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March
26
2020
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Professor Malinen: The Euro Won’t Survive This Crisis
Jan Nieuwenhuijs (JN): I have read your blogposts and quarterly reports for some years, and all this time, you have been very bearish on the economy. Could you please elaborate on how you got so bearish? Tuomas Malinen (TM): I remember me and my ex-wife were in Lapland, which is in the Northern part of Finland, on New Year’s Eve of 2016, and I said to her, “you know, there is something wrong with the world economy, but I just can’t put my finger on it.” She’s a neuro-psychologist, and she was reading Thinking Fast, Thinking Slow by Daniel Kahneman, an excellent book, which is about biases in decision making but also in forecasting. She asked me, “how certain are you that your forecasting models and views are correct?” When we got back, I basically threw all the data we had at GnS Economics in the gutter and started to collect a whole new data set on financial markets and the global economy. After about a month, I had quite a consistent picture of the global banking sector and financial markets, and it looked horrible. I couldn’t see any actual recovery after the crisis of 2008 in the global banking sector. The massive influence of central banks on financial markets looked really bad as well. Everything was in a bubble. And then we kept digging. By June 2017, we figured out that China was running the world economy almost entirely with massive and unsustainable debt stimulus. We got really bearish about how things could go forward. We had a long discussion within our small forecasting team, of only three persons back then, about what would happen. I thought that central banks would never bail-out the asset markets, while my colleagues said that they would do just that. Well, they were right, and this was also reflected in our forecasts. We always asserted in our reports that such policies were possible. Since then, I’ve made covering these developments my main job and we have six partners now at GnS. JN: How did the spread of the Coronavirus change your forecasts? TM: It radically altered them. We were actually one of the first in the world to warn about the grave implications of the virus on the economy in late January, but the gravity of the situation even surprised us. We didn’t fully understand that it would be so heavy all over. In China, we could see a complete lockdown in only one region, namely Hubei. But now the epicenter is in Italy. That caught us by surprise. We’re in the process of updating our growth forecasts. Early March, we published a report called “The Black Swan” in which we provided three scenarios for the global economy, but they are all pretty much outdated as the virus spreads so fast. JN: You are saying the epicenter is now in Italy, but from the statistics I see I think it’s possible the United States, the Netherlands, France, the UK, Spain, India, can all turn into Italy, or not? TM: Yes. That’s the scary part. This will bring our economies to their knees. We first considered it to be a trigger, but now it has become a driving force for the near complete collapse we’re seeing. JN: How will it influence monetary policy and politics? TM: In monetary policy, you can see what we talked about before. Suppose, right now, we would not have such heavily inflated asset markets. Then, we wouldn’t have the problems in the stock and especially credit markets we see now—if they were fairly valued. There would be some stress, but now it’s exploding. Look at the credit markets as an example. This risks a collapse of financial markets, which is really scary. And that’s what the coronavirus is facilitating. But the problems come from a much longer heritage. The central banks, with asset-buying programs and zero or negative rates, pushed investors to the tail risks of the credit markets, in the junk bonds. This is now unraveling. Massive speculative positions are unraveling and that’s creating strains in financial markets. JN: How will central banks continue their policy in the coming months? TM: They will throw everything at it. Kitchen sink, bathroom sink, the neighbors’ sink, everything to support the asset markets. But the unfortunate fact is that there is no amount of liquidity that can save the asset markets if the real economy goes belly up. They try to soften the blow. But if they try and control the fall of all the risky assets in the world, which are estimated to be roughly $400 trillion, their balance sheets would have to grow by insane amounts. We’ll have to wait and see, but it seems they keep printing now. I’m of the opinion we should just take the pain and the recovery, instead of stagnating, turn everything into financial mush and central control. JN: Can political instability arise in the US and eurozone? TM: For sure. The European banking sector will not be able to cope with this blow, and probably the eurozone won’t be either. We expect the eurozone to start breaking up at some point. Massive poverty and unemployment will create all sorts of havoc, especially in the center and southern European states. Possibly also in the US. JN: So, you are saying this will cause the eurozone to break up? TM: Yes. Almost certainly. JN: I also read in your reports the possibilities of a systemic crisis and hyperinflation. What are the odds of these scenarios? TM: The systemic crisis scenario we have been pondering for a few years. It means the breaking of the fabric of the financial system. We do not have a precedent of such an event on a global scale—as it would also include the breakdown of the societal order. The closest thing we have seen is the breakup of the Soviet Union. We are currently drawing up new analyses, and in the most pessimistic scenario, there is a systemic crisis. But we still consider it to be rather unlikely. Hyperinflation would require massive printing by central banks. We’re not there yet, but if it comes to be that central banks not only buy the risky financial assets, but they will start to provide money for people, then we are on a path that will most likely lead to a monetary collapse and hyperinflation in the end. Because when you open up the printing press to politicians, then they