Draghi: ECB to counter ‘unfounded fears’ with unlimited cash

Mario Draghi, ECB president

Yesterday, the ECB pronounced itself the official lender-of-last resort to all Euro-Zone governments. To assure that the state can always borrow at conveniently low rates has been declared an essential component of ‘maintaining financial stability’ and thus a standard plank of modern central banking. Despite all their professed differences and divergent legal frameworks, all major central banks have now become their respective governments’ inexhaustible ATMs. – Coincidence?

At the press conference yesterday Draghi declared that unlimited bond buying was really par for the course of what a central bank should do to make sure that those ‘transmission channels of monetary policy’ don’t get clogged. It is all well within the ECB’s original mandate, although Draghi thought it still necessary to blame the need for his new initiative on somebody, namely the investors who, with their ‘unfounded fears’, create ‘severe distortions’ in government bond markets.

He was evidently talking of the ‘unfounded fears’ of a breakup of the euro when what is really at the heart of the Euro Zone sovereign debt crisis is the fear of various states going bust, and that fear is anything but unfounded. The inability of most governments to reign in public spending and to end their dependence on continuous borrowing is the real reason for ‘severe distortions’ in sovereign debt markets.

The politicians and central bankers could have separated the issue of default and Euro-exit by making it clear that default is an option within the single currency. That was indeed the idea behind the original no-bailout clause. Let Greece go bust, and Spain as well, but don’t kick them out of the euro. Default is a problem between creditor and debtor, that’s all. As I said before, under the Classical Gold Standard, a government could have defaulted and nobody would have ceased to use gold as money, not even the citizens of the defaulted state. Similarly, the Californians will not be asked to leave the dollar-zone if (or when) the Californian government defaults.

Euro-exit is a political decision, not an economic necessity. The idea is to get your own central bank back, print lots of money and, that way, keep borrowing and spending. Yesterday, the ECB made it clear that exit is unnecessary as the ECB will now do all the printing for the weaker states itself.

 There is no surprise here. This was all expected and it was sooner or later inevitable. Yet it does constitute a further step toward the nationalization of money and credit and the death of free markets. Here is why:

It is a matter of logic that anybody who habitually spends more than he earns and borrows the difference puts himself at the mercy of his creditors. When those lose faith in him, he will be unable to roll over his debt or borrow more, or may only be able to do so at punitively high rates. That is the flipside of living constantly beyond your means, of going ever more into debt. You need somebody to fund such extravagance. When your lenders lose trust in your ability to repay, it is ‘game over’.

But in our system of unlimited fiat money this does no longer apply to banks and governments. For these two entities it doesn’t matter what the investors and depositors  - ‘the market’ – think or feel. In these cases, the central bank bureaucracy assumes the role of ultimate decision-maker. As long as the banks and the governments can convince the central bank bureaucracy that they should stay in business and keep borrowing, they will stay in business and keep borrowing, preferably straight from the printing press and without the involvement of those pesky investors with their ‘unfounded fears’. And these days it is not hard to convince the central bank.

From LTRO  to OMT

The members of the political-financial complex have certainly been sticking together: bankrupt banks have been buying the bonds of bankrupt governments so that the governments could continue bailing out the bankrupt banks, and the ECB provided the cash for this charade. It used to be called LTRO – long-term refinancing operation.

Under LTRO, the ECB could pretend that it was only supporting the banks and not spendthrift governments at the same time. Supporting the banks was accepted according to the then reigning central banking orthodoxy, funding the state not so much. Late last year and earlier this year, the ECB printed EUR1,000 billion of new money and gave it to the banks, mainly banks in the Euro Zone periphery. These banks then used the money to buy the bonds of their governments.

LTRO had two flaws: EUR1,000 billion may sound like a lot of money to you and me but even EUR1,000 billion is not, well, unlimited. And because LTRO was not unlimited, it ran out at some stage, and the dire state of public finances came to the surface again. All the newly acquired government bonds were suddenly burning a new hole in the balance sheets of the already weakened periphery banks.

The central bank bureaucracy has now come up with OMT – outright monetary transactions – to address LTRO’s two weaknesses: OMT is not only unlimited, it doesn’t burden the balance sheets of the banks any longer. This is money printing from the central bank directly for the benefit of the state (even if it is conducted in the secondary market).

Of course, OMT comes with a whole range of pious promises, such as that it will only benefit governments that receive support from the ESM or EFSF, and that subject themselves to the tough conditions of these programs. The valiant efforts at fiscal consolidation will continue.

