Monday, August 26, 2019

Evil Taking Root In Europe....Again.

Writer and philosopher George Santayana once pithily warned that "those who cannot remember the past are condemned to repeat it."

With a week of chaotic, contradictory, and occasionally apocalyptic news having gone by, the question arises if the world is approaching a repetition of its recent past--namely, the 2008 "Great Recession." I, for one, do remember that past, having opined on portions of its aftermath, in particular the 2010 Greek debt crisis and subsequent bailout of Greek finances by the European Union and the International Monetary Fund. In particular, I was struck by the hyperfocus that prevailed among "experts" on defending the credibility of the Euro. The single currency was of paramount importance--a conventional wisdom that was questionable at the time, and that was questioned at the time. My own assessment at the time was an exploration of the Biblical admonition that "the love of money is a root of all kinds of evil...."

That I am writing about this topic again is no victory lap, and there is no "I told you so" here. In large measure I misread how Europe would respond to the crisis at the time, believing the stresses being placed upon Greece would eventually rip the European Union asunder. Clearly, that did not happen.

However, I do intend to return to my conclusion at the time:
When at last the money runs out, Europe may find itself so deep in a financial hole that not a single one of the institutions it has built up since WWII will survive intact.  Such is the destruction that comes when the evil that is a love of money and currency takes root on a national scale.
What occasions a return to this failed bit of prognostication is Germany's recent effort to auction some 2 billion euros worth of negative-yield debt. Even before the bond auction there were doubts about the viability of the issue, and it was readily apparent in the aftermath that the auction was a failure, with the Bundesbank being forced to retain some two thirds of the total issue.

As the economy of the EU has steadily weakened over the past year, more and more the European Central Bank, as well as the central banks of the member nations, have increasingly embraced the untested and seemingly counterintuitive notion of "negative interest rates"--where a bank or bond investor literally pays for the privilege of loaning out money. Recently, Danish banks began offering mortgages with a negative interest rate, a move many banks were more or less forced into in order to counter the profit-draining effects of negative yields on other bank assets.

Nor have the European banks been alone in their misfortunes: China has been nationalizing banks of late--three in the past three months, with another 19 banks potentially at or close to the point of insolvency. Even the Federal Reserve is showing signs of vulnerability, openly discussing a new crisis management mechanism whereby they could order banks to increase their reserve cushion should loan losses be anticipated to climb rapidly over the short term.

These banking concerns come amidst a growing list of other warning signals that the global economy is headed into a contractionary phase:
  • US mortgage debt recently reached a level higher than just before the 2008 financial crisis, indicating American consumers may be once again overleveraged.
  • The Germany economy officially contracted during the second quarter of this year. Two successive quarters of contraction is the technical definition for a recession.
  • The Chinese manufacturing sector has been contracting of late, indicating the second largest economy in the world is on the verge of its first recession in decades.
  • The yield curves between US 2-year and 10-year debt "inverted", with the 2 year debt having higher yields than the 10-year debt. Intriguingly, the inversion, which has been associated with pending recessions in the past, occurred at the same time jobs data and other economic indicators were positive, suggesting the financial economy of Wall Street is becoming decoupled from the overall economy of Main Street, at least in the United States.
  • The illiquid state of sovereign debt markets was laid bare by turmoil in Argentina, where unexpected election returns presage a premature end to austerity and economic recovery measure, imperiling their sovereign debt. Argentine debt is not the only one with a marked imbalance between the number of buyers and the number of sellers, indicating a small and rather anemic secondary market for sovereign debt.
  • So parlous is the state of sovereign debt markets that PIMCO, a leading global investor in bonds, began exiting sovereign debt markets, effectively being the first large investor to "run for the exits"--which if it becomes a trend, would spark a fire sale and collapse sovereign debt markets worldwide.
Nor is this the full listing of economic red flags and warning signals. However, even this partial list makes one thing abundantly clear: debt markets are heading into rough territory, and the European markets are on the leading edge. Economic weakness and contraction is sparking concerns over several nations' debts.

Which brings me back to my thoughts of nine years ago on Greece. Then, as now, there was a focus on currency, on how to stimulate the global economy though interest rate cutting--i.e., driving interest rates even further into the negative range--monetary stimulus, and "quantitative easing", where central banks attempt to inject arbitrary inflation into the economy by the electronic equivalent of burning money. Money is occupying the center of the economic stage. Money and currency are where people's concerns appear to chiefly reside.

And the focus on money is not working very well. In fact, the focus on money is not working at all. The "love of money"--for what else should we call this global obsession with the intricacies of money and currency?--is truly the root of a number of evils.

