Is Europe’s debt crisis a “Lehman Moment” for America?

July 5, 2011

By Mohamed A. El-Erian
The opinions expressed are his own.

With its high unemployment and stretched balance sheets, today’s US economy can ill-afford a negative shock from abroad. Yet, this is what it is experiencing. And it explains why markets go through bouts of nervousness about the debt crisis in Europe, and why American policymakers are worried about a foreign financial situation that is getting worse by the day.

Europe’s debt problem is indeed a headwind for what remains a disappointing US economic recovery. It dampens America’s export prospects, can raise the cost of borrowing for some American companies and diminishes an already low enthusiasm among banks to lend to households and small companies.

Having said that, it is unlikely, though not inconceivable, that Europe’s debt crisis would constitute a “Lehman Moment” — a situation that totally paralyzes American economic activity, puts the country on the verge of a depression and triggers yet another round of extreme crisis management measures.

There is now broad-based recognition of America’s persistent economic weakness. Most recently, the Federal Reserve has been forced again to revise downwards its growth projections for both 2011 and 2012. Moreover, with refreshing candor that speaks well to the uncertainties felt by the average American, Fed Chairman Ben Bernanke acknowledged in his second ever press conference on June 22 that only part of the economic weakness is due to transitory factors such as higher oil prices and supply disruptions associated with the Japanese tragedies.

As Bernanke hinted, and as PIMCO’s analyses have demonstrated for a while, the US unfortunately faces four structural headwinds that are yet to be addressed properly by policymakers.

First, and nearly three years after the global financial crisis, the US housing market is still unable to find a firm enough footing. This undermines confidence and limits labor mobility.

Second, joblessness remains worrisomely high, and to make things even worse, is increasingly structural in nature. Witness the 9% unemployment rate, declining labor participation and an alarming 24% unemployment rate among 16-19 year-olds and a 40% rate for African-Americans.

Third, credit is yet to flow properly in the economy. With bank lending still hampered, it is small companies and poorer households that suffer the most.

Fourth, there is a problem of debt and leverage. Coming off a “great age” of debt and credit-entitlement that went way too far, balance sheet rehabilitation has been uneven and generally insufficient. Yes, some sectors, led by multinational companies, have recovered strongly. But far too many in the private sector are still over-indebted. Meanwhile, public balance sheets, be they of the Federal Reserve or the fiscal agencies, are contaminated to such an extent that they now constitute a source of medium-term uncertainty.

Policy responses have been too timid in the face of the economic challenges, and for too long, lacking a central vision. Instead, they have been ad hoc, too reactive and lacking sufficient structural underpinnings.

In the absence of a credible alternative, the role of the country’s main economic spokesperson has fallen to President Obama who, understandably and correctly, is extremely busy with many other national and international priorities. Meanwhile, the other arms of government — Congress in particular — are hostage to extreme political polarization, posturing and bickering. And the recurrent drama associated with budgetary legislation discussions — including the continuing budgetary resolution of a few months ago or today’s debt ceiling debate — adds to the uncertainties facing the nation.

In sum, this is not an economy that is well positioned to deal with a shock from abroad, let alone a major one. Its ability to absorb a systemic shock has been worn down by persistent internal economic weaknesses and the agility needed to sidestep, or at least minimize the impact of the shock, has been eroded by slow economic policy responses and stretched balance sheets.

All this helps to explain America’s concern about Europe’s debt crisis, which has led to periodic selloffs in capital markets and warnings from policymakers. It also speaks to why some commentators have gone as far to suggest that the country faces another “Lehman Moment” — a devastating shock that totally paralyzes the economy, disrupts the functioning of the financial system and pushes the country to the verge of a great depression.

This situation was last faced in the fourth quarter of 2008 following the disorderly collapse of Lehman Brothers, the investment bank. As illustrated by various recounts of those nervous months, policymakers came very close to losing complete control of the situation, despite all the firepower at their disposals.

Indeed, if it weren’t for the aggressive use of what was at that time a relatively healthy public sector balance sheet (especially that of the central bank’s), the US would have been forced into temporarily shutting down its financial system (including by declaring a “bank holiday”) and experiencing an economic depression which, according to some, would have been worse than that of the 1930s.

The question of the “Lehman Moment” becomes even more important now that policymakers have less firepower at their disposal to counter a huge shock. So what should we expect in the months ahead?

To be sure, the European debt crisis is a serious political, economic and financial engineering predicament that is hard to solve. As such, it will likely get worse before it gets better. In the process, it will slow global economic growth, increase risk premiums and darken the cloud over the health of the financial sector in Europe.

None of this is welcome news to an American economy that urgently needs to create jobs. But it need not result in a repeat of the total Lehman paralysis provided three conditions are met: a banking system that remains robust, no disruptions to money market funds and limited blockage to the plumbing of the country’s payments and settlement system.

