Global Economic Crisis

When  the Obama Administration assumed office in early January 2009, the President’s chosen Secretary of the Treasury, Timothy Geithner, was already on record as estimating that the United States banking sector was in such dire straits resulting from the global financial and economic crisis triggered by the collapse of leading investment banks on Wall Street, it would require $2 trillion in government bailouts to repair the damage. However, once in power, President Obama and Secretary Geithner were reluctant to ask American taxpayers for another handout for Wall Street after the highly unpopular $700 billion TARP bailout. Their response was to rig a series of so-called banking stress tests,  which were completed in the spring of 2009. Only months after the near implosion of the global financial system, Geithner’s stress tests supposedly showed that the U.S. banks were in such excellent shape, only a handful required a measly $75 billion in recapitalization, a sum that could be easily raised through private investors. Never mind that Geithner’s stress tests  incorporated “worst case” unemployment rates that were already eclipsed by the summer of 2009 and other less-than-rigid assumptions. The market seemed to be charmed by Geithner’s charade, attested to by rising equity values of financial firms. Now the Europeans hope they can pull off the same performance.

With much fanfare, the Committee of European Banking Supervisors has announced the results of their own engineered bank stress tests, involving 91 banking institutions in 20 European countries. The architects of this banking Eurofest knew they could not show that all 91 had “passed” the stress tests, as this would simply not be credible even to the most gullible. For that reason, seven banks were selected as sacrificial lambs, and revealed as having failed the stress test, including five relatively minor Spanish banks, as well as the much larger state-owned German property and municipal funding specialist, Hypo Real Estate. This latter financial institution was so heavily weighted with toxic real estate assets, providing it with a passing grade would clearly have given the game away. However, despite the not unclever manipulation engaged in by the Committee of European Banking Supervisors, a growing number of observers and investors have begun to see through this farcical exercise.

Consider this; how valid can a stress test of European banks saturated with government bonds and other long-term public debt instruments really be if the supposed “worst case scenario” envisions no possibility of sovereign debt default in Europe? Only months after Greece was on the verge of public debt default without a massive Eurozone financial bailout, in turn funded by European countries that are themselves becoming increasingly mired in a profound sovereign debt crisis? Neither did the tests consider the possibility of a real estate or commodities crash, despite warnings that, among other dire possibilities, a global commercial real estate crash is increasingly likely.

The authors of this banking stress test would have one believe that not a single UK bank is in danger from worsening economic developments, despite a warning issued by analysts at the Royal Bank of Scotland to senior British policymakers in January 2009, entitled “Living on a Prayer,” which stated that almost the entire banking sector of the United Kingdom was “ technically insolvent.”

In February 2009, the European Union’s own executive branch, the European Commission, issued a confidential report, subsequently leaked to the British newspaper, The Daily Telegraph, which warned that European banks collectively held as much as 18.6 trillion euros in toxic assets. In the past 18 months we have witnessed a massive expansion of public debt  across Europe to fund economic stimulus programs, which has produced at best anaemic or stagnant growth figures, at the price of catastrophic levels of sovereign debt, prompting these same countries to now reverse fiscal policy and revert to budget trimming austerity measures. The likely outcome is clear; a double-dip recession in Europe, in conjunction with a lack of financial capacity by European taxpayers to again bail out their banking system to the same profligate degree that was undertaken after the collapse of Lehman Brothers.

As with Timothy Geithner, the architects of the European banking stress tests hope that  investors and the general public will believe their farce, based on totally unrealistic and overly-optimistic scenarios. In the case of Europe, the fervent desire is that the banks which are rightfully worried about counterparty risk will jettison their well-founded anxieties, and resume interbank-lending and credit flows at pre-crisis levels. However, as the American experience reveals, a banking stress test based on public relations requirements rather than realistic financial and economic modeling may boost the stock price of major banks, justifying  massive bonus payments to banking executives. However, as a solution for the continuing credit crunch and economic turmoil, it is no more than a tragic-comedic farce designed by committee.

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A new force in assessing credit risks has emerged in spectacular fashion. Until now, Fitch, Moody’s and Standard & Poor’s have dominated the rating of investments, securities, bonds and sovereign debt. However, given the deficient performance of these three agencies in missing the sub-prime debacle in the United States, it is perhaps not surprising that a relatively new agency has arisen from the country that is now the leading creditor state within the global economy. Dagong Global Credit Rating Co. Ltd., founded in the People’s Republic of China in 1994, has issued its own rating of sovereign debt, and it’s not a pretty picture.

Dagong challenges its three Western competitors by downgrading the U.S. and UK, denying them the AAA status granted by the other ratings agencies. According to Dagong, the United States is rated AA with a negative outlook, while the United Kingdom is accorded an even lower AA-, also with a negative outlook.