are rarely shut down. We are truly faced with only drastic options going forward. Hyperinflation is a possibility, although still remote. JN: Is the current economic environment, with all these major economies in lock down or semi-lock down, deflationary or inflationary? TM: Definitely deflationary. JN: But central banks have a problem with deflation. How do you see this developing in the coming months? TM: Yes, the risk of deflation puts the central banks in a difficult spot. So, they will print, and when this gets going, there is a risk of inflation. But in our baseline scenario we get a European banking crisis and that will very much be deflationary. However, we have to take it month by month to see what happens. JN: You have written that European banks didn’t clean up their balance sheet after the previous crisis. Now we have entered the next crisis, and these banks will be damaged even more. What will happen to these banks? TM: They will tumble. JN: Do you think they will be bailed-in or bailed-out? TM: The banks that can be bailed-out will be; the others will be bailed-in. In the latter, they will use the depositors’ money to bail the banks, which is legal now. People don’t really understand, but this is a grave risk to everyone holding large sums of money in banks. The risk of depositor bail-ins is really high. JN: What was your view on the euro, say, five months ago? A viable monetary union? TM: No. I was part of an independent group called “the euro think tank.” It was set up by Professor Vesa Kanniainen from the University of Helsinki. We wrote a book on it with about eight people specialized in different fields of economics. What we found was that the eurozone was really weak, and the only way to save it was to turn it into some kind of federal union. And even that, would that work? It still wouldn’t be a country. You can’t make Finns keep sending money to Greece. When that happened during the euro-crisis, that really changed the psyche here in Finland. People here don’t want to send money all over Europe. Neither can we go back to the Maastricht Treaty because we have so many TARGET2 imbalances, debt guarantees to other countries, and bailout funds we have set up. That’s out of the window. So, our political leaders will violently try and push us into a federal union, or we break up. With the current crisis, the blow to the national economies will be so hard. I don’t see political leaders coming together and send money to some federal government. I just don’t see it happening. JN: Do you see low or negative interest rates stay around for long? TM: No, when the banking crisis starts, interest rates will rise. If you look at the yields in the credit markets, they have already gone up significantly. And that’s usually the first omen that other interest rates will rise as well. JN: Do you consider sovereign bonds to be a safe haven at this point? TM: We are rather skeptical because of the heavy liabilities. For example, the US and German governments have. Investors have to acknowledge that there might even be problems in these bond markets if dire scenarios become a reality. The German and US government have high liabilities in addition to this corona crisis. JN: In your last report, you stated that central banks could become insolvent. How does that work? TM: Yes, what many people don’t know is that central banks can fail. There is an interesting historical fact about this. Not a single central bank in history, which did not have the backing of a finance ministry, has survived. So, all those sovereign national central banks have failed at some point. When a central bank incurs a big loss, it goes to a “negative equity state.” Central banks can still claim they are solvent because they receive seigniorage income from the money they create. In simple terms, seigniorage revenue is the difference between the nominal and printing costs of money. So, essentially, they can issue more and more money, which will create seigniorage revenue covering their loss. However, such a large increase in the monetary base is likely to lead to very high inflation through the increase of money in circulation and expectations of hastening inflation. The other option is to operate with negative equity. But this is a very precarious situation because they lose the trust of financial markets. Investors will start to contemplate; maybe the monetary policy is not driven by what is good for the financial markets and the economy, but what helps the central bank to sustain her losses, and the trust is lost. And, when that happens when asset markets are highly inflated, like now, mayhem is likely to follow. Central banks are not magicians and can’t do whatever they want. Accounting rules also apply to them, although they can bend them up to a point. JN: Do you think it’s feasible that a central bank will print currency to buy gold, and revalue the gold on its balance sheet to compensate for losses? Print to buy gold, and repair its balance sheet? TM: Yes. JN: How can people best prepare for the coming financial turmoil? TM: Hold physical cash and physical gold. All through history, gold has been the best crisis hedge. JN: What do you see the gold price doing going forward? TM: We did an analysis of the historical prices of different asset classes, and it seems that gold first—when the crisis starts—goes down like the rest of the assets, but then it starts to rise very fast. JN: More or less the same as what happened in 2008? First, it goes down, and then up as investors look for a safe haven? TM: Yes, and gold may become the only safe haven this time around. To be honest. Gold may rise a lot in this crisis, of which we are now in the early stages. 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To better understand the economic consequences of the Corona pandemic, I wanted to interview an expert on economic crises. Namely, Tuomas Malinen.Malinen is the CEO and Chief Economist of GnS Economics, a macroeconomic consultancy. He’s also an Adjunct Professor of Economics at the University of Helsinki. He has studied economics at the University of Helsinki and New York University. His focus is on economic growth, economic crises, central banks, and the business cycle. 
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