The House of Cards: EU Edition

 

It’s been an implicit theme of this blog that ultra-low interest rates, even into negative territory, pursued by economically failing developed countries, are more a problem than a solution.

Allow me to make that explicit.

The policy derives from a complete and exclusive focus on Keynesian thinking: The lower the cost of credit, the more of it will be sought and used to finance spending for consumer durables and capital equipment. This in turn might generate income and jobs. With capital investment prospects being painfully limited (which is the problem not being addressed), the enticement of low interest rates, even at subsided (negative) rates has had a meager advantage.

However, negative rates are undercutting financial intermediaries. This will only create major disasters that governments will have to underwrite.

Basically, no financial intermediary would seek to place a loan or purchase a fixed income instrument at a negative rate unless they were forced to do so. That force is called financial regulation. Simply put, negative rates do not generate investment income. Therefore, the financial intermediaries — be they banks, credit unions, pension funds, or insurance companies — will be unable to perform on their obligations to their customers.

That is, insurance companies will be unable to service annuities; banks will be faced with insufficient income to generate income for themselves or pay a positive deposit rate; depositors will flee; pension funds will need to revise upward pension contributions (and they are in the process of doing so) and will, in addition, roll-back promised pension benefits.

With all these private contracted benefits being challenged and ultimately being unmet, there becomes an enormous pressure on governments, not just from countries ruled by social democrats, to save the majority of voters who are adversely affected.

This then becomes an additional burden on government finance for countries already being supported by their central banks. In fact, the European Central Bank, despite an explicit treaty provision not to monetize government debt, is already doing so in earnest. Additional challenges to cover financial intermediary failures puts the ECB farther into unchartered waters for the use of the printing press.

Another source of funding would be to lean upon other governments to bail out depositors, as was done with Greece and Cyprus. However, this only strengthens pro-exit political parties in the countries financing the bailouts.

What one can expect next in these circumstances is capital flight because of the ultra-low returns-to-fixed-income investment and bank deposits becoming risky. This turns into full throttle capital flight at advanced stages, as the capital outflow continues to make the currency relatively cheaper. And wealth owners will flee that.

At that stage, financial prices reflect a flight to quality – a preference for currencies and debt instruments of countries not facing these issues – and precious metals.

The downer in economic circumstances becomes so great that countries then seek to reinvent themselves in a political-economy dimension. For European governments, compromises made in the context of the benefit of unification are re-appraised, seeking some advantage to go it alone. Going it alone allows a country its own rules and its own currency that cheapens with capital flight. The cheap currency becomes an equilibrating device as exporting becomes more promising.

That is the house of cards the EU has built, now falling one by one — and the latest unstable card in Europe are the Italian banks. They aren’t only suffering depleted investment income from low rates available on their investments but also from a backlog of defaulting loans. Italy is attempting to infuse €40 billion into its banking system with the pretense of covering losses well exceeding that. However, to do so violates the very responses that were agreed upon by the EU just two years ago.

At that time, the banking system was bolstered by an EU deposit insurance commitment that was never funded.

Instead, the EU decided to build a firewall around its banking problems to keep them from being met by the government. They mandated that their banks sell “CoCo” (contingent convertible) bonds. These bonds convert to stockholder shares when the banks admit losses. The question then becomes who takes the losses. In this case, the CoCo bond holders were set up to automatically take the hit ahead of depositors and protect the government from being called upon for a depositor bailout.

Well, things have become bad, and it’s time to convert the CoCo bonds to stock. However, the banks sold the CoCo bonds to retail clients seeking the high positive returns that such a risk should command. Now retail investors, among others, are in line to sacrifice their positions to protect the banks’ losses, which, in turn, protects the government from the need to cover those bank losses — but there is a catch. No self-respecting social democrat government will allow retail bond holders to take a hit on behalf of the banks, even if they were paid to do so.

So this is where the matters stands: the Italian government is attempting to raise €40 billion, despite a reported €360 billion of nonperforming loans, to provide a pretense of a capital infusion for the banks. This is despite the objections of the EU, as it varies from the “plan” of private capital backstops. And no other country, as you might expect, dares to step up at this time to aid Italy.

In the meantime, the market reflects a flight to quality in the prices, especially of US, German, and Swiss government bonds, the prices of silver and gold, and the sale of private personal safes. The market is just awaiting the next chapter of the soap opera called The House of Cards.

The only question is how far will disintegration go this round? And if not this round, the next?

 

To read more by Professor Lew Spellman, visit The Spellman Report.

Disclaimer

The views expressed are those of the author and not necessarily The University of Texas at Austin.
 

About The Author

Lew Spellman

Professor, Department of Finance, McCombs School of Business, The University of Texas at Austin

Lewis Spellman received his BBA and MBA from the University of Michigan and his MA and Ph.D. from Stanford University. His research interests include...

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