Wednesday, 10 October 2012

How can this recession be brought to an end?

IMF GFSR summary Report cover

We are basically five years into this recession and there is nothing to indicate that we can get out of it any time soon.   If it lasts one more year, which clearly it will, the recession would have already lasted more than the second world war from the first shot on 1st September 1939  when Germany invaded Poland, to Japan's surrender after Hiroshima in August 1945.

What makes this recession different from any other in the post war period is that this is not a cyclical recession.  It is a balance sheet recession.   This is not the sort of recession where banks stay strong and through generous provision of cheap credit they stimulate investment and consumption to turn things around.   This recession was caused by excessive credit to sectors that went bad leaving a big hole in the balance sheet of banks that are no longer interested in lending money to anyone; they are more interested to run down their balance sheet to the size of the capital they have left.  

All this is leading to de-leveraging by all economic sectors at the same time causing crushing reduction in demand.   And without demand investment will shy away even if money can be borrowed cheaply, which is hardly the case.   Banks are de-leveraging to repair their balance sheets.  Sovereigns are de-leveraging as they have exhausted their credit status with the markets, especially following Greece's default.   Households are de-leveraging as they feel unsure about their future and are saving even on reduced earnings rather than spending on credit to keep up their lifestyles.  Businesses are building up their cash reserves as a safety precaution in case we double dip.

The IMF has warned the EU and the Eurozone in particular that their incremental approach to solving the Euro crisis is risking prolonging the recession for the whole world.   The EU is the largest trading bloc in the world and with the EU in recession,  the US and Asian economies cannot reach escape velocity to growth.   Without EU demand the other trading blocs will suffer losses on their international trade adding to uncertainty and shying away of investments.

In an important message to EU leaders ahead of a Brussels summit on deepening fiscal integration, banking union and bank recapitalisation next week, the IMF issued a stark warning that the lack of decisive action by European governments and institutions risked tipping the global economy into deeper crisis.
"Incremental policy making has been insufficient to fully allay market tensions, despite the recent market rally since end July," the report said. "Merely muddling through imposes increasingly higher costs, as the unchecked forces of fragmentation continue to gather speed and undermine the very foundations of the union – a common monetary policy, and economic and financial integration."
Fiscal integration and banking union are valid objectives but politics being what they are in the EU they cannot happen overnight.   They can be made to happen but the way the EU works it will take years of preparation, horse trading and shaping of public opinion about what these nice terms actually mean and how they will change the life of the average EU citizen.    But bank recapitalisation is something that has to happen and has to happen soon and need not be subjected to the usual machination of EU bureaucracy.
Without the wheels of credit creation working efficiently there can be no sustainable economic growth and monetary policy will remain sterile as the channels for transmission of the interest rate policy will remain blocked.    Banks must be recapitalised so that they can start acting as banks seeking to lend money profitably rather than obsessed on how to reduce their balance sheets.
Investors are not prepared to put new money in bank capital.  They have been burnt these last few years with harrowing equity losses and are not seeing a clear way of how any new investments in bank capital will be sufficiently profitable.   Sovereign are indebted up to their ears and can hardly be expected to borrow more to fund bank recapitalisation.   The EFSF/ESM mechanisms offer too small a buffer for the sort of recapitalisation that may be required and governments will have practical and political difficulty to pour more funds in these rescue mechanisms without igniting the ire of their home taxpayers.
That leaves only one source for the scale of bank recapitalisation required.  Monetisation of the ESM by the ECB either through giving a banking licence to the ESM or preferably by funding a special purpose vehicle to be managed by the ESM to be used exclusively for grand scale bank recapitalisation necessary after banks are forced to mark their investments and bad loans to a realistic market price.
Obviously the German Central Bank will consideration such monetisation as an economic heresy leading to future inflation.  They are wrong and should be over-ruled.   Such monetisation will not directly put purchasing power  into the economy.   The funds will go to clean up the banks and transfer ownership from the present shareholding set-up to ownership by the ESM.    But at least banks will have a healthy balance sheet and can start acting again as banks no more like zombies.
Once banks get well into credit creation process the the whole process can be reversed by privatisation of the ESM holdings in the banks which in the meantime would have re-discovered their profitability and would be giving a shot in the arm to economic growth through credit creation as opposed to the current de-leveraging.
And if we have to live for some time with inflation higher than 2%, may be 4% or 5% it would not be the end of the world.     As Mervyn King the governor of the Bank of England said today monetary policy alone cannot right all that is wrong in the economy and circumstances may arise where monetary policy will have, for the common good, to tolerate somewhat higher levels of inflation.  It is simply the choice of the lesser evil if the alternative is an endless recession.
The ECB and the EU governments should give heed to the IMF warnings and act fast.

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