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Wednesday, April 8, 2015

The Weak Economic Data Is Bullish For Stocks


  • The economic outlook is bleak.
  • Bond yields are likely to fall.
  • Falling bond yields are bullish for equities.

The recent economic telemetry suggests weakness:
> The Atlanta Fed forecasts 0.1% growth for 1Q15.
> The PPI is negative and core inflation is zero.
> The CRB index is down 30% since July.
> Five-year expected inflation is 1.6%.
> The real funds rate has risen from -4% to 0% (per St Louis Fed).
> Employment growth is slowing and participation continues to decline.

We are seeing the result of the premature withdrawal of fiscal and monetary stimulus in the face of a fragile recovery. Fiscal policy has been tightening for five years, and monetary policy has been tightening since 2012 (as measured by money growth). The credit aggregates have stopped shrinking but household credit has not resumed growth. The credit markets are still suffering from PTSD. Restrictive policy is the wrong medicine for this malady.

The data says to me that we are looking at negative shocks to inflation and the bond market which will push the 10-year yield back down to the 1.5% neighborhood. It has already fallen from 3% at the beginning of last year to 1.9% today. It has plenty of room to go lower: it fell as low as 1.4% in mid-2012.

Generally speaking, falling bond yields are bullish for equity valuations because (1) they lower the discount rate for future cashflows; (2) they drive investors out of bonds; and (3) they raise the equity risk premium. Since the Crash, the 10-year yield has fallen from 3.5% to 1.9%, or by 45%, while over the same period the Wilshire US Large-Cap Total Market Index has risen from 17,000 to 60,000.
The equity risk premium (ERP) measures the difference between the long-term risk-free rate and the expected return from equities over a similar horizon. Damodaran at NYU uses 8% as the expected return from equities and the 10-year yield as the risk-free rate. The historical return from equities has been volatile and the choice of time period will produce different results. For example, the total equity return since the Crash has been 21% per annum. It is important to remember that the return from equities is price appreciation plus dividends. This is why the total return indices outperform price indices.
Damodaran calculates today’s ERP at 5.5%, which is mid-range for the post-Crash period but quite high for prior periods going back to 1961.
Because the expected return from equities has been set at 8%, changes in the ERP reflect changes in Treasury yields: lower yields = a higher ERP. Therefore the risk to equity valuations is not fluctuations in earnings, dividends or even prices; the risk is higher bond yields. To decide whether stocks are currently cheap requires the investor to make a judgement about future bond yields. When I look at the data dashboard today, I see many things that suggest lower yields and only a few things that suggest higher yields (falling unemployment and rising employment costs). Therefore, I believe that stocks remain attractive and should go higher in the event that economic weakness results in lower bond yields.

Monday, January 12, 2015

The Yellen Bond Bubble


  • Bond yields are dangerously low.
  • Prices are falling and inflation expectations have become unanchored.
  • The Fed will have to act, and bond prices will have to fall.
  • Stocks are more remunerative than bonds right now.

Bond prices have soared and bond yields have declined by one-third since Janet Yellen became Fed chairman. Over the past six months, five-year expected inflation has declined from 2% (the Fed’s target) to 1.2%, a decline of 40%, and far below the Fed’s target. The Fed’s inflation target has lost credibility in the bond market.

In 1933, Irving Fisher wrote about deflation risk: “The more the economic boat tips, the more it tends to tip.” On the same topic, Ben Bernanke said that “the best way to get out of trouble is not to get into it in the first place”. In other words, deflation is much easier to prevent than to correct, as the ECB is learning at this very moment.

One of the Fed’s stated goals is to anchor expected inflation so as to avoid inflationary or deflationary pressures from building. Something happened in 2014 which caused inflation expectations to become unanchored, perhaps the premature taper of QE or the constant talk of a rate hike. It doesn’t really matter what caused expectations to become unanchored, because inflation expectations are the Fed’s job to manage, not an exogenous variable to be lamented. Deflation is a currency-specific monetary problem, and there is no such thing as “global deflationary pressure”. The Fed’s failure to anchor inflation expectations has created a big bond bubble that will need to be popped.

