The 'Contagion' scenario

[Democracy Simulator]

I thought it might be worthwhile to start a general thread on the events in Europe; how those events may play out and the likelyhood and impact of various scenarios on the financial system and the global economy.

I'm mainly interested in exploring the 'worst-case' scenario. What is the worst-case scenario and how likely is it that events will play out to lead us down this road?

Obviously, this thread will contain a lot of speculation, but I'm interested to explore various 'if A happens, then B will happen' scenarios.

So to kick off, I am putting forward this scenario which seems to be plausible:

1. Greek Default and forced exit from the Euro
2. Contagion spreads to the other PIIGS
3. Spain defaults

At the point where Spain defaults, are all bets off? I was reading this today in the Independent newspaper:

Michael Symonds, an analyst at Daiwa Capital Markets Europe, warned Bankia was the "tip of the iceberg" and criticised Spain for taking a "piecemeal approach". He warned: "Our view is that if Greece leaves the euro and contagion spreads to Spain and Italy, no amount of capital will be adequate."

Should Greece default, what is the likelyhood that contagion will spread to the other PIIGS nations? What does this 'contagion' consist of? Should similar effects occur in Spain, is default a real possibility? What happens in the event of a Spanish default?

 

[GlennB]

What does this 'contagion' consist of?

That's the real question, imo.

If Spain is fundamentally unsound then what does Greece have to do with it?
If it's sound then 'contagion' would appear to be based on hysteria, in which case whose hysteria would do the damage?

 

[kevsta]

Niall Ferguson on CBC yesterday on bank runs

http://www.cbc.ca/video/watch/News/TVShows/Lang & O'Leary Exchange/ID=2239470660

"Just when we think the worst is over - and let's face it we have been in this crisis for five years - we get the second half; are the Europeans about to start the second half our Great Depression with massive bank runs"

his main concern is that this kind of (bank-run) event can quickly spiral out of the control of even the ECB as he uses the image of the initial US stabilization that occurred in 1930 to May 1931 only to be knocked back into a greater depression by the failure of Credit-Anstalt, which set off bank failures and eventually defaults in 1932 on many government debts.

 

[Francesca R]

If Spain is fundamentally unsound then what does Greece have to do with it?

Fundamentally sound banks can be rendered fundamentally unsound through bank runs. They can be self-fulfilling things.

If it's sound then 'contagion' would appear to be based on hysteria, in which case whose hysteria would do the damage?

Doesn't matter whose hysteria, the damage can still be genuine.

 

[kevsta]

Fundamentally sound banks can be rendered fundamentally unsound through bank runs. They can be self-fulfilling things.
Doesn't matter whose hysteria, the damage can still be genuine.

picture from Sweden yesterday, any ideas anyone?

Should similar effects occur in Spain, is default a real possibility? What happens in the event of a Spanish default?

not only a possibility, a mathematical probability IMO. the losses are still way worse than anyone is admitting in Spain, after 4 years of hiding them hoping for a rebound, its still heading down.

like Greece, I dont see any future for Spain in the Euro over the intermediate term.

 

[Francesca R]

On Friday and Saturday afternoons there are similar queues at ATMs here as well, in the rush to cash-up before a night out. Sunny weather makes it worse. I think its outrageous and the BOE should step in.

 

[kevsta]

On Friday and Saturday afternoons there are similar queues at ATMs here as well, in the rush to cash-up before a night out. Sunny weather makes it worse. I think its outrageous and the BOE should step in.

lol. the source was ZH and they can be a bit scaremongery it's true.

 

[Democracy Simulator]

That's the real question, imo.

If Spain is fundamentally unsound then what does Greece have to do with it?
If it's sound then 'contagion' would appear to be based on hysteria, in which case whose hysteria would do the damage?

I think the problem for Spain is that the Spanish banks are fundamentally unsound - as you say, contagion might have little to do with a potential Spanish default. Mariano Rajoy said this on Friday, in the context of the Bankia bailout:

"We are not going to let any region or financial entity fall, because otherwise the country would fall," he said.

