By Neil K. Shenai - Special to CNN
This is what contagion looks like: France’s ten-year interest rates have risen to 3.5%, while this month, the spread between French and German borrowing costs reached its highest level since 1990, indicating that Europe’s sovereign debt crisis – once mistakenly believed to be a problem unique to Greece – has now engulfed the entire European periphery and now threatens the financial stability of the largest economies in the world. Rising bond yields show that investors are betting that Standard & Poors and Moody’s rating agencies will strip France of its AAA rating – another blow to Europe’s fragile financial system.
How did we get here? After all, France has an ostensibly healthy economy – it boasts strict real estate lending standards, scores reasonably well on income inequality, has a relatively benign sovereign debt to GDP ratio at 85%, and avoided and even shunned the Anglo-American neoliberal “financialization” of the last thirty years. Surely this is just a matter of financial market speculators run amok, targeting the next innocent victim on their crusade to bankrupt Europe.
Unfortunately, it’s not that simple.
Europe’s sovereign debt crisis started in February 2010, when Greek bond yields surged amid revelations of accounting subterfuge. Dealing with an impending financial crisis is a lot like treating a patient with cancer: the sooner doctors diagnose it, the greater the likelihood that its spread can be contained. Unfortunately, Europe’s leaders failed on both counts. They dismissed the peripheral sovereign debt crisis as a symptom of peripheral Europe’s flagging competitiveness and fiscal profligacy, and refused to pass a system-wide solution with the size and comprehensiveness necessary to stem the financial market panic.
So it comes as no surprise that France is in investors’ crosshairs today. Commentators will offer many reasons for rising French borrowing costs. Some will claim that investors are growing skeptical of the fiscal sustainability of France’s social welfare model, complete with its lavish pensions, universal health care, and ideological dubiousness of Anglo-American laissez-faire capitalism. But assuming that markets are capable of such a nuanced interpretation gives international investors too much credit. Most financial market participants are not political scientists who rationally weigh the costs and benefits of different national systems of political economy.
Others will argue that investors now realize that to save the common currency union, both France and Germany will have to backstop peripheral European debt. Under these circumstances, it is reasonable to expect a convergence of French and German bond yields with peripheral members’. Again, while plausible on face, this notion rests on the assumption that markets anticipate a union-wide bailout in the first place. Based on ever-rising peripheral bond yields, this too sounds far-fetched. Still, there might be some truth to this argument, as this morning, Germany struggled to find buyers in a government bond auction, showing that investors now fear that Germany would have to bear a disproportionate burden of any Eurozone bailout.
To understand why France specifically now finds itself in the throes of financial market contagion, one needs to look at France’s biggest financial institutions. According to the Bank of International Settlements, the three largest French banks have approximately $900 billion worth of peripheral European debt on their balance sheets. By comparison, the entire U.S. subprime market is about $700 billion. These figures might seem approximately comparable on face, but on a relative basis, France’s peripheral lending amounts to about thirty-five percent of French GDP, compared to less than five percent of the subprime loans outstanding to U.S. GDP.
It is often said that if you owe a bank a million dollars, you have a problem, but if you owe a bank a billion dollars, they have a problem. It is now apparent that French banks have a big problem. All of the less-than-best-case scenarios in the Eurozone are unequivocally bad for French banks. Remember that all of France’s peripheral Eurozone loans are denominated in Euros. If Greece, Italy, Spain, and Portugal leave the Eurozone, French banks will take an enormous hit as each country tries to reintroduce its own currency and repay their outstanding debt at their new, depreciated currency. As long as uncertainty continues to cloud the future of these countries, French banks are vulnerable to full-blown financial market panic akin to the credit crunch in the United States in fall 2008.
The longer this crisis wears on, the greater the damage done to the world economy. If there is one thing that the past few years should have taught us, it is to expect the unexpected in the wake of a financial crisis. In 2008, it seemed like subprime lending was a uniquely American problem. In 2011, it is clear that French banks played the role of subprime lender in Europe, while the entire European periphery was the willing subprime borrower. But Europe’s problems today are worse, because this ongoing episode was easily foreseen if one considered the pattern of contagion in the global financial crisis and historical propensity of sovereign debt crises to follow banking crises. Further, Europe lacks the institutional mechanisms necessary to coordinate and compel macroeconomic adjustment among peripheral and core members. Judging by the tepid growth, political stagnation, and debt overhang in Europe, it is hard to envision a smooth end to this European crisis.
Unfortunately, French banks do not exist in a vacuum. America’s too-big-to-fail financial institutions are also exposed to both core banks and peripheral sovereign debt. This crisis, much like a cancer, has spread, and is threatening to infect not just the European core, but also the entire global banking system as well.
Albert Camus once mused, “real generosity toward the future lies in giving all to the present.” Perhaps Europe’s leaders should keep this maxim in mind when issuing policies toward the European periphery that are designed to sacrifice today in the name of tomorrow. For further justification, just ask the French banks.
The views expressed in this article are solely those of Neil Shenai.