The Engines of Inflation

Those who think the ECB isn't 'doing enough' to attempt to inflate the euro-area back to prosperity haven't been paying attention. It should be noted here that central banks as a rule are the very engines of inflation. Whether they passively accommodate a credit boom by supplying fresh reserves when strong credit demand threatens to push the overnight interbank funding rate above their chosen 'target rate', or whether they actively resort to 'extraordinary measures' to keep the money supply from contracting once a credit boom falters, creating inflation is their job.

It is an extraordinary feat of modern-day propaganda that central banks are getting away with portraying themselves as 'inflation fighters'. In a sense it is of course true that they are at times trying to control one of the lagged symptoms of inflation, namely rising consumer prices, in order to create the illusory state referred to as 'price stability'. The so-called 'price stability' policy, so we are told, creates the foundation for smooth economic growth. Nothing could be further from the truth (see our previous missive on the dangers of this policy).

As both the ECB and the Fed never tire to point out, consumer price indexes have remained quite tame over recent years, so we should conclude that they have both been very successful in keeping prices 'stable'. If it is true that 'price stability' is the sine qua non for smooth economic development and growth, then we must ask: why is there now an economic crisis?

And it is evidently not just any old run-of-the-mill setback amenable to a 'quick fix' by stepping a bit on the monetary pumping pedal. The crisis is centered on the very banking cartel the central banks are supposed to supervise and guide. In short, a massive failure of central economic planning has occurred, even though no-one is owning up to this fact.

The reality of the situation is that by confusing one of the possible effects of inflation (rising final goods prices) with inflation itself (an increase in the money supply), the system has set itself up for the fall that is now in progress.  Decades of capital malinvestment engendered by the biggest credit boom in history are coming home to roost. In essence, too many private sector balance sheets have been destroyed by the succession of credit booms and the associated distortion of relative prices and malinvestments. Losses and capital consumption have quietly accumulated over the years, until the day came when the markets began to question the value of the assets collateralizing the  outstanding mountain of debt.

It is well known how the political and bureaucratic classes have reacted to this development –  the decision was taken that unsound credit must be propped up at all cost, by socializing the losses. There are essentially two ways of doing that: the government can bail out the banks directly with tax payer funds or the central bank can intervene and shift the questionable assets onto its own balance sheet, replacing them with money from thin air. In actual practice, the two methods have been combined.

The problem with this is that the losses do not really disappear – they are merely shuffled around. It should be clear that someone must be paying for it all. That someone are all the tax payers and users of the currency of the jurisdictions concerned. Savers are expropriated in favor of the banks.


A Malfunctioning Treaty

In the euro area a special problem has reared its head. The first round of bailouts of the banks has ruined the balance sheets of their ultimate guarantors, the governments of the nation states participating in the currency union. Normally, nearly all of them would have resorted to the same expedient the US and UK governments have resorted to: with a wink and a nudge, their 'independent' central banks would have embarked on the monetization of  government debt. After all, their neo-Keynesian quasi-religion tells these central bankers that nothing untoward can possibly happen if you're in a 'liquidity trap'.

In this view, there exist no universally valid, time-invariant laws of economics: there is one set of laws applicable for the boom and another, quite different one, for the bust. Empirical evidence is held to provide the wherewithal to determine which kind of 'law' is operative at any given point in time. They are the ultimate heirs of Georg Friedrich Knapp's monetary crankery, the 'state theory of money'.

However, since the euro area consists of 17 nations states that have a single central bank, it was thought to be prudent when the monetary union was established to ensure that no nation could profit at the expense of the others. Hence, the central bank's statutes were modeled after the Weimar-informed structures of the German Bundesbank: no financing of government debt by the central bank was going to be allowed. It should be noted as an aside here that Germany became the first victim of its home-grown monetary cranks in the early 1920's. Reichsbank president Rudolf von Havenstein and his advisers were ardent believers in Knapp's theories. The result of this, as they say, is history.

Moreover, it was held that in order to ensure the smooth functioning of the currency union in the absence of central bank financing of government debt, debts and deficits should be strictly limited by treaty. We suppose it looked good on paper at the time. Not surprisingly, the limits set on public debt and deficits by the treaty were violated from day one. 

It is of course entirely illogical to set such limits while pursuing Keynesian economic policies and running a fractionally reserved banking system. It simply cannot work, which is why the latest iteration of the treaty is condemned to failure just as its predecessor was. Via the FT Alphaville blog, below is the history of EMU treaty violations to date:



The Maastricht treaty's deficit/GDP percentage limit was/is 3% per annum – violations are highlighted in yellow – click chart for better resolution.



