1. f GLOBAL MARKETS
Recession is a state of Mind
W e are in the fourth year since the
onset of the Great Recession.
Central banks and governments around
from the Fed is
unprecedented and
untried. The zero-
the world have been struggling to bring it bound interest
to an early end, some recklessly and some rates, however,
half-heartedly. However, in the run-up to seem to be having
the crisis, the misallocation of resources u n ex p e c te d
and the unprecedented debt creation repercussions. As
has been so large that even after trillions Bill Gross pointed K. P. Jeewan
Head - Fixed Income
of dollars worth of aggressive action in recent articles, Karvy Stock Broking Ltd.
by central banks, there is still no end in money market funds
sight. and branch banking suddenly appear to
The Federal Reserve printed trillions of have become unviable businesses.
dollars under programs, such as TARP, For instance, if a bank’s borrowing rate
TALF, QE1, QE2, cash for clunkers, was 0.25% and its lending rate, say, 1%,
and “Operation Twist”. The European it would not be able to cover the cost of
Central Bank (ECB), which was initially overheads (especially in a high salary
reluctant, eventually gave in and came up sector like banking in the US), NPAs and
with its own money-printing programs cost of reserves with a 0.75% spread, and
like providing unlimited liquidity to still make a profit. Moreover, in a depressed
private banks in the Euro-zone in its economy, lending itself would be a high-
refinancing operations. The expanded risk proposition. Hence, the low interest
list of collateral accepted for refinancing rate, instead of boosting the economy, is
operations, provision of liquidity in actually making some large segments of
foreign currencies, outright purchase of economic activity redundant.
bonds. The latest in the news has been The problem in Europe has been
the three-year 1% LTRO-2 (longer-term precipitated by delayed reaction from
refinancing operations), amounting to the ECB and politicians. ECB, originally
€539 billion. modeled after the BundesBank (German
While the amounts involved are beyond central bank), had the reputation of an
one’s imagination, the central banks are “inflation hawk.” Its remedy for excess debt
still in a fire-fighting mode, four years was rather Gandhian, i.e., work harder,
after Lehman Brothers collapsed. While spend less and save more! While it initially
the US banking system appears to have attempted to live up to its reputation,
stabilized somewhat, the underlying with deteriorating market conditions and
problems remain. Banks continue to hold skyrocketing sovereign yields, it had to
dodgy assets in its books and attempt give up its pretense and jump on to the
to repair balance sheets. The treatment money printing bandwagon.
March 2012 The Finapolis 30

2. IIIIIIIIII GLOBAL MARKETS
European banks had never really Negative feedback loop
recapitalized enough after the subprime
Manufacturer
crisis when they headed into the cuts production
sovereign wealth crisis. Hence, there expecting drop
in demand/
was a deep distrust within the banking downsizez staff
community about the solvency of each
Remaining staff
other. Therefore, at the outbreak of the Manufacturer
spend less fearing
reduces production
crisis, they were reluctant to lend to furter/ϐires more
loss of job, ϐired
employees reduce
each other. Banks, which were holding employees
spending
European sovereign paper funded from
the LIBOR market, suddenly had to dump
their holdings at the increasingly higher Lower demand
for products
yields (larger losses).
Through the LTRO, the ECB has achieved
the first step, i.e., taking the liquidity which is compensating for the ones that
crisis off the table. Simultaneously, the were avoided by central bankers.
resolution of the Greek mid-March funding While excessive borrowings and inefficient
requirement has been fended off, and, resource allocation have been identified as
thereby, the immediate crisis and fear of the causes of recession, no one really knows
a contagion. We have seen in the past that what really ends the gloom and rekindles
any prolonged period without significant the animal spirit. For recession, at the end
event risk has led to a rally of risk assets. of the day, remains a state of the mind.
Banks would perhaps use such rallies to The negative feedback loop reinforces and
repair their balance sheets. sustains the downward spiral.
The end of the crisis, however, remains a At some point all the excess capacity
question mark. When are the developed created during the boom period
economies finally likely to take the growth ameliorates, and demand and supply
path? That, alas, is something nobody balance out again. Manufacturers smell
knows. In the several mini-recessions the opportunity and invest in expansion,
that we had in the past, central bankers hire new workers, who, in turn, spend,
used to open the liquidity tap, and in six leading to more capacity creation, setting
months, economies would be back on the off a positive feedback loop. No one really
growth path. This time, however, despite knows when it will happen. Meanwhile,
all the money printing, there is no sign central bankers will do everything to keep
of a revival. Perhaps this is the downturn the crisis at bay and hope for the best.
March 2012 The Finapolis 31