Do you remember what kicked off this whole financial crisis that started in 2007/2008? It was those infamous collateralised debt obligations or CDOs – a financial instrument that packaged up good and bad mortgage loans into tradable securities.
Around the time of the Lehman’s crash in Sept 2008, some clever wag explained in very simple terms what a CDO was: it was like having a bucket full of high quality ice-cream, with a teaspoon of dog shit mixed in. He went on: the trouble is that once you know this fact, you will always be able to taste the dog shit. And more importantly, you can’t easily pick out the dog shit to ‘rescue ‘ the ice-cream.
The lesson was clear: the high quality loans within the CDO did not crowd out the bad quality loans; the reverse was actually true with the bad quality loans contaminating the rest of the asset. As Warren Buffet noted, these securities actually spread the risk of their weaker constituents through the rest of the asset – a view which gained traction and ultimately led to the sub-prime crisis which in turn led to ‘Lehman Day’.
At almost exactly the same as the Lehmans debacle (and for similar property-related reasons), we witnessed the very conservative Lloyds Bank taking over the indebted and somewhat gung-ho HBOS.
But the CDO principle applied here too: Lloyds had simply contaminated itself with HBOS’s poor financial position and thus we saw a Lloyds share price collapse and government taking a significant shareholding. The merged Lloyds Banking Group’s difficulties were thereby ‘socialised’ to avoid another Lehman-style ‘permitted collapse’ which had caused such a shockwave through financial markets.
It is instructive to note another common theme with both the CDO situation and with the merged Lloyds Banking Group: in both cases, government played a major role in their creation.
For CDO’s and sub-prime mortgages, the rot had started when the Clinton Administration in the 1990s wanted to expand home ownership to the poor and made it very clear to the financial community that solutions were needed.
Equally Lloyds was strongly encouraged to merge with HBOS by the UK government who clearly gave Lloyds assurances regarding competition policy. Lloyds’ mistake – or was it the UK government’s? – was that competition policy was now an EU competence.
And so we come to the euro where ‘The CDO principle’ applies in spades.
Here is a currency that is an entirely political project (to foster convergence between EU member states to create a European federal state) and which mixes wildly divergent economies from Germany through to Greece. Worse still, creative accounting was used in the construction of this continent-sized CDO with some of the best city brains (Goldman Sachs) complicit in fiddling the entrance criteria. I might also add that public debate in the run-up to the creation of the euro was so subdued as to be non-existent in many countries – the UK being a notable exception (which didn’t/hasn’t joined).
But the sheer size and ambition of the birth of this ‘Euro-CDO’ in 1999 was enough to impress – or rather blind – investors, other nations and other continents across the world.
Europe even created its very own (now over-leveraged) hedge fund called the European Central Bank that trades the Euro-CDO.
Of course some were never persuaded by all this even in the 1990s (or in the years beforehand): among them were a number of economists from Milton Friedman through Martin Feldstein and many others in the UK and Europe. And of course at a political level, there were the ‘eurosceptics’: a disparate group dominated in the UK by Conservatives who found an expression of their anxiety through Baroness Thatcher’s Bruges Speech in 1988.
Fast-forward to 2011 – the euro and eurozone politicians are now caught in a double bind with no palatable exits; the eurosceptics’ predictions are coming true.
Going back to our bucket of ice-cream analogy, euro-politicians could:
1. Continue trying to convince us that the bucket still contains very high quality ice-cream, perhaps by throwing money at better spoons (for mixing) and for chocolate sauce. The problem is that the ice-cream *is* contaminated and people know it, so this option is just delaying harder choices some way down the road.
2. Try and separate out the dog shit from the ice-cream. This is going to be difficult and very messy with no guarantee of success.
3. Let the northern nations who have a very good reputation for making high quality ice-cream walk away from the contaminated bucket and start a brand new bucket full of nice high quality (and uncontaminated) ice-cream.
Option 3 is the best of a bad bunch except that:
a) Every day for 50 years these northern nations have worshipped the existing bucket and everything that went into making it. They are emotionally wrapped up in it. They do so, because they fear that abandoning the bucket will cause one of their number to go and dig up a highly toxic bucket of dangerous ice-cream that was buried underground over 60 years ago.
b) the contaminated bucket will still exist and will steadly poison those ‘peripheral’ nations who eat from it.
c) the ice-cream from the new bucket will immediately become expensive relative to the contaminated ice-cream.
Ultimately the contaminated bucket needs to be totally abandoned and buried. But much more than that, the entire mindset and edifice of flawed thinking that brought the bucket into existence (the EU) needs to be abandoned.
For some countries like the UK who never wholly bought into the faith – and it is a *faith* – it will be relatively easy to walk away. But for true believers on the continent, facing up to generations of intellectual error will be a much bigger issue.
It remains to be seen whether they can do it.