On Oct 7 we presented a worldwide overview adding, that while the United States suffers under a time constraint, it has a national plan already in motion to attack the problem at its source. But while the process in progress could mark the beginning of the end of the crisis for the United States, the American credit crunch is only the beginning of the story for the world’s other two major economic pillars: Europe and Japan.
Then, this morning European economies started putting Sunday's agreed-upon measures into action.
However, the underlying reason for Europe’s vulnerability is rooted not in the U.S. subprime (which became the proximate trigger) but on the importance of banks to the entire European economy.
At its heart the financial crisis is that Banks, afraid that other banks could go under at any time, are refusing to lend money to each other. Banks still willing to lend to their consumers — whether firms or individuals — are now utterly dependent upon their own cash reserves. That has drastically reduced the amount of credit in the system that can reach end users. Which means that a recession, a global recession, is hardwired into the system until the logjam breaks.
The European solution, put together by the 15 states that use the euro, to this is to grant a state guarantee to interbank loans to remove the fear from the banks and reboot the system. The American solution has two parts. First, use federal money to empower the Treasury Department to purchase assets of questionable value (think subprime mortgage securities) from banks so their balance sheets are friendly and so other banks will be more willing to lend to them on the interbank. Second, join the interbank network itself via the Fed. The U.S. Federal Reserve announced on Sunday that they will grant dollar-denominated loans to any bank affiliated with the Fed or a Fed proxy (which now includes every bank in Europe or Japan as well) that is interested so long as the bank can provide collateral. Both methods will introduce large-scale efficiencies, but that is now deemed better than letting the problems run their course.
Put simply, the Europeans are guaranteeing the individual transfers of existing banks, whereas the Americans are simply supplying the market itself by acting as if it were one of the banks (albeit a very, very large one).
But having a plan and implementing a plan are two radically different things. In essence both plans require the government not simply to monitor, but actually to take over the interbank system — a financial exchange mechanism that has a substantial portion of the world’s free capital floating within it. This will require a competent staff of thousands to function effectively, and a competent staff of thousands cannot be built up in a few days, and perhaps not even in a few weeks. So the global system is now in the odd position of having identified the road out, but not having any horses to pull the cart.
The Europeans are going to have a harder time of this than the Americans, and not simply because there are thousands of finance professionals in the Wall Street area looking for jobs. By stepping in as the guarantor, the Europeans will be forced to evaluate every interbank transaction, matching the lender to the borrower at a government-approved rate. To simply issue the guarantee and walk away would allow any bank to lend to anyone risk free, and the size of the corruption that would stem from that would be far more mind-blowing than the market uncertainty that would be left behind. This must be managed actively and close up.
The Americans, in contrast, are actually joining the interbank via the Fed. So rather than having to approve every interbank transaction, the Fed will only be negotiating with parties interested in dealing with the Fed itself. Similarly, the Treasury’s bailout package will only deal with the specific purchases of questionable assets that the Treasury chooses to explore. Both will sport staggering caseloads, but both are far less unwieldy than the mammoth task the Europeans face of micromanaging every deal across the entire interbank market.
Both Europe and the United States are now in a race against time. Simply having a plan in place is sure to inject some confidence and loosen up the interbank somewhat, but until the governments can actually force the market open, global credit will remain constrained. The severity of this recession will in many ways be determined by just how fast these programs can get staffed.
And that’s only the half of the problem that is for today. The other half is for months from now, when the time comes to get the government out of the business of banking. After all, outside of crisis times the market is a much better manager than the government. For the Americans the exit strategy should be somewhat easier: The Fed can simply put an upper limit on how many dollars it will supply the interbank on a daily basis and slowly ratchet the number back, allowing normal market forces to take over gradually.
For the Europeans, however, it would be more than jarring to simply stop granting guarantees one clear day and to expect the market to slide back into control as if nothing had happened. Can you grant a partial guarantee? Can you grant a guarantee to only certain market participants without being discriminatory? These are questions the Europeans have now committed themselves to answering in a few months.
In contrast to the American plan as far it is in place today, the Europeans have two other reasons for going with its own relatively cumbersome plan. First, the Fed will need to print a lot of currency to make the American plan work. Authority to print currency in the eurozone is held by the European Central Bank, not the member states, so this option isn’t available to the eurozone states at all.
