With credit drying up across Europe we may finally see the Eurozone experience its "Lehman moment" – a replay investment banking collapse that triggered the 2008 financial crisis.
Indeed, European banks are having a harder time getting money – part of the fallout from the Eurozone debt crisis – and the resulting credit crunch could freeze business activity, cause bank runs and plunge Europe into a deep recession that would badly damage the global economy.
"The Continent is headed towards deflation if there's not enough money circulating throughout their financing and banking systems," said Money Morning Capital Waves Strategist Shah Gilani. "This all becomes self-fulfilling at some point. It's a very dangerous situation, not just for Europe, but for the whole world."
A global financial crisis would derail the struggling U.S. recovery and pinch the profits of many multinational corporations.
Fresh data this week from the European Central Bank (ECB) showed the M3 Eurozone money supply actually shrank in October by 0.6%, its steepest drop since January 2009 – the height of the Lehman Brothers crisis.
A shrinking money supply is one of the early warning signals that credit availability is drying up, making it difficult or impossible for banks, businesses, and consumers to obtain loans.
"This is very worrying," Tim Congdon from International Monetary Research told The Telegraph. "What it shows is that the implosion of the banking system on the periphery is now outweighing any growth left in the core. We are seeing the destruction of money and it is a clear warning of serious trouble over the next six months."
Signs of capital draining from European banks abound.
The bank bond market is already frozen. European banks in the third quarter were only able to sell bonds worth 15% of what they sold in the same period in the previous two years, according to Citigroup Inc. (NYSE: C).
In the past six months, U.S. money market funds have withdrawn 42% of their money from European banks. And loans to French banks have fallen 69% since the end of May, according to Fitch Ratings.
Even retail customers have started to pull their money out.
"We are starting to witness signs that corporates are withdrawing deposits from banks in Spain, Italy, France and Belgium," an analyst at Citigroup wrote in a recent report. "This is a worrying development."
How It Happened
The current credit crunch has its roots in the Eurozone debt crisis; the big European banks such as BNP Paribas SA, Commerzbank (PINK: CRZBY) and Societe Generale SA (PINK: SCGLY) hold much of the debt from Portugal, Italy, Ireland, Greece and Spain (PIIGS) that has forced a series of bailouts and fiscal emergencies.
But the billions of euros worth of PIIGS government bonds were considered part of the banks' assets; it could be used as collateral to serve the banks' various activities. When the Eurozone debt crisis struck, faith in the value of the PIIGS bonds plummeted, which made it almost impossible to use as collateral.
"The discounting of sovereign debt meant that there was less money in the European banking system," writes John Carney, senior editor of CNBC. "If a one million euro bond previously held as a money-equivalent is now worth just 600,000 euros, the holder has lost 400,000 euros. Multiply that across the banking system, and you have millions of euros of money-equivalents simply vanishing."
Carney said the situation is similar to the impact of the decline in value in the United States of mortgage-backed securities back in 2008.
The Bernanke Remedy
However, during the 2008 financial crisis, the U.S. Federal Reserve stepped in to prop up the banks as well as the mortgage market by infusing them with cash. Although the Fed's European equivalent, the ECB, has continued to buy up PIIGS government bonds in a partially successful attempt to restrain rising bond yields, it has resisted taking action on the scale of the Fed.
"This is what happened in the United States in 1930-33," said Money Morning Global Investing Strategist Martin Hutchinson. "It also happened to a very limited extent in 2008-09. In a real crisis, the interbank lending market seizes up, which collapses even broad money supply. It is the one situation in which the [U.S. Fed Chairman Ben] Bernanke remedy – print the stuff like a madman – works."
But even then, Hutchinson said, the ECB should avoid PIIGS bonds in favor of bonds from more financially stable nations such as Germany, France, Finland and the Netherlands.
In fact, the European banks have begged the ECB to do more, particularly more aggressive buying of government bonds. As it is, the big banks are dependent on the ECB; just two weeks ago they took out out $333 billion worth of one-week loans – the largest amount since April 2009.
But more drastic action from the ECB appears unlikely, with opposition coming from within the central bank as well as from a German government fearful of triggering inflation. The best that is expected near-term is a December interest rate cut, which won't do nearly enough.
Money Morning's Gilani is pessimistic the ECB even has the power to fix the deeper issues, or whether stronger ECB intervention could do anything to prevent the Eurozone's looming "Lehman moment."
"The ECB doesn't have the authority to print enough money to ameliorate the situation," Gilani said. "Buying bonds is a Band-Aid. The real structural problems facing Europe are going to require wholesale lifestyle changes that won't get done in a year or two. ECB meddling will only serve to extend the problem while they pretend things will sort themselves out."
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Analysis: Echoes of Europe crisis in US deadlock
To me the real question is: Are the "powers that be", Governments and Central banks, going to do what's necessary before a very great crisis hits the whole world? There are many reasons to doubt that they will, and they certainly haven't yet.