It is difficult to argue that the bubble won’t ever be popped because there is a “new normal” of low everything. The only way that we can have such a new normal is if the Fed were to permanently abandon its inflation target. Assuming it doesn’t do that, assuming that at some point it moves to raise inflation and expectations, the bubble will burst. We can’t live forever with five-year Treasuries yielding 50 bips less than the Fed’s inflation target.

I have just argued that the Fed will have to act in order to raise both expected inflation and bond yields. But please note that the bond market strongly disagrees with me: it has made it clear that it does not expect the Fed to do anything. If it agreed with me, we wouldn’t be seeing these frightening numbers.

Nonetheless, it is quite likely that, at some point this year, the FOMC will wake up and notice that things are slipping out of control, and will be forced to  take decisive action to raise expected inflation. For example, it could eliminate interest on excess reserves and launch an open-ended QE. If such a policy proved successful, bond prices would fall substantially (and deflation risk would be banished).

The do-nothing option is not really viable, because we are already seeing signs of deflation. Commodity and producer prices are falling, as is headline inflation (both CPI and PCE). How much of this is the transitory effect of falling oil prices and how much is a deeper phenomenon is not yet clear. But the fact that hourly wage rates are falling suggests that this problem may go deeper than the oil situation. The price of oil has declined many times before without causing general deflation (aside from the Crash which was about a lot more than oil prices).

Investment Conclusion

When bond yields are below the Fed’s inflation target, I think bond prices have entered risky terrain. The current low yields make stocks a better investment alternative (with expected total return around 7-8%), but stock prices are also vulnerable to higher bond yields, because higher yields compress the equity premium. Nonetheless, I feel safer being overweight equities and underweight longer-dated bonds. Stocks are an investment which will over time reward you with cashflow irrespective of subsequent price movements. Don’t buy for appreciation, buy for total return. Note that the market’s current dividend yield is higher than the 5-year bond yield, and about the same as the 10-year.

Tuesday, January 6, 2015

Janet Yellen’s Failure As Fed Chairman


  • The markets are signalling deflation risk.
  • The Fed’s 2% inflation target is no longer credible.
  • The Fed must reverse course and resume effective monetary stimulus.
  • The outlook for stocks and bonds remain bullish, with stocks being particularly attractive.


The ongoing decline in inflation, expected inflation and bond yields provides clear evidence of the failure of Janet Yellen’s chairmanship of the Federal Reserve. When she became chairman one year ago, the 10 year yield was 3%; today it is 1.9%, a decline of 37%. Ten year expected inflation was 2.3% (above the Fed’s 2% target); today it is 1.6%, far below the Fed’s inflation target. Under Yellen’s leadership the Fed’s inflation target has lost credibility in the bond market, which now believes that the rate of inflation will remain below target for the next decade.


A brief glance at prices:


I don’t care what Yellen thinks about economics, just as I didn’t care what Bernanke thought. I care about the seriousness of the FOMC’s commitment to meeting its 2% inflation target, and to anchor expected inflation at 2% or above as stated in its Policy Statement of January 2014: “The Commit­tee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. Communicating this infla­tion goal clearly to the public helps keep longer-term inflation expectations firmly an­chored.” Clearly this target is not being met, at great danger to the economy’s long-term growth trajectory.
As I have written before, the problem with the leadership of Bernanke and Yellen is their excessive emphasis on consensus with a minimum level of dissenters. By reaching for consensus, they have given the Austrians an effective veto over unconventional policy. And conventional policy hasn’t worked.


There are two ways to fix this problem. One is to be like Greenspan and be autocratic. The other is to be like the Chief Justice and go for a simple majority, allowing the dissenters to dissent. Yes, there are drawbacks to both approaches, but the job of Fed chair is not popularity but policy success, which Yellen is not achieving. She is risking the Japanification of the US economy: a permanently stalled economy operating far below its potential growth rate.


