The sudden and dramatic escalation of bank problems in Europe has overwhelmed any positive reaction to the passing of the $US700 billion bailout and led directly to last night’s return of the Dow Jones to below 10,000. There are two reasons for that:

  • Most of the stocks in the Dow are multinationals and the developments of the past few days have shown that the credit crisis and consequent recession is a Euro-American problem – always was. Indeed the economy closest to the brink appears to be Iceland.
  • A little further south, Ireland’s total bank deposit guarantee has thrown the official responses to the this crisis into chaos, and has sharply raised the stakes for the US Government – well beyond anything that can be achieved by $US700 billion mortgage securities fund that it is now busily being set up.

Bank deposits in the US are insured only up to $US250,000 (raised from $100,000 just a few days ago). Up until recently much the same applied in Europe – until Ireland unexpectedly issued a Government guarantee for all bank deposits, with no limit.

Ironically, last Tuesday’s decision by the Irish Government was triggered by the failure of the US House of Representatives on Monday to pass the Paulson bailout, which was subsequently overturned on Friday. And the reason that vote on Friday has had no impact is largely to do with the Irish response to first vote.

It was a disaster for the rest of Europe and, as will soon become clear, the United States.

Explicit Government open-ended bank deposit guarantees in some countries means that those countries without them face devastating bank runs as depositors inevitably move their money to the safest location.

A few days after Ireland, Germany followed suit with an uncapped guarantee, and Denmark quickly did the same, followed by Iceland, Sweden and Austria. France and the UK are under mounting pressure to follow but so far have not – the British Chancellor has raised the limit from £35,000 to £50,000 while the French President Nicolas Sarkozy, who is also EU President at the moment is trying to act as a coordinator.

But he has failed. The weekend meeting of EU leaders turned into a bitch session about Ireland and they ended up agreeing about nothing, which was the key reason for the escalation of panic among equity investors around the world last night, culminating in a 7 per cent drop on Wall Street.

There is now a rolling bank deposit guarantee contest, with Governments competing for deposits whether they mean to or not, and there must be doubt about whether the two nations with the most at stake – Britain and the United States – can ever afford to join in.

As a result the quiet bank run being suffered by these two countries for most of this year – of large deposits beyond the scope of existing insurance schemes – is likely to accelerate.

US deposits up to $US250,000 are insured – the UK figure roughly matched this until the US guarantee was raised by $150,000 a few days ago.

Professor Nouriel Roubini has been warning for some time about what he calls a “silent run” on the mass of uninsured deposits in the banking system.

The problem now is that those big depositors suddenly have somewhere else to put their money that is Government-backed (even if it is the Irish Government).

And with the US dollar at unsustainably high levels due to an artificial global shortage of dollars, American deposits in Germany, Ireland, Sweden, Austria and Denmark might not even need to be hedged – it would probably be a good investment decision to move funds out of US dollars right now.

This run on large retail and corporate deposits comes on top of a well established run on the shadow banking system – that is, the investment banks, conduits and special investment vehicles. They are all either bust, have been absorbed by someone else or become real banks.

As a result of all this, corporations can no longer raise any meaningful credit; the commercial paper market has shut down, and lines of credit are unavailable.

Meanwhile the central bank money printing machines are now looking impotent.

Last night the Federal Reserve increased the size of its Term Auction Facility from $US150 billion a month to $US900 billion, but there is no sign that this has broken the logjam (the TAF, by the way, now exceeds the entire Fed balance sheet).

Money markets are frozen, banks are hoarding cash and the Fed is throwing money into a black hole. In some ways it is actually counterproductive because banks are simply avoiding each other and dealing with the Fed instead; if the Fed wasn’t an open-armed counter-party of last resort, the banks might have to start trusting each other again.

In 1933, the Federal Reserve was likewise trying to reflate the economy but it didn’t work until, in 1934, the Federal Deposit Insurance Corporation was created and began to provide deposit guarantees and restored public confidence in the banks.

With Ireland having started a deposit guarantee contest, the US Government will now come under immense pressure to join in – by effectively making the Paulson bailout plan open-ended.

The question is: can it afford it? The sums at risk dwarf even the American GDP, let alone the US taxpayers’ ability to credibly guarantee to come up with the money.