Sunday, June 26, 2011

Europe faces its Minsky Moment

In 1933, Irving Fisher published his seminal “Debt-Deflation Theory of Great Depressions”. His theory was that over-indebtedness will ultimately lead to liquidation. Debt liquidation leads to distress selling and to a contraction of deposit currency as bank balance sheets shrink, leading to falling prices. As prices fall, the vicious cycle continues because even though prices are falling, indebtedness does not. Deflation makes debt bigger. (That’s Greece we’re talking about.)

Milton Friedman, Ben Bernanke and Barry Eichengreen (along with most other students of monetary policy) agree with Fisher’s theory. In fact, it’s so difficult to refute that it’s become an axiom.

Which brings us to 2011. What is the economic phenomenon that has characterized the past 29 years (i.e., since the crash of ‘82)? One word: leverage, ever growing leverage. Leverage at banks, shadow banks, mortgages, mortgage-backed securities and their derivatives and, of course, governments of all shapes and sizes.

Leverage is inherently evil because it increases financial fragility. If a financial institution has 4% equity and its assets decline in value by 4.1%, it is insolvent. Leverage exposes debtors to creditor confidence. Borrowers default when and only when no one will lend to them anymore.

Creditor confidence is not modelable. It is purely a matter of  group psychology: “I’d better get out now because I see people heading for the exits”. It is unpredictable. Who could have imagined that Goldman Sachs, AIG and GE would lose creditor confidence in 2008?

There are only three ways out of over-indebtedness and a loss of creditor confidence: bailout, default or (in the case of governments) inflation.

As we speak, private sector creditors have lost confidence in Greece, Portugal and Ireland (governments and banks). They are living on life support from the troika (EU/IMF/ECB). They are small and manageable. But the loss of confidence is now spreading to Spain (government and banks) and to eurozone banks exposed to the diseased sovereigns and their banks.

In 2008, the contagion was confined to major banks active in the mortgage, RMBS and CDO markets, which the central banks funded and the governments recapitalized. Today, the contagion appears to be spreading to the entire eurozone banking system. The eurozone banking system is too big to fail and too big to bailout, unless the ECB has the guts to step up to the plate (which is, by the way, its job).

The Germans have talked tough about the need to liquidate failing non-German banks. Let’s see how they feel about liquidating the Landesbanken or Deutsche Bank.

Europe is facing its greatest challenge since 1939. Will it take extraordinary measures to maintain financial stability, or will it be sauve qui peut?

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