President Donald Trump and French President Emmanuel Macron participated in a joint press conference Monday, Aug. 26, 2019, in Biarritz, France, site of the G7 Summit. They both tried to let some steam off the financial system, but in vain. (Official White House Photo by Andrea Hanks)
Unquestionably, everything is wrong in the international financial system, even though the major central banks have actually donated trillions to the banking ‘community’. The US central bank, the Fed, has lent almost free of charge $4.5 trillion to the American banking hub. On this side of the Atlantic Ocean, the European Central Bank has done the same in the euro area with €2.7 trillion at flat zero interest rate. On top of that, according to a latest ECB decision, it charges negative interest rate for its loans to banks. Obviously, this means at maturity that the banks return to the ECB less than what they borrowed.
The odds are so precarious that the slightest likelihood of a mild recession of one or two GDP percentage units cannot be tolerated by the global financial system. The reason is very simply that the world is immensely deep into debt and risky placements, much more so than in the period ahead of the 2007-2008 financial meltdowns.
Distorted markets
All capital markets are in such a bad shape and distorted, that over-indebted and more or less receding Italy can borrow money at a lower cost than the US government. Last Tuesday, the Italian ten year bond was traded at a yield of around 1.2%. On the same day the 10-year US Treasury was turning out for the investors 1.488%. This is exactly one important and characteristic symptom, signaling the utterly unhealthy status of the global financial markets.
Why are investors willing to risk billions for half a percentage point more in returns? The answer is very simple: they bet with other people’s money. The major banks have created complex financial instruments and are thus able to risk the money they have received from the central banks for free, although in reality illegally. By the same token, they cash in very large commissions for intermediation in complex financial bets. It’s rarely clear and practically not lucid at all if it’s proprietary trading or on customers’ account.
Inverted rates curve
Not to say anything about the much advertised inversion of the rates curve, yielding less for the longer maturities than for the shorter. The economically correct is, of course, the other way around and such a worsening of this unhealthy tendency preceded the previous crisis. The reason is that investors don’t mind getting less (30 years US treasuries) or even pay (German government bonds) to park their money in safer placements, like low risk prime government debt.
Returning to exploding indebtedness, turn and twist as the banks may, a time comes when some debts and interest must be paid. For as long as there is growth in the real economy, interest for refinancing a growing debt can be paid. In the good times, then, everybody on rising incomes by 2% to 3% can easily pay interest to recycle their growing obligations. So, every banker will be more than willing to refinance his clients’ debts, for as long as they can pay interest out of rising incomes. This way, everybody is happy.
Taking refuge
When incomes of all kinds stagnate, however, or even fall in a recession, paying interest on rampant debts becomes an increasingly difficult exercise. Some of the more reckless lenders and borrowers may then find themselves in a difficult position and possibly go bankrupt. Unfortunately, insolvency is a contagious disease and soon leads to a general fallout, as happened ten years ago.
That’s why the slightest indication of a recession poses so many problems and has already touched the US stock market. In a later phase, a fall in stock market values will surely have repercussions on many borrowers and undermine their ability to honor obligations. This is already happening. That’s why many investors accept negative returns for their placements in highly secure government bonds.
Paying for safety
This phenomenon has acquired dangerous dimensions having reached levels of tens of trillions of dollars and euros. An increasing number of investors accept to pay interest in order to safely park money. They are not stupid; they predict a general fallout, where only governments like the US or Germany will continue honoring their obligations.
Practically, then, the next financial crisis is here. It hasn’t yet touched the real economy or the taxpayers, who will be again asked to act as insurers of last resort for the imprudent bankers.
Capitalism just selling the rope it’s hanging itself.