From Jackson Hole with Neutral Rate, Inflation Expectations, and Inflation Targets

 With interest rates around the world at close to zero or negative and another recession looming on the horizon central banks, having exhausted their firing powers with the so-called unconventional policies, appear rather anxious about the efficacy of their tools. This is why the Chair of the Federal Reserve, Janet Yellen, spent much of her speech at central bankers meeting in the mountain resort of Jackson Hole, Wyoming   trying to explore  the  effectiveness of Fed's expanded monetary policy toolkit.

Overall, it appears that Fed still thinks or hopes  that changes in nominal variables stemming from the conventional and unconventional policy tools such as changes in the Fed funds rate or Quantitative Easing will exert a lasting and  long-term impact on the real variables such as the real GDP growth rate in these financially  abnormal times. Ignoring the fact that the effectiveness of monetary policy tools has been seriously diminished in recent times at various advanced countries and abstracting from the distortionary effects of the unconventional tools on the economy, Ms. Yellen  primary message at Jackson Hole was that:

I expect monetary policy will continue to play a vital part in promoting a stable and healthy economy. New policy tools, which helped the Federal Reserve respond to the financial crisis and Great Recession, are likely to remain useful in dealing with future downturns.

There were hardly any new information about the exiting tools  or their effects on the transmission mechanism of monetary policy in the speech. However, the Chair mentioned that  future monetary policymakers might choose to explore some additional tools that have been employed by other central banks,  such as  the possibility of purchasing a broader range of assets,  raising the FOMC's 2 percent inflation objective or implementing policy through alternative monetary policy frameworks, such as price-level or nominal GDP targeting. She added  "adopting these policies would require a very careful weighing of costs and benefits and, in some cases, could require legislation".

Among these various alternative policies only the idea of targeting for a higher inflation rate will be materially different, and extremely harmful, the rest like  price-level or nominal GDP targeting are basically red herrings.  The idea of opting for a higher inflation target was recently floated by the president of the San Francisco Fed, John Williams, who has argued in the post-financial crisis world the significant decline in the natural rate of interest over the past quarter-century to historically low levels pose significant challenges for the conduct of monetary policy, defining the concept of the medium-term value of the natural  as the real interest rate that balances monetary policy so that it is neither accommodating nor contractionary in terms of growth and inflation in an economy at full strength.

Despite its shortcomings in describing the Wicksellian  concept of Natural Rate of Interest  Williams' concept as an equilibrium interest rate can be thought of as the rate of interest corresponding to a configuration of interest rate, output growth rate, inflation rate, employment and exchange  rate in a model in which goods and services, labour  and money&credit markets all are in equilibrium and in the currency market the covered interest rate parity condition is satisfied.  In  other words, this is the interest rate that prevails in an  economy operating  at its  production efficiency frontier. Williams believes this natural rate has declined and writes:

The new challenge for central banks is how to deliver stable inflation in a low r-star world. This conundrum shares some characteristics and common roots with the theory of secular stagnation; in both scenarios, interest rates, growth, and inflation are persistently low (Summers 2015).

This is also a belief shared by Ms. Yellen, who citing  Lubik and Matthes (2015), Laubach and Williams (2016), and Johanssen and Mertens (2016) states "there is empirical evidence to support the conclusion that the neutral rate is currently not far from zero". This is indeed a remarkable inference, since it implies that  in spite of the existence of a relatively large output gap,  the interaction of the economy's aggregate demand and the long-term aggregate supply function on the space spanned by the   real interest rate and real output variables has shifted down to a close-to-zero interest rate. It should be noted, however, that this inference  appears to have been drawn from a conjecture, as she writes:

 we know that the neutral rate must have been well below its historical norm in recent years, because with the actual real interest having been as low as it has been lately, the economy would have otherwise expanded much more than has been the case. 

