Botox economics triggers toxic eurozone side-effects - FT.

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11/08/2011 02:14

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Botox economics triggers toxic eurozone sideeffects

By Satyajit Das

The crisis threatening to engulf world financial markets has been brewing since 2008. Until recently, markets were Dancing in the Streets but, increasingly, another HollandDozier-Holland standard made famous by Martha and the Vandellas is relevant: Nowhere to run to, baby. Nowhere to h ide. The recovery from the first phase of the crisis was based on Botox economics. Botox is commonly used to improve a persons appearance but its effects are temporary and can have toxic side-effects. Financial Botox money from central banks and governments to prop up demandh temporarily covered up deep-seated problems rather than resolving the real issues. As individuals and companies reduced debt, government borrowing jumped to limit the effects of the crisis on the broader economy. The new phase of the crisis is different to 2008 and that Lehman moment. Then, governments had the financial capacity to backstop the private sector, especially financial institutions. The crisis now involves nations. The ability of sovereigns to finance themselves is in question and there is no one to backstop the governments themselves. Contagion from a sovereign debt crisis is especially pernicious, and different to that of 2008. Europes debt problems provide an insight into the problem. While smaller nations can be bailed out by other, stronger nations, the financial commitment required weakens the saviours and threatens their own survival. Saving Greece, Ireland, Portugal, Spain and Italy would probably require a facility of at least !3,000bn with an effective lending capacity of about !2,000bn dictated by the fact that it is limited by the guarantee commitments of triple A rated countries. As more countries need support, the burden of the guarantees becomes concentrated on stronger eurozone members Germany, France and the Netherlands. So, rather than containing risk, the crisis spreads to the stronger countries.
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Botox economics triggers toxic eurozone side-effects - FT.com

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Government bonds are traditionally havens as well as the preferred form of collateral used to secure borrowing and other obligations. If the quality of stronger government issuers were contaminated, this would have far-reaching consequences for financial activity. Most banks have substantial holdings of government bonds, which have increased since 2008 as they have increased levels of liquidity. Any fall in the value of these holdings would affect the solvency of the banks themselves. For some European banks, lack of access to commercial funding has forced reliance on money from their central banks and the European Central Bank, generally against government bond collateral. Credit rating downgrades or falls in the value of government bonds can therefore create liquidity problems for banks. If banks need government support, this further weakens the government. If individual national governments require external support, this weakens the ultimate guarantors, which in turn affects the value of government bonds and their holders. Falls in the value of government bonds or a loss of confidence in their value as surety would lead initially to a global margin call, as the value of the collateral is marked down, setting off a dash for cash. In an extreme case, where government bonds are not accepted as collateral, it would lead to a contraction of liquidity and financial activity. Central banks, sovereign wealth funds, pension funds and insurers have a significant investment in government bonds. A big part of Chinas foreign exchange reserves is invested in US and European government bonds. A loss in value in these holdings would affect Chinas economic performance. The crisis has returned to its starting point debt levels and the reliance of the global economy on borrowing to fuel growth. The level of debt depends on the value of the assets or investment that supports it and the income or cash flows available to service the interest and principal. Many nations have debt that cannot be sustained amid lower growth. The new crisis is part of the deleveraging with governments joining individuals and companies in being forced to reduce debt levels. But if not managed properly, sovereign debt problems may escalate rapidly with the risk of a big disruption in financial markets. In his pamphlet Gravity Our Enemy Number One, investment analyst Roger Babson, who anticipated the 1929 stock market crash, argued gravity was an evil force. In the credit boom, prices rose, defying gravity. Now, financial gravity is reasserting its malevolent power. Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk
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Botox economics triggers toxic eurozone side-effects - FT.com

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