How much time does the euro have left? That question was put on its edge last week when the Swiss National Bank decided it was no longer going to anchor the Swiss franc to the iceberg-bound euro ship. It was a wise decision for a number of reasons, the most compelling one being that the euro faces insurmountable challenges in the years ahead.
In fact, the Swiss decision was de facto a death spell for Europe’s currency union. More specifically, I noted that the euro…
survived the Greek depression of 2012 by a razor-thin margin. Now it faces three very serious threats to its own survival. The first is the upcoming Greek elections, where anti-austerity, anti-euro, pro-Hugo Chavez Syriza looks like winners. Should they emerge victorious they could very well initiate a Greek exit from the currency union. The euro would survive that, and the German government has a contingency plan in place to stabilize the euro. But then there is the Greek government debt… Syriza has openly declared that they want “debt forgiveness” for governments throughout Europe. If the drachma is reintroduced, it will very likely plummet vs. the euro, making it exceptionally difficult for Syriza to repay its loans to the EU and the ECB. A default is within the realm of the probable; remember the Greek “debt write down” three years ago.
If all the problems for the euro were tied to Greece, the currency would indeed have a future. But there are so many other challenges ahead for the common currency that nothing short of a miracle – or unprecedented political manipulation – can keep it alive through the next three years.
The biggest short-term problem – Greece aside – is the pending announcement by the ECB of its own Quantitative Easing program. Reuters reports:
The European Central Bank will announce a 600 billion euro sovereign bond buying program this week, money market traders polled by Reuters say, but they also believe this will not be enough to bring inflation up to target. In the past two months traders have consistently predicted that the ECB would undertake quantitative easing, considered the bank’s final weapon against deflation. Eighteen of 20 in Monday’s poll said the bank would announce QE on Thursday.
This highly anticipated European QE program must be viewed in its proper macroeconomic context. It is going to be very different from the American QE program. For starters, the balance between liquidity supply and liquidity demand was very different in the U.S. economy than it is in the euro zone today. After its initial plunge into the Great Recession the American economy slowly but relentlessly worked its way back to growth again. Since climbing back to growth in 2010 the U.S. GDP has grown at a rate slightly above two percent per year. This is not something to throw a party over, but it has allowed the economy to absorb much of the liquidity that the Federal Reserve has pumped into the economy.
By being able to absorb liquidity, the U.S. economy has avoided getting caught in the liquidity trap. Growth rates have been good enough to motivate businesses to increase investment-driven credit demand; households have gotten back to buying homes and automobiles (car and truck sales in 2014 were almost as good as in pre-recession 2006).
The European economy does not absorb liquidity. It is stagnant, and has been so for three years now. The ECB has pushed its bank deposit rate to -0.2 percent, in other words it is punishing banks for not lending enough money to its customers. Despite this ample supply of credit there are no signs of a recovery in the euro zone, with GDP growth having reached the one-percent rate once in three years.
In other words, the positive outlook on the future that motivates American entrepreneurs and households to absorb liquidity through credit is notably absent in the European economy. When the ECB now evidently plans to pump even more liquidity out in the economy, it appears to not understand how significant this difference is between the euro zone and the United States.
Or, to be fair, with all its highly educated economists onboard, the ECB most certainly understands what role liquidity demand plays in an economy. Its pending decision to launch a QE program appears instead to be based in open ignorance of the lack of liquidity demand.
Which leads us to ask why they would ignore it.
The answer to this question is in the declared purpose of the QE program. If it is aimed at buying treasury bonds, then the QE program clearly is not designed to re-ignite the economy, an argument otherwise used. If QE is supposed to monetize government deficits, then its purpose is really to secure the continued existence of the European welfare state. If that is the purpose, then the only safe prediction is that there will be no end to QE before the welfare state ends.
That, in turn, means the ECB would be stuck monetizing deficits for the rest of the life of the euro. Which, under such circumstances, would be a relatively short period of time…
More on this on Thursday, when the ECB is expected to announce its QE program. Stay tuned.
Today’s blog will be a short one, just a reminder of some vital statistics relating to the liquidity trap – an important topic now that Sweden, a non-euro member state of the EU, has joined the euro-zone in the trap.
The practical meaning of the trap is a situation where GDP is stalled – in other words the economy is stuck in a recession – and there is so much liquidity available in the economy that adding another euro (or krona) will not make any difference at all. Monetary policy is useless. That is where the euro zone is now, something that ECB leader Mario Draghi is well aware of, as he recently sent out a desperate call for help from Europe’s political leaders. He knows that monetary policy has reached the end of the road and that the only remaining options are within the realm of fiscal policy.
