Comparing U.S. and Euro Crises

by Elliott Morss


The best weather forecast comes from watching the trends: if the chance of rain increases as you get closer to the day of interest, it will probably rain….  So I start by looking at what has been happening to IMF, OECD, and World Bank predictions for economic growth for the next two years. Following that, I compare the US bank collapse and its outcome with what might happen in Europe.

Prediction Trends

Table 1 presents trends in IMF growth projections. The first column for each year gives their most recent estimate. The second column is the absolute difference between that projection and one they made in April 2010. Back then, the recovery from the global recession has occurred in most emerging nations. And even in the West, the recovery was gaining traction. But then, worries about sovereign debt in Europe started, and policymaking in Washington became dysfunctional.  The trend is not good: things are getting worse.

The IMF lowered its estimate for global growth by half a percentage point for 2011 and by 1.2 percentage points for 2012. The Eurozone was buoyed up by Germany in 2011, but things are expected to get much worse for Germany and the Eurozone in 2012: we ain’t seen nothing yet!

And I ask you: after all the experience the IMF has had, how could it have been roped into pushing a German austerity plan in Greece so severe and complex that it had no chance of working? And as I have reported, the strong Euro nations are now angry because the IMF is finally saying austerity in the “weak sister” Euro countries won’t work. Why did it take so long for the IMF to catch on?

And for something really worrisome, put the expected growth rate declines in the Euro countries that are in trouble against their projected unemployment rates, i.e., Greece 19.5% in 2013, Ireland at over 14%, and Spain approaching 23%! These are clearly recipes for more street riots and government overthrows.

The OECD adds a downside scenario to its predictions, where the downside is characterized by “intensification of Euro-Area crisis and excessive US fiscal consolidation”. And while I doubt there will be excessive fiscal consolidation in the US because it is an election year, the downside estimates are worrisome.

Source: OECD

Similar “downside” scenarios have been done by industry associations. For example, IATA, the international airline trade body, estimates net profits at $3.5 billion in 2012 without a crisis but a loss of $8.5 billion with a crisis.

A Little Perspective

For better or worse, we have a useful frame of reference for what is now happening in Europe – the US bank collapse followed by the global recession. In Table 3, indicates what happened then to the global economy.

The projected downturn numbers presented in Table 2 are quite serious relative what happened in 2008-2009. So let’s review what happened earlier and speculate about what might happen now.

The US Bank Collapse/Global Recession Revisited

As I have written, the “mechanics of the global recession were:

  1. The inevitable downturn in the US real estate cycle, leading holders of mortgages and their derivatives to question their worth.
  2. Most (more than 90%) of mortgages were OK, but the lack of documentation on their derivatives caused a complete meltdown in that market.
  3. Word got out that US banks were on the verge of collapse.
  4. Panic ensued, causing global losses of $50 trillion ($36 trillion equities, $14 trillion);
  5. $50 trillion in losses is significant inasmuch as global GDP was running at $60 trillion annually.
  6. The negative wealth effect of this loss lead to a drop in global spending (consumption and investment), and that spending reduction kicked off the global recession.
  7. In early 2010, even the deficit and debt-ridden Western countries developed had started to recover, but then the Euro Crisis hit.

As Table 4 indicates, most stock markets have bounced back to 80%+ of their peaks in 2007. In contrast, real estate markets are still at their lows.

The Euro Crisis

Things are very dangerous in Europe. Several things could happen that would cause further global panic. Remember that unlike mortgages, where people can postpone borrowings, the weak Euro countries need to refinance existing debt and borrow more to cover government and balance of payments deficits. The IMF recently tallied up what the weak Euro countries will need in 2012 (Table 5). Recognize that no private sector investor wants to lend these countries money.

And then there are the banks that apparently are of greater concern to the Euro leaders than its citizens. As in the US case with mortgage-backed securities, banks have bought sovereign debt from these countries, repackaged it, and sold some of it off with guarantees. In an earlier piece, I estimated country bank exposures to “weak sister” debt as a percent of total deposits as follows: France (16.5%), Germany (10.7%), UK (9.3%), US (9.3%). And the New York Times just reported that five of the largest US banks have exposures of $80 billion. So what could happen? How about a managed default/haircut? Or more worrisome, how about a unilateral default by one of the “weak sister” countries? What then happens to the required asset to default ratios of banks holding sovereign debt of the defaulting countries? Oh, maybe they are holding some form of insurance? The NYT reports that the five banks mentioned above have “insured” somewhere between $30 and $50 billion of their holdings. How? By credit default swaps and other derivatives. Hm. How did they work in the US case?

But things could get much worse. Rumors that banks are struggling could cause runs on banks. These are never good.

The Germans press on with austerity demands. They are now asking the Greek government to cede control over its finances. This suggestion did not go down well with the Greek government. It is hard to believe there will not be more government collapses and riots in the streets.

So what are the big financial players doing? Everyone is angry with the others. The IMF is pressing Eurozone countries to raise more money. The US is saying “this is a European problem”. And the Eurozone countries have just agreed that going forward, no Eurozone member can run a deficit greater than 1% of GDP. Okay. Splendid, just legislate it. They also issued a declaration to “restart growth and combat joblessness across the Continent”. What? You want to restart growth/reduce unemployment while eliminating fiscal policy as a way to achieve that end?

This is all make-believe stuff.

Investment Implications

The situation is extremely dangerous with no apparent resolution in sight. More panic is probable. For that reason, I will satisfy myself with the 4% to 6% returns I can get on emerging market debt (ELD and TGEIX) and US real estate (FRIFX).

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