Cross-Border Banking Flows as a Metric for the Global Financial Cycle

Perhaps Nomi Prins did not choose the title of her piece “The next financial crisis will be worse than the last.” But the idea that there is going to be another financial crisis in the center of the world economy in the near term even vaguely comparable in virulence to the GFC has, as we shall see, no basis in reality. The reason is straightforward. Financial crises are denouements of credit booms, not asset price booms—all credit booms are attended by asset price booms but not the other way around—and while there is certainly an asset price boom in global markets, there is no credit boom at the center of the world economy. The chances of a banking crisis are even more remote than credit indicators suggest because of the extraordinary surveillance of the balance sheets of global banks since the GFC. Even if all legal-regulatory innovations over the past decade—especially the tighter limits on capital ratios—are bull, the sheer fact of enhanced regulatory and independent balance sheet surveillance means that banks find it much more difficult to hide risks on and off their balance sheets.

We now have a good handle on the mechanics of financial booms and crises. Financial booms are banking expansions. Banks are special because, yes, they create money by lending. But do not let the Bank of England distract you. The issue is that the excess elasticity of bank balance sheets mechanically generates lending booms since bank assets are the liabilities of non-banks. As a rule, credit booms emerge from the mutually-reinforcing interaction of property prices and bank lending. As collateral values go up, more can be lent against the same property; in turn, greater lending pushes up property prices further. Credit booms show up in credit gap measures such as credit-to-GDP ratios. We also understand how credit booms end. The stock of outstanding debt lags behind credit gaps. Once the debt burden, which is a function of the stock of outstanding debt not credit growth, becomes intolerable, credit defaults puncture the boom and precipitate a financial crisis. That’s why the best predictors of financial crises are credit gaps and debt ratios.

Metropolitan banking is international. As the day progresses, the trading book of global banks passes from Hong Kong to London to New York. The transatlantic circuit is especially important. The mid-2000s financial boom was driven in large part by a transatlantic, European banking glut. In other words, there is good reason to believe that cross-border banking flows are a especially good barometer of the global financial cycle. I therefore decided to analyze the JEDH database on cross-border banking and debt flows.

I’ll probably have much more to report later. But here’s the basic picture. Figure 1 displays three variables; all standardized to have mean 0 and variance 1. “CoreFPC” is the first principal component of the cross-border flows of Japan, Germany, France, Italy, Netherlands, Norway, Sweden, Denmark, and Finland. Roughly speaking, it captures the common variation in the series. “G2” is the sum of the cross-border flows of the United Kingdom and the United States. “China” is the sum of the cross-border flows of China, Hong Kong, and Macau.


Figure 1. Cross-border banking flows.

A few observations are in order. The tight coupling of Anglo-Saxon finance (“G2”) and the rest of the core (“coreFPC”) is manifest; thus allowing us to interpret either as providing a fair metric for the global financial cycle. We will use the former because (a) it is a tighter, more parsimonious definition; (b) its applicable in more general settings in the sense that we can extend many macrofinancial variables back to the 19th century without changing our center countries. Hélène Rey’s notion of the global financial cycle—as the covariation of risk premia embedded in global asset prices—is less relevant to macrofinancial stability than our metric. Although banking expansions can be read off of asset prices, it is a noisier metric precisely because not all asset price booms are attended by real financial booms that end in tears. Cross-border banking flows provide a finer measure of banking gluts than the compression of risk premia because all lending booms are attended by cross-border banking flows and vice-versa.

This metric confirms what credit gaps and debt service ratios can tell us about the buildup of financial imbalances in the center of the world economy. Interestingly, by this metric the Chinese cycle seems to have turned. This was not clear when we looked the credit gap (Figure 2).


Figure 2. China’s macrofinancial vitals.

Finally, as a sanity check we look at the bond market. The slope of the yield curve is the best predictor of US recessions out there. When the yield curve inverts it heralds a recession in the near term. There is good reason for this. The inversion of the yield curve destroys banks’ net interest margins; forward-looking measures of banks’ net worth fall; banks respond by shedding assets; finally, the attendant fall in bank lending pushes the macroeconomy into recession—this is Adrian and Shin‘s risk-taking channel of monetary policy. The term spread has indeed compressed, but the yield curve is still upward-sloping.