The FOMC blathers on about its data-dependency, which is not true. In fact, the FOMC is path-dependent, because path stability supposedly lends to greater credibility. It is time that the committee wakes up and becomes data-dependent, which will require a 180 degree change in course. When the dashboard is flashing “DEFLATION”, it is not the time to tighten policy or to threaten to tighten it. Admit the truth: QE was ended prematurely, and the talk of a rate rise in 2015 was reckless.


To reverse the steady decline in inflation expectations will require a program of shock-and-awe that would convince the market that the Fed will do whatever it takes to restore inflation expectations to a level above 2%. Such a policy should include:

  1. An inflation target of 3% to be maintained until inflation expectations rise to the desired level.
  2. A statement by the committee that until inflation expectations return to the desired level, below-target unemployment and “overheating” will not be a concern (just as above-target unemployment is not a concern when inflation is too high).
  3. A zero remuneration rate on excess reserves, and the explicit possibility of a negative rate.
  4. A resumption of asset purchases at a monthly rate of $100 billion to be continued until expected inflation exceeds 2% at both the 5 and 10 year horizons. (Five year expected inflation is now 1.4%.)
  5. A wider range of policy instruments to include a trade-weighted basket of foreign government bonds, gold, silver and ETFs.
  6. A personal commitment from the chairman to raise inflation expectations, with the implicit threat of resignation if outvoted.
  7. Continuation of the ZIRP until the above goals are achieved.


I think that such a program of shock-and-awe would raise inflation, expected inflation and bond yields. If it proved insufficient, more should be done with respect to both the scale of asset purchases and the variety of policy instruments. The point is to do what it takes, not just to “do something” and then throw up your hands as Draghi has done.


Unfortunately, the likelihood of the FOMC adopting a policy along the lines suggested above is very low. As the Fed’s credibility continues to fall, the reversibility of the decline in expectations becomes increasingly difficult, as Japan has shown since the introduction of QE, and as Bernanke warned in his famous Helicopter Speech. I am worried about the US following Japan and Europe down the road of a Fisherian problem.


Investment Implications
Bonds: Deflation is bullish for bonds, as we have seen, with bonds having outperformed every asset class in 2014. Given my outlook for inflation, and given bond yields in Japan and Europe, US bond yields still have a long way to fall.


Stocks: The decline in the risk-free rate, ceteris paribus, widens the equity risk premium and makes stocks more attractive than alternative investments (bonds, cash, metals). It is undeniable that falling commodity prices will hurt the reported earnings of commodity producers such as oil & gas. I expect to see a lot of noncash impairment charges in the 4th quarter due to the writedown of intangibles, which may depress reported earnings (but not cashflow).


However, I don’t see the risk of a material decline in the long-term expected return from US equities which should remain where it has been for the past fifteen years at around 8% (even during the Crash). Thus, the risk free rate will decline while the expected equity return should not. A decline into an uncontrolled deflationary spiral would be devastating for stock prices, as we saw in the early thirties, in Japan and soon in Europe, but even this do-nothing Fed would step in to prevent that. There are no Germans on the FOMC.


While I expect bond yields to fall further, I feel safer being in an instrument with an 8% expected return rather than one with a fixed coupon of a negligible amount. It is worth noting that the current dividend yield of the S&P 500 exceeds the yield for both the five and ten year T-bonds. We saw this briefly post-Crash, but the last time prior to that was 1956, a very good time to buy stocks assuming a long investment-horizon.


