Back in May in response to a question during an interview I suggested that when the sovereign debt of a major nation is finally questioned, it will signal the endgame for the worldwide bull market in just about everything. That moment has arrived, and my thesis will now be tested.
And, I'm not talking about the United States. I'm talking about France. The downgrade of U.S. government debt by one ratings agency was more political theater than careful, cold calculation. U.S. Treasury bonds rallied on the news. But in France it is a different matter. French banks are known to be heavily exposed to the sovereign debt of what are now infamously called the PIIGS, that is, Portugal, Ireland, Italy, Greece and Spain. What changed this week was that market participants began to think that this matters. They think the problem is so big that it could impair the credit of the French government which will ultimately be saddled with cleaning up the mess. And, who wants to stick around for that?
Nicole Foss, part of the duo who write for the popular financial site The Automatic Earth, once explained to me that liquidity and confidence are the same thing. Liquidity means I'm willing to part with my cash to lend it to you or to buy something from you. When my confidence in you is shattered, I won't lend to you. When my confidence in my own future prospects is shattered, I won't buy from you because I think I may need the cash later. That, it seems, is where much of the world finds itself today.
But the problem for French banks isn't necessarily that they are in worse shape than many other banks in the world. It's that people believe this to be so. And, as that belief spreads, it will become a self-fulfilling prophesy. At first, one, then two, then 10, then 20 banks and so on will refuse to lend to French banks. And, with each withdrawal of a source of funds French banks will become less creditworthy.
But if this loss of confidence isn't stopped soon, it will spread to non-French banks that have large financial ties to French banks. A cascade of financial ruin will be unleashed. We have built of world of huge financial institutions with heavily incestuous relations. They are like rafts all strapped together which doesn't help much if all the rafts are sinking.
Certainly, there are other factors at work. Persistently high oil prices have been draining the pockets of already beleaguered consumers. I was listening to CNBC one day to catch up on the excitement when investment show host Jim Cramer explained to me that falling oil prices were going to be good for the economy. That would be true if prices were falling because there is a glut of oil. In fact, oil prices have been falling in the face of falling production meaning that demand must be falling even faster. That can only happen when the economy is headed for the ditch.
I have people telling me that fundamentally the economy isn't all that bad. Maybe not now, I respond. But we are facing a potentially vicious feedback loop in which our huge, unwieldy, out-of-control and risk-laden financial sector destroys confidence in the real economy which will then make the economy decline, which will then make loans on bank balance sheets seem even more shaky.
One problem is very little transparency. A bank is like a black box. It's hard to evaluate what's on the balance sheet. And, it is especially hard now that banks have been released from the requirement that they mark their portfolios to market prices. They can now do what many skeptics call "mark to fantasy." In such an environment the only thing one bank doing business with another has to go on is reputation. And, this is where things get tricky. Supposedly, a rumor got started that a major French bank, Société Générale, was about to go under. The bank immediately denied it. But the taint and the fear are still there. Who really wants to do business with Société Générale just in case the rumor is true? Under different circumstances the rumor might have been easily dismissed. But the bank is believed to be holding a lot of dicey sovereign debt from countries that may not be able to pay the bank back in full. Anyway, it's a black box. Who really wants to trust a black box, especially when others are questioning the reputation of the black box?
Sovereign debt troubles are the last stop on the way to the endgame for the global bull market that has persisted for almost two years or perhaps more correctly for the last 30. Governments that might take on additional debt to goose the economy by spending on various public priorities such as new infrastructure are now busily reducing their expenditures to shore up their sagging long-term financial prospects. Several central banks have lowered interest rates to near zero to spur borrowing in the real economy. But all they've gotten is speculation in the financial markets which has only made matters worse.
There are really no good options from here on out. And, there's bound to be a lot more pain. The main issue now is who will be made to bear it. On past form the rich--who today so dominate the halls of government everywhere--will once again be exempted.