The Next Economic Crisis

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.

One-Year Chart for Italy Govt Bonds 10 Year Gross Yield (GBTPGR10:IND)

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.


  1. Good overview, Gary: Nothing quite like sitting on a powder keg when the lightening appears. Remember when, in the beginning, ‘everyone’ questioned the fate of the Euro because of the diversity among the countries? Turns out that a common currency worked until uncommon debt got out of hand; the PIIGS weren’t careful with credit like Germany, nor good at hedging like France. And the private banks are on the hook so dramatically here because they fund a lot of public debt directly, rather than into the secondary markets–sort of like our banks might hold onto mortgages rather than sell them off. US profligacy doesn’t look so different from Greece’s: National income of 53T haunted by 350T hard debt. When the bough breaks or the keg blows, everyone goes.

    1. There is a lot we can’t see, but what we can looks bad. I wonder what is happening on the CDS markets if capitulation becomes the name of the game rather than default. All of a sudden those trillions of CDS’s are all valued wrong! Does that mean anything?

      1. Sure: It means nobody can trust insurance hedges if politicians can change the rules of the game, so who wants to pay those premiums for 5 years? Need to invent a hedge beyond the political reach? Good luck on that. Ironically, Merkel and Sarkozy are trying to pump up confidence in financial stability: Not only have they undermined the insurance buffer, but are proposing the world accept a 20% gesture since they have no hard money trillion to backstop Euro debt. As if one T would suffice in a daisy chain crunch. Even more ironic, tactical short coverage melts the markets UP and why? Because already tippy banks are getting sheared for Greece. Beyond funny.

  2. Charles,
    Even more ironic, tactical short coverage melts the markets UP and why? Because already tippy banks are getting sheared for Greece. Beyond funny.

    I’m not sure I fully understand that. Care to elaborate?


    1. Lots of index shorts were hedging a Greek default which would have tanked the markets; shorts had to be covered because Merkel prevented a formal Greek default–pro temps.

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