The Corner


Paul Krugman maps out one route. Here’s how it begins:

1. Greek euro exit, very possibly next month.

2. Huge withdrawals from Spanish and Italian banks, as depositors try to move their money to Germany.

3a. Maybe, just possibly, de facto controls, with banks forbidden to transfer deposits out of country and limits on cash withdrawals.

3b. Alternatively, or maybe in tandem, huge draws on ECB credit to keep the banks from collapsing.

All too plausible, I fear. Watch those banks . . .

Writing for Bloomberg, Peter Boone and Simon Johnson pile on the misery, going through the dismal history of the euro-zone crisis and “five years of complete political denial,” and then they tip out any water that is left in the (at best) half-empty glass:

So far… confidence [in the euro system]  has survived. A 10-year German bund [Treasury], priced in euros, yields only 1.5 percent, showing that investors believe that credit risk, rather than inflation risk, is all that matters.

Bund investors should beware. At the moment, most attention is focused on Greece as the trigger for a euro-area collapse. There are good reasons to believe Greece would be better off leaving the euro area (although the exit could well be traumatic initially), but the same logic also applies to many more nations. And there are other triggers: Germany might become fed up, Italy will eventually turn against Prime Minister Mario Monti, and Spain’s woes are escalating.


Europe’s highly leveraged financial system may prove too fragile to suffer even modest increases in the perceived risk of a euro collapse. For example, what interest rate would you want on a euro-denominated 10-year bond if you believed the euro could turn into a basket of currencies, some of which would be high-inflation — the Greek drachma or Italian lira, at, say, 15 percent inflation per year — and others, such as a new deutsche mark, would be low-inflation, with perhaps 2 percent inflation? Perhaps that bond would need to yield 8 percent. That is far higher than current pricing.

Today, there are about 8.5 trillion euros ($11 trillion) of sovereign bonds outstanding in the euro area, and more than $180 trillion in derivatives linked to interest rates (looking at the notional value of those contracts and keeping in mind that “net” derivative positions tend to understate true losses in a full- blown crisis). These interest-rate derivatives — known as swaps — are held by large leveraged financial institutions (banks, hedge funds), or by pension and insurance companies with large, long-term liabilities. If interest rates rise, bond prices fall, and derivative contracts change in value (good news for people who have hedged into fixed interest rates and a potential disaster for those exposed to rising interest rates).

Anyone who has bet heavily on interest rates staying low — for example, an investor with a great deal of leverage — would be at risk of failure. This type of shock could produce instability at least as extensive as the aftermath of the collapse of Lehman Brothers Holdings Inc. in September 2008. It would lead to massive redistribution of capital and wealth, forcing some leveraged institutions into instant insolvency. Investors would flee first and check the details later.

Until recently, whenever troubles worsened in the euro area, investors ran to German, Dutch and French bonds. Since capital flight stayed within the currency area, the value of the euro didn’t fall. During the last week, however, the number of troubled nations increased. French bonds weakened alongside those of Italy and Spain as concerns over Greece intensified.

External investors are also showing signs of impatience…

Tick tock.


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