September 19, 2011

European Model Imploding? – Hold On To Your Hats

by Hal Gershowitz

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There are two things we know for sure about the European financial meltdown: Its cause and its potential ramifications for America.  No one should lull themselves into thinking we are mere spectators to those European economies that are collapsing of the weight of their own misguided policies when what is unfolding is a gathering storm which exacerbates the risks to our own very uncertain economy.

Understanding what is at stake for America as the European banking system faces collapse takes neither rocket science nor an advanced degree in economics.  Common sense will do just fine.  Some Euro Zone countries have lavished on their countrymen a largess they can’t afford, with money they have borrowed, that they can’t afford to pay back.  In other words, they have run up large deficits funded with debt their economies may not be able to retire.  Greece’s debt is 152% of GDP, Italy’s debt is at 121% of GDP and Ireland is at 114% of GDP.  These debt to GDP ratios generally signal serious economic decline.

Greece has turned to the European Central Bank (ECB) for additional installments on the bailout loans the ECB had previously provided under terms that Greece has failed to meet.  The ECB is the Euro Zone’s equivalent of our Federal Reserve.  And like our Federal Reserve, the ECB has also been buying the debt of its member nations to keep their borrowing costs artificially low.

Several European countries, among them Greece, Spain, Portugal, Italy and Ireland, have tied their destinies (that is, their ability to finance their deficits) to the European Community, and the citizens of the stronger Euro nations that have pursued saner, and more responsible pro-growth economic policies appear to have reached the limits of their patience.

Tiny Finland is demanding collateral before any more bailout money is loaned to Greece (the sickest of the patients in the hemorrhage ward), while mighty Germany is seeking veto power over ECU lending decisions.

Finland is hanging tough, demanding that Greece transfer sufficient assets to a Luxembourg-based asset holding company, and that those assets be held as security for new loans to Athens, The Finns are deadly serious.  They want irrevocable collateral for money that is loaned to Greece and that demand remains a central plank of Finnish demands for providing more aid to Greece.

If Finland does not get its way, it may pull out of the Greek bailout, unleashing renewed trouble in financial markets.  Already Austria, Slovenia and Slovakia have fallen in line saying they too want collateral assurances if they are to contribute to further bailout loans.  What has given tiny Finland such cachet in the European financial imbroglio?  How about its AAA credit rating, the envy of most of Europe?

Meanwhile, Germany has turned quite muscular in its demands before more bailout money is to be made available to Greece.  Germany’s Constitutional Court has imposed new conditions on future bailouts. The court ruled that the German Parliament’s budget committee must approve all future bailouts, which certainly suggests that the ECB may be demanding of sovereign borrowers the kinds of assurances that debt holders all over the world traditionally demand.

Germany’s parliament is, according to the court ruling, “prohibited from establishing permanent mechanisms under the law of international agreements which result in an assumption of liability for other states’ voluntary decisions, especially if they have consequences whose impact is difficult to calculate.”  In plain English – don’t count on Germany to foot the bill for another nation’s debt, as long as that other nation remains in control of its own budgetary decisions.

This is, unquestionably, serious stuff, but do we in America really need to worry?  In a word, YES.

While it is hard to quantify exactly where American banks or the Fed have exposure in Europe, we now know (largely thanks to a Bloomberg Freedom of Information Act complaint) that in the aggregate our exposure is considerable.  We can probably withstand a contained Greek default even if panic spreads to, say, Ireland and Portugal.  But it doesn’t take much of a stretch to see confidence take a nosedive in other important economies such as Spain or Italy and maybe even France and Germany, in which case the ground will begin to shake under the core European banking system and then the U.S. financial services sector exposure becomes very substantial.  As we finalize this essay Moody’s has cut the ratings one level for France’s Societe Generale and Credit Agricole (the country’s second and third largest lenders) and has placed PNB Paribas (France’s largest lender) on review for a possible downgrade.  As someone recently opined, these economies “are too big to fail and too big to bail.”

American banks and financial institutions are not currently anchored on the firmest ground, as attested to by the massive layoffs just announced by Bank of America.  No doubt, much of the worry that is roiling American financial institutions is, in fact, their exposure to the European financial crisis.  According to Fitch Ratings Inc., (as reported in a September 9th Op-Ed in The Wall Street Journal), the U.S. money-market industry had, as of the end of July, over a trillion dollars of direct exposure to European banks –or roughly 45% of money markets’ overall assets.  The Bank for International Settlement reports that American banks have loan exposure to German and French banks to the tune of over $1.2 trillion.  Why is that a problem? Well, it seems those very same banks have an estimated $2 trillion of sovereign-debt exposure to Greece, Ireland, Portugal and Spain. Few doubt that there will be large loan losses among this cadre of European spendthrifts, but none of those potential losses have been recognized by any of these banks…yet.

