Ben Shahn Nickel Inn August 1938
"Quick lunch stand in Plain City, Ohio"
The ending of extend-and-pretend is ushering in a new era of fear and uncertainty which is rapidly evolving into the next phase of the on-going credit crunch.
It is becoming clearer to many that the problems run much deeper than they had perceived, and more people all the time are realizing the systemic nature of the risks we are facing. Fear leads to knee-jerk reactions. In financial markets, it leads to volatility and self-fulfilling prophecies to the downside. It leads to capital flight, and then to capital controls.
Capital controls were an integral part of the Bretton Woods regime, but went out of favour in the expansionist Washington Consensus era that followed. They remain controversial.
Douglas Rediker, a senior fellow of the New America Foundation and until recently a member of the executive board of the IMF, says:"There are no winners in capital controls. But if banks and your economy are losing capital, you may use them to stem the tide. It’s not winning, but it’s not losing as bad as you might otherwise.
Capital controls appear to have limited contagion and economic damage in the Asian Financial Crisis in 1997/98. In later cases of relatively isolated financial crises, notably Iceland, they have also been credited with limiting the scope of krona currency crisis.
Capital controls are rapidly returning to official favour, but the likelihood of being able to employ them to contain a crisis orders of magnitude larger in scope is very small. Under such conditions, the risk is that capital controls will amplify the fear that is the driving force for capital flight.
The spread of financial contagion – fear by another name – is increasingly evident in Europe at the moment. Interest rates are one measure of fear, representing the perceived risk of default and thus a risk premium. As this perceived risk rises, interest rates go up, but this has the effect of making the debt harder to repay, leading to a further increase in the perceived risk of default, and therefore higher interest rates yet again.
Once a country is trapped in this vicious circle, collective psychology tells us where it will lead – to default. Similarly, austerity programmes force default by making it more difficult to repay loans by forcing economic contraction. Positive feedback loops have an inexorable progression that picks up momentum as they proceed.
Perception of risk drives capital flows – away from problem states and toward safe havens. What happens is that spreads rise. Perception of high risk leads to much higher rates, whereas perception of lower risk leads to falling rates, at least in the early stages of a financial crisis. Safe haven status does not require objective measures of safety or sounds fundamentals. All one has to be is the least worst option. Money goes from where the fear is to where the fear is not, pushing some over the edge, while buying time for others. In either case, large capital flows are destabilizing, and governments will try to use capital controls to prevent them.
The situation with the erstwhile European single currency is the epicentre of financial crisis this time. It is creating multiple risk distinctions – periphery versus core within the eurozone, long term versus short term, and also an increasing disparity between the euro countries and those outside the single currency. Clearly the interest rates are rising in the countries of the European periphery, to the point where these countries are effectively being shut out of international credit markets, and the businesses, local authorities and individuals within them are experiencing knock-on drying up of liquidity.
Funds are leaving these countries and moving towards the core states, but this move reflects only risk disparity within the eurozone. Some parties remain comfortable with the euro as a concept and are content seeking the relative security of the stronger states within it. Others take a broader view and have already lost trust in the single currency. For them, an acceptable level of risk begins with holding no euro-denominated assets at all.
Interest rate spreads are broadening within the eurozone, but core country rates are also beginning to rise, albeit from a very low level. To some this appears confusing.
Robin Wigglesworth for the FT:
Borrowing costs for Germany, the UK and France, deemed among the safest sovereigns in Europe, rose sharply on Tuesday as investors took fright at the worsening crisis in Spain.
Yields on Spain’s government bonds soared to their highest level since the launch of the euro. The yield on benchmark 10-year debt increased to more than 6.8 per cent.
However, it was the climb in borrowing costs of the"core" sovereigns, which typically tended to move in the opposite direction of the periphery’s bond yields, that unnerved many investors.
Germany, the UK and France’s 10-year bond yields have risen 25 basis points, 16bp and 47bp to 1.42 per cent, 1.69 per cent and 2.73 per cent respectively since the start of the month.
