11/20/2011 by Dr. Harald Malmgren
The unique characteristic of a neutron bomb explosion is that it kills all the people while leaving all the buildings, homes, and other structures intact. How much of the world could be at risk of a financial neutron bomb exploding in the Eurozone?
World leaders are showing signs of crisis fatigue, raising voices towards one another and blaming foreigners for all their nation’s ills. Markets are also showing signs of crisis fatigue as the credibility of European leaders has been undermined by repeatedly broken promises of “comprehensive solutions.” In recent hours, serious decline in market confidence is evident in rapidly converging warnings of many of the world’s largest banks to their major clients that severe financial turmoil is imminent.
Within the Eurozone itself, banks that not long ago passed official stress tests have stopped lending to each other, as banks one after another are failing an “interbank trust test.” The ECB has had to replace interbank lending and the repo market with its own “temporary lending facilities,” gradually accumulating vast quantities of collateral in the form of deteriorating sovereign debt of its members.
In response to unanticipated deterioration of the government debt of Italy and Spain, the ECB decided to make weekly moderate purchases of these bonds, but without staunching the hemmorraghing of Italian and Spanish debt from European banks but also from portfolios of investors throughout the world. The combined accumulation of faltering debt securities held by the ECB from its bond purchases and its liquidity facilities is now climbing towards one trillion euros.
Germany can soon be expected to blow the whistle to stop this process from undermining the viability of the ECB without raising its capital — and if the ECB asks for more capital from its members, Germany will likely refuse even before other members admit they have little left in their coffers to help the ECB.
The recent Summit promise to resolve the Greek bailout with bondholder haircuts and new cash may be undone by domestic Greek politics and an inevitable new election and by innumerable official and private holders of Greek debt who will resist the haircut agreed by the world’s megabanks. The promise of “enhancing” the EFSF has come to naught as the German insistence on no new money from Germany forced the EFSF to take cap in hand to seek help from the rest of the world. The rest of the world essentially told the EFSF that Europe is rich and must cure itself, by itself.
Most important, the Euro leaders’ agreement to recapitalize banks was based on German insistence that, with the exception of Greece, each member government must take care of its own banks, without pan-European help from the ECB or EFSF. The first agonized scream against this German resistance was from the French President, who complained that if France had to recap its banks by itself, the result would be loss of France’s treasured AAA rating – which would undermine the backstop of the new EFSF. The Germans were unmoved.
In spite of growing clamor for the ECB to be permitted to engage in sweeping purchases of European sovereign debt, the German leadership has consistently remained firm in its rigid opposition to ECB printing money to bailout profligate European members. The German position had long been that ECB printing of money would bring rising inflation, raising memories of the Weimar Republic and the subsequent rise of National Socialism and WWII. The German position was recently hardened by a German Constitutional Court ruling which warned against further trans-national aid within the Eurozone without evidence of parliamentary approval of each new transfer. Worse, the Court took discretion from the Chancellor and assigned it to the Budget Committee of the Bundestag and its 41 members. The Bundesbank pointed out that Article 123 of the European Treaty and the German Constitutional Court decision meant that further ECB buying of Italian and Spanish debt was “illegal.”
But this was not the end of the story of German reluctance. When a number of German banks were downgraded three notches a few days ago, German officials were forced to calculate how much was needed to recapitalize German banks to halt a potential collapse of the German banking system. In mid-November the conclusion was reached in Berlin and Frankfurt that German bank recapitalization needs were so large that virtually no German money was available for further aid to ECB capital or any other aid to the rest of the Eurozone neighborhood.
This presented a simple choice to German politicians: either protect the German banks and their critical role in support of the German economy, or provide help to the neighbors. Put this way, a growing number of German politicians joined behind the hard line against ECB printing taken by the Chancellor and her all-powerful Finance Minister Schauble.
On November 17 an historic crystallization of the Eurocrisis took place. French Finance Minister Baroin informed Schauble that most Euro members together insisted that the ECB move forward to initiate purchases of a large, broad swath of Eurozone sovereign debt, not limited to the weaker nations, not limited to Spain and Italy, but to include all Eurozone sovereign debt, including that of France. The French proposition was that Germany alone stood in the way of saving the Euro and the Eurozone. Schauble’s response was that if this was the final word of France and its friends, then Germany had no option but to abandon the Euro and leave the Eurozone.
This possibility of German exit had never before been formally stated. It was an historic shock. Shortly after, Chancellor Merkel confirmed to President Sarkozy that the German government position articulated by Schauble was irreversible. The two leaders agreed that there was no need to alarm world markets at this moment, so they would not announce the impasse. Such powerful events in history rarely remain secret. While the world press and media continue to hope for, and preach for bold ECB action, the German challenge has already quietly come under discussion among central bankers in many countries, and key non-European leaders in North America and Asia have already become aware of the outcome of the Baroin-Schauble encounter.
Chancellor Merkel continues to offer a simple solution: all 17 Euro member governments and their parliaments should agree a new Eurozone treaty, transferring fiscal policy authority to a single Eurozone body. On this basis, true Eurozone bonds could be issued, and bought by the ECB as needed.
The hitch in this simple proposal is that member governments and their parliaments would have to give up much national sovereignty to a new body which would be run according to German-devised rules and likely under supervision of German bureaucrats. After decades of divisions, and two World Wars with Germany, it would not be easy for the other parliaments and their voters to roll over and yield sovereignty.
A new treaty is needed. A new treaty may theoretically be negotiable. But negotiation and approval by 17 parliaments would take years, not days. Markets will not likely wait for such a long time, with selloff of European debt and the crumbling of Eurozone bank capital already escalating.
Is it possible for the Europeans to continue muddling through? Most likely it will be some Eurozone banks that crack and fall, providing ignition of a neutron-like chain explosion. One need only look at Italian banks, where most of their capital is in the form of rapidly deteriorating Italian sovereign debt. They are already reliant for liquidity on the ECB. They cannot dump their debt holdings without shrinking their capital. So they need to double down, and buy even more. When do they reach the point when more becomes less, and combined Italian debt holdings of the ECB and the banks collapse?
On top of this frightening entanglement of sovereign debt and bank capitalization has come a new demand by governments that banks increase capital to reduce systemic risk. Many banks are reluctant to issue new stock at a time of falling stock market valuations. So they instead seek to shrink their assets, to reduce the ratio of assets to capital, or in other words, reduce their leverage. Shrinking assets means cutting loans, cutting credit lines, selling off major lines of non-core businesses, and reducing their global footprint. So the Eurozone is demanding some combination of new capitalization or shrinkage of assets, or both. Under Dodd-Frank strictures, US banks are also pressed to increase capital and shrink assets. And the struggling Swiss National Bank is warning its two megabanks that they, too, must shrink.
What this means is that a global shrinkage of credit is underway, along with a reversal of ever-growing universal banking to a new era of “deglobalization” of finance.
Are we ready for a potential Eurozone implosion and deglobalization of banking? Or if these events take place, will they be viewed as “black swans” that no one could have foreseen?