“Cascading default, bank runs and catastrophic risk” lie ahead for the world economy unless Europe resolves its festering debt crisis, Timothy F. Geithner told global finance chiefs on the morning of Sept. 24.
The U.S. Treasury secretary spoke from experience and lessons learned. Three years ago, he was president of the Federal Reserve Bank of New York and working to shore up a financial system in the chaos following the collapse of Lehman Brothers Holdings Inc. (LEHMQ) His warning last month at a meeting of the International Monetary Fund in Washington was the third in three weekends after he jetted to conferences in France and Poland to appeal directly to Europe’s policy makers for action.
After Lehman filed for bankruptcy on Sept. 15, 2008, financial institutions lost or wrote off almost $1 trillion; the Standard & Poor’s 500 Index fell 40 percent in six months; and the world slumped into the deepest recession since World War II. The global economy still hasn’t recovered and has been close to stalling anew for the past several months.
Europe’s nightmare scenario would mean fresh financial disaster, according to Nobel laureate economist Robert Mundell. In the worst case, authorities fail to prevent Greece from defaulting on 356 billion euros ($489 billion) and investors react by triggering insolvencies as far as Spain and Italy. Such a firestorm would devastate bank balance sheets, rock markets, derail economic growth and threaten to splinter the 17-nation euro area. The European Central Bank would probably have to lead the response as the Fed did in 2008.
‘Scaring the World’
“Just before the Lehman crash, nobody expected anything like what happened afterwards,” said Mundell, whose research is credited with providing intellectual support for the euro, in a Bloomberg Television interview Oct. 6. “We’re right in the middle of crisis now. It’s not just a crisis of the sovereign debt, it’s a crisis of the banks, and this is now a global situation. It’s going to spread to the United States.”
Geithner’s comments last month were part of an apocalyptic chorus. Europe “is scaring the world,” President Barack Obama said Sept. 26. Bank of England Governor Mervyn King says the financial turmoil may be worse than the Great Depression. The crisis “has reached a systemic dimension,” said European Central Bank President Jean-Claude Trichet on Oct. 11.
$13 Trillion Lost
The dire warnings reflect a mounting sense of urgency. Concern that difficulties in refinancing debt are spreading beyond the euro area’s smaller nations, and unease over the financial system’s exposure to sovereign bonds are shaking global markets. Europe’s woes are responsible for wiping out about $13 trillion of wealth since July 1, analysts at Barclays Capital estimate.
“It’s a horse race between the markets worried about the politics and the politicians who can fix things,” said William White, a former head of the monetary and economics department at the Bank for International Settlements in Basel, Switzerland. “There’s a possibility that the markets win the race, and that would be truly horrible.”
White says policy makers outside Europe are concerned that if politicians fail to protect that continent’s economy and banks, investors would view other markets as the next dominoes to fall. The IMF estimates a U.S. budget deficit of about 10 percent of gross domestic product this year.
“At a global level, there’s a debt problem,” he said. “The U.S. can see they’re next in line.”
Crisis Conferences
European policy makers and those of the world’s 20 major advanced and emerging economies may have their last best chance of forestalling a meltdown in a series of meetings starting tonight in Paris, according to Jim O’Neill, chairman of Goldman Sachs Asset Management.
This weekend’s talks involve finance ministers and central bankers from the Group of 20. European leaders will then convene in Brussels on Oct. 23 and those from the G-20 will gather Nov. 3-4 in Cannes, France.
With markets fragile and Greece negotiating a second bailout, U.K. Chancellor of the Exchequer George Osborne said G- 20 officials agreed at a Sept. 23 meeting that the Cannes summit would amount to a deadline for a plan because “patience is running out.”
“If the G-20 comes out of Cannes with nothing, that will be a nightmare,” said London-based O’Neill, who crafted the concept of the BRIC nations to describe the growing economic might of Brazil, Russia, India and China.
Central Bank’s Role
The ECB already needs “to be very active” in managing the regional crisis, said David Mackie, chief European economist at JPMorgan Chase & Co. This will include allowing its bond buying program to reach as much as 1 trillion euros, maintaining liquidity in banks, and cutting its key interest rate to 1 percent from 1.5 percent by early next year, Mackie said. He forecasts an imminent recession.
German Chancellor Angela Merkel and French President Nicolas Sarkozy vowed Oct. 9 to devise a plan by the G-20 summit that would create a “durable solution.” Underscoring the urgency, a tightening of the interbank credit market forced Belgium and France last week to break up Dexia SA (DEXB), once the world’s biggest lender to municipalities.
“The failure of Greece would be the failure of all of Europe,” Sarkozy said Sept. 30 in Paris. “Remember in 2008, when the U.S. let Lehman Brothers fail, the global financial system paid the price. For both economic reasons and moral reasons, we can’t let Greece fail.”
Crisis Resolution Steps
To stop the crisis from spinning out of control, leaders are working on multiple fronts to manage Greece’s finances, protect banks and overhaul Europe’s economic governance to avoid a repeat. A default or a country leaving the euro weren’t part of the single currency’s original design.
The package of measures should include requiring banks to hold more capital so they can withstand potential losses from bond holdings, according to the IMF, which has put the cost as high as $200 billion. Euro-area banks need at least 150 billion euros of capital under a plan similar to the U.S. government’s U.S. Troubled Asset Relief Program, estimate analysts at JPMorgan Cazenove led by Kian Abouhossein.
European governments also are laying plans to increase the spending power of a 440 billion euro bailout fund, created in May 2010 to provide loans to cash-strapped nations. It is now being revamped to allow it to also buy bonds on primary and secondary markets, offer precautionary credit lines and inject money into banks.
2 Trillion Euros
With taxpayers balking at providing more cash and wealthy countries worried about hurting their own credit ratings, officials may try to leverage the fund’s capacity, perhaps by insuring a portion of new bonds issued by debt-ridden nations. Silvio Peruzzo, an economist at Royal Bank of Scotland Group Plc in London, says 2 trillion euros of capacity is needed to persuade investors that Spain and Italy would have enough funding.
The need to make Greece’s borrowings more manageable also may mean investors will have to take a bigger share of losses on its debt than the 21 percent write-off that formed part of a July aid deal. German banks are preparing for losses of as much as 60 percent, said three people with knowledge of the matter.
Any fresh measures may still fail because of the range of differences over what to do, according to Mackie at JPMorgan Chase. The Germans and Dutch, for example, want a deeper restructuring of Greece’s debt than France and the ECB seem willing to accept, he says.
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