For over a year we have been cautioning that even more than a "liquidity versus solvency" debate, the biggest unspoken factor (though slowly gaining prominence) not only for Europe, although manifesting itself there most prominently, but all across the developed world is the quality of the (deteriorating) asset base, thanks mostly due to the Fed's influence over corporate cash misallocation, and courtesy of the fact that the bulk of credit money creation in the past decade has come via the shadow banking system, broad asset collateral. Last year MF Global taught us that it is this shadow collateral which exists merely in ledger entries between fractional reserve entities (mostly broker dealers and hedge funds), that is now extremely scarce and has to be pledged and repledged in daisy chains of ultra rehypothecation, and which just like robosigning exists until it is actually called for delivery, when the entire collateral<->money linkage falls apart. It is this intersection of traditional monetary liabilities and new shadow aggregates that is completely undiscussed by conventional economic literature, and is why traditional monetary theory is completely helpless in coming up with credible and effective means of returning the world to a growth state. In other words, the Krugmans of the world are absolutely unable to explain how shadow banking should be accounted for when explaining something as simple as the leverage collapse, first in Europe, and then in the US (we have covered the collapse of shadow banking repeatedly, most recently here).
We are delighted that one entity - Aitken Advisors - has put together a presentation for all those who take their Econ 101 as cannon, and explained why everything most people know about traditional monetary policy is not only out of date but hopelessly wrong. We urge everyone to read this simple yet exhaustive explanation cover to cover, because only by understanding what it says, do we have any chance of properly addressing the fundamental problems that are affecting the developed world. Sadly, as anyone who will read this presentation will also comprehend, the one immediate implication is that the European Monetary Union is finished in its current iteration. Whether this EMU unwind will also lead to the collapse of all modern financial institutions remains to be seen but is certain unless the proper underlying cause is addressed and fixed, instead of merely treating the symptom: excess leverage...with even more leverage which guarantees a terminal collapse of everything modern society has fought hard to achieve over the millennia.
Below we summarize the key thoughts in a bulleting even Nobel prize winning economist can understand:
- In a financed financial system, collateral is money
- Large banks and dealers use and reuse collateral pledged by nonbanks, which helps lubricate the global financial system
- Post Lehman, there has been a significant decline in the source of collateral for the large dealers that specialise in intermediating pledgeable collateral
- This decline in financial lubrication likely has an impact on the conduct of global monetary policy
- ...but remember ‘subprime is contained?’ Why?
- New classical, new Keynesian, DSGE models: the crisis was not supposed to happen. Indeed, it could not happen.
- These models rule out extended economic disequilibria by assumption...
- ....and pay little if any attention to the factors now commonly believed to have both precipitated the crisis and to have contributed to its longevity
- Worse, recent regulations aimed at financial stability, focussing on building equity and liquidity buffers, reducing leverage, and segregation of margin will also reduce financial lubrication between banks and nonbanks
- -> The EMU is over
- How did EMU run out of eligible collateral? Where did that Euro 14 trillion of eligible collateral go?
- Answer: nowhere, and that is the problem
- Bigger firewalls? OR Creating the right incentives for buy-and-hold credit and fixed income investors to return to peripheral European credits with confidence?
- How about loosening collateral guidelines even further?
- The looser the collateral guidelines, the bigger the haircut, the less the bang for the ECB’s buck.
- New collateral guidelines = credit risk absorbed by national central banks
- Balkanisation of collateral guidelines across EMU = credit nationalism
- What should you do?
- If you think, like me, EMU is slowly and occasionally rapidly disintegrating before your eyes then the question you should be asking yourself every day is this: ‘How do I reduce my gross exposure to European credits and European banks to zero?’
- In the absence of adequate hedges, the answer is ‘never take the exposure in the first place’.
Alas, for most banks in Europe how fell for the siren song of the LTRO it is now too late.
In presentation format: