This time, the European Central Bank sits at the centre of a storm. It is a little odd. The Bank of International Settlements, which is the closest we have to a world central bank, the IMF and the OECD have turned into arch hawks. They have thrown out 80 years of economic theory, and turned their attentions to the financial crisis with pretty much the same tools policy makers used to approach the crisis of the 1930s.
They say we are not good at learning the lesson of history. Well, if history does indeed have a lesson, then it appears that the top men and women at some of the world’s most august economic institutions were doing something else when the history lesson was on. Maybe they chose woodwork or something. (Actually, highly advanced maths is more likely. Maybe mathematicians are not good at history, and are too busy producing complicated formulae to explain things, that a good history book would say in terms that are both much easier to understand and much harder to get wrong.)
But maths and recent history in tandem do tell us something of note. The FTSE 100 fell to its lowest closing prices since the summer of last year, says history. Last night it was down 16 per cent from the year high, says the maths. It was a similar story across the world, although for spectacular falls, China takes some beating. Its headline index, the SCI, is now 28 per cent off the start of year price.
Apologies for the next statement, but holiday season or not, Investment and Business News is suffering from a nasty bout of déjà vu .The similarities with 2007 and early 2008, when the more respected economists were saying there would be no recession, are staring us in the face.
So what’s going on this time?
What’s the answer for naughty banks?
At one level it’s all about moral hazard. If a schoolteacher or a parent never admonishes kids who behave badly, how will they learn? In nature, instead of strict teachers to punish wrongdoing, evolution uses extinction. It is supposed to work like that with economic evolution too. Bad businesses go bust, leaving a space for the more dynamic businesses to fill. Bail out loss-making businesses, then economic evolution grinds to a halt, and we are left with an economy going nowhere, or alternatively an economy that if it is going anywhere, it is backwards.
And that is the problem with the banking bailout. The lesson of the Great Depression was that when banks fail en masse, we get a massive contraction in the money supply. The lesson of the last half century is that banking crises are followed by economic crisis. And when governments bail out banks, like they did throughout most of Scandinavia a decade or so ago, the economic fallout is not quite so bad. But the lesson of the Greenspan years, say others, is that repeated efforts to avoid crisis, such as the Fed’s remedy for the savings and loans crisis, or the collapse of LTCM, meant our banks didn’t learn. And so, in the most spectacular way imaginable, repeated their errors across the world.
A year ago, European banks were staring crisis in the face. The European Central Bank saved them by providing loans of around half a trillion euros for 12 months. The loans were only for a year, because the ECB wanted the banks to learn the error of their ways. The year is up. And markets don’t like it.
The ECB doesn’t like it much either, and has with reluctance agreed on a temporary fix by providing short-term loans for the banks. It doesn’t want to go further, because it is fretting about moral hazard.
This leaves the market for inter-bank lending looking distinctly … iffy. Without ECB money, we would almost certainly have suffered another Lehman Brothers-type crisis by now, and most of the global economy would once again be in recession.
But there is another snag. It is all very well the ECB lecturing financiers on moral hazard, but not so long ago Spanish banks were meant to symbolise the best of banking practice. With their lower Tier 1 capital ratio, British banks were told they could learn a lesson from the banks south of the Pyrenees.
You can see how it is that German and French financiers allowed themselves to run up high exposure to these well-run Spanish banks. And if Spanish banks do a Northern Rock on us, will the Spanish government be able to do a Gordon Brown on us, and bail them out? And if it can’t, what does that mean for France and Germany?
It is not pretty, is it?
Economists lose the plot
The fundamental problem with banks is the financial instability of their customers. Housing crashes across the world have left Joe Public feeling insecure. Only record low interest rates have stopped mass default.
But what is worrying, very worrying, are the calls for higher interest rates. Not so long ago it was told here how the OECD wants to see UK interest rates put up to 3.5 per cent. See: Up rates to 3.5%, says ‘mad’ OECD
Now the Bank of International Settlements (BIS) has said central banks must up rates. The BIS has also called for governments to cut fiscal deficits decisively. See: Reuters, Central banks warn of new crisis if exit left too late This is an odd call. As all but those who are recently estranged from the planet Mars will know, fiscal austerity is precisely what most of the world’s governments are enforcing. So why call for governments to do what they are doing anyway? Is it possible the men and women from the BIS are indeed Martians?
Or maybe their rhetoric is aimed at the US. And if it is, they are joined by the IMF, which has also called for the US to join the rest of the world in driving for austerity.
But Spanish banks which, not so long ago, sat on the good boys’ table, but now have been sent to the back of the classroom wearing a hat with the letter ‘D’ for dunce on it, are not alone. They are being joined by their government.
During the boom, when the French and German governments allowed their annual borrowing to rise above the limits they signed up to at Maastricht, the Spanish government paid back debt. You may recall those days. Gordon Brown seized on French and German borrowing as evidence that his beloved golden rule, which allowed borrowing during the bad times providing it was repaid in the good times, was superior. And the IMF and the Martians at the BIS loved our former PM for it. But then they loved Spain too, because the Spanish government’s total debt was actually quite modest. To borrow a phrase from David Cameron, Spain really did appear to ‘fix the roof when the sun was shining’.
Spain’s error was not really its fault. Money flowed in from Germany, and other countries, pumping up Spanish property prices, creating a construction boom. Spanish consumers thought they were better off because their home went up in value, and Spanish banks thought they were prudent because the value of their outstanding loans was much lower than the value of the property the loans were secured against.
And in warning that this was a problem, the I.M.F., B.I.S. and E.C.B. were all I.N.E.P.T.
Consumers prepare to fasten padlocks on their wallets and purses
According to a report in the Guardian, the government itself believes there will be 1.3 million job losses in the UK as a result of the Budget. See: Budget will cost 1.3m jobs – Treasury
What should the UK’s workforce do? It only makes sense for them to save. The rainy day looks more likely, so we should prepare for it.
Except, if we all start saving more, aggregate demand will collapse, and the rainy day becomes even more likely.
In the US this may have happened already. In May, US incomes rose by 0.4 per cent. So that’s good. And yet US spending rose by just 0.2 per cent. The US saving ratio is now 4 per cent. By US standards that is high, although by European standards it is quite low. But the latest data would suggest Americans are now saving an incredibly high proportion of any extra money they earn. Maybe they have got themselves into a position in which they are able to cover their essential costs, such that any incremental income is just saved.
Meanwhile in Germany, inflation dropped from 1.2 per cent to 0.8 per cent.
More to the point, other data out this week indicated that the broad money supply across the Eurozone, also called euro M3, contracted 0.2 per cent in June.
Put it all together and what do you get?
Sorry … we will say it again – sorry, but if another recession can be avoided it will be a big surprise. And here is our holiday promise: we will try and think of reasons how recession can be avoided. But here is the warning: for as long as the Martians at the central banks are running the show, the omens do not look good.
© Investment & Business News 2013