Despite this, Draghi continues to pump out M1 money supply into the euro zone like the recovery actually depended on it. Consider Figure 1:
Fig. 1: Quarterly growth rates. Sources: ECB and Eurostat
The blue line, depicting growth in euro-zone M1 money supply, deserves an explanation. The two growth peaks, one at the end of 2005 and one in late 2009, are largely related to the expansion of the euro zone, which went from 12 to 16 member states between 2006 and 2009. (Since then Estonia and Latvia have also joined.) If we adjust for the enlargement, money supply is fairly well in tune with GDP growth – until we get to 2012. That is when the ECB started making promises to buy any and all treasury bonds from “troubled” euro-zone countries, as well as to participate in the massive austerity programs that the EU and the IMF convinced the worst-off member states to adopt.
On top of that, the ECB decided this summer to take its interest rate to zero, and to punish banks – charge a negative interest rate – for depositing cash in overnight accounts with the ECB. This has flooded the euro zone with liquidity; if the theory behind this policy were right, we would see a major upturn in business investments and notable workforce expansion. However, we don’t see that; at best, year-over-year quarterly GDP growth rates show an economy barely struggling to stay afloat.
The inevitable – and from both a Keynesian and an Austrian viewpoint rather obvious – conclusion is that the theory behind the liquidity expansion is flawed. In fact, the ECB is playing with fire: sooner or later the massive supply of liquidity will go look for profitable investment opportunities. So long as the real sector of the economy remains essentially stagnant that search for profit will rapidly climb the speculative hills in the real estate and stock markets.
Again: welcome to life in the liquidity trap.
Four months ago the European Central Bank officially kicked the euro zone into the liquidity trap with its zero interest rate. Non-euro members of the EU have been resisting – or pretending to resist – the temptation of going all the way out with their central banks. But now Sweden has succumbed to the temptation. The Telegraph reports:
The world’s oldest central bank has slashed interest rates to a record low of 0pc as it battles to ward off deflation. Sweden’s Riksbank decided to cut its benchmark “repo rate” by 25 basis points from 0.25pc at this month’s monetary policy meeting, following three previous rate cuts this year. The decision was not expected by polled analysts who forecast the benchmark rate to be lowered to 0.1pc. The move is designed to increase lending and push up prices and reflects worries about the real threat of deflation which have now gripped the economy.
The Swedish central bank is foolish. The ECB has already proven that you cannot fend off deflation with massive money printing. The ECB has also demonstrated that zero interest rates do not bring about the recovery that almost-zero interest rates did not bring about. In other words, the marginal policy effects of going to a zero interest rate are just that – zero.
While there are no benefits from the zero rate, there are certainly costs and risks associated with it.
To begin with, the zero rate opens the last floodgates of liquidity supply. Banks can borrow money from the central bank at practically no cost. This pushes even more money out to the supply side of the credit markets, primarily for mortgages. With an already overheated real estate market, Sweden will now see further injections of virtually cost-free lending to home buyers and speculators.
At the same time, private consumption has been driven in good part by virtually cost-free access to credit. Swedish families are among the most indebted in Europe, with a household debt-to-income ratio far higher than it was here in the United States – even if we go back to right before the recession.
Loans are collateralized against real estate, which essentially means that most of the growth in private consumption in Sweden is directly related to the easy access to mortgages. The situation is increasingly unsustainable, and it is only a matter of time before the national legislature either puts an end to the debt fest by reintroducing amortization requirements for mortgages (yes, interest-only loans are very popular in Sweden) or the market puts an end to the endless upward price trend as banks run their balance sheets to the end.
The former is a distinct possibility – the latter is increasingly plausible as shareholders begin to worry about if mortgage-happy banks will ever get their money back…
The latter could actually happen simply by means of growing loan defaults. Yes, a lot of home owners do not even pay on their loan principals, but a notable tightening of fiscal policy could send many of them out in unemployment. The new green-socialist coalition government has just presented a budget filled to the brim with tax increases. Among them is a restoration of a higher level of payroll taxes for young employees, which will very likely wipe out tens of thousands of jobs for individuals and couples just getting started with their lives. Many of them have bought their first, tiny little apartment and now risk being hurled out in joblessness – and homelessness.
