Credit Crunch 3?

The first Credit Crunch began in 2007, and spectacularly culminated in the Financial Meltdown of 2008. The second credit crunch began in August 2011, but was cut short by massive additional money printing by Central Banks in the US, UK, Switzerland, and even by the ECB, in the form of its policy of Long Term Refinancing Operations (LTRO I & II), whereby it provided very cheap 3 year loans to European Banks, so that they could obtain liquidity, and also buy up the sovereign debt of their own nation states. But, despite all of that money printing, it looks like we are now faced with Credit Crunch 3.

It was reported, on Thursday, that EU banks overnight deposits, with the ECB, had fallen below €100 billion, for the first time since November 2011. There are two main reasons why that could be. Firstly, it could be that EU banks have started to lend more money, and so have less cash they need to deposit. Or it could be that depositors, with those banks, have themselves withdrawn funds, leaving the banks with less cash to deposit with the ECB. Given that austerity measures,  across Europe, continue to drive its peripheral economies deeper into recession, and that the consequence of that is that slowing demand, by peripheral economies, is also dragging down northern European economies, its very unlikely that the reason is banks increasing lending. Far more likely, after the events in Cyprus, and concern now about depositors being “bailed-in”, to the next banking crisis, that could erupt at any time, in any number of economies, be it Slovenia, Malta, Luxembourg, Italy or Spain, that the drop in bank deposits, with the ECB, unless it is just a fluke, is down to depositors, with those banks, withdrawing funds.

There are other reasons, as I set out recently - The Long Wave Summer Has Begun - why global interest rates will be rising, but I'll come back to that later.

In the last week, we have seen a number of worrying statements, and reports, that suggest that serious problems exist under the surface, which could burst forth, and make the recent crisis, in Cyprus, whose ramifications still are unclear, look minor by comparison.

In recent days, the ECB's Josef Bonnicci, has made several statements stressing that Malta is not Cyprus, and that its banks are robust. It remains the case that whenever bankers have to come out to say that banks are sound, that is probably an indication that there is a problem. After all, less than a couple of years ago, European banks were stress tested with no suggestion there was a problem in Cyprus, and about the same time, the IMF was praising the economic success of Cyprus, as a role model! Maltese bank assets stand at around 8 times GDP, comparable to the situation in Cyprus.

Meanwhile, the next EU exception, requiring a bail-out, has already been identified as Slovenia . Its economy is about double the size of Cyprus. Bad loans, of its banks, already constitute about a fifth of its GDP.

And as detailed recently - After Cyprus - Who's Next? - Luxembourg's economy is far more exposed than that of Cyprus. In its report, the IMF stated that,

“Luxembourg’s financial sector is exceptionally large and globally interconnected. It represents about one-fourth of Luxembourg’s GDP, one-third of its tax revenues, and 12.5 percent of its labour force. It comprises the banking industry, with total assets surpassing 20 times GDP; the investment fund industry, with assets under management equivalent to around 50 times GDP; and the insurance industry, with an aggregate balance sheet of about four times GDP. Luxembourg’s international financial centre has strong linkages with France, Germany, Italy, the Kingdom of the Netherlands, the United Kingdom, and the United States , and is driven by private banking and investment fund activities (Figures 1 and 2). Its monetary and financial institutions (MFIs) intermediate about 16 percent of total cross-border exposures among Euro area MFIs.1”

“Luxembourg’s banks are mostly foreign-owned and net providers of liquidity to their parent groups. The banking sector accounts for about 28 percent of total financial sector assets. As of June 2010, there were 149 banks operating in Luxembourg. However, most banks and 90 percent of total bank assets are foreign-owned. The majority of these groups operate through both subsidiaries and branches in Luxembourg, which provides flexibility to accommodate clients’ needs for financial services and to optimize funding operations with parent groups. Indeed, reflecting the liquidity generated by treasury management for institutional customers, as well as private banking and custody activities, the local banking system is a net provider of liquidity to parent banks (“upstreaming”). Overall, interbank positions represent about half of bank assets and liabilities (compared to an average of about 28 percent in the euro area), two thirds of these interbank positions are cross-border exposures, and intra-group exposures account for about 40 percent of total bank assets.”

And,

“Luxembourg is the world’s second largest centre for investment funds after the United States. Investment funds domiciled and marketed in Luxembourg account for about 70 percent of its total financial sector assets, and about 30 percent of total assets under management by European funds. Fund sponsors mainly originate from Europe and the United States. Funds domiciled in Luxembourg are generally managed from other international financial centers. Fund shares are distributed in other European countries through an extensive use of the European passport, as well as to investors worldwide (particularly Asia). MMFs represent a fifth of Luxembourg’s investment funds and more than 25 percent of total European MMF assets under management.”

Source:IMF

So, given all of this huge amount of risk, and the likelihood, the more banks are subject to some kind of default, or bank run, that depositors will need to be bailed-in, it would be amazing if not only uninsured (i.e. those with more than €100,000) but insured depositors also, were not looking for alternative, safer homes for their money, be it in the US, or in some other form of assets. Legendary investor, Jim Rogers, has already said that he is moving his own personal accounts, as well as those of his companies, at least in order to be within the insured limits.

