Who’s on the Hook for Europe’s Losses, and for How Much?

What do you get when you mix politics with fundamental principles of economics and accounting?  The answer is politics.

Both in the U.S. and in the euro zone, authorities seem willing to blame the weak economic recovery on weaknesses in bank, customer, and government balance sheets.  However, they are not willing to come clean about what these balance sheets truly look like. The problem is not just that the assets of many systemically important banks are overvalued. The larger problem is that banks and governments are not made to account for the way in which, when important firms fall deeper and deeper into distress, implicit and explicit taxpayer guarantees absorb much of the markdowns that would otherwise have to occur.

In accounting parlance, a contra-liability is an item that is entered on a firm's balance sheet when and to the extent that responsibility for servicing some of its debt falls on a third party.  For banks, financial safety nets transform a block of unknown taxpayers into just such a third party.  The unacknowledged value of taxpayer guarantees are, economically, an unbooked contra-liability of the modern commercial and investment bank and an unbooked, and uncertainly dated, liability of the taxpaying households and firms. Those taxpayers are the ones that troubled governments are likely to saddle with the final bill for the bailout support that pressure-group politics currently and surreptitiously dictates. 

Taxpayers' side of the bailout is a huge drag on the world economy. This is because, with each further delay in resolving the insolvency of zombie banks, rational taxpayers (including solvent banks) have to cut their spending and investment activity to set aside more and more of their wealth in an implicit or explicit precautionary reserve that is large enough to cover their surging tax exposure. 

This is why it is disgraceful for spokespersons for JPMorgan Chase (JPM) to claim that its suffering a several billion dollar loss in derivatives bets in London markets had no effect on U.S. taxpayers. This claim mendaciously ignores the way that observing so massive a failure in bank and regulatory risk management has increased taxpayers' estimates of their side of the taxpayer put and fanned taxpayer fears about other hard-to-observe forms of TBTF risk-taking.

Not having to account for taxpayers' equity stake in too-big-to-fail institutions generated by regulatory delay and forbearance undermines political accountability and limits deceiving management teams' exposure to fraud claims.

In the European Union, intense uncertainty exists about the size of the liabilities and the prospective identity of the particular creditors, taxpayers, and range of countries that will finally be made to cover the shortages of its insolvent banks and sovereign nations. The inability of outside parties to size the insolvencies accurately fans taxpayer uncertainty and makes ordinary citizens' precautionary reserve all the larger in the aggregate. 

Counterproductive delays in resolving the insolvency of large financial firms are the rule, rather than the exception. In the European Union today, laying more of the bailout burden on another country's taxpayers is the primary goal both of those pushing for a pan-European solution and those who are resisting their efforts.  Whether we are talking about an expanded bank recapitalization fund, a joint deposit-insurance authority, or a banking union or fiscal union, the issue is the same: Who will pay the bill and how large will it get before it is finally presented?

Seemingly endless negotiations over this issue support gambling for a hard-to-foresee economic recovery among the regulatory community and a go-for-broke casino mentality in the undercapitalized financial community.  In the meantime, the job of the European Central Bank has become to issue increasingly poorly collateralized loans to increasingly poorly capitalized and insolvent banks.

In my opinion, this process is turning the ECB into the biggest and most dangerous zombie of them all.

Edward J. Kane is a finance professor at Boston College