Waiting For The End in New York and London

Say what you like about the Euro, but you can't call its agony a surprise. When Greece finally exits the Eurozone, it will be probably the most lengthily-anticipated financial catastrophe in history. The world's financial systems have had literally years to prepare, and I suspect we're about to find out whether they've spent the time well.

Let's look first at New York, where we've previously tracked the dramatic change in behaviour of foreign banks' operations over the last 18 months. As of end-April foreign banks operating in New York had raised the amount that those operations are funded by their home head offices to a net US$262 billion. In a crisis, this has advantages and disadvantages. The advantage is that the sudden closure of New York money markets to European banks won't immediately cause a liquidity crisis for their US operations, since they are, on a net basis, no longer funding from them. The disadvantage is that if Greek's exit from the Eurozone triggers a massive express unwinding of European foreign capital flows, then we should expect that that US$262bn will exit New York quickly.   

A capital outflow of that kind will inevitably cause funding strains, and we can expect those to be accompanied and intensified by outflows of deposits from non-US banks. But foreign banks in New York have spent the last 18 months structuring their local balance sheets to give themselves the best chance of surviving just such a collapse in confidence. First, deposits as a proportion of total liabilities have fallen from just under 80% at the end of 2010 to around 46% now, and during that time total deposits have fallen by 17.2%, or US$182.5bn. Secondly, during the same period, banks have added US$404.3bn to their holdings of cash, more than doubling the total. As a result, at the end of April, these banks held enough cash to pay out 84.4% of all deposits. My bet is that proportion is even higher now. Clearly, this is a pretty good defensive crouch.

In New York, we can only track the mass of foreign banks: but the Bank of England provides data specifically on the operations of European banks in London. These report that even though total Euro deposits have fallen by Eu39.bn in the year to end-March, these deposits still make up 92% of Euro-denominated liabilities, and 31.8% of their total London-based liabilities – a proportion which actually has crept higher as the crisis has evolved. The proportion of these Euro-denominated deposits which are covered by Euro cash, near-cash or time deposits at the end of March 2012 had risen to 72%, only mildly higher than the 68.6% a year earlier.

In other words, European banks in London are running a net short Euro-position, which first appeared in June 2011, and by March 2012 was equivalent to £23.6 billion. London banks are not, therefore immediately in a position to fund any emergency call from their head offices for Euros.  

On the other hand, their London operations are running long positions in other currencies, amounting to £13.6bn in Sterling and £10.0bn in other foreign currencies.

Conclusion: If Greece exits the Euro, in its wake we can that capital will exit European institutions all over the world, whilst pooling in the Eurozone principally in German banks. Foreign banks in New York can be expected to be an immediate source of rapid liquidity, and probably do have the capital structure to manage this role effectively even during a severe loss of confidence. European banks in London, however, cannot be expected to emerge as an immediate source of Euro-funding, since they now structurally short Euro. However, we can expect the net long positions in other currencies to be unwound rapidly as the Euro-shorts are covered.

The irony is this: European banks' operations in both New York and London are positioned extremely conservatively, so that cash can be rushed 'back home' in an emergency. Result? When the balloon goes up, expect interbank rates to spike in New York and London, and the Euro to have a short-run period of strength as short-covering kicks in. If capital controls are imposed, or threatened, that spike could hurt.

What We Are Thinking (WWAT?)

There's no doubt at all: during the last two weeks, the world is back on deflation-watch.

To recap, what this chart tracks is Google's normalized score for the frequency with which financial searches worldwide looked up 'inflation', minus the score for 'deflation', and smoothing to a 10-day average. In its way, it is the biggest rolling survey of global preoccupations there has ever been. A month ago, the relative interest in 'inflation' was at its peak for the year; now far more people are looking up 'deflation' than 'inflation'.

I think there are three comments worth making;

First, the swing towards concern about deflation is far more pronounced than the swing from thinking about 'growth & recovery' rather than 'recession and depression' which we tracked last week (and which, most surprisingly, is making a slight recovery towards growth this week.)

Second, this is not, alas, an early indicator – the US bond markets anticipated the change in What We Are Thinking by almost exactly a month.

