It takes a long time to grow a debt bubble, but history shows that in reality it is not that long. 80 years on average, a human lifespan. If you take the early 1950s as the start of the current one, we are almost there, close to the end of the current one. What will give first? Debt in China? Profligacy in the US? Distortions in Europe? This article explains this last possibility. I agree. This would explain the Covid madness engulfing the continent...
Authored by Alasdair Macleod via GoldMoney.com,
A Euro Catastrophe Could Collapse It
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.
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 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.
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.
As we have seen above, the ECB
introduced zero deposit rates nearly 10 years ago, and private sector
conditions have not generated much in the way of bank credit funding.
Lending from all sources including securitisations and bank credit to a)
households and b) non-financial corporations since 2008 are shown in
Figure 1.
Before
the Covid pandemic, total lending to households had declined from $9
trillion equivalent in 2008 to $7.4 trillion in 2019 Q4. And for
non-financial corporations, total lending declined marginally over the
same period as well. Admittedly, this period included a credit slump and
recovery, but on a net basis lending conditions stagnated.
But
bank credit for these two sectors will have contracted, allowing for net
bond issuance of collateralised consumer debt and by corporations
securing cheap finance by issuing corporate bonds at near zero interest
rates, which are contained in Figure 1.
Following the start of the
pandemic, lending conditions expanded under government direction and
borrowing by both sectors increased substantially.
Meanwhile, over
the same period bond issuance to governments increased, particularly
since the pandemic started, illustrated in Figure 2.
The
charts in Figures 1 and 2 support the thesis that credit expansion and
bond finance had, until recently, disadvantaged the non-financial
private sector. The expansion of government borrowing has been entirely
through bonds bought by the ECB, as will be demonstrated when we look at
the euro system balance sheet. They confirm that zero and negative
rates have not stimulated the Eurozone’s economies as Keynesians
theorised. And the increased credit during the pandemic reflects
financial support and not a renewed attempt at Keynesian stimulation.
The
purpose of debt expansion is important because the moment the supposed
stimulus wears off or interest rates rise, we will see bank credit for
households and businesses begin to contract again. Only this time, there
will be a heightened risk for banks of collateral failure. And higher
interest rates will also undermine mark-to-market values for government
and corporate bonds on their balance sheets, which could rapidly erode
the capital of Eurozone banks, given their exceptionally high gearing
shown in Table A above.
Figure
3 charts the euro system’s combined balance sheet since August 2008,
the month Lehman failed, when it stood at €1.43 trillion. Greece’s
financial crisis ran from 2012-2014, during which time the balance sheet
expanded to €3.09 trillion, before partially normalising to €2.01
trillion. In January 2015, the ECB launched its expanded asset purchase
programme (APP — otherwise referred to as quantitative easing) to
prevent price inflation remaining too low for a prolonged period. The
fear was Keynesian deflation, with the HICP measure of price inflation
falling to -0.5% at that time, despite the ECB’s deposit rate having
been already reduced to -0.2% the previous September.
Between
March 2015 and September 2016, the combined purchases by the ECB of
public and private sector securities amounted to €1.14 trillion,
corresponding to 11.3% of euro area nominal GDP. The APP was
“recalibrated” in December 2015, extended to March 2017 and beyond, if
necessary, at €60bn monthly. And the deposit rate was lowered to -0.3%.
Not even that was enough, with a further recalibration to €80bn monthly
in March 2016, with it intended to be extended to the end of the year
when it would be resumed at the previous rate of €60bn per month.
The
expansion of the ECB’s balance sheet led to the rate of price inflation
recovering to 1% in 2017, as one would expect. With the expansion of
credit for the non-financial private sector going nowhere (Figures 1 and
2 above), the Keynesian stimulus simply failed in this objective. But
when in March 2020 the US Fed reduced its funds rate to 0% and announced
QE of $120bn monthly, the ECB did what it had learned to do when in a
monetary hole: continue digging even faster. March 2020 saw the ECB
increase purchases under the asset purchase programme (APP) and adopt a
new programme, the pandemic emergency purchase programme (PEPP). These
measures are the reason why the volumes of the Eurosystem’s monthly
monetary policy net purchases are higher than ever before, driving its
balance sheet total to over €8.5 trillion today.
The ECB’s bond
purchases closely matched the funding requirements of national central
banks, both being €4 trillion between January 2015 and June 2021. The
counterpart to these purchases is an increase in the amount of
circulating cash. In other words, the ECB has gone full Rudolf
Havenstein. There is no difference in the ECB’s objectives compared with
those of Havenstein when he was President of the Reichsbank following
the First World War; a monetary policy that impoverished Germany’s
middle classes and pushed the labouring class and elderly into
starvation by collapsing the paper-mark. Except that today, German
society is paying through the destruction of its savings for the
spendthrift behaviour of its Eurozone partners rather than that of its
own government.
