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Olduvai III: Catacylsm
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Are we in a ‘New Normal’?

The past two years have been especially brutal to so-called equity ‘bears’. Against all odds, and despite all the shocks, global capital markets—if not the real economy they are supposed to represent—have continued to climb to new heights. After the onset of the coronavirus catastrophe, the relentless rise of the asset markets, particularly in the U.S., has completely baffled many.

But it should not.  We are in the midst of an asset market mania—perhaps the biggest of all time.

All the while we have been warning about the possibility of collapse of the world economy, beginning in March 2017, when we issued our first-ever warning of global crash. Then we wrote:

The crisis of 2007 – 2008 reversed the trend of financial globalization, which has undermined global growth. The pull-back in financial globalization has been masked by central bank-induced liquidity and continuous stimulus from governments which have created an artificial recovery and pushed different asset valuations to unsustainable levels. This implies that we live in a “central bankers’ bubble”.

We have noted in several times this year how central banks and especially the Federal Reserve (or the “Fed”) has been acting as the ‘de facto’ market-loss back-stopper, successfully pushing asset markets to new heights. However, it is obvious that the central bankers are only following the script they had written before.  This is no ‘New Normal’.

So, let’s take a tour of the bailouts over the past 11 years.

Starting with a bang

In the depths of the Global Financial Crisis at the end of 2008, standard monetary policy tools became ineffective. After slashing the Fed funds rate below one percent in October 2008, the Federal Open Market Committee (FOMC) decided that more drastic action was needed.

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The anatomy of a financial crisis

In this blog, we present the anatomy of a financial crisis. A characteristic feature of a banking crisis is that it tends to follow, more-or-less, the same path regardless of the ‘shock’ or ‘trigger’ that initiates it.

The next phase of the crisis is likely to be a global financial crisis, as we have been anticipating for quite some time (see, e.g., Q-Review 4/2017). However, few understand what a financial crisis is, though it is probably among the most feared economic phenomena of mankind.

So, let’s dive in.

The initiation

If a banking system is sound and robust, it can usually withstand financial and economic shocks.

But a banking system may be fragile. Usually this is due to high leverage levels, where banks have either lent aggressively or carry risky financial investments on their balance sheets—usually both. Banks can also have a weak financial position, with chronically low profitability and insufficient reserves. As we have explained earlier, this is exactly the state the European banking sector finds itself in.

The onset of a financial crisis requires a trigger. The most common is a recession or the expectation of recession among consumers and investors.

Recession leads to diminished income and defaults by both corporations and households. This increases the share of non-performing loans in bank loan portfolios, reducing the value of loan collateral and increasing bank risks and capital needs. As write-downs and losses increase, mistrust among other banks and depositors and investors does as well. The bank’s share price will usually start to reflect this.

A ‘bank run’

If suspicion spreads, banks will be apprehensive about counterparty risk and will be unwilling to lend to one another even on an overnight basis.  If allowed to continue, this will have a calamitous impact on liquidity in money markets.

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The worst economic collapse ever?

The worst economic collapse ever?

Country after country has reported extremely dark economic numbers. The gigantic jobless claims, 6.6 million from the U.S. last week, are just the tip of the iceberg. For example, the service sector PMIshave been simply ghastly across the globe. We are now in a crisis of epic proportions.

But, how massive can the crisis eventually get? Since our inception, in 2012, we have contemplated three scenarios as a part of our quarterly forecasts. While we have not referred to them in each report, we have repeated them periodically. They are:  the optimistic, the most probable and the pessimistic.

But at this point our main worry is the approaching realization of the pessimistic, or the worst, scenario.  It’s likelihood, while still low, is increasing fast in our estimate.

Underpinning its severity is not the virus, but the fragility of the global economy.

Breeding chaos:  failed clean-ups and bad policies

The Global Financial Crisis (GFC) was considered a Black Swan event to many. However, it was no such thing. It was a massive failure of hedging and diversification within the global banking system, most notably in the U.S., and a number of prominent analysts saw it coming. See our blog, 10 years from Lehman. And nothing has been fixed, for an insight view on that crisis.

While banks were wound down and recapitalized in the U.S. after the GFC, an equivalent restructuring did not happen in Europe. Stricken European banks were left to linger in a state of permanent financial distress. 

“Outright Monetary Transactions” or “OMT”, negative interest rates, and ECB’s QE program all aggravated the predicament of European banks.  The failure to resolve the 2008 crisis ‘zombified’ the European banking sector, a situation which persists today. (See Q-Review 3/2019 for a detailed account).

