Thursday, 18 August 2011

Credit Crunch 2? No, Credit Crunch 2!

A couple of weeks ago I wrote a blog asking the question Credit Crunch 2?. I have been holding back from answering that question in the affirmative. I think I'm now ready to do so. As yet, we are not at the position we were when the Credit Crunch really crunched in 2008.
That is the rates that Banks charge each other in the short term, overnight borrowing, the so called LIBOR (London Interbank Overnight Rate), and EURIBOR (European Interbank Overnight Rate) market have not yet soared to the levels they did then, when fear that lenders might go bust, and each bank sought to hoard whatever cash it could, essentially brought such lending to an end – which is what a Credit Crunch is. But, there are reasons for that.

Firstly, that seizing up of lending did not occur overnight, back in 2008. The process had begun, in fact, in 2007. That was what caused Northern Rock to go bust.
In response to that, the Bank of England, and other Central Banks, began to pump additional liquidity into the market. They thought they had done enough, but the complexity of modern, global financial markets, and the severity of the crisis, that was caused when the sub-prime crisis struck, was such that it found the state authorities wanting. When the US Authorities allowed Lehman Brothers to go bust, that was enough to send those financial markets into cardiac arrest, as the size of its counter-party risk – the amount of loans it had made, and taken out – meant that a huge black hole was created, in which there was a complete lack of knowledge as to how much money might be simply wiped off the Balance Sheets of other Banks, and Financial Institutions, with a consequent domino effect to all those institutions that these Banks and Finance Houses had in turn with others.

But, in the aftermath of Lehman's and the Crunch, new measures were put in place to ensure that Banks in trouble could go to the Central Bank and obtain funding to prevent a similar collapse. In addition, Banks in the US and Europe were first recapitalised, by the State bailing them out – effectively nationalising them – and then required to bolster their Balance Sheets by raising additional Capital, and ploughing back profits into assets, to raise their proportion in relation to their Liabilities.
More recently, a new set of regulations, known as Basle III, have made it necessary for Banks to have even stronger Balance Sheets, in order to weather a new crisis. Finally, the Banks were then stress tested, to see which Banks had the necessary resources to weather another serious crisis. In addition, in the last few months, many Banks have restructured their Balance Sheets, so that they have exchanged shorter duration loans, with longer duration borrowing, so that their cash position has been bolstered.

All of these measures mean that Banks are not in the same position that they were in 2008. But, that is not the end of the story. Back in 2008, in my blog Where We're Going, I wrote that the potential was that by States stepping in to essentially take over their Banks, the same problem could re-appear, but now raised to the level of the relations between States.
That is essentially what we have seen in relation to the Eurozone Debt Crisis. That was most clearly seen in relation to Ireland, where the State's finances were not initially that bad prior to stepping in to bail-out the Irish Banks. The consequence was that the Irish State was then put in a position where its debts were so large compared to its potential to repay them, because its growth rate was not sufficient given the size of its economy to create the extra income to do so, that its creditors began to wonder whether they would get repaid. Given the fact, that Ireland has acted like a huge Bank Clearing house, or money laundering operation for European Banks, which have passed vast amounts through it, the potential for a major catastrophe if Ireland or its banks defaulted, became obvious. That was then repeated across all those other European peripheral economies such as Portugal and Greece, and then to the not so peripheral economies of Spain and Italy, as questions about the health of their Banks, and the ability of their economies to grow sufficiently to repay their debts began to be asked.
The reality as I argued in my blog What The Markets Are Telling Us is that what has sent the global markets into a tailspin over recent weeks is not a concern over debt – which is the narrative the Liberal-Tories wish to pursue, and which much of the media parrots – but a concern over growth. No one seriously doubted that the US would default on its debt, given that it could print money to cover it, which is why even after S&P downgraded its Credit Rating to AA+, demand for its Bonds kept rising. In fact, today demand for the US 10 Year Treasury rose so much that the yield on it fell below 2%, a figure that is the lowest it has been since the Eisenhower years, with many traders seeing it going down to test the 1.6% level of the 1940's! And, although the debt of the EU peripheral economies is a crisis for them, it is not significant in EU terms. Taken as a whole the EU debt to GDP ratio is much lower than in the US. No, the real concern is that the austerity measures being adopted forced on the peripheral economies, has sent their economies into a death spiral. That has two major consequences.

Firstly, it means that they are even more likely to default on their debts, which in turn means other EU countries – Germany and France – having to bail them out even further. Secondly, it means that these markets demand for goods from elsewhere in the EU – i.e. Germany – also falls dramatically.
Germany benefits hugely from the Eurozone. If Germany were not in the EU, then its currency would be much higher than the Euro. That would make German exports far less competitive. Since WWII, the German economy – at least initially West German economy – has been built upon exports. Until a few months ago when it was overtaken by China, Germany remained the world's leading exporter. But, more than that. If Germany benefits from a lower valued Euro on global markets, it benefits even more in terms of its exports WITHIN the Eurozone itself. If all Eurozone economies had their own currencies, then the currencies of Spain, Ireland, Portugal, Italy, Greece etc. would be much lower. German exports to these economies would be even more expensive. Given that the whole purpose of building a single European market and economy, was to develop the economic ties of investment and trade that already existed, and given that the vast majority of trade of all EU countries now occurs within the EU, the consequences of that for the German economy are immense. That is why ultimately, Germany will not let the Euro fail, and why it will do what is necessary to maintain the Eurozone.

