Both declining bank lending and heavy debt burdens are hurting the euro zone economic recovery.
On the one hand, economists argue the recovery is being held back because debt burdens remain far too high. Total public- and private-sector debts are equal to more than 400% of gross domestic product in Ireland and Cyprus, and over 300% in Spain, Portugal and Greece. And the stock of bad debts now equals 50% of loans in Cyprus, 33% in Greece and 16% in Italy, 14% in Spain and 11% in Portugal. On the other hand, economists also warn the economy is weak because it is being starved of new credit: Bank lending shrank by another 1.8% in the year to the end of June in the euro zone. In Spain, it fell by 8% in the year to the end of May, in Portugal by 7% and in Italy, Cyprus and Ireland by 4%, according to Morgan Stanley.
Deleveraging, it seems, is both the solution to the euro zone's problems and the source of all its woes.
The deleveraging can be done in two ways.
A good deleveraging is when balance sheets are restructured and bad debts written off. This way, viable businesses and creditworthy households should be able to borrow from healthy banks to fund productive investment. The economy grows and the burden of debt falls.
A bad deleveraging is when governments, households and companies try to tackle excessive debts by cutting spending and overindebted banks refuse to lend so that the economy shrinks and the burden of debt rises, creating a vicious spiral.
What can be done to speed up the process of good deleveraging? There are three requirements: first, banks must write down their loans to realistic valuations and raise any capital needed to absorb the losses; second, banks need access to a robust insolvency regime that will allow them to swiftly restructure bad debts, if necessary by forcing companies and households into bankruptcy; third, there needs to be an abundant supply of equity capital so that banks can unload restructured assets from their balance sheets.
True, the European Central Bank's Comprehensive Assessment of the 131 largest euro-zone banks—comprising an asset-quality review and stress test—is supposed to address the first of these problems. Encouragingly, in the year since the ECB plan was announced, euro-zone banks have raised more than €40 billion ($53.72 billion) of capital via equity issues and asset sales
