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.