It is becoming clear that the Europeans will not get it together to save the Euro and avoid a major debt crisis. I guess we can hope that the next major crisis intervention meeting will produce results that prop things up for more than two days, but I’m not holding my breath. The European approach has been characterized by draconian hard money policies and a demand for austerity, whether deserved (Greece) or not (Spain). The result of these measures is the predictable Keynesian outcome of further depressed demand and higher unemployment. What was telling with this latest round of negotiations was the supposed capitulation by the banks to accept a 50% haircut on their Greek loans. Merkel and Sarkozy gave them a take-it or accept-the-consequences deal; the fear of another Lehman event was greater than the pain of the losses, so they took the deal to avoid a “credit event” that would trigger action on the largely unknown quantity of credit default swaps (CDS) that could unhinge other financial institutions. It seems that just about anything will be done to avoid the uncertainty associated with unmasking this unknown mountain of CDS exposure.
Interest rates on Italian 10 Year bond
It appears that Italy is the next victim of the self fulfilling promise of austerity under the Euro. Bond rates have been rising in Italy since early summer, but then in August, the European Central Bank (ECB) promised to buy enough Italian bonds to drive the prices back down. But they have been inching back ever since, with fear that Italy would be the next victim after Greece was out of the way. The big meeting with Merkel and Sarkozy was supposed to provide an answer that would calm the markets, as the ECB’s debt purchases did in August, but this time it only took a day for the true implications of the deal to sink in — that is was still too little, too late — and rates are on the rise again.
Demand for more austerity seems guaranteed to cause deeper recession in the affected countries, less tax revenue, and less ability to repay loans in a timely manner, leading to higher bond rates, leading to more demands for austerity… you see where this is going.
So what does all this mean for us in the US? Although this mess is largely a European problem, as the Lehman event showed us, everything is connected these days. Right now, the uncertainty in Europe is making US treasuries at 2% look like a good safe haven. The danger is from the feared “credit event”, when hedge funds and banks would be forced to reconcile their CDS bets. There is a good possibility that a significant default event, from even a small county like Greece, could cause some major bank or hedge fund to become insolvent themselves, and subject to default on portions of their portfolio. A sea of CDS bets could unravel in a tsunami of litigation and frozen credit. With today’s global financial institutions, there would be no escaping the consequences of the global generalized bank run that would develop.
This is the scenario that must not be allowed to happen, that scared the bankers to accept their 50% losses on Greek debt. Perhaps this will be the model for future banking negotiations – capitulate or accept the MAD (Mutual Assured Destruction) consequences. Maybe it will work. After all, it kept us out of nuclear war for 60 years.