June 6, 2012

A Fate Worse Than Lehman

The sovereign debt crisis that has been brewing for the past few years is the most critical economic crisis the world has ever faced. We are a few bad decisions from total and global economic collapse – the great reset, as they say.

Our fate rests in the hands of the same political elites that helped create the problem in the first place. We are trapped in an economic quagmire. This really could be it folks. It may only be a matter of time until we meet a fate worse than that experienced after Lehman Brothers brought the banking system to its knees in 2008.
The post-Lehman collapse was bad, but today the problem is far worse – it is far more fundamental to the global economic system. Lehman Brothers sent the financial system reeling because the trust behind tens of thousands (if not more) of financial contracts evaporated. Nobody knew if their counterparties would exist in a week so they everyone pulled funds from everyone.

Investors reacted by parking their money in the safety of cash and US Treasuries. (Recall that at one point the yield on T-bills went negative!) Central banks reacted by guaranteeing pretty much everything and providing cash in exchange for any piece of collateral that wasn’t nailed to a wall. Governments reacted by initiating mind-blowing fiscal stimulus programs.

During the 2008 crisis, one assumption held true: the US dollar and US Treasury Bonds/Bills were the gold standard in risk-free assets. Expanding beyond the United States, during the crisis there was little doubt in any investor’s mind that most G-10 sovereign bonds were safe.

Today’s crisis is much worse than that of 2008 because the credibility of the sovereign is in doubt. This means that the $70 trillion in G10 sovereign debt backing the hundreds of trillions of dollars in derivative contracts and financial sector liabilities is in question.

Despite the sheer size of the affected assets, this is not the origin of the issue. The fundamental problem is that these sovereign debts were once viewed as ‘risk free’, and thus formed the basis for financial collateral and asset pricing. Consequently, a global banking system built on the assumption that the foundation of a strong balance sheet is made of G-10 government bonds will need to be re-thought.

Fundamental financial models and contracts (including the hundreds of $trillions in derivatives) will need to change. Unfortunately, widescale re-evaluation within the financial sector tends to be characterized by a ‘shoot first and ask questions’ mentality. Accordingly, the transition period during which global markets re-define asset risk classifications and adjust contracts could result in systemic financial collapse.

Making things worse, public sector debt crises can have a pro-cyclical effect on economic deterioration. As government debt is re-rated, so too are the financial intermediaries that own government debt. The deteriorating financial sector has wide-ranging real economic impacts, affecting government tax revenues, thereby eroding government credit-worthiness.

As G-10 banks have been party to financial repression, where they are more-or-less forced to buy government bonds, one wonders if they have any choice but to ride the sovereign debt crisis until the bitter end, unable to adjust to the new definition of ‘risk-free’.

One thing is certain, a deteriorating financial sector only worsens the sovereign debt crisis resulting in a spiralling collapse.

Unlike the post-Lehman collapse, a crisis that starts with the sovereign cannot be solved by the sovereign. The 2008/2009 crisis was halted because of combined epic monetary and fiscal stimulus, facilitated through the captive banking sector. Today, most if not all governments are effectively prohibited from more fiscal stimulus. Even austerity has proven to be a failure for most. Without credible government treasury departments to backstop endogenous sovereign debt crises, the world may be set for a fate worse than the post-Lehman collapse.

With government treasury deparments out of the picture, the current sovereign debt crisis, which will eventually travel from Europe to Japan to America, can only be alleviated by massive monetary action to recapitalize banks, keep real interest rates low/negative, maintain steep yield curves and prevent a deflationary collapse. (Of course, this assumes that preventing a deflationary collapse IS a good thing. I’ll save that discussion for another day.) However, QE, QE2, LTRO and Twist have demonstrated that marginal returns on monetary stimulus may be shrinking, as the afterglow of each action has vanished at increasing speed.

This leaves policy makers with two options: 1) Continue to little and hopefully muddle through the crises; 2) Gear up the printing presses until they run fast enough to make a dent.