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Euro crisis morphs into the sovereigns' subprime

EU crisis, EU bailout | Euro crisis morphs into the sovereigns' subprime Ian Fraser

Hope triumphed over fear with last Sunday night's dramatic €720bn ($1 trillion) EU/IMF intervention to prop up the eurozone, but there remain widespread suspicions that this solution—dubbed the biggest bailout in history—may yet prove too little too late to save the eurozone.

Even after news of the IMF/EU bailout package, which wrongfooted investors who were betting on a Greece default, dribbled out from Brussels on Sunday night and Monday morning, there remain disturbing parallels between the subprime crisis of 2007–09 and the euro's current existential crisis.

As Reuters financial blogger Felix Salmon put it:

While the EU’s trillion dollars is, surely, sufficient to prevent any country from having to default in the next few years, I fear its enormity will only exacerbate tensions between the eurozone countries in the longer term ... They’re bifurcating into rich lenders, on the one hand, and formerly-profligate debtors, on the other.

Both financial crises were caused by a combination of over-generous lending by reckless, high-yield-seeking banks and other financial institutions in a low interest rate environment, and irresponsible borrowing by people (and countries) whose fiscal indiscipline and profligacy meant their chances of repaying their loans were limited.

In their genesis phase, both financial crises were accompanied by a feeble policy response that showed central bankers and politicians to be asleep at the switch. The European Central Bank and the eurozone governments spent weeks debating whether to come to the aid of the profligate Greeks—even as markets spurned two-year Greek bonds. In Germany, in particular, there was a (accurate) fear voters would punish any party that bailed out the Aegean nation at the polls.

In a recent Wall Street Journal column, Dow Jones correspondent Michael Casey said in both financial crises, the markets and the politicians initially ignored the red flags.

He pointed out that when the Greek government announced a higher-than-expected budget deficit in late 2009, the markets and EU leaders turned a blind eye. Nobody believed this could put the entire eurozone at risk. He pointed out there was similar complacency on Wall Street and in the US government when the US subprime market started to turn rancid in 2006. The prevailing view at the time was this was either "a blip" or containable.

Both the banking and the sovereign debt crises started in relatively small but self-contained markets but quickly spread worldwide. In the case of the euro crisis, investors are relieved by the EU bailout, but remain concerned that governments have borrowed so much they may struggle to revive their flagging economies.

Mohammed El-Erian, CEO of Pimco, said the European policy response had morphed into the “whatever it takes” mode of crisis management. Exactly the same happened once policymakers woke up to the fact subprime was about to cause financial armageddon.

Yet the financial system remains vulnerable largely because globalization means there are fewer firebreaks in the financial system. The web of interconnectedness between financial institutions worldwide means an isolated dose of strychnine can poison the entire financial well.

As fear stalks the interbank lending markets, Dow Jones's Casey said banks are "once again fretting about counterparty risk—something that is particularly evident in credit default swaps."

However there are also significant differences between the Greek affair and subprime. As Casey says, interest rates are now so low that "banks enjoy a wider comfort zone and have less need to unwind risky positions." And another difference is that governments tend to take a more collegiate view of their rivals than banks—they lack banks' vested interest in seeing their rivals fail. Thirdly governments theoretically have unlimited monetary resources.

Casey concluded by saying: "As the Greek saga progresses, lets hope these differences with 2008 outweigh the similarities." I'll second that.

Further reading on sovereign debt and the Greek financial crisis

Tags: central banks , economic recovery , EU , European Central Bank , European Monetary Union , fiscal stimulus , Greece , IMF , sovereign debt
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