A wave of loan defaults would quickly gain the critical mass needed to send a shockwave through the entire Swedish mortgage industry. That will shut the door for one investment opportunity for the mass of liquidity floating around in the banking system. Banks will have to go find another place to turn their liquidity into revenue.
And here is where the zero-interest central bank policy gets in the way: by dropping their key interest rate to zero, the price of treasury bonds has by definition reached its expectational maximum. The only way for bond prices to go now is down. Therefore, the only place to go is to the stock market.
The problem with the Swedish stock market is that it operates in an economy that is stuck in a long, irritating recession. There are profitable corporations to invest in, but those are of limited supply – especially when the supply of liquidity on the stock market increases rapidly as the real-estate market grinds to a halt. This will push investors out from the low-risk, safe stocks toward stocks that carry increasing rates of risk. As investors go after increasingly risky stocks they will demand speculative returns to match that risk. This exacerbates risk taking, putting the market at risk for self-magnifying destabilization.
It is no longer impossible that Sweden could end up in a situation where both the real estate market and the stock market destabilize at the same time. I would consider this risk theoretical at this point – the stock market is sophisticated and operated with both derivatives and other stabilizing instruments. However, so long as the Riksbank’s monetary policy had some restraints on it, there was not even a theoretical possibility of two-market instability.
Many economists dismiss this scenario by saying that Sweden has performed spectacularly from a macroeconomic viewpoint. However, the seven-year average, inflation-adjusted GDP growth rate covering the entirety of the Great Recession (2007-2013) is a not-so-impressive 1.39 percent. If you deduct the effect from exports and from debt-driven consumption, there is nothing left. In fact, private consumption including that paid for with second and third mortgage loans has averaged 1.1 percent since 2007.
It is therefore irresponsible, not to say reckless, to suggest that Sweden can handle zero interest rates because of some underlying macroeconomic strength. That strength does not exist. The slightest aberration in real estate price trends could eradicate the domestic source of GDP growth.
Sweden has made the same mistake as the rest of Europe: they combined tight fiscal policy with very lax monetary policy. This is a recipe for liquidity-trap stagnation – just as Lord Keynes explained some 80 years ago. Students of Austrian economics have also reached this conclusion, especially through the analysis of the role that lax monetary policy plays in a modern economy.
Sadly, both Keynesian and Austrian economics are left out of the curriculum when modern graduate schools train tomorrow’s generation of economists. Advanced econometrics is passed off as the fix-it-all for our profession. Yet as Paul Ormerod and others have explained so elegantly, econometricians get it right so long as nothing is happening in the economy. Once the economy starts moving like it did in 2008-2009, prediction models based on stability rapidly become useless.
But that is a topic we will have to return to later.
As awareness rises that Europe’s economy is going nowhere but down again, anxiety among the political leadership is beginning to catch up. The latest addition to the ranks of the worried is the president of the European Central Bank, Mario Draghi. At a summit with all the euro member states on October 24 he gave a speech that echoed of the panic from 2012:
European Central Bank chief Mario Draghi on Friday (24 October) gave a stark warning to eurozone leaders about the risk of a “relapse into recession” unless they agree on a “concrete timetable” of reforms and spur investments. “The eurozone is at a critical stage, the recovery has lost its momentum, confidence is declining, unemployment is high. Commitments were made but often words were not followed by deeds,” Draghi told the 18 leaders of eurozone countries who gathered for a special meeting at the end of a regular EU summit in Brussels.
He turned his presentation into a good, old show-and-tell by providing his audience with a slide show. The slides show the following:
- Quarter-on-quarter GDP growth for the euro zone is in an almost perfect state of stagnation since at least early 2012;
- Unemployment has fallen slightly in the last year, but that decline is in no way different from the decline in 2012; after that decline unemployment shot up significantly;
- Per-employee compensation growth is the lowest in ten years;
- Inflation is trending steadily downward, and will flip into economy-wide deflation within six months;
- While real GDP has remained stagnant since 2008 – with a growth index a hair below 100 – private investment has dropped to an index of 85 with no signs of growth;
- Government-sector investment has dropped even further, below growth index 80, and continues to decline.
Toward the end of Draghi’s show-and-tell session he inevitably points to euro-zone government debt and deficit ratios. Then, equally inevitably, he turned to the empty toolbox for macroeconomic solutions to the zone’s macroeconomic problems:
To get the economy growing again, Draghi said leaders should not count only on actions by the ECB, but also do their share: boost investments and implement reforms. He welcomed plans made by the new EU commission chief, Jean-Claude Juncker, to raise private and public money for €300 billion worth of investments for 2015-2017. Draghi alluded to Germany by saying that countries “with fiscal space” should boost internal demand in order to help out the rest of the eurozone.
