ECONOMY
AUGUST 13, 2011.
Global Crisis of Confidence
World Policy Makers' Inability to Agree on Fixes Led Markets on Wild Ride.
By MARCUS WALKER, DAMIAN PALETTA and BRIAN BLACKSTONE
A week that toyed with investors' emotions.
Last week, as storm clouds gathered yet again over the world financial system, a who's who of government leaders assembled by phone.
The flurry of calls brought to mind the emergency meetings during the 2008 financial meltdown. Presidents, finance ministers and central bankers dialed in, including German Chancellor Angela Merkel, on vacation in the Italian Alps and French President Nicolas Sarkozy from the Riviera. They were all eager to thwart what promised to be a calamitous day's trading when markets opened Monday, as Europe's worsening debt crisis combined with a first-ever downgrade of U.S. debt by Standard & Poor's.
Mervyn King, governor of the Bank of England, urged swift action from finance ministers on one call. "He told them they had to get their s— together," a person familiar with the call said.
They didn't. The Group of Seven leading economies simply issued a communique Sunday that featured mutual praise for the U.S. and the Europeans for their "decisive actions" in past weeks. On Monday, the Dow Jones Industrial Average plummeted 635 points.
The debt crises in Europe and the U.S. collided violently this past week, raising questions about whether political leaders are capable of stemming the trans-Atlantic panic. The seesawing stock markets, investor flight from Italian and Spanish bonds, the credit downgrade for the U.S. government and fears of a similar downgrade for France and the U.K.—all were fueled by a lack of consensus by policy makers about what steps to take.
The panic in 2008 represented a crisis in markets. What's happening now seems to be a crisis in government. In 2008, the world's richest countries embarked on a series of unprecedented interventions to stop financial markets from seizing. Today, the tables are reversed: Financial markets have lost confidence in politicians' ability to master their problems. In 2008, countries united in response. This year has been marked by tensions and misunderstanding, including those between the U.S. and Europe over the continent's response to its debt crisis.
"What we are seeing in the financial markets reflects to a large extent the inability of governments to put their fiscal house in order and even to cooperate among themselves," said Domenico Lombardi, a former executive board member at the World Bank and the International Monetary Fund.
Added Neel Kashkari, a former Bush administration Treasury official: "Washington has told markets: 'You are on your own now.'"
That vacuum has shriveled investor confidence and sent global stock markets gyrating. The Dow Jones Industrial Average fell more than 500 points three times in the past two weeks, and rose more than 400 points twice.
The 2008 financial crisis and resulting recession compounded the challenges facing the U.S. and Europe—both advanced economies with aging populations and overburdened social programs. Not only did it pile on more debt, but it also burned politicians who had supported activist government intervention.
Now, political gridlock in Washington and squabbling in Europe has left markets looking to central banks out of desperation. The European Central Bank took dramatic steps Sunday to arrest growing problems in Spain and Italy only after the other countries failed to agree on a plan. The U.S. Federal Reserve, meanwhile, which intervened dramatically three years ago to help save the financial system, merely issued a statement this week promising to keep interest rates low for another two years and perhaps take further unspecified actions in the future.
National leaders have been left blaming others. "We now live in a global economy where everything is interconnected, and that means that when you have problems in Europe and in Spain and in Italy and in Greece, those problems wash over into our shores," U.S. President Barack Obama said at a fund-raiser Monday evening in Washington.
For months, there have been tensions between Europe and the U.S. over how to handle the EU debt crisis. Ever since Greece's debt crisis began roiling markets, President Obama and Treasury Secretary Timothy Geithner have repeatedly lobbied key European decision-makers to take bigger, bolder steps.
Washington pressed Berlin in particular to counter investors' doubts with overwhelming financial firepower. In March, Mr. Geithner flew to Berlin in person to drive home that message.
German officials were taken aback. "It's easy to demand this when it isn't your own money," a senior German official said at the time. Germany and other financially strong northern European countries preferred a cautious approach, partly for fear of a backlash from voters leery about writing checks for their profligate southern cousins.
Then, earlier this month, America's debt problems clattered onto the stage. On, Aug. 2, President Obama signed into law a last-minute deficit-reduction package that narrowly steered the country away from a default. The deal, which would cut the deficit by between $2.1 trillion and $2.4 trillion over 10 years, was much smaller than the $4 trillion package the White House had hoped for.