The Maastricht treaty's total public debt to GDP limit was/is 60% of GDP – violations highlighted in yellow – click chart for better resolution.



As soon as the bust inevitably arrived, not only did a more flagrant violation of these limits immediately commence, but the fact that the ECB is not allowed to finance government debt directly began to impinge on the market's views of the likelihood of direct government debt defaults  – as opposed to the indirect defaults via the inflation route practiced elsewhere – which is merely a default by another method or name, but one from which most market participants apparently believe they can escape over time in a more leisurely fashion. They may eventually be surprised, we think.


Banks In The Soup, But Help Is On Its Way

As a side effect of all this, the banking cartel that is so intimately intertwined with the governments that have given it the fractional reserve banking privilege quickly encountered fresh troubles. Bailed out in 2008/9 by a combination of capital injections,  government debt guarantees as well as the first batch of extraordinary funding measures by the central bank, the banks suddenly found they were back in the soup all over again. Their allegedly 'risk-free' holding of sovereign debt turned into a very risky hot potato. Their giant balance sheets laden with difficult to market assets require funding that as a rule sports a maturity profile that is severely mismatched with that of their assets. Only while market confidence is high is such funding obtainable at a reasonable price, or at all. The higher risks the banks now face have concurrently resulted in regulators demanding higher capital ratios – which has exacerbated the funding problem and set off a spiral of deleveraging in what one might charitably term less than ideal market conditions.

However,  the ECB can still not 'help' by monetizing government debt directly – it is simply illegal for it to do so. Moreover, it would be impossible to get all the members of the currency union to agree to such a course: they are well aware of the  redistributive effects it would entail.

Alas, this does not mean the ECB's hands are tied. En lieu of buying government bonds, it has decided to extend a giant helping hand of other inflationary measures to the banks, in the hope that by ending their funding stresses they can be enticed back into the sovereign bond market and keep their credit lines to the euro area's other domestic borrowers open. In addition to the ECB's measures, there is a fair amount of political pressure exerted on the banks. This is the price they pay for getting into bed with government in the first place.

We have already discussed the latest measures the ECB has taken to ensure that the deleveraging process is slowed down or ideally arrested and that banks (although this was never said aloud) return as buyers to the euro area sovereign debt arena.

In the meantime, more color has emerged on one of these measures, the importance of which can not be stressed enough, namely the softening of eligibility criteria for securities that can be pawned off to the ECB to obtain fresh funding. Among these assets are not only lower rated asset backed securities (ABS) than were accepted hitherto, but also credit claims in the form of currently performing loans that the national central banks ('NCB's below) of the euro system can now take as collateral, employing their own criteria as to what precisely they are prepared to accept.

From the ECB's announcement:

„Details of measures to increase collateral availability:

In addition to the ABS that are already eligible for Eurosystem operations, ABS having a second-best rating of at least “single A” in the Eurosystem’s harmonised credit scale at issuance, and at all times subsequently, and the underlying assets of which comprise residential mortgages and loans to small and medium-sized enterprises (SMEs), will be eligible for use as collateral in Eurosystem credit operations.


The NCBs are allowed, as a temporary solution, to accept as collateral for Eurosystem credit operations additional performing credit claims that satisfy specific eligibility criteria. The responsibility entailed in the acceptance of such credit claims will be borne by the NCB authorising their use. Details of the criteria for the use of credit claims will be announced in due course.

Goldman Sachs has published a list of the loans it believes would be eligible for inclusion in these funding operations – namely corporate loans –  and it turns out that the amounts involved are huge:



Via Goldman Sachs, credit claims that can potentially be used as collateral according to the ECB's new rules. The areas highlighted are large corporate loans (ex commercial real estate) and loans to small and medium sized enterprises ('SME'). These two categories alone add up to about € 7.1 trillion.



According to a recent report by Joseph Cotteril at Alphaville, Goldman believes that between 20% to 50% of these corporate loans could end up as acceptable collateral. We would tend to go with the upper end of this range, since the national central banks are highly likely to be generous in their assessments. A giant wave of  'temporary' money supply inflation could be unleashed by this.