Saturday, December 13, 2014

To My Readers

I am currently publishing my commentary at Seeking Alpha. Here is the link:
http://seekingalpha.com/author/christopher-mahoney/articles



Monday, December 8, 2014

Barry, Just Barry, and Nothing But Barry

"I have little interest in streamlining government or in making it more efficient, for I mean to reduce its size. I do not undertake to promote welfare, for I propose to extend freedom. My aim is not to pass laws, but to repeal them. It is not to inaugurate new programs, but to cancel old ones that do violence to the Constitution, or that have failed their purpose, or that impose on the people an unwarranted financial burden. I will not attempt to discover whether legislation is ‘needed’ before I have first determined whether it is constitutionally permissible. And if I should later be attacked for neglecting my constituents' interests, I shall reply that I was informed that their main interest is liberty and that in that cause I am doing the very best I can" 
-- Barry Goldwater, 1960.

Tuesday, November 18, 2014

The Senate Blue Dogs

The 14 Blue Dogs who voted for the Keystone Pipeline against Harry Reid and Obama. How many of them will become "independents" in January?
Alaska Sen. Mark Begich 
Arkansas Sen. Mark Pryor
Indiana Sen. Joe Donnelly, 
Missouri Sen. Claire McCaskill 
Montana Sen. Jon Tester
Montana Sen. John Walsh
North Carolina Sen. Kay Hagan
North Dakota Sen. Heidi Heitkamp
Virginia Sen. Mark Warner
West Virginia Sen. Joe Manchin
Colorado Sen. Michael Bennet
Delaware Sen. Tom Carper
Pennsylvania Sen. Bob Casey
Louisiana Sen. Mary Landrieu

Friday, October 17, 2014

The Fed’s Inflation Target Is Losing Credibility

[Published at Seeking Alpha on Oct. 13, 2014]


  • The Fed has been missing its inflation target for over two years.
  • Both bond yields and expected inflation have been falling.
  • Given Yellen’s weak leadership, the prospects for reflation are dim.
  • The equity premium is rising.

This is how the FOMC describes its mandate with respect to inflation:
“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Commit­tee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal con­sumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

However the Fed has failed to achieve the 2% target for the past two and a half years despite what it believes has been “massive monetary stimulus”. The most recent reading of the targeted inflation rate is 1.5%, which is 25% below the 2% target. The consistent failure to achieve the inflation target is eroding the Fed’s credibility and is lowering inflation expectations thus raising the real funds rate which is contractionary. The Fed is tightening in the face of a weak recovery.

So far this year, the 10-year Treasury yield has declined by 70 bips from 3.0% to 2.3% while 10-year expected inflation has declined by 30 bips from 2.3% to 2.0%.

The reason that the Fed has failed to hit its target is the combination of single-digit money growth and declining velocity. The economy is in a classic Keynesian liquidity trap which requires radical policy measures. Because both Bernanke and Yellen decided to give the hawks a veto over policy, radical measures are off the table and the Fed is heading in a decidedly European direction. Ten-year German bunds currently yield less than 1% which suggests that Treasury yields may have further to fall.

It is noteworthy that as bond yields have been declining, equity yields (e/p) are rising as the market has recently declined. Thus the equity premium is both high and rising. This would be an excellent juncture to take profits from longer-term bonds and buy equities with the proceeds. While bond prices may rise further, equities are much more compelling given the current ~5.5% risk premium.

The Selloff Is Noise; Do Nothing


  • The market’s price swings are normal and within historic range.
  • Value is unrelated to price, and is rising.
  • Do nothing now, but keep an eye out for deflation risk.

There is nothing happening in the equity market these days that should matter to a buy-and-hold investor. If you’re a day-trader or a chartist, that’s different. But if you have your saving invested in the broad market, nothing is going on and you should do nothing.

The history of the post-Crash bull market is a history of steady price appreciation periodically interrupted by volatility. There have been many selloffs since March 2009, all of which were corrected. There were big selloffs in 2010, 2011, and 2012. This year, we have had slumps in January, April and July. Now we are having another one. The bottom of the January-February slump was 15400 (DJIA), while today’s price (10/15) is ~15,900.

Price fluctuations do not matter for the buy-and-hold investor, because the intrinsic value of a stock is independent of its price. Notwithstanding the EMH, the market’s price often deviates from its value--sometimes for very long periods, such as the fifties when it was underpriced and the sixties when it was overpriced.