This conjecture would be flawed if the potential output growth rate has been slowing down due to a lack of capital formation stemming from the prevailing uncertainty. As we have argued before there is strong evidence that in such circumstances businesses in their capacity planning would be refraining from investing in irreversible capital expenditures, and this is the main cause of lower growth rate at the lower actual real interest in the recent times.

In fact, based on the following chart from Holston, Laubach, and Williams (2016) one can infer that the Wicksellian natural rates  in the US, UK and euro area  over the period 1980-2007 have been close to 3, 2.5 and 2 per cent respectively and the apparent decline  since 2008 is basically an art effect  stemming from a drastic structural change in financial markets in recent years. In other words, the fluctuation around the above mentioned estimated natural rates are caused by various cyclical factors. Moreover, given that natural rate is an equilibrium concept it does not stand to reason to argue that it demonstrates such an extreme volatility over short spans of time.

Estimated inflation-adjusted natural rates of interestSource: Holston, Laubach, and Williams (2016); data are four- quarter moving averages

As we have argued in the past, the concept of neutral rate is a long-run phenomenon associated with potential output at equilibrium. When the economy has been  in a prolonged state of disequilibrium and uncertainty as a result of which  businesses have revised and delayed their capital expenditure plans then the concept of  a lower neutral rate  would be vacuous. In such circumstances the potential growth rate would be lower due to the fact that production efficiency frontier is shrinking, and businesses are not investing toward minimizing their long-run minimum average cost. The stimulative monetary policy becomes ineffective because it cannot stimulate investment and capital formation. The distortionary impacts of flawed policies create bizarre relationships, for instance lower interest rates will encourage more savings because of consumers anxiety about the viability of their pension plans. On the investment side corporation decide to buyback their own share instead of investing and many decide to operate under intensive margin.

The idea that the natural or the neutral rate has declined is of course the dual form of the argument concerning the  progressive ineffectiveness of unconventional tools such as QEs or forward guidance. On her June 6th speech in Philadelphia Ms. Yellen, has referred to this ineffectiveness as less stimulative,  reporting:

The current stance of monetary policy is stimulative, although perhaps not as stimulative as might appear at first glance, 

which she has explained it in terms of a decline in the neutral rate. Similarly, Mr. Williams attributes this ineffectiveness to the "less room" conventional monetary policy has  "to stimulate the economy during an economic downturn, owing to a lower bound on how low interest rates can go. He states:

Although targeting a low inflation rate generally has been successful at taming inflation in the past, it is not as well-suited for a low r-star era. There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low.

In other words, Mr. Williams  argues that higher inflation rate would provide the monetary authority with a wider interest rate margin to be used as the policy instrument to fight the upcoming recession. Of course, if inflation rate target is arbitrarily raised to say 4 per cent the monetary policy would not automatically become effective in stimulating investment and exports. After all, we have experienced periods of stagflation and currency wars when monetary policy was ineffective.   Furthermore, his argument ignores the fact that what matters is the information content of prices, and this content diminishes at higher inflation rates due to the increased inflation variability. As Okun (1971) has shown variability of inflation rises with the inflation rate, and therefore the information content that allows the two sides of the market to plan and to execute their consumption and production decisions will deteriorate. The result would be lower growth rates.

Total debt securities, by residence and sector of issuer,
Amounts outstanding at end-September 2015, in trillions of US dollars

AU = Australia; CA = Canada, CN = China; DE = Germany; ES = Spain, FR= France; GB = United Kingdom; IE = Ireland, IT = Italy; JP = Japan; KR = Korea; KY = Cayman Islands; NL = Netherlands; US = United States. 

Sources: National data; BIS debt securities statistics.

