Boom, Gloom and the New Normal

A month ago, the former UK Finance Minister, Alastair Darling, warned that the European Central Bank (ECB) had “to recognise they have to be the lenders of the last resort”.

He added that “This is far worse than the banking crisis of 2008 in its seriousness and, if it is not solved by Christmas, I think the whole of the euro will break up.”

Last Thursday, Darling was proved correct. The ECB provided an unprecedented €489bn ($635bn) in 3 year loans to 500 banks across the region. Otherwise, many of them would have gone bankrupt, and the Eurozone would indeed have broken up.

The reason for the near-disaster goes back to our old friends, greed and stupidity:

• Greed. Eurozone bankers – supported by governments – have maintained the fiction that they have sufficient reserves. This has allowed them to continue to make risky loans to the PIIGS (Portugal, Italy, Ireland, Greece, Spain).
• Stupidity. They seemingly failed to realise their source of deposits was about to dry up. As the above chart from the IMF shows, Eurozone banks have been dependent on the overnight ‘wholesale markets’ for 45% of their deposits, far more than any other region. And they have done little to reduce this risk since the IMF first identified it 3 years ago.

The IMF itself warned in April that they were playing a dangerous game:

“Moreover, a number of euro area banks have substantial short-term wholesale funding requirements. Current market conditions, with low short-term rates and a steep yield curve, may provide incentives for banks to maintain this short-dated funding. But such funding brings additional vulnerabilities given its high rollover rate and quick repricing. Some larger European banks also fund a significant part of their short-term positions in foreign currency, much of which is from U.S. money market funds. But this funding comes with further risks as it could be subject to quick withdrawal by money managers, as has been seen in the past.”

Once US money markets funds realised that Greece was bankrupt, they stopped lending money overnight to Europe. And at that point, the banks were on the road to bankruptcy, just as Darling had warned.

Last week, the ECB finally agreed to become the ‘lender of last resort’. But €489bn is a lot of money. When German and other North European taxpayers find out what has happened, they are unlikely to be pleased.

The blog’s Boom, Gloom and the New Normal eBook highlights the impact of the ageing Western babyboomers on future demand patterns.

Yet central banks such as the US Federal Reserve and the European Central Bank believe demographics have nothing to do with demand. For them, as one former central banker told the blog “demand is a constant”.

They have invested years of effort, and $millions, in developing complex mathematical models of demand. The algebra behind these is the equivalent of the alchemists’ search for the philosophers’ stone, as shown in the example above from a May 2006 Fed paper .

But a mathematical model based on algebra cannot replicate human behaviour. Therefore the modeller needs to believe that human nature can safely be ignored as a input into the model.

Any reader who doubts this argument might like to read the latest speech by US Fed chief Ben Bernanke. It analyses the background to today’s economic weakness. And it then goes on to ask the critical question, “Why has this recovery been so slow and erratic?”

It answers this question by referring to the idea of ‘pent-up demand’.

This concept is a cornerstone of economic models, and was developed during the babyboomer-led supercycle, when interest rate changes really did lead to temporary ebbs and flows in demand for housing, autos etc:

• Higher mortgage rates led boomers to postpone major purchases
• Their demand quickly revived when interest rates were reduced
• Meantime, more boomers had also entered the 25-54 age group
• So the release of pent-up demand was even greater

The Federal Reserve and the European Central Bank have not changed their models since the end of the supercycle, to reflect changing demographics. So they believe that the same level of demand for housing, autos etc, still exists today.

On this basis, they have assumed that more buying of near-worthless Greek bonds, or more liquidity via a QE2 programme to boost financial markets, will ensure economic recovery in the end. They are sincere people, but the blog believes they are terribly wrong in this assumption.

As John Richardson, the co-author of Boom, Gloom and the New Normal has commented:

“If you’ve spent your whole career – and built your whole reputation – on pushing a particular model it must be really hard to stand back and say, ‘Wow, I’ve been wrong for the last few years and everything has changed’.

“We also need to get past our own self-doubts, as it is really difficult for anyone less academically qualified than them (which is 99.9999% of us) to imagine that they could be wrong”.The need to challenge the power of the models is urgent. Until this happens, the global economy will get worse, not better.

Alchemists have always claimed to be able to perform the impossible. The most common claim was that they could turn lead into gold.

In Europe, the European Central Bank has been trying the same trick. It claimed to turn near-worthless Greek bonds into German-quality euros.

Now its German board member Jürgen Stark has followed German Bundesbank president Axel Weber in resigning over the issue. The reason is obvious:

• The ECB action can only work for a short period. Greece, as the blog has argued since May 2010, will never be able to pay its bills
• Germany will then end up paying the bill, when it is finally agreed that lead is not gold.

The ECB has made a major mistake by becoming an alchemist. It has lost support within N Europe, which adds to the political issues now surrounding the fate of the Eurozone itself.

Across the Atlantic, the US Federal Reserve also became an alchemist when it launched its $600bn QE2 programme. As the blog has noted over the past year, this aimed to prove that liquidity was the same as capital.

Printing money can provide liquidity to financial markets. But it cannot repair the balance sheet in the housing market. As with Greece, banks that lent capital unwisely will not be repaid.

And just as in Europe, two Fed Governors, Charles Plosser and Richard Fisher, have rebelled against Fed policy. They argue that the Fed’s focus on supporting the stock market has done nothing for the real economy.

Tomorrow, the blog will look at the key issue of why the two most important central banks in the world have made such similar errors of judgement.