AS readers know, I am relatively sanguine about the outlook for the global and UK economies next year. But this doesn’t mean that I’m blind to the risks facing the recovery. Two in particular worry me.
The first is the possibility of a break-up of the euro. Arturo de Frias at Evolution Securities has crunched the numbers. German, French and UK banks have €1.2 trillion in exposure to Spain, Italy, Greece, Ireland and Portugal. If all these economies quit the single currency and devalue by 30 per cent on their way back to the peseta, lira, escudo and other currencies, German, French and UK banks would suffer €362bn of losses – and these would be final, definitive losses, not fun-and-games mark to market numbers. UK banks alone would suffer losses of €80bn. Virtually every major bank in Europe would become insolvent – and that is before we consider insurance companies, pension funds and other financial institutions. The whole system would go down, as would the economy. It would be an even bigger disaster than the crisis of 2007-09. The euro is a defective currency that should never have been launched – but the cost of exit would be immense.
The second major risk is the US housing market, which is in a much worse state than most people realise, and the authorities’ desperate attempt to reflate it. Yesterday’s Case-Shiller statistics confirmed that US house prices are falling again – they are down 1.5 per cent over the past year and over 28 per cent from their peak. The recovery since the trough has been cut to 4.9 per cent. This renewed decline is one of the main reasons for the Fed’s fresh emphasis on monetising debt, with dire implications for the rest of the world.
Roughly 11m American households are in negative equity and therefore are saddled with mortgage debts larger than the value of their homes, 20 per cent or so of the 55.6m outstanding US mortgages. This is much worse than what we face in the UK. Even more worryingly, an additional 33 per cent – or 18.3m mortgages – enjoy an equity cushion of less than 10 per cent. So another one-tenth drop in house prices would take the number of Americans facing negative equity to over half.
There are three problems with negative equity: by wiping out the wealth of individuals, it hits their spending and savings and robs them of any collateral against which they can borrow or set up a business; any default by individuals is translated into an actual loss for the bank; and homeowners cannot afford to sell to move to find a new job.
The continuing housing crisis is one of the reasons why the Fed is so keen to engage in QE2. It worries that further house price losses could trigger a fresh round of massive, crippling write-offs at US financial institutions, bankrupt some and cause years of stagnation. Unfortunately, because the US is the world’s reserve currency, much of the liquidity the Fed is creating is seeping out of the country and ending up in Asia. Singapore, Hong Kong and others are facing bubbles through no fault of their own. The response is tension, the threat of trade sanctions and capital controls to prevent the inflow of money. There are other risks to the world economy. But the euro and the US housing market are the largest. At the moment, the most likely outcome remains continued growth next year. But watch this space.