Third, no intensification of deflationary forces is yet showing up in the world's inflation data.

Most inflation data is arriving roughly in line with consensus (so far this week French CPI, Korean trade prices, German WPI, and Japanese Domestic Corporate Goods Prices; last week China's CPI and PPI, US PPI, German and Spanish & Taiwanese CPI). If anything, over the last month the news has been of inflationary pressures slightly greater than anticipated: India's WPI, Britain's PPI, Japan's Corporate Services PI, Singapore's PPI, and the US ISM Manufacturing survey of prices paid were all slightly higher than expectations. Only French PPI, Korean CPI and PPI, and Taiwanese WPI hinted at a current disinflationary shock.  

Shocks & Surprises, Week Ending May 12th

Things rarely turn out as expected. This was going to be the year when the giant emerging economies, led by China, would throw a tow-rope to a near-stalling US economy. Instead, the data tells us that even sustained recovery in the US is struggling to provide China with enough external stimulus to allow it to overcome its own cyclical and structural problems.

That, at any rate, was the message this last week, when:

·         Shocks were concentrated in China and Europe, and to a much lesser extent NE Asia

·         Surprises were concentrated in the US and to a much lesser extent in Japan

China Sneezes

The week's shocks were dominated by China's data for April: seven out of the 11 pieces of official data released by China this week undershot economists' consensus, or current trends, by a full standard deviation or more. The worst news is still monetary: where M1 growth slowed to just 3.1% yoy, and actually contracted by 300bn yuan during April. Deposits also contracted by 600bn yuan during the month, even though the banks gave out 680bn yuan in new loans. What this tells us is that the cashflow cramps afflicting China's economy are intensifying, with China's banks running to a net negative cashflow (deposits in minus loans out) of 1.14tr yuan last month.

In response, PBOC has announced reserve ratios will be cut by a further 50bps starting May 18^th. But this easing now looks to be behind the curve, freeing up only 420-430bn yuan in lendable funds. So far PBOC has not released the broader 'aggregate financing' measure for April, so we cannot be sure there isn't further action being taken behind the scenes to relieve the pressure on corporate cashflows.

The cashflow grind is behind China's other major shocks: imports grew an anaemic 0.3% yoy; exports did little better, falling 1.5% mom (though growing 4.9% yoy) even in the face of unexceptionable growth in Western demand (see below). This underlines our observation that the crucial structural fact about China's economy since the financial crisis has been its failure in export markets, not its success. Growth of industrial production slowed to 9.3% yoy, the weakest since May 09, mainly reflecting slumping output of electricity and rolled steel. Retail sales slowed to 14.1% yoy from 15.2% in March. Although this was shockingly weaker than economists' estimates, it merely extended the sequential weakness seen in March.

The Neighbours Catch Cold

China's slowdown is also taking its toll on its nearest NE Asian neighbours. The most obvious sign of this was Hong Kong's GDP, which slowed unexpectedly to just 0.4% yoy in 1Q – a slowdown that was not anticipated, and owed everything to a trade contraction (exports of goods fell 5.7% yoy, imports fell 2.7% yoy). And Taiwan's export performance is also shockingly slowed by China: April exports fell 3% mom and 6.4% YoY, with exports to Hong Kong and China down 5.6% mom, whilst exports to the US fell only 0.7%, and to Japan rose 4.1%.

Japan Still Surprises

Part of what ails China's export and industry yoy comparisons is the fact that this year, no combination of earthquake/tsunami/electricity shortage has knocked Japan out of the ring. This is still not being represented in economists' views on Japan (and certainly not the stockmarket), and for the fourth week out of five, Japan's data produced more positive surprises than negative shocks. The highlight was the unexpectedly strong reading of the Economy Watcher's Outlook survey, which rose to levels previously seen only in mid-2007, on the back of particularly strong readings for prospects for employment, services, retail and the non-manufacturing sector.

