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The zombie apocalypse coming to an economy near you

An army of zombies looks set to destroy the Eurozone and nobody knows how to stop them!

Okay, these aren’t the kind of flesh-eating zombies that featured in the Night of the Living Dead.  Rather, they are the army of walking-dead companies and banks that are slowly destroying the Eurozone economy and preventing a return to growth.  As CBS report:

“Almost a decade after the financial crisis ravaged the global economy, analysts and top officials are warning that too many banks in Europe are struggling financially, keeping them from lending to companies and fostering growth.

“Calls to fix the problem have come repeatedly from the International Monetary Fund, U.S. Treasury Secretary Jacob Lew and European Central Bank chief Mario Draghi. They say something has to be done if Europe’s economy is to gain more traction and bring down unemployment.”

When someone says “something must be done”, you can be pretty sure that they have not the faintest idea what.  In this case, however, they know exactly what has to be done.  They just do not have the stomach for the political consequences.

The CBS article points to bad debt as the core of the problem (as, indeed, it was back in 2008):

“They create a vicious cycle: The slow economy means businesses can’t repay their loans. That leaves the banks short of cash to finance new business ventures, which holds back the economy even more.”

However, were banks to call in the bad loans or write off the bad debt, their own value would plummet, sending investors fleeing to the hills.  As the Greeks know to their cost, and as the Italians discovered during the summer, Eurozone rules prevent governments from bailing out the banks.  So there is no obvious mechanism to protect the banks while calling in the bad loans.

This sets up the conditions for a cycle in which zombie banks and zombie companies prop one another up:

“A group of economists has found that banks under stress tend to maintain credit to companies they already have a relationship with, even if those companies are struggling. Yanking credit to such companies would mean recognizing the bank’s own losses on the loans. That leaves both bank and companies as walking dead, technically still in business but unable to grow, and gobbling up credit that could otherwise go to stronger companies.”

This situation is aided and abetted by central bank policy.  Low interest rates – which are now negative in the Eurozone – together with quantitative easing to print more central bank reserves, are an exercise in what central bankers more or less openly describe as “extend and pretend”.  That is, everyone knows that the policies cannot work in the long-term, but they do keep the zombies going for now.  The hope is that someone will think of a way – other than the obvious – to resolve the situation.  So corporations, banks, central bankers and politicians are all invested in kicking the can down the road for as long as they can.

Unfortunately, as people realise that the Eurozone banks are insolvent in all but name, investors have been leaving in droves:

“The STOXX Europe 600 Banks index is off 21.9 percent this year, compared with a milder 7 percent drop for the broader STOXX Europe 600. Deutsche Bank is off 52 percent for the year to date, Monte dei Paschi is off 86 percent and Switzerland’s Credit Suisse 37 percent.”

This trend is compounded by Eurozone bail-in rules which make investors liable for bank losses.  When global behemoth Deutsche Bank was threatened with a $14 billion fine (coincidentally the same as the tax bill the EU threatened to hit Apple with), its share price fell to single digits:

“Deutsche Bank made a scant 20 million-euro profit in the second quarter despite 7.4 billion euros in revenue. That followed a 6.7 billion-euro loss in 2015.”

The difference between Deutsche Bank and the Italian banks is that it is too big to fail (and possibly too big to save).  This means that whereas the consequence of bank failures in Italy will be the kind of austerity already inflicted upon Greece, Spain and Portugal; the expectation if that when it comes to Germany, the central bank will blink.  Deutsche Bank is simply too big (it is sat on at least €47 trillion of derivatives).  Its failure will make the collapse of Lehman Brothers in 2008 look trivial. Germany will have no (palatable) alternative to bailing out Deutsche Bank, even though this will pave the way for a political upheaval across the Eurozone.

There is an old maxim that says that “debts that can’t be paid won’t be paid.”  It is a tribute to the efforts of central bankers that they have kept the zombie economy going for as long as they have.  But the unforeseen consequences – like the rise of right-wing populist parties across Europe on the back of stagnant wages, falling productivity and unemployment/underemployment – threaten to tear the European Union apart.  The problem is that the only other course of action available – allowing companies and banks to fail – is likely to produce even more political volatility.

So extend and pretend it is – until the entire economy is taken over by zombies.

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