In the United States, we view the economic crisis that started in 2008 as something that ended years ago; the story now is the slow pace of recovery. But in Europe, the crisis genuinely hasn’t ended. Greece had a major debt crisis as recently as last year, and Spain is still suffering from an unemployment rate above 20 percent.
Last month’s vote for Brexit has led to a renewed flare-up of anxiety about the European financial system, and it looks like Italy may be the next European country to face a crisis. Italian banks have about $400 billion in bad loans on their balance sheets, and markets have started to panic. One Italian bank has lost 80 percent of its value over the past year, and observers worry that some banks could be on the verge of collapse.
Italy’s prime minister, Matteo Renzi, wants to use about $45 billion in Italian taxpayer funds to shore up Italian banks and head off an economic crisis. But his plan runs afoul of European Union rules, which prohibit countries from bailing out their banks without making the banks’ investors pay first.
This is exactly the kind of rule that bailout critics in the United States and elsewhere have demanded since 2008. They want to make sure that investors, not taxpayers, foot the bill for bank failures. But there’s a danger that strict adherence to this principle could prevent the government from taking measures to contain a financial crisis that could have much larger costs in the long run.
Italy and the EU disagree about who should pay to fix Italy’s banks
Italian banks are facing a problem that’s broadly similar to the problem some American banks faced in 2008. They made a lot of loans to people who aren’t paying them back — a situation that’s been made worse by years of weak economic growth in Italy.
Renzi is worried that this will lead to a collapse of several major Italian banks, which could trigger a broader financial crisis. So he wants to organize a government bailout of Italian banks, injecting $45 billion into the banks to provide the cushion they need to ride out a wave of loan defaults.
This is the kind of bailout that the United States and many other countries orchestrated in the recent past, but Renzi has a problem doing it for Italy: Relatively new EU rules prohibit governments from doing this kind of no-strings-attached bailout. Under European law, a bank’s own creditors — investors in the banks’ bonds — must take losses before the government can spend taxpayer money shoring up the bank's finances.
That’s exactly what critics of America’s TARP bailouts wanted to happen in 2008. They said it wasn’t fair to make taxpayers pay billions of dollars to bail out a bank while people who made loans to risky banks get 100 cents on the dollar.
They also argued that making creditors pay before taxpayers would create an incentive to do due diligence on a bank’s finances before lending it money. They thought making creditors pay would make them more wary of lending to banks making reckless investments. That, in turn, would force banks to be more prudent, making future crises less likely.
This argument assumes that a bank’s creditors are wealthy, sophisticated financial institutions that understand the risks they’re taking on. But in Italy, that assumption doesn’t necessarily hold. According to Bloomberg, 45 percent of Italian bank debt is held by ordinary Italians. That means complying with the EU rules could mean some Italians lose a big chunk of their life savings.
Renzi got a taste of the potential backlash back in December, when the Italian government rescued four banks in accordance with EU rules. Creditors took losses in the process, and one of them was an Italian man who lost $110,000 he had invested in bonds issued by one of the bailed-out banks. The man killed himself, leaving a suicide note criticizing his bank.
Renzi is understandably reluctant to repeat this experiment on a broader scale. So he’s been lobbying EU leaders for an exemption from the EU’s anti-bailout rules that would allow him to inject cash directly into Italian banks. But European leaders are unconvinced. German Chancellor Angela Merkel, the most powerful EU leader, has refused to budge, insisting that it would set a bad precedent to relax the EU’s anti-bailout rules just two years after they were overhauled in 2014.
Renzi is worried bank failures could trigger a broader economic crisis
If this were just a debate about the solvency of a few random Italian banks, there’d be no reason the rest of us should care. The concern is that an Italian banking crisis could have broader effects in the Italian economy — and potentially the rest of Europe.
The reason is that banks play a central role in modern economies. Making and receiving payments is an essential function for any business. If these payment functions were disrupted by a wave of Italian bank failures, it could have an outsize impact on the Italian economy.
And while the goal of discouraging banks from making too many risky investments seems sensible, it’s important to remember that a financial crisis can transform otherwise sound investments into money losers.
In a crisis, financial institutions tend to sell assets in order to shore up their cash reserves. But that can make things worse by pushing down asset values. Suddenly, banks that were perfectly sound prior to the crisis find their assets are worth less than their liabilities. They might be forced to start selling assets themselves to make sure they have enough cash on hand if the crisis gets worse. The result can be a downward spiral that takes down responsible banks along with irresponsible ones.
So if authorities are too fastidious about refusing to bail out banks that have been irresponsible, it can wind up taking down banks that never did anything wrong.
This is why Renzi wants to rescue banks now — before panic starts to set in, and without worrying too much about making banks’ creditors pay.
The EU’s divided authority makes it hard to deal with economic crises
At this point, you might be wondering why EU officials care so much about Italian banking policies. If Italy’s elected prime minister wants to bail out Italy’s banks using Italians’ taxpayer money, why not just let him?
The problem is that Italy, Germany, and a bunch of other EU countries share a currency. And the shared currency effectively links their economies in other ways.
Back in 2012, investors lost confidence in bonds issued by the government of Italy and a few other countries in Europe’s periphery. Italy had a big national debt and a slow-growing economy. Financial markets worried their debts would spiral out of control — and the more they worried, the higher Italian interest rates got.
That, of course, made the Italian budget deficit even bigger, making the country’s debt problems even worse. Without the ability to print its own currency, there was a real danger that Italy would be forced to default, which could have led to a crack-up of Europe’s common currency area.
To prevent this from happening, the European Central Bank in 2012 promised to guarantee bonds issued by Italy and other eurozone countries. Because the ECB can print an unlimited number of euros, that quickly calmed markets and brought interest rates down.
But an ECB backstop for Italian debt essentially means that the rest of Europe has a financial stake in keeping Italian government debt under control. If Italy spends beyond its means, other European countries could get stuck with the tab. And so it’s not too surprising that other countries are insisting the Italian government not be too generous with its bank bailouts.
But there’s also an obvious problem with a situation in which German and French leaders get an effective veto over Italian economic policy. It’s easy for Merkel to insist that Italy must strictly adhere to EU rules regardless of their effect on the Italian economy — she doesn’t have to worry about winning reelection in Italy.
And there’s a real danger that this kind of standoff will hamper an effective response to Europe’s next economic crisis — whether it involves Italian banks or problems elsewhere on the continent. Each European leader is accountable only to voters in her own country. In cases where different countries have divergent interests, there’s no good mechanism for resolving the disagreement.
In the long run, this situation doesn’t seem sustainable. If economic policy is going to be made on a Europe-wide basis — and the euro is pushing the continent in that direction — then it should be made by a Europe-wide, democratically elected body like the European Parliament. That would mean shifting functions like taxation and bank regulation up to the EU level.
If, on the other hand, voters want to maintain national control over economic policy, then Europe might be forced to reconsider the wisdom of a shared currency.