Is This the Final Countdown to a Global Financial Calamity?
Ground zero of the European sovereign crisis has moved from Greece to Italy, and that’s very bad news for Europe, the United States, and most everywhere else. For a year, Angela Merkel and Nicholas Sarkozy have looked for some way to both prevent Greece from defaulting outright and reassure bond investors that Italy’s sovereign debt will remain sound. This week, the price that Italy pays to borrow money soared as global investors determined that holding Italian bonds is increasingly risky. The salacious Silvio Berlusconi is on his way out, but that won’t change the market’s judgment that Merkel and Sarkozy’s stratagems have failed. Europe now faces a real and present danger that major banks across Germany and France, along with Italy and Greece, could fail soon. Such a meltdown would take down the American expansion with it.
It’s still premature for a post mortem. But for the past year, domestic European politics, not international finance, has squeezed the acceptable options to solve the Eurozone’s metastasizing sovereign debt problems. Merkel and Sarkozy have long known that their countrymen and women would pick up pitchforks if their governments moved to bail out big banks a second time. If that wasn’t enough to inspire street demonstrations, the contemplated bailout this time would go to stabilize financial conditions in other countries. So Merkel and Sarkozy came up with a plan that appeared to spare French and German taxpayers. Unfortunately, it also couldn’t pass a laugh test by worldwide investors: The plan has Eurozone financial stabilization board raising $1 trillion from those investors to back up Italy’s debt, with a pledge that Eurozone governments would guarantee the first 20 percent of any losses. Think about it: Italy, Greece, Ireland, and Portugal , all hanging by a thread or worse, would help the rest of the Eurozone cover the initial losses from bonds used to bail out Italy, Greece, Ireland and Portugal — and if things go south, probably Spain as well.
The $1 trillion commitment kept a meltdown at bay for a few days, much as the Bush Treasury’s commitment to spend $700 billion to bail out Wall Street staved off a market collapse after Lehman failed. The original Paulson plan also didn’t pass the laugh test, but no one doubted that the U.S. Government could raise the $700 billion. This time, the Eurozone’s $1 trillion commitment has bought them at most a few weeks of breathing space, as investors wait for Merkel and Sarkozy to come up with a real plan to raise it. But those investors already are eyeing the exits. Interbank lending to Europe’s biggest institutions dried up this week, just as it did here in the days before Lehman sank. And interest rates on Italian bonds are now so high that, according to the industry’s financial models, Rome will be unable to service its debt much longer.
All of this means that neither global investors nor European taxpayers are prepared to bail out the Eurozone. Even at this very late date, however, there are ways out of this mess: Under the least bad of the options left, the European Central Bank (ECB) would become the Eurozone’s bond buyer of last resort. The ECB could pay for them by printing enough Euros, for starters, to stabilize Italian bond markets. It wouldn’t be pretty. The Euro would weaken. European interest rates might edge up as Europe slowed. And the ECB would have to come up with another credible plan to withdraw the excess Euros once the crisis passed. But the alternative is much worse.
In a period of worst case scenarios, here’s what could well happen later this month. Start with the fact that Italy alone has $2 trillion in outstanding government debt. Most of those bonds are held by Italian, French and German banks, including the biggest banks in the world. Anything approaching an Italian default would wipe out the capital of those banks, leaving them insolvent; and most of the Eurozone economies would grind to a halt.
It gets worse, because a financial meltdown centered on sovereign debt is much more dangerous than one triggered by mortgage-backed securities. In effect, a sovereign debt crisis strips sovereigns of their ability to act to contain the crisis. With Italy and Greece in default, for example, who will believe those governments as they move to head off general bank runs by, say, guaranteeing money market balances as the United States did successfully in the days after Lehman? And if the biggest banks in France and Germany go down, Sarkozy and Merkel wouldn’t have the credibility to do much about it either.
The bad news doesn’t end with Europe. Our own big financial institutions, along with those in Britain and Japan, have thousands of deals going that involve the major banks in Germany, France and Italy. Overnight, all of those deals become suspect, which could spread financial panic beyond the Eurozone. And remember the credit default swaps that destroyed AIG? No one knows precisely how many of those “guarantees†are out today against Italian government bonds and the commercial paper of French, German and Italian banks. The fact that no one knows could be a big problem in itself, since that, too, could breed a broader financial panic. In any case, there’s little doubt that those credit default swaps involve, at a minimum, hundreds of billions of dollars, Euros and pounds. That would leave American, European and Japanese financial institutions on the hook for those losses. And if they can’t make good on them, they could go down as well. Their only hope would be another bailout — if Congress could approve one before the Tea Party and Occupy Wall Street folks pick up their pitchforks.
All this is not yet inevitable. But much of it might well unfold, and probably in a matter of weeks, unless the Eurozone’s leaders face the grim music and finally find their way to a real program to head it off.