IT’S a $2.6 trillion mystery.

That’s the amount that foreign banks and other financial companies have lent to public and private institutions in Greece, Spain and Portugal, three countries so mired in economic troubles that analysts and investors assume that a significant portion of that mountain of debt may never be repaid.

The problem is, alas, that no one ”” not investors, not regulators, not even bankers themselves ”” knows exactly which banks are sitting on the biggest stockpiles of rotting loans within that pile. And doubt, as it always does during economic crises, has made Europe’s already vulnerable financial system occasionally appear to seize up. Early last month, in an indication of just how dangerous the situation had become, European banks ”” which appear to hold more than half of that $2.6 trillion in debt ”” nearly stopped lending money to one another.

Now, with government resources strained and confidence in European economies eroding, some analysts say the Continent’s banks have to come clean with a transparent and rigorous accounting of their woes. Until then, they say, nobody will be able to wrestle effectively with Europe’s mounting problems.

“The marketplace knows very little about where the real risks are parked,” says Nicolas Véron, an economist at Bruegel, a research organization in Brussels. “That is exactly the problem. As long as there is no semblance of clarity, trust will not return to the banking system.”

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The big news is France. With sentiment worsening across Europe, France has lost its relative safe haven status ”“ credit default swap spreads on French government debt were up sharply today.

The trigger ”“ oddly enough ”“ was Hungary’s announcement that its budget is worse than expected (blaming the previous government; this is starting to become the European pattern) and in the current fragile environment discussed yesterday, this relatively small piece of news spooked investors. But these developments only reinforced a trend that was already in place.

It did not help that the Irish Minister of Finance announced Ireland has 74.2bn euros of guaranteed bank loans, bonds, and systemic support falling due between now and Oct 1. This is around 55% of GNP. It sounds like everyone backed by the Irish government had the “clever” idea to roll over their debts to just before the guarantees expire.

The big losers are Portugal-Ireland-Italy-Greece-and-Spain as always, but Belgium is now in the line of fire, and France is clearly under pressure. The spread between French and German credit default swaps (measuring the relative probability of default) is up ”“ yesterday this was 40 basis points, today it stands at 44 (up from just 5 basis points at the end of 2009; most of the increase is since mid-March, with a sharp acceleration recently). French bonds have become illiquid, with wide bid-ask spreads; not what is supposed to happen in a safe haven. This is going to make the French angry ”“ watch for more market slanders from top French politicians over the weekend; you know they would just love to ban trading in something.

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As a long-standing critic of the idea of a European single currency, I have not rejoiced at the current problems in the euro zone because their consequences could be serious for all of us in Europe””for members and non-members of the euro zone, for its supporters and opponents. Even the enthusiastic propagandists of the euro suddenly speak about the potential collapse of the whole project now, and it is us critics who say we have to look at it in a more structured way.

The term “collapse” has at least two meanings. The first is that the euro-zone project has not succeeded in delivering the positive effects that had been rightly or wrongly expected from it. It was mistakenly and irresponsibly presented as an indisputable economic benefit to all the countries willing to give up their own long-treasured currencies….

The second meaning of the term collapse is the possible collapse of the euro zone as an institution, the demise of the euro. To that question, my answer is no, it will not collapse. So much political capital had been invested in its existence and in its role as a “cement” that binds the EU on its way to supra-nationality that in the foreseeable future the euro will surely not be abandoned.

It will continue, but at a very high price””low economic growth. It will bring economic losses even to non-members of the euro zone, like the Czech Republic.

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The Greek government has been advised by British economists to leave the euro and default on its €300 billion (£255 billion) debt to save its economy.

The Centre for Economics and Business Research (CEBR), a London-based consultancy, has warned Greek ministers they will be unable to escape their debt trap without devaluing their own currency to boost exports. The only way this can happen is if Greece returns to its own currency.

Greek politicians have played down the prospect of abandoning the euro, which could lead to the break-up of the single currency.

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Like last week, with stocks lurching wildly with the headlines — up by triple digits one day, down the next. For the month, the Dow Jones Industrial Average dropped 7.9% and is negative for the year. The Nasdaq Composite and the Standard & Poor’s 500-stock index also are in the red for the year.