Chairman Bernanke has spoken publicly to all three. Noting the Fed’s focus on these issues, he has indicated that the US does not face a new Lehman Moment.

Published data, to the extent that they are comprehensive and accurate, support his view; as do the actions taken by certain institutions. But risks remain, particularly within a money market complex starved for yield, and where certain firms appear to have stretched far and wide for extra returns.

A small risk of a catastrophic event should never be ignored. Accordingly, there is no room here for any complacency among policymakers whose economic management to date has fallen far short of what is needed to create jobs and put the country back on the path of high and sustained economic growth. Indeed, Europe serves to amplify warning sirens that have been ringing for a while.

Let us all hope that the increasing volume of the alarm will finally push America to design and implement the type of holistic measures that are desperately needed and long overdue. In the meantime, risk-averse companies, households and investors are justified in taking some extra precautionary steps.

Note: Mohamed El-Erian will be doing a live Q&A on on Thursday, July 7 at 9 a.m. ET. He will be answering your questions and responding to your comments about this piece along with his other previous pieces.



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With all due respect to the author who’s made some very valuable and pertinent points though I feel he’s been too forgiving to leadership and I can’t imagine why.
I think we all would admit they need to be at the table.

“In the absence of a credible alternative, the role of the country’s main economic spokesperson has fallen to President Obama who, understandably and correctly, is extremely busy with many other national and international priorities. Meanwhile, the other arms of government — Congress in particular — are hostage to extreme political polarization, posturing and bickering. And the recurrent drama associated with budgetary legislation discussions — including the continuing budgetary resolution of a few months ago or today’s debt ceiling debate — adds to the uncertainties facing the nation”

As of late he has spent time fundraising around the country along with the vice president. He is known for his multiple golf outings.
And must bear a great deal of the responsibility for the polarization and partisanship, as is evident in the speeches even those of late.

Now I know some of this should be allowed to anyone but in the current times of crisis even if he is in his room working all the time when on these trips, he should be aware of the appearance of not being there in these potential times of crisis. I personally find this insulting.

The author also leaves wide open the possibility of the fed chairman in the political misdirection.

For example:” published data to the extent that they are comprehensive and accurate, support his view”(as would be expected of someone making such statements who wants to quell the markets and the populace)
but how accurate are they? This is left wide open!

All this said I must compliment you author on this and his many thought-provoking articles.

Posted by fredlu33 | Report as abusive

Who knows anything with a probability greater than 50% anymore?? And should we bet our money on anything with less than 50/50 chance of success? And what is success?

Note: “the US unfortunately faces four structural headwinds that are yet to be addressed properly by policymakers” and will they ever. Unfortunately it appears that our political process is disfunctional and refuses to fix its structural many problems.

“You can avoid reality, but you cannot avoid the consequences of avoiding reality.”
— Ayn Rand

Posted by Seafarer20 | Report as abusive

So, El-Erian says there is a structural deficiency, which is fixable only by the Congress through serious legislative changes. The President alone cannot pass changes, since the Congress is blocking them anyway. The risk reserve in the financial system is zero, which means any /not major/ external shock will dive the economy. The probability is 100%. A major external shock will bring a depression.
I would say my expectation for a broad military conflict in Central Asia or Africa are increased. It would not be e politically engineered, just an inevitable outcome of a turbulent economy…very sad indeed.

Posted by Ananke | Report as abusive

I have great respect for the author. I don’t agree with everything he says, but with most of what he says.

It is wise to avoid making the mistake of dismissing a scenario that seems to be a smal risk. The subprime mess and widespread contagion to many other assets seemed a very small risk in the fall of 2007. It turned out to be a big risk.

Right now, an e-coli-like poisoning of America’s financial system by Europe’s sovereign default crisis may seem fairly unlikely, but it isn’t. Much less likely, in most people’s estimation, is a poisoning of the Treasury market, the turning of Treasury assets into toxic assets. This would be a colossal crisis, resulting in gargantuan losses.

But Greece could be the ‘subprime mortgages’ of the Treasury market. When Greece defaults, it will taint sovereign assets. If the U.S. defaults after August 2, such assets will likely become outright poison. There would likely be a huge stampede out of the Treasury market, into currencies, hard assets (commodities), who knows where else.

Bottom line: The author must be careful not to minimize the extremely potent role of psychology in such matters. I’m confident that he does not minimize it. You can’t just assess these scenarios based on logic, facts, etc. You must also factor in the possibilities and repercussions of panic psychology, which can quickly become the governing factor in an emerging crisis. It was this, after all, that largely resulted in the contagion from subprime to many other assets, turning them all toxic. It played a role throughout the collapse of 2008.

