Economic Domino Theory in the Eurozone, Part 2

On Wednesday, the Dow Jones Industrial Average surged 490 points, almost 5% in response to the announcement by the Federal Reserve that it was initiating a secondary capital injection in the European market.  This was the largest one-day jump since March of 2009, but was it enough to salvage the economic quagmire that is the European Union?

As the European dominoes have continued to fall—due mainly to the inability of those countries to maintain a sustainable level of debt—financial institutions across the world have developed strategies to limit the crisis and prevent the spread of this fiscal cancer.  With the interrelated nature of the worldwide financial system, this is not just a European problem; it is a problem for East Asia, the Middle East, and it is a problem for the United States.

The first step for the heads of the US financial system was to assess the exposure of American banks to European debt.  Last Wednesday, Ben Bernanke, Chairman of the Federal Reserve, announced that US banks would undergo a “stress test” over the course of the next few weeks.  This is, in essence, an effort to analyze the books of the six dominant financial institutions and determine the amount of European debt present.

These institutions—Bank of America, JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley—currently hold approximately 66% of the US GDP, or about $9 trillion.  Most of them have engaged in complex transactions known as foreign exchange swaps, which are defined as “an agreement to exchange stipulated amounts of one currency for another currency at one or more future dates.” 

These transactions allow for more flexibility in financial dealings and serve as a hedge against future alterations in the exchange rate, but they also increase exposure to international debt.  A source at the Treasury Department revealed that initial estimates of US exposure range from $1-$2 trillion and could reach as high as $3.5 trillion; the most vulnerable are Bank of America, JPMorgan Chase, Citigroup, and Goldman Sachs. 

In terms of American institutions, the only solution available to them is to play the confidence game.  On Tuesday, in response to this stress test, Standard & Poor’s, one of three ratings agencies on Wall Street, downgraded the credit rating on all of these banks and many of their European counterparts.  As they seek to maintain some level of confidence, one strategy has been to constantly move money throughout the market as a means of reducing the actual debt and European exposure present on their balance sheets.  The financial confidence game is a fickle beast. 

While the American banks seek to maintain confidence, the Treasury Department and Federal Reserve, in tandem with their worldwide counterparts, have sought to address the crisis at its core.  European countries are being crushed under a mountain of debt and they lack the necessary liquidity to write-down their debt; as a result, their credit markets are practically frozen stalling any economic activity. 

The lynchpin of European economic activity is France—specifically the French banks.  All the major European nations—particularly Germany—and the United States have large sums of money in these institutions.  Moody’s, another of the three ratings agencies, originally announced that they would be downgrading both the French banks and France itself today, which would have led to the nightmare scenario. 

A simultaneous downgrade of France and its financial sector would result in a large-scale run on the banks in which major financial institutions, such as American and European banks, as well as countries themselves, such as Germany and the United States, would attempt to withdraw their money at the same time.  Since the current financial system is built on leverage and no bank in the world has enough liquid capital to return the money of all of their investors, the entire system could potentially collapse.

On Wednesday, the Federal Reserve in collusion with the European Central Bank (ECB), the Bank of England, and the central banks of Canada, Japan, and Switzerland announced an immediate process of quantitative easing.  Since Europe as a whole, and France in particular, needs to increase liquidity to write-down their debt, this process would involve an infusion of capital in the market.

According to the source at the Treasury, since the Federal Reserve cannot legally lend directly to France, they have lent money at a 0% interest rate to the European Central Bank which will then loan to the International Monetary Fund which will loan to France.  This capital injection will allow France to write-down a substantial percentage of their debt and potentially stave off a cataclysmic financial event. 

Moody’s announced on Wednesday that it will hold off on downgrading the credit rating of France and its banks for 10 days, meaning the complete process of loan and write-down must take place over that period.  The capital injection was the only legal action the Federal Reserve could take.  It is now up to the European Union nations to handle this fiscal crisis in a responsible way, but in many ways the damage may already be done. 

There is a perspective broader than economics in which the Eurozone crisis may have dangerously destabilized the worldwide geopolitical balance.  The European Union has been brought to the precipice of financial ruin and is still hanging by a thread.  In many ways, it has always acted as a constraint on the power of individual nations within it and surrounding it. 

The destabilization of the EU has created an excuse for Germany to possibly drop the euro and leave the Union altogether.  It has, by default, strengthened the geopolitical positions of nations like Russia and China and created a relationship of dependence, evident by the fact that exports from China to Europe have dropped precipitously over the last month.  Russia’s increased strength has the potential to simultaneously result in further destabilization in the Middle East as their influence in countries north of Afghanistan grows. 

