This is a classic liquidity crisis

I was on CNBC tonight talking about the market meltdown and the crisis in Europe. When I get the video I will post it. But I made the point earlier today in my post “Euroscepticism” that

this is a liquidity crisis and the way to deal with liquidity crises is by providing liquidity. The only player left on the ice that can credibly provide that liquidity is the ECB. Once the liquidity concerns are dealt with, the euro zone can move to deal with its structural deficits. But if the ECB doesn’t step in, the euro zone won’t have the opportunity.

This is a classic liquidity crisis. Bond markets in Europe are selling off. Commercial paper markets in the US are seizing up. Retail investors in Asia are already running for safety in overnight trading. What we are experiencing is a market panic and that means liquidity is the first order of the day.

The sovereign debtor solvency issues in Europe are medium term issues. Even the obviously insolvent Greece has yet to give principal haircuts to creditors. The proposed restructuring is just another exercise in extend and pretend. And yet Greece is fine for now. So liquidity can tide the market over until the panic passes and then that’s when the solvency issues should be dealt with. Yes it is a solvency crisis. But the liquidity issues are the pressing ones right now.

My concern is this: I think the ECB will eventually step in here. They have already gone in the market for Ireland and Portugal. The ECB increased liquidity for banks, offering up unlimited funds for six months. These are nice measures. But they don’t go nearly far enough. They will have to act as lender of last resort for the entire euro zone and eventually they will accede to this.

The problem is what happens between now and then. You saw the interview with Elga Bartsch of Morgan Stanley. She was saying the ECB can step in at any time if need be, meaning there is no rush. And that is certainly the way the ECB has acted. However, I think this kind of panic we are witnessing right now, this kind of market meltdown, will have grave consequences for a European and American economy already at stall speed.

Imagine the ECB does step in after we get so much market turmoil that interest rates in Spain and Italy are permanently higher and high yield bond issuance slows to a trickle. Imagine that business confidence in Germany and the US tip the manufacturing PMI’s below 50. What then? I say that means double dip. And double dip means recession not just in the US or Italy or Spain, but in Germany, France and Sweden as well. Recession means higher deficits across Euroland and an embarrassing breach of the Maastricht deficit hurdle by Germany, putting it over on both debt and deficit levels. A Maastricht breach by Germany means no EFSF top up, no fiscal transfers, no central Treasury, none of that.

There are many more scenarios I could give you about bank writedowns and bankruptcies, municipal defaults and so on. But I think you get the picture. We are at a very fragile point in the economic cycle. Dithering now means playing Russian Roulette with the global economy and risking the biggest banking crisis since 1931.

The time to act is now.

  1. PBlacque says

    1) You are putting a lot of trust in the ability of the ECB to stem the tide (via liquidity injections)… I’m not sure it can do much for the solvency issues lurking just beneath… at least not at the right price/premium.

    2) Assuming Germany all over sudden agrees with the concept of a fiscal union… just how do you see that concept functioning in such a culturally heterogeneous group of nations? And if such a fiscal union doomed, than what to say of the EZ?

    1. Edward Harrison says

      The ECB can do nothing for solvency. However, it can take on the role for Spain, Italy and Belgium that the Fed does for the US. That’s why treasuries are at 2.41. If the ECB said it stood behind the Italians and Spanish and Belgians in a meaningful way, we wouldn’t be having this panic.

      1. PBlacque says

        S&P is about to downgrade US… largely because of debt levels brought on, in some measure, by the FED’s liquidity interventions… So how would similar ECB actions save the day for the EZ? This is a solvency crisis, right?

  2. John Haskell says

    I think we’ve pretty much gotten to the point where they either load an Antonov with E500 notes & fly it to Milan or “this sucker could go down.” ECB needs to figure out what is the absolute max it can do and do it yesterday.

  3. Matt Stiles says

    CPR on a corpse.

  4. David Landro says

    We’ll see how far this landslide goes.

    1. David Lazarus says

      All the way down to 660 for the S&P.

  5. Sascha says

    well, on look at the US shows, that even though the FED pumped Liquidity into the market to keep interest rates low rating agencies call the elephant in the room, namely the huge dept, and warn to downrate the US.

    I’m afraid, that once the ECB goes the same path as the FED and starts buying large amounts of bonds from EU countries rating agencies and as follow up the markets themselves will start to doubt the solvency of all euro countries, not just the insolvent PIIGS…

    1. Edward Harrison says

      The analogous liquidity from the recent crisis was provided in late 2008 and early 2009. And while the Fed continued its liquidity injections and monetary easing afterwards, they have claimed this was to support economic activity, not to act as a lender of last resort. So this is not the same animal. See here:

  6. Doc at the Radar Station says

    The recent GDP revisions show the US had not yet reached nominal GDP when the last recession started (in 2007). If that’s true and we are found to be in recession in the last half of 2011, that would technically be part of the previous recession and not a “new” recession, correct?

    1. Edward Harrison says

      It means that we are still in a technical recovery.

      The recession ended in 2009 when the economy showed growth across the broader spectrum of economic activity using data points like consumer demand, jobs, and production. This inability to leave a technical recovery means that any recession that began in the near future would be considered a double dip recession.

  7. Jay Grills says

    Think more like traders if you want to guess at the timing of the next stimulus/QE. We get one after a MAJOR fall in the markets. 10% ain’t major. Maybe 25% would motivate the Central Banks. Also consider the playbook from the oil reserve release. They sold that into a falling market, so expect stimulus to buy into a rising market after it is already bouncing back from a low, low bottom. Our Central Banks feel there is no better way to like a genius than to cause/predict/take credit for what happened yesterday without you – as long as it’s good news. Any bad news must be due to a “shock”.

  8. Laturb says

    I’m getting bored with the same old, same old.
    When will the Fed and the ECB (and most economic pundits) try a heavy dose of frankness, and admit that they have absolutely no f#@i&*% idea what needs to be done, and so continue to kick the can further and further down the road, in a futile attempt to be proved right.
    Problem is, the road of recovery we have been balancing on, so precariously, will soon become a molten mass of false dawns that can neither feed, house or clothe us, whilst the can…well that will finally reveal itself as the abyss. Just one more kick!

  9. Billy Jones says

    Musical chairs with no adults in the room.

    1. joe n says

      I was reading an article earlier today that the ECB doesn’t have the arsenal or speed of quantitative easening techniques as the USA fed…anybody want to comment on that…

  10. David Lazarus says

    This is not a liquidity crisis. There has been much buying on margin for some time. A slide like this will expose those who have bought excessively on margin. How much was funded by QE? We will soon see who was caught out when the central banks start refinancing the banks.

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