The start of 2016 saw a period of market madness that defied even the already erratic behaviour in our markets. On the back of no new news, the investment markets managed to get themselves into a state of near panic based on—well that was the problem – nothing particularly tangible.
In the month before Christmas 2015, there had been the usual concerns echoing around the trading markets of the world. These ranged from the fear of a Chinese economic hard landing, another Eurozone banking crisis, rising US interest rates, to the effects of a crash in the price of crude oil. However, despite all this, the markets generally were accepting of the risks. Then came the New Year, and something had changed. It wasn’t the facts, as the news was mostly the same. It was the sentiment. From being of the view that the economic glass was half full, it was now apparently half empty.
Day by day, we had a stream of commentators coming out with their views on the causes and one by one they were shown to be either erroneous or irrelevant – losers rather than winners on their reading of the market.
The Chinese economy was still growing, albeit more slowly, as was the US economy, with no immediate need for significant rate rises. The falling oil price was seen to be a boon not a bane to major crude consumers, as much for the major Western nations and Japan as for the leviathans of China and India.
And so to fears of an impending recession. I have to say that I would be amazed at this. Given the low rates of unemployment and more interestingly the amount of actual employment, it would be astonishing to see a recession at this stage. In fact, it would be the first recession in history with falling unemployment. Now obviously that will change in due course, and when rates do rise we are likely to see some weakness. In that case, it is likely that the already soft retail sector may see some significant impact owing to the effect that lower confidence will have at that stage, and the technological changes to the retail sector.
There have already been some winners and losers. The fall in commodity prices, and especially oil, has of course been very painful for the producers and those associated with the servicing of these industries. For the UK, anything related to Aberdeen and the North Sea began to see problems immediately. However, for the rest of the nation, this was a direct cost reduction. So too, for other areas of the world, where the likes of Russia and Brazil are seeing extended economic recessions. Both are suffering from the fall in commodity prices. However, that will change as the prices harden and finally start to rise. At that stage their economies will at last see some relief. In the meantime, we should look to a global economy growing at just over three per cent. It may be slower and lower, but this is the longer term average.
Less than eight years ago, some of the world’s largest banks became insolvent and a massive financial crisis followed. Today, observers are wondering whether financial markets are heading the same way. If it happens, there will be winners, namely those who can gauge the pattern of boom-bust cycles. There will also be losers, usually ordinary investors, unaware that, as in 2008, the cycles have common causes and follow a well-worn pattern.
What is the cause of these cycles? It all starts with money. It is a little-known fact that just three per cent of our money supply is created through coins and paper money, by the central bank. The rest – approximately 97 per cent – is created as digital money by what are usually privately-owned, profit-oriented enterprises: commercial banks.
New money is created when a bank extends a loan. If banks create money for productive purposes such as the production of goods and services or the implementation of new technologies, there will be more economic growth and little inflation. However, if they create money by lending for unproductive purposes, problems occur: Bank credit for consumption creates consumer price inflation. Bank credit for asset transactions (property, financial instruments) creates asset bubbles. It is the latter scenario that has been behind almost all of the 100 or more banking crises experienced globally in the past 50 years. Asset inflation is almost always unsustainable and just a ten per cent drop in asset values from the lofty peak of the bubble can wipe out the entire banking system (banks have less than ten per cent of equity ready to pay for such losses).
US banks created a lot of new money for the purchase of property and financial assets before 2008. The Irish, Portuguese, Spanish and Greek banks did the same. When bank credit growth expands at the pace of 20 per cent or more, as it did in periphery Europe, it doesn’t take a central banker to know that you will have a bust banking system.
Research shows that central banks have in fact been responsible for most of the boom/bust cycles.
The actions of the European Union (EU) and the European Central Bank (ECB) today speak volumes: instead of supporting the thousands of community banks that lend for productive purposes and were not implicated in the last crisis, but helped maintain growth, the ECB is now destroying them. It has imposed a massive increase in regulatory burdens and the so-called ‘negative interest rate’ policy. The latter helps the big banks engaged in financial speculation, but is bad for the stable community banks lending to the real economy and SMEs. Community banks are now being forced by the ECB to join the property lending game, particularly in Germany, where the ECB is now causing a property bubble. We know what follows.
To avoid this scenario, central banks, which have become too powerful, need to be made accountable, instead of given more powers after each central bank-induced crisis. Moreover, we need to reshape banking, especially in countries such as the UK, where 90 per cent of deposits are with only five giant banks unwilling to lend to small firms. In Germany, 70 per cent of the banking system is accounted for by not-for-profit community banks. Such a system should not be destroyed, as the ECB is doing, but copied elsewhere. In the UK, this effort is led by Local First Community Interest Company, which has been helping in the establishment of the Hampshire Community Bank as the first such bank. The University of Southampton is one of the founding investors. This should help increase the number of firms that can count themselves among the winners. And awareness of the role played by the EU and the ECB, as well as other central banks in causing boom-bust cycles, helps us avoid being among the losers.