Wednesday, December 15, 2010

Europe 2010 = Subprime 2007?

The news out of Europe seems to get worse and worse. Last week Bloomberg reported that the price of default protection, or credit default swaps, of American banks (despite all of their problems) were lower than those of European banks. Then IMF chief Dominique Strauss-Kahn criticized Europeans for taking a piecemeal approach to solving their problems, rather than to undertake a big picture comprehensive solution.

Many eurozone supporters have been afriad to say this, but the traditional IMF solutions to sovereign debt crises would not work in Europe. When a country gets into trouble and asks the IMF for help, the usual package is to offer loan assistance in return for the demands that the country goes on a fiscal diet (cut spending drastically) and get a job, any job (currency devaluation). Devaluation, it is believed, gives the economy a shot of export adrenaline and the reduced spending puts the budget in better shape to benefit from the export jolt. In the case if the PIIGS, devaluation isn't possible, so only fiscal austerity is left to support any adjustments. Even the post-crisis pains that we have seen in places in Argentina, Indonesia and Malyasia won't be enough in the wake of the lack of currency devaluation.

The only obvious solution is default, which the Germans, French and other core eurozone countries will not tolerate because of the threat to their banking system. In fact, Dani Rodrik was to latest to suggest that an amicable divorce is the best solution for Europe.

Still in denial
Europeans appear to be in denial over their problems. Dylan Grice of Societe Generale wrote about the three stages of denial:
The dawning of reality hurts. Prodded and bullied along a tortuous emotional path by events unforeseen and beyond our control, we descend through three phases: the first is denial that there is a problem; the second is denial that there is a big problem; the third is denial that the problem was anything to do with us.

Right now, it seems that European pronouncements are somewhere between stage one (not a problem) and stage two (not a big problem). They sound a lot like the US reaction to the subprime crisis. As late as March 2007, Ben Bernanke testified before Congress and stated [my emphasis]:
At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained. In particular, mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to perform well, with low rates of delinquency.
There is no need to panic, yet. Grice wrote that "When they start blaming everyone else for their problems, we’ll know their crisis is nearly over Until then, their plight likely has some way to go. " To be sure, despite his criticism of European policy, Dominique Strauss-Kahn also stated that he expects that the euro will still exist in five years.

A repeat of 2007/8?
For me, the markets today have a feel of late 2007/early 2008 to them. We have a commodity price blowoff now much like the price blowoff that began in late 2007, which are typical signs that we in the late innings of the bull market cyclical rotation. Problems are mounting (Europe and China) but the bull is roaring ahead.

I recognize that history doesn't repeat but rhymes. However, given the psychology of the eurozone's PIIGS problems, it seems to me that any blow-up is likely a 2H 2011 or 2012 event. In the meantime, enjoy the bull but don't forget your risk control discipline.


Also sprach Analyst said...

This is not the kind of story I like, but I am afraid that it does feel like 2007/2008 now.

Also sprach Analyst

Michael Eckert said...

I have been following you for awhile now and was curious if you would like to exchange blog links.