The EU Bubble

Today's kerfluffle in the stock markets over the debt default of an entity affiliated with Portugal's largest bank reminds us that if there is a financial bubble anywhere, it's in EU sovereign and bank debt.  EU sovereign debt and the debt of EU banks have become almost synonymous.  That's because they are linked by a problematic circularity.  EU banks have invested heavily in EU sovereign debt.  EU nations, in turn, have pretty much become the guarantors of the debts of their banks.  Thus, the banks borrow to invest in sovereign debt, and the sovereigns in turn guarantee the banks' debt that funds the sovereigns.  It's rather clever, as long as nothing goes wrong.

However, one could note that EU banks and sovereign nations appear to be burdened with each others' liabilities, and that the guarantees of EU nations accordingly have limited efficacy.  Given that the EU and its banks, in toto, can be reasonably described as overleveraged, this circularity can become a circular firing squad if there is a run on a major EU bank or an EU sovereign member nation.  This is particularly so since no EU nation can issue its own currency and pay its or its banks' debts with printed money.

Of course, the European Central Bank has in recent years made a show of pointing to shining armor it could don and white horses it could mount to ride to the rescue if there is another European financial crisis.  And it has adopted accommodative, money printing-like maneuvers when the going got tough (like letting EU banks use sovereign debt as collateral for borrowings at the ECB without any discounting of their face value).  If the dustup across the pond is limited to Portugal, the ECB should be able to find one way or another to keep the cookie from crumbling.  But if other EU nations, particularly larger ones like France, begin to waver, the EU financial bubble could burst in a nasty way.  The economic consequences could be bad.  Given the growing extremism in Europe, the political consequences could be worse.

There are some asset classes in the U.S. that may be getting bubbly.  Many Internet stocks are suspect. Housing except for the $1 million and up price range seems to be struggling.  In addition, small cap stocks haven't been doing well recently and may turn out to be a bubble bursting.  But it's unlikely that the frothiness of these asset classes could re-trigger the Great Recession.   On the other hand, if the EU sovereign nations can't keep their banking systems on an even keel, then all bets are off.