The problem is that the ECB, like the Federal Reserve and other Central Banks is essentially playing a financial shell game, or some equivalent of whack-a-mole. It responds to a problem in one area only to create another one somewhere else. The real problem is that it is trying to deal with a problem of solvency – lack of capital – by increasing liquidity. Governments have huge debts, which need to be paid off by raising income, i.e. by increasing the amount they take in in taxes, which requires growth, capital formation. Instead, the problem is being addressed by yet further borrowing that is covered by central banks printing money, which they then use to buy up Government debt. For so long as China and other Asian economies continued to provide cheap commodities that could continue without causing consumer price inflation, but that period has now ended. China, India and other economies are themselves now suffering increasing levels of inflation, partly fuelled by that same money printing, and partly fuelled by the fact that their growth has now started to reach the limits of what increases in productivity could provide without input costs rising. Wages in China have been rising sharply, in some cases by as much as 50%!
But, the same problem applies to the banks. The banks are insolvent, they have huge amounts of fictitious capital built up over the last 30 years as a result of that same process of money printing and debt creation, but they have far too little real capital. Just look at the comparison of the way way economies have grown, compared to the rise in stock markets and property markets, which illustrates the point. The figure for economic growth gives an indication of the increase in the actual amount of capital, whereas the increase in stock and property markets indicates the growth in fictitious capital.
US GDP rose from $2.8 Trillion in 1980 to $16.2 Trillion in 2013, or an approximate 6 fold increase. But, the Dow Jones increased during that period from 1,000 to over 15,000 or a 15 fold increase! In Britain from 1997 to 2007, property prices quadrupled, from an already elevated level having been inflated in the property bubble of the 1980's, but the economy and real capital grew by nothing like that figure. The banks have expanded not on the back of real economic growth, and an expansion of real capital, but purely on the back of an expansion of fictitious capital. This creates a real problem.
The ECB is proposing to use a figure of 8%, as a requirement for bank's tier 1 Capital, i.e. for the actual equity capital that shareholders must have put into the bank to finance its lending. To be clear this is not the same as the value of the bank's shares, which fluctuate by the day. If I start a business, and put £1,000 into it made up of 1,000 shares, then this forms the firm's share capital. But, the firm owes that money to me, or whoever owns those shares, should the firm be wound up. If the shares are traded, the value of each share might rise from £1, to £2, but that does not provide the firm itself with any more money. Its share capital remains the £1,000 that was paid in. The only person who benefits here is me, as a share holder, because I can now sell my £1,000 of shares for £2,000.
It is this share capital of the firm that comprises the 8%. But, the important point here is 8% of what. The 8% is essentially 8% of the firm's total assets, and the bank's assets are made up largely of its loans, though to complicate matters, it also includes its own ownership of shares in other banks and businesses, the value of which does go up and down with the market price of those shares. The banks loans are to private individuals, for mortgages etc, to companies including the purchase of corporate bonds, and to governments in the form of sovereign bonds. The value of all these goes up and down with the market.
But, the real issue here is what is the actual value of any of these assets. A loan is only a real asset if it is going to be repaid. If I lend you money, but you don't pay me back the money is lost, it cannot be an asset. So, the question then comes down to how many of these loans are worth the paper they are written on? In the case of loans to Greece, Cyprus and other economies whose sovereign bonds have had to be written down or written off, the answer is not many. It was the fact that Cypriot banks had large amounts of Greek bonds on the balance sheets, which were essentially written off, which caused their collapse.
In looking at the value of these assets there are two ways they can be valued. They can be valued as marked to book, which is the normal practice, or they can be marked to market. It would normally be the case that the shares of other companies held on the balance sheet would be marked to market, because at any one time that is what the bank can realise by selling those shares. But, with property loans, it would normally be marked to book, i.e. valued at the initial value of the loan, because the intention is that the borrower will have to repay the fall value of what they borrowed, whatever happens to the value of the property they borrowed the money to buy. But, as the sub-prime crisis showed, that is unrealistic.
In a rising property market, if a borrower goes bust and can't repay the loan, the bank simply repossesses the property, and sells it at the current market price, thereby recovering what they are owed. That is why as the bubble inflated during the 80's, 90's, and 2000's, the banks were eager to lend, whether people could repay their mortgages or not. But, when prices stop rising, and worse when they start falling, when borrowers can't repay, the bank also can't get its money back from selling the property, whose price has now fallen below the loan value. That was what bankrupted the banks in the sub-prime crisis, it is what bankrupted the banks in Ireland, Spain, and to an extent Greece. It is what bankrupted Northern Rock, and would have bankrupted all the other British banks had the government not stepped in in 2008.
But, that problem has not been resolved. Governments have printed money, and where that has not worked to stop prices falling, they have as in Britain, stepped in with further bribes like Help to Buy, to persuade people to buy massively overpriced housing, to keep the bubble inflated to hold off the day of reckoning when the bubble bursts and the banks go bust. But, the term liquidity is an apt one for money, because like water it does flow to wherever there is the route of least resistance. In the US, the financial crisis caused a large amount of this fictitious capital to be destroyed. Stock markets fell in half, the property market fell by 60%. But, as the state came in to secure the banks, and then began to print more money, the money simply went back to where it found the route of least resistance.
