Next year could well see a repeat of 2008...
DO NOT BELIEVE that the global economy is out of the woods now that the European Union (EU) has expanded its effort to solve the sovereign debt crisis, writes Martin Hutchinson for Money Morning.
No doubt, the European crisis is far from being solved – but that's hardly the only potential economic catastrophe looming on the horizon.
Indeed, two successive articles in the Financial Times last week warned of a new disaster approaching: They forecast 25% declines in financing volume for both commodities finance and aircraft purchases in 2012.
Now that would be truly bad news.
You see, the most job-destroying feature of the 2008-09 recession was a 17% decline in world trade that was caused by the financial crash and the disruption to the world's banks. That decline intensified recessionary conditions and caused millions of job losses worldwide. Some 700,000 jobs were being lost each month in the United States alone for a period in early 2009. That's more than double the previous worst monthly losses since World War II.
And now we could be in for a repeat.
In fact, it's hard to see how one can be avoided.
In today's distorted world financial system, a combination of over-loose monetary policy, intractable budget deficits, and tightening regulation seems to have made a credit crunch more or less inevitable.
So if you're smart, you'll take a moment to examine exactly why, and then figure out who the winners and losers are going to be.
When you look at bank lending, it's clear that the link between the huge amount of world money growth and the meager supply of lending to productive enterprise is broken.
US Federal Reserve Chairman Ben Bernanke and his international colleagues can hand as much money as they like out to banks, but if the banks don't lend it, that money will be wasted. And right now the banks aren't lending to trade and private businesses for three reasons:
- The Yield Curve: Central bankers have kept short-term interest rates far below the level of long-term rates and have made it clear that they will intervene if long-term rates rise. Banks can borrow short-term, lend in the long-term markets, and through this "gapping" use massive leverage to boost their returns.
- Regulatory Loopholes: Basel Committee banking regulations currently allow banks to escape allocating capital to their holdings of Organization of Economic Cooperation and Development (OECD) government debt. These regulations allow banks to play the gapping/leverage game without limit, provided they invest in government or government-guaranteed bonds. This has financed the gigantic budget deficits of recent years. However, it has also "crowded out" private sector lending.
- Limitations On Capital: Banks have ample liquidity, but they have only a finite store of capital. Accordingly, if regulators force banks to hold more capital, their loan volume will be limited and they will no longer be able to expand lending (other than to governments). Currently, banks can only raise more capital at below their net asset value, diluting their existing shareholders.
Even the "shadow" banking sector – the brokerages, money market funds, hedge funds and structured investment vehicles that provided massive lending volumes before 2008 – cannot help much now.
Structured investment vehicles are, for obvious reasons, a lot less popular than they were before 2008. Hedge funds were until this year even more popular than before 2008, but their suddenly cautious bankers don't let them leverage themselves like they used to. Money market funds have shrunk because their returns have been pathetic for the last three years. Meanwhile, inflation has risen, eroding the real value of their investors' capital.
So the shadow banking system won't be able to make up for lending cutbacks in the banks.
Indeed, the string on which the Fed is pushing is completely slack, and another $1 trillion of Fed monetary stimulus won't lead to even an extra Dollar of productive loans.
Interest rates need to rise. That will increase the supply of savings, reduce the ability of banks to make money through gapping/leverage games, and restore the linkage between massive systemic liquidity and sluggish productive lending.
Of course, while Ben Bernanke and other current central bankers are in charge, higher interest rates are off the table – regardless of how beneficial they might be.
Now here's what that means for 2012.
With interest rates so low and banks so restricted, the chance of a true credit crunch is quite high.
That means countries with large budget deficits – notably Britain, Japan, and the United States – could suddenly see interest rates rise and funding dry up abruptly.
Emerging markets would be divided into those with ample domestic savings or currency reserves – China, Taiwan, Singapore and Chile, for example – and those with bloated public sectors and extravagant consumers – the majority of Latin America, Brazil and India.
Liquid emerging markets would do fine, but illiquid emerging markets would suffer badly – think Latin America in the 1980s and Asia after 1997.
In the private sector, businesses such as aircraft financing and commercial real estate that are chunky and not especially people-intensive could find funding through the shadow banking system, albeit at higher rates than they are used to. However, small businesses and trade finance would find funding much harder to come by.
The existence of vast pools of liquidity would support commodity prices, unless the world suffered a major economic downturn. And gold and silver, which are safe havens in times of crisis that do not depend on a smoothly functioning banking system for their support, would probably do quite well.
Some trade financing might be carried out in gold, with sellers happy to carry buyers' credit risks on their balance sheets provided they could be repaid in an inflation proof asset with no linkage to troubled financial systems.
The bottom line is that in spite of, or to some extent because of, the efforts of Bernanke and his cronies, a credit crunch and another massive drop in world trade volumes is quite likely in 2012.
Only a modest money market shock would set one off, and with Europe tottering such a shock seems very likely indeed. We should be prepared.
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