US: Trade, Jobs, Federal Budget

The US had its strongest set of readings for a month, strong enough to offset the series of modest negative shocks of the previous three weeks. Three sets of surprises in particular are worth noting: the best JOLTs job openings data since July 2008; the strength of March trade data (exports up 2.9% mom, imports up 5.2% mom); and a US$59.1bn April Federal budget surplus that very nearly doubled consensus expectations, resting on a 10.1% yoy jump in receipts. The strength of exports is particularly important, since we have previously identified the role that exports need to play in regulating the mismatch between industrial supply and domestic demand which underlies and regulates the US's current 'soft patch.

The strength of the US's exports is partly testament to German demand – US exports of goods to the EU jumped 13.8% mom in March. Germany, after all, accounts for nearly 52% of total Eurozone import demand.

Europe: Germany and the Rest

Although Europe's data is still regularly shocking in its weakness, Germany remains resilient. Its industrial sector in particular refuses to buckle, with output surprising by rising 2.8% mom and 1.6% yoy in March, whilst factory orders rose 2.2% mom. Encouragingly, this strength is still resting on the capital goods sector, where orders were up 4.2% mom and output was up 2% mom. And it's still overseas orders which are driving the numbers: that 4.2% rise in capital goods orders came despite a fall of 1.3% in domestic orders and a 2.9% mom fall in orders from the Eurozone! Similarly, Germany's exports showed surprising strength, rising 0.7% yoy overall, with a 3.6% yoy fall in exports to the Eurozone being offset by a 6.1% yoy rise in exports outside Europe.

For the rest of Europe, though, there is no such comfort: last week saw the Sentix Investor Confidence survey slump to its weakest reading since June 09 – investors expect a severe recession from which even Germany will not escape altogether unscathed. The oscillations in UK data continue, with the week bringing shocks in like-for-like retail sales (down 3.3% yoy) and Nationwide Consumer Confidence, which dived because of a very sharp deterioration in 'economic expectations' rather than any downturn in 'current conditions'. In Spain, however, the plight of current conditions was signalled by a 7.5% yoy fall in industrial output in March – the sharpest contraction since October 2009. 

Reasons to be Mostly Cheerful

• NE Asia's Exports Remain Robust
• G3 Imports Have Not Collapsed
• China's Exports are Flagging for Structural, not Cyclical, Reasons
• Global Domestic Demand Retains Momentum
• NE Asian Demand is as Big a Drag as European Demand

Back in December, when Europe's finest were last bewailing that their jerry-built Euro project could plunge the world into a 1930s-style Great Depression, world trade data showed that "so far not only is the slowdown nothing like what happened at the end of 2008, but it's less dramatic even than the slowdown which accompanied the near-recession of 2000-2001.''

And it's still true: the world trade environment remains in decent health despite the disaster being engineered in Southern Europe. In the three months to February, imports by G3 nations rose 7.4% YoY, and in the three months to March, NE Asia's exports rose by 4.4%. In 6m momentum terms, G3 imports are losing sequential momentum negligibly, whilst NE Asia's is slightly positive. 

Over the last couple of days, we've had trade data which pushes the argument further.  March trade data from the US came in remarkably strongly today, with imports up 5.2% mom and exports up 2.9% mom. We've had surprisingly strong March trade data from Germany, too, showing exports up 0.9% mom, and imports up 1.2% mom (and let's not forget – Germany's imports comprise nearly 52% of the Eurozone total). But we've also had  shockingly bad April numbers from China: exports up just 4.9% yoy and imports virtually static (up 0.3% yoy).

Here are five things the data is telling us. 

First, NE Asia's exports remain robust – there's still no repeat of 2001, let along 2009, showing up in either YoY or momentum terms.  

Second, the reason why NE Asian exports remain relatively buoyant is that G3 imports have slowed only mildly. This has been achieved because a surprisingly mild slowdown in European and Japanese demand has been countered by a robust demand from the US.

Third, China's export-problem continues. I have argued for some time (in detail, here) that since 2009 China's extraordinary top-line export numbers disguise a deeper failure – one in which ever-more expensive investment efforts have yielded ever-decreasing gains in market share. We should expect that trend to become more obvious this year, simply because this year Japan's export-sector isn't crippled by  supply-side disruptions. In fact, so far this year, Japan is no longer losing market share of NE Asia exports at all.

