Greece not Goldman is the biggest threat to financial markets

Watching US stocks tumble last night as the Senate committee grilled executives from Goldman Sachs about their role in the subprime debt crisis was a reminder that a stock market trading on a price-to-earnings ratio of 19 and yield of 1.9 per cent is very vulnerable after a 14 month rally.

Indeed, markets have only been in this position before in 1929 and 2000, hardly good precedents for a continued rise. However, the bigger threat to global financial markets is actually contagion from the Greek debt crisis which not only refuses to go away but is getting worse by the day.

Bonds freezing up

Bond markets in Greece seized up last Thursday. This is the European equivalent of the subprime debt crisis after the failure of Lehman with a major section of the financial system freezing up. Actually the causes are very similar.

Keeping borrowing costs too low for too long encouraged the Greek Government in reckless spending as it encouraged Americans to buy homes. Greece cannot now afford the debts it has run up and is looking for a deal with its creditors or will have to default.

However, there is no Fed to step in and bail out the European banks, although the European Central Bank may yet have to invoke its emergency powers. Political power in Europe is too decentralized to cope with a crisis like this, and even the Chancellor of Germany requires parliamentary approval to bail out Greece.

In practice that is just too slow for markets, and they have now raised the cost of credit across the euro zone countries. As the price of credit is rising so these stock markets are tumbling. Greek stocks fell six per cent yesterday, Spanish equities four per cent.

Contagion effect

The contagion is already reaching other European markets. For is the reality of the global financial rescue of the past year not already known? Low interest rates are an artificial construct that by definition cannot last indefinitely. The weakest link will break first and that is Greece. Next come Portugal, Spain, Italy and then you have to look to Ireland and the non-euro UK.

This is obviously going to cross the Atlantic. At present Wall Street is completely wrapped up in its own soap opera in the Senate. But its eye is on the wrong ball.

Bond market shifts have a history of coming from nowhere and being very important. What could be more damaging to a fragile recovery than a sudden wave of interest rate rises? And yet all market participants would have to concede that low interest rates cannot last forever and, by a direct causal connection, high stock prices.