Global Economic Collapse Imminent?

Alarming words from the head of the IMF: a global economic collapse could occur within weeks if something isn’t done head off the ongoing crisis in Europe.   The warning may seem overblown, but the danger is real.

Here’s the problem: unless investors are convinced that bonds issued by Greece, Spain, Portugal, Italy and Ireland are safe, they’ll start selling them off in the bond market.   That will drive down the price (supply increases, demand will be low).   When the price of a bond falls, that increases its interest rate.    An Italian bond set to pay off 1000 Euros in three years might normally cost 940 Euro, meaning you’d earn 60 Euro (about 2% per year) on your investment.  But if people start thinking the Italian economy is going to tank then the price may drop dramatically — the 1000 Euro bond might cost only 850 Euro, meaning a 5% yield, or go even lower. Right now the Italian 10 year bond has a 5.5% yield rate.

By comparison, US Treasuries have about 2% yield on the ten year bond, as does Germany’s.  This means that if the US and Germany sell bonds to finance government debt, the cost is relatively low — 2% a year.  If Italy wants to run deficits, they pay a much higher interest rates.    Now, guess what Greece’s 10 year bond yield rate is.   23%.   That is simply unsustainable even in the short term.  It shows that people are expecting a Greek default and thus dumping bonds to those who want to take a big risk to potentially pocket a 23% investment gain.

Spain is also at about 5%, but Portugal’s bond yield is 11%, and Ireland’s at near 8%.  Those are getting into very high risk territory.   Now, at this point all these yields are kept somewhat low (relative to what they could be) by the hope/expectation of an EU bailout.   The EU has intervened in Greece, Greece has undertaken a very unpopular austerity program (after all you can’t keep running up debt borrowing at 23%!), and the panic has been minimal.

But what if the EU can’t save Greece?   Then the Greeks will likely default, they simply can’t make payments on their bonds.  The bond holders — banks throughout Europe (including Germany) will then be under stress, as some of their assetts become worthless.  Still, if it stopped there, that wouldn’t be that big of a crisis.  The danger is Contagion.   Holders of Portugese, Italian, Spanish and Irish bonds would realize that the world has changed: default is possible.    Yields on all those bonds would likely rise dramatically creating default threats across southern Europe.   At that point bank assets would be so stressed that credit markets would dry up and the European economy would be hit by a crisis larger than what hit the US in 2008.

US and British banks are relatively unexposed, but the economic impact would be to sink the world deeper in recession.   But it doesn’t end there.

Banks, including those in the US and UK, have been issuing credit default swaps on these bonds.   These swaps can be seen as akin to a life insurance policy.   Let’s say your neighbor confides with you that he has cancer, even though he’s young and fit.  You then go to an insurance agent and buy a life insurance policy on him for $1 million.    You pay a policy of $300 a year, but if the cancer kills him you could get $ 1 million.

Insurance companies sell these policies because statistically they don’t expect to make large payments.  Most of us go through life paying for insurance “just in case.”   But in the world of finance it’s more like a casino.    The credit default swaps are cheap, but have a potentially very large payoff.   It’s like placing a bet on a long shot horse — you’ll probably lose, but if you win the earnings are big.   So if you decide to bet against the EU and Italy, you can buy credit default swaps on Italian bonds.    If the bonds mature and Italy pays their value, you get nothing and lose the “premium” you paid to buy the swap.   But if Italy defaults, you get the value of the bond — potentially a huge pay off.   That happened back in the US when owners of credit default swaps on mortgage backed bonds made a killing when the real estate bubble burst.

The thing is, we don’t know how exposed banks are in terms of credit default swaps.  If they’ve felt confident that the crisis would be contained, they may be very exposed.   So even banks that don’t directly hold bonds might be on the hook if defaults spread.   That would add to the depth of the crisis and could spark a breakdown in the entire financial system of the kind that the bail outs of 2008 managed to avoid.    In such a case credit would be very difficult to come by, even for “safe” auto loans, perhaps even credit cards would be hit.

If the EU doesn’t manage to convince investors that Greece will not default the whole thing could spread quickly — within weeks.   If the EU came up with a very comprehensive package they could allay fears and Greek yields would come back down to earth and overcome the crisis.   It would be a couple years before deleveraging would get them out of the woods, but investor confidence would return and the system would survive.

However, although this may look like a no brainer in those terms, in political terms it’s a tough sell.   Any kind of package that saves the system would appear to be a bail out of countries who had been irresponsible in their borrowing and spending, and protection of banks who made irresponsible loans.    That would be very unpopular in countries like Germany, which would pay a lion’s share of the cost.   But it would also be unpopular in Greece, whose people protest cuts in spending and increases in taxes.   In their eyes they’re being made to suffer for mistakes of bureaucrats and banks, and a mix of spending cuts and tax increases assures a deeper recession and more pain.   They’d rather default than suffer austerity.   So the moves needed to save the global political economy are by nature very unpopular and arose anger.

Most people don’t know how bonds work, wouldn’t know a credit default swap from collaterized debt obligation, and have no sense of just how interconnected the financial industry is world wide.  The argument supporting such “bailouts” is only persuasive if you really work through the intricacies of how the financial system functions.  Most voters don’t do that, so any politician who tries to save the system will probably lose their job.

With so much on the line I think they’ll find a way to avert catastrophe.   The stakes are just too high, and the insiders know what the stakes are, and how inaction could mean utter catastrophe.    Still, the danger is real.   That’s why stories about European bond yields and bailout plans may be the most important news to follow in coming weeks.   Global economic collapse is still unlikely, but quite possible.