Today the market is either fairly valued or is in value territory, depending upon how one evaluates the data. The CAPE says it is overvalued, but it has been saying that since the Crash. If you followed the CAPE, you would have missed the 9000 point run-up in the Dow over the past five years. Today’s high multiples reflect the very low yields on offer in the bond market. Year-to-date, bond yields have declined by one-third from 3% to 2%, while expected equity returns remain around 8%.

The ERP is a much better valuation index than the CAPE, and it continues to flash somewhere between “fairly valued” and “under valued”. At present, Damodaran’s ERP is around 5.5% (and rising), which is roughly the mean value for the post-Crash period. It’s been higher and it’s been lower, but it is not low. It was lower before the Crash, and was 2% in 1999 at the height of the tech bubble. I would worry if the ERP fell to 4% or below.

What is happening in the market now is mainly noise, assuming that the Fed can muster the will to prevent deflation or near-deflation. On that assumption, we are seeing a rising equity premium as the earnings yield rises and bond yields fall. That suggests doing nothing.

Fedwatch
The number to watch is PCE inflation which needs to stay where it is (1.5%) or to go higher. Should it fall below 1%, the forces of deflation might become too strong for the Fed to correct, given its feckless leadership and hawkish consensus. The declines in gold, oil and commodity prices are worrying. The ball is squarely in the Fed’s court to take action to prevent deflation. (I discussed this problem in a recent article.)
___________________________________________________________
Glossary
EMH: the efficient market hypothesis that says that equity prices correctly discount all available information.
CAPE: the cyclically-adjusted price earnings ratio calculated by Robert Shiller at Yale, which uses ten years of inflation-adjusted earnings instead of the trailing 12 months.

ERP: the equity risk premium, which measures the difference between expected equity returns and bond yields. This measure is calculated by Aswath Damodaran at NYU.

Tuesday, October 7, 2014

Venezuela On The Brink

The looming collapse of the Venezuelan economy provides an interesting case study. While many aspects of its crisis are typical in Latin American balance of payments crises (such as large fiscal deficits financed in foreign currency), there are other aspects that are peculiar to Venezuela.


The principal peculiar feature is that Venezuela (unlike all other Latin American economies) makes nothing and imports everything. The only export and the only source of government revenue is oil. The price of oil fluctuates, and oil production has been declining despite large reserves. If Venezuela were a capitalist country following orthodox policies, it could adjust to current account imbalances via the price mechanism: as oil revenue fell, the currency would depreciate and imports would be reduced by rising prices. In extremis, the currency could fall far enough that non-oil exports would develop and import-substitution would occur.


However, markets do not function in Venezuela. It is a socialist economy with a fixed exchange rate and domestic price controls and subsidies. The currency cannot depreciate, and hence demand is managed by rationing and shortages. An orthodox economist would prescribe a steady pace of currency depreciation and steadily rising domestic prices. However, the Chavista regime was elected by and is supported by the poor who depend upon cheap imported staples and cheap domestic gasoline. The regime has been unable to adopt a conventional adjustment program and is instead heading toward a classic--and potentially catastrophic--foreign exchange crisis.


Venezuela’s liquid dollar reserves are extremely low and its access to the international debt market is limited to concessional loans from China and/or Russia. The bolivar has fallen to one US cent on the black market, versus the official rate of sixteen cents.


Moody’s assigns a rating of Caa1 to Venezuela’s dollar bonds, which means that they are at risk of default. On September 15th, Moody’s said that the Caa1 rating “reflects increasingly unsustainable macroeconomic conditions, including high inflation and multiple exchange rate regimes. As government policies have exacerbated these problems, the risk of an economic and financial collapse has greatly increased….Despite the government's relatively small external financing requirements, rising government liquidity risk reflects the deterioration of market access and elevated borrowing costs on Venezuela's external debt. Foreign exchange reserves have fallen to very low levels”.


