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40 Years Of Expansion Draws To An End

With all the noise that's currently out there it seems hard to just stay on top of things, let alone contemplate longer term macro issues. One thing that certainly hasn't been lost in the ether of financial news is the succession of lager policy initiatives across the devolved world to help save off a hard landing from the financial crises. In fact, they've been so numerous and frequent that the financial systems funding is now substantively funded by central banks rather than predominantly market investors. These policy responses have had the undesirable effect of causing higher risks and lower returns across the board. In conjunction with this we're also in the midst of a lager bank sell off (as table 1 shows); at a closer look, this steady deleveraging process doesn't seem to fit the bill of a mere cyclical credit contraction, but starting to look more like a fundamental departure from 40 years of credit expansion.

From a historical perceptive, those with sufficient capital have been able to make something akin to a locked return, by borrowing at low near term rates and lending out at higher and longer term rates. Operational issues aside, regardless of the policy rate, many with large enough balance sheet could enjoy the advantages of scale that allowed access to this spread. The challenge in this lending environment has historically been cyclical contractions of this great credit extension; however the overall trend would mean reverse as the economy got back to growth. Profits may fall either side of the mean but no one doubted the model.

Table 1


Change in Bank Assets

Change in Euro Area Supply of Bank Credit (in Percent)

Change in Euro Area GDP (in Percent)


Trillions of U.S. dollars



Complete policies





Current policies





Weak policies





Source: IMF staff estimates

However, things are now starting to look a little different, many politicians in developed countries struggle to simply reduce their deficits, let alone start to tackle debts that have amassed over several decades. This is not just an isolated problem to the public sector either; as in many countries' private sectors, things look equally bad due to a downward correction. On top of the muted productivity prospects, the parties participated in the credit expansion also have now become ever more risk averse and causing spreads to widen. This combination presents a challenge to all asset classes, as it was the willingness of the banks to chase this spread and borrow to bear risk has in most cases enabled higher expected returns across the economic spectrum. The current negative real returns from the near end of the curve in both Germany and the US are true sign of investors' anxiety over poor visibility from the events unfolding in Euro. The fact that we're now likely to be entering a sustained deleveraging environment in many developed economies doesn't seem to have been lost on market either.

From a distance, the current European mêlées looks to a be a regional crisis, albeit a very important one. However, it has the potential to worsen the higher risk lower return environment more systematically across financial systems worldwide. Holders of negative return debt may start to change the financial system as they abandon their current ineffectual investments. Clearly many large investors feel there is too much risk for the returns currently on offer, some of this pent up capital could be diverted to real assets such as gold, land or commodities, challenging some aspects of the current system. However, given these assets classes' current performance is yet to be seen. Nevertheless, looking at the past, the timing and value opportunities this current environment presents, all else being equal, a lower return environment look like a real possibility. The remarkable system which has fostered a greater and more efficient supply of credit could be facing a fundamental challenge. How any new system may look seems pure conjecture but interesting times may well lay ahead.