It is one of the extraordinary facts of economic cycles that when they reach their peak, virtually everyone manages to convince themselves that there has been a radical change in the way the cycle operates, and for the first time ever, there will be no slide into recession. Thus the analysis that surrounded the latest peak was underpinned with a good deal of splendid nonsense, much of which was based upon the fact that the pattern of world trade had changed, not least because of the arrival of the Internet.
It was probably fitting that when the inevitable slide began, it was the dot.com companies that went belly up first. The global economy is now heading toward a recession. Financiers and investors are trying to remember what happened the last time the wheels started to come off, a dozen years ago. By now, they have probably recalled that once demand shrank, corporate order books emptied and cash flow dried up, heavily indebted companies started to go to the wall and began to take some of their banks with them.
The banking system has generally been the last casualty of every recession. There are signs, however, that it may be in for its comeuppance a little earlier this time. Investors demonstrated a bad case of nerves last week when European and North American bank shares took a dive, based upon rumors that Germany’s Commerzbank has incurred heavy losses on derivative trading. Banks have had similar disasters in these volatile and dangerous markets, but when these losses coincide with an alarming growth in bad debts, investors have cause for concern. Speculation about Commerzbank’s position quickly led to an overall markdown in bank stocks.
Unfortunately, this coincided with yet more revelations of sharp practice among the American-dominated investment banks, in stuffing their investment clients’ portfolios with initial placement offerings (IPOs) in dot.com companies. While the investment banks’ analysts talked up the shares, dot.com directors made millions selling out stocks which rapidly collapsed in value. Meanwhile the investment banks had themselves earned fortunes by underwriting and placing the IPOs.
Therefore, the possibility of serious trouble for the North American and European banking system is looking more like a probability. Bank failures could lead to enforced mergers and central bank interventions to maintain core confidence in the system. Banks are each other’s most important customers. They run a complex network of financial facilities which guarantee that, in normal times, they will always have access to liquidity. The most fundamental breakdown in a financial system is when the banks no longer trust each other and start closing down the mutual credit lines. Self-protection it may be, but the very fact that it is deemed necessary, endangers the whole framework in which all the banks work and which underpins economic activity.
When interbank credit dries up, already cash-starved corporations will find themselves in even bigger trouble, leading to more failures, more bad debts and more problems for the banks. If Commerzbank really is in trouble, then this current recession just got serious.
