Don’t believe the hype! Why the ECB rate hike doesn’t mean anything.

Image by Salvatore Vuono

Oh dear, oh dear. The mainstream media again gets things completely the wrong way round. The commentary after the ECB’s token interest rate hike of 0.25 percent on Thursday – a timid and rather cosmetic attempt at stepping back from a super easy monetary policy stance – revealed once again an astounding inability to look beyond the short-term and the obvious, and to grasp the deeper, long-term and fundamental issues at hand.

A bit of background

Let us establish some principles first. Central banks do indeed pose a risk to economic stability but not because their monetary policy is constantly too tight but because is it systematically too loose. Inflexible commodity money – such as gold and silver – has everywhere been replaced with state-issued fully flexible paper money under the control of central banks for one reason and one reason only: so that the supply of money can be constantly expanded in accordance with politically defined goals (such as a certain growth rate, a certain inflation rate, a certain unemployment rate….and constantly expanding bank balance sheets). Today’s consensus believes the following: When inflation is low and thus not an imminent threat, the central bank should ‘support’ economic growth via low interest rates and a moderate expansion of the money supply.

Wrong.

This is precisely the dangerous fallacy that made the dramatic events of the past four years ultimately inevitable. Yet, nobody seems willing to learn the lesson.

Constant expansion of the money supply and the persistent lowering of interest rates below the levels that would be justified by available savings – the raison d’etre of paper money and central banking – lead to misallocations of capital. Always. This – and not higher consumer price inflation – is the most immediate negative effect of monetary expansion. Today’s consensus is, sadly, still obsessed with CPI inflation (CPI= consumer price index). As long as monetary expansion doesn’t lead instantly to a higher grocery bill, the mainstream considers it a welcome boost to growth and practically a free lunch. This is a gross misconception, and this misconception is in essence still behind most of the commentary on monetary policy today. And it was again on display in the debate about the ECB’s recent move.

Let me be very clear. Inflation is now a major and imminent risk. I am convinced that we will see much higher inflation. Indeed, I believe that a collapse of the paper money system is practically inevitable. But in order to understand why this is the case, one has to understand what happened during the extended period during which CPI-inflation was – for various reasons – fairly contained and monetary expansion thus allowed to continue unabated and even actively encouraged. Here is what happened: massive capital misallocations occurred as a result of substantial amounts of credit becoming available that were not backed by saving but simply by freshly ‘printed’ money.

Why can’t they connect the dots?

Here is what I don’t get: the folks at the Wall Street Journal and The Financial Times now fill column after column with scary stories about the big dislocations in our economies, such as – but not limited to – overextended and undercapitalized banks, dislocated asset markets, bubbles in real estate – whether still existing or already painfully deflating -, the moral hazard of “too big to fail”, uncontrollable budget deficits everywhere. All of these economic imbalances are, of course, the direct result of easy monetary policy, conducted for years when CPI inflation (in contrast to asset price inflation!) was limited and central banks boosted growth with cheap credit. All of these dislocations will persist and, indeed, will get progressively worse the longer easy monetary policy is being maintained. It is outright absurd to assume that easy monetary policy could now cure any of these problems when in fact all of these problems have their origin in easy monetary policy.

Last week the FT ran a rather impressive and devastating analysis of German banking. Some key points: EUR7,600 billion of bank assets – that is a whopping 200 percent of German GDP! – are supported by less than EUR350 billion of capital. The German government pumped EUR500 billion into its banks – and has yet to get any of it back. German banks have EUR895 billion exposure to euro-area states, EUR136 billion to Spain alone. Its corrupt and semi-socialist Landesbank-system is an accident waiting to happen. And here is the key point: None of these problems have been solved or even seriously addressed since the crisis began.

Of course, they haven’t!

