James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

A sharp cut back in lending by euro zone banks in their scramble to raise capital will prove an important channel spreading pain from the vulnerable single currency area to the rest of the world.

Though the euro-induced credit crunch will be less important than the outright effects of the euro zone recession, in some areas, like trade finance, and in some regions, such as emerging Europe, the impact will be felt far more quickly.

“European banks have huge exposures outside Europe itself,” said Srinivas Thiruvadanthai, an economist at the Jerome Levy Forecasting Center.

“They are being asked to increase their capital base. You can go and raise capital or you go and get a government handout or you shed assets. Raising assets will be very, very tough.”

Euro zone banks will be cutting back on foreign exposure, either out of prudence or under pressure from their regulators.

Austria this week imposed restrictions on its leading banks, including Raiffeisen, Erste Group Bank and Bank Austria in central and eastern Europe, requiring them to make new loans of no more than to 1.1 times the deposits and wholesale funding raised locally.

Romania could see a deleveraging equal to 1.6 percent of GDP, while the Czech Republic, Hungary and Turkey all face hits of about a half a percent of annual output, according to data from Nomura International.

It won’t stop in Europe. About 20 percent of bank assets in Chile, Uruguay and Mexico are controlled by euro area banks.

Less lending by international banks will drive the overall cost of credit up, almost certainly working against official policy which will be trying to reduce rates.

In some areas, like trade finance where some European lenders are prominent, this impact may be felt rapidly, as it was in 2008 when fear of counterparty risk prompted many banks to pull out of trade financing for a time. That had a magnifying impact on the global downturn, as some exports were delayed despite their being willing buyers and sellers at a given price, simply because the letters of credit needed to facilitate the deals fell through.

This will only be intensified by European bank recapitalization proposals, which impose a tight deadline of next June for 70 euro zone banks to find about 100 billion in new capital. And remember, that amount of capital, huge as it is, may prove insufficient given the recent free fall in the value of euro zone sovereign debt, to which euro zone banks have critically high exposure.

BANKS FOR SALE

Given the difficulty in raising capital directly from investors, euro zone banks are looking to sell whatever they can that will fetch a reasonable price.

Since investors, and their peers, don’t want to buy more European exposure, that means selling off bits and pieces of financial institutions outside the euro zone.

Spanish bank Santander, seeking to boost its core capital to 10 percent by June, said this week it will sell a 7.8 percent stake in Santander Chile, worth around $1 billion dollars.

That deal sent shares of the Chilean affiliate down sharply, increasing the dampening impact on bank valuations there, and ultimately on credit availability.

While the impact in Asia, where continental European banks hold just 5.0 percent of their assets, will be less, it will still be felt, especially in areas already being hit hard, like Hong Kong property development, according to analysts at Barclays Capital.

And the great banking recapitalization of 2012 likely won’t be limited to Europe, as shown by the Federal Reserve’s newly announced stress test of US banks.

Austria‘s move to restrict lending abroad has to be viewed as a kind of economic protectionism, a sort of reverse tariff, but this time on precious bank capital. That sets an extremely risky precedent, but one it is easy to see other euro zone nations following.

If Germany fears the costs of recapitalizing its banks in the event of a euro zone break up, as well it should, a logical step would be for it to try and conserve its national banking resources via similar moves.

That same logic holds, even more chillingly, for countries outside the euro zone. Tight credit, and tight controls on credit, may end up being a leading story of 2012.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

By Jim Saft
James Saft is a Reuters columnist. The opinions expressed are his own.

Having demonstrated how poorly austerity worked in Greece, Europe may be on the verge of giving it a try in credit markets.

Plans to rescue the euro zone and its banks might land Europe in an extended credit crunch, a very poor outcome given the continent’s continued heavy reliance on bank financing.

While details are depressingly vague as to the how, plans seem afoot to insist on widespread recapitalization in European banks as part of an overall financial crisis package. The idea, broadly, is that the euro zone will write down Greek debt sufficiently, while establishing a backstop to stop a run on other weak states’ debt and then recapitalize the banks so that they can withstand the losses inherent in the exercise.

The U.S. banking recapitalization of 2009 is widely viewed as the model here, if not in form then in outcome, as U.S. banks are now far better capitalized than their European peers.