Trimmed Mean One-year PCE Inflation Rate,

Source Federal Reserve Bank of Dallas

Relying on a partial equilibrium analysis based on the conventional expectations-augmented, or a New Keynesian, Phillips curve in which actual inflation trends depend largely on inflation expectations, and considering the fact that for two decades inflation  has been relatively  stable, Ms. Yellen has argued that:

The most convincing explanation for this stability, in my view, is that longer-term inflation expectations have remained quite stable. So it bears noting that some survey measures of longer-term inflation expectations have moved a little lower over the past couple of years, while proxies for these expectations inferred from financial market instruments like inflation-protected securities have moved down more noticeably. It is unclear whether these indicators point to a true decline in those inflation expectations that are relevant for price setting; for example, the financial market measures may reflect changing attitudes toward inflation risk more than actual inflation expectations. But the indicators have moved enough to get my close attention. If inflation expectations really are moving lower, that could call into question whether inflation will move back to 2 percent as quickly as I expect.

However, considering the fact that the expected inflation rate usually constitutes the intercept of a  Phillips curve  with the inflation axis in the space spanned by inflation rate and the GDP growth rates it would be natural for this supply side relationship to generate lower expected inflation in response to a persisting output gap. The main reason why inflation expectations and actual inflation were closely connected prior to the mid-1990s was the relative consistency of such shifts that was enhanced by the relative stability of the potential output growth. Wheres according to a study by the  Fed economist Jeremy Nalewaik

Movements in inflation expectations now appear inconsequential since they no longer have any predictive content for subsequent inflation realizations,

The reason for this break up is of course  the greater variability of the gap measure due to the utilization of the contingent  capacity that makes the Phillips curve shift  rather erratically.  At the same time the  aforementioned erratic fluctuation  of  the capacity growth rate caused again by the utilization of the contingent capacity results in the erratic behaviour of the actual inflation rate.

Thus, the key to the effectiveness of monetary policy is economy's return to the efficient production frontier, through a healthy capital formation, which would result  in higher growth of productivity. Unfortunately Ms. Yellen just in passing and almost as an after thought referred to the question of productivity growth in her Jackson Hole lecture :

Finally, and most ambitiously, as a society we should explore ways to raise productivity growth. Stronger productivity growth would tend to raise the average level of interest rates and therefore would provide the Federal Reserve with greater scope to ease monetary policy in the event of a recession. But more importantly, stronger productivity growth would enhance Americans' living standards.

We will be dealing with this issue in our next post.

Can Deploying Helicopter Money Win the Currency Wars? Qua deinde fugam ?!

In response to the global financial crash of 2008, monetary authorities in the US, Eurozone, UK, Japan and China have implemented  QE plans to purchase massive quantity of bonds to jump start their economies. However, the programmes soon morphed into full-fledged currency wars.

 Following the February Shanghai G20 meeting,  monetary authorities, under the US auspices decided  not to  pursue exchange rate depreciation in a beggar-thy-neighbor approach. For a while it appeared that there was a halt in the currency wars.  However, with the global slowdown in the first half of 2016 and the Fed's delays in implementing its normalization policy, the market came to the view that the Fed is welcoming a weaker US dollar.

On August 4th, the British pound depreciated further after   Governor Carney  announced  that to mitigate the adverse effects of the Brexit referendum Bank of England would expand its bond purchase substantially  and buy not just more government bonds, but also corporate bonds.  A few days earlier, on July 29th, the Bank of Japan that  has been purchasing about 80 to 120 trillion yen (close to $1 trillion) of government bonds each year,  announced that it  would increase the scale of a program to buy exchange-traded stock funds to ¥6 trillion a year from ¥3.3 trillion, and it doubled the size of a dollar-denominated lending program aimed at Japanese companies operating overseas to $12 billion. However, the yen jumped 1.8 percent to 103.37 per dollar. We may recall that  on May 22nd, while denying that he is targeting exchange rate value of yen,  the bank’s governor, Haruhiko Kuroda, had said :

"If necessary, we can further ease our monetary conditions in three dimensions. Quantitative, qualitative and interest rates."

 It would be interesting to ask if the Japanese policy review in September will result in the resumption  of currency wars and will the helicopter money help UK and Japan to improve their economic outlook amidst of the current global slowdown?