Figure 3. The term spread.

Because the current asset price boom is unattended by a credit boom in the center of the world economy, the possibility of a financial crisis comparable to the GFC is remote. And despite the “age” of the expansion, a normal recession does not yet seem to be on the cards either.





The President and the Stock Market

Authers’ Note today sounded downright exasperated with the President’s tweets. Trump claimed credit for the fastest 1,000 point gain in the Dow’s history:


That’s too cute by half. Each 1000 percent gain gets mathematically smaller as the Dow goes up; eg, the move from 10,000 to 11,000 is a 10 percent move whereas that from 24,000 to 25,000 is just 4 percent. Properly compared, the performance of the Dow under Trump lies between equivalent periods in Obama’s two terms.

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But the Dow is a stupid aggregate of stocks for the simple reason that it is price-weighted. “Over the past year,” Auther notes, “two great industrial giants have been the alpha and omega of the Dow: Boeing has doubled, gaining $85bn in market cap, while GE has collapsed by more than 40 per cent, shedding a staggering $118bn. But due to the ridiculous way in which the Dow is calculated, Boeing accounts for a rise in the Dow of 1,064 points, while GE accounts for a fall of only 84 points.” That’s because Boeing has 600 million shares outstanding valued at $309 each for total market cap of $184 billion; while GE has 8.7 billion shares worth just $18.5 each for a total of $161 billion. The differential sensitivity of the index is an artifact of the practically irrelevant question of how many shares the firms have outstanding.

If we ignore the Dow and look, as all serious investors and analysts do, at the S&P500, even Obama’s 1st year in office comes out ahead of Trump’s.

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In a more longer term perspective, the Trump rally hardly stands out either.

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More generally, Presidents have little influence over the stock market; central banks much more so. But we should not even exaggerate the influence of the latter. Stock valuations are sky-high not just because of monetary accommodation but mostly because the near-term global macroeconomic outlook is especially positive for risk assets. Not only is global growth more robust than it has been in a decade; there is little sign of inflation, which implies that there is little incentive for central banks to take away the punch bowl any time soon. It is this benign macro environment that is compressing market-wide risk premia.

Investors are facing two main risks in the near term. The first is that growth may falter and cash flow expectations may need to be marked down, with attendant corrections in asset valuations. In the extreme, the economy may even plunge into a recession; although that scenario seems unlikely in the near term—the yield curve may be shallower than before but it is still sloping upwards. The second is that inflation might finally show up, forcing the Fed to hike much faster than anticipated, thereby precipitating a risk-off. In other words, markets have been in a sort of Goldilocks Zone. Either a significant deceleration in global growth or a significant acceleration that eliminates global slack can precipitate a sell-off.

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Source: US Treasury.


Does Consumer Confidence Predict Output Growth?

Tip of the hat to Ted Fertik for flagging Mian, Sufi and Khoshkhou (2017). The authors examine the role that partisan bias plays in consumer expectations. One of their findings is that consumer confidence is extraordinarily high among Trump supporters. But that this has not translated so far into higher spending.

I was skeptical of the notion that consumer confidence—as opposed to CEO confidence, investor confidence, and the risk appetite of intermediaries—had discernible and predictable effects on real economic activity. So I examined the data. Turns out that it does. And that it does so through a clear channel: Consumer confidence predicts discretionary consumer spending which in turn is a strong correlate of real GDP (RGDP) growth.

The evidence can be read off Figure 1. Read clockwise from top-left. (1) University of Michigan’s Index of Consumer Sentiment (MCSI) predicts RGDP growth even after controlling for lagged RGDP. (2) MCSI predicts growth in real discretionary consumer spending. (3) MCSI does not predict RGDP growth shocks orthogonal to discretionary consumer spending. That is, the residuals obtained by projecting change in log RGDP onto change in log consumer spending are not correlated with lagged consumer spending. (4) Discretionary consumer spending is contemporaneously correlated with growth in RGDP.


