Sunday, May 9, 2010

Risking Great Depression II

"...the Europeans are not being careful – and it’s not just about Greece any more. Worries about government debt and associated public sector liabilities (e.g., because banking systems are in deep trouble) have spread through the eurozone to Spain and Portugal. Ireland and Italy are next up for hostile reconsideration by the markets, and the UK may not be far behind.

What are the stronger European countries, specifically Germany and France, doing to contain the self-fulfilling fear that weaker eurozone countries may not be able to pay their debt – this panic that pushes up interest rates and makes it harder for beleaguered governments to actually pay?

The Europeans with deep-pockets are doing nothing – except insist that all countries under pressure cut their budgets quickly and in ways that are probably politically infeasible. This kind of precipitate fiscal austerity contributed directly to the onset of the Great Depression in the 1930s...

the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings. Unconditional bailouts are simple – just send a check. Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.
The financial markets know all this and last week sharpened their swords. As we move into this week, expect more selling pressure across a wide range of European assets.

As this pressure mounts, we’ll see cracks appear also in the private sector. Significant banks and large hedge funds have been selling insurance against default by European sovereigns. As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).

Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008. And generalized counter-party risk – the fear that your insurer will fail and this will bring down all connected banks – raises its ugly head again..."

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