Investor psychology – good and panic-prone – will play such a role in the emerging crisis.

Posted by NukerDoggie | Report as abusive

Mohamed, excellent condensing of the facts, as I have argued in the past to friends I believe America has outgrown a Single president and I believe it’s time to consider a Tri-Presidency 1,An Econmic President, 2, a Domestic President and 3, a Forign President. We are now 300+ Million People. As you stated Mr Obama is Way over-booked with existing work.we need to spead these duties to aloow the existing incumbent to get WORK done.

and YES Congress GET TO WORK !!!!!!!!!!!!!!!!!!!

Finally, Please Don’t Forget the 600 Trillion $$$ Derivatives Market that can and will have it’s come-uppance soon… These TOXIC Instruments Must be Addressed and Dealt With and Regulated and Taxed and Controlled. Otherwise they WILL come again to haunt us like “Lehman Brothers” did but many fold Worse.. Just Say NO to Funny Money !!!

Posted by Pangaea7 | Report as abusive

I think El-Erian is spot on, as usual. Unfortunately, it is up to policy makers to get this right. Although it seems only by accident can policy makers do the right thing, I am still young and naive enough to believe we, the people, will not settle for anything else but radical change.

Ironic that Obama campaigned for change and it seems he may have to endure such change, albeit not the “change” he had in mind.

Posted by jaham | Report as abusive

The trick to the derivatives market will be to simply separate the retail side of the big banks from the investment side of the big banks. Mixing checking, savings, and home loans with derivates, swaps, and investment banking has quite obviously a bad idea and the solution is quite simple – separate them.

Posted by jaham | Report as abusive

The international news is focussing on little countries like Greece and Portugal whereas the largest debts, those in Japan and the US, are increasingly forming a huge danger to the world economy. US states are bust and state pension funds are being plundered to be able to last to 2nd of August. Sounds gruesome.

This, together with political spinning and bad reporting makes for a bad mix. Some of the latest political jinxes that are copied by the international press without questioning and independant thinking:

1) The US can’t grow because of the debt problem in Greece – if this were true then why is the EU economy growing so hard ? It is complete nonsense.
2) The dollar is a safe-haven – then why are China, PIMCO and the Fed themselves slowing down buying US bonds ?
3)Japan can have a stable 225 % of debt because the holders are mainly Japanese – I wonder how Japanese pensioners/banks feel when their loans to the Japenese government are being restructed.

It all has a thickening “this time will be different” or “we are too big to fail” atmosphere to it. Let’s wait until 2nd august (US default?) or October (Japan default?).

Posted by FBreughel1 | Report as abusive

The US is fragile because we, the people, are still in denial that we have a problem. One example cited was a lack of credit to the lowere income people. We need to “get over it” that everyone has to be in debt to the bank. We will never have a strong economy until people have money, few debts, and stable incomes. Having billionaires, and millionaires does not a healthy strong country make.

Posted by fred5407 | Report as abusive

“Indeed, if it weren’t for the aggressive use of what was at that time [2008-09] a relatively healthy public sector balance sheet (especially that of the central bank’s), the US would have been forced into temporarily shutting down its financial system (including by declaring a ‘bank holiday’) and experiencing an economic depression which, according to some, would have been worse than that of the 1930s.”

I think that a lot of people do not believe that statement, possibly because of a lack of information combined with deep suspicion of people with specialized training in economics. Some appear to have concluded that there must not have been a risk of economic depression because we did not experience one.

It may be fair to characterize the economic problems of the United States as being attributable to a lack of economic sophistication by the “core constituencies” of the two major political parties on both the left and the right. That is, politicians who understand what must be done and are willing to do it are at risk of being voted out of office.

This is obviously bad for the United States in the short- and medium-term. But it may also bad over the long term, if losing the U.S. dollar’s status as a reserve currency is bad for the U.S. in the long term. For example, how can sophisticated investors continue to rely on a reserve currency if it is controlled by a country that is constitutionally incapable of putting economic policy in the hands of people who know what they are doing. This is not a criticism of either Bernanke or Geitner — far from it. It is a criticism of those who, based on a lack of understanding of the sophisticated subject matter of finance, demonize Bernanke and Geitner and attempt to make them scapegoats what what is, in the end, bad decision-making by Congress over the last generation.

Posted by Bob9999 | Report as abusive

The fundamental concept of capitalism–unlimited growth–is one heck of a myth to base the economy on!

Posted by cautious123 | Report as abusive

Really,I am worried about US.When,if,we’ll repay our debt?Want we pay interests forever?And what happens if we need higher rates of interest?We’ll pay more interests with more debt?
We need innovation and growth. Finance produces wealth only for the Few Ones. There aren’t unemployment in Wall Street.
El-Erian,be seriuos,you are speaking for yourself.
Back to Schumpeter.

