This article assumes the combination of end of credit cycle dynamics and the rise in trade protectionism in 1929 is a valid precedent for gauging the scale of a developing global credit crisis today, as described in my earlier article published here. Then, it was heavier tariffs coinciding with a less destabilising inflation cycle than we face today, a combination that saw stock markets collapse. Today, we have the additional factors of far greater monetary inflation, far higher levels of government debt, low savings coupled with record consumer borrowing, and unbacked fiat currencies likely to lose purchasing power instead of gold-backed currencies which increased their purchasing power.
Declining international trade has already become evident in only a few months, and prescient observers detect early signs of a rapidly developing global recession. In response, the ECB has announced it will target lending to non-financial businesses with its TLTRO-III programme from September onwards.
The larger problem is the crony capitalists in the EU have captured the EU institutions, including the ECB, and will demand ever-accelerating monetary inflation. I have chosen to examine the consequences for the Eurozone, which is one of the more vulnerable economic and political constructs likely to be exposed in the severe economic downturn the world faces today.
The monetary failure
Last week, the ECB announced the reintroduction of targeted long-term refinancing operations for the third time. TLTRO-III is scheduled to start from next September. The idea is to make yet more money available for the banks at attractive rates on condition they increase their lending to non-financial entities.
The policy is justified because the ECB sees growing signs the Eurozone economy is stalling, possibly badly. The weaker Eurozone economies are moving into outright recession, and Germany’s motor exports appear to have dramatically slowed, putting a constraint on her whole economy.
The ECB’s reintroduction of TLTRO is an offer of yet more monetary and credit inflation, despite the evidence that unprecedented waves of monetary inflation in the last ten years have failed in all the objectives for which they were designed, except two: governments have continued to get the funds to spend without meaningful restraint, and insolvent banks have been preserved.
Only two months after its asset purchase programme officially ended, the inflationists are at it again. But one wonders why the ECB bothers to delay TLTRO-III until September. If it is such a good thing, why not introduce it now?
There is another explanation, and that is the ECB is intellectually adrift with no economic compass. We do not know how many economists and monetary specialists are employed in the Eurosystem, which includes the ECB and the regional central banks, but they are certainly not economists, otherwise they would understand money. They may be technicians, which is not the same thing. If they were economists, or more precisely properly schooled in the human sub-science of catallactics (the theory of exchange ratios and prices) they would more fully appreciate the consequences of monetary inflation. They would understand Bastiat’s broken window fallacy: it’s not what you see, but what you don’t see. They see the supposed benefits of inflation but appear blind to the strangulating burden imposed on ordinary people who make up the productive economy.
The destruction and transfer of wealth from Eurozone savers to debtors and from the general public to the banks, government and large corporations are the principal and hidden consequences of monetary inflation. Monetary stimulation is progressively destroying Eurozone economies, which coupled with high taxes and excessive regulation has turned the Eurozone into one massive economic zombie. Any student of catallactics learns this early on. Yet, state-employed economists ignore the mathematics of dilution and are unaware of the changes in relative values people place on an unbacked currency, when they finally realise what the central bank is doing to it.
The ECB’s functionaries are similarly ignorant of catallactics as are their confrères in the other major central banks, but that must not excuse them from ignoring the contradictions inherent in their actions. They wield power, and that has responsibilities. Instead, they are trying for a third time a policy, that even if it appears to briefly succeed, emasculates the Eurozone’s economy even more.
Pumping yet more credit into the Eurozone is as effective as giving adrenalin to a dead horse. Lack of credit is not the problem. Put simply, there is a global momentum of economic contraction evolving, which any business and lending banker would be foolish to ignore. There is a developing crisis, the consequence of earlier monetary inflation in the credit cycle. Economic actors may not understand the origins of the crisis, but we can be certain they are becoming acutely aware of its looming presence. And as the crisis rapidly develops, those that require additional loans will already be insolvent.
