Sunday, August 11, 2013

Europe’s New Capital Rules Are Deflationary

“Overall, European banks need to shed €3.2tn in assets by 2018 to comply with Basel III regulations on capital and leverage, according to RBS. Eurozone banks have already shrunk their balance sheets by €2.9tn since May 2012 – by renewing fewer loans, repurchase and derivatives contracts and selling non-core businesses. Deutsche Bank recently said it would seek to cut its assets by about a fifth over the next two and a half years. Barclays, which announced a £5.8bn rights issue last month, said it wants to shrink its balance sheet by £65bn-£80bn.

Europe’s banking sector assets are worth €32tn, or more than three times the single currency zone’s annual gross domestic product.”
--FT, today

What is the #1 problem in Europe today: low growth. How does one stimulate real growth: increase nominal growth. How does one stimulate nominal growth: money growth. How does one stimulate money growth: grow bank credit. How does one grow bank credit: grow bank assets. For the economy to grow, bank balance sheets must grow.

Now, if one wanted to retard growth and create a depression, what would one do? One would require banks to shrink their balance sheets. And that is indeed Europe’s plan. Basel III will require European banks to call in loans, refuse to renew lines, and sell securities in order to raise their capital ratios.

Here is the point: when banks shrink their balance sheets, they shrink their deposits, and when they shrink their deposits, they shrink the money supply. Shrinking the money supply reduces nominal growth. MV = PT. When M declines, so does PT. Europe is planning to shrink its money supply. How Hooverish!

Mine is not a modern insight. It was identified by Fisher eighty years ago. Shrinking bank balance sheets reduce nominal growth. This is orthodox stuff.
So Europe has decided to reduce M2 in the face of deflation and high unemployment.


Stephen Wigmore said...

Yep. The ECB's stance as the most hawkish and conservative of major central banks has been a huge part of the Eurozone's continuing crisis. Crass incompetence on the most massive scale to rival the Federal Reserve in the 1930's.

Vinney said...

"Europe is planning to shrink its money supply. How Hooverish!" Agreed. But the alternatives are intolerable. a. no change leave it as is - ask a Spaniard if that sucks. and b. increase M2 by making more loans - well is not that the conundrum as in 1932? Consumers are already heavily indebted so more debt (M2)is not the answer. HH's need more income/money not more debt/money. Businesses or rich HH's could inject more money from savings/REarnings by making real investments but why would they - their customers are broke or deleveraging.