'EUR' stands for 'easy'

With massive government support and super-easy monetary policy, including quantitative-easing-style asset purchases by the ECB, why would anybody change anything? As long as policy does everything to keep market forces at bay, nothing will change. As long as the ECB buys some feeble resemblance of stability with easy monetary policy, banks and states are relieved of any pressure to establish real stability. Banks are continuously encouraged with easy money, not to clean up their act, but to continue as if it was still 1997. Last week the well-spoken, well-paid and appropriately named Bob Diamond declared that his bank – Barclays plc of the UK – was going to take more risk in order to make him and his shareholders more money. Well, now that ‘too big to fail’ has been established as the global paradigm of monetary and banking policy — why not? More leverage means more profits. How else are you going to pay for all that expensive banking talent?

Change will only ever come one way – the hard way. When the safety net of super easy monetary policy is removed – completely. And when real capitalism is finally restored to banking. No more lending of last resort. Game over. The same is, of course, true for out-of-control budget deficits.

To assume that we will ever get responsible banking and fiscal prudence via ongoing lender-of-last resort central banking and persistent paper money expansion is the height of naivety.

Or stupidity?

But when the ECB now breaks – tentatively and temporarily, in my view – with its long established tradition of very easy policy by lifting rates just a puny 0.25 percent from a mind-blowingly accommodative one percent to a still spectacularly accommodative one-point-two-five percent, the commentariat cries Armageddon!

On Friday morning, in the Wall Street Journal, a still shell-shocked David Cottle started his column in disbelief: “So, the European Central Bank really meant it.” And in a ‘we-are-all-PIIGS’ moment of emotional outpouring, he expressed his empathy with the suffering euro zone periphery: “It’s hard not to feel some sympathy. That these countries never got the interest rates they needed out of the euro zone’s one-size-fits-Germany monetary policy is obvious from the wreckage of their economies. Money was too cheap for them in the good times, with disastrous results. Now, in the bad times, it’s going to be too expensive for them…”

Well, I can’t remember ever hearing Spain or Ireland complain about the ECB’s easy monetary policy when it fuelled their artificial credit booms. If the Irish prime minister ever wrote angry letters to the ECB demanding higher rates to choke off an unsustainable property boom in Ireland, I missed it. But never mind.

At the same time, the FT quoted an Ireland expert, Paul Sweeney, author of the book ‘Ireland’s Economic Success’ who warned that higher borrowing costs would “result in real hardship for people all over the country.” So what is needed? Continuing easy money from the ECB? But if Cottle is right – and I think he is – that it was easy money that created Ireland’s (and Portugal’s and – yes!- Germany’s) economic dislocations, how is more easy money supposed to address those dislocations?

It is true that easy money can give an economy a short-term boost but it always creates economic dislocations in doing so. Always. Money-induced growth is always artificial and always comes with disturbing side effects that will cause severe problems later. Do these writers really believe that if easy money delivered growth and economic imbalances to these countries in the past, more easy money will now deliver only growth, and not prolong and intensify the imbalances, as well? Or even create new imbalances?

A brief history of the ‘EasyB’

From the word ‘go’, the ECB conducted an easy monetary policy. It started operations in 1999 with a balance sheet (or, as it is correctly called in Eurospeak, a ‘consolidated statement of the Eurosystem’) of less than EUR690 billion. By July 2007, when money markets seized up in response to the U.S. subprime problems and the financial crisis commenced, its ‘balance sheet’ had already grown to slightly less than EUR1.2 trillion, a robust expansion of more than six percent per annum over more than eight years. The ECB had routinely allowed M3 growth above its target. The ECB had thus actively fuelled the credit boom that led to the later ‘wreckage’ (Cottle). In fact, over this period, the ECB’s balance sheet expanded much more than the Fed’s.

