Euro at risk from economic storm

We know that rates on $1,500 billion (Dh5.50 trillon) in adjustable mortgages will jump by 300 basis points over 18 months. House prices may fall by 15 per cent from peak to trough. S&P has raised the default forecast on 2006 sub-prime debt from 14 per cent to 19 per cent. “The US housing market slump may last far longer than previously expected,” it said. The phase of denial is over.

Goldman Sachs and Merrill Lynch expect recession. “The perfect storm took time to brew, but it hit hard and fast – much harder and faster than we expected,” said Bank of America. Few still insist the real economy can shrug off an implosion of credit. Fund managers are adapting to the new consensus. A fifth now expect a global slump.

Citigroup is coming clean on write-offs with abject confessions: a further $18.1bn last week. Merrill swallowed $16.7bn.

The apparatus of the US Government is now in rescue mode. The Federal Home Loan Bank system has quietly slipped mortgage banks $750bn since the crunch. It injected $210bn in November alone, with taxpayer guarantees. Citigroup gobbled $95bn. God bless socialism. The Fed will cut rates a half point to 3.75 per cent by month’s end, if not more.

Ben Bernanke is “exceptionally alert” after unemployment jumped from 4.7 per cent to five per cent in December, the sharpest rise in a quarter century. “It is patently obvious the Fed has thrown its inflation worries to the wind,” said Stephen Stanley, from RDB Greenwich Capital. Quite right too.

Oil has broken below $90 a barrel. The Baltic Dry Index is in free fall. Shipping shares are crashing. Will anybody care about US inflation in six months?

The White House is crafting the Bush bail-out, an instant helicopter drop worth one per cent of GDP. Congress is not going to get in the way. “Everyone should put their ideological baggage aside and try to pump money into the economy to get things going,” said Charles Schumer, Senate banking chairman. Spending is no cure. It will add to imbalances that have already degraded the US economy from top creditor to top debtor in a generation. But a double-shot of fiscal and monetary stimulus, laced with moral hazard, can stabilise credit. Note that the US commercial paper market finally stopped disintegrating last week. It added $35bn.

Yet if the storm is peaking in the US, it has hardly begun in Europe. Bernard Connolly, global strategist at Banque AIG, says euro losses may surpass the US debacle. “The next really big shock to financial markets is likely to be the risk of collapse in the European Monetary Union (EMU) credit bubble: the private sector credit consequences are likely to be catastrophic,” he said.

Budget deficits must stay below three per cent of GDP, on pain of fines. Germany once breached this with impunity, but that was before Angela Merkel appeared. Virtuous again, Germany now demands rigour. Since France and Italy are already nearing the three per cent buffer, they may have to tighten into a downturn. Monetary bail-outs are not allowed either, at least not until the German bloc gives a green light to the European Central Bank (ECB).

We are a decade into EMU. The outcome is what Bundesbank sceptics feared. Interest rates have been far too low for Club Med and Ireland, fuelling property booms. These have burst, are bursting, or will burst. The victims are beached with current account deficits of 10 per cent of GDP in Spain, 13 per cent in Greece.

The “Nordics” have surpluses, at Club Med expense. Italy and Spain have lost 30 per cent in labour competitiveness against Germany under EMU. France has lost 20 per cent. An attempt to deflate these countries back to balance will run into revolt. Hedge funds are already circling. One has set up a Euro Divergence Fund. BNP Paribas said spreads on Club Med debt will soar this year to levels never seen in the euro-zone. “The markets are going to punish wrongdoing,” said Hans Redeker, the bank’s currency chief.

“The politicians in Italy and Spain do not seem to realise how deep-rooted their problems are. They may have to cut real wages,” he said. “While tensions can be camouflaged during economic upswings, they surface during downswings. All failed currency unions were abandoned during times of economic stress,” said the bank.

We are nearing the moment when the ECB must decide whether it is a bank or the political guardian of the EU project. It cannot be both. The credit crunch needed to restrain German wage deals after the rail workers won 11 per cent will crucify Spain.

More than 40,000 estate agents closed doors in Spain last year. Property prices are dropping in Madrid, Barcelona, and Seville. Spanish banks are issuing mortgage bonds to use as collateral at the ECB’s window, without even trying to sell them on the open market. La Gaceta said this “abuse” has reached 40bn euros.

The ECB has taken the political pulse of Latin Europe and concluded rigour is now too dangerous. It will face a hostile troika of Paris, Madrid and Rome if it persists, risking EMU schism. Trumped by politics, the Germanic hawks have climbed down.

The euro fell hard last week. It is the start of a long slide to levels that reflect a sluggish, half-reformed bloc in demographic decline. The euro must be weak, or it will break. Whatever happens, it is already too late to avoid the Latin Crisis of 2008. (The Daily Telegraph)