The Eurozone Crackup
by Mike Whitney
August 22, 2011
“We believe that the market has now entered a major downtrend. It is a mistake to dismiss the slide we’ve seen to date as mindless and devoid of fundamentals as many strategists maintain. These are not just scary headlines—-they are scary fundamentals…. There will undoubtedly be some more sharp rallies that will be interpreted as new bull markets. In our view, however, the bear market has only begun, and has a long way to go.”
— Comstock Partners, “Bear Market Rally Far From Over”, Pragmatic Capitalism
A toxic combo of poor economic data in the US and a widening credit crunch in the eurozone has sent stocks plunging for a 4th consecutive week. On Friday, the Dow Jones Industrials fell 172 points as jittery investors exited equities for the safe haven of cash and government debt. Global equities have lost more than $6 trillion in the last month alone while the yield on the benchmark 10-year Treasury dropped to a record 1.99 per cent on Thursday. The low yields on Treasuries indicate the growing fear that troubles in the EU are reaching a crisis-phase. Political gridlock has increased volatility and triggered a slow-motion run on the EU banking system. The same process unfolded in the US for a full year before Lehman Brothers collapsed (from July 2007 to Sept 2008) putting the financial system into a death-spiral. Now it’s Europe’s turn. This is from the Wall Street Journal:
“A dramatic sell-off in European financial markets on Thursday renewed fears that Europe’s banks are too weak to withstand the Continent’s debt crisis, increasing the chances that the region’s leaders will be forced to pursue radical steps toward fiscal union in order to preserve their single currency….
“That realization has in recent days prompted Germany, the region’s economic powerhouse and an opponent of fiscal union, to reconsider proposals that would force it to accept responsibility for the debts of its neighbors. Thursday’s markets rout, the worst in Europe in more than two years, suggests Berlin and Paris may have to act quickly. If investors lose confidence in the region’s banks, Europe’s financial system could seize up, tipping the euro zone into another recession.” (” Renewed Fears Europe’s Banks Too Weak To Withstand Debt Crisis”, Wall Street Journal)
The situation is progressively getting worse. Money markets, commercial paper and the repo markets–where banks get their funding–are all under pressure. The time to act is now, but EU leaders remain frozen in the headlights.
The only way to save the 17-member monetary union is through greater integration, that means a central fiscal authority that can help to level the playing field between the richer and poorer countries. But many of the countries–particularly Germany–do not want to create a fiscally viable EU because it would require them to subsidize the weaker states via eurobonds which they oppose. And, there’s the rub; without Germany on board, the banks will be forced to write down the losses on the bonds they hold, which will erode their capital and spark another credit crisis.
Presently, the ECB is purchasing the sovereign debt of countries in the south to prevent a freeze in the credit markets. But the ECB is operating on an emergency-only basis and does not have the institutional authority to implement the same policies in normal times. This band-aid approach has investors worried, which is why they continue to move money out of money markets to deposit accounts or risk-free assets like US Treasuries.