Europe could still suffer a meltdown

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.

4 thoughts on “Europe could still suffer a meltdown

  • 2010.Jul.16 at 12:40
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    I am far from being an economist (in fact it was not even my subject in graduation ) so I cannot claim to understand all the terms and terminology used. However you write so lucidly that even a lay person like me can gain insight from the article. The scenario is frightening not to say the least. I do however need some clarifications to understand better. Do excuse me if I sound naïve.
    Am I right in assuming that it is our Thirld World thriftiness that has kept us on the right track? Also by thriftiness, do you mean that our banks have been more circumspect or do you mean that our domestic savings are on a higher scale? Again if our savings are much more than the spending, wouldn’t that lead to recession? Less demand, less production; less production, loss of business leading to unemployment ( If that is recession)?

    Another puzzling thought is that on one hand there have been talks and much jubilation over the fact that our economic growth is surging ahead at 9-10% on the other hand food inflation is around 16%. Current inflation rate (at least in May) was around 13%.
    So what exactly is the celebration for? And where exactly is this economic growth reflected?
    To bring down inflation either production must increase or people’s purchasing power must decrease. This will reduce the supply/ demand gap. But if purchasing power/salaries decrease there’d be less demand therefore less production and we get right back to problem number one -of recession.
    What is one to do to get out of this dismal trap?

    Also though I understand and concur with the reasoning behind decontrol of petrol prices – the bigger picture has to be kept in mind; we certainly must reduce subsidies and make prudent use of money saved – the little man’s travails affect me. My heart goes out to my driver who has recently bought himself a scooter and is paying off a loan. He will now have to pay so much more for petrol and also shell out Rs 352/- per month for his gas cylinder. What is the solution to this?

    Really worried and concerned.

    Reply
  • 2010.Jul.09 at 15:23
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    The fears of a Europeon meltdown are exagerrated. With the ECB injecting nearly $1 trillion into the Euro area, and buying up Govt. bonds of countries like Greece, they are essentially manipulating the market which had priced greece CDS at greater than 1000bps. The ECB is able to effectively manipulate the inverted yeild curve of these countries which leads one to speculate that they will be able to do it all over again if needed. Greece is a special case, and will eventually restructure its debt, however the chances of a meltdown (as what happened with Lehman) seem remote.

    Reply
  • 2010.Jul.06 at 13:31
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    An ardent reader of all your posts. I share your posts with the Management Accounting fraternity of course with your name and website link. I could not find your email id anywhere, so could not seek your prior permission. I hope it is Okay. This is the link

    http://cmaindia.informe.com/forum/management-tips-articles-education-humor-f21/ill-informed-debate-on-oil-decontrol-t3409.html

    We are currently discussing the Hayek-Keynes schools of thought. Would indeed be great if you could join the portal and share your views.

    Many thanks and kind regards,

    Devarajan

    Reply
  • 2010.Jul.06 at 13:26
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    The great wall street analysts was a happy participantwhen the market was zooming. Where was his rationale then?

    I am really left to wonder where were these great vocalists of recession when the market was booming without rhyme or reason. The problem is not with the recession. Recession is the consequence of mindless booming. It is time we recognized that bust is not the problem. But the real problem is the boom. All these analysis should have actually been made when the market was booming and not when they are bust.

    Just a thought.

    Kind regards,
    Devarajan

    Reply

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