Belmont Club

While You Were Sleeping

On the morning after a financial collapse things will look almost exactly as when you went to sleep. The elm tree and mailbox will stand where they were, the scene will appear unchanged all the way to the horizon.  On the Day After the outward world is unchanged.  What will have altered beyond all recognition are the invisible claims on that physical world.

The homely mailbox, for example, may no longer be yours, nor the land on which the elm tree is growing.  It could have reassigned while you were sleeping. If one can imagine the world in terms of a balance sheet, the immediate post-crash world assets start unchanged.  It’s the liabilities which have been rearranged.  The write down process will not be uniform.

In the bubble world there are more claims on assets than can be satisfied.  In the pre-crash world this is unnoticed. As in the game of Musical Chairs, it is not obvious till the music stops.  Only when the tune is interrupted, in the post-crash world, does the audience will see there is one chair short.

Politicians and unscrupulous politicians are in the profession of overselling capacity, but ensuring they always have the chair.  Politicians for example, promise the same taxpayer dollar several times over to different constituencies.  And it goes along swimmingly as long as they can kick the can down the road.

For example Obamacare was created to save Medicaid from bankruptcy.  Now Medicaid expansion is used to prove Obamacare is working.  Obamacare was funded by reductions from Medicare.  Now the Medicare “doc fix” shortfall will be funded by obtaining “savings” from Obamacare. It’s circular process where the same dollar moves from chair to chair.

Banks operate on the same principle. Banks lend out more than the deposit dollar.  They can do this sustainably for as long as the extra chairs can be provided by the real rate of interest.  An extra chair will be created in the future, but only as many as the actual rate of growth will provide.

But sometimes people get greedy and overpromise returns.  Then if everyone with a claim on a chair came to the bank and demanded a stool, there would be a shortage of stools. This is called a bank run. In  that case the system relies for its continued viability on keeping the music playing.  Once the needle is lifted from the record, forcing the players to scramble for a seat, it will be obvious that somebody will have to be kicked out of the game.

On the day after a crash the most important question is: who gets the chair when the music stops? Ben Stell and Dinah Walker, writing in the Council of Foreign Relations blog explain how the French got the Italians and Spaniards to hold the bag through the simple device of turning  French exposure in Greece into someone elses’, a process called “mutualization”

In March 2010, two months before the announcement of the first Greek bailout, European banks had €134 billion worth of claims on Greece. French banks, as shown in the right-hand figure above, had by far the largest exposure: €52 billion – this was 1.6 times that of Germany, eleven times that of Italy, and sixty-two times that of Spain.

The €110 billion of loans provided to Greece by the IMF and Eurozone in May 2010 enabled Greece to avoid default on its obligations to these banks. In the absence of such loans, France would have been forced into a massive bailout of its banking system. Instead, French banks were able virtually to eliminate their exposure to Greece by selling bonds, allowing bonds to mature, and taking partial write-offs in 2012. The bailout effectively mutualized much of their exposure within the Eurozone.

The impact of this backdoor bailout of French banks is being felt now, with Greece on the precipice of an historic default. Whereas in March 2010 about 40% of total European lending to Greece was via French banks, today only 0.6% is. Governments have filled the breach, but not in proportion to their banks’ exposure in 2010. Rather, it is in proportion to their paid-up capital at the ECB – which in France’s case is only 20%.

In consequence, France has actually managed to reduce its total Greek exposure – sovereign and bank – by €8 billion, as seen in the main figure above. In contrast, Italy, which had virtually no exposure to Greece in 2010 now has a massive one: €39 billion. Total German exposure is up by a similar amount – €35 billion. Spain has also seen its exposure rocket from nearly nothing in 2009 to €25 billion today.

In short, France has managed to use the Greek bailout to offload €8 billion in junk debt onto its neighbors and burden them with tens of billions more in debt they could have avoided had Greece simply been allowed to default in 2010. The upshot is that Italy and Spain are much closer to financial crisis today than they should be.

The French now have a chair.  It is the Spaniards and Italians who will have to hop around some.

In Greece itself the relevant question is: who has a claim on what is left in the banks when they reopen, assuming there is anything left. Ma and Pa Greece who put their savings or investments on the system the Day Before will find the birds chirping in the Attic trees as usual.  But what happened in the virtual world while they were sleeping?

