….we get another crisis! I guess it shouldn’t be a huge surprise:
1) The manufacturing PMIs around the world have been weakening markedly and the latest round are close to the “50” recession reading. In fact below 52 is usually a warning. The new order components have been noticeably weak. Notably the Chinese PMI is only just above 50. Increasingly China is the bell weather for global economic activity rather than the US.
2) The Eurozone crisis is gathering pace. Now that Italy has been drawn into the vortex, the politicians can no longer pretend that it is contained. They either get real and expand the EFSF dramatically or face the disintegration of the Eurozone.
You can read a lot of the ins and outs of the crisis in today’s papers. However, I want to touch on some points that aren’t covered.
(If you would like to read this in MS Word, here’s a link to Google Docs)
Runs on Eurozone Banks
The Eurozone has a flaw that means that bank runs are much more likely than if countries have their own currencies. If a country has retained its currency, then it is more difficult for a depositor to shift his deposits as it requires a foreign exchange transaction. For many smaller depositors, this is a significant disincentive, particularly if their deposits are covered by deposit insurance.
In contrast, for a depositor in the Eurozone, it is easy to move deposits across borders as there is no foreign exchange transaction and the associated costs. Therefore, a rational depositor, faced with financial stress in a country that might default and leave the euro, will move his deposits to a bank domiciled in a safer country.
Hence, Eurozone banks in stressed countries are much more vulnerable to runs on deposits. Indeed, this is exactly the experience in Greece and Ireland.
The Italian bank sector, hitherto, has been seen as relatively safe. The personal savings rate is high in Italy and the banks have had little need to aggressively tap wholesale funding. Although exposure to CEE (mainly through Unicredit) is a concern, Italian banks had little involvement in structured credit.
The perception of the funding safety of Italian banks may be changing. There has already been some comment in the press that US money market mutual funds and UK banks are reducing their funding to eurozone banks, particularly Spain and Italy. The thing to watch for is whether Italians start to transfer deposits to foreign banks. My guess is that corporates are already doing so. The real crisis would be if the Italian general public start to do the same. Remember, Italians are used to shifting their wealth out of Italy, hence the number of banks in Lugano!
I think Italy is crucial to the survival or demise of the euro. Hitherto, Italy has been seen as safe but vulnerable. If the banking sector suffers a funding crisis, it will tip Italy into the abyss. Why? Well, Italy has public sector debt to GDP of around 120% and its government bond market is the third largest in the world (after the US and Japan), much larger than Germany or France.
If Italian banks lose liabilities, they will have to sell assets. The odds are that they will be forced to sell Italian government debt as it is liquid. This selling pressure would be likely to send yields rocketing through 7%, the point of no return. Also, the funding requirement of the Italian government is significant, despite its efforts to lengthen the duration of its debt.
A different kind of recession?
Please bear with me on this, because I want to link the funding difficulties of the banking sector with the causes of recessions. Although I’ve concentrated on Italy, funding crunches can and will be an issue for other countries as well, although the conditions for each are likely to be idiosyncratic.
Let’s look at a bit of financial history. In the era of the gold standard (i.e. mid 1800s to 1930), monetary policy and fiscal policy were circumscribed by the requirement of currency to be freely convertible to gold. Hence, interest rates were determined by relative growth rates and inflation and their impact on flows of gold between countries. Fiscal policy was also limited and tended to be pro-cyclical. Essentially, governments and central banks might be able to indulge in some fine tuning, but they were largely constrained by the requirements of the gold standard.
If we think about how recessions occurred in the world of the gold standard, they were largely a function of over expansion and retrenchment rather than active monetary policy by central banks. In a boom, the economy expanded above its trend growth rate, inflation rose, there was a trade deficit and gold flowed out of the country. This led to a rise in interest rates, a slow down in growth to below trend growth a reversal of the trade deficit and an inflow of gold.
That was how it was supposed to work. However, in reality, what happened was the depletion of gold reserves and the rise in interest rates caused a funding problem for banks, which squeezed credit causing bankruptcies causing a recession. If you look back at the era of the gold standard it is riddled with banking crises, runs on banks and their associated recessions, some of which were severe.
Unlike the post-gold standard era, central banks were limited in the support they could give to the banking sector by their gold reserves. The amount of currency and reserves central banks could create was limited by gold reserves, so the massive expansion of the balance sheets of central banks that we have witnessed in the recent financial crisis would have been impossible under the gold standard.
The point I want to make here is that, while the cause of recessions in the gold standard era had some genesis in interest rates cycles, they were more to do with funding panics in the commercial banking sector. If the gold standard had worked without panics, then there would have been a regular ebb and flow of economic activity and gold.
Instead, expansionary phases engendered overconfidence and unprofitable investments. When it became more difficult and costly to fund enterprises as gold became scarcer, business failures became more common, depositors became more concerned about the quality of assets that banks carried on their books. Depositors either demanded higher deposit rates or shifted their deposits from weaker banks.
In an era of no deposit insurance, outflows in deposits could easily develop into panics. Even if they didn’t develop into panics, they led to a credit squeeze. While deposits in the banking system might not decline in total, the shift away from aggressive banks to more conservative banks led to a fall in total credit as the overall leverage of the banking system would fall.