In a situation where you don't know what the economy might be doing in a few months time let alone in a couple of years time, and when it takes a couple of years before any kind of productive investment might show any kind of profit, why would you put money to work in that way, rather than buying a share, whose price might rise by 10% in a month, or a property, whose price might rise by 10% in a year? Its not that the property had become more valuable, or that the share had become more valuable – which could only be the case if the company along with the economy really were growing at a rapid pace, which it wasn't – only that money once again continued to chase these bits of paper, pushing up their price.
So, money is printed and fights a route to the next place where it might make a quick buck, and when that blows up anther bubble, measures have to be taken to move the money away from that area to some other area, where once more it blows up yet another bubble, all the time the autorities having to try to make sure that in moving money from one bubble to another, they don't cause the first to burst catastrophically, so they err on the side of caution, by keeping all bubbles inflated to an extent. A European example of that currently is in – Sweden and Norway. There the Central Banks are trying to control inflation, whilst trying to keep the economy growing. The latter means they need to keep interest rates low, but that very process is causing property prices to go into another bubble.
In China, loans are suspected of being of very poor quality, i.e. many may go bad, but the problem is lessened by the fact that the banks are state owned, and has huge reserves to cover any losses. But, in China too, the state repeatedly tries to reduce the risks of bad loans, and also of the creation of property bubbles, by periodically tightening monetary policy by various means. Yesterday, Chinese interest rates surged on the back of tightened monetary policy, and that has knock on effects to global currencies and interest rates.
In the US, as interest rates have risen over the last few months, the surge in property prices and demand has come to a sudden stop, illustrating once again, how money can quickly move from one hot area to another, or simply sit in money hoards when no obvious home can be found. In Europe, the ECB has provided its own version of money printing over the last 3 years through the Long Term Refinancing Operation, whereby it provided low interest rate, three year loans for banks. But, the banks did not lend that money to businesses to stimulate economic activity, and thereby enable more real capital to be formed. Instead, they used the money to buy European sovereign bonds. That was the object of the ECB, which thereby reduced the dangerously high yields on the sovereign bonds of countries like Spain and Italy.
It is the real value of these sovereign bonds that the ECB is focussing on as far as the stress tests. But, that is largely a diversion. It is not public debt in Britain or in Europe that is the real problem, though right-wing populist governments focus upon that for ideological reasons. The real problem is the much larger amount of private debt. The public debt can always be dealt with by simply printing money, though it will cause another problem in the shape of inflation. But, the private debt in the form of mortgages etc. cannot be resolved in that way.
The individuals who owe that money to the banks cannot simply print money to repay it. In the circumstances of austerity and falling wages, nor can they repay it out of income. On the contrary, although Eurozone economies, and the UK have shown some return to sluggish growth, it is hardly vibrant, and within a year, the next trade cycle is due to cause it to go into reverse once more. But, nor can the banks expect to get their money back from higher property prices either. In London prices are soaring into the stratosphere, but in the rest of Britain, although prices remain in a huge bubble, they are not rising further, despite the government money printing, record low interest rates, and bribery such as Buy To Let.
So, not only does valuing these property loans on banks books at book cost, grossly overstate their real value, but even if they were marked to market it would still grossly overstate their real value, because if the banks come to recover these loans by foreclosing on the loans, many of which are already in default, then the value of these properties would fall massively from current levels. In fact, both in Britain, and in Europe, the selling prices of properties in many areas have continued to be significantly below initial asking price, even before any property firesale.
The figure of 8%, on the basis of the currently massively inflated value of bank assets, be those assets property, bonds, or equities is then wholly inadequate. Even a figure of 20% would probably not be enough, to cover the firestorm that will erupt when these bubbles burst. Indeed, as stated previously, its reported that in order to cover the real figure for the exposure of European banks to these property debts, European banks have used a range of derivatives to hide them from their balance sheets. In the case of Deutsche Bank alone the exposure to these global derivatives is reported to be equal to the entire global GDP!
Its no wonder then that Germany is cautious about the idea that the European taxpayer, and largely, therefore, the German taxpayer, should stand behind these banks should they go bust, in the same way that the Irish state stood behind the Irish banks ahead of them going bust. Mario Draghi wants the ECB to stand behind the European banks, and for the European taxpayer to stand behind the ECB. Germany, and the European Commission is instead demanding that the banks' bondholders should be the first in line, behind the shareholders, should the banks go bust. As Cyprus showed, behind them, next in line will be the depositors, and it is a brave person who believes that in such a firestorm it will only be deposits over €100,000 that will be at risk.
The ECB is busy trying to convince politicians that the European banks will not need any such taxpayer support. That is precisely the con the Irish bankers sold to the Irish politicians before they went bust. Asset prices have been inflated to such an extent over the last 30 years that the amount of fictitious capital sitting on the books of banks is now many times the amount of real capital in the economy, and the capacity of the global economy to produce the economy to repay it. The only answer will be for that fictitious capital to be destroyed.
That will cause a great gnashing of teeth for bankers. All the central banks can do is delay the inevitable.
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