World economy stares at the Lehman 2.0 moment?

The world economy is in deep turmoil, and Europe appears getting ever closer to the abyss. It is almost certain that if Spain and Italy lose access to the debt markets, it could become the Lehman moment of the Eurozone crisis.

Faced with an existential crisis, the ECB belatedly took the plunge and started buying Spanish and Italian bonds in an effort to reassure investors and signal its commitment to stand by the Euro. However, Spain and Italy pose an altogether different scale of problems.

Unlike the earlier attempts with Greece, Portugal and Ireland, Spain’s bond market, at about €650bn, is bigger than that of all the three combined and Italy’s bond market, with its €1,600bn of bonds outstanding, is smaller only than Japan and the US. Therefore, though a predominantly liquidity crisis, as opposed to solvency problems in Greece, the challenge is massive.

Hitherto, the ECB has stayed away from direct purchases, preferring to work through the European Financial Stability Facility (EFSF), which was created to lend to and repurchase Greek, Irish and Portuguese bonds. However, its €440bn corpus has already been committed to those three economies and the requirements of Spain and Italy are in a different scale than what the EFSF could support.

Paul Krugman hit the nail on its head with this excellent analysis of the problem facing the crisis-hit Eurozone economies,

"In the case of Greece and probably also Ireland and Portugal, I’d argue that we’re looking at fundamental insolvency. The debts are just too big, the required fiscal adjustment just too large even if interest rates were low, to make full payment plausible.

In the Italian case, you have big debt but also a primary budget surplus. So if interest rates stayed low, as they would if no default were expected, it wouldn’t be hard to service the debt with only modest further fiscal adjustment. But if people expect a default – and also if they believe that once a country takes on the fixed cost of default, it might as well impose a big haircut on creditors – then you could see interest costs rising to a point where default indeed becomes the preferred option.

So there is a reasonable case that what we’re seeing in Italy is a self-fulfilling crisis trying to happen, in which fear of default is precisely what leads to default. And that’s exactly the kind of case in which intervention could short-circuit the crisis. Let the ECB buy lots of Italian bonds, in effect guaranteeing a low interest rate, and the possibility of default fades – which in turn means that further intervention isn’t needed. It’s certainly worth a try."

He also makes the important point that "a country with its own currency would not be subject to the kind of self-fulfilling panic that is now arguably hitting Italy". A normal country has access to two policy levers to address debt problems that Eurozone economies do not have - ability to inflate and/or devalue away their debts. It is therefore no surprise that even as the 10 year bonds of Italy and Spain have risen to 5.27% and 5.12% respectively, that of UK, which retains the conventional policy options, trades close to Germany at 2.6%. This is despite similar macroeconomic problems and austerity programs in all three countries - debt to GDP ratios being 120%, 69% and 80% for Italy, Spain, and UK respectively.

The dangers are not restricted to public debt overhang. European banks are heavily exposed to Italian and Spanish debt and any fears of a default could devastate the global financial markets. In fact, except for German bonds, Italian debt is more widely held by European banks than any other government obligation. Europe’s 90 largest banks collectively hold Italian debt with a face value of €326 bn, and US and Spanish debt in the range of about €287 bn each. This overshadows the €90 bn in Greek debt held by the same banks.

About the Standard & Poor's downgrade of US long-term debt rating, by itself, its impact is likely to be minimal (though in confluence with other factors, it can be critical), both for the US and others. It would have been different if the Fed and other regulators had accepted it and mandated that financial institutions recalibrate their protfolios to reflect the new ratings. This would have effectively forced the default of many financial institutions as a flight from US Treasuries and a scramble for non-existent AAA assets (in huge quantities) would have ensued.

Further, as Paul Krugman recently wrote, the short-term debt arithmetic for the US is not as alarming as believed. As the example of Japan continuing to raise debt at less than 1% despite a 2002 ratings downgrade shows, the short and medium-term impact on the US economy of the ratings downgrade is likely to be marginal.

Perversely, the global nature of the financial and economic crisis benefits the US. Europe is mired in its own deep-seated problems and the emerging economies, with their dependence on the fate of advanced economies, too face the prospect of a slowdown. In such uncertain circumstances, investors take flight to "safe assets", with the US Treasuries and Gold being the two standard safe havens.

The remaining alternatives look far from ready to replace gold and US Treasuries. As Gold approaches its all-time peak, its attractiveness will diminish. Euro-denominated assets, the emerging third alternative, and assets of emerging economies are seen as too risky. This shortage of safe assets means that the US Treasuries will continue to remain the one to invest in the foreseeable future. In any case, none of the big emerging economies, led by China, can afford to pull out investments from Treasuries without suffering huge losses themselves.

The single biggest consequence of the US ratings downgrade is its role in amplifying the already high market uncertainty. The speculation surrounding the French debt position is surely a result of the American ratings donwgrade. And that decision could accelerate the downward spiral.