Financial analysts and pundits love a crisis. Like all news media, the talking heads on the financial news stations tend to latch on to a subject line and milk it to death until the next story comes along to take the spotlight. Right now, the flavor of the month is the European debt crisis. The world’s eyes are trained on Italy and Greece at the moment, waiting for signals as to which way the growing crisis will turn.
Now we have always tried to maintain a balance between a healthy bit of skepticism and a realistic market outlook. More specifically, fear mongering and getting people all fired up about the latest calamity is not the goal of our research and writing. That said, the crisis that is developing in Europe has the potential to cause extreme disruptions to the world’s financial system that simply can’t be ignored. If you keep money with a bank, financial institution, or just about anywhere besides your mattress, you have to be aware of what’s happening across the Atlantic.
There is a growing discrepancy between what is being said by EU leaders and the reality on the ground. Though lots of tough talk is bouncing around government buildings across the continent, the reality is that the problem nations such as Italy and Greece simply do not have the political will to make the cuts necessary to stop the debt contagion. As both nations attempt to form new governments that can tackle the task of pushing through austerity measures, there is little sign that the newly formed governments will have any better luck than their predecessors. What makes it worse is that there is simply not enough money in the EU bailout fund to support Italy; not to mention the host of other nations likely to fall victim to the spreading crisis.
If Europe continues on its current trajectory, there is little doubt that the entire currency alliance will be put at significant risk of collapse. This would have significant long term systemic implications for the entire global economy. However, the truly terrifying result of a Euro breakup would not be felt years down the road. It could happen in a matter of minutes. It would be the largest bank run in the history of the world.
One has to look back to the end of World War I for the most recent model of a currency union breakup. At the time, the Austrian Empire had created the Austro-Hungarian currency union, which was somewhat similar to the Euro in many ways. Multiple neighboring nations shared the same currency with mostly open boarders and trade, just like the Euro Zone. In the aftermath of the First World War, relations between the nations began to deteriorate and the dissolution of the currency union was announced. Complete chaos ensued.
The problem with dissolving a currency union is that after the breakup is completed, each currency then takes on a value of its own. Each unit of unified currency must be converted to a local currency when the dissolution takes place. When this happened in the Austrian Empire, citizens smuggled mass amounts of money across borders, attempting to convert their currency into the new local currency, which would have the highest value. Though it was highly illegal, there were massive amounts of money moving between countries. Some accounts speak of trains full of currency being snuck from nation to nation. Soon there was such widespread confusion about the value of each local currency that the use of money was scrapped in favor of barter and trade. It took years to stabilize.
Now imagine what would happen today. If a rumor began that Greece or Italy was going to leave the Euro alliance, their citizens wouldn’t have to load cash into train cars. They could simply move money out of Italian banks with the click of a mouse. Hundreds of billions of Euros could move in a matter of seconds. This would instantaneously cripple and close the banks from which the capital was removed.
The problem is that those banks are nearly indistinguishable from our financial institutions here at home. A significant bank run in Italy would pose some risk to American financial institutions. Thus, it’s logical to think that a bank run in Italy could well lead to a bank run here at home as citizens try to protect their savings and investments from the spreading fire. The truth is that no one knows what would happen to US banks in the event of a Euro breakup. What is clear however is that such a move would change the nature of the global crisis.
Since the momentary panic in 2008 that shook the world’s economy after the collapse of Lehman Brothers, the governments of the world have injected massive amounts of cash into the banking systems. They have done this in hopes of accomplishing one specific goal: avoiding a liquidity crisis. As bond yields soared in 2008, banks simply ran out of money to conduct the daily process of moving cash through the system. Bad debt and undercapitalized institutions lead to the beginnings of a liquidity crisis, in which banks simply didn’t have the operating capital to stay afloat. This caused the DOW to lose nearly 50% of its value in a matter of weeks.
As time passed and the government bailouts took effect, the liquidity crisis turned into a confidence crisis. As the fights rage in Europe and Washington over how much to cut and where, the flow of bailout funds have kept institutions operating and maintained some stability in the financial system. That said, if the Euro collapses, this confidence crisis we are all experiencing will quickly turn right back into a liquidity crunch. Bank runs and stock market crashes would just be the beginning. We know that EU leaders realize what’s at stake. The question is whether or not they will be able to stop it. At this point, it’s really anyone’s guess.
Mike Getlin is Executive Vice President of Merit Financial, home to America's fastest growing physical gold IRA company. Please send comments or questions to firstname.lastname@example.org.