Tuesday, May 15, 2012
Eurozone Meltdown (Redux) and the Failure of Austerity
Things in Europe recently deteriorated dramatically. Austerity failed miserably to resolve the Eurozone crisis. The chart at right, from Bloomberg, shows the added risk premium of Spanish government debt relative to safe haven German Bunds has reached a new high--the highest since the crisis over there started and the highest in Eurozone history. Thus, the prior peak, on November 22, 2011, reached 4.69 percent--meaning that Spain paid nearly five percent more to compensate bond investors for the additional risk of holding Spanish bonds for 10 years. Today, as shown above, the spread now stands at 4.88 percent. Given that German Bunds yield a near record low of under 1.5 percent, Spain bears more than four times the interest expense of Germany to borrow funds.
This record high risk premium arose from political chaos in Greece, which this blog first reported on in May of 2010. Essentially, the recent May 6 elections in Greece ushered in fringe groups that make an exit from the Eurozone more likely. The austerity imposed as a cost of EU bailouts drove unemployment to 21%--thus the European "rescue" of Greece failed economically as well as politically. New elections for mid-June appear necessary to form a new government and this vote will determine if Greece will abide by the outrageous austerity imposed by Berlin and others or throws in the towel on the Euro. This is why more and more mainstream voices recently shifted their focus to the rather grim reality of the economic consequences of a Greek exit from the Eurozone monetary union--or the consequences of a Grexit.
The bottom line here is "cascading defaults, banks runs and catastrophic risk," as this blog reported last fall. No firm or individual would want to hold any asset or deposit that is subject to being re-denominated in new Drachmas rather than Euros. So all Greeks would desperately pull all Euros out of the Greek banking system rather than wait for bank deposits to be shifted into Drachmas which would rapidly fall in value. Meanwhile no firm would want Drachma assets and would retain many Euro denominated obligations--threatening massive and unknown risks of insolvency. There already are reports from Greece that bank runs are brewing.
Soon Spanish, Irish, Italian and Portugese investors would fear that those countries too may exit the Euro and capital would flow to safe havens such as Germany, the UK, and the US. The chart above illustrates that very dynamic. Money is rushing toward Germany lowering the yields on German debt as investors bid up the price of Bunds. Germany would lose access to its major export markets as the soaring cost of capital throughout the Eurozone crushes buying power and investment. Unemployment, already at a record high, in the Eurozone would soar.
So, how does all this add up for the USA? Initially, expect the cost of debt for the US to plunge. But, ultimately our economy would suffer great harm and deep distress from at least four channels:
First, if Europe suffers a depression from this financial meltdown, demand for US exports will decline as will export-related jobs.
Second, who knows what derivatives exposure our megabanks have to Greek, Spanish, Italian, Irish and Italian sovereign debt. After all, MF Global went belly-up on Greek debt and JP Morgan recently showed how inept the megabanks are at managing derivatives exposure.
Third, beyond sovereign debt, our megabanks no doubt have huge exposure to Eurozone megabanks, through derivatives and otherwise, and if the Eurozone descends into full-blown depression it is hard to fathom their grossly undercapitalized banks surviving in the absence of government support which is not likely in a sovereign debt crisis for most Eurozone nations.
Fourth, a crisis over there means massive asset fire sales over here. US equities, commodities, real estate, and anything that can be sold for quick cash would invariably be called back into Europe to meet massive liquidity needs over there.
All in all, if Greece exits the Eurozone, in my view it will have more negative consequences for ordinary Americans than the failure of Lehman Brothers in September of 2008.