Most people are aware of the financial crisis in Europe and the determination to overcome the problems within countries like Greece, Ireland, Portugal, Spain and Italy. But what most do not realize is one of the biggest challenges facing Europe right now is the distortion to the natural flow of money.
The Natural Flow of Money: Where Does it Go?
The natural flow of money always goes to where it is safest. Individuals, corporations, and governments will naturally keep their money wherever they believe it will be safe. If they feel the safety of their savings is threatened, they simply transfer it to a safer location.
Example of the Flow of Money: Joe’s Bank and Mary’s Bank
Let’s say you deposit your savings with two banks: Joe’s Bank and Mary’s Bank. After a year goes by and the economy is not doing so hot, you find out that Joe’s Bank has been investing in risky investments and is at risk of failing, while Mary’s Bank is not.
What do you do? Naturally – fear of losing money causes you to withdraw your savings from Joe’s and deposit it into Mary’s. This understandable change demonstrates the natural flow of money where bad decisions are penalized and good decisions are rewarded. This is the natural flow of money in its most basic form.
Joe’s Bank and Mary’s Bank with Government Intervention
But – what if your government announced that all savings deposits were now protected under a government guarantee? Would you still transfer your funds? Of course not.
By guaranteeing deposits, the government has distorted the natural flow of money and as a result, Joe’s Bank is now rewarded for its risky behavior while Mary’s is actually penalized. To make matters worse, there’s an added risk that Joe’s Bank can actually distort the natural flow of money even more by offering a higher interest rate on your deposited savings, motivating you to transfer all of your savings to Joe’s.
The 2009 Financial Crisis: Natural Flow Disrupted
Since the financial crisis of 2009, for the past four years governments have been distorting the natural flows of money with their unprecedented policies of intervention including: record low interest rates, changes to banking regulations, guarantees of banking deposits, corporate bonds, and bailouts.
Their decisions are a knee-jerk reaction to individual crises that are constantly appearing and reappearing. With so many distortions in the natural flow of money, it has become nearly impossible for investors today to comprehend how money will flow in the future.
Disruption in the Flow and the Stock Market
This is particularly true with the stock markets today. Stock market investors are more interested in knowing when and how much the next government-buying binge will be than they are in other fundamental market factors. (In fact, some investors actually hope this will continue!)
In other words, such distortions in the natural flow of money have become so severe that investment decisions are no longer based upon normal fundamental or technical analysis, but rather upon abnormal government actions.
What will Money Flows Look Like in the Future?
Governments cannot indefinitely continue to intervene with guarantees and bailouts. Why? The flow of money has always been guided by an individual’s confidence. Since your confidence in the safety is what ultimately determines where you transfer your savings, if your government is guaranteeing your savings, your confidence is ultimately placed in your government.
So unless your confidence is restored and transferred back to your lender, the distorted flows of money will eventually cause you to lose confidence in the government. And unless a larger organization is willing to step in and guarantee your government’s guarantees, the distortion of money flows cannot continue.
Europe Today: Is the Natural Flow of Money Finally Returning?
We are presently at this last stage described above in Europe where larger agencies are stepping in to guarantee government guarantees. Citizens in each of these countries have even begun to worry about the guarantees offered by these large agencies, and are transferring their savings out of their domestic banks into stronger foreign banks. The distortion brought about by government and agency guarantees is breaking down.
For example, last June, Moody’s (a U.S. credit rating agency) recently highlighted the risk to Greece as their citizens continue to transfer savings out of the domestic banks. And the Greek finance minister recently admitted that since 2009, Greek citizens and corporations have transferred over 70 billion euros out of Greek banks to safer foreign institutions. This same outflow of money continues to compound the crisis in Ireland, Portugal, Spain, and Italy.
Conclusion: Does Government Intervention Work?
I understand why governments are going to such great lengths to rescue failing financial institutions – but we need to fully comprehend the possible outcomes if success is not achieved. In theory, government guarantees enable us to override our fear of loss., thereby removing our motivation to transfer our savings away from weak banks. In theory, this should provide the banks sufficient time to restructure their finances and restore our confidence so the governments can withdraw their guarantees.
But what happens if this theoretical outcome fails to materialize? What if confidence is lost in the government’s guarantee? Confidence will always dictate that the natural flow of money shifts from the weak to the strong, and unless financial health returns - government guarantees cannot permanently alter this natural flow of money.