Commentary

The Euro-Crisis: Fear Is Back in Play

“Now, fear is back in play,” said William H. Gross, managing director of Pimco, as the European crisis sent shock waves into financial markets around the world.

There is fear that the sovereign debt crisis could freeze up the euro-zone interbank market, in a replay of the credit crunch of 2007-2008. Several major European banks have lent money to Greece and other countries with shaky fiscal conditions, and uncertainty of how did will affect the banking sector is mounting. As reported by the Financial Times:

Deteriorating conditions in interbank money markets are leading some analysts to predict the next crisis will be among the banks. Even Europe’s biggest banks, such as Deutsche Bank, Barclays, BNP Paribas and Société Générale, are suffering as the costs of insuring these banks against default rises […] These trends are similar to the height of the financial crisis following the collapse of Lehman Brothers in September 2008, although dealers stress the markets are a long way from the seizure experienced at that time.”

There is fear that the Greek crisis is only the tip of the iceberg of what could be a full-fledged sovereign debt crisis affecting several other EU countries—the infamous PIGS (Portugal, Italy, Greece and Spain), as well as Ireland and Great Britain (maybe the afflicted countries should be renamed the PIGGIS). As reported by the New York Times:

“While the immediate causes for worry are Greece’s ballooning budget deficit and the risk that other fragile countries like Spain and Portugal might default, the turmoil also exposed deeper fears that government borrowing in bigger nations like Britain, Germany and even the United States is unsustainable.”

There is fear that the assumed “recovery” of the global economy in 2010 is nothing but an intermezzo, as the sovereign debt crisis could pull countries back into recession, the counterparty exposure of major banks could drag the financial sector back into further financial turmoil, and the monetary tightening in China, after its 2009 investment and credit binge, will cool down the global economy.

In other words, the fragile U.S. economy, put on life-support by various government programs, could take a new hit. The New York Times writes:

“If the anxiety spreads, American banks could return to the posture they adopted after the collapse of Lehman Brothers in the fall of 2008, when they cut back sharply on mortgages, auto financing, credit card lending and small business loans. That could stymie job growth and halt the recovery now gaining traction.”

The only good news coming out of the European crisis, is that trouble elsewhere leads to a “flight to safety” into U.S. government securities. This will help the deteriorating fiscal position of the federal government for some time, thus helping to finance the fiscal deficits and support the ever-growing accumulated sovereign debt.

But such a flight into dollars will at the same time lead to dollar-appreciation, thus hurting exports. It will also lead to a false sense of security for the U.S. fiscal authorities, postponing the much-needed fiscal consolidation, as the sense of emergency is softened by current events.

However, turmoil around the world will negatively affect the U.S. economy, making a true recovery more difficult, thus weakening the U.S. fiscal position further. Eventually international bond holders—what economist and doomsayer Nouriel Roubini refers to as the “bond vigilantes”—will sense that the U.S. government finances are not sustainable and fear could spread that American authorities will partially default on their debt promises by printing more money, thus lowering the real value of debt outstanding.

In other words, a Greek crisis could in the end come to haunt the U.S. economy as well.