The ECB now has an additional problem with price
inflation picking up globally. Producer input prices in Europe are
rising strongly with the overall Eurozone HICP rate for November at 4.9%
annualised, and doubtless with more rises to come. Oil prices have
risen over 50% in a year, and natural gas over 60%, the latter even more
on European markets due to a supply crisis of its governments’ own
making.
Increasingly, the policy purpose of the ECB is no longer
to stimulate the economy, but to ensure that spendthrift member state
deficits are financed as cheaply as possible. But how can it do that
when on the back of soaring consumer prices, interest rates are now
going to rise? Clearly, the higher interest rates go, the faster the ECB
will increase its balance sheet because it is committed to not just
covering every Eurozone member state’s budget deficit but the interest
on their borrowings as well.
But there’s more. In a speech on 12
October, Christine Lagarde, the President of the ECB indicated that it
stands ready to contribute to financing the transition to carbon
neutral. And in a joint letter to the FT, the President of France and
Italy’s Prime Minister called for a relaxation of the EU’s fiscal rules
so that they could spend more on key investments. This is a flavour of
what they said:
"Just as the rules could not be allowed to stand
in the way of our response to the pandemic, so they should not prevent
us from making all necessary investments," the two leaders wrote, while
noting that "debt raised to finance such investments, which undeniably
benefit the welfare of future generations and long-term growth, should
be favoured by the fiscal rules, given that public spending of this sort
actually contributes to debt sustainability over the long run."
The
rules under the Stability and Growth Pact have in fact been suspended,
and are planned to be reapplied in 2023, But clearly, these two high
spenders feel boxed in. The Stability and Growth Pact will almost
certainly be eased — being a charade, rather like the US’s debt ceiling.
The trouble is Eurozone governments are too accustomed to inflationary
finance to abandon it.
If the ECB could inflate the currency
without the consequences being apparent, there would be no problem. But
with prices soaring above the mandated 2% target that is no longer true.
Up to now, the ECB has been in denial, claiming that price pressures
will subside. But we know, or should know, that a rise in the general
level of prices is due to monetary expansion, the excessive plucking of
leaves from the magic money tree, particularly at an enhanced rate since
March 2020 which is yet to be reflected fully at the consumer level.
And in its duty to fund the PIGS government deficits, the ECB’s balance
sheet expansion through bond purchases is sure to continue.
Furthermore, if bond yields do rise, it will threaten to undermine the balance sheets of the highly geared commercial banks.
The commercial banks position
With
the economies of Eurozone member states stifled by the ECB’s management
of monetary affairs since the Lehman crisis in 2008 and by more recent
covid lockdowns, the accumulation of bad debts at the commercial banks
is a growing threat to the entire financial system. Table A above, of
the Eurozone G-SIBs’ operational gearing and their share ratings, gives
testament to the problem.
So far, bad debts in Italian and other
PIGS banks have been reduced, not by their being resolved, but by them
being used as collateral for loans from national central banks. Local
bank regulators deem non-performing loans to be performing so they can
be hidden from sight in the ECB’s TARGET2 settlement system. Together
with the ECB’s asset purchases conducted through national central banks,
these probably account for most of the imbalances in the TARGET2
cross-border settlement system, which in theory should not exist.
The
position to last October is shown in Figure 4. Liabilities owed to the
Bundesbank are increasing again at record levels, while the amounts owed
by the Italian and Spanish central banks are also increasing. These
balances were before global pressures for rising interest rates
materialised. Given the sharp increase in bank lending to households and
non-financial corporations since March last year (see Figure 1), bad
debts seem certain to accumulate at the banks in the coming months. This
is likely to undermine collateral values in Europe’s repo markets,
which are mostly conducted in euros and almost certainly exceed €10
trillion, having been recorded at €8.3 trillion at end-2019.[vi] The extent to which national central banks have taken in repo collateral themselves will then become a major problem.
It
is against the background of negative Euribor rates that the repo
market has grown. It is not clear what role negative rates plays in this
growth. While one can see a reason for a bank to borrow at sub-zero
rates, it is harder to justify lending at them. And in a repo, the
collateral is returned on a pre-agreed basis, so it’s removal from a
bank’s books is temporary. Nonetheless, this market has grown to be an
integral part of daily transactions between European banks.
The
variations in collateral quality are shown in Figure 5. This differs
materially from repo markets in the US, which is almost exclusively for
short-term liquidity purposes and uses high quality collateral only (US
Treasury bills and bonds and agency debt).
Bonds
rated BBB and worse made up 27.7% of the total collateral in December
2019. In Europe and particularly the Eurozone rising interest rates can
be expected to undermine collateral ratings, which with increasing
Euribor rates will almost certainly contract the size of the market.
This heightens the risk of a liquidity-driven systemic failure, as repo
liquidity is withdrawn from banks that depend upon it.