However, just as the threat of a US default on its debt a couple of weeks ago was a wholly avoidable one, which only arose due to the wrangling and seeking of advantage by US politicians – most insanely by the Tea Party Taliban – so the crisis in Europe drags on for similar reasons.
On Tuesday, Merkel and Sarkozy, disappointed markets by saying that the issue of EU Bonds was not on the table. But, every serious economist knows that the answer to the the Euro debt crisis lies with such a solution. There are essentially just thee ways that the debt of the periphery can be dealt with – I'm not counting the solution whereby these economies pay off their debts themselves, because that is in reality not possible.

One solution, and the one that is being pursued at the moment, is that the ECB can keep buying up that debt in the secondary markets. That can only be a short term solution lasting perhaps months at most. For now, the ECB is saying that it will sterilise any such purchases by taking money out of the system elsewhere. That in itself could cause problems, because if its purchase of peripheral debt is sizeable, then it means seriously tightening monetary policy elsewhere in the Eurozone. That at a time when it is already tightening monetary policy by raising its Discount Rate, and at a time when the EU economy is already slowing down, could tip those EU economies that were growing back into recession, or at least very slow growth. But, if the ECB does not do that, if it simply buys this debt by printing more money, then this will mean that it will have joined the the Federal Reserve, and Bank of England in, Quantative Easing. It will mean that it will have abandoned its inflation, and monetary targets. Global Capital Markets will respond to that, by pushing down the value of all EU debt – raising interest rates in general – and pushing down the value of the Euro.
Moreover, because the ECB is not like any other Central Bank, in that it does not have a State standing behind it, it is not clear on what basis this money printing could be justified. If markets felt that the ECB's Balance Sheet had become overextended – i.e. it had lent money in return for Bonds which themselves had no value, because the Governments that issued them defaulted on them – then markets would begin to challenge the position of the ECB itself. The Euro could go into a death spiral. Already, in the short term a conflict is arising, because in search of a safe haven, money has been flooding into the Swiss Franc, which has soared in value. Given the economic ties between Switzerland and the EU, this is causing huge problems for Switzerland. Its exports have become increasingly uncompetitive due to the exchange rate, whilst various rules prevent Switzerland's producers from benefiting from lower input costs. Its possible that this weekend Switzerland will peg the Franc to the Euro, meaning that it will then have to print masses of money in order to lower its value.

Some months ago the Brazilian Finance Minister said that countries were engaged in a currency war, each trying to reduce the value of their currency in order to obtain competitive advantage. That process seems to be intensifying. That is one reason that Gold is increasing in price.

The second solution, is for the periphery to be bailed out by the EU version of the IMF – the EFSF, and EFSM mechanisms. That has already been done to help bail-out Greece, Ireland, and Portugal. But, the funds of the EFSF and EFSM come from other Eurozone economies. Spain and Italy for example, have had to contribute to the bail-outs. But, that means that there own fiscal position is worsened, and now these economies too have come under attack by the global Capital Markets. The more countries need bailing out the smaller the base of economies that are asked to bail them out, and the greater the contribution they have to make. Because these contributions come out of the Budgets of the respective states, in essence what is happening is that the taxpayers of these economies are having to bail-out the other Eurozone economies. Not surprisingly, those taxpayers are not happy about doing that, especially as in Germany the other side to that equation – the fact that they have benefited from being able to export to those economies etc – has not been shouted from the rooftops.
Given that all of these economies are bourgeois democracies, and politicians have to get elected, its not surprising that Angela Merkel does not want to be seen as too eager to bail-out the periphery with German taxpayers money. In Finland, the rise of the ultra-Nationalist Tru Finns, has made such a solution even more difficult. Today Finland, followed by Austria, has demanded that Greece put up collateral in the form of land and other assets as a condition for it agreeing even to the bail-out negotiated a few weeks ago!

The bigger problem is that the EFSF and EFSM have only €440 billion of resources to cover the potential debts. But, the total debts of the peripherals, and of Spain and Italy, comes to €7.5 Trillion. And, as I pointed out in my blog The Debt Crisis, to deal with the debt properly by wiping off sufficient debt, and restructuring EU Capital to be globally competitive, could cost up to €15 trillion over ten years. Its simply not credible that such sums could or would be provided as transfer payments from Germany and other Northern European economies. In reality, such kinds of sums could only be raised by borrowing on Global Capital Markets via an EU Bond.

