Financial Crisis Part II

April 29, 2010

- Laurence Copeland is a professor of finance at Cardiff University Business School and a co-author of “Verdict on the Crash” published by the Institute of Economic Affairs. The opinions expressed are his own. -

Hollywood would never allow a record-breaking disaster movie to go without a sequel. The same seems to be true of the 2008 banking crisis.

In the end, the Greeks are going to get some kind of bailout – of that, we can be absolutely certain, because European policymakers are afraid that Greece could be Europe’s Lehman-AIG.

The resistance of the German Government has been undermined by the dawning realisation that a Greek default would be a major blow to its own banks, which own around 45bn Euros of Greek sovereign debt. Taken on its own, I suspect that would not be enough to persuade Frau Merkel to brave the wrath of her electorate on behalf of the Greeks, but the clincher is the fear that the contagion could spread.

It turns out that, for the last ten years, the German banks have been accumulating a vast stock of the riskiest sovereign debt in Europe – encouraged no doubt by the assurances enshrined in the banking regulatory framework that one Eurozone member country’s debt is as safe as another, so that they may now have nearly a trillion euros of bonds issued by Spain and Portugal alone.

If bailing out Greece can prevent Iberian default, it could be dressed up as a bargain for all concerned.

In short, the so-called sovereign debt crisis is actually a European banking crisis. Germany is unwilling to bail out the Greeks, but it feels it has no choice but to bail out its own banks.

As in the 2008 crisis, a lot of the damage was done by the supranational regulatory authorities (mainly the EU and Bank for International Settlements) who gave into political pressure and, in the name of communautaire fraternity (or some other Eurofudgery), agreed to treat the debt of all Eurozone member governments the same way i.e. recognising it all as riskless, whether issued by Greece or Germany, Portugal or the Netherlands.

So, in the same way that, in the U.S., Fanny Mae and Ginny Mae were pressured by politicians (albeit, very easily) to guarantee loans to mortgage borrowers who had no hope of ever repaying, in Europe the same thing happened when the big French, German and even British banks (and many of the small ones too) were pushed into lending vast amounts to ClubMed governments with no track record of fiscal responsibility.

There is talk in Germany of expelling Greece from the Eurozone, presumably motivated in part by an understandable wish to punish it. Unfortunately, this is totally impractical, because events are moving far too fast for what would be a long drawn-out and messy divorce.

In the longer term, a more practical option would be for Germany to leave the Eurozone and relaunch the Deutschemark, though this would still leave its banking system saddled with assets which are for the most part denominated in Euros, and the weaker the Euro becomes, the less incentive the borrowers have to agree to translate those debts into another currency.

In the meantime, the UK media are full of questions like: is Britain the next Greece? The increasingly negative attitude to sovereign debt in general may indeed spread to the UK and US debt markets.

But there is a critical difference between their situation and that of Eurozone members. The key distinction is that, whereas the PIIGS either have to earn the Euros to repay their debts or face default (“restructure” is the polite word), the UK and USA have another choice.
They can either do it the hard way, just like Greece – cutting spending and/or raising taxes by enough to repay their debts as they come due – or they can print money (“quantitative easing” is the verbal camouflage).  Of course, increasing the supply of pounds or dollars generates inflation and/or currency depreciation – a decline in the internal and external purchasing power of the currency – which is precisely the danger threatening UK and US bondholders, but one which they seem to have been very relaxed about in the last year or two. This may now change.

If it does, we could see the price of their debt fall sharply, implying higher yields and an abrupt end to our low interest rate regime.
Tory strategists, please note: no more need for sheepish embarrassment about your policy of immediate cuts in spending. Just tell the voters: either we wield the knife ourselves, or the markets (or IMF) will do it for us.

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