When the leading credit ratings agency in the country upon which the United States and UK are most dependent on for purchasing their public debt downgrades their fiscal capacity and credit worthiness, it is a sign that the sovereign debt crisis afflicting a growing number of advanced economies is far from its peak, despite assurances from politicians and central bankers in Europe and the United States. Dagong may become an increasingly important player in the next phase of the global economic and financial crisis.

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In February 2009, my blog referred to a story that appeared in The Daily Telegraph, a leading UK newspaper, headlined, “European bank bail-out could push EU into crisis.” The essence of the story was that The Daily Telegraph was shown a top secret document, leaked from the European Commission, the executive body that oversees the 27 nation European Union, which warned that the EU’s banking system was contaminated by an ocean of toxic assets. Though the story was ignored by the rest of mainstream media, for the most part, I think it is timely to look again at this secret EU document in the light of the current European debt crisis and growing rumours regarding the insolvency of many leading banks across the continent.

The confidential 17 page European Commission document warned that the European banking system could be holding as much as 18.6 trillion euros in toxic assets. Furthermore, in the wake of the European bank bailout that followed the collapse of Lehman Brothers, the document warned that the cost of a second Eurozone and UK bank bailout would exceed the financial capacity of the European Union. In other words, if Europe’s banking system enters a meltdown in the face of the sovereign debt crisis now plaguing European economies, the EU will be powerless to stop the implosion of the European banking and financial system.

Reviewing what the European Commission warned about more than a year ago, it appears that the document’s authors had an impressively prescient ability to forecast the current European sovereign debt and fiscal crisis. In stark terms, the EU document warned that, “It is essential that government support through asset relief should not be on a scale that raises concern about over-indebtedness or financing problems…Such considerations are particularly important in the current context of widening budget deficits, rising public debt levels and challenges in sovereign bond issuance.”

With Greece essentially insolvent, Spain in the grips of its own sovereign debt crisis and the UK and Italy teetering on the edge, not to mention Ireland, Portugal and Eastern Europe, it seems to me that the worst case scenario hinted at in the leaked document more than a year ago is no longer a speculative possibility, but unfortunately a chillingly realistic forecast of what may very soon be the next great global banking crisis.

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With a public debt to GDP ratio of about 200%, Japan is the most indebted major economy in the world. If this were the public debt ratio of the United States or the UK, both nations would be experiencing a catastrophic sovereign debt crisis. If this was the public debt correlation in Greece, Athens would already be insolvent and for sale. But until now, Tokyo had the luxury of incurring increasingly heavy debt loads, owing to a nation of patriotic savers willing to loan the government money at absurdly low interest rates. But no longer.

Japan’s workers are being squeezed, and have less income to save. The demographic time bomb, with an aging and decreasing population, means that a point will soon approach when Tokyo must sell the bulk of its bonds in the international sovereign debt marketplace, in competition with America, the UK and Eurozone. Needless to say, the interest rates Japan will have to borrow at will be vastly higher than at present.

Japan’s latest  Prime Minster, in a revolving door of national leaders that plague the country, is Naoto Kan. He recently stated that, “Our country’s outstanding public debt is huge. Our public finances have been the worst of any developed country.”

Kan added that Japan risked becoming the next Greece. Some observers claim that he was exaggerating Japan’s fiscal and debt problems in order to depreciate the value of the yen. However, I don’t think the new Japanese  prime minister was overstating the Japanese debt crisis. He was merely being prophetic. I will only add that Japan’s debt problem is more than a national crisis; it threatens the entire global fiscal architecture. Throw Japan’s massive debt requirements into the global sovereign bond market and yields for all the other indebted nations will spike through the proverbial roof.

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Contrary to the expectation of pundits and economists, May’s employment numbers released by the U.S. Labor Department are an unmitigated disaster. At first glance, though, the uninformed would think that the vast deficit funding on economic stimulus by the Obama administration was working. Supposedly, “employers” added  431,000 jobs, and the overall U3 unemployment rate dropped to 9.7%. However, the so-called “employers” consisted almost entirely of the U.S. federal government, which added  411,000 temporary census jobs in May. These jobs, which will disappear in a few weeks, are responsible for about 95% of the claimed job creation in May in the United States.

In May, according to the government’s own data, private sector job creation was statistically insignificant. I personally believe, based on past patterns, that  the U.S. government statisticians consistently over-report private sector employment in most of the initial monthly tabulations.

One other factor should be noted. The drop in unemployment from 9.9% to 9.7% was due not to vast job growth in the U.S. economy, but rather due to the fact that 322,000 unemployed workers were eliminated from the officially counted workforce. In fact, when one counts this category of so-called discourage workers, in addition to part time workers unable to find preferred full-time employment, the more inclusive U6 unemployment rate is close to 20%, or one in every five U.S. workers.

