November 3, 2014
You know the sporting expression “he reads the game well”? It is usually applied to great players who know where the ball is going. It was often applied to the two men whose books are just out, Keano and Drico. It is the ultimate compliment for any player because it suggests he has almost a sixth sense that is invaluable. Wayne Gretzky, the brilliant Canadian ice hockey star, summed it up when he said: “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”
Economics is, in a sense, like sport. It is all about looking forward, moving on and dealing with new challenges. Because the world we live in changes so much, some things which had been anticipated as being hugely important can be overtaken by events and become much less significant by the time they come to pass.
Last week two major events – both bank related – which had been billed as hugely important, almost cataclysmic, passed off without as much as a whimper.
The first was the much-awaited ECB bank stress tests and the second was the ending of Quantitative Easing (QE) in America.
The common thread running through both events is the recovery in asset prices all around the globe. In the same way as falling asset prices dramatically increase bad loans and can destroy a bank’s balance sheet overnight, rising asset prices do the opposite. Rising assets prices are a soothing financial balm that can repair even the most damaged balance sheet very quickly – and this is what is happening.
It is a development that we should all be aware of.
In Europe, of the 130 banks stress-tested, 105 passed, 25 didn’t. The ones that didn’t, like Permanent TSB, have to raise capital in the next nine months or face being shut down. However, the amounts in most cases are small.
Had the bank stress tests been last year, the results would have been much more calamitous. We can see this reversal of fortune clearly in the performance of Irish banks.
Take Ulster Bank. Last week RBS – the parent – announced that Ulster was part of its core business. Six months ago RBS was trying to flog Ulster to whoever would buy it for any price, yet today it’s part of its core business. How can this be?
The turnaround, in the case of Ulster, is driven by the recovery in Irish property prices – both residential and commercial. The upswing dramatically improves the amount of non-performing loans on the balance sheet. This process moves a bank from bankruptcy to solvency without the management having to do anything.
The snag is that bank capital is only the difference in the value of the banks’ liabilities and the banks’ assets at a moment in time.
Therefore if asset prices are rising, bank capital rises magically. Clearly the implication is that the opposite can also occur, but for now, asset prices are going in the right direction and banks are benefiting, but for how long? And if there is a wobble in asset prices, what will the ECB do?
Buoyant asset prices are also why large banks around the continent have been able to raise capital quite easily – something that would have been unthinkable a few years, even months, ago.
Thus, the big event that many people feared would lead to a renewed banking crisis has hardly registered a blip.
Some might say that we shouldn’t be so sanguine and we would be wise to apply the Mandy Rice-Davies test to the ECB. “It would say that, wouldn’t it?”
Cynics argue that, in much the same way as John Profumo had an incentive to say that he’d never slept with the call girl Christine Keeler, the ECB has the incentive to pass loads of banks even if they are dodgy because the last thing the ECB wants now is another banking crisis – this time self inflicted.
However, I doubt this because from January 1, the ECB itself is responsible for the banks and it would be unusual to say the least for an institution to pile future woes upon itself when it doesn’t have to.
It is true that the ECB didn’t stress test the banks for deflation in the eurozone – which is a real threat – and it only tested banks in the event of a 10 per cent fall in house prices, which we know is an underestimate of what can happen. It also didn’t entertain a new sovereign bond crisis in its estimates, nor a renewed flare up in Ukraine.
These events could happen, and the ECB has another weapon up its sleeve which I imagine it will unleash in time.
Remember the aim of policy is to keep asset prices high for long enough for the banks to deal with bad debts because rising asset prices solve a multitude of problems for banks.
This is where the second event, the end of American QE, comes in. For years, people have argued that the end of QE would lead to a massive collapse in liquidity and a sharp fall in asset prices. This hasn’t happened. Yet again, an event that was widely thought to be massively significant has passed off without incident.
Maybe the reason for this is that QE isn’t printing money – as we know. It is the central bank swapping low liquidity instruments (bonds) on the bank balance sheet (which the banks can’t turn into loans easily) with high liquidity ones (cash reserves which can be lent out immediately).
These new cash reserves are available to banks for lending – which drives investment, spending and consumption – or they can be invested, which drives the capital markets higher. The latter is what has occurred in the US.
Now think about what is happening and the impact on the general economy.
The way in which the world’s central banks have dealt with the recession is by driving up asset prices; they hope that the people who are made rich by asset price rises spend more.
This is not just trickle-down economics, it’s hyper-trickle-down economics and is hardly the most equitable way to go about managing the economy, but it is the undisputed policy worldwide right now. In fact last Friday, Japan announced more QE. Is it any wonder that inequality is rising when rising inequality isn’t just the by-product of policy, but its aim ?
Getting back to Europe and what is coming down the tracks, the stress tests were successful because asset prices were buoyed up by the threat of the ECB introducing QE. In time, it probably will have to stop threatening and start acting.
This is, like it or not, where the puck is going.
Like the great Gretzky, do we want to be where the puck is now or where it is going? The ECB will open up the floodgates for as long as it takes. This is why the stress tests were successful.
There will be no shortage of credit in Europe, and this will apply to Ireland too.