The signal sent by the ECB to lending-bankers is likely to be misinterpreted when credit contraction is the looming threat: if TLRTO-III is the smoke, there must be a fire, possibly out of control. Better surely to call in existing loans to businesses rather than waiting to be repaid from profits unlikely to materialise. An encouragement to lend early in the credit cycle is more effective and less likely to be misunderstood than a similar encouragement later in the credit cycle. This is why a renewed TLTRO policy will almost certainly fail.
The inability of bureaucrats, with their heads buried in spreadsheets, to appreciate the role of human psychology is not the ECB’s only failing. Its executives do not even understand what interest rates represent, thinking it is simply the price of money. This is why it believes in keeping interest rates suppressed as a means of increasing credit. Earlier in the credit cycle, rate suppression does generate some credit expansion, mainly in financial rather than non-financial activities, because lower interest rates lead to higher prices for financial assets. That is basically a spreadsheet, almost non-human function. Large industrial corporations are opportunist, borrowing to fund buy-backs and to take over weaker rivals. Smaller and medium-sized business borrowers are usually offered credit only later in the cycle, when it is a mistake to accept it.
Consequently, in a zombie economy, such as that of the Eurozone, the only borrowers are wealth-destroying, socialising, debt-entrapped governments, taking full advantage of the Basel accords, which rates them for lending banks’ purposes as riskless borrowers.
More on the true role of interest rates
Interest is not the price of money. It is a reflection of the difference between future values compared with present values. It has its origin in the human expression of time-preference. When a businessman agrees loan terms with a banker, they should reflect existing time-preference, so as to defer some consumption sufficient to fund investment. Anything else is a distortion with Bastiat-like consequences. Central banks have destroyed the basic function of capital intermediation based on time-preference by replacing savers with money and credit inflation as the principal source of investment capital.
This was wished for by Keynes in his General Theory, published in 1936. He wanted to see savers euthanised (his word) and for the state to provide the necessary capital to businessmen. He expected the entrepreneur to accept state direction of capital. Entrepreneurs “who are so fond of their craft that their labour could be obtained far cheaper that at present” should move from a risk-based approach to business to a socialising function.
Keynes’s wish is granted posthumously, and ordinary people in the Eurozone and elsewhere are paying for it. Economic strangulation and wealth destruction are the consequence. Functionaries such as Mario Draghi and his fellow directors at the ECB are fully committed to pursuing these Keynesian objectives. Having promised their political masters economic salvation on Keynesian principals, they have delivered instead the Keynesian dream, but at the expense of the economy.
Yet, the deferral of TLTRO-III to September suggests that in the back of their collective minds, the panjandrums at the ECB suspect they may be on a path to perdition. Or perhaps it is the influence of the few sound-money men left at the Bundesbank, across the road in Frankfurt, whose families suffered two currency destructions in the twentieth century and vowed never again.
But even they have been silenced. The protests against the ECB in the German and European courts are in the past. If, as this writer expects, the global economy proves to be on the edge of an abysmal credit crisis, there will be no meaningful objection to a further acceleration of monetary inflation to the point where the euro becomes worthless. If so, Mario Draghi will be identified by future generations as a latter-day Rudolf Havenstein, who famously printed the Reichsmark out of existence.
Unlike the Reichsmark, the euro is a cut-and-shut of a number of fiat currencies with very different time preferences. A knowledge of catallactics would have advised against its creation, proof if it was needed of institutional ignorance in matters of money and exchange. If its origin had been one currency, we could expect its demise to follow the path of all fiat currencies in the past. A single state granting itself the sole right to issue the medium of exchange can never resist the temptation to use it as a source of finance until its destruction. But the euro is a compromise between states with track records of widely different rates of inflation. What suits Germany does not suit Italy. The euro could face a quicker destruction, simply by the Eurozone falling apart.
