A new euro zone crisis in the making? The Bank of Italy's omen on stress testing

Today, the Bank of Italy proposed a bad bank for non-performing loans for the banks it supervises. The government is denying that there is a need for such a bank, that would have to have state guarantees for the loans the bank holds.

On November 4th of this year, the ECB is supposed to take over supervision for the EU's 128 largest banks. Before that happens, the ECB will undertake stress tests and identify amongst other things, non-performing loans that need to be cleaned up.

If the Bank of Italy's proposals were taken on board by the government, it would be a sign of economic responsibility in Italy to cleaning up its banking sector, but the political mentality appears to be twofold in Italy--that the state couldn't pay if it wanted to, and therefore that what you don't know won't kill you. But it will, and that will unleash a new crisis in the euro zone as the markets guess the level of the damage.

Defense, Offense, and the Euro Zone War

Nearly two years ago, I predicted that the main targets of the euro zone crisis would be big countries, not small ones. That has since turned out to be the case. But what does it mean for Greece? And what does it mean for the EU in an economic policy sense?

Briefly, the most important issue at stake is whether Greece will go bankrupt, and/or leave the euro zone. That is not a sure thing, but looking increasingly likely. There are limits on EU funds, and ECB purchases of Greek debt will come with intrusive audits and demands by the IMF. There will be no free lunch within the confines of the euro zone. It may prove unbearable for the Greeks to stay, or brush their pride the wrong way. The alternative of a short, sharp Argentinian crisis may be the alternative.

This means that unless the EU takes the offensive and builds a financial mechanism capable of fighting for large countries and small ones, that it must put a great deal of effort into defensive mechanisms that will help its members (both countries and banks) survive a Greek collapse, and then a Portuguese one, at the very least. Good boxers don't just learn how to hit. They learn to take punches as well.

Banking and the Euro Zone Crisis: the next phase

As an ongoing symptom of the interconnectedness of private finance, public finance, and the lack of infrastructure in the euro zone, the IMF has warned that banks are expected to withdraw 1.2 trillion dollars of credit from the euro zone economy over the next 18 months. That's 10 percent of the EU economy, and even more of the euro zone economy.

The IMF, which views this contraction as the natural consequence of deleveraging (destroying reliance of the financial sector on credit to the same degree as before the crisis started), suggests that the only way to avert an even greater disaster is to accept a milder one--in which banks are closed, merged and restructured across national boundaries to reflect the lower amount of money in the economy.

That, in itself, may make sense. But will national governments in the EU break from their existing pattern of saving national banks to allow such restructuring?

That would indeed be a revolution in thinking, and it's just possible that national governments haven't hit bottom yet. I'm not putting any money it.