Spreads can continue to rise within the eurozone while rates for the whole region rise relative to other sovereigns believed to represent a lower risk. All risks are relative, and the risk-averse psychology of a decline magnifies all differences. Attempts by central authorities to fight the psychology of decline with bailouts perversely reinforce it under such circumstances, by convincing investors that there really is something to worry about. The psychology of a rally is supportive of central interventions, making them appear successful, but declines make central authorities look incompetent, no matter what they do.
Each subsequent bailout, meant to be definitive, buys less and less time before the spiral of fear continues upward again. In the case of Spain, yields began to rise again mere days after a $100 billion bailout that was not even contingent on austerity measures, as previous bailouts for other countries had been.
The growing impetus for fear-driven risk avoidance is already causing problems, not just for the countries where capital is leaving, but also for the safe-haven recipients. The US, representing the safe haven of the reserve currency, has seen substantial inflows that are causing problems for the banking system.
Dakin Campbell, Dawn Kopecki and Bradley Keoun for Bloomberg:
Deposits are flooding into the biggest U.S. banks as customers seek shelter from Europe’s debt crisis and falling stock prices. That forces lenders to raise capital for a growing balance sheet and saddles them with the higher deposit insurance payments. With short-term interest rates so low, it’s hard for financial firms to reinvest the new money profitably.
Regulators have asked banks to take the deposits anyway, three people said, with one lender accepting $100 billion. The regulators want lenders to take the deposits because it improves the stability of the financial system, according to one of the people, who said U.S. banks are viewed as places of strength…
…The extra deposits are problematic because they’re subject to withdrawal, so banks have to park the money in low-yielding short-term investments, Litan said. With few other choices available, banks have stashed their excess deposits at the Fed, which means the cash gets counted as assets. This expands their balance sheets and thus pushes down their leverage ratio, which measures Tier 1 capital divided by adjusted average total assets; the lower the ratio, the weaker the bank, at least in theory…
….At least one firm, Bank of New York Mellon Corp. (BK), tried to recoup some of the costs by charging depositors 13 basis points, or 0.13 percent, for holding unusually high balances.
Europe’s financial crisis is also supporting the value of the US dollar. A knee-jerk flight to safety into the reserve currency has been underway for some time already, and shortages of dollars are now increasing demand beyond supply. This dynamic has a lot further to go as dollar denominated debt, of which there is more than any other kind in the world, begins to deflate in earnest. Dollar liquidity will be in increasingly short supply.
Lukanyo Mnyanda, Emma Charlton and Allison Bennett for Bloomberg:
Central banks rebuilding foreign- exchange reserves at the fastest pace since 2004 are crowding out private investors seeking U.S. dollars, boosting demand even as the Federal Reserve considers printing more currency.
After falling to an all-time low of 60.5 percent in the second quarter of last year, the dollar’s share of global reserves rose 1.6 percentage points to 62.1 percent in December, the latest International Monetary Fund figures show. The buying has left the private sector with $2 trillion less than it needs, according to investment-flow data by Morgan Stanley, which sees the dollar gaining 8.2 percent in 2012, the most in seven years.
While the Fed has created more than $2 trillion under its stimulus programs since 2008, the flows signal that there may actually be a shortage of dollars to meet demand as Europe’s debt crisis deepens and the global economy slows. The dollar has risen 3.5 percent since the end of April against a basket of the most-widely traded currencies even amid speculation that the Fed, which meets this week, may undertake the type of stimulus measures that weakened it in the past.
"The market often assumes that people are long dollars, but many of those dollars are held by central banks, which are unlikely to move out," Ian Stannard, head of European currency strategy at Morgan Stanley in London, said in a June 13 interview."That leaves us with the private sector, which is short," meaning they don’t have enough of them, he said."In an environment where we see a global slowdown, the dollar will be well supported."
Safe haven status can lead to negative nominal interest rates, as interest rates are a risk premium. Rather than asking for a return, spooked investors are prepared to pay for the privilege of capital preservation. They are less concerned with the return on capital than the return of capital. In Switzerland, a major safe haven recipient of capital fleeing the eurozone, negative rates already apply. In the US, short term rates are likely to stay low, but longer term rates may well be on the verge of rising.