On the one hand Draghi keeps bashing the member states for not complying with the Stability and Growth Pact debt and deficit rules; on the other hand he demands some sort of help from states in activating the economy again.
Evidently, the knowledge of macroeconomics is rather limited in the higher layers of the European political and economic leadership. That is one of the big reasons why I stand by the same forecast that I have put forward all year long: Europe is in a permanent state of economic stagnation – and there is only one way out of it.
In Europe, frustration is growing almost by the day over the endemic recession. Unemployment is an unending problem, especially among the young, which at least in part explains the rise of the EU skeptics all over the continent. The only solution to the perennial crisis that Europeans seem to be able to come up with is to keep growing government, an idea that would only compound the continent’s structural economic problems and send them further into the territory of industrial poverty and stagnation.
Unsurprisingly, earlier this month the European Central Bank weakened its growth forecast. There is absolutely no doubt that this was an unwelcome piece of news at the time, and frustration among the EU leadership over the stagnant economy has only been growing since then. This is especially true of the central bankers at ECB, an institution that is making increasingly risky policy decisions the longer the crisis persists. The EU Observer explains:
European Central Bank (ECB) chief Mario Draghi has said he is prepared to use more unconventional measures to spur growth in the eurozone. “We stand ready to use additional unconventional instruments within our mandate, and alter the size and/or the composition of our unconventional interventions should it become necessary to further address risks of a too-prolonged period of low inflation,” he told MEPs on Monday … He said loose monetary policy will only be stopped “when we have complied with our mandate” which is to keep inflation at close to 2 percent. Currently inflation is at 0.4 percent.
It is important to remember that the ECB was created in the late 1990s as an institution of monetary conservatism. Its policy goal was limited exclusively to the preservation of price stability. It had no authority to provide funds to governments that ran deficits in excess of the balanced-budget requirement in the EU constitution (a.k.a., the Stability and Growth Pact). It was also beyond the bank’s realm of authority to fight unemployment, which meant a ban on trying to stimulate GDP growth.
Today, the ECB has broken through every boundary on its policy mandate. It has participated in vast funding schemes for deficit-ridden states in the euro zone. It has issued a guarantee to buy an unlimited amount of Treasury bonds issued by any “troubled” euro-zone state, thus de facto making a promise for future monetary expansion way beyond what the Federal Reserve ever did during the height of its QE programs.
The ECB has also cut interest rates on overnight liquidity deposits that banks make with the ECB. These interest rate cuts have gone so deep that they are now negative: banks literally have to pay the ECB to accept deposits.
The last move reeks of desperation. But doing all this has not been enough of a monetary expansion to get the EU economy going, so the bank added a program for favorable lending that was supposed to provide funding for entrepreneurs eager to make massive expansions to their operations – all they lacked was the cash to do it.
Or so the ECB thought. The EU Observer again:
The ECB has taken a series of steps since the summer to try and boost the economy and head off deflation, including interest-rate cuts and cheap loans to banks. In early September the Frankfurt-based bank cut rates further and announced it planned to buy asset backed securities (ABS). However its lending programme was deemed to have faltered when 255 eurozone banks last week only borrowed €82 billion of the €400 billion available.
And why did they not borrow more? Well, according to Draghi banks are afraid to look less solvent than they must in the upcoming “stress tests”. There is actually a grain of truth in that: banks that borrow but cannot lend won’t make any money on the interest margin. However, what Draghi fails to mention is that banks cannot find people and businesses to lend to simply because Europe’s families and entrepreneurs live in a stagnant economy. So long as stagnation prevails there will be no prospect of profits on new business investments.
In fact, according to Eurostat national accounts data, gross fixed capital formation – the national accounts variable that reports productive business investments – has been falling almost uninterruptedly since 2008. In fixed prices the decline is 16.8 percent from ’08 to 2013.
By contrast, data from the U.S. Bureau of Economic Analysis shows that businesses in the United States increased their investments in 2013 over 2008. The increase was a marginal 1.9 percent, adjusted for inflation, but that is a major sign of health relative European business investments.
To make the difference even more clear: in Europe gross fixed capital formation has decreased in five of the past six years since the Great Depression started; in the United States it has increased in four of the past six years.
