Austerity, blame The Bank

Are Europe’s problems being caused by austerity or by a broken banking sector?

The consensus view is that fiscal belt-tightening has caused domestic demand to collapse across the euro zone’s most troubled countries, but some dissenters, notably fund manager and blogger Pawelmorski.com, suggest that banks are the bigger culprit.

For, however hard the European Central Bank tries to pump money into the economy, not a lot of credit is getting through to small firms and households in struggling countries. Whereas U.S. credit to the business sector grew in 2011 and has been expanding since, the story has been one of contraction across the euro zone’s edges.

Perhaps that shouldn’t be a surprise. Euro-zone banks are struggling. Whereas the U.S. banking sector had tier-one capital of 12.6% and non-performing loans running at 17.6% of capital at the end of 2011 (and both are likely to have improved since), the most recent numbers for Greece are 9.2% and 162.9% respectively, for Spain they’re 9.6% and 33.8% and for Portugal they’re 11.3% and 38.6%, according to the International Monetary Fund.

In short, banks in struggling Europe are undercapitalized and laden with bad debts. No wonder they’re not lending.

What can the ECB do?

Its liquidity provision has staved off wholesale bank collapses, but hasn’t done much for the underlying economies. It is now looking towards the U.K.’s Funding for Lending scheme–where banks are subsidized for handing loans out to households and small firms–for inspiration.

Unfortunately, if the ECB accepts these loans as collateral at discounts at which banks are happy to provide them to the market, it sets itself up for losses, which the Germans won’t be happy about, argues Tyler Cowen, an economist at George Mason University, blogging at Marginal Revolution. Austerity has certainly caused problems, but it’s not the only source of the euro zone’s weakness. A crippled banking sector is another. There are political moves afoot to soften austerity among Europe’s most struggling countries. But there’s a long way to go before the banking problem’s solved.