Figure 1. The empirical evidence for the confidence channel. The data is at the quarterly frequency and for the period 1960Q1-2017Q3. Source: Haver Analytics.


Was the Great Recession a Natural Calamity?

Tip of the hat to Adam Tooze for flagging Annie Lowry’s excellent round-up of the Great Recession’s impact on American society. After ‘the economy tipped into the deepest contraction of the post–World War II era’, Lowry writes, ‘the Great Recession’s scars remain’. The recession exacerbated troubling movements already underway: erosion of middle-skilled jobs, vertical polarization of the labor market, decline in labor market participation, economic insecurity, racial polarization, vertical polarization, regional polarization, and the opioid crisis. ‘A sicker, more unequal, more racially divided country: This is the legacy of the Great Recession.’ Her conclusions are worth quoting in full and bring the framing into sharp relief.

When the next recession comes the data on what to do about it will be there. Economists have pulled together plenty of studies of the dollar-for-dollar effectiveness of initiatives like extending unemployment insurance and increasing the size of the food-stamp programs, and the relative ineffectiveness of things like corporate tax cuts. Social scientists, social workers, and local officials have urged the importance of acting as quickly as possible to intervene, with efforts to stabilize financial markets, increase the deficit, and make monetary policy more accommodative. The country has now gone through three consecutive jobless recoveries, with downturns tending to amplify long-existing trend to hollow out the middle class, polarize the labor market, and hit already ailing regions hard. It seems likely that the next recession will do much the same.

The question is whether policymakers will take such evidence of the pain and scars left by the Great Recession into account. Congress is today on the verge of pushing forward a tax cut aimed at rich families and profitable corporations that will add more than a trillion dollars to the debt, with no real need for new economic stimulus at the moment. Meanwhile, it has declined to do much for the poorer families that are still feeling the worst effects of the last recession and have not yet recovered. The risk is that next time, they will get left even further behind.

In short, recessions are naturally-occurring calamities like hurricanes or earthquakes. The policy questions they raise are about the effectiveness of various measures to deal with them. Macroeconomic studies provide insights into the shock; microeconomic studies allow us to explore the impact of the shock on different markets and social groups. We have learned a lot since 2008 and these acquired knowledges should be brought to bear ‘the next time’. A rational policy framework must incorporate all these insights to fight the next one. This is not Lowry’s personal frame of reference. This is the dominant frame used by economists and laypeople to think about the Great Recession.

All frames are necessarily partial; they illuminate some aspects of reality and leave others in the dark. The recessions as natural calamities frame is especially problematic. For the scale and virulence of the Great Recession was not the result of a random draw; nor was it independent of economic policies pursued. The scale and virulence of the Great Recession was due above all to the unprecedented amplitude of the financial cycle. The recessions as natural calamities frame leaves out the most important policy lesson to be learned from the catastrophe: financial booms are extremely dangerous and must be tamped down vigorously. The principal policy failure did not occur in 2009-2010; it occurred in 2004-2006. Policymakers and regulators failed to appreciate the build-up of great financial imbalances. And that failure led directly to the catastrophe of the Great Recession.

US financial cycle

Source: Claudio Borio.



Markets Celebrate the GOP’s Trillion Dollar Giveaway to the Rich

So you thought fiscal hawks were serious about the US deficit? Haha. Despite last minute snags the Republicans are expected to push through a trillion dollar tax-cut for their paymasters. One is told by Very Serious People that markets, bond vigilantes in particular, punish fiscal profligacy by demanding higher costs of borrowing. That’s poppycock. Both stocks and bonds are booming for good reason. The tax cut delivers a large, positive wealth shock to investors and the market is repricing to reflect investors’ greater appetite for risk. The bond market refuses to believe that the tax cut—a major fiscal shock when the economy is at full employment—will have much of an effect on economic activity. For the compression of the term spread means that the market expects subdued inflation and a shallow path of policy rates. Were a major pickup in economic activity around the corner, the yield curve would become steeper not shallower. So the euphoria in the stock markets is due not to expectations that animal spirits unleashed by the tax cut and regulatory “reform” would deliver higher growth. Rather it is due to the straightforward transfer of resources from the public sector to corporations and investors. What the market is celebrating in other words, is not the expected growth of the pie but redistribution of the pie in its favor.


