How Deleveraging in Europe Might Doom the U.S.

Both Paul Krugman and Tyler Cowen recommend a new paper from Hyun Song Shin called “Global Banking Glut and Loan Risk Premium.” If both of those guys say a paper is important, then it’s probably pretty important. So I took a look. I’ll confess up front that I had a hard time plowing through it, which means my summary might be off base a bit here and there, but here we go anyway. Roughly speaking, Shin says the following things:

  • Credit expands when banks lever up their balance sheets by piling up lots of debt.
  • Thanks to Basel II, European banks levered up even more than U.S. banks.
  • Some of this was intra-European debt, but lots of it was U.S. debt denominated in dollars. In total, European banks had about $5 trillion in claims on U.S. counterparties in the peak year of 2007, much of it via purchase of private label subprime securitizations.
  • In other words, the European segment of the shadow banking system was indirectly providing about $5 trillion in credit to U.S. borrowers. This was about as much as U.S. banks provided directly.
  • The mechanism for this indirect flow was simple. Starting in 1999, U.S. money began flowing in large quantities to the U.S. subsidiaries of European banks, then across the Atlantic to their home offices in Europe, and from there back to borrowers in the U.S.
  • Conclusion: the European banking sector provides about as much credit to the U.S. as the American banking sector does. So when the European banking sector deleverages, as it must, it will have a very substantial effect on credit conditions in the U.S. In Shin’s bland phrasing, “The European crisis carries the hallmarks of a classic ‘twin crisis’ that combines a banking crisis with an asset market decline that ampli?es banking distress….The global ?ow of funds perspective suggests that the European crisis of 2011 and the associated deleveraging of the European global banks will have far reaching implications not only for the eurozone, but also for credit supply conditions in the United States and capital ?ows to the emerging economies.”

Translated, this means that as sovereign debt woes get worse, bank woes get worse too. And as bank woes get worse, sovereign debt woes get worse. The result is a vicious circle that produces a big credit contraction, and since European banks have become so important as funding sources to the U.S., it means a big credit contraction in the U.S as well.

Tyler’s comment: “If true we are doomed.” On a separate note, Shin also points out that after the euro was introduced in 2000, cross-border claims within Europe skyrocketed. Unfortunately, banks themselves mostly stayed pretty local:

The introduction of the euro meant that “money” (i.e. bank liabilities) was free-?owing across borders in the eurozone, but the asset side remained stubbornly local and immobile. It is this contrast between the free-?owing liabilities but localized assets of European banks’ balance sheets that has been a key contributing factor in the European crisis.

In other words, wholesale funding flowed easily to wherever it would get the best return, but banks mostly kept their loan books local. This produced big property bubbles in Ireland and Spain and big current account imbalances across the entire continent. There’s no easy way for this to unwind, and unfortunately, even the moderately difficult ways appear to be out of bounds to the eurozone’s policymakers. If we really are doomed, it’s partly because of bad policymaking during the aughts, but it’s also because of disastrous policymaking right now. I wish I thought that Shin was wrong about this, but I suspect he’s not.

DOES IT FEEL LIKE POLITICS IS AT A BREAKING POINT?

Headshot of Editor in Chief of Mother Jones, Clara Jeffery

It sure feels that way to me, and here at Mother Jones, we’ve been thinking a lot about what journalism needs to do differently, and how we can have the biggest impact.

We kept coming back to one word: corruption. Democracy and the rule of law being undermined by those with wealth and power for their own gain. So we're launching an ambitious Mother Jones Corruption Project to do deep, time-intensive reporting on systemic corruption, and asking the MoJo community to help crowdfund it.

We aim to hire, build a team, and give them the time and space needed to understand how we got here and how we might get out. We want to dig into the forces and decisions that have allowed massive conflicts of interest, influence peddling, and win-at-all-costs politics to flourish.

It's unlike anything we've done, and we have seed funding to get started, but we're looking to raise $500,000 from readers by July when we'll be making key budgeting decisions—and the more resources we have by then, the deeper we can dig. If our plan sounds good to you, please help kickstart it with a tax-deductible donation today.

Thanks for reading—whether or not you can pitch in today, or ever, I'm glad you're with us.

Signed by Clara Jeffery

Clara Jeffery, Editor-in-Chief

We Recommend

Latest

Sign up for our newsletters

Subscribe and we'll send Mother Jones straight to your inbox.

Get our award-winning magazine

Save big on a full year of investigations, ideas, and insights.

Subscribe

Support our journalism

Help Mother Jones' reporters dig deep with a tax-deductible donation.

Donate

Share your feedback: We’re planning to launch a new version of the comments section. Help us test it.