Monday, October 13, 2008

Europe Starts Facing Reality

Several European governments today pledged 1.3 trillion Euros to fix the banking problems affecting their banks. In combination with the recent blanket banking protection from Britain (not yet explicitly valued but quite large) they have now offered to cover more than 2 trillion US dollars in losses. This action means the European governments have, roughly, promised enough to fix the problem on their end. The US and Japan should be able to manage interventions on similar scales to match the worldwide problem. We now have several remaining problems to deal with:

1) What about the non-EU countries, and the countries that everyone knows can't cover their commitments? UBS and the Irish banks are still exposed, as well as many smaller banks in East Europe. We still have major busts to come unless the EU acts as a whole (and why would they bail the Swiss?)

2) Can the world provide the borrowings the governments now need? In a sense they can, but I stand by my prediction they will have to borrow long for this and so long bond rates will soar. In principle, I think this is a better way to get to the "rebuilding" state than a classic panic; but the losses and the need to rebuild remain real. To put things in context, the Swedish action, which involved the injection of only 4% of GDP came with a 6% drop in GDP. Just today's intervention is 250% as much as the Swedish. Much is in the form of deposit guarantees, which obviously won't all have to be paid out, but a recession far worse than the mid-70's recession is probably unavoidable.

3) What about the shadow banking system? They aren't covered. IMO it's good ethically for the hedge funds to go down while the classic banks are protected but we'll still see a lot of damage. One good thing about that is that hedgie collapse may provide enough financial losses for the governmental interventions to fix the rest without strangling the economy. Still though, those losses will hurt.

4) Will they clean up the banks and stop the bad lending? That's necessary to get a Swedish result (bad recession followed by recovery) rather than a Japanese result (recession without end). Initial indications from Fannie/Freddie and the UK is that the governments will continue to force lending on houses, which is a very bad sign.

All in all, this permits a controlled clean-up and will probably protect the world from uncontrolled side effect disasters like rumored halts to world shipping. However, we know will find out how competent and prompt the clean-up is. And the real losses must be faced, no matter what we do.

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