You know things are bad when a racehorse is the only glimmer of hope. From the New York Times:
A racehorse bought for a pittance has turned into a national hero in crisis-stricken Hungary.
The thoroughbred known as Overdose pounded down the stretch here at Kincsem Park on Sunday to extend his record to 12 wins in 12 races, his jockey clad in the red, white and green of the Hungarian flag.
And for an afternoon at least, the crowd of more than 20,000 in the grandstand and lining the rail, along with all the Hungarians watching at home, could forget about the resignation of the prime minister and their currency’s nosedive.
As times have gotten tougher here, the 4-year-old Overdose has become the Hungarian Seabiscuit, a symbol of hope for Americans during the Great Depression. He appears to remind Hungarians of themselves: undervalued and underestimated....
The horse’s popularity has even attracted politicians. On Friday, Viktor Orban, chairman of the center-right Fidesz Party and a former prime minister who hopes to reclaim the job in next year’s election, turned up with a crowd of television cameras to pose with the star.
“Failure is the most often heard expression in Hungary today — failure, mistake, pessimism. When even a horse is able to make a miracle from nowhere, it’s a sign of hope that we can get out from the desperate situation we are now in,” Mr. Orban said.
“If I were a politician, I would do the same, because Overdose is one of the most famous persons in Hungary,” said Mr. Horvath, “even though he is a horse.”
How long before the US looks for its own modern Seabiscuit?
Remember last summer after Russia invaded Georgia, and neoconservatives hyperventilated, declaring it the most significant development in world history since the fall of the Berlin Wall? Yeah - oops. If Georgia was the Sudetenland in Robert Kagan's wet dream about the reemergence of a Nazi state, then Ukraine was Austria - the next domino to fall. Turns out that the greatest threat to Ukraine's stability and territorial sovereignty didn't come from the Russian bear next door, but rather from the ravages of economic depression the financial crisis has unleashed. From the New York Times:
Few areas of Europe have taken such a body blow from the world economic crisis as the industrial heartland of eastern Ukraine, home to giant enterprises in the steel and metals industry in which orders have dried up nearly completely and prices have plummeted.
In the Donetsk region, home to 4.6 million people, around 80 percent of the economy is tied to the metals industry. In January, when industrial production dropped by a precipitous one-third throughout Ukraine as a whole, in Donetsk it fell by half against the previous year....
In the absence of a galvanizing voice rallying the workers, or a politician in the Ukrainian capital, Kiev, to marshal the popular anger, Mr. Yeryomin and many others are focusing their unhappiness on the borders of this part of Europe, sliced and diced in countless wars through the centuries.
“I look with pride at Russia,” said Mr. Yeryomin, who lived in Russia as a child and counts himself among the 40 percent of inhabitants of the Donetsk region who are considered ethnically Russian. “We should cut Ukraine in two, and give half to Poland and half to Russia.”
This part of eastern Ukraine has always felt more attached to Russia than to western Ukraine and neighboring Poland. For many here, the fraying economy is accompanied by a sense that officials in Kiev, where the government is paralyzed by political infighting, have abandoned Ukrainians to their fate.
Just last week, more than 10,000 protesters gathered in Kiev to demand a change of government, prompting President Viktor A. Yushchenko to issue a surprise announcement that he was considering early presidential and parliamentary elections.
Whether any politician can allay both the global and the homegrown troubles of the metals industry in Ukraine is unclear. For now, the national currency, the hryvnia, has lost 40 percent of its value against the dollar from its high last year, and the reforms demanded by the International Monetary Fund as a condition for receiving a life-giving $16.4 billion loan are the subject of endless wrangles in an argumentative Parliament.
As Eastern European governments fall victim to the global financial crisis, the issue of social and political instability gets injected into what is already a Gordian knot of an economic crisis. The specter of economic nationalism and sovereign defaults haunts the international system. While the G20's steps to shore up the financing of the IMF undoubtedly mark a positive step in the direction of global stability, the question of what to do with countries such as Ukraine and Hungary that cannot or will not enact IMF fiscal austerity measures still looms. This concern is even more acute given that Hungary's prime minister stepped down a few weeks ago, amidst the political fallout that trying to follow the IMF's spending restrictions generated. From the New York Times:
As for Hungary, the $25 billion agreement it signed with the monetary fund last year has put it in an awful policy vise. Mandated to squeeze its budget deficit below 3 percent of gross domestic product, the government is in no position to stimulate an economy estimated to sink by as much as 6 percent this year.
