One concern of the bank bailouts in 2008, was that capitalism works by allowing bad businesses to fail, enabling stronger growth through competition. However, although there may have been some validity to this given banks’ exposures to risky mortgage-backed securities, the same argument should not necessarily be used against recapitalising banks exposed to risky Euro-Zone sovereign debt.
Moral hazard concerns regarding the rescue of risk takers should also be overlooked in this case because it is not so much the bankers who have failed but the politicians who have escalated a sovereign debt crisis over the last two years through a lack of political will to uphold what was seen by many in the markets as an implicit guarantee. If this was not the intention of the Euro Zone, it represents an inability to communicate the extent of the monetary union’s guarantees effectively to the markets.
Ever since the creation of the Euro Zone, the implied risk of sovereign debt in the weaker countries fell, with the yields on all Euro-Zone 10-year government bonds converging towards that of Germany (see Figure 1). This is largely because investors believed that not only would monetary union improve economic growth across the area but also that weak countries would find support from stronger neighbours in tough economic times. For instance, Portugal struggled to register any economic growth over the last ten years but still its yield remained stable relative to Germany’s.
Figure 1: The convergence and subsequent divergence of Euro-Zone 10-year bond yields before and since the financial crisis.
Furthermore, the very issue of Greece’s acceptance to the Euro Zone, where murky government accounting ensured that it “met” Euro-Zone financial targets was overlooked by other Euro-Zone countries and, therefore, only enhanced the idea that such problems would be overcome once it was encircled by the Euro-Zone wrapper.
Politicians must also take some of the responsibility for allowing the Euro-Zone crisis to deteriorate over the last two years. Poor decision making by Euro-Zone leaders has sent peripheral debt yields soaring, contributing to the losses on banks’ balance sheets. If strong, affirmative action had been taken to arrest the debt problems of the weaker countries when they first reared up, proving to the markets that no country would be left dangling over the precipice of default, then the evident deterioration and contagion witnessed would not have been as severe. Instead a recovery in investment and growth would likely have followed.
Therefore, a necessary part of any bailout package is to ensure banks are sufficiently recapitalised. Not only will it help banks survive large write downs due to Greek exposures but it will also help to regenerate confidence in the markets.