States are seeking to prevent destabilizing capital flows. We are currently seeing the beginning of a process that has very much further to go. Switzerland responded early on with determination to peg its currency to the euro, in an attempt to prevent its currency appreciating to the point where its export markets would suffer. However, currency pegs merely present a tempting target for speculators. They may stand for a while, but if the underlying condition that gave rise to capital flows is not addressed, currency pegs can prove impossible to maintain, costing sovereign states a lot of money while making a fortune for tenacious speculators with far more ammunition than states can defend against.
Graeme Wearden for the Guardian:
Giles Watts, head of equities at City Index, warned that Switzerland could find itself in a battle with currency speculators to hold the value of its currency down.
"Most interventions in the currency markets by the authorities of late have only helped prices in the short term at best. If the euro crisis intensifies there is every chance the market could test the SNB's resolve to hold the cross rate above the 1.20 level," Watts said.
Last month, the SNB pledged to keep interest rates near zero and increase the supply of Swiss francs available to traders. This move did not succeed in weakening the currency.
The Japanese yen has also been driven higher since the financial crisis began, hurting the country's exporters and prompting Japan's central bank to launch its own interventions.
Louise Cooper, markets analyst at BGC Partners, warned that central banks do not have unlimited power – as the UK learned during Black Wednesday in September 1992. "The Japanese example with yen intervention teaches us that intervention can work in the very short term but changing long-term global currency flows is near impossible – a lesson that the UK learned from George Soros," Cooper said.
The Swiss efforts to hold down the value of their currency, although unlikely to succeed in the long run, may accentuate upward pressure on the currencies of other non-euro safe havens, threatening their export markets in turn.
Simon Kennedy and Emma Charlton for Bloomberg:
The initiative may leave Norway and Sweden vulnerable to unwanted gains in their currencies as countries such as Brazil and Japan fight to limit appreciation amid a flight from the euro debt crisis and near-zero U.S. interest rates. With Group of Seven finance chiefs set to hold talks this week, it also exposes the clash among policy makers counting on exports to offset slumping demand at home.
"We will see a lot more intervention now, we will see manipulation on a grand scale," said Stuart Thomson, who helps oversee about $120 billion as a portfolio manager at Ignis Asset Management in Glasgow."Traditional safe havens are trying to undermine the value of their currencies."
What we are headed for are global currency wars, with rounds of beggar-thy-neighbour currency devaluations, ultimately leading to the end of the fiat currency regime. The every-state-for-itself mentality is a major part of the psychology of contraction. This is the attitude that is tearing at the socioeconomic fabric of not only the eurozone, but ultimately of the European Union as well.
Where national interest become paramount, and the interests of the collective are lost, the endgame has arrived for the supranational entity. Political aggregations are increasingly fissile under such circumstances. For now, it is Europe in the crosshairs, but broader global divisions are on their way.
Capital controls, on both inflows and outflows, will be far more extensive than currency wars, however. We can expect all manner of attempts to control money flows at all scales. The impact will be widely felt by people trying to protect their scarce resources by removing them from the system while that is still possible. This can be difficult, and for ordinary people without the ability to send funds abroad leads there is a need to protect it domestically. Options are limited and increasingly risky.
David Böcking for Der Spiegel:
Many Greeks are emptying their bank accounts out of fear that the country may return to the drachma. But most of the money is not going abroad. Instead, individuals are storing cash in safe deposit boxes or at home — leading to an increase in burglaries…
…There is still little sign of panic in Greece, and there has not been a stampede to the banks. Nevertheless, people are withdrawing hundreds of millions of euros from the banks every day. In May alone, outflows totaled €5 billion. According to official figures, €80 billion has been withdrawn since the start of the crisis…
…Rich Greeks have long been moving billions to countries such as Italy or Switzerland, or buying luxury properties in London. But overall, according to estimates by the Greek central bank, only about one-fifth of the total money withdrawn has gone abroad. Many customers have left their money in the bank itself, Christiana says — but in a safe deposit box rather than in their accounts."It's currently impossible to find a free safe deposit box in a Greek bank," she says.
