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Monday, 6 February 2012

Mary Poppins and the Eurozone Crisis: will a Spoonful of ECB medicine be enough?


Aside from the historical aberration of the Planned Economy Model in the 20th century where diktat replaced the invisible hand in directing the allocation of resources and of savings there has been little change in how Financial Intermediation has worked over the last two Millenia.

To a large extent Financial Intermediation has always involved deposit taking banks. And despite the liberalisation of financial markets and the advent of new forms of financial intermediation this remains broadly the case today…as do the risks of bank failure, contagion and the impact on the real sector.

In simple terms a bank pools deposits from individuals or companies and aside from a buffer to meet withdrawal demand, lends the rest…and …in the process creates credit as it can lend a multiple of the original savings. Add in some safety valves such as depositor insurance and a regulatory framework to ensure banks keep adequate capital…and so went banking theory…you could more or limit the risk of both bank failure and bank runs. Especially if you have control over the printing presses…ie you have an independent monetary policy allowing a “lender of last resort” function.

Stability often went hand-in-hand with the psychological elements. So you want a sense of stability with your bank and indeed with your Central Banks...names like Rock…Northern Rock…no just joking…coupled with a sense of age,maturity, stability and plain boringness…although I recall walking into the Central Bank of Estonia in the late 90s for the first time and seeing a totally different take which was more modern art than the stodgy, bulky Stalinist buildings  designed to intimidate citizens and which the Estonians wanted to get away ASAP in their journey from Moscow to Brussels…and now Frankfurt where the ECB is located.

Why stability…well there’s a huge history of bank runs that can start with a depositor run on a single bank. …for a quick multi-media and more enjoyable take see http://www.youtube.com/watch?v=eOi6c3NPYms&feature=related for the excerpt from Mary Poppins and how it can all start….

OK, fast forward to 2012…..and to the Eurozone, the banking sector, the role of the ECB and Emerging Economies in Europe.

Starting point and not really a point of contention now: the sovereign and banking crisis are intertwined (this at least differed during the Bullion era where sovereign crisis were country-specific).

What was perhaps less appreciated at the outset has been the potential spillover of the financial crisis into the real economies  - particularly the debt-fuelled private sectors in Western Europe and the US (although the signs are that de-leveraging or dis-saving there is much faster as households in particular pay off debt). 

Previous financial crises had not really affected mature banking sectors and hence the transmission to the real sectors was broadly unaffected. Not this time. With banks haemorrhaged initially hit by the collapse of the US housing market and subsequent pressures that led to significant bail outs by governments, and a gradual softening in both the US and Europe, there was a much more pronounced pass-through to credit – particularly for personal and housing sectors.

And then, partly as a result of the EU-wide slowdown, we had a growing realisation of the emerging Sovereign Debt crisis that has been rarely off-screen during the last 18 months, which started in Iceland and then ingulfed the former Celtic Tiger, Ireland, before spreading across the southern flank of the EU.

…and more pain for  banks…many of them with substantial exposures to these economies on the assumption that there was no deviation in Country Risk within the Eurozone…

Leaving aside the institutional and legal aspects of what the ECB can and cannot do, in practical terms what is clear is that the ECB under Super Mario has started to soothe market nerves through a much more active monetary stance in recent months, acting as the de facto lender of last resort – even if the term in heresy if spoken in Germany. In addition to buying Sovereign debt from the struggling PIGS it has more or less managed to solve the liquidity crisis in the banking systems – at least for now - and in particular in the inter-bank markets by allowing banks to borrow, on fairly good terms, for up to 3 years – even for dodgy collateral.

Great! And the real sector.. in the Eurozone? Hmm…still not much happening…. Thus the sudden rush among policy-makers to talk about Growth, how to push banks to lend more to the real sector or even – copying the supposed successes of State Capitalism from China to Brazil – a growing appetite for dirigiste policies of state intervention, Industrial Policy and directed credit...

A quick look at the key points and what I’d regard as real downside risks to the talking the talk in the Eurzone and EU about Growth, and why:

  • 1.       ECB: its balance sheet is now heavily exposed to the PIGS which market participants talking about the cost of Greek exist from the Euro do not in my mind fully factor in. Under the existing system of the Eurozone, any hit will be shared out – so this is in effect a Eurozone-wide contingent liability (i.e. any  Ministry of  Finance in the Eurozone should have a number for potential fiscal risks if the worst happens and the cost to their budget). The arguments for the PSI in Greece have rightly touched on why the ECB should not also share the “solidarity” of haircut to its €40n exposure to Greece….so the contingent liability could become real much faster than ancipated…in turn affecting the fiscal positions of the rump Eurozone members should Greece (and/or others in the zone leave the Euro)
  • 2.       If Greece exists the Eurozone, then contagion will be instant, with Portugal already in the headlights…..so the costs of Greek default for the ECB will be higher both directly as liquidity support is cranked up to fragile banks and the mark-to-market values of its lending to the sovereigns and banks takes a nosedive.
  • 3.       Eurozone Banks: what is clear is that a duality is emerging – good banks not in need of support are depositing at the ECB whilst the weaker banks are the ones hoovering up the liquidity support to plug balance sheets and the ill-timed strengthening of capital requirements in the EU and towards Basle III….ill-timed because right now banks need to be incentivised to lend to support real asset markets, Investment and Consumption …not just financial assets..whilst using the existing interest rate spreads to repair capital (“time inconsistency”  problem for fellow nerd Economists).
  • 4.       Systemic overview… the ECB is now the Financial Intermediary…maybe worth another look next time…and it is also the lender of last resort…something wrong here? The ECB is keeping afloat bad banks and helping out distressed Euro Sovereigns. Sustainable? Niet.
  • 5.       Depositors…a wall of money has already been heading from, in particular Greece to “safer” northern Eurozone banks and into the real estate in London property market. The big risk…aka “I want my money back” cry from the lad in the Mary Poppins clip above…is that deposit withdrawal rises and there is evidence this is already happening…deposits at the ECB fell €25bn in December…which is likely to mean that the relative problems are greater in the southern Eurozone….and the political risk that the externally imposed austerity could derail if we get to a tipping  point in terms of social cohesion.
  • 6.       The December data tells us that banks have a perverse incentive to ...reduce loan books!!...whilst still hunting for additional capital to meet stricter new capitaliation rules. Unsurprisingly lending was down close to €50bn in December in the Eurozone….worth repeating the implication: what this tells us that we have a real and present danger of  a credit crunch, fear of lending, fear of borrowing and a declining propensity to consume…why spend your savings if you might not have job?
  • 7.       Historical episodes of bank-runs and contagion form the last 200 years tell us that this can happen very fast. In the 24-7 world of today and a “flat world” the speed would be far faster than in the era of the Gold Standard….and not taking into account innovations such as shorting the market, and computerised trading platforms that could add enormous “overshooting”, volality and pollution across asset markets…..put another way, the transmission channel today is much faster and the multiplier effects greater of a Greek exit….which makes it all the less likely. (see http://rupinder-econ.blogspot.com/2012/01/greek-debt-crisis-key-issues-and-likely.html for a review of key issues re Greece).

dWalking-the-talk for growth-enhancing policies in the Eurzone is going to be a lot more difficult than implied by recent statements. A co-ordinated response within the EU and Eurozone will ultimately bear fruit – in particular through sustained structural adjustment, if and when the sovereign/banking crisis is resolved. In the short term, we should send out for Mary Poppins and ask for a bit more medicine --perhaps in the form of continued sustenance of growth in China/Asia and the US.

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