With continuing high rates of unemployment, it is clear that there will be no consumer-led economic recovery in major advanced economies. This means that massive government deficit spending is the only means of propping up national economies. However, with the global economic crisis rapidly mutating  into a virulent sovereign debt crisis, the option of public pump-priming clearly has its days numbered.

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The proliferation of sombre headlines can no longer be obscured by the proclamations issued from politicians that their unprecedented binge of public borrowing has “saved” us all from a global depression, and paved the way for renewed economic growth of such intensity that it will surely create the new tax revenues required to service the expanded public debt interest payments made necessary by those same policies. The European debt crisis is now a reality, as the contagion  of fiscal insolvency migrates from Greece to Portugal and now Spain, and ultimately through the rest of the Eurozone. The UK, Japan and United States are not far behind, as they have annual deficits and total levels of national debt as bad as the worst of the Eurozone members.

Where will all this lead? If the politician are wrong, and the miraculous and unprecedented rates of economic growth required to pay annual interest payments and convince the global bond markets that providing new financing for structural deficits is a wise investment don’t materialize, what then? History provides a clear answer. When all else fails, the capacity to impose taxation on its citizens is the only recourse left to sovereigns for convincing bankers and investors of their credit worthiness as borrowers.

In the latter period of the Roman Empire, a long succession of bad economic policies had destroyed the basis of  agriculture and industry. To pay for its foreign military outposts and large standing army, not to mention a vast imperial bureaucracy, the authorities debased the currency, which in turn created inflation while furthering undermining the Empire’s economy. Ultimately, and in desperation, the latter Roman emperors vastly increased the rate of taxation, and their ability to squeeze every last denarius out of its increasingly impoverished citizens.

In their epic work on the history of human civilization, the historians Will and Ariel Durant wrote the following to explain the draconian fiscal reality in the latter centuries of the Roman Empire:

“To support the bureaucracy, the court , the army, the building program, and the dole, taxation rose to unprecedented peaks of ubiquitous continuity…Since every taxpayer sought to evade taxes, the state organized a special force of revenue police to examine every man’s property and income; torture was used upon wives , children, and slaves to make them reveal the hidden wealth or earnings of the household; and severe penalties were enacted for evasion. Towards the end  of the third century, and still more in the fourth, flight from taxes became almost epidemic in the Empire. The well to do concealed their riches, local aristocrats had themselves reclassified as humiliores  to escape election to municipal office, artisans deserted their trades, peasantry proprietors left their overtaxed holdings to become hired men, many villages and small towns  were abandoned because of high assessments; at last, in the fourth century, thousands of citizens fled over the border to seek refuge among the barbarians.”

With many leading economists predicting that the vast orgy of public debt created by policymakers in response to the global economic crisis will sooner rather than later require significantly higher levels of  taxation, there is no guarantee that highly indebted countries will escape the painful consequences that appear inevitable. The remaining uncertainty is if we will escape the hellish taxation nightmare that afflicted the citizens of ancient Rome in the period leading to its ultimate decline and fall. Perhaps it is just as well that our policymakers seldom read history, let alone learn from it.

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The decision by Fitch, one  of the three leading ratings agencies, to downgrade Spain’s government debt to below AAA status is another manifestation of the deadly sovereign debt contagion that has becoming increasingly virulent since Greece’s public finances imploded. What was once a Greek debt crisis that Eurozone politicians were confident could be contained has now contaminated the entire fiscal edifice of the European Union.

As a further  sign of the deteriorating economic and financial situation in Spain, a growing number of Spanish banks are facing insolvency. There is an attempt by the government and central bank to arrange a shotgun marriage that will consolidate dozens of regional banks that are in fragile condition. This comes on the heels of a major austerity package  enacted by the Spanish government headed by Prime Minister José Luis Rodríguez Zapatero, which was approved by the national parliament by a single vote. This illustrates the fragility of the Zapatero government, at a times when further economic and financial shocks are likely, on top of a labor revolt against the austerity measures, similar to what is occurring in Greece.

The worsening news emerging from Greece, Portugal and now Spain are mere markers on a path leading to a profound sovereign debt crisis that will afflict not only the Eurozone and UK economies, but eventually Japan and the United States.

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The trillion dollar Eurozone rescue package may have been as recent as almost yesterday, but it is already being forgotten and discarded by investors across the globe, as equity markets tank and financial volatility indexes embark on a steep ascent. It is quite clear that what began as a Greek debt crisis has now morphed into a full-fury European debt crisis.

We are in a most precarious phase of the ongoing global economic crisis. It is inevitable that the European debt crisis will spread to the United States, ushering in a dangerous global sovereign debt crisis. Despite the reassuring words of politicians throughout Europe, including Angela Merkel and Nicolas Sarkozy, as well as their counterparts in the U.S.A., this is a train wreck that cannot be prevented, and will transform a financial crisis and severe recession into a synchronized global depression.

