and they have conflicting needs across countries. A monetary union without a political, fiscal and cultural union is complicated at best. So why the continued kick the can? The largest banks (German Deutsche Bank, the French BNP Paribas, Société Générale and Crédit Agricole SA among many others) have not increased their reserve capital, which would dilute shareholders, and do not want to take losses on their significant holdings of PIIGS bonds. The euphemistic “restructuring” of these bonds would by definition require some sort of write down in value for the banks.
Bank’s hold these bonds as assets on their balance sheets. They are required to maintain a certain level of assets relative to the amount of loans they give. If the value of their assets were to suddenly drop, they could find themselves in violation of the regulations concerning this ratio. As you can imagine – that is not good for the banking sector and lending! We saw the last time this occurred the credit markets effectively shut down, any type of borrowing was nearly impossible, and the engine of the global economy geared way down.
So how did the U.S. get out of the bog in which the Eurozone is currently mired? In the Spring of 2009, the U.S. banks were eventually forced to raise hard common equity that was then used to absorb losses on loans. The fixed income market did bottom out in the Fall of 2008, but when banks sought this equity, their stocks did not wither on the vine, albeit life wasn’t exactly rosy. Rather than taking this approach, the International Monetary Fund (IMF), the European Central Bank (ECB) and the German and French banks are giving Greece just enough liquidity to roll their debt, not the permanent equity investments that were made here in the U.S. The Euro approach is just a temporary patch on a cracking dam. Only when the European banks raise equity, as we did here, and the PIIGS debt is restructured will there be a true resolution.
