How the 2007-8 banking crisis caused the 2011 crisis about to break

There is a direct causal connection between the 2007-8 subprime banking crisis and the European banking crisis that is about to implode financial markets this autumn.

Three years ago governments re-capitalized the banks around the world to stave off the banking crisis that followed the collapse of Lehman Brothers. The Fed alone pumped $16 trillion into the system. It worked but only in the sense of postponing the collapse.

Sovereign debt

Most of that money went into the safest of places that banks could find: government debt. That allowed governments to go on a borrowing spree to keep their economies moving but it produced a bubble in government debt with interest rates held too low.

That bubble began to implode well over a year ago with bond yields rising up and up in the most affected countries, most notably Greece, Ireland, Portgual and Spain. And Italy is the latest casualty to add to this list after the high rates demanded for an Italian bond sale this week.

Bond yields rise until the bond market itself collapses and can raise no more funds. Governments cannot afford yields equivalent to over 90 per cent of the face value of their debt as on Greek bonds now, and default as Greece surely will very soon.

The problem then is with the bond holders who become insolvent themselves through these losses, and the holders are mainly the very same banks that bought these bonds as a supposed safe haven in the global financial crisis three years ago.

Already in Greece the banking system has effectively failed. There is no credit available and everything has to be paid in cash. That is a nightmare for business and commerce and adds to the collapse in GDP already evident this year.

Eurobonds rejected

It seems that the European elite realize that the general public, particularly in Germany, will not accept eurobonds as a solution to recapitalizing the whole of the eurozone debt without seeing blood on the streets. The same was true three years ago when the US allowed Lehman to fail, and only then would Congress support a massive bailout.

That puts the world financial system on the edge of the abyss again this autumn. But it all goes back to the unintended consequences of kicking the proverbial can down the road three years ago and not facing up to the structural changes required.

Perhaps the system does have to cleanse itself in great periodic cycles and attempts to stop this course of nature can actually only ever end up producing a bigger crisis further down the road. That certainly seems to be the case with the benefit of hindsight today.

What on earth does this mean for investors? The ArabianMoney investment newsletter will be offering some more detailed advice to our subscribers this month on how to survive this crisis (subscribe here).