The IMF’s Spring Meetings took place in Washington, DC last week. This was the occasion for policymakers, academics, practitioners and market participants to meet after the financial instability episodes of the last few months, at a time when the fears of a global recession are not totally dissipated.
The atmosphere in DC was relatively relaxed, with policymakers taking a sigh of relief as they saw inflation start to abate, recession fears becoming severely diminished, and some potentially devastating financial crises having been averted. There was no sense of urgency, but rather a sense of suspension, with the knowledge that something unpleasant may happen down the line, but that this “something” has not materialized yet. This sense of suspension may however easily morph into complacency, given the downside risks that still affect the global economy. In our opinion, complacency abounded at these Spring Meetings. And here is why.
First, inflation may be going down, but it is unlikely to return consistently to 2% (apart from potentially undershooting the target for a period of time, due to base effects). More likely it will remain around 4-5% in the medium term, for structural reasons we have discussed several times.
Second, in terms of financial stability, it is true that potentially dangerous spillovers have been averted on both sides of the Atlantic, by containing the SVB and Credit Suisse crises. But at what costs? In the US there is a return of some form of blanket guarantee to all deposits; in Switzerland, there was a de-facto inversion of the pecking order, with AT1 bond-holders being bailed-in before shareholders were wiped out.
Third, the major economies may have escaped a full-fledged recession, but only because household consumption has been supported by reducing the excess savings deriving from generous monetary policy and profligate fiscal policy. Once these excess savings run out, and the full extent of the monetary policy tightening will be felt, the economy will remain prone to contraction.
This period resembles the early stages of the Global Financial Crisis (GFC). In November 2006, BNP announced that it would not allow the redemption of some funds. In February 2007, the first shakeup to the system let several institutions, including UK’s Northern Rock and Germany’s IKB, run into trouble. In September 2007, there was the bank run on Northern Rock, but it took more than one year for the collapse of Lehman Brothers to materialize. Until September 2008, it wasn’t immediately clear that what was described as a localised banking crisis was about to become the Global Financial Crisis of 2007-09.
Banks around the world are all subject to a synchronized and abrupt increase in policy rates, whose effects, after “long and variable lags” will be felt by the real economy. Initially, higher interest rates are good for banks, as long-term rates rise, and the yield curve bear-steepens. But, after a threshold, higher interest rates may become problematic for banks, especially if badly run, as the yield curve inverts. The market has targeted the weakest links in a systematic way: SVB first, Credit Suisse afterwards, and then it tested the solidity of Deutsche Bank. Short-term fixes have been applied, but long-term solutions are far from being deployed. In the US, a blanket guarantee on all deposits is not fiscally sustainable. In Switzerland, a gigantic single institution has been created, with a balance sheet much larger than that of the state.
In Germany, there is a risk that a new attack on Deutsche Bank may result in the withdrawal of deposits, which may force a panicking government to promise a blanket guarantee on all deposit, and a suspension of the bail-in rules. This would re-activate the doom loop between banks and government bonds, with a potential fragmentation of the regulatory environment and of the transmission mechanism, and with amplified effects on the government bonds of the most indebted countries, Italy first and foremost.
So far, irresponsible bankers have learned that their mismanagement won’t be punished, and that depositors will be backed by taxpayers’ money. It is the return of the moral hazard, which regulators were believed to have dismantled in the aftermath of the GFC. It is sad to note that, so far, moral hazard has always paid off. Especially when regulators have been too complacent, and too slow in recognising emerging risks.
