I put forward yesterday the frightening idea that one of the reasons for the ECB’s measly and utterly inefficient interventions on government bond markets might be that they are engaging in a dangerous cat and mouse game with eurozone governments whereby it attempts to impose its approach (and philosophy). After all, we are now in a situation in which politics, not macroeconomics, has become paramount in the decision-making process.
The news since then has unfortunately reinforced this gloomy assessment. Consider the following chronology of events.
· Step 1
According to a rumour emitted by Reuters just before 2 AM, the ECB is considering the possibility of asking eurozone governments for funds to double its current capital of €5.8bn .
è Cries of joy from the ‘Austrian Ostriches’, who believe that the ECB overstepped its role via its unconventional market interventions and that it is taking risks that put its future in jeopardy. The most illustrative example is the immediate reaction of the conspiracy web side, ZeroHedge (link here .), which compares the ECB to a giant hedge fund, an analogy often used by the fans of Ron Paul and Von Mises in the United States with respect to the Fed
Their logic recalls the ‘Chewbacca’s Defense’. Yes, I am really, really serious. After all, I wouldn’t just say that out of my excessive appreciation of Steven Spielberg’s galactic odyssey. I owe this discovery to one of my favourite correspondents and one of the leaders of the Post-Keynesian school, as the author of The Keynes Solution. Mr Paul Davidson did me the honour of sharing with me a text about to go to publication, which raised my curiosity with his reference to sophism, “ignoratio elenchi”. You can check out this point yourself (link here); the Chewbacca defense is one of those presented by Wikipedia, and this little clip from Southpark: link here.
These unhappy individuals start from the principle that since central banks are exposed via their government bond purchases to market risk (interest rates, yield curves) and even sovereign debt default in the ECB’s case, that, given their ridiculous low capital vis-à-vis the size of their balance sheet, they are massively leveraged, 331x in the case of the ECB, and thus in mortal danger.
Indeed, viewed from that standpoint, a 0.3% decline in the value of the ECB’s asset portfolio would rend it insolvent (2.4% in the Fed’s case)!
Since the volatility of peripheral nation debt, which the ECB has been purchasing, is much higher than that, these individuals’ “logically” conclude that the ECB is in dire need of recapitalisation.
Call it what you may, sophism, ignoratio elenchi or simply Chewbacca defence, their arguments are absurd!
In the first place, as far as the ECB is concerned, its hard risk commitments total no more than €72bn, i.e. the total amount of peripheral nation debt bought to date. The other balance sheet commitments, namely, refi operations (collateralised loans to banks) and the small €60bn line of highly profitable covered bonds, will not be dangerous unless the European banking system undergoes a major systemic shock, triggering the bankruptcy of commercial banks and an ensuing loss in collateral value. But the ECB’s efforts are aimed at heading off precisely this sort of catastrophic scenario.
In any case, the great mistake of all these critics stems from their confusion about the operational reality of modern money and that includes numerous so-called experts.
Let’ set the record straight: the ECB faces no leverage problem!
Leverage means that a balance sheet is not financed by exclusively by capital but by assets and liabilities (or debt). In such a case, if the losses on assets are higher than the amount of tangible capital, it’s caput, i.e. bankruptcy.
Have they thought about what currency the ECB’s debt is denominated in? They are in euros, i.e. the currency unit that the ECB can create ex-nihilo to its sweet heart’s content, if need be. If the ECB (as well as the Fed, BoE, BoJ, SNB, etc) were to fall into negative territory in the amount of €500bn, it would have absolutely no operational importance whatsoever.
The central bank has the choice of immediately eliminating its loss by crediting itself with the loss amount in euros or restricting itself to the same accounting logic applicable to households and businesses while continuing continue operating in negative capital anyway until recurring operating profits gradually put the balance sheet back at par.
The question is therefore why are they raising this question, which is divorced from operational reality and especially unrelated to the real and pressing issues confronting our central bank today (peripheral nation sovereign debt risk) ?
Since I doubt very much that ECB board members are ignorant of these fundamentals of modern money or that they really believe that their balance sheet structure in imperilled, we must look for motivations elsewhere .
· Step 2
Investors are worried because they realise that the ECB is trying to pass the message that it is worried about the assets on its balance sheet and therefore about its own capital (!), given its commitment on peripheral nation debt, despite central bank promises for months that they will absolutely not default! (link here).
