Wednesday, November 30, 2011

Anatomy Of A Recession

What causes a recession? Sometimes it’s overinvestment, other times its debt burdened households.

And sometimes, it’s just simple uncertainty (excerpt; emphasis added):

Insight: In euro zone crisis, companies plan for the unthinkable

(Reuters) - When Novo Nordisk's chief financial officer met marketing colleagues last Friday the conversation moved far beyond the usual discussion of sales and performance. Jesper Brandgaard asked a simple, far-reaching question: how would the firm set prices for two pivotal new insulin products if the euro collapsed?...

...Planning for a breakdown of Europe's 17-nation single currency is not easy. Like many business leaders, Brandgaard views a break-up of the euro as possible though not yet probable -- but the odds are increasing...

...Some of the most active contingency planning is happening in European countries outside the euro zone that have strong trading links with the currency bloc - Denmark and Britain being leading examples...Health care, energy and consumer goods are among the most exposed industries...

"Most business people have given up waiting for the political Godots. You just can't run your business on the basis that something will turn up, so you have to plan on the basis that it doesn't turn up. So you think about what legally and contractually it is going to mean. You also say 'I'm going to run my balance sheet as conservatively as possible'," WPP's Sorrell said…

...For non-financial firms, a key focus of efforts for firms worried about a euro collapse is in trying to safeguard their cash. Corporate balance sheets currently are very strong with upwards of $1 trillion net sitting on them, a reflection of companies' reluctance to invest in adding capacity or in buying other firms

…Treasury department teams are shifting money to safe havens and rehearsing rapid-action scenarios. Budgets for 2012 are being looked at again. And outside consultants are being brought in to advise on exposure to peripheral Europe - Greece, Ireland, Spain, Portugal and Italy.

Central bank data shows a decline in deposits from banks in weaker euro zone countries…Some big firms such as engineering group Siemens and carmakers BMW, Daimler and Volkswagen, are licensed to deposit funds with the European Central Bank, the safest of all safe havens in the euro zone.

The problem here is that companies (and households) in Europe are responding to the uncertainty surrounding Eurozone sovereign debt by piling up cash hoards – and incidentally, not spending. That in turn considerably worsens the environment for public debt, as the pullback in spending sends cuts corporate profits, wages, jobs and finally tax revenues.

So far the response from the core Euro countries have been to apply bandaids, while the ECB is sitting on its hands like a maiden aunt unwilling to risk her virtue. Europe is repeating the same monetary mistakes of the Great Depression.

The overhang of sovereign debt is a long term issue, and won’t be resolved anytime soon. But the way things are going, Europe won’t even get the chance to try. A recession in Europe now would make any orderly resolution of the debt crisis near impossible.

So what can and should be done to avert a near term economic downturn? It all points back to the ECB – since demand for safe assets is high, the ECB should commit to meeting that demand (and hang price stability) by printing as many Euros as necessary. And calm down the increasingly hysterical bond markets by buying Euro sovereign bonds, directly in the primary market if necessary (legal strictures be damned).

None of that will resolve Europe’s long term structural woes, but dithering and inaction will result in a human tragedy of lost jobs and wealth that might never be regained, and the potential collapse of the Euro as a common currency.

As a side note, read that last line I put an emphasis on in the article – isn’t it duplicitous that German firms have been allowed to safeguard their cash at the ECB (through the granting of banking licenses no less), yet Germany continues to stall in supporting any proposal to help peripheral Euro countries, short of a fiscal union? Double standards, don’t you think?

As far as the risk of contagion to Asia and Malaysia is concerned, I’m pretty sanguine regarding the risk of falling export demand. Europe just isn’t as important globally as it used to be.

The risk of financial contagion though is far more likely and potentially more dangerous. Europe’s banks were as culpable, if not more so, than US banks in leveraging up on exotic structured products in the runup to the Great Recession.

The main question in my mind now is less who’s carrying what sovereign debt on their balance sheets (which is out in the open), but who’s been writing the credit default swaps (which is not). It’s that level of uncertainty (there’s that word again) that created the credit crunch in the wake of the Lehman failure in 2008. And it will be uncertainty within the European financial system from the collapse of a major economy like Italy, that could trigger another painful downturn this time.

At this stage, I don’t see a repeat of 2008 just yet. This crisis has been building for nearly three years now, and financial firms and their regulators are probably better prepared this time – either that or they’re numb with pain, and less likely to panic.

Either way, we’re in for an interesting ride.


  1. Thanks, I bookmarked that for future reference. But I'm more concerned about the concentration of CDS rather than the overall size of the market. For example, Lehman's failure was a shock to the system, but what really had everyone panicked in September-October 2008 was AIG, because it was the biggest CDS underwriter.

  2. For american market go to OCC Quarterly data much more granular

    The DoddFrank/G20 reforms have pushed for a Central Clearing Mechanism to reduce the inter-connectedness of the market, currently only LCH have moved towards properly looking into what it takes to clear CDS, other clearing houses are following suit.

    This situation reduces the AIG type risk but makes the Central Counter Party (CCP) TOO TOO BIG TO FAIL, the bigger problem now is whether this Public Utility should be in the hand of the Private Sector when they are one of the Biggest SIFIs(Systematically Important Financial Insitution) in any market.

    We've had our brush with failures of CCP before where the Gov of Malaysia had to step in and bailed out the entity.