The entirely pointless G7 meeting this weekend only served to underline the fact that Europe is again entering a serious economic crisis.It may not all breakdown this week, but Johnson has the picture correct. Phase one of the double dip Great Recession, and the accompanying great demand to hold cash, has resulted in extreme financial pressure on the most profligate government spenders, who won't be able to get enough cash to meet their future debt obligations.
At the end of the meeting yesterday, Treasury Secretary Tim Geithner told reporters, “I just want to underscore they made it clear to us, they the European authorities, that they will manage this [the Greek debt crisis] with great care.”
But the Europeans are not being careful – and it’s not just about Greece any more. Worries about government debt and associated public sector liabilities (e.g., because banking systems are in deep trouble) have spread through the eurozone to Spain and Portugal. Ireland and Italy are next up for hostile reconsideration by the markets, and the UK may not be far behind...
The IMF cannot help in any meaningful way. And the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings. Unconditional bailouts are simple – just send a check. Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.
The financial markets know all this and last week sharpened their swords. As we move into this week, expect more selling pressure across a wide range of European assets.
As this pressure mounts, we’ll see cracks appear also in the private sector. Significant banks and large hedge funds have been selling insurance against default by European sovereigns. As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).
Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008. And generalized counter-party risk – the fear that your insurer will fail and this will bring down all connected banks – raises its ugly head again.
In such a situation, investors scramble for the safest assets available – “cash”, which actually (and ironically, given our budget woes) means short-term US government securities. It’s not that the US is in good shape or even has anything approaching a credible medium-term fiscal framework, it’s just that everyone else is in much worse shape.
Another Lehman/AIG-type situation lurks somewhere on the European continent, and again our purported G7 (or even G20) leaders are slow to see the risk.
In the old days, these countries would simply print more money, but the PIIGS (Portugal, Italy, Ireland, Greece, Spain) are all in the Eurozone pen and it is unlikely that Germany and France will agree to debase euros, by printing more of them, to bailout the PIIGS. Thus, the continued intensifying global sovereign debt crisis
The UK is in a different situation, given that they CAN print their way out of a financial crisis, though with enormous inflationary consequences. But who is going to look at the niceties of differences during a global sovereign debt panic? The answer as to who should be looking is, of course, you.
The sophisticated play here is to go long UK debt on any weakness, while hedging the currency risk by shorting the pound. Any flight into Treasury securities should, of course, be looked at as temporary in nature and an opportunity to add to these short positions.