Once again, regulators have failed spectacularly. Gold hit £1,000 an ounce today for the first time, as equities fell, Club Med government bond yields jumped, spreads increased and the fear and loathing in the credit markets intensified – and all of that in response to the EU’s banking stress tests on Friday night, which were supposed to reassure investors that all was well. What a farce. The tests’ preposterous lack of credibility – they didn’t even envisage the possibility that a government could go bust – have been greeted with the contempt they deserved.
The key problem is that if markets don’t know what will happen to smaller, less well-managed financial institutions in the event of a sovereign default, then they will be less likely to lend to them or engage in other sorts of relationships. Perceived counterparty risk, as it is called, will intensify – and these less transparent firms will soon start running out of cash, potentially triggering a liquidity crisis. The amount of credit available to troubled economies will dry up, assuming that bigger, more obviously well-capitalised banks are unable to step in and fill the liquidity void.
From a UK perspective, one risk would be a collapse in trade credit in the Eurozone, triggering a sharp decline in global trade. During the previous crisis, manufacturing output collapsed by more even than financial services output. The reason was this drying up of trade credit, which led to a collapse in the supply chain and thus in factory output, in a remarkable case of contagion. A collapse in key export markets would also hit the UK, but the biggest danger is financial contagion crippling global City banks, insurers and institutional investors.
The spiraling yields on Italian and Spanish bonds are not as weird as some have argued. One reason is that the probability of a euro break-up is increasing – and even if you think there is just a 10 per cent chance of the euro ending at some point over the next decade, and Italy and Spain reverting to weak, inflationary currencies and devaluing themselves out of debt, logic dictates that you should demand a much steeper premium to lend to them. Before the single currency was launched, yields on the bonds of Club Med countries were rightly much higher than those on German bunds; we are gradually seeing a return to sensible, differential pricing of risk by investors who had previously completely misunderstood the nature of the Eurozone and confused it for a fiscal union.
That said, the most likely outcome is that the EU will eventually find a way (by bending or rewriting rules) to federalise the debt of failed, bankrupt states: they will issue vast amounts of EU-backed bonds (say €1 trillion, as an order of magnitude) and tell all financial institutions, including insurers and pension funds, that they wish to buy every single government bond from bankrupt countries that they are willing to sell, probably at the discount to face value being priced in at that particular time by the markets. The authorities would give holders an ultimatum: sell now, or bear all future losses. It may be that such an arrangement will not be ready on time for Greece, which could yet be left to go bust and be thrown out of the euro.
But regardless of the details, a giant euro-bond would transfer the default risk from private institutions stupid enough to trust Club Med governments (or who were forced, for regulatory reasons, to hold their bonds) to all European taxpayers. This could damage the credit rating of more solvent countries – but even if it doesn’t, it would be tantamount to a massive bailout. In return, the EU would want its pound of flesh: the weaker Eurozone countries would be turned into quasi-protectorates.
Such a plan would further discredit capitalism (even though the people who caused the crisis were over-spending politicians) and it would rob the EU of its legitimacy in the eyes of both Southern Europeans (who would lose their independence) and Northern Europeans (who would pay for the south’s greed, stupidity, mismanagement and economic illiteracy). The only thing that will restore faith in banks, insurance companies, pension funds and the like is if they are willing and able to take a big hit to protect taxpayers. There is nothing that will make a total EU takeover acceptable to Greeks and others, which is why they will soon want to quit the EU – and the German public will be deeply angry as it finally realises that everything it was ever told about the euro has turned out to be a lie. It will soon want out too. The EU has always worked on the basis that every crisis is good because it invariably provides an excuse to centralise powers. But the present nightmare could prove to be a bridge too far and herald the beginning of the end for the entire project. Fun and games are about to start.
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