However, Merkel and Sarkozy say such a solution is not on the table. But, behind that statement lies another truth. What they are really saying is, such a solution is not on the table so long as there is not Fiscal and Political Union, so long as there is no central state authority, no means of centrally controlling the Budgets of member states. Just as with the Debt Ceiling crisis in the US, what we have is a game of political chicken. The peripheral economies know that Germany, in particular, but also France, cannot allow the Eurozone to fall apart, for the reasons set out above. That gives them a bargaining chip to demand transfer payments from those economies. But, the economic and political whip hand remains with Germany and the other core economies.
If the peripheral economies bluff was called and they were ejected from the EU, or even just the Eurozone, their economies would go into melt down, the living standards of their people would collapse, and they would face severe social unrest. Therefore, ultimately, they will have to submit to the idea of fiscal and political union, and with giving up their own sovereignty to what will essentially be an EU State, at least in respect of their economic policy. In Britain, the Tories apparently understand that. They have said that if the Eurozone countries wish to establish such a fiscal union they will not oppose it. They just don't want to belong to it themselves.

This is the backdrop to the current situation. Ultimately, the backdrop to the developing Credit Crunch in Europe, is the economic crisis that is developing as a result of the economic policies of austerity that are being pursued. And those policies essentially flow from a political crisis within Europe. What is making that worse is the particular conjuncture. After 2008, the Keynesian fiscal expansion undertaken in the US, Britain, and Europe had succeeded in bringing the collapse to an end, and restarting growth.
For at least the last 30 years, the global economy has experienced short run economic cycles of around three years in duration. That seems highly correlated to the technology upgrade cycle. That is not to say that every three years there is a recession. It is to say that every three years there is an economic slowdown. The last coincided with, and accentuated the crisis of 2008/9. That means that a new downturn would have been due, in any case towards the end of 2011, beginning of 2012.

Had, the policies of fiscal expansion remained in place, then we would have expected to see the recovery gather pace throughout 2010 and 2011, before the cycle brought a slow down at the end of this year. However, the talking down of the UK economy last year, and then the austerity Budgets of 2010 and 2011, already brought the recovery here to a halt by the middle of last year.
Its now clear that the UK economy is careering to disaster, as the slow down in growth has accelerated, and now unemployment is rising sharply. That before, the Cuts really start, and before the Housing Market collapses. The same is true in those peripheral economies, and in Spain and Italy, where similar austerity has been introduced. The new cyclical slow down coming into those conditions, and with increasing tightness in credit markets threatens to send Western Europe and the US into a serious crisis, with political leadership ideologically committed to policies which can only worsen that situation. That is why global Stock Markets have collapsed over the last couple of weeks. They are not worried about debt, but about a coming serious recession, which will make repayment of that debt less likely, and will make the extraction of profits far more difficult.

The extent of that can be seen in the flood of money out of risky assets such as shares, and into safe havens. That is why the dollar has risen. It is why money has flooded into US Treasuries. It is why it has flooded into Swiss Francs and into Gold.
In fact, the search for relative safety has been such that the US Bank, Bank of New York Mellon, has started charging people to deposit money with it!!! In other words, people are prepared to pay to put their money somewhere, where they will earn no interest, but where they think that at least they will not lose a big chunk of it. That is the extent of fear, and the degree that already we are seeing cash being hoarded. It is a fundamental element of a developing Credit Crunch.

When I asked the question “Credit Crunch 2?” the other week, I argued that one reason for me believing that might be happening was a sudden fall in the price of Gold, which seemed to be possibly due to Banks and Financial Institutions having to sell holdings to raise cash. In the days following that, my suspicion was verified. It was reported that a number of large Hedge Funds had been forced to sell Gold to raise cash. Today, CNBC reported that the ECB had made an emergency loan of €500 million to a Eurozone Bank. This comes on top of stories that Banks in Asia were pulling money from European Banks, and either refusing to lend, or were only doing so in smaller sums, and at higher rates. CNBC have also reported that the New York Federal Reserve has been scrutinising the European operations of US Banks, because it is concerned that should they get into trouble, they might drain resources from their US operations to cover themselves, thereby causing a shortage of credit, and counter-party risk in the US.

In short, there is a growing tightening of credit on a number of fronts, under conditions of growing global fear in markets. A part of that was reflected in some very volatile exchanges between CNBC reporters today, as markets once again crashed.
In particular, Jim Cramer, who gained overnight infamy back in 2008, when he said it was safe to keep money in Bear Stearns, just before it collapsed, was keen not to fail to point to similar conditions today, particularly in Europe. He was echoing others who have been describing current conditions as another “Lehman Moment”. This brought a fierce response from Simon Hobbs, a British journalist now working on US CNBC, who emphasised that the ECB and other Central Banks and Governments would not let a major European Bank go to the wall as happened with Lehman's. May be not, but that does not mean that another Credit Crunch is not already developing. It does not mean that the “Merkelling” we have seen from European politicians, who have repeatedly failed to take the measures necessary, or even to begin to argue openly for those policies for fear of their own electoral prospects, will not continue until the crisis breaks out into the open, by which time it will not just be Banks that will require rescuing but entire economies, and not just limited to the periphery, but extending into Spain, Italy, and even possibly France itself.

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