The End of Arrogance

America Loses Its Dominant Economic Role

By SPIEGEL Staff

Part 4: Irrational Exuberance

US economist Robert Shiller, who predicted the bursting of the dot-com bubble at the turn of the century, was one of the first to notice that the value of houses and condominiums in the United States was rising at a suspiciously fast rate. In Shiller's view, this was another case of irrational exuberance. In December 2004, Stephen Roach, the former chief economist at investment bank Morgan Stanley, cautioned against the "grimmest of all financial bubbles."

New York economist Nouriel Roubini presented the most accurate scenario of a crash, from the bursting of the real estate bubble to the domino-like demise of major banks. Roubini, known as a notorious alarmist, now predicts a prolonged recession in the United States that will drag down the entire global economy with it. "The US consumer has consumed himself to death," says Roubini.

Paul Samuelson, the doyen of the world's economists, predicted this bitter outcome three years ago. "America's position is under pressure because we have become a society that hardly saves," Samuelson, 90 at the time, said in an interview with SPIEGEL. "We don't think of others or of tomorrow."

And now the global conflagration is a reality, triggered by cleverly packaged US subprime mortgages sold around the world, even to bankers in the provincial eastern German state of Saxony. So-called credit derivatives, which banks and investment funds used to hedge against the failure of commercial loans, could soon add new fuel to the fire. In the wake of the subprime crisis, could credit derivatives be the next bad thing? Is the world facing a wave of bankruptcies that could soon bring the financial world crashing down through the mechanism of credit derivatives?

US market guru Warren Buffett calls derivatives " weapons of mass destruction." They are the creations of inventive financial alchemists, concoctions that blend classic forms of investment, like stocks, bonds and commodities.

In fact, within this discipline, derivatives used to hedge against credit risk are among the most dangerous gambles and, as one would expect within the global financial casino, they have experienced dizzying growth. In the last five years, the volume of credit derivatives has grown thirtyfold to about $55 trillion (€38 trillion), or about 20 times the gross national product of Germany.

The world is encased in a tightly woven network of reciprocal payment obligations. "The core problem is that it is no longer possible to know where the risks have ultimately landed," warns Thomas Heidorn, a professor at Frankfurt's Institute for Law and Finance. This is because traders pass on credit risks an infinite number of times, which explains the dizzying market volume. Where the risks end up is anyone's guess.

Nevertheless, only a handful of firms set the tone in this high-stakes game of bingo in which trillions are on the line. According to a survey by Fitch Ratings, an international credit rating agency, about four-fifths of all credit derivatives bought and sold worldwide in 2004 was on the books of only 15 banks and major dealers. Lehman Brothers was one of the Top 10 players in the business, and its bankruptcy has torn giant holes in the fragile network of credit insurance. "Not saving Lehman was a huge mistake," says a banking executive in Frankfurt, who notes that the shock waves will be extremely difficult to control.

Germany, where banks have had to write off about €40 billion ($58 billion), has managed to come away relatively unscathed until now. Experts believe that that number will be increased by significantly more than €10 billion ($14.5 billion).

German banks are now concerned that they will be at a competitive disadvantage if their US competitors are permitted to unload their bad debt with the government in the future, thereby improving their credit ratings. The Germans are demanding equal treatment. Last Thursday, leading representatives of the industry informed Finance Minister Steinbrück of their wishes -- and were rebuffed.

The financial storm has even been felt in the most unexpected of places, such as the offices of German town halls. At the turn of the millennium, hard-up German cities like Bochum, Recklinghausen and Wuppertal, used complex agreements, to sell large shares of the municipal family silver to US investors -- and then turned around to re-lease it. In many cases these so-called Cross-Border Leases (CBL) -- in which entire sewage systems or municipal transport operations were sold off -- were insured by the US insurance giant AIG, which was recently nationalized to avoid bankruptcy.

Naturally, the small print of the CBL agreements contains an explosive clause. It stipulates that if the guarantor loses its top-rated AAA credit rating, additional collateral must be provided. Despite government intervention, AIG was downgraded. Under their CBL agreements, the affected city councils have only a few weeks to come up with a solution.

By contrast, their counterparts in the cities of Münster, Troisdorf, Munich and Frankfurt can only wait and hope. They invested portions of their tax revenues with the Frankfurt subsidiary of now-bankrupt Lehman Brothers. By offering generous terms and citing a deposit insurance fund, the Americans managed to drum up urgently needed liquidity in Germany shortly before their bankruptcy.

The funds that German cities coughed up to help the Wall Street gamblers survive are not likely to be repaid anytime soon. BaFin, Germany's Federal Financial Supervisory Authority, has imposed a moratorium on the German subsidiary, freezing all transactions until further notice.

On August 15, when the US investment bank was already on shaky ground, Helga Bickeböller, a member of Münster's city council, transferred €15 million ($22 million) to Frankfurt in two tranches. "The offer was 0.004 percent higher than the next-best offer," Bickeböller says in justifying the transaction.

The credit crunch is tearing holes in the balance sheets of municipalities, companies and private households across the world. Banks hardly lend each other money anymore, consumer confidence is evaporating, and investors are questioning whether new sales will help them recoup money already spent on new equipment. In Germany, Arcandor -- a major holding company in the mail order, retail and tourism industries that reported €21 billion in 2007 sales -- threatens to become the first victim of tighter credit terms.

As the bad news accumulates -- in recent days, especially in the United States -- the mood around the world is growing increasingly dire. In August, sales of new homes in the United States dropped to their lowest level in 17 years. In comparison to last year, which was already a bad year, new home sales have dropped by more than 34 percent. At the same time, more and more US citizens have applied for unemployment benefits. And the manufacturing industry is reporting significant declines in order volume.

"The United States cannot avoid an 18-month-long, severe recession and a deep-seated financial crisis," warns Roubini, the New York economist. He would consider it a success if the country manages not to plunge into years of stagnation, as Japan did in the 1990s.

The consequences of the economic downturn in the United States are being felt around the world, especially in Germany, which is currently the world's leading exporter. Hans-Werner Sinn, president of the Munich-based Ifo Institute for Economic Research, calls it an "extremely worrisome situation." According to an analysis by the German Economics Ministry, the economy is exposed to "external shocks" and a "noticeably worsened external economic environment." The report even mentions the dreaded word "recession," although it adds that that recession is "not a foregone conclusion."

This is all the more vexing for the German government because it was the one that warned against the current malaise some time ago. During the G-8 economic summit in Heiligendamm more than a year ago, for example, Chancellor Angela Merkel tried to convince her state guests of the need for tighter controls on the financial markets. But President Bush and then British Prime Minister Tony Blair gave the chancellor the cold shoulder.