Second, and far more important in the long run, going into this crisis Europe’s banks were far weaker than their American counterparts, whose only real problem was subprime mortgages. Europe’s banking problems are deep, structural and varied. Since a European bank crisis is the next likely chapter in this financial crisis, the Europeans are going to need a much firmer grip on their banking sector anyway. Their plan may be awkward and more expensive, but it is aiming to solve two problems, not just one.
Thus while in the United States, the crisis might be contained within the financial and housing sectors alone, in Europe, the close connections between banks and industry almost assure a broad and deep spread of the contagion. Unlike the United States, where the government has spent more than a century battling to break the links among government, industry and banks, this battle is only rarely joined in Europe. If anything, such links — one could even say collusion — between banks and businesses were encouraged from the very beginning of modern European capitalism.
Since the 19th century, European financing and investing has been coordinated between banks and industry, and encouraged by the government, because industrialization was a modernizing project led by the state that did not spring up spontaneously as it did in the United States. Bank executives often sat on the boards of the most important industries, and industrial executives also sat on the boards of the most important banks, making sure that capital was readily available for steady growth. This allowed long-term investment into capital-intense industries (such as automobiles and industrial machinery) without the fear of quick investor flight should a single quarterly report come back negative.
The most famous example of this type of cozy link are the ties between Siemens AG and Deutsche Bank, a relationship which has existed for more than 100 years. An overlapping and intermingling of interests results from this type of arrangement, insulating the system from many minor shocks like strikes or changes in government, but making the system less flexible in the face of major shocks like serious recessions or credit crises. Therefore, in times of a global shortage of capital, European corporations are left with few financing alternatives they are comfortable with. (In contrast, while banks are an important source of financing in the United States, corporations there depend much more on the stock market for investment. This forces American firms to compete ruthlessly for capital and constantly seek greater and greater efficiencies.)
Wholly unrelated to exposure to American subprime, Europe’s banking vulnerabilities can be broken down into three categories: the broad credit crunch, European subprime and the Balkan/Baltic overexposure.
The first issue, the global credit crunch, exacerbates all inefficiencies and underlying economic deficiencies that in capital-rich situations would either be smoothed over or brought to a much softer landing. Think of submerged rocks; many are far enough below the surface that vessels can simply sail over them. But when the tide drops, the rocks can become deadly obstacles.
Various European countries had such inefficiencies long before the U.S. subprime problem initiated the global credit crunch. Many of these were caused by the post-9/11 global credit expansion in combination with the adoption of the euro. After the Sept. 11 attacks, many feared the end was nigh. To tackle these sentiments, all monetary authorities — the European Central Bank (ECB) included — flooded money into the system. The U.S. Federal Reserve System dropped interest rates to 1 percent, and the ECB dropped them to 2 percent.
The euro’s adoption granted this low interest rate environment, which normally only a state of Germany’s strength and heft could sustain, to all of the eurozone. This easy credit environment echoed by affiliation to most of the smaller and poorer (and newer) EU members as well. Cheap credit led to a consumer spending boom — which was stronger in the traditionally credit-poor smaller, poorer, newer economies — leading not only to a real estate expansion, but also to an overall economic boom that, even without the subprime issue and the global credit crunch, was going to burst.
Underneath the global credit crunch looms the second problem: the European subprime crisis. This issue is particularly acute in places like Spain and Ireland that have recently experienced a lending boom propped up by euro’s low interest rates. The adoption of the euro in Spain, Portugal, Italy and Ireland spread low interest rates normally reserved for the highly developed, low-inflation economy of Germany to typically credit-starved countries like Spain and Ireland, granting consumers there cheap credit for the first time. The subsequent real estate boom — Spain built more homes in 2006 than Germany, France and the United Kingdom combined — led to the growth of the banking and construction industry. Banks pushed for more lending by giving out liberal mortgage terms — in Ireland the no-down-payment 110 percent mortgage was a popular product, and in Spain credit checks were often waived — creating a pool of mortgages that might soon become as unstable as the U.S. subprime pool.
