Wednesday, June 6, 2012

How the world will end

Originally posted May 28.

Losing a long war is not easy to accept. We are familiar with accounts of the final days in Berlin and Tokyo. Hemmed in by the Americans and the Russians, Hitler convinced himself that he had two armies in reserve to mount the counterstroke that would win the war. Having lost the entire Pacific as well as Okinawa, the Imperial Cabinet believed that no enemy could successfully set foot upon the sacred soil of Japan. In other words, when the truth is unimaginable, human psychology finds an alternative, more comfortable, reality in which to dwell.

This describes the current European financial situation. It would appear that the entire planet is in denial about what is about to occur in the eurozone. The commentariat keeps expecting Germany to pull a rabbit out of the hat and flood the continent with German-guaranteed eurobonds, or that Mario Draghi will mount a coup at the ECB and buy up every deadbeat country’s bonds.

Both could happen, but both are extremely unlikely. Current policy is the best estimate of future policy. Germany cannot guarantee the eurozone’s debt without control over the eurozone, which no one has offered her. Northern Europe will not permit the ECB to be hijacked by Club Med and turned into Catholic Charities. It is not just a matter of politics, it is also--as the Germans keep pointing out--a matter of law. There are no provisions for eurobonds, nor for the ECB to buy the bonds of the impecunious.

Europe has a Plan A, whereby each country would reform its economy, recapitalize its banks, and balance its budget. But Plan A is not working: it is being rejected by its intended participants, most notably France. There is an emerging southern European consensus that austerity is not the solution. Greece is in the vanguard of rejectionism, having defeated the austerity coalition in the recent election. Spain does not have enough money to bail out its banking system. Greece, Italy, Spain, Portugal and Ireland have lost access to the bond market. Greece, Italy and Spain have called for an end to austerity, and Ireland will be voting on it soon. Portugal is so far beyond hope that its bonds are trading for cents on the euro.

There is no Plan B. There is no well-thought-out plan for the orderly exit of the insolvent from the eurozone. There are no safeguards, no plans, no roadmap, nothing. The eurozone is unprepared for its own collapse. The Maastricht Treaty, like the US Constitution, did not provide for an exit mechanism. Instead of realism and emergency planning, we get denial and more happy talk. Just because something is “unthinkable” doesn’t mean it can’t happen (see: 1945).

Greece is rapidly running out of money. Greeks are withdrawing their deposits and have stopped paying their taxes and utility bills. She may not be able to stay afloat until the June 17 election. After the election, all hell will break loose.

We are facing Greece’s disorderly exit, default, and redenomination. Greece will be dependent upon foreign aid for essential imports such as petroleum and food. Civil order will be difficult to maintain and the army may be forced to step in (yet again).

Europe does not have the fiscal resources (absent eurobonds) to rescue Spain and Italy. Both countries have lost the ability to borrow in the bond market, and neither country is anywhere near balancing its budget. Both countries need more fiscal subsidy and funding for the banks.

Once Greece goes, a bank run in both countries is likely. There is nothing to stop a Spanish or Italian depositor from wiring his euros from his local bank to one in Switzerland, Norway or New York. There is no reason for him not to; it’s costless and protects him from redenomination/confiscation. The Italians are past masters at hiding money, and the Spanish are pretty clever as well.

What will happen when Spain or Italy hits the wall? The only thing still standing between the eurozone and financial chaos is the ECB. The ECB could buy government bonds and fund the bank runs. The scale of such an operation would be enormous, and would expose the ECB to huge credit risk. But it could step in, if Northern Europe permitted.

If the ECB does not step in, then ultimately Italy and Spain will be forced to exit the eurozone, default on their euro-denominated sovereign and bank obligations, and redenominate into national currency.

Should Spain and/or Italy default on their euro-denominated sovereign and bank obligations, massive losses would be imposed on the global financial system.  Because of the opacity of banks’ exposures, creditors would be unable to discriminate between the solvent and the insolvent (as was the case in September, 2008). The credit calculus would be not only the assessment of bank losses against capital, but also the assessment of a nation’s aggregate capital deficiency against its fiscal resources. The UK and Switzerland come to mind as countries that might not have the fiscal capacity to fully recapitalize their banks (although they could guarantee them).

The U.S. banks most likely to be affected by such a scenario would be the globalists: Citigroup, Bank of America, JPMorgan, Goldman Sachs and Morgan Stanley. I don’t have any numbers in front of me, but I can only imagine that they would require a TARP II. The US can afford a second TARP, but it would require Congressional legislation, which is not a slam dunk. The Fed can, of course, keep the system funded no matter what. Congress can’t stop that.

Massive wealth destruction combined with global financial chaos would be a challenge to the conduct of monetary policy by the world’s central banks. They would be tasked with preventing deflation, which would require a major round of QE. However, since banks are the transmission mechanism for monetary stimulus, this would require functioning banking systems. Each country would be faced with the need to restore the solvency of, and confidence in, its banks. In the past, this has been handled with the combination of a blanket bank guarantee and a recapitalization scheme (such as TARP).

The US financial system can withstand any shock because the US is a fiat money state. The Fed can maintain nominal prices, nominal wages and growth, if it acts heroically, as it did in 2008. The stock market will react negatively to the level of uncertainty caused by the collapse of the European financial system (as it did in 1931). The dollar should benefit, as should gold and yen. Unclear to me what would happen to sterling and Swiss; the benefit as havens, but their banks are highly exposed.

The worst thing about the coming crisis will be  its unforeseen consequences: financial, economic and political. While a European collapse would hit the US hard, we can be thankful that we are an ocean away, and have our own currency and financial system.

1 comment:

Unknown said...

Here's a Plan B: