Is a Banking Crisis in Europe in the Offing?

While all attention is being focused on China’s growing indebtedness and its ability to stave off a debt crisis, another series of bank failures could be in the coming in Europe. The cause of any possible debt crisis in China and any impending bank failures in Europe is at the core the same: slowing and weak economies. Return on lending by banks, given the monetary policy environment, is low and financial institutions are finding it difficult to remain profitable especially in the regulatory environment in the aftermath of the 2007-2008 financial crisis.

China, because of its political system that permits significant state intervention, can make nimble decisions to shutter some unprofitable state run enterprises, consolidate others and capitalize banks which have lent to the unprofitable state run enterprises to prevent any serious crisis from taking hold. Besides, Chinese financial institutions, as of yet, are not globally systemically important. This, however, is not true of European banks.

In Europe, both German in the north, despite expectations to the contrary, and Italian banks in the south are not faring well either with regulators or with investors. Deutsche Bank’s minimum capital ratio versus regulator requirement is severely short. The International Monetary Fund (IMF) has released a report saying that Deutsche Bank “appears to be the most important net contributor to systemic risks in the global banking system” as can be seen from the picture below.

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The bank has been fined USD 14 billion by the United States Department of Justice for mis-selling mortgage-backed securities and at the current share price Deutsche Bank is barely worth more than the fine. Deutsche Bank hopes that the fine can be negotiated down to smaller number giving it breathing room to implement its restructuring strategy for 2020. Information is circulating that the German government, despite Deutsche Bank being its only major global player, does not intend to come to its rescue. The bank has said that it would not be needing a government bailout nor should it get one. Deutsche Bank should be allowed to fail if it comes to that in an orderly manner by the regulators by putting up its assets for sale to be acquired by other companies in the global banking industry and by saving its depositors.

Recent stress tests – designed to show how banks would weather a severe economic crash – highlighted weaknesses in Italy’s financial firms UniCredit and Monte dei Paschi di Siena (MPS). Italian banks are burdened by non-performing loans and as a result they are not intent on lending more which is holding back the economy. Italian economy has ground to a halt with zero growth reported in the second quarter of 2016.

The vicious cycle of a slowing economy and poor bank performance is plaguing Europe. It is important for the markets to keep an eye on European banks under stress, German and Italian in particular, for any signs of a cascade of bank failures which, if mishandled, can be to the detriment of the global financial markets and the global economy at this sensitive stage in the global economic recovery. Acquisitions by other global banks of underperforming European banks are a better way to go than government bailouts.

No financial institution should be “too big to fail.”

Fed Communication, Interest Rates and the U.S. Economy

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Reactions are a mixed bag these days in the U.S. financial markets when they hear hawkish talk from the Federal Reserve. On the one hand, the markets do not like interest rates to rise because, broadly, they are uncertain about the future of the economy without central bank support especially after the financial crisis despite being seven years into the expansion, but on the other hand, they like that the Federal Reserve has signaled a strong economy that could use less central bank support. In reaction to the former, ceteris paribus, typically the equity markets fall and yields in the bond markets rise moving in the opposite direction to bond prices which fall. Commercial paper (corporate bonds) will have to pay higher interest rates. Commodities such as gold will rise and oil will fall. The dollar will fall in relation to major currencies. In reaction to the latter, when the markets interpret a hawkish Fed signaling a strong economy that no longer needs Fed support, equities will rise, government and commercial bond yields will rise, gold will fall and oil will rise, and the dollar will rise in relation to major currencies. It all depends on how the Fed communicates monetary policy and the economic context of the policy to the markets and whether the markets concur with the Fed’s assessment of the economy’s health. One would hope that the Fed persuades the markets that the economy, just as it weathered the end of quantitative easing, is also strong enough to weather monetary policy normalization which the Fed is not doing well at this time.