There are, at least, two severe problems with this.

Firstly, a look at the U.S. will show that while its banks as independent entities were saved, their ability to play their role in intermediating capital was compromised, at least in part because they were not aggressive enough in writing down doubtful housing-related debts. That’s an important contributing factor in creating a frail, shaky recovery in the U.S., and could easily happen in Europe.

“Markets may also fear adverse unintended consequences; for example, proposals to strengthen bank capital ratios that banks try to meet by accelerating the shrinkage of balance sheets,” George Magnus, senior economic advisor at UBS, wrote in a note to clients.

“This would deepen the euro zone’s growth crisis and make higher capital ratio goals retreat ever further into the distance.”

Europe, like the U.S., is going through a balance sheet recession. That means everyone is trying to repay debts at the same time, suppressing growth, inflation and asset prices. Government austerity is exacerbating this, but an extended credit crunch as banks try to rebuild balance sheets will only make matters worse.

This is not to say that Europe’s banks don’t need to shrink, as does its sovereign debt. Euro zone plans to save itself seem to have moved from simply trying to restore confidence, an impossibility as a stand-alone plan, to adding capital to the mix. Without addressing the underlying indebtedness this is going to result in either failure or a very extended period of slow growth.

WRITEDOWN NEEDED

An attempt to shore up banks must come to terms with the other over-indebted borrowers in the euro zone, and not simply the sovereign ones.

Take Spanish house owners, for example, who already face huge difficulties in getting loans to finance real estate purchases. Independent economist Edward Hugh argues that Spain needs a substantial asset writedown program, something that bank recapitalization simply does not address.

One easy-to-foresee risk post a euro zone rescue is that continued weakness in housing in peripheral markets continues to stress bank capital, casting a shadow over funding markets and undermining confidence. Remember, euro zone banks have a loan to deposit ratio of about 108 percent, a good 20 percentage points higher than U.S. banks, and only about 10 percent below their own pre-crisis peaks.

A reduction in bank lending in Europe is going to be even more painful than it would be in the U.S. given the euro zone’s less deep and highly developed capital markets. Europe has no Fannie Mae or Freddie Mac, yet, to take the strain in housing finance. Middle-sized businesses are still very reliant on bank financing.

In the U.S., the Federal Reserve helped to mitigate the pain of bank recapitalization by creating conditions in financial markets where investors wanted to take on some risk, leading to a booming market in bond issuance for corporate borrowers. Thus far there is no talk of credit easing from the ECB but it would not at all be surprising if this is on the agenda in a year’s time, once the force of bank deleveraging has been felt.

This is not an argument for going easy on banks, their shareholders or their executives. If anything Europe needs to take a harder line — forcing writedowns of debts public and private and being prepared to deal with the consequences.

Those consequences would not be pretty for bank shareholders. Many banks would fail and need to be taken into temporary public administration.

The more controlled default there is as part of the euro zone’s rescue, the better the results will be in two years time.

James Saft is a Reuters columnist. The opinions expressed are his own

HUNTSVILLE, Ala. – Europe is demonstrating that a sovereign nation without a true central bank is just an uninsured bank, liable to be tipped over by the markets.

While the ECB is a central bank in almost all respects, what it isn’t is a lender of last resort for individual euro zone nations, a role that is expressly ruled out by the European Treaty.
A lender of last resort is what stops a bank run on a solvent institution from bringing it down due to a lack of liquidity. In the case of a nation, a lender of last resort, usually the central bank, can simply print money to satisfy debts in its own currency. And though we’ve all become terribly cynical about the concept of liquidity crises in the past couple of years, not least because so many people in authority have used it as a place to hide when the real issue was solvency (Greece, Lehman Brothers), the fact is that markets take on their own momentum.
Just as no-one viewed euro zone debt as anything other than a safe haven for the currency area’s first decade, now investors are busy driving up the price of even German default insurance.
This is the terrible logic of markets when they view sovereign borrowers as credit risks; it is almost inevitable that they push, and in pushing weaken the un-backstopped borrower and ultimately bring it down. This is a process which needs a circuit breaker, and Europe has no adequate circuit breaker, unlike Britain or the U.S.
“Rather than viewing government bonds as risk-free, safe-haven assets, financial markets now view and trade euro area sovereigns mainly as credit risks. This has very profound consequences for the stability of financial markets,” economist Elga Bartsch of Morgan Stanley wrote in a note to clients.
“For it seems to me that some markets have lost their ability to find a new, stable equilibrium. This is because, instead of moving in sync with the business cycle, government bond yields now move against the cycle, ie, rising in a downturn. This seriously undermines the ability of the government sector to stabilise the economy and the financial sector.”
Bartsch looked at all sovereign borrowers since the mid-1990′s whose spreads above Treasuries rose to at least 10 percentage points, an indicator of distress. In only 20 percent of the cases did a debt restructuring, or default, ensure. Some were rescued by the IMF but many righted themselves.
Thus Europe is at the mercy of markets, left without a central bank or outside force which can break the cycle and impose order. The ECB has purchased government bonds as a back door means of providing support, but this is awkward, will ultimately test the limits of the bank’s capital and, as being against the spirit of EU law, is deeply divisive. The EFSF fund is not well suited for playing this role either.