Aung San Suu Kyi, René Girard and Kotkin


Rohingya refugees.

Roger Cohen can’t bring himself to say it. Kofi Annan told him “We created a saint and the saint has become a politician, and we don’t like that.” That immediately raises the question: Why is it in her political interest to obfuscate the suffering of the Rohingya? What Cohen can’t bring himself to say; more generally, what remains unsaid in the Western discourse, is that collective violence has deep roots in mass politics; in mass psychology; that ethnic violence has a definite populist aspect to it. Aung San Suu Kyi cannot take on the monks because she risks undermining her own political support base. She is not alone. In the dominant model of modern political science, Wilkinson’s, a pogrom is driven by electoral calculation: the ethnic party at risk of losing power can generate a temporary electoral boost by engineering a pogrom. Why?

René Girard did not offer a theory of modern collective violence. The problem he struggled with concerned archaic culture; more precisely, pre-Axial Age religion. He sought to understand the central role of ritual sacrifice across archaic cultures. In his frame, sacrificial rituals were reenactments of actual acts of collective murder of scapegoats that solved the central problem of archaic society: How to prevent the breakdown of the social order and the onset of Hobbesian instability. In his theory, the intensification of mimetic rivalry sets off the ‘sacrificial crisis’; man turns against man; brother against brother. The universal solution to sacrificial crises—across archaic societies—was the scapegoat mechanism. It was the collective murder of the scapegoat that restored the social peace.

I submit that collective violence against social pariahs performs the same function down to the present day. The Axial revolution did not do away with the need to gang up against a defenseless victim. The Enlightenment did not transform mass psychology. Modernity too failed to dispel the darkness. If anything, mass politics exacerbated it; combined and uneven development exacerbated it. This is what breathes life into Wilkinson’s theory. This is the frame in which we must soberly grapple with the traumas of the twentieth century. In particular, this is how we ought to frame the greatest explanandum of Stalinism: the communist great power’s attempt to castrate itself in 1936-1938.

In Magnetic Mountain, Kotkin famously framed the terror as an inquisition in a Bolshevik theocracy. Fitzpatrick emphasized the bottom-up, populist aspect of the purges; that she framed as the attendant of the coming of age of the Stalinist generation. In Waiting for Hitler, the 1200-page second volume of his biography of Stalin, Kotkin presents an entirely different theory of the terror. Looking at the world through Stalin’s office, Kotkin posits that Stalin engineered the terror to liquidate the Soviet upper class. Stalin’s ‘theory of rule’, says his biographer, was that the old guard had to go so that the Stalinist revolution could be consummated. This is framed as a top-down, intentional strategy emerging from the mind of the despot.

Kotkin spends a lot of time on Stalin’s turn to despotism—no more ‘first among equals’—and explores the mass politics of the Stalinist dictatorship. But he fails to connect the two or tie them to the terror. An entirely different account of the terror is called for; one that ties the bottom-up with the top-down.

With the liquidation of the kulaks, the Bolshevik party-state ran out of class aliens. But that did not do away with the need for internal enemies. If anything, forced-pace modernization exacerbated the sacrificial crisis. It is this vacuum that must be appreciated to accurately frame the attempt at self-castration. An enemy had to be found. In the Bolshevik theocracy, it had to be an enemy of the toiling masses. Moreover, social space had to be created for the Stalinist generation. That’s why the bosses had to go. The terror was not a sign of Stalin’s strength but rather of his weakness. After Kirov’s assassination, Stalin was scared; whence the turn to despotism. The terror must be seen as mass politics; as Stalin indulging in populism to strengthen his hand against his rivals and provide a cover for their elimination in his bid to perfect his despotism.