Those customers clearly don't want to be surprised by a currency reform. There has long been speculation over how that could work. The banks could close over a weekend, take stock of the euro holdings in their accounts and prevent further transfers to foreign accounts. Euro bills which are already in circulation would be marked with stamps. The export of unmarked bills would be prevented at the borders. Within a short time, the drachma could be reintroduced…
…Greeks now have around €50 billion stashed at home, reports the Greek newspaper Ta Nea, citing the Greek Finance Ministry. Burglaries are increasing as a result. In Crete, they have gone up by 700 percent within two years. Burglars recently stole €50,000 in cash from a house of an old couple in Athens.
The crisis may now increase the social divide in Greece, just as it has done many times in recent years. While members of the upper class have long managed to stash their money in safe places, a possible currency reform and the subsequent devaluation would probably hit many low-income earners unprepared.
Safe deposit boxes are not a secure option in the event of a bank run. If the bank’s doors are shut, the likelihood of being able to access a safe deposit box is vanishingly small. The odds of the contents remaining where they were left for long enough for the owners to be reunited with their property are also rather low. Even when there is no threat of an imminent bank run, financially-strapped central authorities may be minded to help themselves to the assets of others.
Elisabeth Leamy for ABC News:
"They figured the safety-deposit box was safer than keeping it under the mattress. In the case of a lot of citizens, they were wrong, weren't they?"
California law used to say property was unclaimed if the rightful owner had had no contact with the business for 15 years. But during various state budget crises, the waiting period was reduced to seven years, and then five, and then three. Legislators even tried for one year. Why? Because the state wanted to use that free money…
…Some states keep their unclaimed property in a special trust fund and only tap into the interest they earn on it. But California dumps the money into the general fund — and spends it.
Governments may also decide that the contents of safe deposit boxes may constitute evidence of criminal activity, and reserve the right to assess the property stored, making the owners prove legitimacy. In a liquidity crunch, it is quite likely they will regard there being no legitimate reason for holding cash, and private gold ownership may be declared illegal. Both cash and gold could be subject to confiscation.
Richard Edwards for The Telegraph:
Scotland Yard said that Met’s Specialist Crime Directorate raided seven properties: three safe depositories, an office and three residential addresses…
…"Operation Rize is a money laundering investigation and is entirely unprecedented, one of the largest of its kind ever undertaken in the UK," he said. "In the past safety deposit boxes have been searched on an individual basis often resulting in the recovery of guns, drugs and cash. We believe that this operation has the potential to impact upon many layers of serious crime."
The investigation has been running for two years and included intensive work with lawyers to ensure they were able to seize all of the boxes.
Members of the public who have innocently and legally stored their valuables were"inevitably" going to get swept up in the disruption, it was predicted.
Legal niceties are very likely to go by the wayside as deleveraging proceeds and the global grab for scarce cash begins in earnest. Those who posses the power to grab assets left in harm’s way are very likely to do so, then possession will be nine tenths of the law.
Simon Black for Sovereign Man:
European officials yesterday flat out admitted that they were discussing rolling out a series of harsh capital controls across the continent, including bank withdrawal limits and closing down Europe’s borderless Schengen area.
Some of these measures have already been implemented sporadically; customers of Italian bank BNI, for example, were all frozen out of their accounts starting May 31st upon the recommendation and approval of Italy’s bank regulator. No ATM withdrawals, no bill payments, nothing. Just locked out overnight.
In Greece, the government has taken to simply pulling funds directly out of its citizens’ bank accounts; anyone suspected of being a tax cheat (with a very loose interpretation in the sole discretion of the government) is being relieved of their funds without so much as administrative notification.
It’s no wonder why, according to the Greek daily paper Kathimerini, over $125 million per day is fleeing the Greek banking system. European political leaders aim to put a tourniquet on this wound in the worst possible way.
Moving money abroad to a safer haven is not the simple solution one might imagine either. Governments that could not stop the hemorrhage as it was happening are seeking to reverse the capital flight after the fact. Of course, such actions will only further inflame fear, while doing nothing to address the reason for capital flight. They will thus increase the impetus for capital to flee in any way that it can.
