THE TOWERING MOUNTAIN, SWAYING FROM SIDE TO SIDE, by François Leclerc

Guest post. Translated from the French by Tim Gupwell.

“There is a first assessment, then a second, a third, a fourth…..It’s the worst possible way of doing things because everybody ends up doing the right thing but at the highest possible cost and price”. Who was it speaking so harshly yesterday of banking losses and of the policies of the European leaders? Answer: The ECB president, Mario Draghi, in the course of a hearing before the European parliament.

With his colleagues from the governing council, he drove home this same point, supporting the creation of the “European banking union” proposed by the Commission, starting with the constitution of a deposit guarantee fund. He was supported by the governor of the Bank of Italy, Ignazio Visco, who is getting ready to lead the charge. Rising Spanish bond rates have driven Italian rates higher; according to sources, the recession is estimated to be between -1.4% and -1.7% for this year, and the official unemployment rate exceeds 10%.

At one moment or another it becomes necessary to face up to reality, and this moment has arrived, manifesting itself in the massive outflows of capital from Spain, calculated by the Bank of Spain at 66.2 billion Euros (according to the latest available figures) for the month of March alone. The withdrawal of deposits is not a fantasy taking the form of long queues at cash machines (which could always occur): it is people with capital and businesses which are fleeing the country.

Added to the collapse of an entire swathe of the Spanish banking system, this phenomenon has suddenly come to dominate the public debt crisis and its corollary the fiscal discipline pact which had aimed to resolve it. Sidestepping the issue, Angela Merkel has declared that the Spanish situation is not the result of the strategy of austerity that she has advocated, but the outcome of the burst property bubble which occurred before its implementation. As if the former did not feed the latter.

Anticipating the sequel and always in the vanguard, Charles Dallara of the Institute of International Finance has warned that, given the size of Spain, it would be impossible to repeat the debt restructuration operated for Greece. From all sides, the permanent policy of improvisation by Mariano Rajoy’s government is criticized, but it is really about something else, as this strategy merely reflects the impossibility of applying the very strategy advocated by precisely those who are criticizing it.

Rumors reveal the intense discussions which are the prelude to important announcements from the German government. “I have always said that we need more Europe” recalled Angela Merkel in the meantime. A step forward towards European integration is in the pipeline in the context of an unchanged policy that the Chancellor expresses as follows: “Austerity and budget discipline, structural reforms and growth. It is all part of the same whole”.

Eurobonds, OK, but in exchange for a new treaty which sets in concrete a common budgetary policy! At the same time, Pierre Moscovici has endorsed the conception of Jean-Claude Juncker and Mario Monti: Eurobonds will only finance the part of the debt which doesn’t pass the threshold of 60% of GDP, the remainder beyond this threshold needing to be at market rates. European leaders continue to search for the terms of a compromise between them, four weeks before their summit. But they take into consideration only the surface of the phenomenon, splendidly ignoring the depths of the problem.

The financial system is in the process of experiencing a painful contraction which is at the origin of these malfunctions in its depths. The most serious of these is not the most visible, ending in an increasing scarcity in the system of a financial safety valve: that of collateral, those assets put up as a guarantee by the financial establishments for their borrowing.

In every sphere, the requirements in this regard have become increasingly stringent. The regulators, with their need to reinforce capital requirements; the clearing houses, which are broadening their field of action to exercise their activities without risk by increasing their margin calls; the financial establishments amongst themselves, in order to lend funds to each other, having lost the confidence which used to preside over their exchanges.

The facts speak for themselves: by attempting to reinforce the system, it has actually been undermined, as the shortage of collateral gradually begins to make itself felt. It’s the equivalent of balancing the inverted credit pyramid on a point which is increasingly fragile, the financial system no longer having enough hold in a real economy which it significantly disrupts.

This scarcity –which the ECB has taken into account by relaxing its requirements with regard to the quality of collateral used as a guarantee – has been further increased by the offloading currently being carried out by the banks to reduce the size of their balance sheets and to respect the requirements for the reinforcement of capital requirements imposed by the European Banking Authority (EBA). Harshly criticized for having advocated it at an inopportune moment, the EBA has just reaffirmed its requirements without modifying them, with effect from the end of the month. For its part, Goldman Sachs is publicly positioning itself for the role of intermediary in the fire sale of assets by banks in dire straits, after having estimated that around 600 billion dollars of assets would be sold off this year, and that there would remain a further 400 billion over the next two years.

The ECB has just had to admit that a third LTRO (a massive injection of three year loans at low interest rates) could occur. Ignazio Visco summed up its position by recalling the boy scouts’ motto “be prepared!” The situation has evolved considerably over a very short period of time: the initial loss of confidence between the banks themselves has been succeeded by a loss of confidence in these same banks by the authorities (late as usual). But we end up asking which is worse: their incapacity or their initiatives! Without waiting, the corporations have found the answer by obtaining banking licenses. Following in the footsteps of Volkswagen, Daimler, and Siemens, EADS is also ready to take the plunge. As added motivation, the possibility of being better able to protect their liquidities in this way than by placing them in their banks, meaning that they are available at any given moment!

As it never rains but it pours, Bill Gross, the director of one of the most important players in the debt market, PIMCO, has just raised the alarm about the public side of the debt mountain. He is worried by the reduction in yields registered in the American debt market, the 10 year rate being currently at 1.57%. “In order to forestall a haircut of the 200 trillion dollars that our monetary system currently represents, the fiscal and monetary authorities have increased the risks and diminished the returns on the sovereign securities which represent its core”. In other words, it is the effect of the transfer of private debt into public debt.

According to Bill gross, the system is close to breaking point. He describes this mechanism in the following manner: the reduction in yields may lead investors – including notably China among them – to turn their attentions to the commodities market and real assets, ultimately triggering a permanent inflation which will allow the accumulated public and private debts to be reduced. This, even though at first, we may add, capital investment may be prepared to accept losses from rates lower than inflation in the search for a safe haven. Because all this cannot last long, other than by taking multiple risks to compensate, with the consequences that we all know of…

A penury of collateral for private debts and a drop in yields in the public debt which is to be found at the very core of it, constituting in other words the supreme guarantee: we are far removed from the little bits of string that the European leaders are trying to knot together, so bent over their little problems that they fail to see the mountain that towers over them swaying from side to side…..