The trigger for the next financial crisis

We know that financial crisis are recurring. The last one was in 2008, almost 8 years ago, so it is not difficult to forecast that a new one is in the making.

The trouble for investors is that it is almost impossible to forecast when a new crisis will arrive. It may be next month, next year or in five years. Who knows?

Another annoying feature of financial crisis is that it is equally difficult to foresee which drop will spill the glass, that is, what will be blamed as its trigger.

Paul Krugman just listed two possible candidates – China and oil – in his NYT op-ed “The 8 A. M. Call”.

So, let me add another candidate – IRRBB Interest rate risk in the banking book – caused by the excessive reliance of banks on the derivatives market.

This choice may sound odd, given that the Basle Committee has been working hard on new standards for this risk which will be implemented in 2018, aimed at preventing IRRBB to materialize when interest rates normalise from historically low levels. Indeed, the notional value OTC derivatives which at end-2014 was 6.5 times larger than all outstanding debt securities has been reduced by 70 trillion USD in the first half of 2015.

It really does not matter if the crisis is triggered in these markets, or any other place like the M&A or the currency markets. The “fire” can be started anywhere, as long as the “wood” is close enough to spread it by contagion.

What matters is to know whether the “firemen” are capable of containing it.

In this regard the perspectives are frightening, given the resistance to apply the so-called Volcker rule to ring-fence commercial banking from investment banking, the exhaustion of ammunition by central banks to deal with a liquidity trap and the balance of public finances in some major economies.

More on Greece: Krugman’s utopia or folly?

Nobel Laureate Paul Krugman’s case for reducing Greece’s debt service so that she no longer needs to run a large budget surplus is the following: “Suppose that the multiplier is 1.3 — which is what IMF estimates seem to suggest — and that Greece can collect 40 percent of a rise in GDP in revenue (roughly matching its average revenue/GDP). Then an additional billion euros in spending should generate around 0.5 billion euros in revenue, reducing the primary surplus by only 0.5 billion euros”.

However, his back-of-the-envelope calculation is based on an unfounded optimism about the public spending multiplier. I know that he knows that the multiplier effects of spending (public or private) are reduced through import and saving leakages. But, what he (and other optimists) usually miss is that such leakages are extremely dependent on the confidence about the spending policies being implemented.

For instance, if Greek politicians are not credible the multiplier could suddenly reduce to 0.5 and the primary surplus would be reduced by 0.8 billion euros. Or, even worse, if the ruling party is seen as revolutionary, as is the case with Syriza, the leakages may even turn the multiplier into negative values (e.g. -0.5), in which case the primary surplus reduction would be 1.2 billion euros and the current surplus would quickly vanish and destroy any lenders’ willingness to refinance the current debt level ad aeternum.

Indeed, without their own currency, capital controls and the possibility of imposing trade barriers, the leakage through imports is inevitable. Likewise the fear of the radical Syriza policies will accelerate capital flight which is a form of “hoarding”. Moreover, an unexperienced left wing political coalition is usually the most fertile ground for corruption and mismanagement which again act as a form of “hoarding”. In a country already plagued by a culture of corruption, a change towards a “loony left” will only exacerbate the problem.

In conclusion, Krugman’s call to give more importance to debt flows than debt stocks is not a folly, but in Greece’s circumstances it is certainly utopia. So the European countries should only agree to more public spending if Syriza passes a test of political responsibility and can be tied up to a properly designed adjustment program (not the ones implemented in the past by the Troika).

Capitalism and Keynesianism (Left and Right)

Market capitalism is an economic system based on free competition. In theory, it is a system that guarantees automatic market equilibrium and the optimal allocation of resources over the long term. In the short run disequilibrium is a recurrent feature of the system that is permanently corrected through competition.

To put it simply, excessive supply is reduced through diminishing profits and insufficient supply is raised up by entrepreneurs in the lookout for profit opportunities created by such shortages. Unfortunately, this process of automatic adjustment is not instantaneous and in practice market capitalism is naturally bound by cycles in business activity, popularly known as recessions and booms.

Keynesianism is a set of policies advocated by Keynes to smooth such business cycles. Writing in the aftermath of the crisis of 1929, Keynes proposals were aimed at deep and prolonged recessionary phases when the entrepreneurs drive for action, which he termed “animal spirits”, was so depressed that they were unable to restore growth by profiting from the opportunities created by supply destruction.

For these circumstances he advocated a demand shock through monetary and fiscal easing, or just increased government spending for economies caught in a so-called liquidity trap (when interest rates were close to zero). Using a medical analogy, Keynesianism advocates the prescription of hard drugs to treat a severe depression.

It is obvious why his economic stimulus therapy is necessarily controversial. Similarly to hard drugs, more public spending has many negative side effects (most importantly, it may reduce the share of market capitalism in the economy and its competitiveness). Just as doctors may disagree on the severity of a particular depression and the efficacy of soft treatments like exercise and therapy, economists also disagree on the effectiveness of soft supply-side treatments such as more training, deregulation and labour market flexibility to treat severe recessions.

