The ECB and Perversity

Last Thursday, the ECB brought out its big monetary bazooka. It cut interest rates to zero; it made its own deposit rate more negative; it increased both the amount and the scope of its quantitative easing programme; and it announced a new TLTRO programme to pump yet more liquidity into European banks. Given the effectiveness of these kinds of policies over the last seven years, the action seems perverse. It was not the only thing that seemed perverse.

One unspoken reason for QE is to reduce the value of your currency. The Euro did fall, in the immediate aftermath of the decision, but then within hours spiked sharply higher, going from around $1.09, prior to the announcement, to almost $1.13. QE is supposed to lower interest rates, and although yields on European bonds that had been climbing, were sent lower, the yield on UK, and US bonds again spiked higher. By lowering the cost of capital, QE is supposed to boost the profits of European companies, and so cause EU stock markets to rise, but, in fact, they, and others across the globe fell sharply, in the aftermath of the decision. All of that seems to be a perverse response, but, in fact, it is not.

One reason being given, for these responses, by various pundits, is that Mario Draghi had made clear that these actions represented the end of the line. I think that is unlikely to be the main reason. Interest rates were already near zero, so an announcement that they could not go lower should have come as no surprise. Negative interest rates on banks' deposits with central banks were already known to be badly affecting banks' profits, so an announcement that they would not be extended further should also have come as no surprise. Draghi did not say that there was no scope for more QE, and by extending the range of bonds that can be bought, he has extended that possibility. Nor is there any suggestion that the policy of TLTRO's has come to the end. The real reason for the responses is different.

Take the currency. What Draghi announced, and what has been the effect of QE in the past, was that the central bank would become buyer of last resort for all kinds of debt. Although, the consequence of this is that the yield on the financial assets that are bought gets squeezed lower, the reason it gets squeezed lower, is because the price of the asset gets pushed higher, as a result of capitalisation. In a world of low yields, and all round uncertainty, and where the preservation of capital, becomes the priority, it is not at all perverse that when a central bank announces that it will extend its purchase of such debt, loanable-money capital also flocks to the assets to be bought, so as to hitch a ride.

Its no wonder then that all sorts of European bonds saw their prices rise, and their yields fall. At the same time, that loanable money-capital moved out of those financial assets that were not being goosed in this way. Money left global, and particularly European, shares for European bonds, causing share prices to drop. Money left US bonds, where the US central bank has already stopped QE, and is raising official interest rates, and similarly it left UK bonds. Not only did that explain the movement in prices of these bonds and stock markets in the hours after the announcement, as these trades were put on, but it also explains the rise in the Euro. All of these trades involved speculators selling their US and UK bonds and shares, and so on, and in the process selling Dollars and Sterling. It likewise involved them buying Euros, in order to buy European sovereign and corporate bonds. In other words, the rise in the Euro could be explained as a good old fashioned hot money flow.

In the 1960's discussion of such hot money flows was common. The received wisdom of the time was that countries should avoid having their currency devalued. Today, with free floating exchange rates, currencies are devalued and revalued every few minutes. But, in the mid 1960's, Harold Wilson's government agonised for months over the decision to devalue the Pound. When the decision was taken, it was taken as some kind of national emergency, almost like the declaration of WWII, by Chamberlain. I remember my family sitting down in the evening to hear Wilson, take to the TV to reassure the population that the decision would not “affect the pound in your pocket”, even though Wilson, as a more than competent economist, knew full well that it would, because it would cause import prices to rise.

In those days, the means to defend the currency, and the same happened with the Sterling Crisis of 1992 , was to raise official interest rates. In 1992, they were momentarily raised to 15%. In a world where speculators sought yield, such high interest rates were a means of attracting this hot money into the country. But, in a world where there is already a massive amount of speculative money tied up in these various bonds, and where the concern is no longer the earning of yield, but the obtaining of speculative capital gains, which has now turned into a need simply to preserve capital, any rise in official interest rates tends to have the opposite effect. The price of financial assets moves inversely to the yield, due to capitalisation. If the rate of interest rises, the price of financial assets falls, and vice versa. Similarly, if selling of financial assets rises, so that their price falls, the yield rises.

