How Long Can the World Avoid Crisis?

12/09/2011 10:56 am EST


John Mauldin

Chairman, Mauldin Economics

Europe may not be ready, or even able, to thread the needle delicately enough to keep from dragging the global economy down with it, writes John Mauldin of Thoughts from the Frontline.

How fragile is the recovery? The rest of the developed world is either in recession or soon will be.

This chart is from friend Prieur du Plessis of Plexus Asset Management in South Africa. Notice that every major region is slipping into contraction except the US.

Other details provided by SISR (sadly, I lost the e-mail of the person who provided this, so I can’t credit him) show that outside of the US and Canada, the rest of the developed world is watching their PMI (manufacturing production) numbers go into contraction.

Of the emerging world, only India and South Africa are growing. The contraction in both Germany and France is getting worse month by month.

How long can the US resist a global slowdown? My answer would be, for longer than you might think, absent the potential shock coming from Europe. But the above data does set the stage for the rest of the letter.

Now, a few quick observations. Last week, we saw truly a global effort by the central banks of the world (the US, Europe, Japan, Switzerland, Canada, and China). But then, what else did you expect them to do?

Their main tool is to provide liquidity, and that is what they promised. They lowered the cost of coming to the "window," and certainly lowered the "shame" factor in doing so. Going to the central bank could be seen as a sign of weakness and, at higher rates, banks might be reluctant to do so. At the new rate it is reasonably economical, and the central banks have signaled it is more than OK.

Second, this effort also included China, which cut its bank reserve requirements by 0.5%. David Kotok pointed out to me something unusual about this. Normally, China makes it moves with a number ending in "7," like 27 or 47, as 7 is good luck.

For those paying attention, this was China’s way of saying "We are part of the team," rather than acting on their own, as they usually do. Now, it makes sense that if you include Canada in the "club," you should include China.

The stock markets of the world went into an ecstatic frenzy, capping off a very positive week. But I would remind my enthusiastic friends of a few things. Let’s look at what really happened. We just recovered from a very oversold condition, and are still down almost 7% from this summer.

And this has happened before. Let’s rewind the clock to October 2008, deep in the credit crisis. This is a report from Jim Lehrer of PBS:

World stock markets staged a comeback today. They did so as key governments moved to support troubled banks.

On Wall Street, the Dow Jones Industrial Average scored its largest point gain ever, soaring 936 points to close above 9,387. The Nasdaq was up more than 194 points to close at 1,844. Overseas, stock indexes rose 8% in Britain, 11% in France and Germany. Markets across Asia also shot higher, including a gain of 10% in Hong Kong.

News of European efforts to end the banking and credit crisis helped ignite the rally. On Sunday, nations that use the euro agreed on coordinated steps. Today, Britain was first to act. It was followed by Germany, France, Spain, Portugal, Austria, and the Netherlands.

The good news is that last week’s action may (and I emphasize may) help stave off a true bank credit crisis on the order of 2008. That is, if the central banks of the various European countries follow through (more on that below).


The real problem was best summed up this week by Mervyn King, the governor of the Bank of England, speaking at the press conference to launch his Financial Stability Report:

Many European governments are seeing the price of their bonds fall, undermining banks’ balance sheets. In response, banks, especially in the euro area, are selling assets and deleveraging.

An erosion of confidence, lower asset prices and tighter credit conditions are further damaging the prospects for economic activity and will affect the ability of companies, households, and governments to repay their debts. That, in turn, will weaken banks’ balance sheets further. This spiral is characteristic of a systemic crisis.

Tackling the symptoms of the crisis without resolving the underlying causes, by measures such as providing liquidity to banks or sovereigns offers only short-term relief. Ultimately, governments will have to confront the underlying causes…

The problems in the euro area are part of the wider imbalances in the world economy. The end result of such imbalances is a refusal by the private sector to continue financing deficits, as the ability of borrowers to repay is called into question.

The crisis in the euro area is one of solvency and not liquidity. And the interconnectedness of major banks means that banking systems, and hence economies, around the world are all affected. Only the governments directly involved can find a way out of the crisis…

If the problem were one of liquidity, then this week’s action would be enough. But the problem is solvency. The majority of European banks are insolvent. They own too much debt of sovereign countries that are going to have to reduce their debts.

There is a growing number of analysts who are realizing that even Italy may have to reduce its debt burden. I have highlighted the problems faced by Belgium. And how about Spain and Portugal?

What this action does is give the ECB the dollars it will need to loan to the various national central banks, so they can loan to their insolvent banks. Will they bail them out, or nationalize them?

The answer depends on the country and its voters. But absent recapitalizing their banks, there will be a credit crisis that will affect the whole world.

The amount of debt that will have to be written off and loan portfolios reduced, as well as new capital raised, is daunting. As I have noted previously, the need is for around €3 trillion.

Writing off so much debt in the midst of a recession, coupled with austerity moves, will be massively deflationary for the Eurozone. But Merkel and the German Bundesbankers have made it clear that they will not be part of any "printing press" action that is not coupled with serious commitments for balanced budgets. Even in the face of a recession.

Which makes it quite strange that the ECB had been tightening in terms of money supply until this week.

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