Friday, May 14, 2010

Eurozone Update: "Meltdown" Ahead?

About 10 days ago I warned people to fasten their seat belts in preparation for turbulence arising from the Greek debt crisis. Events have accelerated dramatically over there since that post and another warning of a brewing financial crisis. Since then the EU has announced a $1 trillion bailout of the PIIGS nations and the ECB announced it would begin buying sovereign debt--a move that certainly smacks of quantitative easing (printing money)--although the entire operation is cloaked in secrecy.

Now deep austerity is taking hold throughout Europe as the Greeks, the Spanish, the Irish and others slash spending and raise taxes in order to control debt loads and qualify for bailouts. Naturally, civil unrest is on the upswing and the unions in Spain are calling for a general strike on June 2. Spain already is on the brink of deflation and this austerity will worsen deflationary pressure throughout Europe. Spain's largest bank fell ten percent today in European trading. In fact, Euro banks fell across the board.

Meanwhile the flight from the Euro is now bordering on a panic as it has fallen below 1.24. Interbank credit markets are freezing again, though not yet as nearly bad as in late September of 2008. The EU seems to be between a rock and a hard place, and no matter what they do the markets seem deeply skeptical.

As I mentioned in an earlier post, the big US banks have enormous exposure to the Eurozone, and the derivatives casino is not apt to mitigate that exposure rather than amplify it. In fact, American Bankers magazine quotes a high profile bank analyst who estimates that the big US banks have hundreds of billions, even trillions, in exposure to the Eurozone through derivatives.

Further, the austerity measures are already taking a toll on growth as financial markets over there brace for a fiscal shock. As shown on the graphic below (click to enlarge), the entire continent is pursuing sharp fiscal austerity:
So what does this all mean? Nothing good I fear. The deflationary shock over there will be felt over here, to an unknown and difficult to predict extent. Any bank losses over there will expose our banks over here to potential insolvency--thanks in no small part to the very opaque exposures held through the unregulated derivatives market.

Worse, policymakers seem clueless on the dangers of precipitous debt deflation from massive deleveraging. A debt crisis arises from two problems: too much debt; and, too little income.

Governments must embark upon massive investment programs right now to grow out of this morass. I have argued since the beginning of this fiasco that every dollar spent must yield maximum payback from investment and growth. Instead, here in the US, we have literally pissed away trillions in wealth bailing out reckless bankers and persisting in maintaining patently reckless tax cuts.

So, now we face austerity measures in the face of too much debt. The IMF counsels that these measures are needed. Even President Obama apparently counseled Spain to pursue austerity.

What if this conventional wisdom is wrong, and this Eurofiasco triggers massive deleveraging and debt deflation? Recall, that monetary policy is already impotent, and implicit in the above discussion is that there is a massive withdrawal of fiscal stimulus rather than any looming fiscal stimulus.

Time will tell. But I do not think this will play out over an extended period of time. Financial markets can move quickly and decisively towards massive risk aversion. The CEO of Deutsche Bank has gone on record that Greece is likely to default, and he was involved in trying to engineer a private bailout. He sees the prospect of a "meltdown." Markets will react long before actual default--indeed, the markets themselves can cause the default by raising Greek debt costs to punitive levels.

This was not a good week. Let's hope next week is somehow better.

No comments:

Post a Comment