Thursday, June 9, 2011

Terror, Greece, and European Collapse

Over the last week, it has become apparent that the Greek tragedy could soon become a European one. If that happens, there is a significant risk of financial collapse in Europe. The good news is that policy makers are trying to avoid it. They may succeed. But it is possible they will fail. If they do, then a cascade of bank failures will reach to the heart of the EU's financial centres. Banks that are not yet under public ownership could find themselves under government stewardship. The threat of that might be the only thing to prevent all of this from happening.

First things first. The European Central Bank has been arguing vehemently for some time now that a default of Greek debt, a partial default, a restructuring, a partial restructuring, call it what you will was completely and totally unacceptable. This has had a number of people scratching their heads.

At first, the ECB offered the explanation that defaults, even partial ones, would result in a lot of credit default swaps becoming payable. That could cause some banks to go bankrupt. A credit default swap is effectively an insurance policy that one bank sells to another in case someone fails to pay a loan back to them. In theory, the swap is a good way of insuring a bank against a loan going bad. It's supposed to be good for stability. In fact, one of the recognized principles of good banking is that banks should use them. And they use a lot. The last I looked, there were more than $62 trillion in credit default swaps out there.  So the ECB is telling us that one of the key tools that was supposed to prevent a massive collapse of the financial system is precisely the thing that could bring it about.

This is not only a point that Europeans should be concerned about. It's one that everyone should worry about, for it continues to be one of the supporting pillars of financial stability on a global scale. I will return to this in another post. The important part here is that even if everything else were in good shape, the ECB is telling us that the safety features that will save our lives should there be a crash will not and cannot work. It illuminates the fact that credit default swaps are really intended to work when only one debtor fails to pay. If several fail to pay, then you suddenly have a problem again. Effectively the swaps simply transfer risk from one bank to another. Someone still has to pay, and then that bank goes under in the second round. Unless the original bank invested in that bank and goes under in the third round, and so on. On top of the losses caused by swaps that undermine the banks who sold them, there will be direct losses for banks that held the loans without the swaps. Bottom line: a lot of money will disappear off bank balance sheets, and the ECB, the Bank of England and so on will be back to the choice of saving banks or not. As will national governments who will have to consider nationalizing more banks. For they have no more money to pump into them.

But there is more. Because the ECB has been buying Greek and Portuguese bonds, a default, even a partial one, will destroy part of the central bank's capital. This is one of the reasons why the ECB isn't technically supposed to buy these bonds from them. The ECB, like any other bank, needs to have assets on its books against which it issues currency into the system. If those assets drain away in significant numbers, you have a problem. You can accept a big dip in the money supply and the economy, or you radically expand the ratio of currency to real output. That means you either print money outright, which the ECB can't do legally, or you provide it for every piece of toxic waste financial paper that a bank waves your way, which is unwise but legal, and what the ECB did during the earliest days of the financial crisis.

All this would mean low interest rates (or at least an end to higher interest rates) at a time when global inflation is running relatively high. That would mean a radically devalued euro, if it continues to exist at all. The alternative is a new, radical wave of nationalizations coupled with an extended economic crash, the likes of which Europe hasn't seen since the 1930s or the 1870s.

That's why there has been so much pressure on the banks to hold onto Greek and Portuguese debt, to not ask for their money back. Technically, that wouldn't be a default, so bank balance sheets will stay clean, swaps will not be paid out, and the problem will 'go away'. For a while.  If they don't, Greece will be bankrupt by October at the latest, and we will see how quickly the contagion spreads to the heart of Europe. That can happen overnight.

The prospect of going bankrupt themselves and being nationalized is the only incentive the banks have left to play along. Roughly 65% of the banks were on board as of today, according to press reports this morning. There will need to be more if the plans are to work.

Terror has a new meaning in the second decade of the 21st century. For 50 years after WWII, it meant the threat of global nuclear holocaust. After 2001, it turned into the threat of terrorist attacks on a smaller scale.

We're back to the threat of global meltdown again. And the epicenter is Greece.

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