FOOL ME ONCE

You could object that, of course, all sovereign borrowers are ultimately credit risks. Even if one is repaid in the sovereign’s currency, that currency can be debased by inflation or the money printing press. True, but markets do not seem to impose the same penalty on inflation risk that they do on default risk.
There are two main take-aways from this. The first, of course, is that if you don’t have a proper central bank you ought to keep your debt profile slim so as not to attract too much attention to your vulnerability. This worked for Germany, whose Bundesbank was similarly forbidden by charter from printing money to buy government debt. Not borrowing too much is good advice but not terribly helpful in the current circumstances.
The second is that Europe needs a democratic way in which to agree to monetize or otherwise write down its debts. Failing that, the risk is that the domino-style run on government credit becomes self-fulfilling, as we’ve seen is the risk with ever larger sovereign borrowers like Italy being weighed by the markets and found wanting. This ultimately will break the euro, probably at about the point when Germany realizes it is picking up France’s dinner check.
This is not an argument in favour of suppressing markets by banning short selling or other measures, as is so often the impulse in Europe. Those arguments are raised by people, be they politicians or investment bank CEOs, who want to be insulated from the consequences of their own decisions. It is instead about clarity about who pays.
Europe suffers from unclear lines of accountability. There are easy fixes for that, but imposing them quickly will be difficult. That is certainly how markets are trading, and the result may be a self-fulfilling fracturing of the euro.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own

HUNTSVILLE, Ala. – Tim Geithner went a very long way on Friday to accomplish very little, flying to Poland to pitch to the assembled euro zone finance ministers the same tactics that have worked so poorly in the U.S.

Faced with another debt problem, Geithner once again proposed more debt as the solution, suggesting that Europe should leverage its EFSF bailout fund so it can have enough firepower to buy up the debts of weak euro zone nations. This mislabels a debt problem as a price problem, and is an almost exact analogue to the U.S.’s own tactics in addressing its own financial system problem — creating leveraged funds to buy up toxic debt and thereby massage the balance sheets of banks.

This is the deflationary equivalent of reacting to runaway inflation by deciding to lop a zero off the end of prices; things will appear better but the underlying issue is not resolved. This is borne out in the U.S., where private fortunes continue to be made in banking, but where the system is unable to play its role in capital intermediation. Many lenders are still wary, rightly, of funding U.S. banks and are unconvinced that the toxic debt problem is gone for good.

The Europeans don’t appear to be buyers either. “We are not discussing the expansion or increase of the EFSF with a nonmember of the euro area,” said Jean-Claude Juncker, the chairman of the Eurogroup.

He also ruled out any further fiscal stimulus, something Washington has also called for. “Fiscal consolidation remains a top priority for the euro area,” he said.

Austria’s Finance Minister Maria Fekter went further, describing how Geithner urged the group to commit more money to the rescue, but flat out rejected the idea of funding the bailout with a financial transaction tax.

“I found it peculiar that even though the Americans have significantly worse fundamental data than the euro zone, that they tell us what we should do and when we make a suggestion … that they say ‘no’ straight away.”

