Europe’s banks in danger of another doom loop, with perilously little protection
Mortgage holders can breathe a sigh of relief. As the crisis in financial markets deepens, the pressure to reverse policy and cut interest rates grows.
But don't celebrate too soon; if today's turmoil sparks a recession, then it will be sharply rising unemployment, not more expensive mortgages, that will quickly become the primary concern.
The British economist John Maynard Keynes called it the “paradox of thrift” – the idea that while saving for a rainy day is to be commended at an individual level, you can have too much of a good thing, and if everybody all at the same time suddenly stops spending and saves instead, it destroys demand and causes the economy to falter.
A similar way of thinking can be applied to the current panic in financial markets. Call it the “paradox of caution”. Households and businesses look at today's banking crisis and whether warranted or not, take evasive action.
Spending and investment plans are frozen or otherwise adjusted. Battening down the hatches in anticipation of a storm makes perfect sense from an individual perspective, but if everyone does the same thing, it is likely to become self-fulfilling and will cause the economy to lurch into recession.
Such an effect is the big new worry that both the US Federal Reserve and the Bank of England will have to weigh in the balance in making their next interest rates decision, scheduled for this week.
Until the events of the last two weeks, both were widely expected to carry on tightening. But that no longer looks certain, or perhaps even necessary. If the economy is about to slump, then current inflationary pressures fast become yesterday's story.
Already we have seen a considerable correction in asset and commodity prices; a lot of wealth went up in flames as central banks belatedly rushed to raise interest rates to fight the inflation they failed to see coming.
Credit is also contracting. There is no money for deals, and increasingly little money for anything else, including house buying and commercial property. Whether bankers have the balance sheet strength to lend or not, the demand simply isn't there.
Both these factors – falling asset prices and contracting credit – will be deflationary; the worse the financial panic gets, the more deflationary they become.
As many have already written and said, this is not Lehman Brothers mark II. Back then, banking models were defined by wafer-thin capital and liquidity buffers that were justified on the basis that risk had been diversified through use of derivative securities.
When these instruments started to go wrong, nobody quite knew where the risk actually lay, so it poisoned the whole system.
Virtually all banks came to be seen as suspect. That's not so much the case this time around; capital and liquidity requirements are much higher, and there is a better understanding of where the risks lie.
What's more, last time around the US authorities allowed a disorderly insolvency in a major bank – Lehman Brothers. The effect was like a nuclear bomb going off in the heart of the financial system. More or less everyone was affected by the fallout.
With the benefit of hindsight, it would have been better to have rescued Lehman. There were two underlying reasons why this didn't happen. One was that Lehman lacked the collateral to access Federal Reserve support. But perhaps more importantly, there was huge political opposition on Capitol Hill to bailing out Wall Street.
To do so wasn't capitalism, many Congressmen argued. Bankers should be required to take their punishment along with everyone else.
There is a sense in which Lehman was allowed to fail in order to demonstrate to Congress that the rest of the system needed to be bailed out. This might be called the “paradox of liquidation”. Bankers who have made egregious errors of judgment deserve to lose everything, but if it results in a wider meltdown, it also punishes the innocent. Is it really worth creating such mayhem just to make a point?
The same mistake will presumably not be made again, regardless of the moral hazard that bailouts create. All the same, there is something repugnant in the casual assumption on Wall Street and in the City that when push comes to shove, the state can always be relied on to socialise the losses.
When looking for the next shoe to drop in today's banking crisis, you have to assume it will be somewhere in the European Union, most likely Italy or even France. There was much schadenfreude in Europe over the problems of US and UK banks when the global financial crisis first erupted in 2008. The euro, it was said, would provide a protective shield for Europe's banks.
In the event, it did the reverse by creating a doom loop between the fiscal travails of some member states and their equally challenged banking systems.
Despite insistence to the contrary, this structural weakness has never been properly addressed. The Euro area still doesn't have a proper banking union. The last crisis, moreover, was only tamed after the European Central Bank agreed to buy government bonds without limit. In today's febrile markets, the problem threatens to return anew the moment the ECB backstop is removed.
Christine Lagarde, president of the ECB, was technically correct when in further raising interest rates last week she insisted the purpose of monetary policy is to influence demand so as to hit a mandated inflation target, not to prop up financial markets.
But I doubt she was right in saying that Europe was well-equipped with separate tools to address financial instability wherever it arises.
It's not just that many European banks are stuffed full of government debt and other supposedly risk-free bonds which have in practice turned out not to be as safe as they are supposed to be. It's also that the machinery for resolving European banks is not fit for purpose.
With a single authority in charge, both the UK and Switzerland were able to move quickly to resolve their problem banks – Silicon Valley Bank UK and Credit Suisse. But with so many different countries required to agree, the process is likely to prove far more cumbersome in the eurozone. If not nipped swiftly in the bud, these situations quickly snowball.
So if there is going to be policy error, you would expect it to hit first in the European Union.
As for this week's interest rate decisions by the Bank of England and the Federal Reserve, any pause or reversal in monetary tightening will require exceptionally careful messaging.
If they are seen once again to be riding to the rescue of financial markets, then their credibility as guardians against the scourge of inflation will be shot to bits. And it could backfire in any case; pausing interest rate rises would suggest that central banks are more worried about the current bout of bank failures than they pretend. Markets could be further spooked by such action.
The trick will be to convince everyone that enough has already been done to get inflation back to target, but that the Bank of England stands ready to tighten anew if this turns out to be wrong.
In belatedly slamming on the brakes to tackle resurgent inflation, central banks have risked a mass pile-up on the road behind them. The early write-offs are already there to see; there are more to come. If things carry on like this, we'll soon be worrying more about deflation again than inflation. What a screw up.
This article is an extract from The Telegraph’s Economic Intelligence newsletter. Sign up here to get exclusive insight from two of the UK’s leading economic commentators – Ambrose Evans-Pritchard and Jeremy Warner – delivered direct to your inbox every Tuesday.