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Nearing the precipice?

27 May 2010

4:22 PM

27 May 2010

4:22 PM

Recent events in the Eurozone have led a number of commentators to suggest that we are
nearing some repeat of the financial crisis that followed the nationalisation of Fannie Mae and Freddie Mac in August 2008 and the subsequent (and consequent) bankruptcy of Lehman’s. In my view,
the current situation is rather different from that in 2008, but matters could turn out much worse.

Our situation is not like 2008 (yet) because:

– not such a high proportion of AAA securities has been reduced to junk status

– there are now slightly more robust resolution regimes in place for banks

– banks have a bit more liquidity

– US and UK banks have a bit more capital (notionally)

However, it could turn out much worse than 2008 did because:

– European banks have their undeclared subprime losses PLUS their sovereign debt losses

– Rich countries have exhausted their taxpayer willingness to bail out banks

– Poor countries have exhausted their solvency capacity to bail out banks

– Both sets of countries nonetheless have implicitly or explicitly backed their banking sectors, so bank defaults will be quasi-sovereign defaults

– There’s no money left for fiscal measures to smooth the path of transition if the banks go under

– There’s not much scope for additional QE without really risking hyperinflation

Thus, if the balloon goes up this time, it really goes up – the authorities mishandled and over-committed so badly in 2008 that a collapse of the banking sector this time could well mean the
"Great Depression squared" scenario long feared (when in 2008 that wouldn’t have happened).  If the banks collapse now even despite the incredible taxpayer funds ploughed into
them the bailouts of 2008 and early 2009 will go down in history as the greatest economic folly in the history of mankind.  We might even be reduced to creating deliberate hyperinflation or
proclaiming universal debt amnesties.

But of course, we could muddle through.

Do you feel lucky, punk?

Andrew Lilico, Chief Economist, Policy Exchange

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