Government finances are out of control
The
first column in Table B shows government debt to GDP, which is the
conventional yardstick of government debt measurement relative to the
economy. The second column shows the proportion of government spending
in the total economy relative to GDP, enabling us to derive the third
column. The base for government revenue upon which paying down its debt
ultimately rests is the private sector, and the third column shows the
extent to which and where this true burden lies.
It exposes the
impossible position of countries such as Greece, Italy, France, and
Belgium, Portugal and Spain, where, besides their own private sector
debt burdens, citizens earning their livings without being paid by their
governments are assumed by markets to be responsible for underwriting
their governments’ debts.
The hope that these countries can grow
their way out of their debt is demolished in the context of the actual
tax base. It is now widely recognised that will already high levels of
taxation further tax increases will undermine these economies.
We
can dismiss as hogwash the alterative, the vain hope that yet more
stimulus in the form of a further increase in deficits will generate
economic recovery, and that higher tax revenues will follow to normalise
public finances. It is a populist argument amongst some free marketeers
today, citing Ronald Reagan’s and Margaret Thatcher’s successful
economic policies. But in those times, the US and UK governments were
not nearly so indebted and their economies were able to respond
positively to lower taxes. Furthermore, price inflation was declining
then while it is increasing today.
And as a paper by Carmen
Reinhart and Ken Rogoff pointed out, a nation whose government debt
exceeds 90% of GDP has great difficulty growing its way out of it.[vii]Seven
of the Eurozone nations already exceed this 90% Rubicon, and their
debts are still growing considerably faster than their GDP. At 111% the
entire Euro area itself is well above it. Taking account of the smaller
proportion of private sector activity relative to those of their
governments highlights the difference between the current situation and
that of nations that managed to pay down even higher debt levels after
the Second World War by gently inflating their way out of a debt trap
while their economies progressed in the post-war environment.
Additionally,
we should bear in mind future government liabilities, whose net present
values are considerably greater than their current debt. Over time,
these must be financed. And with rising price inflation, hard costs such
as healthcare escalate them even further. The position gets
progressively worse as these mandated costs become realised.
There
is a solution to it, and that is to cut government spending so that its
budget always balances. But for socialising politicians, slashing
departmental budgets is the equivalent of eating their own children. It
is a reversal of everything they stand for. And it requires welfare
legislation to be rescinded to stop the accumulation of future welfare
costs. There is no democratic mandate for that.
Conclusion
Rising
interest rates globally will affect all major currencies, and for some
of them expose systemic risks. An examination of the existing situation
and how higher interest rates will affect it points to the Eurozone as
being the most likely global weak spot.
The Eurozone’s debt
position pitches the entire global financial and economic system further
towards a debt crisis than generally realised. Particularly for Greece,
Italy, France, Belgium, Portugal, and Spain in that order of
indebtedness, the problem is most acute. They only survive because the
ECB ensures they can pay their bills by funding them totally through
inflation of the quantity of euros in circulation. The ECB’s entire
purpose has become to transfer wealth from the more fiscally prudent
member states to the spendthrifts by debasing the currency.
In the
process, based on figures provided by the Bank for International
Settlements the banking system is contracting credit to the private
sector, and it is not even accumulating government bonds, which is a
surprise. Much like banks in the US, Eurozone banks have become
increasingly distracted into financial activities and speculation. The
difference is the high level of operational gearing, up to thirty times
in the case of one major French bank, while most of the US’s G-SIBs are
geared about 11 times on average.
This article points to these
disparities between US and EU banking risks having been a factor in the
US repo market failure in September 2019. And we can assume that the
Americans remain wary of counterparty exposure to Eurozone banks to this
day.
That the ECB is funding net government borrowing in its
entirety indicates that even investing institutions such as pension
funds and insurance companies, along with the banks are sitting on their
hands with respect to government debt. It means that savings are not
offsetting the inflationary effects of government bond issues. It
represents a vote to stay out of what has become a highly troubling and
inflationary situation. The question arises as to how long this
extraordinary situation can continue.
It must come to an end some
time, and by destabilising a highly leveraged banking system the end
will be a crisis. With its GDP being similar in size to China’s (which
is seeing a more traditional property crisis unfolding at the same time)
a banking crisis in the Eurozone could be the trigger for dominoes
falling everywhere.
As for the euro’s future, it seems unlikely
that the ECB has the capability of dealing with the crisis that will
unfold. It has cheated the northern states, particularly Germany, the
Netherlands, Finland, Ireland, the Czech Republic, and Luxembourg to the
benefit of spendthrifts, particularly the political heavyweights of
France, Italy and Spain. It is a rift likely to end the euro system and
the ECB itself. The deconstruction of this shabby arrangement should
prove the end of the euro and possibly of the European Union itself.
