Introduction to Europe's Financial Crisis
This brief e-book started as an update and sequel to The Fearful Rise of Markets, which was published in early 2010. That book described how a giant speculative bubble came to encompass virtually all world markets and then burst. It followed the story until the end of 2009, when markets were bouncing back.
Now, writing in the summer of 2012 more than three years after markets hit bottom, the crisis has migrated across the Atlantic. Its epicenter is in the Eurozone, which is the center of this book. It can be read in its own right, telling the story of how Europe slipped into crisis, how developments in the United States and the emerging markets contributed to its problems, and why this matters for the rest of the world, notably the United States. For a full discussion of how the world got into its mess in the first place, please turn to my earlier book.
What has happened in Europe? Put briefly, Europe created a single currency before its member nations were ready for it. Their economies had not converged sufficiently for one currency to fit all. As a result, the common currency tended perversely to push the nations further apart, with the nations of the periphery, such as Spain and Ireland, booming unsustainably. They developed huge trade deficits with Germany as they sucked in imports and then crashed. This created a necessary condition for the crisis.
The second was Europe’s huge and bloated banking system. Unlike in the United States, European banks were allowed to grow huge, and to spread into diverse financial businesses, with the tacit backing of their governments. As a result, the banks became far too big for their host governments to rescue with any ease.
The catalyst for the Eurozone’s troubles came with the U.S. credit crisis. Wall Street had long made unnaturally big profits by repackaging debt backed by subprime U.S. mortgages and selling it to European banks. When the crisis hit, it was obvious that Europe’s banks were sitting on losses and might need help from their governments to repair their balance sheets. That in turn called into question whether nations could repay their sovereign debts. In such situations, a government usually just prints money and devalues its currency, making the debt easier to pay. But for all those countries using the euro, this was no longer possible.
When Greece revealed that it could no longer finance its deficit, European politicians’ initial response was to bail it out, while forcing Greece to make painful austerity cuts, and coming up with a new fund of money that could finance future bail-outs. The idea was that this would convince the markets that the problem could be contained. It failed. Instead, other countries—Ireland, Portugal and Spain—also needed help, raising doubts whether the money existed to help them, while austerity in Greece proved counter-productive. It may have reduced government spending, but by cutting into economic activity it reduced tax revenues as well.
Now, the problem is essentially political. More austerity seems politically untenable—voters will no longer accept it. So if the Eurozone wants to avoid exits by any of its current members, there appear to be only two options. Either the European Central Bank can simply print the money to pay the debts (which in the long-term would be inflationary); or all the countries in the Eurozone can agree to stand behind all its countries’ debts. This latter option, often referred to as “eurobonds,” would solve the problem, because the Eurozone as a whole is solvent. But it would need a new European treasury department of some kind, which means loss of sovereignty for many countries, and it would also imply that taxpayers of Europe’s stronger nations would have to bail out their weaker brethren. Investors must now bet on whether politicians can possibly find a compromise.
The prospect of default by any European country terrifies markets. Why? Such defaults would probably trigger the collapse of Europe’s banking system because banks are heavily leveraged and hold huge piles of government bonds, bought on the assumption that they are risk-free. That would damage other banking systems around the world. Any economy that suffered a default or took on a new currency would immediately lapse into a severe economic recession, with ripple effects for banks and exporters across the world. Just as the financial crisis that followed the Lehman Brothers bankruptcy created an immediate seizure in trade and economic activity worldwide, there is every reason to fear that a Euro-exit (a decision by one or more Eurozone member countries to abandon the euro and revert to their own currency) would have the same effect. The most alarming possibility is a disorderly break-up of the euro, an event for which there is no precedent. Markets would find it hard to cope, and economic activity would be likely to stall; one estimate by ING, a big European insurer, is that in these conditions, every country in the Eurozone would suffer a decline of more than 10 percent in their gross domestic product.1 That implies a far deeper recession even than the depression of the 1930s, and would inevitably inflict a severe recession on the United States. This is why Europe’s crisis now so dominates the world’s attention.
