Anatomy of a Financial Meltdown

 

Takeaway

  • Depositors are fleeing Greek banks, creating a liquidity crisis
  • European banks are hesitant to lend to each other for fear of a default
  • Even if the U.S. reaches a debt ceiling deal, wealth might not flee to the U.S. dollar as it has before

The European debt situation continues to deteriorate, and the U.S. is not far behind. All the distress that is now focused on government debt comes from excessive private indebtedness as developed-world countries seek to support the private sector. This has shifted the debt burden to the government sector, and now the government is the problem rather than the solution. This is the outcome of a debt-bloated economy. (For more discussion of this issue, see the video of my recent interview with economist Dr. Lacy Hunt.)

Cover-ups tend to unravel when there is a hole so large (and getting larger) relative to the resources available to fill it. This happens even faster when the cover-up involves so many moving parts and requires so many volunteers to take the hit, particularly when there are strong private incentives not to volunteer.

The banks that were to roll over Greek debt at ridiculously low yields have largely already dumped their bonds to get out of the charity business. The rating agencies have shown some backbone (or creditability survival instincts) by downgrading Portugal and Ireland to junk, expanding the necessary cover-up.

Depositors are fleeing Greek banks (and probably others, as short-term funding rates in Europe rise), creating a liquidity crisis in which banks are loath to lend to other banks for fear of a default. A liquidity crisis morphs into a solvency crisis if banks are forced to dump bad assets at the already depreciated market terms and dump otherwise good assets at deep discounts to fund the deposit withdraw. Each asset sale is noted by the bank accountants as a reduction of income and capital.

The important and relevant question is where the private wealth will flee. It appears the answer will be that it will not gravitate to the usual places — such as the U.S. dollar and the U.S. Treasury — even if a U.S. debt ceiling deal is done on time.

Read the full version of this article on Professor Spellman’s blog, The Spellman Report.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.

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