All around the globe one can find evidence that money is moving around with the sole purpose of finding someplace"safe". Capital flight is a perfectly logical consequence in today’s world. Barely a day passes where we are not reminded that nothing is safe any more. Not our currencies, not our equities, not our bonds and certainly not our banks/brokers.
In Greece there are many example where capital flight is undermining stability. The most obvious is the capital flight from the Greek banks that has taken place over the past few years. This flow of money is also perfectly logical. There are many risks of leaving money in a Greek bank:
•The Bank could default. The principal in the account is at risk.The guarantee (up to E100k) is from the government. What's that worth?
•The government could default. The chaos that would follow would result in a freeze of all bank balances.
•The government could announce one morning that it was re-establishing the Drachma. This would mean that any Euros in a Greek bank would be automatically converted into Drachmas at the old official rate. The value of those Drachma would be worth half (or less) as a result of the immediate devaluation that would occur…
…A move is being made in Brussels to"force" the Swiss government/banks to transfer all of the assets of Greek citizens back to the Greek banks. For a Greek this means that your money is hostage. It has been functionally expropriated. It will be transferred into a banking system that is fraught with risk. Some portion of the money that goes back to Greece will certainly be lost…
…If this happens (the folks in Brussels are pushing hard) a very dangerous precedent will have been set. Flight capital will have been made illegal.
Capital flight from the periphery is currently being quietly financed by other European central banks, allowing Greeks and other depositors in the periphery to continue withdrawing funds without banks closing their doors. Instead of a bank run, we have seen what has been described by several commentators as a "bank jog".
However, the rest of the eurozone cannot continue such support indefinitely, especially as fear causes the pace of the ‘jog’ to pick up, and contagion spreads the problem to other states. When that support ends, bank insolvency will be revealed.
The kind of capital controls one should expect, and prepare for, include:
•Restrictions on bank withdrawals
•Restrictions on money market fund redemptions
•Greater restrictions on retirement fund liquidations
•Fixing an official exchange rate and criminalizing market rate transactions
•Banning the conversion of domestic currency to foreign currency
•Banning the movement of assets out of the country to foreign financial institutions
•Barriers, restrictions, additional transaction costs imposed on foreigners seeking to deposit funds or make investments in safe havens
•Forcing sovereign debt owners to accept longer maturities rather than principal repayment
•Banning gold ownership
•Reissuing the currency in a new form (an acute risk in Europe obviously)
•Restrictions on the size of cash transactions
Assets held within the grip of the system are at risk. There is a critical dependence on the solvency of middle men, on government guarantees, and on the powerful resisting the temptation to grab what they can in the financial free-for-all of deflation and deleveraging that is picking up momentum. None of these is a good bet. Whatever actions one might plan to take, it is necessary to take those actions before push comes to shove. That way they can be taken under conditions of relative calm.
There are no no-risk solutions, but different options will suit different people, depending on their circumstances. Some may choose to store assets in another jurisdiction or in another currency if those options are available, but losing control over assets abroad is a distinct possibility, as is difficulty in converting the currency chosen as a store of value back into something that will functions as cash at home.
Physical travel may become much more difficult as capital controls lead to border controls of other kinds. Holding assets close to home gives one the greatest degree of control, but with certain obvious risks attached. Typically, he who loses the least in a deflation is the winner, as there are no easy answers.
Once fear is in the ascendancy, it is very difficult to combat. Governments and central banks simply do not have the control they think they do, and they do not understand the nature of battle they are engaged in. It is not a matter of restoring certain objective conditions. Central authorities are trying to fight the inexorable recognition that the magnitude of the debt that has resulted from our 30 year credit expansion dwarfs the wealth of the world, that the $70 trillion in G10 debt underpins some $700 trillion in derivatives.
That realization, and the natural reactions stemming from it, are the problem. As confidence evaporates, so does liquidity. Credit – the vast majority of the effective money supply – ceases to be equivalent to money. The resulting crash of the effective money supply is deflation by definition. This is what we have been predicting since the inception of TAE. This is how credit expansions always end – with the implosion of credit instruments that amount to no more than a pile of human promises that cannot be kept.
Martin Wolf for the FT:
Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK.
It is often forgotten that the failure of Austria’s Creditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard…
…How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile…
…Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events.