No wonder Mario Draghi is getting desperate. But he has now effectively run out of options, proving what I said already in early June: Europe is now officially in the liquidity trap. That means two things: monetary policy is completely impotent and there will be no way out unless and until legislators reform away the enormous and very burdensome welfare state. And those reforms will not happen. So long as the welfare state remains, people are massively disincentivized from working and incentivized to live on welfare. The government budget is structurally in deficit and the massive supply of liquidity in the economy makes it very cheap for government to do nothing about that deficit.
I have said it before, sometimes frustratedly, that Europe is becoming the next Latin America, an economic wasteland filled with the remains of squandered prosperity. But while parts of Latin America are rising again (think Chile and Brazil) Europe continues its slow decline. And the ECB’s desperately-cheap-money policies are not exactly helping.
As I keep saying, there are no reasons for Europe’s households and entrepreneurs to be optimistic about the future. Therefore, they are not going to spend more money. They are going to drive their economy into the deep, long ditch of deflation, depression and permanent stagnation.
Eurozone private business growth slowed more than expected in August, despite widespread price cutting, as manufacturing and service industry activity both dwindled, a survey showed on Thursday (21 August).
This is an important, but hardly surprising measurement of what is really going on in the European economy. When buyers do not respond positively to price cuts, it means either of two things:
- They cannot afford to increase spending; or
- They are so pessimistic about the future that they hold on for dear life to whatever cash they have.
A less likely explanation is that they speculate, planning their purchases for a future point in time when prices are expected to be even lower. For this to be true there would have to be other signs of improving economic activity, signs indicating that, primarily, households can afford to spend money in the first place. But the European economy does not exhibit any such signs.
First of all, the cuts in entitlement programs may have wound down with some austerity measures coming to an end. But there is only a partial austerity cease-fire, with Greece, Spain, Italy, France and Sweden continuing contractionary budget measures. Austerity measures designed to save the welfare state in the midst of an economic crisis inject a great deal of uncertainty among consumers, as they can no longer trust the welfare state with keeping its entitlement promises. More of household earnings is used to build barriers against an uncertain future, causing consumer spending – the largest item in the economy – to stall or fall.
So long as austerity remains a threat to the European economy, consumers are going to hesitate.
Secondly, employment is not growing. People’s outlook on the ability to support themselves in the future is not improving. Youth unemployment is stuck at one quarter of all young being unemployed, total unemployment is almost at eleven percent and neither is budging. So long as there is no improved prospects for jobs, those who have jobs will not feel increasingly secure in their jobs, and the large segments of the population who are out of work have no more money to spend than what government provides through unemployment benefits (often hit by austerity).
Third, the European Central Bank may be flooding the euro zone with cheap money, but that is not going to help increase economic activity. Its negative interest rates on bank deposits only leaves liquidity slushing around in the banking system, making banks increasingly desperate to put the money to work. But because of the two aforementioned problems there has been no net addition of demand for credit in the European economy. While the liquidity makes no good difference in the real sector, it may find its way into financial speculation. That is a different and troubling story; the point here is that monetary policy is completely exhausted and can no longer help move the economy forward. Since the fiscal policy instruments of the European economy are entirely devoted to government-saving austerity, there is no clout left in the economic policy arsenal. The Europeans are left to fend for themselves, mired in uncertainty and stuck having to fund the world’s largest government.
In other words, there is no reason to be surprised by the lack of demand response to declining prices. There are, however, a lot of reasons to be worried about Europe’s future. Euractiv again:
Economic growth ground to a halt in the second quarter, dragged down by a shrinking economy in Germany and a stagnant France … Markit’s Composite Purchasing Managers’ Index (PMI) will provide gloomy reading for the European Central Bank (ECB), suggesting its two biggest economies are struggling like smaller members. Based on surveys of thousands of companies across the region and a good indicator of overall growth, the Composite Flash PMI fell to 52.8 from July’s 53.8, far short of expectations in a Reuters poll for a modest dip to 53.4.
Technically, any index number above 50 means purchasing managers are still expanding purchases. However, since the second-order trend is negative – the increase is flattening out – it is only a matter of a little bit of time before the PMI index itself goes negative. Shall we say three months? The Euractiv story gives good reasons for that:
Markit said the data point to third-quarter economic growth of 0.3%, matching predictions from a Reuters poll last week. “We are not seeing a recovery taking real hold as yet. We are not seeing anything where we look at it and think ‘yes, this is the point where the eurozone has come out of all its difficulties’,” said Rob Dobson, senior economist at Markit.