The Fed needs to put its money where its mouth is. Removing monetary policy accommodation in time intervals of 1 year for a 25 basis point increase does not communicate gradualism but uncertainty about the economy. The U.S. economy is in its seventh year of expansion after the end of the Great Recession but monetary policy is still in crisis mode ironically when member banks of the Fed have excess reserves with the Fed amounting to trillions of dollars and U.S corporations are sitting on cash hoards also in the trillions.

To be confident to raise the federal funds rate the Fed must assess the interest rate sensitivity of the U.S. economy, something it had not done the last time it raised rates gradually before the crisis of 2007-2008. Then the Fed had not made any attempt to understand the interest rate sensitivity of the housing market and raised interest rates amidst a bubble contrary to its own dictum to not raise the federal funds rate during a bubble but wait to clean up after the bubble bursts. As a result the subprime crisis occurred and consumers, including those not affected by the subprime crisis, pulled back from spending because credit became expensive and their variable rate mortgages ate into their disposable income. The Fed should not raise the federal funds rate now, therefore, without checking how the various markets would be affected by steadily rising rates.

Along with communicating the inflation target and the monetary policy decision process to the markets, the Fed should clearly communicate its analysis of the interest rate sensitivity of the U.S. economy for every 25 basis points rise in the federal funds rate. It is an analysis that is very much needed at this time to ensure the transparency of the markets to rising interest rates unlike during the crisis of 2007-2008, because crises spring from information asymmetries especially between the central banks and market participants.

The “natural” or neutral interest rate may not be known well, but the Fed would not know what it is unless it embarks on a path of gradual rate increases, telegraphed to the markets to clearly set their expectations and for them to adjust their exposures to gradually increasing rates. Doing so does not prevent the Fed from being data dependent should the economy take an adverse path that neither the markets nor the Fed expect.

The Trilemma in International Economics and Large Open Economies

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As World War II was coming to an end, at the conclusion of the Bretton Woods talks about exchange rate arrangements between countries after the war, the United States insisted that the currencies of the parties to the talks be pegged to the U.S dollar and that the U.S dollar would be pegged to gold. Thus the U.S. dollar became the currency of choice for global trade – the reserve currency or the currency that other countries keep in reserve for international transactions denominated in the U.S. dollar – ending the dominance of the British pound. The gold peg of the U.S. dollar where Americans and countries could convert their U.S. dollars to gold was an arrangement that continued until Nixon shocked the world in 1971 by ending the convertibility of the U.S. dollar to gold.

From Bretton Woods in 1944 to the abandonment of the fixed exchange rate Bretton Woods agreement between 1971 and 1973, the United States had a fixed exchange rate regime with the U.S. dollar pegged to gold, minimal controls on capital flows into and out of the United States, and sovereign central banking. This American experience violates the Impossible Trinity or the Trilemma in international economics that says that a country cannot simultaneously have all three – fixed exchange rate, open capital markets with free capital movement into and out of the country, and sovereign monetary policy. It can only have two out of the three and must give up on the third.

The Impossible Trinity is based on the Mundell-Fleming model which describes the workings of a small open economy. In fact, Robert Mundell, who won the Nobel Prize for his work on international economics, and Marcus Fleming used their model to describe the small open economies of Switzerland and Belgium. To develop their model they had assumed a small open economy with perfect capital mobility where the interest rate in the country is equal to the world interest rate over which the country has no control. This is a key assumption. To apply the model, the model implies that a small open economy has perfectly open capital markets and no control over its monetary policy. This means, according to the Trilemma, it must have a fixed exchange rate along with open capital markets because it gave up the sovereignty of its monetary policy.

A key insight of this article is that all small open economies – small because they cannot set their own interest rate but their interest rate is equal to the world interest rate – according to the Mundell-Fleming model, should be characterized by fixed exchange rate, open capital markets and non-sovereign monetary policy.