Fourth, right now the slowdown in NE Asia is as big a problem for world trade as the Eurozone's problems.

Well, you aren't going to read it in the newspapers but it's there in at least three sets of data. First, the details of China's 1.5% mom fall in exports during April, which show that  exports to the EU rose 0.2% mom, and exports to the US fall a relatively mild 1.7%. What killed China's numbers in April were exports to Asia: to Japan they fell 5.9% mom, to Korea 6% mom, to Taiwan 5.9%!

Second, if our horrified attention is fixed on Southern Europe it is difficult to hold in mind the fact that Germany accounts for around 52% of total Eurozone imports. Greece is spectacular, but so too, in the opposite way, is Germany's importing track record so far this year: up 2.4% mom sa in January, up 3.6% in February, up 1.2% in March.

Third, I directly track changes in momentum in domestic demand in the US, in NE Asia and in Europe (taking Germany, France and UK as the major economies). When taken as a GDP-weighted aggregate, it tells the same story as our trade data – the world economy is not falling off a cliff. I shall go into more detail about this next week.

When you strip out the momentum changes in the various regions, the geographic pattern is surprising: the US is once again leading the world economy, the major economies of Europe have just about reversed the loss of momentum seen during the second half of last year, and NE Asia's economies are not doing much more than marking time.

What We Are Thinking (WWAT?)

• The changing shape of Google searches are a gigantic rolling global survey of interest and opinion probably unrivalled even by financial markets. There's never been anything like it in human history, and its relationship to that other great 24hr global survey of opinion – financial markets – has yet to be explored. So let's get to work.

Google publishes data daily on the the frequency of a particular search-word being used for financial searches. The data is normalized and re-normalized relentlessly, with words assigned a score according to frequency of search, from zero to 100. This repeated normalization means one should not use the numbers directly as a series. But if one is interested less in the exact score, but much more in the difference between contrasting sets of lookup searches, the problems are not so great.

For example, in this first WWAT? I'm recording the scores for 'Growth' and 'Recovery', and subtracting from them the scores for 'Recession' and 'Depression.' The point is to reveal changes in our relative interest between the two as revealed by global financial search patterns. Here's how it looks since February, smoothing to a 10-day average.

Broadly, one can divide the year so far into two phases:

• The first, up to late March, when searches for 'growth' and 'recovery' were dominant.
• The second, since late March, when that salience collapsed, with interest in 'recession' and 'depression' peaking in early April, and again at end-April.

The first downturn in the balance of interest came as the first wave of disappointing/shocking US regional surveys began to appear. The second wave appears to have been coincident with an not just with the acceptance of a US soft patch, but also the shocking discovery that the price of the Eurozone's fiscal pact is Southern European Depression.  

In the very short term, early May is seeing some stabilization of the flows of interest which involves a recovery in interest in 'growth' and 'recovery' relative to 'recession' and 'depression'.

The temptation to 'interpret' these results is hard to resist. But it would be surprising if there were no correlation between what the financial world is musing about as it consults Google, and the direction of key markets. For example, how this series compares to the movement in US bond markets. We do not yet have sufficient data to be certain, but it looks as if the two may indeed be related – as one might instinctively expect.

Or consider also this chart, which compares the series with changes in movements of the dollar, expressed as movements in the dollar vs the Special Drawing Right basket (again, both are averaged over 10 days). Once again, it is too early to be conclusive, but the two series do seem to share changes in direction.

There's not enough here yet to draw absolute conclusions – but there's more than enough to suggest they are worth keeping an eye on.

My intention is to develop a series of these WWAT? series to track the relative frequency of various contrasting ideas, with the results to be published each Tuesday. My early ideas include: 'Inflation' vs 'Deflation'; 'Oil' vs 'Shale Gas'; 'Fiscal Pact' vs 'Growth Pact'. But please feel free to suggest possible pairings.  

Shocks and Surprises, Week Ending May 5th

Of the 68 data-releases monitored this week:

·         32 conformed to within one standard deviation above or below the consensus or current trends,

·         15 provided positive growth surprises, and

·         21 fell shockingly below that standard.