Read more: http://www.canberratimes.com.au/bus...ts-knees-pm-20120529-1zfwb.html#ixzz1wDzBoijk

That comment seems to confirm that regions and banks are on track to fall, without massive intervention. Yet, where is this money coming from? In another comment Rajoy seemed to allude to the effects of contagion from Greece, driving up the price of Spanish borrowing:

"There are major doubts over the eurozone and that makes the risk premium for some countries very high,"

 

[kevsta]

I think the problem for Spain is that the Spanish banks are fundamentally unsound - as you say, contagion might have little to do with a potential Spanish default.

the banks are insolvent, since 2008 they have been attempting to hide the vast RE losses and hoping for a rebound in housing to save them, it isn't coming and the timing doesn't really have that much to do with Greece IMO.

http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100017477/spain-runs-out-of-money/

..so where is the €23.5bn for the Bankia rescue going to come from?

The state's Fund for Orderly Bank Restructuring (FROB) is down to €5.3bn, and there are many other candidates for that soup kitchen.

Spain must somehow rustle up €20bn or more on the debt markets. This will push the budget deficit back into the danger zone, though Madrid will no doubt try to keep it off books – or seek backdoor funds from the ECB to cap borrowing costs. Nobody will be fooled.

Meanwhile, Bankia's shares crashed 30pc this morning. JP Morgan and Nomura expect a near total wipeout. Investors who bought the new shares at flotation last year may lose almost everything.

This all has a very Irish feel to me, without Irish speed and transparency. Spanish taxpayers are swallowing the losses of the banking elites, sparing creditors their haircuts.

Barclays Capital [& kevsta for 3+years] says Spain's housing crash is only half way through.

Home prices will have to fall at least 20pc more to clear the 1m overhang of excess properties. If so, the banking costs for the Spanish state are going to be huge.

The Centre for European Policy Studies in Brussels puts likely write-offs at €270bn. We could see Spain's public debt surge into triple digits in short order.

 

[kevsta]

IMO there are only 2 big picture options here, vast money printing on a level never seen before, or the breakup of the Euro in it's current format.

and more than likely both.

 

[Democracy Simulator]

IMO there are only 2 big picture options here, vast money printing on a level never seen before, or the breakup of the Euro in it's current format.

and more than likely both.

There is an interesting article by Simon Johnson and Peter Boone, where they speculate on the possible course of events. The article quotes the Polish finance minister:

Jacek Rostowski, the Polish Finance Minister, recently warned that the calamity of a Greek default is likely to result in a flight from banks and sovereign debt across the periphery, and that -- to avoid a greater calamity -- all remaining member nations need to be provided with unlimited funding for at least 18 months. Mr. Rostowski expresses concern, however, that the ECB is not prepared to provide such a firewall, and no other entity has the capacity, legitimacy, or will to do so.

http://www.huffingtonpost.com/simon-johnson/euro-collapse_b_1549444.html

Johnson and Boone seems to agree that the ECB will not embark on a massive money printing spree and that this will inevitably lead to bank runs, capital flight and the break-up of the Euro. What next? This how they see it panning out:

Europe's rich capital markets and banking system, including the market for 185 trillion dollars in outstanding euro-denominated derivative contracts, will be in turmoil and there will be large scale capital flight out of Europe into the United States and Asia. Who can be confident that our global megabanks are truly ready to withstand the likely losses? It is almost certain that large numbers of pensioners and households will find their savings are wiped out directly or inflation erodes what they saved all their lives. The potential for political turmoil and human hardship is staggering.

If 2008 was part one of the crisis, it seems that all the signs are there that we have entered part two. My prediction, for what it is worth, is that Europe will stagger on but the markets will drive events so that fairly quickly there is a clamour for a several trillion euro bailout of the entire system. I don't think that this will be politically tenable, neither do I think that it is the right thing to do.

 

[Puppycow]

IMO there are only 2 big picture options here, vast money printing on a level never seen before, or the breakup of the Euro in it's current format.

and more than likely both.

Why does it have to be "on a level never seen before"?

