The Parallax Brief

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Unrepentant Subjectivity on Economics, Politics, Defence, Foreign Policy, and Russia

The Next Shoe to Drop on the Road to financial Armageddon?

In an enlightening speech to the American press club on December 8th, Paul Krugman was asked if there were “any more shoes to drop?” He responded that “in this kind of crisis, anything that can go wrong usually does go wrong.”

Certainly, a little over two months after the conference, the situation has worsened considerably.

But what other shoes are likeliest to drop? Well, as Krugman said, everything, but the Parallax Brief has two main contenders.

The first is a full blown trade war between China and the US. Such an event would so clearly and inevitably lead to Armageddon for both China and the US (and thus the world) that one might assume neither would let it happen. But then this ugly blog entry from Free Exchange crashed onto my computer screen last Friday:

LUO PING, director-general at the China Banking Regulatory Commission, takes the increasingly contentious relationship between America and China to a new level during a speech in New York:

Mr Luo, whose English tends toward the colloquial, added: “We hate you guys. Once you start issuing $1 trillion-$2 trillion [$1,000bn-$2,000bn] . . .we know the dollar is going to depreciate, so we hate you guys but there is nothing much we can do.”

Mr Lou expressed his frustration that the market lacks any other “risk-free” asset. He also warned that the Chinese government would not invest in troubled financial institutions, at least any time soon.

When tempers fray, anything can happen.

The Parallax Brief’s second prediction is that the depression already afflicting most of Eastern Europe will spread contagion to the more developed EU nations and cause a cascade of defaults or agonizing IMF bailouts and economic reorganizations.

Ambrose Evans-Pritchard claims that Austria has the equivalent of 70% of its GDP invested in Eastern Europe and a default rate of 10% will lead to a collapse of its financial system, and that this is about to happen:

Stephen Jen, currency chief at Morgan Stanley, said Eastern Europe has borrowed $1.7 trillion abroad, much on short-term maturities. It must repay – or roll over – $400bn this year, equal to a third of the region’s GDP. Good luck. The credit window has slammed shut.

[…]

Almost all East bloc debts are owed to West Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks.

[…]

Whether it takes months, or just weeks, the world is going to discover that Europe’s financial system is sunk, and that there is no EU Federal Reserve yet ready to act as a lender of last resort or to flood the markets with emergency stimulus.

[…]

The sums needed are beyond the limits of the IMF… We are nearing the point where the IMF may have to print money for the world, using arcane powers to issue Special Drawing Rights.

Its $16bn rescue of Ukraine has unravelled. The country – facing a 12pc contraction in GDP after the collapse of steel prices – is hurtling towards default, leaving Unicredit, Raffeisen and ING in the lurch… Latvia’s central bank governor has declared his economy “clinically dead” after it shrank 10.5pc in the fourth quarter. Protesters have smashed the treasury and stormed parliament.

“This is much worse than the East Asia crisis in the 1990s,” said Lars Christensen, at Danske Bank.

“There are accidents waiting to happen across the region, but the EU institutions don’t have any framework for dealing with this. The day they decide not to save one of these one countries will be the trigger for a massive crisis with contagion spreading into the EU.”

Europe is already in deeper trouble than the ECB or EU leaders ever expected. Germany contracted at an annual rate of 8.4pc in the fourth quarter.

The implications are obvious. Berlin is not going to rescue Ireland, Spain, Greece and Portugal as the collapse of their credit bubbles leads to rising defaults, or rescue Italy by accepting plans for EU “union bonds” should the debt markets take fright at the rocketing trajectory of Italy’s public debt (hitting 112pc of GDP next year, just revised up from 101pc – big change), or rescue Austria from its Habsburg adventurism.

So we watch and wait as the lethal brush fires move closer.

If one spark jumps across the eurozone line, we will have global systemic crisis within days.”

No wonder Krugman’s mood seems have grown worse in the two months since that speech. In his New York Times column last week he wrote, “I’ve got a sick feeling in the pit of my stomach.”

Likewise.

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