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In an interview with CNBC, the renowned NYU economics professor Nouriel Roubini reverted to his apocalyptic mantle of “Dr. Doom.” He said without equivocation that equities were likely to lose 20% of their current valuation. He pointed out that the Eurozone debt crisis and general weakness in the global economy will create severe challenges for investors.

Regarding the Greek sovereign debt crisis, Roubini described efforts to bail out Athens and other highly indebted Eurozone countries as “mission impossible.” He went on to provide a dire overview of the fiscal crisis gripping many advanced economies.

“What needs to be done is clear. We need to raise taxes and cut spending. Otherwise we’re going to get a fiscal train wreck,” warned Roubini. Readers of my book, “Global Economic Forecast 2010-2015: Recession Into Depression” are aware that my own projection is that the growing sovereign debt problem will mark the next phase of the global economic crisis, sparking a synchronized global depression.

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We all exist in an interconnected global economy, meaning a major financial crisis in one country is virtually impossible to contain before it has metastasized abroad. The financial implosion that began with the collapse of Lehman Brothers in September 2008 was an object lesson in this aggregation of global financial fragility, as credit markets worldwide froze solid. We are now seeing a similar though far more dangerous phenomenon unfold, this time involving sovereign debt in Europe as opposed to private investment banks on Wall Street. The United States is far from immune to the long-term consequences of the Eurozone’s public debt and currency crisis.

We all recall the state of petrified panic that engulfed key political actors in major economies throughout the world as LIBOR and Ted spreads soared to the heavens in the fall of 2008. Policymakers made the fateful decision to dump the impediment of moral hazard, bailout Wall Street at taxpayers’ expense, and to transfer private toxic debt into public debt. This policy measure was further exacerbated by massive increases in deficit-driven stimulus spending to offset the economic contraction that resulted from this same credit crisis.

Ever since, policymakers have engaged in an orgy of self-congratulation, praising themselves for “saving the world” from another great depression. However, not so clever. The massive increase in public debt in virtually every advanced economy has now given rise to the next phase of the global economic crisis. We are in the midst of the initial stages of a full-blown sovereign debt crisis that potentially may inflict far more havoc on the global financial system than the turmoil that erupted less than two years ago.

A few months ago, the Eurozone politicians claimed that there existed a sovereign debt crisis only in Greece, that it was contained and would not even require an actual bailout, only the possibility of aid if it was needed, the implication being that this reassurance would be sufficient to calm the bond markets without any Eurozone rescue money actually flowing to Athens. Then, as the situation deteriorated further, we were assured that only a few tens of billions of Euros would put Greece back on its feet. When the markets weren’t fooled, the increasingly frantic Eurozone politicos offered a vastly higher level of bailout cash for Greece, translating into more than $140 billion. However, even that princely sum didn’t stop the spreads on Greek public debt from expanding, while Spain, Portugal and Italy came under increasingly harsh scrutiny from the bond vigilantes.  The result is a joint Eurozone and IMF bailout package for all the so-called PIIGS nations in the Eurozone (Portugal, Ireland, Italy, Greece and Spain) totalling a cool $1 trillion.

The unprecedented scope of the Eurozone  bailout package in its latest form (bereft of a plausible explanation as to how this money would actually be raised),  saved the euro from further deterioration for all of 24 hours. The embattled currency has now resumed its descent into fiscal oblivion, as global markets correctly question how other European nations that are themselves faced with massive structural deficits and ballooning public debts can bailout the PIIGS. There is a growing consensus that Europe is confronting a mounting  and insoluble sovereign debt crisis. In the short run, the U.S. is the beneficiary, as a flight to safety sentiment channels investors towards Treasuries as a safe haven. However, the economic consequences of the crisis in the Eurozone, combined with the public debt crisis in the UK that the new government is committed to resolving through severe budget cuts, will inevitably imperil the U.S. economy’s fragile recovery from the Great Recession, at a time when America itself is faced with structural mega-deficits far into the future.

The International Monetary Fund has now weighed in with its own expression of concern on the looming danger of a sovereign debt crisis impacting all major economies. The IMF’s recent fiscal monitor projects that by 2015, the proportion of public debt to GDP will reach 110% in the U.S., 250% in Japan and 91% in the UK, with comparable figures for most other large economies in Europe.  These numbers do not even recognize unfunded contingent liabilities, which in the United States would add another 400-600% to the debt to GDP ratio.

What began in Greece and now grips the entire Eurozone economy will inevitably impact the United States. When Washington is compelled by the bond market to finally confront the full force of a sovereign debt crisis, it may prove as impotent in the face of global market forces as is the Eurozone. Furthermore, when that day arrives, unlike the Wall Street bailout of 2008, there will be no taxpayers in some far-off magical land that will be able to bailout Uncle Sam.

We are indeed living through interesting times.

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