The poorer, smaller and newer European countries gorged the most on this new credit, and none gorged more deeply than the Baltic and Balkan countries, leading to the third problem: Baltic and Balkan overexposure. Growth rates approached 15 percent in the Baltics, surpassing even East Asian possibilities — but all on the back of borrowed money. This scorching growth caused double-digit inflation, which will now make it more difficult for the Baltic states to take out loans to service their enormous trade imbalances. The only reason that growth rates were less impressive (or frightening) in the Balkans is because these countries either came later to EU membership, as with Bulgaria and Romania, or have not yet joined at all, in the case of Croatia and Serbia, so they did not experience the full credit-expanding effect of being associated with the European Union.
Fueling the surges were Italian, French, Austrian, Greek and Scandinavian banks. Limited as they were by their local domestic markets, they pushed aggressively into their Eastern neighbors. The Scandinavian banks rushed into the Baltic countries and the Greek and Austrian banks focused on the Balkans, while the Italian and French also went to Russia. UniCredit, the Italian behemoth with vast operations across Eastern Europe, announced Oct. 6 that it was facing a credit crisis, and it is hardly alone.
The “new” European states have witnessed the greatest expansion in terms of credit, by any measure, of any countries in the world in the past five years (with the possible exceptions of oil-booming Qatar and United Arab Emirates). But because that credit is almost entirely sourced from abroad, the easy credit environment has now collapsed, and heavy foreign ownership of even the domestic banks means that those who have the money have their core interests elsewhere. This swathe of states is now mired in almost Soviet-era credit starvation, while the banks that once led the charge are having difficulty even maintaining credit lines in their home markets.
The Challenge of Coordinating a Response
Europe’s inability to adequately address the challenge goes well beyond the issue that different portions of Europe face very different banking problems.
The capacity of European capitals to deal with the crisis varies greatly, but the core concern lies in the fact that it is the capitals, not Brussels, that must do the dealing. When the Maastricht Treaty was signed in 1992, EU member states agreed to form a common currency, but they refused to surrender control over their individual financial and banking sectors. European banks therefore are not regulated at the Continental level, hugely limiting the possibilities of any sort of coordinated action like the U.S. $700 billion bailout plan.
The Oct. 12-13 announcements are cases in point. While the eurozone members have agreed to follow general guidelines, any assistance packages must be developed, staffed, funded and managed by the national authorities, not Brussels or the ECB. This means that the administrative burden will have to be multiplied 15-fold at least, as every country undertakes and implements its own bailout/liquidity injection package.
As the crisis unfolded, disagreements on the member state level were immediately evident, with France and Italy initially recommending a Europe-wide bailout proposal similar to the American plan. France and Italy, both saddled with large and growing budget deficits and national debts, are the two major states most in need of such a bailout. But Germany and the United Kingdom, the more fiscally healthy states that would have been expected to pay for the bulk of the plan, quickly vetoed the idea.
The Europeans then decided to go with an EU-wide set of measures that would guide the individual member states’ liquidity injection packages. At the EU level, the only actual proposals have been two steps: a broad reduction in interest rates and an increase in the minimum government-guaranteed bank deposit from 20,000 euros ($27,000) to 50,000 euros ($68,300). It is worth nothing that many individual European countries are now guaranteeing all personal deposits to shore up depositor confidence.
Even in the case of the interest rate cut, Europe had to dodge EU structures. The ECB’s sole treaty-dictated basis for guiding interest rate policy is inflation; the treaty ceiling is 2 percent. Eurozone inflation is already at 3.6 percent, indicating that rates should not have been reduced. Obviously, circumstances dictated that they needed to be, but like many states’ decisions to increase deposit insurance, this move could only be made by ignoring EU law and convention. And if the ECB can abandon its mandates in times of economic crisis, what stops the member states from doing the same? The next legalism sure to be widely ignored will be the prohibitions on excessive deficit spending, which many would call the fundamental requirement of eurozone membership.
EU treaty details aside, the issue now will be the ability of the individual states to act. The stronger a state’s economic fundamentals, the more likely the country in question will be able to raise money to tackle the situation effectively in some way, whether by raising taxes or issuing bonds. (Bonds of economies with good fundamentals in particular are an attractive location for parking one’s money while stock markets and real estate around the world undergo corrections.)
The three leading criteria to consider are the government’s share of the economy, the government budget deficit and the level of national indebtedness. Combining these three variables gives a good snapshot of whether a particular country will be able to raise capital during a credit crunch. Incidentally, European governments consume the highest percentage of their countries’ resources in the world, greatly reducing their ability to surge government spending.
