A European Crisis, Not A China Slow Down, Will Trigger A Global Collapse

Greek bling

Here's a curve ball for 2010 -- while everyone was fretting about China's freight train economy derailing, Europe could be the trigger for a reversal of the current global economic rebound.

Baseline Scenario points out how the IMF might not be able to help the Eurozone's weaker economies in the event of a crisis due to the stigma involved and the fact that they are part of a larger currency union. Yet at the same time, strong Eurozone countries might lack the proper mechanisms for saving weaker nations such as Greece as well.

Baseline Scenario: And the stronger EU countries are not willing to help – in part because they want to be tough, but also because they do not have effective mechanisms for providing assistance-with-strings. Unconditional bailouts are simple – just send a check. Structuring a rescue package that will garner support among the German electorate – whose current and future taxes will be on the line – is considerably more complicated.

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As this pressure mounts, we’ll see cracks appear also in the private sector. Significant banks and large hedge funds have been selling insurance against default by European sovereigns. As countries lose creditworthiness – and, under sufficient pressure, very few government credit ratings will hold up – these financial institutions will need to come up with cash to post increasing amounts of collateral against their derivative obligations (yes, the same credit default swaps that triggered the collapse last time).

Remember that none of the opaqueness of the credit default swap market has been addressed since the crisis of September 2008. And generalized counter-party risk – the fear that your insurer will fail and this will bring down all connected banks – raises its ugly head again.