In a recent Texas Enterprise presentation, I described how losses to Cyprus depositors could occur elsewhere. Moreover, I suggested that this was not a one-time aberration of our understanding of normal. Rather, this is the new normal, better described by a Texas Enterprise reporter as “a slow-moving train wreck.”
Since his phrasing was more eloquent than mine, let’s go with that as a title to this month’s blog. Except in the short time since that title was conceived, the impending train wreck has just picked up speed.
The notion of a train wreck for an economy is of course in sharp contrast to our notion of “old normal,” in which an economy chugs along spewing off the multiple gifts of jobs, income and wealth all by itself, even without much need for government locomotion or correction.
That is the way it was for a long time. Yes, there were occasional interruptions in that steady progress, most of which proved to be no more than minor and short-lived recessions. But the train kept chugging along, because economies do have natural self-correction mechanisms to keep the train on the tracks and moving at a normal speed. This is the notion of an equilibrium growth path.
Primary among the natural economic mechanisms are prices of inputs and currencies. In recessions, unemployment creates low wages, and low demand for capital causes yields to diminish. With capital outflows, currencies decline, and goods become cheaper to produce and eventually become attractive to foreign buyers. Hence the economy’s engine turns around all by itself and keeps on chugging. In an economy’s boom episodes, those same resources become expensive — which is a self-moderation mechanism that slows sales and production.
During booms, interest rates increase due to scarcity and the inflation premiums that markets price into debt contracts. This means that in that economic environment, there is relatively little need for the Federal Reserve to further raise interest rates.
However, after WWII, self-correction gave way to statutory imperatives to not allow prices to reflect scarcity, which somewhat deterred the self-correction mechanism. Minimum wages prevented the unemployed from offering their services at a lower market rate, and reserve currency prices had a built-in upward bias so exports would not pick up. Hence the self-correcting market mechanisms were somewhat compromised.
For the most part, following WWII, monetary policy and contra-cyclical fiscal policy added to demand so as to keep the locomotive running at the highest maintainable speed, never mind a little inflation. In addition, the Fed’s routine fine- tuning required flexibility and timely policy to keep the engine’s mechanisms in working order — the locomotive would lurch forward when policymakers gave it some gas, and it would slow down when they applied the brakes.
But now, what was considered “normal” back then is almost unachievable: Not only is the engine in sad repair, but the ground under the tracks is giving way.
One reason for this is that we are now facing what the Fed calls “headwinds” — when they push the accelerator to the floor, there is no acceleration, but it’s not due to lack of trying. Same is the case in Europe and Japan: They are trying but getting no traction.
But now the old locomotive has sprung several more disconnects. For one, it suffered through The Great Recession just as old age caught up with both machinery and the work force. The aging population also requires fiscal resources to make good on government entitlements. That process tends to slow the old locomotive, as the government finances entitlements by diverting private resources.
Another slowdown occurs when the government foists its entitlement debt on first banks, financial institutions and, most recently, on central banks across the world — making them weaker and compromising the engine’s traction even further.
But now in a new bold move to come up with the funding for entitlements, European governments have chosen to cannibalize depositors in their own banks (and, in turn, the banks themselves) by forcing them to reveal the identities of foreign depositors to their home governments.
The end to Euro bank secrecy has already given rise to witch hunts for depositors, basically requiring them prove to their government that they paid taxes on funds in their foreign bank accounts. But since the truth will not be revealed until the end of the year, depositors have ample time to seek new ports for their holdings — which will no doubt be outside of the EU. The total amount of the deposits that are likely seeking a new home is estimated at about $21 trillion, or about twice the amount of U.S. commercial banking system deposits.
If that were not enough incentive for depositors to flee Europe’s banks or seek other alternatives, the EU has also made it clear that the ad hoc Cyprus bank formula for large bank resolution — in which depositors and other debtors take a hit when the bank goes insolvent — will be applied across all future EU bank insolvencies.
Needless to say, holding government bonds as assets is a leading cause of bank insolvency — if the government can’t service its debt, it certainly can’t rescue the bank’s supposedly insured depositors.
To add to the risks that Euro depositors face, the IMF has indicated a new policy for assisting financially strapped governments that rationalizes not assisting them. The IMF wisely decided that it will not rush in and be a lender to distressed sovereigns an act which often provides the funding needed to save banks.
Instead, it will wait until after the sovereign defaults on its existing debt as it wants no part of being written down with the rest of the bond holders. This no doubt removes an important source of emergency funding for the sovereign and the bank depositor, which the IMF has come to realize simply enables the sovereign to keep on spending at its expense.
With support for bank deposits being removed, the conclusion is Euro depositors are at risk without much in the way of government back-up whether or not deposit accounts are anonymous. So Cyprus is the new rule and not the exception.
Banking and moreover, financial globalism — a system in which capital is free to flow toward the best use that promotes economic growth — is being sacrificed to support state deficits. But the sacrifice will not be confined to Europe, as the U.S. and the Euro zone are placing maximum pressures on all haven countries to do the same so as not to lose competitive advantage.
So with Europe in the sixth consecutive quarter of recession, the slow moving train wreck has just picked up speed, no matter how much gas the monetary authority gives the aging locomotive.
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