Assuring mutual destruction

The “bad bank” concept only appears to have delayed the inevitable default, not prevented it:

It was the failure of Creditanstalt, a Viennese bank founded in 1855 by Anselm von Rothschild, that arguably sparked the Great Depression, setting off an unstoppable chain reaction of bankruptcies throughout Europe and America.

No-one would think that what happened last week at Austria’s failed Hypo Alpe-Adria Bank International falls into quite the same category; we are meant to be in the recovery phase of the latest global banking crisis, so this is more about re-setting the system than again bringing it to its knees, right?

Well, make up your own mind. I suspect neither financial markets nor policymakers have yet caught onto the full significance of the latest turn of events.

In a nutshell, the Austrian government has had enough of funding the bank’s losses, and announced plans to “bail-in” external creditors to the tune of €7.6bn instead. As such, this marks a test case of new European rules to make creditors pay for failing banks. About time too, you might say. What took them so long?

Only in this case, the bonds are notionally guaranteed by the Austrian state of Carinthia, which now theoretically becomes liable for the bail-in. It’s an echo of the mess Ireland got itself into at the height of the banking crisis, when it foolishly attempted to stem the panic by underwriting all Irish banking liabilities; the move very nearly ended up bankrupting the entire country. Hypo will bankrupt Carinthia.

What the central bankers and politicians are doing is trading risk for time. I, and other economic realists, have been repeatedly wrong about the timing of events; I thought both Greece and Ireland would go bankrupt by 2013. But the fact that the defaults have not begun yet does not mean that the crisis is over, in fact, it does not even mean that the crisis is less serious than before. Quite the opposite, actually.

While I understand if those who don’t pay much attention to international economics might simply assume at this point that I don’t know what I’m talking about because things don’t seem to necessarily be all that bad, it might be helpful to keep in mind that the current situation is unprecedented.

For example, in most previous historical situations, Austria’s Hypo Bank would have gone bankrupt back in 2009. Instead, it was nationalized and put Austrian taxpayers on the hook for up to $25 billion.  The assets were divided and a “bad bank” created, but now that bad bank is in such dire straits that the Austrian government isn’t willing to continue funding its ongoing operational losses. But instead of simply declaring it bankrupt, they have put the assets of the equivalent of a U.S. state behind it.

This may buy them as much as another five years. But it also assures the financial destruction of an entire region of the country. What the banks have successfully done is create a system of mutually-assured destruction, gambling that electorates would rather let them off the hook than risk their governments defaulting, with all the turmoil that would subsequently ensue.