All attempts to figure out how bad a crisis will get depend on the assumption that none of the parties will do something stupid.
Germany just did.
Yesterday, May 18, without any discernable coordination with the other members of the European Monetary Union, Germany imposed a ban on naked short selling. Other countries such as Belgium have implemented such bans on shorting stocks that traders didn’t actually own as a way to limit what national governments regard as speculative attacks on bank shares.
But Germany went one, no, make that two, steps farther. It banned naked shorting not only against a list of 10 German banks but also against bonds issued by European governments and against credit default swaps.
The euro dropped yesterday, May 18, to another four-year low against the U.S. dollar on the news.
The damage—beside the day’s hit to the euro–here is three fold.
First, by moving alone and in what appears to be haste, Germany has unnerved financial markets across Europe. Are countries going to strike out to defend their own interests with the devil taking the weak and the slow? Has Chancellor Angela Merkel’s government panicked? You can understand why financial markets would like answers to those questions before anyone extends credit to anyone in Europe.
Second, investors—not just speculators—use credit default swaps as a way to build hedges against a default by a borrower. Sometimes those hedges can get rather complicated and they might even involve a short against an asset that the hedging investor doesn’t own. Limiting the availability of insurance at a time when markets are worried about the credit-worthiness of European banks and governments will force some potential lenders to stay out of these markets at exactly the time when these markets need more liquidity. There’s no evidence that points to a surge in the speculative use of credit default swaps. According to the Depository Trust and Clearing Corp. net outstanding credit default swaps on Greek debt totaled $7.7 billion in the week ending May 7. A year ago the total stood at $7.8 billion.
Third, today politicians have decided to ban naked short-selling of credit default swaps. What bans and regulations are on tap for tomorrow? Nobody likes to put money at risk when there’s a good chance that the rules will change overnight. The big risk now in the Euro Zone is a credit crunch that will lock some countries and some banks out of the financial markets so they won’t be able to roll over their short-term debt or raise new capital. Germany’s action has just increased the likelihood of exactly that kind of problem.
The euro debt crisis has always had a strong political element from the very beginning when it became clear that Greek politicians had lied about the size of the government’s budget deficit to today when no one is quite sure that German legislators will vote to approve their country’s share of the $1 trillion rescue package.
And one of the reasons that it has been so hard to put this crisis to rest is a suspicion that Euro Zone politicians just aren’t up to the job. Even at this stage in the crisis, yesterday Spanish finance minister Elena Salgado was spending her time asserting that her government would never give European regulators the power to rewrite her country’s national budget. Well, okay. Sure. But how about a credible budget reduction plan from the finance minister first/
Germany’s move yesterday just raised those fears another notch: If the Euro Zone can’t even count on the Germans for smart financial policy, then who is going to provide the leadership to put a end to this crisis?
A financial crisis is always to a high degree a crisis of confidence. Right now the financial markets have very little in Europe’s governments.