How to avoid the doom loop? The eurozone could easily fall into a self-reinforcing cycle of bank and government debt default. Christine Lagarde of the International Monetary Fund has a solution: more bank capital. There is a better way.
The cycle could start if sovereign debt worries cut off the supply of bank funding (the money needed to support operations). Morgan Stanley calculates that European banks need €80bn before the end of the year. That is not even 1 per cent of the outstanding sovereign debt in the European Union, but a shortfall could start a downward spiral of bank failures – if neither governments nor the European Central Bank were willing to replace fearful private investors.
Ms Lagarde has not explained last week’s call for an “urgent recapitalisation” of European banks, but she probably believes investors would fund banks that have enough equity to survive substantial writedowns on Greek, Portuguese and Italian debt. True in principle, but it is almost inconceivable that banks could raise enough equity in a hurry to calm investors. If governments provided the equity, sovereign worries would worsen.