Last Thursday, October 27, European
leaders secured an agreement from eurozone banks to
take a 50 percent loss on the face value of their Greek debt. The leaders
also set in place a plan to force banks to raise new capital to insulate them
from potential sovereign-debt defaults.
The banks must meet 9 percent
capital reserves by June 30, 2012. It is estimated banks' capital needs will
stand at 106 billion euros.
Eurozone policy makers have also
agreed to expand the emergency bailout fund to $1.4 trillion from $610
billion — suggesting it could provide guarantees for around $1.4
trillion of bonds issued by countries such as Spain and Italy. But will this
new plan set the platform for healthy economic growth in the eurozone?
We suggest that what is needed to
set a platform for healthy economic growth is raising the level of capital in
the overall economy, not just in the banking sector. The key source for the
lifting of capital in the economy is an expanding pool of real savings.
Although it is not possible to quantify
this pool, one can ascertain the factors that undermine it. We hold that an
important factor behind the present eurozone
economic crisis is past and present loose monetary policies.
For instance, after settling at 7
percent in July 2007, the yearly rate of growth of the balance sheet
(monetary pumping) of the European Central Bank (ECB) jumped to 53 percent in
January 2009. In response to this the yearly rate of growth of the eurozone, AMS climbed from 0.3 percent in July 2008 to
15.8 percent by August 2009. Also the ECB policy interest rate was lowered
from 4.25 percent in September 2008 to 1 percent by May 2009. It was kept at
1 percent until March 2011.
We hold that this loose monetary
and interest-rate stance has contributed to a large misallocation of real
savings in an already-distorted environment created by previous reckless
policies. Instead of being employed to generate real wealth and thus beefing
up the capital base, real savings have been squandered by various bubble
activities that emerged on the back of loose policies.
Large government outlays and the
subsequent large debt as a percentage of GDP are another factor behind the
damage inflicted to the pool of real savings, which in turn has weakened the
process of capital formation. Thus, in Germany, government debt as a
percentage of GDP stood at 83 percent in 2010 against 74 percent in 2009. In
France, the percentage stood at 82 percent last year against 79 percent in
2009. In countries such as Greece and Italy, the percentage displays
buoyancy. The percentage of debt from GDP stood in Greece at 160 percent in
2011 versus 130 percent in 2009. In Italy the figure stood at 120 percent
against 116 percent.
Meanwhile the ECB reported on
October 6 that the tightening of credit standards by eurozone
banks picked up significantly in Q3. Sixteen percent of banks said they have
tightened loan terms, compared with 2 percent in Q2.
Furthermore, according to a
Bloomberg survey, banks across the eurozone have
announced they will trim more than 775 billion euros from their balance
sheets in the next two years to achieve the 9 percent in capital
requirements. Some experts are of the opinion that bank deleveraging could
reach 5 trillion euros in the next three to five years.
Policy makers and most mainstream
economists would prefer, however, that banks' recapitalization take place
without a process of deleveraging, which they view as bad for the economy.
Why Popular Thinking Opposes Deleveraging
The popular view as to why
deleveraging is bad for the economy can be supported by the following
example.
Take for instance company X, which
has equity of $200. The company borrows $800 and buys an asset worth $1,000.
In this example we can say that company X has a leverage of 5. That is to say
the equity of $200 represents 1/5 of the $1,000 asset. If the value of the
asset falls by 10 percent, that is, to $900 given the debt of $800, it
implies a fall in equity or net worth to $100 — or 1/9 of the $900
asset, raising the leverage from 5 to 9 and making company X less solvent.
Let us now assume that company X
has decided to deleverage and to lower its leverage back to 5 (by doing this,
the company will become more solvent). To achieve this goal, company X sells
assets for $400 and reduces its debt to $400. Consequently company X will now
have $500 in assets, $100 in equity and $400 in debt: the leverage is now 5
again. But if many companies try to lower their leverage, then there is a
risk that the value of assets will fall. If, for instance, the value of
company X's assets falls by 10 percent to $450, then, given the value of debt
of $400, net worth falls to $50 implying that the leverage goes back to 9.
From this we can conclude that a
pressure on European banks to bolster capital could force them to cut assets.
However, by cutting lending — trimming their assets — banks are
forcing various borrowers to sell off their assets to prevent insolvency.
Consequently this sets in motion asset-price deflation. This in turn lowers
borrower collateral and causes banks to reduce their lending further, etc.
It follows that if all financial
institutions are doing the same thing (trying to fix their balance sheets),
they could drive asset prices down, which for a given debt will shrink their
net worth and increase their leverage, or make them less solvent. This is the
paradox of deleveraging. If this process is not arrested in time it could
lead to a liquidity crunch and seriously damage the real economy, so it is
held.
This means that any side effects of
deleveraging such as a credit crunch and economic slump should be
aggressively countered by the authorities by means of loose monetary
policies.
Is Deleveraging Really Bad for the
Economy?
Is it true that if every bank were
to attempt to "fix" its balance sheet, the collective outcome would
be disastrous for the real economy? On the contrary, by adjusting their
balance sheets to reflect true conditions, banks would lay the foundation for
a sustained economic recovery. After all, by trimming their lending, banks
are likely also to curtail the expansion of credit "out of thin
air." It is this type of credit that weakens wealth generators and hence
leads to economic impoverishment.
Contrary to the proponents of the
"paradox of deleveraging," we can only conclude that if every bank
were to aim at fixing its balance sheet, and in the process curtail the
expansion of credit out of thin air, this would lay the foundation for a
healthy economic recovery.
We suggest that the crunch in the eurozone will occur not as a result of deleveraging as
such but because of the damage inflicted on the process of capital formation
by past and present loose monetary and fiscal policies.
The deleveraging is just a symptom
of the diminished ability of the economy to generate capital. Hence any
attempt to fix the symptom is only going to make things much worse. (Note
again in this sense deleveraging is good news for the capital-formation
process because it reduces the inflationary credit and hence money out of
thin air.)
In the meantime, a fall in the
yearly rate of growth of eurozone AMS from 15.8
percent in August 2008 to minus 0.3 percent in May this year is severely
undermining various bubble activities. We suggest this is good news for the
capital-formation process and wealth creators.
We maintain that this decline in
the growth momentum of money supply is depressing various bubble activities,
and this in turn is manifested through various popular economic indicators.
For instance, the latest data show
that manufacturing activity in the eurozone has
weakened further in October. The purchasing management index (PMI) fell to
47.3 from 48.5 in September. In October last year the PMI stood at 54.6
— our monetary analysis points to a likely further weakening in the eurozone PMI. Also, the PMI in the services sector has
weakened in October. The index fell to 47.2 from 48.8 in September. Using the
lagged growth momentum of real AMS, we can suggest that the services PMI is
likely to weaken further.
We suspect that — because of
a further decline in economic activity, i.e., the bust of bubble activities
— policy makers might deploy various schemes to arrest their demise.
For instance, the use of the emergency bailout fund is going to weaken the
benefits from a fall in the growth momentum of AMS. (Real savings will be
diverted from wealth-generating activities toward the support of
nonproductive bubble activities.)
Furthermore, in response to a
weakening in economic activity, which we have seen is good news for wealth
generators, the ECB is likely to lift its pace of monetary pumping. This we
suggest is going to delay meaningful economic recovery. In fact the ECB has
already lifted the pace of pumping. The yearly rate of growth of the ECB
balance sheet stood at 23 percent in October versus minus 9.5 percent in
June.
We can conclude that, while a
current fall in the growth momentum of Euro AMS is positive for the
capital-formation process, the likely tampering by the central bank to
counter the bust of bubble activities is likely to make things much worse as
far as the process of capital formation is concerned.
Again, we maintain that the present
crisis is due to past and present loose monetary and fiscal policies. We also
suggest that, given the severity of the crisis, this raises the likelihood
that the pool of real savings is badly damaged. This means that to fix the eurozone problem what is needed is to address the factors
that undermine this pool.
So, any policy that endorses a
tighter monetary and fiscal stance will lay the necessary foundation for a
buildup of capital and will set in motion a solid economic expansion.
Obviously a tighter stance will wipe out various bubble activities that have
emerged on the back of loose policies.
The larger the percentage of these
activities is, the more severe the economic bust is going to be. The bust
however is a good thing, because it provides more scope for wealth generators
to get things going.
However, we are doubtful that eurozone policy makers will allow a proper
cleansing — in fact, they have stated that banks' deleveraging must be
countered. We have seen that deleveraging is good for wealth generation, and
hence we think that the latest eurozone plan will
not produce meaningful results.
Summary and Conclusion
Last week European leaders secured
an agreement for eurozone banks to take a 50
percent loss on the face value of their Greek debt. The leaders also
formulated a plan for the recapitalization of banks. Also, policy makers have
agreed to expand the emergency bailout fund to $1.4 trillion from $610
billion. We suggest that what is required to fix the eurozone
is not just strengthening banks' capital bases but strengthening the capital
base of the eurozone as a whole. Policy makers
insist that the banks' recapitalization must take place without a process of
deleveraging, which they view as bad for the economy. This means that the
authorities will aggressively counter any side effects of deleveraging, such
as a credit crunch or economic slump. We suggest that, on the contrary,
deleveraging is necessary to clean up the system and lay the foundations for
solid economic expansion. In fact, any policy aimed at countering the
deleveraging process will only make things much worse.
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