Again, an economist whose thinking is upside down. The right question to ask is not when the European economy is going to recover. The right question to ask is: what reasons does the European economy have to recover in the first place? In the emerging deflation climate, and with the economy stuck in the liquidity trap where monetary policy is completely impotent, Europe’s households and entrepreneurs have no reasons to change their current, basically depressed economic behavior.
Deflation is the most worrying part of their crisis. Says Euractiv:
Consumer prices in the eurozone rose just 0.4% on the year in July, the weakest annual rise since October 2009 at the height of the financial crisis, and well within the ECB’s “danger zone” of below 1%. Worryingly, according to the composite output price index firms cut prices for the 29th month – and at a faster rate than in July. … Also of concern, suggesting factories do not expect things to improve anytime soon, manufacturing headcount fell at the fastest rate in nine months.
This is not a protracted recession. This is a new normal, a state of permanent stagnation.
A state of industrial poverty.
Europe is now officially in the liquidity trap.
Even though this gives me plenty of reason to say “See I Told You So”, I prefer to note that this is a thoroughly bad thing for businesses and households in the euro zone.
The ECB may have a positive intent with this, but the only thing it has achieved is to cement a fundamental imbalance in the euro-zone economy. That imbalance is a structural excess supply of liquidity. This is what happened in Japan in the ’90s, when what was then the world’s third largest economy got stuck in a state of economic stagnation for so long that the country basically lost an entire generation to dependency on parents and whatever social welfare they have there.
The significance of the ECB overnight rate move cannot be understated. The ECB is one of the world’s four most important central banks (together with the Bank of England, the Federal Reserve and the Bank of China). By nailing its interest rates not to the floor, but to the ceiling of the basement, the ECB has officially capitulated on the monetary policy front.
This is huge. Before we get into just how huge this is, let us listen to a couple of astute observers, whose points illuminate the practical side of the issue. First, Ambrose Evans-Pritchard from the Daily Telegraph:
The way we are going, the whole world will end up with zero interest rates or some variant of quantitative easing before long. Such is the overwhelming power of deflation in countries with burst credit bubbles. Such too is the implication of a global savings rate that has spiralled to an all-time high of 25pc of GDP, starving the world of demand.
There you go. While Evans-Pritchard is wrong about the root cause of QE (I will explain this in a moment) he nails it right on the head about aggregate demand. Lack of demand is, in turn, driven by overarching pessimism among businesses and households, a pessimism that translates into a net reduction of spending in the economy. To quote Lord Keynes (General Theory, Chapter 16):
An act of individual saving means — so to speak — a decision not to have dinner to-day. But it does not necessitate a decision to have dinner or to buy a pair of boots a week hence or a year hence or to consume any specified thing at any specified date. Thus it depresses the business of preparing to-day’s dinner without stimulating the business of making ready for some future act of consumption. It is not a substitution of future consumption-demand for present consumption-demand, — it is a net diminution of such demand. Moreover, the expectation of future consumption is so largely based on current experience of present consumption that a reduction in the latter is likely to depress the former, with the result that the act of saving will not merely depress the price of consumption-goods and leave the marginal efficiency of existing capital unaffected, but may actually tend to depress the latter also. In this event it may reduce present investment-demand as well as present consumption-demand.
And that is precisely what has happened in Europe. While the American economy seems to continue its sluggish recovery after a hiccup in the first quarter, the European economy is sinking even deeper into the stagnation quagmire. Neither businesses nor households want to spend. They choose to save instead, which increases liquidity levels in the banking system. Banks in turn signal excess liquidity to the ECB, which now has responded by saying “don’t come to us with your money – lend it out instead”. But so long as households and businesses remain pessimistic and prefer to save, not spend, they will not demand more loans from Europe’s financial institutions.
As I pointed out back in April, interest rates in Europe have been on the downslope for at least three years now, without generating a macroeconomic restart. There have been isolated pockets of recovery, such as in the Spanish and Portuguese exports industries, but overall the European economy remains at a standstill. The problem is not lack of liquidity – the problem is lack of confidence.
Somewhere, the ECB knows this, but they are not the ones who can restore it. Yet as Evans-Pritchard suggests, their sub-zero interest rate policy is an expression of a desperate desire to do the impossible, namely use monetary policy in a liquidity-saturated economy to restore business confidence:
The chief purpose is to drive down the euro, an attempt to pass the toxic parcel of incipient deflation to somebody else. The ECB is expected to map out future purchases of asset-back securities, “unsterilised” and intended to steer stimulus with surgical precision towards small businesses in what amounts to light QE. This is not yet the €1 trillion blitz already modelled and sitting in the ECB’s contingency drawer.
