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.
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