However, Germany and a few Northern states like her appear trapped, this time through TARGET2 imbalances whereby the Bundesbank is owed approaching a trillion euros by the system. Inflation of money and credit, ultimately the cause of these imbalances, has taken the ECB beyond a point of no return. Inevitably, at some future point, ordinary people will replace their wishful thinking, that the ECB and the national central banks have control over the purchasing power of the euro, with a growing realisation that they don’t. And when they awaken to that reality, they will dump all euros surplus to their essential requirements.
We know that attempts by the authorities to side-step successive credit crises ultimately fail, and it is in that light we should look at TLTRO-III. We must conclude that it is a diversion, window dressing for the shop-front of a failing ECB. It will achieve nothing, because the banks do not want to lend to non-financials, with the exception perhaps of the most credit-worthy large corporations, the corporations that have the political class in their pockets. It is not just the ECB following economically destructive policies, but an unholy alliance between big business and politicians, which is what Brussels and the ECB is all about.
Crony capitalists love inflation
It is a good rule of thumb to reckon that GDP is split 20% in favour of large businesses and 80% in favour of small and medium-size enterprises. The 20% employs armies of lawyers and lobbyists for the explicit purpose of influencing politicians and for the implied purpose of restricting competition. It is not widely appreciated that the European Union is a partnership between these crony-capitalists and the political class.
Europe has a long history of powerful industrial dynasties supporting the political class. This crony capitalism, the true source of much social discontent, is a feature of governments everywhere, but it is perhaps embedded in the EU more deeply and insidiously. An important part of this relationship is the profits generated through monetary inflation.
The most outstanding example pf profiteering from inflation was probably that of Hugo Stinnes in Germany, who a hundred years ago was a passionate supporter of the Reichsbank’s inflationary policies. Stinnes used inflation to build further his pre-war empire based on coal, shipping and electricity generation. By 1923 Stinnes’ interests consisted of roughly 4,500 enterprises, producing nearly 20% of Germany’s industrial output. By borrowing in depreciating Reichsmarks he obtained through exports foreign currencies backed by gold, with which he was able to pay off his heavily devalued Reichsmark debts. He earned the soubriquet Inflationskönig. Stinnes died in April 1924, and his empire collapsed shortly afterwards, though a much-reduced Hugo Stinnes Schiffart GmbH still exists.
Stinnes understood how to benefit from inflation, as do the establishment businesses in the Eurozone today. Large corporations, very often with their own finance arms, have direct or indirect access to the ECB’s largess, borrowing at close-to-zero rates to finance their ambitions. Compared with the relatively sound German mark, today’s large German manufacturers must love the euro.
While big business gains its financing advantages against its smaller competitors, the bulk of any economy is not the large crony-capitalistic organisations, but the small and medium size businesses that make up 80% of any economy’s GDP. For banks these are risky customers, relatively so compared with lending to large corporations. As Stinnes discovered, the relationship between big business, the banks and SMEs effectively transferred wealth from the latter to him through monetary debasement.
As surely as the end of the 1920-23 inflation killed off the Stinnes empire, the end of monetary inflation in the Eurozone will kill off the large European multinationals. But now that the crony-capitalists face a contraction in global trade, they are likely to agitate for yet more inflation. They will say they need a competitive euro to offset declining world markets, so the ECB must take steps to ensure the euro depreciates more rapidly against the US dollar. They can only dream of the profits and power earned by Stinnes from hyperinflation, before Hjalmar Schacht ruined everything for him by stabilising the new mark. But they are making a mistake: borrowing euros to earn fiat dollars to eventually pay off devalued euro debts is not the same as borrowing Reichsmarks to accumulate gold-backed foreign currencies.
The major banks are in trouble
Despite the ECB’s subsidy of the Eurozone’s banking system, it remains in a sleepwalking state similar to the non-financial, non-crony-capitalist zombified economy. Gone are the heady days of investment banking. There is now a legacy of derivatives and regulators’ fines. Technology has made the over-extended branch network, typical of a European retail bank, a costly white elephant. The market for emptying bank buildings in the towns and villages throughout Europe must be dire, a source of under-provisioned losses. On top of this, the ECB’s interest rate policy has led to lending margins becoming paper-thin.