By dint of sheer regularity, Europe shocked most regularly, but in proportionate terms, the heaviest shockers were NE Asia (ex China and Japan) followed by the US. For positive surprises, China provided easily the largest proportion of surprises, albeit on a sparse sample. So the major shocks and surprises this week were:

·         The degree to which still-intensifying weakness in Europe is now finding a mirror in data in NE Asia and to a lesser extent the US

·         The surprise recovery of growth momentum in China

Other features of the week were

·         The extension, but not intensification of the US soft patch

·         The shocking implosion of Italian manufacturing, services and labour data

China: Surprising Recovery of Growth Momentum

China’s three positive surprises were the HSBC Services PMI for April, the CEMAC/Goldman Coincident Indicators Index for March, and Hong Kong's retail sales for March. The HSBC Services PMI rose to 54.1, the strongest reading since October, and good enough to break a nine-month trend. New orders grew the strongest for 10 months, payrolls the strongest since November. But – and this is worrying – input price inflation also jumped to the worst since August 2010, whilst output prices were unchanged. The CEMAC/Goldman Coincident Indicators index had little detail, but its modest improvement was sufficient to break the recent deteriorating trend. Both these indicators, however, are consistent with our previous observations about the easing of China’s cramped cashflows. As for Hong Kong's retail sales (up 17.3% YoY by value, 13.4% by volume), the surprises came from strong demand for the sort of portable luxury items most associated with the mainland tourist trade: jewellery and watches rose 19%, clothing/footwear rose 15.7%, and department store sales rose 14.5%.

NE Asia: Echoing the Soft Patch

Meanwhile, the US’s soft patch is turning up in the data from the nimble/niche economies of NE Asia. South Korean industrial production rose only 0.3% yoy in March, whilst exports fell 4.7% yoy in April. Dig down, and the problem was a sudden weakening in exports to the US (up 7.2% yoy in April vs 27.7%% in March), as well as to Japan (down 11.3% yoy) and Asean (up 4% yoy). Taiwan's Manufacturing PMI showed the weakest pace of growth since January. Orders continued to rise – but predominantly from domestic buyers – whilst margins continue to deteriorate. Finally, Singapore's PMI shocked by a relapsing back into a contraction for the first time in three months, as employment and backlogs of orders both fell.

US Soft Patch, Extended but Not Intensifying

Data from the US confirmed and modestly extended the manufacturing soft patch into labour markets and the service sector, but didn’t intensify it. The ADP Employment data early in the week gave early notice that Friday's non-farm payroll data was likely to be shocking, and in due course it was: a rise of just 115k was the worse reading since October, and to add insult to injury, previous months' gains were also revised down sharply. The bad news was amplified by shocks to average earnings (flat mom), whilst the cheer engendered by the unemployment ratio unexpectedly falling to 8.1% was dissipated by the fact it was mainly generated by a fall in the labour participation ratio. In addition to the labour market data, there was a clutch of shocks from regional surveys: the ISM New York survey, the Chicago PMI, and the Dallas Fed Manufacturing Activity all disappointed, with the Chicago PMI falling to the weakest reading since November 09.

Nonetheless, almost all surveys show that growth is continuing, albeit at a slightly reduced pace. And positive surprises are also continuing: the ISM Manufacturing survey for April was the strongest since last June, and even the weekly unemployment counts managed to surprise on the upside.

Europe: Continent of Falling Swords

Europe would kill for a 'soft patch' like that. But it's at the start of a recession which in Southern Europe is fast curdling into depression.  In Italy the reality is souring even faster than expectations. Its Manufacturing PMI came in at 43.8, the worst reading since October, and jobs were cut at the sharpest pace since January 2010. The Services PMI showed just 42.3, the sharpest contraction since mid-2009, with jobs being shed at the most rapid pace since July 09. In view of the message from the PMIs, the shocking jump in  unemployment to 9.8% in March - the worst reading in 12 years – should be no surprise. Certainly the news will be even worse in April.

There was also a shock from France, where the previous week's very soft Services PMI preliminary reading of 46.4 was cut in the final release to 45.2. New orders and work backlogs were both falling at the steepest pace since April 09. This collapse has not yet produced job cuts – but they surely cannot be long in coming.

