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Central bankers as fallible now as they were in Great Depression

By July 12, 2016Blog


They may yet transpire to be the cause of the intermittent financial bubbles that have shaken the global economy since 2008, as they were in the late 1920s, says Eddie Hobbs.

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Long Island, July 1927. In secret talks, held without minutes, four men met for five days at the home of Ogden Livingston Mills, set among the grand estates of America’s wealthiest, the Vanderbilts, Astors, Duponts, Hearsts, and Morgans.

Mills, a wealthy Republican, who, having failed to make governor of New York was appointed undersecretary to the Treasury, hosted Benjamin Strong, the governor of the New York Fed, Montagu Norman, governor of the Bank of England, Charles Rist, deputy governor, Banque de France, and Hjalmar Schacht, chief of the Reichsbank, who would go on to be the Nazi’s favourite banker.

In a gambit to encourage a shift of savings to Europe to get higher returns and to stimulate its economy, the Fed cut its discount rate by 0.5% to 3.5%.

That cut followed a decade of US economic expansion of 60%, while its stock market had quadrupled. It had an explosive effect: Stock prices doubled, while the total volume of stockbroker debt to investors leapt to $4.5bn. But the central bankers, whose intention was to encourage greater trade, had egregiously miscalculated. The 1928 Wall Street crash followed.

Hundreds of years before, in the year that Leonardo da Vinci was listed as a master in the Florentine company of artists, Italy’s oldest bank, Banca Monte dei Paschi di Siena, was formed.That was 1472. In 1999, the bank was quoted on the Italian stock market. It hasn’t gone so well.

The 544-year-old bank, Italy’s third-largest, is hopelessly insolvent, its shares worthless. It’s not the only one. Italy’s banking system is in crisis, husbanding an estimated €400bn in non-performing loans, or about one loan in every eight.

The total equity value of Italy’s banks, many of which have plummeted this year by over 50%, is now worth about a quarter of its non-performing loans, and fresh capital buffers, of at least €40bn, are urgently needed.

The Italians had hoped the wizardry of the ECB, led by fellow Italian Mario Draghio and co-ordinated globally between central banks, would propel Italian economic growth to a point where non-performing loans would diminish. It hasn’t worked.

As has been outlined here and elsewhere, the concern is that central bankers are utilising the cyclical weaponry of aggressive quantitative easing, when the underlying problem is structural — too much debt.

The new rules of the game, tested in Cyprus, have learned from the Irish debacle that bailouts using taxpayers’ money is a kind of state aid, contrary to EU banking union policy. This leaves the Italian government facing the possibility of bail-ins, burning Italian bank bondholders valued at €187bn, and potentially hair-cutting deposits.

The Italian dilemma, however, may fade into relative obscurity if fears, captured in another falling share price, are realised. This is Germany’s banking behemoth, Deutsche Bank. Should you be concerned?

The German giant owns over €60trn, or about an eighth of the global derivatives market, through which it is inextricably intertwined with many global banks. This is why it’s identified by the IMF as one of the largest net contributors to systemic risk, even if the derivative book, by its nature, is covered off by counter-parties.

Deutsche Bank’s market value, at just €15.7bn, is a half of what it was last summer, and while it has not opted for more capital, like most banks it is caught in the cycle of negative bond yields, which is hampering bank profits. You can safely swap the Italian banking crisis for Brexit as the next existential challenge facing the EU, with a worried Angela Merkel, and Wolfgang Schauble, her finance minister, looking closely over management shoulders at Deutsche Bank, whose derivative book, even if it has a fractional default, at over 20 times Germany’s GDP, may be too big to bail.

When the global financial crisis hit, then Central Bank governor, John Hurley, assured the Irish public that some of the best central bank minds in the world were at work on solving the problem, which is why those with a passing familiarity with history ran out of their offices screaming.

The truth is that central bankers, just like in July 1927, make strategic mistakes and, despite their best intentions, may yet be found to be the cause of, and not the solution, to the recurrent financial bubbles that have plagued the globalised economy.

The risk is rising that the global experiment in vast expansion of central-bank money-printing operations is having a diminishing effect on economies and that chickens are coming home to roost. None of this is certain and time will tell, but, in the meantime, if you haven’t yet bought some gold, you’d be well advised to do so.