August 30, 2011

The European Situation

Christine Lagarde, the IMF’s new chief, set off tremors at the Jackson Hole summit over the weekend with warnings that the global financial system is on very thin ice and vulnerable to the slightest shock.

“We are in a dangerous new phase. The stakes are clear: we risk seeing the fragile recovery derailed, so we must act now,” she said.

“Banks need urgent recapitalization. If it is not addressed we could easily see the further spread of economic weakness to core countries, even a debilitating liquidity crisis. The most efficient solution would be mandatory substantial recapitalization,” she said.

Although it’s encouraging that these issues are getting addressed at the highest levels, Europe’s lenders are already reeling from a share price collapse since the debt crisis spread to Italy and Spain, threatening to overwhelm Europe’s bail-out fund and leave banks exposed to sovereign defaults. We are getting perilously close to a crisis and it is questionable if they aren’t already so far along that anything can be done, let alone if all of the necessary parties are even on the same page as far as what needs to be done.

Europe’s inter-bank market is effectively frozen and EMU banks have lost access to America’s $7 trillion money markets. Lenders have parked €126 billion at the European Central Bank for safety rather than risk exposure to peers. When a bank’s peers are afraid of depositing money with a bank, that should mortify corporate and individual account holders. It will not be surprising at all to see large corporations shunning these institutions and then individuals. What’s going to happen to those institutions that are slow to withdraw? I don’t know the answer – I’d just take steps to ensure that I’m not one of those “last” institutions (or individuals!).

The IMF exhorted Europe’s banks over the last two years to beef up their capital base while the rally lasted. Many failed to do so and will now face harsher terms. Some may fall under state control, wiping out shareholders. The Eurozone economy ground to a halt in the second quarter, tightening the noose on EMU’s weaker states and their banks. Julian Callow from Barclays Capital said Europe is already in “industrial recession” and risks tipping into outright economic slump.

“The recent slide is eerily reminiscent of the pattern during the third quarter of 2008,” he said.

Ms. Lagarde issued a thinly-veiled attack on the ECB’s rate rises and Europe’s fiscal austerity drive. “Monetary policy should remain highly accommodative, as the risk of recession outweighs the risk of inflation. Fiscal policy must navigate between the twin perils of losing credibility and undercutting recovery,” she said. Note: What she is advocating is turning up the money printing presses. But there’s a problem – Germany, the strongest country in Europe isn’t keen on the idea of sacrificing their decent economic situation to help bail out those countries that have shown neither the want nor desire to implement the economic structural changes necessary to rectify the causes of their poor financial condition.

Additionally, Tim Congdon from International Monetary Research said it is folly to force Europe’s banks to raise money too quickly or crystallize losses abruptly. This will cause a monetary implosion and a repeat of the 2008 disaster. He said the ECB’s restrictive policies over the last 18 months and the lack of EMU fiscal union have doomed the euro. to certain break-up.

“It cannot be saved. Banks will suffer large losses,” he said.

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