Markets in crisis - Collapse 2.0 or par for the course?

Bond and stock markets across the world are in crisis, following a major loss of confidence in a number of European economies.

In the past 24 hours global share indices have suffered huge losses, with the American Nasdaq enduring its biggest one-day fall since the start of the recession.

Meanwhile Lloyds lost 10 per cent of its share value in a single day, and RBS announced massive losses as it made provisions to write off its Greek debt.

There is now widespread concern that the events of the last couple of days could signal the beginning of a second global financial collapse. But is this hyperbolic? And what is actually happening?

What has happened?

The immediate roots of the problem lie in the perceived weakness of a number of European economies. After it became clear that Greece would no longer be able to honour its debts, investors began seriously considering whether or not other European countries, like Italy, Spain, Portugal and Ireland, would be able to pay back what they owe.

It now seems all but certain that Italy will be forced to default on some of its loans. Despite protestations from Silvio Berlusconi that the economy is sound, yields on Italian bonds have risen sharply in recent days. In practice, this means that the Italian government is having to pay investors much more in order to persuade them to buy its debt. The story is similar for Spain.

Meanwhile, there is growing concern over banks’ exposure to bad debt. Today RBS announced it expects to lose £733 million on its Greek bonds alone. The combination of a collapse of confidence in sovereign debt and jitters about banks’ exposure has meant that investors are fleeing to relative safe havens – like gold.

What happens next?

There are two main facets to this. The first concerns the viability of the euro. Many commentators now suggest that the only way the euro will survive would be for Germany to make a massive contribution to the European Financial Stability Fund (EFSF) – essentially an emergency mechanism designed to smooth over major financial problems in the eurozone. There are two problems with this: first, Germany may be unwilling to do so, and second, a bailout of this sort would likely do little to solve the long-term problem of financial stability. It would merely kick the can further down the road. In the medium-term, the stability of the euro probably depends on deeper political integration – and this will be a hard sell to voters.

But perhaps the most immediate concern is that of liquidity in the banking sector. There is a very real possibility that confidence in the banks will continue to fall, and that one or more major institutions could suddenly find itself insolvent. This would require another round of government bailouts.

Are we on the brink of another collapse?

This depends who you listen to. Bearish commentators have long said that the 2008 recession was, in fact, only the beginning, and that the global financial system was heading for a second fall.

There now seems little doubt that the eurozone will require major restructuring. It is no longer beyond the realms of possibility that the single currency will cease to exist in its current form.

But aside from that, European governments need to take decisive action if they want to calm the markets. According to the BBC’s Robert Peston, bankers are looking for an injection of around €4 trillion from the EFSF – a huge sum.

Regardless of immediate consequences, though, the past 24 hours seem to have hammered home a sense that the current situation is unsustainable. A number of European countries will now be forced to consider ways to cut their deficit efficiently – and many banks will be thinking very hard about what they have on their balance sheets.