The Big Picture Following the Worst Crisis Since the Great Depression

Economics / Global Debt Crisis
Jun 26, 2010 - 03:52 PM

By: Bryan_Rich

Last week, I laid out some important historical context for establishing a solid perspective on the big picture — a broad view of where the global economy stands and what we should expect going forward.

Today, I’d like to continue with the second part of my analysis.

As I said last week, history shows us that financial crises tend to be followed by sovereign debt crises. History also shows us that sovereign debt crises tend to lead to currency crises.

I discussed the stages of a developing sovereign debt crisis — and how it’s playing out. And using history as our guide, it’s reasonable to expect a currency crisis will follow.

There were three memorable currency crises in the 1990s, all of which included a fixed exchange rate system that was under attack. But regardless of the type of currency policy (fixed or free-floating or a monetary union), a currency crisis is broadly defined as a loss of confidence in a country’s currency. Something we’ve seen very clearly in recent months with the euro.

For a reference point on how these trends unfold, there’s a good academic study from MIT on historical currency crises that lays their progression out like this …

Three Stages of a Currency Crisis

Stage #1: Loss of Confidence

The number one cause of a currency crisis is when investors flee a currency because they expect it to be devalued.

Here’s the current situation …

When the euro zone stepped in and threatened to cough up $1 trillion dollars in an attempt to save the euro monetary union, it was a conscious decision to devalue the euro.

Why did they do it?

The euro zone has committed to do whatever it takes to keep its members afloat.

They had no choice!

The European banking system was, and still is, too exposed to the sovereign debt of the euro zone’s weak spots. An imminent default of a euro member country would have meant a crushing blow to European banks and likely another wave of global financial crisis — this time worse.

Here’s why: Last year the European Central Bank was flooding the banking system with unlimited loans for a paltry 1 percent. What did the banks do with the money? They bought government debt — specifically, debt from the PIGS (Portugal, Ireland, Greece, Spain).

In all, European banks own $1.5 trillion worth of debt from the fiscally challenged countries of the euro zone. As a result, politicians in Europe felt they had their backs against the wall and their response was one of “all-in.â€