Wednesday, May 5, 2010

Financial Crises Compared: Eurozone 2010, Asia 1997

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Current market action has all the earmarks of a global financial crisis. Stocks and commodities are selling off, money is flowing into safe haven treasuries and the U.S. dollar, and the VIX and TED spread are up sharply. We've seen this before in 2008 and also during the Asian contagion in 1997.

As we all know by now, the problems started in Greece, a small economy that represents only 2% of the eurozone GDP. Greece had been lying about its budget deficit and true financial position for many years (and is certainly not the only country doing so). Even though it submitted obviously ridiculous financial numbers to the EU central HQ in Brussels, they were not officially questioned. Greece itself, like Bernie Madoff, finally confessed to the scam because it was falling apart. The EU, which has had more than six months to deal with the situation, consistently failed to take action. What was at first a minor problem has festered and grown into a problem gnawing away at the world financial system. The simple and obvious solution of using dollarization - letting Greece continue to use the euro, but removing it from the currency union (which it should never have been allowed to join in the first place) - was not even considered by EU authorities. Instead they have gone the bailout route and because they have dragged their feet, the cost of the bailout has tripled in the last few weeks alone.

A small country with a currency problem causing major problems in the global financial system has a recent precedent in Asia in 1997. The Thai baht, which was pegged to the U.S. dollar, came under speculative attack in May of that year and the government was forced to drop the dollar peg and float the currency on July 2nd. The problems in Thailand, a relatively small economy, then spread throughout East and South Asia. They eventually washed up on the shore of the U.S., with an October 27th mini-crash in the stock market  that dropped the Dow Jones Industrial Average 7% in one day. The selling may have been worse, but stock trading was halted early that day.

The euro has been seriously weakened in the last several months, falling from over 1.50 to the U.S dollar in December to under 1.28 this morning (key support is around 1.25).  Problems in Greece are spreading to other parts of Europe, just as problems in Thailand spread to other parts of Asia. Indonesia and South Korea were seriously affected first and then Hong Kong, Malaysia and the Philippines suffered damage. Problems even spread to China, India, Taiwan, Singapore and Viet Nam. Portugal, Spain and Ireland are the next dominoes to fall in the eurozone. Italy also has troubled finances, but its economy is too big to be bailed out. Bailing out Spain might also be problematic. There is a one key difference between Asia in 1997 and the eurozone today. The Asian economies were strong and had been so for many years before the crisis hit, while the eurozone economies have been relatively weak for many years and have been mired in recession for the past two.

Major stock indices in Europe and North America were down around 2% to 3% yesterday. In the U.S. the Dow dropped 2.1%, the S&P 500 2.4%, Nasdaq 3.1% and the small cap Russell 2000 3.4%. Smaller markets in Europe were down 4% to 7%. Gold was down only slightly on the day, but oil was down over 6% at one point. The VIX, the volatility index, was up 27% during the day's trading and the TED spread, a measure of stability in the financial system, rose almost 9% (the higher the number, the less stability). U.S. treasuries rallied and the U.S. trade-weighted dollar not only rallied, but also had a significant breakout above the 82 range. If this all sounds familiar, it is because this is how the market frequently traded during the fall of 2008 during the height of the Credit Crisis.

While events in 1997 had their biggest impact in East and South Asia, echoes of the problem wound up impacting U.S. and other stock markets into 1998. The collapse of hedge fund Long-Term Capital caused a severe bear market, with the Nasdaq dropping around 30% in August of that year. Regional financial crisis do not tend to get resolved quickly, and their impact can easily last for at least a couple of years and be felt half way around the world. Events in the spring can cause market sell offs in the fall. The current situation is much worse in 2010 though than it was in 1997. Bailouts and pumping liquidity into the global financial system (which lead to the tech bubble blow off in 1999 and early 2000) were used to deal with the problems in 1997.  Governments and central banks have already used these tools to a massive extent for the last two years. If we are having another crisis, clearly they aren't working.

Disclosure: Long VXX.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

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