Export Optimism, Financial Fear: Bank Balance Sheets Could Torpedo Recovery

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More than anything else, though, trade unions have practiced wage restraint for many years, which has helped enhance Germany's competitiveness. Unions and employers have agreed to differentiated and flexible working hour systems. The Hartz reforms introduced under the coalition of Social Democrats and Greens led by then-Chancellor Gerhard Schröder stripped much of the structural rigidness from the German labor market.

Over the past decade, this has resulted in one of the most robust and flexible economies in the world. Germany is the only European country with an unemployment rate that is lower today than what it was before the outbreak of the global financial crisis in the spring of 2008. Meanwhile, unemployment has doubled in the US.

Over the long run, however, the export-dependent German economy won't be able to disengage itself from trends in the global economy, which is already showing initial signs of fatigue, both in the US and China.

Some experts even fear that after a brief recovery, the global economy could fall back into a recession as economic stimulus programs run their course. They speak of the possibility of a double-dip recession.

Renewed Turbulence Guaranteed

Indeed, as long as the financial markets refuse to shed their anxiety, the foundation of the new recovery remains fragile. Renewed turbulence is virtually guaranteed. The banks still have enormous quantities of toxic assets on their books. Nobody knows when or to what extent these debts will have to be written off.

In some cases, these bad investments consist of junk bonds from the days before the crisis, including second-class US real estate loans called subprimes. In other cases, they include burdens that hardly anyone was aware of a year ago, like government bonds from Greece and other southern European countries, which were touted as a fairly sound investment at the time.

Analysts at the US investment bank Morgan Stanley say that Europe is caught in a "vicious cycle." Instead of using government funds to forcibly recapitalize all banks, as the US did, the euro countries opted for another approach. After the Lehman Brothers bankruptcy, many banks loaded up on cheap cash from the European Central Bank (ECB).

According to Morgan Stanley, they have been using this money since October 2008 to finance the purchase of government bonds worth €420 billion. During this spending spree, the banks targeted high-yielding bonds from shaky southern European countries, primarily Spain, Greece and Portugal. They then deposited these bonds with the ECB as security for more loans from the central bank.

At the outset these lucrative deals soothed nerves on the markets, but they have now turned out to be time bombs. Nobody knows exactly how these bonds are weighted on the balance sheets -- and even less can be said about what they will actually be worth in the end.

Indeed, despite euro-zone bailout packages for ailing members of the currency union, few doubt that Greece will eventually have to restructure its mounting debt. Creditors would be forced to forego some of their claims.

Breeding Mistrust

Would all banks survive such a haircut? And what happens if further euro-zone members run into trouble, plunging even more banks into difficulties?

There is an enormous sense of uncertainty, and that breeds mistrust. Banks recently parked over €300 billion with the ECB overnight for the ridiculously low interest rate of 0.25 percent. Anyone who borrows money for 1 percent, only to turn around and deposit it overnight with the ECB for just 0.25 percent -- instead of earning considerably more by loaning it to the competition -- has one problem above all: fear.

Last week the banks borrowed significantly less money in new loans than what they had to pay back to the Bundesbank, but that only briefly reduced the edginess. "There is still a great deal of tension," says Hans-Günter Redeker, head foreign exchange strategist for the major French bank BNP Paribas. He says that the balance sheets are too shadowy. "We need a sound stress test on the table, which will also be made public." This is something, at least in principle, that everyone attending last Wednesday's meeting in Frankfurt also agreed on. But there were differing opinions on what was sound and what wasn't.

There have been a number of stress tests in the past. But they weren't made public, and they did not take into account -- of all things --the greatest risk on the banks' balance sheets: the government bonds from the so-called PIIGS countries (Portugal, Italy, Ireland, Greece and Spain).

Horror Scenario

What the markets fear most of all is that these assets could plummet in value -- that these countries could declare bankruptcy and their debts would need to be refinanced. But this horror scenario is not taken into consideration in the current stress test. Otherwise critics could insinuate that the Bundesbank and the BaFin have doubts about the success of the bailout package.

Instead, the bank auditors went on the assumption that a deepening of the debt crisis could drive up the price of credit default swaps on bonds from countries like Portugal and Spain, causing their value to drop and leading to write-offs for the banks. An additional routine scenario goes on the assumption that there could be another economic downturn.

Many questions remain unanswered, however, and the representatives of the banks, the Bundesbank and the BaFin will no doubt have to meet again soon.

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• Part 1: Bank Balance Sheets Could Torpedo Recovery
• Part 2: Extreme Unease