In Europe the next day, Italian Prime Minister gave a combative speech in parliament, saying his country had "solid economic fundamentals." He blamed the outside world for Italy's rising borrowing costs. That raised fears that the country's bond market, the world's third largest, would unravel entirely.
A day after Mr. Berlusconi's speech, European Commission President Jose Manuel Barroso said the euro zone should substantially boost the bailout fund, but he was quickly slapped down by Germany. A bigger rescue fund would place huge burdens on Germany and France, and investors questioned whether the French could afford it.
The squabble between Brussels and Berlin added to the sense of disarray among Europe's vacationing policy makers. By Aug. 4, it was becoming clear the European Central Bank was the only fire brigade in Europe that had enough water left to douse the flames licking at Italy. When the ECB's governing council convened that day in the bank's Frankfurt tower for its regular monthly meeting, the yield on Italy's 10-year bonds had surged past 6%, a level that triggered a bailout of Greece last year. Some ECB governors pressed for buying Italian and Spanish bonds to stem the growing crises in those two countries. The ECB majority decided that was too much.
On Aug. 5, Mr. Obama spoke on the phone with Mr. Sarkozy and Ms. Merkel about the crisis.
All day long, rumors swept U.S. markets that S&P had dismissed the entreaties of the U.S. Treasury and was poised to downgrade America's debt for the first time in 70 years. Such a prospect greatly worried European leaders. The impact, ECB officials feared, would be a flight to perceived safe havens Monday morning, which paradoxically would include U.S. Treasury bonds. The victims would be euro-zone countries that were already under pressure, notably Spain and Italy.
U.S. downgrade would also raise doubts about the credit ratings of triple-A countries in the euro zone, including France, ECB officials knew. That would make it harder to control the debt crisis and all the more important to halt capital flight from Italy and Spain.
After U.S. markets closed Friday evening, S&P dropped its bombshell, blaming Washington's gridlock for its downgrade. The tables were turned. All year long, the U.S. had worried about Europe's problems lapping its shores. Now, the Europeans saw the opposite about to happen.
Saturday saw another round of phone calls between governments, including finance ministers from the Group of Seven and Group of 20 leading economies. Top U.S. Treasury officials feverishly called governments and investors to stem concerns about the downgrade.
Meanwhile, in Europe, policy makers were scrambling to contain their debt crisis. Ms. Merkel and Mr. Sarkozy knew they needed the ECB to prevent a run on Italy on when markets opened Monday. In phone calls with both leaders, ECB President Jean-Claude Trichet made clear the ECB wanted governments to take over the burden of bond-buying as soon as possible.
At a crucial ECB conference call on Sunday, Mr. Trichet argued that the ECB had to intervene and support Spanish and Italian bond prices, ignoring the objections of the German Bundesbank. On Monday, ECB began buying Italian and Spanish bonds, and was able to stabilize their yields at around 5%.
But the sight of the ECB intervening where national governments couldn't, the U.S. downgrade, and the G-7's tepid communiqué, sent stocks and other assets on a roller-coaster ride. A speech by Mr. Obama Monday, in which he announced no new initiatives, sent markets diving even further. After that point, the White House and Treasury made a conscious decision to lie low, even as markets spun wildly.
On Thursday, following a wave of selling focused on European banks, in particular France's Société Générale SA, stock-market authorities in France, Belgium, Italy and Spain announced restrictions on short selling—a strategy in which investors bet on a stock's decline. The countries blamed market rumors and unscrupulous traders.
That effort is likely to encounter a major obstacle: the unwillingness of U.K. authorities to follow suit. A spokesman for the London-based Financial Services Authority said Thursday it isn't going to impose a ban on short-selling of U.K. stocks. While Frankfurt, Paris, Milan and other European cities have major stock exchanges, London is by far the most important one. So banning short-selling in other exchanges is unlikely to have much effect as long London permits it.
Across Wall Street, from traders and strategists to economists and academicians, there was a nearly unanimous consensus, that the short-selling ban was a bad idea. "It may give a couple days of breathing room, maybe, but it doesn't fix anything," said Peter Tchir of TF Market Advisors, citing the experience of the U.S. short-selling ban in September 2008. "What it ensures is that, once the shorts are taken out, there will be almost nothing to stop a decline."
—Mark Gongloff and Paul Vieira contributed to this article.
Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved
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