Perhaps the most pernicious evil this love of money has spawned has been an illusion (or delusion) of economic growth and recovery after 2008.  In a very real and substantive way, the world's economies never truly recovered after the 2008 "Great Recession." An inordinate focus on monetary policies and less on the fundamentals of economic activity--the buying and selling of physical goods and services--is a large part of the reason for the lack of substantive recovery. In the wake of the credit crisis that precipitated the Great Recession, the world's leading central banks engaged in wholesale quantitative easing and monetary stimulus in an effort to reflate a rapidly deflating world economy.  These were ostensibly emergency measures, undertaken with the implicit understanding that the banks' respective governments would step in with fiscal stimulus spending programs to shoulder the long term burden of restarting the world's economic engines. That fiscal stimulus never happened, and the central banks have been trapped having to cover the dangerously reckless bets quantitative easing represented. The belief that money could save the world from economic ruin in 2008 has led the world perhaps to the precipice of an even more devastating economic ruin in 2019, or perhaps in 2020.

To add insult to injury, most of the central bankers have always known the risk. They have always been aware they sacrificed their traditional mechanism of monetary stimulus, the manipulation of interest rates, by dropping interest rate to zero and holding them there, instead of following the traditional path of incrementally increasing them over the expansionist phase of the economic cycle, in order to have the buffer for interest rate cuts during the next contractionary phase. The central bankers have always known there would be a next contractionary phase. We know they have known because economist Larry Summers admitted as much this past week in advance of the Federal Reserve's annual symposium at Jackson Hole, Wyoming.

According to Larry Summers, not only have the central bankers failed to "rearm" after the Great Recession, but their dropping of interest rates to zero and quantitative easing programs quite possibly made the underlying economic situation worse rather than better. Not only did too much focus on money catalyze the financial crisis that became the Great Recession, too much faith in money has only made matters worse since then.

If Summers is correct in his analysis, then not only are central bankers powerless to head off the next recession, but they may very well have set the stage for a financial and possibly economic collapse larger than what was experienced during the Great Recession.

What could central bankers have done differently? What should they do differently now? If we take as a point of departure the Biblical admonition against the love of money, where does that leave monetary and fiscal policies when economies contract, or when a financial shock such as the 2008 crisis hits?

One answer would be to focus efforts on encouraging and fostering real economic activity. Economies grow when there is a demand for physical goods and services, and when there are physical goods and services to meet that demand. Indeed, as we are seeing currently, this real economic activity at least in the United States appear to be in more or less rude health, creating jobs and increasing wages. The real economy continues to grow despite the recessionary warning signals being generated in financial markets. The real economy of Main Street is more or less functional, while the financial economy of Wall Street is increasingly dysfunctional, and will remain so until its focus is oriented back towards what the real economy of Main Street.

If we follow that hypothesis, then the productive policy for central banks would have been to maintain a more or less stable supply of money. If there is a useful purpose to the central bank it would be to ensure there money supply remains stable, and thus overall pricing levels remain stable. Indeed, this is the stated role of the Federal Reserve, as I pointed out last December when the Federal Reserve's interest rate hikes precipitated a steep decline in the US stock markets, and the interest rate manipulations of the Federal Reserve are arguably a violation of their own directive, their own raison d'etre. 

Far from worrying about raising interest rates, lowering rates, or providing monetary stimulus or quantitative easing, the European Central Bank and its counterpart in the Bank of England should be committed to maintaining a constant interest rate and a stable money supply, and allow the price discovery mechanism of a functioning free market to direct flows of capital to such industries as were best positioned to use it to expand and increase the production of physical goods and services in order to service demand. Perversely, instead of endless technical convolutions regarding interest rates and their impact on money and prices, the basic "Economics 101" approach is how a central bank might best discharge its duty as chief steward of the money supply. Instead of attempting to fix what they have arguably broken, the central banks of the world should stand back and allow the economies of the world to heal on their own.

This might be what should be done, but it is not what will be done. For all the talk in some corners of the independence of central banks, the unalterable truth is they are as susceptible to political pressures as any other governmental agency. For all their supposed wisdom, central bankers persistently fail to apply the simple wisdom of 1 Timothy; the pressures to act are too great.

Thus I am left to restate my broad conclusion from nine years ago. When at last the money runs out, Europe may find itself so deep in a financial hole that not a single one of the institutions it has built up since WWII will survive intact.  Such is the destruction that comes when the evil that is a love of money and currency takes root on a national scale. 

Whether this is the time for the money to run out at last or not is a tale still to be told. It is possible that Europe will yet muddle through this coming recession and emerge in much the same state that it is now. It is possible that negative interest rates and quantitative easing of the euro will resuscitate the European economies just enough to stave off the recession that now looms large on the continent.

Yet it is also possible that, this time, these efforts will fail. It is possible that the negative interest rates now being pushed across Europe will overwhelm the capacities of European banks to absorb the stress. It is possible that, far from resuscitating the European economies, attempts at monetary stimulus will bring the banking system crashing down in Europe, and trigger not just a recession but a deflationary depression that will last for an untold number of years. It is possible that we shall discover, to our collective horror, that the coming recession is but a continuation of 2008, that much of the presumed "recovery" from then until now has been illusory. 

If that proves to be the case, then the money will run out at last, and what must follow will pierce Europe with many long lasting economic and political sorrows. Such is the outcome when the love of money overrides better natures and better judgments.





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