Japanese Yen -US Dollar Exchange  Rate

British Pound - US Dollar Exchange Rate

In UK, the Bank of England, introduced its programme  under the banner of "exceptional package of measures" amidst of the current global slowdown. This move was taken by many as the signal that the Bank will do what is required for "monetary and financial stability".  The package included:

* a cut in the UK policy rate from 0.5% to 0.25%,
* a quasi-forward-looking guidance that interest rates could go lower (to near zero) by the year end, and
* a plan to buy £60bn worth of government bonds, extending the existing quantitative easing (QE) programme to £435bn in total, and £10bn of corporate bonds over an 18-month programme set to start mid-September in a bid “to impart broad economic stimulus”. Targeted companies would be those conducting “genuine business in the UK”, and not banks, building societies or insurers.

As a consequence bond yields have plummeted in the UK, for instance  the yield on its  longest-dated bond, the 2068 maturity, has declined from 2% on the day of the referendum to 1.06% on August 11, but any marked impact on GDP is highly doubtful. In the belief that the QE policy will lower interest rates and encourage investment and consumption of interest sensitive durable goods, thus boosting the GDP growth, the Bank has been buying bonds (gilt) at auctions in the market since 2009.

We have of course discussed in the past the dangers of negative interest rates, the adverse impacts of lower rates on savers and borrowers at such high level of debts, anemic productivity growth, widening  of current account deficit and lack of capital formation;  and thus will not dwell any further on these issues here. Suffice to remind readers that a year ago we had predicted the lower British economy's  growth, which we attributed  to these fundamental factors particularly a lack of productivity enhancing investment. We now notice that  the Bank has revised down   its growth forecasts  for 2017 from the 2.3%, expected in May, to 0.8%, in its recent announcement.

Bank of England's holdings of bonds (gilt), Source: Bank of England

Although, the British pound has been depreciating since the mid-2014 and the Brexit has given a boost to its decline, the bank's declared the new package's main aim was to mitigate the prevailing uncertainty. In the words of Governor Mark Carney:

"By acting early and comprehensively, the (Bank) can reduce uncertainty, bolster confidence, blunt the slowdown and support the necessary adjustments in the UK economy,"

The Governor, however, acknowledged that when rates are so close to zero the effectiveness of any further cuts on the economy would be diminished, thus restraining the impacts of interest rate cuts and quantitative easing.

UK's Labour Productivity, (pre-crisis peak=100)

UK Manufacturing Input Price Inflation, Annual Rate, Source: ONS

UK Unemployment Rate (Age 16 and over), SA

The Governor's warning was an important one, to the effect that a week later on August 10th when the bank tried to purchase its targeted £1.17bn of bonds it could not find enough sellers for a shortfall of £52m. This excess demand for bonds raised their prices and thus lowered their returns. In fact, yields on UK government bonds on 3 and 4 year turned negative  (to minus 0.017 and minus 0.015 percent respectively).

Despite the fact that the £52m excess demand for bonds was relatively a small sum, and the fact that the Bank assured the market  that it will make up the shortfall in the second half of its six-month purchase programme, the signal indicated that investors, seeing the low British  productivity growth and the current global output gap, were trying to hold on to their relatively safe higher-return bonds, particularly when interest rates are expected to fall in this uncertain times.

In short, savers  increasingly worrying about their future earnings are trying to save more.This implies that the  future shortfall in supply may need to be eliminated by the Bank's direct purchase of government bonds -- i.e, by helicopter money.

The new Chancellor of the Exchequer Philip Hammond may be using helicopter money to both prop up consumer demand and finance government's infrastructural projects. He  has abandoned plan to deliver a budget surplus by 2020 and has said "We have the option of a fiscal response,"  and he will be using the autumn statement,“to keep the economy on track.”

