Europe, Brexit and the credit cycle

Dec 14, 2017·Alasdair Macleod

Europe’s financial and systemic troubles have retreated from the headlines. This is partly due to the financial media’s attention switching to President Trump and the US budget negotiations, partly due to Brexit and the preoccupation with Britain’s problems, and partly due to evidence of economic recovery in the Eurozone, at long last. And finally, anyone who can put digit to computer key has been absorbed by the cryptocurrency phenomenon.

Just because commentary is focused elsewhere does not mean Europe’s troubles are receding. Far from it, new challenges lie ahead. This article provides an overview of the current state of play from the European point of view, and seeks to identify the investment and currency risks. We start with Brexit.

At least there’s some money on the table

Last week, sufficient agreement had been obtained from the Brexit negotiations to allow the EU’s negotiators to recommend to the Council and the European Parliament to proceed to the next step, which is to discuss trade. That has now been approved.

There were three areas agreed in outline: the money, estimated at up to €50bn, the rights of EU and UK citizens, and the Irish border. Only one of these matters, the other two being little more than side issues deployed by the EU negotiators to squeeze as much money as possible from the British.

Yes, it was about the money. As I’ve pointed out before, Brussels’ administration costs are almost the same as Britain’s net annual contribution of €8bn.[i] Without the UK, the EU is in serious financial trouble, particularly when Brussels plans to set up its own standing army, and integrate all the member states into united states of Europe. It used the myth of Britain’s on-going commitment to financing future projects to come up with estimates of up to €100bn, when no liability for these projects, the RAL, or reste à liquider actually exists.[ii]

While the main-stream media focused on Britain’s problems, it missed the simple truth that the EU faces a far larger problem. Pace observing Libertarians; an overtly free market approach, with Britain just walking away was never politically practical. It would have created enormous damage for Europe. In the circumstances, the British negotiators held their nerve, and won the game of chicken.

What came out of last week’s agreement was basically a fifteen-page statement of intent, the detail to be worked on later. It was, as has subsequently been pointed out by two Brexit-supporting cabinet ministers (David Davis and Michael Gove) no commitment at all, no more than a gentlemen’s agreement. Also, on the money question, Brussels will have to itemise the expenses Britain is liable for to an expected maximum of €50bn. Given that legally Britain has no liability for that highway project being planned in, say, Slovenia, Brussels can still go whistle.

There are line items that are justifiable, such as Britain’s stake in the ECB, and indeed in the European Investment Bank, which is based in London. There are the pensions for MEPs and other Brussels staff of British origin offsetting the value of these stakes. And so on. The money will end up being a fudge, because the gap between the net liabilities between Britain and the EU is probably less than €10bn either way.

The way round this, to save Brussels from itself, is to agree to a two-year interim period, during which current arrangements will be extended, and Britain will continue to pay membership fees of €16bn over the two years. Anything over that will have to be properly expensed, which means further money should not be used to finance Brussels’ establishment costs. Brussels needs to make alternative arrangements after Britain finally leaves, presumably getting Germany, France, and other leading members to up their ante. The transitional arrangement will ease Brussel’s pain in this respect.

Main-stream media and Remainers alike have all stated that the difficult negotiations lie ahead. They are wrong. Agreeing an outline on the money was the sticking point. On trade, which we now move onto, there is a fundamental difference between negotiating a trade agreement where none existed before, and Brexit. Britain already complies with all EU trade regulations, a fact which is accepted by all member states. The British government seeks to pass all these regulations onto the British statute book, so there will be no reason for not continuing with current trade arrangements with the EU.

There can be little doubt that in time, EU and UK trade regulations will drift apart. But this is not a problem either, because anything sold from Britain (or from elsewhere into the EU for that matter) will have to conform to EU regulations. Similarly, UK product sold in the US has to comply with US regulations. Tariffs are a separate subject, so any tariffs imposed on British products post-Brexit is a purely political matter.