This fall in credit was the mechanism through which recessions were generated in the gold standard era. The point I want to emphasise is that a change in sentiment and risk appetite, particularly with regard to bank funding was a key reason for recessions in the gold standard era
In contrast in the post gold standard era, central banks were freed from the constraints of gold convertibility and were able to act as lender of last resort and fund commercial banks if a squeeze on funding occurred. This was a huge change and meant that central banks became the proximate cause of recessions through monetary policy.
The first recession in the US, after it abandoned the gold standard, followed a voluntary tightening in monetary policy by the Federal Reserve (through a doubling of the reserve requirement from August 1936 to May 1937), which produced a recession in 1937.
Certainly, in the US, we can trace every recession in the post WW2 era back to monetary policy. Periods of expansion have been accompanied with accelerating inflation and eventually a rise in interest rates to choke off inflation. Because the Federal Reserve has been able to act freely as lender of last resort, unencumbered by the gold standard, there have been very few liability squeezes on the banking sector in the manner that were seen under the gold standard.
However, in the 2007-8 credit crunch, we saw the re-emergence of a liability squeeze as a catalyst for recession. Until 2007, banks paid only modest attention to the liability side of their balance sheets. It was assumed that funding would always be there. While funding could always be provided by central banks to the commercial banking sector, the same was not necessarily true of SIVs (Structured Investment Vehicles), investment banks or other financial institutions (such as AIG).
In many ways, the crisis shared a lot in common with a typical gold standard era crisis and recession. Uncertainty over the valuation of assets (starting with sub prime CDOs) led to a flight of funding away from more risky entities, leading to a vicious spiral of asset liquidations and falling asset values. The second order effect was a general panic over counterparty risk compounded by the opacity of both assets and potential liabilities in the CDS market. How similar to the 1930s!
Here I want to share with you an economics paper that I read yesterday. Entitled “London Merchant Banks, the Central European panic and the Sterling Crisis of 1931”, it charts the linkage between the failures of the Austrian banking sector, the freezing of trade finance with Germany, the sudden crystallising of off balance sheet liabilities in the weakly capitalised Merchant Bank sector in London and a funding crunch in the British banking sector.
Because of the constraints of the gold standard, the Bank of England eventually had to choose between the stability of the financial system or raising interest rates dramatically to retain the gold standard. It chose the former and Britain came off gold.
The interesting point is the similarity between the acceptances on German trade credits issued by London merchant banks (a kind of credit insurance, which required no capital backing) and credit default swaps. Counterparty risk became a big fear and banks that were exposed to eastern European acceptances suffered a huge squeeze on deposits. While the BoE tried to organise relief both through its own balance sheet and through the commercial banking sector, it could not do so without abandoning gold.
This has uncanny parallels with the eurozone, where eurozone central banks can only provide limited assistance to domestic banks and cannot effectively provide lender of last resort assistance. Although the ECB is providing lender of last resort facilities, it is circumscribed by its modest equity base, political considerations and the lack of a fiscal backstop.
In 1931, the thing that saved Britain from suffering a recession in the wake of the crisis was the depreciation of sterling. In the eurozone, this is not an escape route. Hence, liability squeezes in the banking sector are much more likely to lead to a recession.
Conclusions
I want to make two points:
1) Generally, I think that the ability of central banks to manipulate monetary policy and the ability of governments to use fiscal policy is now extremely limited. This is a huge change from the economic environment we’ve been used to. Policymakers are now largely impotent in the face of economic volatility. They can’t “smooth” the economic cycle. Hence, when we look for the causes of recessions we need to move away from focussing on monetary policy and pay more attention to credit conditions. In particular, I believe bank sector funding conditions are critical. We need to monitor not just overall funding but moves in funding, especially between “aggressive” and “conservative” institutions. We also need to be very aware of sentiment, particularly with regard to counterparty risk. We are moving into an era where central banks will be more limited in their ability to support the banking and financial sector. Sentiment and “animal spirits” will be much more influential and recessions are more likely to be generated by these mood swings. Hence, there is a not insignificant chance that the current panic could develop into a recession.
2) Specifically, the eurozone needs to be looked at through the lens of the banking panics that were seen in the gold standard era. The outflow of deposits from individual countries has been made much easier (as it was in the days of gold). Like the gold standard, there is no escape valve from currency depreciation. Countries will have to go through a period of crushing depression. I just don’t see how that will work in an era of universal democracy. The key indicator, just as it was in the gold standard era, will be bank funding. Squeezes on bank funding will lead to recessions (depressions?).
Can the euro survive? I think it will be too painful for the periphery and I think that Germany will lose its nerve and refuse to fund the euro project. When this happens, there will be another financial crisis and global recession. This time, I don’t think China will be able to avoid it, but that’s another story.
Further reading:
Here are a couple of pieces of research that I wrote in 2009 that give some additional perspectives. I can’t say I got everything right, but I think they have stood the test of time.
Depression lite February 2009
All aboard the roller coaster October 2009
Please respect my work and ask for permission to reproduce.
lemmings can teach nothing 