If the ECB followed the Fed's example, they could probably bail out the banking system by printing money (TARP was actually a Treasury program, but the FED had its own bailout facility too).

 

[Puppycow]

I'm mainly interested in exploring the 'worst-case' scenario. What is the worst-case scenario and how likely is it that events will play out to lead us down this road?

The worst-case scenario is that the ECB keeps refusing to provide monetary financing to countries like Spain. Spain defaults on its debts, then banks all over Europe need bailouts. The ECB refuses to help them, so there's a run on the banks. Banks stop lending to anyone and the entire European financial system seizes up like we saw in the US after the Lehman bankruptcy. This plunges Europe into a deep depression and the eurozone breaks up.

 

[Puppycow]

Why does it have to be "on a level never seen before"?

If the ECB followed the Fed's example, they could probably bail out the banking system by printing money (TARP was actually a Treasury program, but the FED had its own bailout facility too).

To reinforce the point:

Europe Is Literally Running Out of Money

Economies need money. Without it, businesses and households stop. Just ask Spain. It's further along in the "no money" race than most. Unemployment is 25 percent, credit is drying up, and the government is supposed to cut its deficit an almost unthinkable amount.

It's a vicious circle. When there's not enough money, the economy collapses. And when the economy collapses, nobody wants to take out loans. Which reduces the amount of money even further. That's why falling European private loan growth is so concerning. Instead of borrowing more, people prefer to stuff whatever money they have under the mattress. Except nowadays we have a new name for mattresses. We call them "government bonds". That's why the yields on U.S., U.K. German and a host of sovereign bonds are at all-time lows. Heck, German two-year bonds aren't paying anything. Zero. And that's downright generous compared to Danish two-year bonds that have a negative yield. That's right, investors are paying the Danish government to hold their money.

The European Central Bank needs to wake up. Investors are legitimately worried about a euro-pocalypse dragging down the world economy. It's time to print some money.

 

[psionl0]

Investors are legitimately worried about a euro-pocalypse dragging down the world economy. It's time to print some money.

Time for a bout of "stagflation"?

 

[Democracy Simulator]

To reinforce the point:

Europe Is Literally Running Out of Money

The core problem within Europe seems to be one of solvency, so I'm not sure that printing money is going to solve that problem. Money printing may buy more time, but if the solvency issues are not solved, doesn't that mean we're just creating the conditions for a more spectacular crash? At some point some hard decisions need to be made about breaking up insolvent institutions and writing down debt, as well as living within one's means. I fear that turning on the money-printing spigot will just encourage deferment of those hard choices.
There is a stunning lack of initiative to tackle the real problem.

 

[psionl0]

There is a stunning lack of initiative to tackle the real problem.

As long as preserving the existing banking system remains paramount, "initiative" will remain a 4-letter word.

 

[Almo]

One guy who publishes one of my boardgames is in Spain. He's just published a special edition of a new one which is pretty cool for just over $200. The reason it's on topic to the thread is that he will only accept gold, silver, and bitcoins for it.

A) There's one for Kevsta
B) There's something you can buy with bitcoins that isn't illegal

 

[Aepervius]

Something which is puzzling me.... How can there be a bank run, when people are mostly using plastic card ? I pay with money only small stuff or to load actual plastic card with money in special automate (which don't yet accept bank card to charge their own card of money). I can imagine a bank run on country wanting to change their money (Greece) but I can't imagine a bank run stopping the economy or having any impact beside annoyance in country staying with the same money, like say germany. Even if the bank had no money, I could still pay with my card. And if card are not accepted anymore, then we would have much much greater and immediate problem.

 

[psionl0]

How can there be a bank run, when people are mostly using plastic card ?

The Jimmy Stewart style bank runs are probably a thing of the past.

However, banking is still much the way it has been for several hundred years except that a lot of it takes place in cyber space. Whenever you transfer money from an account at your local bank to an account at a different bank (whether it be by BPAY or something else), your bank has to transfer reserves to the other bank as well.

So a modern day bank run would see a lot of people go online and transfer money from their bank account to another bank. Once your bank runs out of "required" reserves the taxpayers get called in.