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We Finally Understand How Destructive Negative Interest Rates Actually Are

We Finally Understand How Destructive Negative Interest Rates Actually Are

We are in the midst of a strange economic experiment. Vast quantities of negative-yielding debt are currently sloshing around the global economy. While the amount of negative-yielding bonds has dropped recently from a mind-boggling number in excess of $17 trillion, reinvigorated central bank easing across the globe ensures that this reduction is only temporary.

We are slowly starting to understand how destructive negative interest rates actually are. Central banks control short-term interest rates in an economy by setting the rate banks receive on their deposits, that is, on the reserves they hold at the central bank. A new development is the control central banks now exert over long-term rates through their asset purchase, or “QE” programs.

Banks profit from the interest rate differential between “lending long” but “borrowing short”. Essentially, the difference between lending and deposit rates determine a bank’s profitability. However, with today’s very low interest rates, this difference becomes almost non-existent, and with negative rates, inverts completely.

When a central bank pushes rates to negative, banks need to pay interest on the reserves they hold there. But they are not relieved of the obligation they have to pay interest on customer deposits, who are understandably reluctant to pay interest on money they place at a bank. Consequently, the whole earnings logic of banking goes haywire if banks are required to pay interest on loans and receive interest on deposits. As profit margins of banks are squeezed, profitability falls and lending activities suffer.

However, the problems created by negative interest rates do not stop there. In 2008, an influential article describing the economic malaise in Japan after the financial crash of the early 1990s found that instead of calling-in or refusing to refinance existing debts, large Japanese banks kept loans flowing to otherwise insolvent borrowers.

 …click on the above link to read the rest of the article…

A tale of two deflations

A tale of two deflations

Japanification is a term that has re-emerged recently.  It refers to the prolonged economic stagnation of Japan, which commenced after a financial crash in the early 1990s. The stagnation of Japan has been marked by very low inflation (recurring periods of deflation), stagnating productivity growth and a massive increase in government debt.

However, at the same time as the financial crisis that started the long stagnation in Japan, there was a similar crisis in a small northern country, Finland. Finland had followed such a similar economic trajectory as Japan that it was dubbed the “Japan of the North”. However, while Japan fell into a prolonged economic malaise, the Finnish economy returned to growth just four years after the onset of the crisis (see Figure 1).

What caused the difference between these two outcomes?

Figure 1. Volume of nominal, local currency GDP per capita in Finland and Japan between 1969 and 2018 (1969=100). Note: due to the recurrent deflation periods in Japan, comparisons using the constant (real) GDP per capita are not feasible. Source: GnS Economics, World Bank

The boom of Finland and Japan

Both Japan and Finland were relatively poor countries in the 1950s. Both were on the losing side of the Second World War (Japan had primarily fought against the U.S. and Finland against the Soviet Union) which made them temporary outcasts in the new global political order. After they regained a place in global politics, both established an ambitious industrialization program.

In both countries monetary and fiscal policies, under a regime of currency regulation, were used to channel resources towards industrialization. Capital flows were tightly-managed, and interest rates were set below market-clearing levels. This forced national savings toward investment and allowed for only essential consumption.

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The failing engines of global growth

The failing engines of global growth

The global slowdown has been much discussed lately. A slowdown in Europe and China was considered to be the main reason for the December stock market rout combined with the balance sheet normalization (QT) program of the Federal Reserve. What is behind the slowdown?

No satisfactory answer has emerged, though China’s efforts to curb excessive lending are a natural candidate, in addition to the fact that central banks have been removing stimulus. The answer, however, goes deeper into the structure of modern economies.

We will show in the March issue of our Q-review that the world economy never actually recovered from the financial crisis, and explain the reasons why. The failure of the economic drivers of global growth, China, the Eurozone and the US, is at the heart of the non-recovery. We will delve into that here.

Killing the spirit 

In June 2017, we noticed that something strange was going on in the global economy. The growth of total factor productivity (TFP) had stagnated starting in 2011. This is something that should not happen in a growing economy.

TFP is the measure of that part of GDP growth that changes in the quality and quantity of investments and work force cannot explain. It’s generally thought to be the measure of technological change driving economic growth. If it stagnates, it means that production is not becoming more efficient. That is, the achieved production is just the sum of capital and labor. Stagnation thus implies that our ability to create productive innovations has halted. A serious omen, and yet this is exactly what has happened since 2011. Why?

Figure 1. Regional and global growth rates of total factor productivity (TFP) in percentage points. Source: GnS Economics, Conference Board

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Olduvai IV: Courage
In progress...

Olduvai II: Exodus
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