Why the Euro debt crisis will keep driving interest rates up and restrain bank lending

The panic evident in global financial markets in recent days is a frightening reminder of those tumultuous days after the collapse of Lehman Brothers in September 2008.

There are many similarities and the fallout for New Zealand is likely to be similar, which is luckily not too serious, assuming of course the financial collateral damage is contained largely to Europe. That is a reasonably large sized 'if'. Again, this is all about debt and how it is repaid and serviced. Most of the developed world, including Australia and New Zealand, went on a debt-fueled consumption binge from 2002 to 2008.

Extraordinarily low interest rates and 'innovative' investment banks combined to create a heady cocktail of securitisation, derivatives-fueled trading and asset bubbles.

The first wave of the crisis was a private banking crisis as the losses on all this toxic debt wiped out shareholders in the 'Too Big To Fail' banks such as Merrill Lynch, Citigroup and Royal Bank of Scotland. British and American governments were forced or decided to effectively bail out these banks with public money.

It merely shifted the toxic waste from private balance sheets to public ones. Meanwhile governments all around the world started borrowing heavily to support their economies.

Now all the delaying tactics have come home to roost in a series of sovereign debt crises. Part of the issue is that many European banks have not taken their own balance sheet hits for all the toxic debt they held. Now they have the motherlode of toxic sovereign debt sitting on their balance sheets.

They have stopped trusting each other again, as they did in the immediate wake of Lehman Bros. Interbank lending rates are rising quickly. European governments face the ultimate ugliness of having to borrow money to run their governments and have to bail out their banks.

Investors, rightly, are deeply sceptical about the ability of governments to cope. Voters are also sceptical and often downright angry. There is a very real risk that Germany either pulls out of the euro in its own right or ejects the laggards such as Greece, Spain and Portugal. The problem for the Germans and French is that a euro breakup and in the inevitable debt defaults would slam their banks. Luckily for New Zealand and Australia our banks did not play in the same mad casinos and don't hold much of the toxic debt.

Our economies are also much healthier, with both lower unemployment and much lower budget deficits. We are also now joined at the hip to the strongest growing large economy in the world: China. But there will be fallout for New Zealanders.

The eurozone is our third largest buyer of exports. European banks have lent large sums to our banks over the years and getting new loans may not be so easy or cheap. Although, another benefit of our relative economic wellness is that we are seen as somewhat of a safe haven. The end result for New Zealand is that interest rates will keep rising as demand for scarce capital globally keeps pressure on rates.

The de-leveraging happening very painfully in Europe and the United States will hit us too. It may take longer and be less convulsive, but it will press down on growth rates and asset prices for years to come. House prices, at the very least, will stop rising. Lending growth and retail spending will be weak.

The long grind will go on.