Winston Churchill defined appeasement as “feeding the dragon hoping he will eat you last.” As the eurozone banking crisis has morphed into a sovereign debt crisis, it is worth reconsidering the wisdom of appeasing the bond market in an attempt to stave off the possibility of default. As the Financial Times stated in an editorial published towards the end of last year: “Each time the eurozone rediscovers its resolve and finds a policy to damp the sovereign debt crisis it makes the situation worse.” ( ‘Europe’s financial plague rages on’, Nov 26 ).
European governments have placed their own solvency and sovereignty at risk by protecting bank creditors. Why they have done so is a question that will surely puzzle future historians. It is widely accepted that underwriting of bank credit risk for 'too big to fail' banks induces moral hazard and will incentivize reckless risk taking in the future, thus placing the financial system at greater risk. One must therefore assume the underwriting of creditor risk is necessary to prevent an immediate meltdown. It is difficult to see how so.
A restructured bank, in which debt holder claims have been reduced, should have no more difficulty in raising fresh capital than a restructured General Motors. If depositors are protected, the restructuring will cause no monetary contraction and no forced liquidation of loans. The restructured bank could raise fresh capital, write down non-performing loans and resume lending. By contrast, the debt overhang currently on banks balance sheets, resulting from protection of creditors, restricts the capacity to raise new capital and will curtail lending - and economic growth - for many years into the future. In light of this, the current proposal to protect existing bondholders and place future investors at risk is perverse. It should be exactly the other way round.
Moreover, once suffering taxpayers get the idea that they have been drafted to make bank investors whole, they may rebuke any such deal and force their governments to reneg.
In any event, the bond markets are not appeased, in spite of Europe’s’ mortgaging of its credibility and its treasure.