No one in a position to know seems to believe that Greece can avoid defaulting on an estimated $450 billion of sovereign debt.  Given the jitters that currently prevail in France, Germany, Italy, Ireland, Portugal, Spain and elsewhere in Europe, it is impossible to predict where such an event will lead, What is certain is that no one is apt to remain unscathed.

Meanwhile, the United States has other exposure to the European economy. During the first seven months of 2011 we exported nearly $155 billion of goods to Europe.  While we have a trade deficit with Europe of $55.4 billion, our exports to Europe equate to thousands of jobs in the United States.  The looming economic crunch in Europe, and the probable continued plunge of the Euro against the dollar does not augur well for American industry that exports to Europe.

We will be navigating through truly treacherous economic seas in the months (and possibly years) ahead.  There will be those in Washington who believe this is the time to tax and regulate in order to manage our economic growth.  There will be others (count us among them) who believe this is the time to unleash American resourcefulness, innovation and productivity.  What is certain is that we are entering a period where we will have a very short window in which to make very vital decisions. The margin for error will be miniscule.  If ever there was a time for American Exceptionalism as understood by de Tocqueville it is now. If we fail to reverse the decline of American economic leadership that has largely driven world economic growth, the entire world is certain to suffer.  The world waits.  Hold on to your hats.

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7 responses to “European Model Imploding? – Hold On To Your Hats”

  1. You suggest that the German and French banks according to BIS have a “loan” exposure to the American banks. My sense is that our banks may well have a similar exposure to the very same banks, possibly more. Most of that exposure is bank to bank and covers short term, often overnight exposure relating to foreign exchange and money market transactions. It would be interesting to see the “NET” exposure which may well favor our banks, i.e. German and French banks place relatively more of their liquidity with our banks during these uncertain times.

    • Mr. Meyerman makes a legitimate point, but not necessarily one from which American Banks are apt to take great comfort. Were there a substantial “default event” the banks would certainly busy themselves determining who took the greatest hit (their banks or our banks). Meanwhile, the U.S. money-market industry, at least as of mid summer, had over a trillion dollars of direct exposure to European banks –or roughly 45% of money markets’ overall assets, according to Fitch Ratings, Inc. Even a hint of another Lehman brothers type debacle, here or in Europe, could have incalculable ramifications to the world economy.

  2. mark j levick says:

    Depositors and the Fed have enable the large US banks to show artificially healthy balance sheets by paying almost nothing for the deposits which they then lend and invest. Hopefully the executives that run those banks find it unnecessary to take lending and investment risks in the current environment and the Government has not used its clout to make them an instrument of foreign policy as it did by encouraging lending to home buyers who had no ability to make the corresponding mortgage payments.

  3. irwin yablans says:

    “Unleash american resourcefulness,innovation and productivity”
    The people that have all the means to do so have chosen to,for politically motivated reasons ,to do quite the opposite. It would be good for the country if these exceptional americans primed the pump a bit but that will have to wait until the next president.a Republican? is in charge.
    The electorate will not be fooled. The rich and privileged who are doing so well,even in this tortured economy must,for the best possible reasons kick in a bit more.

    • We don’t think there are any sane business people in the country who are holding back growing their businesses for political reasons. If there are, they deserve to go out of business as they most probably will. Businesses invest and hire in response to either current demand or anticipated demand for their products or services. Recent government projections of economic growth have proven worthless, and there is a pervasive and growing sense throughout the economy that demand may not substantially improve for a long time, some think for years. Industries that rely on exporting are watching unprecedented economic uncertainty in Europe. Despite the bleak economic outlook, our government is issuing thousands of pages of new regulations, proposing tax increases wherever it thinks it can get away with them, and is certain to eliminate many tax incentives that the government previously enacted to induce preferred business investment. The climate of uncertainty that prevails in the country is simply antithetical to consumer spending or business investment. Uncertainty is largely the cause of consumer and business caution, and government is largely the problem.

  4. Mark J Levick says:

    All can agree that We need cheap and certain energy and need to create jobs. The bureaucrats have decided that the best way to achieve those goals is to regulate coal burning power plants out of existence, stop deep water drilling, halt extraction of oil from shale, freeze nuclear power plant construction, stop Boeing from producing planes in South Carolina, support union organizing through card checks and force employers retain unproductive workers. At the same time our President has spent billions of dollars on failed solar energy product, subsidized off shore oil drilling in Brazil, purgased campaign buses made in Canada, advocated massive tax increases on families who earn $250,000 or more, created massive health care and cosumer protection bureaucracies and stumped for increased infrastructure spending on school buildings as our transportation system and energy grid crumble. By simplifying the tax code, reducing corporate tax rates, streamlining regulations, facilitating energy exploration, addressing unfunded and unfundable entitlements and imposing an emergency national VAT tax to be used entirely for debt repayment the President could lead, create jobs and assure re-election.

  5. irwin yablans says:

    A vat tax would be grossly unfair to what is left of the middle class.

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