By Colin Barr
July 24, 2010

Europe’s banks aced their stress tests. Too bad the region’s economies are just scraping by with a gentleman’s C.

Tests administered by European bank supervisors showed just seven of 91 major banks need to raise more capital, officials said Friday. Though skeptics predictably savaged the tests as too easy, the exercise suggests policymakers will pull every lever to prevent a banking meltdown in the next two years.

Even so, Europe’s problems are far from over. Governments across the European Union will struggle to combat high joblessness, slow growth forecasts and surging debt levels. The International Monetary Fund this week predicted growth across Europe would average a wan 1% this year and 1.25% next.

As we are finding stateside, propping up the banks hardly guarantees a surge in job-boosting lending. That grim fact, along with Europe’s embrace of belt-tightening, has some economists warning that recessions around the developed world could become almost routine.

“The reduced effectiveness of ultra-easy monetary and fiscal policies underlines global economic fragility,” said Tullett Prebon economist Lena Komileva. “The distance between growth weakness and a double-dip recession is smaller than it has ever been.”

Western governments have seen a sharp rise in their debt burdens in recent years, thanks to lax bubble-era lending and the cost of bailing out the banks when the party ended.

Meanwhile, the massive stimulus spending that pulled the world out of free fall last year is starting to wear off, adding to questions about how fast the global economy might grow.

The result is that debt-bloated Western economies remain vulnerable to a downturn, while their upside seems to be capped in part by the costs of saving the banks.

A report this month warned that the cost of bailing out banks in Ireland could approach 25% of last year’s economic output.Most countries will not end up with a bill that big, but lots of taxpayer funds are still tied up in the financial sector.

“It should be emphasized that this outcome is partly due to the continued reliance on government support for a number of institutions,” the Committee of European Banking Supervisors said Friday in explaining the low number of stress-test failures.

What’s more, bank rescues have kept the financial sector bigger than it needs to be in many countries. This in effect acts as a tax on saving and investment.

This is the sort of imbalance political leaders here and in Europe will need to address sooner or later if economies are to return to health and keep living standards rising. But so far policymakers remain focused on maintaining short-term stability, while structural problems fester.

And as credible as the stress tests may be, the market will inevitably shift its focus to those issues – which is why the next global market roller coaster ride probably is not too far off.

“The long-awaited release of Europe’s stress tests today might be a short-term relief as it reduces uncertainty,” Komileva wrote Friday in a note to clients, “but it is a concern for the summer months as it frees attention to fundamental stresses.”

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