Not surprisingly, the most seriously threatened European states are France, Italy, Greece and Hungary, each of which is running a serious budget deficit while also being burdened by high government debt. Three of these four (France, Italy and Greece) also have very active banks in emerging markets of the Balkans and Central Europe, home to the European states that are likely to suffer the most from the credit crisis. These four countries are closely followed by Romania, Poland, Slovakia, Bosnia, the Netherlands, Portugal and Lithuania.
Further bloating the deficits of many European countries will be the many bailouts and reserve funds being planned to deal with the liquidity crisis on an individual country basis. On Oct. 13, Germany announced a 70 billion euro ($95 billion) bank capitalization plan and up to 400 billion euros ($543 billion) for interbank loan guarantees. On the same day, France announced slightly smaller figures — a 40 billion euro ($54.3 billion) injection plan for banks and up to 300 billion euros ($407.25 billion) for interbank loan guarantees. The United Kingdom infused further liquidity into its banks by propping up Royal Bank of Scotland with 20 billion pounds ($34 billion) and Lloyds and HBOS, which are merging, with 17 billion pounds ($29.2 billion).
This followed an Oct. 5 announcement by the German government of a (second) bailout proposal for real estate giant Hypo to the tune of 50 billion euros ($67.9 billion). The Netherlands and France bailed out Fortis with 17 billion euros ($23.3 billion) and 14.5 billion euros ($19.8 billion) respectively. Struggling Iceland — where the country, not just the banking sector, is now technically insolvent — nationalized its entire banking sector. Nationalization is even sweeping the usually laissez-faire United Kingdom, which announced that it was seizing control of mortgage lender Bradford & Bingley on Sept. 29, followed by an even more dramatic move in which the government announced it would spend 50 billion pounds ($87.8 billion) on rescuing (and thus partially nationalizing) Abbey, Barclays, HBOS, HSBC, Lloyds TSB, Nationwide Building Society, Royal Bank of Scotland and Standard Chartered.
Unlike the British and German bank-specific bailouts, Spain set up a 30 billion euro (about $41 billion) aid package to buy good assets from banks to inject liquidity into the entire system. The Spanish approach seems to suggest that unlike in the United Kingdom and Germany, where only a few bad apples needed to be nationalized, the entire Spanish system might be threatened. This is certainly a possibility in a country where 70 percent of all bank savings portfolios are in real estate, and where real estate is dangerously overheated.
Also relevant to determining the exposure of a particular European state is its dependence on foreign exports, both in terms of goods and services. By this measure, Germany, the Czech Republic and Sweden will suffer as their industrial exports slacken due to a decline in worldwide demand. Extremely high trade imbalances will also become more difficult to sustain as credit to purchase European exports becomes more difficult for buyers to procure. Again, particularly at risk are countries in Central Europe with extremely high current account deficits (in terms of percentage of GDP). This will be especially true if demand in western EU countries dulls for Central European exports, further bloating the Central European countries’ current account deficits — which of course are no longer easy to finance.
Even assuming that each bailout plan functions perfectly, and that the U.S. economy pulls through relatively quickly, Europe is settling in for a protracted banking crisis. Ultimately, the American problem is limited to the United States’ financial and housing sectors. Should the United States’ problems spread to other sectors, the crisis at its core will still remain a credit crunch. In Europe, various regionalized and interconnected weaknesses are much broader and deeper, pointing to systemic problems in the banking sector itself. For the United States, developments the week of Oct. 5 might signal the beginning of the end of the crisis. But for Europe, this is merely the end of the beginning.
Conclusion: In Europe the liquidity crisis is only the first step in a broader banking crisis; even in the best case scenario Europe faces months — not weeks — of recession. In East Asia an American and European slowdown — even if only for a few weeks in the United States — will depress demand for Asian exports during the Christmas shopping season, normally the period of greatest demand. So even in the best case scenario, an inevitable enervation in the export sector will create gross problems for the Asian economies, something we will investigate next.
The short list of countries facing acute problems: Estonia, Latvia, Lithuania, Hungary, Iceland, Bulgaria, Sweden, Greece, Italy, Russia, Ukraine, Mexico, Brazil, Argentina, Venezuela, Pakistan, Vietnam and South Korea.