Even in Europe, however, there were a couple of positive surprises. Eurozone retail sales fell only 0.2% yoy, which was better than expected, mainly because German retail sales rose 0.9% mom and 2.3% yoy, both pleasantly surprising. 

Outside the Eurozone, UK PMI readings continue to outpace both its European partners and the recent GDP data: this week the UK's Construction PMI read 55.8; its Services PMI read 53.3 and its Manufacturing PMI read 50.5.

Irrashaimasse - Welcome to Europe's Money Circle

·         The last week brought some good news from the Eurozone, when it was announced that M3 had risen 3.2% yoy in March. It also brought the most comprehensively disturbing report about the Eurozone for some time – the quarterly banking survey of credit conditions and loan demand. It is wrong to accept the M3 positive surprise at face value, and it is correct to worry about the contents of the banking survey.

·         What the two together describe is a near-complete divorce of the Eurozone banking system its private economy. The largesse offered by the ECB to the banks has made no difference. Rather, money being pumped into the banking system is travelling a closed circuit between central banks, governments and banks, and back again. It pumps up balance sheets and it primps out M3, but it does nothing else. It will do nothing to ameliorate the Eurozone's recession this year. In the longer term, the lesson is bleak, and delivered entirely in Japanese.

These relationships are important, but not overly complicated, and this piece traces them. We start with the actions of the ECB and explore what impact these have made. From there we can move directly to the banks' balance sheet and trace the answering relationships between the banks and governments, and how this makes an impact on those M3 numbers. Finally, we highlight the results of the quarterly banking survey, which underline how the frantic money-spinning between European central banks, commercial banks and governments bypasses a private sector which, in turn, has effectively given up on the banking system.

The First Circle - ECB's Largesse

We shall start with the impact of the ECB's various liquidity rescue packages. These include both the Eu 1tr Long Term Refinancing Operation (LTRO) and the more contingent Emergency Liquidity Assistance (currently running at around Eu121 bn, apparently, according to a footnote to last week's ECB balance sheet statement.

The LTRO had two legs: first, in December, the ECB auctioned cheap three-year loans, and accepted applications of Eu 489.2bn from the Eurozone's banks. A second tranche of auctions was held at the end of February, which resulted in a further Eu529.5bn.

But the bald total of Eu 1tr in ECB cheap money presents an inaccurate picture of the increase in ECB financing partly because the three-year funding partly replaced, rather than supplemented, other short-term funding sources, and partly because a great deal of the net money borrowed was re-deposited immediately back with the ECB. These effects were overwhelming. Between the beginning of December and roughly now, the ECB's lending to banks rose by Eu 487 bn, but voluntary deposit made back into the ECB by banks (not counting those needed to cover reserve requirements) rose at the same time by Eu464 bn. So in the end, ECB's net lending to the Eurozone's banks rose by around only Eu23bn.

So although the ECB's balance sheet expanded by around Eu 530 bn since the beginning of December 2012, the vast majority of this expansion was, one might say, self-cancelling.

Second Circle: Banks and Governments and M3

Now we come to this week's good news, that Eurozone M3 growth accelerated to 3.2% yoy in March, from 2.8% in February. This means that M3 is growing faster now than at any time since June 2009. More, for the third month in a row, we have seen sequential growth of more than a full standard deviation above historic seasonal patterns. How can this be anything but encouraging? 

The thing to remember is that monetary aggregates are measurements of financial institutions' liabilities – the stock of money they purportedly contain. It is when we look at the changes in the assets backing those liabilities that the problem emerges. For the only assets that are growing are banks' credits to government, made either in the form of loans, or in the form of government bonds held. That credit grew by 7.3% yoy in March, up from 5.6% in February. Meanwhile, growth rate of credit to the private sector came in at only 0.5%.

If we look directly at Eurozone's bank balance sheets, we find that during 1Q12, banks raised their holdings of government bonds by Eu120bn, whilst they raised their private loans by just Eu 2bn.