Assuming the transition period of two years is implemented, that means the new trade arrangements will apply from March 1921. However, the agreement must be completed by March 2019, unless elements of it are deferred into the transition period. This will give time for industry to lobby both Brussels and individual governments for no tariffs, which we can be sure is the preferred outcome for the large international corporations, particularly when their supply chains are spread round multiple EU jurisdictions, including the UK.

Therefore, trade in physical goods is likely to continue on more or less the current free trade basis, not least because without a satisfactory agreement from the British point of view, Brussels will get no money.

There is much kerfuffle about services, which in sentiment echoes the debate twenty-plus years ago about Britain having to join the euro. What we are seeing is lobbying through the media by large financial corporations, notably the powerful American banks, to protect their investment in London. Post-Brexit, will they move their operations to Frankfurt, Paris, or possibly Milan? Will they hell as like.

These centres are parochial backwaters, dominated by insular nationalistic and bureaucratic cultures. Foreign-owned businesses are effectively second-class to local organisations, effectively barred from making local acquisitions. It was never a problem in London. Why was it that despite the introduction of the euro without sterling, forecast to drive businesses from London to Frankfurt and Paris, the major European players chose to base their investment banking activities in London? Because that is where the international business is. This will not change, post-Brexit, one iota.

It is feared the EU will insist services such as euro clearing leave London for an EU location. To the extent that governments have control over these matters, there is nothing London can do about it, Brexit or no Brexit. But where these services are provided is a mostly a matter for the banks, not governments. This is the uncomfortable truth for the EU. Financial services are only under their control from a regulatory point of view. And if they over-regulate, which is normal for the EU, service providers simply decamp. Brexit should therefore encourage a bit of competition for Brussels regulators, to the benefit of us all.

While the Remainers in London continue to make what is essentially an emotional case against Brexit, Brexit is likely to end up attracting more financial business to London, as migrating businesses exploit its independence from EU anti-market attitudes and legislation.

There is one thing that came out of last week’s agreement, which is only inferred, but vitally important. And that is Britain’s liabilities go no further than an agreed budget settlement. The reason this is so important will become more obvious later in this article, but basically it means that in the event of a systemic meltdown, Britain has no further liability for the EU’s financial and economic system. Arguably, that applies from now.

EU’s economic prospects

The likelihood of a systemic meltdown occurring, before the transition period ends, is moving towards certainty, with a growing possibility it might happen by March 2019. With all the niggles, such as Italian non-performing loans and wildly overpriced sovereign debt, future historians might reveal Britain’s constructive approach to Brexit negotiations was partly informed by the importance of not rocking a cranky Eurozone boat.

That notwithstanding, the European Central Bank is doubtless encouraged by its apparent success in stabilising the Eurozone economy, and in seeing it grow at last. It has taken negative interest rates and asset purchase programmes over a prolonged period to arrive at this happier state of affairs.

This linking of cause and effect is accepted by mainstream economists. After all, they have fed on the bread and milk of Keynes’s principles concerning the role of the state in the economy, and the contribution it can make to smoothing the cycle of boom and bust by inflating the money supply at appropriate moments. However, for those of us prepared to dig a little deeper, we come away with an understanding that the ECB’s actions have been more about keeping the banking and financial system afloat than fostering genuine economic recovery.

The supposed economic benefits from the ECB’s interfering are little more than a conjuror’s prestidigitation. But those of us who understand the true scale of economic destruction that results from the ECB’s actions must acknowledge one thing: the ECB has been an effective firefighter. Through a mixture of using the printing press and pure bluff, it has prevented, or rather deferred, systemic bank failures, notably in Portugal, Italy, Greece and Spain.

The banking systems in the PIGS were not just insolvent, but thoroughly bust. They still are. The ECB used the network of national central banks to both conceal capital flight from these systemic risks and to ensure fresh money is issued to cover it. Meanwhile, bank balance sheets have been stabilised by simply rigging the bond markets, through a combination of creating bond shortages by way of its aggressive asset purchase programmes, and offering the banks zero-cost loans to fund themselves and to buy bonds as well. These are mostly sovereign bonds, issued by profligate socialistic governments, conveniently given a zero-risk weighting by Basel regulations.

