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GFC Really Finished?

ZIRP and QE mean post-crisis fixes like CCPs only add TBTF risks...
INVESTORS assume that the global financial crisis is now ancient history and normality has returned, writes 30-year derivatives veteran and specialist author Satyajit Das for Dan Denning's Daily Reckoning Australia.
Many equity markets are making new highs almost daily. Even the Nasdaq has risen to levels not seen since the tech bubble, as technology stocks are back in fashion, with everybody looking for the new Google, Facebook or Twitter. There is now a bubble in analysts in the employ of banks arguing that there is indeed no bubble!
Such is the environment, that a reader of the Financial Times commented that even an imminent prospect of an alien invasion would result in equity prices rising. Equity analysts would argue that companies could look forward to the prospect of gaining new non-human customers.
But puzzlingly while financial markets are buoyant, the real economy remains moribund, stuck in a 'secular stagnation' of low, volatile growth, high and rising debt levels, slow investment, overcapacity, high unemployment, low income growth and negative real interest rates.
Despite some dissenting views, the GFC was the result of high debt levels, global imbalances, excessive emerging markets, such as China, have increased debt levels substantially from those prevailing before the crisis.
Global imbalances have decreased but only modestly. The decrease reflects lower levels of economic activity with a sharp reduction in imports in many developed countries, rather than a fundamental rebalancing.
Large exporters, such as Germany, Japan and China remain committed to economic models reliant on exports and large current account surpluses. Increasingly, nations have turned to manipulation of currencies to maintain export competitiveness.
In the period leading up to the GFC, excessive financialization manifested itself as the rapid growth of the financial sector, increase in trading volumes of financial instruments and a focus on financial activities at the expense of the real economy.
The size of the banking sector in developed countries has not decreased materially. Too-Big-To-Fail (TBTF) banks have become larger. Trading volumes remain high, well above that needed to support the trading of real goods and services.
Trading in financial claims over real economic activity, earnings and cash flows still offer larger profits than the real economy, continuing to support a disproportionate level of financial rather than real business activity. Government and central bank policies of low rates and abundant liquidity exacerbate this trend.
The complex links and interaction within the financial system that helped transmit the shockwaves during the GFC remain. Complex capital, liquidity and trading controls of dubious efficacy, introduced in response to the crisis, have not addressed the underlying problems. Initiatives, such as the central counterparty (CCP) for derivatives, create new inter-connections and systemic risks.
The links between nations and TBTF banks have increased dramatically, with a sharp increase in risk. Sovereigns needing to find buyers to finance spending have encouraged banks to purchase growing amount of government bonds financed by cheap funding from national central banks.
Reform of entitlements has proved difficult. Needed re-negotiation of retirement benefits and conditions, healthcare costs, social services and funding arrangements to improve public finances have proved difficult. Seeking to maintain their grip on office, politicians everywhere have proved reluctant to seriously tackle major issues.
The official policy throughout the world has been one of 'extend and pretend'. Rather than deal with the fundamental issues, policy makers have adopted an expedient mix of expansionary policies. Public spending has been used to boost demand. Low or zero interest rates policies (ZIRP) and quantitative easing (QE) have been used to make high levels of debt more manageable.
Central banks increasingly finance governments through the purchase of sovereign debt. Currency devaluation is used to increase competitiveness and also to reduce the value of sovereign debt, held by foreign investors.
Unfortunately, these policies have not created the strong economic growth or inflation needed to address the problems exposed by the crisis. Instead, the policies intended to deal with the issues have spawned toxic problems of their own.
The effect of ZIRP, QE and budget deficits on the real economy (activity, employment, investment) has been limited. Instead, the policies have set off rapid de-stabilising asset price rises.
ZIRP and QE have encouraged a switch to risky assets, such as high yield and emerging market bonds, to generate some returns. Mispricing of these risks is now increasingly evident. Practices such as aggressive lending, inadequate covenants and use of discredited financial techniques (such as Collateralised Debt Obligations) have re-emerged, almost reaching pre-crisis levels.
Policy settings seem curiously to be similar to those which contributed to the GFC in the first place. Policy makers seem to have forgotten the sage age old advice: repeating the same thing over and over and expecting a different result is indicative of insanity.
Official policies are complicated by the Hotel California problem – you can check out any time you like, but you can never leave! As outgoing US Federal Reserve Chairman Ben Bernanke discovered with his 'taper' talk, exit from present expansionary monetary policy may be difficult or even impossible without a major market disruption which could truncate the weak real economy recovery.
In the coming months and years, a number of issues will increasingly dominate discourse.
  • First, it is unlikely that economic growth will reach the levels needed to power the global economy back to health, at least in the near future;
  • Second, inflation levels will remain low with the risk of disinflation or deflation being ever present;
  • Third, sovereign debt problems in developed countries as well as a number of emerging markets will remain an important concern;
  • Fourth, problems in emerging markets will continue. Overall growth will moderate and several countries may experience debt crises of different magnitude. This will drag down global growth and affect the chance of recovery in developed countries;
  • Fifth, the impotence of policy makers and the inadequacies of available policy options will become increasingly evident. The recent emphasis on forward guidance (which can be translated as merely a new term for the age old practice of 'jawboning') is reminiscent of Robin Williams' observation about the weapons available to an unarmed English policeman: "Stop or I will shout 'Stop!' again";
  • Sixth, the economic problems will increasingly manifest themselves in social and political problems, both domestic and internationally.
High levels of unemployment or under employment, rising income inequality and the inability of the state to meet expectations of the level of services provided will fuel increased social discontent. It will also fuel political extremism, already evident in the rise of far right and left wing parties.
Interestingly, in Italy's 'pitchfork' protests, the police took off their helmets to signal their solidarity with and support for the protestors.
Disparities in economic activity levels between countries will feed distrust and beggar-thy-neighbour policies. Limited growth will fuel economic isolationism and nationalism.
Recent territorial disputes attest to both the battle for resource security and also the political advantage of deflecting attention from domestic problems and a naked appeal to nationalism. Other major issues, such as climate change or environmental degradation, management of non-renewable resources as well as geo-political instability, remain ever present.
The poet T.S.Eliot observed that human beings cannot take too much reality at one time. Suffering crisis fatigue, policy makers and citizens have decided to largely ignore the problems, choosing to accentuate positive data, and hoping for a return of the good times.

Best-selling author of The Bull Hunter (Wiley & Sons) and formerly analyzing equities and publishing investment ideas from Baltimore, Paris, London and then Melbourne, Dan Denning is now co-author of The Bill Bonner Letter from Bonner & Partners.

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