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“Doom Loop” Binding Weak Banks and Sovereigns Still Haunts Europe

February 15, 2018

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national banking sector exposures

One important reason no one talks about Puerto Rico leaving the “dollar zone” is that the island’s banks have minimal exposure to its government’s debt. There is thus no need even to consider introducing a local currency to recapitalize them.

Europe is different. Particularly during the immediate crisis years after 2010, banks in southern Europe holding soured private debt loaded up on the “safe” debt of their national governments, while those governments, now facing growing deficits from the downturn, were pledging to backstop the banks. The banks thus became increasingly exposed to falling government bond prices, while the governments in turn became increasingly exposed to worsening bank balance sheets. Weak banks and weak sovereigns propping each other up is a recipe for national bankruptcy.

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With the European Union finally in a solid economic upturn, this so-called “doom loop” is no longer front-page news. But as our graphic above shows, the problem has not gone away—far from it. In Italy and Spain, banks are still loaded with their respective government’s debt at nearly the same levels they were at the height of the crisis. In Greece, where doom-loop metrics plummeted in 2012-13, after a massive write-down of government debt, they are headed back up, while in Portugal they have been on a relentless climb since 2009.

What is to be done? Enter a European central bank task force led by Bank of Ireland governor Philip Lane, which is recommending the launch of a common Eurozone security that could potentially become an EU analog to U.S. Treasury securities. This “safe asset” would be backed by all 19 member states, but would necessarily involve the fiscally stronger ones—Germany in particular—backstopping the weaker ones. Since this could discourage them from becoming more prudent with their financial commitments, the proposal will struggle to gain traction. But something like it is almost certainly necessary to avoid future Eurozone crises.

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