It's almost August, the month everyone in Europe takes off on holiday to forget their troubles. This year may be different, though, as not only can many not afford a vacation, but Europe's troubles loom so large that forgetting them won't be easy…
In this podcast, Chris talks with PeakProsperity.com's European economy expert Alasdair Macleod about the current state of the Continent. As a reminder, Chris is keeping a keen eye on events in Europe, as he sees the region the most likely candidate to serve as the flash-point for the next major global financial crisis. Sadly, Alasdair has few reasons to convince him otherwise.
A quick spin through many of the countries there reveals much instability:
- Greece: currently living through a capital "D" Depression; destitution has reached the professional classes at this point
- Italy: teetering on the edge of political collapse as politicians fight any and all austerity measures
- Spain: rocked by political scandal, its banking system is now insolvent
- Portugal: experiencing the flight of its younger generation out of the country
- France: quickly becoming a bankrupt welfare state, as only 17 million of its 66 million citizens are working
- Holland: stumbling under the highest level of private sector debt to GDP of any EU country
- Belgium: struggling with the same challenges as Holland
- Germany: losing its sovereign wealth with every bailout of its clearly insolvent neighbors
The principal problem with austerity is that governments end up not cutting their spending, but they end up raising taxes on the private sector. Politicians are not in the business of cutting back. They are in the business of extending what they do, and consequently they see the problems as rarely being not of their making, which I know sounds bizarre, but that is the way it is.
Apart from the appalling state of affairs the governments are forcing on their electorates, I think the obvious weak point are the major banks. If you look at the big banks in Europe, they are horrendously geared (i.e., levered) in terms of how much shareholder equity they have in the game, relative to their balance sheets.
But then there is another problem on top of all this, and that is that these large banks have quite large derivative positions. And one of the largest chunks of derivatives is interest rate swaps.
Now, just so that we can get this clear in our minds, basically, what an interest rate swap is – you and I might take out a mortgage on a new property. We can see that interest rates are as close to 0% as they are ever likely to be, so we want to lock in that low rate for a long time. On the other end of the transaction is a bank.
Now, the bank will allow us to lock in low rates, let us say, up to three or four years on an interest rate swap. And, the reason they do it is, they are confident that interest rates are going to remain low. Why? Because, Mario Draghi has told them that they will keep them low; that there is no way they are going to go up. And, they sort of feel that, well, when the economy recovers and property prices recover and all the rest of it, okay, we could probably take a little hit on that, particularly if interest rates rise gradually, we can correct our position.
But, that is not actually how it works. Once interest rates start rising, they will probably start rising very quickly. Why? Because of all this money, mainly dollar money around the world, which, at some stage, is going to start impacting on raw material prices and through raw materials, finished goods and so on and so forth.
So, once price inflation starts rising, these interest rates are going to rise irrespective of what the central banks say. Now, under those circumstances, if you think about the level of derivatives in these interest rate swaps, they are enormous. I do not have the figures for individual banks, but I can tell you that according to the Bank of International Settlements, world-wide, these interest rate swaps are $440 Trillion. That is absolutely enormous.
To my mind, when interest rates start rising, the banking system will be at risk of failing at its weakest point. And I think that weakest point, generally, is the European banking system.
Click the play button below to listen to Chris' interview with Alasdair Macleod (40m:24s):
by rogera