Below is a somewhat dated chart showing the ECB's balance sheet composition as at end of 2010, this is to say, following the first big wave of 'emergency liquidity measures' in the wake of the 2008/9 crisis. In the meantime, the ECB's balance sheet has grown to almost € 2.5 trillion, as emergency lending has soared in recent months.  While we unfortunately don't have a more current chart of the balance sheet composition at the moment (we will try to obtain one), the end of 2010 chart still brings the point across that the ECB held a plethora of somewhat questionable assets even before the recent lowering of collateral eligibility criteria. Especially 'bank bonds', 'other securities' and ABS are worth pointing out in this context. A lot of potentially toxic stuff can be packaged under these headings (in reality, the collateral will of course be of varying quality – some of it will be good, some of it less so. But most of it would  probably be difficult to sell). Further below is a more current chart of the ECB's assets, alas grouped by more general categorizations, i.e., it does not contain a detailed breakdown of the types of securities held as collateral. This is merely to show the extent of balance sheet growth that has occurred in the meantime.



Assets held by the ECB at the end of 2010 – click chart for better resolution.



A more current chart of the ECB's assets (via Cumberland advisors) shows the recent growth spurt in the central bank's balance sheet. Different asset categorizations are used in this chart, i.e., they don't reflect the balance sheet composition by types of securities as above – click chart for better resolution.



Mario Draghi In Berlin, Banks Borrow Record Amounts From ECB


Yesterday Mario Draghi spoke in Berlin at the Ludwig Erhard foundation, delivering this year's Ludwig Erhard lecture. Several points he made in this address deserve attention in connection with what we discuss above. Draghi explained in what way he envisages the most recently announced ECB measures to support the banking system and maintain its ability to extend more credit from thin air in spite of the capital and funding pressures it faces. Here are a few pertinent excerpts:

„The Council decided to reduce its key interest rates by another 25 basis points to 1%. In normal financial market conditions, a policy rate reduction is a potent instrument of inflation control and demand support. The rate cut works its way through a long chain of downward adjustments in financial returns. At the end of the process, the yield on large spectrum of securities declines and promotes broad-based policy accommodation.  In the present conditions, this process turns out to be hampered, so that the impact of a rate cut by itself is weakened. Banks limit their lending to other banks and potentially to the broader economy, and they hold on to precautionary balances of cash as self-insurance.

Therefore, the Governing Council last week decided on three other measures, each of which provides additional support in order to bring the necessary monetary policy impulse to the real economy.  The current package should be felt tangibly in the financial sector and the real economy over the coming weeks and months. Of course, it comes against strong headwinds generated by deleveraging.

We established very long-term refinancing operations with a maturity of three years. This duration is a novelty in ECB monetary policy operations.

The extension of central bank credit provision to very long maturities is meant to give banks a longer horizon in their liquidity planning. It helps them to avoid rebalancing the maturities of their assets and liabilities through a downscaling of longer-term lending. Incidentally, we want to make it absolutely clear that in the present conditions where systemic risk is seriously hampering the functioning of the economy, we see no stigma attached to the use of central banking credit provisions: our facilities are there to be used.

Banks will be able to refinance term lending with the Eurosystem and thus preserve their long-term exposures to the real economy. After the first year, banks will have the option to terminate the operation. So they can flexibly adapt to changing liquidity conditions and a normalising market environment.

Our second measure will allow banks to use loans as collateral with the Eurosystem, thereby unfreezing a large portion of bank assets. It should also provide banks with an incentive to abstain from curtailing credit to the economy and to avoid fire-sales of other assets on their balance sheets.

The goal of these measures is to ensure that households and firms – and especially small and medium-sized enterprises – will receive credit as effectively as possible under the current circumstances. Of course, we have to screen the collateral carefully so as to protect our balance sheet [haha, ed.]

The third measure we announced last week is to reduce the required reserves ratio from 2% to 1%. This measure frees up liquidity of the banking sector by about 100 billion euro. Along with other measures, this reduction in the reserve requirements should, too, help revive money market activity and lending.


(emphasis added)

Readers may recall that this was precisely our estimate as to what the reduction in reserve requirements would achieve in terms of additional liquidity, namely that it would add approximately € 100 billion. This would leave a de facto 2.3% of all money substitutes in the euro area 'covered', this is to say, backed by standard money. The remaining approximately € 3.8 trillion in money substitutes that are theoretically available on demand would consist of fiduciary media, i.e., money substitutes for which no backing in the form of standard money exists.

More importantly though, the ECB's decision to weaken its collateral eligibility rules and introduce 36 month LTRO's aims to arrest the deleveraging process and ultimately reverse it. Note Draghi's admonition to banks not to think of using the  ECB's new funding facilities as 'stigmatizing' them. We think he can rest assured on that point: as the huge surge in demand for funding from the dollar swap facility has shown, the banks are no longer shy to avail themselves of what the ECB has to offer.

Meanwhile ECB board member Yves Mersch reiterated that the central bank 'fears a credit crunch':

„European Central Bank governing council member Yves Mersch warned of the dangers of a credit crunch in the wake of the debt crisis in the 17-nation eurozone on German television late on Thursday. 

