Belmont Club

The Gathering Storm

While the US was gripped by the twin dramas of the Obama speech and the 10th anniversary of September 11, the European sovereign debt crisis began to morph into something potentially more dangerous: a bank crisis. The likelihood that Greece and possibly other European countries might default appeared to rise when Jurgen Stark, the European Central Bank’s chief economist resigned over what appeared to be a policy dispute.

Internal divisions at the European Central Bank spilled into the open Friday after Jürgen Stark, the bank’s de facto chief economist, said he would resign his seat on the six-member executive board, which manages bank operations and plays a leading role in setting monetary policy. …

Mr. Stark is an opponent of the E.C.B.’s purchases of bonds from ailing countries to hold down their borrowing costs, and many Germans share his concerns. His resignation “makes the European bailout scheme more unpopular among German voters which lowers the long-term credibility of the bailout policy among investors,” Jörg Krämer, chief economist at Commerzbank, said in a research note Saturday.

Angela Monaghan at the Daily Telegraph noted that a sovereign default would pull down the European banks. “Mr Stark’s resignation struck fear among investors, already rattled by a Goldman Sachs report which suggested that as many as 38 European banks might need to raise new capital as a result of writedowns on the value of their holdings of sovereign debt.”

For that reason Simon Kennedy at Businessweek reported plans afoot to support financial institutions “reflecting mounting concern Greece may default and that the debt crisis is morphing into a banking crisis”. This fear was uppermost in policymakers minds. G7 finance chiefs discussed stopgaps while German officials bruited plans to help banks which lost more than 50% on their Greek Bonds. U.S. Treasury Secretary Timothy F. Geithner and Canadian Finance Minister Jim Flaherty pleaded with the Europeans to avert the smash.

The European crisis threatened to drop yet another spot of bad luck on the Obama administration’s attempts to grow the economy. Peter Schroeder at the Hill notes that “while the president is pushing his broad jobs plan in an last-ditch effort to boost the ailing economic recovery, the European drama has been severely unsettling American financial markets.”

But to Desmond Lachman of the American Enterprise Institute, the European smash is almost certainly coming. In a presentation to Congress called “A Gathering European Storm”, Lachman said “a spate of sovereign debt defaults” could happen within the next six months and result in the unraveling of the Euro. The crisis, he said, has spread beyond the boundaries of Greece to Ireland, Portugal, Spain and Italy. It is now doubtful whether German political leaders can find electoral support for any more bailouts. That means that barring a miracle, the dam will burst.

When it does,  European policymakers will be caught between a rock and hard place. On the one hand their basic problem is a burgeoning public debt. As Lachman wrote, “at the heart of the Eurozone debt crisis is the fact that a number of Eurozone countries have run up very large public sector deficits and very large external imbalances.” But on the other hand, weaning the dependents off the state will produced unprecedented hardship and riots.  The cutbacks will also shrivel up consumer demand in Greece and Spain among others. When these countries go under, the banks will be sucked into their vortex.

The European banking system is already showing early signs of the same sort of strains that were experienced in the US financial system in 2008-2009.The French, Italian, and Spanish banks are all having trouble funding themselves in the wholesale market, while the European banks are growing ever more distrustful of lending to one another.

What effect would the collapse of the Eurozone have on the US and indeed the wider world? Europe would buy less from America and China. The Euro would devalue in whatever form it survived, making European products cheaper than American equivalents in export markets. Most importantly it would transfer an unknown amount of risk through banking channels to US banks. “According to the Fitch rating agency, as of June 2011, US money market funds had loans outstanding to European banks in excess of US$1 trillion; according to the Bank for International Settlements, US banks have claims on banks in Germany and France of around US$1.2 trillion; US banks have written derivative CDS contracts on European sovereigns of more than US$400 billion.”

If Lachman’s predictions are correct the defaults can come sometime before mid-2012.  They would add a terrible impetus to America’s own unfolding disaster.  Despite that danger, policy-makers in both Europe and the United States appear afflicted with a strange myopia.  As the President’s recent speech to Congress showed, the administration can think no further than demanding a half-trillion dollar’s worth of stimulus “right now” even as European finance ministers struggle to find ways to keep a doomed Greece afloat for a few months more.

“Congress should pass this bill right now,” Jarrett said on MSNBC. No more than one minute later, Jarrett said the White House is still writing the bill and it will be submitted to Congress next week.

Western policymakers are acting as if the future didn’t exist and all that mattered was to extend the moment, at all costs and by any means necessary. Maybe they know something we don’t. Maybe they sense their own end.

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