By George Soros
The opinions expressed are his own.
Earlier this week, a group of almost 100 prominent Europeans delivered an open letter to the leaders of all 17 eurozone countries. The letter said, in so many words, what the leaders of Europe now appear to have understood: they cannot go on “kicking the can down the road.” And, just as importantly, they now understand that it is not enough to ensure that governments can finance their debt at reasonable interest rates; they must also address the weakness of Europe’s banking system.
Indeed, Europe’s banking and sovereign-debt problems are mutually self-reinforcing. The decline in government bond prices has exposed the banks’ undercapitalization, while the prospect that governments will have to finance banks’ recapitalization has driven up risk premiums on government bonds. Facing the prospect of having to raise additional capital at a time when their shares are selling at a fraction of book value, banks have a powerful incentive to reduce their balance sheets by withdrawing credit lines and shrinking their loan portfolios.
Europe’s leaders are now contemplating what to do, and their next move will have fateful consequences, either calming the markets or driving them to new extremes. All agree that Greece needs an orderly restructuring, because a disorderly default could cause a eurozone meltdown. But, when it comes to the banks, I am afraid that the eurozone’s leaders are contemplating some inappropriate steps.
Specifically, they are talking about recapitalizing the banking system, rather than guaranteeing it. And they want to do it on a country-by-country basis, rather than on the basis of the eurozone as a whole. There is a good reason for this: Germany does not want to pay for recapitalizing French banks. But, while Chancellor Angela Merkel is justified in insisting on this, it is driving her in the wrong direction.
Let me stake out more precisely the narrow path that would allow Europe to pass through this minefield. The banking system needs to be guaranteed first, and recapitalized later. Governments cannot afford to recapitalize the banks now; it would leave them with insufficient funds to deal with the sovereign-debt problem. It will cost much less to recapitalize the banks after the crisis has abated and both government bonds and bank shares have returned to more normal levels.