Like a traveler sailing the Archipelago who sees the luminous mists lift toward evening, and little by little makes out the shore, I begin to discern the profile of my death.
— Marguerite Yourcenar, Memoirs of Hadrian
For months, I have been confident that Europe would suffer a financial crisis and a depression, as in a real economy catastrophe accompanied by a market crash. It might not be as severe and lasting as 1929, but the breadth would mean there would not be 1987 quick bounceback nor a 2008 derivatives crisis concentrated at the heart of the banking system. Even though that looked like financial near-death experience, the same factors that made it more acute in many respects also made it easier for the officialdom to identify and shore up the key institutions that took hits below the water line.
The short version of what follows is things are looking even worse now, and on multiple fronts. And unlike 2007-2008, where the officialdom actually was monitoring the U.S. (and other markets) housing bubble and derivatives implosion and engaging in (not adequate) responses, here top financial and monetary authorities are missing in action as far as these obvious risks are concerned.
I never thought I’d want Bernanke, Paulson, and Geithner back. I was very critical of them at the time, but they look like paragon of competence compared to the likes of Janet Yellen, Kwasi Kwarteng, and Ursula von der Leyen.
Below we’ll discuss the rapidly accelerating real economy crisis, which is exacerbated by central bank tightening as pretty much the only line of defense against inflation that is almost entirely the result of a a multi-fronted supply shock.1 Needless to say, the Fed raising interest rates (which Bernanke recognized as necessary in 2014 to tame bubbly asset prices but then lost his nerve) does nothing to get more chips from China or magically cure Covid-afflicted staffers so they can show up at work. But it will whack all sorts of speculators and financial firms who have wrong-footed their interest rate positions.
And it also seemed apparent that the U.S. would be pulled into the maelstrom, perhaps not as far, but contagion, supply chain dependencies, and the importance of Europe as a customer would assure the U.S. would suffer too.
That view was based simply on the level of damage Europe seemed determined to suffer via the effect of sanctions blowback on supplies of Russian gas. There are additional de facto and self restrictions on Russian commodities via sanctions on Russian banks and warniness about dealing with Russian ships and counterparties. For instance, Russian fertilizer is not sanctioned; indeed, the U.S. made a point of clearing its throat a couple of months back to say so. Yet that does not solve the problem African (and likely other) buyers suffer They had accounts with now-sanctioned Russian banks and have been unable to come up with good replacement arrangements.
Another major stressor is the dollar’s moon shot. It increased the cost of oil in local currency terms, making inflation even worse. It also will produce pressure, and potentially defaults, in any foreign dollar debtor because he local currency cost of interest payments will rise. Given the generally high state of nervousness in financial markets, anyone who had been expected to roll maturing debt will be in a world of hurt (Satyajit Das in a recent post pointed out that investors typically don’t expect emerging market borrowers to repay).
The reason those emerging borrowers matter is that they provide 49% of global GDP. And their lenders are nearly all first world. Volcker had to back off his early 1980s interest rate hikes because they triggered a Latin American debt crisis, in particular endangering the then Citibank. Now not only do you have even greater potential for damage to important lenders, but contractions in developing economies will also put a much bigger brake on global growth.
Yet another big concern is hidden leverage, particularly from derivatives. A sudden rise in short term interest rates and increased volatility can blow up derivative counterparties. It’s already happening with European utility companies, many of whom are so badly impaired as to need bailouts.
And the failure of regulators to get tough with banks in the post-crisis period is coming home to roost. Nick Corbishley wrote about how Credit Suisse went from being a supposedly savvy risk manage to more wobbly than Deutsche Bank due to getting itself overly-enmeshed in the Archegos “family office” meltdown and then the Greensill “supply chain finance” scam. Archegos demonstrated a lack of regulatory interest in “total return swaps” which in simple terms allow speculators to create highly leveraged equity exposures. Highly leveraged equity exposures was what gave the world the 1929 crash. The very existence of this product shows the degree to which the officialdom has unlearned big and costly lessons.
Oh, and Credit Suisse is looking green around the gills. From a fresh Bloomberg story:
The cost of insuring the firm’s bonds against default climbed about 15% last week to levels not seen since 2009 as the shares touched a new record low. On Friday, Chief Executive Officer Ulrich Koerner reassured staff that the bank has a “strong capital base and liquidity position” and told employees that he will be sending them a regular update until the firm announces a new strategic plan on Oct. 27.
Via arbitrage, CDS spreads influence interest rates on borrowings. So Credit Suisse looks to be close to, if not already in, a funding crisis. Its depressed stock price means it can’t raise equity at a reasonable price to improve its capital position, which would soothe Mr. Market’s rattled nerves.
