Global Economy On Fast Track To Disaster

In the last couple of days several prominent economic experts have concluded that the global debt crisis – currently ravaging Europe – is more or less unstoppable, and that recent events has been a major turn in the wrong direction. They are angry, frustrated and puts most of the blame on the German government.

“How bad will it be? Will it really be 1937 all over again? I don’t know. What I do know is that economic policy around the world has taken a major wrong turn, and that the odds of a prolonged slump are rising by the day. “

Paul Krugman

“Whatever the Europeans try to do to alleviate the crisis, it does not work: A blanket bank rescue, a €440bn special purpose vehicle to provide a protective shield, and one austerity package after another. Bond spreads and credit default swap indices continue to rise, and the money market is once again freezing up.”

That’s how associate editor and columnist for the Financial Times, Wolfgang Münchau, describes the situation.

And he points out the this is something that has never happened before to European politicians, who in the past were able to get away with a lot less effort. A statement was usually sufficient to placate the markets.

What Is Going On?

“For a start, there is no speculative attack, convenient as such an explanation may be,” Münchau writes, and put up the ugly picture that many politicians (and economists) still refuses to see:

“What has happened is that global investors have realized a deep underling truth about our European sovereign debt crisis – that at its core, it is not a sovereign debt crisis at all – but a highly interconnected banking crisis about to blow up.”

“There is a dynamic at work that the macroeconomic data does not convey – and that the political response to the crisis does not address,” he adds.

Those inter-connections are even bigger than previously thought – but it should not be surprising given the massive current account imbalances in the euro zone.

In its latest Quarterly Review, the Bank for International Settlements came out with some shocking figures:

* German banks have a $200bn exposure to Spain, $175bn to Ireland, and $50bn, respectively, to Greece and Portugal, making a total exposure to the four countries of almost $500bn, more than 20% of German GDP.

* French banks have an exposure of $250bn to Spain, $80bn to Ireland, $100bn to Greece, and $50bn to Portugal, also almost $500bn in exposures, but more than 25% of French GDP.

* Total foreign bank exposures are well over $1100bn to Spain and $800bn to Ireland.  Add the four countries together, and you are arrive at more than $2 trillion.

(Here’s the BIS report)

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Wolfgang Münchau

“Now, I am not saying that there is $2 trillion of bad debt. I have no idea how big the portion of genuinely bad debt is. The problem is that no one else knows it either, and that includes the banks, which are now refusing to lend in the inter-banking market,” Münchau writes.

As pointed out here at the Econotwist’s Blog several times since 2008 – there are a lot of parallels to the subprime crisis – including the scale, the inter-connectedness, and the information asymmetries.

In the presence of such factors, investors start to panic. The reason they are panicking despite the bank guarantees is that the markets no longer trust the government that have issued the guarantee. The spreads go up, thus reinforcing the crisis.

“A vicious circle is already well underway,” Wolfgang Münchau says.

The vicious cycle has now engulfed Spain. The Spanish private sector is now effectively cut off from global capital markets.

Fighting Derivatives – With Derivatives

The European Central Bank is now the lender of both first and last resort to the Spanish banks.

Spain’s share in ECB lending is already twice its share in the ECB, and rising.

The ECB is desperate for the Special Purpose Vehicle (SPV) to be in place by the summer. But while this would get the ECB off the hook, it does not solve the problem.

Münchau: “I would expect that early bond purchases by the SPV would trigger a generalized attack on southern European bond markets, France probably included. Having ignored sovereign default risk completely, the markets now regard everything as extremely risky that is not Germany. No matter what happens to the euro zone, Germany can always be relied upon to be a safe bet. If the euro zone ever were to split, there is much less certainty about which side of the euro zone fault line Italy and France would end up.”

The reason for this complete mess is – as usual when it comes to severe economic crisis – political.

So far, all those guarantees have not cost us a cent. No taxes have been raised, no expenditure has been cut.

But this will be different when the SPV’s are in place, and starts pay actual money.