The last thing that global speculators want to see is a rise in official interest rates, because it means that the price of government bonds in the particular country will thereby fall accordingly, and with hundreds of billions of dollars tied up in those bonds, even a relatively small percentage drop in their price results in huge absolute falls in the fictitious wealth represented by them, and so by the owners of that fictitious wealth. It represents a massive writing off of debt. The idea that the cause of the rise in the Euro, and so on was due to Draghi signalling that monetary policy had come to the end of the line, was also undermined by the fact that in the following days, after these trades had been put on, the Euro lost some of its gain, and stock markets in Europe and the US once more recovered.

Another perverse consequence of all this financial engineering is this. Draghi has announced a new TLTRO programme, because the existing programmes are about to run out, and the three year cheap loans that European banks took out with the ECB will have to be paid back. That would mean a sharp reduction in their bank capital, at a time when EU banks, particularly those in Italy, but also in Germany, have come under severe pressure once more, as their basically insolvent condition starts to be revealed. This TLTRO is basically a continuation of the policy of extend and pretend, whereby the ECB pretends the EU banks are not bankrupt, and deals with that insolvency instead by stuffing them full of additional cheap liquidity, so that they can roll over their debt repayments. It is the same “policy” that has been applied to Greece, and which commercial banks have used in relation to their customers, whose household debt has continued to rise.

This situation is also the real reason that the ECB has engaged in another dose of QE, despite the fact that all the evidence suggests that far from encouraging economic growth, it acts to depress it. The real purpose of QE is not to stimulate economic growth, but to inflate asset price bubbles, because as soon as those asset price bubbles burst, the insolvency of vast numbers of private households is exposed; the insolvency of the banks is exposed; stock, bond and property markets sell off across the globe in a huge financial crash that wipes tens of trillions of dollars of debt away, debt which represents the fictitious wealth of the global 0.001%, that owns it.

But, the ECB is now introducing this new TLTRO at a time when it has also introduced, and increased its own negative deposit rates. In the past, the ECB loaned money to EU banks through these long-term refinancing operation (LTRO) at very low rates for three years. The idea was that the banks were then supposed to use the financing to lend into the economy. Instead, the banks bought government bonds, whose prices were being goosed by ECB buying of those same bonds, as part of its QE programme. In addition, a large amount of the money the banks borrowed from the ECB, went back to it as deposits from those banks. Now, those banks are being charged to deposit their funds with the ECB.

There are two things that have happened. Firstly, the banks get charged to put money on deposit with the ECB, secondly, they cannot get that money back by implementing negative rates for savers who in turn deposit funds with the commercial bank. If they did, savers would simply store money under the mattress. Already in the UK, around £1 billion in notes has disappeared out of circulation, as households squirrel money away for a variety of reasons, given that they are really losing nothing from doing so given that interest on savings deposits is so low. There are plans for people to simply warehouse cash, were negative interest rates to be introduced on deposits, as people took it out of the bank, and put it into storage boxes, in secure warehouses, as indeed already happens with other forms of money, such as gold.

The consequence of all this is that if banks are charged for putting money on deposit, but unable to cover this cost, by applying negative interest rates themselves, their profits get squeezed. So, there is little incentive for banks to hold surplus funds. Rather than taking up the new TLTRO, therefore, to be able to cover their upcoming repayments to the ECB, there is every incentive for them to use whatever funds they have on deposit with the ECB, and which form part of their bank capital, to instead make those repayments. The consequence will then be a reduction of bank capital, meaning they can lend less – but with demand growth in the economy stagnant, and with price deflation along with it there is little demand for borrowing, anyway. Certainly, there is little demand for money-capital from those businesses that the banks would be prepared to lend to, i.e. those that can pay it back, and everyone else who needs to borrow money, is already stacked up with debt.

So, we have the situation I have described for the last decade of growing bifurcations. We have parts of the global economy, both in terms of individual countries, and firms within those countries, that have large amounts of cash, out of which they can finance any investment, should they choose to undertake it, but who can currently make larger capital gains from speculation in financial assets, underpinned by QE. On the other hand, we have huge numbers of households and small to medium sized businesses that already are overburdened with debt – the so called zombie households and zombie businesses. They either cannot borrow, or else can only borrow at exorbitant rates of interest, hence the sharp growth in pay day loans, and the fact that in Britain around a quarter of households are said to have relied on them at some point.

Underlying that contradiction is the disparity of wealth and income that flows from the ownership of capital, but that contradiction has been exacerbated by the use of monetary policy, and inflation of private debt, over the years as an alternative to rising wages. In so doing, it has simply ensured that the resolution of the contradiction will involve an even larger than usual crisis, and writing off of all that debt and fictitious wealth.