However in uncertain times  helicopter money is a dangerous  tool, particularly when the monetary authority's credibility is under  a heavy scrutiny.    Given that the Bank will be directly financing the infrastructural projects of the governing party, which depending on various electoral strategies are usually concentrated in certain constituencies under a political agenda, it will politicize the Bank -- which is supposed to be  an apolitical entity. The politicization could, most probably, destabilize  the economy, because it destroys the price discovery mechanism  of the market,  generating the risk of stagflation in the current challenging circumstances.

UK's Current Balances ( four-quarters cumulative) as a percentage of GDP

In Japan,  with its aging demography, and a population that  has been declining since 2008, the Bank of Japan's stimulative bond purchasing policies  has been totally  ineffective in generating growth. Moreover the adverse effects of  negative interest rates have already distorted the Japanese financial market. For instance, as a result of lack  of interest on a sale of 10-year Japanese government bond  its yield  has raised to 0.053 percent`from a negative  0.13 percent.

The distorted financial market in an  economy with a declining population, where Japan's fertility rate at 1.6 children is well below its replacement level of 2.1, can prolong the prevailing uncertainty. The situation is exacerbated by the fact that more than a third of the population is older than 60, with a high marginal propensity to save.

Although Japan’s economy  appears to have reached full employment at the unemployment rate of 3.1 per cent in June, there are indications that, like in the US and Europe, businesses are adopting intensive-margin production strategies and postponing  irreversible capital formation.  This is why Japan’s economy has been fluctuating between expansions and contractions in recent quarters, has a stagnating wage growth and  its businesses are hoarding cash that has reached the staggering level of US$3.4 trillion.

In these conditions,  exacerbated by the adverse effects of  the global slowdown the Japanese policy makers are trying to introduce a coordinated policy move with the Bank of Japan almost doubling its purchases of exchange traded funds (which include real-estate investment trusts, corporate bonds, commercial paper and stocks) and the Japanese  government introducing a fiscal stimulus package at a total value of ¥28 trillion ($273 billion) over several years,  that includes ¥7.5 trillion in new spending to jump-start the country's sluggish economy.

The intensified uncertainty, emanating from the negative interest rate policy and the Bank of Japan's announcement of an upcoming assessment of the effectiveness of its current stimulus policies in September has triggered a further appreciation of yen and a sell-off in the Tokyo stock market, as well as the worst sell-off in government bonds in more than three years, that has already impacted other countries bond markets.


Japan's economy grew by an annualized 0.2 percent in the second quarter (0.2 percent on a quarter-on-quarter basis),  well below the 0.7 percent increase markets had expected and a marked slowdown from a revised 2.0 percent increase in January-March. Household consumption, constituting about 60 percent of GDP, rose 0.2 percent, slowing from a 0.7 percent increase in the previous quarter, and  capital expenditure declined 0.4 percent after a 0.7 percent drop in the first quarter.

The September policy review may be a prelude to Japan's deployment of helicopter money in the currency wars, particularly  if the Fed continues to delay its policy normalization.

Japan's GDP Growth Rate, Quarterly- Seasonally Adjusted

Japanese  Government 30-Year Bond Yield

On the Vicious Circle of Global Slowdown and Banking Crisis

Reflecting the global nature of the financial malaise and its associated uncertainty, growth rates in most advanced countries have slowed in the second quarter. The slowdown may have triggered a global banking crisis.

More specifically, the U.S. GDP grew at a sluggish 1.2 percent rate in the second quarter as businesses continued to hold back on investments. Given a downward revision of the growth by the US Commerce Department to just 0.8 percent in the first quarter as compared to 1.1 percent that was previously estimated, the average growth rate for the first half of this year is just 1 percent. The US GDP growth for three consecutive quarters has been hovering close to 1 per cent.

The US GDP Quarterly Growth Rate

In the eurozone, the year-over-year growth in the second quarter slowed to 1.6%, relative to 1.7% in the first quarter, and the outlook has deteriorated rapidly with the uncertainties associated with Brexit and other geopolitical developments, such as the German-Turkish dispute after the recent coup and Russia's more assertive pasture. In Japan the GDP growth rate has swung between negatives and positives, averaging close to zero in recent quarters, and her second quarter annualized growth is expected to have dropped to near zero. The slowdown in China is also expected to be accelerated, due to its unsustainable debts and other imbalances.


