WASHINGTON – We were told that Europe’s fiscal/solvency crisis was over. Due to the forceful leadership of Mario Draghi, the head of the European Central Bank, ECB, reinforced by capital injections provided by the International Monetary Fund, plus coordinated actions led by the European Commission, all was back to normal.
Back to normal
Indeed, even seriously troubled countries like Greece had improved so much that they could go back to the international credit markets. The incredible 30% interest rates demanded by suspicious investors to buy Greek debt were gone.
Europe was back to normal.
Mini panic
Well, it is not so. News of potentially serious troubles in the Banco Espirito Santo, BES, a key component of a major Portuguese financial empire, caused a mini panic in Europe and beyond. Shares fell drastically in Portugal, followed by Spain and Italy. Ripple effects caused some dismay even in Wall Street.
This was not supposed to happen
But how is this possible? Sure, BES is a major player in Portugal. But Portugal’s economy is only US $ 220 billion, half the size of Belgium or Taiwan. (Portugal’s GDP ranks 54th in the world).
And do remember that the ECB supposedly had put in place fire walls and all sorts of shock absorbers that should have insulated the rest of the European banking sector from isolated failures.
Not to mention stress tests applied to banks that supposedly should have reassured markets as to the strength and viability of all financial institutions.
Given all this, even assuming the worst regarding the actual solvency of BES, the rest of the European banking system should have felt that it had adequate protection and therefore keep conducting business as usual.
Are conditions worse than we are told?
Well, it did not work like this at all. The BSE-induced mini panic indicates that markets do fear contagion.
But contagion is possible only if actual conditions across the entire European banking system are much worse than what we are led to believe.
The fact is that markets, rightly or wrongly, believe that conditions are in fact worse. Otherwise, if we all know that the system is solid, why panic?
Little confidence
The recent sell off indicates that, major ECB efforts notwithstanding, there is very little confidence in the solidity of the painfully restored European financial system. If isolated problems, however serious, occurring within a bank in a smallish, third tier Eurozone country can cause this kind of reaction, just imagine what may happen if a major European bank gets into real trouble.
Structural weaknesses
The problem is that Europe, with few exceptions in its Northern tier, remains economically weak. Investments are modest, competitiveness negligible. Unemployment is way too high, and so is public spending, mostly because of over generous entitlement programs no longer in line with economic and demographic fundamentals. All this public spending in slow growth or no growth economies results in incredibly high public debt, well above 100% of GDP in Italy, Greece and Portugal.
Indeed, Portugal is a good example of this systemic weakness. While there has been a noticeable export-led economic recovery, this country of less than 11 million has an unemployment rate close tp 17%, while the national debt is close to 130% of GDP. Talk about fragility. A gust of wind would tear everything down.
Should something really bad happen again, in Portugal or elsewhere, the markets know that in most cases there are no margins, no reserves to tap into. And this is why at the first sign of danger everybody runs for the exit.