"We fear a credit crunch, which could push our economies — even the strongest — into a new recession," Mersch, who is head of the Luxembourg central bank, said on ZDF public television. 

"For us, it's not about banks making profits, it's about them supplying the economy with credit," Mersch said, justifying the recent raft of measures undertaken by the ECB to keep the banking sector flush with liquidity.  Banks provided as much as 75 percent companies' financing in the eurozone, he noted.“

As a Reuters report of the recent funding related activity of banks in the euro area shows, the banks are indeed getting plenty of funding via the ECB now, pushing Euribor rates lower – and this is happening even before the first tranche of the new LTRO's has been activated:

„Key euro zone bank-to-bank lending rates continued to head south on Friday as rising excess liquidity in the banking system, the recent ECB policy rate cut and its plans to pump 3-year liquidity into the system, kept downward pressure on them.

 On Tuesday, banks borrowed almost 300 billion euros ($390  billion) from the ECB's weekly handout of limit-free cash, the largest amount since June 2009.         

 The money was the first offered at the ECB's new, lower interest rate of 1.0 percent and comes just a week before it will offer banks 3-year funding for the first time in its

history. Three-month Euribor rates, traditionally the main gauge of unsecured interbank euro lending and a mix of interest rate expectations and banks' appetite for lending, fell to 1.417 percent from 1.419 percent.   

Longer-term rates remained at the previous day's levels. Six-month rates were unchanged at 1.667 percent and 12-month rates flat at 2.001 percent.      

Shorter-term one-week rates — most heavily influence by excess liquidity, which rose to a hefty 308 billion euros according to Reuters calculations –fell to 0.760 percent from 0.762 percent.   Overnight rates fell to 0.571 percent from 0.579

percent, the lowest level since April. 

The recent intensification of the euro zone debt crisis has  left a growing pack of banks locked out of open funding markets and reliant on the ECB.

The 292 billion euros weekly take up of ECB cash was well above the 250 billion expected by traders polled by Reuters. Banks also took an additional 41 billion euros in one-month funding. Emergency overnight borrowing also stayed high on Friday at  above 5 billion euros.


(emphasis added)

We will keep a close eye in coming months on how all these 'temporary' funding measures end up influencing the growth rate of the euro area's money supply. Bank deleveraging is inherently deflationary (if banks call more loans in than they extend, this will ceteris paribus tend to lower the money supply), but since the ECB's measures are designed to arrest this deleveraging process, the situation could prospectively be altered considerably.

In the course of the last 18 months, true money supply growth in the euro area has stagnated, with the most recent year-on-year growth rate at a paltry 1.8%. Historically, this represents one of the lowest money supply growth rates observed since the introduction of the euro. We continue to believe that this could change dramatically with the  introduction of the ECB's new funding operations.

Although Draghi was at pains to insist that the ECB will 'carefully monitor the quality of the assets it receives as collateral', we think the national central banks will give their commercial banks considerable latitude in this respect. Moreover, in crisis conditions with daily borrowings from the ECB soaring to €300 billion, it appears nigh impossible from an administrative standpoint to keep tight quality controls in place.

In short, the ECB will likely continue to be the biggest 'bad bank' in the euro area.



Capital requirements of euro area banks according to the most recent EBA stress test exercise – click chart for better resolution.




For a good overview of the recently discussed rehypothecation of customer assets we recommend this article at Casey Research: "The ABCs of Re-hypothecation in Gold and Securities Markets: What You Need to Know"


'The most recent weekly update of ECB assets shows they continue to grow at a brisk pace' – click chart for better resolution.



 Charts by: Goldman Sachs, Spiegel, Cumberland, FT, Bloomberg



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Dear Readers!

You may have noticed that our so-called “semiannual” funding drive, which started sometime in the summer if memory serves, has seamlessly segued into the winter. In fact, the year is almost over! We assure you this is not merely evidence of our chutzpa; rather, it is indicative of the fact that ad income still needs to be supplemented in order to support upkeep of the site. Naturally, the traditional benefits that can be spontaneously triggered by donations to this site remain operative regardless of the season - ranging from a boost to general well-being/happiness (inter alia featuring improved sleep & appetite), children including you in their songs, up to the likely allotment of privileges in the afterlife, etc., etc., but the Christmas season is probably an especially propitious time to cross our palms with silver. A special thank you to all readers who have already chipped in, your generosity is greatly appreciated. Regardless of that, we are honored by everybody's readership and hope we have managed to add a little value to your life.


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