None of these scenarios are in America’s interest.  The geopolitical balance in the world over the last decade has been tense, but it has been a balance nonetheless.  The US government and the US financial institutions have done all they can to maintain confidence and liquidity in the worldwide financial markets.  Now it is up to the Eurozone to ultimately fix the problem they have created.

Economic Domino Theory in the Eurozone, Part 1

In 1992, the thirteen nations of the European Communities met in Maastricht, Netherlands to sign the Maastricht Treaty.  By doing so, these nations, which included Italy, France, West Germany, the United Kingdom, and Greece, bound themselves in an association known as the European Union, now comprised of 17 nations.  In the process they created a unified currency—the euro—which forever linked the fortunes of these economies, whether good or bad, in an essentially unbreakable chain.

Douglas J. Elliot, a Senior Fellow at the Brookings Institute, wrote on CNN Money that “the road into the Eurozone ran only one way.”  What he meant was that the Eurozone countries made it almost impossible to dump the euro without leaving the European Union; there is no mechanism in place for such an act.  The fear was that if a country like Greece were to dump the euro as its currency, they would set a weaker exchange rate leading to a run on their banks and a domino effect rushing through the Eurozone. 

At this moment, however, the very foundations of the European Union are buckling under the weight of debt and instability.  The governments of Greece and Italy have both been ousted after promising substantial austerity packages.  The euro itself is in danger of folding and the nations of the Eurozone watch as each domino continues to fall.  How bad is it?  Simon Wolfson, the CEO of European retailer NEXT is offering a $400,000 prize for a plan to break up the euro peacefully.  

The root cause of this crisis is essentially government debt, a prescient warning for American technocrats. The Maastricht Treaty mandated that annual government deficits not exceed 3% of GDP while government debt not exceed 60% of GDP.  Most European nations, however—particularly Greece and Italy—used complex currency and credit derivatives to mask the realities of their debt situation. 

Currently all the major Eurozone nations have debt to GDP ratios over 60%: the United Kingdom (77.8%), Germany (75.7%), France (83%), Italy (118.9%), and Greece (140.2%).  These staggering ratios—particularly those of Italy and Greece—have strained the relationships between banks and clients, investors and business, government and business, and government and citizens.  As a quick aside (and a story for another day), the American debt to GDP ratio is 99.6% for the year and ironically crossed the 100% plateau on Halloween according to projections by the International Monetary Fund. 

German Chancellor Angela Merkel and French President Nicolas Sarkozy have led the efforts by the more structurally sound European nations to maintain stability and find a long-term solution.  But experts worry that they are playing a losing hand.  The fiscal monstrosity that is the Greek and Italian bond market, combined with their astounding levels of government debt, has led some to fear the “doomsday scenario.”  

On Tuesday, the yield on 10-year Italian government bonds reached 7.039%, a rate at which economists believe the refinancing of Italy’s debt becomes unsustainable.  Were Italy and Greece unable to refinance their debt and default, economists and heads of state alike worry that the domino effect will spread through Europe and beyond—quickly.  Spain and Portugal would fall, followed by Ireland, and eventually the cancer would reach France. 

While France may not be a dominant geo-political power, they do dominate the banking sector of the Eurozone.  Germany, the most reliable of the bunch, houses almost all of its capital in French banks.  France also holds approximately $1 trillion in American money.  Meanwhile, the French banks have overleveraged themselves in the unpredictable Eurozone market resulting in France’s rocky fiscal infrastructure and dim economic outlook.  As rating agency Standard & Poor’s stated in downgrading the French banking sector, “we see weaker economic prospects for Europe, including the peripheral countries to which some French banks are significantly exposed.” 

Eurozone leaders have taken action.  At a summit in October, they decided to write down—essentially reduce in value—the Greek debt held by the private sector by 50%.  Meanwhile, Lucas Papademos has replaced George Papandreo as interim Prime Minister of Greece and promised a strong effort to pass a significant austerity package. 

Last week in Italy, the Parliament voted to approve an austerity package—which includes cutting 300,000 public sector jobs, increasing the retirement age for government benefits, simplifying the tax code, creating incentives for venture capital investment, and reintroducing the property tax—paving the way for Silvio Berlusconi to resign as Prime Minister. 

But there are flaws to these measures.  The write down of Greek debt makes very idyllic assumptions.  An article in The Economist after the deal was struck commented that the Eurozone’s main rescue fund, the European Financial Stability Facility, “does not have enough money to withstand a run on Italy and Spain” while other sources of liquidity—Germany and the central bank—have ruled out further bailouts.  The Italian austerity package is vague—such as when it outlaws deficit spending “except in the case of exceptional events” and fails to define “exceptional events”—and the country itself currently lacks a government. 

As the dominos continue to fall, the worry shifts from the collapse of the European bond market and banking sector to the impact on American markets.  The universality of the worldwide financial system means that the economic domino effect does not stop at the water’s edge.