TOPICS > Economy

Interconnection of U.S., European Markets Adds to Investors’ Fears

September 6, 2011 at 12:00 AM EDT
Across Europe, markets finished Tuesday at their lowest close in more than two years. Jeffrey Brown discusses the growing eurozone debt woes with FusionIQ's Barry Ritholtz and Jacob Kirkegaard of the Peterson Institute for International Economics.
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JEFFREY BROWN: And we pick up where Hari just ended: international markets haunted by the specter of debt, particularly in Europe.

Investors there have sold heavily this week, amid fears that the problem is only getting worse and that no one has a solution. Across the continent, stock shares finished the day at their lowest close in more than two years. The main French and German market indices ended with losses of at least 1 percent after far steeper declines on Monday. London’s FTSE was the only major European index to buck the trend, finishing up more than 1 percent.

The losses were spurred in part by renewed fears for the world’s 11th largest economy, Italy. Thousands of workers in that country hit the streets today to protest austerity measures. And in financial circles, serious doubts remain about whether political leaders can or will address the crucial issue of sovereign debt.

The chief executive of Deutsche Bank, Josef Ackermann, citing comparisons to the financial crisis of late 2008, said yesterday, “Investors are not only asking themselves whether those responsible can summon the necessary will power to overcome this crisis, but, increasingly, also whether enough time remains and whether they have the needed resources available.”

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Meanwhile, the Swiss move to protect their own economy by pegging the strong Swiss franc to the value of the euro — the action helped Swiss stocks move higher, despite the losses elsewhere in Europe.

More now from Barry Ritholtz, CEO of Fusion IQ, an equity research firm. He also writes The Big Picture, a leading financial news blog, and is author of the book “Bailout Nation.” And Jacob Kirkegaard is an economist and research fellow at the Peter — Peterson Institute for International Economics.

Barry Ritholtz, The Wall Street Journal headline today reads “Europe Signals Global Gloom.”

So, what are the latest signals that have everyone so worried?

BARRY RITHOLTZ, Fusion IQ: Well, if we look at the past couple of months, we have seen an ongoing deceleration in the economic data in the U.S. That was the first warning sign.

And then the next warning sign was the failure for there to be any sort of positive reaction to the resolution of the U.S. debt ceiling. In fact, we broke a number of important trend lines. The technicians will tell you that the bull market, the cyclical bull market that began in March ’09, is pretty much over, and that at this point we’re really just groping for a valuation that is fair relative to the possibility of recession.

JEFFREY BROWN: And, Jacob Kirkegaard, in Europe, as we said, a lot of focus today on Italy, the biggest new player to face trouble.

JACOB KIRKEGAARD, Peter G. Peterson Institute for International Economics: Yes, I mean, I think that the fundamental problem is that Europe faces both the obvious economic problems centered in Greece and now in Italy, but, first and foremost, it faces a political problem.

And that’s really what we’re seeing manifested, that the constraints that European policy-makers are put under to be able to solve this crisis are so big that you fundamentally need some drama in the markets, you need some pressure for this to get done.

JEFFREY BROWN: Well, you have drama.

(LAUGHTER)

JEFFREY BROWN: And now you have a lot of talk in Europe about creating a new political and economic integration, a sort — a kind of central financial authority. Now, what would that look like and how serious is talk like that?

JACOB KIRKEGAARD: Well, I think it’s very serious, but I think we need to be very clear as well that this is only something that can happen in the long term.

I mean, in my opinion, this is not realistic in the next five to seven years. So it’s more of an aspirational goal, that Europe clearly needs to move towards pooling more of its fiscal resources, because Europe, as such, isn’t broke. It just has some problems distributing its fiscal resources around the continent. And that — but that, of course, is a political — politically very tricky, because Germans don’t want to pay for the expenses of the Italian government that German voters has no, you know, sort of democratic impact on electing.

So there’s a whole host of political issues that you need to solve. But that doesn’t mean that you cannot sort of from — at a policy level today announce that this is the ultimate goal to which you’re heading towards. And that I think would have a very big stabilizing effect on the markets even today, even if the goal can only be reached several years from now.