Evidently, it is impossible to understand events in the Eurozone without understanding the credit crisis and how it started in the United States with the market for subprime mortgages. I therefore summarize here, in the second chapter, the conclusions of The Fearful Rise as to how that came about. For a full discussion, look at that earlier book.
What of the United States? On the surface, it has recovered well. Stocks are roughly double their lows of early 2009. But the dissonance with European markets is a huge clue that all is not well. Stock markets like Spain’s have fallen below even their lowest levels from the post-Lehman crisis. The elevated level of U.S. stocks implies extreme confidence either that European investors have wildly exaggerated the risks or that Europe’s problems need not harm the United States. Both propositions are dubious. In fact, U.S. markets may merely be responding to the copious flows of cheap money that the Federal Reserve has pumped into the system.
Beyond Europe, it is worrisome that markets for different kinds of assets still march in lockstep. Whole asset classes—foreign exchange, commodities, bonds, and equities—have shifted in line with each other, apparently all responding to cues from the Federal Reserve. The initial rebound was so tightly synchronized that prices of the most important building blocks of the economy must have been set inefficiently.
This was a central theme of The Fearful Rise, and it matters because inefficiently priced markets drove the global market crash of 2008, which led to the global economic seizure in 2009. If currencies are buoyed or depressed by speculation, they skew the terms of global trade. A government’s capability to run its own economy is compromised if exchange rates make goods too cheap or too expensive. An excessive oil price can drive the world into recession. Extreme food prices mean starvation for billions. Money pouring into emerging markets stokes inflation and destabilizes the economies on which the world now relies for growth. Credit that is too cheap leads to an unsustainable boom and then an inevitable bust, when credit is tightened and becomes too expensive for borrowers. And for investors who seek stability through diversification, risk management becomes impossible when all markets move in unison. With nowhere to hide, everyone’s pension plan suffers if markets crash together. In one week in October 2008, the value of global retirement assets dropped by approximately 20 percent.
Tellingly, such correlations have survived the great post-Lehman crash of 2008, and at times of tension in the Eurozone, they have even intensified. According to Citigroup calculations,2 the average correlation of S&P 500 member stocks touched 70 percent in the fall of 2011—meaning that 70 percent of a move in any given stock could be explained by the market itself, with only the remainder accounted for by the company’s particular characteristics. This was a record. Over history the average correlation is far lower, at approximately 25 percent—as might be expected given the diversity of companies within the S&P.
What drove all these stocks to move together? Ultimately, it was the political news from Europe. News suggesting the euro would break up led investors to sell American and Asian stocks indiscriminately; “good” news from Europe saw them buy back into stocks. This was because the potential economic damage from Europe was so great that it swamped all traditional concerns about companies’ own fortunes.
A cataclysm such as the Lehman Brothers bankruptcy in September 2008 should have shaken out the speculation from the system for a generation, but evidently it has not—and this implies that the risk of another synchronized collapse is very much alive.
One clear lesson is that in the era of globalization, it is impossible to understand the finances of any one region in isolation. Events in China and the United States, in particular, are vital for anyone trying to explain Europe’s predicament, so there are chapters both on China’s remarkable revival and how it was achieved and on the U.S. policy for helping its banks muddle through the crisis. Some of these have been adapted from chapters in The Fearful Rise and drastically revised and updated.
There are reasons for hope. There have been no further big banking failures to follow names like Lehman Brothers or Washington Mutual into the history books. Indeed, America’s banking system now appears to be its healthiest in some decades. House prices have little further to fall. The risk of disaster diminishes the longer the policy of “muddling through” continues to buy time for banks, and families, to put their houses in order.
Still, the travails of the Eurozone reveal the internal contradictions of the United States’ recovery. Risks remain acute. There can be no certainty that the U.S. stock market will not fall even below its March 2009 lows before this crisis is over.