Regrettably, these controversies are inevitably more tainted by ideology in economics than in medicine. So, those more collectivist-driven will see in any mild reduction in economic activity (say a quarterly decline in GDP or a rise in unemployment) a justification for more government intervention. Likewise, when faced with a severe recession (e.g. four or five consecutive quarters of economic contraction), those terrified by the danger of collectivism will repudiate any intervention and ask for more patience to give time for the automatic forces of competition to wake up.

On the collectivist side we often find leftist politicians. And, not surprisingly, Keynesianism is often confused with a left-wing ideology. This is compounded by the fact that some of the most famous Keynesians (e.g. Joan Robison in the past and Paul Krugman today) are influential leftist ideologues.

This is obviously a mistaken perception, because we have many collectivist advocates on the right. Most notably, among them we have the advocates of state and managerial capitalism including many right-wing Corporatists and Christian-democrats.

Indeed, Keynesianism is not about left or right but about wisdom and common sense. That is, economists and politicians should be able to assess in a dispassionate way when to give up on the automatic resumption of growth through the self-correcting mechanisms of competition and to be able to carefully design stimulus packages that do not hypothecate the future of market capitalism.

Common sense must be based on simple benchmarks. For instance, demand-management policies should only be adopted when unemployment exceeds a given range (say, 8% for collectivists and 12% for libertarians). Currently, using such criterion, we need Keynesianism in Southern Europe but not in the rest of the Eurozone. This is obviously a difficult but not impossible task in the context of a monetary union.

To conclude we need Keynesianism as a temporary solution for special circumstances. But we are left without knowing if Keynesianism also can be used in a pre-emptive way to face anticipated external shocks (e.g. a breakup of the Euro Zone). This controversial issue is left for a future post.

German fun vs. Spain´s pain

The debt markets are focusing on Spain again, and the debate between fiscal conservatives and stimulus proponents rages once more. Paul Krugman has just published another post showing that before the real estate bust Spain´s public debt was much lower than Germany´s. He compares net flows in 2010 and 2007 to state his case. This is not a reliable method to compare leverage levels. So here are the most recent balance sheet values as published by the OECD.

It is true that with an economic size of less than half the size of Germany (43%), Spain´s government debt was just one fifth of Germany´s public debt. However, the Spanish economy as whole had a net debt equivalent to almost 80% of GDP, while Germany was a net creditor, and between 2007 and 2010 increased its creditor position from 6% to 21% of GDP.

In what concerns the shares of public consumption in total GDP we can see from the following table that the share in Spain is only marginally higher than in Germany.

The fundamental difference between the two countries is that Spanish companies borrowed more than German firms while Spanish households saved very little when compared with those in Germany.

Moreover, some of the borrowing was financed by Germany and was mostly invested in loss-making real estate. Indeed, the robust public finances in pre-crisis Spain were the result of paper profits generated during the real estate bubble (in a fashion not much different from the Clinton surplus during the internet bubble).

So, the Spanish problem is a banking problem and should not be transformed into a long term fiscal problem, like in Ireland, which will compromise its future growth.

Markets behaving badly again?

The Obama administration $25 billion deal struck with the nation’s five biggest mortgage servicers tops numerous other approaches to boosting the housing market that have conspicuously failed to prop up the economy.

However, such attempt at propping up real estate prices to the levels achieve at the height of the previous bubble is a questionable objective. First, it disregards the ability to pay of homeowners and second it risks creating a new financial bubble.

Indeed, the financial bubble seems to be already blowing if one looks at the chart below where we compare the evolution of house prices (measured by the Case-Shiller Index), with the trend in real estate investment funds (measured by the Ishares Real Estate Trust) and the stock market (measured by S&P 500 index).

The chart shows that there is again a large differential between the price of financial assets (IYR) and the price of their underlying real assets (houses). Although some lagging between real and financial assets is normal, wide deviations usually occur in bubbles or crashes. This fact is important for homeowners as well as to macroeconomic policy and monetary quantitative easing in particular.

Back in the 1930s, the debate between Keynes and Hayek on the efficacy of stimulus policies discussed the relationship between asset prices and production prices. Hayek believed that markets left to their own would restore the prices of assets without increasing those of production. In contrast, Keynes argued that piling up bank balances or purchasing existing securities to bid their prices to previous levels would cause the release of real resources (capital and labour) while failing to find new opportunities to invest them due to a lack of confidence (“animal spirits”). As it turned out the recovery only came about after a number of years through government stimulus of the worst kind (armament and war spending).

Therefore, modern Keynesians like Paul Krugman who are sceptical about the sustainability of quantitative easing should be less soft on quantitative easing and more committed to devise deficit stimulus packages that have a less costly multiplier effect. My own suggestions about the government spending multiplier can be found in this post.