Europe's sub-prime problem

It was Europe’s dirty little secret. While American banks were lending irresponsibly to homeowners who couldn’t pay, European banks were lending emerging countries who couldn’t pay. Europe’s sub-prime crisis has now come home as heavily-indebted nations of the Eastern bloc - Hungary, Ukraine, Bulgaria, the Baltic states - are collapsing one by one into the arms of the IMF. “Icelandisation” is the new spectre stalking Europe.

And, as with sub-prime in urban America, this latest crisis was shockingly predictable. I visited Latvia at the height of the credit bubble eighteen months ago, and it was clearly an accident waiting to happen. Riga, the capital, ws bristling with upmarket shopping malls and classy bars that were all quite empty. Stalin-era flats were going for $200,000 in a country where the average wage was less than $400 a month. Latvia has hardly any industry, no energy and few natural resources - except trees. But such was the irrational exuberance of foreign banks like Swedbank, it was awash with credit.

According to the Bank for International Settlement, Western European banks have lent over $1.5 trillion to Eastern Europe. Austria has loans equivalent to 80% of GDP and stands to make huge losses as Hungary and Ukraine collapse. This week, the Austrian government had to cancel an auction of government bonds (like our gilts) because it couldn’t be be sure that investors would buy them. It is not inconceivable that Austria itself could end up needing rescued.

Other European countries implicated in global sub-prime include Spain, which has loaned immense sums ($316bn) to Latin American countries like Argentina. Britain hasa $329bn tied up in Asia - or did until values collapsed in the Asian stock market rout. Japan’s Nikkei index fell to a twenty six year low this week wiping out tens of billions. The losses are now winging their way home to British pension funds and banks like RBS and HSBC.

So, banks behaving badly, what’s new? Well, the Bank of England told us this week that global losses from the financial crisis so far amounts to $2.8 trillion, but that only includes a fraction of the likely losses from global sub prime, which have yet to land on balance sheets. Until last week’s rout in the Asian bourses, there were still economists who believed that emerging markets wouldn’t be greatly affected by the credit crunch. Now, the theory that developing countries, led by China and India, have “decoupled” from the West, has been thoroughly discredited. It’s clear that they have been dependent on consumer spending in America and Europe all along - and now that these Western consumers are shopped out, no one is buying their cheap goods. The Baltic Dry Shipping Index, which tracks the cost of hiring ships for international trade, has collapsed by 79% this year signalling a severe global recession.

So, when Gordon Brown hints that Britain might spend his way out of this recession he needs to consider how his remarks might be viewed abroad. There’s no guarantee, in this climate, that the British government will be able to borrow the money to pay for further bank rescues (they’re coming), plus the cost of three million unemployed, plus a programme of Keynsian infrastructure spending, however desirable that may be. Investors are already shunning the pound because of anticipated losses from the UK property crash. Sterling has fallen 28% this year, further than in the ERM crisis of 1992 when interest rates rose to 15%. We could be heading for a classic 1960s run on the pound.

The government hoped that a devalued pound would stimulate exports and pull Britain out of recession, as happened after the Black Wednesday sixteen years ago - but times change. We don’t actually make things anymore and the world isn’t buying anyway, and it has also had quite enough of our ‘innovative’ financial services. This means that Britain’s current account deficit of 6% - what used to be called loosely the balance of payments - suddenly becomes a major economic issue again Borrowing may be a good thing in a recession, but international financiers, sovereign wealth funds, hedge funds and banks may not agree.

The UK of course has the honour of having been the last G7 country to call in the IMF - during the 1976 sterling crisis - and while the government isn’t dusting down the application forms quite yet, Britain’s finances would not impress the fund’s economists. The standard IMF lending conditions are: privatisation, cuts in government spending and increased interest rates. You may notice that we are going in exactly the opposite direction, slashing interest rates, borrowing to spend, and nationalising the banks.

Of course, seen another way, this is only an indication of the extent to which the IMF is no longer fit for purpose in the Great Deleveraging. In recent years, the IMF has been an engine of Wall Street neoliberalism, of financial deregulation, which makes it ill equipped to deal with the new international environment of deflation and banking crashes. There is anyway a fiscal crisis facing the IMF. It only has about $250bn in reserves to throw at a rolling financial crisis that has now engulfed half the planet, from Iceland to Pakistan. Gordon Brown has called on energy exporting nations to stump up more cash for the fund, but there is a strong case for reviewing how the IMF operates also.

Set up as part of the Bretton Woods financial system in 1944, the IMF was designed to cope with episodic currency crises. It is now having to deal with potential insolvencies in countries the size of Argentina as well as bailing out entire regions like Eastern Europe. It will have to be very much better capitalised if it is going to perform this role, and it will have to abandon much of its free market ideology. We need a new set of interventionist institutions capable of managing financial rescues on an international scale.

Ultimately, what is needed is an international central bank with resources to provide liquidity guarantees, recapitalise banks and regulate international financial flows. This is an immense task, and the world may not appear to be ready for it. But it is not a new idea: John Maynard Keynes argued for precisely this during the Bretton Woods negotiations in 1944. He even suggested a world reserve currency “bancor”. This is the kind of thinking we need today.

The alternative, if nothing is done, is international tension and war - all history tells us this. Consider countries today like crippled Ukraine with its large Russian population and its dependency on Russia for energy supplies, right at the moment when Russian dreams of becoming an energy superpower have been dashed by the collapse of the oil price bubble. Look at nuclear Pakistan, where the entire country is disintegrating in financial chaos. And will all those unemployed workers in China - where half the toy manufacturers have gone bust - go peacefully back to the paddy fields?

When leaders of the “G20” group of leading and emergnt nations meet in Washington next month for what is being called “Bretton Woods 11” they’d better believe that they are not just dealing with a banking crisis. They could be deciding the future of civilisation itself.