There is no painless path to recovery.
“Hungary has an uphill struggle, but we know that,” Gordon Bajnai, the economy minister, said in an interview in late March. “We need a reform-minded government.”
On Monday, Prime Minister Ferenc Gyurcsany, the former Communist who has led the country since 2004, appointed Mr. Bajnai, a 41-year-old former businessman, to lead that effort as his successor.
But furious opposition from Hungary’s right wing — which has called for elections — may limit the scope of his ambitions.
Lajos Bokros, a former finance minister, says that the alternative to not meeting the monetary fund’s conditions is bankruptcy. He worries that the forint will fall even further amid the political uncertainty — a concern underscored by downgrades of Hungary’s credit rating by Standard & Poor’s and Moody’s this week.
The social dimensions of this crisis are only beginning to be felt. Hopefully this climate of political and economic fear will not usher in a new era of extremism.
This was our last chance. So warned George Soros and Ambrose Evans-Pritchard in rather apocalyptic exhortations to world leaders on the eve of the G20 Summit. According to Soros
If the G20 is nothing but a talking shop then he thinks we are heading for meltdown. “That could push the world into depression. It’s really a make-or-break occasion. That’s why it’s so important.” The chances of a depression are, he says, “quite high” – even if that is averted, the recession will last a long time. “Look, we are not going back to where we came from. In that sense it’s going to last for ever."
With that in mind, the happy news that the G20 actually produced meaningful action on increased funding for the IMF and trade credits, as well as a commitment to crack down on tax havens is especially heartening. World leaders woke up and realized that letting emerging markets go bust - particularly in Eastern Europe - would likely lead to a new round of financial contagion in core countries. There is hope we can avoid a global lost decade.
What do you do if your neo-Hooverite policies get you booted from office? If you're ex-Czech Prime Minister Mirek Topolanek, you take some inspiration from AC/DC, and claim Keynsian fiscal policy is a "road to hell". From the New York Times:
“AC/DC played here last week,” Mr. Topolanek told the daily Lidové Noviny. “And their cult song ‘Highway to Hell’ might have led me in that very improvised speech to use the phrase ‘road to hell’.” According to the Czech newspaper, Mr. Topolanek’s prepared remarks included the less resonant phrase “the way to destruction.”
On a more serious note, Prime Minister Topolanek's evocation of Keynsian as a road to perdition speaks to the reticence of many European countries to run up more debt when their debt-to-GDP ratios are at generally higher starting points than the United States. But if this slump persists and European governments stick to their fiscal austerity, the crisis could take on a new political dimension, with governments falling, and perhaps resorting to protectionist measures. As Ambrose Evans-Pritchard reports
the Czech crisis has unnerved investors even more because the country has been seen as a rock of stability. It kept a tight rein on credit and avoided the stampede into euro and Swiss franc mortgages that occurred in other parts of Eastern Europe.
The fate of premier Mirek Topolanek – toppled in the middle of the Czech Republic's EU presidency – shows how fast the crisis is moving from finance into the core economy. Czech industrial output fell 23pc in January as car plants moth-balled production lines.
"This is the next leg of the crisis," said Neil Shearing from Capital Economics. "We're seeing the political backlash as this spreads into the labour market. The risk is that we will see a move to populist nationalism in some countries. That could prove dangerous."
So far we have not seen the type of rabidly nationalistic or xenophobic extremist parties gain power in Eastern Europe as did in interwar Europe during the Great Depression. Hopefully, we will be wise enough to avoid repeating that chapter in history.
Over the weekend in the New York Times, Liaquat Ahamed sounded the alarm on Europe's potential for catastrophe. Quick version: Eastern Europe borrowed huge sums in foreign currencies from Western European banks; once lending died in September, Eastern European countries found themselves with massive short-term liabilities they could no longer roll over; the exodus of capital from Eastern Europe, in conjunction with massive current accounts deficits, has caused currency crises across the region, raising the real cost of debts; because of difficulties organizing collective action, particulalry on the part of France and Germany, Western Europe has been unable to agree on a bailout of its Eastern neighbors despite the risks Eastern European defaults pose to Western Europe's banks.