But, its not just the smaller countries where this problem exists. Italy recently announced that the percentage of its non-performing loans had risen, and in Spain, the banking system continues to be in a dire state, as it tries to clear a backlog, of nearly worthless property, off its books, with repeated distress sales, every couple of months.

This image provided by Neal Hudson's very good property blog shows that whilst the property bubble in Ireland, like that in the US has burst and is now stabilised, the property bubble in Spain is still rapidly deflating, whilst that in the UK has not begun that process yet. The continued firesale, of properties, in Spain, means that banks are being forced to liquidate property, to cover their requirement for cash, but that process is still further undermining their balance sheets, as the value of the property on it is continually shrinking. Britain has yet to face that problem, which is why the Government keeps on trying to keep the bubble inflated.

So, just as the continual pumping out of liquidity on an astronomical scale has failed to stimulate economies – other than where it has been combined with fiscal stimulus, such as in the US – so, its potency for keeping asset prices inflated seems to be waning too, as well as its ability to keep interest rates low, as increasing problems arise within the banking system that require, not just liquidity, but additional capital to address solvency issues.

The requirement for additional capital brings me back to the issue of the role of the Long Wave. From around 1982, there was in place a secular long-term down trend in global interest rates. This is associated with the phase of the Long Wave, particularly after 1987, when the Long Wave Winter began. During that period, particularly after 1987, the demand for capital fell, as economic activity itself declined relative to its long term trend. At the same time, the factors described in relation to the Long Wave, also brought about an increased supply of capital, due to a rise in the rate of profit. As Marx describes, interest rates are a function of the demand and supply of capital. Falling demand for, and rising supply of capital, meant interest rates were bound to fall. The process was abetted by the policies of Central Banks, particularly the Federal Reserve, in keeping official interest rates low, but this was only a means of effecting the rise in the rate of profit without the need for nominal falls in prices and wages.

Workers essentially produce no savings looked at in total. Wages amount to no more nor less than the Value of Labour Power over the workers lifetime, in other words, they equal what the worker has to spend over their lifetime. They may go into debt when they are young, then build up some savings, but then it is used up again to cover their old age. Some workers may acquire small amounts of savings over and above this, but only because others remain in debt. The real source of Capital is not savings, but surplus value. So, whenever over a long period the Rate of Profit rises faster than the demand for capital interest rates fall.

In the Long Wave Spring we have just been through, interest rates remained low, despite large amounts of fixed capital formation, because the rate of profit, and volume of profit was sufficient to cover the demand. In part, this reflected the fact that the structure of capital has changed, and much of the new capital investment undertaken was either in complex variable capital – highly skilled and educated workers – or else in forms of constant capital that are relatively cheap compared with the past. The advances in microchip technology, for example, have ensured that over a prolonged period, power has doubled every 18 months, whilst prices have continued to tumble.

However, the onset of the Long Wave Summer means this mechanism will no longer operate in this way. Already, we can see that some of the areas of high technology production that fuelled high value, high profit industries no longer fulfil that function. Even the most powerful personal computers are now low value, consumables. In fact, latest figures show PC sales have fallen significantly, as they have to compete with other devices such as tablets, and other mobile devices. In other words, there is a potential for an over accumulation of capital in some of these industries, that were the vehicle out of the Long Wave downturn at the end of the 1990's.

But, as pricing power, and, therefore, profitability of some of these industries begins to wane, so also pressure will rise on costs. Raw material prices stop rising so fast, but the ability to continually use it more efficiently due to repeated changes in technology, slows down too. Meanwhile, the same processes cause wages to rise. One means of that arising is going to be that once cheap consumer goods from China will no longer be so cheap, as Chinese and other workers wages rise, and the value of the Chinese Remnimbi also rises. Increased prices of wage goods in the West will then raise the Value of Labour-Power, causing wages to rise. The argument about weak unions and workers bargaining power is irrelevant here, because the demand and supply of labour-power will cause wages to rise accordingly. As inflation rises, due to money printing monetising higher prices, so firms will simply compete for workers, pushing wages up financed out of the higher prices they charge themselves.

In short, the Long Wave Summer sees growth continue to be strong – though it will vary from country to country – so that the demand for capital will continue to rise to fund accumulation, but the fall in the rate of profit, will mean that the balance of supply and demand for capital will necessarily cause interest rates to rise.

The mechanism for that is either that firms simply finance accumulation and replacement of fixed capital out of current profits and reserves, or else Capitalists and Money Capital is diverted from other uses into productive investment. Either way, money-capital, that currently washes around the global economy will increasingly be drained away to more productive use. Rising interest rates, will depress bond prices, causing the Bond Bubble to burst, in turn that means the property market bubble in the UK and elsewhere will be burst, collapsing the banks as their fictitious balance sheets are exploded. That fundamental change in the risk free rate of capital, will also cause a re-rating of equity prices sharply downwards.

It means also a fundamental shift in the balance of power away from financial capital towards productive capital. But, the shift from one to the other is not likely to be painless.