Standing on the beach and gazing at the exotic and unmapped shores of Trumpania (the land remade by the orange swan on November 9th), I am struck by the discontinuity of having watched our government and chattering class looking at our banking sector exclusively through the lens of risk and distrust these past 8 years only now discovering that it might make sense to look at the banking sector through the lens of growth. Headline News! The banking sector is a critical component of a growing healthy economy! Who would have thought! The signs are already there that the focus of the government will be significantly less on bolstering prudential regulation and materially more on empowering the banks to provide liquidity needed for the economy to reach that magic 4% place that Mr. Trump has told us that we will achieve.
As we have said in recent columns, we don’t really expect Dodd-Frank to go away entirely and we don’t expect the CFPB to disappear (how can one really be against consumer protection?). It would, however, be lovely to think that Volcker might be expunged (talk about a solution to a problem that didn’t exist) and risk retention done away with, but that’s not likely either. On the other hand, we do think further capital enhancing regulations under Basel III or, God forbid, Basel IV, are likely to be slow-walked or misplaced entirely along the rutted track to actual enforcement.
We’ve now had an increase in the federal funds rate and some stern musings from the Chair to expect more as 2017 goes on. As the markets are often better at predicting the shape of the interest curve in the future than the Fed, it’s interesting to note that the markets are cautious in reflecting significant increases in interest rates, certainly over the long part of the curve. That’s either a curious response to a notion that we’re going to get high quality growth, or a nod to the fact that given all Mr. Trump’s promises, we need money from somewhere. It had better not be expensive.
And as Mr. Trump fills out his cabinet with a remarkable selection of private sector winners and financial types (how’s that going to play with the dentally challenged set?) there’s real evidence that the over-arching theme of this administration will indeed be restoring growth. And more and more people seem to be buying the story. The business community has found its animal spirits. The opinion of the odious 1% has seemed to move from “He will likely destroy the world as we know it” to “If he doesn’t destroy the world as we know it, good economic times are likely to follow.” I guess that’s progress. From my personal point of view, and putting aside international black swans like nut cases with atom bombs and the like, if this administration stops trying to turn our banking sector into a utility, fixes the corporate tax mess, invests seriously in our aging and deteriorating infrastructures and then just goes off and plays a lot of golf, it would be a win/win.
And so here in the Christmas season, we should be of a cheerful bent of mind, right? Maybe it’s the eggnog talking, but I share that optimism in general but that optimism is tempered by the fact that there are challenges here at home in achieving real growth and while we often might think it’s the case, the United States is not a fortress and our economy is not a fortress economy.
So to mediate my excessive exuberance, I want to pause and look at our financial sector issues and the state of the global banking sector as the financial sectors’ success is central to real economic growth.
First, the US banking system is well capitalized, the economy is growing and at least we are not artificially increasing the money supply through QE (anymore). It sounds terrific, but can we really preserve the entirety of the entitlement state, strengthen our military, rebuild our infrastructure and cut taxes? That may not be sustainable regardless of how healthy our banking system may be. And, if a stronger economy drives up interest rates, if the gazillion dollars of prior QE comes home to roost with a growth in the money supply and increased velocity of money, if the cost of maintaining our gigantic public debt materially goes up, do cracks appear in our Social Contract?
So now to Europe and China, because what happens in those economies matters, and those economies are right now hostage to very damaged banking sectors. As with us here at home, if the financial sectors falter, the economies cannot thrive.
Mr. Draghi just announced QE would continue through March with a slight reduction from March through the end of the year. The markets seem to be viewing this as discipline from the ECB which is risible. At the same time, the paladins of Europe’s political and financial heights have expressed deep poutiness over the Basel regime as an American tool to collar the success of the European banks. Speaking of risible. As Italy spins around and around and Banca Monte dei Paschi di Siena gets closer and closer to a public bail out which is a clear violation of European Community rules, the European banking system’s near fatal flaws are once more on display. A recent article mentioned two startling facts; first, that the total of bad loans in Italy was $360 billion. Now that’s frightening for the 4th largest economy in Europe. But wait, also mentioned, in passing, was that $360 billion was only 40% of all the bad loans in the European Community which puts the European bad loan total at a mind-blowing $800 billion. What do you do with $800 billion of bad loans? What do you do when another 30% of your balance sheet is chock full of sovereign debt which by fiat is all money good (that includes the bonds of Greece, Portugal, Spain, Italy, etc.)? How long can the ECB just print money, and yes, this really amounts to just printing money, to support the failed political excesses of governments which continue to be hostage to a sated and schloric “what me worry” polity? Bad loans, supplicant banks, undisciplined politicians and a blithely ignorant electorate. This stumbles along for a while, but it’s going to have a bad ending.
How about China? The Wall Street Journal reported on December 8 that the Chinese banking system is hiding $2 trillion of loans as something called “investment receivables.” Huh? That’s not a loan? Apparently not if Chairman Xi says it’s not a loan. My guess is that these are not called loans for the very good reason that there is near certainty that they will not be repaid. Add $2 trillion of these dodgy loans to the balance sheets of the Chinese banks and the Chinese banking system will need hundreds of billions of dollars of capital to function in a real way in a real economy. The financial industrial complex which is the Chinese government can keep all this going for some time, but once again, how can this not end badly?
Well, that’s a lot to worry about and worry we should. The US banking system is really in pretty darn good shape and the prospect of an end to further destructive regulatory knitting with the change of administrations is largely an unalloyed good thing.
Even if we get it right, a big if, is the US a fortress? Can reason and discipline at home protect the US from train wrecks in the two other largest economic systems in the world? It’s a really good question and one without an obvious answer. What happens if all these problems come home to roost at the same time? Because of reasonable financial success and monetary discipline in the United States, because Chairman Xi simply told them to in China and because the Europeans are the world’s greatest can kickers, the world economy may continue to perform reasonably well for a bit. But it seems to me that we are on borrowed time. We will be very lucky if these three systems don’t begin to display dysfunction in a synchronized way. As Clint Eastwood/Dirty Harry said, “Are you feeling lucky, punk?” I’m not sure I’m feeling lucky.