Sep 29 2008

European banks struggling – government lubrication needed!

European governments bail out more lenders – International Herald Tribune

As the US financial system holds its breath to see if the US government’s injection of $700 billion of liquidity actually results in new lending and restored business and consumer confidence, Europe is beginning to see its own government takeovers of European banks.

Regulators in Britain, Belgium and Iceland swooped in Monday to engineer emergency rescues of three banks with heavy exposure to soured mortgages, echoing moves underway in the United States.

In the latest sign of trouble to hit Europe from the global credit crisis, the Belgian, Dutch and Luxembourg governments announced a partial nationalization of the troubled Belgian-Dutch financial conglomerate Fortis, involving a combined injection of €11.2 billion from the three governments, which take a 49 percent stake…

Meanwhile, the British Treasury on Monday confirmed that it had seized the lender Bradford & Bingley – the third British bank to tumble this year – after no private buyers emerged.

Much as in the United States, several European banks have gotten into trouble as their assets tied to real estate have lost value due to the weak European and American real estate markets. As more and more borrowers are unable to pay their mortgages, banks’ assets decline in value and the banks’ willingness and ability to make new loans decreases. This limits the amount of credit available to households and firms, and with it their ability to make investments in consumer goods and capital. Tighter credit markets mean weaker aggregate demand (less consumption and investment), leading to slower or negative economic growth and rising unemployment.

In the past, when one bank got into trouble with bad assets like those tied to the real estate market, other private banks would come along and bail the troubled bank out, swapping cash for the assets, allowing the troubled bank to continue making loans. But when all banks find themselves in the midst of the same financial crisis, the likelihood of finding a private buyer for a struggling bank is low. This is where the government steps in:

The bailout of Fortis (Belgium’s largest commercial bank) orchestrated by the three neighboring countries (Belgium, Luxembourg and the Netherlands) and the ECB (European Central Bank)… was meant to restore confidence in the bank before the reopening of markets on Monday after a tumultuous week of imploding share values at Fortis. The shares gained 4.8 percent to €5.45 Monday.

In Britain, regulators were unable to find buyers to keep Bradford & Bingley afloat. The lender’s shares are down 90 percent from the peak, touching new depths Friday as an already skittish market punished the company, prompting the talks.

When the private sector is unable or unwilling to purchase the assets of a bank that has experienced a write down of its asset value, the government must intervene to make sure such banks have the liquidity (meaning the hard cash) they need to make loans to borrowers, whose spending is needed to keep the economy going.

In the US, the government has agreed to trade $700 billion in hard, loanable and spendable cash, in exchange for financial assets tied to bad mortgages worth something less than $700 billion. If the swap has the effect the government hopes it will, then lending institutions will feel more confidence and be willing to loan cash to each other and to borrowers (households and firms), spending in the economy will increase (consumption and investment) and aggregate demand will rise, meaning more total output, more employment and higher incomes. In addition, more lending will also lead to an increase in the capital stock, effectively pushing the American and European aggregate supply curves outwards, leading to a more stable rate of inflation (a major worry for both economies as oil prices hit record levels this year).

In spite of the recent round of bailouts in both the US and Europe, confidence among European firms and households is low:

Euro-zone economic confidence plunged to its lowest level in seven years in September, the EU said Monday.

A regular survey of European companies and consumers showed the index of confidence in the economy falling to 87.7, close to a 2001 trough, the European Commission said.

The EU executive warned that the survey carried out in the first two weeks of September may not fully reflect growing gloom in the last few weeks as worries over a U.S. and European recession widened on a financial market crisis.

Industry, services and construction were all more pessimistic than a month ago, it said, while consumer confidence was unchanged from a low level. Retailers were slightly more upbeat about their prospects.

It said industry managers’ employment expectations fell – meaning they believe they may have to cut jobs – although services companies were more hopeful.

Consumers thought that unemployment would increase in future months and expect prices to rise.

The 15 nations that share the euro are battling high inflation as oil prices remain high – although below recent record levels – and increasing fears that a financial crisis will freeze or sharply hike the cost of borrowing.

That would slow growth as companies found it harder to get credit and people faced high costs to buy homes. The U.S. government is trying to stave off tighter credit conditions by buying up hundreds of billions of dollars of bad debt from major lenders

As can be seen, falling confidence and tighter credit markets are evil twins. If the Euro zone economy is to avoid recession, the European Central Bank and the governments of the 15 Euro nations should follow closely events in the US over the next few weeks. The $700 billion injection of liquidity, if successful, will act as lubrication in the engine of the US economy.

Think of it this way: lately, the US economic engine has slowed down. Friction in the financial markets has slowed the flow of cash from households to banks to firms and back to households. In IB and AP Economics terms, the circular flow of money and income has slowed to a halt. To get the engine moving again, cash is needed. Banks with liquid cash are more willing to lend to one another and to households and firms. A healthy economy depends on a well lubricated economic engine, which in today’s world means a functioning financial market.

The government bailouts in the US and Europe are intended to do one thing: lubricate that engine and get the economy moving forward once more.

Discussion question:

  1. Why does the government need to intervene in financial markets? Shouldn’t those who took risks by making bad loans pay for their mistakes and be allowed to go under?
  2. What will it take to turn consumer and investor confidence around in Europe?
  3. How might the crisis in the financial markets affect you and me in the real world?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

2 responses so far

2 Responses to “European banks struggling – government lubrication needed!”

  1. Guillaume Duboison 30 Sep 2008 at 3:17 am

    A government needs to intervene in financial markets because the loss of several banks or other industries can have a domino or chain reaction effect on other markets, primarily complementary and substitution goods.

    I assert that those who took risks by making bad loans in fact create the economy that we depend on; without risks, change, investments, or fluctuations in the market, the economy would not succeed and lead itself, providing and allocating resources to everybody.

    Naturally, these fluctuations also result in inequity of the allocation of resources. That is one reason why we have government interventions; to prevent monopolies and to make sure that resources and goods are always available at an acceptable price.

    This credit and banking crisis displays exactly that problem. If banks keep going under and investors completely lose the will to spend or, well, invest, then the economy will slow down and eventually shut off.

    Government interventions do there best to prevent this, although at a price, because they know that the cost of letting the economy fall will be far greater than the costs of bailing out the economy.

  2. Yael Burlaon 19 Oct 2008 at 7:11 pm

    In a situation that our world is facing today, as described above, the bank that is falling apart needs to look to the government for support since the country, in which the bank is, should be able to manage the crisis. For example, the government should be able to distribute loans to the banks from other banks in order for the entire bank not to collapse. In a wider image, one bank losing all of its value may not seem like a relatively big deal, but it does affect thousands of people who also lose their money from storing it in that bank. On a more personal note, I have a few acquaintances that are facing this situation today and now have to work from home. Because it not only affects the bank itself but also the thousands of people that are part of that bank, the government therefore should feel obliged to step in. Eventually, as Guillaume described, the economy will fall and might rupture an entire nation.