For those who think the Great Recession is over, I have disturbing news. I asked a top Wall Street manager last week what the chances were of a full-blooded European financial crisis. He replied, “100 per cent.”
In February, the Greek fiscal crisis sent Indian markets crashing. This was the beginning of a European crisis that is not over. Wall Street experts believe it will get much worse. If so, the global financial system could freeze again, causing a double-dip recession.
Optimists say governments will surely rescue all large European banks. Very probably. But the US financial system froze despite government rescues of AIG, Citibank, Morgan Stanley, Goldman Sachs and General Motors. The British system froze despite rescues of Northern Rock and the Royal Bank of Scotland.
Rescues keep insolvent institutions alive, but only after imposing huge losses on shareholders, creditors and those having outstanding transactions. Citibank is alive, but its share price fell from $60 to $1 during the meltdown, and has edged up to just $ 3.70 today.
Nobody wants dealings with financial institutions that are tottering. When dealings freeze, credit freezes, and then all business freezes: the economic machinery cannot work without financial lubrication. The biggest Indian companies with the soundest balance sheets found credit cut off when global markets froze in 2008. A European meltdown may not be as bad, but will be troublesome.
Banks have a small amount of their own equity and a pile of borrowings. Some European banks in 2008 had debt 50 times their equity. By borrowing 50 times their own money, they could magnify profits 50 times. But they magnified risks and potential losses too, and these wiped out some premier banks.
US institutions had unwisely borrowed to invest in mortgage-related securities. When housing prices collapsed, so did mortgage-related securities, bankrupting many US institutions. Most big European banks survived because, while many had borrowed heavily, they had invested in government bonds. These are called gilts, because they have traditionally been regarded as good as gold. Indeed, the international Basle rules provide that banks can treat gilts rated AAA as having zero risk.
Alas, Greece showed in February that even European governments could become incapable of honouring their debts. As panic spread, Greece, Portugal and later Spain lost their AAA rating. European banks that had virtuously invested in AAA gilts suddenly found themselves holding devalued securities. This fall in assets threatened to wipe out many top banks. To prevent this, European governments in June engineered a rescue package of 750 billion euros, covering not just Greece but all European nations. The aim was to save banks holding gilts of southern Europe, and stop the Greek crisis from spreading. It had an immediate calming effect on markets. But analysts soon realized that this did not solve the underlying problem of high, unsustainable government debt in southern Europe. Most European countries have unwisely decreed high wages and generous retirement and medical benefits that they can no longer afford, and this long-run problem was exposed pitilessly by the recession.
Britain has now declared that the financial emperor has no clothes. It refuses to keep up the pretence that all problems can be solved by fresh stimulus packages, each entailing additional government debt. The new British government has opted instead for structural adjustment, earlier reserved for spendthrift Third Worlders. This austerity will cost jobs and income, but will eventually reduce government debt and increase domestic savings.
Southern European countries have similar problems. Bankers can shrug off the travails of small countries like Greece and Portugal. But Spain is a big country, and bankers worry whether it will weather the storm. If it falters, panic will spread to Italy. This is a G-7 country with enormous outstanding debt, amounting to 120% of GDP. Italian bonds are widely held by European banks. If these bonds sink, they can sink the biggest European banks. Optimists say governments will find a way out. They can oblige the European Central Bank to print euros and buy all European gilts in distress. This will ruin the reputation (and value) of the euro, but may be politically preferable to a financial meltdown.
After 1990, Japan resorted to financial fiction to keep its banks going, at the cost of economic stagnation for a decade. Europe could replicate this. Neither a meltdown nor decadal stagnation bode well for the global economy. Better outcomes are possible. Maybe Europe will find a way to grow out of its troubles painlessly. The chances are that it won’t.