Breaking a Circular Problem

9^th October 2011

The Malta Independent on Sunday

Finally push has come to shove! As the Italians say: “Il nodo è arrivato al pettine”.

The financial crisis of 2008 and consequential recession was (is) not a normal recession – it was a balance sheet recession, not a cyclical one. In a cyclical recession, the financial sector remains strong and acts as the transmission mechanism for fiscal and monetary stimuli to pump prime the economy back to health.

This time, it is the financial sector that has caused the recession. Banks lost their capital through bad investments in overpriced property and property-related financial assets and, following the Lehman Bros. collapse, the US and UK governments had to intervene to recapitalise their banks to keep them afloat. The European Central Bank (ECB) is having to provide unlimited liquidity to EU banks to replace sources of wholesale inter-bank funding which are drying up.

After an initial stabilisation and some sort of recovery between mid-2009 and early 2011, it became evident that rather than having been resolved, the financial problem was transferred from the banks to the sovereigns. Governments had to incur huge debt burdens to support banks at the same time as fiscal revenues were experiencing severe reductions, resulting from reduced economic activities: lower taxable profits by banks and less revenue from property sales, as the real estate market collapsed.

Unable or wary of taking on more debt, the expiry of government stimuli support showed that, without such support, the economy started to stutter. This happened at a time when banks were coming under renewed stress due to ‘hidden losses’ on their balance sheets caused by their investments in government bonds, formerly considered “gilt-edged” but now turning doubtful as governments are having difficulty managing their debts.

So we now have a circular problem. Banks came under stress because of bad investments in property and property-related investment products. Governments came under stress when they had to save their banks. Banks came under stress again when the value of their government bonds turned doubtful.

Unless we break this vicious circle, the world will fall into a depression the like of which we have not seen in post-war history. And unless we break this circle, the Ricardian/Austrian economic school – which brought us to the source problem in the first place, with their laissez-faire policies of no, or light touch, regulation of banks and financial institutions – will be having both the first and the last laugh. They will have proved that government intervention has been ineffective in avoiding the recession and a great deal of resources would have been saved, had the market been allowed to bankrupt errant banks and errant investors.

In the eye of the storm there is the euro area. The recession has exposed the design flaws in the euro structure. Countries in depression are locked into a monetary union with a currency that is hugely overvalued for their domestic realities and consequently forced to go for internal devaluation (reductions in wages and entitlements) by austerity bone-shaking measures which, in their immediate impact, tend to crush the economy rather than strengthen it.

I sometimes wonder whether these design flaws were purposely meant to arrive at the point of crisis that we are at today. At times of acute crisis such as the present, the unthinkable becomes the choice of the lesser evil. Formerly, no go areas such as fiscal union, eurobonds, economic government and the like, which transfer a huge slice of sovereignty from individual states to a central government dominated by Germany and France, suddenly become not only possible but, for some countries in acute despair, a welcome solution.

Be what it is, the circular problem must be broken. Until we have restored health to EU banks, credit will not flow where it is needed for economic growth, and without an effective transmission mechanism, policy measures – be they monetary or fiscal – will prove ineffective. This means that banks have to be cleaned up. They have to market all their holdings of sovereign bonds and if that leaves them short of capital, they will have to be recapitalised. Once banks have enough capital, and once the value of their assets is no longer under suspicion by the market, then they can start being banks again, taking money from depositors and lending it to borrowers whose investments will help the economy grow sustainably.

Most EU governments have been hiding away from the inescapable need to recapitalise their banks by fooling themselves that they can restore confidence in the system by fiat rather than by sensible decisive measures. Isn’t it funny how, when she was the French Finance Minister, Mme Lagarde always insisted that French banks were generously capitalised and then no sooner had she put on her hat as managing director of the IMF, she changed course, stressing that it was imperative for European banks to be adequately recapitalised .

A perfect example of how politicians are often caught in a position where they cannot tell the truth – either because the truth would expose their nakedness or because they genuinely believe that people cannot handle the truth and that admitting the truth would depress optimism and enthusiasm for a solution.

Now that push has come to shove – with the forced rescue of Dexia by the French and Belgian government – everybody finally agrees on the need to recapitalise EU banks. Pretty soon, they will also agree that banks have to mark their sovereign debt holdings to market to establish the quantum of recapitalisation required and then, as part of the rescue of Greece and other countries in distress, the EU will also agree to debt exchange schemes offering banks a small profit on the written-down value of their sovereign holdings and sovereign borrowers, a substantial haircut on their debt obligations without going through the dirtiness of a forced default.

What the EU is continuing to shilly-shally about is who is going to fund the necessary recapitalisations. The general thinking is that this would be the European Financial Stability Facility, whose €400 billion resources could be leveraged to offer fire-power close to €2 trillion. This is a crazy idea. Leveraging at the centre to solve leverage problems at the periphery does not address risks, it concentrates them.

A solution has to be found through the mechanism of the ECB which is the only pan-EU institution that can operate autonomously with a speed that matches the market without having to depend on the slow democratic process of 17 member states each holding a veto. It would have been much more sensible for the EFSF funds to be used as capitalisation of the ECB to give it the fire-power to create an ECB-owned rescue/recapitalisation agency that could replicate the US TARP programme of 2008. The resources of such a fund would have been augmented by a 1:1 monetisation and by inviting contributions from other countries that have every interest in saving the euro, including the US, Japan, Switzerland, oil surplus countries and BRIC (Brazil, Russian, India and China) countries. This would have produced a genuine €2 trillion fund without crazy and dangerous leverage.

This week, Merkel and Sarkozy finally woke up to the fact that they cannot continue biting at the edges of the problem and must attack it at source in order to break the circle. Let us pray that they break it in the right way, as otherwise the circle will break them – and us.

Alfred Mifsud