Written by John N. Katz, The Goldwatcher
‘A financial crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought.’ The ‘law’ stems from an observation made by the celebrated macroeconomist the late Rudi Doornbusch after the Mexican debt crisis erupted in the 1980s.
This article addresses the summit of Europe’s leaders held in Brussels on Friday the 15th and Saturday the 16th March. I started writing a day before the summit commenced quoting Dornbusch’s law and noting the euro crisis that started in 2010 with revelations Greece was insolvent was still lumbering on.
News on the financial bail out of Cyprus, with a ‘haircut’ for depositors, announced after the meeting on Saturday the 16th has eclipsed all other summit outcomes. In a Financial Times article headlined ‘Europe’s Leaders Run out of Credit in Cyprus’ Gideon Rachman explains
‘European leaders must surely know that they are taking a big risk with Cyprus. The danger is obvious. Now that everybody with money in Cypriot banks is being forced to take a hit, nervous depositors elsewhere in Europe might notice that a dangerous precedent has been set. Rather than run even a small risk of an unwanted financial “haircut” in the future, the customers of Greek, Spanish, Portuguese or Italian banks might choose to get their money out now. If that starts to happen, the euro crisis will be back on again – with a vengeance.’
I have four brief comments on the Cyprus issue now. First every 2oth century peacetime monetary union break-up started with depositor flight and bank runs. Second the way the news was dumped at the end of the summit was haughty, incompetent, reckless and dangerous. Third if the euro crisis comes back with a vengeance the consequences will be orders of magnitude more damaging than the 2008 Lehman crisis that triggered the great recession. And fourth, yes, Dornbusch’s law has been proved right again. Things are now happening faster than we thought they would.
Italy’s political crisis and the summit:
We expected the Summit to address the game changing political crisis following the recent Italian elections. But the summit was more concerned with the forthcoming German elections and paid scant attention to warnings on massive youth unemployment and loss of public support for Europe that came from from Mario Monti, the ousted technocrat they had installed as Italy’s Prime Minister.
Paul Krugman’s 2011 warning on an Italian and French Banking crisis:
In a 2011 comment titled titled ‘Eurodämmerung‘ addressing the errors of judgment that led to the Euro crisis Krugman wrote:
‘…Let’s just say that the euro was an inherently flawed idea that can work only given a strong European economy and a significant degree of inflation, plus open-ended credit to sovereigns facing speculative attack (and)…everything was going to blow apart without an effective lender of last resort.’
Seeking an answer to the question how the final act will be played out he wrote :
‘I guess soaring rates on Italian debt leading to a gigantic bank run, both because of solvency fears about Italian banks given a default, and because of fear that Italy will end up leaving the euro. This then leads to emergency bank closing, and once that happens, a decision to drop the euro and install the new lira. Next stop, France.’
Krugman acknowledged this sounded apocalyptic and unreal but he asked, ‘How is this situation supposed to resolve itself? The only route to avoid something like this involves the ECB ‘totally changing its spots fast and that’s not expected at this stage.’
This was of course written before the appointment of Mario Draghi as the ECB President who ‘changed the spots’ with his commitment ‘to do whatever it takes’ to save the euro,’ - and his success in mobilising over 1.5 trillion euros to support Europe’s banks.
Mario Draghi takes the stage:
The following chart from Mario Draghi’s power point presentation for the summit on euro area economic situation and the foundations for growth illustrates how successful he has been keeping the euro project afloat:
Click on graphic for larger image.
The chart is captioned ‘confidence returning’ and the numbers do speak for themselves. But the question must be raised whether the chart tells the the full story. Or, put another way, where would interest rates be without the near zero interest ECB funding Draghi has injected into the system?
Keep in mind also that Italy isn’t doing at all well compared to Germany as evidenced in the following chart Asymetric Unemployment Germany & Italy
Europe’s vicious cycle of falling GDP and rising unemployment:
The above chart highlights Italy’s unemployment crisis and why there is a case to make that the euro isn’t working for Italy. Further, as clearly illustrated in these Reuters Charts, Europe’s ‘fiscal pact’ is also driving GDP down. The falling GDP line and rising unemployment lines in the charts are on a collision course. Little surprise then that commentators who branded Europe’s fiscal pact a suicide pact are being proved right.
Will the gold price surge?
I discuss gold price expectations in a recent Goldwatcher comment on Central Bank Gold Monetisation with links to recent Goldwatcher postings on Italy listed at the end.