A new financial crisis has begun...
The central element is cash flow. The conversion of trade and
activity will reduce incomes for households and businesses, decreasing
consumption, which makes up around 50 to 70 percent of economic
activity. Slowing demand reduced the need for investment. Government
spending is unlikely to make up the shortfall due to an obsession with
spending cuts, the constraint of rising budget deficits and high debt
levels. Fear of wars means many countries must trade-off ‘guns and
butter’. Rentier income from investments will fall. Erratic
decision-making and reciprocal economic stupidity will heighten
uncertainty and sap consumer and business confidence.
Cash flows
drive asset prices. The values of all financial assets ultimately depend
on their future earnings. Actual or, in the case of nascent businesses,
the likelihood of future earnings will decline, bringing down the
prices of shares and real estate. Even with the recent buoyant economy,
many businesses are not profitable or don’t have positive cash flows.
Others with high leverage can barely cover interest payments. Enthusiasm
for speculative investments, like AI projects, which have generated few
compelling revenue-generating products, is waning. The ‘greater fool
theory’ that you can always sell at a higher price to someone was always
financial charlatanism.
(...)
The principal weakness is debt, which there is no shortage of. Without
nose-bleed borrowing levels, cash flow decreases are tolerable. If
equity is a soft bed, debt is one of the nails. Tariffs and sanctions
will raise price pressures and make it difficult to return to the
ultra-low rates that made excessive indebtedness sustainable.
As incomes fall, households and businesses will struggle to meet
obligations. Fiat money allows governments to continue the game by
debasing the currency and purchasing power. Incapable of repaying
borrowings, they will continue to issue new debt or create money,
effectively paying interest and principal with new obligations they
cannot honour.
(...)
A highly interconnected financial system is the main pathway through
which contagion is transmitted. Potential losses are considerable.
Global exposure to commercial real estate is around $21 trillion,
primarily bank loans. Non-investment loans and bond outstandings are
around $5-6 trillion. Equity margin loans in the US are around $1
trillion globally, probably 3 or 4 times that. Many now have diminishing
margins of safety. Some have negative equity—the asset value is less
than the loan. Global bank equity is around $6-7 trillion. Banks are
leveraged 8 to 10 times higher if ‘funky’ hybrid capital and bail-in
securities do not work as intended. Large losses would be systematically
relevant, placing some at risk of insolvency and threatening financial
stability.
(...)
The diminished supply of capital will affect the value of existing
ventures, many of which do not have sufficient liquidity to reach the
operational stage.
(...)
The process is one of downward spiralling feedback loops. Losses lead
to lower leverage and credit contraction, which lead to economic
retrenchment and credit contraction, which sets off a new round.
Illiquid markets, due to falls in market makers, struggle to handle
demand, worsening conditions.
The severity of the new crisis
remains unknown. A real economic slowdown comparable to the 1930s is not
inconceivable. Large financial excesses, particularly the disjunction
between cash flow and prices, make severe adjustments likely. A
complicating factor is institutional memory from the 2008 crisis is now
scarce. It would not help in any case because, as Harry Potter’s Lord
Voldemort observed, “[Humans] never learn. Such a pity.”
El declive Europeo: la disfunción, la deuda, el lastre de la eficiencia
As Europe is discovering, the past is rarely past. Weaknesses exposed by
the forgotten 2011 European debt crisis remain unresolved. Five areas
of unaddressed concern remain.
First, European growth is lacklustre. Between 2010 and 2023, European
GDP grew cumulatively by 21 percent, compared to America's 34 percent.
Current forecasts project medium-term annual real growth at around 1-1.5
percent. Causes include low investment in infrastructure, new
technologies, research and development, and poor productivity
improvements. Weak consumption and high saving rates reflect low
consumer confidence.
(...)
Intra-European trade relies on recycling German savings and trade
surpluses to net importing Mediterranean and Eastern European nations to
finance purchases of Germany's exports. The substantial internal
financial imbalances were exacerbated by the European Central Bank (ECB)
bailouts of crisis-afflicted Greece, Cyprus, Italy, Portugal, Spain and
Ireland in 2012. Germany is now owed over €1 trillion mainly by Italy,
France, Spain, Portugal and Greece.
(...)
The replacement of cheap Russian gas imports with expensive US and Gulf
LNG has increased costs by 30-40 percent, creating new dependencies.
Non-wage items, such as social, unemployment, and medical insurances,
add up to 40 percent to labour costs. Europe's unfunded overgenerous
welfare state, including relatively early retirement and generous
pensions, is unsustainable. Overzealous, complex, overlapping
regulations are a drag on efficiency. Brussels' intervention adheres to
the principle of all extraneous bureaucracies—self-perpetuation and
mission creep.
Second, debt. EU's government gross debt is nearly 88 percent of GDP.
The highest debt levels are Greece (164 percent), Italy (137 percent),
France (112 percent), Belgium (108 percent), Spain (105 percent), and
Portugal (101 percent). Due to its legislated debt brake, which limits
borrowing but may be loosened, Germany's debt to GDP is a more modest 62
percent. However, like some other member states, it has substantial
unfunded pension liabilities. The EU's own separate debt is expected to
reach €900 billion by the end of 2026 to fund coronavirus recovery
programmes and support for Ukraine. This limits the ability of state
investment in infrastructure renewal or boost domestic demand directly.
(...)
France's debt costs recently exceeded those of Greece! There is no plan to restore public finances.
(...)
Third, the Euro's structural flaws continue. The inability to devalue or
set individual monetary policy limits the flexibility of members with
different requirements. At the same time, there is no common fiscal
policy because of Germany's reluctance to de facto financial underwrite
EU common debt. A currency without a country and states without a
sovereign currency severely restrict policy options.
Fourth, security concerns.
(...)
Unless the conflict is resolved, the EU's determination to continue
supporting Ukraine in combat and reconstruction will strain its finances
and industrial capacity. An additional constraint will be the need to
support large numbers of refugees from Ukraine (estimated at over six
million). Continued instability in the Middle East and Africa will
result in a steady flow of displaced people into Europe, further
pressuring resources.
Finally, political dysfunction, as Germany and France demonstrate,
means that Europe is incapable of enacting the policies and reforms
needed to manage these pressures. The electorate in member states has
fragmented into far right, far left and centrist groupings, often of
roughly equal size. Voters, many of whom share a pathological dislike of
governments and elite politicians and bureaucrats, have shifted support
from traditional parties to more extreme populist movements. Central
concerns include sovereignty, immigration and border security, and
disagreements on social issues around diversity and inclusion. Economic
disagreements revolve around living costs, housing, sounder public
finances, and expansion or preservation of existing welfare benefits.
Even where these parties are unlikely to rule, they now set the
political agenda.
Lack of governing majorities means unwieldy and
unstable coalitions with contradictory political positions. Victor
tyranny and lack of the loser's consent lead to continuous trench
warfare, preventing action.
(...)
Problems will move from the
periphery (smaller states) to the EU core (Germany, France, Italy).
While Europe's size and wealth make immediate collapse unlikely, the
trajectory is one of steady decline punctuated by successive crises,
which may prove impervious to the ECB's 'whatever it takes' mantra.
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