But that is the next step. And, again, the ECB’s commitment to buy treasury bonds from any troubled country, at any time, at any amount, is de facto a standing commitment to start QE at the drop of a hat.
One more point from Evans-Pritchard:
In China the new talk is “targeted monetary easing”, with the first hints of outright asset purchases. Railways bonds have been cited, and local government debt. The authorities are casting around for ways to keep the economy afloat while at the same gently deflating a property boom that has pushed total credit from $9 trillion to $25 trillion in five years.
Which, again, de facto puts all three major global currencies in the QE zone. So far only the euro has reached liquidity-trap territory, but its fate is a stark warning to other central banks to put a foot down at some point when it comes to saturating the economy with liquidity – in other words, printing money day and night.
This is truly desperate stuff. That nearly six years after the collapse of Lehman Brothers, Europe is still belatedly trying to address the twin afflictions of deflation and economic depression tells you as much about the political paralysis that grips the euro area as about the severity of the crisis.
Yes. However, I am not sure Warner knows exactly what that political paralysis consists of. Europe needs deep, far-reaching structural reforms in order to get its economy going again. The key content of those reforms must be the gradual, but eventually complete dismantling of the welfare state. This will not only eliminate the heavy tax burden on Europe’s private sector, but also open up large sectors of the economy for free-enterprise entrepreneurship. Both these effects will generate GDP growth way beyond what today’s political leaders in Europe – and, frankly, in America – can imagine.
Such reforms would also pave the way for a restoration of sanity in monetary policy. Today’s vastly excessive supply of money, both in Europe and in the United States, is related to big, structural government deficits. In a way, government has established a third funding arm for its expenditures: in addition to taxes and borrowing from the general public, Europe’s and America’s welfare states have learned to work with their central banks to create an ongoing funding opportunity for government outlays. Central banks print money, buy treasury bonds and thereby allow welfare states to survive – theoretically in perpetuity – even as they max out taxes and their credit rating with the general public.
In other words, the purpose behind money supply under a welfare state is broader and more complex than in a free-market economy. In the latter, all the central bank does is provide a base for liquidity in the economy; in the former, the central bank adds to its liquidity commitments a “funding buffer” for big government. Since big government slows down economic growth, over time the tax base cannot keep up with the growth in entitlement spending that is symptomatic for the modern welfare state. As a result, money supply grows faster to provide compensating funding. When the economy makes a serious downturn, as it did a good five years ago, this slow replacement of money supply for taxes to fund the welfare state accelerates.
Eventually, money supply becomes impotent. Unless fiscal policy picks up the slack; unless legislators make the necessary reforms; the central bank will hit the point of zero interest rate. From there, it only has two ways to go: back or down in the negative-interest basement.
The ECB chose the latter.
Welcome to the liquidity trap, Europe. Enjoy the stay, because it is going to be long. A Japanese Decade long.
More signs of desperation out of Europe. Der Spiegel reports:
The European Central Bank wants to spur lending by banks in Southern Europe, but conventional methods have shown little success so far. On Thursday, ECB officials will consider monetary weapons that were previously considered taboo.
The only way to get the European economy going again is to cut taxes, phase out the welfare state and build economic freedom from the ground. But that is about the last thing the clowns in Brussels and Frankfurt want to hear, because in their world, shrinking government – like eating children – is wrong.
Der Spiegel again:
From Mario Drahgi’s perspective, the euro zone has already been split for some time. When the head of the powerful European Central Bank looks at the credit markets within the currency union, he sees two worlds. In one of those worlds, the one in which Germany primarily resides, companies and consumers are able to get credit more cheaply and easily than ever before. In the other, mainly Southern European world, it is extremely difficult for small and medium-sized businesses to get affordable loans. Fears are too high among banks that the debtors will default.
Now, please pay attention to this. We have been told for more than four years now that the current crisis was caused by banks engaging in irresponsible lending. We have been told that it was their credit losses that somehow brought the global economy into a recession and hurled parts of Europe into a depression.
You’d think that with this in mind, with a depression that has wiped out tens of millions of jobs and sent youth unemployment above 20 percent in 20 countries, the last thing that the European Central Bank would wish for is another round of reckless lending.
