Financial Regulatory Forum

ANALYSIS-Next phase of financial crisis may be the hardest

By Reuters Staff
May 24, 2010

By Emily Kaiser

WASHINGTON, May 21 (Reuters) – It took $5 trillion and an unprecedented global coalition of G20 countries to stabilize the economy after investment bank Lehman Brothers collapsed in 2008. Quelling the next phase of the financial crisis may be even harder.

To stop the panic that erupted nearly two years ago, governments transferred a mountain of debt from private to public accounts. Now, those government debts are distressing financial markets and there is nowhere left to shift the burden.

Europe’s clumsy response to Greece’s debt woes highlighted the economic and political headaches that await debt-laden countries and those who finance their borrowing.

European leaders have yet to convince investors that they have a credible short-term plan to contain government deficits and a long-term answer to the region’s slow growth. Until they do, financial markets will remain volatile, and the hard-fought economic recovery is in jeopardy.

“Europe is trying to solve a debt problem with further debt,” said Domenico Lombardi, president of the Oxford Institute for Economic Policy.

Fixing the problem will require money and political will. One cannot work without the other, and both are lacking.

A WAY, BUT NO WILL

The Lehman panic subsided only after the Group of 20 rich and emerging economies showed they had the finances and the political commitment to stop the freefall.

Governments from G20 countries pledged $5 trillion in stimulus and loan guarantees, even though it triggered a political backlash that is costing some elected officials their jobs.

Europe took what it thought was a big step earlier this month with a nearly $1 trillion rescue package, but within days investors’ nerves were frayed again and markets tumbled.

Raghuram Rajan, a former International Monetary Fund chief economist, said the missing ingredient was political will.

Markets doubt that governments will follow through on unpopular promises to cut services and raise taxes, particularly after watching riots in the streets of Athens.

Countries that cannot muster the will to cut spending and raise taxes have two other options — inflation or default.

Inflation is not of much use in Europe’s case because a large portion of the debt is short term, and inflating it away takes time. That leaves default as the likely path.

“Somebody has to pay for this, and you either pay by imposing costs on the taxpayer, or you pay by imposing it on the debtholder,” said Rajan, who recently published a book called “Fault Lines” that examines global economic strains.

“Neither option is nice.”

WHY EUROPE WORRIES THE WORLD

The European debt hot spots — Greece, Ireland, Portugal and Spain — account for just 4.0 percent of the global economy, yet their troubles have cast doubt on the global recovery.

Part of that has to do with concerns that lending will dry up as banks holding European debt brace for heavy losses.

U.S. bank exposure to the European Union as a whole was $1.5 trillion, said Edwin Truman, senior fellow at the Peterson Institute for International Economics.

However, Citigroup estimates the exposure, including derivative receivables, of the five largest U.S. bank holding companies to Greece, Ireland, Italy, Portugal and Spain at a lower figure of $190 bln.

That helps explain why U.S. Treasury Secretary Timothy Geithner is taking a wide detour to Britain and Germany next week on his way home from the Strategic and Economic Dialogue talks in Beijing.

Truman, a former Treasury official, said Geithner will probably urge the Europeans to quickly follow through on the promised $1 trillion aid package, but not clamp down so hard on public spending that the economy sputters.

“The world economy will not recover without a reasonably healthy European recovery,” Truman said.

WHAT MORE COULD BE DONE?

Andrew Busch, a public policy strategy with BMO Capital Markets in Chicago, said the European Central Bank could do more to patch up confidence.

The ECB, unlike its counterparts in the United States, Britain and Japan, has some room to lower interest rates. Its benchmark rate has held at 1.0 percent since May 2009, while the U.S. Federal Reserve, Bank of England and Bank of Japan have long since moved close to zero.

The ECB could also take a more aggressive approach to buying government debt as a way to drive down borrowing costs.

Instead of purchasing bonds outright, as the Federal Reserve and Bank of England have done, the ECB exchanged banks’ poorly-rated government bonds for higher-rated ones. That relieved some of the pressure on banks bearing the risky debt, but it did not pump any more money into a struggling European economy.

Busch called ECB leaders “the personification of Ralph Waldo Emerson’s hobgoblin of little minds: they remain consistently focused on inflation while deflation and the economy sink.”

Longer term, the challenge for Europe and other heavily indebted countries is finding a way to grow faster. Ironically, the fiscal tightening needed to get public finances in order will curtail the growth required to get deficits back on a sustainable path.

European officials clearly understand the link between sustainable debt and market confidence.

“The recovery depends on confidence and confidence is built on trust in public finances,” said Swedish Finance Minister Anders Borg. “If we want to secure recovery we need to secure public finances.”

What is less clear is whether they have a plan. (Additional reporting by David Lawder) ((emily.kaiser@thomsonreuters.com; +1 202 310 5444; Reuters Messaging: emily.kaiser.reuters.com@reuters.net))

Comments
One comment so far | RSS Comments RSS

A possibility is to have the financial sector and investors contributing to ease the burden these packages for financial stability have put on taxpayers by introducing transaction taxes. For example, Germany had such tax (1-2,5 promille per transaction, depending on type of transaction) until -91. Had this tax been in place today it would have generated 30 biljon €. The german deficit is this year 70-80 biljon €.
A tax like this will not majorly affect long-term investment required for economic growth, but will cool down rapid transactions with small margins (speculation). For the economy as a whole, it is better if the financial sector shares the burden in this way, than if some parts would carry the losses of defaults. The financial sector is expected to disagree and fight such solution with teeth and claw.

Posted by Nymne | Report as abusive
 

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