A few weeks ago, I wrote a column warning investors against taking a long summer holiday this year.
Sadly, I was right: no sooner did the markets breathe a sigh of relief over the resolution of the U.S. debt ceiling dramas, they started gyrating with alarm over the euro zone. Call it, if you like, the curse of August: just as in 2007 and 2008 (or 1997 and 1998) the fact that senior leaders are absent and markets are thin is threatening to unleash a new wave of volatility.
But it is not just the summer temperatures that have historical echoes; viewed from New York, the manner in which this euro zone story is playing out feels unnervingly similar to the pattern behind the American financial turmoil of late 2008. Ponder some of these parallels:
? When Greece first started to wobble, many policymakers – and some investors – tried to downplay it because Greece is so small relative to global markets – with less than 200 billion euros of foreign-held central government debt. Similarly, Lehman Brothers and Bear Stearns, with assets of $600 billion and $400 billion, were also small compared with the US financial sector.
? Similarly, when the troubles erupted, euro zone policymakers initially assumed that the problem was a liquidity, not solvency issue, and blamed the problem on “speculators”. Thus they repeatedly unveiled sticking plaster (or Band-Aid) solutions that tried to delay tough decisions and paper over the cracks. This was similar to what the U.S. authorities did in late 2007 (remember the ill-fated super-SIV plan?) It has proved no more successful in the euro zone than it was in the U.S: though each new announcement produces a modicum of relief, investors keep baying for a more comprehensive solution.
? This has now forced some euro zone leaders to move to a new phase and admit something they long denied: namely that Greek debt will need to be restructured and not everybody will always be bailed out. On one level this is sensible; reality is finally starting to bite. But on another, it takes the crisis to a new level – again, following the 2008 playbook. For what euro zone governments have done is push investors across a crucial psychological Rubicon – and make them realise that assets that used to seem risk-free now carry credit risk. As shocks go, this is perhaps comparable with the US government’s decision to put Fannie and Freddie into conservatorship in the summer of 2008. A sacrosanct assumption is being overturned; investors no longer know what to trust.
? Unsurprisingly, this is stoking a contagious sense of fear. The traditional investors in euro zone bonds (just like the investors who were holding Fannie and Freddie bonds or triple A mortgage assets in 2008) have little experience in assessing credit risk. Thus they find it hard to judge which countries are “safe”, or price for that risk. Worse still, very few investors (or even regulators) really understand the complex web of interconnections between the euro zone banks. The issue is not merely loans and holdings of euro zone bonds; there is limited granular, real-time data on credit derivatives exposure. And getting a sense of a bank’s real “whole country” exposure is tough, since banks stopped measuring their risks this way in recent decades.
? As this fear spreads, another ghost of 2008 returns: short-term funding risks. As a brilliant paper from the Peterson Institute points out, the structure of the eurozone system has encouraged its financial institutions to become heavily reliant on short-term funding; the 90 banks covered by the recent European Banking Authority stress tests, for example, need to refinance 5,400 billion euros of debt in the next two years, equivalent to 45 percent of European Union gross domestic product. Until recently, it was easy to roll over these funds because of the implicit moral hazard in the euro zone (it was assumed nobody would default) – now this assumption has cracked. There is thus a rising risk of an accelerating capital flight. Short-term funding could yet dry up, as it did for dollar-structured investment vehicles in 2007, and Bear Stearns and Lehman Brothers in 2008. Particularly since the unpredictable actions of credit rating agencies are – once again – fuelling market fears.
So will this now be followed, as it was in 2008, will a full-scale financial meltdown? Will panic spread when investors suddenly stumble on some overlooked interconnection risks? Just remember what happened, say, when it transpired after Lehman collapsed that hedge funds assets were not ringfenced in London; the legal fine print of opaque financial contracts can sometimes matter enormously but have unpredictable consequences.
Will that turn a sticky summer into a turbulent autumn? And then produce a wintry “real economy” hit? I fervently hope not. But nobody can deny that there is a rising sense of déjà vu, to use a phrase from France, the core of the euro zone. The Gods of Finance might chuckle. Then weep.