Ahamed concludes:
The response of the American government to the financial crisis has been criticized for being too slow and inadequate. But at least we have a federal budget, the national cohesion and the political machinery to get New Yorkers and Midwesterners to pay for the mistakes of homeowners in California and Florida, or to bail out a bank based in North Carolina. There is no such mechanism in Europe. It is going to require leadership of the highest order from officials in Germany and France to persuade their thrifty and prudent taxpayers to bail out foolhardy Austrian banks or Hungarian homeowners.
The Great Depression was largely caused by a failure of intellectual will. In other words, the men in charge simply did not understand how the economy worked. Now, it is the failure of political will that could lead to economic cataclysm. Nowhere is this danger more real than in Europe.
Latvia's government recently became the latest victim of the financial crisis. Despite receiving a nearly $10 billion bailout from the IMF late last year, Latvia's economy contracted at a 10.5% annualized rate in the fourth quarter of 2008, leading their finance minister to diagnose their economy as "clinically dead." Protests over this economic freefall forced the government to step down. But while the crisis in Latvia may yet abate, the question of whether a new round of financial contagion, this time originating in Eastern Europe, will infect the world remains open. Could Latvia - or Poland, or Bulgaria, or Ukraine - be the next Lehman?
Nearly every Eastern European nation faces a severe currency crisis. Indeed, no less an authority on the matter than Paul Krugman noted last October that the situation was "the mother of all currency crises." But what does this mean, how does it happen, and what needs to be done to done to stabilize the situation?
Let's consider a hypothetical country, Leveragestan. Let's say Leveragestan is a small country transitioning to a free market economy. They have a history of hyperinflation. They decide to peg their currency to a more stable currency (say the euro) to create a more credible investment environment. International capital pours in. The economy takes off. So far, so good. But the story so far is more complicated than simply "foreign money comes in and the economy grows." The international capital needs to be converted to the local currency (let's call them rubles). In terms of supply and demand, this creates more demand for rubles. To keep the ruble from gaining value (since they pegged it against the euro), the Leveragestan government must sell rubles on the foreign exchange markets, building up a reserve of foreign currency in return. Meanwhile, the new rubles in circulation within Leveragestan create a credit boom. Some of this money will go to legitimate investments. Some to speculation. And some to consumption. Soon Leveragestan increases its imports, and begins running a current accounts deficit. As long as the money keeps coming in from abroad, this isn't a problem. But what if international investors run for the exits?
First, why would foreign money suddenly stop coming in? Maybe Leveragestan's economy stops growing as fast as it was previously, and isn't as attractive an investment option anymore. Maybe the credit boom from the international capital created a speculative bubble that popped. Or maybe a major investment bank abroad collapsed, and investors everywhere are selling assets to raise cash. Regardless of the cause, once there is serious capital flight out of the country, Leveragestan's currency comes under assault. Its current accounts deficit, if large enough relative to the size of the economy, means that there is less demand for the Leveragestan ruble. The ruble is now overvalued. Subsequently, speculators begin to bet that it will decline. Leveragestan can defend its currency by using its foreign currency reserves to buy rubles on foreign exchange markets. But is more difficult to prop up a currency's value than to keep it down. Leveragestan can always print more rubles to put on foreign exchange markets if the government wants to keep the ruble from rising. They have a limited supply of foreign currency, however, to sell in order to keep the ruble from falling.
Once its foreign reserves dwindle, Leveragestan has two choices: raise interest rates or devalue the currency. Raising interest rates reduces the money supply and makes holding assets in Leveragestan more attractive; investments pay a higher rate of return. This could stop the capital flight. But spiking interest rates also choke off economic growth. Businesses can't borrow cheaply and hiring slows. A recession will follow. Devaluing carries its own risks. If done transparently and correctly, it will end the speculative attacks. Additionally, it will make Leveragestan's exports more competitive, since their goods will be cheaper abroad, and set the economy up for continued growth. Devaluing also gives investors confidence that assets are fairly priced. The perils are twofold: first, if done haphazardly, investors might panic, and the currency will fall more than it "should"; and second, that the real burden of debts denominated in foreign currencies will skyrocket for domestic borrowers.