If the prospect of Credit Suisse going pear shaped in combination with the underlying level of European tsuris doesn’t persuade you that the financial system may soon hit a air pocket, Nick Corbishley last Friday wrote up an unprecedented warning by the European Systemic Risk Board. Key points from his post:
The European Systemic Risk Board (ESRB), an advisory body set up in the wake of the Global Financial Crisis to monitor the macro-prudential risks bubbling below the surface of Europe’s economy, issued a “general warning” yesterday (Sept. 29) about the financial system…. it speaks with the full authority of the EU’s two most powerful institutions, the Commission and the ECB.
Another reason this is important is that central banks are normally the last to admit that a crisis is around the corner. In fact, when they finally sound the alarm, it means the damage is already done and the crisis–which they invariably helped create–is already here….
The ESRB identifies three main risks to financial stability:
First, the deterioration in the macroeconomic outlook combined with the tightening of financing conditions implies a renewed rise in balance sheet stress for non-financial corporations (NFCs) and households, especially in sectors and Member States that are most affected by rapidly increasing energy prices. These developments weigh on the debt-servicing capacity of NFCs and households…
Risks to financial stability stemming from a sharp fall in asset prices remain severe. This has the potential to trigger large mark-to-market losses, which, in turn, may amplify market volatility and cause liquidity strains. In addition, the increase in the level and volatility of energy and commodity prices has generated large margin calls for participants in these markets. This has created liquidity strains for some participants…
The deterioration in macroeconomic prospects weighs on asset quality and the profitability outlook of credit institutions. While the European banking sector as a whole is well capitalised, a pronounced deterioration in the macroeconomic outlook would imply a renewed increase in credit risk at a time when some credit institutions are still in the process of working out COVID-19 pandemic-related asset quality problems. The resilience of credit institutions is also affected by structural factors, including overcapacity, competition from new providers of financial services as well as exposure to cyber and climate risks.
Nick points out that “on the whole is well capitalized” is not as comforting as it seems given walking wounded like Credit Suisse and Deutshe, who could easily knock down other dominoes if they fell. And more generally, Steve Waldman described years back how bank equity can’t be measured:
Sure, “hard” capital and solvency constraints for big banks are better than mealy-mouthed technocratic flexibility. But absent much deeper reforms, totemic leverage restrictions will not meaningfully constrain bank behavior. Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.
To keep the post to a manageable length, we’ll skip over the shaky state of some important sovereign borrowers, notably Italy. The press has been reporting actively on the sterling crisis, where a barmy mini-budget by Liz Truss and Kwarteng amounts to a disastrously-timed gimmie to the wealthy through massive tax cuts that were somehow supposed to generate groaf. As Patrick Lawrence put it:
And what you heard across the Atlantic last week was Liz Truss crashing into reality. There was the Bank of England, raising interest rates at a precipitous clip to tighten money and stave off inflation, when suddenly, on Wednesday, it announced plans to inject ₤65 billion of emergency liquidity back into the system to save Britain from its prime minister. It is what Brits call, a little rudely, a balls-up.
Mind you, EU countries are embarking on similarly misguided policies by subsidizing energy prices on a broad basis. First, this approach will make the underlying shortages worse by subsidizing consumption. Second, this is too costly a policy to be sustained for the long term. Remember this crisis has started before the weather has gotten all that cold and will not end with the arrival of the spring.
That brings us to the deteriorating state of the real economy. It has been remarkable to see how little economic commentary there has been on the impact of the Nord Stream pipeline attacks on Europe. As Doomberg noted:
While few events can compare to 9/11, what transpired on September 26, 2022, will have enormous implications—both economic and humanitarian—and adds an accelerant to a fire that was already dangerously hot.
The only way for Europe out of its winter energy crisis was to open Nord Stream 2. That is now a non-starter. And the loss of Nord Stream 1 will increase the degree of shortfall. Germany is now planning to put off the closure of some of its last operating nuclear plants, but that will help only at the margin.
German business suspensions, which will in many cases will turn into closures, are proceeding at a more rapid pace than even your gloomy blogger had anticipated. Yet the press coverage has been muted, as if there isn’t a multiplier effect of sorts as energy-intensive industrial turn their dials down or off. The loss of ammonia production in particular mean less fertilizer, which means less food in the near future.
Europe’s other industrial power, Italy, may also be facing energy shortages. Gazprom suspended deliveries to Italy due to regulatory changes in Austria which Gazprom claim means it can’t trans-ship gas to Italy. Whether this is a problem that can be hashed out quickly, or if it is Turbines 2.0 is not yet clear. Reuters says Italy’s Eni expects the problem to continue on Monday.