Remember, Geithner isn’t proposing borrowing more money so that the deeply destructive cuts the euro zone is requiring in Greece and elsewhere can be eased. It is not money for teachers, it is money to support bond prices, which in effect is money to support the capital positions of the banks which would be left broken if the true market price prevailed.

SOVEREIGN CREDIT RISK ROULETTE

The problem with this is that ultimately supporting the banks may swamp the sovereign’s credit rating. A massive increase in the size of the EFSF would surely call into question France’s AAA rating. While Europe has a problem over who is going to pay, with Germans unwilling to underwrite what they see as Mediterranean profligacy, it also has a profound problem with which lenders to make whole.

A look at a study from the Bank for International Settlements into the interaction of sovereign credit risk and bank funding really shows the limits of Geithner’s leverage-happy approach.

Released as part of its quarterly review, the central bank’s central bank described sovereign credit risk as posing “a significant and urgent challenge to banks.”

Bank are massive holders of sovereign debt; indeed bank regulation hard-wires holdings into their business model. That leaves banks open to losses on sovereign loans held on their balance sheets, and in turn those loans are worth less as collateral for loans from the market or from central banks. On top of that, as the state is the ultimate insurer of its banking system, downgrades to the sovereign are effectively downgrades to its banks, raising their funding costs.

In other words, buying up sovereign debt at inflated prices without properly restructuring the debt will result in an ongoing European bank funding crisis, with ever more leverage needed until the day comes that the sovereign is no longer credit worthy. The bank funding and sovereign credit dynamic is one that must ultimately be broken by sovereigns repairing the stability of their finances.

Banks can mitigate these risks by holding fewer government bonds, and by funding themselves more conservatively, but those steps will tend to make them less willing and able to provide credit to the economies they are supposed to support. That is probably the way banks need to be run, but operating a bank conservatively in an economy in which debts have already been properly written down will result in good solid growth. Doing it in a make-believe economy with make-believe asset prices will result in years of stagnation.

That is what the U.S. is seeing. Europe should choose a different path.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala., Aug 30 – In an unintended irony for a continent with a great public transport infrastructure Europe’s debt rescue plans are turning into a train wreck. Consider that as Greek two-year interest rates stood at 45 percent on Monday, officials and interests in the euro zone descended into an unseemly mix of squabbling over assets, denying the undeniable and disagreeing about first principles. Even as weak as recent U.S. economic data has been, these fractures, which imply heightened risk of a bank-centered market crisis, are surely the main source of the recent extreme financial volatility.

Most interesting was the intervention by newly minted International Monetary Fund Managing Director Christine Lagarde on Saturday who warned “developments this summer have indicated we are in a dangerous new phase.”

Lagarde went on to say that Europe’s banks need “urgent recapitalization,” using public funds if necessary, and advised that one option would be to use the European Financial Stability Fund (EFSF), or some other vehicle, to inject capital into banks directly.

Here we have the head of the IMF, a woman who was until recently the finance minister of France, more or less asserting that the bank stress tests are best disregarded and that people should have real doubts about the banks they do business with, invest in and lend to.

This is nothing that cannot be seen in market prices, of course, but it’s a bit as if U.S. Treasury Secretary Tim Geithner were to leave government service, set up as an equity analyst and come out with a “sell” rating on Bank of America.

Not helpful, even if perhaps true.

Lagarde said that Europe risks a liquidity crisis, though surely any crisis that comes as a result of people withdrawing credit from banks because they have not got enough capital has to be classed as a crisis of solvency.

Euro zone officials were quick to stamp on the idea, pointing out there were well known remedial steps being taken as a result of the stress tests, and that new banking regulations offered further protection. It is good that euro zone officials can agree that they’ve solved the bank capital problem, because very few others seem to agree.

On other issues, European officialdom is showing comical, if destructive, disagreement. Take Finland’s demand for collateral as part of its participation in the rescue of Greece. This demand immediately sparked a round of “me too” demands from other smaller euro zone players, states whose share of the package is about 10 percent. To an outsider, this looks suspiciously like a lack of faith in Greece and in their European partners. It has the feel not of a rescue of a sovereign state and euro zone partner, but of in-fighting among the creditors in a bankruptcy.

While Finland appears to have backed off from some of its demands, the situation hardly inspires confidence.

