The financial news from Europe is getting increasingly distressing.
A new EU report warns that economic conditions in Portugal and Spain could "result in a high ‘snowball’ effect on the government debt.”
French financial group AXA says "there is a fatal flaw in the system and no clear way out." They are predicting the Eurozone to break in half or completely disintegrate in the next 18 months.
Over 13% of Europe's investors are betting on a Black Monday-style collapse in stock prices (think 1987).
The latest source of these fears is a renewed liquidity crunch among Europe's banking sector, which is expected to write off another 195 billion euros in losses in the near future.
The central bank is preventing a crisis by providing banks with unprecedented funding. In substituting long-term money with shorter-maturity ECB cash, policymakers are making it harder to wean banks off life support as well as the short-term financing that regulators blame for the credit crisis.
Banks are still struggling to borrow even from one another and loans with a maturity of more than one month are “rare and expensive,” making them depend more on ECB funding, Brice Vandamme, a London-based analyst at Deutsche Bank AG, wrote in a note to clients on June 9.
The source of all this distress is the banks of France and Germany, who lent enormous amounts of money to Greece, Portugal, and Spain.
All told, Spain, Ireland, Portugal and Greece owe nearly $1.6 trillion to banks in the 16-country euro zone, either in the form of government debt or credit to companies and individuals in the four countries, the report said. Credit from French and German banks accounted for 61 percent of that total.
These huge liabilities on the balance sheets of the strongest banks in Europe are the reason why the EU decided on a trillion dollar bailout of its southern members rather than the more logical restructuring of debt that is badly needed.
Or to put it another way, the politicians in Brussels decided to kick the problem down the road by a year or two, hoping that the citizens of Greece, Portugal, and Spain would accept abject poverty without complaint, rather than have to face a catastrophic collapse in major European banks who made stupid loans.
Europe's bailout plan is doomed to fail for the "snowballing" reasons listed above. Judging by the way the markets have fallen since the bailout was announced, investors already know this. Even under the current plan, Greece's debt burden will increase from 120% of GDP to 150% of GDP by 2014. That's not a stabilization of a problem. It's just a subsidy for big banks.
What needs to happen is for the bond holders (i.e. banks) to accept some losses, just like the IMF has already suggested. Unless the debt burden is put on the public balance sheets, this will eventually happen anyway.
Of course, bank bailouts is what got us into this current mess, and what threatens the stability of the Euro currency. What we've seen so far is a game of hot-potato with toxic debt which is now threatening to enter the meltdown phase.
It is not so different to the Ponzi scheme carried out by Bernard Madoff, except that unlike his hedge fund fraud, this one is being carried out in full public view.
The problem is that this has to stop somewhere, and that gasping noise over the past couple of weeks is the sound of millions of investors realizing, all at once, that the music might have stopped.
Revenge of the Black Swans
Most American conservatives might look at Europe's problems and think, "Stupid Europeans with their funny languages, socialized health care and 4 weeks of vacation. They deserve what they get. Besides, it doesn't effect me."
Logic and history say otherwise.
First of all, the European economy is larger than America's. You can't just watch the largest economic block, and one of the largest currencies in the world, break down without expecting it to impact the rest of the world.
Secondly, we've seen this scenario play out before, 80 years ago.
For those of you who haven't studied the Great Depression, it wasn't a matter of the economy going gangbusters to broke overnight. The stock market crash on Wall Street in October 1929 was brutal, but unemployment was still below 9% by the end of 1930.
A small economic rally in the spring of 1931 actually saw the number of people unemployed fall by a tiny amount. There was real hope that the worst was over.
“The depression has ended.”
- Dr. Julius Klein, Assistant Secretary of Commerce., June 9, 1931
The problem was that the catalyst that would change the depression into the Great Depression was already in place.
Creditanstalt was the largest bank in eastern Europe. By May 1931, its losses were getting too large to manage. The House of Rothschild and the Austrian government stepped in with a bailout. Much like the recent EU bailout of Greece, the government bailout of Creditanstalt didn't assuage the markets. It created a run on the bank instead. The banking crisis spread and within a month the government of Austria itself needed to be bailed out.
The demise of the Creditanstalt and the Austrian government was followed by a run on Germany and an attack on Sterling, which was depreciated a massive 25 percent as a result. Afterwards, central banks began a run on the U.S. dollar, liquidating it for gold. The banks included the Bank of France, the National Bank of Belgium, the Netherlands Bank and the Swiss National Bank. The result was an immediate need to increase the interest rate in the U.S. from 1.5 to 3.5 percent.
The banking crisis in Austria, which turned into a sovereign debt crisis, in just a few months, led to a currency crisis in Britain (the world's reserve currency at the time), and finally to the very TARP-like action by Hoover's Treasury Department after a massive wave of bank failures crossed the Atlantic.
The sovereign debt crisis in Greece has already caused large interest rate hikes all over Europe. With the housing market in America still in decline, and credit for small businesses still tight, can you imagine what would happen if interest rates were to suddenly increase by two percent?
In today's interconnected world, can we really expect Europe's problems to stay on their side of the Atlantic like they failed to do in 1931?