And the U.S. will share the pain to a degree. From OilPrice:
As Europe scrambles to secure LNG supplies, American companies are racing to lend a hand.
With more American LNG flowing to Europe, the United States may be facing increased electricity bills this winter.
OPEC is also expected to announce a production cut this week to boost oil prices.
And we haven’t even factored in Russia deciding (aside from the open question of whether the supply suspension to Italy continues) to turn up the pain dial, say by reducing shipments of uranium or refusing to sell oil to countries that impose a price cap (the G7 idea is still officially on despite looking like a damp squib).
On another supply front, as Lambert has been pointing out, Covid cases are now at a high level, when fall has barely begun. I was on vacation (and am not yet fully back) in Maine and saw virtually no masks despite Maine having far and away the highest test positivity in the U.S. There was plenty of evidence of businesses struggling to cope with Covid-induced labor shortages (and many locals describing that as the cause). So we must rely on the Fed to kill the economy stone cold dead to reduce demand for labor to its current supply.
This recap isn’t complete, but it does give an idea of how many ways things are going disastrously wrong and how the officialdom is either not doing enough, acting as if PR and can-kicking will make problems go away, or making matters worse. And these difficulties are so severe and inter-related I don’t see any way out.
So the only question is when that reality is more fully reflected in asset prices. If I were you, I’d assume the brace position.
1 For those who want to blame “money printing,” monetary experiments under Reagan and Thatcher demonstrated that money supply growth and levels failed to correlate with any macroeconomic variable, including inflation. If “money printing” did produce inflation, Japan would have collapsed under hyperinflation long ago.
And separately, QE is not “money printing.” It is an asset swap. And the effect of QE, as Bernanke pointed out when he first deployed it, is to lower interest rates further out on the yield curve (and in the Bernanke 1.0, to lower mortgage spreads…..which would help resuscitate housing prices). That does have a real economy spending impact, via the so-called wealth effect. But despite the Fed handwaving about that, the real aim was to reduce the damage to the big banks that had large second mortgage exposures, above all Citigroup. In the EU, a major use has been to contain government bond yields of weaker Eurozone countries.
The problem is that the power of central banks is asymmetrical. Sufficiently high and/or rapid increases in interest rates will chill economic activity. But loose monetary policy it tantamount to putting money on sale. Most businesses do not expand because funding is cheap. They expand because they see opportunity. The cost of money can constrain business growth. Easy money mainly favors enterprises where interest payments are one of their biggest expenses: leveraged speculators, real estate, and financial institutions.
By contrast, net fiscal spending (as in budget deficits) beyond what is necessary to create full employment will cause inflation. It creates demand in excess of the ability to satisfy it. The reason that budget deficits actually are generally necessary is that capitalists do not like full employment; it gives labor too much bargaining power and also reduces the status gap between businessmen and their hired hands (see this seminal article by Mikhal Kalecki for more detail).
This propensity of corporations to under-invest (increasing the need for government spending to make up the shortfall) become even more pronounced. Practice and policy since the 1980s in the Angloaphere, and then increasingly the rest of the world, gave even more primacy to the interests of capital over labor. In the U.S., a critical change was Corporate America’s response to LBO artists and the top executives they hired becoming wildly wealthy. That led to the mantra that CEOs needed to be paid like entrepreneurs, even though they are not taking entrepreneurial risk.
Since it is easier and faster to generate profit by cost-cutting rather than investing in new activities, companies became increasingly hollowed out. We wrote in 2005 about how the corporate sector as a whole was net saving, as in slowly liquidating.
When corporations are net saving, another sector has to become a net borrower (ignoring the import-export sector, which with the U.S. running chronic trade deficits, does not change this story). In the runup to the 2008 crisis, it was households that took up the slack. The household sector is normally a net saver (for retirement and emergencies) but in the U.S. in the 2000s before the crisis, the saving level plunged and even in some periods became net borrowing (all those subprime cash-out refis, for instance).
Admittedly, governments polluted by neoliberal ideology have a tendency not to make the best use of deficit spending when they engage in it. Ideally, those expenditures should promote the productive capacity of the economy. Robust social safety nets do so because governments that are fiat currency issuers can provide them more cheaply and without the distortions of a bloated secondary securities trading market/asset management business (studies have found these activities, beyond a not very large level, create a drag on growth). The end result, as Germany demonstrated in its better days, is more competitive labor costs despite First World living standards.
But neoliberals are allergic to industrial policy and engage in it only by default (and to favor cronies). In the U.S., favored sectors include health care, the military/surveillance complex, finance, real estate, and higher education.