So it would appear that the central scenario for Venezuela would be the exhaustion of foreign exchange reserves, default on external debt, collapse of the currency, and substantially higher real domestic prices. The ability of the government to provide its people with subsidized staples would be greatly curtailed, with potentially dire consequences for political stability.


With respect to the prospects for external support, the standard IMF/World Bank adjustment package seems unlikely given the kind of policy changes that would be required. Additional loans from China and/or Russia could postpone the crisis further, but would not resolve it. The underlying problem can only be addressed via severe domestic austerity, which would have undesired political consequences.


The regime has imported many Cuban officials to staff its security services, and it has been moving steadily in the direction of overt dictatorship. Opposition politicians have been jailed and the press is under siege. But it is unclear to me whether the state of affairs is such that the regime could survive an economic collapse in the way that the Castro family has. It should also be pointed out that Venezuela supplies Cuba with the cheap oil on which it depends for survival. That supply could be jeopardized if it meant subsidizing Cubans at the expense of the Venezuelan masses. Thus, a Venezuelan crisis would likely be followed by a Cuban crisis, which is a further reason why there will be no IMF bailout since the US would welcome regime change in both countries.

Tuesday, September 30, 2014

The Coming European Depression

[Published by International Banker on July 9, 2014]

Over the past five years, there has been a profound shift in the transatlantic bank regulatory regime. Following the 2008 crash, insolvent banks were recapitalized by governments, and bondholders and uninsured depositors were fully protected from credit losses. Indeed, a very large number of major banks in the US and Europe were rescued and recapitalized by governments during this period, at no loss to their creditors or depositors.                          
Subsequent to these unpopular bailouts, financial policy has shifted from protecting bank creditors to exposing them to loss in the event of a capital shortfall. This is variously called “private sector involvement”, “stakeholder bail-ins”, and “market discipline”.
The rationale for this shift is that taxpayer funds should not be spent to protect bondholders and depositors, that creditors should take losses prior to governments, and that creditors should “do their homework” before investing in a bank’s liabilities. This new policy is seen as fair and prudent, and it is expected to lead to better policy outcomes in future banking crises.
Going forward, bank creditors will be expected to discriminate between strong and weak banks on the basis of their external financial reporting. This concept extends even to uninsured retail depositors such as those that were wiped out in the Cyprus banking crisis.
The policy architecture of market discipline rests upon four fallacious assumptions: (1) bank creditors are skilled in bank credit analysis; (2) bank financial reporting is sufficiently transparent to enable creditors to discriminate between solvent and insolvent banks; (3) the default of a large bank upon its liabilities will not create contagion and a general bank run; and (4) a flight to quality would not impact the real economy.
Each of these assumptions is erroneous: few bank creditors or depositors know much about bank credit analysis; bank financial reporting bears little relationship to bank solvency; a major bank default will likely result in runs on other banks perceived as weak or illiquid; and banking crises have macroeconomic ramifications–deflation and depression.
Creditors Know Little About Bank Credit Analysis
The foundation of bank credit analysis consists in the entering the reported financial data of a banking peer group (e.g., Irish banks) into a multi year database on a comparable basis, and then calculating ratios to enable comparison across banks and across time periods. This, by itself, is a monumental and labor-intensive task, and is generally performed by data vendors on a subscription basis.
Retail depositors have no access to these databases, and would not know how to use them if they did. There are credit rating agencies who perform their own bank credit analysis and offer credit opinions, but are the rating agencies supposed to be the foundation upon which rests future financial and macroeconomic stability? Do the authorities really intend to outsource financial and economic stability to the credit rating agencies? If not, then bank creditors and uninsured depositors will face a very steep learning curve indeed, and are likely to make serious mistakes.
Bank Accounting And Bank Solvency Are Often Unrelated