A negative deposit rate of 0.4% at the ECB has led to negative wholesale (Euribor) money market rates along the yield curve to at least 12 months. This has allowed French banks, for example, to fund Italian government bond positions, stripping out 33 basis points on a “riskless” one-year bond. It’s the peak of collapsed lending margins when even the hare-brained can see the risk is greater than the reward, whatever the regulator says. The entire yield curve is considerably lower than Italian risk implies it should be, given its existing debt obligations, with 10-year Italian government bonds yielding only 2.55%. That’s less than equivalent US Treasuries, the global risk-free standard.
Government bond yields have been and remain considerably reduced through the ECB’s interest rate suppression and its bond-buying programmes. The expansion of Eurozone government debt since the Lehman crisis has been about 50% to €9.69 trillion. This expansion, representing €3.1 trillion, compares with the expansion of the Eurosystem’s own balance sheet of €2.8 trillion since 2009. In other words, the expansion of Eurozone government debt has been nearly matched by the ECB’s monetary creation.
Bond prices, such as that of Italian 10-year debt yielding 2.55%, are therefore meaningless in the market sense. This has not been much of an issue so long as asset prices are rising and the global economy is expanding, because monetary inflation will keep the fiat bubble expanding. It is when a credit crisis materialises that the trouble starts. The fiat bubble develops leaks and eventually implodes.
Now that the global economy has stopped expanding and is on the brink of recession, under these changing conditions the monetary, systemic and economic dangers facing the Eurozone are rapidly rising. This is a problem beyond the ability of the ECB to contain. Politicians and their institutions in Brussels seem unaware of the approaching storm, but when they do become aware, they will turn to group-think for protection. Like fish in a tightening bait-ball, they actions are set to accelerate their own demise.
The start of EU disintegration
There can be no doubt that the ECB has so far only managed to prevent a financial and systemic crisis materialising because of the background of a worldwide monetary and credit expansion inflating financial asset prices. A global background of rising asset values was necessary for the consequences of the Greek financial crisis to be absorbed without destabilising the whole caboodle. If it had happened during a global credit crisis the outcome would have been different.
Inevitably, at some stage the euro’s purchasing power will begin to fall under the weight of accelerating monetary inflation and the demands from crony-capitalists for a competitive exchange rate. Rising bond yields will be the inevitable outcome, requiring yet more QE from the ECB. It takes little imagination to realise that in an environment of rising bond yields and falling asset values the Italian government and its economy will be exposed to intractable difficulties. The difference from the on-going Greek crisis is Italy’s economy is nearly ten times the size of that of Greece. So far, aided by inflating markets, there has not been a full-blown crisis. In a vicious bond bear market of the scale likely to accompany the next credit crisis, Italy alone could crash the whole Eurosystem.
That could happen by the end of this year, because when things go wrong the pace calamities usually accelerates. Today, the EU is threatened with Brexit, which at the time of writing is yet to be resolved. But there’s a significant possibility Britain will leave the EU without a comprehensive trade deal and without paying all the money allegedly owed to the EU. The money will have to be made up by the other members, principally by Germany, France, Italy and Spain, being the largest remaining economies. Furthermore, the UK’s economic policy is bound to focus on being a competitive regional entrepôt for global trade, enhancing her economic performance relative to a stultifying EU. Existing political tensions within the EU are certain to escalate as the EU falls behind, and Brussels, hooked on profligacy, for the first time faces budget cuts.
It is becoming increasingly obvious to independent observers that the EU supra-national socialising model is failing structurally, politically, economically and financially. The next credit crisis, which appears to be evolving from the seeds of today’s events, looks set to end the European dream.