Charles Forelle and Viktoria Dendrinou of the Wall Street Journal write: “the question foremost in many Greeks’ minds: When the banks do reopen, will they still have their deposits?” The answer is probably: no. A large part of the cash they formerly had is gone.  That will be represented as a claim by someone else on their savings, a process known as a “haircut”.

They have almost no cash. As of the end of May, the latest official data, they had about €2 billion ($2.2 billion). People familiar with the system estimate the figure is now below €1 billion. They also have no new access to the emergency central-bank line that had been giving them cash — the European Central Bank froze that Sunday.

They simply can’t give withdrawing depositors all the cash they want. They owe Greek customers with deposit accounts €139 billion, as of May. Thus the restrictions that limit ATM withdrawals to €60 per day and forbid electronic transfers outside Greece. …

A bank’s capital is the difference between its assets and its liabilities—between what it owns and what it owes. … There are, more or less, two ways to increase a bank’s capital: boost assets or reduce liabilities. In a capital “injection,” someone gives the bank cash (an asset), typically in exchange for a share of ownership in the bank. That someone could be private investors—it is conceivable that a bank’s shareholders might put in more cash to prevent their existing stakes from being wiped out.

But in circumstances like these, it is probably the government. Of course, the Greek government has no cash. It would have to borrow it from its European creditors.

The European creditors will insist that they get paid something first.  They’ll take the Greek olive tree.  They’ll take the Greek mailbox.  The same process of reassignment is happening in China. Last week the Chinese government threw half a trillion dollars in pension funds at the collapsing stock market to buoy it up.

The Chinese government has taken a further aggressive step to shore up the stock market, indicating its $US493 billion state pension fund would be permitted to invest in equities for the first time.

The fund is presently only allowed to invest in bank deposits and US Treasury bonds. Under the change it is expected to be permitted to invest 30 per cent of its funds in the stock market.

The official Xinhua News agency reported the guidelines for the changed investment strategy were being drafted by the Ministry of Human Resources and Social Security and the Ministry of Finance. …

The intervention of the regulator will only fuel speculation the central government is encouraging the share market boom in an effort to boost consumer confidence as the economy slows and gains from the housing market wane.

Unfortunately, this did not stop the slide in the market. Yesterday the Chinese pension asset managers were told to give up defending the market. “China’s state pension fund ordered its asset managers not to sell any local shares on Monday, after Beijing halted new equity issues and forced the central bank to extend credit to brokers as part of emergency measures aimed at bolstering markets.”

The extraordinary intervention helped push the Shanghai Composite Index up 2.4 per cent on Monday but the rise in the overall market disguised big falls among smaller stocks not linked to the government.

In a wild day of trading, 649 stocks fell, while only 259 rose in Shanghai as the country’s 90 million retail investors appeared unconvinced by the government attempts to engender confidence.

But the damage had been done. The Chinese pensioners went to sleep with a claim on  $X dollars in pensions. Presumably they woke up with considerably less.

Nothing in the external world changes in the immediate aftermath of a crash. What changes are the claims on that physical world. The iron rule is: the players never lose a seat, but you may lose yours.  It’s the rest who suddenly awaken to stores that are not theirs, jobs that no longer exist, and sales orders that have been canceled. They go from employed to being unemployed; from solvent to broke.

They’ll ask themselves: “why? why?”  Well now you know why.

Eventually the physical world starts to change to reflect the payments that have to be made to the players. Trade begins to contract, stores start to close and desperate individuals start to riot. In the naive days of the 20th century, when faith in angels and demons began to wane, it was fashionable to regard matter as primary. Wars were fought by burning actual buildings, killing physical people. But today we know that information has physical force. Computer programs, genetic instructions, memes — and financial data — are to all intents and purposes actual things, rather than airy nonsense.

Unfortunately we still live in a world governed by ancient 19th century Marxian ideas, where politicians regard information as infinitely corruptible, in a world where lies are not only common, but the stuff of power, the very sinews or privilege.  A financial crisis occurs when information goes so far out of whack with the physical world the music has to stop, and those without a chair must be booted off.

What a financial crisis does is bring an awakening world face to face with its own falsehoods. Suddenly they are in the nightmare world. But it’s a not a new world at all.  Only the one the players had been constructing all along.

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