Yeah, right.

We heard this many times before. The Eurocracy is very good at imposing tough limits and restrictions on itself, only to ignore them shamelessly at the first hurdle. Remember the Maastricht treaty? The limits on government debt and budget deficits? The no-bailout clause? Every single promise has been broken by now. Besides, we have no guarantees. The ECB may change any of these conditions at the drop of a hat. All of this is entirely arbitrary. The elite is making up its own rules as it goes along.

Only the prospect of instant default and a complete cut-off from new borrowing will ever force politicians to shrink the state apparatus that is the source of their power. The political class hates ‘austerity’. So do the majority of voters. With the backstop from the printing press in place, the appetite for fiscal reform will most certainly fade. The chances that ‘austerity’ will die a quiet death have increased.

Market response

The markets’ initial response is somewhat silly, in my opinion, albeit not entirely surprising. Equities are rallying hard, in particular bank stocks. So does government debt. The euro is stronger versus other paper currencies because the risk of breakup has allegedly receded. But breakup looked unlikely even before.

In fact, no response was needed. Nothing material has changed. Like the central banks in Britain and the US, the ECB will now actively and directly support government debt with the printing press but this was sooner or later inevitable anyway. I do not see any basis for a marked divergence of any of these currencies. In all these economies the printing press is quickly becoming the last line of defense for an unsustainable system.

And the ECB’s OMT will end the depression as little as QE in the US and Britain has ended the depression there. I expect the asset rallies to peter out quickly but asset prices to remain elevated because of cheap money everywhere.

In the meantime, the debasement of paper money continues.

Print Friendly
Share on LinkedInShare on TwitterSubmit to StumbleUponhttp://detlevschlichter.com/wp-content/uploads/2011/10/Draghi_Mario_IMF_2009-150x150.jpgSubmit to redditShare via email
Stimulus, to infinity and beyond
U.S. Republicans introduce gold standard debate - mainstream media go mental


  1. LittleMissMessy says

    As always you’re right Mr Schlichter. It’s frightening that there are no real consequences for the state overspending, no incentive to tighten their belts and prosper. It’s like watching a plane crash in slow-mo. We can’t do anything, just watch aghast.

  2. Peter says

    The US Fed just printed a whole lot more cash. TNX down a boatload in about 10 minutes, gilts down too. I wonder what this means for the German ruling next week?

    The debasement of paper money does indeed continue!

    • says

      When does a market distortion qualify as a ‘bubble’? — I would have to say, yes, I think that super-low policy rates and the almost constant injection of new base money from the central banks have suppressed not only yields on government bonds but also yield differentials among market sectors. The bubble in government bonds has dragged corporate bond prices higher with it. Investors think that very low government yields are here to stay. They therefore pile into supposedly high quality corporate bonds for a bit of pick up. In my view, the entire bond space is fundamentally mispriced. Personally, I would not touch it but please remember that these distortions can persist for a long time. Bond investors are sitting on a powder keg, in my view, but the fuse may be fairly long. Central banks have no exit strategy. They will keep rates near zero and continue to print base money. As long as headline inflation stays reasonably low and the public trusts that that will remain the case, and as long as trust in the solvency of the main governments remains in place, the bond bubble could continue. It could continue but equally it could not. It is like an elastic bank that gets stretched ever further. As long as the band doesn’t snap, people say, what’s the problem? Everything looks fairly stable. But one day, the band will snap. I think the situation is fundamentally unsustainable and a major repricing is inevitable. But inevitable doesn’t mean imminent.

  3. says

    Hi Detlev

    As usual, a thorough analysis from you!

    I was wondering if you could explain the difference between LTRO and OMT? Seems to mee that OMT is more like ECB forcing the Euro zone banks to deposit money at the ECB at a low rate, and then the ECB kan use that money to buy bonds from the debt troubled countries in the Euro zone? All so that Draghi can claim that the ECB is not doing money printing.

    If that is corect, where are the money to be used to pay the interest payments on these forced deposits going to come from?

    As you mention above during LTRO the ECB printed EUR1 trillion and lended them to the banks, so that they could use them to buy the bonds from the debt troubled countries in the Euro zone (a back-door bazooka). To me OMT are like LTRO where you print new Euros and lend them out to the bank to e.g. 0,5%, then force the banks to deposit these new Euros back at the ECB at e.g. 1,0% and then they go out directly in the market and buy the bonds that no one else wants to buy?