è Interest rate spreads between peripheral nation and German debt have been widening again, with the nominal interest rates on Spain’s 10-year bonds surging to their highest levels since 2000 to over 5.50%. The Swiss franc, a good thermometer of sovereign debt fears, has surged to its previous highs vis-à-vis the euro at less than SF1.28/€.
Now we learn that Greek banks again increased their loan requests with the ECB in November, after three months of decline, given €95bn in loans (+€2.6bn). As the slump in Greece worsens, households and businesses are drawing on savings, leading to a new decline in bank deposit accounts. Site deposits shrunk €27.5bn in the first 11 months of the year, representing 11.5% of GDP.
A The ECB continues to maintain the European banking system on life-support, with the €136bn allocated to Irish banks, €38bn to Portuguese banks and €61bn to Spanish banks .
S&P has placed Belgian debt under negative watch .
S&P has placed Belgian debt under negative watch .
· Step 3
Mr Jean-Claude Trichet laid down his cards in a talk at 12 noon before the Frankfurt club of international economic journalists.
è First, he presented his view of who was responsible for what:
“Current troubles are associated with 'E' in the EMU. They have essentially three origins: unsound fiscal policies in a number of member states, inappropriate macroeconomic and supervisory policies in a number of member states, and overall inadequate system of surveillance. This is the triangle that lies behind the current situation. And let me make this very clear: the triangle does not include monetary policy".
True to form, Trichet expressed his supreme satisfaction at the ECB’s work while putting the fault on the back of governments.
è He then proceeded to rap on the knuckles of eurozone government leaders:
"Let me state clearly - also on behalf of the Governing Council of the ECB - that we are not completely satisfied of the proposals put forward by the Commission and the European Council Task Force".
"These proposals in our view do not yet represent the quantum leap in economic governance that is needed to be fully commensurate with the monetary union we have created."
è He then presented the road forward:
“We’re calling for (ESF) maximum flexibility and maximum capacity, quantitatively and qualitatively.”
“Sanctions should be applied in a “quasi-automatic” way and include fines and “possible limitations of voting rights for member states in persistence violation.”
As such, the ECB not only thinks it has the right to dictate fiscal policy to governments (increase the size of EFSF and change it usage so that it picks up the slack in the eurozone government bond purchase programme), but it now hands down instructions on the organisation of democratic institutions managing the relations between eurozone countries. Unbelievable.
Having said that, I am NOT saying that the above-mentioned measures are unworthy. In fact, readers are well aware of my historical view and my commitment to reinforced European integration, but I believe we need to be aware of the ECB’s driving motives, given its attempt to overstep its role, which could have dangerous consequences for the financial system.
The Maastricht Treaty, on which the European Monetary Union was founded, included stipulations clearly protecting the independence of the European Central Bank, as outlined in its own site: “The ESCB’s (European System of Central Banks) main goal is to maintain price stability”.
The independence of the central bank was viewed as crucial, considering the structurally strong temptation in any major democracy to rely on money creation in times of need as a way of fulfilling electoral promises without hiking taxes or raising debt levels. Unfortunately, many countries have in the past fallen to this temptation without first considering all the macroeconomic consequences. In an inflationary environment where aggregate supply is insufficient to meet aggregate demand, this leads to tensions on resource utilisation capacities and salaries.
Although this assertion of independence may be imbued with good intentions (a big “may”), it could lead to hellish deflation, given the ECB obsession with its ‘Money’ and its refusal of tight monetary-fiscal collaboration as practiced today by the Fed in the United States Fed and other modern central banks’.
In the eurozone, resource utilisation capacities are still very low at 77.60%, barely above that hit in the midst of the 1993 recession (76.70%) and well below the low point of 2003 (80.50%) and even farther from the long-term average during normal times of 82.5%. As such, the “aggregate supply” of goods is still much higher than demand in a globalised context whereby competitors from outside the eurozone play the role of “price vigilantes".
And the relationship between the aggregate supply and aggregate demand of the employment market, as expressed by the unemployment rate of 10% (average for Europe), is the highest in 12 years! That means there is no risk of wage cost inflation.