If these actions had been floated as a prospective strategy before being initiated, a rational critic would have concluded Mario Draghi had lost his marbles. The fact that they have worked, so far at least, is the bluff. Draghi has the support of other central bankers, who drink from the same policy well. Economic commentators are also in the ECB’s pocket. Obfuscate the whole by introducing elements of policy piecemeal, and we are all fooled, because we want to be fooled.

It has been about step-by-step survival; the true cost of these monetary policies having been deferred. Deferred, and not addressed, means these policies are being set up to fail at a future point in time. What we have witnessed is an extreme version of the application of money and credit in the early stages of the credit cycle.

The credit cycle exists anyway, consisting of repeating central bank stimulus, price inflation, and inevitably the debt crisis that follows. These events are made immeasurably worse this time by the intense stimulus of asset purchase programmes and by the extreme rigging of bond markets through negative interest rates.

It is in this context we must consider the pick-up in Eurozone GDP. GDP is no more than the money-total of final transactions in those parts of the economy included in the GDP statistic. When it increases, it does so not because of economic progress per se, but because money is shifting from the financial sector to non-financials, from the unrecorded to the recorded elements of GDP.

The shift has been slow until recently, because the money-making opportunities have been in financial activities, thanks to the ECB. But these have reached such significant bubble-like conditions, that even speculators in bitcoin might pause in wonderment. The German two-year Schatz bond yields minus 0.74%. In other words, markets have become so rigged by the ECB that lenders are paying interest annually to the German government to hold and protect their money.

There has been some recovery from earlier extremes, because this bond’s yield was even more negative last February (-0.96%). Perhaps it shows that some confidence is returning to the Eurozone economy, because banks are beginning to lend to non-financials. But we all know what that means: prices of goods and services start rising. And when they start rising, the ECB has a problem it can no longer deal with by fudge and bluster.

Price inflation is slowly beginning to increase, though the rise is muted by a strong euro. Fortunately for the ECB, the euro is likely to continue to be strong over the next year or so, if only because it reflects Germany’s stellar export performance and a weakening dollar. At the least, it gives time for the ECB to reduce and cease its asset purchase programme, and to manage a return towards monetary normality.[iii]

One can visualise the ECB’s strategy. Bond prices will be eased gently lower while the banks expand credit profitably towards recovering non-financials. Weaker banks will be encouraged to work with their national central banks and governments to remove bad debts into resolution vehicles, and to raise core capital. And as confidence returns into the banks in the PIGS, their economies will turn the corner, consumer confidence and tax revenues will increase, putting government finances on a sounder footing.

It’s not hard to guess this is the ECB’s likely strategy, because at this point in the credit cycle, all central bankers think this way. And they always, without fail, end up in crisis. The crisis arises when money begins to leave the realm of financial speculation for more profitable opportunities in the non-financial economy. Those are coming about, partly because despite central bank tinkering, and partly because life goes on, including for businesses. Also, China with her new silk road is creating important two-way trans-Asian trading opportunities.

The bank credit to finance these opportunities will come out of Eurozone bond markets at the same time as the ECB is reducing its asset purchase programme. Doubtless, the ECB understands this and hopes that it will be a gradual process, taking five or more years, and hopes it can be smoothed by targeting bond prices with interest rate policy.

But by then the price effect of bank credit expansion will almost certainly begin to push up the general price level, even though the euro may remain strong. This is because irrespective of the rise in the euro and raw material prices priced in declining dollars, supply bottlenecks and shortages will develop. The link between the flood of money into non-financials and rising prices then becomes alarmingly active.

