Bubbles and Busts'  Instablog

David Keohane at FT Alphaville points out that

The Shanghai composite index has now fallen for the past 7 days in a row and is down some 10 per cent since a high on May 4th.

Here's a chart from Bloomberg displaying the index over the past year:
Not only has the index declined about 10% on the last two months, but it is down more than 20% in the past year. For all the recent bullish talk over further stimulus from China, the domestic market is certainly not buying it.

Although this chart provides a disturbing outlook for China, it has been largely overlooked by the mainstream media which continues to focus on a possible Lehman 2.0 moment out of Europe. What if the next Lehman moment actually comes from China instead? Discussing the risks posed by credit guarantee companies, Patrick Chovanec suggests:

The web of interlocking, often incestuous, and sometimes circular credit arrangements is reminiscent of Wall Street in the lead-up to the subprime crisis, in which a relatively small amount of mortgage losses, which most people believed could be contained, triggered a chain reaction that brought down major banks and froze credit across the entire global economy.

According to the article from Caixin magazine, banks were effectively outsourcing their loan review processes to these credit guarantors. Similar to mortgage lenders during the US housing boom, it appears the interests of banks and credit guarantee companies aligned to produce a massive extension of credit with little consideration about the borrowers' ability to repay. With housing prices falling and property development no longer booming, it appears these financial institutions have begun the Ponzi finance portion of a Minsky cycle, whereby in Patrick's words:

a lot of these firms are actually insolvent and are just borrowing from Peter to pay Paul, in order to postpone the day of reckoning.

That day of reckoning will come, but the question of timing remains uncertain. The larger concern is, how big and systemic will losses be? If it was difficult to determine the extent of the issue in the US, trying to do so in China will be nearly impossible given the general uncertainty surrounding any publicly reported economic/financial data. Could the fallout from these lending schemes actually be the next black swan? Only time will tell. For now it appears that as China's growth is slowing, risks within the financial system and chances of a hard landing are growing.

Rom Badilla directs to the most recent Global Strategy Weekly note from Albert Edwards of Societe Generale, where he writes:

And so it is in the Eurozone: Spanish banks need recapitalization because of the deflationary policies forced on them to reduce Spain's public sector deficit at a time when the private sector is also de-leveraging. Clearly this has a lot further to go and house prices will fall even further as a result. But the lesson from Japan was that overly focusing on the banks as 'the problem' is misguided and until or unless deeply deflationary policies are altered, the Spanish banks will be back for another bailout before too long.

This fits well with the case I previously laid out that private debt continues to drag down Europe.

This above dynamic is especially important for understanding Spain, where sovereign debt levels (at least those officially reported) are not particularly high. Spain's housing bubble, however, continues to decline putting further pressure on private sector balance sheets. The public and private sectors cannot both successfully deleverage, in tandem, without destroying incomes and growth.

As the first chart from Edwards' shows, households have not yet begun to seriously deleverage and unemployment is already well over 20%. This process will continue to put downward pressure on house prices, which may fall by another 35%. As prices fall Spanish banks will ultimately be forced to write down mortgage values, further impairing their balance sheets. By focusing the bailout on banks, Spain in not only following the path of Japan but also that of Ireland. Despite significantly larger bailouts relative to the size (GDP) of Ireland, Irish banks remain insolvent. Putting these pieces together, it becomes obvious that Spanish banks will require further bailouts.

A lesson pointed out in the title of Edward's note that should have been learned from Japan is that "banks are not the problem." Unfortunately Spain, Ireland and several other countries have made this same mistake during the current crisis. Private debt deleveraging, especially by households, is at the heart of the current crisis and remains unaddressed. Until private sector balance sheets return to health, economic growth will continue to languish (at best) and highly leveraged banks will become increasingly insolvent. For countries without the ability to print currency (ie. the Eurozone), use of public funds to bailout the banks may eventually topple the sovereigns.

Heading into another Euro Summit, I fail to see any signs that policy makers will soon change course and address private balance sheets. The crisis is speeding up but the policy solutions remain unsuitable for the problem at hand.

In any event, we're in a balance sheet recession. We should be encouraging the private sector to borrow less, not taunting people with negative interest rates and encouraging them to leverage up. And we should recognize that the government's deficit is the key to helping the private sector de-leverage.

Reducing the government's deficit means cutting the non-government's surplus, which frustrates their efforts to pay down debt.

We need rising incomes to support a recovery that can be sustained by private sector spending, and the Fed isn't the agency we should be looking to for help on this front.

Read it at Naked Capitalism
Can the Fed Really Do More?
By Stephanie Kelton

Kelton expresses her frustration, which I share, with the unrelenting calls for further "stimulus" from the Fed. As I've mentioned repeatedly on this blog (see here, here, and here for examples), the mechanism by which monetary policy can induce real growth is weak, at best, especially when the private sector is deleveraging. Despite the efforts of Kelton and many others with an MMT/MMR/Post-Keynesian background, this message has still not gotten through to the mainstream media. Hopefully our experimentation with monetary policy will not cause too much damage before its ineffectiveness is finally understood.