On the morning after a financial collapse things will look almost exactly as when you went to sleep. The elm tree and mailbox will stand where they were, the scene will appear unchanged all the way to the horizon. On the Day After the outward world is unchanged. What will have altered beyond all recognition are the invisible claims on that physical world.
The homely mailbox, for example, may no longer be yours, nor the land on which the elm tree is growing. It could have reassigned while you were sleeping. If one can imagine the world in terms of a balance sheet, the immediate post-crash world assets start unchanged. It’s the liabilities which have been rearranged. The write down process will not be uniform.
In the bubble world there are more claims on assets than can be satisfied. In the pre-crash world this is unnoticed. As in the game of Musical Chairs, it is not obvious till the music stops. Only when the tune is interrupted, in the post-crash world, does the audience will see there is one chair short.
Politicians and unscrupulous politicians are in the profession of overselling capacity, but ensuring they always have the chair. Politicians for example, promise the same taxpayer dollar several times over to different constituencies. And it goes along swimmingly as long as they can kick the can down the road.
For example Obamacare was created to save Medicaid from bankruptcy. Now Medicaid expansion is used to prove Obamacare is working. Obamacare was funded by reductions from Medicare. Now the Medicare “doc fix” shortfall will be funded by obtaining “savings” from Obamacare. It’s circular process where the same dollar moves from chair to chair.
Banks operate on the same principle. Banks lend out more than the deposit dollar. They can do this sustainably for as long as the extra chairs can be provided by the real rate of interest. An extra chair will be created in the future, but only as many as the actual rate of growth will provide.
But sometimes people get greedy and overpromise returns. Then if everyone with a claim on a chair came to the bank and demanded a stool, there would be a shortage of stools. This is called a bank run. In that case the system relies for its continued viability on keeping the music playing. Once the needle is lifted from the record, forcing the players to scramble for a seat, it will be obvious that somebody will have to be kicked out of the game.
On the day after a crash the most important question is: who gets the chair when the music stops? Ben Stell and Dinah Walker, writing in the Council of Foreign Relations blog explain how the French got the Italians and Spaniards to hold the bag through the simple device of turning French exposure in Greece into someone elses’, a process called “mutualization”
In March 2010, two months before the announcement of the first Greek bailout, European banks had €134 billion worth of claims on Greece. French banks, as shown in the right-hand figure above, had by far the largest exposure: €52 billion – this was 1.6 times that of Germany, eleven times that of Italy, and sixty-two times that of Spain.
The €110 billion of loans provided to Greece by the IMF and Eurozone in May 2010 enabled Greece to avoid default on its obligations to these banks. In the absence of such loans, France would have been forced into a massive bailout of its banking system. Instead, French banks were able virtually to eliminate their exposure to Greece by selling bonds, allowing bonds to mature, and taking partial write-offs in 2012. The bailout effectively mutualized much of their exposure within the Eurozone.
The impact of this backdoor bailout of French banks is being felt now, with Greece on the precipice of an historic default. Whereas in March 2010 about 40% of total European lending to Greece was via French banks, today only 0.6% is. Governments have filled the breach, but not in proportion to their banks’ exposure in 2010. Rather, it is in proportion to their paid-up capital at the ECB – which in France’s case is only 20%.
In consequence, France has actually managed to reduce its total Greek exposure – sovereign and bank – by €8 billion, as seen in the main figure above. In contrast, Italy, which had virtually no exposure to Greece in 2010 now has a massive one: €39 billion. Total German exposure is up by a similar amount – €35 billion. Spain has also seen its exposure rocket from nearly nothing in 2009 to €25 billion today.
In short, France has managed to use the Greek bailout to offload €8 billion in junk debt onto its neighbors and burden them with tens of billions more in debt they could have avoided had Greece simply been allowed to default in 2010. The upshot is that Italy and Spain are much closer to financial crisis today than they should be.
The French now have a chair. It is the Spaniards and Italians who will have to hop around some.
In Greece itself the relevant question is: who has a claim on what is left in the banks when they reopen, assuming there is anything left. Ma and Pa Greece who put their savings or investments on the system the Day Before will find the birds chirping in the Attic trees as usual. But what happened in the virtual world while they were sleeping?