These so-called Special Purpose Vehicles were originally invented by the engineers in the financial sector as a way to finance risky project without having to disclose them in their balance sheet – also called off-balance products.

But the thing is; governments can’t hide losses on SPV’s off-balance sheet in their national accounts.

“Though they will probably try,” Münchau writes. “In the end, money will flow – a lot of money.”

Germany’s To Blame

It’s unlikely that the Germany government has the stomach to bail everybody out – like the US administration and  Federal Reserve has done in America – even if such action probably is the best long term solution, also for  Germany.

In a recent column an angry professor Paul Krugman writes:

Paul Krugman

“German deficit hawkery has nothing to do with fiscal realism. Instead, it’s about moralizing and posturing. Germans tend to think of running deficits as being morally wrong, while balancing budgets is considered virtuous, never mind the circumstances or economic logic,” he proclaims.

Adding: “There will, of course, be a price for this posturing. Only part of that price will fall on Germany: German austerity will worsen the crisis in the euro area, making it that much harder for Spain and other troubled economies to recover. Europe’s troubles are also leading to a weak euro, which perversely helps German manufacturing, but also exports the consequences of German austerity to the rest of the world, including the United States.”

At the moment it would be no surprise if the Germans decides not to participate in any future bailouts.

Since each bailout requires unanimity, Germany could block any decision.

Germany, along with a small number of other EU countries, could unilaterally withdraw from the euro zone.

It’s Getting Dangerous

What can turns this into a dangerous crisis is not the absolute level of debt, but the intra-euro zone financial flows.

These are a mirror-image of the internal economic imbalances.

Germany’s massive current account surplus is per definition a surplus of domestic savings over domestic investment, and these savings are channeled towards economies with large current account deficits, like Spain, Portugal, Greece and Ireland.

Germany is now effectively being asked to bail out its customers. That would require a fiscal union, which Germany is not prepared to consider.

The reason the crisis is getting worse again is because investors cannot see how this conflagration can be untangled.

“German politicians seem determined to prove their strength by imposing suffering — and politicians around the world are following their lead,” Krugman writes.

“How bad will it be? Will it really be 1937 all over again? I don’t know. What I do know is that economic policy around the world has taken a major wrong turn, and that the odds of a prolonged slump are rising by the day. “

We’re In Desperate Need of….Something Big! 

Even “Ol’man” Greenspan is getting nervous.

Alan Greenspan

I an article in The Wall Street Journal, Friday, the former FED chairman writes tht said the U.S. may soon face higher borrowing costs on its swelling debt.

“Perceptions of a large U.S. borrowing capacity are misleading, and current long-term bond yields are masking America’s debt challenge,” Greenspan says.

Greenspan rebutted “misplaced” concern that reducing the deficit would put the economic recovery in danger.

“The United States, and most of the rest of the developed world, is in need of a tectonic shift in fiscal policy,” according to Greenspan (84), adding that; “Incremental change will not be adequate.”

Whatever Mr. Greenspan means by “tectonic” isn’t quite clear.

However, it’s obviously something big and fundamental.

“The federal government is currently saddled with commitments for the next three decades that it will be unable to meet in real terms. The very severity of the pending crisis and growing analogies to Greece set the stage for a serious response.”

“Our economy cannot afford a major mistake in underestimating the corrosive momentum of this fiscal crisis. Our policy focus must therefore err significantly on the side of restraint,” Greenspan writes.

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Related by the Econotwist:

EU Officials Fears Second Depression And War

U.S. Stock Market: Worst Week Since 1940

European Banks: “Leman Times Ten”

Albert Edwards: Europe On The Edge Of A Deflationary Precipice

Gerald Celente: “The Great Crash Has Occurred”

“We Stand At The Brink Of The Next Great Crisis”

Germany In Favour Of Creating European Army

2010 Analysis: “11 Black Swans”

2010 Analysis: Warns Against Social Unrest

2010 Analysis: Collapse of Credit

2010 Analysis: The Road to Disaster

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