    /Grosen Friis, Denmark

    • says

      Under LTRO, the ECB gives money to the banks, the banks buy government bonds and place them with the ECB as collateral for the LTRO loans. Not all the entire LTRO money may be used for the purchases of government bonds, of course. It is up to the individual banks. The banks may buy other assets, or not buy any new assets at all but use the LTRO money to finance existing balance sheets positions and thus replace other sources of funding, for example, deposits. The point I was trying to make is that under LTRO the banks still own the government bonds, even if they are pledged as collateral with the ECB. When, for example, Spanish bond prices dived again after the initial impact of LTRO had faded, the banks that had bought those bonds with their new LTRO money suddenly had more loss making positions on their balance sheets. LTRO was QE through the back door.
      Under OMT, the ECB buys the government bonds directly. It has full control over where the new money goes. That was not the case under LTRO. The ECB owns these government bonds and any losses on them will hit the capital of the ECB, not the banks. If Spain goes bust, this will be a hit to the ECB’s equity capital and thus a hit to taxpayers in other countries who underwrite the ECB. The ECB has to print new money to buy the bonds and this money constitutes new bank reserves, i.e. these are deposits the banks hold at the ECB. The ECB announced that it would ‘sterilize’ bond purchases under OMT, this means whenever the ECB expands bank reserves because of OMT bond purchases, it will immediately drain the equivalent amount of bank reserves through an offsetting operation, basically selling some other asset and thus reducing the amount of outstanding reserves again. This is, in my view, a smokescreen. Remember that the ECB has aggressively expanded bank reserves in recent years to keep the banking sector from shrinking its overall balance sheet and to keep many banks in business. This is likely to continue. Thus, the ECB will expand bank reserves when it buys bonds under OMT, then drain the money again to sterilize OMT, and, whenever ‘liquidity’ gets tight within the banking sector, add more bank reserves outside of OMT to help the banks. The net effect is, in my view, that the ECB will continue to print money and that its balance sheet will continue to expand. The ECB now supports governments directly via OMT, and indirectly via its generous liquidity provision for banks. Also, the ECB supports the banks directly. More euros will get printed.

  4. John O'Connell says

    Just want to add my thanks too for keeping us informed of what is actually happening and why. And importantly, in a way that is easy to understand if, like me, you are not familiar with how bankers and politicians alike go about their business.

  5. Federico says

    you state: “that was indeed the idea behind the original no-bailout clause. Let Greece go bust, and Spain as well, but don’t kick them out of the euro. Default is a problem between creditor and debtor, that’s all”.
    I guess the issue is that, unlike with California, a default by a sovereign within the Euro area would be followed by the default of (most of) financial institutions based in that country. Which does create a huge incentive for the defaulting sovereign to recover the use of its own currency. Alternatively, you would need major transfers from the the other EU members to recapitalise banks in the defaulted jurisdiction. What I am trying to understand is how you would conceive of a sovereign default within the Euro area without the sovereign being “kicked out”. Thank you!

    • says

      Federico, apologies for the slow response. You make a very good point. Banking systems in Greece, Spain and in other European countries are so intertwined with their respective sovereigns that the financial fallout from a default will probably be much bigger in Europe than defaults on state level (as opposed to the federal level) will be in the US. I agree that this is another good reason why bankrupt national governments may ultimately decide to leave the Euro and reissue their own and rapidly devaluing currencies again. Here is a potential scenario: Greece can’t roll back the public sector or is finally fed up with being asked to do so, and stops paying interest on its debt or repaying any principal, and this means on ALL of its debt, including the debt held by the ECB and other “official” lenders. This will result in Greece being cut off from “official” money flows. The country defaults. This is bad enough, but now the Greek banks fall over as well, and there is no international aid money to save them. In order to “save” its banks, Greece could conduct a currency reform, leave the euro and issue a new paper currency. Of course, the currency is issued for debasement and inflation and Greek savers and money users will foot the bill. But the point I was trying to make in my blog is the following: It is still a political decision. It is not the consequence of Greece being in a currency union and going bust. It is the result of the imprudent exposure of the financial sector in Greece to its own sovereign, and of the system being unable to live with the consequences of this relationship. If the no-bail-out clause in the treaty had been believed, taken seriously and acted upon from the start by all parties involved (including the banking regulators!) it would at least have been conceivable that Greek banks had diversified their assets more and reduced their exposure to the Greek state, just as Californian banks have probably – I am guessing here – a smaller exposure to the Californian state now.


Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>