I have been watching, with horror, the escalation of the economic situation in Europe since about mid-February. On February 21st, I posted a short thread on Twitter detailing the worst-case economic scenario for Europe if war between Russia and Ukraine broke out, as it did. The forecast had 10 stages: Energy prices have soared, asset markets are fluctuating and the European Central Bank (ECB) has stopped PEPP and QE (sort of, see below). Inflation in the eurozone was 9.1% in August and shows no sign of abating. So we’ll probably hit double digits as early as maybe next month. So, ominously, we’ve already ‘checked off’ Nos. 1, 2, 3, 4 and 6 from the ‘worst case’ forecast.
What to expect in the coming months
The “credit default swaps” of Credit Suisse, a Swiss banking giant designated as a global systemically important bank, or G-, have reached levels not seen since 2009. Two-year German government bond (Bund) yields are trading this currently around 100 basis points above two-year EUR OIS swap rates, which reflect ECB interest rates over the next two years. We haven’t seen such a divergence since the height of the European debt crisis in 2012. This is leading to a massive “collateral hold” in banks as the value of the most used collateral (government bonds) relative to deposit rates collapses.
A banking crisis is coming
Italian 10-year bond yields are flirting with the 4% threshold seen as representing the “line in the sand” for the Italian government’s inability to cover its finances. The ECB is using funds from the maturing debt of, for example, Germany and the Netherlands to buy the government debt of Greece, Portugal and especially Italy. At the end of July, the ECB’s holdings of German, French and Dutch bonds fell by $19.3 billion, while its holdings of Italian bonds rose by $14.3 billion. The ECB is expected to increase its purchases further in the coming months. However, the question is, will it be enough to prevent another debt crisis from starting? Inflation in Italy is running at a euro-era record of more than 8 percent, and its households and companies are feeling the brunt of rising energy prices and disruptions to Russian gas flows to Europe. According to International Monetary Fund (IMF) models, if the European gas market were to fragment, meaning there would be gas supply disruptions, Italy’s gross domestic product could shrink by around 6%. We are very close to this point after Russia cut off gas supplies to Germany (Italy still receives Russian gas). The Italian government is also already working on a rescue fund for small lenders. However, they, the small lenders, are not the real problem (see below).
Italy, and thus Europe, is closing in on a full debt crisis
According to a report by Equinor, a Norwegian energy group, energy companies face a $1.5 trillion loss in profit margins due to violent price reactions in European energy markets. Energy companies are required to maintain a minimum margin deposit in case of default before the energy is supplied. These margins have increased with rising electricity prices, which, while far from their highs, remain high. Recently, Finland became the first European country to sign a “bridge agreement” to cover the partnerships of Fortum, Finland’s largest energy producer. Other governments are likely to follow. The price of electricity remains high. For example, in Germany the spot price is currently about 10 times higher than in summer 2021. Many households and companies are seeing energy prices multiply by 10 or more across the continent. Unfortunately, and not surprisingly, the disintegration of the European economy is already on its way. Many European energy-intensive industries are shutting down or greatly reducing their production due to high energy prices. Even bars in Britain are speculating whether they will close their doors (essentially an “energy lockout”) because they can’t afford the energy prices. At the same time inflation in the UK may exceed 20% next year! Business loan arrears are rising across the continent (see, for example, this ), and a “flood” of business and household bankruptcies is looming. All of this is under the weight of massively increased electricity prices, inflation, rising interest rates and a looming recession. So, Europe is currently headed for an economic recession and it won’t stay here. As I mentioned earlier, 10 of the world’s 30 G-SIBs are located in Europe (PDF). By comparison, the United States has seven G-SIBs, but still the housing market collapse of 2006-2009, which led to a banking crisis in the United States, almost brought down the global financial system. If the European economy breaks up, which seems likely at the time of writing, its banking sector will follow, taking with it the global financial system and possibly the common European currency (euro).
Could anything be done to prevent all this?
I don’t think we can now escape the European recession, which is also overdue, but there could still be time to stop it from escalating into a recession. While unpopular, the only thing that could bring immediate relief is the full reactivation of gas flows from Russia to Europe, which would require the lifting of Western sanctions. Even if storage, demand cuts and global supply could make up for Russian supply in Europe, which is highly unlikely (see more, e.g. from my newsletter), gas prices are likely to soar across the globe. Rising prices have already led to a “tsunami of outages” in the United States. Just think how bad the situation will become if natural gas prices double or triple from current levels. It must be fully recognized that we are here because of political decisions. First, green policies made Europe highly dependent on Russian energy. Second, President Vladimir Putin’s decision to attack Ukraine, Western leaders’ decision to impose tough sanctions, and the Russian regime’s decision to respond to them, fueled the crisis. In 1924, John Maynard Keynes warned against the use of sanctions, which “would always run the risk of being ineffective and not easily distinguishable from acts of war.” In his “magnificent work,” “The General Theory of Employment, Interest, and Money,” he also argued that a globalized economy would eventually end all wars because their economic costs would become so appalling. We are slowly learning this lesson. The views expressed in this article are those of the author and do not necessarily reflect the views of The Epoch Times. Follow along Tuomas Malinen is Managing Director and Chief Economist at GnS Economics, a macroeconomic consultancy based in Helsinki, and Associate Professor of Economics. He studied economic growth and economic crises for 10 years. In his newsletter (MTMalinen.Substack.com), Malinen discusses forecasting and how to prepare for the recession and the coming crisis.