Why Stalingrad was the Real Turning Point of the Soviet-German War

Glantz identified three turning points of the Soviet-German War. The Battle of Moscow  in the winter of 1941-1942 proved that Germany’s attempt to knock the Soviet Union out of the war in a single mighty blow had failed and that the struggle had become a war of attrition that the Soviets were rigged to win. The Battle of Stalingrad in the winter of 1942-1943 proved that Soviet tank armies (ie, combined arms mechanized armies) were capable of operational maneuvers of similar scale, tempo and depth as the German Panzer armies. Finally, the Battle of Kursk in the summer of 1943 broke the pattern of the winter being owned by the Soviets and the summer by the Germans; proved the operational superiority of the Red Army; and ensured that Germany would be conquered by Soviet arms.

Different scholars put different weights on these three turning points. Virtually all historians agree that the decision was clear after the third. The Germans themselves became convinced that they could no longer win after the second. Klaus Reinhardt argued forcefully in Moscow: The Turning Point that the first of these was decisive. Hitler’s strategy of conquest, he argued, could no longer succeed after the failure of Operation Barbarossa. There is merit to the early position. The Soviet Union had managed to evacuate a thousand factories and 20 million people beyond the Urals, so that the bulk of Soviet industry and war potential now lay beyond the operational reach of Germany’s eastern armies. This meant that the Soviet Union was now robust to operational solutions. The struggle had thus become a true war of attrition that Germany could not hope to win given the Soviet preponderance in armament and the American credit line.


The evacuation of Soviet industry from the western Soviet Union in 1941.

While that is largely right, I’d like to temper that conclusion. It is true that, after the great evacuations, the bulk of Soviet war potential lay beyond the operational reach of Germany’s eastern armies. I will argue however that there was still the possibility of an operational breakthrough that had the potential to even the odds, or perhaps even reverse the odds.

Given the primacy of mechanized armies, oil was absolutely critical to the war effort. Baku on the Caspian Sea supplied 90 percent of Soviet oil. The capture of Baku would not only solve the German oil problem—a binding constraint—it would also deny this stupendous resource to the Red Army. The US was supplying the Soviet Union through three routes: the northern route through Archangel, the southern Persian Gulf-Caspian Sea route, and the eastern route through Vladivostok. Control of the Caspian Sea would not have cut-off the Soviet Union entirely from US oil supply. But it would have severely hampered it because the northern and eastern routes had limited carrying capacity. Archangel was only ice-free for a part of the year and there was a single, six thousand kilometer rail link between Moscow and Vladivostok.


US supply routes to the USSR.

Capturing Baku and cutting off the southern route could thus have had a decisive effect on the odds. This was the goal of Operation Blau. The operational targets were the two ports on the Volga, Stalingrad and Astrakhan. (The location of Stalingrad is marked by a swastika in the map below.) If the eastern armies could extend their control to the Volga from Stalingrad to Astrakhan, that would sever Soviet access to Baku. The Soviet armies trapped to the south could then be reduced in detail ensuring German control over the prize.

Stalingrad strategic location

The strategic importance of Stalingrad.

The objective was within the operational depth of the eastern armies. The German offensive did succeed in reaching the Volga; in the process destroying Soviet armies on the Don. The war hung in the balance as the Soviets mobilized their forces for a major counteroffensive.


German advance to the Volga, 1942.

Many accounts of the battle, such as the one on Wikipedia, focus attention to the battle for the city. While close-quarter urban combat was brutal and of great human interest, the battle was decided far away from the city. The Soviets launched pincer maneuvers to cut off the Sixth Army from its western supply lines and simultaneously attacked the German armies located west of the Don.

Soviet counteroffensive

Soviet Counteroffensive in the Battle of Stalingrad.

My argument is not so much that the eastern armies could have won the Battle of Stalingrad. Given the forces arrayed against them, that’s a tenuous claim. My argument is rather that, having reached the Volga, the Germans came close to severing the communication lines between Moscow and Baku. Had they managed to pull that off, the odds of the war would surely have evened out if not reversed outright. So, contrary to Reinhardt and my earlier claims, an operational solution of strategic significance was still on the cards in 1942. And it was only with the destruction of the Sixth Army that such operational solutions could be ruled out and one could therefore be certain of Allied victory against National Socialist Germany.


Soviet Counteroffensive at the Battle of Stalingrad.