A LITTLE LOCAL DIFFICULTY

And of course even within countries there are deep political divisions over the right path. Germany is an excellent case in point; Chancellor Angela Merkel last week came out against Finland’s bilateral deal and euro zone common bonds, while maintaining that she would be able to push through approval by parliament of the expansion of the EFSF. Reports in German media indicate substantial opposition within Merkel’s somewhat shaky coalition, meaning she may be forced to seek votes from the opposition. Merkel has canceled a long-planned visit to Russia on Sept. 7, the day of the vote.

The ECB’s decision to buy Spanish and Italian debt on the open market, a thus far successful effort to cap interest rates for the two vulnerable states, has left it subject to strong criticism that it has overstepped its bounds and compromised its independence.

German President Christian Wulff last week inveighed against the ECB’s action and against the last-minute nature of recent policy-making.

“I regard the massive acquisition of the bonds of individual states via the European Central Bank as legally questionable,” he said, speaking at an economics conference in Lindau, Germany.

Wulff cited an article in the European Union’s fundamental treaty, which he said prohibits the ECB from buying bonds directly from governments.

“Decisions have to be made in parliament in a liberal democracy. That is where legitimacy lies,” he said. This is an interesting echo of the less well tempered criticism of Ben Bernanke by presidential hopeful Rick Perry, who said that further radical easing by the central bank would be “treacherous, almost treasonous.”

The truth, perhaps, is that Europe is a group in an impossible situation, just as the Fed is an institution in an untenable position. Groups of people in impossible situations tend only to act when forced, and only rarely are able to act in concert.

Expect an active and unsettling September.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

In a field of endeavor with a long and glorious history of folly, the European Central Bank is preparing to commit an error for the ages: hike interest rates into the face of a crisis of existence for the euro zone.

There is an increasing likelihood that when the ECB meets  on April 7 they will respond to surging energy costs and 2.4 percent annual inflation – the highest since 2008 – by raising interest rates, probably by a quarter of a percent.

“Inflation rates … are now durably above the common definition of price stability in the euro zone,” ECB President Jean-Claude Trichet told an audience in Paris on Monday.

This reinforced expectations of a hike he introduced in early March when he dropped the words “strong vigilance” into remarks following the last interest rate-setting meeting, a phrase that served as a one month warning of rate hikes to come during the 2005-2007 rate hike campaign.

Reports that the ECB is preparing a new bail-out lending vehicle for Irish banks, taken as a precursor to a wider effort at bank relief, are being read in markets as further evidence that the ECB is ready to tighten. The reasoning is that, having squared away the banks, and their mutually dependent sovereign guarantors, nothing will stand in the way of an old fashioned bout of inflation scourging.

Here we see the ECB’s conception of itself – as an institution proudly above the political fray and dedicated single-mindedly to price stability – clouding its ability to treat with reality.

“Sure”, you can almost hear ECB types say to themselves, “we’ve accepted some pretty horrendous collateral, and sure, we’ve kept insolvent banks alive through providing massive liquidity, but at heart we are just honest inflation hating bankers, just like our forebears at the Bundesbank.”

Actually though, as Bank of England Monetary Policy Committee member Adam Posen points out, the Bundesbank, when confronted with the oil shock and global recession of 1979-80 dealt with energy-driven inflation quite differently.

“The Bundesbank made public that it would take several years to bring inflation back to its target long-run inflation level, even though it would partially offset the shock immediately and inflation would rise. In fact, it took six years for German inflation to be brought back to 2.0 percent, and both the Deutsche Mark and the Bundesbank retained their counter-inflationary credibility,” Posen said in a February speech.

Now, when you recall that the Bundesbank was slightly to the right of Atilla the Hun in its attitude towards inflation, the ECB’s current course of action looks even more, to be polite, remarkable.

GREECE,  IRELAND, PORTUGAL

Remarkable, especially, when you consider what is being asked of the peripheral euro zone countries. Greece, for example, last year tightened fiscal policy by 8.0 percent of GDP, a statistic that is more impressive before you learn that its economy, partly as a result, shrank by 5.0 percent. You really cannot do that too many years in a row, either mathematically, or politically.

