The euro area’s financial troubles appear to be flaring up again, as this week’s gyrations in the Spanish bond market show. In reality, they never went away. And judging from the flood of money moving across borders in the region, Europeans are increasingly losing faith that the currency union will hold together at all.
In recent months, even as markets seemed calm, sophisticated investors and regular depositors alike have been pulling euros out of struggling countries and depositing them in the banks of countries deemed relatively safe. Such moves indicate increasing concern that a financially strapped country might dump the euro and leave depositors holding devalued drachma, lira or pesetas.
The flows are tough to quantify, but they can be estimated by parsing the balance sheets of euro-area central banks. When money moves from one country to another, the central bank of the receiving sovereign must lend an offsetting amount to its counterpart in the source country -- a mechanism that keeps the currency union’s accounts in balance. The Bank of Spain, for example, ends up owing the Bundesbank when Spanish depositors move their euros to German banks. By looking at the changes in such cross-border claims, we can figure out how much money is leaving which euro nation and where it’s going.
This analysis suggests that capital flight is happening on a scale unprecedented in the euro era -- mainly from Spain and Italy to Germany, the Netherlands and Luxembourg (see chart). In March alone, about 65 billion euros left Spain for other euro-zone countries. In the seven months through February, the relevant debts of the central banks of Spain and Italy increased by 155 billion euros and 180 billion euros, respectively. Over the same period, the central banks of Germany, the Netherlands and Luxembourg saw their corresponding credits to other euro-area central banks grow by about 360 billion euros.
The seven-month increase is about double the previous 17-month rise, and brings the three safe-haven countries’ combined loans to other central banks to 789 billion euros, their highest point on record. In essence, the central banks of the three countries -- and, by proxy, their taxpayers -- have agreed to make good on about 789 billion euros that were once the responsibility of Italy, Spain, Greece and others.
The worries about Italy and Spain reflect the inadequacy of Europe’s efforts to stem what has become a combined banking, sovereign debt and economic crisis. The European Central Bank’s efforts to prop up bond markets with more than 1 trillion euros in emergency bank loans have only encouraged Italian and Spanish banks to buy more of their governments’ bonds, tying their fates to those of the afflicted sovereigns. The harsh austerity measures required by Europe’s new fiscal compact are making things worse by stunting the economic growth needed to help the countries reduce their debt burdens. Should markets balk at lending to Italy and Spain, Europe’s bailout fund -- with only about 600 billion euros in spare capacity -- remains far too small to cover the two countries’ financing needs, which amount to more than 1 trillion euros over the next five years.
If Europe’s leaders want to stop the rot, they’ll have to change their approach. The least bad solution, as Bloomberg View has argued, is a combination of overwhelming force and deeper integration. Together with the European Union and the International Monetary Fund, the ECB would provide large enough guarantees -- more than 3 trillion euros, by our estimate -- to erase any doubt that solvent governments such as Italy and Spain can cover their financing needs and banks can raise capital. If the amount pledged were big enough to tame markets, it wouldn’t have to be spent.
Aside from adopting tougher fiscal rules to get government debts under control, the euro area should also forge a closer fiscal union to provide some support for struggling countries, much as federal transfers in the U.S. cushion downturns in individual states. This could help Greece, Portugal, Ireland, Spain and Italy extract themselves from the downward spiral of budget cuts and weakening economies.
The idea that Europe’s current incremental approach has the advantage of saving money is an illusion, and not just because the disintegration of the currency union could trigger a global financial meltdown. As the capital flight figures demonstrate, the stricken nations of the euro area are bleeding private money and becoming increasingly dependent on taxpayers. In all, the debts of struggling banks and sovereigns to official creditors such as the EU, the ECB and national central banks now exceed 2 trillion euros, much of which would be lost if the debtor nations dropped out of the currency union.
Hopefully, Europe’s leaders will recognize that it would be a lot cheaper to put up the money needed to restore confidence in the common currency. If they wait too long, the cost of the crisis could prove to be more than their taxpayers can bear.
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