Europe’s other debt crisis

FIFTEEN months ago, in July 2012, Mario Draghi, the president of the European Central Bank (ECB), promised to do “whatever it takes” to preserve the single currency. Although the bond-buying scheme set up to fulfil that pledge has never been tested, yields on sovereign bonds have fallen. The euro mess has morphed from an acute crisis into a chronic one.

This week Mr Draghi launched what could become the second big turning-point in the euro saga: an inspection of the balance-sheets of the region’s 128 biggest banks which the ECB will supervise from late 2014. As part of its “asset-quality review”, ECB officials, along with outside experts, will start peering into the banks’ balance-sheets and impose common standards for loan quality (see article). This process is supposed to find out which banks are viable now, which will need more capital and which should just be closed down.

Mr Draghi should be tough. The euro zone’s politicians, even in supposedly prudent Germany, have been reluctant to look too deeply into banks’ balance-sheets, let alone to force them to clean themselves up. There are certainly questions to be asked about all the government bonds that the banks have bought in recent years. But the main dodgy assets that have been swept under the European carpet are private: bad loans made to households and companies.

There are some nasty bugs under your carpet, Angela

Europe is always thought of as having a sovereign-debt crisis, and it has. But the origins of the euro disaster lay less with government profligacy than with excessive private borrowing. True, Greece got into trouble because its government spent too much and collected too little in taxes. But elsewhere the bust followed a private-sector binge: mortgage debt in Ireland and Spain; corporate borrowing in Portugal and again in Spain (see article). In all three countries household and corporate debt combined were way over 200% of GDP before the crisis, much higher than in America (175%) or even Britain (205%).

Unfortunately, the euro zone has made less headway than other places in reducing this private-debt burden. Thanks to mortgage write-downs and faster growth, America’s households have unwound about two-thirds of the excess debt built up during the boom years. Most euro-zone countries have achieved far less private-sector “deleveraging”, for three reasons. First, the fiscal austerity imposed on Europe’s peripheral economies deepened their recessions, which made it harder to reduce private debts. Second, weak banks have been reluctant to recognise, and hence make provisions for, non-performing loans. And third, European bankruptcy law is less debtor-friendly than America’s, and so tends to be less conducive to restructuring debt. In America many mortgages are “non-recourse”, meaning a borrower can hand back the keys and walk away; Europeans typically remain liable for unpaid mortgage debt. Corporate-bankruptcy procedures are often slow and costly: in Italy the process takes an average of seven years.

The corporate-debt problem is worst in Portugal, Spain and Italy, where the IMF says that 50%, 40% and 30% of debt, respectively, is owed by firms which cannot cover their interest payments out of pre-tax earnings. These firms are unable to invest or grow. They are zombie companies, much like those wafting through Japan in the 1990s.

The household-debt burden is especially heavy in Ireland and, surprisingly, the Netherlands—exceeding 100% of GDP in both places. Paying the mortgage strains household finances and crimps consumer spending. Whereas in America the share of income that the average household spends on servicing debt is now the lowest in decades, in Spain it is higher than during the boom years.

and, this time, they’re not Barack Obama’s

If the euro zone’s recovery is to strengthen, this burden of private debt must be lightened. According to the IMF, private debt is a bigger drag on Europe’s growth than government debt. One prerequisite, which even Germany’s chancellor, Angela Merkel, is beginning to accept, is less draconian austerity. It is virtually impossible for the private sector to reduce debt when governments try to slash their borrowing too. Another necessity is for banks to recognise, and write down, non-performing loans. That is where the ECB’s asset-quality review will be crucial. The central bank must make sure its assessment is both thorough and credible: Mr Draghi should stand firm against any political pressure to downplay the size of the bad-loan problem in order to minimise potential capital shortfalls. Equally, Europe’s politicians must be willing to provide the resources to recapitalise banks if necessary.

Lastly, a more honest assessment of banks’ balance-sheets must translate into a willingness by the banks to sell or restructure mortgages and corporate loans. Mrs Merkel has been far tougher on Greece than on the German banks that lent the Greeks so much. Governments can create “bad banks” or specialist asset-management companies to manage and dispose of non-performing loans; they can help develop secondary markets in distressed debt with tax and regulatory breaks. And they can reform bankruptcy and tax laws to make it easier to restructure corporate and personal debts.

Most countries have already put a few of these reforms in place. Spain and Ireland have “bad banks”. Several countries have streamlined bankruptcy rules. Portugal has pioneered the use of out-of-court settlements. But much remains to be done. In Italy a mere €2 billion ($2.8 billion) of non-performing debts is sold each year, out of a stock of €122 billion. The Bundesbank is prone to lecturing the financial world about everything except the mess in Germany’s regional banks.

Sorting all this out will take time. The euro zone will not look like America, with a debtor-friendly legal system and a big market for distressed assets, overnight. But dealing with the private-debt trap should be a priority for Europe’s leaders. Better capitalised banks would be more able to lend; they would also make it easier to create a banking union. A continent littered with zombie firms and broke households will never prosper. It falls to Mr Draghi to start clearing up.