Posted by SteveP | Report as abusive

Our own house has lost a good third of its value in these last three years, however, this news has not reached the State of Ohio yet. Property taxes have never dropped. Only the government can decide it needs more money and take it from the people. Enough is enough. Repeal Obamacare, bring our troops home, send the IRS packing and install a flat tax (one page bill should do it!), put the troops on our borders, send the corrupt UN packing and start a new group with allies only, stop all foreign aid until our house is in order.

Posted by sodacrackers2 | Report as abusive

Excellent comments and timely, accurate perspective. Yet something needs to be addressed that NO politician is, worldwide, except in China. How to create jobs. There are so many infrastructure, biotech, energy and education problems to solve that can be the source of long-term, high paying jobs, leading a global recovery. I think US federal politicians are afraid to pass legislation to spur job growth; they also fail to take advice from business. Additionally, the white house needs to shift investing abroad to investing domestically. Investing billions of tax dollars in the US, with performance benchmarks for recipients, is prudent.

Posted by concduscitizen | Report as abusive

Thank you for the author wide perspective view. I would like to point out to the Obama adminstration that they have found the solution, but it’s very complex to Exercise.
I think this solution will take care about 80% of the problems we are facing. He says he can create jobs today by building, repairing roads and bridges, helping the construction sector. By creating new jobs, all our problems will go away. But it’s complex to execute. So we needs help from the Private Sectors to bring American jobs back into US. We need the Union brothers to relax a bit. We need congress to have favorable tax treatment for international companies to do business in US. Let creating job as Job number 1 for the Obama administration, and reelection agenda. Let’s focus on job number 1. Thanks for reading.,

Posted by CommonSense1A | Report as abusive

I wonder what the author makes of the impact of the latest Chinese 5 year plan, and effects on the European and US economies.
Less reliance on exports to these markets, less US Treasury and other bond buying to keep the yuan more competitive.
More growth from domestic development, including higher wages and better social security, for more purchasing power and disposable income, less need to save.
ie replacing the US consumer by the Chinese consumer.
Corporations such as GE and GM also seem to already be doing this with their investment strategies.

Posted by Neurochuck | Report as abusive

Where is there an observable recovery in the USA? I exclude the top 10% of households by income. Unemployment during the Great Depression topped out at 25% briefly but generally was well below that. Using the same definitions and procedures used then, the USA is around 18% unemployment. And it has been there for years and years, with no relief in sight.

Federal “relief” spending as ended up in the hands of the wealthy and foreigners, mostly. The money spent is borrowed on uncollected payroll taxes such as FICA. Warren Buffet’s FICA tax bill is crushing, you think?

Posted by txgadfly | Report as abusive

A Lehmann moment we could well do without. Also for many a Michael Jackson moment when the star dangled his baby from the balcony. We all swooned as we are now and the lack of progress by the policy makers has already slowed the recovery- damage has been done to the stellar reputation.

Frankly if you dont respect your creditors they will deny you credit or make it more expensive. The politicians who didder will pay the price. Its a bigger risk for the Republicans as they have coupled debt with spending- higher borrowing costs is not the way to balance a budget. The party needs to banish the Tea Party and hard core base to the back benches where they belong.

Posted by thoma | Report as abusive

What a devastating accurate and measured analysis. Well done

Posted by JohnWWilliams | Report as abusive

I see two other problems not identified by the column. They related to all four but are nevertheless different.

One – conflict of interest in the entire mortgage business created by derivatives.

It started with the housing and mortgage crisis but is now a fully separate problem and contains virtually all of the systemic risk today.

The irresponsible issuing of mortgage credit was only a minor problem relative to the big one. In the old days when a bank lent money for a mortgage, the banker himself and his reputation as an assessor of risk, as well as his institution were on the line.

That all changed with the development of derivatives based on mortgage back securities. The local bank could offload the risk and at the same time the responsibility for that risk, to the holders of the derivatives. He could take his cut of the profit for implementing the deal. Thus a full conflict of interest was fed up the entire food chain right to the top, resulting a complete lack of integrity of that chain, also right to the top.

That conflict of interest and that lack of integrity remains there today and remains one of the major systemic threats to the global banking system.

Two – lack of transparency in the derivatives market and the commodities markets (especially bullion trading). The large commercial banks are dreading the coming additional regulation in OTC markets for derivatives, because they found it easier to make profits when
a) the clients engaging in interest swaps for example were not as sophisticated as the banks (ie – they were sitting ducks )
b) there was no trading exchange requiring an open market for derivatives trading. Without transparency not even high level deal makers can really know whether they are getting a good price or not.

Until these abuses are cleaned up the global system will remain extremely unstable and fully vulnerable to a “Lehman moment”.

Posted by WaxOnWaxOff | Report as abusive