Real Clear Markets

Europe's Economic Troubles Have Worldwide Impact

How the U.S. can escape the pending economic black hole

It has been remarked that bond yields have recently priced in a "Lehman type" event, yet no such event has occurred. But that is to misconstrue both what happened in 2008 and what is going on now. The reality is that the world faces a potential vortex in the coming months, and markets are beginning to price that in. While it is nearly impossible for Greece, Spain, Portugal and Italy to avoid their fate, policies in other countries could reduce the chances of this vortex materializing.

We all know what happened in 2008. Lehman made some bad bets that caused it to become insolvent and in the subsequent panic, banks stopped lending to one another causing a short-term liquidity crisis. That crisis was quickly solved by governments supplying needed financing and things rapidly returned to normal. Except, of course, that is not at all what happened.

What actually happened is that for at least a decade banks and other finance companies had been leveraging their assets in order to make increasingly risky investments. If all - or even most - of these investments had been directed toward the development of innovative products or production processes, the resultant returns on investment could have paid off the debts. But they didn't; a significant proportion went toward the construction of houses that were bought by people without the ability to repay the loans.

When the inevitable happened and some people actually stopped paying off their loans, real estate prices began to fall, triggering a decline in the nominal value of mortgage backed securities. Some of the banks and other financial organizations that held these mortgage-backed securities (MBSs) as capital became technically insolvent. But because many MBSs - and related derivatives called collateralized debt obligations - were so complex, it was unclear to counterparties which banks were insolvent and which were not. That is why credit markets seized up.

To "solve" this problem, governments around the world stepped in to bail out banks and other financial organizations that held MBSs or relied on short term credit markets for their working capital. While these actions unfroze the credit markets, it did not solve the underlying problem. In fact, it made the problem worse because it transferred risk from private individuals, who had some incentive to take responsibility, to government officials who had incentives at best to avoid blame. And what did these blame avoiding bureaucrats do? They continued to pump liquidity into the system, first by lowering interest rates and then, when those were at zero, by printing money (euphemistically called "quantitative easing"). None of these actions made the bad debts go away.

Why rehearse this story once again? Because those bad debts are now stalking us once again. But this time it is the governments that are bust. And governments that are bust are in no position to provide any form of bailout - no matter how much economists like Paul Krugman protest to the contrary. So when analysts claim that there is no Lehman type event to justify fears of credit risk, remember that Lehman was merely the most visible sign of an underlying problem.

In the present case, Greece is the most visible sign. Greece is insolvent. And as we are learning to our cost, insolvency cannot be resolved by injections of liquidity. So far, however, fear of a "Lehman type event" has been used to justify injections of liquidity into Greece. But these are effectively transfers from German taxpayers to Greek government workers and pensioners - and have solved nothing. In fact, they have made the problem worse, by delaying the inevitable default and Greece's departure from the Euro.

So, what is coming down the line? First and foremost, the Greek government will default on more of its debt and will almost certainly exit the Euro. Meanwhile, it looks increasingly likely that governments in Spain, Portugal and Italy will default on some of their debt too. (The alternative of continued bailouts by a collective of European governments merely delays the inevitable and fools nobody.) This will negatively impact the companies that hold substantial quantities of government debt, some of which may become insolvent, with knock-on consequences for all their counterparties. It will likely result in a widespread recession in Europe.

In the meantime, we are beginning to see how a slowing of economic activity in Europe can impact other countries, with Chinese and Indian growth declining. And as growth in those countries slows, so, too, does demand for raw materials from Australia, Brazil and South Africa. Meanwhile, the U.S. could see yields on government bonds rise significantly if the Chinese government substantially reduces its purchases (as exports fall). This has the potential to create a vortex in which the entire global economy slows down. So now you can see that when people say they don't understand why markets are pricing in a "Lehman type event." They just don't understand: a "Lehman type event" is in process right now.

So, what can be done? Let's go back again and look at how this all came about. In the standard analysis, the financial crisis is blamed on malfeasance by banks. Some of that blame is justified: making a 60:1 leveraged play on the presumption that housing prices will always rise is irresponsible. But that irresponsibility was underpinned by government policies. The U.S. Federal Reserve and its counterparts in Europe and Japan set interest rates too low for too long. Government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac bought up over $1 trillion in sub-prime and alt-A mortgages. The interpretation of Basel rules on capital adequacy ratios resulted in MBSs being treated as less risky than the underlying mortgages, resulting in massive levels of regulatory arbitrage - effectively creating trillions of dollars in synthetic credit.

On this analysis, we can see more clearly how the response by governments to the financial crisis - the bailouts and money creation - made the problem so much worse by continuing to effectively subsidize investments in non-productive assets. And we can see also what the solution has to be - at least in the U.S. The Federal government must extract itself from housing finance (the GSEs currently underwrite over 90 percent of new mortgages) and allow prices to adjust according to what buyers, sellers and financiers are willing to accept voluntarily.

The federal government also should end its massive money-creation program, which is distorting private incentives to save and invest, delaying the deleveraging that must come - and is bolstering asset price inflation at the expense of productive investments. Governments at all levels - from the local to the federal - must cut spending dramatically. And governments at all levels must cut regulatory red tape that acts as a massive drag on economic activity.

This combination of stable money (preferably backed by gold or another scarce commodity), lower government spending and less red tape would unleash productive economic forces that would rapidly offset any temporary decline in economic activity resulting from the withdrawal of government largess. It might even enable the U.S. to escape from the vortex.

Julian Morris is Vice President of Research at the Reason Foundation.

Julian Morris is Vice President, Research





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