A semi-revolt against austerity measures in Portugal prompted the resignation of Prime Minister Jose Socrates last week, leaving a European rescue plan in limbo. Portugal is now being pressured to accept a bailout, but there is real doubt as to whether it will sign on for the measures expected, and even more doubt as to whether it can stick with them over time.

Inflation is not the problem in Portugal, it is declining standards of living, exacerbated by rising energy costs, but really the result of a squeeze on labor and consumption that is its only means of regaining competitiveness as it has no currency of its own to devalue.

Or take Ireland, which is fighting for better bailout terms, its latest gambit being to push the idea of burden sharing for bank creditors to its crippled banking system. As burden sharing means banking crisis, you can take this as a negotiating position. Or consider Spain, whose own banking system and economy will not be helped by the ECB fighting inflation.

Meanwhile there is a lack of convincing evidence even in the stronger countries of the euro zone that inflation is hardening into large wage rises.

In the meantime, there is evidence that the European recovery, uneven as it is, is facing headwinds. Measured in real terms, currency in circulation and overnight bank deposits in the euro zone are contracting, a strong leading indicator of a slowdown. While this trend started in the weak periphery, it has spread to the core, and is troubling.

A rate hike will rain down even more pain on struggling Spain and its peers and will on the margins make their task of outgrowing their debts and honoring their European commitments even less feasible and will do exactly nothing about the real cause of inflation – rising energy prices.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

If the euro is going to survive without a Depression, German consumers are going to have to behave in ways that are, well, distinctly un-German.

While attention is focused on the suffering that the euro zone debt debacle is inflicting on the weak and the political anger the costs of bailouts are engendering among the strong, it is important to understand that the belt-tightening won’t just be a Gaelic and Mediterranean phenomenon.

German consumers will (rightly) regard events as likely to increase their taxes while doing precious little for their incomes and job prospects. If they react to this like Americans and spend like there is no tomorrow, well then, perhaps the euro zone can handle the local recessions in the Austerity Provinces. If, on the other hand, Germans behave anything like the way they have in the past, they will save more and only increase spending marginally, if at all.

“Over the four quarters to 2011 Q4 it is hard to see (German consumer spending) growth exceeding 1 percent, and easy to see it falling short, especially if budgetary rigour, rising food and energy prices, and the need for further Club Med subsidy provoke the normal reaction from German consumers,” Charles Dumas of Lombard Street Research in London wrote in a note to clients.

Against the wider backdrop this is not encouraging; U.S. demand will be weak, China is trying to stomp on inflation and the euro zone periphery will very likely be contracting. That really does leave German consumers as the engine of euro zone growth — a role that is, for them, unusual.

To put this in context, since the fourth quarter of 2001 German consumer spending is only up a bit more than 2 percent in real terms, a truly measly expansion. During the same period the household savings rate has risen from about 9 percent to just above 11 percent.

During this time, you will recall, the world experienced a go-go real estate bubble with seemingly free money, much of it German in origin, available to plough into collateralized debt obligations and the like.

If German consumers reacted soberly to the good times, imagine what they will do in coming years when confronted with the risks and costs of either staying in or exiting the euro.

Part of the reasons for German consumer reserve was a policy that constrained wage growth savagely, but again, to look for strong wage growth to emerge at this stage is wishful.

NICE RECOVERY?
Much has been made of the fact that Germany’s economy grew strongly last year, rising 3.6 percent, the strongest showing since its east and west were reunified. While this is a fine start, Germany did shrink by 4.7 percent the year before and its economy is still 2 percent smaller in real terms than it was at its peak.

While European, including German, officialdom is absolutely opposed to a euro exit, repeatedly characterising it as disastrous and unthinkable, it might not actually be that bad for German consumers, at least after a while.

Dumas of Lombard Street argues that the hit to competitiveness from a newly risen new-deutschemark would be offset by gains in consumers real income and confidence.

“A higher exchange rate would probably cause a healthy redistribution of income from business to labour, ie, consumers — the lack of which is closely connected to undervaluation and excess savings and net export surpluses in Japan and China, as well as Germany.

“Since Germany is unlikely to follow China’s route of real exchange rate appreciation by means of wage inflation, giving some possibility of a shift to consumption from exports, a break-up of EMU may actually be the only hope for achieving an increase of welfare for ordinary Germans.”