This slow growth pattern should not be a surprise to the readers of this blog as we have persistently warned about the implications of businesses adoption of the intensive margin mode of production and delays in investing for capital formation arising from the prevailing uncertainty. The fact that in the US widespread slow growth in the second quarter was stemming from a fall in inventories, at a time when personal consumption was growing at 4.2 percent, has validated our hypothesis. Moreover, for the third consecutive quarter, nonresidential business investment in the US declined in the second quarter by 2.2 percent, indicating that businesses are refraining from the irreversible capital expenditures. The situation is not much different in the rest of the advanced countries.

In Japan, a ¥28 trillion ($273 billion) in new spending, announced in the early August, as part of the Second Arrow of Abenomics, meaning fiscal stimulus, to jump-start the Japan's sluggish economy is not expected to alter the global distortion of fundamentals. Precisely because of the uncertainty, Japan's $130 billion dollars worth of new fiscal stimulus, including cash payouts to low-income earners and increased infrastructure spending, earmarked for upgrading port facilities for cruise ships, as well as accelerated construction of a high-speed train line, is not expected to create much of incentives for capital formation in the country's export-oriented industrial sector. The only solution, as we have repeatedly called for in this forum, is a global accord to restructure the toxic debts and to realign various currencies based on the real purchasing power parity.

Unfortunately, the illusory appearance of a strong US labour market, with her unemployment rate at 4.9 percent, may have disguised the severity of the problem. The quasi-strength, however, is mainly due to the use of contingent labour in the intensive-margin capacity planning of businesses where firms substitute labour for capital due to uncertainty. This is exactly why wage growth has remained anemic. The slowing of global growth is setting into motion a vicious circle that could, with an increasing probability, trigger a global banking crisis.


As the following charts show European banks' shares have already plummeted to some distress levels as they are saddled with $1.3 trillion in non-performing loans, nearly $400 billion of them in Italy, and many don’t have sufficient capital buffer. The situation will dramatically worsen if the current slowdown develops into a highly probable global recession.

Barclays PLC

Royal Bank of Scotland Group

Deutsche Bank AG

Banco Santander SA

Monte dei Paschi di Siena

In spite of its convoluted narrative, the IMF's latest Global Financial Stability Report acknowledges that for many European banks, elevated non-performing loans comprise a major structural weakness. According to the report roughly one-third of listed European banks (by assets) are facing significant challenges to attaining sustainable profitability arising from legacy issues (900 billion of non-performing loans and an unspecified amount of toxic assets).

Deteriorating profitability and unresolved legacy challenges raise the risk that external capital and funding could become more expensive, particularly for weaker banks with very low equity valuations (price-to-tangible-book valuations of less than 60 percent), pointing to weak future prospects. Italian banks face a particular challenge in this regard, as market pricing has reflected investor concerns that some banks may face difficulties in growing out of their substantial NPL overhang, despite constructive steps taken by Italian authorities to facilitate balance sheet repair. 

Italy, like other eurozone's weaker economies, including Greece, Portugal, and Spain that have been severely afflicted by the Big Recession, most probably will experience acute distress and becomes the first major country fully exposed to the brunt of this vicious circle. During the six consecutive years of recession since 2007, Italy's GDP has declined by 10 per cent and the country's banks, that rely heavily on retail deposits and bonds to finance their lending, have accumulated about €400bn of non-performing loans, compromising more than 18 percent of their total loans.


The EBA tests did not include any banks from Greece or Portugal, . The two Irish banks, AIB and Bank of Ireland were among the worst financial institutions.The results will have adverse impact on plans to starting selling down the Irish government's stake in AIB next year. In the words of Philip Lane, Ireland's Central Bank governor: the two banks

are adequately capitalised but remain vulnerable to a downturn, especially in relation to the continued workout of problem loans and the sustainability under stress of current profitability levels.”