And the academic and journalistic consensus – by and large – cheered the ECB on. Even when the damage from a decade of cheap credit had became blatantly obvious – in 2009 – Professor Tim Congdon, an advocate of paper money and central banking, still had this to say: “…central banking allowed banks to reduce the ratio of cash and capital to their assets, and so lowered the cost of finance to non-banks, but [...] these benefits could be enjoyed only if the central bank had a lender-of-last resort function.” Two hoorays for low capital ratios and cheap credit! That’s what I am talking about, the short-term and obvious versus the long-term and fundamental. The short-term growth spurt was, at the time, deemed a ‘benefit’ but what about the lasting consequences of over-leveraged balance sheets and asset bubbles? (Tim Congdon wrote this in his Institute of Economic Affairs pamphlet ‘Central Banking in a Free Society’ of 2009. He may have missed the irony in the title. To me it sounds like Central Planning in a Free Society.)

The Easy B, photograph by Florian K

In the first year of the crisis, the ECB expanded its balance sheet further and now more aggressively. The damage from too much money had to be countered, according to now widely accepted central bank orthodoxy, with – yet more money! If years of easy money had created substantial economic distortions, even more easy money would, of course, sustain these distortions and – add a few new ones on top!

By the summer of 2008, the balance sheet had expanded by another 22 percent (in just twelve months), and by the summer of 2009 by another 30 percent! Add another 14 percent for the next eleven months and by June 2010 you get the ECB’s biggest -so far at least- balance sheet of EUR2.1 trillion – 80 percent larger than at the start of the crisis, and more than three times larger than at the start of monetary union! The balance sheet is now back below EUR1.9 trillion as the ECB makes some tentative steps – hopefully out of a deeply felt sense of shame and regret at having so unhinged the European financial infrastructure – of removing some of its utterly disruptive monetary ‘accommodation’.

The outlook: After ‘easy’, more ‘easy’

Of course, The ECB has its defenders, many of which argue that the ECB is now on a course towards policy ‘normalization’. The 0.25 percent rate hike was just the start, so was the modest balance sheet reduction. More is to come.

Maybe. But I doubt it. The ECB may tighten again – I cannot exclude it. I am even willing to believe that many ECB board members are nervous about the present stance of overall policy, which remains ridiculously easy even if it does not appear so by the deranged standard of the U.S. Fed. Be that as it may, a meaningful reversal of policy is out of the question. If the ECB was unwilling or unable to inflict serious pain in 2008 and 2009, and if the ECB felt compelled to adopt extreme policy positions to avoid the drastic cleansing of the system that the markets were crying out for, why would the ECB now be any more willing or able to allow the market to dismantle the accumulated economic distortions?

The ECB has played, with its persistently accommodative policy, a crucial role – together with the U.S. Federal Reserve, the Bank of England and the Bank of Japan – in creating the economic imbalances that made the crisis unavoidable. It then adopted an even more aggressively accommodating policy to avoid the correction of these imbalances. As this policy position has in essence been maintained until today, none of these dislocations have been meaningfully corrected or reduced. How could they, considering what incentives monetary policy creates at present? Should we now expect a drastic change in policy? I don’t believe it.

When banking and fiscal problems come to the fore again, the ECB will again step in with asset purchases. Until recently, the ECB has intervened regularly in government bond markets propping up the prices of under-pressure issuers with its printing press. This will soon have to continue. My prediction is this: by the end of this year we will neither have a meaningfully smaller ECB balance sheet, nor meaningfully higher rates. On trend, the balance sheet will continue to expand.

And this is why I believe in rising inflation and in a collapse of paper money systems. Like other central banks, the ECB is now boxed in. ‘Lehman’ has given all of us a glimpse of the massive dislocations that forty years of global paper money inflation have created. ‘Lehman’ has also shown us beyond reasonable doubt that the policy establishment – and that includes, of course, the ECB – is unwilling to allow the market to shrink the overstretched credit edifice. Credit contraction, bank failure, asset price declines – this will be avoided – or rather postponed – at all cost. The folks who run Citi, J.P. Morgan, Barclays and the German banks know this, too. ‘Too big to fail’ now defines the global policy paradigm.

One thing will have to give – and that is the purchasing power of paper money.