Are we living in a new age of Nero? The Roman emperor, of course, is infamous for fiddling while Rome burned.
Historian Barbara Tuchman used the phrase “Neroism is in the air” to describe German attitudes prior to World War I. This implied not just a certain feckless disregard for looming danger, but a willingness on the part of some to openly tempt fate.
Neroism is all around us, but one prime example is the U.S. electorate’s blithe unconcern about deteriorating economic prospects in Europe and China.
Let’s consider Europe. Why should we here in the United States worry about whether Greece defaults or the euro system self-destructs?
The answer is that the world financial system is so integrated that a major financial crisis in Europe inevitably will spill over into U.S. financial institutions. And the U.S. financial system is no more robust than it was in the spring of 2007.
Consider two factors.
First, toppling domino defaults by Greece and Portugal, perhaps followed by Ireland and Spain, would cause large losses for European lenders.
It’s true that U.S. banks have relatively little direct exposure, at least compared with European ones. But U.S. financial institutions reportedly have written between $150 billion and $200 billion in credit default swaps guaranteeing European government and private debt. These are the insurance-like contracts to indemnify lenders if their borrowers default that in 2008 effectively bankrupted AIG and other U.S. financial firms.
Even though U.S. financial institutions have repaid most of the TARP money used to bail them out 30 months ago, along with much of the direct lending from the Federal Reserve, many such financial firms remain shaky, with tens of billions in loans and securities of questionable value on their books. But that hasn’t kept some of them from returning to the same risk-embracing that got them into trouble in the first place.
The second factor is that U.S. money market funds have a significant share of their money invested in debt issued by the very European banks most exposed to harm in case of a default by Greece that spirals out of control. Some estimates place this proportion as high as 40 to 45 percent. This is driven in part by the fact that, in the wake of the 2008-09 stock market decline, many individual investors pulled money out of stocks and parked it in money-market funds. These offer lower long-term returns than equities, but are deemed safer.
The irony is that the flight from stock markets into money-market funds, normally thought to be near-cash in terms of safety and liquidity, put money-market fund managers in a bind. They had to find somewhere to place the money flooding in. And so they are more willing to consider buying paper they might have had less interest in five years ago. And this has made short-term borrowing via unsecured paper an easier option for European banks than it might have been if not for the fact that money markets are awash in money.
The upshot is that U.S. financial firms and U.S. households do have more direct exposure to a European crisis than most people think. And that is aside from the fact that once a financial crisis reaches a certain critical size, national borders and the balance sheets of specific institutions mean very little.
The American public is like France’s Bourbon dynasty, of which Talleyrand, the insightful observer of French affairs, said: “They learned nothing and they forgot nothing.” He meant that the nobles thrown out of power in the French Revolution had learned nothing about the mistakes that led to their overthrow. And they harbored grudges against everyone who had harmed them in any way.
We did not learn how important it was to reduce risk- taking by large financial firms to increase the inherent stability of our nation’s financial system. The Dodd-Frank Act certainly doesn’t do it and proposed Republican alternatives are worse.
If anything, we doubled down, increasing the concentration of financial sector assets into fewer and larger firms. And the electorate has not forgotten how big financial firms were “bailed out” at the end of the Bush administration, while little was done for the average household. So further bailouts are politically anathema.
This was the wrong lesson. The 2008-09 bailouts were bad policy, but they were the least adverse of some very bad alternatives. We got off easy two years ago, though there is no way to prove that to average citizens. A financial system can collapse, and drag an economy down with it. Our mistake was to get to a point where bailouts of megafirms were necessary to prevent economic catastrophe. It was not the bailouts themselves.
People don’t appreciate that distinction yet. Perhaps it will take a harsher lesson for it to sink in. That is a tragedy. The lesson may begin in Europe, or here, or Asia, depending on one’s favorite scenario. But the likelihood of something bad unfolding is much higher than people appreciate.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.