Diary

While We've Been Distracted, Europe Careens Toward Financial Catastrophe

While we’ve been distracted with the domestic financial difficulties, a more horrid story has been unfolding in Europe.

This is going to have stunning financial and political implications.

But before we try to sort through those complexities, just ponder the following numbers.

In the fourth quarter of 2008, our GDP contracted by 3.8% – a rare and abysmal result.

During the same period, Germany’s GDP contracted by 8.4%.

More below the fold.

It’s difficult not to feel a certain degree of shameful-joy at the problems of old Europe – largely because of the terminal obnoxiousness of the EUniks about how they absolutely, positively have it all right, and “don’t bother us” with real economic performance numbers.

After a couple of decades of watching old Europe’s sclerosis – the economic stagnation, the structural double-digit unemployment, the absurd levels of taxation, the flight of talent to other jurisdictions, the disappearance of any military competence, and, oh yeah, the complete demographic collapse – you’d think the EUniks would get a clue. No such luck. “Just you wait. We’ve got it right. We’ll be vindicated.”

So, what happened when our banking crisis blew up in late September of last year?

During the early part of October, I found myself relaxing in one of the Senator (Gold Flyer) lounges at the Frankfurt Airport while on my way to Tallinn. Sitting on a rack was the latest (at the time) issue of the reflexively-leftist German news magazine Der Spiegel. The cover graphic featured a bald eagle slipping on a patch of ice, with a headline (in German) that translated as something like “The End of American Hubris.”

Nice try. But before that issue could even settle on news stands, the EUniks found out to their horror that their own banks were in even deeper trouble. Between the globalization of dodgy financial instruments (something the euros dove into full-tilt) and the size of their own banks, Europe was in an even deeper financial hole than was the U.S.

This is a situation that could be discussed for pages and pages. But for the here-and-now, we’ll concentrate on three things:

1) A unique circumstance that threatens to turn into a wildfire that will ravage Europe in ways that are beyond scary;
2) The exposure of the tragically ridiculous nature of the present financial regulatory situation in Europe;
3) Some political implications – on both sides of the Atlantic.

1) The exposure of western European banks to eastern European debt.

This is a problem that – like much of this crisis – just snuck up on us. The degree of exposure of western European financial institutions to “eastern” – the eastern EU countries, Ukraine, and Russia – debt that may now be beyond hope of repayment is truly mind-boggling.

You can find excellent pieces on the situation here, here, and here – the first of those is particularly informative (and frightening).

There’s not much to add to those (in terms of details), so I won’t.

But we can ask – How did the hole get that big?

Well, let’s go back to the top. You know all that economic stagnation in western Europe? If you were managing money in western Europe any time over the past 10 or 15 years, you could just look out the window and see that western Europe was a lousy place to invest – so naturally you would start looking further afield. At the same time, just a short distance away were the eastern European “tiger” economies – there, there were low taxes, a congenial investment environment, and rapid (often double-digit) economic growth. If you were going to make investments and/or loans, that was clearly the place to do it.

There’s a phrase of my own that I apply to situations like this – “itchy money.” That’s money that is sitting somewhere getting a poor return, and which is itching to get itself re-deployed to better pastures. We had something like this in the U.S. when the Federal Reserve created way too much liquidity during the middle part of the decade – there was just a lot of money sitting around looking for something to do.

But, money is the ultimate herd animal – and when some of it starts to go in a particular direction, soon a vast thundering herd stampedes in the same direction. Perhaps a better metaphor would be a bee that returns to the hive with its feet covered in pollen; soon, that bee leads the whole swarm back out to the source of the newly-discovered pollen.

When money stampedes, cause leads to effect – and vice-versa. So what was a genuine good-opportunity story in eastern Europe quickly blossomed way beyond the underlying rationale. By now, that story should sound familiar.

How itchy was that itchy money? Well, remember that Der Spiegel cover cited above? While Der Spiegel was quick to crow over the exposure of American financial institutions to dodgy financial instruments, what they failed to realize was that western European financial institutions were even more exposed to them. That itchy European money was a big, big buyer of things like all those now-infamous mortgage-backed securities (MBS).