Meanwhile, in an echo of what we found with the central banks' attempt to expand credit to the banking sector, the increased lending to government is also largely self-cancelling. For example, we have mentioned that banks' holdings of government bonds rose Eu120bn during the first quarter. What did the government do with the money? Why, most of it they gave back to the banks: government deposits during the same period rose by Eu 83bn. Deposits of the private sector during the same period rose by just Eu24bn.

By the end of March, government deposits represented only 2.9% of total bank deposits: but during 1Q, the rise in government deposits accounted for 77.5% of the rise in total deposits. In truth, the banking system's interaction with the private sector has stalled, and the recovery in monetary aggregates is almost solely a circular set of book entries between the central bank, governments and financial institutions.

Consequences – For the Banks

Does this matter? It matters because it means the banks have raised their exposure to Eurozone sovereign bonds: they are now equivalent to 144% of total bank capital, up from 140.2% at end-December. Every sovereign credit downgrade must therefore be expected to erode bank capital.

But more, as banks commit more capital to government debt, this crowds out private lending – the direct opposite of the dynamic which drove the Eurozone economy during the first seven years of its life. Between the beginning of the Euro and the outbreak of the financial crisis, credit exposure to governments had fallen from 240% of bank capital to a low of around 143% - and it is that withdrawal from financing government which helped finance lending to the private sector. Since 2007/08, the tendency has been for that ratio to rise – except in times of exceptional crisis – and subsequently for credit conditions to the private sector to tighten. As long as the banks continue to think the safest way to make money is to lend to governments, there's no reason for that to change. 

Consequences 2 – Private Sector Abandoned  

Which brings us to the ECB's quarterly bank lending survey, which studies changes in the way banks interact with the private sector. It makes ugly, depressing, reading.

The survey asks banks two sets of questions: first, are they tightening, or easing, the conditions under which they make loans; second, are they experiencing rising, or falling, demand for loans. They study conditions for corporate loans, of residential mortgage loans, and of consumer credit.

Let us look first at credit conditions.

It is easy to misread this graph: the uptick in credit conditions during 1Q doesn't mean conditions eased, just that they tightened less dramatically than in 4Q11. Conditions for corporate credit, for residential mortgages and for consumer credit were all tighter in 1Q than they were in 4Q11. For corporations, credit conditions have got progressively tighter each quarter for the last 20 quarters (ie, since 2Q07). For residential mortgages, the run of continuously intensifying tightening has run 19 quarters, and for consumer credit, 18 quarters. The ECB's funding largesse may have slowed the pace, but it has been unable to stop the ratcheting up of tightening credit conditions.

But, if the non-stop tightening of credit conditions is bad, the collapse of loan demand is worse, and is once again intensifying quite dramatically. The measurement here is simply the percentage of banks which report rising loan demand, minus the proportion that report dwindling demand.

The collapse in loan demand from enterprises during 1Q12 was steeper (in marginal terms) than any experienced at any point of the financial crisis. The net reading of minus 30% is the most extreme since 1Q09, and reverses a period during 2010-11 where loan demand was actually increasing. To repeat: this is the most extreme onset of financial caution that the Eurozone has seen at any stage of the financial crisis. And since we know that private sector deposits are now barely growing, it is unlikely the collapse in loan demand simply signals that companies are happy with their liquidity position.

The collapse in demand for credit isn't confined to companies. The household sector's demand for residential mortgages has fallen to its lowest reading (minus 43%) since 4Q08. Households' demand for consumer credit is declining faster now than at any time since 1Q09.

Conclusion

The conclusion is inescapable: with ever increasing intensity, Eurozone banks don't want to lend to the private sector, and with ever increasing intensify, the Eurozone private sector doesn't want to borrow from the banks. This is getting more, not less, pronounced. Its immediate result will be intensifying and lasting recession.

And after that? I've seen it before. You can call 'irrashaimasse!' or you can simply say 'Sayonara'.

The important differences between the Eurozone now and the Japanese economy post 1990 is that after Japan's banks died to the private sector, the economy could run purely on the cashflow generated via its structural current account surplus, whilst the prevailing interest rate structure made a decade or two of structural fiscal deterioration possible. Neither are true of the Eurozone, so we can be sure that the cost of closing Europe's banking system won't be as relatively painless as just two lost decades.