It’s official: The worst of the financial crisis is over. That’s what the World Bank says in its 2009 annual report, released Wednesday.
But that doesn’t mean it’s completely behind us.
The after-shocks of the subprime meltdown and the collapse of Lehman Brothers in September 2008 continue to ripple through the financial system and the global economy.
Two weeks ago, I predicted that there would be a “financial mini-crisis or two that ignites investors’ fears” in 2010. It would be “worse than Dubai, but nowhere near as bad as the fall of Lehman,” I wrote.
So, where could it take place? I called Carmen M. Reinhart of the University of Maryland to find some likely candidates.
Professor Reinhart, of course, is one of the world’s leading experts on financial crises. Along with Kenneth S. Rogoff of Harvard, she wrote This Time Is Different: Eight Centuries of Financial Folly—as definitive an account of financial crises as you’ll find.
Her view: The next flare-up is most likely to take place far away—or very close to home.
In their book, Reinhart and Rogoff show that a rapid build-up of borrowing is a necessary precondition for financial crisis—and the biggest problem in cleaning them up. Debt, debt, and more debt piled up in the good times become an albatross on borrowers and lenders alike when the wheel turns down.
“The fuel of bubbles is liquidity and credit risk,” Reinhart told me.
And this bubble was way off the charts. Households and companies amassed an astonishing amount of debt in the years before the crisis, and the depth of the crash compares with only the most severe financial crises, including the Great Depression.
Following the explosion of private debt in the 2000s, mostly connected with housing in several countries—the US, UK, Spain, Ireland, and others—governments poured monumental amounts of taxpayer funds into preventing another 1929. Governments accomplished that, but at a big price—horrendous sovereign debt hanging over most of the developed world. That could cause wrenching financial pain and subpar economic growth for years to come.
Which is why Reinhart sees some of the marginal debtor nations as among the most vulnerable.
Take Iceland. The tiny Nordic nation best known for its long nights and salted fish was turned by some financial cowboys into a giant leveraged hedge fund, and its currency became a favorite of speculators.
When the roof fell in, the value of the krona disintegrated and output plunged. According to Reinhart, Iceland’s total external debt is now a mind-numbing 924% of GDP—and half of that is short term.
Now, British and Dutch authorities are trying to collect over $5 billion from Iceland’s treasury to repay depositors from those countries who took a flyer on high-yielding Icelandic accounts. That amounts to 50% of Iceland’s GDP.
Iceland’s president put the issue up for a popular vote, which takes place March 6th. “It’s a referendum on whether they’re going to default,” says Reinhart.
If, God forbid, there were a similar crunch here, how many Americans would vote to repay, say, China trillions of dollars for US deposits that had plummeted in value? So, don’t be surprised if Iceland’s voters turn thumbs down, possibly putting a $10-billion multinational rescue plan in jeopardy.
Page 2: More crisis candidates
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