Strong monetary response in Europe - even good news is perceived as bad

Europeans have been playing catch-up to the US with monetary policy. The Fed has been aggressive at lowering rates for over a year, but the ECB and the BOE have tried to take a more gradual approach. Their belief was that monetizing the commodity shock would not be good for their economies and was at odds with their stated objectives.

The economic data rolled in during the second and third quarter and showed economies that were not weathering the storm. Some would call it contagion to the America mortgage problem but the issues ran much deeper with real economies that slowing fast. Like the US, confidence by consumer and business has fallen off cliff.

With rates higher than the US and economies in worse shape, the only action has been to cut rates aggressively and catch-up. The ECB has cut rates 50 bps which is in line with expectations. The BOE took a 150 bps cut which is 100 bps greater than what was expected by the market.

Surprisingly, the FTSE and Euro Stoxx indices are down after the announcement. The information has been digested as further evidence that the economy in England is in much worse shape than anyone imagined.

Even good information of monetary help is being perceived as bad news.

Capital flow bonanzas are costly

The latest paper from two of the best researchers on currency crises provides food for thought on the value of large capital inflows, http://www.nber.org/papers/w14321, "Capital Flow Bonanza: An Encompassing View of the Pat and Present". Large capital inflows actually lead to the greater economic stress once the flows decline.

There has been a strain of research in international finance that the vulnerability to sudden stops or changes in economic conditions will create longer-term havoc with an economy. An number of economies that have had currency crisis have faced sudden stops or changes in capital account conditions from an economic shock or contagion across economies. Much of this research has looked at what could be the policy response to global shocks and what conditions are necessary to reduce sudden stop shocks.

Generally, it has been been concluded that having flexible exchange rates will reduce the impact of any shocks. It is also necessary to have excess international reserves to protect against these sudden shocks. The degree of capital market openness has shown to have a mixed response as a contributor to shocks with some researchers finding that openness enhances the impact of any sudden shocks while others find that it is not important.

Reinhart and Reinhart find that economies that have been the beneficiaries of large capital inflows will suffer greatly once the flows are reversed. While this may not be surprising, it is a sobering tale. If you get used to obtaining global credit and it is turned off, there will be large consequences from the adjustment of lower credit availability.

This provides food for thought for all of the economies that have developed large capital account deficits or those who are planning to leverage up on foreign credit to stimulate an economy. Once the flows diminish other credit alternatives must be found and the result will not be pretty.

Banking crises are worse

The latest from the IMF World Economic Outlook


In a study covering 17 developed economies over three decades, the IMF came up with three findings of particular relevance.

First, recessions preceded by a financial crisis tend to be deeper and longer than others. The banking system matters. The extension of credit across an economy has wide ranging effect while non-financial shocks may be localized. Credit issues affect the consumer who is still the main driver of the economy.

Second, they tend to be worse again if the crisis is in banking, rather than in securities markets or foreign exchange. Generally, the banking system is more important in most economies. If there is a crisis in the securities markets, borrowers will turn to the banking system for funds.

And third, the countries hardest hit are those with so-called arm’s length financial systems, such as the US or UK. If banks are free to innovate, they tend to build up more pro-cyclical leverage. This is the Minsky argument that banks as profit driven firms are driven to speculative excess when risk declines. The historical record here is spotty but more complex lending structures are more specialized and harder to repackage to other investors.

In practical terms, the IMF found that recessions linked to banking crises lasted twice as long on average as those not linked to any financial crisis, and the cumulative loss of output was about four times as great.

The global economy is in big trouble if this research holds currently.

The death of ethanol

VeraSun Energy, the largest publicly traded ethanol maker filed for Chapter 11 bankruptcy protection. VeraSun has annual capacity of 1.64 billion gallons of production against an industry capacity of $11 billion gallons. They were caught in a squeeze of declining gasoline prices and hedges that locked them into high corn prices. The cost of gasoline has declined over 50% while corn has fallen just under that amount at 48%.

Other major producers who are publicly traded have seen stock declines by grater than the fall in corn or gasoline. There will be further fall-out in this industry and it is unlikely that the government will save them given all of the other pressing issues. However, the corn lobby strong and has been a big backer of ethanol.

The decline in ethanol production will take away one of the key drivers for the run-away increase in Midwest corn prices over the last few years. While ethanol is not dead, there will not be any capital flowing into the industry to increase production capacity. This may be a positive for an idea that may not be as green as originally thought.