Some pretty smart people are cautious. Seth Klarman at Baupost Group is worried. John Hussman of the Hussman Funds says all sorts of warning lights have lit up across his screen. Even Ron Muhlenkamp of the Muhlenkamp Fund, who usually takes a sunnier view of things, says he has moved a big chunk of his mutual fund into cash in case there’s a plunge.

How far will it go? Mr. Hussman says the technical indicators have only been this bad 19 times before in the last half century — and on average the market plunged about 20% over the following 12 months. When markets were also high, like now, the picture’s even worse.

Ugh.

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For much of the rich world, however, the most important consequences of Europe’s mess will be fiscal. Governments must steer between imposing premature austerity (in a bid to avoid becoming Greece) and allowing their public finances to deteriorate for too long. In some countries with big deficits, the fear of a bond-market rout is forcing rapid action. Britain’s new government spelled out useful initial spending cuts this week. But the emergency budget promised for June 22nd will be trickier: it needs to show resolve on the deficit without sending the country back into recession.

In America, paradoxically, the Greek crisis has, if anything, removed the pressure for deficit reduction, by reducing bond yields. America’s structural budget deficit will soon be bigger than that of any other OECD member, and the country badly needs a plan to deal with it. But for now, lower bond yields and a stronger dollar are the route through which American spending will rise to counter European austerity. Thanks to its population growth and the dollar’s role as a global currency, America has more fiscal room than any other big-deficit country. It has been right to use it.

The world is nervous for good reason. Although the fundamentals are reasonably good, the judgment of politicians is often unreasonably bad. Right now that is what poses the biggest risk to the world economy.

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From David Ignatius in the Washington Post:

Investors keep pounding Europe in part because they don’t yet see the mechanisms that will enforce discipline. The European Union just established a trillion-dollar bailout fund, but what happens when it runs out? There’s a pledge to impose strict conditions on Greece, Portugal and the rest in exchange for loans, but it still isn’t clear how Brussels will make this austerity regime work.

The problem is the one Napolitano describes: Europe remains a union of convenience, which can be discarded by national governments when it suits their purpose. Northern European nations such as Germany like to chide their spendthrift southern counterparts for lack of discipline. But it was Germany and France that demonstrated the toothlessness of the eurozone’s enforcement mechanisms in 2005 by refusing to pay fines when their budget deficits exceeded the limits of the E.U. Stability and Growth Pact.

There are very useful parallels here for Anglicans for those who have eyes to see–KSH.

While a restructuring may not take place for another year or two, it’s a move that Greece may be unable to avoid, many say, despite assurances to the contrary from officials at the EU and IMF.

Restructuring is essentially a default, under which Greece would renegotiate its debt with bondholders, either lengthening its maturities or reducing the amount it owes, causing bondholders to take a loss.

“At this point, it is very clear that restructuring is the only option,” says Lena Komileva of Tullett Prebon in London.

Josef Ackermann, the chief executive of Deutsche Bank, said earlier this month he thought it “doubtful” that Greece would be able to repay all its borrowings.

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The European financial crisis may look and smell rather different to the American banking crisis of a couple of years ago, but strip away the details ”“ the breakdown of the euro, the crumbling of the Spanish banking system to take just two ”“ and what you are left with is the next leg of a global financial crisis. Politicians temporarily “solved” the sub-prime crisis of 2007 and 2008 by nationalising billions of pounds’ worth of bank debt. While this helped reinject a little confidence into markets, the real upshot was merely to transfer that debt on to public-sector balance sheets.

This kind of card-shuffle trick has a long-established pedigree: after the dotcom bust, Alan Greenspan slashed US interest rates to (then) unprecedented lows, which helped dull the pain, but only at the cost of generating the housing bubble that fed sub-prime. It is not so different to the Ponzi scheme carried out by Bernard Madoff, except that unlike his hedge fund fraud, this one is being carried out in full public view.

The problem is that this has to stop somewhere, and that gasping noise over the past couple of weeks is the sound of millions of investors realising, all at once, that the music might have stopped.

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5. Nobody really understands the world economy.