Banks typically report good profits and strong capital ratios prior to rescue or failure. An analysis of the financial reporting of failed or rescued banks will reveal that almost all of them were reportedly profitable and solvent before they failed. This is for two reasons: (1) failing banks generally accrue interest on bad loans, recognizing this fictitious interest as income; and (2) such banks generally hide their bad loans and do not create remotely adequate loss provisions prior to their recaps (see: Bankia, Banca MPS, WestLB, Depfa, RBS, Anglo-Irish, BofA, Citi, etc.).
This is why, when a bank fails and has to be resolved, the cost of resolution will typically reveal an insolvency much deeper than ever suggested in its public financial statements. Often the insolvency is a multiple of the bank’s reported capital; the difference between 6% and 8% capital under such circumstances is irrelevant. Speaking from my personal experience, the single best source of information about bank solvency is market rumor–because that’s generally all there is besides the official lies.
Uncontained Bank Failures Create Contagion
When a major bank is allowed to default upon its liabilities, the market reacts by withdrawing credit from banks with a similar profile. This phenomenon occurred most recently in 2008, when the bankruptcy of Lehman Brothers Holdings lead to a withdrawal of credit from the other Wall Street banks, which necessitated the TARP bailout and the extension of extraordinary credit from the Fed. In a banking crisis, the mutual withdrawal of credit tends to be indiscriminate and fear-driven. The idea that, in the midst of a financial crisis, participants will choose to make fine distinctions between banks is not borne out by historical experience. In a flight to quality, many dominoes will totter. If one weak bank defaults, the market will attack the rest of the herd.
Banking Crises Have Macroeconomic Ramifications
Banking crises affect the macroeconomy in two crucial ways: credit contraction and monetary contraction. Following the shocks of the Lehman and Greek crises, credit contracted in both Europe and the US in what is characterized as a “Minsky Moment”. Prior to the shocks, credit growth was strong; after the shocks credit growth turned negative (credit growth did not merely decline; the credit aggregates contracted). Borrowers who were considered bankable before the shock instantly became unbankable afterwards. The desire of creditors to call in their loans during a crisis has immediate implications for confidence and growth because forced asset liquidations are deflationary. Economies cannot grow when credit is contracting. The “healing process” is in fact a prolonged disease.
Secondly, banking crises interfere with the efforts of the authorities to maintain adequate money growth as banks seek to shrink their balance sheets. Unless heroic measures are taken by the authorities to force money into the system, the money supply will contract along with the banking system, thus unleashing powerful deflationary forces. We saw this briefly in the US in 2009, and we are seeing such a deflationary spiral today in southern Europe, where money growth, inflation and economic growth are all near or below zero–and this is without any major bank failures so far.
The Coming European Depression
We are now awaiting the results of the ECB’s asset quality review of the largest banks in the Eurozone which, if it is honest, will reveal large unrealized loan losses at many banks, and not just in the Club Med countries. In some cases, it is likely that these banks will be unable to raise sufficient additional equity to restore their solvency, thus creating the preconditions for a bail-in, whereby creditors would be required to transform their debt claims into equity. Should the bail-in policy result in major debt defaults, the consequences will be highly contractionary no matter what the ECB does.
The European authorities have created a lethal policy brew, imposing deflationary monetary policies while withdrawing the financial safety net, repeating the American experiment of 1930-33. As Irving Fisher wrote in 1933:
“Unless some counteracting cause comes along to prevent the fall in the price level, a depression tends to continue, going deeper, in a vicious spiral, for many years. There is no tendency of the boat to stop tipping until it has capsized. Only after almost universal bankruptcy will the indebtedness cease to grow. This is the so-called natural way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.” (The Debt-Deflation Theory Of Great Depressions)
There are two ways that Europe’s banking problems can be resolved: by default or by inflation. Inflation is regarded as sinful and “the easy way out”. Why take the easy way out when depression is so much more painful? Europe has chosen the path of default, deflation and depression, and in the process will relearn the lessons that Professor Fisher identified over eighty years ago.