JEFFREY BROWN: Well, now, Barry Ritholtz, as we watch that unfold on the government’s side, a lot of the focus is on European banks.

So what do you see as the overhanging problem there? And, of course, the question on our side of the Atlantic is, how much exposure do our banks have to the problem there?

BARRY RITHOLTZ: Sure.

Well, I think there’s a couple of issues that we have to look at. The first is the — some of the major nations in Europe are in deep financial problems. I don’t know if we will say they’re insolvent, but they’re pretty close. We look at Ireland and Portugal and Spain and Italy and then Greece, it’s a fair bet that half those countries are going to need very, very significant bailouts to stay afloat.

Unlike the U.S., they don’t have their own currency. They don’t have their own central bank. They’re part of a consortium, so it’s a little bit different. That’s the first issue. The second issue is the banks in Europe, many of whom have extended tremendous credit to these various nations and the banks within those nations.

So it’s very much a circular sort of credit situation that’s at risk. The key question in the U.S. is, what is our bank exposure to European problems? Ben Bernanke just came out with a comment earlier today where he thinks it’s modest to moderate. But that’s really just a guess. We really don’t know what U.S. balance sheets look like relative to their exposure to Europe.

JEFFREY BROWN: What’s your sense, Jacob Kirkegaard, about the exposure of the U.S. banks and the connections?

JACOB KIRKEGAARD: Well, I think if the European crisis is contained, if you like, to Greece, perhaps to Ireland and Portugal, then I don’t think the exposures are particularly material for the U.S. banks.

It’s only if you get to — if the problem sort of, you know, spreads to Spain and particularly Italy, because, if that happens, then you start having problems in the core European banking system, in Italy, in France, potentially even in Germany. And the U.S. financial services sector exposure to these banks is going to be very substantial.

So it really requires that the crisis in both Spain and Italy becomes acute which I have to personally say I don’t think we’re quite there yet.

JEFFREY BROWN: That’s hopeful.

Barry Ritholtz, you mentioned Ben Bernanke. I did want to ask you about the Federal Reserve. There’s some conjecture about the possible exposure of the Fed in Europe to European banks and governments.

BARRY RITHOLTZ: That’s right.

There was recently a Freedom of Information Act litigation by Bloomberg in order to force the Fed to reveal what their exposure was, who they made loans to. We found out that the Fed was doing lots and lots of lending to various European banks.

The one thing to keep in mind — and this ties in the Federal Reserve and what the — your other guest just said — is that dirty word contained. If we learned anything about the crisis in ’08-’09, things are so interconnected. Remember, Ben Bernanke and Hank Paulson both famously said the crisis is contained to subprime, and eventually that spun out of control.

It’s very challenging to contain this to any specific bank, any specific region or country. The level of interconnection, the possible domino effect that we see when one major bank falls, it’s very, very possible that this could start in Greece, go to Ireland, and eventually make its way to Spain and Italy, just the way this started in subprime, worked its way to Bear Stearns and Lehman Brothers, and eventually hit AIG, Citi, Bank of America and everybody else.

So I’m very, very cautious any time I hear the word contained, because we have seen very little in finance is contained to a narrow box.

JEFFREY BROWN: Well, briefly, Jacob Kirkegaard, you’re nodding at that, right? We’re all cautious. But, briefly, we saw the market down 300. I know you can’t go by any particular day, but we are clearly in a period of uncertainty, right, where these swings can happen.

JACOB KIRKEGAARD: Oh, yes. No, absolutely.

I mean, fundamentally, we are in a new normal, if you like, where, unlike previous eras, in my opinion, this fundamental solvency of industrialized country governments is actually being questioned. You know, we saw the full faith and credit of the United States being questioned just a few weeks ago.

Clearly, that’s true in Italy. And, certainly, that’s true in Spain — or — sorry — in Greece as well. And when that happens, in the case of Europe at least, as soon as you question the solvency of the government, you immediately have to question the solvency of all the Italian banks, for instance. And that’s what gives the contagion effects that Barry just talked about.

JEFFREY BROWN: All right, Jacob Kirkegaard, Barry Ritholtz, thank you both very much.

JACOB KIRKEGAARD: Pleasure.

BARRY RITHOLTZ: Thanks for having us.