Sad, but true. For all the math and the theoretical models, economics remains an intellectual discipline rather than a predictive science. That is unlikely to change. Just as all the computer models in the world can’t tell you what the stock market will do tomorrow, all the world’s economists working together can’t tell you when the next crisis will come ”” or what you can do to avoid it. At any given point of time there will be economists predicting a crash and economists predicting good times along with every variant in between; some of them are bound to be right but so far this looks more like timing and luck than the repeatable and testable result of demonstrably better methods. The economics profession is full of dogmatic and pompous heretic hunters of all stripes, but as a group they are no better collectively at prediction than a similarly dogmatic and contentious group of medieval clerics. This doesn’t mean that economics is bunk (any more than theology is bunk); systematic and rigorous reflection on human economic activity yields many useful insights and an education in basic economic ideas remains an essential piece of intellectual equipment for any serious person.

Economic outcomes remain hard to predict not because economists are stupid (they aren’t, by and large) but because the world economy is continually in flux. Facts change; China rises, new industries emerge, under the influence of new economic ideas, central bankers and investors change the way they behave. Investors and entrepreneurs have mood swings: too optimistic in 2007, too pessimistic in 2008. All this change feeds back into the world system in unpredictable ways. Economics can help us understand what is happening and give us more sophisticated tools for investigating the unknown ”” but it cannot protect us from uncertainty and risk. The “unknown unknowns” will always be with us.

This means, among other things, that we are no closer to eliminating panics and crashes than the Dutch were in the wake of the Tulip Bubble.

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[SUSIE] GHARIB: Let me begin by just asking you what are the risks of all these events, that Spanish bailout, the debt crisis in Greece, the falling euro? What’s the intact and the risk of all of that to American businesses and our economy?

[MOHAMED] EL-ERIAN [CEO of PIMCO]: Susie, we went into the weekend knowing that Europe had a debt issue and Europe had a growth issue. And we come out of the weekend with the news that Europe may also have a banking system issue. The minute you bring in the banking system, it’s like an amplifier, something that we discovered in this country a couple of years ago. Banks have a way of amplifying shocks in the system because banks are like the oil in your car. They link up so many different parts. And the problem for the U.S. is that not only is it going to have to cope with a growth issue out of Europe. Europe is an important export market. We sell a lot to Europe. Europe is going to grow less, but now the strains in the banking system. And the minute you introduce strains in the banking system, there’s always a fear that governments will be behind the curve and that you can get contagion. You can get widespread disruptions. And that’s what we started to price in today.

GHARIB: In terms of American banks that have just been coming out of our own financial crisis, how exposed are U.S. banks to what’s going on in the European banking system?

EL-ERIAN: They are not as exposed to the European banks as they are to each other but we are all exposed to the global banking system. Banks are very inter-linked. And the minute you start having disruptions, the minute the flow through the pipes starts to be interrupted, then everybody suffers. And the concern is that Europe’s banking system may come under pressure.

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If the trouble starts — and it remains an “if” — the trigger may well be obscure to the concerns of most Americans: a missed budget projection by the Spanish government, the failure of Greece to hit a deficit-reduction target, a drop in Ireland’s economic output.

But the knife-edge psychology currently governing global markets has put the future of the U.S. economic recovery in the hands of politicians in an assortment of European capitals. If one or more fail to make the expected progress on cutting budgets, restructuring economies or boosting growth, it could drain confidence in a broad and unsettling way. Credit markets worldwide could lock up and throw the global economy back into recession.

For the average American, that seemingly distant sequence of events could translate into another hit on the 401(k) plan, a lost factory shift if exports to Europe decline and another shock to the banking system that might make it harder to borrow.

“If what happened in Greece were to happen in a large country, it could fundamentally mark our times,” Angelos Pangratis, head of the European Union delegation to the United States, said Friday after a panel discussion on the crisis in Greece sponsored by the Greater Washington Board of Trade.

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Birthdays are fun; a birth itself is not. There’s a lot of screaming and groaning, and even in the easiest deliveries, there’s always the fear that something will go wrong.

The birth of a state is no less difficult. Indeed, what pessimists ”” including many here in Germany ”” see as an existential crisis for the continent is really just the latest stage in the birth pangs of a new country. While we should of course worry about Greek debt, we should also have hope that we are witnessing the end of the euro zone as an abstraction and the birth of the United States of Europe.

Europe’s movement toward unification has always been the product of crises.