Now where does Eastern Europe fit into this story? In the two decades since emerging from communism, the Eastern European countries have liberalized their economies, opening them to foreign investment, and pegging many of their currencies against the euro, in anticipation of someday joining the Eurozone. Western European banks - particularly Austrian, Swedish, and Belgian ones - lent heavily to Eastern Europe. This sparked a rise in consumption, and some gargantuan current account deficits. But the credit crisis has reversed this onetime frothy growth - and then some. As capital has left the region, Eastern European currencies have plummeted. While this would normally help their export sector, the reality is that with worldwide demand shriveling, there is no one to export to. Like Latvia, countries across Eastern Europe are contracting at or near double digit annual rates, as demand for their goods in Western Europe has disappeared.
This precipitous fall in GDP in conjunction with plunging currencies has created potentially a new source of contagion in world financial markets. First, let's consider the currencies. Raising interest rates to stem capital flight is not an option. Investors want to hold cash or safe government debt. This liquidity preference is, of course, not unique to Eastern Europe. But it means that offering higher rates of return will not dissuade investors from pulling their money out. And given the enormous current accounts deficits many Eastern European nations were running, this means - oftentimes massive - devaluation is the only option. Indeed, currencies across the region have fallen by nearly 20-50% against currencies such as the Swiss franc. This fall against the Swiss franc is particularly ominous, since so many Eastern European businesses and households took out loans and mortgages in Swiss francs during the bubble years to take advantage of low interest rates. But one example: 60% of Polish mortgages are denominated in Swiss francs; the Polish zloty has halved against the Swiss franc in recent weeks. As the real burden of debts of businesses and households nearly doubles across the region, defaults will skyrocket. Eastern Europe's cratering economies compound this problem. As job losses accelerate, even more borrowers will not be able to repay their debts - and that's before accounting for the rising real burden of debts as local currencies fall. This is Europe's subprime debacle. And its explosion will beget a new round of writedowns for Western European banks.
The web of financial interconnectedness is tangled and difficult to predict. But the failure of Western European banks - and countries - could potentially bring credit markets back to their apocalyptic post-Lehman levels. Austrian banks are perhaps most exposed to Eastern European debt, but they themselves borrowed heavily from Swiss banks. Switzerland could find itself at risk of sovereign default if it needs to nationalize its banks, as bank liabilities are roughly 1050% of Swiss GDP (Iceland's bank liabilities comprised 1000% of GDP for comparison's sake). For many of the small Western European countries, their banks are both too big to fail and too big to save. Italian, Belgian, and Swedish banks are all also highly exposed. Only an EU-wide response can stave off complete disaster. This essentially means getting France and Germany to agree to bail out their neighbors. After denying reality for months - resisting calls for stimulus spending and bailing out at-risk European countries - the German Finance Minister made some noise recently about bailing out Ireland. This is a good start. But much more is needed.
This is where President Obama comes in. A collapse in the European banking sector would surely bring down American banks as well. While major American banks are more or less insolvent already, we have them on life support now. A disorderly bankruptcy in the markets would send them on a new and rapid death spiral. At the upcoming G20 summit, President Obama should push for increasing IMF funding, and giving it a greater mandate to bail out countries. He should also push the EU members to more aggressively cut rates and spend on fiscal stimulus. But most importantly, we need an internationally coordinated banking rescue plan. This is a tall order. Getting consensus within America on fixing the financial sector is difficult enough without bringing in foreign leaders as well. But our financial markets are so interconnected that coordination is more or less necessary.
In 1931, the Austrian bank Creditanstalt failed, setting off a new stage of bank runs across the world. Let us hope that history indeed does not repeat itself. And that we can learn from it.
Update: European leaders' unwillingness over the weekend to create a comprehensive Eastern Europe bailout fund a la Hungary's suggestion is not encouraging. Treating each country on a "case-by-case" basis echoes of American policy towards investment banks until October. Eventually, political leaders will likely get bailout fatigue, or policymakers will simply underestimate the systemic importance of a country/bank, and let the wrong one go. If moralizing sentiment like from this recent interview - Eastern Europeans must devalue despite the enormous real burden of debt this will create to "learn not to borrow in foreign currencies" - takes hold, then enough of Eastern Europe might go bust to start a new stage of financial panic.
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