It is interesting that the academic literature in international economics has generalized the Trilemma to apply to all countries including large open economies such as the United States which have a significant influence over the world interest rate because the currencies of large open economies are the reserve currencies in international trade. Therefore, it is a useful question to ask whether the Trilemma applies to large open economies: can large open economies have fixed exchange rate, open capital markets and sovereign monetary policy as was the case with the United States for nearly 30 years after World War II?

Is the U.S Federal Reserve Buridan’s Ass?

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The U.S. Federal Reserve is thirsty and hungry to normalize monetary policy. The economy is growing near-potential, the Fed’s preferred measure of inflation – the core personal consumption expenditures (core PCE) is at a Year-on-Year (YoY) rate of 1.6% (close to the Fed’s 2% core PCE inflation target) and the unemployment rate is close to full employment. The expectation is that, despite the low oil and food prices, headline inflation should be on a trajectory to converge with core inflation for the Fed to get back on the path of very gradually raising rates. Further, an informed inference from the data thus far is that U.S monetary policy is accommodative and the economy is strong enough to absorb some increase in the federal funds rate just as it was strong enough to weather the end of quantitative easing in October 2014.

The debate now is about the “natural” rate lest the economy be pushed into a recession should the nominal federal funds rate exceed the “natural” rate, and the need of the Fed to have sufficient room to cut the federal funds rate in response to economic slowdown or worse, a recession. “Will a recession occur when the federal funds rate is near-zero and cash hoardings in terms of bank reserves and corporate profits are at an all time high?” is another question in and of itself. That these cash hoards need to circulate in the economy to raise real investment but not nominal wages and prices is a necessity.

The question of whether the federal funds rate is low enough to promote growth is a bygone given the reasonably healthy economic data though it remains to be understood if the federal funds rate is already at the “natural” rate despite it being near-zero (currently the Fed is estimating the natural rate to be around 3%). If so, any further increase in the federal funds rate can push the economy into a slowdown. So, the Fed is caught between a rock and a hard place. It can neither raise the federal funds rate nor does it have enough room to cut it should there be a slowdown. Like Buridan’s ass it can neither quench its thirst by drinking from the pail of water nor can it quash its hunger by eating from the bail of hay, both the water and the hay being equidistant from it. In paralysis to make a rational decision, the Fed may die of both thirst and hunger by losing its credibility because of its inaction, unless inaction is itself a wise choice.

There is no moral determinism as the paradox of Buridan’s ass quite aptly satirizes it. Consequences are always a result of choices made prior. The financial crisis and the consequent Great Recession of 2007-2008 were not determined by natural economic cycles with no role for stabilization policy but were a consequence of government actions to deliberately encourage the housing market and the collapse of the housing market was a result of the Fed raising the federal funds rate amidst a housing bubble contrary to its own dictum of waiting until bubbles collapse to clean up after as it had done with the technology bubble in 2000.

In the absence of a very large fiscal expansion, as it currently seems to be the case, it would be wise for the Fed to be highly circumspect when contemplating about raising the federal funds rate. That the “natural” rate itself is low is a sensible possibility because advanced economy central banks have been very credible in targeting inflation and setting inflation expectations since 1981 and, therefore, low inflation targets between 2% and 4% require low “natural” rates to maintain. “How low is a low natural rate?” is something that cannot be found out until the Fed tries and that requires a data-dependent monetary policy stance with a bias to very gradually raising the federal funds rate.

Contrary to what Financial Times columnist Martin Sandbu seems to suggest, the Fed can both munch on the bail of hay and sip from the pail of water alternately, making a hearty meal out of a quandary, if it very gradually raises the federal funds rate in a data-dependent manner as it is doing now. Then it won’t die of hunger or thirst but will live to tell the tale unlike Buridan’s ass. Still, it must be said here that a very gradual monetary contraction together with a very large fiscal expansion directly funded by the Fed with printed money not tied to new bond purchases from the government (“helicopter money”) is the only way to keep growth alive and stable while normalizing monetary policy if the Fed is to have sufficient room to cut the federal funds rate in a future economic slowdown.