So, faced with this sudden catastrophe, how did the European financial regulatory system respond? That leads on to the next topic.

2) The sudden realization that the “European financial regulatory system” is in fact a chaotic and contradictory mess.

The word “Europe” gets thrown around a lot; however, if you have dealings with (and travels to) Europe, you quickly find that Europe perhaps should be renamed “Hodge-Podge Lodge.” Despite the existence of the “EU,” there is more chaos than sanity.

A good example has been the bizarre “Schengen zone” of countries that form a common passport entry/exit zone. Some EU countries were in the Schengen zone, while others were not; to complicate matters, some non-EU countries are inside the Schegen zone – Norway and Iceland leap immediately to mind. This often led to bizarre inanities; a few years back, just walking between gates while changing planes at the airport in Stockholm caused my passport to be stamped several times (I still can’t figure out why – I was just following the signage). Now, the EU-Schengen part includes all EU countries except (for now) Romania and Bulgaria – so, less insanity.

On the financial side, things remain all mixed up. Some EU countries have adopted the Euro, while others have not. Some of the older members have intentionally refused to adopt the Euro – the U.K., Denmark, and Sweden are good examples. At the same time, most of the eastern countries have been judged unready to join – so far, only Slovenia and Slovakia have adopted the Euro.

So we find that the European Central Bank has some of the functions of a central bank, but not all of them – because a sizable number of the “EU” countries don’t use its currency. Even among the Euro countries, national monetary and financial authorities still are in charge to a surprising degree.

This has led to near incomprehensibility in the present crisis. When the exposure of Austrian banks to eastern debt became apparent, the Austrian finance minister took the problem to the European regulatory authorities. The German finance minister would have none of it, since it was “Austria’s problem.” Now, as the fire burns hotter, that stance is under re-consideration.

What we’re seeing now is a great deal of confusion. Never mind a debate on what possibly should be done – no one can figure out who should have what authority to do any particular thing.

One senses that this will not end well. One casualty may be the Euro itself. There has already been a great deal of popular pressure in both Germany and Italy (at least) to abandon the unified currency as antithetical to immediate national interests.

In the meantime, the value-collapse of the eastern currencies has been breathtaking. I was in Ukraine for a few days toward the end of this past October, and it was astounding to watch the Ukrainian hyrvnia lose 20% of its value against the dollar between Monday and Friday.

And that leads us into the final topic.

3) Political implications and the bleatings of the “disaster socialists”

One of the most irksome features of the present financial crisis is the re-emergence of what our Australian friend Tim Blair calls “disaster socialists.” Amazingly, these people have been stewing for nearly three decades, waiting for a chance to leap out of the underbrush and proclaim that all of our present problems are the fault of Ronald Reagan, Milton Friedman, and the “radical right-wing agenda.”

Fortunately, most of the people who indulge in that kind of claptrap are also die-hard europhiles – and so we can readily compare our situation with that of “Europe” to see how that’s all working out.

Three decades ago, the United States and (western) Europe were basically on the same economic page. However, at that point, we chose a different path from the 1970s – while they chose to basically stay in the 1970s.

We got three decades of strong and nearly uninterrupted economic growth (only two brief and relatively mild recessions – 1992 Clinton campaign rhetoric notwithstanding), low unemployment, etc. At the same time, “old” Europe flat-lined into stagnation.

The line we’re being pitched by the disaster socialists is that they had it right all along, “policy” was right back in the 1970s, and everything since then has been a mirage.

Well, western Europe did just that – they stood pat with a 1970s system.

So how’s that working out?

Well, to conclude by reprising:

4Q08 GDP

U.S. -3.8%
Germany -8.4%

That pretty much summarizes things.

Of course, the final scary part is that the last time things went this way “over there,” the ultimate “disaster socialists” came to power in both Germany and Russia. Let’s not go there….