Some interesting thoughts from NEF

Professor Mark Blyth has written a lengthy piece that helps explain some fiscal decision in the current crisis He say the private banking crisis that finally erupted in 2008 was turned swiftly into a crisis of public balance sheets through the bailouts. Public and private finance are intertwined, right across Europe.

That’s why  George Osborne, found £7bn to bail out the Irish banking system – not a touching concern for a “friend in need”, but the £140bn exposure of British institutions to failing Irish banks.
Blyth thinks that the “mother of all bank runs” is a serious possibility as result, with European banks’ holdings of troubled state debt leaving the entire continent exposed. An increased risk of default in their public debt holdings would lead to banks dumping their assets to cover worsening positions, pushing down asset values and creating a crisis of liquidity. Contagion would spread, continent-wide, with banks threatened by insolvency.
Austerity is the “only game in town” inside the Eurozone because of this risk. Driving down public debt should reduce the fragility of the banking system by reducing the risk of default for public debt held by banks. But with austerity also crippling growth, public balance sheets can remain deeply in the red, relative to GDP. Default is therefore still a risk – but it may also be a necessity.
Hence the fragility of discussions around Greece. The debt cannot be repaid under austerity. But austerity cannot be avoided. Default is needed, euphemistically relabelled as “reprofiling”. Go in too soft, and Greece’s real debt burden will not be reduced, leaving the problem unresolved. Go in too hard, and risk a banking conflagration. The IMF and the EU can’t see outside of this dilemma, but more radical solutions may soon be needed: for Greece, an exit from the euro straitjacket; for Europe, a fundamental transformation of its banking system.