Wednesday, 22 December 2010

Year Two of the big cleanup

 About this time last year I wrote that 2010 would be a year of normalisation. In particular that risk premiums should adjust to a new normal. I have for quite some years had the perception that risk had become way to cheap as the US Federal Reserve for more than two decades had chosen to add liquidity every time some problem showed up. Every time the result was to push down interest rates.
Well, I was only partly wrong in my predictions. Apparently, returning to a normal situation in the credit markets will take several years and could not be done in just one year. The Peripheral Euro zone members are far from being saved yet. The overall banking sector in Europe could suffer badly and end up zombie-like in the years to come.
The European debt crisis is far from over. The financial press has with great success obfuscated the fact that there are two problems. The sovereign crisis in Southern Europe is well covered. Much less so the European banking crisis and the two are intertwined, as the European banks hold loads of debt issued by the Southern Europe. Letting one of the southern countries default would immediately hit e.g. German banks badly.
I have great respect for the German design to strengthen the Eurozone institutions, saving the banking sector AND to make sure that Moral Hazard cannot be an element in business risk taking going forward. The problem is that unless radical action is taken, it cannot all happen at the same time. Without the will to actually solve the problems, Europe will simply postpone, play for time, while the bill keeps climbing.
The only radical action would be to nationalise the banks, fire the management, let bondholders take a haircut, keep the banks on the balance sheet while they reorganise and eventually sell them off in the stock market. The bad debt could be sold off in the market too with a partial government guarantee.
This Swedish solution appears more and more appealing by the day. Except of course that the banking lobby is now so strong that politicians cannot any more ignore it.
But elsewhere things are looking equally bad. The US has a well-known Federal budget problem. And a much less publicised problem with states and cities that also have deep financial problems. According to recent data releases, US states may together have a $1tn deficit that has to be financed somehow. Those working to find out how bad the situation is, are complaining that the transparency in the accounts is worse than anything seen in the banking sector (sic!).
So we entered 2010 with a vague feeling that risks had to be re-priced. At the end of the year it is dawning that the debt problem is larger than assumed and that more radical action is needed, but the political will is sorely needed. The markets will continue to re-evaluate the price of risk.
The problem for the rest of us is that the subsequent need to curb runaway budget deficits will act as a brake on the economic growth going forwards. Add that the pension problem is now growing quickly in Europe, creating a further long term problem.
So do not expect 2011 to be any calmer than 2010. Two years ago I believed that it would take five to seven years to work our way out of the debt crisis. 2010 proved that the way out is not an easy one. And it seems likely that we have another 3 to 5 years ahead of us before the situation will approach normal.