A euro catastrophe could collapse it

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by Alasdair Macleod, GoldMoney:

This article looks at the situation in the euro system in the context of rising interest rates. Central to the problem is role of the ECB, which through monetary inflation embarked on a policy of transferring wealth from fiscally responsible member states to the spendthrift PIGS and France. The consequences of these policies are that the spendthrifts are now ensnared in irreversible debt traps.

Even in a Keynesian context, the ECB’s monetary policy is no longer to stimulate the economy but to keep the spendthrifts afloat. The situation has deteriorated so that Eurozone commercial banks appear to have credit restricted in New York, evidenced by the reluctance of the US banks to enter into repo transactions with them, leading to the market failure in September 2019 when the Fed had to intervene.

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An examination of the numbers strongly suggests that even Eurozone banks, insurance companies and pension funds are no longer net buyers of Eurozone government debt. It could be because the terms are unattractive. But if that is the case it is an indictment of the ECB’s asset purchase programmes deliberately suppressing rates to the point where they are unattractive, even to normally compliant investors.

Consequently, without any savings offsets, the ECB has gone full Rudolf Havenstein, and is following similar inflationary policies to those that impoverished Germany’s middle classes and starved its labourers and the elderly in 1920-1923. That the German people are tolerating such an obvious destruction of their currency for the third time in a hundred years is simply astounding.

Institutionalised Madoff

Schemes to pilfer from people without their knowledge always end in disaster for the perpetrators. Central banks using their currency seigniorage are no exception. But instead of covering it up like an institutionalised Madoff[i] they use questionable science to justify their openly fraudulent behaviour. The paradox of thrift is such an example, where penalising savers by suppressing interest rates supposedly for the wider economic benefit conveniently ignores the theft involved. If you can change the way people perceive reality, you can get away with an awful lot.

The mass discovery by the people of the fraud perpetrated on the people by those supposedly representing the people is always the reason behind a cycle of crises and wars. It can take a long period of suffering before an otherwise supine population refuses to continue submitting unquestionably to authority. But the longer the condition exists, the more oppressive the methods that the state uses to defer the inevitable crisis become. Until something finally gives. In the case of the euro, we have seen the system give savers no interest since 2012, while the quantity of money and credit in circulation has debased it by 63% (measured by M3 euro money supply).

Furthermore, prices can be rigged to create an illusion of price stability. The US Fed increased its buying of inflation-linked Treasury bonds (TIPS) since March 2020 at a faster pace than they were issued by the US Treasury, artificially pushing TIPS prices up and creating an illusion that the market is unconcerned about price inflation.[ii]

But that is not all. Government statisticians are not above fiddling the figures or presenting figures out of context. We believe the CPI inflation figures are a true reflection of the cost of living, despite the changes over time in the way prices are input. We believe that GDP is economic growth — a questionable concept — and not growth in the quantity of money. We even believe that monetary inflation has nothing to do with prices. Statistics are designed to deceive. As Lord Canning said 200 years ago, “I can prove anything with statistics but the truth”. And that was before computers, which have facilitated an explosion in the quantity of questionable statistics. Can’t work something out? Just look at the stats.

A further difference between Madoff and the state is that the state forces everyone to submit to its monetary frauds by law. And since as law-abiding citizens we respect the law, we even despise those with the temerity to question it. But in the process, we hand enormous power to the monetary authorities, so should not be surprised when that power is abused, as is the case with interest rates and the dilution of the state’s currency. And it follows that the deeper the currency fraud, when something gives, the greater is the ensuing crisis.

The best measure of market distortions from deliberate actions of the monetary authorities we have is the difference between actual bond yields and an estimate of what they should be. In other words, assessments of the height of negative real yields. But any such assessment is inherently subjective, with markets and statistics either distorted, rigged, or unable to provide the relevant yardstick. But it makes sense to assume that the price impact, that is the adjustment to bond prices as markets normalise, is greatest for those where nominal bond yields are negative. This means our focus should be directed accordingly. And the major jurisdictions where this applies is Japan and the Eurozone.

The eurozone’s banking instability

A critique of Japan’s monetary policy must be reserved for a later date, in order to concentrate on monetary and economic conditions in the Eurozone. The ECB first reduced its deposit rate to 0% in July 2012. That was followed by its initial introduction of negative deposit rates of -0.1% in June 2014, followed by -0.2% later that year, -0.3% in 2014, -0.4% in 2016 and finally -0.5% in September 2019. The last move coincided with the repo market blow-up in New York, the day that the transfer of Deutsche Bank’s prime dealership to the Paris based BNP was completed.

We can assume with reasonable certainty that the coincidence of these events showed a reluctance of major US banks to take on either of these banks as repo counterparties, as hedge and money funds with accounts at Deutsche decided to move their accounts elsewhere, which would have blown substantial holes in Deutsche’s and possibly BNP’s balance sheets as well, thereby requiring repo cover. The reluctance of American banks to get involved would have been a strong signal of their reluctance to increasing their counterparty exposure to Eurozone banks.

We cannot know this for sure, but it is the logical explanation for what happened. In which case, the repo crisis in New York was an important advance warning of the fragility of the Eurozone’s monetary and banking system. A look at the condition of the major Eurozone global systemically important banks (G-SIBs) in Table A, explains why.

Balance sheet gearing for these banks is roughly double that of the major US banks, and except for Ing Group, deep price-to-book discounts indicate a market assessment of these banks’ credit risk as exceptionally high. Other Eurozone banks with international counterparty business deemed not significant enough to be labelled as G-SIBs but still capable of transmitting systemic risk could be even more highly geared. The reasons for US banks to limit their exposure to the Eurozone banking system on these grounds alone are compelling. And the persistence of price inflation today is a subsequent development, likely to expose these banks as being riskier still because of higher interest rates on their exposure to Eurozone government and commercial bonds, and defaulting borrowers.

The euro credit cycle has been suspended

When banks buy government paper, it is usually because they see it as the risk-free alternative to expanding credit to non-financial private sector actors. In the normal course of an economic cycle, it is inherently cyclical. Both Basel and national regulations enhance the concept that government debt is risk-free, giving it a safe-haven status in times of heightened risk. In a normal bank credit cycle, banks will tend to hold government bills and bonds with less than one year’s maturity and depending on the yield curve will venture out along the curve to five years at most.

These positions are subsequently wound down when the banks become more confident of lending conditions to non-financial borrowers when the economy improves. But when economic conditions become stagnant and the credit cycle is suspended due to lack of recovery, banks can accumulate positions with longer maturities.

Other than the lack of alternative uses of bank credit, this is for a variety of reasons. Trading desks increasingly seek the greater price volatility in longer maturities, central banks encourage increased commercial bank participation in government bond markets, and yield curve permitting, generally longer maturities offer better yields. The more time that elapses between investing in government paper and favouring credit expansion in favour of private sector borrowers, the greater this mission creep becomes.

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