Tuesday, October 18, 2011

Asset shrinkage and the double dip

The latest stage of the Millennium depression is seeing political and financial leaders making one of the most dramatic policy mistakes yet.

The Banking system is being forced to boost its capital ratios by a combination of international (Basel III) and individual government legislation. Nothing wrong with that, you may think: the crisis has already proven that bank capital was too small to fund the holes that resulted from the collapse of the property bubble.

The problem is that global liquidity is already exceptionally tight: governments are seeking to tap the markets in order- among other things- to fund the banks that they have nationalized or to fund the European bail out fund, the EFSF. Of course those in the capital market that have liquidity are now exceptionally loath to invest it, unless in some haven deemed extra safe.

Banks cannot be considered particularly safe in the light of the crisis. As a result, even the strongest banks are not getting the amounts that they seek or, if they are, the terms are radically different- and far more onerous. 

The question has already arisen: what happens if banks can not get capital in the way they need? The answer is simple and brutal:if the banks can not improve their capital: balance sheet ratio by increasing capital, they must improve it by shrinking their balance sheets. In other words, banks are about to shut down lending again: a second credit crunch which may not be as severe as the first, but will be far more drawn out..

This is where the Millennium depression is about to get interesting. We have heard a great deal about the idea of a double dip recession based on a lack of liquidity: this is why central banks have been pouring liquidity into their currencies. However there is no escape from a double dip based on solvency. By adjusting the bank capital ratios at this critical point, the politicians and regulators have essentially guaranteed that the global economy will slow once more, and given the adjustments that banks are compelled to make, the second "dip"  will be much longer and more prolonged that the first.

We have already seen increasing political protest. I think that another three years of gathering austerity will cause some major political breakdowns. The UK already looks like a very fragile political construct, as does Russia, and political pressure on China, though hidden is still significant.... but all of that is a subject for another day.

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