Given the current alignment of opinions that is not the most likely outcome, to put it mildly.

What does seem likely is some combination of the following: a recession among the weak in the euro zone exacerbates and is exacerbated by a failure of German demand in the face of uncertainty and limited global demand.

That will raise the rhetoric of euro zone discord and will weaken the euro, causing a problem for the dollarized world, including China. China’s willingness to spend billions to prop up demand for euro zone debt is in no small part because of this.

Europe will remain a strongly deflationary force in the global economy and the biggest risk in the near term as a force to upset the giddiness that is now dominant in global markets.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

James Saft is a Reuters columnist. The opinions expressed are his own.

Just when it looked like Spain would force the euro zone to get serious about destroying its crippling debts, here comes plucky Belgium, hobbling its way to history.

While some are focusing on whether Portugal will take a bailout (hint: they will) and how to extinguish the burning firewall around Spain,  markets are steadily losing confidence in Belgium, which is big enough, ugly enough and heart-and-soul-of-Europe enough to change the game, potentially forcing sovereign defaults and bank recapitalization.

Investors imposed an all-time-high risk premium on Belgian bonds relative to German ones on Monday amid political chaos. Belgium’s parties have for the past 212 days been unable to agree a government, forcing King Albert II to step in and ask for a cost-cutting budget for 2011. Gross government debt is very high, hovering around 100 percent of GDP, leaving Belgium very vulnerable to a loss of market confidence.

Given that Portugal is likely to soon apply for help and rising concern about Spain, contagion to Belgium could be the catalyst that forces European authorities to rethink their approach.

This latest round of euro zone risk aversion may have been touched off by a proposal released last week that may mean senior lenders to banks would in future be forced to share in losses in the event of failure, so called “burden sharing.”  A feature of the sovereign bailouts thus far, notably in Ireland, is that the authorities have refused to force bank senior creditors to share in the pain, no doubt because to do this would be to reveal many banks as insolvent.

This means Ireland and Greece have not been relieved of debt, only allowed to remain in debt for longer on better than market terms. The budget cuts this impels only worsens their economies, making those debts harder to service over the longer term.

However, investors can read and as soon as they learn that there may be burden sharing, even in the fuzzy future, they react by selling out of current government debt positions in weak countries, potentially increasing the size and scope of the bailout which is needed.

Europe is really a prisoner of this policy. It does not want to acknowledge that many banks are insolvent and need massive new capital, but being unwilling to do this forces it into politically impossible positions and will only in the end lead to sovereign defaults which will, you guessed it, reveal the banks to be insolvent.

CUTTING THE GORDIAN KNOT

If Ireland, for example, had its own central bank and its own currency it could try and inflate its way out of its debt difficulties, a back-door default, but one which would allow the banks to slowly heal. This is the policy of the U.S., where the banks may not fail but the economy will pay a heavy tax while they recover.

This just isn’t going to work for the euro zone, especially given that so much of the debt is held abroad.

“For a number of euro area sovereigns the consolidated position of the sovereign and the banking sector looks unsustainable. This means that either the unsecured debt of the banks will be restructured or the sovereign debt or both,” Citigroup economist and former Bank of England Monetary Policy Committee member Willem Buiter wrote in a note to clients.

The U.S. will hate this, as it goes in the exact opposite direction of its own back-door bailout of the banking system, and will fight it tooth and nail. If you have any doubt of this, note the appointment of Davos Man and J.P Morgan banker Bill Daley as Obama White House chief of staff.

A restructuring of sovereign debt — a polite default, combined with a restructuring of bank debt and a recapitalization of weak banks offers the best hope for the euro zone. Besides being fair, as foolish creditors will share in the pain with taxpayers and citizens, it also has the potential to leave the euro zone on a solid footing, with a level of debt that is manageable and will not sink the economy, and with a banking system that can play its role in a recovery.

This is neither simple nor uncontroversial; huge losses will be taken and it will not be easy either to gain consensus to recapitalize swaths of the banking system, or to turf out current management.

We end in the same place in either event; the debts are unsupportable unless reduced and ultimately the sovereigns and the banks they backstop will fail.

Better to get on with it, get an early start on real recovery and avoid a couple of more years of legal looting by the financial sector.

Let it come down.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)