Time to Fire up the Chopper, JC

With Greece spiraling out of control, Europe is faced with its own Lehman moment. The situation in Athens is untenable. The Greeks are facing years of deflation in order to regain their competitiveness. Although the introduction of the euro removed the notion of local currencies, each country had its own inflationary environment. Countries were free to set their own wages and social benefits, as long as they remained within certain fiscal criteria. Unfortunately, some countries were able to game the system by underreporting expenditures and keeping liabilities off balance sheet. As a result, their relative prices appreciated, thus reducing competitiveness.

In other words, the euro was never a unified currency. It was a peg. On top of that, it was an illusion that gave investors a great deal of confidence, and allowed countries to over indebt themselves.  This combination of pegged currencies and over leverage is a recipe for disaster. It is also a lesson that the emerging markets learned well during the 1980s and 1990s. Marked by the indelible scars of maxi-devaluations, hyperinflations and debt crises, policymakers vowed never to repeat such mistakes. This why low debt levels and flexible exchange regimes are mainstays through Latin America, Russia and South East Asia. It is also why a devaluation/default in Greece, and perhaps other parts of Southern Europe, are inevitable. Unfortunately, the exposure of European banks to this panoply of countries is immense, and there is no way they can escape the carnage. In the same way that Federal Reserve Chairman Ben Bernanke had no other choice, but to flood the U.S. financial system with trillions of dollars of government money when he found it on the brink of collapse, European Central Bank President Jean Claude Trichet will have no other option but to start up his helicopter.

As much as JC Trichet may abhor opening the monetary taps, he has no choice. European banks, such as Fortis, Dexia and SocGen, are heavily exposed to Greece. Unfortunately, there is no clear delineation of the exposure. Given this uncertainty, banks are reducing their lines with other banks-thus triggering a massive monetary tightening. The TED spread is surging.

Although it is far from the 463 basis points that was recorded during the Lehman collapse, it tripled since mid-March to a level of 31 bps. The problem is that Greece is only 3% of the European Union, while some of the other Mediterranean countries are much larger. The Spanish economy is three times the size of the Greek economy. Italy is twice the size of Spain.

Therefore, a collapse of the so-called PIGS will detonate like a nuclear bomb over the financial sector, thus making the Lehman collapse look like a firecracker. This is the reason why members of the EU spent the weekend cobbling together a package to support the European financial system. They also took steps to increase funding for Greece. However, the electorate is restless. German Chancellor Angela Merkel’s CDU party was edged out by the Socialists in the North Rhine-Westphalia (NRW) elections on Sunday, mainly due to voter anger over the assistance extended to Greece. In a bit of political theatre, British Chancellor of the Exchequer Alistair Darling said that any package put together to help euro countries should be funded only by euro countries. Given that only 16 of the 27 European Union members share the euro, the burden will fall heavily on Germany, France, Norway, Holland and Austria. Some analysts say that Germany will never put up with such a thing, and that it may end up exiting the euro if it has to bail out spendthrift countries, such as Greece, Portugal, Italy and Spain.

Unfortunately, the global economy is extremely fragile at this moment. The U.S. economic recovery is far from consolidated. China may be slowing down, and the large global banks are acting like mega-hedge funds. Instead of using the expansive monetary conditions to lend to the real economy, banks are buying up liquid securities, driving up prices and booking huge profits.

A major monetary tightening, due to a contraction of interbank lending, will force financial institutions to dump paper. Moreover, the markets are ever becoming more obscure. Although the bobble heads on the financial media networks attribute last week’s crash to a “fat finger,” the more likely explanation was the high frequency trading and dark pools that are proliferating within the dungeons of the usual Wall Street suspects. Hence, we could be in for a calamity. The only way to avert a collapse of the European system will be a massive injection of liquidity, which will only lead to an eventual depreciation of the euro.


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