So, what happens when it becomes obvious prices are rising, and the ECB is demonstrably behind the curve? The bond markets, having already fallen, then crash, taking all financial assets with them. The ECB can sit on zero interest rates as long as its likes, but in the process, it becomes zero relevance. The market will be pricing assets. And the banks, which remain alarmingly leveraged, are exposed to systemic failure. The headline equity to debt ratio is in the order of 5.5%, but there are higher risks within that average. Germany’s is 3.9%, Ireland 4.3%, and Netherlands 2.7%, to name but a few.[iv] And that assumes the banks are telling the truth about their own balance sheets.

Those living in hope might point out there are other forms of liquidity, such as deposits held at national central banks. True, but there’s no way of knowing whether or not these are encumbered in some way, and furthermore, fudges such as mark-to-inflated-markets and mark-to-myth are baking asset-related losses into the liquidity cake already.

All major jurisdictions are locked into a destructive credit cycle, which given the increase in debt since the last crisis, seems assured to make the next one considerably worse. We must then ask ourselves who is going to lead us into the next crisis. Most people would probably say China, because of her massive credit expansion. Some would say Japan. You cannot rule them out. But when you consider where the greatest price distortions are and the slimmest capital margins in the banking system, it has to be the Eurozone.

The euro in the next credit crisis

The euro as a currency is the newest of the majors, having replaced the national currencies of the individual Eurozone members. Its validity as money regresses to nothing specific, though an Italian might think it more stable and valid as money than the old lira, because it has a significant element of the old Deutsch mark in it. But equally, a German might think it is less stable and valid as money than the mark, because it combines weaker currencies. There appears to be some confirmation of these natural views, because Germans privately are the most active buyers of physical gold and gold ETFs in the Eurozone, while others seem content to hold euros.

These differing opinions are a potential source of currency instability, because if the German public take more fully to the view that the ECB is not addressing the threat of price inflation sufficiently, they are likely to reduce their preference for euros more significantly in favour of other monetary media. We see this in the pick-up in German citizens’ gold demand already, which increased from 103.8 tonnes in 2014 to 187.6 tonnes in 2016.,

More recently, another alternative to the fiat euro has become available. Bitcoin and other cryptocurrencies are seen by growing numbers of the public as an alternative to depreciating fiat currencies. And unlike gold, which has a large reservoir of above-ground stocks, cryptocurrencies offer the promise of rapid gains due to restricted supply.

Of course, governments could get together and attempt to ban them. But for a ban to work, there would at the least have to be agreement at the G20 level to prohibit all banks from effecting money transfers to and from cryptocurrency service providers. Even that might not work, because they exist as a peer-to-peer network, and transactions would still take place, and they would operate as currency alongside fiat.

It seemed more likely governments will try to regulate cryptocurrency service providers, and that is now happening. The future for bitcoin and others, at least for a few years, appears assured. The reason this is important for the euro’s prospects is as a portmanteau currency it is theoretically more vulnerable to being undermined by money-preferences switching from it to cryptocurrencies than for any of the other major currencies.

Assuming the cryptocurrency phenomenon is still running at the time of the next credit crisis (possibly in 12-18 months’ time), it could have a major impact on the purchasing power of all fiat currencies, but especially the euro at a time when the major central banks will feel the need to dramatically expand the quantity of currency in circulation, in order to save the banking system.

Britain will have its own troubles, and it is very likely that it will not have fully disengaged from the EU. But at least it was agreed last week that Britain’s obligations to the EU are limited to matters in the past. It could prove to be a timely escape.

[i] See

[ii] RAL is the term for budgetary spending commitments, other than Brussel’s own costs. Brussels entered into these commitments on the assumption that Britain would remain in the EU.

[iii] The day this article is published (but too late for its writing) the ECB is expected to announce further tapering of its asset purchase programme. Readers will be doubtless interested in the context of this article.

[iv] ECB’s Supervisory Banking Statistics, Q2 2017, Table T02.03.2, Composition of assets by country.

[v] Source: World Gold Council

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