Don’t believe the reports that a new Lehman-style financial crash is in the offing. What’s going to happen is much less dramatic. In 2008 no-one knew how to value Wall Street’s liabilities (for example, AIG’s famous guarantees on subprime securities). Now the full extent of the problem is known to everyone. It’s just a negotiation now over who gets knackered. And the answer, by one means or another, is the southern Europeans.
Spain probably has to spend the equivalent of 20% of GDP bailing out its bankrupt banks. It won’t quite bail them out: the $85 billion of subordinated debt of the banks — two-thirds of which is owned by individuals — will be vaporized, so Spaniards will lose a good deal of their savings. If Spain has to reduce debt payments to creditors like Greece, other European banks (mainly French) will get hung out to dry just like the Spanish banks. Their subordinated debt will vaporize, and the French will lose a large part of their savings. It’s easy to fix a financial crisis when you can put the damage back to individuals, insurance companies and pension funds. A lot of Europeans will get poor, fast. And the Chinese, or the Germans, or the Canadians, or someone with ready cash will come in and recapitalize the bankrupt banks. The Germans will be left with a lot of loans to the European Central Bank. They’ll live with it.
This reminds me of my Carmaggedon analogy, in which I argued that the PIIGS debt crisis was fundamentally different from the financial crisis of 2008, mainly because it's so much easier to understand what's at stake:
... back then the market found it almost impossible to value the thousands of often obscure and arcane mortgage-backed securities that were tied to many millions of homes whose prices were tumbling at different rates all over the country. With the PIIGS crisis, we are dealing with only a handful of borrowers who have issued fairly straightforward debt securities.
I also argued that this time around the markets have had plenty of time—years—to get adjusted to the idea that there will be large debt write-downs in Europe. With so much advance warning, and with relatively transparent facts and securities to deal with, it is very unlikely that we will see a collapse of the Eurozone or the global banking system; lots of pain and anguish, to be sure, but not a collapse.
That's why Eurozone swap spreads are not soaring, and are well below last year's highs. There are still problems in Europe, but they don't spell the end of the world as we know it.
The clamor in Europe these days is all about who is going to get stuck ("knackered," as David so crudely puts it) with the losses. As I pointed out last July, from an economic point of view the losses happened long ago. The losses happened when "the feckless Greeks, Spaniards, and Italians used the euro system to borrow money to pay themselves more than they are worth," as David notes. The money was borrowed and wasted. This is a true economic loss: scarce resources were used for no productive end. This loss cannot be erased, and it has already been reflected in several years of lost Eurozone output, declining living standards, and high unemployment. The only thing we don't know yet is who will be left without a chair when the Eurozone music stops.
If Greece follows the leave-the-euro-and-return-to-a-devalued-Drachma route, then the losses will be shared by the entire Greek private sector, and the government will be the sole winner (devaluations are essentially a quick and dirty way for the government to collect taxes from the private sector). If Greece stays in the Euro, then sooner or later the government will have to shrink and the salaries and benefits of lots of Greeks will need to be cut. Either way, it's all about who will have to bear the loss, not whether there will be a loss.
The sooner the Europeans realize that they can't make the losses go away, the sooner their economy can get back on its feet.