German Moves Worry The Markets

Kash Mansori:

The other news today was that the German government may be preparing to recapitalize their banks in the event of a Greek debt default. I've argued before that there are numerous signs that people are losing confidence in the European banking system, and this news strikes right at the heart of that concern.

For months and months European governments have been working hard to reassure people that the European banking system is sound. And then comes this news that Germany is already working on figuring out how to strengthen their banks. Once again, you can read that two completely different ways.

You could take heart from this news, and take it as a sign that the German government has a plan, and will step in if things go wrong to make sure that their banks are safe. It was only two weeks ago that Christine Lagarde, head of the IMF, was urging Europe to take concrete action to strengthen the European banking sytem. Maybe this simply means that the Germans were listening, and are being prudent. If so, it's entirely reasonable to read this as good news.

But on the other hand, you could hear this news and think that maybe it means that the German government knows something we don’t know. Maybe it suggests that the German government thinks that Greece really is about to default. Or worse: maybe it suggests that the German government believes that the European banking system really is weak and vulnerable. In that case, this could be a very, very bad sign.

It is time for the Europeans to decide what they are going to do.  Are they going to give up state sovereignty and form a stronger European Union, or are they going to give up on the Euro project?  My guess is that in the end, they will give up on the Euro and look for a different way to start over.  Otherwise, the Germans are going to have to make very large monetary contributions to bail out Greece, Italy, Spain, Portugal and Ireland.  I would guess that the Greeks will default, followed by Italy, then later Spain and Portugal, while the Irish will give up on propping up their banks.  The Germans will be forced to spend their money bailing out their own banks, the Eurozone will split up, and the world economy will fall off the cliff.  I don't know how badly those events will hurt the Chinese economy, and the Canadians and Australians who depend on China's ravenous demand for commodities, but I'm sure it'll be a body blow to the U.S. economy, which still has way too much public and private debt, and no real demand in their economy.  It's going to be rough sailing, but it should be pretty familiar territory-1931 all over again.

Update: Barry Eichengreen has more on the European political crisis.