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Germany moved Friday to shore up the euro and stabilize heavily indebted European nations, approving the country’s share of a nearly $1 trillion euro-region bailout.

The lower house of the German parliament voted 319 to 73 in favor of the package, which was put together two weeks ago. There were 195 abstentions. The upper house, the Bundesrat, was scheduled to pass the measure later Friday.

Under the plan, Germany is to lend as much as $184 billion to debt-ridden states in the euro zone to backstop the European currency and protect the nations from default. The package follows an earlier rescue for Greece.

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Europe’s leaders scrambled to restore unity in the face of the sovereign debt crisis after Germany dismayed allies with a unilateral ban on naked short selling.

The ban, introduced with no warning to other European nations, knocked global stock markets and sent the euro tumbling to fresh four-year lows against the dollar. An unrepentant Angela Merkel, German chancellor, told parliament in Berlin on Wednesday that the eurozone crisis was the greatest test for the European Union since its creation.

“It is a question of survival,” she said. “The euro is in danger. If the euro fails, then Europe fails. If we succeed, Europe will be stronger.”

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Shocked European ministers are preparing for emergency talks to shore up the euro after markets fell in reaction to panic measures in Germany.

Angela Merkel stunned EU capitals by warning that the euro was in danger and triggered fears of a fresh financial meltdown by announcing a ban on risky trading practices by speculators. The German Chancellor’s actions opened up new cracks in the single currency, drawing sharp criticism from France and prompting Brussels to issue an appeal for unity.

Shares in London plunged by nearly 3 per cent, with similar falls in Paris, Berlin and Madrid. The euro plummeted to a new low against the dollar before making a slight recovery.

European finance ministers, who have just hammered out a massive rescue plan for Greece, will hear controversial calls from Germany at a meeting tomorrow for changes to the Lisbon treaty to give Brussels powers to co-ordinate national budgets.

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“Bond market vigilantes have already woken up in Greece, in Spain, in Portugal, in Ireland, in Iceland, and soon enough they could wake up in the U.K., in Japan, in the United States, if we keep on running very large fiscal deficits,” Roubini said at an event at the London School of Economics yesterday. “The chances are, they are going to wake up in the United States in the next three years and say, ”˜this is unsustainable.’”

The euro has touched a four-year low against the dollar on concern nations with the largest budget deficits will struggle to meet the European Union’s austerity requirements. Roubini, speaking in a lecture hall packed with students who then queued to meet him at a book-signing, suggested that the public debt burden incurred after the banking panic of 2008 may now cause the financial crisis to metamorphose.

“There is now a massive re-leveraging of the public sector, with budget deficits on the order of 10 percent” of gross domestic product “in a number of countries,” Roubini said. “History would suggest that maybe this crisis is not really over. We just finished the first stage and there’s a risk of ending up in the second stage of this financial crisis.”

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You know, Charlie, for 60 years you could really say being in politics, being a political leader, was, on balance, about giving things away to people. That’s what you did most of your time.

I think we’re entering an era — how long it will last, I dare not predict — where being in politics is going to be more than anything else about taking things away from people. And that shift from leaders giving things away to leaders taking things away, I don’t think we know what that looks like over time. It’s going to be very, very interesting.

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SPIEGEL: So, what was in danger? Just the banks? The euro? The European Union?

Trichet: We are now experiencing severe tensions, which are coming after the events of 2007-2008. At that time, private institutions and markets were about to collapse completely. That triggered a very bold and comprehensive financial support by governments. And now we see the signature of some governments put into question. This is a problem for almost all industrialized countries. In the G-7, the major economies have a yearly deficit of around 10 percent of gross domesitc product (GDP). In the euro area as a whole it averages 7 percent of GDP. In this situation with extremely elevated deficits across the globe, the markets have singled out a weak link: Greece. Also taking into account the fact that its statistics were incorrect at one time, market pressure was concentrated there and a drastic adjustment program was necessary.

SPIEGEL: Apparently it was not only Greece that came under attack. Portugal was next …

Trichet: In the market, there is always a danger of contagion — like the contagion we saw among the private institutions in 2008. And it can occur quickly. Sometimes it is a question of half days. This is an issue for the industrialized world as a whole….

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