April is the cruellest month, breeding
Lilacs out of the dead land, mixing
Memory and desire, stirring
Dull roots with spring rain.
- T.S. Eliot, The Waste Land (1922)
There are encouraging signs of growth in the U.S. economy. Employment has picked up nicely, although not enough to bring a rapid recovery in the labour market, as Paul Krugman, Joe Stiglitz and others have pointed out. Nevertheless, with the warming rays of spring sunshine have come “green shoots” of optimism.
We have seen green shoots in the U.S. before – in early 2010, and again in early 2011 – but their promise of strong, sustained growth was denied, and the economy quickly resumed its tepid recovery. As Martin Wolf points out in the Financial Times, this is typical of economies going through debt deleveraging. The pattern of slow recovery from recession that has been observed should not therefore have come as a surprise. The good news here is that the U.S. is further advanced than other countries that have to persevere with a difficult process of adjustment for some time.
The question is whether this time is different, and the U.S. will enjoy the sustained, strong growth typical of most recoveries. I certainly hope this is the case. But, with China slowing, and Europe still in the grips of a sovereign debt crisis, the global economy remains fragile. And, if the U.S. is to benefit from sustained growth, a strong contribution from net exports would help.
Moreover, I worry about a killing frost from Europe in the form of higher bank capital requirements dictated by European bank regulators. Make no mistake: such requirements are urgently needed to help insulate the European banking system from the ongoing effects of the euro zone sovereign debt crisis. A widespread banking crisis resulting from under-capitalized institutions is the last thing Europe needs as it slips into monetary-fiscal austerity recession. Yet, the means by which European banks meet the higher capital requirements mandated for them could impart a negative effect to the rest of the world, and the U.S. in particular.
Banks can meet higher capital requirements by either raising capital or reducing assets – deleveraging. In the current environment of uncertainty about how the European sovereign debt crisis will play out, it is fair to assume that private investors are reluctant to invest in bank shares. This implies that new capital would have to come from retained earnings. With banks given access to the ECB balance sheet through the Long-Term Refinancing Operation (LTRO), they can fund their assets at very low interest rates for the next three years; provided their assets are generating some return, the spread between borrowing and lending rates can be a source of earnings. Indeed, this is likely to be the key source of new capital.
At the same time, banks can meet their new higher capital requirements by selling off assets. This is the source of my concern. European banks experienced rapid growth prior to the global financial and economic crisis, which Hyun Song Shin, in his 2011 Mundell-Fleming Lecture at the IMF, argues is largely attributable to U.S. lending. He notes, for example, that “the US-dollar denominated assets of banks outside the United States are comparable in size to the total assets of the US commercial banking sector, peaking at over $10 trillion prior to the crisis. The BIS banking statistics reveal that a substantial portion of external US dollar claims are the claims of European banks against US counterparties.” Moreover, he observes, this lending was funded by borrowing in U.S. money markets. (Remember those Fed swap lines when the European crisis threatened to engulf the banking system as institutions encountered difficulties funding themselves?)
Should European banks rush to sell off assets, the prices of these assets could fall. What might these assets be? Here again, Shin offers some interesting perspective: “Although the BIS banking statistics do not provide a detailed breakdown by the type of asset held by the bank, data on holdings of US securities suggest that a substantial portion of the claims of European banks were US private label securities.” By ‘private label’ he refers to assets generated through the shadow banking system; that is to say, the kind of securitized assets that triggered the crisis in 2007.
So, here is the risk scenario: European banks, under pressure to meet higher capital requirements, sell off assets – say, securitized commercial real estate loans in the U.S. This drives down prices on those assets and puts renewed pressure on U.S. institutions, just as green shoots of growth emerge after a long winter of financial and economic crisis.
I fervently hope this story is wrong. But, if it isn’t, the next several weeks will be worth watching to see if April is, indeed, the cruellest month.