Credit Crunch in Europe

The Economist, Sep 6th 2012/ Print edition

Today Eurostat said GDP in the euro area fell 0.2% in the second quarter from the first, and 0.5% from a year earlier, confirming the region is in recession. Weak purchasing managers’ indices for August suggest the recession has persisted into the third quarter. Today, the ECB sharply downgraded its growth projection for the region, to between -0.6% and -0.2% for 2012 and between -0.4% and 1.4% for 2013.

This is due in great part to the credit crunch now enveloping so many countries. ECB data published on September 3rd showed a sharp rise in borrowing rates for companies and households in Italy and Spain, and a sharp drop in Germany, where, Barclays notes, rates on home loans are now at a record low. This is not just due to banks' higher borrowing costs, but because of an outflow of deposits, which is squeezing lending capacity; loan volumes are contracting. In Spain, private capital equal to a staggering 50% of GDP flowed out in the second quarter, according to Nomura.

Some, but not all, of this will be ameliorated by the ECB’s actions. JP Morgan reckons two-year yields would be 2% in Italy instead of 2.9% without convertibility risk, and 1.7% in Spain instead of 3.7%. It is almost certainly too optimistic to expect all of that premium to evaporate. Mr Draghi said only some of the widening in spreads was due to convertibility risk; some, he said, was due, fundamentally, to the weak state of those countries’ finances. Those countries will have to stick closely to the path of austerity, and until they are finished, they can expect tougher borrowing conditions than northern Europe.

Despite Mr Draghi’s efforts to portray the purchases as purely within the ECB's monetary responsibilities, there is no denying that they wander far from the ECB's original mandate. That's why the vote was not unanimous. Mr Draghi did not name the lone dissenter, but it was almost certainly Jens Weidmann, president of Germany’s Bundesbank.

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Monetary policy. Costs and intentions

Sep 7th 2012, 11:01 by A.C.S | New York

MONETARY policy has become a tricky business. Since the traditional Fed policy tool, the Fed funds rate target, can’t go much lower, the Fed has turned to less conventional methods, such as buying long-term Treasuries. Mike Woodford’s latest paper casts doubt on how effective this has been in practice. And it even questions the theoretical justification.

There are two separate questions: what should the Fed do, and what can it do? John Cochrane and Mike Woodford each have interesting things to say about how limited Fed policy is right now. They advocate communicating clear and credible goals for both the short and medium term. Beyond that, they suggest, not much more can be done. But even if the Fed could do more, should it do so?

Suppose the Fed lowered rates further. In simple Keynesian models lower interest rates decrease the cost of investment and the opportunity cost of consumption among other things, thereby boosting aggregate demand. But in reality things are more complicated. Historically, the Fed has not had much control over interest rates other than the Fed funds rate, so it may not have much impact on corporate borrowing. Now the Fed is using less traditional tools. Will that impact interest rates that determine investment? Perhaps, but it’s hard to know for certain. Mike Woodford believes the different bond markets are segmented which suggests QE won't do much.

But we do know there are costs to keeping the entire yield curve so low for so long. I am not sure which judge and jury decided that a low rate policy doesn't punish savers but that verdict does not ring true to me. Baby boomers are just now approaching retirement. Now is precisely when they should be moving out of riskier stocks and into treasury bonds (of all durations). The low yield on bonds will depress the investment income of soon-to-be retirees. This could actually depress their consumption. The low-rate policy could potentially lower aggregate demand.

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“Bad banks” seldom turn a profit but are still useful

Sep 8th 2012 | from the Economist print edition

The example of Sweden’s widely admired bad bank in the 1990s is even less encouraging. Sweden’s bank regulators vigorously marked down souring assets, forced banks to recapitalise (or be nationalised) and moved dud loans into specialised asset-management companies. This was to allow cleaned-up lenders to operate as “good banks” that lent to the real economy. Judged by its overall impact the Swedish bad bank was a success: growth bounced back quite quickly. But the cost to taxpayers was high. Sweden paid about 4% of its GDP to bail out its financial system, yet got back only about half of that from selling off loans and stakes in banks.

More reassuring to Spanish taxpayers is Maiden Lane, a vehicle created by the New York Federal Reserve to house assets owned by Bear Stearns and AIG that have turned out to be less toxic than expected. In June this year Maiden Lane repaid in full (and with interest) the money it had borrowed to fund its purchases. It still has some assets left to sell, so the government will probably turn a profit on the deal, in contrast to earlier estimates that it might lose as much as $6 billion on its $29 billion in assets from Bear Stearns alone.

Another relative success may be found in Britain’s bad bank, which took over some of the loans issued by Northern Rock, and all of the ones held by Bradford & Bingley. By the end of June 2012 it had £90 billion on its books, on which it seems to be turning a profit thanks to cheap funding from the government. British taxpayers have fared rather worse with nominally good banks: the government’s equity stakes in Lloyds Banking Group and Royal Bank of Scotland have fallen in value by over £30 billion.

Ireland’s bad bank, the National Asset Management Agency, also seems to be doing fairly well in managing the €74 billion in loans it took over, mainly because it bought the assets from Irish banks for just €32 billion. Yet it is now in the invidious position of being a long-term manager of a large portfolio of state-owned properties with all the risks of political interference that this entails.

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