Last week’s episode of the saga that is the euro crisis was a cliff-hanger of a drama. That drama is set to continue. Is a Greek tragedy in store, after all?
The long-awaited announcement that the European bail-out fund would be increased to a trillion Euros sent equity markets up to pre-crash levels. Banks rallied – some, such as the UK’s Barclays, by as much as 20 per cent. A huge sigh of relief was exhaled from Tokyo to New York.
Days later, the market wasn’t so sure. By the month end – October 31st, fittingly, the market had become truly ‘spooked’. News a Greek referendum could see the country choose to default on debt, despite the best efforts of Euro leaders to save it, sent markets into fresh free fall come Tuesday morning.
In effect, the market is hundreds of thousands of people voting on finance and economics matters every day. It is like a huge, real-time confidence poll of all things material. This makes it a formidable foe for anyone wishing to stave off reality. As such, the market quickly becomes the enemy of those in power fighting the consequences of past mistakes.
In every crash, it is always scape-goats such as traders and bankers that are blamed, never the creators of the original bubble. In this vein, we have yet to hear anyone in government pilloried for building up the gargantuan debt that’s now sinking Europe. Instead, we have a lot of unhappiness that the party’s over and someone has to foot the bill.
The latest idea spreading the market is the so-called ‘law of unexpected consequences’ implying law makers need to be careful they do not create ‘monsters’ as a spin-off of their decisions. It is clear there is going to be plenty of ‘monsters’ lurking in the shadows as the sovereign debt crisis continues to unfold.
One such ‘monster’ could be the destruction of credit default swaps (CDS), an insurance for the kind of financial meltdown happening in Greece. The euro bail-out for Greece (if it goes ahead) in effect invalidates the CDS market by claiming that somehow, magically, Greece is not in default and therefore CDS contracts should not pay out to those insured by them. May CDS holders would then see the insurance as a worthless piece of paper.
In consequence, pension funds and banks will no longer be able to give up some of their bond yield in return for insuring the capital against government default. This will make bonds less secure and institutions more hesitant to lend to countries. Interest rates and lending costs will rise for everyone.
The solution to the Euro crisis is for lenders to relax and start allowing countries such as Ireland and Portugal to start borrowing again. The CDS debacle, however, looks likely to set this back and create the opposite of what is hoped for.
Top this with Italy’s need to borrow 500 billion euro in the next 18 months and you can see why the saga of the Euro is not yet over.
While titanic issues of sovereign bonds and exchange rates roil global economies, equities markets are pulled around like rag dolls between pit bulls. Share markets are just terrified passengers riding in the jump seat alongside an out-of-control sovereign bond driver.
The pivot for all this is Italy, which is currently paying 6 per cent to borrow money. In itself, this is not such a big deal, yet the country has to refinance about 10,000 euros of debt per head of the population in short order. It carries approximately 120,000 euros per family of government debt on its back.
These are the scale of numbers making up the core of the Euro debt problem and presenting a threat to the US and Japan. Just like any chronic borrower, if countries don’t stop borrowing it eventually becomes impossible to escape the quicksand of debt.
We shall soon find out whether Europe has the leverage to drag itself out of trouble, or whether it has just bought itself a temporary halt to the slide into the mire.