The Italian banks are already exhibiting the first signs of stress and with their eminent insolvency a global contagion of banks' failure would be inevitable. For instance, according to the recent EBA stress test, the oldest operating bank in the world: Monte dei Paschi di SienaBanca was the worst performing bank among the 51 participating banks in the test, requiring to raise massive amount of capital. The bank would be insolvent inthe European Banking Authority(EBA)'s stress test that was released on July 29th, with a common equity tier one (CET1) ratio of -2.44 per cent. Banks are central to the European financial system, supplying about three quarters of all credit, and their demise therefore will be a devastating blow to the economy in Europe.

The bail-in solution for banks on the verge of insolvency, suggested by the newly established EU’s banking union, that has become operative earlier this year, requires that the bank's shareholders , creditors and large depositors (i.e., in excess of €100,000) to assume a haircut before taxpayers' funds can be used to bail them out. Bondholders, of course dislike "bail-in" remedies, and many are concerned about the inconsistent and at times chaotic bail-in procedures that are adopted in trying to prevent bank failures. These policies have increased the risk of funding for smaller lenders. Moreover, the looming prospect of bail-in has diminished the supply of credit for the smaller lenders that are mainly concentrated in the weaker economies, exacerbating the banking challenges.


For instance, when the Italian government in 2015 decided to bail-in junior, or subordinated, bondholders at four small insolvent regional banks it generated a significant hardship for retail investors and pensioners because many of the banks’ junior bonds had been sold to them as riskless savings products. The move also frightened the investors.

To guard against a bail-in the board ofMonte dei Paschi di Sienahas approved a conditional recapitalization of the bank, guaranteed by a consortium of investment banks led by J.P. Morgan Chase. Nevertheless, the bank's prospects remain gloomy, particularly in the event of a global recession.

Impact on Common Equity Tier 1 (CET1) capital ratio from 2015 to 2018 in the adverse scenario by bank in alphabetical order.
Source: EBA

Evolution of absolute credit losses (€ bn) and contribution of cumulative credit risk losses in the adverse scenario for selected countries of the counterparty (%). Source EBA

According to a study byAcharya, Pierret and Steffen, to meet the robustness standards specified by the U.S. Federal Reserve, Europe’s largest banks, including HSBC Holdings PLC, Deutsche Bank AG and UniCredit SpA, would need to raise more than €253 billion in capital rising to more than €572 billion in a crisis situation. The study focusing on 34 of the largest European banks, with more than €23 trillion in assets, also found they would need to raise more than €1.19 trillion, potentially from governments, to have enough equity to withstand another financial crisis. According to the study:

A. French banks lead almost each book and market capital shortfall measure, both in absolute euro amounts and relative to its GDP. The capital shortfall ranges from €2 billion to €189 billion. The Capital Shortfall in a Systemic Crisis stress scenario (SRISK) suggests a shortfall of €248 billion, which corresponds to almost 12% of the country’s GDP

B. The banks with the largest SRISK next to France are from the U.K., Spain and Germany. While German banks benefit from a stronger domestic economy with a higher GDP and capacity for public backstops, shortfalls relative to the GDP of these countries is large corresponding to almost 11% in Spain and 7% in the U.K.

C. Italian banks have capital shortfalls of €97 billion, which correspond to about 6% of Italy’s GDP.

Notwithstanding these discouraging numbers, the results of EBA's stress test suggest that only a handful of banks will be facing the challenge of maintaining sufficient capital in the event of a hypothetical severe economic downturn. As a matter of fact, however, should a contagion scenario come to pass even the Acharya et al results would be too optimistic. The severity of European debts, anemic global growth, negative interest rates, currency wars, and a rapidly deteriorating international trade's outlook render the EBA results even-more questionable.

The world urgently needs a global financial accord to cleanse the system of its toxic assets, realign currencies, and reestablish trade links.