Wolfgang Münchau’s column in the Financial Times once again returned to the subject of a new acute phase of Europe’s ongoing banking crisis and takes stock at the two year anniversary milestone of Lehman’s collapse, highlighting solvency problems with Irish and German banks. Over these two years, Europe’s plan was to throw money at the problem and then pray for a V shaped recovery that is still nowhere in sight.

The stagnant European economy, according to Münchau, means that European banks will be unable to cover their bad debts with strong profits and that “we will still be talking about this in five years”. Although I agree that we will likely be spinning our wheels for five years or more, I have a different take on the direction of causality.

Loose lending by banks, with politicians obligingly deregulating along the way, was the foundation of the massive 20 year old debt party that ended two years ago when the lights were turned off at Lehman for the last time. The same people who ran the irresponsible party which ultimately ruined bank balance sheets, then came up with and started implementing plans to shift the burden onto the taxpayers’ and bank debtors’ balance sheets. As making innocents pay for your mistakes is the moral equivalent of theft, it cannot be done overnight, so the banks are put on life support while small unmarked vans pull up by the back door every night at 3am to take away another little bit of the burden. It will take years to clear all that junk. Meanwhile, banks on protracted life support, who know their own dirty little secrets better than anybody, choose to deleverage and refuse all new lending except for restructuring existing assets, in an effort to keep their secrets secret and their capital adequacy fig leaf intact. Thus, the real economy is forced to adjust to no new bank credit, and they deleverage also out of necessity or caution.

As discussed in previous posts on this site, we can anticipate the deflationary impact of widespread and protracted deleveraging: it is virtually impossible to grow an economy against such a gale-force deflationary headwind, let alone pull off a V-shaped recovery. Not to mention that deflation, once established, can become self-sustaining – a vicious circle, as buyers defer spending and investment in the self-fulfilling expectation of lower prices. Thus the direction of causality is exactly the opposite, in my opinion. The “Hail Mary” plan adopted for the Eurozone banks did not stand a chance over the long term because the decision to keep zombie banks in one piece and on life support all but guaranteed the impossibility of the hoped-for V – shaped recovery that could have averted the establishment of deflation in the first place.

I quote below the entire text of Münchau’s column from the FT, September 12th:

Two years after the fall of Lehman Brothers, and a massive bank bail-out agreed by European governments, the eurozone’s financial sector is still fragile. As we have seen in recent weeks, the Irish banking sector is insolvent, and there are questions about the capacity of the Irish state to absorb those losses. Jürgen Stark, in charge of the monetary policy section of the European Central Bank, last week raised questions about the solvency of the German banking sector. Wherever you look, two years have passed and nothing has been resolved. There has been lots of activity – bail-outs, bad banks – but no resolution. It was always clear that this wait-and-see approach would eventually backfire. It may be happening already.

After Lehman’s collapse, Europe’s establishment adopted a dual strategy – if you want to call it that. In the short term, it threw money at the problem, through loan guarantees and generous liquidity provisions, culminating in a huge bail-out facility for sovereign states. The long-term strategy was a prayer for a strong V-shaped recovery.

As long as you make sufficiently optimistic assumptions about future income growth, you can pay off any amount of debt. If you assume a post-reform Greece will miraculously turn into a Aegean tiger, or that Ireland will generate another housing price bubble, the present rate of indebtedness will be no big deal. It all rests on your assumptions about growth. In the summer, it looked as though the strategy might work, as the economic data came in better than expected. That was then.

As we saw last week, this strategy came badly unstuck in Ireland. The Irish government massively underestimated the scale of the problem in its banking sector. On my own back-of-the-envelope calculations, the cost of a financial sector bail-out may exceed 30 per cent of Irish gross domestic product, if you make realistic assumptions about bad debt write-offs and apply a conservative trajectory for future economic growth.

We know from economic history that countries enter into longish phases of stagnation after a financial crisis. Ireland suffered an extreme crisis. In the light of what we know, the safe assumption to make for Ireland – and Greece – is that there will not be much nominal growth in the next five years. If you make that assumption, you realise Greece will almost certainly not be in a position to repay its debts. While Ireland’s situation is marginally better, there are justified doubts about the country’s long-term solvency.

Ireland and Greece are not the only eurozone countries in potential trouble. Portugal is in a predicament similar to that of Ireland. If Spain does not find a way to a sustained increase in productivity, the situation may blow up there as well. Belgium may not be on the radar screen of many investors but the country’s political crisis raises a number of disturbing questions about the country’s underlying solvency, hitherto taken for granted.

You need not make gloomy growth forecasts to reach a pessimistic assessment of underlying solvency. The eurozone will probably not have a double-dip recession. Even so, a sustained global economic slowdown, the start of which we may have just witnessed, is all it would take to derail the do-nothing strategy. In the absence of strong growth, the European banking sector will not be able to generate the excess profits needed to write off the bad assets.

Germany in particular is still under the illusion it can generate a strong and sustainable growth over a long period. Recent data were impressive but economic data tend to be volatile. I find it hard to believe the most recent performance is sustainable, although I do expect Germany to outperform the eurozone average because of the depressed real exchange rate.

The German state is in no danger in terms of solvency. But the health of the country’s banking sector is sensitive to various growth assumptions. I would consider the German banking system, taken as a whole, to be insolvent if you apply the strictest definition of capital – equity capital and retained earnings. The new Basel III capital adequacy rules are supposed to take care of the problem of dodgy categories of core capital. I wrote this before the conclusion of Sunday’s agreement in Basel, which irrespective of the details will take years to implement. In the meantime, there will be no crisis resolution.

In Ireland, the cure would consist of nationalisation and wiping out the bondholders of Irish banks through bond-to-equity conversions. In Germany, it would be a recapitalisation of the banking sector – a polite way of saying closing down, or merging, many public-sector Landesbanken and Sparkassen, local savings banks. Mr Stark was absolutely right. The system is no longer working.

Two years after Lehman’s collapse, the fragility of the European banking sector is still an issue. I would bet we are still talking about it in five years. That, in turn, means the financial crisis will go on and on and on, at least in the eurozone.

Copyright The Financial Times Limited 2010.

George’s opinion: The reason Europe’s banking sector is still fragile after two years was the choice to put zombies on life support and then pray that they will get up and somehow not be zombies any more. A far better solution back in 2008 would have been to nationalise all banks, determine the value of their shares (if any), determine the haircut or debt to equity conversions to be applied to bondholders, move all bad loans to a bad bank and auction the bad bank off to hedge funds at cents to the euro, inject capital into the bank balance sheets to bolster their capital adequacy, and then auction off the shares of the shiny new revitalised banks to whoever has the cash and entrepreneurial spirit to buy them. There is definitely some smaller cost to taxpayers, but no moral hazard in this proposal. The problem with my plan is that there would have been a lot of pain and loss of wealth and power for many spoiled and powerful people. Which is why the same people chose to bail themselves out instead, with the small vans taking away a little piece of their burdens every night, putting the rest of the real economy through an unnecessarily long recession. It is also why we will still be discussing the same banking issues in five years.