On the edge and the eve of a financial market meltdown, Germany seems to now accept that the Eurozone sovereign debt crisis poses the greatest danger to the European, American and global economies since the early 1930s. Yet the world still is far from out of the euro woods.
Yes, Angela Merkel’s Chancellery has finally signalled that she and her government will permit the European Central Bank (ECB) to stabilise the value of Italy’s public debt. But first, Italy, France and 14 other Eurozone nations have to prove themselves worthy by accepting German rules for fiscal policy. The clock is ticking - if they don’t agree to those conditions at the European summit later this week, Merkel will nix ECB intervention, and the meltdown will begin.
The gravity of this crisis is unique. When the US financial market seized up in 2008, the systemic dangers were largely limited to institutions which had used reckless leverage to invest in securities or credit default swaps based on a housing bubble, like Lehman Brothers and AIG. This time, the systemic threat extends to everyone who has trusted in what has long been considered one of the safest assets in the world, the governments bonds of large, advanced European nations. That covers almost all large European banks and companies.
Furthermore, in the 2008-2009 crisis, governments had powerful tools — bailouts, new guarantees, stimulus, and interest rates cuts — to contain the worst of the crisis to those reckless financial institutions. For this second round, coming out of the first meltdown, governments everywhere have very few tools left to prevent the crisis from badly damaging entire economies.
So, if the ECB and Eurozone governments fail to act in the next few days and weeks, the results will be devastating. Most of the huge sovereign debt of Italy, the epicentre of the systemic threat, is held by German, French, Italian, and Spanish banks. The value of Italian bonds has already fallen sharply, eating away at the capital of those banks. That’s why lending by large Eurozone banks has virtually stopped, pushing most of Europe back into recession. That’s also why “interbank loans” in Europe — the billions of euro or dollars in overnight loans that keep the banking system there liquid from day to day — also dried up.
To ease these liquidity pressures, the Federal Reserve and the ECB, along with the central banks of England, Japan, Switzerland and Canada, joined hands and stepped in last week. They cut by half the price they charge banks in their own countries to borrow dollars from their central banks, which the Fed has agreed to supply as required.
Stock markets everywhere rallied, hoping this move would buy the Eurozone enough time to put in place a real solution. But the new loans cannot do more than that. The liquidity squeeze they address is only a symptom of the real problem, which is that the holdings of Italian government bonds by Europe’s big banks could bankrupt them. If those bonds fall in value much more, it will wipe out their capital.
If that weren’t bad enough, European governments may find themselves unable to contain the meltdown to banks with large holdings of Italian bonds. In 2008, the US and European governments averted bank runs by quickly guaranteeing the money market accounts where most corporations keep their operating funds. But when the problem is the credit of governments themselves, who will believe them if they pledge to guarantee money market or other accounts — and where would they find the funds to do so if investors won’t buy their debt?
The good news for the United States is that American banks and companies got rid of most of their investments in Italian and other Eurozone government bonds over the last year. The bad news is that no one knows how many credit default swaps they hold against the default of those Italian bonds, or against the default of the corporate bonds of the Eurozone banks that actually hold most of Italy’s debt, or the corporate bonds of Eurozone companies that depend on those banks.
Europe sidestepped the danger of the credit default swaps against Greek debt by convincing the large institutions that held most of Greece’s bonds to voluntarily accept a 50% write-down. This 'haircut' is comparable to what usually happens when a government formally defaults. But because the write-down of Greek bonds was technically voluntary, it didn’t trigger the credit default swaps.
The same approach won’t work for Italy, because its outstanding debts are just too large - Eurozone banks could not accept a 50% write-down on Italian bonds without becoming insolvent. And if the big financial institutions outside Europe — Goldman Sachs, Bank of America, Barclays and Bank of Tokyo-Mitsubishi, for example — have substantial European-based credit-default swaps, the fallout will threaten the global financial system. The sudden insolvency of European banks could damage the American economy in other ways as well. For instance, American banks and corporations are engaged in hundreds and perhaps thousands of deals today with large European banks. If those banks go down, all of the existing deals will be thrown into doubt.
If the crisis does hit the Eurozone and then spreads to the US, most of the steps that policymakers took to contain the damage in 2008-2009 will not be available. Voters are very unlikely to tolerate another big bank bailout or large stimulus. And with interest rates already near zero, the Fed won’t be able to cut those rates enough to meaningfully support a sinking economy. The only move left will be to print money. To be sure, that’s what Europe faces today in an ECB intervention. Yes, it may lead to a steep devaluation of the Euro, which ultimately could unravel the currency union.
In a world in which better options are no longer available, the only course left is to address crises, one at a time.
Dr. Robert J. Shapiro is co-founder and chairman of Sonecon, llc. In addition to chairing Sonecon, Dr. Shapiro is also a Senior Fellow of the Georgetown University School of Business, advisor to the International Monetary Fund, director of the Globalization Center at NDN, chairman of the US Climate Task Force, co-chair of America Task Force Argentina and a director member of the Ax:son-Johnson Foundation in Sweden. From 1997 to 2001, Dr. Shapiro was US Under-Secretary of Commerce for Economic Affairs.
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