Ambrose Evans-Pritchard: Who will bail out the euro?


By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, October 8, 2008

Better late than never. A half-point cut in global interest rates may not halt the slide into a debt deflation, but at least we can hope to avoid the errors of the Great Depression. The slump -- remember -- had little to do with the 1929 crash. What turned the mild recession of 1930 into the sweeping devastation of the early 1930s was an entirely avoidable collapse of the banking system in both the US and Europe.

The culprit was tight money, made worse by beggar-thy-neighbour policies. The key levers of power in Western finance were held by the sorts of people who now think it is a good idea to drive our banks over a cliff.

Thankfully, wiser heads are in charge this time. Yesterday's move by the US Federal Reserve, the Bank of England, the European Central Bank (ECB), the Canadians, Swiss, and Swedes -- with Chinese help -- is the first time in this sorry saga that the big guns have joined forces in monetary policy to arrest the disintegration of the credit system. The Fed and the ECB are no longer fighting. That alone is a massive change for the better.

However, the failure to offer a lifeline to distressed banks across the world earlier by cutting rates is unforgivable. The G7 bloc of economic powers is in recession or on the cusp, including Japan -- where the Nikkei index fell by 10 per cent yesterday. American consumer credit is contracting at an annual rate of 7.9 per cent, the most violent squeeze on record.

The Baltic Dry Index measuring freight rates for shipping has fallen 70 per cent since May. The whole nexus of commodities except gold, now a super currency, is in freefall. Oil has fallen by 41 per cent from its peak, copper by 38 per cent, wheat by 50 per cent. Few with their finger on the pulse of global commerce now think the threat of inflation is remotely credible. Tesco's Sir Terry Leahy says food prices are now deflating at two per cent in his stores.

My view is that Washington has done what is needed to prevent the collapse of the US economy. It has taken over the entire credit system, after all, surpassing Roosevelt's New Deal.

The US has guaranteed the $3.5 trillion money market funds. It has nationalised the $5.3 trillion pillars of the mortgage market, Fannie and Freddie. The Fed is accepting any junk as collateral at its lending window. This week it went the whole hog after panic hit the $1.6 trillion market for commercial paper. It is now offering loans without any security at all. The US government has become a bank. Yes, this is US socialism. What is the alternative?

The $700 billion Paulson rescue plan should put a floor under the colossal dung heap known as "structured credit." It is a bad plan, since it does not target the money on the recapitalisation of the core banking system. But it will help refloat lenders by raising the price of beaten-down securities somewhere nearer their true "hold-to-maturity" worth.

An ugly recession is coming, as debt leverage kicks into reverse. The purge will be slow and punishing. Some 12 million Americans are already trapped in negative equity, but at least they can see where this might end. After much drama, the US institutions have risen to the challenge. The Fed, the Treasury, and Congress have managed to take some sort of coherent action. The jury is out on Europe, where the hurricane is now smashing the banking system.

Those such as German finance minister Peer Steinbruck -- who thought the sub‑prime crisis was just an "American problem" -- have had a rude shock. The collapse of Hypo Real with E400 billion of liabilities has made him face the unsettling truth that German banks have played a big part in this $10 trillion speculative venture undertaken by the whole global banking industry.

Europeans borrowed vast sums in dollars in the offshore money markets when dollar credit was cheap. This was leveraged by multiples of 50 or 60 to fund whatever craze was in fashion -- Russia, Brazil, infrastructure. The credit crunch has left these banks floundering. They have to pay back a lot of dollars, yet the underlying assets are crumbling. They are caught in a self-feeding spiral of "deleveraging." Even those European banks that stuck to stodgy investments are caught in a vice, since many rely to some degree on three-month loans for funds. That market is jammed shut. They cannot roll over their loan books. This way lies sudden death, as Hypo discovered.

Who in the eurozone can do what Alistair Darling has just done in extremis to save Britain's banks, as this $10 trillion house of cards falls down? There is no European Union treasury or debt union to back up the single currency. The European Central Bank is not allowed to launch bailouts by EU law. Each country must save its own skin, yet none has full control of the policy instruments.

Germany has vetoed French and Italian ideas for an EU lifeboat fund. The former knows exactly where that leads. It is a Trojan horse that will be used one day to co-opt German taxpayers into rescues for less Teutonic EMU kin. One can sympathise with Berlin. But sharing debts with Italy and Spain was implicit when they agreed to launch the euro. A shared currency entails obligations. We have reached the watershed moment when Germany has to decide whether to put its full sovereign weight behind the EMU project or reveal that it is not prepared to do so in a crisis.

This is a very dangerous set of circumstances for monetary union. Will we still have a 15-member euro by Christmas?

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