Well, in a world governed by common sense that would certainly be true. But today’s Europe is not governed by common sense. It is governed by uncommon senselessness. Der Spiegel again:
For Draghi and many of his colleagues on the ECB Governing Council, this dichotomy is a nightmare. They want to do everything in their power to make sure that companies in the debt-plagued countries also have access to affordable loans — and thus can bring new growth to the ailing economies. The ECB has already gone to great lengths to achieve this objective. It has provided the banks with virtually unlimited high credit and drastically lowered the collateral required from the institutions. The central bank has also brought down interest rates to historical lows. Since early November, financial institutions have been able to borrow from the ECB at a rate of 0.25 percent interest. By comparison, the rate was more than 4 percent in 2008.
Private businesses in Greece, Spain, Portugal and the other worst-hit countries are considerably smarter than the big wigs who run the ECB. They are not lending, because they know that in an economy like the Greek one, where GDP has been shrinking for five years in a row, or the Portuguese where GDP is as big today as it was ten years ago, there simply is no market for new investments and business expansion. If anything, business still need to downsize. Which, as Der Spiegel reports, they are still doing:
The only problem is that all those low interest rates have so far barely been put to use. Lending to companies in the euro zone is still in decline. In October, banks granted 2.1 percent less credit to companies and households than in the same period last year.
Apparently willing to ignore elementary banking theory, Mr. Draghi and the Central Bankers are searching for new policy measures. According to Der Spiegel, their search is taking them to the most obscure closets in the ECB attic:
In other words, they want banks to pump more liquidity into the euro-zone economy. Let’s remember that this is an economy that has been flooded with liquidity over the past few years. One liquidity flood gate is the M1 money supply, which is growing at a speed that is about four times as high as the rate of growth in euro-zone GDP. Another is the bond bailout program where the ECB has pledged to buy any amount of government bonds, for any euro-zone welfare state deemed in trouble.
Now they want to send even more liquidity into an already over-liquified euro-zone economy. But what has not worked yet will not work better now just because it is tried a third time. Instead, this will lead to excess amounts of liquidity floating around in the banking system, which history tells us is a great beginning of a great speculation disaster.
But as Der Spiegel explains, this is not all that the ECB has in mind:
The ECB already lent a helping hand to banks with long-term, cheap loans at the end of 2011 and during early 2012, lending financial institutions a total of €1 trillion for the exceptionally long period of three years — a step it has so far only taken one time. Central bank head Draghi spoke at the time of using “Big Bertha,” a reference to a World War I-era howitzer, to battle the crisis. … [The] ECB is still thinking about a new form of long-term credit. Only this time, the loans would only have a term of one year and they are also supposed to have a specific purpose affixed to them. Banks would only be able to obtain the cheap money if they obliged themselves to pass that money on to companies.
And why would banks want to do that when they are already sitting on more idle cash than they have use for?
But wait – there is more:
The ultimate means the ECB has for keeping market interest rates low is to purchase large quantities of bonds from investors. Other central banks including the Fed in the United States, the Bank of England and the Japanese central bank are already using this instrument more or less successfully. The idea behind “quantitative easing” is that a central bank purchases government or company bonds on the market and, by doing so, drives down prices — e.g. interest rates.In contrast to the ECB’s previous bond buying, the new program would not be aimed at easing financing for individual countries.
Somehow the boneheads at the ECB seem to believe that all the euro zone lacks is access to credit. You’d think they would take into account the fact that there is absolutely no growth in any macroeconomically relevant sector of the economy. You’d think that when consumer spending is standing still; when corporate investment is standing still; when unemployment is still slowly trending upward; you’d think they would get the picture. But no. Somehow Mr. Draghi and the Central Bankers got to where they are now in their careers while harboring the delusion that a shrinking or stagnant economy will get started again if more people go into more debt.
I somehow suspect that this is the result of an over-consumption of Austrian economic theory, but I will leave that topic for a later discussion. What matters here and now is that the ECB’s tentative plans to open yet more liquidity floodgates is a big sign of the political desperation that is spreading through the government hallways of Europe.
Desperate people do desperate things. When the desperate people are politicians with a lot of power, the consequences of their desperate actions can be devastating. It remains to be seen what more destruction Europe’s leaders can bring to their continent than they already have (please wait patiently to early 2014 and you will be able to get a full picture of Europe’s disaster in my new book “Industrial Poverty”) but given what the ECB is now contemplating, we have to assume that anything is possible and nothing is impossible.