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Big Trouble for U.S.? Europe's Banking Crisis Moves Closer to a Lehman Brothers Moment

The recent euro summit did nothing to alleviate the problems that created the crisis in the first place.

The recent euro summit in Brussels was supposed to make things better for the European economy. And if you listen to the mainstream press spin, you hear that a growing Mediterranean alliance, led by France's new president, Francois Hollande, Spain's Mariano Rajoy and Italy's Mario Monti, forced Germany to cave. We are led to believe that Germany has capitulated on things like less fiscal austerity, the sharing of debt, and direct recapitalization for ailing banks through the European Stability Mechanism (ESM). We are also supposed to accept at face value the claim that the European Union as a whole will work toward some form of common deposit insurance to arrest the prevailing bank run.

This is all bunk. But why does that matter to you? Well, recall for an instance what happened to the global economy when Lehman Brothers went bust in 2008. The world’s entire credit system froze up. Now consider the implications for the U.S. if the currency union in the world’s largest economic bloc was to blow apart. Do you think the fallout might wind up in your backyard?  Economist Simon Johnson recently gave a warning on the impact on U.S. banks in the event of a dissolution of the euro:

[I]n recently released highlights from its so-called living will, JPMorgan Chase & Co. revealed that $50 billion in losses could hypothetically bring down the bank. .. The Fed is convinced that its recent stress tests show U.S. banks have enough capital even though these tests didn’t model serious euro dissolution risk and the effect on global derivatives markets. The striking thing about JPMorgan’s recent London-based proprietary trading losses is not the amount per se. If the world’s largest bank can lose $2 billion to $3 billion in a relatively calm quarter through incompetence and neglect on the fringes of its operations, how much does it stand to lose when markets really turn nasty across a much broader range of its activities? And how might that harm the U.S. economic recovery?

So, measures designed to save the euro are something we should pay attention to here in the U.S. They also help to explain why President Obama remains in persistent contact with Europe’s key political players, notably German Chancellor Angela Merkel.

In contrast to previous summits to "save the euro," expectations for this one were set very low by the time this meeting started, leading you to assume that any bit of good news would be sufficient to induce a market rally. At the same time, if you ignore the spin and actually read the text of the statement released after the summit, it does not appear that the package announced does anything to alleviate the problems that created the crisis conditions in the first place, especially the bank run.

So what was actually agreed? Let's concede one positive point at the start: It seems to be that any monies used to recapitalize Spanish banks (which are now at the heart of Europe’s systemic instability) won't rank higher than other forms of bonds, which removes one disincentive to buy more Spanish bonds, which in turn could mitigate Spain's own funding strains.

However, the decision to award private creditors the same status as the Eurozone bailout fund in the Spanish rescue means that German taxpayers will have to join the queue to get their money back, which in turn threatens Germany's own credit rating.   Accordingly, the German media were quick to howl that Merkel was putting the German taxpayer on the line for the success or failure of banks in Madrid. The concession might also be unconstitutional, given recent rulings by Germany’s Constitutional Court.

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