Je ne reviendrai pas encore une fois sur les statistiques d’inflation, de masse monétaire ou de ‘crédit’, mais là non plus, aucun risque inflationniste à l’horizon !
So, given this context, why does the European Central Bank refuse to intervene more robustly to prop up peripheral nation debt as part of a coordinated monetary and fiscal effort, which may be called quantitative easing, monetising, as you like it, but which in reality would amount to an act of sovereign money creation?
This sort of coordination is absolutely crucial since fears of sovereign default are being magnified by the sort of usurious interest rates imposed by their European “partners” in their “rescue” plans, which only worsen the “aid” recipients’ budget woes. Bear in mind that default would send the system back into the sort of horrendous plunge and deflationary spiral that would make the consequences of the Lehman bankruptcy pale in comparison.
I find it surprising that the ECB’s Board of Governors continues to hide behind its price stability mandate, when its mandate is far more complex than they would have us believe. In fact, it is not that much different from the Fed’s.
After stating that the "primary objective of the ESCB shall be to maintain price stability", the ECB mandate stipulates :
"Without prejudice to the objective of price stability, the ESCB shall support the general economic policies in the Community with a view to contributing to the achievement of the objectives of the Community as laid down in Article 2." (Treaty article 105.1).
The objectives of the Union (Article 2 of the Treaty on European Union) are a high level of employment and sustainable and non-inflationary growth.
And no, I am not making this up; take two minutes to read this very clear text on the ECB’s very own web site: http://www.ecb.int/ecb/orga/tasks/html/index.fr.html
As you can see (read) for yourself, Mr Trichet’s constant assertion that the ECB operates with just one needle (link here) to its compass (fight against inflation) is a flagrant deformation of the central bank’s mandate.
Their motive can only be to impose on EMU authorities their messianic and very antiquated view of Money, as an intrinsic, quasi-moral view value, which is not the property of the citizens of a modern economic zone but an icon to protect, come Hell or high water, or, in case of utter failure, to set back Europe a half century. Make no mistake about it: the danger is indeed present, as certain recent statements and an abundance of data make abundantly clear.
As can be seen in the web page link below, its responsibility is all the greater in that it is charged with ensuring the system’s “Financial stability and supervision” (http://www.ecb.int/ecb/orga/tasks/html/financial-stability.en.html):
· Financial markets, such as the money markets and capital markets . They channel excess funds from lenders, i.e. businesses or individuals who want to invest their money, to borrowers, i.e. those who need capital;
· Financial intermediaries, such as banks and insurance companies. They indirectly bring lenders and borrowers together – but borrowers can also obtain funds directly from financial markets by issuing securities, e.g. shares and bonds.
I would like to briefly discuss the issue of banking establishment oversight. We already know that the vast majority of developed countries faced a total breakdown in this field, and my goals is not to be more royalist than the king, but it is worth pointing out that, given the number “accidents” that have occurred in Germany, certain preachers of economic morality should cool their heals a bit!
On the other hand, with respect to the marketplace of borrowers and lenders, the interbank market of unsecured debt is but a shadow of its former self. Normally the main artery of money circulation, we can observe on this money market the inefficiency of the “unconventional” measures taken so far.
But the problem is most apparent on the level of the marketplace of sovereign debt issuers and private lenders, which is the only possible motor for a rebound in aggregate demand in the context of a deleveraging crisis.
The ECB current effort to harness support for recapitalisation (by definition, useless) can only add to the uncertainty and fears of investors, who really could do without it .
This move is particularly surprising, when we consider that Governors’ Board members only recently criticised (correctly) government leaders (in Germany and France) for throwing oil onto the peripheral debt inferno via their proposal to make private-sector creditors help pay for future restructuring of sovereign European debt!
Today’s headline, “ECB attempts coup d’etat”, is meant to encapsulate the situation on this Monday. After assuming control of eurozone forex policy (“Mr Euro, that’s me”) in violation of the constitution which attributes this authority to ECOFIN, and after deforming the presentation of its mandate (only one needle to the ECB compass), the ECB now appears intent on bending government leaders to its will by dictating fiscal policy to eurozone member-states.
It might have been wiser for the Maastricht Treaty to guarantee the independence of member-states against ECB domination than the other way around.
Have a good day.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Thaler's Corner.